Greetings to everyone who's dialed in today for the Freshworks webinar. With me, we have one of our longtime presenters here at the conference, Tyler Sloat. He's the CFO, runs the finance department at Freshworks. Great to see you again, Tyler, and thank you so much for being here.
Yeah, Brian, thanks for having me. You're right, we've known each other for a long time, so I really enjoy doing this with you. Thanks again for inviting us.
Great. Let's dive into the story here first. Why don't we start out with the right to win for Freshworks in the market? When you win a competitive deal, what's the single most decisive reason for the customer to choose Freshworks? Maybe if I could add a second question on that, has that changed at all over the last 12 months as the company has built out more of the EX portfolio?
Yeah. What I can say, Brian, is every deal is competitive, right? It's not like we are going into a lot of greenfield space and have the opportunity to go close a customer without any competition. This is an EX must-have product. If you're a company of any scale, you really need to have this. What is your right to win for us? It really comes down to really providing our customers with the enterprise-grade capabilities that they need without enterprise complexity. What do I mean by that? It's like, okay, the easy use of the product has to be there, which is kind of in our DNA, and I think started with us servicing SMBs from the very beginning, specifically on the desk side.
But really, as we add feature functionality, making the products continue to stay true to that DNA of ease of use, ease of deployment, time to value. That, coupled with the fact that, yes, what has changed over the last couple of years, is that we've really moved from just a pure ITSM product that is focused on core ticketing for IT, really, to now we've got multiple pillars across our product portfolio that are all on the same platform, staying true to that ease of use. Starting with ESM, which is Enterprise Service Management, selling to functions outside of IT, then moving to ITAM, which is IT Asset Management, which is a Device42 acquisition that we made. And now, ITOM, which is IT Operations Management, which is the FireHydrant acquisition that we made with AI across the entire portfolio.
Now, our AI capabilities, that is now something that if you want to compete, which I said every single deal is competitive, you have to have that. It's kind of table stakes at this point. You need to be able to deliver AI capabilities that is going to deliver efficiencies for your customer in the way that they operate. And the testament there is that as the companies are buying, the attach rates, specifically for Freddy Copilot, on significant deals, which we just say are over 30K, are very high, and they're growing. It just means that as companies are evaluating, they're evaluating that as part of your product. And you have to be able to demonstrate that you can deliver those AI capabilities, which we are. And so hopefully that answers the question. Every deal is competitive.
Our right to win really comes with, hey, being able to deliver an enterprise-grade product without that enterprise-grade complexity. That also means that we can save our customers money, compared to our competitors.
Terrific. Great lead-in to the next question. As you said, a lot of the right to win for your business in that upper mid-market is having enterprise capability without enterprise complexity. So just thinking about the durability of that. So if AI makes competitors easier to configure, administer, and implement, does that wedge narrow? So if you think about it over a medium term or a three-year perspective, what do you see as the durable differentiator? Is it the product? Is it the platform? Is it the unification price point? Is it the data gravity that you have over the years?
Yeah. I don't think it narrows. I think that if you look at what we're offering to our customers, the moat that we have is really that system of record and all of those workflows that are built in in an ITIL-compliant manner. If a company is going to come in, say, as, like I say, pure AI native, and through an agent, those things are still needed. You still have to have a system that's doing that internally, and we are that system. I don't say the moat is narrowing. I do think then it's like, okay, how can we actually make our software even that more attractive to a customer because of what it can provide on top of that moat?
That's where our investments in our AI Agent Studio for EX, in Copilot capabilities, and AI Insights, those are the things that are really providing all of that new capability on top of what we view as a pretty entrenched moat around that system of record and workflow that we've built over the last 10 years.
Sounds good. Let's talk a little bit about the EX platform. There's been a lot of development organically and inorganically to that platform over the last couple of years. Where do you think you go from here? What agencies feels most natural for you? Do you go deeper into IT operations? Cybersecurity is a hot category right now. What feels like the most natural next step for the platform?
Yeah. Brian, thanks. If you look at what we've done over the last, say, two and a half years, it's really, okay, EX was really starting to take hold and get attention for larger customers, but purely on the corporate IT ticketing side of the house. As we started to engage with those customers, started to understand, okay, what would be needed for us to come in and do an end-to-end displacement of all of your other IT solutions that you might have internally. There's a couple things that came up. Number one is, okay, if you're going to deliver us a product, you have to make it look and feel as if it's one product, and everything has to work seamlessly together. Otherwise, what's the difference between having a whole bunch of disparate systems and that one product?
Second is, okay, here are the capabilities that we need. We started with the ESM, and ESM is enterprise service management. We saw a ton of our customers using our ITSM product for functions outside of IT. When we went to talk to them, said, "Okay, what's going to require you to really make proliferate this out?" We talked to customers who weren't, and the customers who weren't, it was all about security and compliance around those different functions. Think about HR, which is the biggest one that we sell to today.
We spent about a year re-architecting the product, moving the entire database layer down, so that we could come up with workspaces that had that compliance, so that if you're an HR professional sitting inside of an ESM instance, you have the confidence that somebody in the IT instance isn't going to be able to just go over and look at all that data in there. That was a requirement, so we built that. The second thing that we looked at is, hey, one of the areas that we had light capabilities but not enterprise-grade was asset management.
That was one of the things that CIOs were telling us that we have to have this, and when something goes down, we have to be able to map the landscape of all of the assets that we're responsible for to be able to pinpoint where something is broken, so that we can go fix it seamlessly and in an automated fashion. For that's when we went out and looked at everything that was available in the open market as standalone companies, and Device42 is by far the leader. We partnered with them first. We did an integration, and we partnered with them and resold their product for a year, made sure that we knew that this was going to be something that would match the need of our customer base. Then we brought Device42 on the Freshworks family.
We spent the last year and a half completely rewriting the CMDB in our Freshservice product, to be able to take advantage of all the capabilities that Device42 had, but do it in a cloud framework. They were an on-prem term license product, and now that is now released. You're going to see us do the same exact thing now with ITOM, and that's the next area that we said, okay, now you have asset management, but all these incidents are happening on the periphery. The incidents, we get notification of the incident, and then you have incident management. The asset management capabilities allow us to go solve it once you have the incident. But we have all these other systems that are tying into the logging solutions. As you mentioned, Brian, this gets us a little bit closer to security.
ITOM is a different buyer, typically, than IT. It happens, it's your tech ops team that oftentimes is in the product organization or your CTO organization, but they're the ones responding to anything that happens. FireHydrant, again, modern-day solution with enterprise-grade capabilities. They didn't have any go-to-market capabilities, so we feel it's going to be a great partnership. That's one of our top three deals in Q2, was a FireHydrant land, where they're not even a Freshservice customer. It was a very large organization that chose FireHydrant after going through a lot of competitive analysis against all of our biggest competitors there. We're super excited about that. To your question, we're going to continue to look at the breadth of our portfolio and see what other adjacencies could be out there. There's a lot of things that we think are interesting.
At the same time, once we bring something on board, we have to stay true to our DNA, and that's the depth. Make sure we truly are delivering those enterprise capabilities, but doing it in a seamless way for our customers to enjoy it all and easily manage that Freshservice portfolio product, to stay true to that lack of enterprise complexity. We need to make it simple for them to use. You're going to see us do both and continue to do both.
Tyler, I wanted to tap into a little bit about the operating leverage from the business. The last couple of years, you've been reporting record operating margin after record operating margin. You did it again in Q2. I assume that AI is helping the business with the operating efficiency. I want to dive into that. Specifically with AI, what areas of the business are you realizing the most internal operating efficiencies from AI? What you're seeing, does that give you greater confidence in being able to continue to drive margin growth for the business?
Yeah, Brian, I think you're right. We've done a great job, I think, on bottom line, but then also managing efficiencies internally and where we are deploying our capital internally to make sure we have the best return for it. As a result, we've done a couple of reductions on headcount, where I think historically Freshworks have solved problems by throwing bodies at it. We feel like we're at a point where we don't need to do that anymore, and that we can become much more efficient with systems and processes and tools. In some cases, that means, okay, maybe we're going to have more expensive headcount, but we're going to have less. Our headcount is down over 20% since its peak a couple of years ago, yet ARR is continuing to grow, and it's up like 30%. We're doing more with a lot less.
How are we doing that, is your question. Well, internally a lot the probably most prolific use of AI internally is within the engineering organization, that they have completely shifted their capability to go code, and use tools to really make them much more efficient so that we can innovate a lot faster with a lot more accuracy, and do it with fewer people. That has been fantastic kind of watch and see. At the same time, we have initiatives across every single company, and I break it into three categories where you have, we consume a lot of software ourselves, and just like our customers do to us, if that software we consume is coming with a promise of AI capabilities, let's go use it, because we're essentially already paying for it.
Second is, bringing in new tools that are AI kind of native that, as we're picking new tools to replace software or to add new capabilities, ensuring that we're going with an AI-first company that is going to actually help us become much more efficient. Then the third is a pure AI tool within itself. These would be things like Gemini, which we'd use a lot, but also Claude, and even OpenAI, and making that available for our employees internally, but at the same time holding them accountable to get true returns for it, right? Not use these as kind of like little toys, but really have a very prescriptive view of projects and returns and things like that you can actually do.
What we're seeing is that, you have certain groups are completely transforming the way they work, and the kind of the efficiencies that they demand of themselves. Lastly, we use our own products too. The stuff that we've been able to do within Freshservice and Freshdesk internally, and even the deployments of Freshdesk and Freshservice across workspaces, and for things outside of customer support on desk side. But turning on like Email AI Agent, internally on the desk side, has had dramatic improvements in some of our teams, which has been great as well.
Terrific. I want to ask you about the topic of tokenmaxxing. It was highly topical in 2Q kind of across the software industry. So maybe asking you the question about how you're dealing with it internally, how you're dealing it with customers. So internally, how are you handling tokenmaxxing so you don't blow through the IT budget faster than planned? Then for your customers that are maybe heavy users of your AI products, how are you handling the cost for that, the inferencing cost? Are you able to pass it on? Are you just absorbing it? Or are you capping it?
Yeah. I already mentioned, first of all, yes, I think token costs are going to be a pretty significant thing for IT departments to go manage, and I think it's going to fall on the IT departments to go manage it, that and FP&A kind of. Internally, I already just mentioned, hey, we've been pretty prescriptive around looking at projects and return. If we are going to go license out a technology that is token-based, we are going to do it pretty carefully, in terms of, okay, we're going to allow our employees to go use it, but we're going to actually monitor the cost, but then also kind of demand the returns. We've been doing that internally. We have teams dedicated to kind of managing that internally.
Some of the stuff that is happening is pretty amazing, in terms of the deliverables that they're making and the speed to those deliverables. That part's great. From our customer perspective, our AI usage internally from our customers has increased pretty significantly this year, which is great. That's what we want. We've designed pricing to be able to, you said pass it on. We're not really passing it on because you have a Freddy Copilot, which isn't add on price, but AI Agent Studio, where the majority of say, volume could come from, those are session packs. Session packs are supposed to kind of emulate what would a resolution be. Right now, it's $0.49 per resolution.
As the usage of kind of the AI Agent, both on CX and EX, continue, then now stuff like Email AI Agent, which is also under a session pack usage, like we're going to start to see the purchase of those session packs increase. But at the same time, we're delivering a ton of value to our customers, and as their costs kind of go up, it's an easy cost to absorb. I think you're going to see all these companies kind of continue to look at companies like us, continue to look at pricing and packaging to ensure that, number one, we're providing the most value to our customers that truly delivers a return that they can see, but second, that we can keep to our margin structure. To date, you've seen our margin structure, we're still mid-80s on the gross margin side.
I think we've done a really good job at that, and it's just something that we're continually going to go look at, as our customers adopt our AI capabilities more and more. In some of those capabilities, we don't necessarily have to be doing it with the latest and greatest LLM frontier model. A lot of those things will be able to be solved with things that are a lot more efficient, and I think that's the other thing you're going to see happening across companies, is that the models are starting to look at parity, but also that the stuff that was released six, nine months ago is still incredible to solve a lot of use cases. I think that's just going to continue, I think.
Great. Let's switch to monetization for your AI. You talked about the AI agent is moving to $0.49 per session. Your MCP is going to be going to usage pricing in October. Is there a way of framing how big that could ramp into the install base or where it is today under this promo? Then the second question with that is, last year. Oh, I'm sorry, this year at the Financial Analyst Day, you put out a $1.3 billion revenue target. Does this AI pricing, is that included in that target, or could this be a potential offset driver to it?
It's included. We've anticipated that we would have all of our products have AI capabilities and that the AI usage is going to continue to increase. I think you will see, as I just mentioned, pricing and packaging changes. We're constantly looking at what is the market absorbing, but also what would be the best for our customers. We do these Customer Advisory Boards, and we're doing them twice a year now. We're really going in. We are asking our customers, "Hey, what do you guys want to see in pricing and packaging as we deliver you AI capabilities?" Knowing that, hey, we need to make a margin, but our whole job is to deliver you a product that allows you to be much more efficient. Through collaboration, I think we're going to arrive at the right pricing.
I think you've seen that we don't want to take a jerky approach to it. We've had a lot of our competitors announce multiple forms of pricing and packaging and changing it. I think it's really confusing for customers. We've been pretty, I think, prudent. Hey, we have our session packs at $0.49, and we haven't really. We have a Copilot that is an add-on. Outside of those two things, we haven't changed anything yet. MCP, we haven't announced because it's in early release. We need to watch customers and how they're using it. We have a couple of, about 100 customers using MCP right now, and some are using it heavily.
Really working with them on seeing what they're doing, how they're using the product, what does it mean for us cost-wise, and then as we engage with them, what pricing would make sense. That's kind of the way we're approaching this. When we look forward, Brian, I don't think there's going to be a difference between our core products and our AI products and things like that. When we get to that $1.3 billion and then beyond a billion dollars, and I think it was $1.4 billion on the ARR side and $1.3 billion on the revenue side, you're going to see a lot of products that have AI embedded in them. It's also one of the reasons that we're like, I don't know if it makes sense to report on AI every single quarter, and we're not doing that anymore.
We made that clear because we don't want to do allocations, and we don't want to kind of play games with the investor base, which I think some other companies do. The numbers that we reported historically have been very SKU-based. If it's an AI SKU, standalone SKU, and we sell it, that's what we're saying. But when a product has AI Insights embedded in it, we're not trying to carve out what is the value of insights, because I don't think that's a good practice. Going forward, we're going to be super clear on products that are what we're selling and how we're selling them. If we start to embed things and include them, which could happen, then we'll probably be giving much more around usage metrics and things like that. The total ARR would be inclusive of any AI capabilities.
That's a good lead into my next question, just asking about the structure. Because these sessions packs, they're getting recognized as consumed and not ratably.
No, they are ratable. I should be clear.
Oh, they are ratable.
Yeah, they are ratable. There's like you have time-based and you have usage-based, and you kind of go, hey, what is the predominant component to it? A session pack is. Just to be clear, if a customer signs an annual agreement and they buy one session pack, that session pack's actually recognized over 12 months in that annual agreement. But as the customer uses it, if they run out, they have to buy another one, and then that next one would be ratable over that next 12 months kind of thing. Or not the next, whatever the period that is remaining is, right? These are. Even the GAAP accounting on all this stuff will get a little bit kind of tricky based on what the predominant is at usage or session.
We're constantly working with our auditors and stuff to make sure that we're still doing stuff on subscription terms. Again, some of this could change too based on different products that you release and how it's accounted for.
Perfect on that. Wanted to just ask you a question on the uses of cash for the business. Because your balance sheet is very strong. You have $664 million of net cash, effectively no debt. A lot more than most of the other software companies that I'm following. The question is, do you think the business is over-capitalized at this point? Then how do you think about prioritizing the use of cash?
I don't think we're over-capitalized, but we are using our capital, right? We are buying back stock. We continue to do net settles on RSU, which is another form of buyback. We've been open that we will look at opportunities to buy companies. So far we've bought FireHydrant, we bought Device42, and we used cash for that. We're going to continue to look at opportunities. I think they're going to look and feel more like Device42 and FireHydrant, meaning not huge significant deals, but more strategic things on how do we expand our portfolio or go deeper in our portfolio. Those are going to be all of our uses of capital. We constantly, every board meeting, we talk to the board, and we talk about other uses of capital, meaning including continued buybacks and things like that.
We are at a point now we're going to produce $265 million of free cash flow this year. And we said at our Refresh event, you could see a point in the future that we're going to make some commitment to use free cash flow every single year to do buybacks. And I could see us doing that as well, right. Because we have proven that we can build both a growth business but also a very profitable growth business, and to me, that's pretty exciting. No, I don't think we're over-capitalized. We've proven that we will use our capital to reduce dilution and our share count, and we're going to continue to do that. I think one thing we're super proud of is that focus on free cash flow per share and the commitment that we're going to grow that by 20% a year.
You either have to continue to grow the top line significantly to produce more free cash flow while running a very profitable business, or you can also reduce your share count. And I think we're trying to do both.
Perfect. Last question. Tyler, I see you have your Refresh event coming up.
I changed it. I wanted to look like you, Brian, as we started.
Good. No, I'm glad you did, but I thought maybe you can take an opportunity to share that event with the audience, because I know that's always a big customer event.
Yeah. This is going to be our virtual summit in October of our Refresh event, where it is going to be highlighting all of the new feature functionality that we're delivering out there to that customer. We're doing two of these a year, one more in person, one virtually. This will be the virtual one. We kind of surround it with what are the big technology things that we're putting out there. Obviously, a lot of it is centered around AI and the capabilities that we're delivering. Then it's also just a great opportunity for us to engage with our customer base, but also have our customers engage with each other. We typically have been doing our CABs, our Customer Advisory Boards, right around the same time as our Refresh events.
We are trying to get more and more of our customers involved, not just to be advocates for us, which they're already doing, but to create the network across themselves. We feel that the more our customers engage with each other, the more they are going to collaborate, and feedback is going to be great for us and helps us determine what we're going to go deliver for them next. We're super excited about this. I think Kady and her team, our CMO, has done an incredible job of really honing in and making these pretty valuable events. The event we had in May in New York was awesome. That was in person. This is the virtual one, which will be in October.
Well, we have it on our calendar, and we will be there. Tyler, I want to thank you very much for your time today and presenting Freshworks. It's a great story.
Yeah. Brian, thanks again for having us, man. We appreciate it.