Description

Intro

JFrog is a software as a service (SaaS) provider of DevOps tools to help clients accelerate and optimize their software development process. Despite operating in a white-hot space (DevOps), the share price performance has been a disaster, down ~50% from listing price and ~70% from its opening day close. While the company has not shown the upside to estimates typically expected of new tech IPOs, financial performance has generally been solid with 30%+ revenue growth and positive FCF generation. After a softer than expected 2Q21, fundamentals have reaccelerated. With continued execution I expect FROG to regain market confidence and a multiple more in line with similar growth peers.

Business

JFrog is a leading player in the emerging DevOps market with a code-to-cloud platform designed to simplify and automate the release of modern software applications. JFrog’s initial product, Artifactory, has become the industry leader in binary repositories. Binary repos store and manage machine readable, executable programs, outputs, and byproducts of the software build process. Artifactory provides benefits to software developers and IT operations personnel in the form of easy and automated software management (a painfully manual process historically), integrations across the breadth of the development ecosystem, enterprise features like high availability, and the ability to deploy across private data centers and the major public cloud providers. Building on the success of its core product Artifactory, JFrog has extended its platform to offer other features such as security, distribution, pipelines, and edge deployment.

JFrog has an A+ list of clients including software giants such as Google, Microsoft, Twillio, Netflix, Spotify, Workday, and Cisco.

One can think of JFrog’s products as sitting in the middle of the software development and production pipeline. Modern software development combines custom source code with third party open-source code to create an application. JFrog’s platform provides a single repository that validates the software, scans for security vulnerabilities, and optimizes the software for production runtime.

The company’s management team has used the analogy of a car manufacturer. All the car parts (usable pieces of software code) are managed by and stored in this warehouse—whether the parts are manufactured internally (source code written by a company’s developers) or externally by subcontractors (primarily open source, third-party code or packages). When car parts need to go through quality control (testing or security scanning), they are taken from the warehouse, tested, and returned. If there are issues or parts that need to be reprocessed, they are taken from the warehouse, fixed/updated (by developers), and then returned as a more robust version (software update) of the previous part. Once ready for assembly, the relevant car parts (software packages) are pulled from the warehouse and sent to the physical assembly line (the CD pipeline), and when the fully assembled car is ready, it is distributed to car dealers for final delivery to consumers (full software applications released to production for use by end-customers).

The company has benefited from viral adoption of its Artifactory product among developers due to its freemium sales model and developer community outreach efforts. The company charges on a per-server basis, so that as the company products become more penetrated in a customer, the total customer spend increases.

Key Investment attributes

Significant upsell opportunity

JFrog offers several tiers to customers that provider different levels of functionality. Starting from the open-source version or free-trial option of Artifactory, the company scales its subscription tiers from one to four, 1) Pro – single server of Artifactory, 2) Pro X – Artifactory plus Xray (security) plus SLA support, 3) Enterprise – three servers of Artifactory plus Xray high availability plus JFrog Mission Control console and SLA support, and 4) Enterprise Plus –everything in Enterprise plus JFrog Pipelines, Insight, Distribution, and Artifactory Edge. ~60% of JFrog’s 5,800 customers use Artifactory alone and the average price for the top tier is roughly 40x the basic tier providing substantial upsell opportunity.

An increasing percentage of total revenue coming from Enterprise Plus demonstrates the company’s ability to upsell effectively. In 4Q21, 35% of total revenue came from Enterprise plus customers, up from 16% in 2020 and 10% in 2019. Continuing to sell additional features to existing customers should provide ample opportunity for revenue growth going forward at a relatively low cost.

Large and growing addressable market

IDC, a research and data analytics firm, forecasts the addressable market for DevOps tools to grow to $18bn in 2024 from $8.5bn in 2019, representing a market CAGR of 16%. The company’s own bottom-up TAM analysis suggests an addressable market of $22bn. The market today is highly fragmented with the top five vendors accounting for roughly 40%. In more mature areas of software infrastructure, the top five vendors often account for 70%+ of the market.

With respect to market maturity and penetration, we remain very early in the adoption of DevOps tools and practices. In an IDC DevOps survey of large enterprises, roughly 67% of respondents had less than half of their total application estate developed and deployed using DevOps methods. This is expected to rise considerably over the next decade as companies implement software development best practices utilized by the likes of Netflix, Uber, Salesforce, Facebook.

A recent report from DORA (DevOps Research and Assessment; a DevOps think tank owned by Google), found that high-performing DevOps teams within an organization (the top 20% of survey teams that have implemented DevOps methodologies successfully at both cultural and technical levels) perform 208 times more frequent code deployments than low-performing teams. In addition, these high performing groups have 106 times faster lead times, 2,604 times faster time to recovery, and are one-seventh times less likely to see deployed code changes fail. The report has revealed similar statistics over the last five years, offering clear evidence that when development and operations teams properly adopt DevOps methodologies within their organization, they are able to substantially increase both the speed and stability of software deployments. I expect the adoption of DevOps tools to accelerate in the coming years, providing a significant tailwind to JFrog given its best of breed technology in the binary repo space.

Efficient go to market approach underpins profitable growth

Unlike most high growth enterprise software companies, JFrog is unique in its ability to drive strong topline growth while maintain positive operating margins (before M&A integration expenses) and cash flow. Much of this is due to the company’s go to market strategy. JFrog utilizes a bottom-up approach to sales and marketing, focusing on driving adoption of its Artifactory product within DevOps teams. A vast majority revenue and new customers come through inbound channels resulting in a very efficient go to market strategy and scalable business model. Once a customer is onboarded through self-serve channels, JFrog may deploy its high touch strategic sales team to drive further adoption within the customer. This model should enable to company to continue to expand margins over time. The company expects to scale to 30% FCF margins over the next several years.

Why now?

Shares slid from $45 to $35 following the company’s 2Q21 earnings results and have been further punished in the broader software/tech sell off. The two most recent quarters have demonstrated improving fundamentals with topline reaccelerating to +38% in 3Q and +39% in 4Q.

The company’s new sale pipeline sits at its highest levels ever and the strategic field sales team (which targets larger enterprises for expansion) is helping the company gain traction in closing large deals. Finally, co-selling partnerships with the major public cloud providers are seeing strong traction as customers enjoy the benefits of easy onboarding and a fully hosted end to end DevOps solution.

Initial guidance for 2022 calls for ~33% revenue growth at the midpoint which should prove to be conservative given the company’s 130% NDRR and improving go to market motion.

Valuation

I model 36% revenue growth in 2022 and 34% in 2023. On my estimates, the stock current sits at 5.8x 2023 EV/revenue ($2,185/$376m). In the comp sheet below I have included 25-40% SaaS growers. FROG trades at a big, and in my view, unwarranted discount. (Note: I pulled this from the SS so GP and FCF numbers are ex-SBC).

The below chart plots DevOps/Dev Tools SaaS companies based on their “rule of 40” (on the X axis and their valuation (EV/ NTM revenue) on the right axis. FROG is a clear standout in the bottom of the chart.

As a sanity check on valuation, I consider a normalized FCF multiple. Management expects to hit 30%+ free cash flow margins over time as the business scales. I think this is readily achievable given the business is at ~20% today ex-one offs. If we assume a 20% margin (30% normalized FCF less 10% for SBC) on my 2023 revenue estimates, the stock trades at ~30x, which I think is more than reasonable given the growth trajectory.

With reaccelerating fundamentals, I think it is likely FROG trades much more in line with the peer group average. A peer group average multiple is close to 70% upside from here. Longer term, I think the company can be a multi-bagger as revenue compounds at ~30%+ and margins move towards management’s targets. If the stock continues to languish, I think it is pretty likely the company will be bought. As a final aside, I spoke with a senior engineer at Atlassian who thought it would be a great fit.

Catalyst

Earnings

Cessation of the SaaS implosion