JFrog Stock: High Quality Long-Term Growth Investment (FROG)

Investment thesis

JFrog (NASDAQ:FROG) is a software and SaaS company with a quite differentiated offering in the Dev(Sec)Ops and security space, with its SaaS business growing faster than the overall business (which I remarked was somewhat reminiscent of MongoDB (MDB) in my original coverage in 2021).

The company has been able to maintain somewhat elevated growth rates for the last several years. After the rally (after years of downward trend) through 2023, the valuation has increased a bit. Combined with a bit of slowdown in growth rate, this does not make the stock a must-buy/bargain, but could still be a solid pick to keep on one’s radar, or to invest/open a starter position for the long-term.

Background

The stock is up 25% since my previous coverage in August 2022, with an even greater return for those who bought it at the lower prices it reached in between. At the time, I noted that given its (sustained) growth rate, the 8x P/S multiple was quite reasonable: JFrog: Rock Solid Growth Stock (FROG). This has indeed proved to be the case: despite the higher stock price, given its growth the stock is still valued around 8x (forward) P/S, although the growth rate has come down a bit over the last year.

Q3 results, guidance

As noted, JFrog’s growth rate has come down, from around 40% to 23%, with $88.6M revenue in Q3. The cloud side of the business continues to grow faster at 46% ($30.6M). However, note that some part of that is due to on-prem customers shifting to cloud.

On the profitability side, non-GAAP profit was $16.6M (19% margin), or $0.15 EPS, and FCF was $25.4M (29% margin). Operating profit of $11.9M represented 13% margin. This shows the first signs of leverage as the focus has become more balanced from purely growth around IPO.

Customer growth of $100k ARR customers was firm at 22% growth. For $1M ARR, the amount grew from 18 to 30, showing JFrog has the ability to upsell existing customers. This is also visible in the solid net dollar retention of 119%, which is “stabilizing” (down from ~130%).

For Q4 guidance, JFrog expects Q4 growth of 21%, a bit of a further slowdown. Given the net retention, although that is a backwards-looking metric, a far further slowdown is unlikely, but it does mean a lower level of growth should be expected going forward.

Business update

JFrog sees 4 reasons for its continued success (that should allow it to continue to grow at 20+%), which are enterprise focus, cloud, its comprehensive platform, and AI. The latter is quite new, with JFrog claiming it is “the first and only repository manager to proxy the most popular public AI and ML model repository, Hugging Face.”

JFrog further noted three new product launches, becoming “the first solution in the industry to deliver end-to-end software supply chain security, providing customers complete coverage from code to production”. Combined with its existing products, it provides a complete DevSecOps solution.

Long-term outlook

From the May earnings call, JFrog expects to maintain a long-term growth rate above 20%.

In closing, I’d like to reflect on JFrog’s commitment to profitable long-term growth and cash flow generation while creating value for both our customers and shareholders as we focus on execution across the business. Driven by the strength in adoption of the JFrog Platform and our expectations for future contributions from the platform security core, we believe our operating model can achieve a 5-year revenue CAGR of 22% to 24% through fiscal year 2027, which would imply a potential revenue range of $775 million to $825 million, while delivering free cash flow in the range of $200 million to $240 million, implying estimated margin of 26% to 29%.

Investors may remember the previous long-term outlook was for sustained 30% growth (discussed in previous coverage), so in that sense the new outlook represents a downgrade. Still, the company has solidly executed over the years and maintains a strong net retention rate, so this outlook isn’t unrealistic.

Valuation

The forward P/S remains 8x (based on December 2024 estimate). Given a market cap of ~$3.3B, the stock trades for 50x non-GAAP profit or 33x FCF (annualized from Q3). Given that the growth rate is coming down from 30-40% to 20-30%, combined with the increase in share price, this means the valuation has increased a bit (since paying 8x P/S for a 20% grower is more expensive than paying 8x for 40% growth), but is arguably still not expensive, at least depending on the intended holding period and also considering the potential leverage from the near-90% gross margin if the company would (theoretically) pivot to a purely profitability focus.

Looking at the long-term outlook, investors are potentially paying about 4x for 2027 revenue or 13x FCF. If the company can maintain its 8x P/S multiple, then this implies a doubling in share price. Even a reduction to for example a 6x P/S by 2027 could still yield a solid return. Of course, is the growth may not slow down/stall during these years.

So, while the stock is currently perhaps a bit expensive on a P/E basis, expanding net/operating profit margins combined with a compounding of revenue over time gives JFrog the potential to deliver on the investment thesis of a growth stock, which warrants the valuation (and still deliver sizeable returns for long-term holders)

Investor takeaway

Compared to my previous coverage, JFrog’s growth rate and outlook has come down noticeably, but it remains a firm 20+% grower, or at least has the realistic potential to. Another key indicator is the elevated cloud rate (mid-40% for 2023), although some portion of this is due to the cannibalization of its own on-prem business, which has closer to a mid-teens growth rate currently. JFrog did say it expects or aims to accelerate the on-prem business through its new product launches.

Since the P/S valuation after the rally through 2023 has climbed back to 8x forward (9x run rate), this does mean the stock is a bit more expensive currently. Although arguably not excessively so, given the company’s near-90% gross margin. The operating margin is primarily weighted down by R&D and other investments/expenses of around 70% revenue combined. So clearly there is the potential for higher leverage as revenue scales further over time.

Ultimately, the main risk or difficulty in growth investing is the necessity to find a stock that can maintain elevated growth rates for many years in order for the revenue and income/FCF to grow exponentially over time, to levels far beyond what the valuation at the time of investment originally accounted for. Given the company’s differentiated offering and solid execution, JFrog remains exactly such a compounder that should be of interest to long-term growth investors.