JFrog – Note 20201027

[October 27th, 2020]

JFrog has been doing quite well since its IPO in mid September. In the first 10 trading days, it doubled from its IPO price of $44/share and gained 50% from close of the second day of trading.

Due to limited free flow before lock-up expiration, the stock has been quite volatile. Technically, the stock looks good as of today while fundamental-driven investors might be more concerned about valuation.

As of this writing, JFrog has market capitalization of US$7.5B with EV/NTM Sales is over 40x. As I mentioned in my quick calculation post before IPO, JFrog’s product is mission critical and it has outstanding financials with high topline growth, GAAP profits and positive cash flow. That said, what kind of assumptions and underlying characteristics does it need to support the valuation at current level or higher?

The characteristics of software business is well understood that it has limited marginal cost to scale which leads to high contribution margin. If the software business can acquire customers and retain them efficiently and effectively, the business might be able to quickly enjoy operating leverage once it breaks even. The adoption of software-as- a-service business model further makes the revenue stream more recurring and financials of the business more stable and less product cycle driven.

JFrog just had accounting profit in last quarter (2Q20). JFrog is likely to have accounting profit going forward even though the company mentioned it planned to increase S&M spending in the prospectus. If JFrog doesn’t reinvest its contributing profit into R&D and S&M too aggressively, I expect that the operating leverage will kick in very quickly. I think this pattern is quite clear so the thesis on margin expansion will more likely to suffer from negative surprise in the short term when everyone takes margin expansion for granted.

While margin improvement is not enough to support the stock, at least we know JFrog had healthy unit economics to generate attractive financial results. Future industry-leading profitability is not enough. That profitability needs to be at a scale that matches the valuation. Eventually, it’s all about growth. There are few areas for growth.

  • Story: TAM, TAM Expansion, Adjacent Markets / Other Uses Cases

This depends on how large the problem JFrog is solving. Software is enabling every industry. The volume of software written, the demands for a faster release cycle, and the increasingly complex layers of dependencies and security requirements are self-reinforcing tailwinds that are all increasing the size of the market that JFrog addresses. The opportunity in adjacent markets includes improved security solutions for DevSecOps and enabling software updates at the edge (Internet of Things, IoT).

  • Acquisition of New Customer and Geographic Expansion

In addition to typical initiatives and process to acquire new customers, JFrog intends to continue to expand internationally as DevOps practices are increasingly around the worlds.

JFrog doesn’t further breakdown revenue from the rest of world. I was wondering whether China could be major revenue contribution but I realized in a call with Chinese video conferencing provider that pure enterprise SaaS model might not be working in China because corporate procurement process is different from markets like the U.S. Bottom-up or Land-and-Expand might not work that well China. Sometimes SaaS companies still need channel partners to market the product and maintain the customer relationship. This is why contribution profit after the sales and marketing might not look that great in China because there’re relatively high on-going costs on maintaining the customer. It might be difficult for products that use freemium or self-service (inbound) model to get adoption. I’m not sure whether community-driven marketing will work there. Hope some analysts will ask this during the conference call next week.

My another hope is that JFrog can get traction in Japan. I notice that the company has developer advocates based in Japan. Currently, digital transformation has become a buzzword (DX) in Japan. Maybe this can fuel some adoption.

  • Cross-sell / Upsell / More Usage from Existing Customers

To date, JFrog has not deployed a significant outbound sales force, relying primarily on its self-service and inbound sales model. Moving forward, Jfrog is building a small, high-touch strategic sales team to identify new use cases and drive expansion and standardization on JFrog within its largest customers.

JFrog has outstanding ARR growth, gross dollar retention and net dollar retention.

The most impressive chart in the whole prospectus is their cohort analysis.

ARR from customers in the 2011 cohort, 2012 cohort, 2013 cohort, 2014 cohort, 2015 cohort, 2016 cohort, 2017 cohort, and 2018 cohort in 2019 represent an increase over each cohort’s initial aggregate ARR by 13.2x, 14.6x, 7.9x, 6.6x, 4.3x, 2.9x, 2.0x, and 1.4x, respectively.

On average, customer cohorts have expanded by approximately 3.0x within the first three years. All of customer cohorts have continued to expand in 2020, as of June 30, 2020.

JFrog Prospectus

My interpretation is that the usage of JFrog products has an underlying trend and JFrog has done a great job retaining and monetizing existing customers. If the past cohorts have similar pattern of ARR growth, I would assume new cohorts might behave likewise. If theses characteristics hold, I would expect JFrog’s growth rate might be at least 30%+ (this bottom should be higher if there’s no COVID-19 impact) from existing customers for an extended period of time with additional growth coming from new customers. This 30%+ growth period might be much longer than some participants’ expectation. This is my key assumption to the currently 40x+ EV/NTM Sales.

Frog has market with trend and products with attractive economics to address the market. My bet is that JFrog can ride on the trend and fend off the competition from much larger but less focused players. Risks come from competition and sector-wise valuation correction.


Prospectus Summary

The CSRM Platform

  • JFrog is Continuous Software Release Management (CSRM) platform which enables organizations to continuously deliver software update across any system.
  • The platform is the critical bridge between software development and deployment of that software and provides the common ground for software developers and IT operators, making it integral to the DevOps workflow.
  • The specific platform is JFrog Artifactory which is an universal package repository. JFrog’s approach to software release is package-based and enabled the CSRM category. The platform
    • enables organizations to store all package types in a common repository where they can be edited, tracked, and managed,
    • connects all of the software release processes involved in building and releasing software,
    • empowers customers to shorten their software release cycles and enable the continuous flow of current, up-to-date software from any source to any destination,
    • is agnostic to the programming languages, source code repositories, and development technologies that our customers use, and the type of production environments to which they deploy.

Basically, Jfrog is a market leader in mission critical category in the DevOps workflow.

Market Opportunity

  • Core (TAM): The volume of software written, the demands for a faster release cycle, and the increasingly complex layers of dependencies and security requirements are self-reinforcing tailwinds that are all increasing the size of the market that JFrog addresses.
    • My Thesis: the complexity and volume this tool addresses grows exponentially.
  • Adjacent (TAM Expansion): improved security solutions for DevSecOps and enabling software updates at the edge (Internet of Things).
    • My Thesis: big market, particularly IoT but adoption trajectory is relatively uncertain.

Business Model

  • Bottom-up, community-focused approach to driving increased usage of product.
    • Demonstrating the value that products can provide to software developers and IT operators before their organizations become customers.
    • Try to make developers and operators champions of JFrog.
    • The go-to-market and multi-tiered subscription structure for both self-managed and software as a service (SaaS) subscriptions and technology partnership ecosystem fuels the growth.
  • Go-to-Market (focus on reducing friction)
    • The subscriptions are offered in multiple tiers that differ based on both product breadth and functionality.
    • The pricing has various options including free trials, freemium offerings, and open source software options providing low-friction entry points for software developers and IT operators.
    • Support for public cloud on-premise, private cloud and hybrid deployments reduces friction adoption and prevents vendor lock-in for customers.

Growth Strategy

  • Building new capabilities and extending the platform to have broader range of use cases.
  • Cross-sell, up-sell and usage expansion within existing customers
    • To date, JFrog has not deployed a significant outbound sales force, relying primarily on our self-service and inbound sales model. Moving forward, Jfrog is building a small, high-touch strategic sales team to identify new use cases and drive expansion and standardization on JFrog within its largest customers.
  • Customer acquisition
    • In addition to typical initiatives to acquire new customers, JFrog intends to continue to expand internationally as DevOps practices are increasingly around the worlds.

Competition

  • With respect to self-managed deployments, diversified software companies, such as IBM, Inc. (Red Hat), Pivotal Software, Inc., and VMware, Inc., and developer-focused software companies, such as GitLab Inc. and Sonatype, Inc., have offerings that compete with certain of JFrog’s products.
  • With respect to SaaS deployments, cloud providers, such as Alphabet Inc. (GCP), Amazon.com, Inc. (AWS), and Microsoft Corporation (Azure DevOps including GitHub), have offerings that compete with certain of JFrog’s products.

Monetization and Metrics

Revenue Streams

  • Subscription – Self-Managed and SaaS
    • Subscription – self-managed and SaaS revenue is generated from the sale of subscriptions which includes support and upgrades and updates on a when-and-if-available basis for JFrog self-managed software products, and revenue from JFrog SaaS subscriptions, which provides access to software managed by JFrog in the public cloud. For subscriptions to JFrog self-managed software products, revenue is recognized ratably over the subscription term. For our SaaS subscriptions, revenue is recognized based on usage as the usage occurs over the contract period.
  • License – Self-Managed
    • License revenue reflects the revenue recognized by providing customers with access to proprietary software features. License revenue is recognized upfront when the software license is made available to JFrog customer.

Metrics

  • ARR, Gross Dollar Retention and Net Dollar Retention

  • Cohort Analysis

ARR from customers in the 2011 cohort, 2012 cohort, 2013 cohort, 2014 cohort, 2015 cohort, 2016 cohort, 2017 cohort, and 2018 cohort in 2019 represent an increase over each cohort’s initial aggregate ARR by 13.2x, 14.6x, 7.9x, 6.6x, 4.3x, 2.9x, 2.0x, and 1.4x, respectively.

On average, customer cohorts have expanded by approximately 3.0x within the first three years. All of customer cohorts have continued to expand in 2020, as of June 30, 2020.

Historical Financials

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