In this episode of Industry Focus: Tech, Dylan Lewis chats with Motley Fool analyst Brian Feroldi about one of the most recent SaaS companies to go public. JFrog (FROG -0.93%) is a pioneer and leader in the space it operates in, and the guys explain the value proposition behind it, its history, business model, products, management team, opportunities, and much more.

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This video was recorded on Sept. 18, 2020.

Dylan Lewis: It's Friday, Sept. 18, and we're talking about a recent IPO that has not gotten enough attention, JFrog. I'm your host Dylan Lewis, and I'm joined by's chief curator of cautious, continuous compounding, Brian Feroldi. Brian, how's it going?

Brian Feroldi: Dylan, we have been incredibly spoiled with the number of IPOs that are actually worth talking about over the last two months, and we have yet another one today that is worth a look.

Lewis: You know, it's remarkable, because you would think -- if I were to tell you, maybe eight months ago, "Hey, we're going to be in wildly uncertain times, there are going to be some serious whipsaws happening in the market, there's going to be a lot of unemployment, do you think a lot of companies are going to be going public?" [laughs] You'd probably say, "Huh, maybe not. There's probably going to be some people sitting on the sidelines waiting for things to stabilize." And yet, we've seen some very quality businesses come out.

Feroldi: Yeah. And this company we're going to talk about today, JFrog, one that I never heard of before till I looked at the S-1. I did hear some buzz about it from some people I respect on Twitter. When you look at this company, I understand why it's something that has caught a lot of smart people's attention.

Lewis: Yeah. And it's a business that needs some explanation, and we're going to get into that, and it's possible, even if you were following the news this week that you might have missed this one, because Snowflake got all the attention. It was kind of the darling IPO to date; and we'll touch on that, because we did that prospectus show a little while ago on that business.

But we're going to start out talking about JFrog. Just came public on the same day as Snowflake -- kind of a two parties on the same day type situation. Thankfully, both of them were well-attended, Brian.

Feroldi: Yeah. JFrog, which is ticker symbol FROG, had a, you could say, successful IPO. They priced at $44 per share. The company raised a net of $480 million. Of note to me, about three-quarters of that went to the company. So, the company added $327 million to its balance sheet. $146 million of that went to insiders that were looking for an exit at the IPO price. So, again, they came public at $44; that's where they priced. That same day, they reached a peak of $77 per share, before settling at $64. So, while SNOW caught all the media attention and so many people were paying attention to it, JFrog did have a successful outing; although it depends on your view, just like with Snowflake, you could've argued, boy! The banker screwed up here and they underpriced it.

Lewis: Yeah. And actually, we can talk about that a little bit later with Snowflake, because I have some comments from their CEO related to that. But at least at this one, you know, where the price ultimately settled is fairly close. You know, there's a premium that was out there, they might have been able to capture. The pricing on IPOs is difficult, but they got a lot closer to what the market was willing to give them than Snowflake did.

Feroldi: Yeah, they certainly did. But this is a fascinating business. When you dig into it, it is definitely worth getting to know. And the market valuation is somewhere around $6 billion; so, less than a tenth of the market cap of Snowflake.

Lewis: [laughs] I wonder if they're always going to suffer from that comparison or if we'll get to a point where they're like, you know what, these are two businesses, they're both great businesses, we're just going to let them go; we'll have to see. But this company has actually been around for a while. They've been around for over 10 years. And I think what we need to do upfront here is basically to find just who they are and what they do, because this is a little different than our standard software business.

Feroldi: Yeah. Some software businesses are consumer-facing and we can see them, we can understand them. Other software businesses are designed to meet the needs of other software developers. And understanding how those businesses work and what they do is really hard. In a way, this reminds me of Twilio. Twilio is a company that's been phenomenally successful, but their market is other software developers. The same thing is happening with JFrog.

So, JFrog was founded in 2009 by three co-founders. The company is aimed at addressing the problem of software updates. I think that most people are aware that historically software updates always came out version 1.0, version 2.0, version 3.0. Prior, before the advent of the internet and the cloud, you had to manually update them, you had to put a new CD into your computer, and you had to overwrite the existing program and create a new one.

The pace of innovation in the software market has exploded. And I love this quote on their site, they say: "Users now expect their software to update continuously, not intrusively and without them even knowing." When you wake up in the morning, you expect that your iPhone will basically have the latest and greatest software on it, and all the apps on the iPhone will instantly work. When you log into Gmail or anything in the cloud, you just expect that you are going to be automatically on the latest version without having to do anything. That is what JFrog enables.

Lewis: Yeah. And I think it's tempting when we talk about the cloud to really fixate on the big cloud providers, you know, the people that provide infrastructure. And I think what JFrog is really good at illustrating is, the cloud has created a huge space for a lot of businesses to operate. And I don't know that this model would work in a world that doesn't have the cloud, because we wouldn't have this continuous software upgrade cycle, people would just be shipped their CDs.

Feroldi: Yeah. It took vision to see this as an idea 11 years ago when the company came out with this. And they called this idea liquid software, the idea being "the best version is no version," it's continually being updated. When a developer has a new idea, a bug fix, or whatever, they don't want that to be the next version release, they want that to be instantaneously pushed out to all users at the same time, they want it to be verified and they want it to just work. So, this software makes developers' lives easier.

And what's fascinating about this is that it works both on-premise, in a hybrid model where some is on-premise and some is in the cloud, or a 100% natively in the cloud. It works with Azure, it works with AWS, and it works with Google Cloud. So, if you're a developer and you go with JFrog, you have plenty of options ahead of time.

Lewis: [laughs] I like your comparison to Twilio, because Twilio has been a wildly successful company to own. It is also one of those sneaky businesses that you don't even realize that you're interacting with most of the time, because it is under the hood, because it is such a developer platform. And those businesses, while Twilio has shown they can be very successful, are very hard for the average person to really understand and really understand the value proposition behind.

Feroldi: It really is. And when I was digging into the details of this company, one thing that I always like to see is, some other company validating that yes, this is the real deal. And when we go through their customer list, when we go through their partners, when we go through the people that they have chosen to integrate into their ecosystem, it just becomes super-clear that these guys are the pioneer and they are the industry standard. And when you're looking from the outside, that's what I like to see. I like to see that the financials are backing up what the company says, and some of the big tech players are validating it too.

Lewis: [laughs] The test is basically, do other smart people think that this thing works? If the answer is "Yes," then I'm willing to go along with it. And I mean, that's part of understanding what you know and what you don't know, because there are some really great businesses out there that operate on the fringes of my tech knowledge. And that's where having conversations with folks like Tim Beyers and Tim White can be so helpful.

Feroldi: Yeah, exactly. Some of the details here really matter. And when you see that Microsoft is a customer, Google [Alphabet] is a customer, Amazon is a customer, in fact, all 10 of the biggest 10 tech companies on Earth are customers, clearly, they're doing something right.

Lewis: Yeah, those are some big endorsements. And they've had some pretty big names for a while. I think even when they were doing some of their early-series funding rounds, they were able to have some pretty big names, the likes of Netflix and some other pretty big tech names on there. So, clearly, a lot of people believe in this platform even though it is early days and they still have quite a bit to prove.

Feroldi: Yeah. And again, it reminds me here, I think the comparison to Twilio is really good. Twilio excels at creating APIs that enable communication. It's much easier for even big tech companies like Facebook to buy from a company like Twilio rather than develop the tools themselves. The same thing I think could be said of JFrog, where big companies are clearly saying, we have the resources to develop this technology, but it's easier and simpler to buy from a company like JFrog. Their hyper-focus on this one thing and doing this thing well, has really paid off.

Lewis: Yeah. And there are a lot of reasons why those things also make more sense. The interoperability of those types of things is often better than whatever you will make at home, you know? [laughs] They have a lot of companies that are using the same thing, chances are it is going to play nice with other people's tech, which is always helpful as well.

Feroldi: And that's exactly what we see. JFrog basically says, we don't care what program language you're using, we don't care what platform you're using to develop, we don't care if you want to go on-premise, off-premise, in the cloud. We want to be Switzerland. Whatever software you want to use, we want to enable you to get the most recent version out to all of your users instantaneously.

Lewis: Yeah. And that's a proven model. I mean, I think that's exactly what we said about Snowflake as well, Brian, to draw another comparison. Are there any other core things that you want to hit when we're talking about the product and what they do?

Feroldi: I think that we'll leave it right there, but essentially, it's a tough thing to really wrap your head around exactly what the company does, but you just have to focus on, they enable continuous software updates, and they have clearly won over developers and IT professionals globally.

Lewis: Yeah. And Brian is on the show, so you know what's coming when it comes to the business model. This is a SaaS company, they wind up, you know, having a lot of the attributes, when we start to look at the books and we start to look at how they do what they do, that feels very SaaS-like, Brian.

Feroldi: Yeah, they are a pure-play SaaS company, and they're deploying a freemium business model. So, developers can download a trial version of their software right from day one, give it a try, bring it into their system, see if it works out from there. From there, they have a tiered subscription model where enterprises can move upstream to bigger and bigger packages depending on their needs. When you look at the company's revenue and the company's ability to attract more than 5,800 customers, clearly the strategy is working.

Lewis: Yeah. And they're seeing some pretty high growth rates. We're working on some small numbers when it comes to the top line, but 50% growth in the first half of 2020 puts them at just about $70 million. And that software number you love to see, 81% gross margins. This is obviously a business that is going to produce a lot of profits once it hits a pretty big scale, it's just a matter of getting there.

Feroldi: Yeah, high revenue growth. So, for the first half of 2020, so again, the first six months of the year, that's the period that we're looking at, almost $70 million in total revenue, that was up 50%. 81% gross margin, really strong. The surprising number to me, Dylan, was that net loss over the first six months of the period, $400,000. So, this is a company that is extraordinarily close to profitability already. And even more important to me is, they've been free cash flow positive for five years.

I love this stat that they called out in their S-1. They said, since our founding, we had raised a total of $162 million in capital; that was prior to coming public. And yet, prior to coming public, $171 million in cash on their balance sheet. So, they have raised a little capital and they basically have retained all of their capital. The reason they can do that is they have an efficient business model that pumps up free cash flow.

Lewis: Well, you mentioned that they were almost profitable in the first half of 2020. Their most recent quarter, they actually posted a profit, which is pretty incredible for a business that is this early on, especially when you look at the revenue base they're working off of. You know, I expect them to still be in that hyper-growth mode, so for them to be showing profits this early is surprising. Big part of that is that the customers that they bring on seem to like the product and they seem to stick around.

Feroldi: Yeah, this company has a history of getting them in with their core product and then upselling them over time to more products. So, they have developed, for example, security tools; they have developed something they call Mission Control, which allows for the control and monitoring of the entire process and feedback and analytics. Because of that, we see a really, really impressive dollar-based net retention rate. Remember, retention, that's the good one, that's the one that includes churn. In the first half of the year, in the first half of 2020, 139%. Translation: 39% revenue growth without taking on any new customers. Awesome!

Lewis: That's awesome. And they were able to still continue to post pretty impressive numbers even with COVID, and I think it's kind of a testament to the fact that they have a very happy customer base. You know, this is a period where sometimes you get to benefit from accelerating some trends if you are a software player, sometimes budgets are a little bit stricter because businesses are scaling back a little bit. But when they have such delighted customers, it means that even as you're trying to weather these periods, you're still going to wind up putting up some pretty decent numbers, and that's exactly what they've done.

Feroldi: Yeah. And COVID is such a great thing for investors to see what companies are actually willing to pay for. When they are pushed up against the wall and they are forced to make budgetary decisions, what actually continues to get funded? JFrog clearly continues to get funded. That should give you some confidence that this is a must-have product, not a need-to-have product. The other thing to point out is, post coming public, spotless balance sheet. $500 million in cash. Zero debt and free cash flow positive. So, this is a financially very strong company.

Lewis: For folks that listen to the show for a while, Brian, they know, the SaaS model creates very high switching costs, it makes it difficult for customers to leave once they're in. We like to talk about moats. Aside from, kind of, the standard software stuff, what do you see with this business?

Feroldi: I think it's the standard software stuff, to be completely honest. I think that they have a very big partnership ecosystem, so their products work directly with all of the big cloud providers. They do have technology partnerships with the likes of Atlassian, NetApp, Pure Software, (sic) [Pure Storage] Microsoft Azure, AWS, Google Cloud, etc. They also work within dozens of development environments. So, it caters to the needs of the developers. It's basically like, you do what you want and we're going to tailor our product to fit on top of your current workflow. That creates some pretty big switching costs, especially since this company is the first-mover.

And again, I think an overlooked thing that benefits Twilio is, what would be the cost to a company to develop this technology on their own versus what is the cost to just buy from JFrog? Clearly, it's cheaper and faster and more effective to just buy from JFrog. We see that in the dollar-based net retention.

Lewis: Yeah. And I think if we're looking for a parallel that has nothing to do with software, it's like, you can buy premade cabinet kits from IKEA or you can try to hire someone who works with wood to build you those cabinets to fit your kitchen. Both of them will probably work. One of them is probably going to take a little bit longer and be a lot more expensive. The other one fits out of the box and probably has some components that other people have built on top of them to work, whether it's accessories or ways to store things in the cabinet. That's the benefit that a company like JFrog offers enterprise customers.

Feroldi: That's an interesting analogy, Dylan, [laughs] I'll roll with it and just say, yeah, imagine that you worked with wood in your day job and you still bought from another cabinetmaker, you would do so because that one can do it cheaper than you can make it on your own. Sure. Great analogy.

Lewis: [laughs] You can tell that I'm going through the home renovation process right now, Brian. Cabinets have lost meaning to me entirely, with all the catalogs that I've been looking at.

What I like about this business is the management and culture, in particular. We have a lot of co-founders, three, all of them still involved in the business. And I think the founding story is kind of interesting here, but let's profile some of these folks first and then we'll get into that.

Feroldi: Yep. So, as you pointed out, all three co-founders are still currently with the business and operating the roles of CTO, chief data scientist, and CEO. Shlomi Ben Haim, he is the CEO of the company. He was previously the CEO of a company called AlphaCSP that was acquired, and his two other co-founders both worked alongside him at that company. So, this trio has been together for a long time. And it's really great to see that not only do they found this company together, all three of them are still in the C-suite. And as we alluded to before, the company has been extremely conservative financially and hasn't had to raise a lot of capital. Because of that, the inside ownership percentages here are really impressive. The CEO owns 6%, the chief data scientist owns 6%, and the CTO owns 8%. That right there is 20% ownership just from the co-founders. Insiders, in general -- meaning the board of directors and other managers -- own another 33% on top of that. All told, insiders, in this business, hold 53% of shares outstanding -- impressive.

Lewis: Yeah, that is serious skin in the game. And one of the other things I like about this business is the founding story. So, they've been around for over 10 years. They basically were born into the financial crisis. So, I think that is probably why you see such a lean and efficient business now; I think it's a big part of that. But also, this was not a company that had easy access to funding. I was watching an interview that Shlomi Ben Haim did, and he said, it took me four years to raise a series A, and three weeks to [laughs] raise a series D.

And they were relatively early in the DevOps world. It was at a point where I don't think a lot of people really understood what that market looked like, and a lot of people thought it was too small to really warrant having some big money. And so, early on, they had to do basically self-funding to get this thing off of the ground, and then they were able to progressively raise money through some outside funding. But I look at that and I say, they have been scrappy and they've been able to do it pretty lean for a while and they've wound up with a lot of adversity along the way and have managed to build what is now over $5 billion business. That's really impressive. And I like what that possibly indicates for how this company can handle adversity in the future.

Feroldi: I agree. Some companies just have profitability and conservatism built into their DNA. And I like to see that this company struggled in the beginning and had to be extremely efficient with capital. You clearly see that scrappiness paying off today, because the company is profitable, generating cash flow, and has a world of opportunity ahead of it. Great to see.

Lewis: We have mentioned Twilio several times during this podcast in talking about JFrog. I think one huge way that JFrog is different and possibly better than Twilio was when it was a much younger public company, is the fact that it does not have a lot of customer concentration. This is a very diversified business; they are not overly reliant on any one customer. And if you backtrack and look at Twilio's stock performance, there is a steep drop-off that happens around the news that one of their major customers was going to be moving away from them. That's always a risk when you offer these types of tools. I think JFrog is insulated from a lot of that based on how their customers break down.

Feroldi: They completely are. More than 5,800 customers that exist today, including all of the big tech companies that we talked about before, including Spotify, Workday, Netflix, Atlassian, all 10 of the top 10 tech organizations. And it goes beyond that -- eight of the top 10 financial services companies, nine of the top 10 retailers, eight of the top 10 healthcare organizations, and seven of the top nine telecommunications companies. 75% of the Fortune 100 are JFrog customers. And their largest customer is 2% of revenue. Customer concentration is not an issue here at all.

Lewis: Yeah, and that's huge, because it means [laughs] that if someone does decide to make that move where they're like, "You know, we like this tool -- in fact, we like it so much [laughs] that we figured out how to make it ourselves and we're going to do our own thing," they don't get immediately stung as a business. They're well-insulated from that risk. And they have their hands in a lot of pots, which is what we like to see. It's the same thing that we preach with people and the individual stocks that they own, you know, you can apply that concept directly here.

Feroldi: Yeah. And one question that I had before I started going in here was, how big is the opportunity here? I mean, this seems like a really niche product to be pushing out there. I was pleasantly surprised to say that the company said -- again, the company said -- that they estimate their TAM [total addressable market] at $22 billion. That's a big number, but it came from the company, so you know, discount accordingly. But IDC, they are a respectable third party, they did say that, by 2024, they believe that the opportunity for this company is somewhere around $18 billion. Based on Q2 run-rate, this company should do about $140 million-ish in revenue for the year. If you buy that potential in the $18 billions or even an order of magnitude lower than that, there's still lots of room for this company to run.

Lewis: Yeah. And if you're factoring that revenue run-rate into where they're currently valued, that puts them at about 40 times sales, which is hefty, you know, it's definitely a rich valuation, Brian, but I think also, you know, we talk about it all the time with these software businesses. Really high margin, they're already showing that there's a clear path to profitability, they've been able to do it for some quarters. As they scale, I imagine that's only going to continue, unless they're doing some heavy, heavy investment to grow the business. And the customers stick around. The retention rates don't lie. It's one of the most important numbers we look at and we really emphasize it for a reason; it signals so much strength for a business.

Feroldi: Totally. This is a company that I thought was going to trade at a big premium, it certainly did, about 40 times sales. It's crazy to say this, [laughs] that is a significant discount to some of its direct comparisons, most notably Zoom and Snowflake and even Shopify. But, yes, the market clearly sees quality here, and they're paying up accordingly. So, that, to me, is probably the biggest risk here.

Again, I don't see customer concentration risk, I think that they are the first mover, I think that they have strong relationships, I think they have lots of room to grow, I like the inside ownership, I like that the co-founders -- there's a lot to like about this business. The biggest risk to me is that, you're buying today, you're overpaying.

Lewis: Yeah. And a big part of that is, so much of the story hinges on can they grow this business to one that does 5X the revenue that it currently does? We're looking at a company that has just over $120 million in trailing 12-month revenue. That is not a big base. The growth numbers are always going to look really impressive when the denominator is that low. Can they keep that growth train moving? The retention rate seems to signal yes. But if there are any hiccups along the way, man! that valuation is going to take a haircut.

Feroldi: You got that right. And while we said that they are the pioneer, they do not have this marketplace to themselves. They do call out some pretty big-name competitors, including many of their partners and customers. So, they call out Microsoft, GitHub, Pivotal Software, IBM, Google -- all competitors that offer similar products. Clearly, JFrog is the leader and they have carved out a strong competitive position for themselves that those companies are both competitors and customers, but still, you can't ever ignore big-name companies like that.

Lewis: So, Brian, before we wind up talking about the other company that debuted, and checking back in on Snowflake, where do you stand on JFrog? Is this a watch list stock for you? Is this something that you're considering buying some time soon?

Feroldi: Yeah. I mean, this checks a lot of the boxes that I look for in a business. I usually do not buy directly after the IPO, especially now when so many companies are coming public at just ridiculously high valuations, but this checks basically every box that I look for in a business. So, I'll be putting it on my watch list for sure. How about you, Dylan?

Lewis: It's definitely a watch list stock for me. As I start freeing up some more cash, I'm going to be looking to put it to work. I think that's a nice way for me to put some guardrails on and say, you know I'm going to wait a little while, let this thing ride and, kind of, let the market figure out where it wants to value it, let some of the IPO hype die down, but this is definitely going probably to the top five, 10 names on the watch list.

Feroldi: Great. I think that that's appropriate. It's definitely a high-quality business.

Lewis: Speaking of watch list stocks, Brian. We talked about Snowflake at the end of August, and that feels like months ago at this point, particularly because the news cycle has been so active for this company. So, not only did the company go public, but they also had the stamp of approval of some pretty well-heeled investors before they did.

Feroldi: Warren Buffett. Warren Buffett got into this company at the IPO. And I believe the other big name was Marc Benioff, the founder and CEO of Salesforce made a big purchase of this company. I mean, Warren Buffett, and it might not have been him, it might have been one of his lieutenants, but nonetheless, they bought Snowflake stock at the IPO price of $120, and that was at a valuation of 70 times sales. That was the IPO price. Now, Dylan, it didn't exactly stay at 70 times sales, did it?

Lewis: No, it did not; [laughs] went up in the $300s at some point. I think it's down to the low-$200s now, but still a very [laughs] rich multiple even now, it's over 100 times trailing sales, which is pricey. And there are a couple of different ways you can look at this, Brian. You can say, well, the folks that got those early shares from the investment bank must be pretty happy. You can also make the argument the company probably left some cash on the table.

Feroldi: I think so. I mean, clearly, when the stock hit the public markets, I think it came at, like, $260 or $270, that was the first price that outside investors who weren't able to participate in the IPO got in. So, more than double the price that Warren Buffett bought in at the IPO. And that really takes money away from the company. That is money that should have gone to the company but went to people that bought in the IPO. So, that's something that we've seen time and time again with new IPOs, especially this year.

Lewis: Yeah. And I saw Frank Slootman, the CEO of Snowflake, had some comments about this. Because this is a question that came up a ton. You know, when you see a pop like this, you're like, boy! there seems like a pretty big gap there, what do you make of that? And his point was basically, you're selling shares to big institutions, they are making large commitments. It's not like you and I who can put maybe a couple of thousand bucks behind something, and there's a point where they stop being comfortable. And they were trying to stick within that comfort zone for pricing. There are a lot of critics of the IPO process that feel like it is a way to enrich some high net worth individuals that investment banks have as clients and make sure that they are happy. I think the truth is probably somewhere in the middle there.

There was definitely some room for them to up the ante on this. There was, kind of, a perfect storm of excitement with this company, right? SaaS business, really impressive financials, and then you have Warren Buffett hopping into tech, which is like the friend who never goes out, [laughs] you know, deciding that they're going to join you guys at the bar. And so, when you have all that coming, there's going to be a lot of excitement, you're going to see some crazy price movements.

Feroldi: You can even call it a perfect blizzard of excitement, Dylan.

Lewis: [laughs] Oh, boy! I hope the audience just groaned, Brian. [laughs] So, does anything about what we saw with Snowflake in the first couple of days of it being out in the public markets change your outlook on it, Brian?

Feroldi: It doesn't change my outlook on the business. I think both of us came away extremely impressed with the business, but the company was setting fire to capital extremely rapidly. So, if I was forced to choose between JFrog and Snowflake, I'm going with JFrog. Its valuation is high, but more reasonable. It's also already reached profitability and generating free cash flow. So, to me, the big story on Wednesday was, hey, JFrog goes public; not Snowflake. [laughs]

Lewis: [laughs] That's a good perspective to have, you know, nice to challenge the conventional wisdom there, nice to maybe find another narrative. And I'm always happy to have you on to do that, Brian.

Feroldi: Oh, always great to be here. Love going through newly public companies. So fun.

Lewis: So fun. And I think we're going to have more. I don't think this is the end in 2020, I think we're going to have a couple more businesses come out, and when they do, we'll be doing little rundowns through their prospectus.

Feroldi: Given these valuations, it's a great time to IPO if you have anything to do with SaaS.

Lewis: [laughs] Listeners, we're going to end things there. That does it for this episode of Industry Focus. If you have any questions or you want to reach out and say "Hey!" shoot us an email at [email protected] or tweet us @MFIndustryFocus. If you're looking for more stuff, subscribe on iTunes or wherever you get your podcasts.

As always, people on the program may own companies discussed on the show, The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear.

Thanks to Tim Sparks for all his work behind the glass today, and thank you for listening. Until next time, Fool on!