It’s not difficult to see why investors have bid up JFrog (NASDAQ:FROG) stock. Software has been one of the hotter — and best-performing — sectors in the market for years now. And JFrog offers one of software’s most intriguing stories.
But the buying since last month’s initial public offering has been frenzied. FROG stock went public at $44. It’s now at $84. Even by the standards of a still-hot IPO market, that’s a huge pop.
So at this point, FROG stock looks like a name for traders, not investors. The initial buying enthusiasm is fading somewhat, with modest declines in each of the last two trading sessions. Valuation is a question mark after the run-up.
Over the long-term, JFrog certainly has a chance to be yet another big winner in software. But there’s likely to be some volatility along the way. At this point, investors simply don’t need to rush: there seems a good chance that a better price will be an offer at some point before FROG stock takes off again.
The JFrog Story
JFrog provides DevOps (developers and operations) tools to software companies worldwide. Those tools allow customers to deliver software updates anywhere in the world, at any time, across any system.
In an industry that increasingly has moved to the cloud, the appeal of the product is almost self-evident. Long gone are the days when software users had to be prompted to (or remember to) update products hosted on local disks. Cloud-based platforms do that work themselves. But as a result, they require continuous updates to ensure security, fix bugs, and add new features.
JFrog’s tools make that process run far more smoothly. It connects developers (who write the code) and operations staff (who deploy the software and steer the overall direction). Releases and updates can be tracked from start to finish. And JFrog can run in the cloud, on-premise, or via a hybrid solution (a combination of the two).
From an investment standpoint, FROG stock thus is a “picks and shovels” play on software growth, and particularly cloud software growth. As the old saw goes, during a gold rush it’s not the gold miners who consistently strike it rich. The real winners are those who sell them the tools to do the mining.
JFrog is selling tools that are integral in providing a cloud platform. Cloud software is as close to a gold rush as the modern world gets, which is why investors are so bullish on FROG stock in the early going.
The Risks to FROG Stock
Of course, as early trading in FROG stock shows, investors are well aware of that story and how attractive it can be. And with the 90%-plus gains off the IPO price, valuation is becoming a question mark.
In the first six months of 2020, JFrog generated about $69 million in revenue. That’s about $140 million annualized.
Meanwhile, JFrog now has a market capitalization now over $7 billion. That in turn is more than 50x annualized revenue at the moment.
Obviously, that’s a huge multiple. That alone isn’t a problem. Growth stocks right now aren’t cheap, because growth stocks right now shouldn’t be cheap. There are a number of megatrends developing that will drive enormous growth in a number of industries. Software is one of those industries.
But for FROG stock, the multiple is a bit more concerning. This is a company that grew first-half revenue at a 50% clip. That’s impressive, but there are stocks elsewhere in the market with faster growth rates that trade at lower multiples to sales.
I’d consider it this way. Some value investors are fond of a metric known as ‘PEG’, or the ratio of the PE (price to earnings) multiple to its profit growth. A PEG multiple under 1x generally is seen as attractive: if an investor can pay 25x earnings for a stock growing those earnings 26%, they should be getting a good deal.
JFrog stock, however, has a higher PS (price to sales) multiple than its sales growth rate. To coin a term, its ‘PSG’ is above 1x. I’d wager there’s not a value investor in the world who sees that as attractive. At this point, many growth investors might agree.
No Need to Rush
Again, there’s a highly attractive story underpinning FROG stock. 50% growth is nothing to sneeze at. The market opportunity is big and getting bigger every month.
But at this point in the post-IPO process, some volatility is to be expected. Lock-up restrictions will begin to expire, and traders will start positioning ahead of those events. Profit-taking wouldn’t be a surprise, even from some of the larger institutional investors that were able to get IPO allocations.
The story here is good, but it’s not quite good enough to keep FROG stock moving up and to the right forever. Already, we’re seeing a bit of fatigue at the moment. A pullback wouldn’t be a shock — and it’s then that long-term-focused investors should pounce.
On the date of publication, neither Matt McCall nor the InvestorPlace Research Staff member primarily responsible for this article held (either directly or indirectly) any positions in the securities mentioned in the article.
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