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Here's Why JFrog's Stock Could Still Be Too Hot to Handle

JFrog's (NASDAQ: FROG) stock recently dipped after the software company posted its first quarterly report since its IPO in September.

Its revenue rose 40% year over year to $38.9 million in the third quarter, beating estimates by $1 million. Its adjusted net income surged 98% to $5.3 million, or $0.05 per share, clearing estimates by a nickel.

JFrog expects its revenue to rise 42%-43% for the full year, marking a slowdown from its 65% growth last year but beating expectations for 41% growth. On the bottom line, it expects to post an adjusted profit of $0.11-$0.13 per share, well above expectations of $0.07 per share.

JFrog's headline numbers were impressive, but its stock could still be too hot to handle for a few simple reasons.

Image source: Getty Images.

What does JFrog do?

JFrog's core product, Artifactory, stores software updates on a universal repository that can be accessed by multiple computing platforms.

Large companies usually install a wide range of software across different computing architectures like microservices, containers, and hybrid and multi-cloud environments. Manually updating that software across all those systems can be tedious, time-consuming, and prone to human error.

To streamline that process and break down the silos across an organization, Artifactory automates the process with its continuous software release management (CSRM) "Liquid Software" system.

JFrog's approach is disruptive, but about 75% of the Fortune 500 companies -- including most of the top technology, financial, retail, healthcare, and telecom companies -- already use its services.

Decelerating growth in a maturing market

That saturation indicates JFrog's total addressable market is gradually shrinking. But for now, JFrog's customer growth remains robust.

Image source: Getty Images.

Its number of customers generating over $100,000 in annual recurring revenue (ARR) rose from 234 at the end of 2019 to 313 at the end of September. It ended the third quarter with nine customers with at least $1 million in ARR, up from seven at the end of 2019.

Its trailing 12-month net retention rate stayed high at 136%, but it dipped from 139% at the end of the second quarter and 142% at the end of 2019. JFrog management blamed that slowdown on COVID-19, which curbed the company's ability to upsell new services to its existing customers.

JFrog expects its revenue growth to decelerate for the full year, while analysts anticipate 31% growth next year. That gradual deceleration, which can't simply be pinned on the pandemic, suggests JFrog's core market is maturing.

Tougher competition and widening losses

As this market matures, JFrog could face tougher competition from IBM's (NYSE: IBM) Red Hat, Amazon (NASDAQ: AMZN) Web Services (AWS), Microsoft's (NASDAQ: MSFT) Azure DevOps with GitHub, and Alphabet's (NASDAQ: GOOG) (NASDAQ: GOOGL) Google Cloud Platform -- all of which offer similar ways to break down silos and seamlessly update software.

Artifactory is compatible with all those cloud-based services, but those tech giants could use aggressive bundling strategies to pull customers away from JFrog. In its prospectus, the company admits those tech giants could leverage their other "resources to gain business in a manner that discourages customers from purchasing our offerings."

JFrog isn't profitable on a GAAP basis, and its GAAP net loss widened year-over-year from $3.1 million to $5.3 million in the third quarter as it relied heavily on stock-based compensation. JFrog still has $324.3 million in cash and equivalents thanks to its recent IPO, but it could gradually burn through that cash as the competition intensifies.

The right company at the wrong price

JFrog enjoys an early-mover's advantage in the universal repository space, but its valuation is too high. At $60 a share, the stock is already valued at 36 times this year's sales and about 500 times this year's adjusted earnings.

By comparison, Amazon's revenue and earnings are expected to rise 35% and 51%, respectively, this year. But its stock only trades at four times this year's sales and 87 times this year's earnings.

Therefore, it's tough to justify paying such a high premium for JFrog as its growth decelerates, its GAAP losses widen, and it faces a growing list of massive competitors. In short, JFrog is a good company trading at the wrong price -- and I'd only consider buying some shares if the market crashes.

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