Unity (Ticker – $U) has been a stock that has caught the attention of many people on Twitter. Just like most of the popular growth stocks, Unity has taken a beating the past month or so. Unity went public in September 2020 and rode the wave of hot growth-focused tech stocks reaching a 52 week high at $174.94 in late December. They currently have a $26.5 billion market cap and trade for about $95 a share. Right now, they are currently down about 45% from their all-time high, catching my attention as a potential investment.
What Does The Business Do?
Coming from their 10-k, “Unity is the world’s leading platform for creating and operating interactive, real-time 3D content. We believe the world is a better place with more creators in it. Creators, ranging from game developers to artists, architects, automotive designers, filmmakers, and others, use Unity to make their imaginations come to life.”
So what does this actually mean and look like? Unity develops the software that creators use to create and execute their designs. A large percentage of the customers using their software are game developers, but specifically mobile game developers. In 2020, 71% of the top 1,000 mobile games were made by using Unity. Even though Unity is known for helping game developers, their software can also be used to create films and help in the construction industry. They allow their customers to create 2D and 3D models to be used at their discretion.
Unity prides themselves in their software’s interactive 3D real-time rendering capabilities, “creators can live-edit the characteristics of objects in games and applications they design, and these changes can be rendered and displayed faster than the blink of an eye. This instantaneous adaptation allows for creators to simultaneously create and visualize, simplifying the creative process and making collaborative content development more seamless and efficient.”
Another positive about their software is that they are agnostic to the end users platform. Users of Unity have the ability to publish their games and contents across “20 platforms, including Windows, Mac, iOS, Android, PlayStation, Xbox, Nintendo Switch, and the leading augmented and virtual reality platforms, among others.”
The actual software looks a lot like Photoshop. There are a ton of great examples of some of the games and creations that have been born out of Unity. Games such as Fall Guys and Cuphead were developed in Unity. I think this clip from the 2021 Game Developer Conference gives a good idea of how the software works.
How Do They Make Money?
Unity breaks out their revenue into 3 distinct categories – Create Solutions, Operate Solutions, and Strategic Partners & Other.
- Create Solutions – This is the subscription revenue they get for selling access to their different software products. These are the licenses that people pay for to do their work across the different versions of software that Unity sells. There is also additional revenue from associated services with their main products, such as “consulting, integration, training and custom application and workflow development.”
- Operate Solutions – This is revenue that gives “customers the ability to grow and engage their end-users, and to run and monetize their content, optimizing end-user acquisition and operational costs while increasing the lifetime value of their end-users.” Do you know when you are playing a mobile game and you see advertisements for another game or product? Unity is taking a cut of that money. They help enable the sale of ads in the games that are developed on their platform. They also sell machine learning based programs to game developers so they can have better analytics on how to keep people playing their games. There is a high churn rate in mobile games and it’s crucial for game developers to capture an audience that will continuously come back to their game instead of uninstalling after playing one time.
- Strategic Partnerships & Other – Unity has formed relationships with other companies where they recognize revenues from sales of other goods. This is “primarily arrangements with strategic hardware, operating system, device, game console, and other technology providers for the customization and development of our software to enable interoperability with these platforms.” For example, Unity has a strategic partnership with Oculus for development.
Before I started to dig into different documents, I thought most of the revenue from Unity would come from their “Create Solutions” segment. I thought they made money off of their software and that was it, but the Operate Solutions line of business accounts for more than 60% of their revenue in 2020. This was up from 54% of total revenue in 2019. Unity is a growth story and can be seen through their revenue growth of 43% overall from 2019 to 2020. They also had more than 40% of revenue growth from 2018 to 2019.
Despite the great growth in their revenue, Unity is not profitable, but they have shown signs that they are moving in the correct direction. We can see that its revenue has increased year over year, so has its operating expenses, specifically around research and development. This doesn’t scare me away because, for a company operating in the software space, they need to be on the cutting edge for the products and technology they are offering their customers. Eventually, they will need to slow down growth mode and produce cash for their shareholders, but they are not there yet.
Another thing to look at is how the different expenses track year over year as a proportion of revenue. It can be easy to get lost with absolute numbers, especially when a company is growing rapidly. Year over year, there isn’t necessarily one line item that jumps out to me.
The step in the right direction for Unity is that they had a positive value from their cash flow from operating activities. In previous years, they lost $81M in 2018 and $67M in 2019, but they made $19M in 2020. Despite this positive news, they were still not free cash flow positive. They also said in their 10-k, “The year-over-year increase in free cash flow was primarily due to strong performance within our Operate Solutions, as well as savings in operational expenses due to COVID-19. We expect our free cash flow to remain volatile from quarter to quarter and likely to decline in 2021.” It’s always great to have additional commentary from leadership then just trying to draw your own conclusion from just looking at the data.
Valuation Compared To Peers?
As previously mentioned, the stock has taken a fairly large hit over the past few months, pulling down the valuation into a more reasonable range. The current Price to Sales ratio for Unity is about 27, when it was over 60 at the all-time high. Compared to other popular SaaS companies, we can see that all valuations have come down – Okta: 32.35, DataDog: 42.09, Zendesk: 14.62, CrowdStrike: 44.24.
Another key figure to look at is the growth in revenue. Unity had over 40% revenue growth and their similar stocks compare as such: Okta: 40.30%, DataDog: 56.20%, Zendesk: 23.30%, CrowdStrike: 74.20%.
It would be nice to look at common multiples such as EPS and PE, but a company needs to earn money before those can be in play.
Summary
My biggest takeaway from research on Unity was how much of their growth is driven by the Operate Solutions segment. They initially sell their software through their Create Solutions segment, but their real growth is by having the games being created on their platform be successful. They want the games to succeed so they can take a piece of the advertising revenue and sell additional solutions to game developers on how to keep users on their platform.
I love subscription-based businesses with how predictable their revenue is for the future. More and more companies are shifting to this operating model. There are other competitors to Unity, but the goal is to continue to expand out their product capabilities and then take a piece of the pie with the games created on their platform. Just like how there are competitors out there to Photoshop, Photoshop is a hard juggernaut to topple. I’m not ready to hit the buy button on Unity yet, but if they can continue to scale their Operate Solutions business, then I think they will do very well in the future. I really do enjoy how scalable this business can be with what is developed on their platform.