Value Investing Analysis of Unity Software ($U)

Analysis of Unity Software ($U)
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Posted: 16 Oct 2020 05:44 PM PDT

Hi All,

This is my first time posting on this sub.

I did a deep-dive on Unity Software ($U) recently, which I believe is an interesting opportunity. Would love to know what you all think.

I have posted a summary version here. If you are interested in a more detailed version, you can find it here: https://knowyourstocks.substack.com/p/unity-u-creating-the-future

Unity Software ($U)

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What does it do?

Unity is a very cool company and an impressive business. It makes two types of products:

Create Solutions: 30% of revenue

Software which allows creators (artists, developers etc.) to develop many different types of content across platforms (Mobile, PC, incl. Virtual Reality). The company charges a monthly subscription fee for this solution, across various tiers. Smash hit Pokemon Go was built on Unity.

Operate Solutions: 61% of revenue

A wide variety of software and solutions that allow content / game creators to operate and monetize their games (e.g. analytics to optimize engagement, In-App Purchases). Unity charges a share of the revenue that content /game creators make or sometimes usage based fee. This is a healthy business model as it grows with the usage of any game / content using Unity operate solutions.

Key to note here is that customers can use Operate solutions even on content that was not created on Unity.

I like:

High gross margins (80%)
Large Gaming TAM ($12B, growing at 6%) and Non Gaming TAM ($17B)
Lot of room to grow in Non Gaming category
Accelerating revenue growth, but cost efficient
Asymmetric opportunity to benefit if VR becomes a dominant technology in future

I don't like:

Platform risk (dependency on Apple / Google)
Dynamic competition leading to pressure on free cash flows

One thing I really liked about Unity was their focus to grow their large customers (>$100k TTM revenue) from 389 to 716 in last 10 quarters. This results in a lot of sales efficiency.

Additionally, their dollar net expansion rate is 122-142% in the last 10 quarters (this means a customer who spent $100 last quarter, spend $122-$142 this quarter - a very positive sign). Unity's net expansion rates are in the upper quartile of all high growth SaaS companies.

One of the key risks I see with Unity is platform risk. As we saw with Epic games recently, Google and Apple control Unity's access to its customers and this poses platform risk for Unity. This is a serious issue and not unique to them, but they have to find a way around this. Their foray outside gaming should help to some extent.

Another key point is that they are in an industry where they have to constantly innovate and have dynamic competition. Their R&D cost grew by 40% YoY to $167M in H1, 2020 and now represent 47% of its revenue. This is quite high and a drain on cash flows. Unity has to continue to perform well on revenue growth, else cash flows can suffer a lot in future which will become a risk on stock price.

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Valuation

Unity had a spectacular IPO (no surprises) on Sept 18, and since then has gone on to reach a market cap of $22B (~$83.5 / share, ending Friday Oct 2, 2020), resulting in an EV / Sales (TTM) of 35.3. This valuation puts it in the category of other high growth SaaS companies like Docusign, Cloudflare who are also growing revenue upwards of 40%.

Overall I like Unity's leading position, and its future growth prospects. The valuations are quite rich as is with the sector in general. I would look for any decent drop as a good opportunity for opening new positions.

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If you continue to find this post useful, please let me know - I will share similar takes of other interesting growth stocks as well recent IPOs like Palantir, Amwell etc.

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I write about stocks in my weekly newsletter @knowyourstocks.substack.com

Disclaimer - This post is just meant for information purposes. Please do your own research before investing / trading

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