Share prices for game development platform Unity Software (NYSE:U) are losing steam.
Since hitting a record $174.94 a share in December 2020 amid an epic rally in tech stocks, Unity has lost almost 30% of its market value. The stock is down more than 10% this year, underperforming the S&P 500.
But after the recent stock decline, is this company's stock still a buy? Let's explore further.
A leading platform in the gaming industry
Unity Software is an important player in the gaming industry that most investors haven't heard of.
It provides the software tools that help game developers build, run, and market world-class games. In 2019, over half of all mobile, PC, and console games -- including billion-dollar games like Angry Birds and Pokemon Go -- ran on the Unity platform.
Unity's core technology lies in its game engine, which is software that helps developers create exciting in-game experiences while powering the complex processes running in the background.
Being the market leader makes it easier for Unity to attract new developers since they would want to work with the most popular platform. Besides, most game developers don't have many viable development options to choose from, aside from the Unreal Engine (owned by game developer Epic Games).
Moreover, as game developers use Unity's platform, the company gains deep insights into their activities, which it uses to improve its software tools. By continuously improving its offerings, Unity attracts even more developers while staying ahead of its rivals.
Unity also benefits from having a highly sticky customer base. Studios tend to settle with one game engine at the onset of the development process and stick with it until launch day. Why? Because developing a game often takes years, and can cost up to hundreds of millions of dollars. Switching engines halfway could mean restarting the development process all over again.
Besides, game release cycles are getting longer. Studios have realized it's better to squeeze more bang out of money-printing hits instead of rolling out riskier new releases. So they're focusing more on creating updates and downloadable content (DLC) for already-popular titles, extending the revenue lifecycle. Thus, if these studios have used Unity's software to develop a particular game, they will likely keep the game's updates and DLC on Unity.
All this could explain Unity's high dollar-based net retention rate of 138% as of Dec. 31, 2020, up from 133% a year ago.
Unity's bigger opportunity lies beyond gaming
In 2020, Unity reported a 43% surge in revenue to $772 million as lockdowns supercharged video game demand. While that was an explosive growth rate, I think the best is yet to come.
For one, Unity's 2020 revenue represented just 6% of its estimated addressable market of $12 billion, giving it plenty of room to run.
But Unity has an even bigger opportunity beyond gaming. Its 3D augmented reality (AR) and virtual reality (VR) content creation tools have far-reaching applications in industries such as automotive, manufacturing, and architecture. Non-gaming markets represent a $17 billion opportunity today -- a figure that could rise as more use cases emerge. And as Unity expands its range of tools for creators across these industries, its total addressable market will only grow.
Capturing all this enormous upside does not come without costs. Unity's net losses more than doubled from $132 million in 2018 to $282 million in 2020, amid heavy ongoing investments in marketing and software development. For Unity to turn around its profitability, it needs to grow to the point that operating leverage kicks in. This will take some time. Luckily, Unity has stashed away almost $1.8 billion in cash and marketable securities. That's enough to last it for a few years, assuming the cash burn rate remains the same.
Game on, or press pause?
There are plenty of good reasons to like Unity. It has a commanding lead in its industry, a sticky revenue base, and a long growth runway.
This might explain why Unity trades at an extremely high valuation of around 45 times 2020 sales, even after the recent pullback. For perspective, gaming giant Tencent trades at a third of that multiple.
To me, that's a deal-breaker. I think investors will be better off waiting for a better entry point before making a move.
This article represents the opinion of the writer, who may disagree with the "official" recommendation position of a Motley Fool premium advisory service. We're motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.