Coming off its IPO on Sept. 18 of last year, Unity Software (U -2.55%) had been one of the hottest stocks on the market. Shares were priced at $52 ahead of the company's public debut but reached as high as $170 over the last few months. But during the first six weeks of 2021, Unity's stock price has taken the rollercoaster back down, with shares backtracking 20% in value off recent highs.
With a large and growing market opportunity in Real-Time 3D (RT3D) content, is now the time to get this video game software development company's stock at a discount?
Business opportunities in early stages for Unity
Before looking at Unity on its own, we need to understand the market it is going after. The RT3D industry is the set of software tools (or engines, as they are also called) that developers use to render lifelike virtual content across different devices like smartphones, desktop computers, and gaming consoles. The prime use case is video game developers, which use Unity and other engines to make their games more realistic.
Image source: Getty Images.
Outside of gaming, the applications for RT3D content are wide-ranging, but still in the early stages. For example, automotive companies can use RT3D tools to build incredibly detailed renderings of concept cars, which can help save workers' development time but also save costs from a research and development perspective. Unity has partnered with Autodesk (ADSK -0.01%), the leader in software tools for the architecture, engineering, and construction industries, to bring better 3D visualization tools to its customers.
On the consumer side, RT3D content is slowly pushing into social products. For example, Unity has partnered with Snap (SNAP) to bring its advertising technology and creative tools to Snap developers. Snap is a leader in augmented reality (AR) integrations, so adding Unity's tools to its platform should help it make its AR content more and more realistic over time.
In its S-1 (the public document all companies are required to release pre-IPO), Unity estimates it has a total market opportunity of $29 billion. But it is not going after this alone. Companies like Epic Games (with its Unreal engine) compete with Unity for customers, so don't think it has this market opportunity all to itself.
Unity's financials are still firming up, valuation is expensive
Unity released its fourth-quarter and full-year financials earlier this month. Revenue grew 43% to $772 million for the year with an operating loss of $275 million. That operating loss may look steep, but Unity had multiple non-cash charges related to its public offering and stock donated to charity, which overstates the company's cash burn. In fact, Unity actually generated $20 million from operating activities in 2020.
Management guided for $970 million in revenue in 2021 at the high end, which would be 26% growth from 2020. While not locked in stone, this is lower than Unity's long-term sales growth target of 30% and was the likely reason why the stock sold off after the earnings announcement.
Unity is unprofitable at the moment, so we can really only look at the stock's price-to-sales (P/S) and price-to-gross-profit (P/GP) ratios when analyzing its valuation. With a market cap of $32 billion, Unity trades at a P/S north of 40. With gross margins of 77.7%, the company has a P/GP of around 53. Both these metrics are expensive when looking at the broad market and Unity's software peers.
The verdict on Unity
Unity is a fantastic business with a large market opportunity and a clear path to sales growth for years to come. But with the stock trading at 40 times sales, a lot of future growth is already priced in. If you are going to invest in Unity, you need to have confidence in its ability to grow its financials at a high rate for a long period of time. Can Unity do that? Possibly. But looking at the valuation, there might be better opportunities for investors at the moment.
