Unity Software (U -2.31%) was one of the most successful tech IPOs of 2020. The gaming engine company priced its initial public offering at $52 a share last September, the stock opened at $75 on the first day, and it's now trading above $120. Is Unity's stock worth buying after those big post-IPO gains?
Let's examine three reasons to buy Unity -- as well as one reason to sell it -- and see if we can find an answer.
1. It's essential to the gaming industry
In the early 2000s, most game developers built their graphical rendering, animation, lighting, physics, sound, and user interfaces from scratch. Those features also needed to be coded separately for different gaming platforms, which was an error-prone, expensive, and time-consuming process.
Image source: Getty Images.
Unity's game development engine, which was initially launched in 2004, resolved those problems by bundling together all those features into a software suite that ran across multiple gaming platforms. As a result, developers could use Unity to easily create cross-platform games.
Today, more than half of all the PC, console, and mobile games in the world are built with Unity. Unity faces some competition from Epic Games' Unreal Engine and in-house game engines at major publishers, but its early-mover's advantage has made it a linchpin of the global gaming industry.
That position ensures Unity will grow alongside the global gaming market, which Grand View Research expects to grow at compound annual growth rate (CAGR) of 12.9% from 2020 to 2027. If Unity merely matches that growth rate, its annual revenue could rise from $772 million in 2020 to over $1.8 billion in 2027.
2. It's outpacing the growth of the gaming market
However, Unity has actually been growing faster than the global gaming market. Its revenue rose 42% in 2019 and 43% in 2020, and it anticipates 35%-37% growth this year.
Unity is outpacing the market because it's generating more revenue per existing customer by expanding its total addressable market while cross-selling additional services.
Unity's Create Solutions business hosts its core game engine, but it also provides 2D and 3D tools for non-gaming applications. Its Operate Solutions business provides tools for integrating in-app ads, in-app purchases, and in-game communication tools, as well as support for multiplayer games and analytics services.
Unity's expansion of its Operate Solutions segment enabled it to achieve a dollar-based net expansion rate (which gauges its year-over-year growth in revenue from existing customers over a 12-month period) of 138% in 2020, compared to 133% in 2019 and 124% in 2018. So long as that ratio remains above 100%, Unity should continue growing faster than the global gaming market.
3. Non-GAAP losses are narrowing
Unity's non-GAAP net loss narrowed from $113 million in 2019 to $66 million, or $0.39 per share, in 2020. Analysts expect it to narrow its loss again to $0.25 per share this year.
Unity's losses are narrowing because its margins are improving. Its non-GAAP gross margin held steady year over year at 79% in 2020, while its non-GAAP operating margin rose from negative 17% to negative 7%. It expects to post a negative non-GAAP operating margin of 5%-6% this year.
During last quarter's conference call, CFO Luis Visoso reiterated Unity's goal of achieving non-GAAP profitability by 2023, but noted it would still "invest to extend our technological lead and reach more customers."
The one reason to sell Unity: Its valuation
Unity has an early-mover's advantage in a high-growth market, its ecosystem is sticky, its fundamentals are improving, and it has clear plans for the future. However, Unity's stock trades at over 30 times this year's sales -- which indicates a lot of those strengths are already baked into its price.
Unity faces several near-term headwinds, including a post-pandemic slowdown in the gaming market, a potential crackdown on video games in China, and challenges for in-app ads as Apple (AAPL -1.22%) tightens its privacy standards on iOS devices. If those challenges cause Unity to miss its own growth targets -- even by a small margin -- its stock price could crash.
Do Unity's strengths outweigh its weaknesses?
Unity's stock is expensive, but its strengths justify that premium. Its platform remains essential for game developers that want to quickly develop cross-platform games, its sticky ecosystem is expanding, and it has plenty of long-term growth opportunities in the augmented and virtual reality markets.
Unity's margins are stable, and its profit forecast for 2023 suggests its revenue will continue to rise faster than its expenses. Therefore, Unity remains a solid long-term investment -- and it could generate hefty gains for investors who ride out the near-term volatility.
