Is It Too Late to Buy Unity Software Stock?

Unity Software's (U -1.22%) stock price soared to an all-time high after the software development company posted its third-quarter earnings on Nov. 10.

Its revenue rose 43% year over year to $286.3 million, beating estimates by nearly $20 million. Its adjusted net loss widened from $13 million to $14.8 million, or $0.06 per share, which also topped expectations by a penny per share.

Unity now expects its revenue to rise 40% for the full year, compared to its previous guidance for 35% to 37% growth. It also announced its plans to buy Weta Digital, the visual effects studio which was co-founded by The Lord of the Rings director Peter Jackson, for $1.63 billion in cash and stock. It expects the deal to close in the fourth quarter.

Unity's growth is impressive, but its stock already trades at nearly 50 times this year's sales. Is it too late to invest in Unity at these valuations?

Image source: Getty Images.

What does Unity do?

In the past, game developers built most of their rendering, animation, lighting, physics, sound, and user interfaces from scratch. Those features needed to be rewritten for different gaming platforms like PCs and consoles.

Unity's game engine, which was initially launched in 2004, simplified that costly and time-consuming process by bundling all those tools into a cross-platform software suite. Developers can create an entire game once within Unity's engine, and it can seamlessly run across multiple gaming platforms.

Today, more than half of the world's PC, console, and mobile games are built with Unity's game engine, and it now provides additional tools for integrating ads, in-app purchases, multiplayer support, communication services, and analytics tools into games. It also gradually expanded beyond its core gaming market with 2D and 3D applications for non-gaming markets.

How fast is Unity growing?

Unity's revenue rose 42% in 2019, grew 43% in 2020, and is on track for 40% growth this year. Analysts expect its revenue to rise 28% in 2022.

Unity operates three main businesses: Its Create Solutions segment, which hosts its subscription-based game engine and development tools for non-gaming markets; its Operate Solutions segment, which provides its add-on services with usage-based and revenue-sharing plans; and its Strategic Partnerships and Other segment, which generates revenue from its partnerships with hardware and software makers. All three businesses grew their revenues year over year throughout the first nine months of 2021:

Source: Unity. YOY = Year over year.

The robust growth of its Operate Solutions segment is particularly encouraging since its add-on services enable Unity to boost its revenue per existing customer as well as improve the stickiness of its ecosystem.

That's why Unity's dollar-based net expansion rate (DBNER), which gauges its year-over-year growth in revenue from existing customers over the previous 12 months, continuously rose over the past three years:

Source: Unity.

Unity's ability to consistently generate more than 40% revenue growth as it increases its DBNER is extremely rare for a high-growth company. Many other companies that use that metric -- including the cloud-based communication services provider Twilio -- have posted a declining DBNER as they rely more heavily on acquisitions for consistent revenue growth.

Unity ended 2020 with a negative adjusted operating margin of 7%, and it remains deeply unprofitable on a generally accepted accounting principles (GAAP) basis. However, it expects its adjusted operating margin to improve to negative 5% to 6% this year, even after it acquires Weta Digital.

Unity won't turn profitable anytime soon, but it has plenty of pricing power, and its adjusted losses should stabilize as economies of scale kick in. It also won't run out of cash anytime soon: It ended last quarter with $1.28 billion in cash, cash equivalents, and marketable securities, and its low debt-to-equity ratio of 0.4 gives it plenty of room to take on more debt for additional investments.

But is it too late to buy Unity?

Unity's valuation is high, but I don't think it's too late to buy the stock for three simple reasons:

1. It's an established market leader.
2. Its ecosystem is sticky.
3. It's growing faster than the gaming market.

The global gaming market could grow at a compound annual growth rate of 12.9% between 2020 and 2027, according to Grand View Research. If Unity simply matches that growth rate, its annual revenue could increase from $772 million in 2020 to about $1.8 billion in 2027.

But if Unity can maintain an average annual growth rate of at least 30% from 2021 to 2027, its revenue could top $5.2 billion by the final year. So even if Unity's price-to-sales ratio cools off from 50 to 20, the company could be worth well over $100 billion -- about twice its current value -- by 2027.

Therefore, if you believe Unity will continue to grow faster than the global gaming market as it expands its add-on services and non-gaming tools, then it's definitely not too late to buy this high-growth stock.