Investors usually call a stock "undervalued" when its market cap is less than the cash it is generating now plus the cash it will generate in future years discounted back to the present. It is a fairly simple formula, but can cause a lot of headaches, because the future is unknowable. Using this definition, it doesn't matter whether a stock is considered to be in the "value" bucket or "growth" bucket. All that matters is what price you pay versus the future cash it will generate.
Under this classification, high-growth stocks can be considered undervalued if you have a long enough time horizon. Is Unity Software (U 2.09%), a popular growth stock among investors, undervalued right now? Let's take a look.
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What is Unity?
Unity is a platform that helps other companies and developers build and operate real-time 3D experiences. Its main business line is powering and monetizing video games, but it also serves the industrial, animation, architectural, and engineering industries. The non-gaming portion of the business could be meaningful sometime in the future, but for this article, we're just going to focus on gaming.
The gaming division can be categorized into two segments: Create and Operate. The Create Solution segment is a game engine that helps developers build and scale a game more easily. These include tools like cloud coding (which allows you to update in real time), in-game voice chat, multiplayer games, and matchmaking. Essentially, game studios pay to use Unity's services to get their games to the next level faster and with fewer employees. The Operate Solutions tools help game studios make money on their games. These include in-app purchases, advertising, and acquiring users.
Current growth is solid
In November 2021, Unity reported its latest quarterly earnings results, covering the three months ending in September. Total revenue was $286.3 million in the period, up 43% year over year, which helped management raise their full-year 2021 guidance to over 40% growth and $1.08 billion in revenue.
In the quarter, Create Solutions did $83.7 million in revenue, growing 34% year over year, while Operate Solutions did $185 million in revenue, growing 54% year over year. Clearly, right now the most valuable part of this business is the Operate Solutions segment, as game studios come to Unity to help monetize their content.
Moving down the income statement, Unity is still unprofitable, with an operating loss of $126.8 million in Q3. However, it is actually cash flow positive, generating $34.2 million in free cash flow this quarter, or a 12% free cash flow margin. If this quarter is any indication, Unity is growing quickly and is well on its way to generating large amounts of free cash flow in the coming years.
Concerns with the addressable market
One concern I have with Unity is its addressable market. You might disagree with me, given that mobile games (Unity's core market) have over $20 billion in annual spending just in the U.S. that is expected to grow to $30 billion in 2025. However, when you look at the top-grossing mobile games on Alphabet's Google Play Store, none of them are utilizing Unity's Operate Solutions. This could mean that Unity just has a long runway to grow its monetization business, but I think it shows that big studios do not need Unity's tools to succeed.
Take-Two Interactive (with its acquisition of Zynga), Electronic Arts, and Activision Blizzard all have in-house monetization techniques for mobile games and likely will not need to turn to Unity to grow their businesses in the future. There's also Roblox, a rapidly growing competitor to Unity that helps studios build and monetize games on its in-house platform. The company is doing over $2 billion in annual bookings and growing almost as quickly as Unity.
With that being said, there is definitely a market for Unity to help build and monetize games for smaller studios like the team that built Among Us. Just don't expect it to power the entire gaming industry anytime soon.
So is Unity undervalued?
Unity is expecting to do between $1.08 billion to $1.085 billion in revenue in 2021. Its current market cap is $34 billion, giving it a price-to-sales ratio (P/S) of 31.5, or almost 10 times the market average. This means that investors are expecting Unity's revenue to grow much faster and with higher cash flow margins than the average public company over the next decade.
Can Unity beat these expectations? Maybe, if it continues to be successful powering and monetizing mobile games while also leaning into other verticals like animation, architecture, and industrials. But given the current premium P/S ratio, expectations are extremely high right now. For that reason, it is likely that Unity's stock is not currently undervalued, even though it is down 18% in the last month.
