Years ago, it was obvious when something was animated in a movie or video game. Now, it can be difficult to distinguish between what is real and what has been created using state-of-the-art animation software. One company providing creators with this amazing capability is Unity Software (U 3.47%).
Not only is Unity involved in cinematics, but it also has a video-game development platform, engineering uses, and augmented reality (AR) and virtual reality (VR) solutions. Because of the company's focus on 3D animation, the stock has made its way onto multiple metaverse-themed investment lists. With so many uses, could Unity Software be a decade-defining stock?
Image source: Getty Images.
A key metric is accelerating
While Unity is becoming more known for its applications in multiple industries, its gaming segment brings in the bulk of the revenue. Its operate solutions revenue was $195 million during the fourth quarter, making up 62% of total revenue. This segment focuses on monetizing games created with its platform.
Content creators have multiple tools to monetize and understand their user base. Armed with these insights, studios can lengthen a game's life span as well as create fewer failures. This segment is well established, yet still grew at a 44% year-over-year clip during the fourth quarter.
The segment many investors have their eye on is the create solutions division. Within its domain are its industry-specific tool kit -- like the ability to create an AR or VR space from building information models (BIM) -- as well as metaverse aspirations.
Although Unity is still a solid company without this segment, the growth prospects are more exciting than the operate solutions component. In the fourth quarter, the division's revenue increased year over year by 49%, an acceleration from previous quarters.
| YOY Create Solutions Revenue Growth | ||
|---|---|---|
| Q4 2021 | Q3 2021 | Q2 2021 |
| 49% | 34% | 31% |
Source: Unity Software. YOY = year over year.
With Unity's most important segment growing at a quicker pace, investors should be excited. As more companies adopt the company's solutions, they will have an edge over their competition. Providing customers with realistic digital representations is a game-changer for clients, and those who fall behind in the technological arms race will either be a late adapter or be known as a technology-poor business -- a stigma potential customers want to avoid.
Unity Software is becoming the industry standard in many fields, and investors should take notice.
Metaverse aspirations
CEO John Riccitiello said during Unity's conference call that the use of real-time 3D interactive technology is going to expand many times over. The real-time 3D technology he speaks about is what many people call the metaverse, and his company's products give artists and creators the tools they need to design in the 3D space. And Riccitiello said most NFT (non-fungible token) games have been built using Unity's platform and are maintained by the company.
Estimates of the metaverse market opportunity are all over the place, with Morgan Stanley claiming it could be worth $8 trillion in China alone. Regardless, Unity won't be directly involved in the virtual land grab within the metaverse. Instead, it will be powering the games and visuals inside of it, making the stock a lower-risk way to play the metaverse rather than companies that are going all in.
Still, chief financial officer Luis Visoso believes Unity Software can grow its revenue by 30% or more for the long term. Sustained growth like this can create incredible returns for investors if they hold on to the stock. Should the company fulfill this promise, its revenue could be substantial by the end of the decade.
| Annual Revenue With 30% Annual Growth | ||
|---|---|---|
| 2021 (Current) | 2024 (3 Years) | 2026 (5 Years) |
| $1.1 billion | $2.4 billion | $4.1 billion |
Source: Unity Software
Looking at future revenue doesn't provide a clear picture of how it affects the stock price, but applying different price-to-sales (P/S) multiples gives investors an idea of the returns sustained 30% revenue growth generates. To calculate the potential return, multiply the annual revenue by the P/S ratio to get the market cap, then divide the market cap by shares outstanding to get the future price per share. That value can be compared with the current stock price to calculate the return potential.
| Unity Software Stock Potential Five-Year Return | ||||
|---|---|---|---|---|
| P/S Ratio | 2026 Market Cap | 2026 Stock Price | Return | Annual Return |
| 15 | $61.2 Billion | $209.17 | 84% | 13% |
| 20 | $81.6 Billion | $278.89 | 146% | 19% |
| 28 (Current) | $114.2 Billion | $390.31 | 244% | 28% |
Source: Unity Software.
Even if Unity Software's valuation is cut in half, the stock would generate around 13% annual returns, which beats the long-term market average. It may have a high valuation, but long-term sustained growth wipes out valuation concerns over time.
One flaw with this calculation is the assumption of a constant share count, something Unity has not maintained. Last year, it grew share count at a 66% clip, and this year management projects a 24% increase. Either percentage is far above average when compared to other fast-growing tech companies, and this can be seen as a large investment risk. As the company grows, the stock-based compensation bill won't increase at the same rate. Eventually, it will become a smaller part of operating expenses, but it could be a while before that occurs.
Still, I think Unity has a huge market opportunity ahead. Investors should feel confident in purchasing shares with the price down more than 40% from its high, despite reporting nothing but good news during the fourth quarter. Unity Software is building the future; growth investors with a long-term horizon should find a place for it in their portfolios.
