Unity Software: Interesting 3D Play, At A Price (NYSE:U)

September 22, 2020 By [email protected]_84 Off

Unity Software (U) has gone public in an offering well-received by the market. The market is still very friendly towards new technology IPO’s even after the general technology sector has seen a small setback in recent weeks alongside the wider market.

Investors have welcomed Unity as well as it operates in a specialized field, has wide adoption, shows strong growth and has a bright future. Nonetheless, paying >20 times sales for a company with growth <50% seems like a risky proposition to some extent, factoring in still reasonable losses, as I am particularly worried about competitive threats here.

A Play On 3D Content

Unity claims to be the leading platform for creation and operating both interactive and real-time 3D content. The platform includes 1.5 million active creators on a monthly basis, sees more than 3 billion downloads per month as many games are made with the software. Besides game developers, the platform is furthermore used by artists, architects, filmmakers and sees many other applications.

With the platform, creators can rather easily create engaging and better experiences than static content. Specific features include 3D shapes, depth, viewing angles and augmented reality. The great improvements in computing power makes that gaming, being a prime use case is showing rapid growth as it has allowed for the rise of customized development as well.

Originally founded in Denmark in 2004, the company has relocated and moved to San Francisco, looking to play a continued dominant role within the gaming industry as well as other adjacent industries in which the technology can be used. The company renders its platform and software and earns its money in three ways. For starters, it allows clients to create solutions, it furthermore allows them to run the solutions, and at last a smaller portion of revenues are generated from strategic partnerships.

IPO Thoughts & Valuation Discussions

Early September, the company aimed to sell 25 million shares in a range between $34 and $42 per share. Strong demand and pricing made that the company and underwriters priced the offering at $52 per share, as the company raised $1.3 billion in connection to the offering. From those levels, shares rose to $70 on their opening day.

The 263.4 million shares outstanding value the company at an impressive number of $13.7 billion at the offer price. Operating with $330 million in net cash ahead of the offering, I peg pro-forma net cash balances at more than $1.5 billion, thereby valuing operating assets at $12.2 billion.

The company had quite a revenue base of nearly $381 million in 2018. A significant R&D expense of $204 million, and other expenses, made that an operating loss of $130 million showed up on the bottom line. Revenues were up 42% to $542 million in 2019 as operating losses rose to $150 million, although coming down a bit on a relative basis.

The company has seen solid demand in the first half of this year with revenues up 39% to $351 million. Promising is that operating losses fell from $60 million to $52 million in the meantime. The good news is that second quarter revenues rose 42% to $184 million, running at a run rate close to three quarters of a billion while quarterly operating losses fell below the $25 million mark. So based on the most recent numbers, the company supports a 16 times annualized revenue multiple. This looks reasonable these days given the 40% growth rate as the company is seeing some leverage on the bottom line.

Of course this analysis is based on the IPO price. With shares having risen to $70, the equity valuation has increased to $18.4 billion which makes that operating assets are valued around $17 billion. At these levels, revenue multiples have expanded to around 22-23 times sales.

What Now?

I must say that I like the platform as it is quite unique and distinctive from other offerings these days. It is quite obvious given the current growth and the long-term outlook that better days might arrive for the company, yet the issue is that of heightened expectations, with shares trading at 22-23 times annualized sales.

So while the valuation itself seems to be the biggest risk, as the current loss rate can be financed for a decade with the IPO proceeds, my biggest risk seems to be that of a competitive threat. Unreal Engine, the platform developed by Epic Games has gained real traction as well with (game) developers using open source software quite intensely. Epic is a very strong competitor (in private hands) which furthermore is owner of Fortnite of course, set to report $5 billion in revenues this year and reportedly set to be solidly profitable.

This is actually a larger competitor and while the growth rates of Epic are not revealed, it seems that Unity is facing stiff competition from Epic, yet on the other hand game developers might find it a risk to use Epic’s software as well after it picked a battle with Apple (AAPL) over the fee charges in its app store.

So while the valuation is steep and the company is facing an intensive competitive battle, I do think that the technology is kind of special with the company operating in a niche segment not just related to games. Furthermore, I would not rule out M&A interest by a large technology company as well.

For now, I am not jumping on board with shares having doubled since the preliminary pricing process at the start of the month, yet do look forward to seeing what will happen going forward.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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