I Just Added Unity Software to My Stock Watch List. Here’s Why

Shares of Unity Software (NYSE:U), a leading platform to create and monetize interactive games, have more than doubled after the company went public at $68.88 per share. While optimism surrounding tech stocks has definitely helped, investors are also clearly excited about Unity’s prospects.

I took a deep dive into the company to learn more about its business. Here’s what I found.

How Unity makes money

Unity Software offers a set of software solutions that allow creators, mainly game developers, “to create, run, and monetize interactive, real-time 2D and 3D content for mobile phones, tablets, PCs, consoles, and augmented and virtual reality devices,” according to the company’s promotional materials.

Image source: Getty Images.

There are three parts to its income, categorized under Create Solutions, Operate Solutions, and Strategic Partnerships and Others. The segments account for 54%, 31%, and 15%, respectively, of Unity’s 2019 revenue.

While most of its revenue is from the Operate business, Unity’s main attraction is its popular game engine — a set of software tools — that helps developers create 2D, 3D, and augmented reality (AR) video games like Pokemon Go. Using Unity’s pre-built game engine, developers can focus on designing the game itself, instead of the technology behind the game.

Sales of Create Solutions leads to sales of Operate Solutions, services that help developers host games, grow their user base, and monetize content. For example, the Unity Ads network helps developers generate revenue by displaying in-game ads or promoting their games to attract more players. In 2019, 63% of Operate Solutions’ revenue came from customers using Create Solutions. 

Unity has a highly sticky business model

To build an immersive game, developers have to rely on the latest game engine. Traditionally, game studios have spent millions to develop their own game engines, and the large capital requirement served as a huge barrier for any new company to join the gaming industry.

However, with Unity and Epic Games offering their game engines as software as a service (SaaS), developers can now build their games at a low cost. And here’s where Unity’s strength lies. In 2019, over 50% of all mobile, PC, and console games — including hits like Call of Duty: Mobile — ran on Unity. The remaining half mainly ran on privately owned Epic Games’ Unreal Engine.

Because it is expensive and difficult to build a good game engine — Unity has invested over $450 million to improve its services — most developers have few options beyond Unity and Unreal Engine.

Moreover, once developers choose an engine, it is almost impossible to switch throughout the game development lifecycle, which can last for years. The cost and potential disruption from changing game engines is just too high.

Hence, it is not surprising that Unity has a recurring and growing income base. For perspective, revenue grew 52% and 39% in 2019 and the first half of 2020, respectively. Similarly, its net retention rate — a metric used to measure growth from existing customers — reached 142% in June 2020, up from 133% in December 2019 and 124% in December 2018.

Unity has plenty of growth opportunity

While it has grown rapidly over recent years, Unity has only touched the tip of the iceberg.

According to its prospectus, the addressable market for its software is about $29 billion — $12 billion for gaming and $17 billion for non-gaming industries. Unity’s $351 million in revenue for the first half of 2020 represents less than 3% of its addressable market, which suggests ample room for growth within existing markets.

Beyond that, there could be new opportunities multiple times larger than what it’s tapping now. For example, Unity could develop new software and tools to help game developers design and operate futuristic games.

It also views augmented reality (AR) and virtual reality (VR) as a key growth opportunity, and has partnered with companies like Microsoft and Sony to build VR experiences for Microsoft’s HoloLens and Sony’s Playstation VR.

Similarly, it could develop software and tools for industries beyond gaming, such as automotive, manufacturing, and others. Though it’s too early to say whether Unity’s offerings will be a credible alternative to industry-standard software, just 8% of Unity’s existing client base is in non-gaming industries, representing massive room for growth.

Why investors shouldn’t buy the stock now

After a 117% rally post-IPO, Unity trades at a ridiculously high price-to-sales ratio of 75 (based on 2019 revenue). The company is also unprofitable, which might remain the case as it pours cash into research and development and sales efforts. To err on the safe side, investors should wait for any potential dips in the stock price before initiating a position.