Can Unity evolve beyond its niche market position?

Equities 10 minutes to read

Peter Garnry

Head of Equity Strategy

Summary:  Unity is the world's leading gaming development platform with a 53% market share in mobile gaming in 2019 and high revenue growth rate around 40%. The company has already raised its IPO price range and will likely settle higher as we have just seen with Snowflake as the IPO market for technology stocks is red hot. The company will have a market value around $11.9bn if the shares are priced at $50 per share translating into a valuation multiple of 15.8x on price-to-sales which is in line with software companies in general when adjusting for growth and gross margin.


The US IPO market is red hot these days evident by the 112% jump beyond IPO price in Snowflake shares as described in our research note earlier today. The next IPO in the pipeline is Unity which is cross-platform game development engine. Just like Snowflake, Unity has raised its IPO price from $32-42 to $44-48 and we would not be surprised if the final IPO price is $50 or above when it is settled today. At $50 per share Unity would be valued at $11.9bn and raise $1.25bn in fresh capital excluding the overallotment option to the investment banks. The shares will start trading tomorrow on NYSE under the Saxo ticker code U:xnys.

It started with gaming, but can Unity evolve?

Unity is world’s leading platform for creating and operating interactive real-time 3D content with 1.5 million active creators on the platform. Its business and strong market position has been built in gaming with an estimated 53% market share of the 1,000 most downloaded mobile games in 2019 according to the S-1 filing. That is a dominant market position and ultimately a good setup for superior profitability in the future.

Unity offers two solutions to creators: Create Solutions and Operate Solutions. The first is a subscription-based model whereas the latter is a revenue-share and usage-based model. The Operate Solutions segment is the biggest with 54% of total revenue and in terms of geography Unity has managed to diversify its revenue sources driven by strong growth in Greater China and APAC region.

Most of the revenue is assumed to come from the gaming industry, but the company describes how other industries such as architecture, engineering, construction, manufacturing and automotive are adopting this technology in their processes and planning. This means that the total addressable market is much larger and perceived by Unity to be around $29bn globally. Unity does not break down revenue from gaming and non-gaming industries, so the non-gaming industries are likely to be a small part of total revenue.

Source: Unity S-1 filing

This means that buying into the Unity case is all about two things. First, that growth will remain high for gaming but even more importantly that the company can expand beyond gaming, so the revenue stream becomes better diversified and robust. Unity’s biggest competitor is Epic Games with their Unreal Engine which is currently fighting with Apple over monetization and platform access. This could provide a tailwind for Unity if developers are scared over Epic Games’ fight with Apple.

Should investors just close their eyes to the valuation

Based on the current numbers and growth trajectory we estimate Unity to generate $756mn in revenue in 2020 up 39.5% y/y. The company could surprise to the upside on the Epic Games vs Apple legal battle. The company has never made a profit, as per usual for technology companies these days, but judging from their numbers it seems like a deliberate business decision as the company is spending 47% of its revenue on R&D which is an exceptionally high allocation. Some studies suggest that the market is underestimating the effect of high and increasing R&D on future earnings.

Source: Unity S-1 filing

The first half of 2020 also showed a narrower loss potentially indicating that Unity is moving towards profitable growth in order to avoid making a “Uber” where the market has a hard time of seeing profits on the horizon, at least for the foreseeable future.

Based on a market value of around $11.9bn and our expected FY20 revenue figure of $756mn then Unity is valued at a forward price-to-sales ratio of 15.8x which is high but actually in line with software companies if you adjust for the expected revenue growth rate and gross margin at 79%. The valuation is at least not as big a concern as for Snowflake that is valued at 70 times FY21 sales.

Risks

Unity’s biggest risks are a failed international expansion and entry into new industries beyond gaming as a lot of the market value is discounting this trajectory. Retention of developers and pricing pressure from competitors such as Unreal Engine are also key risks to Unity. Most of the revenue comes from the Operate Solutions and as such the revenue sharing model is a key risk to revenue growth if developers feel that Unity is too greedy or lower prices from competitors are more compelling.

New technologies and platforms can arise over time making it costly to adapt or new players in the industry creates a better technical solution for developers and creators. Cyber security threats are also a risk for the company as it can lower the trust among customers.

Disclaimer

Saxo Capital Markets (Australia) Pty Ltd prepares and distributes information/research produced within the Saxo Bank Group for informational purposes only. In addition to the disclaimer below, if any general advice is provided, such advice does not take into account your individual objectives, financial situation or needs. You should consider the appropriateness of trading any financial instrument as trading can result in losses that exceed your initial investment. Please refer to our Analysis Disclaimer, and our Financial Services Guide and Product Disclosure Statement. All legal documentation and disclaimers can be found at https://www.home.saxo/en-au/legal/.

The Saxo Bank Group entities each provide execution-only service. Access and use of Saxo News & Research and any Saxo Bank Group website are subject to (i) the Terms of Use; (ii) the full Disclaimer; and (iii) the Risk Warning in addition (where relevant) to the terms governing the use of the website of a member of the Saxo Bank Group.

Saxo News & Research is provided for informational purposes, does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. No representation or warranty is given as to the accuracy or completeness of this information. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. No Saxo Bank Group entity shall be liable for any losses that you may sustain as a result of any investment decision made in reliance on information on Saxo News & Research.

To the extent that any content is construed as investment research, such content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication.

Please read our disclaimers:
- Full Disclaimer (https://www.home.saxo/en-au/legal/disclaimer/saxo-disclaimer)
- Analysis Disclaimer (https://www.home.saxo/en-au/legal/analysis-disclaimer/saxo-analysis-disclaimer)
- Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)

The Saxo trading platform has received numerous awards and recognition. For details of these awards and information on awards visit www.home.saxo/en-au/about-us/awards

Saxo Capital Markets (Australia) Pty Ltd ABN 32 110 128 286 AFSL 280372 (‘Saxo’ or ‘Saxo Capital Markets’) is a wholly owned subsidiary of Saxo Bank A/S, headquartered in Denmark. Please refer to our General Business Terms, Financial Services Guide and Product Disclosure Statement to consider whether acquiring or continuing to hold financial products is suitable for you, prior to opening an account and investing in a financial product.

Trading in financial instruments carries various risks, and is not suitable for all investors. Please seek expert advice, and always ensure that you fully understand these risks before trading. Trading in leveraged products such as CFDs and Margin FX products may result in your losses surpassing your initial deposits. Saxo Capital Markets does not provide ‘personal’ financial product advice, any information available on this website is ‘general’ in nature and for informational purposes only. Saxo Capital Markets does not take into account an individual’s needs, objectives or financial situation.

Apple, iPad and iPhone are trademarks of Apple Inc., registered in the US and other countries. AppStore is a service mark of Apple Inc.

The information or the products and services referred to on this website may be accessed worldwide, however is only intended for distribution to and use by recipients located in countries where such use does not constitute a violation of applicable legislation or regulations. Products and Services offered on this website is not intended for residents of the United States and Japan.
Please click here to view our full disclaimer.