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Equity outlook: The high cost of global fragmentation for US portfolios
Charu Chanana
Chief Investment Strategist
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Can Unity evolve beyond its niche market position?
Peter Garnry
Chief Investment Strategist
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.
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.
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.
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