Valuation: Slightly Overvalued

Unity Investment Summary:

Currently, there is a great opportunity in the Interactive, Real-time 3D space that has potential applications ranging from game development to architecture/design, to engineering, and much more.
- There are a couple companies that have a very good opportunity to capitalize on this trend/forecast, however, I believe that unity can best take advantage of this trend.
However, my valuation techniques indicate that Unity is slightly overvalued given current market conditions. But there still is a way to capitalize on this.
My final valuation indicates that Unity’s fair value is $102-103/share, which implies a share price decrease of over 3%.
- Overall, I am bullish on Unity, however, I will wait until prices are at/below these levels before I would consider accumulating more.

Unity as a Company:

$U - Unity Software Inc. is the leading platform for creating and operating real-time, 3-D content for developers, architects, artists, designers, filmmakers, and many others. Unity provides their customers with a set of software solutions so that they can create, run, and monetize their content for mobile, PC, console, and VR users.

Unity has over 2.7B monthly active users that make content, which is accessible to other Unity users, and potentially beyond. Unity allows their users to make 2D and 3D creations for a variety of uses and allows their users to edit content simultaneously (if they are given the permission to do so), making the process easier and more efficient.

With compute processers becoming faster, improvements in bandwidth, and the ability to use cloud computing, creators on Unity can now develop more complex and immersive experiences for their community of gamers.

Unity has a large customer base, a great reputation in the industry, and a wide variety of compatible platforms. All of these factors have helped Unity to expand their platform/software so that 71% of the top 1000 mobile games being developed on Unity’s software.

Furthermore, Unity provides solutions that allows their creators to monetize their content through in-app purchases, and through in-app advertising. This helps Unity to generate more revenue/business, and it allows their community of developers to make money, which is truly a win-win.

However, unity is not just for videogames, and there are many Fortune 500 companies that use Unity’s software for design, architecture, engineering, construction, transportation, and other industries that could benefit from Unity’s 2D and 3D creation software. One example of this could be safety training videos in 3D, VR, or AR. The potential use cases of Unity’s software is constantly expanding, which is good for the future of Unity.

Unity has 2 main sets of solutions that they offer. These are their Create, and Operate solutions, and these will be discussed later in this analysis.

$U – Unity Software Investment Information:

Initial Public Offering (IPO):

On September 22^nd, 2020, Unity completed their IPO. Part of this IPO required Unity to list more of their common shares, among other forms of dilution. These factors played a big role in Unity’s overall dilution for the year ending 2020, however this will be discussed later on in this analysis.

Interactive, Real-Time 3D Outlook:

Unity believes that they are in the midst of an interactive, real-time 3D content explosion, especially in the gaming industry. Unity has quickly moved from the static 2D space, into the interactive 3D space to take advantage of this.

In just the past 20 years, the gaming industry has grown from $15B to an $159B industry, which represents a historical CAGR in this industry of 11.97%. This is not expected to slow down any time soon as analysts have predicted that it will continue to grow at a CAGR of 10.5% for the next 5 years.

However, the 3D videogame software industry is expected to grow at a CAGR of 15.5% over the next 5 years and is expected to lead the ongoing surge in the videogame industry. This is fantastic news for unity as they dominate this space and can capitalize on the trends like no other.

However, there are also many uses for this software outside of gaming, 3 of the biggest potential markets for this software is in the architecture, automotive, and film industries. This is also a favourable trend for Unity, as their software is used by many Fortune 500 companies, which implies that their software is reputable, reliable, and most likely the first choice for other businesses looking for this type of software. This should help Unity to capitalize on the expected 24.5% CAGR of the Visualization and 3D rendering software industry.

Sources:

Gaming Market - Growth, Trends, COVID-19 Impact, and (globenewswire.com)

3D Gaming Consoles Market | Growth, Trends, and Forecasts (2020 - 2025) (mordorintelligence.com)

Global Visualization & 3D Rendering Software Market (2020 (globenewswire.com)

Unity’s Creator Community:

Unity has a large active community of over 1.4M monthly active creators, who have developed an average of 8,000 games/apps per month. This level of creation helps unity take advantage of their in-game purchase and advertising solutions; however, it also keeps Unity’s community of gamers constantly engaged and satisfied with their selection/variety of games.

Unity’s creator community is growing rapidly and are looking for ways to further collaborate and learn. Unity is looking to address these concerns/wants so that they can bring together/integrate their creators like never before. These additional features/resources should help Unity to increase engagement and acquire new long-term customers and clients.

Furthermore, Unity is investing in student and independent learners, through the provision of licenses, and curriculum to expedite their learning and creation. This investment has the potential to pay off massively, as these students/learners will be creating and getting familiar with Unity’s platform, which should help Unity retain these people even after their learning on Unity has concluded.

Unity’s Solutions:

As previously mentioned, Unity has 2 main solutions, which will be discussed in this section of the analysis, these solutions include:

Create Solutions: Offer developers, artists, designers etc. a suite of technologies that they need to create immersive/interactive experiences that they can then share with others. These solutions allow creators to create, edit, and post interactive 2D, and 3D content. These solutions can also be combined with 3^rd party features found in Unity’s Asset Store.
- Consists of Unity: Pro, Enterprise, Student, Personal, Plus, Reflect, MARS, Forma, as well as, ArtEngine and Granite
Operate Solutions: Offer customers the ability to grow and monetize their audience and content. This helps to maximize the lifetime value of users, lower acquisition costs, drive engagement, and easy operating/hosting. These solutions are easier to implement, and very powerful when combined with create solutions.
- Includes: personal and contextual advertising, Unity Ads, Unity IAP, DeltaDNA, GameTune, Multiplay, Vivox, Cloud Content Delivery, Build Server, Furioos, and Simulation.

Financial Performance:

Financial Performance (Good): In 2020 Unity increased their revenues by 43%, increased their gross profits by 42%, increased their “create solution” revenue by 37%, increased their “operate solutions” revenue by 61%, decreased their provision for taxes by 79%, and decreased their non-GAAP loss from operations by 45%.
Financial Performance (Bad): In 2020, Unity increased their cost of revenue by 45% (which is worse considering their cost of revenue increased faster than their revenue, as it decreases their gross margin), increased their operating expense by 52% (this is bad because it increases their loss from operations), their loss from operations increased by 82% (very bad as it affects their net loss), and their net loss increased by 73%. Overall, 2020 was not a good year financially for Unity.
Issuance of Common Stock: In 2020, Unity issued 4,545,455 common shares to the public. The issuance of these shares caused a dilutionary effect of 3.69%.
Issuance of Common Stock (due to IPO-related activities): Unity underwent an Initial Public Offering (IPO) in September of 2020. Due to this IPO, and the associated underwriting and commissions, Unity offered an additional 28,750,000 common shares. The issuance of these shares diluted the value of the pre-existing shares by 23.32%, which is a sizeable amount.
Issuance of Common Stock (charity purposes): Furthermore, in 2020 Unity offered 750,000 common shares as a charitable donation. This shows that Unity is Socially Responsible, which may lead to good press and increased investments (as there is a growth in Socially Responsible investing). Additionally, this offering also provided Unity with a tax benefit (which doesn’t hurt). This issuance diluted the existing shares by 0.61%.
Stock Options: In 2020, Unity had an influx of options that were exercised. The exercise of these options resulted in 6,758,226 common shares being released into the markets. These new shares had a dilutionary effect on Unity’s shares of 5.48%.
Issuance of Common Stock (Acquisition related): Unity offered more shares in 2020, however this time they were offered as a result of an acquisition. In total there were 1,103,190 shares offered to the public as a result of this acquisition, which diluted shares by 0.90%.
Share Repurchases: In 2020, Unity repurchased some shares (it was not all dilution). Unity ended up repurchasing 5000 shares through the retirement of treasury shares. This share repurchases had an inflationary effect on existing shares of 0.004%, which is essentially nothing, even without the mass dilution they experienced. However, the fact that they did this is worth mentioning, due to the possibility of future buybacks.
Convertible Preferred Shares (Upon IPO): Lastly, in 2020, Unity experienced a mass conversion of their convertible preferred shares as a result of their IPO. This mass conversion led to the release of 102,717,396 common shares into the market. This conversion had a dilutionary effect of 83.33%, which is massive.
Total Dilution: In 2020 Unity experienced a total share dilution of 121.92%.

Share Dilution as a result of IPO:

As you should have already noticed, the biggest forms of dilution in 2020 were all attributed to their IPO. However, what would Unity’s share dilution look like if the dilutionary effects caused by their IPO were disregarded?

If we were to disregard the factors of dilution that Unity experienced as a result of their IPO, it would help us to get a better sense of the share dilution we can expect in the future. By disregarding these factors of dilution, we arrive at a share dilution of Unity in 2020 of 10.27%, which is much more realistic.

If I were to look at this type of dilution in Unity, I would not be surprised given that they are a rapidly growing software company. This figure is also much more common and may even be inflated a tiny bit due to the smaller effects of the IPO that cannot be directly attributed to a form of dilution.

Valuation Information:

WACC:

I found Unity’s WACC to be 7.44% through a site called “Gurufocus”. Additionally, there were other sites that I found Unity’s WACC to be between 7-8%, so this result is most likely accurate.

CAGR:

I found Unity’s CAGR to be 41.55%. I found this by taking the average growth in their gross profit (which is the field in which I applied this CAGR to) over the past 2 years. I arrived at an end result of 41.55%/year.

Operating Expense Growth Rate:

I found this growth rate by taking Unity’s average yearly growth rate of their operating expense over the past 3 years. This resulted in a growth rate of 32.48%.

Interest Expense Growth Rate:

Once again, I found this rate by taking Unity’s average yearly growth in their interest expense, and by doing this I arrived at a figure of 32.30%.

Depreciation and Amortization Growth Rate:

I found Unity’s depreciation and amortization growth rate by taking its average yearly increase over the past 3 years, which cam out to be 29.92%.

Tax Rate (Negative Income):

According to their SEC 10-K filing, Unity’s effective tax rate in 2020 was -17%, which means that they actually received money through tax benefits. I used this negative tax rate to calculate the tax benefit when there is forecasted to be negative earnings.

Tax Rate (Positive Income):

I used a standard tax rate of 20% to estimate Unity’s effective tax rate when they manage to report positive earnings, which in my model will not be until 2024.

Competition:

For my comparable analyses, I needed to compare Unity’s financial ratios and multiples to some of their competitors.

These competitors need to be publicly listed, how similar business models and operations, operate in similar geographies, and be of similar market cap.

I chose 4 companies that fit this profile, that I could use to compare to Unity, these companies include:

$RBLX – Roblox Corp: Roblox offers their customers applications that allow them to create in 3D worlds. These customers can develop using Roblox’s suite of tools to build, publish and operate their games/content.

$SKLZ – Skillz Inc: Skillz connects their community of freelance developers to their equally enthusiastic community of gamers. These developers can create, publish, and monetize their content/games, that will be consumed by Skillz community of gamers.

$TTWO – Take-Two Interactive Software: Take-Two develops, publishes, and markets interactive entertainment solutions under Rockstar games, 2K Private Divisions, Social Point, and Playdots. Some of their most successful games are NBA 2k, PGA TOUR 2K, GTA, and Red Dead Redemption.

$EA – Electronic Arts Inc: EA develops, market, publishes, and distributes video games/content. Some of EA’s best performing games are FIFA, UFC, NHL, NFL, and Star Wars.

Valuing Unity’s Stock:

In order to value Unity’s stock, I underwent a DCF model and 3 comparable analyses.

DCF:

Using the information/figures found above in the “valuation information” section, I was able to undergo a DCF model. This DCF model estimates that the fair value per share of Unity is $22, which would imply a potential downside to this investment of 79%. However, this is very unlikely, so I decided to undergo some comparable analyses to get a better idea of a valuation.

Comparable Analyses:

EV/Assets:

By comparing Unity’s EV/Assets multiple to their public competitors (listed above in the “competitors” section of this report) I found Unity’s fair value to be $86/share, which implies a downside risk of 19%.

EV/Revenue:

By comparing Unity’s EV/Revenue multiple to that of their competitors, I found Unity’s fair value to be $68/share, which implies a downside of 36%. This is relatively consistent with the EV/Assets multiple based on the fact that they both find Unity to be undervalued.

P/B:

By comparing Unity’s P/B ratio to that of their competitors, I found that Unity should have a fair value of $180/share, which implies an upside potential of 70%. However, this result contradicts the results achieved in the other 2 comparable, and as a result of this I decided to take the average comparable result to get one final estimate.

Average Comparable:

By taking the average result of the 3 comparable analyses that I underwent, I found Unity to have one, all-encompassing comparable fair value of $111/share, which implies an upside of 5%.

Weighted Average Valuation:

Due to the fact that there is so much of a difference in the result achieved through the DCF and through the result as achieved in the average comparable, I decided to take a weighted average of the two results.

Due to the DCF being so low, and the software industry typically being “overvalued” I decided to weigh the average comparable as 90%, and the DCF result as 10%.

By taking this weighted average, I arrived at one final valuation of $102/share, which implies a downside of 3%.

My $U – Unity Software Inc. Investment Plan:

I believe that entering into a position in Unity above the $102/share level increases your risk as an investor, and I personally would wait until the price drops to this level before entering into a position. This will help limit the downside risk by ensuring that you entered in at fair value.

Risks to investing in Unity:

Financial Performance: In 2020, Unity did not have the best financial performance, with most of their key metrics (net loss, operating loss etc.) all increasing significantly. This is not good to see as a potential Unity investor and may scare people away/out of their positions. If this kind of financial performance was to continue, it would have negative effects on their share price.
Share Dilution: In 2020 Unity experienced rampant share dilution, however this share dilution was largely a result of their IPO process. Even without the dilution from the IPO, Unity cannot continue to dilute their shares by over 20%, and virtually buy back no shares. If this trend continues over the long-run, I would be very concerned about investing into Unity.

$U – Unity Software Inc. Stock Catalysts:

Financial Performance: Despite an overall poor financial performance in 2020, there was some good to come out of it, especially their revenue and “solution” revenue growths. In the future, we are hoping to see better financial performances, and if these performances come soon, it could help the stock greatly.
Share Repurchases: Unity has repurchased very little shares in 2020. However, the fact that they purchased shares back may mean that they will continue to do this on a larger scale in the future. However, if they do not increase the size of their buybacks, it will be unfavourable for the stock and its investors.