Unity Software, a solid growth stock

Strategy:

After the peak in Nov/Dec 2021, US stock market has been declining since 2022. The decline is triggered by anticipated interest rate increases, which hurts growth stocks particularly: a lot have dropped 30% or more.

What can we learn from it?

As a long term investor, I still believe growth stocks are the future (imagine EV or VR), not value stocks (imagine railway or retailing are the future?), nor are bonds (you kidding me?). It’s just a matter of time and chemistry fo the market to realise this.

Secondly, sure, majority of growth stocks will have to battle against headwind in the next several years, but I also believe there are growth stocks whose businesses will not be materially impacted by the macro environment change (those companies who can 1. continue with strong revenue growth; 2. generate free cashflows; 3. have no financing problems).

While the whole market participants are emotional and the overall growth stocks all declined significantly, it means opportunities if we can identify those treasures from the trash. One of them, I believe, is Unity Software.

Why?

Unity Software will enjoy strong revenue growth in the next 5 years;

Unity Software has enough cash in the next 5 years;

Unity Software doesn’t have major debt re-financing problem in the next 5 years;

Start with its Business:

Unity software’s core business is to provide platforms to game developers. It earns platform license fee, as well as add-on services (esp. those services post game publish). It specialises in 2D/3D real time / VR/AR game engine, and is the market leader with 45% (some source says 63%) market share and over 4.5Mio developers worldwide. In the past several years, Unity has achieved over 30% annual revenue growth. The gaming market is massive and fast growing, so I can imagine the forward-looking revenue growth is guaranteed. On top of it, the non-gaming business grow even faster, fueled by metaverse (and movie industry in the near future),.

Unity has one major competitor, which is Unreal (from EPIC). Here I listed some comparison between the two, from articles and comments from internet,

	Unity	Unreal (EPIC)
Founded in	2004	1998
Market share	Market share 45%~63% (from different sources)	13% (from different sources)
Advantage	Easy to use (C#)	VFX, rendering, Animation
Customers	Majority are Indie	Enterprise level
Cost	$75 per month for pro license	no license fee, 5% royalty fee on game sales
Overall	beginner’s choice (1st choice)	switch to it in advanced stage

I’m very comfortable with Unity’s position compared with Unreal, as Unity is recommended as the first choice for game developers. This not only helps it to gain new users, but also helps it to build a very large user community. Actually I think this is the core competitive advantage: Unity drives the innovation based on the feedbacks and requests from its user community. In the past two years, Unity has purchased several companies (Ziva Dynamic, Parsec, Metaverse, etc.) aiming to provide better user experience and a completed toolkit to its developer community. This in turn will attract more game developers to use its platform. In Dec 2021, it completed another deal to buy Weta Digital at $1.5B, which further expand its arsenal and open the door to movie industry.

Cash flow: Unity operating cashflow is almost break-even ($-0.1B in 2021). Although its profit is negative, the projection is by 2023 the company should be profitable (which is not a concern to me anyway, for a tech and growth company).

Debt: the company did carry a $1.7B debt, but it’s a very interesting story. the debt was issued in late 2021, in the form of convertible note for 5 years, 0% interest rate, convertible at $308 per share. This means the lender will not collect any interest in 5 years, but have the option to convert his debt to shares at $308 per share. I interpret it that the lender believes the company’s value is at least 20% above $300 in 5 years. I also believe the management team has strong motivation and confidence to lift the share price to be above $300 level in 5 years.

What I don’t like: stock based compensation. Growth stocks tend to issue new shares as compensation to its employees instead of paying cash to manage its cashflow. But it means shareholder value is diluted (with more outstanding shares). Unity has this problem. 2021 year end shares outstanding is 292Mio. it’s Q1 2022 outstanding shares projection is 343Mio. 2022 year end projection 349Mio.

Share price: its share price is closed at $97.15 on Friday (March 19th), quite depressed compared with its relative highs ($160~$180). Compared with $308 debt conversion rate, it means the stock has great upside potential.

Overall, Unity Software is a solid growth stock. It will not face much of the headwind (interest rate topic). Instead, it will enjoy strong tailwind (gaming, Metaverse). Although the share dilution is annoying, the current share price implies huge upside potential. Since I started to draft this article (earlier this week), its share price has rebounded from mid $70s to $97, about +30%. Any chance that this stock decline back to $80s level, I will comfortably accumulate more and hold.