Unity Q2 Earnings Preview

Aug. 10, 2021 12:05 PM ETUnity Software Inc. (U)2 Comments

Summary

  • Unity Software reports Tuesday 10 August after the close.
  • The stock has outperformed the Nasdaq considerably since IPO, but proven volatile of late.
  • The stock chart indicates a move up is certainly possible.
  • Absent a goodly amount of deferred revenue or remaining performance obligation - meaning low revenue visibility - we rate the name at Neutral before earnings.
  • But we own the stock in staff personal account(s) - we believe long-term upside is possible from here.
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human head and table for metaverse concept 3d rendering
niphon/iStock via Getty Images

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This Time We'll Know If It's For Real

Unity Software (NYSE:U) holds great promise as a long-term investment opportunity. The opportunity here is to invest in a company which could be one of a handful of key suppliers into a large and fast-growing industry, being, videogame and movie/TV production software. In addition to the greater use of computer generated imagery we all see daily in our own lives - more games being produced, more electronic content in movies and TV - the next-level opportunity in this end industry is a whole new world of VR and AR which is becoming referred to, in a rather cringeworthy fashion, as "the Metaverse". Anyway, all companies everywhere are now laying claim to their place in the Metaverse. If they have 20-something year old CEOs we can just about live with that. Longer in the tooth executives, less so. When the Unity CEO, John Riccitiello, was talking up the Metaverse in the last earnings call it was a little less convincing than the average true-believer-definitely-their-first-rodeo VR startup founder. But - Unity is right to identify the opportunity because the Metaverse has to be created somewhere and the God Box of choice is likely to be an AR/VR content creation system as offered by Unity or its competitors.

Unity stock has outperformed the Nasdaq significantly since IPO, but it has been a painful ride for anyone who bought in even a month or two post the listing.

Here's its trajectory thus far vs. QQQ as a proxy for the Nasdaq.

The stock is now back on the uptrend, as can be seen in its own chart.

Source: TradingView, Cestrian Analysis

Having run up very quickly from its October 2020 IPO to a high of some $175 in February 2021, the stock pulled back hard, giving up almost all its gains at one point - in May this year, the second pullback for growth names (March was tough, May, brutal), the stock hit $76 before it started climbing.

To our eye the stock looks like it could break to the upside if earnings are sound. You have a generally positive backdrop for tech stocks, a narrative about "the Metaverse" that can lift a number of these names, and technically speaking you have the price running up along that sloping line of support towards a horizontal resistance level - all at relatively low volume implying folks have forgotten about Unity. So, if earnings are broadly positive, we think the stock can move up. So far on a short term basis, Unity stock has been brutal so we make no short-term claims here. Could go up or down. But we think that long term the name remains one of very few public stock pureplay ways to own this emerging Metaverse narrative and on that basis we remain bullish owners of the stock.

We rate at Neutral for now because any weakness in earnings could really hurt the stock short term - for that reason we have no intention of adding to our position before earnings. The business model has relatively little revenue visibility - both deferred revenue and remaining performance obligation are modest as a proportion of TTM recognized revenue - so it's hard to be very confident of fundamental strength ahead of the earnings release.

Here's the numbers so far.

Source: Company SEC Filings, YCharts.com, Cestrian Analysis

Valuation is punchy but not silly at 34x TTM revenue for 44% TTM growth.

Source: Company SEC Filings, YCharts.com, Cestrian Analysis

As you can see, revenue growth accelerated in Q1 2021 - we want to see at least that rate of growth in Q2. We're also looking for improvements in EBITDA and cashflow margins because both are poor given this is a vertical market play (i.e. a company selling into a small number of specific industries only). Such plays - Veeva Systems (VEEV) being the poster child - tend to be high margin because they don't have to comb the world looking for customers (they know where all their customers live already) and there is limited competition therefore less price pressure than in other more widespread plays such as analytics. The balance sheet looks in perfectly good shape.

So - we own U and hope for strong earnings and a positive stock reaction. Our confidence is limited given the stock's stumbles to date, so a Neutral rating for now, though that stock chart above does indicate material upside potential.

Cestrian Capital Research, Inc - 10 August 2021.

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Disclosure: I/we have a beneficial long position in the shares of U, VEEV either through stock ownership, options, or other derivatives. Business relationship disclosure: See disclaimer text at the top of this article.

Additional disclosure: Cestrian Capital Research, Inc staff personal account(s) hold long position(s) in U and VEEV.

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