Game engine maker Unity (NYSE:U) fell short of analyst expectations in Q3 FY2022 quarter, with revenue up 12.7% year on year to $322.8 million. On the other hand, guidance for the next quarter exceeded analyst expectations with revenues guided to $435 million at the midpoint, or 11.8% above analyst estimates. Unity made a GAAP loss of $250 million, down on its loss of $115.1 million, in the same quarter last year.
Unity (U) Q3 FY2022 Highlights:
- Revenue: $322.8 million vs analyst estimates of $325.8 million (0.9% miss)
- EPS (non-GAAP): $0.70 vs analyst estimates of -$0.15 ($0.85 beat)
- Revenue guidance for Q4 2022 is $435 million at the midpoint, above analyst estimates of $389 million
- Free cash flow was negative $80.7 million, compared to negative free cash flow of $58.2 million in previous quarter
- Net Revenue Retention Rate: 111%, down from 121% previous quarter
- Gross Margin (GAAP): 65.3%, down from 78.1% same quarter last year
- Unity announced that it has completed the merger with ironSource
Started as a game studio by three friends in a Copenhagen apartment, Unity (NYSE:U) is a software as a service platform that makes it easier to develop and monetize new games and other visual digital experiences.
Instead of having to build everything from scratch, game developers can use Unity’s game engine that handles things like the physics of how players and objects move or how networking and in-app purchases work.
Similarly to when opening a new restaurant a chef just buys an oven and other tools needed, and focuses their effort on the recipes and the food, a game developer can now focus on the story, characters and rules of their game rather than having to build their own tools. While it has been lately venturing into VR and movie production, Unity is still most popular with mobile game makers, powering a large share of the top 1,000 games.
The demand for rich, interactive 2D, 3D, VR and AR experiences is growing, and while the ubiquitous metaverse might still be more of a buzzword than a real thing, what is real is the demand for the tools to create these experiences, whether they are games, 3D tours or interactive movies.
Competitors include Autodesk (NASDAQ: ADSK), Blender, Unreal Engine, and Roblox (NYSE:RBLX).
As you can see below, Unity's revenue growth has been very strong over the last two years, growing from quarterly revenue of $200.7 million in Q3 FY2020, to $322.8 million.
This quarter, Unity's quarterly revenue was once again up 12.7% year on year. On top of that, revenue increased $25.8 million quarter on quarter, a strong improvement on the $23 million decrease in Q2 2022, and a sign of acceleration of growth, which is very nice to see indeed.
Guidance for the next quarter indicates Unity is expecting revenue to grow 37.7% year on year to $435 million, slowing down from the 43.3% year-over-year increase in revenue the company had recorded in the same quarter last year. Ahead of the earnings results the analysts covering the company were estimating sales to grow 32.8% over the next twelve months.
Large Customers Growth
You can see below that at the end of the quarter Unity reported 1,075 enterprise customers paying more than $100,000 annually, a decrease of 10 on last quarter. We have no doubt shareholders would like to see the company regain its sales momentum.
One of the best things about software as a service businesses (and a reason why they trade at such high multiples) is that customers tend to spend more with the company over time.
Unity's net revenue retention rate, an important measure of how much customers from a year ago were spending at the end of the quarter, was at 111% in Q3. That means even if they didn't win any new customers, Unity would have grown its revenue 11% year on year. Despite it going down over the last year this is still a good retention rate and a proof that Unity's customers are satisfied with their software and are getting more value from it over time. That is good to see.
What makes the software as a service business so attractive is that once the software is developed, it typically shouldn't cost much to provide it as an ongoing service to customers. Unity's gross profit margin, an important metric measuring how much money there is left after paying for servers, licenses, technical support and other necessary running expenses was at 65.3% in Q3.
That means that for every $1 in revenue the company had $0.65 left to spend on developing new products, marketing & sales and the general administrative overhead. This would be considered a low gross margin for a SaaS company and it has been going down over the last year, which is probably the opposite direction shareholders would like to see it go.
Cash Is King
If you have followed StockStory for a while, you know that we put an emphasis on cash flow. Why, you ask? We believe that in the end cash is king, as you can't use accounting profits to pay the bills. Unity burned through $80.7 million in Q3, with cash flow turning negative year on year.
Unity has burned through $106.2 million in cash over the last twelve months, resulting in a negative 8.45% free cash flow margin. This below average FCF margin is a result of Unity's need to invest in the business to continue penetrating its market.
Key Takeaways from Unity's Q3 Results
Since it has still been burning cash over the last twelve months it is worth keeping an eye on Unity’s balance sheet, but we note that with a market capitalization of $7.13 billion and more than $1.68 billion in cash, the company has the capacity to continue to prioritise growth over profitability.
We were impressed by the very optimistic revenue guidance Unity provided for the next quarter. On the other hand, it was less good to see the deterioration in revenue retention rate and there was a slowdown in new contract wins. Overall, it seems to us that this was a complicated quarter for Unity. The company is flat on the results and currently trades at $21.46 per share.
Is Now The Time?
Unity may have had a bad quarter, but investors should also consider its valuation and business qualities, when assessing the investment opportunity. We think Unity is a good business. Its revenue growth has been strong, and analysts believe that sort of growth is sustainable for now. And while its cash burn raises the question if it can sustainably maintain its growth, the good news is its customers are increasing their spending quite quickly, suggesting that they love the product.
Unity's price to sales ratio based on the next twelve months is 3.9x, suggesting that the market is expecting more moderate growth, relative to the hottest tech stocks. There is definitely a lot of things to like about Unity and looking at the tech landscape right now, it seems that the company trades at a pretty interesting price point.The Wall St analysts covering the company had a one year price target of $52.6 per share right before these results, implying that they saw upside in buying Unity even in the short term.
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