Unity (NYSE:U) Q4 Sales Beat Estimates But Stock Drops

Game engine maker Unity (NYSE:U) reported Q4 FY2022 results topping analyst expectations, with revenue up 42.8% year on year to $451 million. However, guidance for the next quarter was less impressive, coming in at $475 million at the midpoint, being 9.49% below analyst estimates. Unity made a GAAP loss of $287.8 million, down on its loss of $161.7 million, in the same quarter last year.

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).

Sales Growth

As you can see below, Unity's revenue growth has been very strong over the last two years, growing from quarterly revenue of $220.3 million in Q4 FY2020, to $451 million.

And unsurprisingly, this was another great quarter for Unity with revenue up 42.8% year on year, driven by the merge with ironSource. On top of that, revenue increased $128.1 million quarter on quarter, a very strong improvement on the $25.8 million increase in Q3 2022, and a sign of re-acceleration of growth.

Guidance for the next quarter indicates Unity is expecting revenue to grow 48.4% year on year to $475 million, improving on the 36.4% year-over-year increase in revenue the company had recorded in the same quarter last year. For the upcoming financial year management expects revenue to be $2.13 billion at the midpoint, growing 52.8% compared to 25.3% increase in FY2022.

Large Customers Growth

You can see below that at the end of the quarter Unity reported 1,340 enterprise customers paying more than $100,000 annually, an increase of 265 on last quarter. That is a bit more contract wins than last quarter and quite a bit above what we have typically seen lately, drive by the merge with ironSource. 

Product Success

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 116% in Q4. That means even if they didn't win any new customers, Unity would have grown its revenue 16% year on year. Significantly up from the last quarter, this 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.

Profitability

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 69% in Q4.

That means that for every $1 in revenue the company had $0.69 left to spend on developing new products, marketing & sales and the general administrative overhead. While it improved significantly from the previous quarter this would still be considered a low gross margin for a SaaS company and we would like to see the improvements continue.

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 $63.9 million in Q4, increasing the cash burn by 19.4% year on year.

Unity has burned through $116.6 million in cash over the last twelve months, resulting in a negative 8.38% 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 Q4 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 $14.7 billion and more than $1.59 billion in cash, the company has the capacity to continue to prioritise growth over profitability.

It was unfortunate to see that Unity's revenue guidance for the full year missed analysts' expectations and without the merge with ironSource, Unity would have actually reported decline in customers. Overall, we think this was a complicated quarter. The market was likely expecting more and the company is down 8.06% on the results and currently trades at $34.79 per share.

Is Now The Time?

When considering Unity, investors should take into account its valuation and business qualities, as well as what happened in the latest quarter. 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 gross margins show its business model is much less lucrative than the best software businesses, the good news is its customers are increasing their spending quite quickly, suggesting that they love the product.

The market is certainly expecting long term growth from Unity given its price to sales ratio based on the next twelve months is 5.9x. 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 $36 per share right before these results, implying that they saw upside in buying Unity even in the short term.

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