Unity Software (NYSE:U), which makes a real-time 3D software development platform, released strong quarterly results for the year ending Dec. 31, 2020. And for the second quarter in a row, it has now produced positive free cash flow (FCF). That is important, since U stock has a very high market capitalization that depends on making high FCF margins in the next several years.
On Feb. 4, Unity Software released its Q4 and full-year 2020 results. It showed net income losses, including on a non-GAAP basis. But most importantly the company made $14.8 million in cash flow from operations (CFFO) and $3.6 million in Q4.
Projecting Unity’s Value Using FCF
This was the second quarter the company made positive FCF. In Q3 Unity Software produced $10.9 million in FCF. Nevertheless, the company still ended up with negative $20 million in FCF in 2020 from earlier FCF losses.
Moreover, its FCF margins are nowhere near enough now to justify U stock’s existing $25.66 billion market value. For example, even if the software company had a 1% FCF yield, that would imply annual run-rate FCF was $256.6 million (i.e, 0.01 times $25.66 billion). Therefore, making $3.6 million or even $10.9 million in FCF in quarterly FCF will not get it to $257 million annually in FCF.
However, we can work out when this might happen, given Unity Software’s fast-growing revenue. For example, by 2023 analysts surveyed by Seeking Alpha project that revenue will hit $1.61 billion. That represents a gain of 108% over revenue in 2020 of $772.5 million and 67.7% over 2021 forecast sales of $960 million.
Therefore if Unity Software can produce 20% FCF margins by 2023, its FCF will hit $322 million (i.e., 0.20 times $1.61 revenue in 2023). And following that, if we assume that by then U stock will trade at a 1% FCF yield, the market cap will be $32.2 billion. This is seen by dividing $322 million by 0.01.
As a result, in three years, assuming a 20% FCF margin and using analysts’ sales forecasts, Unity’s stock could rise by 25%.
Implied Values With Various FCF Margins
That represents a potential price of $117.73 by 2023. However, this represents a compound annual return of just 7.86% per year. That is nothing to write home about.
We can take this one step further. Analysts project sales to reach $2.09 billion by 2024. Therefore, using a 20% margin, FCF might hit $418 million. And using a 1% FCF yield implies a market value of $41.8 billion, or 62.9% above today’s price. That represents an average annual return of 13% per annum in each of the four years to 2024.
That is a good ROI, but not a great one. What this means is that the market must believe that Unity Software will likely make greater than 20% FCF margins over the next several years.
In other words, the 20% FCF margin level is sort of a minimum level justifying Unity’s huge market cap today. In reality, it is going to need to make around 30% or higher FCF margins if the stock is going to move significantly higher.
For example, let’s assume it makes 30% FCF margins by 2023 with $1.61 billion in sales. That implies FCF of $483 million and a market cap of $48.3 billion using a 1.0% FCF yield metric. That is 88.2% over today’s price and implies a target price of $176.56 by 2023. If that happens, then an investor would make an average annual return of 23.5% over each of the next three years.
What To Do With U Stock
To summarize, assuming Unity Software makes 20% FCF margins by 2023, the stock should be worth at least $117.73. But if it makes 30% margins by then, the market would likely value U stock at $176.56 per share.
In the first case, this represents an average annual return of just 7.9% each of the three years. But using a 30% FCF margin assumption, the stock return produces an average 23.5% annual return each year.
Therefore, you can see why the company emphasizes free cash flow so clearly in its earnings release. Unity said it has “dedication to a path to free cash flow break-even.”
It knows that its $25 billion-plus market value today depends very highly on not only getting FCF breakeven but then pulling in high FCF margins.
This is going to be a big feat to pull off. For example, a similar software company Datadog (NASDAQ:DDOG) made $22.7 million in FCF in its latest quarter on $177.5 million in revenue. That represents 12.8% FCF margins. DDOG stock has a similar $25.19 billion market cap.
However, Slack Technologies (NYSE:WORK) made just 6% FCF margins on its $250.6 million in quarterly revenue. It received a $27.7 billion takeover offer from Salesforce.com (NYSE:CRM) at the beginning of this year.
Obviously, CRM believes that its margins will eventually be much higher. But this goes to show that getting to at least a 10 to 12% FCF margin will justify Unity Software’s existing market cap.
On the date of publication, Mark R. Hake did not hold a long or short position in any of the securities in this article.
Mark Hake writes about personal finance on mrhake.medium.com and runs the Total Yield Value Guide which you can review here.
