What happened
Shares of Unity Software (U +1.47%) plunged 17.1% in December, according to data provided by S&P Global Market Intelligence. A large portion of this drop occurred immediately after the company announced the completion of its acquisition of Weta Digital. But the bigger reason for December's underperformance may have simply been general market conditions. Stocks with more aggressive valuations, like Unity, took a haircut during the month. And it's something that's continuing so far in January.
So what
Unity is a software platform for creating and monetizing 3D digital content and is often used by video game companies. So it might have surprised some to see it go out and acquire Weta Digital, a special-effects company involved in making TV shows and movies. Weta was used in making films well known for their special effects, including Avatar and the Lord of the Rings trilogy. Therefore, given Weta's accomplishments, it makes sense that Unity might want to own its software tools.
Image source: Getty Images.
However, investors may have been balking at Weta Digital's price tag of $1.625 billion considering Unity only had $766 million at the end of the third quarter. This meant that the company needed to raise capital, which it did in December by issuing $1.5 billion in convertible senior notes.
It's possible the market didn't care much for this financing arrangement, leading to some of Unity's underperformance. But the bigger factor in December seemed to be general market conditions. Analysts and retail investors are increasingly concerned about high-valuation growth stocks, and Unity fits the bill. Even though it's currently down 38% from its all-time high, it still trades at a price-to-sales (P/S) valuation of almost 40. It would probably have to trade with a P/S ratio under 10 before value investors would even consider buying.
Maybe that's why Unity stock is still falling. It was down a painful 17% in December, but it's down another 12% so far in January.
^SPX data by YCharts.
Now what
Unity is wonderfully positioned to maintain its leadership in the 3D content-creation software space. Small companies and students can use the software for free, which is strong motivation to choose Unity instead of a competitor. And its pricing model allows for greater upside as its customers succeed. Because of this, it's a company I expect will have greater longevity than a lot of other technology companies out there.
And besides content creation, Unity has a business segment that helps creators monetize their products. For example, game developers can choose Unity to manage their in-game advertisements. And this part of the business had an encouraging development in December.
On Dec. 16, Unity announced a partnership with Facebook's parent company, Meta Platforms. In short, Unity games will be able to display ads from Meta customers. Not only does this have the potential to greatly increase Unity's reach, the Meta Platforms partnership could also increase competition for video-game ad slots, boosting ad rates and revenue for Unity's customers. That's an encouraging development for shareholders discouraged with Unity's 17% drop in December.
