Unity Stock: Bear vs. Bull

Unity's (U 0.52%) stock hit an all-time high of $210 last November after its third-quarter earnings report dazzled investors. But over the following three months, the stock plummeted nearly 50% as rising inflation and higher interest rates caused investors to dump their higher-growth tech stocks.

Should investors consider Unity's steep decline to be a good buying opportunity? Let's review the bear and bull cases to find out.

What does Unity do?

Unity's game engine makes it easy for developers to create cross-platform games for mobile devices, gaming consoles, and PCs. Roughly half of all video games across those platforms are now created with Unity.

Image source: Getty Images.

Unity's Create Solutions segment (29% of its revenue in 2021) hosts its main subscription-based game engine and development tools for non-gaming markets. Its Operate Solutions segment (64% of its revenue) provides add-on services (including ads, in-app purchases, and analytics tools) and revenue-sharing plans for developers, while its Strategic Partnerships and Other division (7% of its revenue) signs partnerships with video game hardware and software companies. Its two largest businesses generated impressive revenue growth in both 2020 and 2021:

Source: Unity. YOY = Year-over-year.

What the bears will tell you about Unity

Those growth rates are impressive, but the bears will point out that Unity is still unprofitable, it faces plenty of competitors, and its stock isn't cheap.

Unity generated $772.4 million in revenue in 2020, but it booked a net loss of $282.1 million on a generally accepted accounting principles (GAAP) basis. It also incurred a non-GAAP net loss of $65.6 million.

In 2021, Unity generated $1.1 billion in revenue but posted a much wider GAAP net loss of $533 million (partly due to its $1.6 billion acquisition of Peter Jackson's visual effects studio Weta Digital in the fourth quarter). On a non-GAAP basis, its net loss narrowed slightly to $61.8 million.

All that red ink makes Unity an unappealing investment as rising interest rates boost borrowing costs for unprofitable companies. It also raises concerns about Unity's ability to retain its pricing power against similar platforms like Epic Games' Unreal Engine and Autodesk's (ADSK 0.52%) 3ds Max and Maya.

Unity's stock has been crushed over the past few months, but it still trades at 21 times its projected sales for 2022. That high price-to-sales ratio might cause investors to shun Unity as rising inflation compresses the long-term valuations of higher-growth stocks. Autodesk, which is profitable but growing at a slower rate than Unity, trades at 12 times this year's sales (the company's fiscal 2022 ended on January 31.)

What the bulls will tell you about Unity

The bulls will point out that Unity's growth rates are robust, its margins are improving, and it will benefit from the secular expansion of the gaming, mixed reality, and media production markets.

Unity expects its revenue to rise 34%-36% in 2022. In its latest conference call, CEO John Riccitiello also reiterated Unity's ambitious forecast for maintaining more than 30% annual revenue growth over the long term.

Meanwhile, Unity's non-GAAP gross margins expanded by a percentage point to 80% in 2021, which suggests it still has plenty of pricing power in the gaming market. Its non-GAAP operating margin also improved from -7% to -5%. For 2022, Unity expects its non-GAAP operating margin to improve to -3% -- which supports its target of breaking even on a non-GAAP basis in 2023.

Unity has also been gradually expanding beyond mobile, console, and PC games with new development and monetization tools for virtual reality, augmented reality, and non-gaming 3D experiences. These newer tools could make it a foundational building block of the metaverse market.

The company's acquisition of Weta Digital, which produced the special effects for Lord of the Rings and Game of Thrones, should also accelerate its expansion into the special effects market for TV shows and films.

This ongoing expansion of Unity's ecosystem should widen its moat against Epic, Autodesk, and other competitors. Over the long term, Unity could gradually evolve into a diversified cloud-based provider of creative software -- which might put it in the same league as Autodesk and Adobe.

Unity looks like a compelling investment

I was reluctant to buy Unity last year because its valuations were too frothy. But after its latest pullback, it looks like a much more compelling investment. Its core businesses are still firing on all cylinders, it's gradually expanding its margins, and its ambitious long-term goals seem achievable.

The stock might remain volatile in this grueling market for growth stocks, but I think it's finally the right time to start accumulating shares of Unity.