Is Unity Software Stock a Buy Now?

Unity Software's (U -2.31%) stock price plunged 29% during after-hours trading on May 10 following its first-quarter earnings report. The game-development software company's revenue rose 36% year over year to $320.1 million but missed analysts' estimates by $1 million.

On a non-generally accepted accounting principles (non-GAAP) basis, Unity narrowed its net loss from $27.3 million to $25.4 million, or $0.08 per share -- which matched analysts' expectations. On a GAAP basis, its net loss widened from $107.5 million to $177.6 million.

Image source: Getty Images.

For the second quarter, Unity expects its revenue to rise just 6% to 8% year over year, which broadly misses the consensus forecast for 31% growth. For the full year, it expects its revenue to rise 22% to 28% -- compared to analysts' expectations for 35% growth. That weak forecast raises troubling questions about Unity's plan to grow its annual revenue by 30% over the long term.

However, Unity's stock now trades at a 35% discount to its initial public offering (IPO) price and more than 80% below its all-time high. Should investors consider buying some shares of Unity at these depressed levels?

Why did Unity's growth sputter out?

During the first quarter, Unity generated 36% of its revenue from its Create Solutions business, which hosts its core game development engine and development tools for non-gaming businesses.

It generated 57% of its revenue from its Operate Solutions business, which handles ads, in-app purchases, analytics tools, revenue-sharing plans, and other features for developers. The remaining 6% came from its Strategic Partnerships and Other division, which mainly handles its deals with gaming companies.

Unity's Create Solutions and Strategic Partnerships businesses generated impressive growth in the first quarter, but those gains were partly offset by a severe slowdown in its Operate Solutions business.

Data source: Unity. Chart by author. YOY = year over year.

The Operate Solutions segment's growth sputtered out as it struggled with software problems with its Audience Pinpointer tool, which uses machine learning algorithms to deliver targeted ad campaigns.

Those problems prevented Unity from effectively analyzing and monetizing a lot of the data that flowed through its platform. Its ingestion of "bad data" from a large, unnamed customer exacerbated that loss of revenue.

Unity's Audience Pinpointer issues weren't related to Apple's privacy update on iOS, which Unity had successfully navigated before the recent problems cropped up in February and March.

The company expects these issues to reduce its full-year revenue by about $110 million. Excluding that impact, which will be recognized over the next three quarters, its full-year guidance would have actually matched Wall Street's expectations.

Unity expects its slowdown to be temporary

During the conference call, CEO John Riccitiello said the Operate Solutions segment's slowdown was "mostly caused by internal factors in Unity monetization in an otherwise healthy market." He also said the company views "these challenges as temporary and not structural" and does not expect them to adversely impact its growth "beyond 2022."

Riccitiello also reiterated his expectations for Unity to "sustainably grow revenue at or above 30% per year over the long term." CFO Luis Visoso also said Unity's goal of achieving non-GAAP profitability in 2023 remained unchanged.

But before that happens, Unity still expects its non-GAAP operating loss to widen from $50.7 million in 2021 to $60 million to $75 million in 2022 -- even as it reins in its spending to cope with its slowing revenue growth.

Its non-GAAP gross margin, which declined two percentage points year over year to 76% in the first quarter, could also continue to contract as it integrates its recent acquisition of Weta Digital -- which created the special effects for several blockbuster movies and popular TV series like Game of Thrones -- to expand its non-gaming business.

Unity deserves to go to the penalty box

Unity's slowdown could be temporary, but it expects its Operate Solutions issues to drag on throughout the whole year.

That's a dim outlook for a stock that still trades at seven times this year's sales after its post-earnings plunge. Based on the valuations of its hypergrowth peers, Unity will likely be stuck in the penalty box for a while.

For reference, Twilio, the cloud communications company expecting to generate at least 30% organic revenue growth through 2024, trades at less than five times this year's sales. Palantir, the data-mining firm that expects to grow its top line by at least 30% through 2025, trades at less than eight times this year's sales.

But Unity also deserves to sit in that penalty box. I'm still bullish on the company's long-term prospects -- since its engine powers over half of the world's mobile, console, and PC games -- but its stock isn't worth buying again until it resolves its disappointing internal issues.