Shares of Unity Software (U 0.44%) were down over 30% last week after the company said revenue growth would slow to between 6% to 8% year over year in the second quarter. That is a massive deceleration from the first-quarter revenue increase of 36%. Management had said previously that it expects to grow revenue by about 30% per year over the long term.
However, the fast-growing gaming software provider entered the quarter trading at a high price-to-sales multiple over 15, which is expensive for a company expecting to report single-digit growth in the near term. When a company doesn't deliver the growth that is implied in the stock's high valuation, the stock usually falls.
But now that it has tumbled to new lows, should investors buy it expecting a rebound? Let's first review what management had to say during the earnings call.
Image source: Getty Images.
What went wrong
Unity ran into a problem within its Operate Solutions business, which made up most of its revenue in 2021. For a quick primer, the company generates revenue from Create Solutions, including revenue from subscriptions to real-time 3D software development tools. Operate Solutions includes revenue for additional services, such as monetization tools for video game developers, in addition to hosting and in-game voice-chat services.
| Segment Revenue | 2021 | YOY Growth |
|---|---|---|
| Create Solutions | $327 million | 41% |
| Operate Solutions | $709 million | 51% |
| Other | $75 million | 7% |
| Total revenue | $1.1 billion | 44% |
Data source: Unity Software. YOY = year over year.
Unity has revenue-sharing agreements with mobile app advertisers, which is included within Operate Solutions. This segment had been experiencing a deceleration in revenue growth, stemming from Apple's mobile iOS privacy changes that make it more difficult for advertisers to track users.
However, a fault in Unity's Audience Pinpointer tool caused a challenging situation to get even worse. This tool uses machine learning to assist with user acquisition for app creators, but a problem is causing reduced accuracy for customers, which is hurting sales.
Another issue that affected revenue guidance is some bad data that was ingested from a large customer. It will take time to rebuild the data and model training that Unity uses to serve customers. Management estimates both issues will shave about $110 million, or 8%, off its full-year revenue for 2022.
Unity's competitive advantage
The good news is that these issues affecting the Operate Solutions business are speed bumps that are not expected to carry over to 2023. Buying growing companies after a sharp sell-off that is based on fixable problems can be a winning investment strategy. CEO John Riccitiello certainly believes Unity will conquer near-term obstacles.
NYSE: U
Key Data Points
During the earnings call, Riccitiello said: "We have the right strategy to address today's challenges, and we have the right talent that has overcome many challenges in the past and come out ahead. We are on it."
Riccitiello reminded investors of the long-term advantages that Unity has to serve a growing addressable market for real-time 3D content. Its main advantage is that more than half all video games are built with its software and analytics. This provides Unity proprietary data from over 3 billion monthly active users across all the games built with its software.
Chief financial officer Luis Visoso's comment nailed the most important reason to consider buying the stock: "We believe we are in the early stages of one of the largest transformations in tech: the move to real-time 3D. We will continue to invest to capture the opportunity while quickly driving to sustainable and growing profitability."
Indeed, Unity increased its long-term revenue opportunity from $29 billion to $45 billion with last year's acquisitions of Weta Digital and Parsec. These deals expand Unity's ability to reach more customers by broadening the accessibility of its products across multiple devices and enlarging the diversification of its product offering in 3D design.
Unity will keep growing
The stock hit a 52-week high of $210 in late 2021 and has fallen all the way down to $39.74 at the time of this writing. The recent fall has brought Unity's market cap (total shares outstanding times the stock price) down from $45 billion to $11.8 billion. That's a price-to-sales ratio of 9.4, based on Unity's trailing-12-month revenue of $1.2 billion.
U P/S ratio. Data by YCharts. TTM = trailing 12 months.
I believed Unity was a good stock to own at $100, and I believe it could be a genuine value at under $40. The only issue that might keep the stock down for a while is the losses on the bottom line, which is something that has weighed on many growth stocks in 2022.
Since Unity is a software services company with recurring revenue from subscriptions, it should grow into a very profitable business as it expands its customer base over time.
