As one of the leaders in the game development space, Unity Software (U -5.58%) could capitalize on the enormous gaming market, which is expected to be worth $300 billion in the next five years. In a survey done by Unity in 2021, 61% of game developers use Unity to build their games.
However, if you look at Unity's stock price today, you might think it's struggling. Shares are down over 73% year to date, between the broader tech-stock sell-off and a recently disclosed machine-learning error that will cause serious problems for Unity's business. But while it might not be ideal to buy shares today, investors might want to think twice about selling as well.
What happened to Operate?
Unity has two primary businesses: Create and Operate. Create solutions are subscription-based and help businesses build high-quality video games and other content, and they represented 36% of total revenue in Q1. Operate solutions, which made up 58% of Q1 revenue, are consumption-based and help developers monetize their games, as well as grow and engage their user base.
The company ingested some faulty data from a large customer that caused the machine learning for its Audience Pinpointer tool -- a targeted advertising tool that's part of its Operate solutions -- to draw bad conclusions, placing the wrong ads in front of the wrong users. With the whole system flawed by this miseducation, Unity will likely have to start from scratch and rebuild a stronger data set to retrain its machine learning.
As you would expect, this is going to ding Unity's top line. The company expects a $110 million revenue hit for the full year, with almost 90% of the damage coming in Q2 and Q3. This crushed Unity's guidance, so instead of expanding the top line at 44% year over year as it did in 2021, Unity is expecting just a 22% to 28% 2022 revenue increase.
This slowdown deals a serious blow to many investors' investment theses. The company sets itself apart by offering a platform where a developer can do everything from creating a game to growing, monetizing, and running it. However, if developers can't effectively use Unity's tools to make money off their games, this value proposition becomes much weaker. Even if the company can effectively rebuild, it will still have a steep hill to climb convincing developers that its ad targeting is working again.
The company is still executing
That said, this quarter also had some good news. Create solutions skyrocketed in Q1, growing 65% year over year. Additionally, Unity had over 1,000 customers spend more than $100,000 on the platform in the trailing 12 months, which signals that there are plenty of customers leaning heavily on the platform.
Unity also saw impressive expansion outside of the gaming space. It now has 3,000 customers building digital replicas of their real-life spaces so that they can experiment and test for space efficiency, among other things. These include companies in the manufacturing, construction, and simulation industries. As the rest of the world adopts digital tools, Unity is proving that it can be used for more than just gaming.
Another highlight was the company's free cash flow generation this quarter. The company had $86 million in free cash flow in Q1, which improved substantially from a free cash flow burn of $101 million in the year-ago period. The majority of this improvement came from an increase in deferred revenue, which means that customers are paying cash up front for their future usage.
Is Unity a buy?
Unity stock might not be worth buying today, but it certainly isn't worth selling, either. Unity needs to clearly show that it is successfully retraining its machine learning engine with good data that will pay off for customers aiming to make money off their video games. However, the rest of the business is doing extremely well. Create solutions are skyrocketing, partly because of the company's success outside of the gaming space. Unity is already a leader in a massive industry, and seeing it spread its wings into other markets like manufacturing should excite investors.
Shares trade at just 9.3 times sales, the lowest valuation this company has ever seen since coming public a little more than a year ago. Before 2022, it consistently traded around 30 times sales or above. If Unity can overcome this monetization issue, the current price could look like a major bargain in hindsight. If the company can turn things around, shares will likely rise, but they're unlikely jump back to anywhere near its former highs -- which could give investors a relatively good deal, even if it's slightly higher than today's rock-bottom prices.