Unity Software (U +2.61%) has faced a few headwinds over the past few quarters, but will that be changing soon? In this clip from "The Rank" on Motley Fool Live, recorded on June 6, Fool.com contributors Jamie Louko and Jason Hall discuss how the video game software company will build on its role as a market leader and be set up for future success.
Jamie Louko: It basically has software for game developers to create, run, operate basically everything from start to finish for video games and developing video games, Unity offers it. You can start and build your game, but you can also operate it, run it, monetize it. It's really that one-stop shop for game development and game operations, basically.
They are the top dog in this space. They have over 50% market share across all devices and really there's no other competitor that has this size and scale. There's Epic Games' Unreal Engine. That is in the double-digits, I think it's around 20% market share. But Unity is the leader and that's led to some decent success.
Just pulling some metrics from their first-quarter revenue, grew steadily 36% year over year and large customers are now spending a lot on the platform. Over a thousand customers are spending over $100,000 annually with Unity to mainly operate and monetize their video games, which is really good.
Now, like a lot of tech stocks, it's not profitable. It's losing plenty of money. It was about $178 million this quarter and that actually increased pretty substantially at about 65% year over year. But it is free cash flow positive and it transitioned from being free cash flow negative to free cash flow positivity, which is great. I love to see that in a lot of tech companies that transition generating cash, that's really good to see.
But there was a huge panic in Unity the last quarter, this little drop halfway between April and today. That was basically because of Unity's guidance going forward. They projected about 7% growth in Q2 for their top line and about 22-28% year-over-year growth for their full year.
This was primarily because one of Unity's solutions, Unity Monetize, they have an AI engine that basically uses a ton of data to figure out where ads should be placed on these games. It was built on faulty data from one big customer that basically just caused the advertising on some of these video games on the people that use these monetization platforms to just be really bad.
These ads were not put in front of the right people. Unity realized this and they basically have to scrap this solution and rebuild. They have to generate new data. They have to train their AI and their machine learning engine with that data, then they have to bring it to the market, and then they have to convince their customers that, hey, this engine is better now, it's built on better data, we'll give you better results.
That's going to take about a $100 million hit to the company's top line over the next year. Primarily, it's going to be in Q2 and Q3, and it shouldn't go into the full year of 2023. That's what management is saying, but it is a big hit to the company. A lot of their money comes from their operating solutions, especially their monetization solutions. Yeah, that's a big damage.
But the long-term thesis for Unity, I think is still relatively on track. It's a leader in a massive industry with no major competition, really even coming close to Unity's size and scale. I bought it because it's this all-in-one solution where developers can go for literally everything from starting the game to running it five years later.
However, this problem with the AI kind of puts a wrench in that thesis, in that idea. It's really important that they need to recover and then that this AI engine can successfully monetize consumers' video games again. Because if Unity can't help drive monetization for its customers, that doesn't really mean that it's an all-in-one solution and that's a big part of a game developer's operations. They have to monetize their game. If Unity can't do that, that puts a wrench in the plans.
That's why I ranked it basically middle of the pack. I think I ranked it about fifth. Overall, I think it's a really strong business but it had a really big hiccup in its last quarter. Management has to prove that that won't be a long-term thesis buster.
Jason Hall: I think it's easy to look at it and say, well, this is still pretty expensive. If you're looking at cash flows, it is. But it trades Jamie for less than 10 times sales now. That economic engine is really kicking off.
I want to just share this. Over the past 12 months, the past four quarters generated $33.6 million in free cash flow. It generated almost $87 million, just last quarter. Again, we're seeing that trend really start to kick off and I love it. A $12 billion dollar company, you look at a company like Adobe Systems (ADBE +1.87%), it's a $200 billion company.
I'm not saying this could be an Adobe or an Autodesk (ADSK +3.10%), but somewhere between where we are now and where those companies are, I think 5-10 years from now, is realistic. I really do.
