Software stocks that trade at high valuations have been hit the hardest in this bear market, so Unity Software's (U -1.85%) recent collapse can mostly be attributed to the broader market sell-off. The company entered 2022 with strong momentum across its business, but investors have turned a cold shoulder to Unity after its disappointing outlook in the last earnings report in May.
Two analysts recently downgraded the stock. An analyst with Benchmark went so far as to issue a sell rating. This comes after Unity lowered its second-quarter revenue guidance after experiencing some problems related to its Audience Pinpointer monetization tool for mobile app developers. Management expects revenue growth to decelerate to between 6% and 8% in the second quarter, which is well below what investors are used to with this fast-growing business.
I believe Unity stock is a bargain right now and will resume its previous growth soon enough. The problems contributing to slowing growth appear to be related to self-inflicted wounds. Management said as much during the earnings call. "We understand the problems and we are well advanced in addressing them," CEO John Riccitiello said.
Once we take a step back from the focus on quarterly numbers, the long-term direction of the business and the stock's return potential become more apparent.
Unity's weak outlook is misleading
The lower outlook for growth seems to be scaring investors about Unity's post-pandemic momentum. Benchmark analyst Mike Hickey downgraded the stock to a sell rating, citing concerns over players spending less time playing games this year compared to the shelter-at-home environment in 2020. But long-term investors don't need to be concerned about this. Gaming is still a growing industry that should drive Unity's business for years to come.
Unity's software and monetization services are widely used by video game developers, which is why analysts pay close attention to trends in the gaming industry. The company provides game developers with the tools to create 2D and 3D content. Unity's Create Solutions segment, which includes subscription revenue from these software tools, is also seeing traction outside of gaming in industries like aerospace, medical, and construction.
In addition, Unity's Operate Solutions business provides gaming companies access to a variety of services to help them monetize players in their games, release content updates, and grow their business.
Despite the slowdown in the gaming industry following the surge in 2020, Unity still reported revenue growth of 44% in 2021. This was balanced across Create Solutions, up 41%, and Operate Solutions, up 51%.
What's more, the number of games made with Unity increased by 93% last year. Perhaps most important is that the number of creators using its software grew by 31%, which gives management a new set of customers to upsell additional services over time -- a key part of its growth strategy.
| Segment Revenue | 2021 | % Increase |
|---|---|---|
| Create solutions | $327 million | 41% |
| Operate solutions | $709 million | 51% |
| Strategic partnerships and other revenue | $75 million | 7% |
| Total | $1.1 billion | 44% |
Data source: Unity Software.
In the first quarter of 2022, Unity reported another good quarter, driven by Create Solutions' revenue increasing 65% year over year. But the market was more concerned about slowing growth in Operate Solutions, where growth decelerated to 26%. But as Riccitiello explained on the earnings call, the slower growth was partly caused by a fault with one of its mobile advertising tools.
Most importantly, Riccitiello characterized the market for Unity's services as "healthy." Management expects no carryover of the issues they ran into last quarter into 2023.
Long-term trends suggest Unity is a strong buy
Unity will recover and resume its previous growth over the next few years. It is serving a gaming industry that is expected to reach $300 billion by 2027. Newzoo forecasts the industry to cross $200 billion in 2022.
Most analysts view Unity's obstacles as temporary. The consensus analyst estimate has Unity more than tripling its annual revenue to $3.7 billion by 2026. That's consistent with management's long-term target to grow revenue around 30% per year.
All said, this is a perfect opportunity to buy shares of this software stock that could see new growth opportunities in the metaverse.
