Shares of Unity Software (U -5.55%) have had a rough year, now down more than 74% in 2022. This dominant game development platform helps build everything for a video game. From coding to design to monetization, Unity helps with it all.
However, investors have largely lost interest in the company after a problematic first quarter. The company announced strong adoption, but one major hiccup contributed heavily to shares sinking. However, this error looks to be temporary, and while this is a riskier investment, it might be wise to buy a small amount of Unity on the dip.
Unity's fall from grace
The game development platform posted stellar growth in the first quarter. Its top line jumped 36% year over year to $320 million, driven by its Create Solutions segment, which soared 65% higher year over year to $116 million. The company's business breaks down into two primary revenue streams: Create and Operate Solutions. Create Solutions are subscription-based and help developers create the game. Operate Solutions provides usage-based products that facilitate the monetization and engagement of the game.
So what was the big concern for investors? In Q1, management found an artificial intelligence (AI) error with its monetization service due to bad initial data. In other words, the company took on faulty data from a large customer and built its AI on it, which caused inaccuracies.
As a result, management will have to rebuild, retrain, and improve its AI with new data. As a whole, this error will impact the top line to the tune of $110 million over the rest of 2022.
Add this to the company's $177.6 million net loss in Q1, which jumped 65% year over year, and investors fled. The company's trailing-12-month free cash flow of just $34 million wasn't enough to excite investors, resulting in the steep drop.
The game isn't over for Unity
This might seem bad on the surface, but there are some silver linings. First, Unity has more than $1.8 billion in cash and securities on the balance sheet to fuel this net loss. Additionally, Unity expects to be profitable as early as Q4 2022, and management sees this continuing in 2023. This shows that this risk might not be as significant as investors believe.
Another silver lining is that while Unity management predicts this AI error will impact 2022, there won't be any carryover into 2023. Therefore, this should only be a short-term issue, making it less worrisome for long-term investors who are planning to hold this company for many years, not just the next six months.
Lastly, Unity is a dominant force in game development. In a study by Unity, 61% of the game developers surveyed used the platform in 2021, and other estimates put Unity's market share at 48%, meaning that it is the far-and-away leader in the space. Considering this market is expected to be worth over $300 billion by 2027, being the top dog could result in immense success over the long term.
Importantly, Unity has an advantage over its main competitor, Epic Games' Unreal Engine: Its coding language is easier to learn than the code used by Unreal. Unreal does have a no-code offering, but for those looking to develop their games by hand -- rather than using a plug-and-play solution -- Unity is the easiest place to do so.
Should investors buy Unity?
If you want to invest in the gaming space and capture the expansion in this industry over the coming years, Unity looks like the best way to do that. The company stumbled recently, but long-term investors should realize that this is only a short-term problem and that their monetization efforts should recover next year. However, it will be critical to make sure that actually happens. If Unity's monetization tools remain inaccurate, that would be cause for concern.
While Unity seems like it's worth buying right now, there's still a risk, and investors should size their position accordingly. If you want to buy Unity on the dip right now, it should be a small position given the uncertainty in the future.
At 8.8 times sales, Unity trades at a bargain relative to its life as a public company. Since the company came public in 2020, it has never sold at a valuation this low. Considering this stock is a high-growth (and soon-to-be-profitable) company, this looks more like a bargain than a value trap. Therefore, while investors should keep this company on a short leash and ensure that it can effectively rebuild its monetization tool this year, investors might want to nibble on Unity shares.