On Feb. 3, Unity Software (U 10.20%) CEO John Riccitiello made a bold statement. During a conference call to discuss financial results for 2021, Riccitiello said, "We expect to grow revenue above 30% for the long term."
Three months later, Unity's full-year 2022 revenue guidance was lowered, implying just 22% to 28% year-over-year growth. In other words, it took just three months for the company to fall short of Riccitiello's long-term guidance. And since Feb. 3, Unity's stock price is down a painful 65%.
Unity will fail to achieve management's lofty 30% revenue-growth guidance in 2022 due to a problem in its Operate Solutions segment. However, it looks like management is working to fast-track a solution to the problem by acquiring competitor ironSource (IS).
This appears to be a sensational move for Unity.
Unity has a problem
Unity has three business segments. The two biggest are Create Solutions and Operate Solutions. When Unity's management discussed Q1 results, it noted that Create revenue had come in ahead of expectations at $116 million. But revenue for the largest segment -- Operate -- had come in behind expectations with $184 million.
With Operate Solutions, Unity's customers can monetize their mobile apps -- typically gaming apps. Targeted ads are served up based on the company's algorithm. But Riccitiello said, "We lost the value of a portion of our data training due, in part, to us ingesting bad data from a large customer."
In other words, Unity built its monetization business up by feeding good data to its machine-learning software and improving its algorithm over time. As the algorithm improved, customers got better results, causing them to increase their spending. This progress was wiped out in one fell swoop. And unfortunately for Unity shareholders, there isn't a quick fix.
Riccitiello went on to say, "We expect recovery to go through steps in sequence, data rebuilding, model training and improvement, and then revenue recovery." In other words, tear down the current algorithm so it can be rebuilt. Only then can revenue start recovering. In the meantime, Unity's management expects $110 million in lost revenue in 2022 from this one mistake.
Is ironSource the solution?
While Unity is the larger company, ironSource has been eating Unity's lunch in the app-monetization space. Therefore, if Unity needs gobs of good data for its algorithm, I'm betting ironSource has it in spades.
According to ironSource, as of the first quarter of 2022, 89 of the top 100 most downloaded mobile games in the U.S. were using ironSource's software. And because ironSource has been so successful in getting downloads, customers have increased their spend substantially over time. The company's dollar-based net expansion rate (which represents increases in existing customer spend) has been between 149% and 181% for at least 10 consecutive quarters -- world-class numbers.
In short, ironSource is clearly doing something right in the app-monetization space. Therefore, it's no surprise that a competitor like Unity would look to acquire it.
Unity's management expects its merger with ironSource to close in the fourth quarter.
What could go right
Investors often wonder what could go wrong. But here, I want to consider what could go right for Unity by acquiring ironSource now.
First, Unity is still doing well with growing and retaining customers. Customers often start their journeys with Unity in the Create Solution segment. And in Q1, Create Solutions revenue was up 65% year over year. Moreover, it added 31 net new customers spending $100,000 annually compared to the previous quarter, bringing its total to 1,083.
By the way, ironSource brings 397 more $100,000 customers to the table.
Unity's customer base is still strong. Now it must rebuild its monetization algorithm so these customers spend more over time. This is the perfect time, therefore, to add ironSource to the mix. Not only can Unity rebuild with its own dataset but it can also incorporate ironSource's data, which is likely high quality.
In the merger agreement, Unity management lowered its 2022 revenue guidance to $1.3 billion on the low end. But ironSource management reaffirmed its revenue guidance of $750 million on the low end. Therefore, these companies combined should be at a $2 billion revenue run rate this year.
The merger agreement is a little complicated. But based on where these two stocks are trading right now, the post-merger market capitalization of Unity will be around $13 billion. This is a price-to-sales (P/S) valuation of about 6.5 -- quite a discount to Unity's P/S ratio of 55 less than one year ago.
Here's the takeaway: IronSource could fast-track Unity's rebound. Moreover, Unity's monetization algorithm may actually be better with ironSource's data than it would be without it. This could put 30% annualized revenue growth back on the table, making Unity stock a screaming bargain at today's valuation.
It's always important to consider what could go wrong. And there's certainly more to consider with Unity stock. However, I believe Unity's merger with ironSource is the perfect move at this time and it's rekindled my desire to be a long-term Unity shareholder.