Unity Software (U 3.47%), operator of a popular game creation and monetization platform, made a big splash on July 13 when it announced it was acquiring ironSource (IS) -- owner of a platform that helps businesses scale and monetize mobile apps -- in an all-stock deal.
Shares of Unity promptly dropped 17% after the announcement, signaling that Wall Street was unhappy with the deal. The transaction valued ironSource at $4.4 billion -- a 74% premium to the 30-day average exchange ratio of the stocks. While there are certainly benefits for Unity to the acquisition, there's more to this deal than meets the eye. Here are three things investors should know.
1. This is risky
Unity's solutions cover two areas for game developers: game creation (via its Create solutions unit) and operations (via its Operate solutions unit), which includes monetization. Unity has recently struggled with its monetization solutions, and this addition may have been viewed as a way to help solve its issues.
This is why this acquisition makes sense on paper. In theory, ironSource could help accelerate Unity's recovery from its recent errors and get it back to operating an effective all-in-one platform for game developers.
However, not all deals are successful, especially ones that take immense integration. Just look at Teledoc Health's purchase of Livongo Health. If Unity and ironSource cannot effectively integrate their operations, the value of this acquisition could be less than hoped.
There's also a chance that Unity overpaid for ironSource, given the high premium. Clearly, it wasn't a bargain based on what investors have thought of the company recently.
2. Unity stock is funding this purchase
Every share of ironSource will be exchanged for 0.1089 shares of Unity's stock. If the buyer's share price keeps dropping, it could potentially pay less in dollar terms for ironSource, but one thing is certain: existing Unity shareholders will face dilution. When the deal gets closed, existing Unity shareholders will only own 73.5% of the combined company.
Buying a company in stock and creating significant dilution isn't appealing to existing shareholders, but Unity made another move that displeased its investors. The company announced a $2.5 billion stock buyback program. This is likely an effort to help reduce the dilution from this deal, but the buybacks will be funded partially by debt. Unity will receive $1 billion in convertible notes from its two largest shareholders, Silver Lake and Sequoia.
So the share repurchases will help diminish one concern, but create another in that it will push Unity's debt load higher. Considering the company is unprofitable and was free cash flow neutral over the trailing 12 months, the best way to spend capital right now might not be to buy back shares. Instead, holding that cash on the balance sheet for a rainy day or preparing for a potential recession during which activity and revenue could decline might have been a smarter choice.
3. ironSource could ease Unity's profitability problems
Speaking of Unity's bottom-line issues, ironSource could help on this front -- it brought in $623 million in revenue over the trailing 12 months. Of that, $139 million turned into free cash flow, and $63 million became net income. The company might be small compared to Unity (which generated over $1.2 billion in revenue over the trailing 12 months), but it's more profitable.
In theory, this could help subsidize Unity's losses. In Q1, the business lost $178 million, so ironSource's profitability -- albeit slim -- could partially offset this.
What should Unity investors do?
If this merger can get done smoothly, it could prove lucrative. The synergies between their businesses make integration look plausible, and ironSource's profitability and monetization strength could be a significant value add.
That said, this is a risky purchase. There's a lot at stake if this doesn't pan out, and Unity investors would be stuck with dilution, debt, and little cash if that happens.
Therefore, investors should be in a "trust but verify" state of mind. Monitoring the company's profitability and free cash flow will help confirm that ironSource is contributing to the bottom line. Additionally, if the combined company continues to stumble with monetization, that could prove this business combination isn't going as planned. Lastly, it will be critical to monitor Unity's goodwill and watch out for impairment charges over the coming years.
The deal is expected to close in the fourth quarter, so 2023 could be telling, but there is certainly reason to be optimistic about this purchase.
