Although the world is full of uncertainties, one transition that seems inevitable is a move to a more digital society, regardless of whether it is at work or home. Now that technology exists to make life-like renderings, businesses are using it more to develop digital twin models with various uses.
One company powering this transformation is Unity Software (U 3.80%). With its powerful animation software, Unity has quickly become the choice of many top content creators. However, Unity started primarily as a game development platform, and the expansion outside gaming marks a significant departure from its original business but unlocks a massive market.
The use case of Unity's creation software seemed endless in 2021, but the hype quickly wore off as the stock crashed from its all-time high. Now down 70% from that high, is Unity Software worth another look?
A tale of two segments
Unity's business has two segments: Create solutions and operate solutions. The create segment is pretty self-explanatory -- it's the software that helps designers create life-like models and develop video games. It's also Unity's fastest-growing segment. In the second quarter, it grew 66% year over year to $121 million in sales.
Furthermore, the revenue share outside gaming increased from 33% in the fourth quarter of 2021 to 40% this quarter, showing that this software has a broader use outside of video games. As Unity grows, I'd expect this number to increase even more. This growth would be ideal for shareholders, as there is a much broader market than just gaming that demands high-quality digital renderings.
The operate division is still Unity's largest, but it had a challenging quarter due to some self-inflicted wounds. In the first quarter, Unity had an issue with its Audience Pinpointer tool, which caused the wrong ads to be displayed to specific audiences. This mistake caused Unity to lose an extensive data set and its monetization to drop. While this is a significant headwind, it's not expected to affect revenue in 2023.
As for Q2, revenue dropped by 13% to $159 million. However, there's another factor in Unity's operate solutions that I haven't discussed -- its merger with ironSource (IS).
Are profits around the corner for Unity?
ironSource's software allows its users to optimize apps by maximizing revenue, acquiring users through advertising, and analyzing how an app is performing. These services combine well into Unity's existing platform and make for a strong combined company.
After the merger (expected to be complete by Q4), Unity expects its adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) to be $1 billion annually by the end of 2024. That's a bold prediction, but it makes sense given the enormous market opportunity and expected synergies between the two businesses. For context, the trailing-12-month revenue for the combined businesses is $1.89 billion, so there's still a lot of growth to be had.
The one thorn in Unity's side (which also plays into the bold EBITDA projection) is its massive stock-based compensation bill. In Q2, that figure amounted to $106 million, or about 36% of revenue. This expense helped drive an operating loss of $198 million at a 67% loss margin. That's a big hole to dig itself out of to reach profitability.
Even with the ironSource merger (a profitable business), the combined entity has a long way to go before it can break even. Keep in mind that the adjusted EBITDA value subtracts stock base compensation, so management's $1 billion figure has a slight asterisk on it.
However, the stock trades at 14 times sales, which isn't mind-bogglingly expensive. In fact, it's right in line with perhaps the most iconic content-creating software company, Adobe, which trades at 13 times sales.
While Unity has a long way to go to reach Adobe's level of profitability and widespread use, it has the potential to do it. Because of this, investors can purchase the stock right here without too much valuation concern.
However, the stock isn't without risk, as the ironSource merger may not provide the expected synergies and could be an expensive write-off down the road. Still, I think the upside outweighs the downside, making Unity a solid buy for long-term growth investors who understand the business's risks.