Sometimes, a business makes an acquisition so significant that it changes the fundamental investment thesis of a stock. After Unity Software (U 0.92%) announced it was buying ironSource, many investors had to reevaluate the company. With the merger complete as of Nov. 7, investors now have to decide if the stock is worth holding on to.
After digging into Unity's latest earnings report, there are valid points on both the bearish and bullish sides for the company going forward. However, I think one side has the better argument.
The new company
Unity Software gives content creators the tools they need to bring their designs to life. With its various offerings, users can create realistic renderings of a new product, create a realistic building model that clients can tour using virtual or augmented reality, or design a video game with best-in-class graphics. Basically, if you want to make anything in 3D, Unity Software is the go-to company.
The ironSource merger is a nod to its video game wing, giving designers the tools they need to create an app that supports a business. With its tool kit, creators can understand what advertising campaigns work and better monetize the platform.
Combined, management believes it will create a full-scope offering that allows clients to more consistently create hit games that are more monetizable. While the vision is inspiring, Unity shareholders took a hit with the merger because it cost the company $4.4 billion to buy ironSource. The kicker? The whole deal was paid for in shares.
This deal will cause the fully diluted shares outstanding to rise from 299 million in Q3 to 562 million in Q4 -- an 88% increase. Essentially, anyone who owned one share of Unity Software premerger now owns about half as much of the company.
However, with the synergies management predicts, the business growth may overshadow this acquisition. But there are still some concerns.
The red flag: Unity's losses are rising, and a business segment is struggling
In Q3, Unity's loss from operations rose from $127 million last year to $240 million this year. To add insult to injury, Unity's revenue only rose 13% YOY (year over year) to $323 million. So not only did revenue barely rise, Unity's operating expenses nearly doubled.
One segment that is causing Unity trouble is its Operate solutions -- the side of the business that helps creators monetize their games. This segment was down 7% YOY but has been dealing with some fierce headwinds lately. Earlier this year, the algorithm behind ad placement was fed bad info, resulting in ads that were not successfully targeted to their intended audience.
While Unity has corrected this issue, the damage was done, and ad prices on the platform fell substantially. Additionally, the current advertising market is weak, and management expects advertising growth to be flat in Q4.
Neither of these realities is great news for Unity shareholders, but there is a light at the end of the tunnel.
The green flag: Future outlook is strong
The market is a forward-looking mechanism, but with Unity trading at an all-time low valuation, the market doesn't seem to have much hope for Unity's future.
U PS Ratio data by YCharts
However, management still believes that Unity will be a strong company in years to come. Starting with Q4 guidance, management expects YOY revenue growth of $435 million at the midpoint. This projection also includes ironSource revenue, so investors need to keep an eye out on Unity's core segments to ensure they aren't slipping.
Additionally, CEO John Riccitiello reiterated his guidance that the company can provide a sustainable 30% compounded annual growth rate over the long term. That level of sustained growth is rare, but if Unity can pull it off, it will be one of the best-performing stocks in the coming decade.
Unity is close to breaking the profitability threshold, despite how bad Q3 was. In Q4, the company expects to deliver about $10 million in non-GAAP operating profits. There is a significant caveat here: This metric doesn't include stock-based compensation, which Unity paid $155 million of in Q3. That's a considerable expense, but it isn't a big deal if the company continues to grow at a 30% pace.
By 2024, management expects the ironSource merger to produce about $1 billion in EBITDA. If it can accomplish that, Unity will be a highly profitable company that investors will be excited to own.
However, the key phrase here is if. A lot of Unity's green flags are based on projections, while the red flags are based on reality. I believe in Unity's market opportunity, so I'm more inclined to believe in management's guidance. However, I also understand the risk of this stock, so to balance these two realities out, I'm keeping the positing size of Unity in my portfolio low.
If the business transformation works out, those few shares of Unity will drive massive growth. If it fails, the small position sizing won't hurt my portfolio. This is the best way to invest in Unity, but that logic will likely change within the next year as Unity's merger plays out.
