It's official: Unity Software's (U +5.50%) acquisition of digital advertising platform ironSource is complete. Since the deal was finalized and Unity announced its third-quarter earnings report, the stock has gone from $21.50 (on Nov. 9) to over $40 a share at the beginning of December.
The market must be pleased with this tie-up between a leader in 3D content creation and an app monetization outfit like ironSource, right? Not so fast. Even with ironSource now in the fold, Unity should still be viewed as a high-risk stock -- one with an uncertain payoff in the coming years. Here's why.
NYSE: U
Key Data Points
Unity's rally is more than just business optimism
Unity stock may have been sold off hard in early November as investor angst built about a possible recession next year. As such, a relief rally may have been in order, but Unity stock is also up so much in the past month because the U.S. Federal Reserve indicated it will begin moderating its pace of interest rate hikes. Fed chair Jerome Powell has said just a 0.5% hike is on the table for December, versus the 0.75% hikes at recent meetings. However, Powell also said the fight against inflation isn't over yet.
As a reminder, higher interest rates lower the present value of stocks, especially those like Unity, since the company doesn't generate a profit yet. Thus, hope for interest rates peaking has many shareholders cheering after an incredibly painful 2022.
But what of Unity's Q3 2022 earnings update? The company is clearly facing a slowdown in growth, just like every other software company is these days. Create Solutions grew 54% year over year to $129 million (down from 66% growth in Q2).
The real bummer, though, was the Operate Solutions segment, which declined 7% year over year to $172 million (compared to a decrease of 13% in Q2). Unity is still rebuilding its revenue from its Unity Monetization product that helps developers sell ads after some mistakes were made.
Overall revenue grew just 13% as a result. And profitability is still elusive as well. Even on an adjusted basis (which excludes noncash items), Unity lost $37.4 million in Q3. Free cash flow was -$80.8 million, though management reiterated it expects to reach breakeven in Q4, no doubt helped by the inclusion of ironSource, as the two businesses begin to integrate operations and trim redundant expenses.
The most important milepost to focus on
If recession strikes, 2023 could be another tough year for Unity, especially its already beaten-up digital ads segment, since marketing activity tends to take a hit during economic downturns. Management said it will provide a preliminary outlook during its fourth-quarter update in a couple more months from now.
But by the end of 2024, the expectation is still for Unity and ironSource together to be generating adjusted EBITDA (earnings before interest, tax, depreciation, and amortization) of $1 billion on an annualized basis. After issuing new stock to take over ironSource, management said it will have about 562 million shares outstanding by the end of this year. Based on the current $40-per-share price as of this writing, Unity is valued at $22.5 billion.
For a company that generates $1 billion in profit and is growing at a double-digit percentage right now, this might be an acceptable valuation for a lot of investors out there. But there are a lot of question marks for the economy, and Unity itself, between now and the end of 2024.
Trading for over 20 times expected adjusted EBITDA two years from now is a bit of a steep price tag. This explains my contention that this is still a high-risk, potentially high-reward investment. Most investors may want to take pause before buying here, especially after shares nearly doubled in recent weeks.
That being said, Unity also still believes it can accelerate its overall growth rate back to the 30%-per-year range once the risk of a 2023 recession is in the rearview mirror. That hope, based on demand for 3D content creation tools in the cloud, might be enough to keep you interested. I remain a shareholder of Unity, though I'm not adding to my position at this juncture.
