Unity Software's (U 0.92%) stock price tumbled 16% on Feb. 23 after it posted its fourth-quarter earnings report. The video game engine developer's revenue rose 43% year over year to $451 million and topped analysts' estimates by $13 million. That growth was partly driven by its takeover of the ad tech company ironSource last November.
On a generally accepted accounting principles (GAAP) basis, Unity's net loss widened from $162 million to $288 million, or $0.82 per share, which missed analysts' expectations by $0.38. But on a non-GAAP basis -- which excludes its stock-based compensation, its acquisition of ironSource, and other one-time expenses -- it generated a slim net profit of $13 million, compared to a net loss of $22 million a year ago. That represented its first non-GAAP profit as a public company.
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Investors clearly weren't impressed by Unity's mixed numbers, and its stock remains nearly 40% below its IPO price of $52 in 2020. Let's review the bear and bull cases to see if it's a worthwhile turnaround play.
How does Unity make money?
Unity's game engine enables developers to efficiently create video games by offering tools for creating graphics, sound effects, and multiplayer features. It also helps them monetize games with in-app purchases and ads. Over half of the world's mobile, console, and PC games are developed with Unity products. That business model sounds promising, but it's also a freemium platform that arguably encourages the development of low-quality "shovelware" games that are quickly "shoveled" out for a quick buck. Those free users might boost Unity's market share, but they don't boost its revenue or strengthen its brand.
The growth of Unity's game engine -- the core pillar of its Create Solutions segment, which generated 35% of its revenue (on a combined basis with ironSource) in 2022 -- accelerated during the pandemic as people played more video games. However, the segment's growth cooled off with the gaming market in a post-lockdown world.
The remaining 65% of Unity's revenue came from its Grow Solutions segment, which houses the advertising and monetization segments that were expanded by its takeover of ironSource. This business suffered a severe slowdown last year after Apple's privacy changes on iOS blocked it from collecting user data for its integrated ads. Unity was forced to rewrite its entire advertising algorithm and buy ironSource to cope with that unexpected slowdown.
What the bears believe will happen to Unity
The bears will point out that Unity faces stiff competition from other game engines like Epic Games' Unreal Engine. Top game publishers like Electronic Arts also use their own proprietary game engines instead of third-party engines. Therefore, Unity's long-term prospects could be limited as the market becomes increasingly fragmented.
They'll also note that both of Unity's core markets -- video game development and digital ads -- are highly exposed to macro headwinds. Consumers are less likely to splurge on digital purchases during economic downturns, while advertisers are less keen to buy digital ads.
Unity's guidance reflects those challenges. On a combined basis with ironSource, it expects its revenue to decline 6%-8% year over year in the first quarter and only grow 2%-9% for the full year. Those are weak growth rates for a stock that still trades at 7 times this year's sales.
The bears also believe that Unity's non-GAAP profits matter a lot less than its widening GAAP losses in a market with rising interest rates. The main problem is its stock-based compensation (SBC), which rose 58% year over year in 2022 and gobbled up 40% of its revenue. That surging SBC, which was exacerbated by its all-stock takeover of ironSource of $4.4 billion, will continue to dilute Unity's existing investors -- even though it's buying back some shares to cushion the blow.
Why the bulls believe Unity can bounce back
The bulls believe Unity's growth is gradually stabilizing. During its latest conference call, CEO John Riccitiello said the "macro environment remains surprisingly resilient" as developers continue to produce a "huge number of games." Riccitiello also claims the advertising market "stabilized as of the middle of 2022" -- which suggests the ironSource deal is saving Unity Ads.
Unity also believes its ongoing expansion beyond video games with Weta's digital effects for film, digital twin models, and non-gaming VR and AR features will drive its long-term growth. Those tools could transform it into a more diversified cloud-based creative software provider like Adobe or Autodesk. Therefore, Unity's organic growth could accelerate again after it laps its acquisition of ironSource and the macro environment improves.
As for its profits, Unity expects to remain profitable on a non-GAAP basis throughout 2023 as it gradually reins in its SBC expenses. It also ended 2022 with $1.6 billion in cash, cash equivalents, and short-term investments, so it still has plenty of liquidity to ride out the storm and narrow its losses.
Which argument makes more sense?
Unity isn't headed off a cliff yet, but its stock isn't cheap and its near-term growth will remain sluggish. So for now, the bearish thesis makes more sense than the bullish one. Its growth might eventually accelerate again, but its stock could get a lot cheaper before that happens.
