Unity Software (U -1.85%) is a mess right now. The video game industry, the main source of Unity's software subscription revenue, is still growing at a brisk pace despite economic headwinds (as it has been fairly consistently for decades now). But disruptions to the digital ad industry in the last year, plus some internal stumbles and a bear market that turned the microscope toward Unity's lack of profitability, have left plenty of question marks surrounding this business.  

Nevertheless, Unity finally wrapped up its acquisition of ironSource at the end of 2022 and is looking forward to a new chapter featuring profitable growth in 2023. That's at least one reason investors might want to buy Unity stock right now, albeit cautiously. 

One reason to buy: Unity and ironSource, a better growth business together?

2022 was quite a dramatic one for Unity, and not just because of the bear market (Unity stock crashed 80% last year). One business line in particular called Unity Monetization (formerly reported under the "Unity Operate" segment, which has now been changed to "Unity Grow") got the hiccups. Basically, the company found a fault in its digital ads pinpointer tool that helped game developers monetize their work, and the use of faulty data didn't help matters.

Long story short, Unity took a revenue hit to its largest revenue segment last year. 

However, when combined with ironSource and comparing the newly formed "Unity Grow" segment to a year ago (as if the two businesses were one all along), things could have been worse. 

Period

Q1 2022

Q2 2022

Q3 2022

Q4 2022

Total 2022

Unity Grow revenue (Unity + ironSource)

$345 million

$318 million

$317 million

$321 million

$1.3 billion

Unity Grow revenue (excluding ironSource until Q4)

$156 million

$132 million

$134 million

$253 million

$675 million

YOY growth (decline) excluding ironSource until Q4

26%

(15%)

(15%)

51%

12%

Data source: Unity. YOY = year over year.

The takeaway here is that the Grow division (led by game ads) is back to...well, growth -- at least on a sequential quarterly basis. Unity is of course going to get some positive traction from the inclusion of ironSource, so investors would be wise to compare Grow revenue in 2023 to the combined Unity-plus-ironSource revenue line item it provided for 2022. 

The "Create" subscription business (which finished out 2022 up 41% to $716 million in sales) is what continues to sizzle. Management thinks this will remain a top driver of business overall in 2023, with subscription price increases last year pairing with higher adoption of "digital twin" use cases (read: the metaverse) from industrial users. The overall outlook for 2023 calls for total revenue of $2.05 billion to $2.2 billion, up 5% at the midpoint of guidance compared to Unity-plus-ironSource revenue for full-year 2022.

One reason to be cautious: It's all about profitability, and that remains lacking 

With Unity growth rates expected to be muted in 2023, the market's focus will once again be on the bottom line. 

And it's here that Unity has been sorely lacking. Net loss based on generally accepted accounting principles (GAAP) was a whopping $919 million in 2022, and free cash flow was in the red as well at negative $117 million. The big discrepancy between the two profit metrics was primarily due to employee stock-based compensation.

Employee stock-based compensation will again feature prominently in 2023. Management's guidance for fully diluted shares outstanding (actual stock outstanding, plus employee stock options and related stock awards yet to be exercised, as well as debt convertible to stock) anticipates over 493 million shares at the end of 2023. That's up from 474 million at the end of 2022, implying a 4% increase in total share count.

This outlook doesn't include the possibility of any stock buybacks. As part of the financing agreements for ironSource, Unity executed a $1.5 billion accelerated stock repurchase program in Q4 2022. The newly combined businesses expect to generate a positive adjusted EBITDA (earnings before interest, taxes, depreciation, and amortization) profit margin of at least 11% this year, which has led many analysts (myself included) to conclude Unity will actually generate positive free cash flow for full-year 2023. If the company delivers, I'd expect Unity to use that free cash flow to repurchase stock to offset the negative effects of stock-based comp.

To be certain, I think there are safer long-term buys in the video game industry right now (I nibbled some Nintendo (OTC: NTDOY) recently). However, I'm cautiously optimistic Unity can begin to turn things around, especially if it can reignite some revenue growth and turn that into profitable upside. I'm holding on to the small position I have in Unity and might nibble a bit more later this year if it can prove the merits of its tie-up with ironSource in the coming quarters.