Unity Software (U 0.92%) faced challenges in the first half of 2022, including high inflation, rising interest rates, and execution issues in a critical business segment. Consequently, revenue dropped significantly, and the stock declined by 80%.
Although Unity still has significant upside potential and has fixed the issues responsible for much of its share-price slump in 2022, it is currently trading at its lowest valuation since going public. So, is this an attractive buying opportunity, or is it game over for the software specialist?
Let's investigate.
Why you might want to stay on the sidelines
Investors are hesitant to invest in Unity's stock for several reasons. One of the main concerns is that the company has yet to generate any profits.
Although Unity recently announced its first profitable quarter in its Q4 earnings release, don't be confused; it reported non-GAAP profitability, which doesn't follow generally accepted accounting principles (GAAP) standards.
According to the chart below, the company has lacked GAAP profitability since coming public in the third quarter of 2020, a significant disadvantage in this current poor economic climate. Investors tend to steer clear of unprofitable businesses during times of market instability.
U Operating Margin (Quarterly) data by YCharts
Some companies include non-GAAP accounting in their quarterly reports as a supplement to GAAP figures with the logic that it helps investors better understand the business's core profitability. However, non-GAAP metrics can be confusing for many investors.
Non-GAAP accounting excludes many non-cash and non-recurring expenses management must report under GAAP by U.S. regulators.
The downside of non-GAAP accounting is that companies can exclude certain expenses that accounting experts believe management should always include. In addition, many unprofitable companies will use non-GAAP reporting to create the illusion of increasing profitability for inexperienced investors. Therefore, only investors with an aptitude for accounting should make investment decisions based on non-GAAP metrics.
One expense Unity excludes in its non-GAAP numbers is stock-based compensation (SBC), which is how many tech companies pay their employees, executives, and directors -- through stock options or restricted shares instead of cash.
In Berkshire Hathaway's 1992 shareholder letter, Warren Buffett ranted against SBC being excluded from earnings. He wrote:
It seems to me that the realities of stock options can be summarized quite simply: If options aren't a form of compensation, what are they? If compensation isn't an expense, what is it? And, if expenses shouldn't go into the calculation of earnings, where in the world should they go?
Unity has an SBC as a percentage of revenue ratio of 38.56%, much higher than similar software and gaming companies. Usually, if this number exceeds 20%, it falls into an area where you should tread cautiously.
U Stock Based-Compensation (% of Quarterly Revenues) data by YCharts
When employees are primarily paid through SBC, a declining stock price means a loss of compensation, unhappy employees, and possible loss of key personnel. So to retain their best employees, many companies will ramp up the SBC to recoup employee compensation losses in a declining stock market. But, of course, increased SBC comes out of investors' pockets in the form of dilution, making the stock even more unattractive, resulting in further share-price declines. Therefore, it's essential to be cautious of companies with high SBC in a bear market because a slumping stock can quickly worsen.
The chart below shows the rapid snowball effect in 2022.
Considering most economists expect the economy to worsen, why would anyone buy this stock?
Unity Software is enticing for long-term investors
If you're assessing Unity Software as an investor, there are two compelling reasons to maintain your enthusiasm.
First, management solved significant execution issues within its advertising monetization tools business for video game developers. Since Unity's primary revenue source is video game advertising, any advertising problems will immediately show up in revenue growth loss.
The chart below shows a notable drop in revenue growth when the company first reported issues with its advertising tools in early 2022. However, revenue growth bounced back to nearly the same level as in late 2021 after executives resolved those advertising tool problems. This provides reason for optimism toward Unity stock moving forward.
U Revenue (Quarterly YoY Growth) data by YCharts
Next, shareholders love this stock because there is a massive opportunity beyond gaming. Unity initially built its Create Solutions segment to help game developers make real-time 3D (RT3D) content. However, the use cases for RT3D have already expanded beyond the gaming industry to encompass all industries seeking to produce 3D content. For instance, Unity Software is behind many popular movies' computer-generated images (CGI), like filmmaker James Cameron's Avatar: The Way of Water. Additionally, as its software finds more and more use cases, it's producing massive triple-digit revenue growth.
Its fourth-quarter 2022 shareholder letter noted that the company's fastest-growing area is use cases outside of gaming: "Create Solutions 2022 revenue grew 41% year-on-year. Revenue growth was broad-based with games up 24% year-over-year and industries (beyond games) up 118% year-over-year."
The best part is that Unity only has one major competitor in the RT3D software space, making up one-half of a duopoly with Epic Games. So the sky is the limit for this company.
Unity stock is risky in the short term
While Unity has strong long-term growth potential, its weak financial position and excessive stock dilution make it a risky choice for investors today. Consequently, prudent investors should wait until economic conditions improve before considering investing in the company.
