Unity Software (U -1.28%) took investors on a wild ride after its public debut in September 2020. The gaming company priced its initial public offering at $52, and its stock surged to an all-time high of $201.02 in November 2021 amid the buying frenzy in growth and meme stocks.
The bulls initially rushed to Unity because it was growing rapidly and its namesake game development engine was used to produce about half of the world's mobile, PC, and console games. It also locked in those developers with tools for monetizing their games through integrated ads, in-app purchases, and multiplayer features. Furthermore, on the company's fourth-quarter 2021 earnings call, Unity CEO John Riccitiello repeatedly claimed the company could grow its revenue by 30% annually over the "long term."
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But today, Unity's stock trades at about $30. The bulls retreated as its growth cooled off, Apple's privacy-oriented iOS changes rendered its advertising algorithms nearly useless, and it diluted its own shares with a $4.4 billion all-stock merger with the adtech company ironSource to address those existential advertising challenges.
At its peak, Unity's enterprise value bubbled to $56 billion -- or 40 times the revenue it would actually generate in 2022. But today, it has an enterprise value of $12 billion -- or 6 times the revenue it expects to generate in 2023. Does that lower valuation make Unity a worthwhile investment in this rough market for out-of-favor growth stocks?
What happened to Unity?
Unity's revenue rose 43% in 2020 and grew 44% in 2021. But in 2022, its revenue only climbed 25% to $1.39 billion as it grappled with the post-pandemic slowdown of the gaming market and Apple's ad-disrupting changes on iOS.
In the first quarter of 2023, Unity's revenue declined 2% year over year on a pro forma basis (which accounts for its merger with ironSource). It generated 63% of that revenue from its Grow Solutions, which include its advertising and monetization features. The other 37% came from its Create Solutions, which include its game development engine, Weta theatrical special effects division, and professional services (such as scanning digital twins of real-world objects) for nongaming markets.
During that quarter, Unity's Grow revenue fell 9% year over year on a pro forma basis as its rebooted advertising business faced persistent macro headwinds and difficult comparisons against the industry's "COVID elevated" performance a year earlier. Its Create Solutions revenue rose 14% as developers produced new games and it expanded its nongaming services, but that growth couldn't offset its declining Grow Solutions revenue.
Has Unity reached an inflection point?
That's a bumpy start for the year, but Unity expects the growth of both the Grow and Create segments to reaccelerate throughout the rest of the year. It expects the combination of ironSource with Unity Ads to boost its market share and drive the growth of its Grow business. As for the Create business, it expects its acceleration to be driven by its recent price hikes, the increased adoption of digital twins across nongaming markets, and the recovery of the Chinese market.
Based on those factors, Unity expects its revenue to rise 3% to 9% on a pro forma basis in 2023. That organic revenue growth seems anemic, but it's also been aggressively cutting its costs with three rounds of layoffs over the past year. As a result, the company expects to generate $250 million to $300 million in adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) for the full year -- which would represent its first positive annual adjusted EBITDA as a public company. It also reiterated its long-term goal of achieving a $1 billion adjusted EBITDA run rate by the end of 2024.
Unfortunately, Unity still isn't anywhere close to breaking even on a generally accepted accounting principles (GAAP) basis due to the stock-based compensation expenses that gobbled up nearly a third of its revenue in the first quarter. The company also faces stiff competition from similar game development engines like Epic Games' Unreal Engine, and its freemium model still seems to attract more low-quality "shovelware" developers than higher-value developers.
It's not cheap relative to its near-term growth
Unity's stock still isn't cheap at 6 times this year's sales and 45 times its adjusted EBITDA. Its merger with ironSource might stabilize its advertising business, but it still faces too many near-term headwinds to be considered a viable turnaround play. Investors should stay away from Unity unless its revenue growth actually accelerates on a pro forma basis.
