Unity Software's (U -1.06%) stock price rallied about 35% over the past month on two positive developments. First, the video game engine developer posted better-than-expected first-quarter results on May 10 and raised its full-year guidance. Second, Apple (AAPL 0.52%) said it was working with Unity to develop mixed-reality apps for its new Vision Pro headset during its Worldwide Developers Conference on June 5.
Those two developments brought some bulls back to Unity, but its stock remains 30% below its initial public offering price and more than 80% below its all-time high. Is it the right time to buy Unity as a turnaround play, or is it too late to hop on the bandwagon?
Image source: Apple.
Why did the bulls initially abandon Unity?
Unity's game development engine is used to create more than half of the world's mobile, console, and PC games. It simplifies the entire process by bundling tools for creating graphics, sound effects, and other assets on a single platform. It also helps developers monetize their games with ads and in-game purchases.
Unity initially impressed the bulls with its dazzling growth rates. Its revenue rose 43% in 2020, climbed 44% in 2021, and management claimed the company could maintain an annual growth rate of 30% over the "long term." But in 2022, its revenue only grew 25%.
Unity's growth cooled off for two reasons. First, the video game market faced tough year-over-year comparisons against its pandemic-induced growth spurt throughout 2020 and 2021. Second, Apple's privacy changes on iOS disrupted Unity Ads' ability to craft targeted ads from third-party data. That disruption forced Unity to reboot its entire advertising business by rewriting its algorithms and merging with the adtech company ironSource last November.
At its all-time high, Unity's enterprise value reached $56 billion, or 40 times the revenue it would generate in 2022. That bubbly valuation, along with its slowing sales growth and lack of profits, set it up for a steep drop when interest rates started rising last year.
Will the latest news bring back the bulls?
On a pro forma basis (including its merger with ironSource), Unity management expects revenue to rise 3% to 9% in 2023. It expects the company's top-line growth to stabilize this year as it reboots Unity Ads, benefits from China's recovery from the height of the COVID-19 pandemic, and gradually raises the prices for its paid tiers. It also expects its expansion into adjacent markets -- including digital twins and theatrical special effects (through its Weta Digital subsidiary) to bring in more revenue.
Apple's new Vision Pro partnership with Unity could complement those plans. That deal isn't surprising, since its engine was already used to develop games for Meta Platforms' Quest headsets. But Apple might sell more headsets than Meta, which already sold nearly 20 million Quest headsets over the past four years, and drive more developers to use Unity to create mixed-reality apps. That growth could further diversify Unity's business away from mobile, console, and PC games.
But with a hefty price tag of $3,499, Apple's Vision Pro could get off to a slow start when it launches in the U.S. in early 2024. Meta's new Quest 3 headset will only cost $499 when it arrives this fall. Therefore, investors who expect Apple's Vision Pro to boost Unity's near-term revenue will likely be disappointed. Investors should also recall that Unity operates a freemium platform, which tends to attract a lot of "shovelware" developers -- who "shovel out" low-quality apps without contributing any revenue. A lot of those shovelware developers could initially flock to the Vision Pro when it finally arrives.
Will Unity's stock continue to rise?
Unity currently has an enterprise value of $15 billion, or 7 times its projected revenue for 2023. That valuation is a bit high for a company that expects its revenue to only grow by the mid-single digits (on a pro forma basis) this year.
But after lapping its merger with ironSource, analysts expect Unity's revenue to rise 19% in 2024 and 18% in 2025. Investors should take those estimates with a grain of salt, but they suggest it can overcome its near-term advertising issues and benefit from the long-term growth of the gaming, mixed-reality, digital twin, and theatrical effects markets.
Unity also expects to generate $250 million to $300 million in adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) this year as it aggressively reins in its spending. That would mark its first positive annual adjusted EBITDA as a public company. It also believes it can generate a $1 billion adjusted EBITDA run rate by the end of 2024.
Based on those longer-term estimates, Unity still seems reasonably valued at 6 times its 2024 revenue and 15 times its adjusted EBITDA. Therefore, if you believe Unity's business will continue to stabilize and expand, then it's not too late to buy its stock. Unity's insiders have also bought nearly 5 times as many shares as they sold over the past 12 months -- so brighter days might be ahead for this software company.
