Unity Software's (U 3.47%) stock plunged 80% in 2022 as the growth of its game development engine cooled off in a post-pandemic market, Apple's (AAPL -0.35%) iOS update disrupted its advertising algorithms, and rising interest rates popped its bubbly valuations. By the end of the year, many investors had likely written off Unity as another burned-out meme stock.
Yet Unity's stock has rallied nearly 30% this year as four green flags appeared. Let's review those positive developments and see if it's finally safe to sound the all-clear on Unity, which is still trading nearly 20% below its initial public offering price of $52.
Image source: Getty Images.
1. Its integration of ironSource
Unity's biggest challenge last year was Apple's privacy-oriented iOS update, which enabled its users to opt out of data-tracking features in individual apps. That abrupt change prevented Unity Ads, a core component of its Grow business (with 63% of its revenue in its latest quarter), from delivering effective targeted ads within its games.
Unity initially tried to rewrite its advertising algorithms to counter Apple's seismic changes, but it eventually merged with the ad tech company ironSource in an all-stock $4.4 billion deal to reboot its advertising business last November.
During Unity's first-quarter conference call, CEO John Riccitiello said the combination of Unity and ironSource was already bringing in more data to "enhance the performance of both networks." Unity expects those synergies to boost its market share in integrated ads and drive the accelerating growth of its Grow business throughout the rest of the year, so it certainly seems like one of its fiercest headwinds from last year is finally dissipating.
2. Its adjusted EBITDA is turning positive
The bears often claimed that Unity would never turn a profit. Even when calculated on the basis of adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA), its loss more than doubled from $20 million in 2021 to $51 million in 2022.
But over the past year, Unity aggressively reined in its spending with three rounds of layoffs. As a result, it now expects to generative a positive adjusted EBITDA of $250 million to $300 million in 2023 -- which would represent its first year of adjusted EBITDA profitability -- and for that metric to reach a positive run rate of $1 billion by the end of 2024.
3. Its mixed reality partnership with Apple
In early June, Apple revealed it was working with Unity to develop mixed reality apps for its new Vision Pro headset. That announcement wasn't too surprising, since developers already use Unity to create apps for Meta's (META 0.43%) virtual reality headsets, but it's a clear vote of confidence in Unity's future in the nascent mixed reality market.
The Vision Pro's high launch price of $3,500 might prevent it from becoming an overnight success, but the broader mixed reality market could still see a compound annual growth rate of 35% from 2022 to 2032, according to Persistence Research, as more devices enter the market. Unity could capitalize on that secular expansion and diversify its core game-development engine away from the mobile, console, and PC gaming markets.
4. Its introduction of a new AI marketplace
Unity's stock surged 15% on June 27 after the company launched a new AI services marketplace for its game development engine. Through that marketplace, developers can shop around for AI tools from independent companies (like Inworld AI and Polyhive) to add AI-generated in-game dialogue, graphics, and textures to their games.
As John Riccitiello, the CEO, stated in a recent interview, those AI tools could help developers produce their games "faster, cheaper, and better." An AI marketplace would also likely lock more developers into its game development engine, which drives most of the growth of its Create segment (which generated 37% of its revenue last quarter).
Do these green flags mean it's safe to buy Unity?
All of these developments are encouraging, but Unity's top-line growth should remain sluggish this year and its stock is still expensive. It expects its revenue to only rise 3% to 9% on a pro forma basis (including ironSource) this year, and its enterprise value of $17 billion is still eight times higher than this year's sales and 63 times higher than its adjusted EBITDA.
Therefore, Unity's valuations could be inflated by the near-term hype regarding Apple's Vision Pro and its AI marketplace, instead of by the underlying improvements to its business. Investors can still nibble on Unity if they believe in its long-term growth potential, but they should also be aware that its stock could remain volatile for the foreseeable future.
