Unity Software (U +0.32%) initially attracted a stampede of bulls when it went public at $52 on Sept. 18, 2020. The game-engine developer's stock opened at $75 and eventually soared to a record high of $201.12 on Nov. 18, 2021.
But today, Unity trades at about $31, sinking below its initial public offering price as it disappointed investors with its slowing growth, lack of profits, and divisive business strategies. Rising interest rates also popped its bubbly valuations.
Should investors still buy Unity after that steep decline? To decide, let's review four reasons to buy this stock and four reasons to sell.
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Four reasons to buy Unity
The bulls love Unity because it's still a dominant game engine, its advertising business is stabilizing, its ecosystem is expanding into non-gaming markets, and its margins are improving.
The company's game development engine is used to create more than half of the world's mobile, console, and PC games. It dominates that market for two reasons: It established an early mover's advantage in the space, and its "freemium" model makes it easy for small developers to create their own games.
Unity also helps developers monetize their games with integrated ads, but that business suffered a major crisis last year after Apple's (AAPL +0.47%) privacy changes on iOS rendered its advertising algorithms obsolete. Yet the company overcame that existential crisis by merging with another ad tech company, ironSource, to reboot its entire ad business.
Its core game development business suffered a slowdown when the pandemic eased and people played fewer video games. However, it's been expanding its ecosystem beyond the traditional gaming market with its acquisition of Weta Digital, which created the special effects for Game of Thrones; new services for creating digital twins of real-world objects; and development tools for augmented reality and virtual reality apps.
Unity still isn't profitable on the basis of generally accepted accounting principles (GAAP), but its margins under adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) turned positive over the past three quarters. It expects its adjusted EBITDA margin to rise from negative 3.7% in 2022 to a midpoint of positive 15.3% in 2023.
NYSE: U
Key Data Points
Four reasons to sell Unity
The bears think Unity is still a lemon because its organic growth has slowed to a crawl, its stock looks expensive, it recently alienated a lot of its developers with an abrupt change to its fees, and insiders are dumping a lot of shares.
On a pro forma basis, which includes ironSource, Unity expects its revenue to rise only 5% to 9% in 2023, compared to its 25% growth on a reported basis in 2022 (which includes less than two months of ironSource's revenue). That's also well below the original goal of generating more than 30% annual revenue growth over the long term.
Analysts expect Unity's reported revenue to rise 57% to $2.2 billion in 2023, then grow 20% to $2.6 billion in 2024 after it fully laps its merger with ironSource. They also expect it to generate a positive adjusted EBITDA of $340 million this year, and for that figure to surge 85% to $630 million in 2024.
Those rosy estimates suggest that Unity's organic growth will accelerate again as the macro environment improves, but a lot of that recovery is already baked into its current valuations. With an enterprise value of $13 billion, Unity trades at six times this year's sales and 38 times its adjusted EBITDA. So if Unity doesn't live up to Wall Street's expectations for a brisk recovery in 2024, it could quickly shed its premium valuations.
That's why the alarm bells sounded when Unity abruptly introduced a new runtime fee that will be charged every time a game is installed after a developer exceeds certain revenue levels. The backlash was so severe that Unity quickly backtracked and revised its original fee structure to exclude its lower-end users. But the blunder has already tarnished its brand and could drive developers to competing platforms like Epic Games' Unreal Engine.
Lastly, Unity's insiders don't seem to be expecting a recovery. Over the past three months, they sold more than four times the number of shares they bought. CEO John Riccitiello also sold a lot of shares right before its runtime fee announcement.
Which argument makes more sense?
I own some underwater shares of Unity right now, but I'm not buying any more shares or advising investors to start a new position yet. I was initially impressed by Unity's potential, but the clumsy way it handled Apple's privacy update, its dilutive merger with ironSource, and its recent runtime fee decisions all make it difficult to have great confidence in its management.
The stock isn't cheap, insiders are selling, and it hasn't proved that it can meet Wall Street's rosy expectations for 2024 and beyond.
