Is Unity Software Stock a Buy Now?

Unity Software (U 3.47%) posted its fourth-quarter earnings report on Feb. 26. The gaming software developer's revenue rose 35% year over year to $451 million, which exceeded analysts' expectations by $56 million. However, that figure was significantly inflated by its shutdown of Weta Digital, which resulted in the release of its deferred revenue during the quarter, as well as inorganic gains from its merger with the ad tech company ironSource last November.

Excluding those two factors, Unity's revenue fell 2% year over year on a pro forma basis to $510 million. It narrowed its net loss from $299 million to $254 million, or $0.66 per share, but it still broadly missed the consensus forecast by $0.21 per share.

Image source: Getty Images.

Those headline numbers were disappointing, and Unity's stock slumped after the report and remains more than 40% below its IPO price. Should contrarian investors still buy this out-of-favor stock as the bulls look the other way?

What does Unity do?

Unity's game engine bundles together a wide range of tools for creating graphics, sound effects, and multiplayer features for video games. It also helps developers monetize their games with microtransactions and integrated ads.

Unity's platform has been used to create more than half of the world's mobile, console, and PC games. It leads that market because it established an early mover's advantage with its unified platform, it isn't tethered to a larger gaming publisher (like Epic Games' Unreal Engine), and its freemium model is appealing to smaller developers. Its revenue rose 43% in 2020 and 44% in 2021, and it initially claimed it could grow its revenue by more than 30% over the "long term."

Unity's impressive growth rates and rosy long-term outlook caused many investors to gloss over its net losses and soaring valuations during the buying frenzy in growth stocks in 2021. On Nov. 18, 2021, Unity's stock hit an all-time high of $201.12 and boosted its market cap to $57.5 billion -- or 41 times the revenue it would generate in 2022.

Why did the bulls retreat?

But over the following two years, rising interest rates compressed Unity's valuations and cast a harsh light on its slowing growth and persistent losses. In 2022 its revenue only grew 25% as the gaming market cooled off and Apple's privacy-oriented iOS update abruptly rendered its advertising algorithms obsolete.

To counter that pressure, Unity merged with ironSource to reboot its advertising business and rolled out more non-gaming tools for creating AR, VR, and digital twin applications. It also expanded Weta Digital (which it acquired from Peter Jackson's special effects studio Weta FX in late 2021) to provide more tools for theatrical special effects. But in late 2023 it shut down Weta Digital to streamline its core business. Its growth also remained sluggish on a pro forma basis over the past year.

Data source: Unity Software. YOY = Year-over-year.

Last September Unity tried to implement new "runtime fees" that would be charged every time a game was installed after a developer exceeded certain revenue thresholds. However, the backlash from its developers was so severe that it quickly reversed those fees. CEO John Riccitiello resigned a month later.

Unity reined in its spending as its growth cooled off, but it only narrowed its net loss from $921 million in 2022 to $826 million in 2023. On the bright side, its adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) margins -- which exclude a lot of its one-time expenses -- improved significantly over the past year.

Data source: Unity Software.

But its future is murky and its stock isn't cheap

Starting in 2024, Unity will no longer provide guidance for its total revenue. Instead, it will only provide an outlook for its "Strategic Portfolio" of core services (Engine, Cloud, and Monetization) while excluding the non-core services it plans to wind down or divest. But even on that basis, its outlook seems dim. It expects its Strategic Portfolio revenue to stay flat year over year in the first quarter and grow 2%-4% for the full year. Analysts expect its total revenue to decline 17%.

Unity expects its adjusted EBITDA margin to rise from 20% in 2023 to "over 25%" in 2024 as it resets its spending strategies. It also expects its free cash flow (FCF), which turned positive for the first time in 2023, to continue rising.

Unity's tighter spending might prevent it from heading off a cliff, but its stock still isn't cheap at 7 times this year's sales and 31 times its adjusted EBITDA. So unless Unity can reignite its core growth engines, its upside will remain limited as the bulls rush toward better growth stocks. So for now, it still makes more sense to avoid Unity than to buy it.