Unity Software: Down Now, Much Stronger Later

Summary:

• Unity shares are down 85% from their peak and haven’t recovered this year.
• The culprits have been the previous excessive valuation coupled with a disappointing forecast for organic revenue growth delivered in the last quarterly report.
• There is some suggestion in the context of the forecast that the macro headwinds have reached their apogee.
• The company’s sales synergy opportunities through the combination with Iron Source are little valued by many at this point, yet are substantial.
• The company has announced important non-Game product initiatives, most recently including Unity Manufacturing.

Unity shares: Unloved, left as road kill – is there something here to consider?

Unity (NYSE:U) Software is the largest, and most well established company in the market for creating, running and monetizing interactive, real-time content (mainly games) for mobile phones, PCs, consoles and augmented and virtual reality devices. It is not the largest company in terms of generating revenue from games, themselves, but it is the largest company, these days in terms of the tools developers use to create, run and monetize games. It has had its shares of bumps in the road over the past year including some significant problems with its software, followed by a merger that brought together two of the leading companies in the industry just in time for macro headwinds to chill demand.

Just how much will macro headwinds wind up impacting the market for in-game mobile ads? And how is Unity’s business model likely to evolve now that the merger with IronSource has had a few months to resolve? The company’s latest earnings report, released on 2/23 contained disappointing guidance, and the shares fell by 25% over the next few days to a level where they continue to dwell. Earnings are next expected to be released May 10th. Earnings estimates fell for the current quarter after the last earnings report, but were actually increased for the full year and beyond. Since then, estimates have been more or less unchanged. The company has provided investors an update about the state of the mobile game market place and its resilience, and like all software companies striving to satisfy investor longing, it is now in the early phases of offering customers a generative AI marketplace. It has also doubled down on its initiatives beyond the gaming market with the release of Unity Industry, its latest offering for in the market for what are called digital twins and immersive experiences.

Are these developments enough to consider the shares anew at current valuations in an environment characterized by macro headwinds? Like much else software, I think concerns about macro headwinds while certainly grounded in reality, have probably been overdone. Macro headwinds have created lots of demand destruction and seem likely to continue to do so for at least another 1-2 quarters. With that backdrop, equity markets remain in thrall to fears of many kinds. Fears of falling or negative growth. Fears of inflation, fears of Fed actions. As long as these fears are paramount in the minds of the preponderance of investors, companies such as Unity simply will be unable to trade at valuations that allow investors to achieve reasonable positive returns.

The investment thesis here is not that Unity’s resilience in the face of recession is significantly greater than other IT vendors, but rather that the company’s prospects in a recovery are under-appreciated. And the positive impacts of the IronSource merger have seemingly been swept aside in evaluations of this company by many. For some time after Unity’s IPO almost 3 years ago now, the shares were evaluated as though the company was without risks and as though there was no cyclical component to the company’s growth. At this point in my opinion, the opposite is true. The company’s EV/S has fallen to less than 7.5X, and for the first time since the company has traded in the public markets it has a measurable forward P/E-33X based on the analyst consensus forecast for 2024 non-GAAP EPS. The analyst consensus for Unity’s revenue growth 2024 is a rather tepid 19%, all organic at that point, essentially reflecting a rather cramped view of a potential recovery in mobile ad spending, and creating an attractive set-up for longer-term investors.

The shares have been languishing now since last May, partly reflecting the market for high growth IT stocks, but also reflecting operational performance that has been far from stellar. Before that time, the shares had already imploded by no less than 75% since the high they reached in November 2021, and unlike some other high growth IT shares, their decline has continued. This is a contrarian call, and in this market many investors are probably not interested in considering those kinds of opportunities.

But the fact is that the mobile gaming industry isn’t going away, and it isn’t going to stop growing. And more to the point, the growth in the market for tools to create, tools to operate, and tools to monetize mobile games will grow more rapidly in revenues than the amount that gamers actually spend. It’s a huge market, with revenues this year for mobile games said to be reaching $92 billion, up 9% from last year. According to one third party research firm, ad spending on mobile games is forecast to reach $110 billion by 2025. While penetration is substantial, there is still plenty of room for the business in which Unity competes to grow substantially.

I have written about Unity Software in the past during its torturous journey to acquire Iron Source. The shares have declined somewhat since that point, but have remained in a tight range due to both macro headwinds, and a somewhat more opaque picture about cyclical components in terms of demand. I think there is a bit more clarity now, and the shares have continued to settle which suggests that a refreshed analysis is in order.

Should investors consider buying a position in Unity shares now? I think this is a reasonable time and entry point. The latest forecast is markedly conservative, and reflects no possible recovery in the company’s markets at any time in the current year. And the forecast for revenue growth takes a rather constrained view of the opportunities the company has to exploit cross-selling opportunities within the merged company, and for the opportunities of the companies several initiatives utilizing digital twin technology.

Unity shares are as sensitive as any to market moods, and they will not do well until there is a more locked-in risk on sentiment that is willing to overlook short term growth trends in order to invest in substantial long-term growth opportunities. In my view, most of the negatives surrounding Unity are well known and baked into the share price. If that isn’t the case, then more patience will be required than my recommendation implies.

Unity uses stock based compensation. For those readers who focus on that, these shares will not be an acceptable investment. Stock based comp. expense, as reported last quarter was $174 million, or 39% of revenues, a very elevated level that would make it very difficult to justify the valuation of the shares. The level of stock based compensation, however, is not quite representative of the real dilution the company’s option grants are costing, but instead reflects, to a significant degree, the vesting of options due to the completion of the IronSource transaction.

As part of the transaction, and in part to offset some dilution, the company also committed to repurchasing $2.5 billion of shares. The company has forecast that fully diluted and outstanding shares would be 493 million at the end of Q2. In the interest of conservatism, I have used 510 million outstanding shares in calculating valuations that I present further on in this article.

Reviewing the quarter: Just how disappointing was that guidance

It has been 2 months now since Unity announced its Q4 results and provided guidance for this current year. The company actually exceeded revenue guidance for the period and its non-GAAP operating income was in line with the company’s prior forecast. That said, and looking at the revenues of the combined Unity/IronSource business, sequential revenues showed just marginal growth.

In the wake of the merger, the company is managing and reporting its business in two discrete segments. Much of what investors know of Unity is centered in its Create business whose products…well they are used to create games, and nowadays to create industrial designs-twins as they are called. This segment is still growing fairly consistently with revenue growth last quarter exceeding 30%. The company’s Grow segment, which includes the IronSource business. Grow includes all of the company’s ad businesses, as well as Supersonic, a game publishing solution, Aura, a platform for mobile network carriers which facilitates the offering of services at various points during the lifetime of a device, and Luna. LevelPlay is the now the company’s mediation solution, basically superseding Unity’s former entry in the space and is part of the Grow set of products.

As of last quarter, Grow constituted 62% of revenue, while Create revenues are the balance. The company doesn’t plan to forecast by revenue segment, but will report numbers in the two segments. Overall, the company is forecasting revenue of about $2.15 billion for 2023. On a headline basis, that would be growth of a little more than 50%. On an organic basis, however, that is growth of less than 2%. No wonder investors were upset.

On the other hand, the company is now forecasting full year adjusted EBITDA margins in the range of 13%. Part of the company’s rationale for merging with Iron Source was to create a business with a reasonable level of non-GAAP margins, and that is what is being forecast. Part of the reason to look at Unity is and has been its forecast to achieve $1 billion of adjusted EBITDA run rate by the end of calendar 2024. The relationship between adjusted EBITDA and reported non-GAAP income is currently about 85%, i.e. non-GAAP earnings are running about 85% of adjusted EBITDA. While the company is buying back shares as a concomitant of the agreements made with stakeholders at the time of the IronSource merger, the company is projecting fully diluted outstanding shares at the end of the year 493 million. On that basis, the projection of a $1 billion run rate in adjusted EBITDA, is the equivalent of a run rate EPS by the end of next year of more than $1.70. Because deferred revenue is not a significant component in this company’s business model, over time free cash flow should be more or less congruent with non-GAAP operating income, although that was not the case last quarter because of balance sheet items that can swing significantly in the short term.

The issue that investors have to mull is whether or not guidance for EBITDA for both this year and thereafter is reasonable; I doubt that there are too many observers or investors who are going to challenge 2% organic growth guidance as aggressive even in this less than optimal environment for monetizing revenues for mobile games. Like many other IT companies, it is worth noting that the guidance being provided was unusually conservative, and that was despite, and not because of the latest trends. While the CFO talked about the forecast this way:

But to answer your question, yes, we are taking a prudent view on the market and it’s for both businesses, but particularly for the growth business. That’s where we are being even more conservative on the business. And I don’t want to give you a forecast for each of them for Q1.

The CEO remarked that:

And so it’s been very hard to read the underlying signal. Again, which is why we’re emphasizing right now, what we’re seeing is really strong consumer engagement in games, really strong pipeline outside of games and Create, stabilization in the ads business based on strong consumer engagement and slightly weaker eCPMs, which is typical of a recessionary period around which you some – we recover at some point. So we’ve been trying to keep you as much of that understanding as we can. We see a lot of data. We’ve modeled the heck out of it and we understand it, we think pretty darn well, but it is definitely a challenging time to sort of be an econometric type person in this space.

In other words, despite some demand trends seen as stabilizing or even showing a positive direction, the company chose to be more prudent than normal. Probably the right call in this environment.

One issue called out by some is: just how is EBITDA going to climb from a quarterly rate of $10 million in Q1, to a full year estimate for EBITDA of $230 million-$300 million. On the mechanical front, with non-GAAP gross margins of around 80%, and flat to slightly down opex forecast over the balance of 2023, $120 million of greater revenue for the company’s Q4, which is the implied forecast, is going to produce an incremental $100 million in adjusted EBIDA. The real question is whether it is reasonable to forecast the growth in revenues of that magnitude over the course of the year.

The overall model framework presented by Unity management is the expectation for non-GAAP opex to be flat over the course of the current year, while revenues, are forecast to increase from a relatively low base forecast of $480 million in Q1, or organic growth in the range of negative 6%, to Q4 revenues of about $600 million in Q4, or organic growth of about 15%. Since opex is something that is within the company’s control, and the “Operate” segment of the business is now being run by the team from IronSource who were responsible for that company enjoying non-GAAP EBITDA margins of greater than 30%, I feel reasonably confident that the company will achieve or better its opex targets for the current year. So what about revenues?

Handicapping the probabilities for Unity Software to achieve its forecast revenue ramp for 2023.

Times are tough in the software business. It is a rare company not feeling the chill breath of macro headwinds. I certainly don’t purport to have second sight, and must confess I haven’t the courage of third party analysts who confidently talk about prospective growth in the mobile app market.

Unity is forecasting that the in-game ad marketing to contract by about 10% this year compared to 2022, with the percentage contraction greater in the first two quarters which are more difficult comparisons.

Within Grow Solutions, we expect the in-game ads market in 2023 to remain stable versus trends we have seen in recent quarters starting in Q3 2022. This translates to the overall in game ads market to contract by approximately 10% as compared to an uneven 2022. The in-game ads market was very strong in the first quarter of 2022 and strong in the second quarter but declined year-over-year in the third and fourth quarters as some in-game publishers became more conservative with their advertising spending as economies softened. While we are not forecasting a recovery in the in-game ads market in 2023, we believe it is possible when the economy improves.

Part of the forecast reflects seasonality. It is typical for Q4 in a year of normal seasonality to be 10%-15% greater than the prior quarter. So, about half of the revenue increase being projected is seasonal, and half is based on easier comparisons, while some of the forecast for increased revenues reflects the recent price increase which will affect users only upon their renewal dates.

Part of the Unity revenue forecast implies market share gains for the year in the spaces in which it competes.

John Riccitiello

So thank you for asking that question because it allows me to address something I wanted to say on the call. What we’re seeing is that there’s strong interest in the combined offering that we have with the collection tools like LevelPlay and the two ad networks. We are seeing market share growth. We’re picking up customers under our mediation platform. And of course, that drives increased share of wallet. Now these things are not instantaneous. You come to an agreement to do these things. It takes some engineering time and effort to bring them on to our platform and that it’s typically phased.

And so there’s not a significant impact in our Q1 from the market share gains we’re seeing, but we are expecting to gain market share in Q1 and throughout the year, which is why we were confident in predicting growth for the business for the year. It’s – essentially, what we’re trying to say is we’re seeing starting in the middle of last year, a stable market for the advertising business. We do expect that to pick up at some point. Luis and I made a hard call a while back to say, no matter what anybody tells us, we’re not going to predict a recovery in 2023, even though there’s a fair amount of folks that would argue there should be by the end of this year. We’ve chosen not to do that because it put a enable us to put a stronger focus on cost and get the EBIT leverage that comes from that.

No doubt there will be readers and others who do not believe the market share stories at this time. Market share stories are never obvious, except in arrears. And in this case, there are essentially two market share stories, one having to do with the Create tools and the other having to do with optimizing and monetizing in game aps for developers. But in my opinion, the combination of IronSource and Unity has many potential go-to-market synergies, and provides users with platform capabilities that are not readily available from a single competitor. In particular, at this point, I think Unity is likely to be taking share from AppLovin (APP).

In the case of Create, the overall revenue growth projection which is organic rather than a function of the IronSource merger, the elements that have to the forecast include price increases, growth in China and growth in the digital twin space. The pricing changes took place last fall and their impact will be seen through 2023. The price increases were fairly substantial-in the range of as much as 30%.

China is not a substantial market for Unity, but it is the largest single market for mobile games. China recently started to permit new games to be licensed, and this seems to be a sign that Unity will be able to sell more Create solutions in that country.

At this point, Digital Twins is not a huge revenue generator for Unity, but it is experiencing triple digit growth. A digital twin is a virtual copy of a physical asset or process. It is basically a way that users have of predicting performance outcomes and issues and is used to help design real products so they can avoid issues that are predicted by the use of virtual products. The concept is becoming widely accepted at this point in many different areas of industrial design. A substantial use area for digital twins is in designing manufacturing workflow but as this link shows, there are many, many uses for the technology which is in early stages of deployment. As mentioned above, Unity introduced Unity Industry about 10 days ago. This is a complete set of offerings that utilize digital twins to enhance and automate product design capabilities.

Unity is always going to be considered as a mobile gaming company. But the opportunity presented by digital twins is substantial. While Unity does not discuss specific projections for its expected revenues from digital twins other to disclose a triple digit growth rate, according to the linked market survey, the size of the market is supposed to rise from about $9 billion last year to $96 billion by the end of the decade, a CAGR of more than 40%. That kind of revenue opportunity is rarely explicitly considered in terms of validating Unity’s own revenue growth forecast. Apparently the TAM for digital twins is likely to reach and even exceed the TAM for Unity’s games development tools in the not too distant future.

The software world has recently been convulsed by all things generative AI. Software companies, wanting to see their stock prices maximized have piled on, trying to convince investors that they are part of the AI revolution, and Unity has been no exception. There is more than a little hype surrounding generative AI-presumably because it is seen as replacing humans in some workflows. AI will be a real resource for game developers. The technology really expected to replace humans in some situations. It is there-but I certainly have no quantitative tool that might forecast the value of Unity’s newly announced market place for the company’s revenues.

No doubt the use of AI will help game developers enhance the characters and the dialogue they use in their games. In my view, this marketplace announcement is a case of the company keeping up with competitive developments in the space; while I think Unity is a worthwhile investment, I would absolutely not recommend purchase of the shares because it has a horse in the generative AI race. That said, current valuations suggest that investors are far from considering the company’s recent AI marketplace announcement as much of a potential revenue growth driver.

This is a difficult environment in which to sell all kinds of development software tools. 6 weeks ago, when Unity released its earnings and presented a guide that showed very constrained organic revenue growth, that forecast was viewed as presenting a pessimistic outlook for the company, and the shares fell noticeably. Now, in the middle of April, the forecast looks much more mainstream. I do expect that there are enough tailwinds to partially offset macro headwinds which should allow the company to achieve its revenue targets.

Unity’s Competitors-Can it be a consistent share gainer?

As mentioned, Unity operates in two different segments, Create and Grow and it actually has a couple of other solution areas that are outside of these two umbrella descriptions. That said, one of the competitive advantages this company has and which is likely to evolve over time is its cross selling opportunities. There are of course numerous competitors within both components of Unity’s business.

Most investors, when they think of Unity, consider Unity, look at it as a leader in tools to create 3D games. It is that, of course, and that is certainly where most of Unity’s customers are derived. Here is a link to a list of Unity’s competitors in the game creation space. Unless you are a game creator yourself-and I am not-it is difficult to suggest that Unity has some functional advantages compared to other vendors in the space. It has some significant partnerships such as the recently enhanced relationship with Google (GOOG). UGS is certainly the current leader in the market in terms of share which most recently was reported at 25.6%, followed by Discord (17.6%), Blender (16.6%) and Unreal (13.4%). Those 4 companies collectively encompass about 73% of the market. I have linked here to a comparison of Discord and UGS. Again, I think one has to be a developer more than a financial analyst to determine the difference between the two offerings. While AppLovin is often considered to be an investment alternative to Unity, it is not listed as a major competitor in terms of its engine to create mobile games.

There are another set of competitors who are involved with monetizing the games of developers through a technology called mediation. Just to be clear, the mediation written about here has nothing to do with an attempt to reconcile differences as in a labor negotiation. Linked here is a list of the major competitors in the space.

But while this is a reasonable starting point in looking at who is a leader, in some ways the list is not up to date. Last year, AppLovin (APP) bought Mopub from Google and essentially shut it down and through monetary compensation, got many users to migrate to its platform. That really is not represented in this compendium. And of course Unity acquired/merged with IronSource, and has shut down its own mediation solution, and now sells what had been the Iron Source Level Play app to users. But while the Unity mediation solution is gone, it has retained its ad network and the Iron Source ad network also continues as an offering.

Also within Grow, Unity has an application called Luna which helps developers publish their creations. At this point, Luna is considered to be the leading application to do that. And Unity continues to offer Aura, a significant competitor of Digital Turbine (APPS). These are solution that mobile phone producers embed in their phones which can lead to end-users buying more content at various points during the life of a device. APPS has had a rather checkered operational history recently; Unity maintains that it is winning some competitive engagements and gaining share.

Our offering, we believe, is well differentiated from the principal competitor in this space Digital Turbine. And it’s another area where we can’t get too specific because when we talk about winning market share, it’s like winning a major national carrier. So these deals are not like you pick up 0.5 point a day. These are – or 0.5 point a quarter. These are material trends.

I don’t think I can really say that Unity’s technology in mediation is “better” than competitors. Where Unity does have a noticeable advantage is in its offering of an end-to-end platform. There are potentially substantial sales synergies in being able to offer creators such a solution. I believe that the synergies inherent in an end-to-end sales platform are going to resonate with users for years into the future and will create a significant growth tailwind for Unity-one that seems to me to be underappreciated. In fact these synergies are one of the pillars of the investment case that I am presenting in this article. While understandably investors and some commentators were disappointed with the company’s organic growth forecast last quarter, I would focus more on the opportunities to achieve market share growth and cross selling synergies as the CEO described:

John Riccitiello

Okay. So let me give you this in a sort of a time phase way. In the present moment, we are winning customers in mediation, which is a very lucrative outcome for us, an important driver of the EBIT performance we’re going to see through the year. That added market share and not added share of wallet yields a more profitable Unity. Now it’s happening precisely right after the acquisition because what we are carrying to market is a message.

And the message is the power of the combined data platform, the power that drives a better performance for our customers. Now these are things that are, if you will, that come about as a result of a presentation.

Very specifically, the more data ingested by a mediation, the more accurate its results are likely to be and that is part of the sales story Unity is now making.

Finally, digital twins is really an entirely different market compared to anything in which Unity has ever competed heretofore. It is a very nascent space, and at this point there aren’t the usual competitive compendiums to present. Unity already does have some significant reference customers and use cases. I think that the Unity is likely to be a major competitor in this space and it appears to have significant first mover advantage.

Unity’s business model: Very much a work in process

Unity acquired Iron Source a bit more than 5 months ago now. The quarter it most recently reported was just a stub, of course. The company has provided a forecast that basically calls for no opex growth beyond the levels most recently reported; it may be that opex will actually show some declines throughout the course of the fiscal year. I usually present an analysis of the individual cost items at this point in an analysis but none of them are particularly meaningful at this point.

The company’s non-GAAP gross margin last quarter was 79% compared to 80% in the year earlier period. Over time, and depending on mix, gross margins should improve based on pricing actions undertaken by the company in the fall of last year.

Wrapping Up-Making the case to invest in Unity shares at this point

Unity shares have fallen disastrously even by the standards of valuation implosion of the last 18 months. They are in fact down by 85% since the high they set in November, 2021, and are barely off the low point they set a bit earlier this year. That is, by itself, not a reason to buy the shares, but is presented simply to suggest just how far the pendulum has swung since the shares were an investor favorite.

Unity presented disappointing revenue growth guidance two months ago and the shares fell to their low point in the wake of that announcement, and have simply not recovered. The reason is pretty simple; organic revenue growth guidance for this year was forecast to be about nil, and highly valued stocks really can not readily deal with a year without revenue growth. Should you take advantage of the disaster?

I confess that forecasting a bottom for a poorly performing stock is never an easy undertaking. My recommendation relates to investing in Unity Software shares for the long-term at the current price which I believe represents good value. As of the close today, April 13, 2023, my estimate of the EV/S on a forward 12 month basis is about 7.2 X. That is a slightly below average for my estimate of the company’s growth cohort in the upper 20% range. The company’s forecast for adjusted EBITDA of about $260 million at the mid-point, works out to a free cash flow margin of 10% for this year. The combination of free cash flow and growth is also slightly below average for the company’s growth cohort.

The company continues to forecast that its EBITDA will reach a run rate of $1 billion by the end of next year. That would be equivalent to non-GAAP EPS of around $1.70. I think the company has laid out a strong case as to how it will achieve that target, and of course, if that happens, the shares are, if not singularly attractive, attractive enough for most long term growth investors.

These days companies are deliberately trying to de-risk their forecasts by providing a greater than normal buffer, and Unity is no exception in that regard. The company has maintained that the market for mobile ads that drive the revenues of its Grow business segment has stabilized over the last several months; on the other hand it is forecasting that such revenues will decline by 10% in the quarter to be announced next month. Part of that forecast decline relates to particularly robust market strength in the year earlier period. Most of the forecasted sequential growth in subsequent quarters is a function of normal seasonality; the company is forecasting just minimal cross-selling revenue opportunities between its Create and Grow products this year as that opportunity will take time to develop.

Overall, the pillars of the investment thesis include sustained leadership within the game creation software business, the leading mediation solution, a unique position that allows the company to sell mediation solutions to creators who use its technology which creates a market share gain opportunity, a substantial opportunity outside games through its digital twin’s technology, and a strong focus on margins.

Is that enough? Don’t buy the shares because of some bet on Q1 earnings or hopes of better guidance. I don’t know if there is a huge chance of that happening. Indeed, I would doubt it. There is a recession either here or nearby. Many, if not most IT vendors are facing headwinds. Unity is already dealing with that issue.

Do buy the shares if you believe the company’s competitive position and product strategy will achieve outsize percentage revenue growth when the economy starts to recover. And buy the shares because you think there will soon be a Fed pivot that will better support stronger valuations for so-called risk-on shares. Of course the timing of that pivot is debated daily and I simply find that I am unable to present a credible case as to when the pivot happens. I doubt that Unity shares will show strong sustained performance until the Fed finally acknowledges that it has destroyed enough demand or until investors are convinced that a pivot is starting.

Unity’s IPO came at a different time in the market with investor focus on growth. But its valuation was undergirded by its leading 3D technology in game creation and the opportunity of that technology to support a multi-year hyper growth cycle. Now, while the first part of the thesis is intact, the company has significant sales synergy opportunities in its game monetization offerings, a very substantial new vertical outside games in which it has a leading offering and a focus on profitability. All of those pillars make for a company that will achieve substantial positive alpha when the difficult environment starts to ease.

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Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, but may initiate a beneficial Long position through a purchase of the stock, or the purchase of call options or similar derivatives in U over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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