- The merger between Unity and ironSource is now complete.
- Unity has reset financial expectations for the combined business specifically calling for a multi-year CAGR of more than 30%, and for a $1 billion run rate EBITDA.
- The combined company offers an end-to-end solution for game developers with more comprehensive functionality than any of its competitors.
- The in-game mobile ad market is feeling recessionary headwinds and that will constrain growth for Unity in 2023.
- The shares, while far cheaper than they have been since the IPO, are still not valued at “bargain basement” levels.
Down 75% from so far this year, and by 82% from its high, should investors consider the shares in the current environment?
Of course being down 75%-80% in the last few months is far less of a distinction than it used to be. And, I for one, am far less interested in the percentage decline of shares, as opposed to considering if their present valuation makes sense and can provide an investor with a reasonable return.
Unity Software (NYSE:U) is another of a crop of busted IPOs. The shares went public in Sept. 2020 at $52 and rapidly climbed to $201, before descending almost 83%. Fact is they are up by almost 60% from the low they made just before the company’s latest earnings report on 11/9 and yet they are still down 83%.
The company went public at a time of very rapid growth in its space and for Unity specifically, and significant enthusiasm about its sophisticated tools to build mobile apps that could be monetized by selling in-game ads. The company’s tools were indeed responsible for some exceptional games with excellent visual characteristics, and the company had and has a market share of more than 70% in the 1000 leading mobile games. Despite the decline in growth of in-game advertising in 2022, the overall business of creating, publishing and monetizing mobile games has lots of remaining growth, and while there are plenty of competitors selling alternative tools, Unity has maintained and enhanced a dominant position in the space according to several blogs.
Just to be clear, investing in Unity at this point is not about trying to make a quick trade. Unity is a leader, probably the leader, in a space with an elevated growth outlook. It is run by experienced individuals who are well experienced in this industry. With the ironSource merger now complete, it offers the most comprehensive set of creation and monetization tools for the mobile gaming industry, although it hasn’t abandoned creators and studios in more traditional areas of the gaming space. And it has made a commitment to profitability; essentially the EBITDA margin it forecasts to achieve by the end of 2024 would be near 30%. It has forecast that it will be profitable, and generate cash at a lesser level next year.
But Unity exists in a world slithering into a recession. And that recession has already become evident in demand for the ads that are a principal component of the company’s revenue. One part of the investment consideration is essentially encapsulated in this quote from the company CEO,
“The timing here is clear. The declines take place as the world’s banks increased interest rates and the spectrum of recession was everywhere in the press, not earlier when privacy changes took place. When we talk with our advertisers, the sense we get is clearly one of caution and reticence to commit to the aggressive campaign spends that would crowd out competition at the bid and elevate CPMs.
In this context, we remain confident. The market for ad is experiencing recession sentiment. And while we don’t know when it will end, strong consumer engagement will ultimately bring back growth in this dynamic ads market.
And the other part of the investing consideration is this quote,
“While market conditions are challenging, we have a unique opportunity to gain market share and invest in positioning ourselves to grow rapidly, once macro conditions improve. Our end-to-end platform will be a critical enabler in helping creators thrive, even in a challenging market. By enabling more game creators to build successful businesses ultimately will be growing the market overall.
Trying to form an investment opinion regarding Unity shares presents a bit of a conundrum. I think Unity represents reasonable value at this point. But it is dependent on ads for growth, and the market for in-game ads is not expanding at this point, and is unlikely to expand until macro headwinds cease blowing. Usually, but certainly not always, stocks anticipate the return to growth before it happens. Investing in Unity at this point is akin to such anticipation. While I don’t necessarily believe that the fact that shares are down 80% or more over a year is a reason to invest, I do think that the fact that the shares are down 80% is because the outlook for the in-game ad space has deteriorated so significantly over the course of the year. Or “baked-in” in terms of valuation if one prefers.
In addition, the sentiment relating to high growth equities is basically at a nadir. Currently, the correlation between growth and valuation in the wake of Fed Speakers pouring icy water on hope for a near term pivot in rates, has depressed to the growth to valuation correlation to levels never heretofore seen in the period I have been tracking such correlations (7 years). Unity shares are probably not going to see sustained appreciation until that correlation rises, and it can only do so I believe, at such time as the Fed pivot is either in place, or broadly anticipated. Currently, the correlation between growth and valuation is 10%. Just as a reference point, the correlation had been well above 50% for many years until the current rerating started a year ago, and has fallen further recently as tech companies reported slowing growth.
Investing in Unity shares is based on an expectation that the correlation between growth and valuation will start to show more benign trends. I cannot possibly know when that will happen, but it will happen. Will investors start ignoring Fed Speakers and focus more on actual inflation data? Will actual inflation data show more benign trends than some expect? And just when will advertisers decide that their current posture with regards to investing in the in-game advertising space is ignoring opportunities due to the rising level of user engagement and the falling CPM of in-game advertising.
Unity’s latest earnings
Unity shares rallied strongly in the wake of earnings, and in the wake of the brief market bounce for high growth shares that ensued after a couple of more benign inflation reports. Probably the key to the rally was the company speaking at length and with some specificity about its goal of reaching a $1 billion run rate for EBIDA by the end of 2024. But for any rally to be sustained, the risk-off mentality is going to have to modify.
So, should investors buy Unity shares? The opportunity is huge, the short term is murky and patience will be required. The ability to call a turn in advance is, I suppose, the Rosetta Stone of investing. But lacking the translate key, I believe that a reasonable case can be made to be early. I think this an exceptional space with huge opportunities, and I am willing to start building a position in Unity shares, not expecting significant alpha in the current months, but also understanding that the shares, being exceptionally volatile, will move prodigiously when the sentiment pivot starts to happen.
I last wrote about Unity Software at the time its merger with ironSource was initially announced last summer. The shares are actually a little higher now than they were at the time of publication back in July, and in this market environment, that is a win, I suppose. The shares had been oversold, and bounced along with many other IT names on 11/10-11/11. The company’s Q3 results were more or less in line with expectations. Its guidance for Q4 includes the results of ironSource for a stub period so it really isn’t possible to evaluate how it compared to prior expectations. The company hasn’t provided expectations for 2023; at this point, I am expecting total revenues to reach $2.15 billion. That brings the forward EV/S ratio to about 9X. The company CFO said that Unity would deliver significant EBITDA and free cash flow progress next year on the way to a goal of $1 billion run rate EBITDA in 2024. I have chosen to be pretty conservative; I am projecting a free cash flow margin of 3% next year.
As many readers know, Unity had been offered a merger deal by its arch-rival AppLovin (APP) with the proviso that it drop its merger agreement with ironSource. At the time of the proposal, the offer was said to be worth $18 billion. Of course, as it was an all-stock deal, and APP shares are down by 2/3rds since the time the merger proposal was announce, Unity shareholders are far better off than might have been the case had management accepted the AppLovin offer. The value of the consideration to have been received by Unity shareholders would be around $20 based on the current market price of APP shares.
The reason to write about Unity now is that the merger with ironSource is complete, and it is feasible to at least make an effort to model some expectations of the combined company. The further reason is to assess whether there is some reasonable prospect for the company to deliver against its goal of $1 billion in adjusted EBITDA run rate by the end of 2024. Further, some of my subscribers to my Ticker Target service have asked for an update and given the extent to which the numbers have been recast, that is probably a reasonable idea.
Over time, adjusted EBITDA, non-GAAP operating earnings and free cash flow will probably converge. So, adjusted EBITDA of $1 billion will probably translate into free cash flow of $1.1 billion. The company’s enterprise value these days is a bit less than $20 billion, and the company’s growth objective is 30%. So, if $1.1 billion of free cash flow is somewhat of a realistic objective, and with a fully diluted outstanding share count of 562 million, the shares are well worth their current valuation, and offer significant upside as the ironSource synergies play out and as the in-game ad market recovers.
As mentioned earlier, buying into the Unity story at this point is somewhat of a bit of a contrarian play. Given the state of the market, it faces many obstacles in yielding positive alpha in the short term. While the technology issues that plagued the company earlier this year are behind Unity, there remain issues of integration of the ironSource business, and beyond that, issues of macro headwinds. The in-game ad market has deteriorated steadily this year, and it is expected to be without growth in this current quarter. That is a huge current challenge for Unity, although really not implying anything about the long-term CAGR of the company. In addition, while Operate, the unit with the technology issues reported sequential growth last quarter, it is obvious that the road back to user enthusiasm with regards to investing in the service will be long, and not necessarily without fits and starts. Unity may be the leading company in its space[s], and it may have advantages in terms of technology and share; but these are and will remain tough times for companies selling digital ads. It is almost impossible to say when what is essentially a tsunami flattening ad growth might end, because digital advertising and mobile gaming was nascent, if that, back during the last recession. What can be said is the CPM for in-game advertising has declined, particularly as engagement has climbed, and at some point, the more attractive economics of buying in-game ads is likely to significantly impact ad bidders.
At this point, the average analyst rating for Unity shares is just better than a hold, and the average price target is just a bit greater than 10% above the current price. In this market, that kind of potential upside is a sign that analysts are very conflicted about the shares. Analysts are having a difficult time coming to grips with a recessionary environment that has wrought damage to growth rates of this company along with many others. While the damage is transitory, many analysts are unwilling to look through the current environment-and therein lies the opportunity.
I think investing in Unity at this point is an intriguing speculation. Of course I fully recognize that in this market environment it is almost impossible for a company such as this to appreciate except during event-driven rallies such as the one earlier this month. It is difficult enough to describe what makes a successful IT investment these days, but one that is just emerging from an existential technology crisis and hasn’t reported free cash flow certainly doesn’t tick what appear to be investor boxes these days. There is an almost absolute buyers strike within the high growth IT space, and it transcends almost every category and filter within the space.
In any event, this company won’t next report earnings until February, and in this environment, there will be much speculation about recession/macro headwinds, the in-game ad market and integration issues. But with all of that on the table, and well recognized, I believe, initiating a small position in the shares in the nature of a placeholder, with the recognition that appreciation awaits a different market phase might be interesting. It should be remembered here that the shares appreciated by 30% in just two days the last time they got dramatically oversold and when the market had hopes for a Fed rate pivot. The Fed will pivot on rates-we just don’t know when and under what circumstances. So, on a contrarian basis, I advise, where appropriate, initiating a small position with the idea of expanding it when market signs cease to be so toxic.
The company has not generated free cash through the first 9 months of the year, although last quarter’s $70 million cash burn included about $28 million of one-time negative items. While the company hasn’t forecast cash flow, the CFO commentary in the script is that the company would be cash flow positive by the end of the year, implying that Q4 will probably achieve operating cash flow of $15 million or more, to make up the deficit in that metric through the first 9 months of the year. I think the shares are not likely to reflect future prospects until there is a very visible path to a decent level of free cash flow generation. That said, the current valuation seemingly reflects many of the risks that I will outline. The shares are not for the faint of heart, or for those looking to achieve immediate alpha; they make sense if one’s time horizon looks beyond the current economic malaise and considers the strategy and the likely progression of the new Unity, in the wake of the Iron Source merger.
What does Unity look like now that it includes ironSource?
Historically, Unity has been composed of two units, Create and Operate. The Operate business ran into significant technical difficulties in 2022 with bad data feeds and a loss of the ability to appropriately optimize its ad engine. That crippled results of Unity earlier this year, and last quarter was just the first one in which Operate’s sequential revenues rose. Operate and ironSource have now been merged with the former CEO of ironSource, Tomer Bar-Zeev. The Unity team from Operate still remains. Mr. Bar-Zeev was one of the founders of ironSource and has long industry experience in dealing with the many challenges that the in-game, ad optimization business generates. The new business will be called Growth Solutions going forward, i.e. growth for Unity’s creator customers.
Unity’s mediation platform is now LevelPlay, formerly the ad mediation platform of ironSource. LevelPlay will have tight integration to Unity’s Editor and should help to improve the performance of the ad networks of Unity and ironSource. One of the keys to offering a successful mediation platform relates to the number of active daily users as this provides the inputs that the optimization engine uses. The newly combined entity now has more than 3 billion monthly active users.
In addition, Unity is incorporating the Supersonic game publishing capability that had been a growth driver for ironSource as part of its create offering. Over time, there will doubtless be additional integrations and product choices as the company rationalizes and also expands the totality of its product offerings.
The company is continuing to operate three ad networks, those of Unity, ironSource and TapJoy which ironSource acquired earlier this year.
Even with the limited number of integrations the company has announced, the cost synergies are such that the company, despite the strong headwinds being experienced in its ad market, is forecasting to non-GAAP profitability next quarter. The company also has suggested that the combination will start to achieve market share gains, buffering, to some extent, the baleful state of the in-game ad market.
A brief review of the Unity Create
Unity Create is one of the more significant offerings that help app developers to put their ideas into a usable format. Over the past several years, most game creation has migrated from 2D to 3D and the company has been at the forefront of that migration. Create features loads of artist tools including Weta, Ziva, and SpeedTree. Unity is the market leader in terms of creation tools; inevitably different 3rd party analysts rate market share differently. One study shows that Unity tools are used by 71% of the top 1000 mobile games. Other studies show Unity with a market share of 52% or 23%. It really depends on the definition of the relevant market. Unity has a dominant position in providing tools for developers of mobile games and a significant but less dominant position within the overall gaming market that includes PCs, consoles, and XR. Mobile gaming development is apparently the fastest growing segment of the overall game development market. The game development software market itself has been projected to achieve a CAGR of 13% over the next several year while tools to develop mobile games are thought to be one of the chief growth drivers according to the study linked here. The fact is that overall, Unity’s business with creators has been exceptional and has not been impacted by any noticeable headwinds.
The CEO of this company has projected a CAGR of 30% for Unity’s business, of course not including a forecast for 2023. To reach that kind of a CAGR requires market share gains as well as achieving revenue synergies from ironSource. In terms of Create, the company will need to integrate some of the ironSource publishing technology into the stack it offers to developers. In particular, as mentioned earlier, ironSource has a game publisher, Supersonic Studios that seems to be an excellent fit with the creation tools offered by Unity. There are obvious potential revenue synergies as Unity customers are likely to consider the Supersonic service in terms of publishing their games.
The company’s Create division achieved revenue of $129 million, up 54% year on year, and up 7% sequentially. Some of this growth has been inorganic; the company has acquired Ziva. Parsec and SynchSketch. Weta Digital, a company based in New Zealand and known for providing tools to creators to produce digital visual effects, sold its tools development division to Unity. Overall, the Create division achieved organic growth of somewhat greater than 30%, and that has been a consistent level throughout 2022 despite the macro headwinds presented by the economy, I don’t purport to be an expert on the creation of games. But Unity has been innovating prodigiously in this space according to industry analysts and has been gaining market share. One recent product offering is the company’s Data Oriented Technology Stack which allows creators to optimize performance on any device by taking advantage of modern chip architecture. The company also introduced Entities, a 1.0 experimental release. Again, it’s not possible for me to evaluate the specifics of the company’s newest offerings, and the newest games built using its technology stack. One of the latest games developed on Unity has been Marvel Snap, which is currently the #1 game on the iOS and the Android stores.
One of the more interesting opportunities that Unity is addressing is the offing they call Digital Twins. This is far removed from games; Digital Twins is a dynamic virtual copy a physical asset or process. It is meant to help users predict the performance of products, and thus enable product designs to be optimized. It is all about enabling teams to design, build, and deploy complex systems. It enables optimized product design. It is the next step in 3D CAD modelling and simulation. The company hasn’t discussed the revenue impact of its product offering at any granular level of detail. About all that has been said is that the last quarter was marked by continued strong momentum. It would be useful to know just what strong momentum means in dollar terms but for now, this offering is apparently a significant tailwind creating strong revenue growth for Create.
About a year ago, Unity introduced Unity Game Service. It is a platform approach to creation that also extends capabilities into the ad network. UGS was the toolset recently used to create Marvel Snap by Second Dinner. Overall, in gaming as in much else in the software world, a successful strategy appears to be that of offering users/creators an end-to-end capability. That is what distinguishes Unity from its competitors, as much as the advanced features, and its initiative into industrial design capability.
Unity raised prices for most of its creative products by between 13%-25% for its most significant offerings in the Create space. The price increases also included packaging changes, with more functionality as part of each offering tier. Most of the effect of the price increases should be seen in 2023.
Unity Growth-It’s all about synergies and market share
With the ironSource merger, the combined monetization offerings of the merged company will be referred to as Unity Growth. Last quarter, Unity Operate, the Unity business that operated in this area, reported revenues of $172 million, down 7% year-on-year but up by 8% sequentially. Operate, as indicated earlier, had run into significant technology and data difficulties earlier in the year, and while the problems have been solved, the service is still fighting negative perceptions, and an unwillingness of users to expand their commitments, coupled with a deteriorating macro environment. Unity’s last earnings release did not specifically discuss the Q3 results of ironSource. So, it can be difficult to interpret guidance absent the ability to look at sequential comparisons. While it is not clear, at least to me, if any of ironSource properties will be included in the Create segment, just based on the latest quarterly report that was released by ironSource, the Growth Solutions segment of the Unity business will have revenues of around $375 million, or about 73% of the total. Iron Source was actually acquired on November 7, so the Growth business will only generate revenue from the combined entity for a little more than half of the current quarter. Hopefully there will be some more transparency, regardless of the numbers themselves, when the company next reports in February.
One of the principal benefits of the Iron Source merger for Unity is solving its mediation issues. By acquiring Iron Source, and adopting its LevelPlay platform, the company will go from an also-ran in the space, to offering what observers consider to be the most effective mediation solution in the market. Self-evidently, there will be substantial synergies, both in terms of revenue, as more Unity Create users are likely to turn to LevelPlay for mediation, and of course expense benefits, as the combined company will be supporting but a single platform. Mediation is basically what makes the mobile game business possible. The word “remediation” has different meanings in context. It even has different meanings within the software space. In terms of what it means for Unity, mediation is the technology for managing and optimizing the monetization ad stack. It enables publishers with tools they need to drive more competition for their inventory. These tools facilitate what are called network waterfalls, or enable ad bidding from a Unity dashboard. The tools can be used with many different networks including those from Meta (META) and Google (GOOG) as well as with Unity Ads. Without discussing various mediation strategies in detail, over all the technology allows the owners of content to optimize the revenue generation for their inventory. Waterfalls and bidding can be used together.
ironSource had been very successful in recruiting customers for its mediation service; it had been one of the principal growth drivers for that company. Now that the company is part of Unity, the expectation is that there will be significant cross sell opportunities in which Unity Create users choose the LevelPlay mediation service.
The success of a mediation service is highly dependent on the data that is collected from users. With the combination with ironSource, Unity is going to have the largest data feed in the space, and that will make its mediation technology more effective in terms of optimizing the yield of content.
Other components of the ironSource platform include Luna, a cross channel marketing platform for mobile games and Aura, the company’s mobile engagement platform that competes with Digital Turbine (APPS), although it is much smaller. Luna is another service that seemingly has significant cross sell opportunities within Unity’s base of creators. Aura has been a small, but rapidly growing component of ironSource; its business should be relatively unaffected by the merger. In the last couple of calls, ironSource has talked about a nascent business of selling ads outside the confines of the in-app mobile game space. It is an intriguing potential that probably will see some revenue synergies in combination with Unity.
While the most obvious cost synergy is that of only supporting a single mediation service, there should be cost synergies in almost all parts of the combined business. The specifics of the cost savings through this strategy haven’t really been discussed but are likely to be substantial. No doubt general and administrative expenses will be targeted, and there should be available cost synergies in terms of sales and marketing as well. ironSource was a highly profitable company before its acquisition with its latest reported EBITDA margin of 31%. Given that the CEO of ironSource and some of his team will be holding leadership positions at the Growth Solutions component of Unity, I think it is reasonable to assume that cost containment will be a significant part of the strategy for the newly merged operation.
Comparing Unity to AppLovin
Many investors and readers will want to compare Unity and AppLovin (APP). They are both in the same space-for the most part. APP has had an even rockier road this past year than Unity with its shares down by 85%. The company is attempting to restructure itself, with its new emphasis to be solely on its software platform, while it seeks to deemphasize its apps business whose revenue declined 24% last quarter. Unfortunately for APP, its apps business is 57% of the total, and while its software business rose by 59% last quarter, the net result was a revenue decline of 2%, with results lagging the analyst consensus. Guidance was cut noticeably below prior analyst consensus, and BofA cut its price target in half and lowered its rating. The company has eliminated its annual revenue guide-not entirely unexpected after lowering the guide 3 times this year. That 59% software revenue should be considered in context as it includes a major acquisition earlier this year when the company bought the Mopub business from Twitter. Sequential growth of the APP apps business was flat.
The two companies compete for ad volume. They both have large networks and it is hard to say which one is better. As the link here suggests, it is usually better to use multiple networks including that of AppLovin and Unity.
I am not going to try to do a financial comparison between the two companies. There are simply too many moving pieces in both companies to make any such comparison valid. APP has a much lower set of valuation metrics than Unity-its projected EV/S is less than 3X and it is generating free cash, and a case could be made that its software business, even on an organic basis, is attractive and competitive with an EBITDA margin given by the CFO during the latest conference call as in the mid 60% range, while its declining business of creating and operating game properties will produce significant free cash flow. It is those numbers that have kept many analysts maintaining a favorable rating on the shares; and I suspect it is those numbers specifically that limited the share price downside when earnings were released. In a different environment, where there was some appetite for risk, I might consider that argument as reasonable. On the other hand, with its largest business segment in decline, and likely to remain so, growth is not in prospect in the near future. Currently, in a risk-off environment, where investors are eschewing risks of all kinds, betting on a transition is simply a bridge too far for this writer.
There is a large and growing market for software monetization tools including mediation solutions that facilitate the sale of in-game ads by creators. At the moment, the growth in that market is stymied by macro headwinds, but eventually growth will return as economic headwinds subside. There isn’t going to be just one company in the space. At the moment, LevelPlay and the AppLovin technology are thought to be about equal in market share.
That said, the combination of Unity and ironSource, and in particular the end-to-end platform now offered by Unity, will likely tilt the competition more towards Unity in the future. I am a firm believer in the platform approach in most things software; that was one of the points of the ironSource/Unity combination, and I believe it will prove a valid concept going forward.
The Unity Business Model
Usually at this point in an article, I try to review the various cost segments of a business to see what trends can be discerned. Given that the last Unity earnings release was on a stand-alone basis, it doesn’t make sense to go into that level of detail until the next earnings release which will provide visibility into some of the initial cost ratios of the combined company. As mentioned, ironSource hasn’t provided the results of its Q3 operations so there is little to go on in forecasting any specific cost ratios. Just for the record, in the most recent reported quarter, Unity research and development cost ratios rose from 41% to 45%, its sales and marketing expense ratio remained consistent at 34% and its general and administrative non-GAAP expense ratio rose from 17% to 18%.
One cost ratio that should be discussed is that of non-GAAP gross profit which fell from 81% to 74% last quarter. That is substantially a function of the issues that Unity faced in its Operate business. Operate has higher gross margins that Create, the mix changed toward Create last quarter, and for the year to date, and this impacted gross margins. In its last reported quarter, ironSource had a non-GAAP gross margin of 87%. ironSource revenues, based on its last reported quarter, were 36% of the revenues of the combined entity. While it is probably too simplistic to add revenues and gross margins to reach some kind of guess as to the non-GAAP gross margins of the new entity, that result would be in the range of 78%-79%.
One of the points of this merger is cost synergies. So far, Unity hasn’t set a specific goal for what those cost synergies might reach. Both companies have relatively elevated cost ratios with regard to sales and marketing and research and development. There are many obvious cost synergies to be achieved in both of those categories and of course in general and administrative costs as well. Unity’s CEO and CFO reiterated their goal to reach a 30% margin EBITDA run rate by the end of 2024 during the latest conference call. To reach an adjusted EBITDA margin run rate that would be about 30% by the end of 2024 is going to require a combination of substantial revenue growth-30% and more above the consensus forecast for 2023, cost synergies, and expense discipline. I don’t think expecting that combination of factors is unreasonable, especially in a year (2024) likely to feature economic expansion, and a return to strong growth of the in-app advertising market. In any event, there will be specific quarterly reports along the way to gauge progress, but it will be the risk that investors contemplate in owning the shares.
Wrapping up-Some thoughts on Valuation and the attraction of the shares as an investment
Unity shares started their life IN THE public market as an over-hyped, “sexy” investment known for providing tools to create exciting, visually attractive games, mainly for mobile devices. Many game players, no doubt, bought the shares primarily because of the company’s leadership position in providing the tools to create the most popular games that were well received by gamers themselves. The company still has a dominant position in creating games that are played on mobile devices with a 71% market share for its tools used to create the 1000 most popular games. Its most substantial revenue driver, that of helping its creators monetize their revenues enjoyed a substantial tailwind because of elevated user engagement during the pandemic that fostered rapid growth of all categories of digital advertising.
These days the valuation is much less elevated, and if the company can achieve its goal of a run rate of $1 billion in adjusted EBITDA by the end of 2024 with growth returning to 30% or more, the current valuation makes for an investment with substantial upside.
I will caveat here, as I often do in articles for SA, that Unity has used, and will use a significant level of SBC. Readers who are sensitive to elevated SBC ratios will not find these shares attractive, and should look outside of the on-line gaming space for an investment. SBC ratios will almost certainly be elevated when the company next reports as the impact of the ironSource acquisition, and the vesting of ironSource option grants will be reflected in SBC. Because the cost of SBC is really dilution, rather than the specific reported number, I adjust for dilution in my valuation and otherwise mention, but do not consider SBC.
In my DCF analysis, I use 569 million shares which is the company guidance adjusted for 3%/year dilution. I also use a forecast of 3% free cash flow margin for next year, rising rapidly thereafter, a revenue estimate of $2.275 billion for the next 12 months with 31% growth for the following 4 years, and a weighted average cost of capital of 9.19%. There are some additional assumptions, but the net is that the DPV is more than $73. I really don’t think that is a realistic price target in this environment, but when a confirmed Fed pivot finally occurs and investors are willing to look through the current economic malaise, I think the shares can reasonably reascend to that kind of price level.
Unity provided relatively conservative guidance when it reported its results earlier in November-certainly a prudent decision given the macro headwinds and the difficult environment for in-game ad sales. This will be a stub quarter in terms of the contribution of ironSource with the acquisition transaction completed on November 7; the actual revenue forecast of about $445 million, is more or less flat with the results of the prior quarter when using a 58-day contribution/$121 million for ironSource revenue. The projection of a non-GAAP operating margin of 3% does represent significant progress when compared to the non-GAAP loss margin of 12% in the recently reported quarter. In its last reported quarter, ironSource reported $61 million of net income or about $39 million for 58 days, while Unity’s non-GAAP loss was $40 million. So, non-GAAP operating income of $14 million will represent a significant margin improvement, given that sequential revenues are forecast to be flat.
Ultimately, the question for this article is should readers buy the shares. Again, I have to write that one size does not fit all, certainly when it comes to investing. I believe that in the wake of the ironSource merger, Unity has the strongest position in terms of its monetization offerings for the developers of in-game apps, and even as an advertising platform for brands who wish to advertise within mobile games. Its Twins offering is nascent, but quite intriguing in terms of its growth potential. And it is clear, just even looking at guidance for the current quarter that the company has gotten “religion” when it comes to profitability. The combination of ironSource and Unity has just so many likely synergies, both in terms of costs and revenues that it lends strong credibility to Unity’s goal of $1 billion of run rate EBITDA by the end of 2024.
Just looked at in terms of the company’s projected EV/S ratio, Unity shares are not particularly cheap-although they are obviously far cheaper than they have been most of the time since the company went public a bit more than 2 years ago. That said, I think the prospects for the company in terms of both growth and profitability have improved substantially since that time. It is hard to dispute that the company’s end to end platform offers game developers more of what they are looking for to optimize their revenue from their creations.
One consideration here is that the most significant alternative in the space, AppLovin, has shares valued significantly less than Unity. I ultimately decided to focus on Unity because I think it is the leading company in the space, and because the AppLovin transition in which it deemphasizes the Studio component of its business is likely to be messy in terms of optics and because the end to end approach that Unity has put together is likely to result in significant market share gains over the years.
The other side of the argument is that 2023 is shaping up to be a difficult year for in-game advertising revenues, and ultimately for the ability of Unity’s Growth Solutions business segment to achieve substantial organic growth. If one owns or buys the shares, looking over that valley is going to be necessary. Patience will be required, and not all quarters will present well.
I have initiated a small position in the shares, and if they react poorly to a particular quarter, my plan is to expand my holding. Some readers don’t like it when I suggest that looking for a Fed pivot is of most importance in evaluating the performance of the shares. But it is, and the shares are unlikely to continue their recovery from recent lows until expectations for the pivot become far more pervasive than is currently the case. But all that said, I believe that over the next year the company’s shares will produce significant positive alpha, albeit not in some smooth line fashion, but with fits and starts.
Disclosure: I/we have a beneficial long position in the shares of U either through stock ownership, options, or other derivatives. 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.