• Unity Software’s stock, despite past struggles, is set for a comeback in 2025.
• Unity’s graphics engine dominates the mobile game market and is having increasing success in consoles, PC games, and AR/VR, offering developers ease of use and interoperability.
• The gaming industry is stabilizing, and Unity’s focus on its core business and reduced costs will drive sharply improved profitability.
• Unity’s competitive moat, asset store, and market position make it a strong investment candidate within the gaming industry.

Looking for software companies that could deliver outsized returns in 2025? I believe Unity Software (NYSE:U) fits that description. While the company’s stock has been stuck in a brutal downtrend for years now, the firm’s operating results

Analyst’s 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.

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• U has been enjoying a robust uptrend support, thanks to its ongoing diversification through VR/ advertising opportunities and the raised FY2024 guidance.
• If anything, the company reported a +12% YoY growth in subscription revenues and improved profit margins, with it implying a successful business reset and (still) loyal developer base.
• These have led to the promising consensus forward estimates, with it signaling that the worst of the runtime snafus may very well be behind us.
• Combined with the moderating short interest, we believe that U appears a lot more compelling now, despite the management’s cautious near-term commentaries.

U’s Reversal Is Already Here – Growing Bullish Support Observed

We previously covered Unity Software Inc. (NYSE:U) in September 2024, discussing its reversal from the controversial runtime fees to the typical SaaS subscription price hikes effective

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within 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.

The analysis is provided exclusively for informational purposes and should not be considered professional investment advice. Before investing, please conduct personal in-depth research and utmost due diligence, as there are many risks associated with the trade, including capital loss.

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• Unity has suggested that cancelling its run-time fee has unblocked its renewal pipeline. While this is a positive, the company now needs alternative avenues to improve game engine monetization.
• Unity’s business outside gaming is expanding, this is not enough to offset headwinds in the rest of the business though.
• Unity is still rebuilding its machine learning stack in an attempt to enhance its advertising business. In the meantime, AppLovin’s business is going from strength to strength.
• Unity could prove significantly undervalued if adtech advances leads to improved growth. Given Unity’s ongoing struggles, it is difficult to see this happening though.

While Unity’s (NYSE:U) business appears to be stabilizing, the company remains in no man’s land. Revenue has stagnated, and despite positive cash flows, Unity continues to record losses as a result of stock-based compensation.

I tend to feel that Unity’s move away from runtime fees and deemphasis of artist tools has reduced the upside potential of its Create business, a situation that could be exacerbated by rapidly evolving AI capabilities.

Unity’s near-term prospects are now almost solely dependent on its ability to improve its adtech using machine learning. The company continues to invest in this area and management commentary is positive, but AppLovin (APP) has rapidly established a dominant position, and it is not clear that the performance gap can be closed.

I previously suggested that Unity’s monetization issues would take time to address, and while the stock is now up close to 40% since then, there have been no positive developments from a fundamental perspective. I continue to think that Unity’s share price will be dictated by investor sentiment until the company demonstrates it can develop advertising solutions.

Unity Business Updates

While Unity’s business has struggled in recent years, the company retains significant potential due to its platform, which spans from game development to live service management, user acquisition and monetization. The 3 billion downloads per month of products made using Unity also provide a large advertising opportunity.

Unity recently cancelled its planned run-time fee, removing much of the potential upside from the Create side of the business. The run-time fee caused significant tension with Unity’s user base though and its elimination has reportedly unblocked the company’s renewal pipeline. Unity now appears to be focused on pushing through subscription price increases and trying to drive adoption of tools with consumption-based pricing (multiplayer tools, live op services, tools for data management, asset management, AI-enhanced tools). While price increases are a tailwind, this will only play out slowly over time as customers upgrade/renew. Price increases go into effect in January and will start to roll through the customer base in 2025.

Unity’s business outside of gaming continues to expand and remains the fastest-growing part of its subscription business. KLM is now using Unity to power a VR cockpit training application and Deutsche Bahn has a built a series of training simulations. Most of automotive businesses globally are also using Unity for new machine interfaces in their vehicles. Unity is not trying to develop digital twins for complex simulations though and is focused on providing a 3D visualization layer that can be run on any device.

Unity is also still in the process of rebuilding its machine learning stack and data infrastructure to improve the performance of its advertising business. The company is already testing on live data and is reportedly pleased with the progress of this work. Unity is still validating the performance of these models under different conditions, which is taking time.

While AppLovin is dominant at the moment, Unity doesn’t believe it will be a winner take all market. Unity must dramatically improve its performance to prevent this outcome though. This is a question of data as much as algorithms, with Unity believing it has unique insights into how to maximize the lifetime value of gamers across platforms. While I believe there is nothing preventing Unity from closing the performance gap, AppLovin appears to be extending its lead if anything. Moving into 2025, investors will want to see a meaningful growth acceleration from Unity’s Grow business, or the stock is likely to come under pressure.

As part of its shift in strategy and renewed focus on profitability, Unity appears to be moving away from rapidly expanding its creation tools and introducing AI-enabled features into its editor. Unity now appears happy to allow startups to create gaming tools and integrate that functionality into its editor. The risk of this approach is that the capabilities of AI improve to the point that Unity’s competitive positioning is weakened. This represents a growing risk highlighted by the recent AI releases.

Decart and Etched recently introduced an AI-generated version of Minecraft where the model internally simulates physics, game rules, and graphics. The model was trained on millions of hours of Minecraft gameplay and uses an end-to-end transformer to perform next-frame prediction in response to mouse and keyboard inputs. The real innovation appears to be creating a model which provides a reasonable frame rate and low enough latency to enable a real-time experience though.

Google’s DeepMind has also developed a generative model that makes Super Mario-like games. Genie can generate a playable game in the style of classic 2D games using a range of inputs (text, sketch, photo). It was trained on 30,000 hours of video of hundreds of 2D platform games taken from the internet. The game only run at one frame per second, versus the typical 30-60 fps though. There is no fundamental limitation that prevents a higher frame rate though.

While the technology is impressive, the game suffers from thinks like hallucinations, low resolution and a lack of object permanence. Improved hardware and algorithms and access to more data could help to address some of these issues. Given the nascent state of the technology, significant advances in coming years seem likely.

Financial Analysis

Unity’s strategic portfolio generated 429 million USD revenue in the third quarter, down 2% YoY. Third quarter Create solutions revenue from the strategic portfolio was 132 million USD, up 5% YoY, driven by 12% subscription revenue growth. Growth solutions revenue from the strategic portfolio was 298 million USD, down 5% YoY. Unity is now guiding to 1.73-1.78 billion USD revenue in 2024, implying more than a 25% YoY decline in the fourth quarter.

The number of job openings mentioning Unity in the job requirements has been in decline for several years, much of which is likely due to general gaming headwinds. While the elimination of runtime fees could provide Unity with a tailwind going forward, it is not really clear how much of a headwind the proposed change was in the first place.

The number of Unity job openings is also still depressed and doesn’t suggest an imminent turnaround. Any rebound in hiring is likely to occur on the back of improved ad performance in 2025.

Despite Unity’s focus on extracting more engine from its engine and focus on cost control, the company’s margins are yet to move meaningfully higher. Adjusted EBITDA totaled 92 million USD in the third quarter, along with 115 million USD free cash flow. While this likely provides some measure of support to the stock, SBC was over 100 million USD, meaning Unity is a long way from creating real value for shareholders.

Conclusion

Unity’s share price has rebounded somewhat in recent months on the back of optimism regarding a change in management and a potential turnaround. This may be premature though, as there are no tangible results, despite management’s positive commentary. If anything, AppLovin appears to be extending its lead, generating strong growth at scale and with extremely strong margins.

While Unity’s move away from runtime fees could strengthen user sentiment toward the company, Unity must still demonstrate that it can improve the monetization of its engine, particularly if its Grow business continues to languish.

From a valuation perspective, investors are faced with uncertainty. If Unity cannot turn its business around, the stock could have a long way to fall before it begins to find support. On the other hand, if Unity can replicate even a small part of AppLovin’s success, the stock will prove significantly undervalued. At this point I tend to think the former scenario is more likely.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within 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.

Seeking Alpha’s Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

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• Unity Software is recommended as a speculative investment despite its past missteps, with new leadership aiming to revitalize the company and its offerings.
• The company’s “Grow” segment, which focuses on in-game advertising, has faced significant challenges but is undergoing a fundamental rebuild to enhance ROAS.
• Unity’s “Create” business has launched Unity 6 with substantial improvements and repealed unpopular runtime fees, aiming to regain developer trust and market share.
• The potential for Unity to emulate AppLovin’s success in the in-game advertising space presents a compelling turnaround opportunity with significant upside if successful.

Can Unity pull off a comeback after blowing some significant opportunities?

Turnarounds are not the most popular of recommendations-particularly in the IT space. I doubt if their success ratio reaches 50%. They sound good in the

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.

Seeking Alpha’s Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

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• Unity Technologies is gaining momentum with operational changes, product innovations, and AI-enhanced advertising, expanding into non-gaming sectors like virtual reality training and simulation.
• Despite holding $800 million in net debt, Unity’s projected free cash flow for 2024 and 2025 makes its valuation of 31x forward free cash flow appealing.
• Key risks include potential struggles in regaining revenue traction, competition from Unreal Engine, and recovering strained customer relationships.
• Unity’s growth prospects are promising, driven by Unity 6 and AI advancements, but challenges in market share and customer trust remain critical factors.

Investment Thesis

Unity Software (NYSE:U) is a stock that I’ve been bearish on for a long while. But now that my bearish thesis has played out, I don’t believe it sensible to remain bearish.

Not only do I see the risk-reward a lot more balanced, but I actually can see a path for where investors rally behind this stock.

Basically, at $20 per share, it could go either way, as I estimate that Unity is priced at 31x next year’s free cash flow. Even though I continue to see blemishes in this bull case, I believe a neutral rating makes more sense at this juncture.

Rapid Recap

Back in May, I said in my analysis,

I appear to be one of the few investors who sees Unity Software for what it is, a stock to be avoided.

As you can see above, my sell ratings have been directionally right. Even though there’s been a very strong bull market for tech stocks, which appears to carry all the boats higher, but not Unity.

Unity’s Near-Term Prospects

Unity Technologies is a platform for creating and managing interactive 3D content for the gaming industry.

Its tools allow developers to handle the entire lifecycle of a game or 3D project from prototyping and design to live operations, user acquisition, and monetization.

Unity’s value proposition lies in offering a unified platform that integrates advanced features, as well as advertising insights. These capabilities empower creators to maximize the economic value of their projects.

Additionally, the company is leveraging AI to enhance its advertising and monetization capabilities, which could potentially lead to improved results. Therefore, as Unity optimizes its offerings, it anticipates growing faster than the mobile gaming industry while expanding into broader markets.

Given this background, let’s now discuss its fundamentals.

Revenue Growth Rates Should Improve in 2025

The graphic above shows Unity’s consolidated revenues for 2023, whereas for 2024 the graphic focuses on its strategic portfolio. The strategic portfolio is Unity’s attempt at refocusing its business and cutting away investment from non-core operations.

Nonetheless, one way or another, Unity is delivering very poor growth rates right now. But this, I argue, is now old news. What matters for investors is what 2025 will look like?

And while it’s too early to make a prediction of how things will unfold, I also start to believe that a lot of bad news is now starting to be priced in.

What’s more, it appears possible, at least from the earnings call, to start to buy into the idea that through price increases, Unity could see more than +5% topline growth in 2025.

And given where investors’ expectations are, this could be a good base to move higher.

U Stock Valuation – 31x Forward Free Cash Flow

As an Inflection investor, I like to back companies with strong balance sheets. For its part, not only is Unity’s balance sheet not strong, but in fact, it holds approximately $800 million of net debt.

This means that 10% of its market cap is made up of debt. For me, generally speaking, this is an easy pass. Although, I have been known to make exceptions. For example, most recently, with SuperMicro (SMCI) which holds about 20% of its market cap as net debt.

Furthermore, for the 9 months of 2024, Unity’s adjusted EBITDA was $284 million. And this translated into $168 million of clean free cash flow, once we account for its capitalization of intangibles. This means that it’s possible that Unity could make around $230 million of clean free cash flow in 2024.

What’s more, if we presume that in 2025, Unity’s revenue grows by around 5%, and its operating margin will improve further, it’s possible that Unity’s free cash flow could reach $260 million.

This would put the stock priced at 31x next year’s free cash flow. That’s not that expensive, and I could easily see investors get behind this name.

Key Investment Risks

The main risk here is that Unity’s offering struggles to regain traction and grow its revenues. If it does that, its revenues could shrink further, and it will be increasingly challenging to grow its free cash flow profile. Altogether, this would leave the stock too stretched, and the stock could tumble further.

Furthermore, despite its prospects, Unity faces challenges, including recovering from strained customer relationships due to its now-repealed run time fee policy. Restoring trust amongst its customer base could take time.

Also, Unity’s main competitor, Unreal Engine by Epic Games (PRIVATE), offers high-end graphical capabilities, creating stiff competition for market share. How this unfolds and weighs on Unity’s prospects remains to be seen.

The Bottom Line

Looking back, my bearish stance on Unity Software has largely been validated, yet I now find myself shifting to a more neutral outlook.

While risks remain, such as its financial leverage, customer trust issues, and intense competition; Unity’s valuation at 31x forward free cash flow leaves room for optimism if growth re-accelerates.

At $20 per share, the risk-reward appears balanced, and I’m open to the possibility of investors finding renewed confidence in this stock.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within 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.

Seeking Alpha’s Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

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• Unity Software Inc. reports Q3 results next week, with expectations for weak results.
• The company has a ton of potential in 3D and AI game development software, but consensus targets forecast limited growth for the next year.
• The stock isn’t wildly expensive at 4.5x sales targets, but the entirely new management team sets up for a spooky reporting period.

Unity Software Inc. (NYSE:U) is still in the midst of its turnaround, with the stock trending higher since Q2 earnings despite lowering guidance and shaking up management. The company has a massive opportunity ahead, and the stock has likely rallied on beating low expectations. My investment thesis remains Neutral on the stock, looking toward quarterly results next week to see any positive signs to warrant interest in the turnaround story.

Big Q3 Ahead

Unity expects to report Q3 earnings on November 7. Since the company guided down 2024 expectations and further shook up the executive team since ending Q2, the results are difficult to predict.

The gaming development software company reported Q2 revenues actually beat consensus targets back in August, but management slashed 2024 numbers. Unity reported quarterly revenues of $449 million, yet the consensus estimates have revenues only topping this number by Q4 ’25 with the lowest analyst estimates still flat with the forecast for Q3 ’24.

A big issue facing the company was the implementation of new fees called the “Runtime Fee.” Unity was planning to charge customers with a fee per install, in conflict with how games are developed.

New CEO Matt Bromberg announced the elimination of the fee in September via this blog post. The Runtime Fee was eliminated, with Unity reverting to the seat-based model and hiking subscription fees based on apparent customer agreement to pay higher fees.

Unity will now move forward with price increases reviewed on an annual basis, but notably, the Unity Enterprise subscription price was hiked a rather large 25%. The company just launched the Unity 6 gaming engine on October 17. This could lead to a volatile period with vast changes to the pricing models and new management, along with a new software version with CPU performance improved by 4x in testing and dynamic AI experiences.

Along with the Q2 earnings report, the company announced the CFO was departing and a new Chief Product Officer for Advertising was hired effective August 12. The CEO only started on May 15 and CTO Steve Collins was just hired.

The gaming development platform enters the Q3 results with only the CEO in place for the full quarter and an interim CFO. The updated pricing model was just announced towards the end of Q3 and Unity just launched the new gaming engine with only a few weeks on the market in the earnings report next week.

In reality, Unity won’t have a full picture of the business until the start of 2025. The CEO has already had the chance to kitchen-sink expectations, with guidance cut along with the Q2 results. However, the new executive leader has changed a lot of the management team and the product pricing with unknown impacts, especially from a CEO not completely familiar with the customer base over such a short term on the job.

Stock Trough

While Unity is still in the midst of restructuring the business, the stock has already hit bottom months ago. The market cap has only rebounded to $8 billion versus levels regularly 5x higher when the stock traded above $100 during the COVID-19 boosts to mobile games, but Unity probably won’t rally much from here.

Even under the business reset, Unity still forecasts Q3 ’24 revenues of $420 million. The company is on the pace to produce ~$1.7 billion in annual sales.

The stock trades at just 4.5x 2024 sales targets. The valuation is intriguing, if Unity can return to producing growth via software sold to the gaming development sector and continue to expand into the industrial sector and others to increase the growth opportunity.

The company should be able to use its unique role in the marketplace, sitting at the intersection of mobile, 3D, AI, gaming, data, and digital advertising, to build a much stronger business with solid growth metrics. The disruption from the last year will take time to sort out.

Unity is targeting up to $350 million in adjusted EBITDA now for 2024, but the restructuring of the business makes profit metrics difficult to utilize to value a stock. The company was previously targeting $400+ million in adjusted EBITDA, and the reduced results have a higher impact on the bottom line due to leverage in the system for a high making software application.

Even with the target cut, Unity is attractively priced for a company with an opportunity in AI game development. The issue is that all the executive changes and disruption in the business will make the situation very difficult for the company to blow past current estimates.

If the company only turns the $420 to $425 million Q3 ’24 revenue target into just $454 million by next Q4, the stock likely doesn’t trade much higher for the next year.

Takeaway

The key investor takeaway is that Unity Software is in the midst of a scary turnaround. The quarterly results and guidance aren’t likely to improve until the calendar turns into 2025 and the company shows some stability in management and product pricing.

Investors should continue watching the story from the sidelines knowing Unity isn’t a bargain for the current financial targets, but the story could change fast in the next year, if new management executes.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within 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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• Unity Software provides tools for 3D content creation used across gaming and non-gaming industries like automotive and healthcare.
• The company faces stiff competition from Epic Games in gaming and Autodesk in industrial sectors.
• Recent strategic missteps, including a controversial fee structure, have alienated key customers, particularly indie developers.
• Unity’s revenues are declining, and its workforce was cut by 25% earlier this year to address financial issues. Meanwhile, Unity’s stock is not yet “cheap” by most standards.
• I recommend selling Unity stock unless significant operational improvements or market expansions materialize.

Unity Software Inc. (NYSE:U) develops a platform for creating and monetizing real-time 3D content that is primarily utilized for gaming and various other industries. Some well-known games built using Unity’s platform include “Pokémon Go” and “Among Us.” The company makes money by selling software subscriptions for development tools (“Create Solutions”), in-app advertising services, and game monetization solutions (“Grow Solutions”). Unity primarily competes with Epic Games’ Unreal Engine and faces less direct competition from Amazon.com, Inc.’s (AMZN) Lumberyard, CryEngine, and Autodesk’s 3D software. According to Verified Market Research, the game development software market is expected to grow at a CAGR of 10% to reach $2.75 billion by 2031. Unity is also making efforts to expand their market outside of gaming. For instance, Unity teamed up with Audi to create virtual car prototypes. In healthcare, Unity collaborates with Rady Children’s Hospital to create real-time 3D content for medical training. These are examples of Unity applications in the “industry.” Within this market of non-gaming 3D applications, Unity competes with companies like Autodesk (architecture, engineering, and construction), Dassault Systèmes (automotive and aerospace), PTC (industrial design and augmented reality applications in manufacturing), and Siemens (product lifecycle management and 3D visualization). In all of these specific industrial applications, Unity’s competitors can be argued to be the market leaders. The most obvious example is Autodesk’s widespread use in architecture, engineering, and construction, with well-known tools such as AutoCAD and Revit. For context, AutoCAD was initially released in 1982. In the 2010s, Unity dabbled in industrial applications with film and automotive projects. It was not until April 2023 that Unity introduced “Unity Industry” to market its Unity Editor to industry customers.

In Q2, Unity’s revenue dropped 16% YoY to $449 million (FCF margin of 17.72%). This drop was associated with an underperformance in Grow Solutions. Meanwhile, Unity’s Create Solutions continues to face stiff competition from Epic Games. Epic’s Unreal Engine is widely considered superior in graphics, making it popular among AAA games (in particular, on PC and console) that are graphically intensive projects and is making headway in the mobile space, which is Unity’s strength. The fact that Epic’s Unreal Engine brought Fortnite, a game that was first released for consoles and PCs, to mobile platforms despite its demanding graphics requirements, is an example of the company’s advancement in mobile gaming.

Unity’s revenues have also been impacted by leadership changes, restructuring expenses, and strategic setbacks. Unity announced in September 2023 a pay-per-download strategy that would impose a fixed fee on developers each time a game built with Unity’s software was installed. This was believed to disproportionately affect smaller or indie developers, as games that are downloaded many times may not procure sufficient revenues to cover Unity’s runtime fee. This was supposed to start in January 2024, but there was so much backlash from developer customers that the company issued an apology and made adjustments just a few weeks later. This likely pushed many of Unity’s key and loyal customers (smaller or indie developers) away. This has, undoubtedly, had an impact on revenues. Earlier this year, Unity announced its intention to cut a whopping 25% of its staff and made executive changes (including the departure of CFO Visoso). Its staff reduction was, supposedly, intended to reduce “the number of things we are doing in order to focus on our core business and drive our long-term success and profitability.” If I learned anything in business school, it’s that you don’t cut a large portion of your staff to “drive long-term success.” In my opinion, this is the move a declining business makes to cut costs and improve short-term profitability.

Unity’s strategic focus in Q2 was on the upcoming release of Unity 6 (“faster rendering and lighting capabilities, end-to-end workflows for building, testing, and running multiplayer games, extended AI capabilities, and deeper support for growing platforms like mobile web and spatial computing”), as well as its mobile advertising efforts. However, Unity faces stiff competition from several major players in the market, including AppLovin, Google AdMob, and Facebook Audience Network.

Unity reports Q3 earnings on 11/6 (post-market). The revenue estimate is $427.58 million, and the EPS GAAP estimate is -$0.39. In Q2, Unity lowered its full-year revenue guidance from “$1,760 to $1,800 million” to “$1,680 to $1,690 million” for their “strategic portfolio” due primarily to “a more cautious approach to the recovery in our Grow Solutions business, where investments in fundamental product enhancements will take some time to manifest in sustainable increased performance.”

Valuation Assumption Analysis Model: Forecasting Growth and Return Expectations

I believe markets are generally efficient, making it crucial to understand the assumptions driving a stock’s valuation. By identifying these assumptions, we can assess whether they are realistic and evaluate how key factors can affect future returns.

Based on the current metrics and estimates, the market appears to be assuming the following for 2025:

The FCF margin of 13.1% is implied by U’s current P/FCF, market capitalization, and consensus revenue estimate for 2025.

The data below represent what, I believe, are the market’s implicit expectations for revenue growth and FCF margins based on U’s current valuation.

I believe these implicit expectations are overly optimistic for the reasons stated above, as well as Unity’s rapidly declining revenues in fiercely competitive markets where they appear to lack an edge.

Here is how the estimated values and returns appear based on changes to key metrics like growth rate.

Financial Health

As of June 30, Unity reported having $1.267 billion in cash and cash equivalents. Total current assets were $1.984 billion, while total current liabilities were $841.542 million. This indicates a current ratio of just over 2.0, which implies Unity can reasonably cover any short-term obligations. Unity does owe $2.237 billion in convertible notes.

Unity reports net losses on a consistent basis.

Here’s a look at some key trends during the past few years:

U Stock: Unrealistic Expectations and Structural Issues Weigh on Unity’s Future

Unity is experiencing a rapid decline in revenues, and their response has been to cut a quarter of its workforce. Within the game software development market, Unity faces intense competition from Epic. Due to strategic mishaps, Unity has pushed away its own key customers (e.g., smaller developers). Outside of gaming, Unity’s foray into industrials and mobile advertising is not likely to become strengths, especially in the context of a competitive landscape with established and much larger companies. Despite its stock declining 50% YTD, Unity is not yet cheap according to underlying metrics like EV/EBITDA (25.54 versus sector median of 14.9). In fact, judging from my DCF analysis, Unity’s current valuation implies 8% annual revenue growth, which appears optimistic. Subsequently, if Unity does not turn things around, and fast, I think its stock could be subject to much more downside. In conclusion, Unity’s valuation, in my view, has not yet represented these realities. As such, Unity is a “sell.”

Risks to my “sell” recommendation include the possibility that Unity will turn things around. Last year, the company experienced 57% YoY revenue growth. In fact, this type of growth has been occurring since 2019. As I explain in my “What If?” simulation, in the (unlikely) scenario in which Unity achieves 18% sustained annual revenue growth, annual stock returns for investors could easily exceed 20%. Importantly, I may be underestimating Unity’s revenue potential outside of gaming. Industrial and advertising applications are multibillion-dollar markets, and if Unity can find a niche, it could result in significant revenue growth. Finally, I may be underestimating Unity’s efforts to improve operational efficiencies, which could increase their FCF margin and boost their estimated value.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within 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.

This article is intended to provide informational content and should not be viewed as an exhaustive analysis of the featured company. It should not be interpreted as personalized investment advice with regard to "Buy/Sell/Hold/Short/Long" recommendations. The predictions and opinions presented are based on the author's analysis and reflect a probabilistic approach, not absolute certainty. Efforts have been made to ensure the information's accuracy, but inadvertent errors may occur. Readers are advised to independently verify the information and conduct their own research. Investing in stocks involves inherent volatility, risk, and speculative elements. Before making any investment decisions, it is crucial for readers to conduct thorough research and assess their financial circumstances. The author is not liable for any financial losses incurred as a result of using or relying on the content of this article.

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• The video game industry, valued at $273 billion, is projected to reach $664 billion by 2033, driven by cultural and demographic shifts.
• Unity Software faced a rough 2023, with PR problems that caused their CEO to resign.
• Unity’s restructuring, which cost $201 million and was finalized in June 2024, included significant layoffs in 2023 and 2024. The aim was to reset the company.
• The crisis led Unity’s CEO to attempt a reset with new product launches, an AI-powered assistant service, and a smaller structure due to layoffs.
• A strong balance sheet and decent margins showcase the possibility of a turnaround if the product launches prove successful and the company’s reputation is restored.

Investment Thesis:

Unity Software Inc. (NYSE:U) Has a strong balance sheet and recently launched a well-received product with AI, yet the lack of positive earnings growth and damaged reputation paint a complex situation for the company. I believe the turnaround could be starting but not in full effect until sales and the company’s standing improve.

Videogame Industry

From its humble beginnings in 1958, when physicists at Brookhaven National Laboratory created the first video game, tennis for two, a small point in the screen moving from one end to the other, it is now roughly $273b. It could potentially reach $664 billion by 2033.

There is a cultural and demographic shift, with 77% of millennials playing video games and using them as their main form of entertainment, unlike previous generations, who used TV or radio.

It is clear the videogame industry is here to stay and will continue to grow, especially as the global economy expands and more people join the middle-class ranks, giving them access to more time and cash to spend on entertainment.

This is a truly global and globalized industry, with teams of developers scattered worldwide but using similar tools to develop video games, and such tools are the videogame engines like Unity, Unreal, or Godot.

They bridge the many different skills and allow teams to fast-track the development of their projects. In the past, it would have taken years to develop an engine and, later, a game, effectively creating a barrier that prevented many smaller projects from coming to fruition.

With Unity, skilled developers are easier to find and train thanks to the widespread use of the platform, which creates a better, more efficient industry.

U’s Market Dominance

Unity Software holds 70% of the mobile game engine market, a fast-growing $90 billion industry, and 38% of the broader video game market. This is a result of the long history of U in the market, as it was founded in 2005. It’s ease of use compared to its alternatives and especially powerful tools for 2D and 3D games make it an attractive alternative for video game creation.

U is not simply a software program with a license cost and subscription tiers; it’s an ecosystem with its own marketplace for ready-made assets and tools.

As such, it represents much more than simple software, especially considering its longevity in the industry and usage in thousands of videogame projects.

I believe Unity could continue to build up a moat. The recent restructuring and new product launch, combined with learning from the most recent errors, could potentially improve Unity’s already dominant position and grow not only from the broader industry growth but also from increasing market share it.

Unity’s 2023 Runtime Fee Blunder

In May 2023, Unity went ahead with what’s considered a widely disastrous move: Changing their fee structure to charge videogame developers for every install above a threshold, ranging from $0.01 to $0.20 depending on the version of Unity used, revenue generated, and number of installs.

The real damage to the relationship between U and game developers didn’t come from the fee structure but from the change being retroactive. This means that games launched under the previous flat fee structure would now have to pay for installs.

This was especially problematic for smaller indie studios whose games were downloaded thousands or millions of times at low prices or even free promotions and could potentially find themselves deep in debt to Unity.

While the decision could be justified from a business perspective (it would have brought in strong cash flows), the retroactive and heavy-handed aspect of changing an existing business relationship so suddenly caused a hard hit to Unity’s reputation and widespread condemnation from developers.

The crisis and PR hit brought by this finally culminated in the CEO stepping down in October 2023.

Restructuring And Layoffs

Unity went ahead with layoffs in 2023 and 2024 with an overarching plan to “reset” the company.

The job cuts meant 25% of its workforce would be fired in early 2024, after three other rounds of layoffs that saw 1100 jobs cut in 2023.

This restructuring came with a cost of $201M and was finalized in June 2024, according to their last quarterly report.

Videogame Industry Engines

We are seeing a trend where game developers ditch their in-house game engines for one of the more popular choices: Unity, Unreal, or Godot.

Once, the in-house proprietary game engines were a source of pride and business advantage, allowing for a deeply customized and finely tuned framework for developing games.

However, the costs and time involved in creating, maintaining, and updating game engines proved too much to handle, and industry titans like CD Project Red and Halo Studios switched to Unreal.

The benefits of this are especially notorious for cutting workforce costs, as training staff into proprietary engines takes time, and nothing guarantees long-term employee loyalty in the volatile videogame industry.

Having a few big game engines in the market instead makes for a more dynamic human resources situation, as new hires would require much less training if they are already experienced with the engine used by the developer.

This also makes for greater specialization, putting the weight of developing new tools and improving game engines on the software companies that make them instead of the developers, who can now focus entirely on making the best possible video game.

Unity And The Rise Of The Indie Developers

Unity has a clear advantage over all other game engines: It has the softest learning curve, which means that time and money-strapped game developers naturally choose Unity Software.

This is a prime source of growth for U, as the Indie Game Industry is a fast-growing and exciting market sector.

Indie games offer freedom of expression, creativity, and boundary-pushing appeal that their bigger and richer corporate cousins do not, which makes them attractive to a myriad of different consumers.

Here is a clear path to continued growth for Unity: continue being the easiest alternative to use, rebuild the trust of game developers, and keep innovating to grow alongside the growing video game industry.

New Engine, New Company, New AI

A big part of what makes the reset button on U is that parallel to the cutting in staff numbers, change in CEO, and aborting the disliked runtime fees was the launch of a new and improved product.

The new CEO has also declared that Unity is taking seriously its change as a company.

That product also came with AI support in Muse, a subscription-based generative AI tool and assistant that aims to help projects save time.

The new AI tool can chat like a virtual assistant inside the software, giving personalized answers based on the current project and also generating sprites, editing images, animating models, and enhancing models.

A subscription-based model for AI will also help diversify cash flows and add more value to U’s business proposition, potentially bringing more developers into the ecosystem.

A new engine, Unity 6, was recently launched on October 17 and has received positive reviews, citing improved performance and stability.

I believe these are all positive signs of a bullish turnaround for this beaten-down stock.

Unity Software Earnings

U has had problems with earnings in the past; in fact, that’s probably the main reason that pushed management into the unpopular attempt at changing fees.

In fact, current EPS Diluted (Quarterly) is $-0.32, and EBITDA (TTM) is $-220.26 million, with Revenue at $426 million and GAAP Net Loss for Q2 of $126 million.

This is a situation of a company that was in a deep business downturn, a situation that propitiated a bad business decision in the form of the previously mentioned Runtime fees.

On the positive side, it did beat estimates with a $0.27 EPS Normalized Actual vs. an estimate of $0.15.

I believe the situation is really now dependent on the success of the new product launches of Unity 6 and Muse AI.

There is still opportunity for bullish upside, if sales can improve, pushed on by positive reviews of those new products.

Balance Sheet Of U

Here, Unity shows a strong position, with a Current Ratio of $2.358, showing a robust capacity to cover short-term obligations and a Financial Debt to Equity Quarterly Ratio of $0.336, showcasing how U is not a leveraged company.

These will be reasonable bases for any bullish thesis. Unity can survive quite well while PR relations are repaired and product sales materialize.

While this is a strong point per se, it also helps establish a financial base from which any bullish thesis for increased growth can expand.

I rate this a very good point.

Unity Software Profit Margins

Here is a mixed bag for Unity Software Inc., with a few negative margins like EBIT and EBITDA and other positive ones like Gross Profit Margin of 68.36% and Levered FCF Margin of 28.69%, both above the sector median.

It also boasts $3.21 cash per share, which, for a company that has suffered so much in recent times, is proof of financial strength.

As we can see, the issue does not lie in the bottom line, which has a strong capacity for creating cash flow after meeting financial obligations (this is, of course, in line with the previous lack of heavy debt).

The main problem for U continues to be a downturn in sales and a damaged reputation, choking up potential growth.

Competition In The Video Game Engine Industry

The main risk for Unity is a continued expansion in other game engines’ market share. Unreal holds a comfortable 16.45% of the market (Unreal is owned by Epic Games, a private company). Another new competitor is the free and open-source Godot, which threatened Unity’s dominance in the smaller developers sector.

The situation showcases a two-front war for Unity, with Unreal as a larger, more complex alternative for bigger and better graphic projects, while Godot offers itself as a low-cost, easy-to-use alternative for indie projects.

How will this affect U? The answer lies in how well developers react to Unity 6 and its AI tools.

Also, Unity Software has made inroads into other projects, such as customer experiences created with Unity for Audi and Diageo and 3D modeling for pediatric care; this is an excellent sign that U is attempting to broaden its market horizons using its powerful tools.

Conclusion

Based on the solid balance sheet, combined with new product launches and decent margins, the situation is more positive than negative. Yet the lack of continued growth in earnings makes this a mixed bag. The company’s reputation needs to improve in order to make the necessary increases in the top line. I rate it as HOLD.

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.

Seeking Alpha’s Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

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• U has finally terminated the controversial runtime fees, while reverting to the typical SaaS subscription price hikes effective 2025 onwards.
• However, it remains to be when we may see the erosion in its customer base/topline/remaining performance obligation ends, as the management works hard to restore trust in the gaming community.
• Combined with the lowered FY2024 guidance and the expensive stock valuations, we believe that it may not be wise to chase U’s rally over the cliff.
• Things may get worse in H2’24, before eventually improving from FY2025 onwards, thanks to the price hikes.

U Does Not Offer A Consistent Investment Thesis – Downgrade To Hold

We previously covered Unity Software Inc. (NYSE:U) in July 2024, discussing why its prospects remained highly speculative going into FQ2’24 earnings call, despite the reiterated FY2024 guidance and the promising new management team after the previous runtime fee debacle.

Despite the still elevated short interest and the potential volatility, we had believed that the stock appeared to be relatively cheap then, with it offering a speculative growth play assuming a successful turnaround ahead.

U YTD Stock Price

Since that Buy rating, U has recovered drastically by +32.2% compared to the wider market at +2.9%.

Part of the tailwinds are naturally attributed to the new management’s “intention to revert to a more traditional cycle of considering any potential price increases only on an annual basis,” particularly:

• Unity Personal will remain free with annual funding ceiling doubled to $200K and the “Made with Unity” splash screen to become optional for Unity Personal games made with Unity 6 upon launch.
• Unity Pro – funding ceiling raised to $200K and annual subscription fee per seat increased by +8% to $2.2K from January 01, 2025 onwards.
• Unity Enterprise – funding ceiling fixed at over $25M and annual subscription fee per seat increased by +25% on a customized basis from January 01, 2025 onwards.

Most importantly, U has decided to cancel the runtime fee in an effort to “reaffirm our mission and partnership with the (gaming) community,” with “no new or existing Unity games have been, or will be, subject to the Runtime Fee.”

For reference, the previous runtime fee was the biggest issue that game developers had opposed last year, since it implied that they would have to pay variable fees (potentially higher depending on the pay-per-download numbers), instead of the typical monthly/ annual subscription rate per seat.

With this issue finally out of the way, we can understand why the market has decided to award the U stock with the immense rally since it may actually trigger a new growth opportunity.

The same development has already been observed in another SaaS company, Shopify (SHOP), with the subscription price hikes already flowing into the drastically improved top/ bottom-line performance thus far.

Unity’s Game Engine Market Share

On the other hand, we are less optimistic since the U management still has the immense task of restoring the gaming developers’ lost trust, one that may erode its market leading game engine share from those observed in 2023.

For now, the company already reports mixed FQ2’24 earnings call, with impacted revenue from strategic portfolio of $426M (inline QoQ/ -6% YoY) albeit with expanding adj EBITDA of $113M (+43% QoQ/ +28.4% YoY), with the latter attributed to headcount reductions.

U’s top-line is currently kept relatively stable on a QoQ basis, thanks to the Create Solutions SaaS revenue of $129M from strategic portfolio (-2% QoQ/ +4% YoY) well balancing the mixed Grow Solutions advertising revenue of $296M from strategic portfolio (+1% QoQ/ -9% YoY).

Even so, readers must note that the management has already lowered their FY2024 revenue guidance to $1.685B at the midpoint (-2.6% YoY) and adj EBITDA guidance to $345M (+25.9% YoY). This is compared to the previous guidance of $1.78B (+2.8% YoY) and $412.5M (+50.5% YoY), respectively.

The same has been observed in U’s moderating multi-year remaining performance obligation of $352M (-1.4% QoQ/ -43.5% YoY), with these developments implying further market share losses as game developers likely transition to other platforms.

The Consensus Forward Estimates

As a result, we can understand why the consensus have lowered their forward estimates, with U expected to generate an underwhelming top/ bottom-line growth at a CAGR of +4.3%/ -14.1% between H1’24 and FY2026, respectively.

This is compared to the original estimates of +26.6%/ +72.25% of between FY2023/ FY2026 and the historical top-line growth of +36.9% between FY2019/ FY2022, respectively, with it exemplifying the market’s uncertainty about its intermediate term prospects despite the recent stock rally.

The only silver lining to U’s investment thesis will be the still healthy balance sheet with lower net debt of -$0.97B by FQ2’24, compared to -$1.06B in FQ1’24 and -$1.06B in FQ2’23.

This implies its ability to weather the near-term uncertainty, with the convertible notes of $1.2B only due by 2026 and $1B by 2027, significantly aided by the relatively rich Free Cash Flow generation of $65.04M in H1’24 (+362.2% YoY).

Even so, we believe that things may get worse in H2’24, before eventually improving from FY2025 onwards thanks to the price hikes.

So, Is U Stock A Buy, Sell, or Hold?

U 2Y Stock Price

For now, the market has reacted positively to the subscription hike, with U enjoying a nearly vertical rally of +20.8% after the announcement while breaking out of its 50/ 100 day moving averages.

Even so, given the minimal top/ bottom-line growth prospects over the next few years and the stock’s rather expensive valuations at current levels, we believe that there is a minimal margin of safety here.

At the same time, after U’s previous runtime debacle and the sudden reversal by “canceling the Runtime Fee for its games customers while increasing subscription fees for its largest customers,” it goes without saying that there is little consistency in their monetization strategy.

We are inclined to think that developers may have a hard time sticking to Unity’s gaming platform after the numerous back and forth in pricing changes, with investors likely to remain uncertain about its long-term prospects until the critical show-me-the-money moment occurs by FY2025.

U Valuations

In addition, U continues to be rather expensive at FWD P/E non-GAAP valuations of 23.52x, albeit moderated from the 1Y mean of 31.03x while nearing the sector median of 24.23x.

Even if we are to compare U’s FWD EV/ Sales of 5.32x to its direct competitor, Epic Game’s approximate FY2023 EV/ Sales of 4x, based DIS’s latest $1.5B investment, estimated enterprise value of $22.5B, and estimated $5.62B in 2023 gross revenues, it is undeniable that there is a minimal margin of safety for those looking to add the former here.

Furthermore, based on its 1Y P/E mean of 31.03x and the consensus lowered FY2026 adj EPS estimates of $0.87, U appears to have pulled forward part of its upside potential to our updated long-term price target of $27.00.

This is on top of the ongoing equity erosion, based on the 392.53M of shares outstanding by FQ2’24 (+5.38M QoQ/ +12.18M YoY/ +278.09M from FY2019 levels).

Combined with the elevated short interest of 6.86% at the time of writing and the ongoing insider selling, we prefer to downgrade our previous Buy rating for the U stock to a Hold instead.

Do not chase this rally over the cliff.

Analyst???s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within 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.

The analysis is provided exclusively for informational purposes and should not be considered professional investment advice. Before investing, please conduct personal in-depth research and utmost due diligence, as there are many risks associated with the trade, including capital loss.

Seeking Alpha’s Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

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• Since we initiated on Unity Software, the company has faced major growth and profitability issues.
• With significant management changes and new leaders focused on profitability and growth, we believe the worst is behind us.
• Unity 6 upcoming release and the cancelation of the recent Runtime Fees could fuel a new growth phase.
• We updated our models based on our expectations and management guidances.
• We maintain a STRONG BUY rating, with a target price of $25.47, representing a 22.41% upside potential.

Introduction

On January 11th, 2023, we initiated coverage on Unity Software (NYSE:U) with a strong buy rating and a $35 price target, citing key growth opportunities in both gaming and non-gaming sectors. We also highlighted potential synergies from the IronSource acquisition in the advertising space. However, since then, Unity’s performance has fallen short, delivering a -35% return, while the Russell 2000 (IWM) gained +18% over the same period. In this article, we’ll explain this decline and evaluate whether it presents a new buying opportunity. Then we will examine potential catalysts that could drive Unity’s recovery to finish with an updated valuation based on our assumptions and company guidance.

Unity’s Profitability Struggles and 2024 Outlook

In our previous article, we expected the company to become profitable in 2024. We were wrong. This won’t be the case due to a strong slowdown in growth especially on the digital advertising solutions business and higher than expected costs which weighted heavily on margins.

We acknowledge that it has been a recurring problem for Unity. Initially, only issues related to profitability remained. Unfortunately, some related to growth also appeared. As a matter of fact, for the year 2024, the firm forecasted revenues between $1.68-1.69bn marking a 29% decline versus the $2.19bn generated in 2023 and an adjusted EBITDA of $340-$350m versus $ -200 for the year 2023.

Facing a tough environment, the company revised several times its outlook and guidance after the catastrophic quarter of Q4 2023 where the group missed by 92% on EPS, printing a $-0.5 EPS versus $0.26 expected.

Since then, the consensus has revised downward its expectations.

The company has been delivering better than expected on the profitability side but the path is still long as issues remains on the top line.

The Runtime Fees Backlash and Leadership Changes

Unity’s growth challenges were, in our view, not solely due to a complex market but also a series of poor decisions.

A clear example: The introduction of the Runtime Fee.

In September 2023, Unity shifted from its original subscription model, where developers paid fees based on revenue thresholds, to a model charging fees per game install, including retroactive charges. This decision sparked rightful backlash, particularly from indie developers.

In our opinion, this decision was terrible and clashed with Unity’s philosophy of supporting developers, potentially penalizing unprofitable games and damaging even more the firm reputation by creating instability and disproportionate costs.

After the negative reaction to the Runtime Fee model, CEO John S. Riccitiello was dismissed just a month after its introduction. This explains how bad this buzz was, especially after considering that Riccitiello has been CEO at Unity for more than 9 years! Under his leadership, Unity saw significant growth but remained unprofitable. The slowdown in growth combined with a poor profitability were already problematic. This unpopular decision came as the straw that broke the camel’s back.

Bromberg’s Strategic Vision and Growth Catalysts

Since then, the company has appointed Matt Bromberg, who previously served as COO at Zynga. During his tenure, the company saw a 6-fold increase in value just before its acquisition by TTWO for $12.7 billion.

We view this positively, especially after he announced the cancellation of the Runtime Fee and reverted to the previous subscription model. Not only he cancelled run time fees, he also initiated price increases of 8% for Unity Pro and 25% for Unity Enterprise for larger customers.

As shown by this decision, we have the conviction that Bromberg is and will be mostly focused on enhancing execution and profitability which we view as positive.

On the growth side, we think that positive catalysts stand in the horizon with the upcoming launch of Unity 6, which is set to be its most stable and high-performing version yet with key improvements and new features.

According to Bromberg’s intervention Unity’s Q2 Shareholders’ letter:

Unity 6 empowers developers with faster rendering and lighting capabilities, end-to-end workflows for building, testing and running multiplayer games, extended AI capabilities and deeper support for growing platforms like mobile web and spatial computing.

The company continues its expansion into sectors like healthcare and automotive, securing key clients.

Simultaneously, there is whole review of the firm leadership to implement all the changes that are needed.

The company is also rebuilding its machine learning stack to enhance its advertising business. To drive this effort, Unity recently appointed Jim Payne as Chief Product Officer for Advertising. Payne, who founded MoPub in 2010, which was acquired by Twitter in 2013, brings extensive experience to the role.

We believe these major changes are a positive signal highlighting management’s commitment to accelerate innovation in its ad tech capabilities, a sector that hasn’t delivered as expected especially when looking it’s potential.

Financials and Valuation

We wanted to have another look at the firm financial statement. When we initiated on Unity, the firm already had a robust balance sheet and we wanted to be sure that it was still the case. By analyzing it another time, we haven’t seen anything worrying. The firm still has a robust liquidity position with a cash ratio close to 1.8 and a current ratio of 2.22. On the other hand, total liabilities represent only 50% of the firm Total Assets.

We’ve updated our valuation using a DCF model, incorporating both the company’s guidance and our own projections. Over the next five years, we foresee top-line growth in the low teens, while SG&A and R&D expenses are expected to gradually decline by 15% annually, stabilizing around $900 million and $750 million, respectively. These estimates are based on the three-year historical averages.

Management has reaffirmed its commitment to cost-cutting and operational efficiency, taking decisive action by reducing the workforce by 25% in 2024.

We anticipate further cost-saving measures in the near future.

The company has made significant investments in R&D, particularly in developing Unity 6 and enhancing its AI capabilities. With the conclusion of this R&D cycle, we expect a reduction in spending, leading to a more sustainable expense structure.

We believe the company’s strong product lineup and upcoming innovations position it well to meet these targets.

Additionally, we expect depreciation, amortization, and capital expenditures to stabilize as well.

All these elements lead us to expect a 25% Growth Rate of FCF for the 5 upcoming years.

Discounting these figures with an 11.62% WACC and using a 3% perpetual Growth Rate, we reach a target price 25.47 representing a 22.41% increase potential

Risks and Opportunities to Watch for the Future

Our forecast will largely depend on management’s ability to reduce costs while still attracting and retaining customers, particularly with the upcoming release of Unity 6. That’s where we are seeing the majority of risks.

We also want to clarify that Unity’s valuation has always been a tricky subject, especially considering that the company had its IPO in 2021, a unique period with near-zero interest rates and, as a result, inflated valuations. The recent rate hikes have significantly penalized the company, but we believe that this pressure is now behind us, especially after the Fed’s pivot.

Furthermore, following the partnership with Apple (AAPL) on the Vision Pro, we are convinced that Unity has a unique product that appeals to even the biggest names in tech. Considering these elements, we also see Unity as a potential M&A target, which could further support the stock price in the future.

Conclusion

Despite recent underperformance, we remain confident in Unity’s ability to rebound. The challenges of the past year, including the misstep with the Runtime Fee and weaker financial results, have been significant, but we still see substantial opportunities ahead. The leadership change and strategic shifts under Matt Bromberg represent, in our view, a positive step toward profitability. With the launch of Unity 6 on the horizon and continued expansion into non-gaming sectors, we believe the company is well-positioned for growth. We trust management’s ability to control expenses and focus on high-potential areas like the non-gaming “create business”. After updating our model and assumptions, we maintain a STRONG BUY rating, with a target price of $25.47, representing a 22.41% upside potential.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within 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.

Seeking Alpha’s Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

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