Unity software (NYSE: U) released its fourth quarter earnings report on February 26. The game software developer’s revenue rose 35% from last year to $451 million, beating analysts’ expectations by $56 million. However, that number was boosted significantly by the Weta Digital shutdown, which resulted in the release of deferred revenue during the quarter, as well as inorganic gains from its merger with ad tech company ironSource last November.
Excluding those two factors, Unity’s revenue fell 2% from last year on a pro forma basis to $510 million. It narrowed its net loss from $299 million to $254 million, or $0.66 per share, but still missed the consensus forecast of $0.21 per share.
Image source: Getty Images.
Those headline numbers were disappointing, and Unity shares fell after the report and remain more than 40% below their IPO price. Should contrarian investors continue to buy this stock out of favor while the bulls look the other way?
What does Unity do?
Unity’s game engine brings together a wide range of tools to create graphics, sound effects and multiplayer features for video games. It also helps developers monetize their games with microtransactions and integrated ads.
Unity’s platform has been used to create more than half of the world’s mobile, console and PC games. It leads in that market because it has established an early mover advantage with its unified platform, it is not affiliated with a major game publisher (such as Epic Games’ Unreal Engine), and its freemium model is attractive to smaller developers. Its revenue is up 43% in 2020 and 44% in 2021, and it initially claimed it could grow its revenue by more than 30% over the “long-term.”
Unity’s impressive growth rates and rosy long-term outlook led many investors to gloss over its net losses and soaring valuations during the 2021 growth stock buying frenzy. On November 18, 2021, Unity shares hit an all-time high of $201.12 and increased its market cap capitalization at $57.5 billion — or 41 times the revenue it would generate in 2022.
Why did the bulls retreat?
But over the next two years, rising interest rates compressed Unity’s valuation and cast a harsh light on its slowing growth and steady losses. In 2022, its revenue grew only 25% as the gaming market cooled and AppleA privacy-oriented iOS update suddenly made advertising algorithms obsolete.
To counter that pressure, Unity has teamed up with ironSource to relaunch its advertising business and roll out more non-gaming tools for creating AR, VR and digital twin apps. It also expanded Weta Digital (which it acquired from Peter Jackson’s special effects studio Weta FX in late 2021) to provide more theatrical special effects tools. But at the end of 2023, it closed down Weta Digital to streamline its core business. Its growth also remained sluggish on a pro forma basis over the past year.
|
Metric |
Fourth quarter 2022 |
First quarter of 2022 |
Second quarter of 2022 |
3rd quarter 2022 |
Fourth quarter 2023 |
|---|---|---|---|---|---|
|
Pro forma revenue growth (YOY) |
9% |
2% |
11% |
8% |
(2%) |
Data source: Unity Software. YOY = Year to Year.
Last September, Unity tried to implement new “uptime fees” that would be charged every time the game is installed after the developer has exceeded certain revenue thresholds. However, the backlash from his developers was so harsh that he quickly reversed those fees. CEO John Riccitiello resigned a month later.
Unity reined in its spending as its growth moderated, but it only narrowed its net loss from $921 million in 2022 to $826 million in 2023. On the bright side, its adjusted earnings before interest, taxes, depreciation and amortization (EBITDA) margin — which excludes many one-time costs — has improved significantly over the past year.
|
Metric |
Fourth quarter 2022 |
First quarter of 2022 |
Second quarter of 2022 |
3rd quarter 2022 |
Fourth quarter 2023 |
|---|---|---|---|---|---|
|
Adjusted EBITDA margin |
5% |
6% |
19% |
24% |
30% |
Data source: Unity Software.
But its future is murky, and the stock is not cheap
Beginning in 2024, Unity will no longer provide guidance for its total revenue. Instead, it will only provide an outlook for its “Strategic Portfolio” of core services (Engine, Cloud and Monetization), and excludes non-core services it plans to shut down or sell. But even on that basis, his prospects look dim. It expects its strategic portfolio revenue to be flat year over year in the first quarter and to grow 2%-4% for the full year. Analysts expect its total revenue to fall by 17%.
Unity expects its adjusted EBITDA margin to grow from 20% in 2023 to “over 25%” in 2024 as it resets its spending strategies. It also expects its free cash flow (FCF), which turned positive for the first time in 2023, to continue to grow.
Unity’s spending cuts could keep it from going off the cliff, but its stock still isn’t cheap at 7 times this year’s sales and 31 times adjusted EBITDA. So unless Unity can reignite its fundamental growth engines, its upside will remain limited as bulls rush toward higher-growth stocks. So for now it still makes more sense to avoid Unity than to buy it.
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Leo Sun has positions at Apple and Unity Software. The Motley Fool has positions in and recommends Apple and Unity Software. The Motley Fool has a disclosure policy.
The views and opinions expressed herein are those of the authors and do not necessarily reflect those of Nasdaq, Inc.