Unity Software Has More to Lose Before Growth Rekindles (NYSE:U)

Unity Inc SoftwareNYSE:U) reported unimpressive financial results for Q2 2024, with revenues in both Create and Grow segments continuing to decline, down -16% overall. The board is taking steps to improve the company’s position with new CEO takes the helm, introducing new growth initiatives to recreate the ad revenue segment using machine learning and other dynamic capabilities. Despite the excitement, management reiterated its eFY24 guidance with a significantly reduced revenue trajectory as the company grapples with the loss of non-core customers due to restructuring in early 2024. I believe management is taking the right steps to re-ignite growth; however, I predict it will be an uphill battle as the company faces a challenging macro environment. I reiterate my SELL rating with a target price of $12.72/share at 2.86x eFY25 P/S.

Unity Planned cuts will not be enough to increase profitability

Unity Software is refocused and may be ready for a merger

Unity Operations

Unity is struggling to find its way in this economy. Early in CY24, management released a major update to its business strategy, making major cuts to headcount and service offerings in order to improve profitability. This included a massive 25% headcount reduction at a time when the company’s growth began to stall and GAAP operating and net margins continued to decline into a deeper loss as seen in Q1 2024. Margins began to recover in Q2 2024 as a result of restructuring. Moving into Q2 2024, management announced a new go-to-market strategy and enhancements to its advertising and businesses.

The restructuring hasn’t turned a profit so far; however, the company has significantly reduced stock-based compensation as a percentage of total net income. I believe the workforce reduction was partly due to the bloated employee compensation packages that the tech sector is known for. According to TechCrunch, 254 companies have cut about 60,000 jobs in 2024 alone. While it’s not the best news to read, the loosening of tech employment could allow for a reset in employee benefits and allow companies to bring in new talent with fewer stock-based benefits. If that happens, Unity’s new growth strategy could keep operating costs higher and could alleviate some of the margin pressure. While I believe it is too early to tell whether this feature will continue into future quarters, stock-based compensation as a percentage of revenue has significantly declined from 30% in 4Q23 and 1Q24 to 25% in 2Q24. Given management’s weak revenue guidance for e2h24, I believe management may be hasty in hiring as margins could decline even further as a result.

We are also hiring world-class talent to accelerate this transformation of our advertising business.

Matt Bromberg, CEO

Their new advertising strategy is expected to include additional features related to AI/ML capabilities, potentially leading to more targeted features and capabilities.

I believe a strong, targeted ad platform will be key for Unity to reverse its growth trajectory. Depending on the types of data Unity collects in its ecosystem, the company should be able to build a robust service similar to Roku, Inc.’s (ROKU) ad platform. The biggest caveat is the opt-in feature on mobile devices in terms of data sharing, which makes it difficult to use cross-app data to develop an ML model. Despite this, Unity should be able to leverage its 70% market share of mobile gaming platforms to create a functional ad targeting feature. Management believes the mobile ad space is $150 billion TAM, suggesting Unity is serving less than 1% of the total addressable market.

On the business development side, Unity plans to release Unity 6 this fall. The powerful platform is expected to improve rendering speeds, provide better game development workflows, and include AI capabilities.

In addition, Unity 6 is expected to support further app development for Apple’s Vision Pro headset. Their partnership with Apple has been going on for a little over a year now, which I would argue has yielded Unity with mixed results. Apple boasted over 2,500 native spatial apps and 1.5mm compatible apps for Vision OS during its recent Q3 2024 earnings call. Despite this excitement, IDC reported that Vision Pro shipments are unlikely to exceed 100,000 units in the quarter and is facing a decline in volume. This will likely result in shipments of less than 500,000 units in 2024.

I believe these delayed results will put significant pressure on gaming apps built specifically for the Vision Pro, as developers may be forecasting lower returns on invested capital compared to mobile gaming. In addition to lower-than-expected headset adoption, higher platform costs may also put pressure on game developers to not build features that support the Vision Pro, which could lead to fewer gaming features for the product.

Unity Finance

Unity saw a significant decline in top-line revenue, down -16% year-over-year. This was largely due to a -22% decline in Creation Solutions as the company restructures its offerings to meet the needs of its core customers. Management noted that non-core revenue is expected to decline further in the coming quarters from the current level of $23 million, likely due to the withdrawal of customer-specific offerings, as discussed in previous Unity reports.

The eFY24 guidance is a concern as the company attempts to rebuild its offerings and regain its growth position. The eFY24 guidance has been lowered to $1,680-1,690 million, from $1,760-1,800 million. This would represent a -23% decline from the FY23 data as opposed to a -18% to -20% decline. I believe most of this decline is due to both feature consolidation and price increases, which may have prompted customers to migrate to other gaming platforms. Given Unity’s large market share in mobile gaming, the company has more to lose than to gain as it reshapes the future of its development platform and sets prices for its offerings at market-appropriate levels.

Looking ahead to eFY24, I expect margins to remain under pressure as a result of the company’s more challenging growth outlook. Additionally, I expect management may increase its capital investment in eFY25 as it seeks to rebuild Unity’s ad revenue platform. Compared to consensus free cash flow forecasts, I expect Unity’s cash generation to remain under pressure as a result of these factors. I believe rebuilding its ad platform will be a more difficult undertaking than initially anticipated, similar to the challenges faced by Netflix, Inc. (NFLX), which is in a similar position.

In addition, I predict that the broader economy will contract and potentially fall into recession. If this happens, marketing budgets may be reduced to manage cash positions, leading to further declines in Unity’s growth segment. For comparison purposes, this thesis is embedded in my thesis on Roku, where I develop this theory.

I expect Unity to regain its growth position in Create once the company releases Unity 6 with the right AI features. If the contraction thesis holds true, I think game developers will look to this tool to save costs, as it can help automate some of the development process, allowing fewer employees to develop a single mobile game. Despite my forecast of modest improvement in gross margin in eFY24 due to restructuring and headcount reductions, I expect margins to compress to 81% as a result of the restructuring process. Operating margins will likely follow suit as management strengthens its go-to-market strategy to revive growth.

Another factor driving the modest growth forecast is the wearable market. While Apple Inc. (AAPL) is relatively optimistic about a smartphone sales revival thanks to the iPhone 16, I predict a continuation of the flat or declining market environment like in CY24. In its latest earnings update, QUALCOMM Incorporated (QCOM) noted that chip sales in the wearable segment are likely to remain flat throughout eFY24, given the macroeconomic environment. Assuming another year of flat wearable sales, mobile gaming growth could follow suit.

Unity for the future

I’ve previously suggested that Unity may be positioning itself for an acquisition in previous reports on Seeking Alpha. Their new CPO for Advertising, Mr. Jim Payne, previously built ad platforms that were inevitably acquired by Twitter and AppLovin.

It’s hard to say which company will be able to successfully acquire Unity, since the mobile gaming platform is set to be an omni-device platform. That likely puts Alphabet Inc. (GOOG), (GOOGL) and Apple out of the running, as each company could face a less-than-successful antitrust lawsuit. Microsoft Corporation (MSFT) may have more success, given its recent acquisition of Activision Blizzard; however, that could put too much control over the gaming industry under one umbrella. Given the company’s exposure to the mobile market, this deal could potentially happen at the right price. Given that Jim Whitehurst, the previous interim CEO, has been named chairman of Unity’s board, that makes me believe the company is preparing for an acquisition. The appointment of Mr. Whitehurst as interim CEO was part of my original M&A thesis for Unity.

Valuation and shareholder value

Unity’s valuation has come under significant pressure over the past year as the company struggles to restart its growth trajectory.

In order for the company to re-engage investors, it will be necessary to make many changes to the company’s image and develop it, which – in my opinion – will be a very difficult and difficult challenge.

Looking at Unity from a company comparison perspective, the gaming platform appears to be significantly undervalued when using a market cap-weighted average price/sales approach. Despite this low valuation, I don’t think the stock will undergo mean reversion until revenue growth returns.

Using an internal valuation method in which I weight historical trading premiums, I value U stock at $12.72/share, in line with its current volume multiple of 2.86x eFY25 sales. I reiterate my SELL rating for U stock.