While the world is full of uncertainties, a transition that seems inevitable is a transition to a more digital society, be it at work or at home. Now that technology exists to create lifelike displays, companies are using it more to develop digital twin models with different applications.
One company that makes this transformation possible is: Unity software (YOU -8.82%). With its powerful animation software, Unity has quickly become the choice of many top content creators. However, Unity started out primarily as a game development platform and its expansion beyond gaming marks a significant departure from its original business but unlocks a huge market.
The use of Unity’s creation software seemed endless in 2021, but the hype quickly faded as the stock crashed from its all-time high. Is Unity Software worth another look?
A story of two segments
Unity’s business consists of two segments: creating solutions and exploiting solutions. The crafting segment is self-explanatory – it’s the software that helps designers create lifelike models and develop video games. It is also Unity’s fastest growing segment. In the second quarter, it grew 66% year over year to $121 million in revenue.
Furthermore, the revenue share outside of gaming increased from 33% in the fourth quarter of 2021 to 40% this quarter, demonstrating that this software has a wider use outside of video games. As Unity grows, I expect this number to increase even more. This growth would be ideal for shareholders, as there is a much broader market than just gaming that requires high-quality digital displays.
The operating division is still Unity’s largest, but had a challenging quarter due to some self-inflicted injuries. In the first quarter, Unity had an issue with its Audience Pinpointer tool, causing the wrong ads to show to specific audiences. Due to this flaw, Unity lost an extensive data set and its monetization decreased. While this is a significant headwind, it is not expected to impact revenue in 2023.
For the second quarter, revenue declined 13% to $159 million. However, there is another factor in Unity’s operational solutions that I have not discussed: the merger with iron source (IS -8.90%).
Are profits around the corner for Unity?
IronSource’s software allows users to optimize apps by maximizing revenue, recruiting users through ads, and analyzing how an app is performing. These services fit well into Unity’s existing platform and form a highly combined business.
Post-merger (expected to be completed in the fourth quarter), Unity expects its adjusted earnings before interest, taxes, depreciation and amortization (EBITDA) to reach $1 billion per year by the end of 2024. That’s a bold prediction, but it makes sense given the huge market opportunities and anticipated synergies between the two companies. For context, 12-month revenue for the combined businesses is $1.89 billion, so there’s still a lot of growth to be done.
The only thorn in Unity’s side (which also plays in the bold EBITDA projection) is its huge stock-based compensation account. In the second quarter, that figure was $106 million, or about 36% of sales. This release generated an operating loss of $198 million with a loss margin of 67%. That’s a big hole to dig out to become profitable.
Even with the ironSource merger (a profitable venture), the combined entity still has a long way to go before breaking even. Note that adjusted EBITDA value deducts compensation from the stock base, so management’s $1 billion figure has a small asterisk.
However, the stock is being sold 14 times, which isn’t mind-bogglingly expensive. In fact, it’s right in line with arguably the most iconic content-creating software company, Adobewhich trades at 13 times sales.
While Unity still has a long way to go to achieve Adobe’s profitability and widespread adoption, it has the potential to do it. This allows investors to buy the stock here without too much worry about valuation.
However, the stock is not without risk as the ironSource merger may not deliver the expected synergies and could be an expensive write-off in the long run. Still, I think the pros outweigh the cons, making Unity a solid buy for long-term growth investors who understand the company’s risks.
Keithen Drury holds positions in Adobe Inc. and Unity Software Inc. The Motley Fool holds positions in and recommends Adobe Inc. and Unity Software Inc. at. The Motley Fool recommends the following options: Long January 2024 $420 Calls on Adobe Inc. and shortly January 2024 $430 appeals to Adobe Inc. The Motley Fool has a disclosure policy.
