5 Red Flags for Unity Software’s Future

Unity Software (U -0.48%) was one of the hottest tech IPOs of 2020. More than half of the world’s mobile, console, and PC games were already created by its namesake engine — which greatly simplified the development of cross-platform games — and it was expanding its ecosystem with integrated ads, other monetization features, and tools for non-gaming applications.

Unity went public at $52 per share in September 2020. It opened at $75 and surged to an all-time high of $210 last November, but now trades in the low $30s. Unity’s stock collapsed for three simple reasons.

A PC gamer gets angry while playing a game.

Image source: Getty Images.

First, rising interest rates drove investors away from frothier growth stocks. At its peak, Unity traded at over 50 times the sales it would generate in 2021. Today, it trades at a more reasonable eight times this year’s sales. Second, that shift caused investors to abandon unprofitable companies like Unity.

Third, Unity’s top-line growth is decelerating. Its revenue rose 43% to $772 million in 2020 and grew 44% to $1.1 billion in 2021, but it expects a severe slowdown this year as it rebuilds the machine-learning algorithm for Unity Ads, a key component of its Operate Solutions platform which started ingesting “bad data” in the first quarter of 2022. That “bad data” was likely related to apple‘s (AAPL 3.28%) privacy update on iOS.

Unity might seem like a contrarian buy after its steep decline, but investors should review these five red flags before pulling the trigger.

1. Unity laid off its AI and software engineers

Last month, Unity laid off about 4% of its workforce, or slightly more than 200 employees. Most of those layoffs reportedly occurred across its artificial intelligence (AI) and engineering departments, which was odd because it likely needed those employees to rebuild the company’s problematic advertising algorithm.

2. Unity bought ironSource right after those layoffs

Investors were likely to scratch their heads until July 13, when Unity abruptly agreed to merge with ironSource (IS 0.00%)an Israeli ad tech company that helps companies monetize their apps.

The all-stock deal values ​​ironSource at $4.4 billion, which represents a whopping 74% premium to its 30-day average trading price, and will further dilute Unity’s existing shares — which have already expanded 7% year over year on a weighted-average basis in its first quarter of 2022. It will also inherit ironSource’s workforce of 995 employees and 126 contractors.

Bringing in ironSource right after dismissing its own employees suggests that Unity realized it would be easier to simply buy another company’s app monetization platform instead of rebuilding its own algorithm.

Unity claims the merger will deliver a run rate of $1 billion in adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) by the end of 2024, as well as over $300 million in adjusted EBITDA synergies by the third year. However, this merger could also suffer from acquisition indigestion — and there’s no guarantee ironSource can fix Unity Ads.

3. Unity is reducing its full-year forecast

Along with the ironSource announcement, Unity reduced its full-year revenue forecast from 23% to 30% growth to just 18% to 23% growth.

That’s well below Unity’s long-term target of generating more than 30% annual revenue growth and implies that Unity Ads is still in deep trouble. The broader slowdown of the gaming market in a post-lockdown market could also be exacerbating that pain. In addition, it suggests that Unity is buying ironSource — which is expected to generate almost 60% as much revenue as Unity this year — to inorganically achieve over 30% revenue growth again.

4. Unity is taking on $1 billion in fresh debt

Unity’s two largest investors, Silver Lake and Sequoia, plan to invest $1 billion in Unity through new convertible notes which will be issued after the merger closes. Those notes will bear an annual interest rate of 2%, mature in 2027, and sport a conversion price of $48.89 per share.

Unity had already issued $1.7 billion in convertible notes (with a 0% rate), and it ended the first quarter of 2022 with a debt-to-equity ratio of 1.1. ironSource ended its latest quarter with a much lower debt-to-equity ratio of 0.3. Therefore, it seems like Silver Lake and Sequoia are pushing the companies to merge to reduce Unity’s leverage so it can take on more debt.

5. Unity’s board OK’d at $2.5 billion buyback

On its own, Unity is unprofitable on a generally accepted accounting principles (GAAP) basis. ironSource squeezed out a GAAP profit of $60 million from $553 million in revenue in 2021.

That’s why it was baffling when Unity’s board authorized a $2.5-billion buyback plan, which will last for 24 months, to be executed after the merger closes. Unity says it will use those buybacks to reduce the dilution from the all-stock merger, but it would arguably be wiser to invest that cash into improvements for its core game engine and ancillary services.

I’m less hopeful about Unity’s future

I personally own some shares of Unity, and I’ve been cautiously optimistic about its turnaround efforts so far. However, these five red flags suggest it’s still stuck in the mud and could continue sinking for the foreseeable future.

Leo Sun has positions in Apple and Unity Software Inc. The Motley Fool has positions in and recommends Apple and Unity Software Inc. The Motley Fool recommends the following options: long March 2023 $120 calls on Apple and short March 2023 $130 calls on Apple. The Motley Fool has a disclosure policy.

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