Unity's Earnings Report Recap

Unity (U) Software is a platform that lets other companies tell beautiful stories in video games and beyond. Unity and its nemesis, Unreal Engine, owned by Epic Games, dominate this digital experience development software market as a duopoly. Unity is more focused on mobile experiences and Unreal on PCs. Believing in Unity's story and expecting its stock to generate a massive return on your investment is so easy to accept, especially in a world where digital experiences become more immersive, beautiful, and unbelievably real.

But, as investors, we can't fly with the stories. We must look behind the proverbial curtain and see what's happening behind the scenes. The last time I looked at Unity Software (Ticker: U), several investors I trust were selling their Unity shares because of the company's revenue growth slowdown, high stock-based compensation that results in diluting current shareholders, and the management's tendency to keep information close to the chest and not be straightforward with investors. 

That was back in November 2022. Fast forward five months, and the stock just popped over 13% after releasing its latest earnings report on May 10th. Is Unity a buy now, or do the concerns of growth, dilution, and management attitude still hold true? 

Let's talk about that!

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I'm Hoda Mehr, founder, and CEO of Stock Card, and on this blog and its accompanying YouTube channel and Podcast show, I share detailed fundamental analyses and interesting investment stories.

This post is part of a series I started a few weeks ago to research companies that are down significantly from their all-time highs to decide whether to buy more or sell and allocate money to other companies. I've already researched Canopy Growth (CGC), Fastly (FSLY), Snap (SNAP) ,  Shopify (SHOP). and Airbnb (ABNB). I'll continue with this series for a few more weeks.

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How To Fundemantally Research Unity

I own Unity's shares directly and indirectly through owning ARKK ETF, which allocates 3.5% of its assets to this company. Therefore researching Unity's fundamentals is quite interesting to help me decide what to do with its volatile shares. In October 2021, the stock was priced at more than $170. As I'm recording this episode today, the stock is up 12% during market hours and down by 6% in the after-hours trading on the same day. It's quite volatile and hovers around $32 per share, down 80% from October 2021's price. 

We can only hold on to the shares after such a big drop if we have a fundamental conviction that the stock is worth holding. In the next few minutes, we'll research Unity fundamentally using a 6-part framework:

1. How the company makes money,
2. Its top and bottom line trends,
3. Noteworthy changes in the top and bottom line,
4. Balance sheet strength,
5. Ability to generate cash to reinvest in its future,
6. Current valuation and the feasibility of growing into it.

Unity's Latest Earnings Recap

Unity software is mostly known for its presence in the video game industry. However, its software enables any developer or artist that wants to make high-quality 3D content to do that easily and beautifully. It also offers its customers ways to sell advertisements through the 3D environments they create using Unity's software. In Q1 2023, roughly 40% of the company's revenue came from the 3D creation software and solutions and 60% from advertisement and monetization. 
Unity has been making new acquisitions to strengthen its advertisement and monetization division. And it is still integrating ironSource, one of the key acquisitions for the advertisement division, to shore up the revenue. 

Topline:
We can see the result of all its effort in its 56% year-over-year revenue growth, which is entirely due to the revenue from the acquired companies such as ironSource. Without the acquisition's contribution, commonly known as a proforma basis, revenue was down 2%, Y-O-Y. This is a double-edged sword. On the one hand, as investors, we are happy to see the company growing; on the other hand, we are worried that the company has lost its ability to grow revenue organically. 
There's our first red flag. 
If we dig deeper, it looks like Create Solutions, the 3D creation unit, was up 14% year-over-year. That's not bad, but it is far from the rapidly-growing company Unity once was or needs to be. The management believes the revenue growth will accelerate in the coming months due to price increases, new customer adoptions, and growth in China. That promise to accelerate growth reduces my worry about the slow revenue growth we discussed earlier. 

Unity's Net Dollar Retention Trend:
The other red flag related to the revenue is the net dollar expansion rate reduction. In Q1 2021, the company had a 140% net dollar expansion, which means for every dollar the customer was paying Unity, it spent 40% more the next quarter. In Q1 2023, the rate is down to 107%. Some of that decline can be due to price increases, but it is still a red flag. 


Unity's Bottom Line:
On the bottom line, the company is still committed to generating $1B in adjusted EBITDA by the end of 2024. This means the company takes its net loss and adds back stock-based compensation, amortization of its assets, and a few other non-cash expenses and gets to its adjusted EBITDA. With that method, Unity made $32M in adjusted EBITDA this quarter. What's surprising is the company's belief in getting to $1B in adjusted EBITDA by 2024. 
The major contributor to Unity's net losses is a more than $100M increase in sales and marketing expenses, which the company attributes to a higher headcount related to the ironSource acquisition. You can see the impact of such an increase in headcount on the number of outstanding shares as the company issued more than 100M shares compared to Q1 2022 but flat compared to Q4 2022. Generally, as investors, we don't like new shares issues because it reduces our company ownership and earnings per share. Regardless, the company plans to keep its outstanding shares stable in 2023 and manage its headcount well, which is good news. 
Overall, the company's profit generation power isn't better or worse than what we discussed in November. I leave a link to November's Unity review video so you can compare it with today's episode and notice the changes. 

Unity's Balance Sheet:
The next point is Unity's balance sheet strength. It holds $1.6B in cash and cash equivalents and more than $2.3B in current assets, including accounts receivables. Compare that to $1B in liabilities. Overall, Unity doesn't have a major balance sheet risk. 
The red flag on the balance sheet is not associated with running out of cash but is related to future share issuance. Unity has almost $3B in convertible notes, eventually converting into common shares and further diluting us, the existing shareholders. 

Unity's Free Cash Flow:
Talking about cash on the balance sheet, Unity returned to negative free cash flow this quarter, and that means it still needs to use the cash it holds on its balance sheet to fund portions of its projects to grow in the future. The management explained it expects to generate free cash flow in the year, and that is something to hope for.

So let's recap Unity's fundamental analysis:

1. Revenue is growing slowly compared to its past, but the management believes the growth rate will go back up
   
2. The operations are unprofitable, with stock-based compensation costs still dragging the business. 
   
3. The company didn't generate free cash flow but plans to do so this year.
   
4. Unity has a stable balance sheet and isn't in immediate cash crunch danger.
   

Unity's Valuation

Knowing all that, Unity isn't yet the slam-dunk company it once was. So when I look at its valuation ratio of more than six times the price-to-sales ratio, this seems quite expensive. Compare this with Tencent's valuation, which owns Unity's competitor and is priced five times sales.  
We can argue Tencent is a much different business because its Unity comparable business is just a small portion of its operations. 
So, instead, let's do some math. To become six times bigger in the next five years:

• Unity has to grow its sales by 43% per year.
  
• To achieve it in 10 years, it has to grow by 19% per year.
  
• Unity forecasts $2B revenue for 2023, a 3 to 9% pro forma growth.
  

​​There is a big difference between 3-9% and 19% to 43% annual growth rate in the next 5 to 10 years. Of course, if Unity becomes more profitable and generates cash, there are more reasons to give the company a higher valuation, but that's yet to be seen and proven.

Is Unity's Stock A Buy Now?

Overall, it seems Unity is on the right track. But the stock market investors are also already jumping ahead, pricing the stock for success. I wouldn't have been buying new shares if I didn't own shares. Since I own it, the shares go to the hold-until-find-a-batter-choice bucket. Unless I find a better opportunity to reallocate my capital, I'll monitor the company to see how it executes its plans to generate free cash, reach $1B in adjusted EBITDA, and return to rapid growth. In a way, my conclusion didn't change much compared to the last November. 
Now it's your turn to lock up Unity's Stock Card and share your research in the comments so we can all learn from each other. If you have a recommendation for better stocks than Unity to buy now, don't forget to share them too. I left a link to Unity's Stock Card and a few other resources and YouTube channels I used to create this video in the show notes too.
See you next time!

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