Unity Software Tanks 48% YTD: How Should You Play the Stock?

Unity Software U has been in particularly choppy waters so far in 2024 as the stock has plummeted 48.2% compared with the Zacks Computer and Technology sector's 23.4% return, leaving investors wondering whether this represents a buying opportunity or a sign of deeper troubles ahead.

Unity, known for its widely-used game development engine, has been grappling with challenges in its core business segments. The company's recent financial performance and guidance revisions have sparked concern among analysts and shareholders alike.

In its latest quarterly report, Unity delivered mixed results. While the company showed improvements in free cash flow, generating $80 million in the second quarter — a 137% increase from the previous year — revenue growth in key segments has been sluggish. The Grow Solutions segment, which encompasses Unity's advertising and monetization business, experienced a 9% year-over-year decline, reaching $296 million. This downturn in the advertising side of the business has been a significant factor in Unity's stock performance, as it represents a substantial portion of the company's revenues.

Year-to-Date Performance

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Unity Rebuilds Ad Tech Amid Mobile Gaming Supremacy

Despite these challenges, Unity maintains a dominant position in the mobile gaming market. The company powers 70% of the top mobile games globally. In 2023, applications built with Unity averaged 3.7 billion downloads per month. On the advertising front, Unity delivers over 65 billion impressions monthly, reaching more than 1.5 billion individual gamers.

To address the headwinds in its advertising business, Unity has embarked on a comprehensive rebuild of its machine learning stack and data infrastructure. The company aims to create a more agile environment for continuous innovation, potentially leading to improved performance and greater ROI for customers. Additionally, Unity has made strategic hires, bringing on board industry veterans like Jim Payne as the new chief product officer for Advertising and Alex Blum as SVP of Corporate Development.

Unity's Create Solutions division, which includes its strategic portfolio, has shown resilience with a modest 4% year-over-year increase in revenues to $129 million. This growth was primarily driven by a 14% rise in subscription revenues, attributed to successful price increases and customer upgrades to higher-priced tiers. The company's ability to upsell its existing customer base demonstrates the value proposition of its offerings and the potential for continued revenue expansion.

The company's Industries segment, which focuses on non-gaming applications of Unity's technology, has emerged as a significant growth driver. In the second quarter, Industries grew by 59% year over year, now representing 18% of total Create Solutions revenues, up from 12% in the previous year. This diversification into new markets could open up additional revenue streams and reduce Unity's dependence on the gaming sector.

Unity's Cautious Outlook Amid Intense Rivalry

These initiatives, however, will take time to bear fruit, as reflected in Unity's revised guidance for the full year. The company has lowered its revenue expectations for its strategic portfolio to $1,680 to $1,690 million, down from the previous range of $1,760 to $1,800 million. This adjustment represents a year-over-year decrease of 2% to 3%, signaling a more cautious approach to the recovery in the Grow Solutions business.

The reduced guidance has also impacted Unity's projected adjusted EBITDA, now expected to be between $340 million and $350 million, down from the previous range of $400 million to $425 million. This decrease is primarily due to lower projected revenues, though partially offset by incremental cost savings.

The Zacks Consensus Estimate for Unity's 2024 revenues is pegged at $1.76 billion, indicating year-over-year growth of 19.5%. The consensus mark for 2024 earnings is pegged at a loss of $1.86 per share, unchanged in the past 30 days. 

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Besides, Unity Software operates in a competitive landscape within the game development and advertising technology sectors. Its primary rival in the game engine market is Epic Games' Unreal Engine, which is particularly strong in high-end console and PC game development besides Amazon-owned Lumberyard (now Open 3D Engine). Other competitors include Godot, an open-source alternative gaining popularity, and CryEngine, known for its graphical capabilities.

In the mobile ad tech space, Unity faces competition from companies like AppLovin APP and Alphabet-owned Google's AdMob. Additionally, as Unity expands into non-gaming industries, it will encounter competition from specialized software providers in sectors such as architecture, automotive and film production. The company's ability to innovate and maintain its market share against these diverse competitors will be crucial for its long-term success.

It is also important to consider whether the stock's current valuation accurately reflects the company's long-term growth potential and ability to navigate the competitive landscape. Unity is trading at a premium with a forward P/S ratio of 4.72X compared with the Zacks Internet - Software industry's 2.77X, reflecting a stretched valuation.

Unity's P/S F12M Ratio Depicts Stretched Valuation

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Conclusion

As Unity works to rebuild its advertising capabilities and leverage its strong position in game development, the company's ability to execute its strategic initiatives will be crucial. More conservative investors may prefer to wait for clearer signs of a turnaround in the advertising business and improved financial performance before committing capital. For current shareholders, holding onto Unity stock may be a prudent strategy. Potential buyers, however, may want to exercise patience. Unity Software currently has a Zacks Rank #3 (Hold).

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