AAPL - Unity Software: Can The Stock Break Back Above $50 In 2024?

2023-12-26 16:03:34 ET

Summary

• Unity stock initially tumbled due to poorly received pricing changes but has since recovered from those losses very quickly, perhaps too quickly.
• Management has unveiled a plan to aggressively cut costs and exit unprofitable business segments.
• I explain why it is time to move on, at least for now.

Unity ( U ) has been one of the more volatile stocks in the market today. The stock initially tumbled due to the company's poorly received pricing changes, but has since recovered strongly amidst hopes for interest rate cuts. The potential for long-term evolution of the pricing structure remains the most important long-term bullish thesis. In the near term, however, the focus should be on management's plan to aggressively cut costs and exit unprofitable business segments. The market might not be appreciating the dramatic shift in profitability that might be taking place here - I expect the company to emerge in 2024 with a stronger balance sheet position and renewed focus on profitable growth. Much of that optimism appears to have been priced into the stock after some strong trading sessions, and I see some execution risk given the scale of the overhaul. It is difficult to stand by the stock amidst a melt-up in the tech sector, leading me to downgrade the stock to "hold."

Unity Stock Price

After crashing just a couple of months ago due to customer blowback on its runtime fee changes , U has recovered those losses and is now approaching resistance at the $50 level. The stock hit an intraday high of $50.08 on July 13 and proceeded to drop below $23 in early November. It hasn't closed above $50 since August 2022.

I last covered the stock in September, where I rated it a "strong buy" on account of the long-term metaverse opportunity.

Unity Stock Key Metrics

In its most recent quarter, U delivered solid results. Revenue grew 69% YoY, or 8% pro forma, given that the company is still benefiting from its acquisition of ironSource. The more impressive line item was the 24% adjusted EBITDA margin posted in the quarter. Like many tech peers, U has shown an increased focus on profitability amidst tough macro conditions.

U saw some headwinds from China, with Create Solutions revenue coming in flat YoY at $189 million, but growing 19% YoY excluding China. Ongoing government restrictions on gaming were to blame, and I note that the newly released restrictions may add further pain moving forward. Management believes that the runtime fee changes will show "minimal benefit" in 2024 but ramp up from there. The company ended the quarter with $1.5 billion of cash versus $2.7 billion of debt, representing a significant leverage position even accounting for the improving adjusted EBITDA showing.

Management opted to not provide guidance for the upcoming quarter, noting that they intend to instead provide 2024 guidance then. On the conference call , new CEO Jim Whitehurst discussed plans to refocus the business on the core growth priorities, implying a significant "reset." Management stressed that this is "not like a business model transition that takes a year or two years or three years to complete" but instead something that will be "100 percent done next quarter." And indeed, the company quickly announced a round of layoffs and office closures subsequent to the quarter end. I found it unusual that U executed on $250 million in share repurchases in the quarter prior to announcing such a transformational reset - time will tell if these repurchases were well-timed or not.

Is Unity Stock A Buy, Sell, Or Hold?

U has seen its growth story stalled by a tough macro environment, and near-term outlook muddied by tough decisions to exit unprofitable business segments. The company remains a compelling way to invest in an increasing 3D future, which may include a growing metaverse. Recall that U was named as an early adopter for Apple's ( AAPL ) Vision Pro headset.

I expect growth rates to return in earnest, though consensus estimates expect just a modest recovery to a mid-teens growth rate.

Besides an improving macro picture, it is important to note that U is not currently earning a cut of revenues generated in-game. This is in stark contrast with the Unreal Engine owned by Epic Games, which takes a 12% commission . In the game development community, U is often seen as a budget alternative to Unreal Engine, making up for the difference in technology with an easier start-up and lower fees. Over time, I expect U to eventually roll out a new fee structure which allows U to take a cut of in-game revenues. Such a move would undoubtedly lead to uproar similar to that seen with this latest runtime fee changes, but I can see such pricing changes proving successful if U can keep its fees lower than competitors.

U stock is currently trading at around 8x forward sales (as I noted in my prior report , diluted shares outstanding is around 470 million inclusive of convertible notes). I assume that U can generate 30% net margins over the long term and that the stock should trade at around a 1.5x price to earnings growth ratio ('PEG ratio'). If U can return to 30% top-line growth, then the fair value might hover at around 13.5x sales, implying a solid upside. If growth instead comes in at around 15%, then the fair value drops to around 6.75x sales, implying less than stellar upside. This does not appear to be an attractive setup given the high reliance on a strong recovery in revenue growth rates. Management's announced business overhaul may help to decrease the risk profile due to enhanced profit margins from a leaner business. That may help to eventually justify a premium valuation, given the company's strong positioning amidst long-term growth stories. However, U has not quite executed enough on this transformation to justify that premium valuation, making the stock trade at the upper end of its fair value range.

What are the key risks? Valuation remains an important risk. The rally of the past several months appears to be mainly macro-driven and not company-specific, given that U is likely to see pressured near-term results from the runtime fee and shut down business segments. If interest rates were to rise or investor sentiment were to worsen, U stock could experience downward pressure alongside broader macro trends. As just noted above, U stock is not trading at obviously cheap valuations unless one assumes a return to aggressive top-line growth rates. Another risk is that of management execution with respect to the lean transformation. While management is confident that they can complete the overhaul within a quarter, that might not prove so trivial in practice, and it is not clear if the aggressive cost-cutting may negatively impact the long-term growth profile of the business.

I am downgrading the stock to "hold" given the great uncertainty in near-term growth rates, as I expect the profitability gains from exiting unprofitable businesses to be offset by lower revenue contribution from those exited businesses. If Unity's stock is going to break back above $50, I believe the company will have to show improving fundamentals before it can overcome the technical resistance level.

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