U - Unity Software: Regaining Trust After It Is Broken

2023-10-31 10:00:00 ET

Summary

• U's prospects have been mixed after the recent pricing change, leading to an immense backlash from the gaming community and the abrupt departure of its CEO.
• The breach of trust may trigger a decline in its market share, with developers more likely to explore other game engines as a way to manage pricing risks.
• While U's valuations appear to be fair, seemingly near to Epic Games, the stock may face more downside, worsened by the peak pessimism observed in the stock market.
• Then again, assuming that the new management is able to restore trust while tap into the AR/VR market with the help of AAPL's Vision Pro, we may see its prospects lift moving forward.
• We maintain our speculative Buy rating on the U stock, with a long-term price target of $74.92.

We previously covered Unity Software Inc. (U) in June 2023, discussing its brilliant prospects from the surprising partnership with Apple (AAPL), attributed to the Vision Pro spatial computing headset.

This news had directly contributed to the stock's extreme rally back then, with multiple analysts naturally upgrading its prospects over the next few years, attributed to the increased onboarding of AR/VR developers from H2'23 onwards.

In this article, we will be discussing U's mixed prospects after the recent runtime fee debacle and the CEO's abrupt departure , with it remaining to be seen if the company may be able to regain the gaming community's trust.

While we continue to rate the stock as a Buy, thanks to its improving profitability and excellent prospects from Vision Pro, investors may also want to temper their near-term expectations, since its eventual recovery may be prolonged with the macroeconomic outlook still uncertain.

The U Investment Thesis Has Soured Drastically, Reversal Hinges On Vision Pro

U 6M Stock Price

U has had an exciting six months indeed, with the stock going through a dramatic rollercoaster thanks to multiple events, with the latest being the runtime time fee hike, as noted in the price chart above.

We will not be delving deep into the sordid details, since we believe that a fellow analyst has offered great insights into the whole issue here. Interested readers may want to head over for a better understanding.

Thanks to this issue, it seems that U may have burned bridges with the gaming community, with many developers greatly protesting the sudden pricing change and some others "threatening to never use Unity again or port their existing projects to other game engines."

We believe that the ramifications may be great indeed since it is uncertain if the new leadership may be able to appease its existing consumer base, especially since the company only relies on a single SaaS game development platform as its top and bottom line driver.

On the one hand, many developers may use this opportunity to try out U's competitors for the development of new games, namely Unreal Engine from Epic Games and/ or the open-source Godot, due to the evident breach of trust.

Not only will this impact its eventual monetization from 2024 onwards, but we believe that U's market share may also deteriorate from current levels, as game developers manage their risks in the event of another change in U's terms of service.

On the other hand, we do not expect any of U's consumers to transit their existing games to new platforms, attributed to the immense migration costs and development hours involved.

Its game engines are usually very sticky as well, given the immense tools offered by U's dedicated 2D/ 3D/ VR development platform, with developers often having great inertia in migrating to an entirely new platform with unfamiliar tools. Thanks to the gaming company's excellent offerings, we believe that there is still some hope ahead.

Even then, assuming that no further changes are made to U's pricing structure, we believe that many game developers may still choose to stay, since its 2.5% runtime fee is obviously cheaper than Unreal's 5% royalty upon $1M revenues, though still expensive compared to Godot's free/ open source license .

U Valuations

For now, it is hard to accurately value U, since its direct competitors in the gaming engine sector are not publicly traded, namely Unreal Engine from Epic Games and Godot.

However, it appears that Epic Games is trading at an approximate TTM EV/Sales of 5.11x, with market analysts estimating the company to be worth approximately $32B in 2022 and its FY2022 revenues at $6.26B .

Based on these numbers, it appears that U's FWD EV/ Sales of 5.19x is not over-aggressive indeed, after the much-needed normalization from its 1Y mean of 6.22x, implying that the company may be currently fairly valued.

Game Engine Market Share

Game Revenues By Engine

Perhaps part of the premium may be attributed to U's leading market share in the indie game segment at 51.9%, though lagging behind Unreal's at 17.7% in the AAA game segment.

In addition, U generates a more than decent game revenue of approximately $9.2B, though still lagging behind Unreal at $20B.

The other part of the premium valuations may also be attributed to U being AAPL's chosen development partner for the Vision Pro spatial computing headset, with Tim Cook unlikely to have a change of heart.

Investors may also want to note that the upcoming FQ3'23 earnings call may bring forth excellent numbers, thanks to the recently launched beta developer program for visionOS in July 2023.

Assuming so, U may have a good chance to put the runtime fee disaster behind them, for so long that no further fee changes occur.

This may allow the gaming company to reverse its fortunes, especially since AAPL users have been reported to spend up to seven times more than Android users, with Asymco's Horace Dediu expecting up to $100 in monthly spending on the Vision Pro.

While U indeed trades at a lofty FWD EV/ EBITDA of 33.45x, we believe part of the premium is warranted, since the company may be able to achieve an exemplary FY2023 adj EBITDA profitability of $321.2M (+728.5% YoY).

This is based on its FQ1'23 adj EBITDA generation of $32.46M (+242% YoY), FQ2'23 of $98.74M (+204.1% QoQ/ +362.3% YoY), and projected FQ3'23 of $95M at the midpoint (with the assumption that FQ4'23 is inline with FQ3'23).

Combined with its FQ2'23 share count of 380.36M and its FWD EV/ EBITDA valuation of 33.45x, it appears that the U stock is also trading near its fair value of $28.09.

The Consensus Forward Estimates

For now, the consensus estimates that U may generate a robust top and bottom line growth at a CAGR of +30.4% and +155.84% through FY2025, respectively, compared to its hyper-pandemic top-line expansion at a CAGR of +36.9%.

Based on the consensus FY2025 adj EBITDA estimates of $855.69M, it appears that there is a great upside potential of +193.3% to our long-term price target of $74.92.

Despite the growing SBC expenses of $157.53M (-3.3% QoQ/ +33.2% YoY) in the latest quarter, U has also generated Free Cash Flow of $33.53M (+272.3% QoQ/ +157.5% YoY).

Assuming that the new management is able to sustain this trend, we may see its balance sheet remain healthy at current levels of $1.64B (+3.1% QoQ/ -6.2% YoY), without having to rely on additional debts.

These glowing numbers have painted a somewhat optimistic picture for U's prospects indeed, no matter the ongoing noise in the gaming world, the potential engine migration, and the impact of the uncertain macroeconomic outlook on the stock market.

So, Is U Stock A Buy , Sell, or Hold?

U 1Y Stock Price

Thanks to the recent headwinds, the U stock has returned most of its Vision-Pro-induced June 2023 gains, with it currently retesting its critical support levels of $25s.

Based on its lower highs and lower lows since the July 2023 peak, we may unfortunately see the stock further retrace to its November 2022 bottom of $21 in the near term, implying a -17.7% downside from current levels.

SPY Price

Even then, we are not certain if there will be a floor to this decline, with the stock market already entering extreme fear territory and the SPY retesting its critical support levels of $410s.

As a result, while we may rate U as a Buy for opportunistic investors looking to take advantage of the recent correction, they may want to monitor the stock's movement for a little longer and add only if the $25s support levels are not breached in the near term.

Even then, the stock is only suitable for investors with higher risk tolerance and long-term investing trajectory, since its reversal may be prolonged until sentiments from the gaming community and the stock market improve.

Only time may tell.

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