U - Unity Software: Severity Of Job Cuts Was A Negative Surprise

2024-01-11 06:30:00 ET

Summary

• Unity Software Inc. announced a reduction in force, cutting approximately 25% of its workforce, leading to a negative market reaction.
• The job cuts may result in weaker near-term revenue growth, as reflected in revised financial forecasts for the company.
• Despite the short-term impact, Unity Software's long-term growth potential remains intact, with opportunities in the game engine market and potential AI-driven revenue upside.

Elevator Pitch

My rating for Unity Software Inc. (U) is a Hold. I previously wrote about U's quarterly performance and financial prospects in my July 28, 2022, article .

The focus of the current update is Unity Software's latest Reduction in Force or RIF announcement and the company's long-term growth potential. The market was shocked that U decided to cut 25% of its workforce, which implies that Unity Software's revenue growth for the near term might be weaker than what the analysts expected earlier. But Unity Software's long-term outlook relating to top line expansion and margin improvement is still intact considering third-party research and consensus estimates. This provides support for my decision to maintain my Hold rating for U.

Significant Job Cuts Were Received Badly By The Market

On January 8, 2024, after trading hours, U issued an 8-K filing revealing that the company "plans to reduce approximately 1,800 employee roles." Unity Software's shares fell by -8.0% to close at $35.87 at the end of the January 9 trading day. Even though U's stock price recovered by +3.5% to $37.13 as of January 10, the company's last done share price was still -4.7% below where the stock had traded at ($38.98 as of January 8) prior to the latest announcement.

It is reasonable to think that investors had an unfavorable view of Unity Software's recent disclosure.

At the company's earlier Q3 2023 earnings briefing in November last year, U had noted that it was "continuing to adjust our cost structure" which "will lead to a reduction in force" that it "will be announcing over the next few months."

While it was expected that Unity Software was going to lay off staff, the severity of job cuts and its impact on U's top line outlook were a negative surprise. The 1,800 workers to be laid off was equivalent to roughly a quarter of Unity Software's employees.

In the 8-K filing announcing the layoffs, U emphasized that the job cuts were proposed to "position itself for long-term and profitable growth", as the company "restructures and refocuses on its core business." It is natural that Unity Software's portfolio restructuring process will involve the company trading off short-term revenue weakness for margin improvement in the long run.

However, the substantial 25% reduction in Unity Software's number of workers implies that the actual hit to U's near-term revenue could be much worse than what the market had anticipated. This is reflected in the latest changes to the consensus financial forecasts for Unity Software. According to S&P Capital IQ data, U's consensus FY 2024 top line estimate was lowered from $2,424 million as of January 7 to $2,412 million as of January 10. The consensus FY 2025 revenue projection for Unity Software was also revised downwards from $2,817 million to $2,808 million during the same time period. This implies that the market currently expects U's revenue growth to decelerate from +53.4% for FY 2023 to +13.0% and +16.4% (source: S&P Capital IQ ) in FY 2024 and FY 2025, respectively.

It is likely that Unity Software's consensus FY 2024 and FY 2025 revenue projections could be further reduced in the coming days and weeks as more sell-side analysts revise their respective financial estimates for U in light of recent developments.

To sum things up, the larger-than-expected job cuts and the resulting impact on future revenue meant that Unity Software's recent share price correction was justified.

But Long-Term Prospects Are Intact

The +3.5% rebound in Unity Software's share price on January 10, 2024, suggests that investors still have a positive opinion of U's long term financial outlook, notwithstanding the negative surprise associated with the company's latest workforce reduction announcement.

Unity Software highlighted at its Q3 2023 results briefing that its portfolio restructuring efforts (including workforce reduction) will enable it to focus on being "an indispensable partner for game creators to build, operate, and profit from their creations." Polaris Market Research forecasts that the worldwide game engine market will expand at a CAGR of +17.1% for the 2024-2032 time frame, which implies that the current FY 2023-2025 consensus top line CAGR forecast of +14.7% (source: S&P Capital IQ ) for U is realistic.

Separately, there could be further upside relating to Unity Software's future revenue, assuming that AI tailwinds materialize. According to Morgan Stanley's ( MS ) March 2, 2023, report (not publicly available) titled "Sizing the $6 Trillion AI Internet Opportunity", "a 1% increase in engine subscribers and ad revenue" for Unity Software driven by the "adoption of AI-based game content production" could potentially "translate to 1% upside to revenue."

On the other hand, Unity Software's normalized EBITDA margin is projected to expand from 17.7% (estimate) in FY 2023 to 26.4% and 30.4% for FY 2024 and FY 2025, respectively.

The recently announced job cuts are likely to translate into meaningful costs savings and margin improvement for U. Sell-side analysts from JMP Securities are expecting U to realize yearly expense reductions of almost $400 million with the company's portfolio restructuring efforts. U also indicated at its third quarter earnings call that it is looking to exploit "synergies" and improve "efficiencies" between the company's various divisions and reviewing "G&A (General & Administrative" expenses, on top of portfolio restructuring, and these moves should eventually lead to lower costs and higher margins.

Final Thoughts

I view Unity Software as a case of "short term pain, long term gain" which warrants a Hold rating. The severe job cuts will hurt U's near-term revenue growth momentum, but the company's future profitability should benefit from its restructuring moves. Also, Unity Software is a beneficiary of the growth in the worldwide game engine market and AI tailwinds relating to game content creation.

I think that U is currently trading at a fair valuation taking into account its consensus next twelve months' EV/EBITDA multiple of 28.0 times and the company's consensus FY 2023-2027 EBITDA CAGR of 28.6% as per S&P Capital IQ data. A valuation rule of thumb indicates that a stock is valued fairly by the market if its earnings multiple is roughly equivalent to its future earnings growth rate.

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