In 2021, the metaverse created the loudest buzz in the investing world, and Unit software (NYSE: U) was seen as a key architect of that future. Shares soared above $200 a share as management said it expected revenue to grow at a compound annual growth rate of at least 30% for the foreseeable future.
In the first quarter of 2024, Unity’s revenue fell 8% year-over-year. In short, investor expectations were not met. Therefore, it is not surprising that Unity stock is now trading at an all-time low of $16 per share.
Unity shares underperform S&P 500 by a huge margin. Since going public in 2020, it’s down about 75%, while the S&P 500 is up about 67%.
U-data from YCharts.
As disappointing as that performance is, it is a performance from the past. Looking ahead, Unity stock has several possible paths. My analysis of the stock suggests there is still reason to be cautious.
What Unity has in its favor
When you hit rock bottom, it’s often a good time to step back, reflect, and make changes. That’s what Unity is doing. The company’s new CEO, Matt Bromberg, took over in May. And when he took over, management restructured the company, laid off some employees, and spun off parts of the business. The slate is now cleaner as it looks to the future.
According to Statista, the mobile video game space is expected to generate approximately $100 billion in revenue globally this year. The space is expected to continue to grow. And fortunately for Unity, the software is considered one of the two major creation and publishing engines out there, the other being the Unreal Engine from privately held Epic Games.
In other words, Unity is well-positioned in the large and growing mobile gaming space, giving it an “easy” opportunity to expand its business. Additionally, the company’s latest version of its software is due out later this year. The new version will have a different pricing structure, which should help Unity generate more revenue for successful games built on its platform. The pricing structure will be more similar to the one for Epic Games, so customer resistance should be minimal.
In terms of valuation, Unity stock once traded at a price-to-sales (P/S) ratio of 55; even for a high-quality company with impressive growth, that’s steep. Paying such a high price creates valuation risk if things don’t work out. And things certainly didn’t work out as expected for this company, which partly explains why it’s fallen so hard.
In contrast, Unity stock is now trading at a price/sales ratio of less than 3.
U PS Ratio data from YCharts.
The P/S valuation for Unity stock now makes sense. If the company can grow again, it has strong market-beating upside potential from this lower starting point. But another issue could hold it back.
Why investors should remain cautious for now
As far back as publicly available data goes, Unity has never had a positive net income. Granted, profitability can be measured from a number of angles, from accounting perspectives or by looking at cash flows. But from most angles, Unity hasn’t even been particularly close to profitability.
For software companies, there is always hope for profitability with scale. Because software is digital, companies incur costs to create it but can sell it over and over again, so scale is important. However, Unity’s margins have been declining. For example, gross margins have been down significantly since the company went public.
You Gross Profit Margin data from YCharts.
Whether intentionally or not, Unity’s management has given reason to doubt that it can improve margins in the short term. There are multiple parts to this business. In one segment, it generates revenue by helping mobile game companies monetize their apps. This puts it in direct competition with AppLovina company that is doing quite well.
Unity management says its customers are waiting for it to release a new version of its software so they have alternatives to what AppLovin offers. This seems to give AppLovin the lead. But more importantly, it suggests that its customers want more competition. And competition usually results in price wars, which reduces margins.
Earnings matter for stocks that perform well. If Unity had a history of profits, you might give it the benefit of the doubt. But it doesn’t; it has a history of losses, which is reason for caution. And the need for caution is heightened by declining margins and competitive pressure.
Unity needs to deliver earnings improvements and top-line growth over the next five years to outperform the S&P 500. The growth component is possible. But earnings improvements may be elusive, which is why I’m sitting on the sidelines with Unity.
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Jon Quast has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Unity Software. The Motley Fool has a disclosure policy.