Unity Software Stock Plummets. Is it a Buy Now?

There’s an old saying the Americans have which goes something like this. Take a number two or get out of the loo. It’s about being decisive and acting with conviction. In the world of investing, this becomes critically important. When a stock you’re holding falls and your thesis hasn’t changed, you add more shares if you have capital allocated to that position. That’s where we stand today with Unity Technologies (U) – which we will henceforth refer to as Unity Software because our SEO ninja said so.

As the market hits the skids harder than Pete Dougherty on any weekday night, we find our tech investing methodology changing a bit. While before we focused on revenue growth above all else, now that capital is drying up, we’re also focusing on runway. You better have made hay while the sun shined because now that share prices have plummeted off a cliff, raising capital by selling equity means you’re diluting existing shareholders much more significantly. As for raising debt, that’s more costly as well. So with that in mind, let’s take a look at the latest growth angel to fall from grace after a lackluster earnings report.

Through virtually every major crisis, the game industry has grown. Through recession, the game industry has grown. Through catastrophes like 9/11, the game industry had strong weeks immediately following. It is what people do when they’re frustrated.

Unity Software

Unity Software Stock Plummets

When you talk about a stock “plummeting,” you need some context. These days, all stocks are plummeting because fear is in the air. Just look at how the VIX – a simple measure of fear – has risen sharply lately. Below in yellow highlight, you can see how the market reacted to the Rona in March 2020 with a huge VIX spike. Today, it’s about half that level, but steadily rising;

Yahoo Finance graph showing in yellow highlight, you can see how the market reacted to the Rona in March 2020 with a huge VIX spike. Today, it's about half that level, but steadily rising
Credit: Yahoo Finance

While the market may be fearful, Unity has been plummeting for a while now. In the past six months, Unity stock lost 74% of its value. Then, when Q1-2022 earnings dropped, shares dropped another 37% in yesterday’s trading session. If you squint a bit, you can see just how heavy trading volume was (lower right of the below chart):

Yahoo finance graph showing Unity stock losing 74% of its value. Then, when Q1-2022 earnings dropped, shares dropped another 37%
Credit: Yahoo Finance

If you bought U stock six months ago at $182 a share, today those shares would have lost around 83% of their value. So, when we say the stock has plummeted, we’re making a fair statement. What we’re concerned with today is examining if this quality company that appears to be significantly discounted presents an opportunity to enter a position or buy more shares. In other words, we need to make sure our thesis hasn’t changed. We’ll do that by examining the insights given by management in the earnings call.

The Unity Q1-2022 Earnings Call

It’s not often companies will air their dirty laundry when some big internal faux pas happens. When they do, it’s usually a sign that they believe honesty and being forthright is the appropriate way to address shareholders, and we couldn’t agree more with that approach. Early on in the call, their head honcho says the following (our emphasis in bold):

While there are external factors to consider, the Operate challenge is mostly caused by internal factors in Unity monetization in an otherwise healthy market. We see these challenges as temporary and not structural and do not expect them to impact future prospects of our business beyond 2022.

Credit: Unity

Our default is to trust a management team because that’s a given when you invest in a quality company. At this point in time, they could have left it at that, but there’s loads more detail provided.

Two Main Issues

The CEO goes on to talk about two major internal issues that caused 2022 revenue guidance to stumble. He says:

  • The first was a fault in our platform that resulted in reduced accuracy for our Audience Pinpointer tool, a revenue expensive issue given that our Pinpointer tool experienced significant growth post the IDFA changes.
  • The second is that we lost the value of a portion of our data, training data due in part to us ingesting bad data from a large customer. We estimate the impact to our business of approximately $110 million in 2022 with no carryover impact to 2023.

Notice how we’re given very specific details about the internal problems that took place. Several more paragraphs follow which detail the issues further, with the most important statement being the following:

We understand the problems and we are well advanced in addressing them. We are deploying monitoring, alerting and recovery systems and processes to promptly mitigate future complex data issues.

Credit: Unity

When you muck something up in such a major manner, the first thing a competent manager will ask is if root cause was addressed. This was an issue of a data problem going undetected, so questions will be raised like “are there other similar problems we don’t know about yet?” It’s likely those questions were answered prior to the earnings call where the worst news would have been laid out all at once. Always get all the bad news out of the way because people have short memories.

Lowering Guidance

In reading through Unity’s issues, it seems the company is in control of the problems and confident they can be fixed in a timely manner so that the issue doesn’t extend beyond this year. During the call, the CFO gets into detail about how the aforementioned revenue impact will be distributed throughout the year, details we find irrelevant. What matters is that they adjusted 2022 revenue guidance downwards by about 9%:

For the full year, we’re lowering our guidance to $1,350 million to $1,425 million. This implies 22% to 28% year-on-year growth.

Credit: Unity

Here’s a look at all the numbers that were adjusted (top is before, bottom is after):

A look at all the numbers that were adjusted in Unity's 2022 Revenue guidance (top is before, bottom is after)
Credit: Unity

So this $9 billion firm might be able to achieve 25% growth at their current midpoint guidance. That’s not too shabby. And the earnings call wasn’t just doom and gloom. Unity announced the highest quarterly revenues ever recorded at $320 million, net retention of 135% (above average for a SaaS business), and the number of customers paying Unity more than $1,000 surpassed 1,080, up 29% from the year prior. They also said the following which investors should hold them to because this is a great time to become a profitable company:

“We have looked hard and can reduce our spending by over $100 million versus our internal plan,” and, “…we believe we will achieve profitability in the fourth quarter of this year, which is sooner than previously communicated.”

Credit: Unity

So another bit of good news to soften the blow of this temporary setback for virtual reality / metaverse darling Unity.

Other Bits and Bobs

The earnings call was chock full of rich information and questions were answered in a competent manner. A number of mentions were made around the traction the company is seeing in the “digital twins” space which is an exciting growth prospect we talked about in a piece earlier this year titled,Unity Technologies Stock: A Pure Play on the Metaverse.” Overall, there was nothing in the call that would affect our long-term thesis and we trust management when they say, “we are on it.”

As for the price of the stock, don’t try and pick a bottom just yet. According to our simple valuation ratio, Unity isn’t quite trading at bargain-basement prices just yet. The below data was taken directly from the Nanalyze Disruptive Tech Stock Catalog and shows the relative valuation of some other pure-SaaS or some-SaaS companies compared to Unity.

 Market CapQ4-2021 RevsRatio
CrowdStrike Holdings, Inc. (CRWD)31,87938021
Confluent, Inc. (CFLT)5,12312011
Okta, Inc. (OKTA)14,34935110
UiPath,Inc. (PATH)7,7812219
Palantir Technologies, Inc (PLTR)14,9124339
Schrodinger, Inc. (SDGR)1,522468
Darktrace PLC (DARK.L)2,934968
Unity Software Inc. (U)8,9593167
C3.AI, Inc. (AI)1,480586
Splunk, Inc. (SPLK)15,2716656
Alteryx, Inc. (AYX)3,6311745
Credit: Nanalyze

How far she goes, nobody knows.

Lastly, we’d like to thank the NLP algorithm the Motley Fool used to transcribe the Unity Q1-2022 earnings call which made this article possible. Thank you, little algorithm. Even though you made a few small mistakes, we appreciate your hard work. And if you ever want to come work for a firm where Thirsty Thursday is every day of the week, we’re always hiring.

Conclusion

Whenever a stock falls because of a “bad” earnings report, everyone has access to the exact same information – the SEC filings, the press releases, and the earnings call transcripts. Very few people looking in from the outside have an information advantage which means the only variation is in how we interpret the information.

Firms will have large internal cock ups. Guaranteed. It happens more often than we think, so we’re impressed that Unity’s management team has been so honest. (To be fair though, in a world of lying SPACs, the bar has been set pretty low.) If Unity hits their guidance – and we have no reason to think they won’t – and the impact of the two major internal issues doesn’t extend to 2023, as management has promised, then there’s absolutely nothing for long-term investors to be worried about.

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