5 red flags for the future of Unity Software

Unit Software (U 3.69%) was one of the hottest tech IPOs of 2020. More than half of the world’s mobile, console and PC games have already been created by its namesake engine – which has greatly simplified cross-platform game development – ​​and it was expanding its ecosystem with in-app ads, other monetization features, and tools for non-gaming apps.

Unity went public at $52 per share in September 2020. It opened at $75 and hit an all-time high of $210 last November, but is now trading in the low $30s. Unity shares plummeted for three simple reasons.

Image source: Getty Images.

First, rising interest rates drove investors away from the frothier growth stocks. At its peak, Unity was trading at more than 50 times the sales it would generate in 2021. Today, it is trading at a more reasonable rate of eight times this year’s sales. Second, this change caused investors to abandon unprofitable companies like Unity.

Third, Unity’s revenue growth is slowing. Its revenue rose 43% to $772 million in 2020 and 44% to $1.1 billion in 2021, but it expects a severe downturn this year as it rebuilds the learning algorithm for Unity Ads, a key part of its Operate Solutions platform that began ingesting “bad data” in Q1 2022. This “bad data” was likely related to Appleit is (AAPL 1.15%) privacy update on iOS.

The unit may seem like a contrarian buy after its steep decline, but investors should consider these five red flags before pulling the trigger.

1. Unity laid off its AI and software engineers

Last month, Unity laid off about 4% of its workforce, or just over 200 employees. Most of those layoffs reportedly took place in its artificial intelligence (AI) and engineering departments, which was odd because it likely needed those employees to rebuild the company’s problematic advertising algorithm.

2. Unity bought ironSource right after those layoffs

Investors were probably scratching their heads until July 13 when Unity abruptly agreed to merge with ironSource (IS 6.40%)an Israeli ad tech company that helps businesses monetize their apps.

The all-stock deal values ​​ironSource at $4.4 billion, representing a whopping 74% premium to its 30-day average trading price, and will further dilute Unity’s existing stock, which has already increased by 7% year-on-year on a weighted average. base in the first quarter of 2022. He will also inherit ironSource’s workforce of 995 employees and 126 contractors.

Bringing in ironSource right after laying off its own employees suggests that Unity realized it would be easier to just buy another company’s app monetization platform instead of rebuilding its own algorithm.

Unity says the merger will generate a run rate of $1 billion in adjusted earnings before interest, tax, depreciation, and amortization (EBITDA) by the end of 2024, as well as more than $300 million in business synergies. Adjusted EBITDA by year three. However, this merger could also suffer from acquisition indigestion — and there’s no guarantee ironSource can fix Unity Ads.

3. Unity cuts its forecast for the whole year

Along with ironSource’s announcement, Unity cut its full-year revenue forecast from 23% to 30% growth to just 18% to 23% growth.

This is well below Unity’s long-term goal of generating over 30% annual revenue growth and implies that Unity Ads is still in deep trouble. The broader gaming market downturn in a post-lockdown market could also exacerbate this pain. Further, it suggests Unity buying ironSource – which is expected to generate almost 60% more revenue than Unity this year – to again inorganically achieve revenue growth of over 30%.

4. Unity takes on $1 billion in new debt

Unity’s two largest investors, Silver Lake and Sequoia, plan to invest $1 billion in Unity through new convertible notes to be issued after the merger closes. These notes will bear interest at an annual rate of 2%, will mature in 2027 and will have a conversion price of $48.89 per share.

Unity had already issued $1.7 billion of convertible notes (with a rate of 0%) and ended the first quarter of 2022 with a leverage ratio of 1.1. ironSource ended its last quarter with a debt ratio well below 0.3. Therefore, it looks like Silver Lake and Sequoia are pushing the companies to merge to reduce Unity’s leverage so it can take on more debt.

5. Unity’s board agreed to a $2.5 billion buyout

By itself, Unity is not profitable on a generally accepted accounting principles (GAAP) base. ironSource posted a GAAP profit of $60 million on $553 million in revenue in 2021.

That’s why it was baffling when Unity’s board authorized a $2.5 billion buyout plan, which will last 24 months, to run after the merger closes. Unity says it will use these buybacks to reduce dilution from the all-stock merger, but it would arguably be wiser to invest the money in improvements to its core game engine and ancillary services.

I have less hope for the future of Unity

I personally own a few shares of Unity, and have been cautiously optimistic about its turnaround efforts so far. However, these five red flags suggest that it is still stuck in the mud and may continue to sink for the foreseeable future.

Leo Sun has positions in Apple and Unity Software Inc. The Motley Fool has positions in and recommends Apple and Unity Software Inc. The Motley Fool recommends the following options: long calls $120 in March 2023 on Apple and short calls $130 in March 2023 on Apple. The Motley Fool has a disclosure policy.

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