Unity software (NYSE:U) will report its fourth quarter 2023 results on Monday, February 26 after the close. This is a business that I claim is now cast as a “show-me” story.
And as such, I don’t I believe this stock offers investors a positive risk-reward. At the heart of the bull’s thesis is that Unity could drive for nearly $1 billion in EBITDA in 2024. And yet, for my part, I struggle to see that as a realistic scenario.
Therefore, I am once again reviewing this stock in a sell.
In October, I wrote one neutral analysis for Unity, where I said:
I know stocks never move in straight lines. While I continue to believe that Unity is overvalued, as I have for a long time, I also know that the stock in short term is the price with a lot of pessimism. Consequently, it does me no good to now issue a sell rating, as I understand that the stock is now negatively charged.
As you can see above, since I stated that I believed the stock was too bearish, the stock jumped 33% for the year. But now that tempers have moderated, looking at Unity again, I believe this stock is once again likely to disappoint investors.
Unity’s Long-Term Prospects
Interim Unity CEO Jim Whitehurst states that Unity is in a transition period and forced to be smaller and still more nimble. The company aims to position itself as a trusted leader in fostering a community of creators who build on its technology. Over the next three to five years, Unity envisions becoming an indispensable partner for game creators, making it easier to develop, operate, and monetize their creations. With a focus on the gaming market, Unity plans to provide a leadership role by providing technology that is not only relevant to enterprises, but also serves as the default choice for individuals and enterprises engaging with 3D content. By focusing on core competencies, building strong partnerships and emphasizing community engagement, Unity aims to tap into a broad market in the gaming industry, providing a profitable business.
However, Unity faces near-term challenges, especially in the context of a comprehensive evaluation of its product portfolio. The company recognizes the need for intervention to align products with customer needs and increase revenue growth.
As part of this evaluation, Unity anticipates making changes to its product portfolio, including a potential further workforce reduction.
Achieving a delicate balance between maintaining market share, fine-tuning pricing strategies, and effectively implementing the necessary changes poses a challenge and positions Unity as a “show-me” story. Therefore, I don’t believe investors will be willing to continue paying a large premium for a stock that offers such uncertain prospects.
Income growth rates will slow
Basically, the problem facing Unity is that its revenue growth rates need careful interpretation due to the impact of the IronSource acquisition. Unity’s Q3 2023 pro forma revenue growth rates were up 8% YoY. Therefore, this means that Q4 2023 will have a strong “reportedly inorganic” quarter of revenue growth rates before 2024 guidance is given.
For my part, I struggle to see Unity guiding for CAGR higher than 18% for the year ahead. Why?
Because Q1 2024 will have an easy comparable figure to climb, where Unity’s pro forma growth rates were down 2% year-over-year in the same quarter a year ago. But as we move forward beyond the first quarter of 2024, Unity’s quarterly growth rates will begin to rapidly progress toward low-teens CAGR.
As you can see in the chart above, this is a consideration that is beginning to be accepted on the sell side as well. As close followers of my work will know, I strongly recommend avoiding investing in companies where the sell-side is down by reviewing the valuations on your shares.
You end up in a battleground stock, where all your emotions are on display as you regularly read about popular analyst firms lowering their price target on your stock. And Unity goes from being a favorite to a story for me.
Share value U – 14x 2024 EBITDA
The problem is made more complicated because Unity is still being valued as a growth stock. And given that it’s a favorite among the “growth crowd,” it’s therefore rated as a growth stock.
But the fact is that Unity has a lot of debts. More specifically, Unity carries $1.2 billion in net debt. Although Unity continues to claim that it will reach $1 billion in EBITDA in 2024, I have a hard time seeing how that will happen.
Consequently, I am reducing the target for Unity in 2024 to $900 million EBITDA from $1 billion. Even then, however, that would still be about 140% higher than where it expects to end 2023. Can Unity grow its underlying profitability this significantly in 2024?
At first glance, I realize that paying roughly 14 times EBITDA up front seems cheap. But at the same time, with so many moving parts and so much uncertainty, along with a significant amount of debt, I believe that all together, this stock is best avoided.
While I appreciate Unity Software’s near-term outlook, skepticism arises about its ability to reach roughly $1 billion in EBITDA in 2024, a key element of the bullish thesis.
Recent challenges, including a comprehensive evaluation of the product portfolio and possible workforce reductions, present immediate obstacles.
The complications of balancing market share, price adjustments, and implementing the necessary changes can prevent investors from paying a premium for uncertain prospects.
Additionally, Unity’s valuation raises further doubts. While the forward EBITDA multiple looks reasonable at around 14x, the uncertainties facing Unity stock offer investors an unfavorable risk reward.