Is Unity Stock Undervalued?

Unity Software Inc. (NYSE:U) is a leading gaming company that relies on its proprietary Unity Engine to create games with 2D, 3D, VR, and AR across platforms.

Besides gaming, Unity technology is used a broad number of industries from film to architecture and even healthcare. The wide number of applications highlights how interactive digital experiences apply to many verticals.

But the gaming industry is its bread and butter, where it enables creators to build and grow successful games and real-time experiences. Almost 69% of the top 1,000 mobile games are developed with Unity.

On the management front, the focus is on creating a unified, cutting-edge solution for the game market through its Engine, Cloud, and Monetization services and developing its real-time 3D technology to support non-gaming customers. 

However, all those tailwinds have not translated to share price success. By sharp contrast, Unity share price is down 54% over the past 12 months so is it on sale?

Is Unity’s ‘Reset’ Working?

In light of its struggles, management put into action a two-phase company reset in the fourth quarter of 2023, which is designed to serve as the propeller of long-term success for both customers and shareholders.

In the first phase, the company planned to shift its portfolio back to its core business: Engine, Cloud, and Monetization. It also involves cutting costs in order to provide a stronger financial base for future growth.

Unity has lowered its cost structure, which includes the decrease of the workforce by 25%, cloud hosting savings, office consolidation, and software license optimization. These measures are projected to trim down the annual non-GAAP operating expenses by about $250 million.

As part of this initiative, the firm is looking to exit industries in which it cannot provide a unique value proposition to customers. 

These non-core businesses brought in $283 million in revenue in 2023 but commensurately led to huge losses. Management has made the decision to forego top line growth in the non-core segment to better preserve bottom line.

Phase two is focused growing revenues, which are forecast to accelerate in the second half of 2024.

The company is hoping these initiatives will lead to higher user engagement, not least with the tailwinds of generative AI applications also. So too are real-time 3D capabilities across industries set to support new revenue opportunities.

Following the portfolio reset, the company is now dedicated to fast revenue growth and expects to achieve profitability with steady cash flow margins.

How Is Unity Performing Financially?

Total revenue for the first quarter was $460 million, which is 8% less than what it was in the same period last year. The revenue from its strategic portfolio was $426 million, a 2% increase while guidance was $415 to $420 million in revenue for its strategic portfolio.

Q1 revenues of the non-strategic portfolio were $34 million, a 59% decline year-over-year as a result of the portfolio reset, which included exiting non-strategic businesses.

Management anticipates that revenue from its non-strategic businesses will continue to fall and be in the single digits by the end of this year.

The main difficulty of Unity is that its main source of income depends on helping mobile games sell ads, a form of income that is not especially stable. That uncertainty has translated to bottom line fluctuations.

The net loss for the quarter was $291 million, which included $212 million of restructuring costs. This compares to a net loss of $254 million in the same period the previous year, including a $14 million restructuring charge.

For the current quarter, the company guided revenue for its strategic portfolio to $420 to $425 million, indicating a fall of 6% to 7% year over year.

The industry is still suffering from severe layoffs and the closure of studios. The traditional business models that were widely used are now questionable in view of the changing advertising dynamics, which can be translated to lack of growth.

Although the gaming industry is facing a lot of structural obstacles, the long-term prospects seem to be bright, especially when we look to the financial opportunity.

Is Unity Stock Undervalued?

Unity stock is 51.5% undervalued according to the consensus estimate of 20 analysts who have a price target of $27.20 per share.

A discounted cash flow forecast analysis puts fair value closer to $21 per share and implies 25.7% upside opportunity for investors now.

In spite of those forecasts, the recent financial performance may create a sense of worry because the company is still losing a lot of money. The profitability issue may still remain, raising doubt about whether it is a sustainable business model in a market environment that increasingly values profitable companies and strong cash flows.

Though Unity is in a leading market position, it is still facing tough competition from other players in the gaming and real-time 3D sectors, like Epic Games with its Unreal Engine. This competitive environment raises questions about Unity’s capacity to keep or increase its market share and flip the bottom line from red to black.

Some measures also provide cause for concern, such as the non-GAAP forward earnings of 28.25x that is a good deal higher relative to that of its peers. Plus, the stock is trading at 4.91x forward sales, over 70% higher than the industry median.

Considering these factors, investors should likely approach the stock with caution even though it is a major player in the industry. 

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The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.