Will Unity Stock Recover?

Gaming development engine Unity Software (NYSE:U) has been among the few major technology stocks that haven’t benefited from the bull run of the last year and a half.

The stock peaked at over $200 per share during the metaverse hype of 2021 but these days shares of U trade in the mid-teens. What happened to Unity, and is the stock a buy on the dip?

Why Did Unity Stock Fall?

Unity’s initial problem was its excessive valuation as investors hyped up its prospects for dominating the metaverse.

To a certain degree, the incredible enthusiasm behind the stock was understandable. In 2021, the company’s year-over-year revenue growth was above 40% in each quarter.

The irrational exuberance, however, came to an end as investors lost interest in the metaverse and a technology selloff ensued.

Many companies later bounced back from this selloff, especially as AI replaced the metaverse as the bullish technological trend of the moment. Unity, however, didn’t benefit from this rebound and has instead its share price remained repressed.

Another driver of Unity’s troubles more recently was an ill-fated attempt to revamp its pricing structure. Under the change, developers would switch from paying an annual fee to paying every time one of their games was installed.

The model would have raised costs massively on popular games, and led multiple large industry players to threaten to leave Unity.

The disruption caused by the pricing change also contributed to further problems for Unity investors in the form of declining revenues. In Q1, Unity’s revenues fell 8% compared to the year-ago quarter, a first for the company.

This turnaround in revenue growth spread fuel on the fire when it came to Unity’s share price performance, and to some extent explained away why the stock has fallen by nearly 60% YTD.

Can the Company Turn Itself Around?

Now, Unity has an opportunity to put itself back in investors’ good graces by returning to revenue growth, moving closer to profitability and refocusing on its core video game business. Proving itself to investors after such large losses, however, may be easier said than done.

Unity’s problems were sufficiently large to warrant a management change and a sweeping program of layoffs. The company has cut about 1,800 staff members to reduce costs with the goal to eventually turn profitable.

Under the new management team, it has also abandoned the deeply unpopular new fee structure that played a role in undermining its revenue growth.

On the surface, Unity’s opportunities for growth seem attractive. At about 27%, Unity has a substantial game development market share lead over its closest competitor, Unreal Engine. As such, the company enjoys a prime spot in an industry that is only expected to keep growing in the coming years.

By the end of this decade, gaming is expected to be a nearly $400 billion industry, and compounded annual growth is expected to hold steady at about 10%.

Unity’s engine is also well-suited to the increasing use of multiple platforms in the gaming world. Games built in Unity can easily be published on mobile, PC and even VR gaming platforms. This may well support Unity’s user retention goals and offset some of the bad will it generated by attempting to institute its new pricing scheme.

Unity is expected to re-ignite revenue growth of about 13.5% over the coming 12 months. This would likely restore some investor confidence, as the revenue drop in Q1 was a major red flag for shareholders.

Even so, Unity may have to demonstrate a more reliable and consistent return to growth before investors decide to give the stock another chance.

Unity Is Still Losing Money Quickly

Today, Unity’s major headwinds are its slowing revenue growth and high losses. In the last fiscal year, the company lost over $822 million on revenues of $2.2 billion, resulting in a net margin of -40.1%.

Even though the company’s revenues are expected to start growing again, the path to profitability is much less clear.

The layoffs executed by management were meant to position the company for profitability as its revenues grew. In Q1, however, Unity still lost about $291 million.

With that said, one financial bright spot for Unity is its debt management. Though the company has a slightly high debt-to-equity ratio of 0.7, it also reduced its debt by about 17.4% in Q1 compared to the year-ago quarter.

Has Unity Become Undervalued?

At 3.0x sales and 30.5x cash flow, Unity appears quite cheap for a software company with high growth potential and a moat in a major industry.

In light of the company’s other problems, though, it’s at least worth considering the possibility that Unity may be a bear trap. If the company fails to regain its growth momentum or the changes instituted by management can’t bring it closer to profitability, Unity might well still prove to be overvalued.

It’s important to recognize now that analysts have widely disparate views on Unity’s value and future potential. Price targets for the stock range from $16 to $33.50, implying any outcome from a further loss of 5.5% to a gain of over 97%.

Will Unity Stock Recover?

Unity stock has the potential to recover and rise all the way to $25.67 per share according to the consensus among 21 analysts.

The company has an attractive business model and a major advantage in the game development industry. As the overall industry continues to grow, Unity certainly stands to benefit. And with new management in charge, a leaner labor model and a prime position in a growth industry, it’s likely that Unity at least has the potential to regain some of the ground it has lost.

However, Unity likely isn’t a buy just yet to all but the most risk-seeking investors. With the company having undergone so much difficulty and alienated part of its user base with its attempt to impose a new fee structure, there is a chance that the stock is a bear trap rather than a diamond in the rough.

Having already reported such steep losses, new shareholders may want to be careful about getting in before the company can prove that it is really capable of a rebound.

In addition to the question of whether Unity can successfully begin growing again, investors may also be concerned by the company’s ongoing losses. Although Unity is managing its debts well, it will eventually have to achieve positive net income on a GAAP basis. With so many unknowns around the company’s future, Unity is likely a bit too risky for most investors to find appealing at the moment.

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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.