As one of the leaders in the game development space, Unity Software (U -0.56%) could capitalize on the enormous gaming market, which is expected to be worth $300 billion in the next five years. In a survey done by Unity in 2021, 61% of game developers use Unity to develop their games, which signals the company's reign in the industry.
However, if you look at Unity's stock price today, it would imply that Unity is struggling. Shares are down over 73% year to date, partly due to the widespread tech stock sell-off and valuation compression that investors are seeing right now. The other part is due to Unity's 37% plummet after it reported first-quarter earnings on May 10. Unity faced a machine-learning error that has some major ramifications for the business. That being said, while it might not be ideal to buy shares today, investors might want to think twice about selling their shares.
Image source: Getty Images.
What happened to Operate?
Unity has two primary businesses: Create and Operate. Create solutions are subscription-based and help businesses build high-quality video games and other content. This is small, representing 36% of total revenue in Q1. Operate solutions, which made up 58% of Q1 revenue, are consumption-based and help developers monetize their games, as well as grow and engage their user base.
The company ingested some faulty data from a large customer that caused the machine learning for its Audience Pinpointer tool -- a targeted advertising tool that's part of its Operate solutions -- to be inaccurate at placing ads in front of the right users. This means that its machine learning engine was taught by bad data, which makes the entire system flawed. As a result, Unity will likely have to start from scratch and rebuild a stronger data set to retrain its machine learning.
As you would expect, this is going to ding Unity's top line. In terms of revenue, the company expects this to be a $110 million hit for the full year, with almost 90% of the damage coming in Q2 and Q3. This crushed Unity's guidance, so instead of expanding the top line at 44% year over year as it did in 2021, Unity is expecting just a 22% to 28% 2022 revenue increase.
This is a big hit to many investors' investment theses. The company has a unique aspect of being a platform where a developer can do everything from creating a game to growing, monetizing, and running it. However, if developers can't effectively monetize, this value proposition becomes much weaker. Even if the company can effectively rebuild, it will still have a steep hill to climb convincing developers that it is effective again.
The company is still executing
All of that being said, there were some highlights this quarter. Create solutions skyrocketed in Q1, growing 65% year over year. Additionally, Unity had over 1,000 customers spend more than $100,000 on the platform in the trailing 12 months, which signals that there are plenty of customers leaning heavily on the platform.
Unity also saw impressive expansion outside of the gaming space. It now has 3,000 customers building digital replicas of their real-life spaces so that they can experiment and test for space efficiency, among other things. These include companies in the manufacturing, construction, and simulation industries. As the rest of the world adopts digital tools, Unity is proving that it can be used for more than just gaming.
Another highlight was the company's free cash flow generation this quarter. The company had $86 million in free cash flow in Q1, which improved substantially from a free cash flow burn of $101 million in the year-ago period.
Is Unity a buy?
Unity stock might not be worth buying today, but it certainly isn't worth selling either. Unity needs to clearly show that it is successfully retraining its machine learning engine with good data and that it is paying off for customers when it comes to monetizing their video games. However, the rest of the business is doing extremely well. Create solutions are skyrocketing, partly due to the company's success outside of the gaming space. Unity is already a leader in a massive industry, and seeing it spread its wings into other markets like manufacturing should excite investors.
Shares trade at just 9.3 times sales, which is the lowest valuation this company has ever seen since coming public. The company has only been public for a little over a year, but before 2022, the company consistently traded around 30 times sales or above. If the company can overcome this monetization issue, this could be a major bargain, but investors should still sit on their hands until the company proves that it is recovering from this data error. When that happens, investors might want to add shares at these lower prices.
