In 2021, the metaverse was creating the loudest buzz in the investing world, and Unity Software (U -0.56%) was seen as a key architect of that future. The stock soared past $200 per share because management said it expected to grow revenue at a compound annual growth rate of at least 30% for the foreseeable future.
In the first quarter of 2024, Unity's revenue dropped 8% year over year. In short, investors' expectations weren't met. Therefore, Unity stock unsurprisingly now trades near an all-time low of $16 per share.
Unity stock is underperforming the S&P 500 by an enormous margin. Since it went public in 2020, it's down about 75%, whereas the S&P 500 is up about 67%.
As disappointing as that performance is, it's past performance. Looking ahead, Unity stock has several potential paths. My analysis of the stock suggests there's still reason to be cautious.
What Unity has in its favor
When you hit rock bottom, it's often a good time to take a step back, think, and make changes. That's what Unity is doing. The company's new CEO Matt Bromberg started in May. And as he was coming in, management restructured the business, laying off some workers and offloading parts of the business. The slate is now cleaner as it looks ahead.
The mobile video-game space is projected to generate about $100 billion in revenue worldwide this year, according to Statista. Further growth is expected in the space. And fortunately for Unity, its software is seen as one of the two major creation and publishing engines out there; the other is the Unreal Engine from privately held Epic Games.
In other words, Unity is well positioned in the large and growing mobile gaming space, which gives it an "easy" opportunity to enlarge its business. On top of this, the latest iteration of the company's software will come out later this year. The new version has a different pricing structure, which should help Unity tap into more revenue upside for successful games built on its platform. The pricing structure will be more similar to the structure for Epic Games, so customer pushback should be minimal.
Turning to valuation, Unity stock once traded at a price-to-sales (P/S) ratio of 55; even for a high-quality business with impressive growth, that's steep. Paying that high a price creates valuation risk if things don't pan out. And things certainly didn't play out as expected for this company, which partly explains why it's down so much.
By contrast, Unity stock now trades at a P/S ratio below 3.
U PS Ratio data by YCharts.
The P/S valuation for Unity stock now makes sense. If the company can return to growth, it has strong market-beating upside potential from this lower starting point. But another issue might hold it back.
Why investors should stay cautious for now
As far back as the publicly available data goes, Unity has never had positive net income. Granted, profitability can be measured from different angles, from accounting perspectives or by looking at cash flows. But from most angles, Unity hasn't even been particularly close to profitability.
For software businesses, there's always hope for profitability with scale. Since software is digital, companies incur a cost to create it but can sell it over and over, which is why scale is important. However, Unity's margins have slipped. For example, its gross margin is down considerably since it went public.
U Gross Profit Margin data by YCharts.
Whether intentional or not, Unity's management gave reason to question whether it can improve margins in the near term. There are multiple parts of this business. In one segment, it generates revenue by helping mobile game companies monetize their apps. This brings it into direct competition with AppLovin, a company performing quite well.
Unity's management says that its customers are waiting for it to release the new version of its software so they can have alternatives to what AppLovin provides. This appears to concede the leadership position to AppLovin. But more importantly, it suggests that its customers want more competition. And competition usually results in price wars, which lowers margins.
Profits are important for stocks that perform well. If Unity had a history of profits, maybe one could give it the benefit of the doubt. But it doesn't; it has a history of losses, which is reason for caution. And the need for caution is amplified by slipping margins and competitive pressures.
Over the next five years, Unity needs to show improvement to profits as well as top-line growth to outperform the S&P 500. The growth component is possible. But profit improvements may be elusive, which is why I'm sitting on the sidelines with Unity.
