Unity Software Q1 Earnings: Sell This Name, Do Not Look Back (NYSE: U)

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Investment Thesis

Unity Software (NYSE: U) guided for a slowing down in revenue growth rates.

To recap my position, in mid-April, I made public a two-part series on why I made a shift from tech to commodities where I discussed this. This thread was available to Marketplace subscribers a month earlier.

Here are the bullet points from part 1:

Why I Went From Tech To Commodities And You Should Too (Part 1)

Why I Went From Tech To Commodities And You Should Too (Part 1)

If you have read my work of late, you’ll have seen me turn my back on nearly all tech companies. I’ve positioned myself in commodities. And it’s working out really well.

That being said, even before my move into commodities, I had written about Unity saying this:

Author's Unity article

Author’s Unity article

Please read my Unity article here.

It’s these two themes that are the reasons why I’re bearish on this name. You have a company that’s diluting shareholders, with slowing growth rates, and a stock that’s overvalued.

Revenue Growth Rates Dip

Unity revenue growth rates

Unity revenue growth rates

Back in February, when Unity reported Q4 2021 results, Unity guided for its full-year 2022 revenue growth rate to be in the range of 34% -36%.

As you can see above, its updated guidance now points to 28% y / y. At least a 600 basis point deceleration. This has a few implications.

Unity revenue consensus estimates

Unity revenue consensus estimates

In the first instance, you can see that analysts’ revenue consensus expectations were for Unity to grow in Q2 2022 by 31%, rather than post single-digits growth in Q2 2021.

Accordingly, there is a clear gap between where analysts have the company growing, or better said investors’ expectations are, and reality. We are talking about a 2,000 base point gap in the upcoming quarter.

In the second instance, you are going to see countless analysts coming out in the coming weeks with negative reports and lowering their price targets for Unity.

Having learned the hard way what that feels like, let me be clear with you, that’s a seriously tough battle. One that you do not want to have with your own capital on the line.

Unity Believes Its Slowdown to be Temporary

Unity is a leading platform for creating and operating interactive, real-time 3D (RT3D) content. Unity’s software allows users to create, run, and monetize their content across any device in either 2D or 3D. Users can write and deploy their content anywhere.

Unity has two main business units, Create and Operate. Unity’s Create Solutions is its flagship platform. It used to be bigger than its Operate Solutions.

However, recent acquisitions have changed the company’s split.

Unity's Q1 2022 revenues

Unity’s Q1 2022 revenues

As you can see above, Unity’s Operate segment now makes up nearly 60% of the business. And this segment is having problems with monetization.

However, Unity states on the earnings call that these problems are temporary and will have no spillover into 2023.

Do Profits Matter?

Unity expects to finish 2022 with a non-GAAP operating margin of negative 4%. This compares with a negative 7% non-GAAP operating margin in 2020 and a negative 5% margin in 2021.

Consequently, there’s no question that we are seeing an improvement in Unity’s profitability profile. I repeat, on a non-GAAP basis.

But on a GAAP basis, we see that for Unity to grow its revenues by 36% y / y, its operating income has moved in the wrong direction by 66% y / y.

This exemplifies my whole thesis with countless tech names. For the business to grow at attractive growth rates, you have to pay these executives with a lot of stock-based compensation. To illustrate, for Q1 2022, stock-based compensation was up 61% y / y.

Furthermore, with Unity’s stock falling, how do you think Unity will retain top executive talent? They’ll have to increase the amount of stock-based compensation further.

Shareholders Are Getting Diluted

Next, as I highlighted in the introduction, Unity is diluting shareholders. Please consider the following.

Unity ended Q2 2021 with 288 million shares outstanding. Then, in Q4 2021, Unity’s 2022 guidance showed the following:

Unity Q4 2021 results

Unity Q4 2021 results

This guidance was given 90 days ago.

Now, its guidance for Q2 2022 points to 350 million shares outstanding.

Consequently, for Unity to grow its revenues by 8% y / y, shareholders are getting diluted by approximately 25%.

Bulls will push back that the reason for the elevated total number of shares outstanding is that Unity is unprofitable, for now, and needs to raise funds via a convertible.

Bulls would probably note that the convertible senior notes are not due until 2026.

Personally, I find that faulty reasoning. If I own a company, I’m happy to embrace a small level of dilution as the business attempts to increase its intrinsic value.

A dilution as high as 25% is off the cards. That becomes too high a hurdle for the investment to return a positive internal rate of return, or simply said, upside potential.

Unity Q1 2022 results

Unity Q1 2022 results

What we see above is Unity’s now updated diluted shares outstanding guidance for 2022. Over the course of 90 days, Unity has sought to further dilute shareholders by a further 3%.

Now, you may declare that this is not that big a dilution. But remember, this figure is an average for the year.

I believe that by Q4 2022, Unity’s total diluted shares outstanding could reach 365 million. I’m making this statement now, to circle back in the future analysis of Unity.

U Stock Valuation – Overvalued

Including the after-hours sell-off, Unity is priced at 9x forward sales. And what do you actually get for 9x forward sales? You get an unprofitable business, that’s diluting shareholders.

What’s more, a business that we had previously been told had what it took to grow its revenues by 30% over the long term. The long term in Unity’s case was a few quarters.

The Bottom Line

I find Unity’s case particularly frustrating because it’s yet another company that has overpromised and undelivered.

Here’s an excerpt from the commentary that Unity gave investors in February.

Unity Q1 2022 earnings call

Unity Q1 2022 earnings call

I had my doubts about the company, so I put a “hold” on this stock because I believed in their mission and felt that if they had the confidence to so bullishly assert that they could grow by 30% CAGR over the long term, I would have at least 1 year of 30% CAGR.

However, Unity’s valuation in February did not align with the other stocks in the market. So, I put a hold on the stock. But when the facts change, you know what you have to do, right? Whatever you decide, good luck and happy investing.

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