Unity software (NYSE: U) shares initially fell 14% in after-hours trading on Nov. 9 after the company reported its third-quarter earnings. I believe investors should be cautious as Unity, a provider of real-time 3D developments and tools, has come under pressure not only due to its lackluster third quarter earnings, but also due to the fundamental challenges facing the company is facing. I’m neutral on U stock because I think it will take some time for the company to gain traction in the market, despite having a long growth trajectory.
The deep-rooted challenges of Unity
Unity reported revenue of $544.2 million for the third quarter, a year-over-year improvement of 69%. This stellar revenue growth helped the company beat Wall Street’s earnings expectations, but the stock initially sold off after earnings as investor attention shifted to the challenges looming on the horizon.
Unity’s biggest challenge today is repairing relationships with developers who are calling for the company to backtrack on recently announced pricing changes. On September 12, Unity announced major changes to its pricing model. Under the new model, developers will be charged a “runtime fee” for all games built with the video engine, provided they meet a minimum revenue threshold and a minimum install threshold.
Many game developers rushed to oppose this decision, with some vowing to boycott Unity when these price changes take effect on January 1, 2024.
Under these unforeseen circumstances, Unity quickly made several changes to its planned new pricing model. In a September 22 blog post, Marc Whitten, president of Unity Create, explained that only games with revenues over $1 million and over a million installs will be charged the runtime fee. More importantly, Unity clarified that this new model will only apply to games released in 2024 and beyond.
However, the damage has been done. The company had spent years building trust among developers through favorable pricing policies and high-quality tools, but the new pricing has put the company’s reliability into question. Amid the backlash from developers and investors, Unity CEO John Riccitiello retired in early October, handing over the duties to James Whitehurst, who is now acting as the company’s interim CEO.
The need for a sudden price change stemmed from two factors: Unity underpriced its products, and the company found itself in a financial corner amid challenging macroeconomic conditions. Unity is a company with a market cap of just over $9 billion, but has a debt load of $2.7 billion. Following its third-quarter earnings report, Unity also announced the sale of $1 billion in senior convertible notes.
Although Unity has been moving in the right direction in recent quarters, evidenced by declining losses, the company is still forced to spend significant amounts on research and development projects to maintain its competitive advantage. Although these R&D investments are necessary, they will prove to be a major drag on the company’s profitability in the near future.
To recover from the current slump, Unity will need to better communicate with developers and find a balance between investing in growth and focusing on profitability. It will take some time for the company to make progress on both fronts, and Unity stock will likely remain under pressure for the foreseeable future.
Unity still has room to grow
Not everything goes wrong for the company. Since the departure of the former CEO, interim CEO James Whitehurst has overseen the company at this pivotal time. Mr. Whitehurst was CEO of Red Hat before the company was acquired by IBM (NYSE:IBM), and after the deal he served as president of IBM before taking on duties as special advisor to the board of directors.
Mr. Whitehurst’s extensive experience – both as a successful tech executive and an advisor to Silver Lake, Unity’s second largest shareholder – will be useful as Unity enters a transformation phase.
Despite the recent PR issues Unity has faced, the company remains well positioned for growth. Its growth will be fueled by the increasing use of artificial intelligence and augmented reality and the growing prevalence of the Metaverse. Unity offers state-of-the-art 2D, 3D, and VR tools to help developers design high-quality games and other experiences, and the company’s customer base is likely to remain sticky in the long run due to the high quality of the tools offered through Unity.
In its third quarter shareholder letter, Unity highlighted how the company is increasingly focused on becoming a leaner and more agile company, which is an encouraging development. Heading into 2022, Unity’s approach was to deliver growth at any cost, but this strategy backfired when interest rates started to rise. The new strategy must enable the company to grow sustainably.
While Unity still has room to grow, growth rates are likely to slow down in the future. A few years ago, then-CEO John Riccitiello claimed that Unity would grow more than 30% annually in the long term, but analysts expect revenue growth to slow to 20% in fiscal 2024 and remain below 20% thereafter. The market will need more time to adapt to the lower growth rates expected in the coming years.
Is Unity Stock a Buy According to Analysts?
Based on the ratings of 18 Wall Street analysts, Unity Software’s average price target is $32.16, implying an upside of 6.5% from the current market price.
Despite the upside potential, analysts say investors should be cautious. The company is likely to see its earnings forecasts revised negatively in the coming weeks as analysts digest third-quarter earnings results and the company’s updated growth strategy, which will likely be discussed once a permanent CEO is named.
The takeaway: Too risky to bet on
Unity Software still has room to grow, but a slowdown in growth is inevitable. Moreover, the company will have to work hard to repair the reputational damage caused by the failed rollout of the new pricing model and the former CEO’s comments about some developers. In the near future, Unity’s challenges are likely to play a major role in determining its stock price movements, which paints a bleak outlook.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.