Unity Software (NYSE:U) stock initially fell 14% in after-hours trading on Nov. 9 after the company reported its third-quarter earnings. I believe investors should exercise caution as Unity, a provider of real-time 3D development and tools, has come under pressure not only because of weak third-quarter earnings, but also because of fundamental challenges the company faces transfer. I am neutral on U shares as I think it will take time for the company to gain traction in the market despite a long growth trajectory.
Unity’s deep-seated challenges
Unity reported revenue of $544.2 million for the third quarter, a year-over-year improvement of 69%. On the back of this stellar revenue growth, the company topped Wall Street’s earnings estimates, but the stock initially sold off after earnings as investors’ focus shifted to the challenges on the horizon.
Unity’s biggest challenge today is repairing its relationship with developers, who are calling on the company to back recently announced price changes. On September 12, Unity announced major changes to its pricing model. Under the new model, developers will be charged a “runtime fee” on all games built with its 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 blog post dated Sept. 22, Unity Create president Marc Whitten explained that only games with over $1 million in revenue and more than one million installs will incur the runtime fee. More importantly, Unity clarified that this new model will only apply to games shipping in 2024 and beyond.
However, the damage is done. The company had built trust among developers for years through favorable pricing policies and high-quality tools, but the new pricing saga has called the company’s credibility into question. Amid the backlash from developers and investors, Unity CEO John Riccitiello retired in early October, handing over duties to James Whitehurst, who now serves as the company’s interim CEO.
The need for a sudden price change came on the back of two factors: Unity has underpriced its products, and the company found itself in a corner financially amid challenging macroeconomic conditions. Unity is a company with a market capitalization of just over $9 billion, but has a debt burden of $2.7 billion. Following the Q3 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, as evidenced by narrowing losses, the company is still forced to spend significant amounts on research and development projects to maintain its competitive edge. While these R&D investments are necessary, they will prove to be a significant drag on profitability for the foreseeable future.
To recover from the current crisis, Unity will need to communicate better with developers and strike a balance between investing for growth and focusing on profitability. It will take time for the company to make progress on both of these fronts, and Unity stock is likely to remain challenged for the foreseeable future.
Unity still has room to grow
Not everything goes wrong for the company. Since the previous CEO’s departure, interim CEO James Whitehurst has filled in to oversee the business at this crucial time. Mr. Whitehurst served as 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 a special advisor to the board.
The extensive experience that Mr. What Whitehurst has brought to the table – both as a successful tech executive and advisor to Silver Lake, Unity’s second-largest shareholder – will come in handy as Unity enters a transformational phase.
Despite the recent PR struggles Unity has faced, the company remains well positioned to grow. Its growth will be aided by the increasing use of artificial intelligence and augmented reality and the growing prevalence of Metaverse. Unity offers advanced 2D, 3D, and VR tools to help developers design high-quality games and other experiences, and the company’s customer base is likely to stick around in the long run due to the high quality of tools offered by Unity.
In its third quarter shareholder letter, Unity highlighted how the company is increasingly focusing on becoming a leaner and more agile business, which is an encouraging development. Leading up to 2022, Unity’s approach was to achieve growth at all costs, but this strategy backfired as interest rates began to rise. The new strategy must enable the company to grow sustainably.
Although 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 Unity would grow more than 30% annually in the long run, but analysts expect revenue growth to slow to 20% in fiscal 2024 and remain below the 20% mark thereafter. The market will take longer to adjust to the expected lower growth rates in the coming years.
Is Unity Stock a Buy According to Analysts?
Based on ratings from 18 Wall Street analysts, the average Unity Software stock price target is $32.16, implying a 6.5% upside to the current market price.
Despite the upside potential, investors should be cautious, according to analysts. The company is likely to see its earnings estimates revised down in the coming weeks as analysts digest Q3 earnings and the company’s updated growth strategy, which is likely to be discussed once a permanent CEO is named.
Takeaway: Too risky to bet on
Unity Software still has room to grow, but a slowdown in growth is inevitable. On top of that, the company has to work hard to repair the reputational damage caused by its failed rollout of the new pricing model and the former CEO’s remarks about some developers. For the foreseeable future, Unity’s challenges are likely to play a large role in determining share price movements, which portends a bleak outlook.
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