Unity Software Stock: Good Buy or Value Trap?

Shares of Unit Software (U 1.96%) had a rough year, now down over 74% in 2022. This dominant game development platform helps build anything for a video game. From coding to design to monetization, Unity helps with it all.

However, investors largely lost interest in the company after a problematic first quarter. The company reported strong adoption, but a major setback contributed heavily to the stock plunge. However, this error seems to be temporary, and although it is a riskier investment, it might be wise to buy a small amount of Unity on the downside.

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The unit falls out of favor

The game development platform saw meteoric growth in the first quarter. Its revenue jumped 36% year-over-year to $320 million, driven by its Create Solutions segment, which jumped 65% year-over-year to 116 millions of dollars. The company’s business is broken down into two main revenue streams: building and operating solutions. Authoring Solutions are subscription-based and help developers create the game. Operate Solutions provides usage-based products that facilitate game monetization and engagement.

So what was the biggest concern for investors? In the first quarter, management discovered an artificial intelligence (AI) error with its monetization service due to poor initial data. In other words, the company took bad data from a big customer and built its AI on it, which caused inaccuracies.

As a result, management will have to rebuild, retrain and improve their AI with new data. Overall, this error will impact revenue by $110 million over the remainder of 2022.

Add to that the company’s first-quarter net loss of $177.6 million, which jumped 65% year-over-year, and investors fled. The company’s trailing 12-month free cash flow of just $34 million was not enough to excite investors, leading to a sharp decline.

The game is not over for Unity

It might look bad at first glance, but there are some silver linings. First, Unity has over $1.8 billion in cash and securities on the balance sheet to fuel this net loss. Additionally, Unity expects to be profitable as early as Q4 2022, and management expects this to continue into 2023. This shows that this risk may not be as significant as investors believe.

Another silver lining is that even though Unity management predicts that this AI error will impact 2022, there will be no carryover into 2023. Therefore, this should only be a short-term issue, which makes it less of a concern for long-term investors who plan to own this company for many years, not just the next six months.

Finally, Unity is a dominant force in game development. In a study by Unity, 61% of game developers surveyed used the platform in 2021, and other estimates put Unity’s market share at 48%, meaning it is the leader in far in space. Given that this market is expected to be worth over $300 billion by 2027, being the top dog could lead to immense long-term success.

Above all, Unity has an advantage over its main competitor, Epic Games’ Unreal Engine: its coding language is easier to learn than the code used by Unreal. Unreal has a no-code offering, but for those looking to develop their games by hand – rather than using a plug-and-play solution – Unity is the easiest place to do so.

Should investors buy Unity?

If you want to invest in the gaming space and capture the expansion of this industry over the next few years, Unity seems like the best way to do it. The company has recently stumbled, but long-term investors should realize that this is only a short-term problem and that their monetization efforts should resume next year. However, it will be essential to ensure that this actually happens. If Unity’s monetization tools remain inaccurate, that would be concerning.

Although Unity appears to be worth buying right now, there is still risk involved and investors should size their position accordingly. If you want to buy Unity lower right now, it should be a small position given the uncertainty ahead.

At 8.8 times sales, Unity is trading at a premium relative to its life as a public company. Since the company went public in 2020, it has never been sold at such a low valuation. Considering this stock is a high-growth (and soon to be profitable) company, it feels more like a bargain than a value trap. Therefore, while investors should keep this company on a leash and ensure that it can indeed rebuild its monetization tool this year, investors might want to munch on Unity shares.

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