2 reasons why Unity Software’s virtual world faces a harsh reality

Unity software (and 3.69%) was one such company that spurred investors to new heights due to the Metaverse hype sparked by Facebook when it announced its name change meta platforms (META 4.21%) Late October 2021. However, it wasn’t long before Unity began to confront the brutal nature of reality, and the stock plummeted over 80% from its heights. As a result, some investors might now be wondering if Unity can recover from its recent market mishaps.

Here are two reasons Unity stock could see a tough climb.

Three people are using virtual reality headsets while another person is watching and laughing.

Image source: Getty Images.

1. The Operate Solutions business stumbled

While Unity is best known as a development platform for creating 3D and virtual content, the company generates 64% of its revenue through Unity’s Operate Solutions business, which helps game developers monetize content through Unity ads and in-app purchases .

Operate Solutions got off to a strong start in January, but stumbled in February and March as revenue fell significantly. Additionally, during the company’s conference call, Chief Executive Officer John Riccitiello said the company narrowed Operate’s problems down to two self-inflicted issues.

First, Unity identified a bug in its platform that reduced the accuracy of its Audience Pinpointer tool — an advertising tool that became popular after Apple’s privacy changes. Audience Pinpointer uses machine learning (ML) to help game developers target the users who are most likely to continue a game after installation.

Unity only noticed the issue with Audience Pinpointer when it started generating less revenue. Game developers often measure the effectiveness of their advertising campaigns, and when Audience Pinpointer’s usefulness diminished due to an unspecified bug, developers stopped using it and revenue fell.

Second, Unity’s ML algorithm picked up some bad data from a large customer. As a result, Unity lost the value of part of its training data.

As a result of the two issues, management estimated the impact on its business at $110 million in 2022, or nearly 8% of Unity’s expected $1.4 billion in full-year 2022 revenue.

News of Audience Pinpointer’s poor performance was first announced on May 10, prompting a 33% sell-off in shares. And while management promised the issue wouldn’t carry over into 2023, investors should be careful about putting their trust in Unity’s management team, as Audience Pinpointer’s problems could be a symptom of larger issues within the company.

2. Unity wasn’t prepared for a bad market environment

Since going public in September 2020, Unity has pursued revenue growth at the expense of profitability. For clarity, this chart shows that Unity’s operational expenses are growing faster than revenue.

U Total Cost of Ownership (TTM) chart.

U Total Cost of Ownership (TTM) data from YCharts

While chasing growth in the face of rising unprofitability can be a winning strategy when interest rates are low, it’s a disastrous strategy when the Federal Reserve is raising interest rates.

Rising interest rates erode the value of future profits – hurting unprofitable businesses more than profitable ones. And Unity’s profitability in terms of net income has steadily deteriorated over the past two years.

U Net Income (TTM) chart

U Net Income (TTM) data from YCharts

As you can see above, Unity’s price-to-sales multiple fell off a cliff in late 2021 as investors already pondered the impact of the Federal Reserve raising interest rates to curb inflation.

Unity is reversing course

While Unity may have pushed for growth at all costs over the past two years, management seems to recognize the environment it finds itself in and has been quick to position the company for profitability rather than growth.

On the first-quarter 2022 earnings conference call, Chief Financial Officer Luis Visoso said the company will reduce expenses by $100 million to become profitable in the fourth quarter of 2022 — earlier than previously announced. And the company expects to be profitable for the full year of 2023.

However, since the most significant portion of operating expenses are personnel-related costs, Unity plans to achieve its $100 million in cost savings through layoffs. At the end of June, Unity laid off 4% of its workforce. And according to website Kotaku, the releases came several weeks after CEO Riccitiello assured workers that Unity was not in financial trouble and that there would be no layoffs — a misleading statement that led to employee dissatisfaction. Additionally, it doesn’t help the employee morale that Unity has acquired iron source (IS 6.40%)whose tools are helping app developers monetize their creations, just two weeks after the layoffs.

So while Unity has very high upside potential in its end markets, it also has very high execution risk due to the consequences of laying off employees while acquiring another company. As a result, most investors will likely be better off avoiding this stock.

Randi Zuckerberg, a former director of market development and spokesperson for Facebook and sister of Mark Zuckerberg, CEO of Meta Platforms, is a member of The Motley Fool’s board of directors. Rob Starks Jr. holds positions at Unity Software Inc. The Motley Fool holds positions at and recommends Meta Platforms, Inc. and Unity Software Inc. The Motley Fool has a disclosure policy.

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