Unity's Potential Turnaround, Will It Pull It Off?

is recommended as a speculative investment despite its past missteps, with new leadership aiming to revitalize the company and its offerings.

The company's "Grow" segment, which focuses on in-game advertising, has faced significant challenges but is undergoing a fundamental rebuild to enhance ROAS.

Unity's "Create" business has launched Unity 6 with substantial improvements and repealed unpopular runtime fees, aiming to regain developer trust and market share.

The potential for Unity to emulate AppLovin's success in the in-game advertising space presents a compelling turnaround opportunity with significant upside if successful.

Can Unity pull off a comeback after blowing some significant opportunities?

Turnarounds are not the most popular of recommendations-particularly in the IT space. I doubt if their success ratio reaches 50%. They sound good in the reading, but then something emerges from the woodwork, and they simply do not work out. That said, there have been some significant exceptions, and indeed AppLovin $Applovin (APP.US)$ , perhaps the most successful stock IT stock in 2024 is a significant example. And yet here I am, recommending Unity Software $Unity Software (U.US)$ as an investment, or least a speculation.

Unity shares have fallen by more than 17% in the last year, and they are down almost 50% in the last two years. Rally attempts have been feeble and met by selling. The shares are up by about 64% since their absolute nadir of $13.93, their closing price on 8/8/24. But after a positive earnings report in early November that drove the shares to as high as $22.86, they have fallen back by 22% before a very recent back to the post earnings report level.

There are plenty of investors who won’t touch these shares and choose to exit the shares whenever an opportunity arises.

The former CEO and his team made several major missteps that have brought this company, once a titan in terms of its technology in the gaming space, to a low ebb. First, the company’s ad monetization engine ran into significant technology issues on his watch. That was followed by a misbegotten and poorly executed merger with in-game advertising leader, ironSource. And finally, in an attempt to boost short-term revenue, the company, instituted a change to the pricing of its game creation software that infuriated game developers and has just recently been rescinded.

As might be expected, the CEO whose miscues brought the company low, John Riccitiello, is gone now. He “retired” a bit more than a year ago. After a transitional CEO, Jim Whitehurst, who came from Silver Lake Partners, still a major investor in Unity with an 8.7% ownership stake, a new permanent CEO has been hired. Matt Bromberg started with the company in Mid-May. He had previously been the COO of Zynga, before its acquisition by Take-Two $Take-Two Interactive Software (TTWO.US)$ and previously had held leadership positions at Electronic Arts $Electronic Arts Inc (EA.US)$ . By October, Bromberg had brought in Steve Collins, a very well-known and respected game developer, as the Chief Technology Officer. In addition, a new CFO, Jarrod Yahes has been hired. He comes to the company from Shutterstock $Shutterstock (SSTK.US)$ , a company that provides a subscription service and à la carte access to stock photos that are used by a variety of customers in different industries, including the digital advertising space.

All of that said, why look at Unity now at this price and this time. In the last several months, shares of AppLovin have taken off. I last recommended AppLovin shares on SA on July 5, 2024. In the last 4 months +, it has had a strong run-it has risen a bit over 280% in that span.

Many subscribers have been wondering if there is another AppLovin out in cyber land. No doubt, AppLovin is going to be one of the best stocks to have owned in 2024. The shares are up no less than 653% YTD-that’s more than twice the percentage gain of Palantir , no slouch in appreciation but trailing APP shares as the best performing IT stock in 2024. At this point, it seems like every institution that can justify owning APP shares wants to pile into the equity, which most recently has seen its RSI reach exorbitant levels.

At this point, while the shares are a reasonable investment in terms of looking at the longer-term potential, the spectacular opportunity that they presented when they first introduced their version of AI, Axon 2.0 has been narrowed by the rapid appreciation of the shares.

The recent success of AppLovin has been more or less entirely a factor of the success of Axon 2.0. For those unfamiliar with that product, it is an AI-powered engine whose predictive capabilities are based on machine learning that significantly improves the targeting accuracy of in-game ads. This has substantially increased the return on advertising spend (ROAS) for users and as their campaigns, based on Axon 2.0 produce positive results, they have continued to increase their Axon 2.0 investment. There is a significant virtuous cycle impact here-the greater the use of Axon 2.0, the more data is collected. More data improves the accuracy of predictions, raising the ROAS for customers, and they increase their spend on Axon 2.0. That is why AppLovin has been able to achieve such startling growth combined with extraordinary margins.

Unity began its life offering a set of software tools to create sophisticated games. It was a pioneer in providing game creators with the tools they needed to create 3D games, and that was the focus of the company. It held a successful IPO in a bit more than 4 years ago. A logical evolution was the development of a set of what are called mediation tools which the game developers could use to monetize their creations.

This was the foundation of Unity’s own in-game advertising product-the segment of its business that it calls “Grow.” Initially, Grow was very successful and was a leading vendor in the space, leveraging its position with Unity’s community of game creators. For a time, it was market leading and growing more rapidly than AppLovin.

At the start of 2022, the efficacy of Grow’s algorithms saw an unexpected decline. It turned out that some of its algorithms had been corrupted and were not forecasting properly. In addition, the company discovered an error in its data collection technology which also crippled the efficacy of the solution. Needless to say this led to a decline in Grow revenues.

In the summer of that year, Unity announced its intention to acquire an Israeli-based company called ironSource. ironSource probably had the industry-leading market share of the in-game advertising space at that time and had been growing rapidly. The merger process was attended with some drama as AppLovin, at that point, tried to merge with Unity on condition that Unity abandon its transaction to acquire ironSource.

Ultimately, the AppLovin proposal was rejected and in November 2022, Unity acquired ironSource. The merger did not go well. There was a botched integration of ironSource into Unity Ads. Then the ironSource senior managers all departed Unity. Subsequently, there may have been an effort by ironSource middle managers to bully Unity staffers into resigning. ironSource and AppLovin had been existential competitors. That meant that the ironSource style was far more aggressive and clashed with Unity’s culture. I have linked here to an article that purports to provide an insight into the problems at the Unity Grow division. It is not pretty reading, and one has to be careful to try to disentangle the wheat from the chaff: fired or bullied employees are often less than objective in their evaluation. Many of the bullied or fired employees were ones who had apparently let the Unity mediation technology get stale and uncompetitive.

Where is Unity Grow at this point?

Unity is a tale of two businesses. I have started this article looking at Grow-both because it is larger but also because it is the segment that competes with AppLovin and which perhaps has the potential to achieve some of the success that AppLovin has had with Axon 2.0.

Unity Growth is actually the larger of the two revenue streams at Unity today. Last quarter its revenues were $298 million, down 5% year over year, but up by 1% sequentially Overall, Grow was 69% of total revenues. Obviously, at least some of the critique in the linked article above is a significant exaggeration, given that sequential revenues actually grew, albeit modestly. Just how much of the article represents the state of affairs within Unity Grow is difficult for me to determine as an outsider. Cultural clashes are never pretty, but are often necessary. A new management was never going to permit Grow to remain stuck in neutral.

Grow revenues reached $253 million in Q4-2022. In the immediate wake of the purchase of ironSource, Grow revenues were $344 million. Overall, Grow revenues have declined about 26% over the last two years. Over the same span, AppLovin software platform revenues have risen from $306 million to $835 million, essentially a function of the performance of the Axon platform in creating superior ROAS for customers.

Unity has a somewhat different vision of its go-to-market strategy for Grow when compared to AppLovin.

Finally, we talked last quarter about embarking on a fundamental rebuild of our machine learning stack and data infrastructure designed to enhance the return on investment we’re able to deliver to our advertising customers. We’re happy to report great progress on that work, which is already in testing on live data. We’re very encouraged by the early results we’re seeing. We believe that our new data platform will not only drive performance improvements in user acquisition and monetization, but also surface insights critical to game production and live service management, where understanding consumer behavior is core to being able to build and operate great games. These investments are core to our vision of a unified platform that can deliver for our customers across the full lifecycle of game development.

This strategy comes from the playbook that has marked Unity’s vision in this space almost from the start of it creating its Grow business. As can be seen from the above quote from the company’s most recent shareholder letter, Unity sees in-game advertising as an integral component of …well, a unified strategy that goes from game creation to monetization.

We're the only company in the world capable of providing a platform to power the entire development cycle from prototyping through live service management to user acquisition and monetization.

That is quite different from what AppLovin is currently doing; while it still has games that it has created, it does not offer game creation tools and its gaming business is a cash cow, and not really a part of its go-forward strategy.

According to the company, despite the revenue decline of the Grow business, Unity’s customer base has not migrated to other in-game advertising solutions. What has happened, at least according to the management, is that because of the relative lower level of ROAS from the existing Unity platform, its users have moderated their spending for the in-game ads available on that platform, but haven’t deserted as customers either. I really have no way of validating the assertion.

Like most anything else in the gestation process, evaluating the probability of success for is more of a guess than anything else. It has just been 15 months since Axon 2.0 was launched. At the time of the launch, some analysts were skeptics. I am linking here to an article which highlights some of the skepticism at that time.

This is not intended to deprecate the skills of the mentioned analysts. As it happens, the Benchmark analyst mentioned in the article still has a sell rating on APP shares. The fact is, that when a product such as this is launched, many analysts will be skeptical and others will be more optimistic, and there simply will not be enough information to make much more than a guess.

At the end of the day, it is all about efficacy. The buyers of ads are looking for quantifiable results. If the results are there, then there is a high probability that users will increase their investments on ad spending through the platform. I think management is very well aware of this. For the most part, developing this is a tedious and iterative process, but one that technology has made very doable over time.

Management has made the assertion that because it offers both creation and monetization tools, it is in a position to offer unique insights.

And as I said again, in in the opening statements, we think we are in a unique spot with respect to being the only company we believe in the world, that can sit as a platform through the entire lifecycle of development, from prototyping through to operating live service, and into monetization and advertising in UA. And those insights that we glean from being a platform, we can share those with our customers, and fundamentally offer insights that we think over time that no one else can. And to your point, we've got work, to do that. But we know what the work is and its work that's doable. And we're excited about it. And we're seeing, we're seeing, and feeling the wind at our back from, from the perspective of Unity how customers are responding, and some of the early results of the investments we're making. So this is an -- it's a business that we really couldn't be more excited to be in.

It seems like a reasonable assertion, but again, at this point, it is difficult to validate. The CEO talked about the fact that game monetization is not necessarily a winner-take-all market.

Game monetization will not be a winner to take all market. I can tell you for certain from personal experience that customers don't desire that outcome.

I think that is highly likely.

The company hopes to replace its old solutions by the end of calendar Q1 or in Q2. Is a buy recommendation premature here? The opportunity to emulate some, if not all of AppLovin’s explosive growth probably will not start until the summer of next year. While I am a long-term investor, I recognize that not all readers will want to wait on that long to see any validation of a thesis. But, as it turns out, that is not necessary. The company’s other business, Create, has had some new initiatives and those initiatives have the potential to move the CAGR needle in the immediate future.

Unity’s Create business: There’s a lot new, including a 6.0 release, a pricing change, and the issue of using AI as a game development tool.

Unity’s Create Solutions revenue last quarter was $132 million, up 5% year-on-year and 2% sequentially. At this point, Create is 31% of Unity's total revenues.

Unity 6 was announced for general availability last month. It should be noted that the company’s new CEO, Matt Bromberg, is an erstwhile game developer/game entrepreneur, and is apparently intimately familiar with the specifics of what features and functions creators need and crave. Some of the features will be familiar to developers and only developers. Others are universally understood. One of those is performance enhancements based on optimizations. Another is something called a GPU Resident Drawer. Overall, the company has cited a more than 2X improvement in the performance of its new offering. There are many other new features which probably resonate more with game developers than anyone else and are of less interest to many investors.

At least as important as the new product itself was the repeal of run time fees. It was about a year ago when the company announced a significant pricing change by instituting runtime fee for the development of new games. This was enormously unpopular with many users and had crippled Unity’s ability to grow. It led to market share losses and immense customer dissatisfaction.

So if you didn't want to pay the new prices, all you have to do is not upgrade. That obviously was not a great dynamic from our perspective. So in addition to the sort of relationship elements and changing fundamentally how we're talking to customers, there was also a really enormous practical impact in which, for example, at our Unite conference in Barcelona, where literally, 50 customers came up and said, hey I had said I told everybody internally no upgrade in Unity 6 and now that we've -- you've repealed it and you reverted to the subscription, we're a green light.

So those dynamics change real radically.

While the company did eliminate run time fees, it has instituted price increases. Typically, these increases play out over some time and they should be a significant tailwind over the course of 2025.

Another investment issue regarding Unity’s Create business has been that of genAI. Simply put, the question has been if the use of genAI can eliminate or reduce the need to use Unity, or any other set of tools, to create modern games. It is a more complex question than might be imagined. AI has been used for some time now as a part of the overall game creation process. It makes the process more efficient and speeds up the time to deliver a new game. The new CEO provided some insights into his perspectives on the issue: not terribly surprisingly it was anodyne and generic. Most likely the process of integrating genAI into the game creation process will be more incremental than existential.

The CAGR estimates for game creation software overall range between 5% and 11% depending on which analysis is used. For many years, prior to the recent upsets, Unity Create had a CAGR many times that level because of its technology. The guidance this company provided on its latest call was sparse, both because of caution surrounding the cadence of a turnaround, and also because the CFO is interim, and will soon revert to a different role. Further, headline numbers still reflect the impact of Unity’s exit from non-core businesses.

Revenues last quarter from the company’s core business components were $429 million. That compares to the prior forecast of $415-$420 million. The company increased full-year guidance by more than $50 million at the mid-point, suggesting some growth acceleration in its Create business in Q4. Understandably, in the midst of what is an existential product transition, it is not expecting Q4 will see any growth in its Grow business segment. Current published expectations for this current quarter are for revenues of $433 million. Published expectations for 2025 are for revenue growth of just 2%. After all that has gone on at Unity over the past couple of years, forecasts should and do err on the side of extreme caution. There are more than a few unknowns that need to be considered and evaluated in establishing forecasts for this company at this time.

My own estimate for 2025 revenue is $1.92 billion, compared to the published consensus of $1.82 billion. It all depends on just how successful the turnaround is, and particularly if the Grow segment of the business can …well, start to grow itself when its new technology replaces the current flawed version being offered.

Unity’s competition

There are many vendors offering game development software. I have linked here to the Gartner listing of competitors; it isn’t particularly useful. I have also linked to both the Reddit and the Quora threads.

None of the analysis presented here is really relevant. Unity 6 is just now available, and it wasn’t available at the time these threads were compiled. And these threads were compiled prior to Unity rescinding its run time fees. Further, the appointment of a new CEO who has been a game developer and is intimately familiar with that culture and is able to understand and act on developer concerns is a factor that is likely to change the competitive calculus.

Unity has lost a significant amount of user goodwill, although its market share loss, if any, is less clear. It can take time to reestablish favorable vibes in the developer community. I expect with the new products that have been introduced, coupled with a management that is likely to be perceived as developer friendly and concerned, market share gains are likely - although not all at once.

With regard to Unity’s Grow segment, its competitor is AppLovin. If the technology that Unity ultimately brings to market can produce ROAS equal to or greater than that which AppLovin is currently providing its users, it will see substantial growth-far greater than anyone-and that includes this writer-is willing to currently forecast.

I don’t think there is any secret as to what has to be done. As the CEO said on the recent conference call, it is an iterative process. If the integration of game creation and game monetization winds up actually producing a better ROAS, then the opportunity is enormous, and particularly so given the current intense skepticism that Unity will actually become a significant competitor to AppLovin. All things considered, it is one of the better bets available in the enterprise software space, but competing against AppLovin at this point is a high bar-although not really insurmountable.

Unity’s Business Model-What it will be is a function of how successful its Grow initiative is.

Invariably, at this point in writing an article, I like to discuss the details of a company’s business model. That is what I am trained to do. In this case, discussing the details of the latest quarter are really not totally relevant. I am recommending Unity shares because I believe that the company’s efforts to reinvent itself have a reasonable probability of success. In particular, I think that the opportunity it has to become a realistic alternative to AppLovin within the in-game advertising space is significant and as yet under-appreciated. That is relevant because the margins that APP has achieved in that business are so substantial.

Last quarter, AppLovin’s adjusted EBITDA margin in its software platform segment was 79%! The company’s overall free cash flow margin, which includes its margin on the games that it has created and published, was 45%. I do not wish to suggest that Unity will achieve these kinds of margins in the near future. But I present AppLovin’s most recent results simply to show what is possible.

In this most recent quarter, Unity’s adjusted gross margin was 84%. The other cost ratios are elevated as the company will have to scale revenues to support its current infrastructure. Non-GAAP research and development expense was 29% compared to 27% in the year earlier period. Sales and marketing were 24% up by 400 bps year-on-year. Non-GAAP general and administrative expense, declined by 25% in dollars, and that was enough to hold the expense ratio steady at 10%.

Overall, while the GAAP net loss margin was 28%, the company’s adjusted EBITDA margin was positive 21%. The company has been able to remain free cash flow positive. Much of its net loss has to do with its relatively substantial depreciation and amortization provision, which most recently was 24% of revenues. As capex is less than 2% of revenue, and stock-based comp. is 24% of revenues, the company, despite its current state, has been able to achieve free cash flow margin of 27%.

What the business model might look like is entirely a function of how the company’s efforts to undo past errors and to develop an app monetization offering that can produce a strong level of ROAS for users evolves. Unity, like APP, has the potential to be very profitable, but it is all a function of the company’s product initiatives.

Risks to the investment thesis.

This is a turnaround. And inherently, that makes the investment thesis risky. I don’t know the statistics-but my guess is that more turnarounds don’t achieve their full promise than those that do. There really are no secrets about the risks to this thesis.

Unity has to be able to offer an in-game advertising solution that produces a very high ROAS-at least equivalent to what the ROAS has been for AppLovin’s Axon 2.0. Without the ability to offer that, the company will not be able to capture the potential growth is this, its major revenue segment.

The company has rescinded its run-time charge. The issue, of course is, will the developer user community return and choose to upgrade to Unity 6.0. The price/performance advantages are there and so, too, are the functional improvements. But there are lots of customers who have become conspicuously unhappy by the aborted pricing change. Will they return as enthusiastic Unity customers? Will they upgrade? Will they accelerate their game creation efforts on the Unity platform?

The gaming business has been cyclical. It saw exceptional growth during the period of the pandemic, when users reached a high point in terms of their engagement as other forms of recreation were severely circumscribed. Subsequently, as user engagement returned to more normal levels, the growth of the gaming business slowed. The overall environment has shown some improvements, but certainly should macro conditions deteriorate, this would impact Unity-it still has a 70% market share according to analysts for game creation tools.

I think management chose the right individual to turn this around-at least based on his public pronouncements. He says the right things, and he is certainly on a mission to prove his ability to run a large game creation and monetization vendor. But the tasks ahead are non-trivial and require lots of execution and some luck as well. Those are the risks to the thesis.

Wrapping up-The case to buy Unity shares now

The case to buy Unity shares is a bet on its potential turnaround. In particular, the thesis relates to the potential for Unity Grow, which has embarked on a complete revamp of its in-game advertising platform, to mimic some of the success that AppLovin has had with Axon 2.0. Management is well aware of what is needed to launch a successful offering in this space, and it is well along in terms of developing the appropriate technology for users. It is a tedious, iterative process, but it is the only way to ensure that users will get at least the level of ROAS that they are expecting.

In addition, the company has rescinded the toxic run time fees that were misguidedly instituted by the prior CEO. And it has launched a new generation of its gaming engine with substantial price/performance improvements as well as significant improvement in graphics capabilities. The new CEO has a lengthy experience in the gaming industry, both as a developer and as the operator of a good-sized vendor. He seems likely to be able to restore Unity’s reputation in the space.

Because this is a turn-around, precise quantification of the potential is not really possible. Whatever a prudent guess might be, it would be substantially bettered if the strategy works-and if the strategy doesn’t work, the investment won’t be saved by attractive valuation metrics-which, after all, are as much retrospective as prospective. Based on a revenue forecast that in no way reflects the potential for a turnaround, or one that starts to achieve results in 2025, my estimate of the EV/S ratio is a bit greater than 6X. But the reality is that if the turnaround works, that ratio would, perhaps, be 4X on 2026 revenues, and with a free cash flow margin that could easily top 40% as it is currently 24% without any positive impacts from new products.

Over the course of writing this article, over the past week-just a few days really, Unity shares have appreciated 31%. Some of this is apparently a rumor that Microsoft might be interested in making a bid to acquire the company. I, personally, don’t quite see the logic of that transaction and whether I did or not, it would probably receive antitrust objections. I would not recommend Unity shares because of a potential merger-if it were to happen it would be lagniappe, at least for me.

Also, recently, Cathy Wood’s ARK Innovation ETF sold $48 million of Unity shares after the company reported its most recent quarter.

High-growth IT stocks have staged an impressive rally this week. A benchmark ETF, the IGV has rose by nearly 5% Investor seem of a “risk-on mindset. Speculating on the success of Unity’s turnaround is congruent with that mindset. I am not trying to opine here with regard to how investors should allocate portfolio resources to risk-on positions. Some readers will doubtless be concerned about the sharp rally in high-growth IT shares in the few weeks since the election. That is obviously a different subject than what I have tried to write about in this article.

I believe that the risk/rewards of investing in Unity shares are quite compelling and that remains the case after the spike in valuation of the last few days. There is really room for another monetization engine in the in-games advertising space, and my belief is that Unity has a reasonable chance to be that alternative. I think the odds favor Unity shares achieving positive alpha over the next year and beyond.