2 reasons why the virtual world of Unity Software is facing a harsh reality

Unit software (NYSE:U) was one of those companies that investors took to new heights thanks to the metaverse hype created by Facebook when it announced its name change to Metaplatforms (NASDAQ: META) end of October 2021. However, Unity was quick to deal with the brutal nature of reality, and the stock plunged more than 80% from its peaks. As a result, some investors might now wonder if Unity can rebound from its recent market woes.

Here are two reasons why Unity stock could face a tough climb.

Image source: Getty Images.

1. The Operate Solutions division 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 division, which helps game creators monetize content through Unity Ads and in-app purchases.

Operate Solutions had a strong start in January, but stumbled in February and March as revenue fell significantly. Additionally, CEO John Riccitiello said on the company’s earnings call that the company had reduced Operate’s problems to two self-inflicted problems.

First, Unity identified a flaw 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 users who are most likely to continue playing a game after installation.

Unity only noticed the problem with Audience Pinpointer after it started generating less revenue. Game creators often measure the effectiveness of their ad campaigns, and when Audience Pinpointer’s usefulness declined due to some unspecified issue, creators stopped using it and revenue plummeted.

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

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

News of Audience Pinpointer’s poor performance first broke on May 10, prompting a 33% share sell-off. And although management has promised that the problem will not continue into 2023, investors should beware of putting their full trust in Unity’s management team, as Audience Pinpointer issues could be a symptom of larger issues. important within the company.

2. Unity was unprepared for a poor market environment

Since its IPO in September 2020, Unity has continued to grow revenue at the expense of profitability. As an illustration, this chart shows that Unity’s operating costs are growing faster than its revenue.

U Table of total operating expenses (TTM)

U Total operating expenses (TTM) given by Y-Charts

While pursuing growth in the face of growing unprofitability can be a winning strategy when interest rates are low, it is a devastating strategy when the Federal Reserve raises interest rates.

Rising interest rates erode the value of future earnings, hurting unprofitable businesses more than profitable businesses. And Unity’s overall profitability in the form of net income has steadily worsened over the past two years.

U Net Income Graph (TTM)

U Net Income (TTM) given by Y-Charts

As you can see above, Unity’s price-to-sales ratio fell off a cliff at the end of 2021, as investors were already considering the impact of rising interest rates from the Federal Reserve to curb inflation.

The unit backtracks

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

During the first-quarter 2022 earnings call, chief financial officer Luis Visoso said the company would cut spending by $100 million to reach profitability in the fourth quarter of 2022 — earlier than expected. And the company expects to be profitable for the whole of 2023.

However, since the largest portion of operating expenses is personnel costs, Unity expects to realize its $100 million in cost savings through layoffs. At the end of June, Unity laid off 4% of its workforce. And according to the Kotaku website, the releases came several weeks after CEO Riccitiello assured workers that Unity had no financial problems and there would be no layoffs – a misleading statement that has created employee dissatisfaction. Also, it doesn’t help the morale of the employees that Unity has acquired ironSource (NYSE: EAST)whose tools help app developers make money from their creations, just two weeks after the layoffs.

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

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

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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