Best Software Stock: Adobe vs. Unity

Adobe (ADBE -0.87%) and Unity (U -0.21%) may at first glance seem like two very different types of software vendors. Adobe develops a wide range of cloud-based design, documentation, and enterprise software, while Unity primarily provides development and monetization tools for game developers.

However, Unity has gradually expanded into Adobe’s backyard with VR and AR development tools, “digital twin” tools for digitizing real-world objects, and theatrical special effects with its acquisition of Weta. Digital. This expansion could eventually make Unity a more diverse provider of cloud-based digital design tools like Adobe.

Image source: Getty Images.

Both stocks hit all-time highs last November but then slumped as rising interest rates drove investors away from more expensive growth stocks. Adobe stock plunged nearly 60%, while Unity stock fell more than 80%. Should investors view either of these software stocks as turnaround play?

What happened to Adobe?

Adobe’s revenue grew 23% to $15.8 billion in 2021, while its adjusted earnings per share (EPS) rose 24%. But this year, analysts expect its revenue and adjusted EPS to rise only 12% and 9%, respectively. This deceleration was primarily caused by the slowdown in business spending in the current macroeconomic environment and exacerbated by currency headwinds.

This slowdown was not surprising, but Adobe recently surprised investors with its decision to buy Figma, a design startup that competes with Adobe XD in the user interface (UI) and user experience markets. (UX), for $20 billion – or 50 times the $400 million in annual recurring revenue (ARR) the company is expected to generate this year. Adobe’s decision to finance half of the deal in stock could also dilute its existing stock by 7% and offset much of its previous buyouts.

It makes sense for Adobe to take out a rapidly growing competitor, but the price seems way too high. To make matters worse, Adobe expects the deal to be dilutive to its EPS in the first two years before becoming accretive in the third year.

Adobe shares look reasonably priced at 19 times forward earnings and eight times sales this year. However, these valuations are still tied to outdated estimates that do not fully account for its surprise takeover of Figma, which is expected to close in 2023. For now, analysts expect revenue and Adobe’s adjusted EPS grow 13% and 15%, respectively, in 2023.

What happened to Unity?

Unity’s revenue grew 44% to $1.1 billion in 2021, but remained unprofitable on both generally accepted accounting principles (GAAP) and non-GAAP measures. However, analysts expect its revenue to rise just 22% this year as it grapples with three main headwinds.

First, Unity Ads, a major component of its Operate Solutions segment, suffered a severe downturn after ingesting “bad data” that rendered many of its in-game ads useless. named directly Apple (AAPL -1.51%) as the culprit, but the tech giant’s iOS update – which allowed users to opt out of targeted ads – likely caused the crash.

To address this issue, Unity has rebuilt its entire advertising algorithm. It also agreed to acquire the controversial ad tech company ironSource (IS -0.28%) $4.4 billion to accelerate this transformation. The move prompted ironSource’s rival AppLovin (APP 1.56%) to try to buy Unity for around $58.85 per share – a deal Unity ultimately rejected.

Second, growth in the broader advertising market has slowed amid recent macroeconomic headwinds. Therefore, even if Unity successfully restarts Unity Ads, its short-term growth rates may still be low. Finally, the growth of the broader video game market, which pushes developers towards its core game engine, has slowed in a post-pandemic market.

Unity shares are now trading at a 33% discount to their IPO price, but they’re still not particularly cheap at eight times this year’s sales.

Adobe remains the safest investment

Adobe’s slowing growth and Figma takeover disappointed investors, but it’s still a more stable investment than Unity at the moment. Adobe simply needs to weather the cyclical headwinds and successfully integrate Figma to silence the bears, but Unity is still trying to rebuild a key growth engine while its core games and advertising markets cool.

Unity also faces more direct competitors, including Epic Games’ Unreal Engine, as Adobe comfortably dominates the creative design software arena with its Photoshop, Illustrator and Premiere Pro services. More importantly, Adobe should remain firmly profitable as Unity continues to bleed red ink in this unforgiving market for unprofitable growth stocks.

Leo Sun has positions in Adobe Inc., Apple and Unity Software Inc. The Motley Fool has positions and recommends Adobe Inc., Apple and Unity Software Inc. The Motley Fool recommends the following options: long January 2024 $420 calls on Adobe Inc. , March 2023 long calls at $120 on Apple, January 2024 short calls at $430 on Adobe Inc., and March 2023 short calls at $130 on Apple. The Motley Fool has a disclosure policy.