Software stocks have been completely wiped out in 2022, both due to slowing growth expectations and heavily compressed multiples. The threat of a prolonged recession and higher rates is a bad combination for growth stocks, and it has cost shareholders dearly This year.
However, such conditions create value for those willing to take risks, and one such stock that I find attractive today is Unity (NYSE:U). The company is currently embroiled in a three-way M&A mess, but on its own I view Unity as having a very favorable risk/reward for the bulls.
The stock hit a higher low in July, the first hint that the worst was over for Unity. It then rose from $33 to $58 in a straight line, but has since retreated. The stock bottomed a few days ago at $38 and ended a very strong Friday last week at $41.
All of this means that stocks are below the 20-day exponential moving average and the 50-day simple moving average, and those levels are looming just above it. They are both in the same zone at $43, which may prove to be a temporary headwind. However, as long as the next pullback ends above the $38 low set a few days ago, Unity is still in its next uptrend.
The accumulation/distribution line is moving nicely higher as the stock rallies, meaning there is intraday buying. This is a good sign as investors are adding weakness rather than selling on strength.
The PPO looks good too, and while I would have liked to see the PPO low on the midline, it is turning higher. The PPO shows that the stock was well overbought and expected to decline, but it has fallen and I see this indicator as another feather in the bulls hat at the moment.
I showed relative strength in the bottom two panels just to show that, well, there is no relative strength. Software, in general, has been horrible, and Unity is keeping pace. Not much to like there, so that’s cause for caution.
Overall, though, as long as Unity’s next pullback is above $38, this thing seems like it’s set to go higher.
Let’s take a look at the basic situation to see what it’s all about.
Strong growth remains
I mentioned that growth stocks have seen their estimates reduced everywhere in 2022, and perhaps nowhere is this more palpable than in advertising-related growth stocks. If we go back to last year, Snap (SNAP) and Meta (META) both led the way in what was an epic decline in advertising-related stocks. Unity is certainly one of them, and it suffered with the group. However, with the stock having fallen from $200 to $40, one could argue that a huge amount of pain is now priced in. I am one of those who would make this argument.
Part of this optimism is due to the fact that Unity does much more than generate ad revenue. Its platform enables creators of almost any type to generate interactive 2D and 3D content. It can certainly be used for gaming – and is – but there are plenty of business apps too. For example, companies that design furniture, do interiors, or manufacture just about anything can use Unity’s technology to design/build/run their processes more efficiently. There’s an endless list of apps for Unity products, and it continues to branch out away from ads.
Additionally, the pessimism that saw the company’s revenue estimates fall precipitously earlier this year appears to have been eliminated at this point.
The last few years, in particular, have leveled off, which is a good start for the stock bottoming out. When Unity was $200, the estimates continued to grow, and with them, the multiple shareholders were willing to pay. But when an unprofitable company sees lower growth estimates, the multiples are wiped out, and that’s exactly what happened to Unity.
It’s clear that the estimates we saw earlier this year were excessively high, but based on this evidence, it looks like we’re at or near an all-time low. Once estimates begin to rise again, this stock could rise rapidly.
Moreover, even according to current estimates, analysts expect revenue growth of around 20% for the coming years. It’s not too shabby, but you would never know by looking at the stock price chart.
The drama surrounding the company’s proposed takeover of ironSource (IS) continues to grow juicier as shareholders are due to vote in a month on the takeover. AppLovin (APP) for its part saw its offer rejected by Unity, which is not surprising. No one can guess how this happens, but if I had to guess, my base case is that AppLovin loses and ironSource is effectively acquired by Unity.
ironSource has also struggled this year in terms of creating shareholder value, so I’m not sure management has huge credibility with shareholders on that front. If the company is acquired, shareholders will get a premium on their shares to then hold Unity shares, which I think have better upside potential.
This is especially true if Unity’s projections materialize. The company believes that not only will the products look better together, but there are significant cost savings to be made. The cost savings is something Unity could do considering it’s perpetually losing money, so I like the deal from that perspective. We will see.
I mentioned money loss, which usually means cash burn as well. Unity is no stranger to spending money, as we can see with the trailing twelve month free cash flow data for the past two years below.
The last two quarters have seen TTM FCF just above zero, which is great. However, as Unity invests heavily in its future growth, it must ultimately generate Something on a lasting basis because it cannot last indefinitely. According to Unity management, the purchase of ironSource would greatly help in terms of increasing revenue while reducing costs. This should theoretically limit cash consumption.
Unity recently started issuing debt in order to remedy this situation, which is not surprising given its FCF history.
Net debt is essentially zero, so there’s hardly a cash crisis ahead for Unity. However, I’m pointing this out to show that Unity’s financial flexibility is suffering a bit right now, given that it’s already taken a net cash position to offset debt issuance. It may issue a little more debt, but that well will also run out at some point.
If you hold the stock for the longer term, cash burn is probably the biggest threat to shareholders right now. Whether that’s enough to keep you out or not is up to you, but it’s something we should all be aware of.
Let’s enjoy this thing
Obviously, we can’t value Unity on its earnings because there aren’t any. However, we can price it based on sales, so let’s do that.
Unity’s advanced P/S ratio has seen a dramatic drop from over 50X at the end of 2020 to 8X today. We can argue all day about 50X sales effectiveness, but the fact is that Unity is cheaper today than any other time in its existence as a public company. Even if we take its average P/S multiple and cut it in halfit’s still 13X forward sales, and we’re at 8X today.
Unity continues to grow by 20% per year, its platform is very attractive and its gross margins are excellent. Additionally, if it can acquire ironSource and achieve its cost savings goals, profitability could be closer on the horizon.
At 8X sales, Unity is priced for an extended recession, in my view, which means the odds are firmly in favor of the bulls at this point.
If we use caution in terms of stop loss below previous support, we can further limit risk, and that’s how I think you play this one. Current evidence suggests that Unity is starting a new uptrend, and I see the fundamental picture supporting a higher valuation. It’s a good combination, and I’m bullish on Unity for that.