Drive Software (New York Stock Exchange:U) led by a slowdown in revenue growth rates.
To summarize my position, in mid-April I released a two-part series on why I made a shift from technology to commodities in which I discussed this. East thread was available to Marketplace subscribers a month earlier.
Here are the points from part 1:
If you’ve read my work lately, you’ve seen me turn my back on it. nearly all technology companies. I have positioned myself in commodities. And it is working very well.
That said, even before moving on to raw materials, I had written about Unity saying this:
Read my Unity article here.
It is these two issues that are the reasons why I am pessimistic about this name. You have a company that is diluting shareholders, with slower growth rates and a stock that is overvalued.
Falling revenue growth rates
In February, when Unity reported fourth quarter 2021 results, Unity indicated that its full-year 2022 revenue growth rate would be in the range of 34% to 36%.
As you can see above, their updated guidance now points to 28% y/y. At least a 600 basis point slowdown. This has some implications.
At first glance, you can see that consensus analyst revenue expectations were for Unity to grow 31% in Q2 2022, rather than single-digit growth in Q2 2021.
Consequently, there is a clear gap between where analysts have the company growing, or rather, investors’ expectations, and reality. We are talking about a gap of 2,000 basis points in the next quarter.
Second, the coming weeks will see countless analysts reporting negatively and lowering their price targets for Unity.
Having learned the hard way what that feels like, let me be clear with you, that is a very difficult battle. One you don’t want to have with your own capital at stake.
Unity believes its slowdown is temporary
Unity is a leading platform for creating and operating real-time interactive 3D (RT3D) content. Unity software enables users to create, run and monetize their content on any device, whether it’s in 2D or 3D. Users can write and deploy their content anywhere.
Unity has two main business units, Create and Operate. Unity Create Solutions is their flagship platform. It used to be bigger than their Operate solutions.
However, recent acquisitions have changed the division of the company.
As you can see above, Unity’s Operate segment now accounts for almost 60% of the business. And this segment is having problems with monetization.
However, Unity states on the earnings call that these issues are temporary and won’t extend until 2023.
Do earnings matter?
Unity expects to end 2022 with a negative 4% non-GAAP operating margin. This compares to a non-GAAP negative operating margin of 7% in 2020 and a negative margin of 5% in 2021.
Consequently, there is no doubt that we are seeing an improvement in Unity’s profitability profile. I repeat, on a non-GAAP basis.
But under GAAP, we see that for Unity to grow revenue by 36% per year, their operating income has moved in the wrong direction by 66% per year.
This exemplifies my entire thesis with countless technological names. For the business to grow at attractive growth rates, you need to pay these executives a large amount of stock-based compensation. To illustrate, for the first quarter of 2022, stock-based compensation increased 61% YoY.
Also, with Unity stock falling, how do you think Unity will retain top executive talent? They will have to further increase the amount of stock-based compensation.
Shareholders are thinning out
Next, as I highlighted in the introduction, Unity is diluting shareholders. Please consider the following.
Unity ended the second quarter of 2021 with 288 million shares outstanding. Then, in Q4 2021, Unity’s guidance for 2022 showed the following:
This guidance was given 90 days ago.
Now, its guidance for the second quarter of 2022 points to 350 million shares outstanding.
Consequently, for Unity to grow revenue by 8% per year, shareholders are diluted by approximately 25%.
Bulls will deny that the reason for the high total number of shares outstanding is that Unity is not profitable, for now, and needs to raise funds through a convertible.
Bulls would likely note that the senior convertible notes don’t mature until 2026.
Personally, I find that reasoning flawed. If I own a business, I’m happy to embrace a small level of dilution as the business tries to increase its intrinsic value.
A dilution of up to 25% is ruled out. That becomes too high a hurdle for the investment to return a positive internal rate of return, or simply put, upside potential.
What we see above is Unity’s updated diluted outstanding share guidance for 2022. Over the course of 90 days, Unity has sought to further dilute shareholders by a further 3%.
Now, you can state that this is not that big of a dilution. But remember, this figure is a average For the year.
I believe that by the fourth quarter of 2022, Unity’s total outstanding diluted shares could reach 365 million. I’m making this statement now, to get back to the future discussion of Unity.
Stock Rating U – Overpriced
Including after-hours settlement, Unity is priced at 9x forward sales. And what do you really get for 9x forward sales? You get an unprofitable business, which dilutes shareholders.
Also, a business we were previously told about had what it took to increase their revenue by 30% over the long term. The long term in the case of Unity was a few quarters.
The bottom line
I find Unity particularly frustrating because it’s another company that has over-promised and under-delivered.
Here is an excerpt from the comment Unity gave to investors in February.
I had my doubts about the company, so I put “hold” on this stock because I believed in their mission and felt that if they had the confidence to state so bullishly that they could grow at 30% CAGR long-term, I would have at least 1 year of 30% CAGR.
However, Unity’s valuation in February did not line up with the other stocks in the market. Therefore, I put a hold on the action. But when the facts change, you know what to do, right? Whatever you decide, good luck and happy investing.