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Unity Software - It's Not What It Seems

Galatians Chapter 6 verses 7-8 state, "Do not be deceived: God cannot be mocked. A man reaps what he sows. Whoever sows to please their flesh, from the flesh will reap destruction; whoever sows to please the Spirit, from the Spirit will reap eternal life."


The Bible can be difficult sometimes because taking one verse doesn't always clarify everything. There are many passages that can be construed to performance equating to salvation. But the overarching principle still remains, that I am a sinner (no where near perfect) and only God's grace can save me. But it is still up to me to decide whether or not I will seek and follow God.


I try my best to put out information related to investing that can be used to help investors make decisions. I by no means should be making investment decisions for anyone but myself and my family. And I try to develop tools that can serve as illustrative mechanisms to create greater transparency.


Unity Software, Inc. (U) reported their earnings after the close of the market today. Here's the key line driving the SP higher by over 15% in after-hours - "Unity Software Non-GAAP EPS of -$0.05 beats by $0.02, revenue of $315.86M beats by $20.15M." Another factor likely contributing is the company's Revenue guidance for 2022 which has been increased towards $1.5 billion


Oh the games of Wallstreet. Digging deeper, I think that Unity will be headed back towards an unsustainable premium setting the company up for another downfall at some point. If you are a trader, the market has been your friend for a while now. When it comes to investing and aggressive growth, the key metrics that I subscribe to are the rate of Revenue growth and Cash Flow performance. Financial strength as evidenced by the B/S is also a critical area to pay attention to in unison.


Meta Platforms, Inc. (FB) also completed their 10-K filing and the company's new operating segment, Reality Labs has now placed an equal comparison for Meta, Roblox Corporation (RBLX), and Unity, of which I'll provide my perspectives. Let's begin with Unity.


Unity

Unity ended the year with $1.1 billion in Revenue equating to 44% growth from 2020, which was solid. However, the company saw a severe reversal of OCF performance witnessing negative OCF of $111 million. This compares with the company's first inflection in 2020 of $20 million. More interesting and possibly concerning is the fact that Unity ended 2020 with $1.8 billion in Net Cash and only $45 million in 2021. This of course was due to the acquisition spree of nearly $1.6 billion last year.


With the spending on deals, Unity has adjusted its Revenue higher by just below $100 million from prior estimates. It's not entirely clear if Unity will be headed back towards improving Cash Flow performance. Initially I was less optimistic, but after considering the company's guidance towards $1.5 billion in Revenue, I've determined that we could see substantial improvement from 2021. It's not entirely clear so I'm still projecting negative performance, but this could change.


Regardless, over the mid-term I am modeling Unity to head towards a 20% OCF margin. We've seen the volatile nature of reset valuations, with Big Tech finally being impacted. So looking out to 2026, having Unity sport 17 times EV/Revenue and 85 times SP to OCF/Share multiples still places risk to the downside in my opinion. I am forecasting Unity to generate an annualized Revenue growth rate of 25.5% from 2021's $1.1 billion level.


For me, the biggest concern stems from the $1.6 billion spent on deals. I'm not entirely concerned if Unity can leverage these deals into further post-deal organic growth. But it is important to note that the substantial line items on the B/S are as follows; $2.4 billion in Goodwill/Intangibles, $1.7 billion in Cash, and $1.7 billion in Debt. If Unity will become a growth-by-acquisition company, irrespective of Cash Flow performance, Net Debt will become an increasing reality and I for one, do not like aggressive growth companies fully dependent upon leverage to grow the business. Just take a look at Paysafe Limited (PSFE) as a horrid example of how growth-by-acquisition runs amuck.


I've watched Unity ever since it went public and I've stayed away. Investors who bought in in the $60s did well, it's just too bad that the SP didn't stay there for long. While I doubt Unity will revisit that level, unfortunately for me, I wouldn't touch this company above $70. That's due to my ambitions of owning companies with the potential to provide annualized investment returns north of 20%.


Meta/Roblox


I will tease readers with Unity's financial model above and withhold both Meta's and Roblox's, only because I will be providing a direct blog update on Facebook and Roblox has yet to report its year-end results.


As many may know Meta has adjusted its operating segments to include two core areas now, Family of Apps and Reality Labs. This all is timely as Meta continues to shift its focus stronger on the Metaverse, hence the company name change. I like the transparency here as we now have a good way to measure three unique companies that are competing in the same Metaverse space. Here's how they stacked up for 2021:

  • Meta: $2.3 billion

  • Roblox: $1.8 billion (estimate)

  • Unity: $1.1 billion

Meta is in the lead followed by Roblox, but Roblox has strong potential growth prospects as well, with both companies doubling their Revenue from 2021 levels versus Unity's 44% growth. Roblox is in a much stronger position with its OCF margin north of 40% and Net Cash standing at $1.9 billion. Roblox is not without controversy though as it has pulled services in China, been criticized of its addressable market demographic, and today's harsh criticism of the company's ties to pedophilia leaves less to be desired. Although these accusations can easily cut across many if not all social media platforms.


Meta's Reality Labs is focused on hardware, software, and content. Judging by its massive Operating Income Loss, the company is focused to compete aggressively in the space. Meta's Reality Labs generated $2.3 billion in Revenue and lost $10.2 billion from Costs and Operating Expenses. Much of this could likely be tied to SBC (Stock-Based Compensation) as it grew from $6.5 to $9.2 billion in 2021, and to a lesser extent D&A (Depreciation and Amortization). Meta's Family of Apps segment generated nearly $57 billion in Operating Income, fully capable of absorbing Reality Labs excessive Cost and Operating Expenses. This is why I would take Meta much more seriously than a company like Apple, Inc. (AAPL) with respect to Metaverse ambitions, even though Meta did spend $44 billion in Share Buybacks during 2021. In two years, Meta has already committed over $20 billion in Costs and Expenses for Reality Labs to compete.


Conclusion


From my perspective, Meta remains interesting with the recent sell-off. The company has now only averaged a less than 8% annualized return since 2017, while Revenue has averaged 30% growth, and OCF has averaged 24% growth. Meta is much too big of a company by EV for me to consider within my aggressive growth portfolio, so I currently own Roblox as my core Metaverse play. I am not excited about the recent pedophilia claims and I will continue to assess whether this is a company culture issue or rather has been an issue that doesn't permeate the company. That being said, the fundamentals support Roblox over Unity today, and based on each company's respective potential over the mid-term, as I expect Roblox to substantially outperform Unity's Revenue growth and Cash Flow performance.

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