To The Moon

Down 75% from so far this year, and by 82% from its high, should investors consider the shares in the current environment?

Of course being down 75%-80% in the last few months is far less of a distinctionthan it used to be. And, I for one, am far less interested in the percentage decline of shares, as opposed to considering if their present valuation makes sense and can provide an investor with a reasonable return.

Unity Software (NYSE:U) is another of acrop of busted IPOs.The shares went public in Sept. 2020 at $52 andrapidly climbed to $201, before descending almost 83%. Fact is they are up by almost 60% from the low they made just before the company’slatest earnings report on 11/9and yet they are still down 83%.

The company went public at a time ofvery rapid growthin its space and for Unity specifically, and significant enthusiasm about its sophisticated tools to build mobile apps that could be monetized by selling in-game ads. The company’s tools were indeed responsible for some exceptional games with excellent visual characteristics, and the company had and has amarket share of more than 70%in the 1000 leading mobile games. Despite the decline in growth of in-game advertising in 2022, the overall business of creating, publishing and monetizing mobile games has lots of remaining growth, and while there are plenty of competitors selling alternative tools, Unity has maintained andenhanced a dominant positionin the space according to several blogs.

Just to be clear, investing in Unity at this point is not about trying to make a quick trade. Unity is a leader, probably the leader, in a space with an elevated growth outlook. It isrun by experienced individualswho are well experienced in this industry. With the ironSource merger now complete, it offers the most comprehensive set of creation and monetization tools for the mobile gaming industry, although it hasn’t abandoned creators and studios in more traditional areas of the gaming space. And it has made a commitment to profitability; essentially the EBITDA margin it forecasts to achieve by the end of 2024 would be near 30%.It has forecastthat it will be profitable, and generate cash at a lesser level next year.

But Unity exists in a world slithering into a recession. And that recession has already become evident in demand for the ads that are a principal component of the company’s revenue. One part of the investment consideration is essentially encapsulated in this quote from the company CEO,

“The timing here is clear. The declines take place as the world's banks increased interest rates and the spectrum of recession was everywhere in the press, not earlier when privacy changes took place. When we talk with our advertisers, the sense we get is clearly one of caution and reticence to commit to the aggressive campaign spends that would crowd out competition at the bid and elevate CPMs.

In this context, we remain confident. The market for ad is experiencing recession sentiment. And while we don't know when it will end, strong consumer engagement will ultimately bring back growth in this dynamic ads market.

And the other part of the investing consideration is this quote,

“While market conditions are challenging, we have a unique opportunity to gain market share and invest in positioning ourselves to grow rapidly, once macro conditions improve. Our end-to-end platform will be a critical enabler in helping creators thrive, even in a challenging market. By enabling more game creators to build successful businesses ultimately will be growing the market overall.

Trying to form an investment opinion regarding Unity shares presents a bit of a conundrum. I think Unity represents reasonable value at this point. But it is dependent on ads for growth, and the market for in-game ads is not expanding at this point, and is unlikely to expand until macro headwinds cease blowing. Usually, but certainly not always, stocks anticipate the return to growth before it happens. Investing in Unity at this point is akin to such anticipation. While I don’t necessarily believe that the fact that shares are down 80% or more over a year is a reason to invest, I do think that the fact that the shares are down 80% is because the outlook for the in-game ad space has deteriorated so significantly over the course of the year. Or “baked-in” in terms of valuation if one prefers.

In addition, the sentiment relating to high growth equities is basically at a nadir. Currently, the correlation between growth and valuation in thewake of Fed Speakerspouring icy water on hope for a near term pivot in rates, has depressed to the growth to valuation correlation to levels never heretofore seen in the period I have been tracking such correlations (7 years). Unity shares are probably not going to see sustained appreciation until that correlation rises, and it can only do so I believe, at such time as the Fed pivot is either in place, or broadly anticipated. Currently, the correlation between growth and valuation is 10%. Just as a reference point, the correlation had been well above 50% for many years until the current rerating started a year ago, and has fallen further recently as tech companies reported slowing growth.

Investing in Unity shares is based on an expectation that the correlation between growth and valuation will start to show more benign trends. I cannot possibly know when that will happen, but it will happen. Will investors start ignoring Fed Speakers and focus more onactual inflation data?Will actual inflation data show more benign trends than some expect? And just when will advertisers decide that their current posture with regards to investing in the in-game advertising space is ignoring opportunities due to the rising level of user engagement and the falling CPM of in-game advertising.

Unity's latest earnings

Unity shares rallied stronglyin the wake of earnings, and in the wake of the brief market bounce for high growth shares that ensued after a couple of more benign inflation reports. Probably the key to the rally was the company speaking at length and with some specificity about its goal of reaching a $1 billion run rate for EBIDA by the end of 2024. But for any rally to be sustained, the risk-off mentality is going to have to modify.

So, should investors buy Unity shares? The opportunity is huge, the short term is murky and patience will be required. The ability to call a turn in advance is, I suppose,the Rosetta Stoneof investing. But lacking the translate key, I believe that a reasonable case can be made to be early. I think this an exceptional space with huge opportunities, and I am willing to start building a position in Unity shares, not expecting significant alpha in the current months, but also understanding that the shares, being exceptionally volatile, will move prodigiously when the sentiment pivot starts to happen.

I lastwrote about Unity Softwareat the time its merger withironSource was initially announced last summer. The shares are actually a little higher now than they were at the time of publication back in July, and in this market environment, that is a win, I suppose. The shares had been oversold, and bounced along with many other IT names on 11/10-11/11. Thecompany’s Q3 resultswere more or less in line with expectations. Its guidance for Q4 includes the results ofironSource for a stub period so it really isn’t possible to evaluate how it compared to prior expectations. The company hasn’t provided expectations for 2023; at this point, I am expecting total revenues to reach $2.15 billion. That brings the forward EV/S ratio to about 9X. The company CFO said that Unity would deliver significant EBITDA and free cash flow progress next year on the way to a goal of $1 billion run rate EBITDA in 2024. I have chosen to be pretty conservative; I am projecting a free cash flow margin of 3% next year.

As many readers know, Unity hadbeen offered a merger deal by its arch-rival AppLovin (APP) with the proviso that it drop its merger agreement withironSource. At the time of the proposal, the offer was said to be worth $18 billion. Of course, as it was an all-stock deal, and APP sharesare down by2/3rds since the time the merger proposal was announce, Unity shareholders are far better off than might have been the case had management accepted the AppLovin offer. The value of the consideration to have been received by Unity shareholders would be around $20 based on the current market price of APP shares.

The reason to write about Unity now is that themerger with ironSourceis complete, and it is feasible to at least make an effort to model some expectations of the combined company. The further reason is to assess whether there is some reasonable prospect for the company to deliver against its goal of $1 billion in adjusted EBITDA run rate by the end of 2024. Further, some of my subscribers to my Ticker Target service have asked for an update and given the extent to which the numbers have been recast, that is probably a reasonable idea.

Over time, adjusted EBITDA, non-GAAP operating earnings and free cash flow will probably converge. So, adjusted EBITDA of $1 billion will probably translate into free cash flow of $1.1 billion. The company’s enterprise value these days is a bit less than $20 billion, and the company’s growth objective is 30%. So, if $1.1 billion of free cash flow is somewhat of a realistic objective, and with a fully diluted outstanding share count of 562 million, the shares are well worth their current valuation, and offer significant upside as theironSource synergies play out and as the in-game ad market recovers.

The company has not generated free cash through the first 9 months of the year, although last quarter’s $70 million cash burn included about $28 million of one-time negative items. While the company hasn’t forecast cash flow, the CFO commentary in the script is that the company would be cash flow positive by the end of the year, implying that Q4 will probably achieve operating cash flow of $15 million or more, to make up the deficit in that metric through the first 9 months of the year. I think the shares are not likely to reflect future prospects until there is a very visible path to a decent level of free cash flow generation. That said, the current valuation seemingly reflects many of the risks that I will outline. The shares are not for the faint of heart, or for those looking to achieve immediate alpha; they make sense if one’s time horizon looks beyond the current economic malaise and considers the strategy and the likely progression of the new Unity, in the wake of the Iron Source merger.

Unity Growth-It’s all about synergies and market share

With theironSource merger, the combined monetization offerings of the merged company will be referred to as Unity Growth. Last quarter, Unity Operate, the Unity business that operated in this area, reported revenues of $172 million, down 7% year-on-year but up by 8% sequentially. Operate, as indicated earlier, had run intosignificant technologyand data difficulties earlier in the year, and while the problems have been solved, the service is still fighting negative perceptions, and an unwillingness of users to expand their commitments, coupled with a deteriorating macro environment. Unity’s last earnings release did not specifically discuss the Q3 results ofironSource.

So, it can be difficult to interpret guidance absent the ability to look at sequential comparisons. While it is not clear, at least to me, if any ofironSource properties will be included in the Create segment, just based on the latest quarterly report that was released byironSource, the Growth Solutions segment of the Unity business will have revenues of around $375 million, or about 73% of the total. Iron Source was actually acquired on November 7, so the Growth business will only generate revenue from the combined entity for a little more than half of the current quarter. Hopefully there will be some more transparency, regardless of the numbers themselves, when the company next reports in February.

One of the principal benefits of the Iron Source merger for Unity is solving its mediation issues. By acquiring Iron Source, and adopting itsLevelPlayplatform, the company will go from an also-ran in the space, to offering what observers consider to be the mosteffective mediation solutionin the market. Self-evidently, there will be substantial synergies, both in terms of revenue, as more Unity Create users are likely to turn to LevelPlay for mediation, and of course expense benefits, as the combined company will be supporting but a single platform.Mediationis basically what makes the mobile game business possible. The word “remediation” has different meanings in context.

It even has different meanings within the software space. In terms of what it means for Unity, mediation is the technology for managing and optimizing the monetization ad stack. It enables publishers with tools they need to drive more competition for their inventory. These tools facilitate what are callednetwork waterfalls, or enable ad bidding from a Unity dashboard. The tools can be used with many different networks including those from Meta (META) and Google (GOOG) as well aswith Unity Ads. Without discussing various mediation strategies in detail, over all the technology allows the owners of content to optimize the revenue generation for their inventory. Waterfalls and bidding can be used together.

ironSource had been very successful in recruiting customers for its mediation service; it had been one of the principal growth drivers for that company. Now that the company is part of Unity, the expectation is that there will be significant cross sell opportunities in which Unity Create users choose the LevelPlay mediation service.

The success of a mediation service is highly dependent on the data that is collected from users. With the combination withironSource, Unity is going to have the largest data feed in the space, and that will make its mediation technology more effective in terms of optimizing the yield of content.

Other components of theironSource platform includeLuna, a cross channel marketing platform for mobile games andAura, the company’s mobile engagement platform that competes with Digital Turbine (APPS), although it is much smaller. Luna is another service that seemingly has significant cross sell opportunities within Unity’s base of creators. Aura has been a small, but rapidly growing component ofironSource; its business should be relatively unaffected by the merger. In the last couple of calls,ironSource has talked about a nascent business ofselling ads outside the confinesof the in-app mobile game space. It is an intriguing potential that probably will see some revenue synergies in combination with Unity.

While the most obvious cost synergy is that of only supporting a single mediation service, there should be cost synergies in almost all parts of the combined business. The specifics of the cost savings through this strategy haven’t really been discussed but are likely to be substantial. No doubt general and administrative expenses will be targeted, and there should be available cost synergies in terms of sales and marketing as well.ironSource was a highly profitable company before its acquisition with its latest reported EBITDA margin of 31%. Given that the CEO ofironSource and some of his team will be holding leadership positions at the Growth Solutions component of Unity, I think it is reasonable to assume that cost containment will be a significant part of the strategy for the newly merged operation.