unity software is currently down about
80 percent from its 52-week high this
former high flyer recently plunged after
it reported its first quarter results so
is this a busted company or is right now
a good chance for investors to get in
here's why we think it's the latter and
we're excited to add shares to our
public portfolio today my name is brian
feraldi and my name is brian stoffel
[Music]
thanks to common stock for supporting
today's video as of the time of this
recording both brian and i are currently
shareholders of unity software so brian
though unity was once valued at 42
billion dollars not so long ago today it
trades for just eleven and a half
billion dollars unity's mission
statement is to enable more people to be
creators this is simple inspirational
and optional i love it i do too but how
does the company do that it's a software
as a service company that has a platform
for developers there they can create
realities in the metaverse now its
primary application has been in gaming
but it also has potentials for tv shows
and movies in architecture and
engineering as well as in automotive
divisions because of the rise of
autonomous driving the company makes
money in two primary ways first is the
company's create solutions divisions
this is subscription-based revenue the
second is operate solutions business
this is optional usage-based revenue
simply put the create solutions business
is where game developers create the
games and the operate solutions is where
they test them market them and monetize
them now if we look at the company's
history we see that the operate division
is the largest that's no surprise
because as games get popular the company
is able to collect more revenue usually
operate grows faster than create does
although that situation reversed in the
most recent quarter but we'll get to
that in a minute unity has a history of
upselling its customers over time as
evidenced by the fact that it now has
more than a thousand customers that are
gonna pay the company more than one
hundred thousand dollars this year and
if we look at the company's dollar base
net expansion rate we can see that is
quite elevated it got a boost from the
pandemic but is still doing quite well
at getting customers to spend more on
the platform every year unity is
currently focused on top line growth and
it is spending heavily on sales and
marketing to bring new customers in the
door however not as much as other
software as a service businesses at the
same time we think that the demand for
unity's products is irrespective of the
business cycle and the vast majority of
this company's revenue is recurring in
nature turning to the moat we give the
company some credit for the network
effect that's because each additional
customer makes the company's machine
learning perform better and that machine
learning is very important for the
operate side of the business we also
think that the company benefits from
high switching costs as evidenced by the
number of tools this company has and the
company's high dollar-based net
expansion rate unity's brand is also
very important this is part of a duopoly
in the development platform for the
metaverse and when we think about the
number of tools that this company is
rolling out and the number of customers
that have signed on we think that this
company's moat is currently expanding so
how do the financials look well it
depends on what you're looking at on the
top line revenue growth has been solid
at 42 per year with gross margins above
76 percent on a non-gaap basis however
if we look at the bottom line losses
have been substantial a big part of that
is stock based compensation thankfully
the company recently crossed into
becoming free cash flow positive and its
balance sheet is in okay shape the
company does have 1.7 billion dollars in
debt that is mostly due to the company's
recent acquisition of weta digital
meanwhile since the company is currently
not focused on profitability at all its
returns on capital are currently
negative turning to management unity was
co-founded by david helgeson and joaquim
ante helgeson is on the board of
directors ante is the chief technology
officer but running the company as ceo
is john richitiello who has been on
board for eight years and has a previous
stint as the ceo at ea sports the
company's employer ratings on glassdoor
seem to be very good which is a good
indication that this is a great place to
work moreover insiders currently own 13
of this business which is worth more
than a billion dollars at current prices
so does this company have optionality we
believe the answer is yes not only does
it roll out new tools for game
developers to use but its applications
are growing beyond gaming we think that
the potential in automotive in
construction and in media is large
turning to operating leverage the
company has not optimized her
profitability or free cash flow at all
that prevents an opportunity for this
company to drive higher profit growth
and revenue growth once the focus
becomes profitability turning to the
total addressable market management
believes that it's about 29 billion
dollars with half of that being in the
gaming division of which the company has
already captured about five percent and
while the company did recently make an
acquisition of what a digital prior to
that the vast majority of this company's
revenue growth was organic in nature so
how's unity been as an investment the
answer not very good since coming public
recently shares are down 50 while the s
p 500 is up and that's despite the fact
that it has exceeded wall street's
expectations over the past year
meanwhile this company is not focused on
returning capital to shareholders at all
so there's no buybacks no debt
repayments and there's no dividends to
speak of turning to risk we think
there's a medium level threat from
competition that's because unity is part
of a duopoly epic games has its unreal
engine and these two dominate the field
however we do think that dilution is a
risk that investors should keep an eye
on the company's stock based
compensation practices are currently
very high and it also issued stock to
acquire weta digital beyond that despite
the fact that the stock has fallen over
80 percent from its all-time highs the
valuation is still at a medium high
level and we'll get to more on that in a
second so why did shares recently plunge
in response to their first core results
well brian stofel recently did a review
and you can watch that if you click the
link that you see on your screen but the
highlights are this revenue growth came
in at 36 for the period to 320 million
dollars that was slightly behind what
wall street estimated however the
company did manage to meet wall street's
targets on the bottom line on an
adjusted basis if you look at the
company's margins on an operating basis
gross margins came in above 76 while
operating in net margins were a loss of
seven to eight percent and while there
wasn't much change in the net income
basis there was a big swing in free cash
flow swinging from negative 100 million
dollars in the previous quarter to
positive 86 million dollars this quarter
moreover there was some good news in the
conference call too management noted
that it's unity create division has hit
an inflection point and they're now
seeing strong demand outside of their
core gaming franchise but now let's get
to where the real problem is and that
was from unity's operate side of the
business that's because it revealed that
it's machine learning digested some bad
data which made it difficult for game
developers to place ads within their
games to go back and fix that machine
learning is going to take time and it's
going to cost unity 110 million dollars
throughout the rest of this fiscal year
so in response to that head when
management only guided for six to eight
percent revenue growth in the upcoming
quarter that is nowhere close to what
wall street was expecting and while the
full year guidance isn't as bad the same
dynamics are at play with management
believing that revenue will grow about
25 whereas wall street was expecting 35
so what should investors watch from here
first and foremost keep an eye on that
operating solutions business if this 110
million dollar hit is indeed a one-time
thing then the long-term potential of
unity is looking bright however if the
company can't fix this problem and this
becomes a recurring issue then this
could be thesis busted for this business
second keep an eye on that dollar based
net expansion rate we don't expect it to
stay above 130 percent forever but if it
can remain above 125 we know that
customers are still sticking with it
despite this problem with placing ads
and operate third keep a look at the
company's adoption outside of its core
gaming franchise that is a huge
long-term tailwind for this business and
we want to see continued success in
other avenues and finally keep an eye on
free cash flows we saw that it swung to
a positive recently some of that had to
do with its acquisition of weta digital
but we want to see the trends continue
to go up and to the right if we were to
grade the company's moat given the
number of users that are paying a
hundred thousand dollars or more and a
high dollar in base net expansion rate
we can't help but think this company's
moat is widening overall we don't think
that the thesis is busted here we're
going to trust management that they can
fix this problem and operate solutions
but we need to verify that that actually
happens over the coming quarters given
the uncertainty and decline the
company's share price the valuation has
come down to a much more digestible
level for investors shares are currently
chaining at about nine times sales which
is the lowest level on record
unfortunately we don't have a ton of
other metrics to value the company on a
free cash flow basis it's trading for
about 325 times that figure which is its
lowest ever but still elevated and it
trades for about 13 times trailing gross
profit so how does this company score on
our investing checklist today we both
recently deducted a few points but for
me this still got a 76 which is well
into my investable category that's right
and on mine an 11 is a great score if
this company can write it ship it could
easily land back in that green zone
overall we think that unity is still a
high quality business that is facing a
temporary one-time problem we want to
take advantage of mr market's generosity
and add this company to our portfolio
today for those keeping track at home
this is the fifth company that we're
adding to our investment portfolio if
you want to follow along with that you
can do so by clicking the link in the
video description if you head on over to
common stock you'll see these slides
posted with an explanation of our
decision to purchase shares common stock
will be giving away 250 to the poster
that offers the most insightful feedback
on our decision so there you have it
head on over to common stock and let us
know what you think about our purchase
of unity stock today brian's out