rewrite this title Unity Software Still Can’t Grow. Time to Bail? – Nanalyze

Say it again everyone. Proof of disruption is revenue growth. Profitability can come later. Today, it’s all about capturing as much market share as possible. And when a company has a sustained period of stalled growth in a growing market, that means their competitors are getting ahead. That brings us to Unity Software (U) which has been disappointing growth investors for at least a few years now. Below you can see the “growth” that’s taken place since our last piece on Unity.

We ended that piece with one simple conclusion. If growth hasn’t resumed, it’s likely Unity will get kicked to the curb. Here we are, one year later, and growth hasn’t resumed.

Unity’s Failed Growth

While the end of 2024 saw a glimmer of growth, hope seems to be dashed as the midpoint of guidance for the coming quarter would be the lowest quarterly revenue seen in several years. The last earnings call saw plenty of tactical updates and more obscure metrics pointing to the potential of future growth which largely felt like fluff. Strength in one area is just being offset by weakness in another.

“…as the performance of Vector continues to improve, we expect to see the overall Grow business return to revenue growth with the performance improvement from Vector outpacing any other headwinds we face. In Create, we expect continued momentum in our subscription business across the gaming and industry verticals. However, we’re forecasting a slight sequential decline in Create due to an expected runoff in nonstrategic revenues.”

Vector is their (wait for it…) AI-powered solution which they expect will boost revenues, while it remains to be seen how long they’ll be able to milk the “strategic reset” reason for declining growth. There always seems to be legitimate excuses. “Just wait a few more quarters.” We’ve waited long enough. Unless this coming quarter has some blow out results, it’s hard to justify continuing to hold a company that does nothing but disappoint.

The Latest Earnings Call

There’s an earnings call coming up in about a week, but we always find it’s useful to arrive at conclusions beforehand, so we’re not being swayed by quarterly noise. While we may likely exit Unity Software, is there a compelling bull thesis to be made here for holding the company? Having achieved positive operating cash flows, the business ought to be self-sustaining now, but they don’t have any dry powder to acquire growth. And after the failure of their last big acquisition, that’s probably a good thing. What they ended up with was a mountain of debt and an even bigger mountain of goodwill (this reflects the premium they paid during the acquisition – or as some might put it, how much they overpaid).

With $1.5 billion in cash on the balance sheet and $2.2 billion in convertible debt, there’s a net cash deficit which means the ability to manage debt comes into focus. This past quarter they pushed $690 million in debt that comes due next year out to 2030.

That leaves about $560 million that’s still coming due next year with another billion coming due the following year. As they issue new convertible notes, there’s a risk of dilution in the future, not to mention that kicking the debt can down the road only works for so long. Eventually, they need to pay their debts.

With 80% gross margins, Unity has the ability to generate cash, but they’re stuck between a rock and a hard spot. Decreasing R&D spending means there’s a likelihood of deploying functionality that generates more revenue, like Unity Vector, the AI model they talked about incessantly in the last call and a possible driver of future growth. Basically, clients who spend ad revenues on the Unity platform will now see a better return on ad spend (ROAS) and therefore spend more over time. That’s because the AI algos are using all the data generated on their platform to more effectively advertise to the whales out there.

If existing customers are going to spend more money on the platform, then that means we should see an increase in net retention rate (NRR). That metric has deteriorated even more since the last time we checked, ending last quarter at 97% which means existing customers continue spending less over time.

The above graph can be found tucked away in their SEC filings and is a key metric to be watched as the company claims an eventual return to growth. For a healthy growing software-as-a–service (SaaS) company, NRR ought to be in the 120% range.

The Original Thesis

As AI algorithms take over all the jobs, people will resort to entertaining themselves in other ways. Being a professional video game player is now a thing. Even if you’re not of Asian descent, you can still benefit from this trend in any number of ways. One is to invest in the growth of gaming which is exposure Unity Software gives you in spades. You can also capture incidental exposure, like our investment in NVIDIA (NVDA) which has also benefited from the growth of gaming over the years. However, gaming isn’t a theme we’d actively pursue for investment exposure – not much blue ocean market – but it’s compelling just based on size. The consumer base is fickle, so best to invest in the picks-and-shovels of gaming. Unity checks that box, but they’ve been miserable at execution.

Perhaps the most compelling reason we invested in Unity is because their platform can be extended to real-world uses cases. Says Unity, our platform “has tremendous potential outside of gaming, and we are increasingly optimistic about our ability to capitalize on this opportunity at scale.” They’ve been saying that since we first invested in the company though.

We’ve talked before about how the winner for, “the metaverse,” and whatever that might entail, will likely involve the most formidable player in this space right now. Aptly named Meta sees AI as a complimentary technology that will render their metaverse all the more useful. It’s eventually coming, they say. One can imagine “smart glasses” that allow you to see the world using “data overlays” that mesh the physical world with the digital world. While Meta targets consumer applications, we also want to invest in solutions targeting the global manufacturing industry which produces $44 trillion worth of goods. Unity seems to be a bit preoccupied right now to be expanding into other verticals.

Best Case Scenario

Going forward we’d expect Unity to start pivoting the conversation towards profitability if growth can’t happen. It’s always just around the corner, and what’s the best-case scenario here? They return to high single-digit growth? While they’ve been languishing, competitors like Epic Games are stealing their market share. (ARK Invest happens to be invested in Epic Games.) Perhaps we see net retention rate drift back above 100%, and Unity manages to refinance their outstanding debt and start paying it off using strong cash flows that result from trimming overhead costs. Or we could keep hearing the same song and dance about future growth until a private equity firm finally steps in and ends the pain for investors.

Conclusion

It’s now been three years since Unity first saw those large visible execution mistakes which management openly addressed. That was after their market cap had declined nearly 75%. Back then they still expected double-digit growth, but today they won’t provide guidance beyond the next quarter. So, investors are left hoping that eventually growth resumes on the back of new functionality they’ve been spending loads of R&D dollars on. In the meantime, large debt balances are coming due, and the company is likely feeling the need to cut costs to generate more cash flows to make their business more attractive to lenders who care about the ability to pay back a loan. It’s hard to see a good reason to continue holding shares of a company that can’t execute nor grow.