What happened
Shares of Unity Software (U 5.24%) dropped 27.6% in December, according to data provided by S&P Global Market Intelligence. The S&P 500 was down nearly 6%, so these market conditions certainly helped nudge Unity stock downwards. However, an analyst highlighted some challenges facing Unity’s industry, which caused the stock to have a more pronounced drop early in the month.
So what
On Dec. 8, BTIG analyst Clark Lampen downgraded Unity stock to a neutral rating from a buy rating, according to The Fly. The rating change rattled investor confidence as did his commentary. Lampen believes that Unity’s growth will be challenged for potentially the next two years.
Lampen’s concerns for Unity’s markets are well founded. For starters, Unity’s 3D image-creation software is often used by mobile-gaming companies. Third-party gaming-research company Newzoo recently noted that mobile gaming is expected to have contracted by 4% in 2022 in a surprise correction.
Moreover, a large portion of Unity’s business is in the advertising sector. And Unity’s own management acknowledged a tangible slowdown in the space. In the third-quarter earnings call, CEO John Riccitiello said, “When we talk with our advertisers, the sense we get is clearly one of caution.”
This caution among advertisers is causing them to spend less. And as they spend less, the value of each ad slot goes down; this is measured with a metric called cost per mille (CPM).
The bear market rages on, and Unity’s markets are challenging right now. And this is why the market wasn’t interested in Unity stock in December.
Now what
Unity stock was already down 72% in 2022 before December. I point this out because, clearly, the company had bigger issues before Lampen’s December comments.
One such issue relates to one of Unity’s business segments. Mobile-gaming companies build games with the company’s Create segment and later monetize games with its Operate segment. Unity stock crumbled in 2022 because of a data issue with its Operate segment that caused it to underdeliver for clients. And the only fix was to rebuild the algorithm with good data.
Unity reported Q3 financial results on Nov. 9, with management noting that, “These problems have been addressed and are now in our rear view mirror.”
As noted, Unity’s markets could be challenged in 2023. But it’s reasonable to assume these markets will improve eventually. Therefore, rather than focus on macroeconomic concerns, I’d recommend investors monitor the business for tangible improvements.
Unity is expected to report Q4 earnings in early February. Investors can monitor cash flow for starters; management is guiding for positive adjusted operating income after steep losses in 2022. It recently completed its acquisition of ironSource, so commentary on that integration will be helpful. But perhaps most importantly, if problems with the Operate segment are truly fixed, then I’d expect impressive revenue growth in that area.
If all of these parts of the business look good, Unity may be a stock to start buying again in 2023.
Jon Quast has positions in Unity Software. The Motley Fool has positions in and recommends Unity Software. The Motley Fool has a disclosure policy.
