3 Reasons U is Risky and 1 Stock to Buy Instead

Unity has been on fire lately. In the past six months alone, the company’s stock price has rocketed 97%, reaching $49.20 per share. This was partly thanks to its solid quarterly results, and the run-up might have investors contemplating their next move.

Is now the time to buy Unity, or should you be careful about including it in your portfolio? Get the full breakdown from our expert analysts, it’s free for active Edge members.

Why Do We Think Unity Will Underperform?

We’re glad investors have benefited from the price increase, but we don't have much confidence in Unity. Here are three reasons we avoid U and a stock we'd rather own.

1. Declining Billings Reflect Product and Sales Weakness

Billings is a non-GAAP metric that is often called “cash revenue” because it shows how much money the company has collected from customers in a certain period. This is different from revenue, which must be recognized in pieces over the length of a contract.

Unity’s billings came in at $478.1 million in Q3, and it averaged 2.5% year-on-year declines over the last four quarters. This performance was underwhelming and shows the company faced challenges in acquiring and retaining customers. It also suggests there may be increasing competition or market saturation.

2. Projected Revenue Growth Is Slim

Forecasted revenues by Wall Street analysts signal a company’s potential. Predictions may not always be accurate, but accelerating growth typically boosts valuation multiples and stock prices while slowing growth does the opposite.

Over the next 12 months, sell-side analysts expect Unity’s revenue to rise by 12%. While this projection implies its newer products and services will spur better top-line performance, it is still below the sector average.

3. Operating Losses Sound the Alarms

Many software businesses adjust their profits for stock-based compensation (SBC), but we prioritize GAAP operating margin because SBC is a real expense used to attract and retain engineering and sales talent. This metric shows how much revenue remains after accounting for all core expenses – everything from the cost of goods sold to sales and R&D.

Unity’s expensive cost structure has contributed to an average operating margin of negative 27.5% over the last year. Unprofitable, high-growth software companies require extra attention because they spend heaps of money to capture market share. As seen in its fast historical revenue growth, this strategy seems to have worked so far, but it’s unclear what would happen if Unity reeled back its investments. Wall Street seems to think it will face some obstacles, and we tend to agree.

Final Judgment

Unity doesn’t pass our quality test. After the recent rally, the stock trades at 10.3× forward price-to-sales (or $49.20 per share). At this valuation, there’s a lot of good news priced in - we think there are better stocks to buy right now. Let us point you toward the Amazon and PayPal of Latin America.

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