Unity (U)

Game engine maker Unity (NYSE:U) reported Q1 CY2025 results beating Wall Street’s revenue expectations, but sales fell by 5.5% year on year to $435 million. On the other hand, next quarter’s revenue guidance of $420 million was less impressive, coming in 1.9% below analysts’ estimates. Its non-GAAP profit of $0.24 per share was significantly above analysts’ consensus estimates.

Company Overview

Started as a game studio by three friends in a Copenhagen apartment, Unity (NYSE:U) is a software as a service platform that makes it easier to develop and monetize new games and other visual digital experiences.

The demand for rich, interactive 2D, 3D, VR and AR experiences is growing, and while the ubiquitous metaverse might still be more of a buzzword than a real thing, what is real is the demand for the tools to create these experiences, whether they are games, 3D tours or interactive movies.

A company’s long-term sales performance can indicate its overall quality. Any business can put up a good quarter or two, but the best consistently grow over the long haul. Over the last three years, Unity grew its sales at a 14.3% annual rate. Although this growth is acceptable on an absolute basis, it fell short of our standards for the software sector, which enjoys a number of secular tailwinds.

This quarter, Unity’s revenue fell by 5.5% year on year to $435 million but beat Wall Street’s estimates by 4.4%. Company management is currently guiding for a 6.5% year-on-year decline in sales next quarter.

Looking further ahead, sell-side analysts expect revenue to grow 1.6% over the next 12 months, a deceleration versus the last three years. This projection is underwhelming and implies its products and services will see some demand headwinds.

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 $435.1 million in Q1, and it averaged 10.2% year-on-year declines over the last four quarters. However, this alternate topline metric outperformed its total sales, meaning the company collects cash upfront and then recognizes the revenue over the length of its contracts - a boost for its liquidity and future revenue prospects.

The customer acquisition cost (CAC) payback period represents the months required to recover the cost of acquiring a new customer. Essentially, it’s the break-even point for sales and marketing investments. A shorter CAC payback period is ideal, as it implies better returns on investment and business scalability.

Unity’s recent customer acquisition efforts haven’t yielded returns as its CAC payback period was negative this quarter, meaning its incremental sales and marketing investments outpaced its revenue. The company’s inefficiency indicates it operates in a highly competitive environment where there is little differentiation between Unity’s products and its peers.

One of the best parts about the software-as-a-service business model (and a reason why they trade at high valuation multiples) is that customers typically spend more on a company’s products and services over time.

Unity’s net revenue retention rate, a key performance metric measuring how much money existing customers from a year ago are spending today, was 95.8% in Q1. This means Unity’s revenue would’ve decreased by 4.2% over the last 12 months if it didn’t win any new customers.

Unity has a weak net retention rate, signaling that some customers aren’t satisfied with its products, leading to lost contracts and revenue streams.

For software companies like Unity, gross profit tells us how much money remains after paying for the base cost of products and services (typically servers, licenses, and certain personnel). These costs are usually low as a percentage of revenue, explaining why software is more lucrative than other sectors.

Unity’s gross margin is good for a software business and points to its solid unit economics, competitive products and services, and lack of meaningful pricing pressure. As you can see below, it averaged an impressive 74.8% gross margin over the last year. Said differently, Unity paid its providers $25.18 for every $100 in revenue.

Unity’s gross profit margin came in at 73.8% this quarter, up 1.9 percentage points year on year. Unity’s full-year margin has also been trending up over the past 12 months, increasing by 6.8 percentage points. If this move continues, it could suggest an environment where the company has better pricing power and stable or shrinking input costs.

While many software businesses point investors to their adjusted profits, which exclude stock-based compensation (SBC), we prefer GAAP operating margin because SBC is a legitimate expense used to attract and retain talent. This is one of the best measures of profitability because it shows how much money a company takes home after developing, marketing, and selling its products.

Unity’s expensive cost structure has contributed to an average operating margin of negative 28.4% over the last year. Unprofitable software companies require extra attention because they spend heaps of money to capture market share. As seen in its historically underwhelming revenue performance, this strategy hasn’t worked so far, and 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.

Over the last year, Unity’s expanding sales gave it operating leverage as its margin rose by 15.9 percentage points. Still, it will take much more for the company to reach long-term profitability.

In Q1, Unity generated a negative 29.4% operating margin. The company's consistent lack of profits raise a flag.

If you’ve followed StockStory for a while, you know we emphasize free cash flow. Why, you ask? We believe that in the end, cash is king, and you can’t use accounting profits to pay the bills.

Unity has shown impressive cash profitability, driven by its attractive business model that gives it the option to reinvest or return capital to investors. The company’s free cash flow margin averaged 17.2% over the last year, better than the broader software sector. The divergence from its underwhelming operating margin stems from the add-back of non-cash charges like depreciation and stock-based compensation. GAAP operating profit expenses these line items, but free cash flow does not.

Unity’s free cash flow clocked in at $7.31 million in Q1, equivalent to a 1.7% margin. Its cash flow turned positive after being negative in the same quarter last year, but we wouldn’t put too much weight on the short term because investment needs can be seasonal, causing temporary swings. Long-term trends trump fluctuations.

Over the next year, analysts predict Unity’s cash conversion will fall. Their consensus estimates imply its free cash flow margin of 17.2% for the last 12 months will decrease to 12%.

Unity reported $1.54 billion of cash and $2.23 billion of debt on its balance sheet in the most recent quarter. As investors in high-quality companies, we primarily focus on two things: 1) that a company’s debt level isn’t too high and 2) that its interest payments are not excessively burdening the business.

With $395.2 million of EBITDA over the last 12 months, we view Unity’s 1.7× net-debt-to-EBITDA ratio as safe. We also see its $131 million of annual interest expenses as appropriate. The company’s profits give it plenty of breathing room, allowing it to continue investing in growth initiatives.

We were impressed by how significantly Unity blew past analysts’ revenue, EPS, and EBITDA expectations this quarter. On the other hand, its revenue and EBITDA guidance for next quarter fell short of Wall Street’s estimates. Overall, this quarter could have been better. The stock traded up 1.8% to $21.72 immediately after reporting.

Updated: May 16, 2025 at 10:02 PM EDT

The latest quarterly earnings matters, sure, but we actually think longer-term fundamentals and valuation matter more. Investors should consider all these pieces before deciding whether or not to invest in Unity.

Unity isn’t a terrible business, but it doesn’t pass our quality test. To kick things off, its revenue growth was uninspiring over the last three years, and analysts expect its demand to deteriorate over the next 12 months. And while its expanding operating margin shows it took many unnecessary costs out of the business, the downside is its software has low switching costs and high turnover. On top of that, its customer acquisition is less efficient than many comparable companies.

Unity’s price-to-sales ratio based on the next 12 months is 5.2x. Investors with a higher risk tolerance might like the company, but we think the potential downside is too great. We're fairly confident there are better investments elsewhere.

Wall Street analysts have a consensus one-year price target of $25.84 on the company (compared to the current share price of $22.19).

Although the price target is bullish, readers should exercise caution because analysts tend to be overly optimistic. The firms they work for, often big banks, have relationships with companies that extend into fundraising, M&A advisory, and other rewarding business lines. As a result, they typically hesitate to say bad things for fear they will lose out. We at StockStory do not suffer from such conflicts of interest, so we’ll always tell it like it is.

Want to invest in a High Quality big tech company? We’d point you in the direction of Microsoft and Google, which have durable competitive moats and strong fundamentals, factors that are large determinants of long-term market outperformance.

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