What a time it’s been for Unity. In the past six months alone, the company’s stock price has increased by a massive 77.8%, reaching $39.32 per share. This was partly due to its solid quarterly results, and the performance may have investors wondering how to approach the situation.

Is now the time to buy Unity, or should you be careful about including it in your portfolio? Check out our in-depth research report to see what our analysts have to say, it’s free for active Edge members.

Why Do We Think Unity Will Underperform?

We’re happy investors have made money, but we're swiping left on Unity for now. Here are three reasons why U doesn't excite us 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 $472.7 million in Q2, and it averaged 6% 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. Long Payback Periods Delay Returns

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.

3. Operating Losses Sound the Alarms

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 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 28% 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

We cheer for all companies solving complex business issues, but in the case of Unity, we’ll be cheering from the sidelines. Following the recent surge, the stock trades at 8.6× forward price-to-sales (or $39.32 per share). At this valuation, there’s a lot of good news priced in - we think other companies feature superior fundamentals at the moment. We’d suggest looking at one of Charlie Munger’s all-time favorite businesses.

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