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Is This Cathie Wood Favorite an Acquisition Target?

Motley Fool - Thu Oct 26, 2023

Remember when the metaverse was all the rage? Investors poured into gaming companies in particular as enthusiasm around virtual reality (VR) and other metaverse applications reached a fever pitch.

One stock that witnessed a meteoric rise was Unity Software(NYSE: U), a staple in Cathie Wood's highly tracked portfolio that could represent a buying opportunity, as it now trades 80% below all-time highs.

But investors might want to approach Unity stock with caution. The company is in a transition as CEO John Riccitiello resigned earlier this month after a botched attempt at new pricing structures. Given the number of questions around the company's forward path, some on Wall Street are speculating that an old suitor, AppLovin (NASDAQ: APP), might sense desperation and pounce on the opportunity to acquire Unity.

What's the lowdown?

To keep it simple, Unity's financial profile is upside down. Revenue growth has come to a screeching halt while expenses remain bloated. As losses mount, the company tried to employ one of the oldest (and most mundane) revenue growth strategies in the book.

Seemingly out of nowhere, Unity decided to change its fee structure, which directly affects how much money developers can make. In a way, this is similar to a subscription service like Netflix raising your monthly fee. While this often helps boost revenue in the short term, it's not exactly the most innovative way to generate more sales.

Unsurprisingly, Unity's new pricing strategy was met with thundering backlash from developers. As a result, management issued a formal apology and changed its new policy to better suit developers. In the middle of all the hoopla, the company's CEO resigned.

A person playing video games.

Image Source: Getty Images.

What goes around comes around?

While this is not always the case, acquisitions can occur when a business is operating from an undesirable position. Given the revolving door of chaos at Unity, the company does not exactly have a lot of leverage at the moment.

Last September, rival gaming company AppLovin tried to acquire Unity for a reported $20 billion, or about $59 per share. To put this into perspective, Unity stock currently trades around $27 per share and has a $10 billion market capitalization. Basic arithmetic would suggest that Unity probably should have accepted the takeover from AppLovin. Now, with top-line growth plateauing and cash burn eating into the operation, is it appropriate to think AppLovin might come back around?

Following Riccitiello's exit, research analysts at Citigroup quickly began stoking the rumor mill. Given the suboptimal financial profile of Unity's business coupled with the damage it has done to its reputation, the stock has been on a downward spiral. For this reason, Citi presented the idea that AppLovin could be interested in a second try at an acquisition.

Should you invest in Unity stock?

While this is an interesting theory, my fellow Motley Fool Nicholas Rossolillo made a crucial point in his take on the possible takeover. He accurately points out that Unity's business is in shambles.

In other words, there is a reason the stock is getting crushed, so while AppLovin might be able to scoop up Unity on the cheap, by no means would the integration come without its share of headaches.

My opinion is that AppLovin will continue operating on its own and will not pursue Unity. While the combination of the two gaming enterprises looks tempting on the surface, it could lead to further losses for shareholders. Long-term investors could use the current pricing action to lower their cost basis in Unity stock right now if their conviction remains strong.

And I think if Unity accepted a deal now, it would effectively be admitting that management is giving up. The company has seen better days and is having a rough go of it at the moment. But that doesn't mean new management can't turn things around. I would not buy the stock on speculation of a takeover, but rather on the long-term secular tailwinds of gaming and the metaverse.

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Adam Spatacco has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Netflix and Unity Software. The Motley Fool has a disclosure policy.

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