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Unity Software Inc(U-N)

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3 Must-Have Tech Stocks for the Upcoming Bull Market Surge

Motley Fool - Sun Nov 19, 2023

In an economic landscape dominated by two years of soaring inflation and rising interest rates, smart investors are looking for robust businesses with promising growth opportunities. Here, three of The Fool's top tech experts are bringing you excellent innovators with bulletproof business models, poised to thrive when the next bull run starts. It's hard to say exactly when the next upturn will come, but every storm is eventually followed by sunshine -- even on Wall Street.

Cadence Design Systems(NASDAQ: CDNS) stands at the forefront of semiconductor software innovation, Universal Display(NASDAQ: OLED) exemplifies financial health and technological advancement in OLED technologies, and Unity Software(NYSE: U) is poised for a majestic turnaround story.

This chip design software company sees accelerating growth

Billy Duberstein(Cadence Design Systems): In the prior low-interest-rate environment, cloud-based software companies thrived. That's because they were seeing consistent growth, and while their stocks looked expensive, a lower-rate environment helped raise the value of profits far out in the future. So if rates, fall, software companies may rise again.

Cadence Design Systems is a unique type of software company, as one of only two large software makers that dominate the electronic design automation space for semiconductor companies.

As many have learned this year, semiconductor innovation is taking off, especially because of the rise of artificial intelligence and ChatGPT. And artificial-intelligence chips are only growing more complex, with new transistor structures, "chiplet" architectures, and new types of packaging techniques. More chip complexity, along with more and more players entering chip design, such as large cloud computing giants designing their own in-house accelerators, along with a dearth of engineering talent to go around, all play into the hands of Cadence.

Cadence's software suite for chip and system design automation, simulation, and verification helps engineers design chips faster and more accurately than ever before. In addition, Cadence also owns several IP chip "blocks" that designers can fold into their chip designs for a license fee. Cadence also has some hardware testing products, but around 85% of its revenue is recurring, making it very close to a pure software company.

Not only does Cadence's software enable designers to make AI chips, but Cadence itself is now incorporating generative AI into its software itself, helping to speed up and suggest new designs to meet new and evolving specifications.

Revenue has accelerated as Cadence maintains and expands with key AI customers such as Nvidia(NASDAQ: NVDA), Tesla, and Broadcom. Of note, Nvidia just announced it will be speeding up its cadence of new architecture releases from two years to one year. One can be sure Cadence's software has a lot to do with that.

The growth of semiconductors, their importance, and Cadence's importance to the ecosystem are all increasing, which is why Cadence has managed to not just grow but accelerate. In 2017, Cadence's growth rate was 7%, but that growth accelerated to a 19% rate in 2022. For 2023, the company estimates a healthy 15% growth rate. Moreover, Cadence is highly profitable, with an adjusted (non-GAAP) operating margin of 42%, with incremental operating margin of 50%. So as it grows, more should flow to the bottom line.

Of course, Cadence doesn't look particularly cheap, at around 45 times next year's earnings estimates. However, if long-term interest rates drop, that would certainly lift high-growth stocks that can grow or accelerate through any type of slowdown. In that sense, Cadence fits the bill as a great long-term compounder, even at these levels.

An interim CEO's swift turnaround strategy

Anders Bylund (Unity Software): In the ever-evolving world of technology, few companies stand out as both innovators and survivors. Unity Software is one such company, demonstrating flexibility and potential for significant growth as we anticipate the next bull market.

Unity, best known for its game engine that powers over half of the world's mobile, console, and PC games, has faced its share of challenges recently. The company's stock took a hit following a controversial policy update and a leadership transition. However, these setbacks may have set the stage for a strong comeback, especially under the guidance of interim CEO Jim Whitehurst.

Whitehurst is a respected industry figure with a proven track record at open-source software vendor Red Hat and household name IBM. He brings a wealth of relevant experience and a clear vision for Unity's future. In a recent earnings call, he emphasized the need for swift and decisive action.

"I want zero incentive for anybody here to slow anything down. We need to move and we need to move fast. And the faster we move, the better shape we are," Whitehurst said. "I think we're sandbagging when we say by the end of Q1. I'm hoping we can do it a lot faster than that."

This high-speed approach is crucial for Unity as it navigates current challenges and positions itself for future growth. The company will wind down some underperforming operations, revamp the C-suite, and look like a very different business in the end. But as long as Jim Whitehurst is calling the shots, I'm confident that these heavy changes are all for the best.

Financially, Unity's fundamentals remain strong. Despite not yet achieving GAAP profitability, the company has shown impressive growth, with a top-line compound annual growth rate (CAGR) of 38.5% over the past five years. Moreover, Unity's adjusted EBITDA margins have recently turned positive, indicating improving financial health.

Unity's diversification beyond gaming into augmented and virtual reality markets is another reason for optimism. As these technologies gain traction, Unity's expertise and established platform position it to capitalize on these emerging opportunities.

The company's valuation also suggests potential for growth. The stock has traded sideways all year long, posting a gain of just 1% in 2023. With a forward P/E ratio of 27.2 and a P/S ratio of 5.4, Unity's stock appears reasonably priced, especially considering its growth trajectory and market position.

In summary, Unity Software's current position might seem precarious to some, but it's precisely these moments of transition that often precede significant growth. With a seasoned leader like Whitehurst at the helm, a robust business model, and a foothold in burgeoning tech sectors, Unity is not just weathering the storm -- it's preparing to sail ahead when the market winds shift favorably

Investors looking for a tech stock with potential for substantial returns in the next bull run should absolutely consider Unity Software. Some turnaround stories work out in the end, especially when a management genius like Jim Whitehurst is involved.

Now let me get back to crossing my fingers, toes, and earlobes -- hoping for Whitehurst's interim title to turn permanent.

A new year is coming, and newer and better displays are coming with it

Nicholas Rossolillo (Universal Display): Shares of Universal Display have been on a roll this year. The stock is up 44% over the last 12-month stretch, rebounding from the toll the bear market of 2022 took on it.

This may come as a surprise, though. After all, the patent holder on organic light-emitting-diode (OLED) displays and supplier of base materials relies on smartphone sales -- and specifically high-end smartphones -- for the bulk of its revenue. Perhaps you've heard. There's been a deep downturn for consumer electronics sales in 2023, smartphones included. How's Universal Display pulling off its market outperformance?

It all has to do with the manufacturing business cycle, and specifically investors eyeing an upswing in smartphone purchasing activity in 2024. OLED TV adoption also continues to steadily rise as the price tag on those high-end TVs gradually becomes more affordable. And as the new year gets rolling, Universal Display has been talking about all of the PC and laptop makers that are (finally) beginning to offer an OLED display option. This could be just in time for the next upcycle in PC market sales too, joining the flagging smartphone industry in a possible rebound.

Universal Display is also readying its newest base material for the OLED market, blue phosphorescent emitters, which will join its current red, yellow, and green phosphorescent emitters. This could lead to a new, and sizable, revenue stream in 2024 after years of research and development.

Management has not provided initial guidance for 2024 just yet, but it's been hinting that a return to growth -- and all-time high sales -- could be right around the corner. In the meantime, the stock does trade for a premium 38 times trailing-12-month earnings per share. However, that includes some muted financial results in the last year. I'm a happy Universal Display shareholder and might nibble a bit more of this top growth tech stock as 2024 gets rolling.

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Anders Bylund has positions in International Business Machines, Nvidia, and Universal Display. Billy Duberstein has positions in Broadcom. His clients may own shares of the companies mentioned. Nicholas Rossolillo has positions in Broadcom, Cadence Design Systems, Nvidia, Tesla, and Universal Display. The Motley Fool has positions in and recommends Cadence Design Systems, Nvidia, Tesla, and Unity Software. The Motley Fool recommends Broadcom, International Business Machines, and Universal Display. The Motley Fool has a disclosure policy.

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