ironSource Sells Out To Unity

Investment Thesis

ironSource (NYSE:IS) is selling itself out to Unity (NYSE:U) at a price that is not favorable to shareholders – except for those who by chance bought at the absolute bottom. Since ironSource is a highly profitable company that is growing faster than Unity and had made acquisitions of its own to bolster its addressable market, the company actually didn’t even need to merge with Unity, especially not for such an unfavorable price. Unity has gotten a great deal.

Analysis: Unity Gets a Bargain

After over half a year of continued declines, it was initially nice to see a decent pop in my portfolio, so I went to Seeking Alpha to see which stocks were rising. It turned out ironSource was up by about 50%. So far so good, so I went to the news section to see what caused the pop.

Now, this is where the fun ended. I have written about ironSource before, and in the last months, it has become one of the biggest pieces of my portfolio due to its combination of very high growth, strong profitability and a rock bottom valuation of about 3x P/S (before the pop). I envisioned this could become a 10-bagger eventually.

Instead, it turned out ironSource was merging with Unity for a price below my DCA: every IS share will convert to slightly less than 11% of a Unity share. The 18% Unity drop that followed due to its own weak quarterly report and this merger (dilution) announcement certainly didn’t help.

For those who haven’t followed Unity recently, the gist is that Unity dropped earlier this year due to a severely underperforming quarter and reduced guidance. The cause was basically an engineering errata in the training/data of one of its products. Unity said that it was fixing this and didn’t expect any long-term effects beyond 2022.

As such, arguably one could propose that Unity could be a buy due to this near-term issue that should not impact its long-term growth trajectory. As a reminder, Unity has guided to 30% long-term growth, and even after the reduced 2022 guidance, Unity will still meet this guidance this year.

However, the issue here is that Unity had been an expensive stock at basically any point since its IPO, so the decline since the Q1 report doesn’t necessarily make the stock very cheap now. For example, taking 11% of $100, roughly at or even below Unity’s average price before the April 2022 crash, then the same agreement would have yielded an ironSource valuation of $11 per share, which at least would have brought ironSource’ valuation back to where it started after the SPAC.

Of course, this is just speculation since if either Unity’s or ironSource’ share price/valuation would have been different, then so may have been the merger terms. In any case, given that ironSource was trading around its all-time low price, over 80% below its all-time high (and while at those double-digit stock prices ironSource wasn’t exactly cheap, it was still quite less expensive than Unity), Unity is certainly getting an absolute bargain.

In other words, Unity shareholders have absolutely no reason not to welcome this deal, as this merger extends Unity’s portfolio with a high growth, scaled business in addition to ironSource’s profitability, which Unity lacks.

Conversely, though, ironSource shareholders are objectively getting an unattractive deal (see valuation comparison below). Perhaps the only glimmer here is the Unity stock crash. Just imagine if instead of taking the ~0.11x conversion ratio as “ground truth”, Unity had bought ironSource for ~$4B while its own stock was still above $100 (which it may have been if it wasn’t for the aforementioned engineering blunder). This would have implied a much smaller conversion ratio, which means ironSource shareholders would have owned a much smaller piece of Unity after the merger, which means ironSource shareholders would have gotten an even worse deal. (Since in that case after the merger IS shareholders would have owned U shares valued at ~$100, which leaves less upside for appreciation than in the current case where shareholders will get U shares valued at ~$32, which may or may not at some point go back to $100.)

Put differently, Unity is buying ironSource for 3-4x less than the stock’s ATH. On the other hand, Unity itself is currently also 3-4x below its previous trading range (and even more from its all-time high). So from that view, one could argue that perhaps the deal is simply neutral for ironSource shareholders, since both stocks have similarly collapsed from their highs. In other words, if Unity does go back to $100 or so per share, at some point, then for current ironSource shareholders this would be equivalent to their original IS stock going back to $11 per share (ignoring dilution). At $150, the ironSource part of the business would be valued at $16.5 per IS share, and at $200, which is around Unity’s ATH (although the stock was there only very briefly), ironSource would be valued at $22. This would, indeed, turn ironSource into the 10-bagger that I imagined the stock could become.

However, the above reasoning is flawed for two reasons. First, Unity will print new shares to realize the merger, which means both companies’ shareholders are getting diluted. Unity did promise a $2.5B buyback, but to execute this Unity needs to raise (convertible) debt, and it still doesn’t fully offset the $3-4B dilution, which compares to Unity’s $10B market cap currently. More on this in the thread below:

Secondly, and most importantly, the reasoning is flawed because there is always a ground truth called valuation. The fact of the matter is that with a ~$3.5B market cap, ironSource is being valued at ~4.5x P/S. Meanwhile, even after Unity’s decline, it is still valued at 7x P/S. In other words, even after the ironSource pop and Unity drop, there is still a large discrepancy in valuation. Hence, on a P/S basis, ironSource shareholders will see their cheap shares getting converted into much less cheap Unity shares.

Put differently, the discrepancy in valuation acts as an additional form of dilution for ironSource shareholders. It is as if as a shareholder you wake one day and suddenly ironSource announces that it has issued 60% more shares: nothing about the business has changed, but one share is suddenly worth 1.6x less. That is effectively what ironSource has done here.

This discrepancy is in Unity’s favor since Unity is buying a company with a (much) lower P/S multiple than its own valuation. However, arguably the only reason this discrepancy exists is because Unity is a quite well-known name (similar to Cloudflare (NET)), whereas ironSource is not. On all other (objective) metrics, Unity simply trails ironSource as a company: it has lower growth, no profitability and its standalone valuation is more expensive.

As an aside, it has often been said that in the current macro environment profitability is important, but ironSource had declined to an incredibly cheap valuation despite its profitability. Again, Unity is getting a real bargain here.

Investor Takeaway

I do not personally believe the ironSource board has acted in the best interests of its shareholders by merging itself with a company that has a considerably higher valuation, despite that the company it is merging with also has a lower growth as well as nonexistent profitability. It simply makes no sense for ironSource to sell itself to Unity for so much less than Unity’s own valuation. In other words, ironSource should have been valued (at least) at a similar P/S ratio, which would have translated into a ~$6 share price: that is the absolute minimum that ironSource’ board should have agreed to in my opinion.

This fundamental discrepancy in valuation means that, in any case, ironSource shareholders are seeing their shares lose ~1.6x of their P/S valuation. Most shareholders, except for the few who were lucky enough to buy the absolute bottom, will likely not be getting a positive return from their original IS share purchases.

Given ironSource’ standalone strong business characteristics, the company could likely by itself have returned at least back to its post-SPAC price, simply by continuing to grow over time, and likely with expanded P/S and P/E multiples over time as investors would eventually have warmed up again to growth names in the aftermath of the inflation and recession concerns. In that regard, it should be stressed that given ironSource’ profitability, the company had absolutely no reason at all to sell itself out. Instead, after the merger pop, the stock is still over 3x below its ATH.

The only solace here is that Unity itself had already dropped considerably – the additional 18% drop more or less offsets the stock dilution, or even more than that given the announced $2.5B stock buyback. This means that shareholders who make the jump to Unity – which at the current price could certainly be a compelling investment in its own right – could still aspire for their Unity stock to appreciate back to a triple-digit price perhaps, in which case they might end up with roughly a 5-bagger (or more) from where ironSource was before the merger was announced.