Is ironSource Stock A Buy After Unity Software Acquisition Announcement?

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AsiaVision

On July 13th, ironSource (NYSE:IS) announced that it was being acquired by Unity (NYSE:U) for $4.4 billion in an all-stock transaction. The deal came after both stocks crashed amidst a generational weakness in the broader tech sector. In this report I discuss how IS shareholders should view the deal and whether the stock is still a buy ahead of the closing of the acquisition. While the stock prices might not reflect it, IS (and U for that matter) remain secular growth stories priced at compelling valuations.

IS Stock Price

IS peaked above $13 per share just prior to the tech crash. The stock bottomed at $2.20 per share, basically right before the acquisition announcement.

Data by YCharts

The stock has since run-up to around $3.70 per share as investors have sought to take advantage of the takeover premium. There still remains some arbitrage upside left even with the stock up over 70% from the lows.

IS Stock Key Metrics

In its latest quarter, IS showed 58% top-line growth.

2022 Q1 Presentation

Most of that growth came from an impressively strong dollar-based net expansion rate of 153%.

2022 Q1 Presentation

While IS is a former SPAC and its plunging stock price is not too dissimilar from other de-SPACs, it has differentiated itself from other SPACs through its resilient growth rate as well as its solid profit margins. Adjusted EBITDA stood at 31% of revenues in the latest quarter. I note that the company has $441 million of net cash on its balance sheet and has minimal capital expenditure requirements, making adjusted EBITDA a more reliable metric (indeed the company did generate positive GAAP net income).

2022 Q1 Presentation

For the year, IS had previously guided for up to 41% revenue growth and 32% adjusted EBITDA margins.

2022 Q1 Presentation

While IS stock plunged hard amidst the crash, its fundamentals remained strong – that is why it was one of the stocks named in my Tech Stock Crash List provided for subscribers.

When Is Unity Software Acquiring ironSource?

U announced the acquisition on July 13th and stated that it expects the acquisition to close in the 4th quarter.

How Will The Acquisition Impact IS And U Stock?

IS helps immediately fix U’s problem: monetization. U had previously lowered its guidance due to issues with monetizing ads. This marriage combines a leader in development with a leader in monetization.

Unity-ironSource Transaction Presentation

We can see below that this deal has few overlaps and adds much functionality for U – I don’t see significant risk of regulatory intervention here.

Unity-ironSource Transaction Presentation

The deal calls for every share of IS to receive 0.1089 shares of U. At the time, it reflected a 70+% premium to where IS traded prior to the deal. At present, there remains around a 5% arbitrage spread (that is the potential excess return you could earn by owning IS over U). It is possible that the spread widens in the event of volatility, but due to the low regulatory risk, I wouldn’t hold my breath.

Unity-ironSource Transaction Presentation

At the $4.4 billion purchase price, U would be acquiring IS at 7.1x trailing sales and 21x trailing adjusted EBITDA – rather discounted multiples for a profitable company growing at a 30+% clip.

Unity-ironSource Transaction Presentation

Some IS shareholders have voiced their disappointment. Indeed, with the stock down 70% since it came public via SPAC, perhaps some IS shareholders felt almost betrayed by management. But one must always take the broader market into context here. In this case that isn’t hard – U stock itself is down even more than IS.

Data by YCharts

Sure, IS is cheaper here than U on an EBITDA multiple basis, but U isn’t more expensive on a price to sales basis. U is trading at only 7x sales in spite of having a 30+% growth engine over the long term. For IS shareholders, this transaction may be dilutive from a valuation perspective but on the other hand, U is more likely to get a premium multiple – so this is also a trade up on a risk-reward perspective. Considering that, I’d actually call the transaction to be highly successful for IS shareholders.

What Is ironSource’s Outlook After The Acquisition?

While U reduced its full-year revenue outlook from $1,350-$1,425 million to $1,300-$1,350 million, IS reaffirmed its prior outlook. Consensus estimates call for the company to achieve the midpoint of revenue guidance.

Seeking Alpha

While both companies have strong growth outlooks, U has the ability to sustain elevated growth rates for longer, as shown below in Unity consensus estimates.

Seeking Alpha

Assuming the deal goes through, the outlook for U will end up being the outlook for IS – I assume that their combination can lead to even stronger future results. Indeed, U has given guidance for $1 billion of adjusted EBITDA by 2024. That would imply significant synergies and operational leverage, as IS is on track to generate $240 million in adjusted EBITDA this year and U has guided for breakeven EBITDA this year.

Is IS Stock A Buy, Sell, or Hold?

The answer to that question depends on one’s views of both IS and U stock. If one is only interested in the 4% to 5% arbitrage spread, then my view is that IS stock is not a buy because the arbitrage spread is not big enough. I view IS stock as buyable for those who want to own IS and also want to own U. That view is not difficult to understand considering the compelling valuations that both stocks trade at today. Without the deal, I consider IS to be quite undervalued at only 5.5x sales. Assuming 30% long term net margins and a 1.5x price to earnings growth ratio (‘PEG ratio’), I could see IS trading at 11x sales, representing a stock price of $9.40 per share or 156% potential upside. Assuming the deal goes through, the combined company would have 474 million shares outstanding and trade at around a $17.1 billion market cap. Based on $2.13 billion in projected 2022 revenues, the combined entity trades at 8x sales. I could see the company sustaining 30% growth, achieving a 30% long term net margin profile and trading at a 1.5x PEG ratio. That would place the stock at 13.5x sales or a stock price of $78 per share, representing 118% potential upside over the next 12 months. What are key risks here? Both companies have solid balance sheets. But these kinds of acquisitions always carry execution risk which should not be underestimated. Furthermore, the ongoing market uncertainty appears to be hitting U quite hard in the near term as the company has already reduced guidance twice in a span of a quarter. I expect investments in both IS or U to require long-term holding periods with sizable volatility in the interim. U’s valuation has held up largely due to management’s guidance for 30% growth over the long term. If management backtracks on that guidance, then I can see the valuation declining to around 6x sales, presenting at least 25% potential downside. I remain bullish in the long term outlook for both companies, leading me to rate IS a buy at current prices.