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Adobe (NASDAQ: ADBE) and Unity (NYSE: U) might initially seem like two very different types of software companies. Adobe develops a wide range of cloud-based design, document, and enterprise software, while Unity mainly provides development and monetization tools for game developers.

However, Unity has been gradually expanding into Adobe’s backyard with VR and AR development tools, “digital twin” tools for scanning real-world objects, and theatrical special effects with its acquisition of Weta Digital. That expansion could eventually make Unity a more diversified provider of cloud-based digital design tools like Adobe.A person works on design software.

Image source: Getty Images.

Both stocks hit their all-time highs last November, but subsequently crashed as rising interest rates drove investors away from pricier growth stocks. Adobe’s stock has plunged nearly 60%, while Unity’s stock has fallen over 80%. Should investors consider either of these out-of-favor software stocks to be a turnaround play?

What happened to Adobe?

Adobe’s revenue rose 23% to $15.8 billion in 2021, while its adjusted earnings per share (EPS) increased 24%. But this year analysts expect its revenue and adjusted EPS to grow just 12% and 9%, respectively. That deceleration was mainly caused by slower enterprise spending in the current macro environment and exacerbated by currency headwinds.

That slowdown wasn’t surprising, but Adobe recently stunned investors with its decision to buy Figma, a design start-up that competes against Adobe XD in the user interface (UI) and user experience (UX) markets, for $20 billion — or 50 times the $400 million in annual recurring revenue (ARR) the company is expected to generate this year. Adobe’s decision to fund half of the deal in stock could also dilute its existing shares by 7% and offset a large portion of its previous buybacks.

It makes sense for Adobe to take out a rapidly growing competitor, but the price seems far too high. To make matters worse, Adobe expects the deal to be dilutive to its EPS in the first two years before becoming accretive in the third year.

Adobe’s stock looks reasonably valued at 19 times forward earnings and eight times this year’s sales. However, those valuations are still tethered to outdated estimates that don’t fully factor in its surprising takeover of Figma, which should close in 2023. For now, analysts expect Adobe’s revenue and adjusted EPS to grow 13% and 15%, respectively, in 2023.

What happened to Unity?

Unity’s revenue rose 44% to $1.1 billion in 2021, but it remained unprofitable by both GAAP (generally accepted accounting principles) and non-GAAP measures. However, analysts expect its revenue to rise just 22% this year as it grapples with three main headwinds.

First, Unity Ads, one of the core components of its Operate Solutions segment, suffered a severe slowdown after ingesting “bad data” that rendered many of its in-game ads useless. Unity didn’t directly name Apple (NASDAQ: AAPL) as the culprit, but the tech giant’s iOS update — which enabled users to opt-out of targeted ads — likely caused that meltdown.

To rectify that issue, Unity has been rebuilding its entire advertising algorithm. It also agreed to acquire the controversial ad tech company ironSource (NYSE: IS) for $4.4 billion to accelerate that transformation. That move prompted ironSource’s rival AppLovin (NASDAQ: APP) to try to buy Unity for about $58.85 per share — a deal that Unity eventually rejected.

Second, the growth of the broader advertising market has cooled off amid the recent macro headwinds. Therefore, even if Unity successfully reboots Unity Ads, its near-term growth rates could remain tepid. Lastly, the growth of the broader video game market, which drives developers to its core game engine, has decelerated in a post-pandemic market.

Unity’s stock now trades at a 33% discount to its IPO price, but it still isn’t particularly cheap at eight times this year’s sales.

Adobe is still the safer investment

Adobe’s slowing growth and takeover of Figma have disappointed investors, but it’s still a more stable investment than Unity right now. Adobe merely needs to weather the cyclical headwinds and successfully integrate Figma to silence the bears, but Unity is still trying to rebuild a key growth engine while its core gaming and ad markets cool off.

Unity also faces more direct competitors, including Epic Games’ Unreal Engine, as Adobe comfortably dominates the creative design software field with its Photoshop, Illustrator, and Premiere Pro services. More importantly, Adobe should remain firmly profitable as Unity continues to bleed red ink in this unforgiving market for unprofitable growth stocks.

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Leo Sun has positions in Adobe Inc., Apple, and Unity Software Inc. The Motley Fool has positions in and recommends Adobe Inc., Apple, and Unity Software Inc. The Motley Fool recommends the following options: long January 2024 $420 calls on Adobe Inc., long March 2023 $120 calls on Apple, short January 2024 $430 calls on Adobe Inc., and short March 2023 $130 calls on Apple. The Motley Fool has a disclosure policy.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


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