Unity (NYSE: U) | Into The Metaverse


Key Points

  • Unity is a software development company mainly serving the gaming and mobile advertising industry

  • The management has a combined total stake of 12.23%, ensuring alignment of interests between the management and shareholders

  • Revenue has grown significantly, increasing at a CQGR of 9.4% from 1Q18 to 1Q21

  • Robust gross margins of 75% and strong current ratio of 4.1

  • MAU ballooned to 3.0 billion as of 1Q21, rising by 11.1% QoQ

  • It is expanding into industries beyond gaming (E.g., Extended reality, automotive, engineering and construction), significantly expanding its total addressable market

  • Rich value proposition to stakeholders promotes positive flywheel effect

  • VR & AR advantage presents significant optionality

  • Highly scalable recurring revenue business with attractive unit economics

Company Overview

Founded in 2004, Unity Software Inc (Unity) is an American software development company. The company is the world’s leading platform for creating and operating interactive, real-time 3D (RT3D) content. The company is popular for its game development and some of the established mobile games created with Unity’s solution include Pokémon GO, Call of Duty: Mobile, Beat Saber and Cuphead. Apart from game developers, its other users range from architects to automotive designers, filmmakers and more.

Revenue Segments

Unity monetises primarily through three segments: Create Solutions, Operate Solutions and Strategic Partnerships & Other Revenue. The business segments complement one another, with the subscriptions for Create Solutions providing upsell opportunities in Operate Solutions.


Create Solutions

The Create Solutions enable creators to easily develop, edit and deploy interactive, real-time 2D and 3D content. Unity also offers professional services to larger enterprise customers, such as assisting them in creating content and applications, which are largely based on fixed-fee contracts.


Unity uses a subscription model to monetise its Create Solutions. Depending on their needs, there are various plans that the customers can choose from (See table below). These solutions are mainly targeted at customers with more than $100,000 in annual revenue or funding. Customers include developers, artists, designers, engineers and architects.



In addition, Create Solutions software enables customers to create their content once and deploy it to over 20+ platforms, eliminating the hassle of writing platform-specific codes.


Operate Solutions

Operate solutions enable customers to grow and engage their end-users and to run and monetise their content. The solutions aim to optimise end-user acquisition and operational costs while increasing the lifetime value of end-users.


Unity’s Operate Solutions have two monetisation routes - revenue-share and usage-based (See table above). Almost all of the Operate Solutions can be utilised regardless of whether the content was created with Create Solutions.


Strategic Partnerships and Other Revenue

Unity enters into strategic contracts with companies such as Apple and Google to customise software licenses to enable interoperability with these platforms. This allows Create Solutions customers to build and publish content on multiple platforms without having to write platform-specific code. For instance, Unity partnered with Google, allowing customers to publish their games on their cloud gaming platform, Google Stadia. Unity earns royalties based on the sales of its products that incorporate or use Unity’s customised software.


In addition, Unity generates other revenue from the share of sales generated from their Asset Store. The Asset Store is a marketplace and aggregator for software, content and tools used in the creation of real-time interactive games and applications.



Management

Unity was founded in 2004 by Chief Executive Officer (CEO) David Helgason, Chief Creative Officer (CCO) Nicholas Francis and Chief Technology Officer (CTO) Joachim Ante. In 2013, CCO Nicholas Francis left the company to pursue game development and in 2014, David Helgasonstepped down from his role as the CEO to be the company’s Executive Vice President in charge of strategy and communications. John Riccitiello, the former CEO of Electronic Arts, took over the role of Unity’s CEO.


Currently, Co-founder Joachim Ante has the highest ownership among the management team with a stake of 10.6%. The combined total ownership of the management is at 12.2%, ensuring that the management and shareholders’ interest are aligned.

Industry Overview


Video Games Industry

Video games are a billion-dollar business, with the global video game market size estimated to be around US$154.6 billion in 2021. According to Statista, the video game industry is projected to grow at a CAGR of 9.1% from 2021 to 2025. The video game industry is poised to benefit from the tailwinds of the pandemic restrictions, with a secular shift in trend as end-users demand home entertainment. In particular, mobile games are the most popular form of video games, making up about ~70% of the video game market. It is expected to continue thriving, growing at a CAGR of nearly 10.0% from 2021 to 2025.


Extended Reality Industry

Extended reality (XR) is an umbrella term to encompass Virtual Reality (VR), Augmented Reality (AR) and mixed reality (MR).

  • Virtual Reality - relies on a special headset to fully immerse users in a computer-simulated reality. Inside the headset, users experience an interactive virtual world through the realistic sounds and images generated.

  • Augmented Reality – relies on a device such as smartphones, using the cameras to overlay digital graphics and sounds into a real-world environment.

  • Mixed Reality – blends real and digital worlds, creating an environment where physical and digital elements can interact in real-time.

Boston Consulting Group and Mordor Intelligence reported that the XR market is predicted to be approximately US$30.7 billion in 2021 and projected to balloon to US$296.9 billion in 2024, growing at an impressive CAGR of 113.1%.


Mobile Advertising

The mobile advertising industry has grown exponentially due to the mass adoption of smartphones, improvements in technology and effectiveness of mobile advertising. With nearly half of the entire population owning a smartphone, this makes mobile advertising a preferred form of expanding audience reach. The global mobile advertising market is forecasted to swell to US$24.8 billion dollars in 2022.



Competitors

According to Unity, the company’s game engine primarily competes against proprietary game engines built-in-house by large game studios, Unreal Engine (Epic Games) and Cocos2d (Chukong Technologies). Epic Games could be considered its biggest competitor as they are both serving similar industries (PC Games, mobile games and industries beyond gaming).


DeltaDNA, a subsidiary of Unity, conducted a study in 2020 surveying a broad range of game developers to find out the trends of the mobile gaming industry. From the chart above, it is evident that Unity game engine is the preferred software to develop mobile games, commanding a significant share of 61.0% among the respondents.


As for the mobile advertising industry, Unity competes mainly against Google Admob, Facebook Audience Network and AdColony.


Unity’s mobile advertising platform is the second most preferred provider, having a share of 34.0% among the respondents. This demonstrates the strength of its platform, trumping Facebook Audience network share of 23.0% and not far behind Google Admob share of 42.0%.

Financial Highlights


Revenue


Unity’s revenue has been consistently growing over the years, clocking a figure of US$234.8 million in 1Q21, representing a growth of 9.4% CQGR from 1Q18 to 1Q21.


The Create Solutions segment has been growing at a CQGR of 8.8% over the past 12 quarters. Growth took a hit in 1Q20 as pandemic restrictions hindered sales cycles, resulting in segment revenue slowing down by 2.8% QoQ to US$46.7 million. However, the impact was short-lived and 2Q20 Create Solutions revenue rose by 18.0% QoQ to US$55.1 million and has been growing steadily since.


The Operate Solutions segment has been growing at a CQGR of 11.3% over the past 12 quarters. Unlike the Create Solutions segment, COVID-19 provided tailwinds for the Operate Solutions segment as end-users engaged more with Unity-built games, resulting in revenue uplift from heightened ad spend and usage-based services.



Operate Solutions contributes the most to the revenue, ostensibly due to the effective monetisation of its huge 3 billion-strong end-user base.



Profitability

Unity’s gross margins have been consistently strong, hovering at around 75.0% ~ 80.0% from 1Q18 to 1Q21. In spite of the healthy gross margins, the company is still operating at a net loss mainly due to elevated spending on Sales and Marketing (S&M) as well as Research and Development (R&D)


R&D and G&A spiked in 3Q20 mainly due to the restricted stock unit expense recognition associated with the IPO, as well as a one-time charge related to the charity donation of 750,000 shares of common stock. Since then, R&D and G&A margins have slightly recovered but dipped again in 1Q21. This dip was primarily influenced by the increased expenses due to vesting of the Restricted Stock Units coupled with the expanding headcount. Moving forward, operating expenses are likely to remain volatile as they are still in a high-growth stage.



Liquidity Ratio



Unity’s current ratio has been generally healthy, standing at 4.1 as of 31 Dec 2020. The ratio went down from 1.7 in FY18 to 1.0 in FY19 as they are currently still in the growth stage, heavily acquiring customers and expanding the team, resulting in negative operating cash flows for both years. In FY20, Unity completed its IPO, which resulted in an injection of cash that lifted the current ratio to 4.1. With a current ratio of 4.1, this should enable the sustainability of its cash position for the near future.



Cash Flow

Unity’s operating cash flow has been on an uptrend since FY18, turning positive in FY20. The negative operating cash flow in FY18 and FY19 was largely attributable to the huge net loss incurred. In FY20, the positive operating cash flow was primarily influenced by the stock-based compensation and a one-off stock donation expense, which were given out during their IPO.

Investment Thesis


Thesis 1: Strong value proposition to stakeholders promotes positive flywheel effect

Network effects continue to expand customer base

Unity boasts a large community of approximately 1.5 million monthly active creators that developed over 8,000 games and applications per month for its fiscal year 2020. Furthermore, the creators are highly engaged, spending about an average of 5.2 hours per day using the platform.


Unity’s platform is able to attract creators to use their Create Solutions due to its value proposition of convenience, cost and time savings. The platform enables customers to create their content once and deploy it to over 20+ platforms. Going back to around 5 years ago, there were not many good engines available to develop AA or AAA games, resulting in gaming studios building their in-house proprietary engine. As stated by Unity’s CEO John Riccitiello, it could take years for the studio to create their game engine and games, and often result in a negative return on investment for most developers to build their own technology. That being said, Unity provides developers with the tools needed to create gameplay and to deploy the games and content across multiple platforms without having the need to write platform-specific code. Hence, Unity’s software is able to save money and time for developers.


Expanding creators through acquiring small businesses, students and hobbyists

Additionally, Unity is expanding its creator base by acquiring small businesses, students and hobbyists by giving them the license for free. As long as the entities have less than US$100,000.0 of revenue or funds raised in the prior 12 months, they are eligible to use the Unity Personal/Unity Student solution. This benefits Unity as more consumers will be accustomed to Unity’s Create Solutions and over time, customers might upgrade to its paid products and services, generating revenue for the company. Additionally, this enhances Unity’s product stickiness as there is a considerable learning curve to game engines. Apart from that, the free users also serve as ambassadors for the company by creating word-of-mouth advertising for its products and services.


Companies incentivised to partner with Unity

With a large number of active creators on the platform, companies are incentivised to partner up with Unity, allowing creators to deploy their games onto the partnering companies’ platform. This benefits the partnering companies as they are now able to offer more content, which in turn attracts more end-users. For instance, Google launched the Stadia Makers program to attract more indie developers to publish their games on their cloud gaming platform. Hence, by onboarding more third-party platforms, it helps Unity to maximise its audience reach for the customers and retain the platform’s position as the leading hub for real-time 3D content creation.


Wide selection of games to grow and engage end-users

As of 4Q20, applications built with Unity were downloaded on average 5.0 billion times per month, up 41% YoY. Furthermore, games made with Unity accounted for 71.0% of the top 1,000 mobile games in the same period. With such a high demand for the games, it is to no surprise that Unity has approximately 3.0 billion monthly active users. This speaks volumes of its engagement levels, with Unity’s MAU almost 7x that of Activision Blizzard’s (One of the largest gaming companies) MAU of 435.0 million.


With more companies and partners onboard, Unity’s large pool of end-users are able to enjoy a larger selection of games and entertainment across multiple platforms, captivating the end-users under Unity’s ecosystem.


Extensive data analytics delivers value to both customers and end-users

Having a large MAU allows for comprehensive data analytics. As reported in their 1Q21 earnings call, Unity captures and analyses over 50.0 billion in-app events each day, which is about 35.0 million in-app events every minute across 20+ platforms. This extensive data and analytics capability allows customers to optimise content performance, end-user acquisition, engagement and monetisation based on the projected lifetime values of end-users, delivering value for both customers and end-users.


Hence, the network effect fortifies their moat through broadening the number of partnering companies and creators, which in turn drives more engagement leading to a higher number of MAU. Consequently, this could possibly lead to higher revenue growth for Unity if management continues to deliver value to its stakeholders.



Thesis 2: VR / AR advantage presents significant optionality


As outlined in the industry overview, the extended reality market is forecasted to balloon to US$296.9 billion in 2024, growing at an impressive CAGR of 113.1%. The pandemic restrictions are likely to continue fuelling demand for home entertainment, supplying tailwinds to the extended reality industry. Unity is well-positioned to dominate the extended reality space as Unity’s game engine is the top choice for several companies. Below are some statistics to prove that:

With strong XR capabilities, Unity could possibly expand into the following industries:


Marketing products in the e-commerce industry

E-commerce platforms could utilise AR technologies built with Unity to allow consumers to try on the products through a mobile application. For example, consumers could preview the furniture to see how it would look in their living room. This expands audience reach, increases customer engagement and reduces returns. A case in point would be Nike’s mobile AR application, in which consumers could visualise how the footwear would fit them.


Extended Reality metaverse content

Metaverse refers to an alternate reality universe and the term is typically used to describe the concept of future iterations of the internet, which consist of virtual experiences and environments.


Games that utilises the metaverse concepts had enormous success:

As seen by the large potential of metaverse, Unity could possibly be the preferred game engine to develop XR metaverse games.


Immersive home fitness experience in VR

The pandemic has caused a surge in demand for home fitness products, as consumers seek alternative ways to exercise during the stay-home restrictions. Connected fitness products, which combine technology and traditional fitness equipment, have been widely successful as they provide an entertaining workout experience (E.g., Peloton).


A study conducted by Brunel University London revealed that VR technology could enhance the exercise experience, making the workouts more enjoyable for the user. A case in point would be a VR application developed by FitXR, a company that develops VR fitness content for sports such as Boxing, Dancing and High-Intensity Interval Training (HIIT). FitXR was built on Unity’s platform, and its VR app received a favourable rating of 4 out of 5 stars from AndroidCentral due to its immersive experience. This shows that Unity’s platform is capable of building VR-enabled fitness applications and thus, connected fitness companies could also build VR content using Unity’s software.


Therefore, Unity is in an advantageous position to dominate the XR market and could significantly expand its TAM due to the many different use cases of its XR capabilities.



Thesis 3: Highly scalable recurring revenue business with attractive unit economics


Besides harnessing network effects and having a long growth runway, Unity’s business segments are synergistic and allow for scalable value capture within its ecosystem.


Robust customer pipeline with strong brand loyalty

Unity boasts >800 customers contributing >US$100,000 in revenue. This figure climbed from 389 customers in 1Q18 to 837 in 1Q21 (6.6% CQGR). These power users boast a 99.0% retention rate, indicating that once customers commit to big-ticket purchases, they seldom churn.


In addition, there were ~100,000 non-paying customers subscribed to its Create Solutions. I opine that these are smaller-scale game developing houses or hobbyists who have not reached the US$100,000 revenue mark where they need to purchase a paid plan. Even though these users do not presently contribute to Unity’s revenue, having a large community of Unity developers does have its merits. Given the sticky nature of Unity’s larger customers, I speculate that a large portion of this pool of non-paying customers might convert to Unity’s paid plans should their game development endeavours become successful. As a result, this might keep Unity’s future customer acquisition costs low.


Ecosystem lock-in with proven upselling track record

Create Solutions drive adoption for Operate Solutions since Operate Solutions allow game developers to further monetise their offerings through ads and in-app purchases. According to management, 64% of 1H20 Operate Solutions revenue from customers with >US$100,000 in annual revenue came from customers who were subscribed to Create Solutions.


Moreover, Unity’s dollar-based net expansion rate (DBNER) has been well above 120.0% over the past three years. Since the start of FY19, DBNER has been on a consistent uptrend, signifying management's ability to expand the wallet share of current customers. In my opinion, this could come from sources such as a) expanding the number of seats in large game studios b) promoting the use of Operate Solutions to monetise games.


These data points indicate that acquiring customers would be highly value-accretive for Unity given that the company is able to extend its customer lifetime value through low churn rates and a strong value proposition for upsold solutions.


Risks


1. IDFA Changes

Identifier for Advertisers (IDFA) is a unique identifier for mobile devices and is used to target and measure the effectiveness of advertising on a user level across mobile devices. In Jun 2020, Apple announced that iOS14 users now have the choice to block the IDFA identifier at the app level which would negatively impact advertisers’ ability to target specific users, which might affect the return on advertising spend and hence advertising revenue.


Even though Unity has guided that the company will be facing approximately US$30.0 million of headwind related to the Apple IDFA changes, this makes up only 3.0% of its FY21 revenue guidance of US$1.0 billion. Moreover, the company has been actively preparing for the changes for at least the last two years by leveraging its access to large amounts of data. This data advantage enables them to shift their advertising business to ROI-based campaigns through the Audience Pinpointer software which aims to maximise advertiser-set KPIs. Notably, this new model does not rely on the usage of IDFA, which would partially negate the impacts of IDFA.


Should Unity be successful in maintaining high returns on advertising spend for advertisers through various measures, they should continue to maintain their dominance in mobile ads.


2. Execution risk

While Unity is doing well in the gaming space, the company might not be able to effectively penetrate the other markets beyond gaming.