Executive Summary

Unity (U) is a game engine platform that has greater than 50% market share in all mobile games across IOS and Android. It also is a leader in VR and AR game development with greater than 60% market share. Given the potential to transition into other industries (engineering, film making, and art) along with the growth of XR, Unity is poised to ride the generation of interactive 3D platforms.

Background

Unity is a game development platform that assists developers in creating primarily mobile games that started back in 2005. U’s bread and butter is in mobile gaming. This industry has been growing at around 15% CAGR (by revenue) and makes up about half of all gaming revenues including PC and console. For 2020, mobile gaming revenue will be almost 80B. About 85% of this is from In App Purchasing and the other 15% is from in game advertising (this was found by examining game publishers’ financial statements such as Zynga (NASDAQ:ZNGA) and Glu Mobile’s (NASDAQ:GLUU)). Unity currently dominates the mobile space as their engine is convenient to use and the games developed are not processor intensive. Their ecosystem is also far vaster than any of their competitors giving it a significant moat. Ecosystem here means developer threads and assets being sold on their marketplace. Unity has 5x more assets and more article citations than their closest competitor. This is especially critical for new fields such as VR and AR as it “seeds” the environment and feeds on itself. New developers looking to create games will pick software that has significant community engagement as it makes their job significantly easier. The job market for unity developers is far vaster along with their academic reach. Safe to say, Unity is dominating the mobile gaming industry.

Unity has two segments – Create and Operate Solutions. Create Solutions is a subscription service to use their software to create games. Unity has their subscriptions priced per “seat” depending on how much revenue one is generating. The greater your gaming revenue, the more you pay. Only about 30% of its revenue is generated from this segment. The rest of their revenue is from their Operate Solutions segment which provides ancillary services such as game analytics to manage IAP and Advertising. Unity generates the majority of its revenue from advertising as it takes a cut from advertising revenue and does not do this for IAP. Unity has a platform which connects advertisers with game developer demographics to deliver highly personalized ads. Developers also use U’s analytics to reduce customer churn and garner more revenue. The pareto principle applies here with a small # of customers that generate more than 100k in gaming revenue making up about 75% of their total revenue. U has about 720 of these clients in the latest report (Q2 2020). The other 25% of revenue is generated from indie developers.

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Unity has started branching out into other industries and that has been growing at a decent clip- the revenue from beyond gaming customers has grown 25% in the past 6 months. They have 12 customers in the >100k group from other industries which make up about 5% of the customers in that lot. These customers are big names in their respective industries which gives Unity social proof (e.g. Disney (NYSE:DIS) used Unity for the making of Lion King).

Thesis

Unity will continue to dominate the gaming space in both mobile and VR. Growth rate in their Create Solutions will likely be a bit higher than industry growth (around 20% CAGR). Their growth in the beyond gaming segments will grow >40% CAGR for the next couple of years as they are also starting off with a small base. Forecasting their operate solutions is a bit opaque due to the pending iOS 14 changes. Although Apple (NASDAQ:AAPL) and Google Play (NASDAQ:GOOG) will be a revenue hit and the market may penalize them, this could cause them to switch up their business model to a revenue share agreement.

Valuation

At the valuation Unity is currently trading at (almost 20x revenue), there is quite a large growth rate being attributed to beyond gaming segments. This is because Unity’s mobile market share is greater than 50% and crossing that threshold typically marks the slowdown of growth. We listed other reasons why we believe this is happening below as well. This leaves beyond gaming as their real source of growth (unless VR takes off). Beyond gaming industries make up about 5% of their revenue and it will take time to gauge Unity’s ability to win against entrenched competitors in other industries.

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Unity could also be a play on VR which could be the next computing platform. The first was the PC, the second was the phone, and the third and last will be virtual reality- the screens keep getting closer! Zuckerberg even contemplated buying Unity back in 2015 for this purpose. If VR does take off, Unity will be at the center of it and will likely be worth many multiples of what it is currently trading at.

Growth catalysts

Widespread 5G could spawn a new era of mobile games and VR games. 5G decreases latency by a factor of 5x to 5ms and increases upload speed by 20x! Mobile and VR will become even more immersive.

Penetration in other markets grows more rapidly than expected. Unity’s software could be both cheaper and more convenient. In their S1, Unity believes this opportunity to be even larger than gaming.

Unity starts taking a cut from IAP. This is a large untapped revenue stream for them. If they had the same business model as Unreal Engine (5% take on all gaming revenue if revenue is greater than 1mm), Unity would have revenue totaling to about 1B, a 30% increase from their revenue today.

Triple AAA and other top mobile developers start transitioning to Unity.

Risks

Growth stalls in the mobile segment due to >50% adoption in mobile gaming, we believe their growth is slowing due to the following reasons:

  1. Unity is trying to aggressively expand into new fields (architecture, engineering, art, film)
  2. They raised prices of Create Solutions subscription 20% (Jan. 2020) and still did not see a meaningful uptick in both revenue and deferred revenue from their Create Solutions segment even during COVID-19 times.
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Apple’s change to IDFA will hit Unity’s revenue stream. It will probably cut their operate solutions revenue (majority of revenue here is derived from advertising) by about 30% bringing total revenue down about 20% if more than half of game players opt out of wanting to be tracked by advertisers. Google will probably follow suit so within a year with their Android platform so in total Unity could be talking a 35% hit to revenue.

Competitors such as Unreal Engine/Lumberyard could start taking market share in mobile gaming segment.

There might be some risk to their Asian revenue (roughly 30% of total revenue). Tencent (OTCPK:TCEHY) owns 40% of Unity’s competitor, Epic Games (unreal engine) and Unity uses Tencent’s cloud services in China.

There is some key man risk with the CEO. Riccitiello has a pending sexual harassment case. If there is any legitimacy to this, he will most likely be fired. He has been instrumental to Unity’s growth for the past six years and replacing him would be a tall order.

Conclusion

Given the negative catalyst ahead with Apple iOS 14 and the possibility of growth slowing down in Unity’s gaming revenue, we believe that it would be better to wait for either a cheaper entry price or at least crystallization of their ability to successfully translate their engine platform to other industry applications.

Note: We generally don’t look at IPOs given the extremely high valuations they command, however given the nascence of interactive 3D content (especially VR) and the rise of mobile gaming, we thought Unity was an interesting candidate to dive into.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.



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