Table of Contents:
Report Highlights
Company Overview
Competitive Landscape
Company Strengths & Competitive Positioning
Catalysts & Opportunities
Company & Industry Risks
Valuation & Financial Analysis
Report Highlights
Unity is at the forefront of a global digital revolution. Its game engine can be used for far more than just gaming – 3D content, AR and VR, and industries such as engineering, architecture, digital marketing, and construction all have proven use cases for Unity’s platform capabilities.
Unity can leverage partnerships with brands such as Autodesk, Volkswagen, and Oculus to showcase its world-class platform flexibility and penetrate new markets.
The Unity ecosystem possesses an inherent moat – strong network effect among the creator world, low barriers to entry with an easy-to-use and free platform when starting out as an individual developer, and high switching costs from re-training development / creative teams and re-coding content would deter current customers from leaving Unity.
The sky is the limit – the metaverse could open an entire universe of new opportunities and use cases for Unity’s special Real-Time 3D and AR / VR capabilities.
CIStrategies is long Unity shares at a sub-$100 price level, sized as one-third of a full position. We believe a $340 / share 2030 exit price target, using prudent and reasonable financial and multiple assumptions, possesses an attractive IRR of 14% through 2030. Under a “blue sky” scenario, the price target would be multitudes higher. We would like to emphasize we are focused on execution in the next 2-5 years, rather than assume perfection right off the bat.
Company Overview
Brief History
Unity Software Inc. (“Unity”) is a video game software development company founded in 2004 in Copenhagen, Denmark as Over The Edge Entertainment (“OTEE”). The founders – Nicholas Francis, David Helgason, and Joachim Ante – developed and launched their debut game, GooBall, using the Unity platform in 2005. The commercialization of GooBall failed but the founders realized their development software could be used to “democratize” 2D and 3D interactive content and game creation for non-console game developers. Unity looked where console game developers did not – the mobile game industry. Alongside the release of the first iPhone in 2007, Unity produced an early engine compatible with the Apple platform. This move went on to prove itself revolutionary – Unity now hosts 2.7 billion Monthly Active Users (“MAUs”) and sees an average of 13,000 new projects each day across a variety of use cases on 25 different platforms.
The Unity Business
Unity software solutions to create and monetize real-time 2D and 3D content for mobile phones, tablets, PCs, consoles, and AR / VR devices. The platform is mainly used by content creators to develop mobile games, although other industries are increasingly embracing 3D content creation for practical use cases outside the gaming world. Architects, artists, automotive designers, filmmakers, and engineers are leveraging Unity’s platform for automobile and building design, online and augmented reality product configurators, autonomous driving simulation, and augmented reality workplace safety training, among others.
Per the above, Unity’s focus can be categorized into three main industries:
Gaming
AR & VR
Industries Beyond Gaming
Creators are particularly attracted to Unity for its interactive, real-time 3D (“RT3D”) content creation capabilities through which content can be tested and iterated in real time and in collaboration with other creators on the Unity platform. Unity users can create content quickly and effectively across many formats and use cases with the help of the Unity Asset Store, a marketplace for Unity customers to find “assets” – software, content, and tools – to assist them with building their own content.
Unity operates two main groupings of solutions:
Create Solutions
Operate Solutions
Create Solutions
Unity provides a variety of tools and software for content creators and artists to create real-time 2D and 3D content. ArtEngine is the content creation tool that helps creators design “ultra-realistic digital artwork” in 3D using a powerful AI system. Granite is Unity’s advanced texture system that gives Unity graphics the “pop” they need to satisfy every gamer’s eye.
Non-gaming industries are also seeing the value of Unity’s RT3D content creation tools. These creators also have a suite of Create Solutions tailored to their needs:
Unity Reflect – Facilitates creation of RT3D experiences for the purposes of architecture, engineering, construction, and AR / VR.
Unity MARS – Service providing professional-grade workflows for AR and VR development.
Unity Forma – Used largely in the digital marketing community, this product configuration toolkit allows content creators to make visually appealing content for product and service commercialization.
Operate Solutions
Operate Solutions, in a self-explanatory manner, refer to a suite of solutions provided by Unity to operate the content created using Unity’s Create Solutions, as well as external content not sourced from the Unity platform. The goal of Operate Solutions is to facilitate the monetization and commercialization of content made by the creator, for the creator. The set of tools provided allows subscribers to maximize the lifetime value of end-users, optimize the cost of acquiring and engaging end users, and hosting and operating their solutions.
Operate Solutions contain the following methods and tools to maximize commercialization success for customers:
User Acquisition and Monetization
Unity Ads – allows creators to leverage Unified Auction to earn the highest value for each impression by an end user on their content. Each time an end user views or uses a creator’s content, Unified Auction identifies and shows the best advertisement to show the customer.
Unity IAP – IAP refers to In-App Purchases, a micro-transaction revenue capability that allows creators to sell virtual goods within free or paid games across major marketplace apps (e.g. Google Play, Apple App Store).
End-User Engagement
deltaDNA – High quality analytics, predictive, machine-learning, and Dynamic Ad Placement toolsthat enables customers to gain insight into behaviours of end users within their game and act in a manner consistent with the data provided to improve end-user engagement.
GameTune – “DSaaS” – data science as a service. Customers use data of end users compiled by Unity to optimize end-user engagement based on a variety of game elements (i.e. in-app purchase bundles, difficulty settings, and game progression speed).
Cloud Operations
A group of services – Multiplay, Vivox, Cloud Content Delivery, Build Server, Furioos, and Simulation (GameSim and Unity Simulation) – again, designed to maximize the end-user experience by reducing and suppressing technical challenges, delays, downtimes, and unpredictable costs when content is launched to the world.
Unity works with creators from the ground up. From the initial idea, to creation, and eventual launch and monetization, Unity Software equips creators with a vertically integrated platform to set them up for success.
How Does the Company Make Money?
We know how customers make money, but how does Unity make money from its customers?
There are three main sources of revenue for Unity:
Create Solutions
Primarily through a subscription model with varying levels of financial eligibility (Figure 1). Generally, companies and developers with higher revenue or funding will be using more expensive plans (i.e. Pro and Enterprise) based on eligibility criteria.
Operate Solutions
Primarily through revenue-share and usage-based models.
Advertising through Personalized Advertising and Contextual Advertising, Unity leverages large amounts of data it gathers on opted-in users via machine learning and opted-out end users using aggregated, non-personal data.
Strategic Partnerships
Primarily from partnership contracts, typically on a multi-year software development arrangement, with hardware, OS, device, and game console providers.
Predetermined share of sales through the Unity Asset Store, tools used in the creation of games and applications, and from verified third-party partners that sell software and tools in the Unity platform.
Figure 1: Unity Software Subscription Plans
Unity earned $772.5MM in 2020, of which 30%, 61%, and 9% stem from Create, Operate, and Strategic Partnerships, respectively. Operate Solutions generate most of Unity’s revenue, implying advertising, post-development solutions, and creator monetization represent a substantial portion of Unity’s business and focus. It is fair to say, in our opinion, Unity is mainly in the business of helping content creators monetize their content and its Create Solutions platform is the “hook” that draws in customers in hopes of these customers scaling using the entire Unity ecosystem (Figure 2).
Figure 2: 2020 Gametech Ecosystem
Unity attracts customers of all sizes, from large global enterprises, to government and non-profit organizations, and small- and mid-sized individuals and businesses. The company had 793 customers with over $100,000 LTM revenue as at December 31, 2020. These customers represent a “substantial majority of [Unity’s] revenue”. Although Unity appeals to small-scale developers, the company is reliant on large enterprises for most of its revenue. Unity’s customer base is also well-diversified – no one customer accounted for more than 10% of revenue 2018 – 2020 and revenues are generated from the EMEA, Asia-Pacific, and Americas (approximately one-third of revenues each).
Competitive Landscape
Market
Mobile gaming, currently Unity’s largest focus area, was expected to generate revenue of $77.2 billion in 2020 based on Newzoo’s report, almost half of the $159.3 billion the entire global games market was expected to generate. Mobile game engagement is also expected to outpace the growth of other game segments, such as Console and PC. The main reasons cited are mobile gaming’s low barriers to entry and simpler development process versus other game segments. The global games market is expected to continue growing at high single digit rates, from $159.3 billion in 2020 to over $200 billion in 2023, a CAGR of ~8% per year. Mobile is expected to be the fastest growing segment due to rising smartphone penetration, especially in emerging markets, new technologies and developments improving player engagement, and the integration of social mechanics into casual, moderate, and hardcore games.
Unity’s robust RT3D capabilities stretch beyond use cases in gaming. This will allow Unity to benefit substantially from an expanding global real-time rendering solutions market expected to grow at a CAGR of ~17% between 2019 and 2027, far outpacing mobile game growth. RT3D is already a massive market - $1.1 billion in 2019 - and it is estimated to hit $4 billion by 2027.
Lastly, the global game engine market is expected to grow to almost $6 billion by 2027, according to Research and Markets. Growing demand for AR and VR games and applications outside the gaming industry are cited to be the main drivers for the ~14% CAGR through 2027.
According to Unity’s S-1, the company believes it operates within a total addressable market (TAM) of $29 billion. Approximately $12 billion of this amount is related to gaming and the remaining $17 billion is the emerging opportunity in industries beyond gaming – in construction, engineering, auto design, and more.
Unity’s powerful and well-known RT3D platform places the company in a unique position take advantage of these trends and the ~$29 billion market opportunity.
Competitors
Unity competes with many in-house game engines created by large game studios, as well as Unreal Engine (Epic Games) and Chukong Technologies in China. However, Unity’s main competitor is Unreal Engine (“Unreal”), the platform on which Fortnite was developed, for uses in the gaming industry and beyond.
Unity and Unreal effectively operate in a duopoly, acting as the two major independent platforms enabling creators to create games and content. According to Unity, 50% of mobile games and about 60% of AR / VR content are created through Unity. Unity holds a large and dominant position in the industry, although it is difficult to gauge its positioning relative to Unreal since Unreal is private.
From a gaming perspective, Unity and Unreal are both phenomenal platforms. Whether one prefers to use one platform over the other is generally a matter of personal preference, network effects, and specific requirements that one platform may support but the other does not.
After sifting through numerous of gamer blogs and YouTube videos, we have compiled the most notable advantages of each platform below.
Unity
Unity is better suited for lower-powered devices, such as mobile; Unreal hosts a bulky platform that is not necessarily suited for lower-powered devices;
Unity is a more intuitive platform than Unity, making it the perfect choice for small(er) developers; larger development teams working with Unreal typically require “specialists” to dedicate their time focusing on subsets of the development process, whereas less-experienced, lone developers or small teams on Unity benefit from the easy-to-use platform;
Related to the point above, Unity is simpler to use mainly because of its larger and more robust Asset Store. Developers can tap into this resource to pre-populate their games with a wide variety of stored assets to get their game to look, feel, and perform as closely to what the developer had imagined without creating code from scratch;
Although Unity does not offer a visual scripting method like Unreal’s Blueprints, the platform identifies problematic or incorrect strings of code for the developer. This is a great feature as C# has slightly more complicated syntax than other languages;
Unity’s 2D focus and toolset make it the better choice over Unreal 2D development;
Unity is more versatile in the realms of AR and VR – Unity has more experience with AR and VR and contains flexible plugins.
Unreal
Unreal produces “high-fidelity” 3D visuals from the moment of creation; Unity also produces great graphics but to a lesser extent and with more work required than Unreal;
Visual artists tend to prefer Unity due to Unreal’s better graphics vs. Unity;
Unreal is completely free, offering a no-barrier entry to begin using the platform. The only kicker is that Unreal collects royalties from any of your published games. Unity offers a free version of its platform, but it is much more limited than Unreal;
Unreal offers Blueprint (Figure 3), a visual scripting method, as an alternative to using C++ on Unreal. The developer does not need to know how to code in Unreal – they can simply use Blueprints;
Unreal is most popular amongst the AAA-game industry due to its more powerful platform and graphics capabilities; and
Unreal also creates its own games, the most notable being Fortnite and Gears of War. Unity does not create its own games.
Figure 3 – Unreal Blueprints
In summary, both platforms are great for their own, unique reasons. From a high level, Unity is the preferred choice for smaller developers that focus on mobile while Unreal provides a more powerful platform for AAA-rated and 3D content development. However, Unity and Unreal have been and will continue to converge in quality, usage, graphics, and number of use cases as competition increases and demand for games, RT3D content, and content development in industries outside gaming grows throughout the 2020s.
Company Strengths & Competitive Positioning
Platform and Community
Unity’s main design platform, Asset Store, and Creator Community are excellent value propositions and worth reiterating as major advantages to Unity’s past, current, and future success.
Unreal arguably hosts a better platform for 3D graphics, but Unity’s track record should not be ignored. Pokémon Go (Figures 4 and 5), Temple Run, and Escape From Tarkov were created on Unity – these games are immersive, engaging, and frankly, addictive. Temple Run, probably the most widely known mobile experienced created on Unity, was downloaded over one billion times when this TIME article was written in 2014. This short compilation of games showcases other impressive, high-resolution games created by developers of all sizes on Unity.
Figures 4 and 5: Realistic Pokémon Go AR Game and Graphics
The Asset Store and Creator Community are valuable supplements to Unity’s user experience. The former equips developers with the tools to create incredible content using other developers’ work. A large barrier to entry is eliminated as the starting point for a creator’s first project could be their favourite game or content made on Unity that they find inspiring. Assets can be sold to other Unity members, a lucrative incentive and positive reinforcement to the original developer, platform, and the community in its entirety. The Creator Community is large and active - approximately 1.4 million active monthly creators that developed about 8,000 games and applications per month were recorded as of December 31, 2020. The sheer scale of the community offers outstanding reach to third-party platforms, which can strategically partner with Unity to expand their own business, and allows creators to collaborate with, and learn from each other within the Unity realm.
Optionality
Unity’s Form S-1 demonstrates Unity’s aggressive research and development (“R&D”) strategy to succeed inside and outside the gaming industry. Unity expects to maintain its R&D strategy to:
add features, automation, visualization, collaboration and experiential capabilities to Create Solutions;
meet the growing demands of its customers;
increase the number of use cases for Unity products;
continue to support Create Solutions with Operate Solutions tailored to various industries and platforms;
innovate with new products, features, and functionality; and
support the integration of third-party integration into the Unity ecosystem.
Expansion into industries beyond gaming is Unity’s sought-after apex. Heavy R&D investments are required to keep pace in a world with improving technology, fierce competition, and rapid circulation of information. Unity fully expects its “investments will occur in advance of [their] realization of significant revenue that may be derived from these strategies”.
Fortunately, Unity has already begun to reap the rewards from its world-class platform and strong brand recognition since its inception in 2004. Unity can do so due to the astounding level of innate optionality within its ecosystem. The same platform that creates games can create cinematic content, real-life simulations, graphic and architectural design, and VR / AR content, among many other use cases.
Unity created a short film entitled, “Adam” in 2016 to showcase the graphical quality achievable with the platform. Oats Studios went on to create two sequels – the third part below can be played in 4K (2160p). The graphics created by Unity’s game engine are nothing short of phenomenal. The video demonstrates the platform’s quality, ability to design natural movement, and flexibility to create a wide array of content.
Figure 6: Adam: Episode 3 by Oats Studios
Unity introduced Unity Forma (See “The Unity Business” subsection) in late 2020 as a revolutionary toolkit for use in the digital marketing world. Unity partnered with Volkswagen to show the globe what verticals its capable of penetrating. In the words of Unity, “Marketing is one of the most compelling applications of real-time 3D”. Figure 7 shows why Volkswagen is excited to be one of Unity’s earliest partners on Unity Forma – the final product presents shot patterns and angles that would be difficult to obtain using live cameras while maintaining realistic 3D looks, overall aura, and textures. What’s exhilarating is this is just the beginning – Unity is committed to invest heavily into its ecosystem to expand graphical capabilities and expansion into verticals.
Figure 7: The Power of Real-Time 3D: Volkswagen ID.4 EV
Autodesk – a global leader in 3D design, engineering, product design and manufacturing, architecture, construction, and entertainment software and services – and Unity announced they will collaborate to bring 3D AR and VR solutions to the sub-industries in which Autodesk operates in. At first glance, this appears to disproportionally benefit Autodesk. This is a clever move by Unity – this is the first step in penetrating a massive industry outside of gaming. Autodesk is trusted for its 3D platform around the globe and its collaboration with Unity is bringing new VR and AR capabilities to their customers. Figure 8 exhibits yet another impressive 40-second clip – which includes some of the content created between Unity and Autodesk’s Revit, VRED, Shotgun, 3ds Max, and / or Maya products – filled with realistic 3D frames, vibrant colours, and life-like experiences.
Figure 8: Unity and Autodesk Collaboration
Shortly after purchasing Oculus VR to make a move into AR and VR gaming and the metaverse (see “Catalysts & Opportunities”), Facebook contemplated buying Unity in 2015. It is worth bringing attention to two points in Mark Zuckerberg’s 2015 email:
“Our vision is that VR / AR will be the next major computing platform after mobile in about 10 years. It can be even more ubiquitous than mobile – especially once we reach AR – since you can always have it on. It’s more natural than mobile since it uses our normal human visual and gestural systems. It can even be more economical, because once you have a good VR / AR system, you no longer need to buy phones or [TVs] or many other physical objects – they can just become apps in a digital store”
“…Unity will help us build world class VR / AR experiences required to deliver on this overall mission…”
Unity was a (potential) target of choice for a company on the forefront of the AR and VR revolution. We believe this speaks volumes to Unity’s true present and future capabilities and its importance to the technology world. It should come with no surprise Facebook wanted to purchase Unity as a supplement to Oculus. Currently, Unity provides VR support for Oculus content and devices.
Data Footprint
As a technology company, Unity possesses the ability to garner mass amounts of data from end users. The continuous capture and analysis of end-user behaviour and application performance allows Unity to see how end users interact with games and content. By tracking this behaviour, Unity can optimize content performance, user acquisition and engagement, and monetization based on predicted lifetime value of each customer. Ultimately, this creates value for the content creator and the end user – ease of use and performance of the platform and the final product and its quality benefit both groups of users.
Moat
Unity saw, on average, approximately 2.7 billion monthly active users (“MAUs”) consume or create content each month in Q4 2020, a 63% increase versus Q4 2019. The vast amount of “input” and “output” users creates a strong network effect – increasing usage on both ends of the spectrum cascades into more content creation from existing users and attracts new creators and end consumers. The full extent of this “input” and “output” network effect is demonstrated in these reported statistics:
An average of 13,000 new projects were seen each day in 2020; and
Unity applications across all formats were downloaded, on average, about 5 billion times per month in Q4 2020, an increase of 41% versus Q4 2019.
Guided onboarding, access to learning resources, intuitive content creation, and partnerships with high schools and universities ensure all developers, especially the young and relatively inexperienced, enjoy and benefit from using Unity. The combination of running an intuitive platform and working with students at no cost to them boosts knowledge of how to create and use RT3D software and content prior to graduation. The former is an inherent low barrier to entry that allows newer and / or younger creators to learn the platform and iterate content quicker. In turn, Unity is more likely to generate a lifetime user through ease of use. The latter is clever in that Unity is aware of the high switching costs associated with game engines – as one learns and continues to accumulate knowledge and real experience on one game engine, switching costs (i.e. re-training, re-coding, and opportunity costs) rise.
Unity’s moat can be demonstrated through its market presence – 71% of the top 1,000 mobile games were made with Unity and 94% of the top 100 game development studios were customers of Unity. Strong brand recognition, network effects, low barriers to entry, and high switching costs are instrumental to Unity maintaining its position as a market leader and its future ability to expand aggressively within its existing customer base and in industries beyond gaming.
Talent Acquisition
A company cannot succeed without an inspired and innovate workforce. Unity recognizes the need for strong talent and places a relentless focus on hiring “highly talented software engineers and developers” to expand on its market-leading position and strong brand recognition. We were pleased to see employees rank Unity a virtually perfect 4.9 / 5.0 overall rating (Figure 9). It is also worth noting that almost every employee surveyed approves of the CEO. It appears management fosters an environment that allows employees to flourish, inspire, and innovate alongside talented and approachable individuals.
Figure 9: Unity Technologies Glassdoor Reviews
Catalysts & Opportunities
Verticals
A company grows because of two main traits – it recognizes the world is full of opportunity and it possesses the optionality to be able to explore various ventures and ideas. Unity sees a TAM of $29 billion, although this could be substantially higher as aggregate attention and excitement shifts away from mobile and towards the metaverse.
Unity has already laid the groundwork to begin penetrating these verticals. It has a large amount of partnerships with world-class companies across many industries. Its ecosystem of partnership areas and respective partners of Unity include:
Platform – Apple / Google / Magic Leap / Microsoft / Nintendo / Oculus / Sony
Technology – Autodesk / Intel / NVIDIA / Samsung / Arm
Verified Solutions – Adjust / Agora Video SDK / Genvid Technologies / Houdini / Unit040
Channel – A2KTechnologies / Cadac / Cadline / Compusoft / Diatec / DMOA / EscapeTechnology / GC Micro / Imaginary Spaces / Immersion SA / Naska / Prodware / Softbank / SoftwareONE / Studica / Symetri / Syssoft LLC / VegaSoft / Weltenbauer
Centre of Excellence – Appearition / Tata Elxsi / Tech Mahindra / Veative
Education & Training – Coursera / Knowledge Point / Platzi / Pluralsight / ThinkEdu / Udacity / Udemy
Unity Distribution Portal – Samsung Galaxy Store / HUAWEI AppGallery / Xiaomi - Mi GetApps / OneStore / QooApp Game Store / TPAY Mobile Stores / JioGames / APPTUTTi / VIVEPORT / Uptodown
Strong partnerships, consistently growing penetration of vertical markets, and development and adoption of AR, VR, and RT3D in industries outside gaming can drive Unity to prosperity in a highly competitive market.
Favourable Industry Trends
Vertical opportunities aside, Unity will continue to operate within a high-growth industry as an industry leader. Global mobile gaming revenues are expected to grow faster than the global games market, which is already expected to grow over 9% per year through 2023. COVID-19 accelerated mobile gameplay around the world, but this effect may subside when economies re-open in a post-pandemic world. Growing global smartphone penetration, increasing mobile game consumer spend, and Unity maintaining its top position in the mobile and AR / VR game development space should provide ample opportunities for growth within the areas Unity currently operates in.
Metaverse
The metaverse, simply put, is a wave of computing that will blur the lines between reality and the virtual world. The internet as we know it today is where we “log in” to or “go to” to search for products, read the news, watch videos, and interact with friends and family. The metaverse is predicated on a constantly available realm where people will play, work, and socialize with each other and experience a digital realm and reality simultaneously. Simple use cases for the metaverse include AR and VR capabilities to view virtual real estate, try on clothes, and model furniture. It may also include virtual billboards and advertising and fantasy-like brain-computer capabilities and virtual online stores. This Adobe MAX 2019 video (view 2:01 to 3:52) visualizes what the metaverse might look like.
Tim Sweeney, CEO of Epic Games, said, “[t]his Metaverse is going to be far more pervasive and powerful than anything else. If one central company gains control of this, they will become more powerful than any government, and be god on Earth”. Albeit a far-fetched statement considering nobody “owns” the internet today, Sweeney expresses the opportunity of the metaverse well. The metaverse can single-handedly blow Unity’s $29 billion TAM estimate out of the water to a number substantially higher than we can imagine. The changes we may see in digital marketing, pop culture, economies, shopping, entertainment, and many others could be beyond our imagination. Therein lies the massive opportunity for Unity to capitalize on a gigantic new wave of computing through its AR and VR investments and capabilities.
Company & Industry Risks
Identifier for Advertisers (IDFA)
Apple announced that its iOS 14 update will allow Apple users to choose between blocking the IDFA on an app level or “opt-in” to user targeting and / or tracking. Previously, Apple users were opted in by default to be tracked by the IDFA. Currently, a substantial portion of iOS users share their IDFA with apps on their phone. After Apple’s new IDFA “opt-in” and “opt-out” prompt, the number of users that remain opted in could drop to a miniscule minority. Advertisers will be largely impacted through potentially ineffective ad targeting whereby users will no longer see the most relevant, personalized ads based on their app / site and cross-app / cross-site activity.
Unity engages in the advertising business and uses IDFA for ad targeting. Per Barclays’s equity research report published in February 2021, advertising makes up approximately 50%of Unity’s total revenues. Management’s estimate of a 3% downward adjustment to 2021 revenues would imply a 6% hit to advertising revenues.
Potential Mitigating Factor(s) / Strategies:
Management appears to have been anticipating adverse IDFA changes for a long time. Announced in their Q4 2020 shareholder letter, Unity said, “[w]e have deepened our data, analytics and A.I. capabilities and we have begun testing several new, innovative ways to help our customers optimize the effectiveness of their marketing spend while complying with the changes from the iOS 14 IDFA changes.”; and
IDFA is likely only a near-term risk as advertisers recalibrate to offer customers valuable solutions.
Competing Against Partners and Customers
Expanding into new markets as a lone player or disruptor, such as creating in-house games or penetrating architectural design, digital marketing, and construction industry RT3D needs could place Unity in a position where they are directly competing against customers and partners of their own platform. Additionally, many of these customers could be well-established, forward-looking incumbents that dominate the industry, such as Autodesk in the engineering and construction industries. Expanding into these markets may prove to be substantially more difficult than management explains in their 10-K and other investor material.
Potential Mitigating Factor(s) / Strategies:
Target niche industries / sub-industries;
engage in M&A of small- to mid-sized market players to gain size and competitiveness; and
increase value proposition in existing partnerships to extract a greater share of the pie.
John Riccitiello, CEO of Unity
John Riccitiello is under scrutiny as he faces publicized allegations against himself and other “men in management positions” who “spoke openly about women in a sexual manner, made sexist jokes, and flirted with and pursued sexual relationships with female employees and contractors”. If proven true, this could lead to reshuffling upper management at Unity and create uncertainty for shareholders and the future performance of the company.
Riccitiello was the former CEO of EA, generally hailed as a leader who took on the role during a time of radical change in the industry and led the company to into a long-term, competitive, and modern digital position. However, his time at EA included a few execution mistakes and overly expensive acquisitions. Doug Creutz – Analyst, Cowen and Company – explained, “[t]he first half of Riccitiello's term was marked by flawed strategy while the latter half was impacted by spotty execution”. Riccitiello may be tempted to act in an overly aggressive manner given the secular tailwinds from which Unity will benefit. It may take time for Riccitiello to find a stable path forward for Unity as it strives towards profitability.
Potential Mitigating Factor(s) / Strategies:
Sexual harassment allegations are withdrawn or proven false;
solid, consistent business and financial execution is apparent quarter-after-quarter, year-after-year; and
evidence of ability to find attractive, accretive deals and partnerships for tangible and intangible benefits.
Valuation & Financial Analysis
Unity Financials
Unity, overall, is a strong performer from a financial standpoint. The company is growing quickly, capturing and retaining high-quality customers, and penetrating new and growing industries beyond gaming. Figure 10 showcases the power of Unity to retain and grow existing customer portfolios with a Dollar-Based Net Expansion Rate (“DBNER”) of 138% in Q4 2020 versus 133% in Q4 2019. Management expects the DBNER to remain “very healthy” going forward with seasonal gyrations that should not be viewed as a slowdown in existing customer portfolio growth. The number of customers with LTM revenues > $100,000 has increased by almost 60% since Q1 2019.
Figure 10: Dollar-Based Net Expansion Rate
Total revenues have grown 42% and 43%, respectively, on a year-over-year basis. Operate Solutions have grown at the fastest pace of the three major segments at ~60% YoY in 2019 and 2020. Create Solutions experienced between 34% and 37% growth and Strategic Partnerships were basically flat in 2019 and 2020.
In our forecast (Figure 11), we assumed a temporary slowdown in 2021 revenues due to COVID-19-accelerated growth effects wearing off. We believe Unity can return to almost 33% YoY revenue growth in 2022 which eventually tapers off to ~15% growth in 2030. Additionally, we have modelled positive EBITDA and Free Cash Flow beginning in the year ended December 31, 2024 as opposed to Unity’s guidance of breakeven FCF by 2023. It is important to note that we feel this “base case” contains conservative assumptions to adjust for uncertainty in future execution by the business and the industries in which Unity will operate. There is a severe risk these assumptions are too conservative if the company continues to execute well while expanding into verticals and the metaverse revolutionizes modern computing as we know it sooner than expected. Again, due to the uncertainty surrounding the aforementioned factors, we believe it is prudent to model long-term revenue growth in line with industry growth rates (see “Competitive Landscape”) and expect some challenges as market players make mistakes, learn from them, and improve in these new and speculative industries.
Unity could emerge as the global market leader in RT3D and AR / VR. The $29 billion cited TAM by Unity could swell to magnitudes above $50 billion and blow our forecasts out of the water. Despite the temptation to model a global revolution, we are modelling what we believe are modest assumptions, and will be constantly re-modelling company and market assumptions considering new information as it arises.
Figure 11: Unity Summary Financials and Free Cash Flow Calculation
Unity Valuation and Target Price Output
We achieve our 2030 price target by using an equally weighted average multiples method. As Unity has not yet reached profitability, it would be cumbersome to use the DCF method and its varying assumptions. Figure 12containspublic company comps in the Application Software space. We used the median of EV / EBITDA, Price / Sales, Price / Earnings, and FCF Yield using 2022 consensus forecast numbers for ANSS, SNPS, CDNS, COUP, CDAY. We are using current 2-year forward multiples to apply to Unity’s 2030 figures for a 2030 exit to provide an additional “margin of safety” as to not use potentially overoptimistic trailing multiples and assume multiples today will be the multiples of 2030. We believe these companies represent the maturity Unity likely will attain in 2030. As this is a long-run forecast, we also believe it is prudent to use multiples for companies with a similar growth and margin profile today that aligns with where Unity will be in 2030. In other words, we are expecting significant multiple contraction over the next decade and revenue, EBITDA, net income growth – supported by margin expansion – will be the main drivers for our stock price target. Each of the four ratios / metrics we use yield similar results (Figure 13). We estimate an exit share price of $340 / share by 2030 using our forecast assumptions above and exit multiples of 32.3 x EV / EBITDA, 11.8 x Price / Sales, 44.7 x Price / Earnings, and a 2.50% FCF Yield. This would yield an IRR of 14% through 2030 after accounting for significant multiple contraction as the company matures and realizes a substantial portion of its growth opportunities this decade.
Although we have calculated a downside and upside scenario, the results produce an extremely wide range due to the length of the forecast. Therefore, we believe there is no value in presenting these figures and would like to remain consistent with our base case forecast of $340 / share by 2030, believing this is a reasonable forecast given Unity’s potential.
Risks to Price Target
While interest rates are near record lows and valuations for technology companies are at record highs, Unity is no exception. Trading at 24.8 x EV / 2021 Sales and 26.8 x Price / 2021 Sales, Unity is anything but cheap. Granted, investors are pricing in massive growth for a company that has been executing well historically. However, continued strong stock price performance is largely contingent on the current market environment to remain accommodative on the monetary policy, interest rate, inflation, and pervasive “risk-on” sentiment fronts.
Although we have accounted for significant multiple contraction, median multiples are based on today’s valuations. It is possible that risk appetite, interest rates, and market / industry multiples close this decade in a much more unfavourable state. Unity’s growth could also slow tremendously due to risks that cannot possibly be foreseen 10 years in advance – these risks could also warrant further multiple contraction.
Potential Mitigating Factor(s) / Strategies:
Accommodative monetary environment;
low-inflation / low-growth economy (favourable for technology stocks); and
moderate to elevated investor risk appetite throughout this decade.
Figure 12: Valuation Statistics – Unity and Application Software Peers
Figure 13: Target Price Output
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