Thursday Deep Dive: Unity
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This week, Ryan, Ian, and I discussed Unity. Unity, from a thousand-foot view, enables creators to bring things to life using 3D technology. Through their “create” and “operate” business lines they enable software developers of all sizes to more easily build and then monetize interactive content. The company got its start in gaming with the Unity engine but has since expanded to engineering, construction, design, even filmmakers use the creative tools provided by Unity’s platform.
Unity is an international company, founded in Copenhagen, Denmark as Over the Edge Entertainment. Three founders started the company: David Helgason, Nicholas Francis, and Joachim Ante. Helgason is now a board member, Ante is the CTO, but Francis is out of the company. In the early days, the company found its niche in mobile games by being the first engine catered to that market.
Industry and Competition
Unity is a cog in the $150 billion video game industry. From the engine side, their main competitor is the Unreal Engine from Epic Games. The difference between the two is that Unity is simpler while Unreal can handle more complex content built for the next generation consoles. This simplicity is likely why 53% of the top mobile games are built on Unity with 93 of the top 100 studios working with the company. Both Unity and Epic have ambitions outside of gaming, and it will be interesting to see who can grow faster in the adjacent markets.
On the Operate side of things (60% of Unity’s revenue), they don’t necessarily have a big competitor. Yes, Google and Facebook compete in digital ads, but it’s not like they care too much about this specific part of the industry. They are not maniacally focused on crushing them, or at least, I don’t think they are.
If you’re confused about what Operate solutions actually are, just think of enabling ads to be run seamlessly on mobile games as well as in-app purchases, and then Unity gets a slice of whatever revenue the game brings in. It doesn’t feel like a large opportunity when you first look into it, but it didn’t become the majority of Unity’s revenue for no reason. It is important to take a look and understand how that business actually works before you consider investing.
Unity’s current CEO is John Riccitiello. He was the CEO of Electronic Arts from 2007 to 2013 and went over to Unity in 2014. Since the company just went public, Riccitiello was on the media roadshow giving out the typical executive commentary. His main talking points revolved around them being applicable to all industries and how non-gaming will eventually be the majority of their revenue. He also talks a lot about the companies mission (?) which is this:
“We believe the world is a better place with more creators in it”
That sounds great and all, but in reality, the world will be more profitable for Unity with more creators in it, and that’s what investors are looking for. Riccitiello owns 3.1% of outstanding shares, with a total of 16.7% insider ownership. Sequoia and Silver Lake were the main VC firms that invested in Unity, and they own a combined 38% stake.
It is also important to note what we decided was a yellow flag for the company, which is Riccitiello being sued by a former VP for sexual harassment. Nothing may come of this, but it is important to keep on the radar nonetheless.
Valuation, Earnings, and Balance Sheet
267.2 million shares after the IPO
Enterprise Value estimated to be $25.1 billion (as of recording)
EV/rev of 35.8 (annualized FH of 2020)
(14.8%) operating margin
(10%) FCF margin
Stock-Based Compensation at 6.1% of revenue
Earnings (2019 numbers):
$542 million in revenue, growing 42% YoY
78% gross margins
45% of opex spent on R&D (that is a number we generally like to see high or at least higher than G&A)
Had 600 customers spending more than $100,000, up 24% YoY
DBNER of 133% in 2019
Raised $1.3 billion on the IPO
$218 million in Goodwill at about 10% of assets, a little concerning
Current ratio at about 5 right now mainly because of IPO proceeds
$125 million revolver was drawn in Spring, will likely be paid back now
Does Unity Have any Competitive Advantages?
Every show we ask each other to find one unique competitive advantage (the way we like to describe a moat or a developing moat) the company has. For Unity, all three revolved around building the developer base and switching costs. Within these giant gaming studios, there are huge embedded costs within the gaming engine used, and it would be difficult to switch an entire development team to another one. Think if Netflix decided to switch from AWS to Azure. The cost is so high that it gives an inherent advantage to AWS even if the products are equal.
We thought another advantage Unity has built is its free student tier. While this sacrifices revenue in the short-term, it builds the developer base necessary to be profitable in the long-run.
Lastly, Unity’s “create once and deploy anywhere” gives them an advantage over other general-purpose game engines. It might hurt them if someone went super-niche, but that is the sacrifice they need to make if they want to be the most ubiquitous digital engine on the market.
What are Unity’s Future Growth Opportunities?
Like the competitive advantage segment, all three of our future growth opportunities revolved around Unity getting outside of gaming and into more professional markets. These included:
Automotive. Car companies spend a lot on R&D, especially on design. Many car companies have used Unity to improve the design process, and we think this is a large opportunity for them. AR/VR solutions (which Unity has products for) likely will be big for autonomous vehicle testing and may be where the profits are instead of the cars themselves.
Architecture, Engineering, and Construction (AEC). AEC is probably the largest non-gaming market Unity can enter. They’ve made a strategic partnership with AutoDesk, and it will be interesting to see how this and any other projects work out. I also wonder how it will affect their margins.
Film/TV. The most famous example of a game engine working on video is Unreal being used for the Mandalorian. Ian was versed on this one, and I honestly forget the exact reasoning (gotta listen to the show and find out!), but the way he explained it I realized these engines will replace green screens when trying to do things virtually. It is not a giant opportunity, but one that could be meaningful for Unity.
What We Liked About Unity
There was a lot to like about Unity. And with it trading at an EV/sales above 35, the market seems to like it as well. Ryan described them as providing the “pick-axes to the metaverse” while Ian loved how they were making it easier for developers to recreate life in digital formats.
From a financial note, I loved that their SBC was not absurdly high (at least relative to other tech companies) and that they were spending a ton on R&D.
We also came to an agreement that their competitive advantage in the form of switching-costs and developer mindshare (I know, puke, but it’s true) was positive too.
What We Didn’t Like About Unity
Outside of the yellow flag with management, and the fact that they aren’t founder-led, it was hard to find any lowlights with this business. And I think the valuation reflects that. However, we did think that the Unreal engine had solid momentum right now and that they may gain overall market share because of the new consoles launching in 2020.
Lastly, since they just IPOed, we found ourselves hesitant to invest in Unity until they are under the public eye for at least a few quarters. It seems like a solid business trading at a nosebleed price, and we all concluded we were going to stay patient before putting our money to work.
Links to Further Reading/Learning
Unity S-1 (must read before investing)
Disclosure: Authors are not financial advisors. Anything written on Chit Chat Money is not formal advice or a recommendation.