Happy Lunar New Year from PB&G to y’all! Hope everyone is doing well amidst the pandemic and its associated restrictions 🙂 Today, I (PB) have decided to share some views regarding Unity Software (NYSE:U). Disclaimer: I took much inspiration from this and this. All monetary values shown are presumably in US$.
P.S. this is our first time writing such a thought / analysis post, so would appreciate constructive feedback if you guys have any!
Disclaimer: not financial advice, do your own due dilligence!
What do they do?
Firstly, a brief introduction: Unity Software is a video game development company most well known for Unity, a cross-platform game engine used for creating and monetising games. Their software solutions allow game developers to “to create, run, and monetize interactive, real-time 2D and 3D content for mobile phones, tablets, PCs, consoles, and augmented and virtual reality devices” (source).
Why are they interesting?
From the developer angle, its biggest selling point is that if the games you create with them generate <US$100K annually, you can use their software for free (a.k.a. you need the paid license only if you generate more than that every year). This makes their platform very accessible to small developers or individuals hoping to get into game development.
The company has 3 primary sources of income, in decreasing % of their total revenue: (1) Create Solutions (54% of 2019 revenue); (2) Operate Solutions (31% of 2019 revenue); (3) Strategic Partnerships and Others (15% of 2019 revenue). Of course, its main attraction is its game engine, allowing developers to focus on creating 2D, 3D and AR (Augmented Reality) games, while leaving the bulk of the technology workload to the engine itself.
As top-level game engines are presumably difficult and time-consuming to create and maintain, Unity releasing their game engine as a SaaS is a great positive for me. I’m not a game developer, but I am a software developer and use plenty of open-source tools. If a paid tool has a lot of features or an ecosystem that I’m very used to, it tends to be prohibitively costly for me to change, unless there’s a huge problem with e.g. cost or features that I desperately need. Hence, Unity has an unsurprisingly large and recurring revenue base, as shown by their dollar-based net expansion rate below (144% and 138% in Q3 and Q4 of 2020 respectively). I don’t expect this percentage to grow dramatically, but a general uptrend and significantly >100% is great to see since it means they’re getting more out of their existing customers.
Their biggest competitor in the game engine space is Epic Games’ Unreal Engine. Since I’m not a game developer, I don’t know the differences, but in 2019, over 50% of all mobile, PC and console games ran on Unity and they have 71% of the top 1000 mobile games, so I think they appear to be the dominant player overall.
In short, what I like to see so far is that (1) they’re attractive to small players, which helps them gain market share; (2) they’re growing revenues at a good pace; (3) they have lots of recurring revenues as a SaaS provider; (4) they are the dominant player in their space.
Why did their share price drop after Q4 earnings?
If you follow Unity, or you do some research after reading this post, you might have noticed that their share price fell drastically after their Q4 earnings on 4th Feb 2021. But why?
From their Q4 earnings report, they reported a 39% y-o-y increase in revenues to $220m. While this exceeded general analyst expectations of $204m, this was nonetheless a significant slowdown from 53% revenue growth in Q3. Furthermore, management guided for Q1 2021 revenues to be $210m – $220m, a 26-32% y-o-y increase. As far as I can tell, the market reacted harshly by dumping their price due to lower guidance (slower expected growth).
To me, I see the conservative guidance as a good example of the underpromise-and-overdeliver strategy. Additionally, the growth rates are still pretty good, and their trump card, AR, is only starting to get mainstream media and investor attention, thanks to games like Pokemon Go. If AR pays off, it could pay off hugely for them. I picked up a few shares (positions at the end of this post) after this drop.
What does PB think?
In general, PG and I like SaaS, and one of our gold standards for this is Adobe. I’ve been a Lightroom / Photoshop / Premiere Pro user for a few years, and I hated it as a customer when they moved to a subscription-based model, but as an investor, it’s excellent to have recurring revenues. Unity is a bit in the same spot here.
I see pros for Unity as follows:
- Game developers don’t pay for using their platform if their annual revenue is <$100K, which attracts many small developers and is a generally good way of gaining users
- They are a mobile gaming GIANT, with 71% of the top 1000 mobile games being created with Unity’s engine: think Temple Run, Angry Birds, Mobile Legends: Bang Bang, Among Us etc.
- Their 2 largest income segments, Create Solutions and Operate Solutions, grew revenue 37% and 61% respectively over the last year. These numbers are large, which is good, but not too large that they might create unrealistic further expectations
- TTM overall revenue growth ~40%, similar point to the above
- Number of customers spending >$100K grew 32% y-o-y, while number of customers spending >$1M grew 86% y-o-y
- Dollar-based net expansion rate at 138% and has been well above 120% for the last 8 quarters. This metric shows how much of their existing customers spend from one year to the next, a.k.a. meaning sales to Unity’s previous customer base grew 38% y-o-y
- 2.7 billion monthly users on Unity’s platform (that’s the same scale as FACEBOOK!), and apps built with them were downloaded 5 billion times per month in Q4 2020
- Healthy balance sheet: cash (~US$1bil) is approximately 10x their debt ($100+mil)
- Currently only 13% of their revenue is derived from non-gaming segments so lots of growth potential if they choose to tap it e.g. education
Of course, we do see some risks:
- AR/VR today is still at a relatively infant stage, where it’s a lot of hype and true potential is not fully realised. If their AR/VR investments kick off, they could do very well, but if not, might be meh
- The mobile game crowd (generally gaming crowd, but especially for mobile games IMO) is pretty fickle, and they have to continuously be successful to keep their growth going
- I’ve heard claims that Unity doesn’t monetise their users very well (could be a case of gain market share first, profit later) – can anyone explain this to me?
- They are not profitable, with negative EPS (but healthy balance sheet as cash >>> debt)
Overall, I think the pros outweigh the cons for me, and that’s why I’ve invested a bit of money into this. Gaming in general has been on the rise for a while (just look at the Dota 2 International prize pool over the last few years), of which mobile gaming has arguably the most potential as most people aren’t in front of a computer all the time, but they have their phones practically all of the time they’re awake. I see gaming as a secular trend, with the possible trump card of their AR, and non-gaming investments helping out as well.
What do you think? Do leave any comments or feedback if you have, and we would love to hear other thoughts on Unity and the gaming space in general!
Disclaimer: PB is vested at an average buy price of $127.95
Peanut Butter & Gem 