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Building a Game Engine to Power Creators
In a world increasingly dominated by digital experiences, the realm of possibility is limited only by our imagination. Virtual environments are the new frontier of exploration, and the ability to explore and create these alternate realities draws a constantly growing userbase. All around the globe, people are playing, making, working, or otherwise interacting in a digital realm.
While gaming lies at the center of this movement, the desire to go virtual is pervading most corners of our lives. Artists and creators are increasingly drawn into virtual environments, and their imaginations have the potential to expand the virtual environments we immerse ourselves in.
Yet, blending imagination with the ability to create is easier said than done - it requires a complex mix of technology and creative skills, a balance between designers and developers.
It requires a platform that can unite the two.
Enter Unity Software (Ticker: U), a platform that allows artists to create interactive digital experiences and turn their imaginations into reality. Unity’s goal is to democratize game development through a 3D-creation software so accessible that anyone, from young gamers to experienced industry professionals, can create immersive virtual realities.
Creating this platform wasn’t simple - the complexity involved with building it out went parallel with the ambition of the vision that Unity’s three founders had. But their vision was merited, and the company has grown from a small and disruptive gaming startup to an established player in the tech space that is helping to power some of the world’s most popular video games while expanding the potential of their 3D creation software to industry and film alike.
**Disclaimer: I am not a financial advisor, planner, analyst, or any other such fancy title. This article is meant to provide a basis for your own research and decisions, and should not be taken as financial advice. I own shares in Unity Software, and may be biased towards its success as a result. Please, please don’t make decisions based on what you read today.**
Mkt Cap: ~$15bn
Gross Margins: 68%
"Reality is broken. Game designers can fix it."
- Jane McGonigal
Unity was founded in Denmark in 2004, when the three founders of the company - David Helgason, Joachim Ante, and Nicholas Francis - came together with the idea to solve a very real problem that the trio was facing; creating quality video games on a lean budget. They set out to create a platform that would not only solve their issues, but also diminish barriers to entry across the entire video game industry and democratize game creation. This was the foundation that Unity Technologies was built upon, and the beginning years of the company were characterized by the founder’s mission.
The company found success after launching the first iteration of their platform in 2005 - the problem they were working to solve was one faced by a number of people, who formed Unity’s early customer base. As the business grew, the founders made the decision in 2014 to bring in John Riccitiello - former CEO of EA - to head up the business as CEO, taking over the chief position from Helgason. Riccitiello arrived with a vision for what the company could become - by focusing not only on game developers, but a broader customer base that included artists, creators, filmmakers, designers, and architects, Unity would be able to provide its 3D-creation capabilities to a variety of industries and thereby continue its growth trajectory.
The plan worked. Under Riccitiello, Unity has begun offering its platform, once solely a game development tool, to a wider market. Their 3D modelling and development software is now a comprehensive creation ecosystem widely used in film and animation, manufacturing plants, and VR/AR design. Accompanying this expansion to adjacent markets, the Unity team has continued to offer additional capabilities for wider use cases and enhanced customer usability: analytics, monetization tools, multiplayer networking, and enhanced creation tools.
Unity’s penetration and brand recognition in the digital world and among its creators has continued to grow, helping to foster a more innovative and robust digital landscape. Their success story continued to write itself, and was aided by a 2020 direct listing on the NYSE under the ticker: U and an opening price of $68. Unfortunately, since going public, the narrative has gotten topsy-turvy, delivering a -33% return and cratering from an eye-watering $197 /share to just north of $45 /share as of writing. Declining performance in several key metrics has scared away many investors,
Despite the poor return for investors, Unity’s evolution as a business hasn’t let up - the creation platform’s array of tools has been leveraged to create several popular games, including Beat Saber, Subnautica, Pokemon Go, Rust, and (my personal favourite) Cuphead. The success of their game creation platform has resulted in 5bn monthly downloads and 3.9bn monthly users of Unity-made apps, as well as more than 50% of all games being created on Unity. Meanwhile, their expansion into industry and film settings has continued to show successes with uses in an African renewable energy project and the film Avatar 2, respectively.
Given the contrast in narratives here, it can be difficult to get a true sense of Unity’s future prospects, and its potential as an investment opportunity. So, buckle in and let’s dive into what’s driven Unity’s success as a company, and why this hasn’t yet translated to a fantastic share performance.
Unity can be roughly divided into two segments: the Create Segment, and the Grow Segment. Within each segment, they offer a range of products and solutions for various stages and sizes of project development. It is easier, from an investor’s perspective, to partition the two segments so as to get a better sense of how each is performing; however, from a creator’s perspective, the two segments are very much interoperable and meant to be used in conjunction with each other.
At its core, Unity’s development platform operates on a freemium model that is designed to fulfill Unity’s foundational purpose of making 3D-creation software accessible to everyone. Individual developers, hobbyists, and small studios grossing <$100K /year are all able to use Unity’s basic creation products entirely free. In addition to fulfilling Unity’s foundational purpose of making 3D-creation software accessible to everyone, the freemium model allows the business to funnel more users into the Unity-verse. As users realize the capabilities of the Unity products, they may be interested in expanding beyond the limits of the free version, especially as projects expand in size or complexity (this is more applicable to game studios than individual users).
When users stretch the limits of the free offerings, Unity offers a paid license on a subscription basis, which accounts for 35% of the business’ revenues. Plans can scale with the needs of the user or size of the studio; the Plus and Pro plans are aimed at very passionate hobbyists, professionals, and mid-sized studios ($400/yr - $2000/yr). Above these plans are the Industry and Enterprise plans (at either $5000/yr or requiring custom pricing), which are designed for use in larger studio and business settings, with increased functionality for managing projects with large teams.
That is not to say that Unity exclusively makes money from licensing to larger customers - they also have the Unity Asset Store, which is a two-sided marketplace that allows developers to create, sell, and buy a massive range of products that can then be integrated into creations, ranging from specific animations (vegetations, characters, etc.) and sounds to AI & ML addons. The variety of additional tools available to creators on the Asset Store is impressive, and I imagine many creators would be tempted to pay for a few extras in order to make better games. This all stands to benefit Unity, which is able to take a cut ranging from 12-30% on all Asset Store purchases without requiring the upfront investment to develop all these tools themselves.
Once focused exclusively on game designers, Unity massively grew its total addressable market by focusing on adjacent markets requiring 3D modelling and creation software. The subscription plans, along with an expanded toolbox available for customers, are now available for multiple industries. This not only widened Unity’s potential runway for future growth, but also provided immediate revenue streams and a broader customer base.
Unity’s business is not focused exclusively on their creation software - designed to be a one-stop-shop solution for 3D creators, Unity offers monetization services through their Grow Segment to help their customers build success with the products they create. While this portion of the business is less aimed at larger enterprise or industry customers, who already have established brands and marketing teams of their own, it is very helpful for smaller creators.
The Grow segment, which makes up ~65% of Unity’s revenues, offers users the ability to add and manage advertisements to their games, plugins for allowing in-app purchases, and user acquisition strategies like ad campaigns targeted towards user growth and retention. This is all done on a central platform that allows users to scale and monetize through multiple ad networks (they offer this for all creators, even if the game wasn’t developed using Unity’s game engine), as well as utilize analytics and optimization tools to sustain profitability - more advanced analytics tools are available for additional fees. To date, Unity Ads has generated more than $1.1bn for creators, demonstrating the success it can unlock for developers.
The Grow segment is the much larger portion of the business - while this may be surprising, given that they are primarily known for their creation software, it’s a clever design by Unity - they funnel as many users onto their platforms as possible for free or on inexpensive plans, and then take revenues (through a revenue-sharing model) based on the success of the platform, which Unity aids. This allows Unity to grow with their customers, creating a win-win flywheel for both buyer and seller - I find this sort of value proposition highly attractive in looking for investment opportunities. As the company expands its Grow segment capability, it drives more value for creators, which are then much more likely to continue utilizing both the Grow and Create products while also contributing greater revenues to Unity.
Products & Use Cases
Unity’s 3D software can be used for a variety of uses and sectors, which the company splits into three main segments - Gaming, Film, & Industry. More to give a sense of Unity’s impressive technology than to get down and dirty with the minutiae of technical details, let’s dive into a high-level overview of the different products and their uses.
This is what Unity is known for - few people really consider the business as anything other than a video game creation company. While this isn’t remotely true, it is certainly one of their core offerings; Unity Engine allows users to design and create games, with a focus on making vast games easy to create with a variety of tools, including plugins to allow no-code game creation, a simple, drag-and-drop style user interface, and the following additions:
SpeedTree allows for the easy addition of pre-made vegetation, and makes it extremely repeatable for larger environments. While this may not seem like a huge deal, the creation of realistic landscapes has historically been an extremely time-consuming and costly process for game studios - so much so that natural landscapes are frequently avoided or limited. SpeedTree fixes this problem for creators, expanding the possibilities for video games and offering a ton of value for game studios. SpeedTree has been used by most of the large game creators and studios in the world, and the integration (through a 2021 acquisition) into Unity Engine brings makes this impressive software accessible for Unity creators.
Ziva helps to bring characters and animals to life (again, with a focus on making the process repeatable) with physics-based, AI-assisted character creation and animation. This tool, which Unity got through their acquisition of Ziva Dynamics, actually blew my mind. It makes me super excited for the future of both Unity and the video game industry as a whole.
Unity also offers a variety of features designed to make workflow and collaboration between teams seamless, minimizing the barriers for medium- and large-scale businesses to sign up for the Unity engine.
Unity can be used to create games for VR, all major consoles, desktop, mobile, and cross-platform. The ease-of-use and creator-centric approach to the platform has allowed it to garner a lot of success with users, with over 70% of the top 1000 mobile games being made with Unity and Unity games being available on 17 platforms.
As mentioned above, Unity has already been used in the creation of several big-name productions that include Lion King, Avatar 2, Game of Thrones, Planet of the Apes, and several Marvel movies. This segment of the business was boosted by a late-2021 acquisition of Peter Jackson’s Weta Digital virtual effects & CGI studio, which is best known for its use in the Lord of the Rings trilogy.
This is a fantastic tool, and as mentioned in the video above, a huge partnership for Unity. Weta’s digital creation capabilities are central to the modern film industry, which relies heavily on special effects to consistently deliver more impressive, immersive, and unimaginable worlds to the big screen.
Real-time rendering of scenes created in Unity allows filmmakers to create, shoot, and recycle fantastical sets while ensuring they get exactly the scene that they want, saving an immense amount of time and making virtual effects production a far more efficient process.
Films can also use the Ziva character creation tool for photorealistic character creation and animation, as well as SpeedTree for vegetation. The combination of these tools with Weta makes it incredibly easy for filmmakers to enhance their digital capacity and quality, and help to further enable CGI technology, digital humans, and simulation tools in a highly repeatable and efficient creation process that makes it easy for Unity customers to succeed.
Unity Industry gives industry customers access to a series of tools that can be integrated with workflows and other industry tools, such as AutoCAD.
Unity’s tools for industry allow a wide range of uses across different businesses:
Automotive companies can use Unity 3D software to visualize, blueprint, and design different vehicle models. While automotive is an easy example, nearly any design team can utilize 3D renditions to assist in modeling and design (think shoemakers, airplane manufacturers, etc.).
Renewable energy companies can use Unity’s digital twin feature to create virtual copies of their assets, in turn allowing them to simulate weather conditions, power output, and optimize their operations.
Manufacturing plants are able to re-produce digital versions of their factory floors to simulate (using AI) different production outputs and test the impact of different scenarios, thus allowing them to create contingency plans, gain a better understanding of their manufacturing capacity, and optimize for efficiency.
Engineers & architects have a ton of opportunity to leverage the software - they can essentially turn their AutoCAD (if you’re not familiar with this product, it is a design system used by nearly every engineer and architect in the world) workflow into 3D models, as well as run training programs and utilize AI to run predictive maintenance on buildings and workplaces.
There are a ton more use cases I won’t get into, but the one I think has the most potential is the digital twin software, though they certainly aren’t the only company in the space. There are so many unique uses for digital twins that can help to make businesses more efficient that it almost deserves a future article for itself; this feature is already being used by a renewables company in Africa, a port in Finland, and the airport in Vancouver, Canada, to increase safety and reduce operational logjams through forecasting and predictive analysis. Management reported a 100% YoY growth in digital twin revenues in 2022.
Overall, addressing the 3D needs of industry customers grows Unity’s total addressable market and diversifies their clientele, which should help to make the business more resilient during macro-economic downturns.
I'm highly impressed with Unity’s ability to make acquisitions - SpeedTree, Ziva, and Weta were all highly additive enhancements to Unity Engine and the creation segment of the business. Weta was acquired for ~$1.5bn in cash and stock and Ziva for $130m (which seems like highway robbery), while the SpeedTree acquisition cost was not disclosed.
Unity also recently announced a merger with ironSource, a company focused on app monetization, to expand the Grow segment of the business. The merger cemented Unity as an end-to-end platform for creators, with a significant amount of value being added for mobile game developers looking to monetize. The merger was completed in November of 2022 in a $4.4bn all-stock deal - shareholders did not appreciate the dilution, nor management’s assertion that the merger wouldn’t lead to greater revenues upfront, but rather a growth in market share. Commenting on the merger, CEO John Riccitiello said;
“The gap on Unity's data was no visibility on the mediation component, which is a very important part, where advantage lived if we had a very strong ROAS (Return on Ad Spend) well set. And so we took two large data sets and pulled them together under one roof, which allows us to target users better”
ironSource’s mediation platform, LevelPlay, is designed to act as a smooth intermediary between multiple ad networks and developers, making monetization easier and more profitable. It has already seen some big customer acquisition wins since joining under Unity’s umbrella, with Sega and Supercell joining to monetize their games and Tinder to increase the profitability of ads on their dating platform.
Despite the fact that it was a fairly large price tag to merge these datasets, and that it came at significant dilution, I do believe the ironSource merger could ultimately pay dividends for Unity - if that return on ad spend figure cracks up to be all management is saying it will be, it would play very much into Unity’s flywheel for growth.
Unity’s balance sheet will leave you wanting. On top of the dilution from the ironSource merger, they have declining figures in what is definitely their most important key performance indicator, and have some other shaky features the company will need to overcome for investors to start feeling secure enough to commit their long-term investments into the company.
Balance Sheet - The Bad & the Ugly
Declining Gross Margins
Gross margins took a pretty significant downturn from 77% to 68.4% in 2022 as a result of much faster growth in the cost of revenues than in total revenues. This isn’t wholly surprising, given that it was a tougher year on this front for a lot of companies - this is slightly less discouraging when taking a closer look at all margins in 2022 compared to TTM margins, where some improvements can be seen:
Gross Margin: 2022 = 68.4% → 68.5% TTM
FCF Margin: 2022 = 13.6% → 19.5% TTM
EBITDA Margin: 2022 = -45.2% → -31.5% TTM
Operating Margin: 2022 = -60.4% → -50.8% TTM
So, you can see that there has actually been a lot of improvement over the last year on overall margins, though EBITDA and operating margins remain significantly in the red (adjusted EBITDA margins were reported at 18.5% in Q2). This is likely a result of the large layoffs and focus on efficiency that Unity underwent over the last 8 or so months. Still, gross margins have a ways to go to fully recover to the previous high watermark.
The ironSource deal was an all-stock transaction, the Weta acquisition was made with a significant bit of stock, and basic shares outstanding increased by 29% YoY. That is a wicked amount of shareholder dilution, all-told. While much of this is likely necessary to the business, so as to attract and retain top talent in the highly-competitive labour market in tech, it still hurts for shareholders. Furthermore, huge deals like the ironSource and Weta transactions that were made using a lot of stock, can really add up in the dilution department.
Balance Sheet - The Good
Free Cash Flow Positive
Unity is free cash flow positive, allowing them some wiggle room to make further investments in the business with the surplus profits. Unity delivered $33m in free cash flow for Q2 ‘23, and operate at a solid 19.5% FCF margin over a trailing twelve month basis.
After a grim looking second quarter of 2022, Unity has certainly righted the ship, jumping right back up to an 80% total revenue growth, boosted by a significant re-acceleration of the Grow Solutions segment. Given the size of the markets that Unity is operating in, which I’ll get into more a little further on, I expect strong double-digit revenue growth to continue for many more years.
A Nice Nest Egg
Unity has a decent amount of cash sitting under their mattress, with $1.6bn in cash ready to deploy for growing the business. Personally, I hope they use it to continue their savvy acquisitions while lessening the strain on existing shareholders. Whatever they use it for, it’s encouraging that Unity has a bit of a contingency fund lying around.
Key Performance Indicators
Unity announced Q2 results on August 2nd, just a few days prior to this article being released, so I’ll be going off figures announced in the freshest quarter possible.
Dollar-based Net Expansion Rate
There aren’t a ton of metrics that investors interested in Unity have to keep an eye on to monitor the health of the business. Dollar-based Net Expansion Rate is without a doubt the most important one though - this figure determines the amount of additional revenues Unity recognizes from already existing customers, such as through purchases from the Asset Store, upgraded plans, or funnels into the Grow segment products.
Unfortunately, things haven’t looked great for the company on this front. After boasting an impressive 142% expansion rate as recently as two years ago, this figure has steadily declined to just 106% as of today. Much of this can be explained by a weakness in the overall digital advertising market, but it still doesn’t look great - management commented on this during the recent earnings call, saying that selling additional subscription plans has managed to keep them afloat on the expansion front, suggesting that customers are still willing to spend more for the creator products.
This is the #1 metric I monitor for Unity, and the decline, while not thesis-breaking, has been disconcerting to watch. If Unity is not able to right the ship as advertising spend slowly ramps up again, I would strongly consider selling my position. It should also be noted that dollar-based net expansion rate does NOT take into account customers who exit the platform entirely, which means it needs to be monitored in conjunction with the number of customers.
Customers Contributing >$100K
Unity measures its customer count in the number of clients spending more than $100K on their products - I’m glad they do this, as they could cherry pick this figure a bit by including the total number of users, which wouldn’t give very good insight into the revenue recognized off customers.
On this front, Unity has done much better - their total number of customers contributing more than $100K has grown at a ~22.5% CAGR over the last two years, from 888 in Q2 ‘21 to more than 1300 today. I’m quite impressed with this figure - though growth rates have stagnated a bit over the last year or so, the fact that they are managing to continue growing their customer count during a tougher macro-economic period speaks for the quality of the product and how much customers are willing to spend for it. It also suggests to me, though this is more of a hunch, that their penetration into more resilient industry customers has been going well.
Grow & Create Revenues
Finally, it’s important to monitor the revenues coming from each segment of the business. I see Grow as the more important of the two, given that it makes up a greater portion of Unity’s total revenues and is currently going through a more turbulent period as a result of softened ad spending.
Grow Solutions grew a whopping 157% YoY to $340m, which was a huge improvement from the -13% decline and $159m announced in Q2 of last year.
Meanwhile, Create Solutions grew 17% YoY to $193m for Q2 ‘23, which was a very meaningful slowdown in growth from 40% in Q2 ‘22, and $165m in revenues. Within the Create segment, I also like to monitor the revenues contributed by Industry and Film - in Q4 ‘22, these customers accounted for 30% of total Create revenues and their contribution had grown +141%. In the most recent quarter, management didn’t provide a growth figure, but the makeup remained the same at 30% of Create revenues, meaning they must have grown fairly in-line with the wider segment.
I should note that if you look at older earnings calls (pre Q4 ‘22), my figures may look wrong. This is a result of a change in the reporting structure that was announced for both the Grow (formerly the Operate) and the Create segments of the business.
Core Subscription Growth
This one is a little difficult to find, and I often have to scrape through the earnings call transcript to find it, but it does offer some insight into how the growth of their subscription services to Create Solutions is going. In Q2 ‘23, core subscription growth was 22%, according to Unity CFO Luis Visoso.
Defense & Offense
Switching Costs - Defense
There are massive switching costs involved with changing up the gaming engine that developers use. Firstly, creators spend a ton of time learning the engine they use to build a game; there would have to be enormous benefits involved with a different engine to justify the re-training required to learn a new engine.
While this is true for all creators, it is especially critical for game studios - re-training an entire staff to work with a new engine would be enormously costly, and would essentially halt development in the near-term and slow it down in the longer-term as employees got used to a new platform. It would also make it almost impossible to provide updates to older games, or to transition older code onto the new engine. A transition would pose such a massive logistical nightmare that, if a newer and more robust platform entered the market, most game studios would likely be willing to stay with a slightly inferior product to avoid it.
These switching costs work both for and against Unity. While it helps them to retain customers that are already on their platform, it also limits their growth with studios or developers that are using a competitor’s platform. Thankfully, this isn’t a huge problem as the industry is heavily concentrated between just a few key players that mostly serve different creator markets.
VR/AR - Offense
As seen with the struggles experienced by Meta’s Reality Labs division, VR has hardly skyrocketed in popularity; while they’ve done alright (nothing spectacular) in selling headsets, retaining regular users has been a struggle. However, I believe the future for VR & AR is massive - as technology in the space advances, the use of VR/AR headsets will become more rampant in popularity and potential use cases. As that boost in popularity takes place, which I see as nearly inevitable, more VR/AR apps will be developed using Unity’s technology.
In fact, I’m currently writing this article while using a Meta Quest with the Immersed app, which was developed using Unity. Immersed allows me to connect with my computer and add up to five extra monitors in the office space of my choice (right now, I’m in a space station overlooking Earth, with a wonderful view of Africa floating by and a nebula above me). Now, this isn’t an ad for Immersed, but rather a demonstration of a use case for VR and Unity’s place in developing these use cases. As the market for virtual and augmented realities ramps up, Unity will be a key player in providing the backbone infrastructure (apps/games) required to make headsets both fun and useful, which in turn will greatly expand the market for their Create Solutions.
The Gaming Industry - Offense
Unity should stand to benefit from the massive tailwinds in the gaming market as a whole, which today is estimated to be worth ~$250bn globally with a projected CAGR of 9% through to 2028 (making it worth $376bn by the end of the forecasted period; other figures have this closer to $380bn today and >$500bn by 2028). While there are certainly a lot of players in the space, and Unity’s technology doesn’t specifically cater to all gaming studios, the company should still stand to benefit from a growth in the industry as a whole.
The fastest growing market within the greater industry is mobile gaming, which will provide huge upside to Unity as the leading development platform for mobile apps. Mobile gaming is expected to reach nearly $350bn by 2030, with surges coming from the greater availability of smartphones globally and a growing userbase in the Asia-Pacific region.
Acquisitions - Offense & Defense
Unity’s acquisition strategy to date has been extremely additive to their overall platform - you can make a very valid case that many of these have been dilutive to shareholders, but there’s no doubting that the tools they’ve acquired have allowed them to address larger markets and improve offerings in markets they’re already operating in. Continuing to make these kind of acquisitions, so long as they’re done strategically and at the right prices, should continue to offer Unity the opportunity to expand their toolbox. As they offer more tools, they should allure a wider customer base while also encouraging existing customers to remain on the platform, providing Unity with simultaneous offense and defense.
In early 2022, Unity stated that the total addressable markets was $45bn, a significant raise from the $29bn they had proclaimed as their TAM during their IPO announcement. This is not a result of exaggeration from the management team, but rather from the much larger market they built for themselves through acquisitions and in-house development that offers a greater number of customers, across a number of industries, a more expansive suite of tools. Given the total market size and growth for gaming as a whole, this figure should only increase as time goes on, further aided by the $60bn virtual reality market that is projected to grow at a CAGR of 27.5% through to 2030. Industry customers should also grow contribute a greater portion of revenues as adoption continues in these more-resilient markets, particularly with the growth of digital twins, a market that is expected to grow to $150bn by 2030 with a 36% CAGR.
All of the markets that Unity is catering towards are expanding rapidly with significant tailwinds behind them. If the company can take advantage of wider sector growth, they should be operating within a massive total addressable market by the time this decade draws to a close.
I should begin this section by stating that Unity and its two primary competitors, Roblox and Epic Games’ Unreal Engine, operate in different niches of the creator market, depending on the complexity of the project. While Roblox caters to a beginner set of developers and requires no coding experience (the average age of their users is <16), Unreal Engine serves the high-end of the market and requires a significant amount of coding knowledge. Unity falls somewhere in the middle, requiring some know-how for slightly more complex projects, but nowhere near the expertise that is required for competent use of Unreal Engine. I believe Unity addresses the wider market of the three, but is not as good for specialized use cases, which Unreal and Roblox help to fulfill.
Like Unity, Unreal is leveraging its platform for use in the automotive, film, architecture & engineering, AR/VR, and simulation industries. However, there are some differences between the two companies and their offerings:
Unreal Engine takes the edge over Unity in virtual effects and rendering quality, as well as in rendering, key tools that help to make it a more advanced 3D creation software. I should note that most of the reading I did on this gave only a slight edge to Unreal, but an edge nonetheless.
Unity uses C# coding language, while Unreal uses a combination of C++ and Epic’s proprietary Blueprint language.
Unity takes wins out on ease-of-use, making it a more open and accessible form of development for a wider customer base. According to many of the users that I talked to, Unity’s UI is more user friendly and manageable than Unreal, doesn’t require learning a new programming language, and has a large range of pre-made products readily available in the Asset Store, which are the features that make it easier.
Unreal makes its software free as well, but takes a 5% royalty fee on all games created with the engine, which makes it quite different from Unity’s model - Unity’s fee structure is likely more attractive for developers, as a 5% royalty on all sales would add up to a greater total cost than Unity’s subscription licensing quite quickly, if it was a decently popular game.
Unreal Engine has faster rendering and processing speeds than the Unity Engine; this matters less for smaller developers, but for enterprise customers that are working on tight schedules and strict deadlines, the efficiency from Epic’s Unreal would be a huge plus.
Unreal is undoubtedly the more advanced 3D creation software, with faster speeds and higher quality rendering and VFX - many of its tools far outstrip Unity’s capabilities, while Unity takes the edge in other head-to-head comparisons, like team collaboration and ease-of-use. Unreal’s value proposition clearly leans its uses more towards high-end developers and larger game studios that require the fastest and highest-quality platform, and are willing to put the time into training staff on a better product. Their engine was used for Epic’s own Fortnite, as well as a recent Minecraft update.
Unity, meanwhile, provides an easier platform for individual creators and beginners, and the fee structure would also help to lean customers that don’t want to pay a 5% royalty on all sales. They hit the mid-range corner of the market, where creators don’t require super high-end quality of Unreal but still require some sophisticated tools and features for building out what can still be very impressive, robust games.
For film, Unreal offers many of the same products as Unity, including real-time rendering, animation, and digital humans that make filmmaking more efficient, and was used in the production of The Mandalorian and Ford v Ferrari.
While many of Unity’s and Unreal’s products directly compete, Unreal slightly distinguishes itself from Unity through an additional offering of rendering and special effects for sports broadcasting and live shows - the Unreal Engine was used for the most recent Super Bowl to create 3D version of players, coaches, and the halftime show, as well as in a light show during a set at the Tomorrowland music festival.
In contrast, Unity is distinguished by its Grow Solutions, which Unreal seems to offer no competitor for. This further supports Unity’s value proposition for small- and mid-sized developers that may need more help scaling and monetizing their creations than already established game studios that likely have their own marketing teams/strategies in place.
In summary, I believe Unreal Engine to be the superior product for creating the highest-quality products, especially if working on a project with time-restrictions. However, Unity’s ability to cater towards beginners and mid-range creators with their friendly user interface, Asset Store offerings, fee structure, and end-to-end platform helps to even the scales while still providing a very strong digital creation software capable of producing extremely high quality games, films, and industry experiences.
I feel I have to mention Roblox because they essentially do the same thing as Unity - provide a platform for creators to make a game. However, the capabilities and target customers are so different that it’s almost a joke to mention them in the same conversation. Roblox is more designed towards kids and very beginner-stage creators who want to make a fun and super simple game. For anyone more serious about creating a scalable or high-quality game, or earning money from their creations, the obvious choices are Unity or Unreal. I’m not taking a poo on Roblox here, I think it’s an awesome tool for getting younger users into creating games in a fun and easy environment - but they simply don’t cater to the same customers, offer competitive enough products, or appeal to as broad a customer base as Unity or Unreal.
It’s time for the Glassdoor segment! The result are in, and…
Well, it doesn’t look great. A 66% approval rating of the company isn’t terrible, but it’s certainly not great either, and doesn’t do a lot to inspire confidence in shareholders that employees are incentivized to stick around or that the company is attracting top talent. Every single negative review commented on terrible management, including several about a backstabbing political culture, an overbuilt mid-level management team, and an extreme lack of competence, vision, or experience from senior-level management that has never used the products. Another common critique was a lack of direction or ability to move towards goals, which would suggest to me some bloat within the company.
This is a situation I am closely monitoring with Unity - it’s always important to take reviews with a grain of salt, especially after several rounds of layoffs and reduced benefits packages in a tough macro-economic environment, but CEO Riccitiello doesn’t have a great track record when it comes to leading teams (as I’ll get into more below), and the dismal collection of negative reviews seems to suggest that this hasn’t changed. Keeping track of the company culture at Unity will be crucial - if the work environment is so bad that the company isn’t able to retain top talent in a competitive industry, then they are kaput. Simple as that. The worsening Glassdoor situation has Unity very much in my portfolio’s hot seat, and if reviews don’t start to pick up in the next year or so, I will likely sell off my position.
Out of the original three founders - David Helgason, Joachim Ante, and Nicholas Francis - only Helgason is still involved with the company. After stepping down as CEO and allowing the role to be filled by someone more experienced (Riccitiello), Helgason moved into a position on the board of directors, where he remains today to assist and advice the company. COO Nicholas Francis left the company in 2013, as he felt more impassioned by making games than working on the engine itself, while Ante, who had served as the CTO, was at some point quietly replaced by Luc Barthelet for unknown reasons. I couldn’t find any information on whether Ante was still directly involved with the company.
I generally prefer founder-led teams, as they have a lot more skin in the game, tend to be more aligned with shareholders, and are statistically more likely to outperform the market. Unfortunately, Unity just doesn’t fit this bill. Does that mean it’s impossible for them to succeed. Certainly not. But it definitely doesn’t garner any bonus points for the report card.
John Riccitiello has been around the gaming and media industries for a long, long time. He first joined Electronic Arts as the COO in 1997, after a few brief stints as CEO at other companies, and worked in that position until 2004, helping to grow the company from a few hundred employees to several thousand before leaving to co-found an investment firm specializing in media and entertainment businesses. He return to EA as the CEO in 2007 and filled the role for 6 years, during which time the stock fell 66% and EA was voted ‘America’s Worst Company’. This led to EA’s board of directors accepting his resignation for poor financial performance of the company in 2013. Unfortunately for Riccitiello’s reputation, EA’s stock almost immediately began to bounce up since his resignation and maintained several years of steady gains. While this could make it easy to view Riccitiello’s time at EA very negatively, and there are many that do, it should be noted that he actually helped to re-focus the company on publishing high-quality games and developing new IP - he also took on the top job immediately prior to the Great Financial Crisis, which is a pretty tough go for just about anyone.
He clearly wasn’t scared away from the gaming industry as a whole though, as just a year and a half later he transitioned from a board member position at Unity to the CEO position, stepping in for David Helgason. He steered the company through several rounds of funding and expansions into the film and industry spaces, as well as driving partnerships to get Unity technology onto most of the world’s major platforms.
Unfortunately, his business decisions don’t seem to have garnered him a lot of love from the Unity staff, with just 42% of employees giving Riccitiello a positive review. He’s made a series of gaffs that could best be described as “out of touch”, including having a relationship and ultimately marrying Unity’s HR director, calling developers that don’t want to add microtransactions into games “f***ing idiots”, and purchasing a $30ish million dollar mansion in the middle of the pandemic.
Overall, I don’t quite know what to make of Riccitiello. He seems to have done some… questionable things in the past. He also seems to have a keen business acumen and made some excellent calls on Unity’s moves into adjacent film and industry markets, but his low approval rating from employees, in addition to his shaky track record, don’t give me a ton of confidence.
Despite the many reviews complaining about management on Glassdoor, there were as many good reviews about the overall work culture, which many mention being focused on high-growth and innovation. I found this snapshot from Comparably on the company culture:
An A+ company culture, with particular bright spots in Happiness, Benefits, and Retention help to dispel some of my concerns from the Glassdoor reviews - what the difference is between the Comparably and Glassdoor reviews is anyone’s guess, but the CEO grade certainly seems to be quite a bit stronger here.
Now, for the fun part. A great business doesn’t always mean a great investment, particularly if it’s bought at the wrong price. Unity is perhaps a prototype example of this; investors who bought at the peak prices in late 2021 experienced nearly a 90% drawdown before Unity shares began to recover slightly at the beginning of 2023, though they would still find themselves well short of recovering their investment at today’s prices. But we’re talking about today - let’s dive into whether current prices present an attractive investment opportunity.
At a share price of $40.17 ($15.2bn market cap), Unity is trading at 8.5x TTM revenues and 7.3x forward-looking sales figures (from guidance provided by management). This is lofty, but not as expensive as it could be for a business with nearly 70% margins and a well-recognized name amongst investors.
Time for the ol’ back of the napkin return modeling. For this one, I’m basing my projections based off total market penetration to date and potential for future growth - I’m using this method because Unity’s whole shtick is the huge upside it can offer it can find success in some fast-growing markets. Assuming that the TAM for the Grow and Create segments are correct ($45bn), then Unity is currently hitting 4% of the market (based on TTM revenue figures of $1.8bn), and that will serve as the foundation for this sketchy model;
I assume that Unity can grow to hit 10% of this market by 2028, and that the market for Grow & Create will grow to $68bn (in line with growth of overall gaming market - conservative, given that management actually estimates they’re growing faster than the market presently) - that puts them at $6.8bn in revenues by 2028, which would represent a 30% CAGR over the coming 5 years.
Then I factor in just a tiny bit of multiple compression - only a small bit though, because they will still be operating in a fast-growing market - from 8.5x revenues to 6x sales.
That would put Unity at a $41bn market cap by 2028, good for a 22% CAGR that would out-perform the market in its sleep.
Let me be clear that this is a super sketchy rough model for the future potential, and that there are a ton of things I don’t factor in here (including stock dilution, which will likely continue to be a huge cost to shareholders!!!) that would probably make professional analysts cringe. So, don’t build my model into your investment thesis or take it as set-in-stone returns. I am just providing it as a rough demonstration of how I think the stock could grow into the larger market opportunity - feel free to play around with the figures based on your own assumptions.
Nevertheless, I think a $40ish billion market cap by 2028 is in the realm of possibility for Unity if it can stabilize the decline in dollar-based net expansion rate and grow its number of customers contributing >$100K, potentially through the success of their Grow Solutions or just the wider growth of the markets they operate in, like digital twins and VR.
I always like to see what Wall St. is thinking about a stock - the opinions from analysts on the one-year price target for Unity is pretty varied, ranging from $16 to $61. Based off the current share price of $40.17
Low: $16 - (-60%) decline
Average: $45.86 - +13% upside
High: $61 - +52% upside
I will, as always, point out that these are short-term, 1-year outlooks and that analysts, just like the rest of us, can be wrong about their assumptions. There are a number of reasons they might not be able to hit these targets…
Threats to Share Performance
Though not as richly valued as other companies, Unity still trades at a premium for a company that is not yet profitable. If the company misses on revenue guidance or fails to meet/exceed analyst expectations, a (potentially) overvalued share price is much more prone to taking a deep plunge.
The current writer strikes have halted a lot of production in the larger filmmaking industry, and it’s unclear how long the strikes could continue. While it’s hard to tell exactly how much in the way of revenues is directly contributed by uses in filmmaking, a prolonged strike and lack of production from the film industry could hurt Unity’s top-line growth and ultimately its share price if it ends up resulting in a failure to meet guidance.
Continued Decline in Dollar-based Net Expansion Rate
As perhaps the most important metric to keep an eye on for monitoring Unity’s health as a business, a continued decline in dollar-based expansion rate could mean Unity is failing to cross-sell its other products to existing customers, or that customers aren’t seeing enough value in them to purchase them. Either way, a continued decline on this front would almost certainly scare away investors that are looking for Unity to continue this organic growth in their existing customer base.
I’m going to switch up the format on the red & green flags a bit for this article to keep things more brief. Here are the things that make me most nervous about the stock, and that all investors looking at a potential position in Unity should be aware of:
Toxic Management (according to some)
Most Video Game Studios Choose to Create Their Own Engine
Out-Competed on Quality by Unreal Engine
Savvy & Value-Additive Acquisitions
Proven Ability to Expand into Adjacent Markets
Huge & Rapidly Growing Industry
Unity is continuously out-competed by Unreal Engine - UE manages to make their platform’s user interface more customer-friendly so that there are few reasons to pick the inferior product made by Unity, even for beginners and small-sized game studios. Growth slows down significantly, and the share price is significantly damaged as both the number of customers contributing >$100K and the dollar-based expansion rate decline as a result of an exodus to Unreal. VR/AR prove not to be as fast-growing as predicted, limiting their upside potential even further. Riccitiello proves himself as a lackluster CEO, and the culture & work environment at Unity become so toxic that all the top talent leaves for other opportunities, hampering Unity’s ability to improve products to try and compete with Unreal. They enter a death spiral, and investors lose all their money.
Unity is able to retain its leadership position in the middle of the market for developers (in terms of the complexity of the engine). Their Grow Solutions, as a result of a successful merger with ironSource, are able to meaningfully contribute to the monetization and growth of developer’s creations, in turn attracting more customers and new developers, improving dollar-based expansion rates and the number of customers contributing >$100K. VR/AR markets expand considerably, as many are betting they will, and Unity proves to be a highly instrumental in allowing this by enabling the easy creation of VR apps, and subsequently the two-way marketplace that is crucial to making VR successful. They continue to make good acquisitions with their free cash flow, further contributing to improvements in their KPIs, and growth continues for a number of years to come. Shareholders are happy.
The Short Story
Unity has an end-to-end platform that provides an attractive option for developers looking not only to create, but grow and make money off their creations. They have also expanded into other industries to broaden the scope of their total addressable market and their 3D creation software now has a variety of use cases, including amongst much more resilient customers in industrial sectors like engineering, architecture, and film.
They operate in a huge and quickly-growing market with only one other significant competitor, and there is quite likely enough room for both of them to succeed, even if they were directly competing for the exact same niches. Their platform has potential to be used in several interesting markets, including digital twins and AR/VR.
The company has made a number of value-additive additions to their platform in both the Create and Grow segments, though this has come at the cost of shareholder dilution, and time has yet to tell whether they overpaid for the acquisitions.
They are headed up by CEO John Riccitiello, who has very mixed reviews and a shaky track record as a leader. Only one of the founders is still involved with the company today, and many of the reviews on Unity as a workplace are mixed as well. It’s hard to get a good read on the culture or effectiveness of leadership and upper-level management; some of this could be due to recent rounds of layoffs and cut benefits, but if the company is not a good workplace for top talent, the company will have difficulty growing.
The balance sheet has some splotches, including quickly growing SBC and declining margins, while what I believe to be their #1 key performance indicator, dollar-based net expansion rate, has been steadily dropping since 2021. It’s not all doom and gloom on the balance sheet though, as they also have revenues that continue to grow fast, aided by a massive recovery in their Grow Solutions segment, are free cash flow positive, and positive on an adjusted EBITDA basis.
Final Grade: B+
That’s all for Unity Software. Let me know what you think about the company in the comments! I hope this was a helpful foundation for learning about the business and potential investment opportunity. I’ll be back in 2 weeks time with another deep dive article for you all. Til next time, happy investing folks!