Introduction
Unity is the leading end-to-end development platform that provides a comprehensive set of tools to create, run and monetize interactive, real time 2D and 3D content for mobile phones, tablets, PCs, consoles, and augmented and virtual reality devices. Real time 3D allows viewers to see and interact with 3D images or scenes that appears to be moving in real time. Traditionally, a creator that wants to create real time 3D content must invest significant amount of time and resources to build their own development applications, in order to develop high 2D, 3D, AR/VR experiences. Unity solves this problem by providing creators the applications for them to focus only on building their content, which is similar to what Word provides to writers and Adobe to visual content creators. This article is going to take a deep dive into Unity’s products, total addressable market, Unity’s competitive edges, Unity’s competitors, Unity’s financials and valuations. Hopefully you will enjoy reading this article and after reading it, you will have a better understanding of Unity!
Unity’s Products and Business Model
Unity provides an end-to-end development platform for content creators to create real time interactive 2D, 3D, AR and VR content as well as monetizing their content. Unity achieves this through its two interrelated products; Create Solutions and Operate Solutions.
Create solutions
Unity’s create solutions offers content creators a graphics engine with one of the most featured tools kit to create real time 3D content. Create solutions are primarily offer through monthly subscription, usually ranging from 1 year to 3 years. Some notable games built with Unity’s engine includes Pokémon Go, Hearthstone, Crossy Road and Assassin Creed. Unity’s engine (aka create solutions) is primarily used by game developers, but are also being used more and more by artists, designers, engineers and architects.
Operate solutions
Unity’s operate solutions make it easier for game developers to monetize their games, engage their players and simplify their backend system. These objectives are done firstly through Unity Ads and Unity’s In-App Purchase, it allows developers to maximize the revenue potential for their games with easy integration from the get-go. Secondly, operate solutions allow game developers to obtain their games’ data with deep analytics to better understand and engage their users with content management system, in-game messaging and push notifications capabilities. Thirdly, Unity offers a ready-to-use backend system, cloud content delivery network and remote content configuration management system. Lastly, Unity allows game developers to deliver multiplayer experience easily with server hosting, cloud platform, matchmaking and in-game communications features in placed.
Unity primarily offers it operate solutions via a revenue sharing and usage-based model. Therefore, Unity generate revenue when their customers succeed and grows. Operate solutions are not only offer to games that are built with Unity but all game engines.
What Create and Operate Solutions offers:
Source: Loupventures.com
Unity’s Competitive Edge
1. Leading game engine with the greatest number of developers – In 2020, 71% of the top 1000 mobile games in App store and Google Play were made with Unity according to Unity’s estimate). 50%+ of games across mobile, PC, and console were made with Unity. 93 of the top 100 game development studios by global revenue in 2019 were Unity customers. 2.5B monthly active users who consumed content created or operated with Unity Solutions. These numbers indicate Unity’s dominance in the game engine market. Unity’s closest competitor Unreal Engine only has around 13% of market share.
2. Largest community - Unity has the largest community for any game engine. This creates a network effect and makes Unity users more compiling to stay. Furthermore, Unity also has the greatest number of tutorials online, biggest marketplace and just in general most resources that are accessible by a Unity user compare to its competitors’ user.
3. Large amount of data - As the leading game development platform, Unity’s scale allows them to access a large amount of user data. These data allow Unity’s operate solutions to increase revenue for developers effectively through well targeted personal ads and better engagement with in app purchase via predicting end-user’s behavior. This creates a positive loop as more values are created for game developers more game developers will use Unity’s operate solutions. This will lead to Unity having an even larger set of data, which in turn creates more value to game developers.
4. Conveniency – Unity allows developers to create their content once and run-on 20+ platforms. This lightens the troubles on game developers to fix bugs and compatibility issues over different platforms. On the gaming engine market, only one competitor, Unreal Engine, also offers the same kind of conveniency.
5. Capable yet easy to use – The Unity engine is one of the most capable graphics engines out there (just slightly behind the Unreal Engine). Meanwhile, it also has a very user-friendly interface and is friendly to beginners. This makes Unity one of if not the ‘go to’ engine that beginners use but also by many experienced and professional users.
6. Unity Ads – Unity Ads allows game developers to monetize their entire player base. According to Singular report, Unity ads as an advertisement network is ranked 3rd on Android and fourth on IOS globally, only trailing behind Facebook, Google and Apple. Unity Ads currently serves more than 23 billion ads per month. Unity Ads is the best network for game developers and related advertisers. Unity Ads score a 4.4/5 on G2.com, which is slightly higher than Google AdMob (4/5) and Facebook Audience Network (4/5). Reviewers have commented that Unity ads are effective and can be easily integrated with their apps. As no other game engines offers in house ads solutions, Unity Ads is usually the way to go for in game advertisements. Unity Ads makes developing a game with Unity even more appealing.
7. Stickiness – Same with any software that people use, when people get used to it, people do not tend to change it, unless there is an alternative that is significantly better. This is even more true for the Unity engine, as game engine is inherently a complex software. Users will incur time cost and decent efforts if they want to change to another game engine. Furthermore, they may need to learn another coding language. This cost of change coupling with Unity’s network effect of Unity makes it hard for users to switch to a competitor.
8. Beyond Gaming – Although Unity may be perceived as a ‘game engine’ company, it has a lot of opportunities outside of gaming. Some of the opportunities are already turned into revenue. Some examples are top-car companies such as Toyota, Audi, Benz use Unity to enhance their workflow for inspections and design, Disney used Unity to create the movie, Lion King, and Skanska, one of the largest construction company, uses Unity for safety training. Anyone and any company that requires real time 3D content is a potential Unity customer.
9. Leading AR/VR platform – Not only is Unity the leading game engine, but it is also the leading AR/VR content creation platform by a big margin. Nearly 60% of AR and VR content are currently created with Unity according to Unity’s estimate. This also creates a network effect, meaning that newcomers to the AR/ VR space are more likely to use Unity over its competitors.
10. First Mover Advantage in the AR/VR industry– As the AR/VR market develops in the coming decades, Unity already has the infrastructure in place and it will be harder for competitors to compete with Unity overtime, when it is already a couple of steps ahead.
Total Addressable Market
Unity has 3 main addressable markets, gaming, industry/enterprise, and the AR/VR market as the following diagram shown. Currently Unity has only exploited the gaming industry in depth, whereas there are still a lot of room for growth in both the industry side and the AR/VR market.
Unity’s Addressable Market
Source: Loup Venture
1. Gaming Industry Today, there are 2.7 billion gamers worldwide in 2020. The global gaming industry is larger than the music and movie industry combined with revenue hitting $160 billion in 2020. The industry is expected to grow between a CAGR of 10.5-16% to 270 billion-365 billion by 2025 according to Statista and Ark Invest. In game purchase revenue is also expected to grow to 200+billion (base case) to 350billion (bull case) by 2025, which is a CAGR of 9% to 21%. This directly benefits Unity with its revenue sharing model for Unity’s In App Purchase. Withing the gaming market, mobile gaming makes up the most portion, at 48%. It is also projected to grow the fastest eating into shares of PC and console gaming. This benefits Unity, as Unity is the predominant game engine used for developing mobile games, where it has over 50% of market share. Furthermore, its largest competitor, Unreal engine, is not such well-known for mobile gaming but for PC and console gaming.
Segments of the Gaming Market
Source: Newzoo – 2020 Global Games Market Report
According to a study conducted by Altman Vilandrie & Company, a Unity’s third-party strategy consulting firm, the estimated market opportunity for Unity in the gaming industry is approximately $12 billion (across 15 million potential creators in 2019) growing to over 16 billion in 2025 (CAGR of 5.9%). However, when considering the growth of the gaming industry as a whole with CAGR of around 10%, and growth in mobile gaming, the growth potential for Unity in gaming should be higher, at least around 10%. Unity is perfectly positioned to continue to grow as the gaming industry grows.
2. Industry/Enterprise Currently, only 13% of Unity’s customers spending over 100k are categorized as non-gaming customers. Although it is a relatively small portion, there are some big-name companies as Unity’s non-gaming customers. Below are some notable examples:
1. Car manufactures - Toyota, BMW, Volkswagen, Audi and Mercedes Benz have all been using Unity. These car companies use Unity to conduct training sessions in VR, create realistic car configurators and condense inspection workflow. In the case of Toyota, it uses Unity to create a mixed reality system for diagnostics and repairs for their dealerships and service networks, which decreases the workflow time from 200 hours to 30 minutes.
2. Movies and Ads - Disney’s famous movie, the Lion King, has been built on the Unity engine. Nike has also used Unity for producing creative short animate ad campaign.
3. Construction - Skanska, one of the largest construction company, has been using Unity to develop its VR training program into their standard worker-safety training program thereby reducing physical risks.
4. Real Time Simulation - The Hong Kong International Airport has been using Unity to simulate changes in passenger volume. There are many more opportunities in non-gaming for Unity to exploit (including design, construction, engineering, animation and anything related to real time 3D content). As of June 2020, Unity estimates the market opportunity for them for non-gaming to be approximately 17billion. Most of them are not yet exploited. However, it must be noted that, although the non-gaming market is large, how much revenue will Unity generate from it largely depends on whether Unity can exploit these market opportunities successful. There is no guarantee that these potentials will turn into real revenue streams if Unity executes poorly.
3. Augmented Reality (AR) and Virtual Reality (VR)
Unity is the leading platform for creating content for AR and VR, as 60% of AR and VR content are created with Unity. As the devices for VR and AR matures with higher adoption rates, Unity will be greatly benefited. However, as you may see from the table below, there is no consensus for both the projected market size and growth rates of the AR/VR market. Therefore, there is not a surefire growth rate or projection for this side of growth for Unity. However, one thing is certain. All this research expects AR/VR to grow rapidly over the next 5-10 years.
Growth estimates of the AR &VR markets:
To better understand where these growths may come from, the following are some benefits or use case predicting what VR/AR can bring to us in the future.
1. Gaming – VR/AR can deliver another level of gaming experience, making the gaming experience even more enjoyable. Just imagine how fun it will be if you can play combat games in real life similar to the movie, Ready Player One.
2. Travel – Who wouldn’t like to take virtual tours and experience different places where we couldn’t go or afford in real life. Even if you still desire the ‘real experience’, VR can be used for you to experience different places first and make a more informed decision as to where you want to go as your next destination.
3. Entertainment – VR can bring sport and concert into real life and allow us to experience them ‘in person’ at our home. VR can also make all our favorite Netflix and YouTube videos way more immersive and pleasant.
4. Education - Imagine when students are studying history, VR can bring students to the event to experience it in real time. AR can make visual representation way more interesting and engaging, which can improve the experience of education for students.
5. Healthcare – AR/VR can be used for medical student to practice surgeries without having patients at risk. This can make them more comfortable and confident before the real surgery. AR/VR can be used to treat Post-Traumatic Stress Disorder by replaying what patients has went through and help patients to process their traumatic experience. AR/VR can also be used for Treatment of Autism by simulating a social environment, which gives the patient chances to practice and adapt to the real-world environment in a controlled manner.
6. Corporate/safety training – More companies can use AR/VR to simulate their training without risk. This will be especially valuable if the job itself are in dangerous environments. Pilots can use VR simulators to better practice their skills. Firefighters can use VR to prepare before their first fire or any dangerous training.
7. Military training – VR can be used for the military to simulate some combat which they could not replicate in real life.
8. Communication – AR/VR have the potential to bring the person you are calling with in front of you. In a corporate setting, this may allow people to actually meet face-to-face on VR rather than on zoom. This provides another level of experience to what we are currently having.
9. Retail – AR/VR can be used for the consumers to see and experience the product better. With AR, it can enhance online retail experience by bringing the product into life (Imagine with Ikea online, you can fit your furniture to your home directly just on your phone). This will help customers when choosing the right product and decreased returns. AR can even help shoppers to put on the clothes they like online and remotely.
10. Construction/Manufacturing/Design – AR/VR allows designs to be bring into real life by simulation. This allows easier changes, thereby making product development more efficient.
It is evident that AR/VR can create a lot of value. As AR/VR grows, Unity as the content creation platform will be benefited greatly as all these use cases require content. However, it must be noted that, although the growth seems very promising, currently, there are still some barriers for AR/VR to become mainstream. The following are some main barriers with AR/VR:
1. Cost – Although AR apps, mobile AR experiences, and webAR experiences are mostly free, a high-end (more capable) AR glasses or VR headset is still relatively expensive. Some of the ‘best’ VR headsets that delivers an enjoyable experience ranges from a listed price of $399 (Oculus Quest 2) to $899 (HTC Vive Cosmos). Although some VR headsets, e.g., Oculus Quest 2, can be operated as a standalone device and deliver a pleasant experience, current VR headsets still requires a powerful PC with high graphics specifications to support it for optimal experience. This PC may cost upwards of $1500, costing the whole bundle over $2000. Although, it is encouraging that the prices of VR headsets have been decreasing constantly by 5-10% annually, a couple of years may still be required for VR to become ‘affordable’.
There is a similar story with AR glasses. Big tech companies have been teasing with AR glasses for almost a decade. At the start, it was Google, who launched the infamous Google glasses in 2013 for an expensive price at $1500. Now, there is Microsoft, who sells their AR glasses, HoloLens 2 for an even higher price at $3500. Despite these attempts, AR glasses that are both capable and affordable at scale are still not on the market. (Or will the rumored Apple glasses finally be the one?!)
2. Hardware Issues – With AR/VR devices, there are still a handful of technological difficulties that must be resolved before mass market adoption. These include, firstly, inadequate battery life. Best in the market VR headsets offer 2-3 hours of battery and AR glasses south of 8 hours on average. Secondly, for VR headsets, the immersive level, gesture and movement control still have tons of improvement room. Thirdly, a typical VR headset today is still ‘bulky’ and weighs heavily at around 500g. Compare to a typical overhead headphone that weighs 250g. Fourthly, some users still report VR motion sickness (headaches, dizziness and general discomfort) after their VR experience. Fifthly, more capable VR headsets are not mobile as it needs to be connected to a high graphics PC via a cable. Sixthly, Field of view for VR devices typically only ranges from 90 degree to 130ish degree. In comparison, normal human vision ranges around 190 degrees.
3. Content – A lot of the AR/VR contents are buzz contents aim at welcoming people to the technology rather than for long duration consumption (think Pokémon Go for most people). As there are currently not many AR/VR devices, developers may not be motivated to create content for AR/VR devices. There must be enough devices and monetary returns before there are many contents. At this moment, there are just not enough devices. However, this problem should be solved naturally when there are more devices on the market. All these barriers are real and cannot be overlooked. The growth of the AR/VR market will vastly depend on whether these issues can be overcome. The same can be said for Unity’s growth. If the AR/VR, market grows rapidly, Unity will also grow rapidly. But if the market grows slower than expected, Unity will also be capped as to how much growth it can deliver.
Unity’s Competitors
Unreal Engine by Epic Games
Unreal engine is developed by a famous game studio, Epic Games. In the game development and AR/VR market, Unity and Unreal are regarded as the only two powerhouse engines that are both capable and accessible. Unity is currently the largest real time 3D graphics engine with around 50% of market share, whereas, Unreal, has around 13%. However, Unreal is by no means a weak competitor. Unity and Unreal have very similar features and are head-to-head to each other. When one updates a new feature, the other usually follows soon. Furthermore, they both support code once and deploy in multiple platforms. Below is a full comparison between Unity and Unreal.
And finally, their respective price. For Unreal, until a creator earns over 1 million dollars on a project (app/game), Unreal is free to use. After crossing the million-mark, Unreal charges a 5% royalty on that specific project’s gross revenue. Whereas Unity’s pricing structure is as follows:
Both Unreal and Unity are free for users under $100k. However, Unreal’s pricing will be more beneficial to smaller developer with revenue ranging from 100k to 1 million. Whereas Unity will be more beneficial for higher earnings developers or companies. Overall, Unity is a game engine that is easier to use and more beginner friendly with more than adequate performance. In comparison, Unreal is more complicated but also more powerful, particularly with its graphics by a slight edge. This fundamental difference is due to Unity being a bottom-up engine, first developed for light use, with graphics and capability gradually improves overtime. Whereas Unreal is a top-down engine, as it was first designed for developing high end games and not for the masses. The competition of the two are fierce, with Unity winning the mass market today. However, it will be important for Unity to continue to improve their graphics and performance or otherwise, if Unreal can overtime makes its engine more friendly to beginner users and improves it user experience, it may start eating into Unity’s market share.
Other Engines
Besides Unreal, Unity still has some other competitors, for example, Godot engine, Cocos2D by Chukong Technologies, CryEngine by Crytek, Lumberyard by Amazon and a lot more. In comparison with these competitors, Unity generally has better 3D graphics development, performance and rendering, as it is the industry standard, and most these competitors are not as well established. These engines may be good at some niche segments, however, none of these can match Unity’s robust offerings.
Most of the other engines do not support the developer to only code once and deploy its content onto as many platforms as Unity does. Although, they may still deploy onto IOS and android simultaneously, the different lies in console and AR/VR devices. When new hardware devices are released, some of these, if not most, other engines do not have compatibility from day 1. On the other hand, these engines may have some edges, such as being open source, very easy to use and beginner friendly because of its inherent nature gearing more towards basic functions and to new bees. However, overall, at this moment, none of these competitors have a robust offering and capable performance to act as a serious competitor to Unity.
In-House Engines built by Large Game Studios
Most famous gaming studios usually uses their own in-house engine to build their games because it may reduce their cost and make the engine more suitable to their games. Some notable examples are Electronic Arts and Activision Blizzard, two of the largest US game studios. Their engines are not a direct competition to Unity as they are not made available for the public. However, in the future if they made their engine public, it will be a competitor to Unity. Although the chance of it happening is fairly low, this is not entirely impossible, as this is exactly how the Unreal engine had come about. First used by Epic Games in house, then released to the public. However, on the flip side, there have also been an ongoing trend that some game studios start to experiment with both Unity and/or Unreal, as it is expensive to maintain a proprietary engine. Therefore, this may also represent an opportunity for Unity in the long run if their engine can satisfy these game studio’s needs adequately.
User Generated Content (UGC) Platforms
UGC platform, such as Roblox, a game that allows players to develop a game within it, does not competes with Unity in the near term. This is because they are gear towards very simple games development. Even if they do draw some Unity users over, it will likely be those ones in the free tier. In the long run, if one such UGC platform becomes very popular, it may draw more users away from Unity (at least for the time when its viral). However, the chances of such happening should be quite low.
Financials
Revenue
Revenue is arguably the most important measure for Unity as it is a high growth company that is still losing money. Unity’s revenue breakdown is shown below. The CAGR of Unity’s total revenue growth, create solution and operate solution have all been encouraging at 43%, 35.72%, 59.85% respectively over the last two years. Unity has generated this growth by strengthening its leader position in the real time 3D graphics engine market while the gaming and industrial market grew. This dominance is showed by 2.7 billion monthly active users (MAU) (67% YOY growth) who consumed content created/operated with Unity, and 5 billion downloads on average per month for apps built with Unity (41% YOY growth) as of Q4 2020.
Data obtained from Unity
Unity Revenue Breakdown
Source: Unity
COVID-19 has created both some headwinds and tailwinds for Unity. It impacted create solutions negatively as game developers required some time to adapt to work from home. However, Unity has claimed that this adverse impact has recovered in late Q3 through year end. Whereas for operate solutions, during lock-down periods, as more people play games, more ads revenue and in app purchase are also generated. This increased Unity’s operate solution’s revenue, as it uses a revenue sharing model. Unity estimates the total impact of COVID was a net 25 million benefit to revenue for 2020, which represents 3% of total revenue.
For Unity’s negative growth in strategic partnership, Unity explains that this reflects residual effects of longer deal cycles driven by COVID-19 as well as the sunsetting of certain products within Unity partner’s portfolios. Unity also said that this revenue line can be lumpy from quarter to quarter in terms of growth. This should not be too big of a concerned, as it only makes up a small portion of Unity’s revenue. Furthermore, the majority of growth for Unity in the future will likely be generated in create and operate solutions anyways.
It is worth special noting that Unity’s presence in industries beyond gaming has gained momentum in 2020. Customers generating revenue over 100k from industries beyond gaming has increased from 8% of total customers in mid 2020 to 13% at the end of 2020. This is promising growth and especially important, as Unity will need to continue to grow their non-gaming side of business in order to maintain high growth.
Net Dollar Retention Rate & >$100k Customers Growth
Unity’s dollar-based net expansion rate as of December 31, 2020 was 138% compared to 133% as of December 31, 2019. Dollar-based net expansion rate over 100% indicates that there is an increase in revenue from existing customers. Therefore, 138% is quite positive, which shows that Unity has been earning more from existing customers via both cross selling its two solutions and their customers’ revenue increasing leading to more revenue being shared with Unity. Unity also acquired new customers over the same period. This is demonstrated by an increase of the number of customers who each generated more than $100k of revenue in one year, from 600 to 793 (32% YOY growth), from 2019 to 2020.
Source: Unity
Gross Margin
Both Unity’s GAAP and non-GAAP gross margin has been around 78-79% over the last 3 years, which is very high on average but typical for a software business. This level of gross margin is likely to remain in the future as Unity should not have a large cost of goods sold.
Operating Margin
The below graph shows Unity’s GAAP and Non-GAAP operating margins, what Unity reported. Regardless of the measures, Unity is still unprofitable as both its operating margins are below 0. The major difference between the GAAP and non-GAAP measures is that GAAP takes into account stock-based compensation expense, taxes related to such transactions, amortization of intangible assets expense and charitable expense. Its non-GAAP operating margins have been steadily improving and edging to 0, however when taken into account these other expenses, Unity is still far away from profitability. It is especially noteworthy that for Q3 and Q4 of 2020, Unity’s GAAP margins had taken a big hit to -71% and -37%. This should not be a big concern, as it is caused by one off large transactions of stock-based compensation expenses, charitable expenses and relevant IPO expenses, which should not be recurring expenses.
Data obtained from Unity
Although Unity is still unprofitable, it is heading towards the right direction, as it spends more than half of its revenue on research and development as shown in the graph below, which is what investors want to see for a high growth company. As Unity matures, both its R&D and sales and marketing expenses should gradually decrease alongside with positive revenue growth, thus increasing its operating margins.
Data obtained from Unity.
Net Loss
Currently, Unity is still a losing money. As shown below, Unity had not yet had a positive net income quarter over the last three years. Furthermore, its net loss did not improve over time. Unity’s net loss has widened in Q3 2020 mainly because of the aforementioned one-time charge of $63.6 million related to the donation of 750000 Unity shares to a charitable foundation after Unity’s IPO in September 2020, and relevant IPO charges. In Q4 2020, Unity’s net loss did not recovery to previous level, as Unity has increased its R&D expenses and sales and marketing expenses by 41% and 57% respectively in Q4 2020 from Q2 2020. This is not a concern over the short run as it is an encouraging sign that Unity, a high growth company, is investing more in R&D and sales/marketing with the proceeds from IPO for it to gain a higher market share. It must be noted that Unity’s management did not provide any guidance as to when Unity will be earning a net profit. Unity’s ability to obtain a net profit will largely depend on how fast Unity’s revenue grows.
Data obtained from Unity
Return on Assets & Return on Equity
Since Unity’s have a net loss, both its return on assets and return on equity are still negative over the past three years. Both haven’t showed signs of major improvements too. For Unity’s ROA and ROE to become positive, it will mainly depend on Unity’s revenue growth as Unity is unlikely to decrease its expenses in the near term considering that it is still in a high growth stage.
Data obtained from Unity
Liquidity – Current, Quick and Debt Ratios
As shown below, Unity’s current and quick ratios are both well above acceptable rates (1 to 2), indicating that Unity will not have any short-term liquidity issue. Furthermore, Unity’s debt ratio as of 2020, is also quite heathy as it is lower than the normal 0.3-0.6 range. These all indicate that Unity have a strong balance sheet, which should not be surprised as a direct result of the cash raised from its IPO last year.
Data obtained from Unity
Forecast - 2021 and Beyond
Covid may well have a lasting impact on gaming, as some people’s way of entertainment have been changed forever, resulting in elevated game engagement. Furthermore, it is quite likely that adoption of real time 3D content will continue at an accelerated pace, as Covid definitely speed up digitalization for all industries. Both these are positive for Unity’s future growth.
Apple has recently updated its privacy settings for IOS users via IOS14 on Identifier for Advertisers (IDFA), which makes targeting advertisement less effective. This adverse impact will not only be experienced by Unity, but all advertisement businesses. From a relative standpoint, all advertisement will be worse, thus not incentivising Unity Ads’ customers to switch if all else are same. Nevertheless, this will still have a material impact on Unity’s revenue, as Unity Ads will likely not create as much value for their customers, thus leading to less revenue being shared with Unity. As a result, Unity estimates that this will reduce its revenue by approximately 30 million dollars, or 3% of its 2021 revenue.
Unity’s CEO and CFO have repeated stated that Unity’s goal is to deliver revenue growth of approximately 30% over the long run. Furthermore, Unity is aiming to a free cash flow break-even by the end of 2023. Unity will need to maintain its leader position in real time 3D creation in order for such growth rate to be possible for the next five years. Furthermore, Unity will need to continue to expand their non-gaming side of business alongside the growing AR/VR industry, for them to achieve this 30% growth rate over the next 5 years or more, as the gaming industry itself is not growing at such rapid pace.
Although Unity’s CEO has aimed for a 30% long term growth rate, the guidance provided by Unity for the expected full year revenue growth for 2021 is shy of 30%, at around 25%. Unity attributes this to some early growth opportunity already been materialised in 2020 because of Covid, thereby, making 2020 a higher based year and the one-off changes to Apple’s privacy rule.
Q1 2021 and 2021 Full Year Guidance
Source: Unity
Valuation/Pricing
Since Unity’s IPO on September 17, 2020 for $52 a share and closed at $68 for the day, its share price has been a roller coaster as shown below. It reached an all-time high of 172 dollars in last December, which represents a 152% increase from its first closing price. Then it gradually decreases to its current price at 93.82 dollars as of 5th March. That’s a 45% drop from its all-time high. Although that is already a massive drop, it is currently still trading at a P/S ratio (trailing twelve months) of 33.22, which is not cheap by any means. At $93.82 per share, Unity’s one year forward P/S ratio is 26.46 assuming that its 970 million of revenue indicated from its guidance is fulfilled.
Source Yahoo Finance
Data obtained from Finviz.com
The above table and below graph show some noticeable companies with a similar P/S Ratio as Unity. The noticeable one is ZM with way higher revenue growth both for q4 and full year 2020. That may be due to a lower base in 2019 as there was no pandemic yet. Zoom aside, the average revenue growth for these companies for Q4 is 39% and for full year 2020 is 35%. Unity’s revenue growth for Q4 and full year 2020 is on par and slightly above the averages respectively. However, for better representation by also taking out Air BNB, as it was impacted heavily by the pandemic last year, the average revenue growth for Q4 jumps to 47% and for full year 2020 to 44%, making Unity’s both revenue growth figures slightly behind. Therefore, just from a revenue growth perspective, Unity’s P/S ratio is not particularly attractive, as it is at best ‘average’.
Data obtained from Finviz.com
In terms of margins as shown below, Unity has the third highest gross margin, which is encouraging. However, its operating margin is the second lowest. Although it may not be concerning considering that Unity is still at a high growth stage, it can mean that Unity will likely take longer than some others until it can achieve profitability. From a pure number’s standpoint, Unity is just an average high growth stock when compare to these similar high growth stocks given that most of them have similar P/S ratio, growth rates and even margins.
The following table shows Unity’s 2025 revenue at 20%, 25% and 30% CAGR, and its respective market cap at multiple P/S ratios, which are all possible. In the projected worst-case scenario, Unity will only have an increased market cap of 12% from now (20% CAGR revenue growth and P/S of 15). The projected bull case will be a 372% increase from its current market cap (35% CAGR revenue growth and P/S of 35). When considering that the management’s goal of revenue growth is 30% in the long run (as highlighted in red) and the continued growth of gaming, industrial use and AR/VR industry, it should be appropriate to expect Unity’s market cap to increase between 68% to 291% based of 30% CAGR revenue growth and depending on different P/S ratios. When considering that the VR/AR market is likely to still be reality young and not fully exploited by 2025, Unity should still enjoy relative high growth in 2025 and beyond (as long as it keeps executing well and maintain its leader position). Therefore, a P/S ratio of 20-30 may be appropriate, which results in a market cap increase of 123% to 235%, which yields an annual return of 17.44% to 27.36%.
Discounted Cash Flow (DCF) Valuation
The following tables are a full DCF valuation for Unity. The stock price that it returns is $89.32 per share, which is slightly below the market price of $93.82 as of March 5th. Please note that I have capitalized R&D expenses and convert operating leases into debt (courtesy of Aswath Damodaron’s teaching), so some figures may differ from Unity’s financial statements, however the underlying figures will still be the same.
There are some key assumptions within this DCF valuation that must be pointed out. Firstly, the inputted revenue growth is 30% for the next 10 years, which is the goal that Unity’s management seeks to achieve over the long run. I believe as the AR/VR industry grows more rapidly over the decade and as Unity continue to expand to non-gaming industry, this growth can be achievable. However, a 30% CAGR over 10 years is by no means an easy growth to pull off, Unity must keep execute well for such growth to be obtained. Furthermore, when a 25% CAGR is inputted instead of 30%, the estimated share price plummets to $58.56. Whereas, when a 20% CAGR is inputted the output is only $36.92. Therefore, whether Unity can obtain this 30% CAGR will be key in the future.
Secondly, a lot of the software industry averages have been used for many of the stable growth inputs and inputs for the terminal year. The real outcome is likely to differ from these averages, meaning that the valuation may not be accurate.
Thirdly, please remember a lot of the inputs are just educated guesses, and there is no way to verify whether those inputs such as beta, cost of equity, cost of capital is an accurate reflection. At the end of the day, the real numbers may likely differ from these educated guesses, and this valuation is just my best educated guess of what Unity is worth.
Please feel free to change any inputs if you disagree with and see what valuation you get! Click this link for the excel spreadsheet: Unity DCF Valuation
(Spreadsheet format obtained from the best valuation teacher Aswath Damodaran at : http://pages.stern.nyu.edu/~adamodar/)
Risks
1. The biggest risk over the long run is whether Unity will be able to maintain a 30% or higher revenue growth rate. This will depend on a range of factors; mainly whether it can maintain its leadership position away from Unreal engine’s competition, how fast the AR/VR industry will grow and how much can Unity expand to non-gaming industry. Revenue growth is especially important as Unity is not trading at a cheap relative valuation and a decrease in revenue growth may decrease its share price. Also remember that the computed share price from the DCF valuation shows that Unity’s share price will be a lot lower at $58 and $36 if its revenue only grows at 25% CAGR or 20% over the next 10 years. Thus making 30% revenue growth especially important.
2. Whether Unity can continue to expand into new industries (for example: architecture, engineering, construction, automotive, transportation, manufacturing, film, television, retail, automobile, building design and autonomous driving simulation) will be virtue to the overall revenue growth. Although there have been positive signs of growth for its non-gaming customers over the past year, there is no guarantee that this growth will carry forward, as it will depend on different firms’ openness to adapt to real time 3D content and Unity’s execution and marketing. Furthermore, the growth projected, and confidence assured by its management may well be an overestimation.
3. Whether Unity can maintain its dominating leader position from Unreal engine is a major factor to Unity’s success. As discussed before, although Unity still has the majority of market share now, Unreal is a real competitor. If Unreal can improves its user experience and ease of use drastically while Unity does not improve its performance, Unity will be in trouble and Unreal may starts to eat into more of Unity’s market share from all markets. Therefore, unity must continue to have the leading platform that offers capable performance while being one of the easiest to use. If Unity does not remain as the leading platform, Unity’s operate solutions may not create as much value for Unity’s customers as Unity will not have access to as much data as before. This will create a vicious cycle. Furthermore, as more people switch away from Unity, its network effect will not be as strong, thus may cause more people to switch and less newcomers to join.
4. The growth of the AR/VR market will be virtue to Unity’s long-term success. In the short term, a sluggish growing AR/VR industry may not affect Unity much because it is not contributing much to Unity’s current existing revenue. However, over the long run, without a fast-growing AR/VR industry, it will be hard for Unity to maintain a 30% or higher revenue growth as growth in the gaming industry or industrial uses may plateau 5 years down the road.
5. With the rise of privacy issues, Unity may not be able to continue to advertise effectively, which may decrease Unity’s operate solutions’ revenue. This is especially true with Apple new rule change on IFDA via the update on IOS14. Although Unity has estimated that the impact of this change will only be costing around 3% of its 2021 revenue, the real impact may be larger than expected. Furthermore, although it is unlikely for android to follow through these decisions, because of the nature of Google’s business, if apple or some other platforms continue to tighten their privacy rules, Unity’s revenue will continue to be hit. Furthermore, this change may cause a temporally disruption to the advertising market for IOS, which Unity must continue to execute well, or else other advertisement providers may take Unity’s customers away. Although very unlikely, but if advertisement becomes very ineffective for advertisers, advertisers may just stop advertising as they may see no value in it.
6. Unity currently obtains only around 1/3 of its revenue from the US and others from all over the world. It will be especially important for Unity to continue to expand to emerging markets as they will enjoy higher growth in the coming years. If Unity falls to continue to grow in such market, its revenue growth potential will be hempen.
7. Last but not least, valuations always matters and because of Covid, Unity is currently not trading at a discount or a ‘cheap’ price. It is currently having a slight premium valuation in comparison to the DCF valuation computed. This will mean that there less of a margin of safety for you as an investor if you buy Unity stock. Furthermore, as Unity is a growth stock, its volatility and price movement in the future couple of years will likely continue to remain wild with lots of ups and downs. This may be a real ‘risk’ or concern for investors that are more risk adverse.
Conclusion
If you make it here, I want to first say a big thank you to you. Thank you for spending your time to read my write up. This is my first ever write up so please feel free to give me any feedbacks and apologies for any part that may not be up to your expectations! In summary, Unity is a stock that currently trade at a valuation that is not ‘cheap’. Its valuation will only be justified if it can continue to maintain its 30% growth over the next couple years or even decade. Personally, I believe there’s a decent chance that they will be able to. This revenue growth will depend mainly on more industrial use for real time 3D content and the boom of the AR/VR market. Given that Unity is a market leader in its category and its total addressable market may experience prolong growth in the coming decades, it will be a nice VR/AR play if you are considering getting into this space and if you can handle its volatility. Unity has the potential to be an Adobe like company in the next decade or two if they keep executing well.
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This is not investment advice and just for entertainment purposes.
A Deep Dive into Unity (NYSE: U)
Really great write up, much appreciated! Would love to see more analysis of other exciting companies!
Brilliant analysis. I really really enjoyed reading your due diligence post. Thank you