Unity Software Inc.

Moat: 2.5/5

Understandability: 3/5

Balance Sheet Health: 4/5

Unity Software Inc. is a leading platform for creating and operating real-time 3D content, used across diverse industries, particularly for video game development and other interactive experiences.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Business Overview

Unity Software operates a real-time 3D development platform primarily used for creating interactive and immersive content. Its platform provides a suite of tools for game developers, artists, designers, architects, engineers, and more to create and operate 2D and 3D experiences across a variety of devices.

  • Revenue Distribution:
    • Create Solutions: This segment is the heart of Unity’s business, offering the tools and workflows that creators use to design, develop, and iterate on their interactive 2D and 3D content. Revenue is generated primarily through subscription-based licenses for various software tiers.
    • Grow Solutions: This segment focuses on enabling creators to succeed in their work through monetization. Revenue is derived from data and analytics, cloud services, and, most significantly, revenue sharing from ads and in-app purchases made by users on platforms created with the Unity Engine.
    • Strategic Partnerships and Other: This represents the company’s relationships with key players in the industry, along with other aspects of the business that don’t fit into the previous categories.
  • Industry Trends:
  • The gaming market, especially mobile gaming, is still massive but also rapidly changing.
  • The metaverse concept and immersive experiences are a big catalyst and a potentially transformative market trend for companies like Unity.
  • AI is making its way into game development, including both tools and game assets.
  • There is increased competition in the gaming engine space (eg. Epic Games with Unreal).
  • Demand for both creation and operation tools in gaming is increasing, including more focus on cloud-based solutions.
  • Competitive Landscape: Unity has a dominant position in the game engine market but faces stiff competition from both established players and new entrants. The main competitor, Unreal engine by Epic Games, is making rapid inroads and trying to capture the industry lead. Unity’s dominance in mobile is also being challenged. Other competitors are also emerging, creating a more fragmented and competitive landscape. Many are also now providing cloud-based infrastructure. Unity also has to compete with Unity clones and others copying its tech.
  • What Makes Unity Different: Unity’s wide cross-platform reach, coupled with its focus on enabling monetization for its users. Unity’s asset store also helps retain developers to continue creating their content on the platform and makes it sticky. The platform is also designed to allow those who are new to programming to create games with no real coding knowledge. All together, this gives them their moat.
  • Margins: A large part of Unity’s revenue comes from highly profitable recurring subscriptions, while its high reliance on data also helps keep its profit margin high, in 2022 their gross margin was at around 77%. The gross margin has been around 70%-80% for many years, despite the company’s overall unprofitability.

Financial Analysis

Unity’s financials reveal that despite significant revenue growth, it has yet to achieve profitability on a GAAP basis. However, non-GAAP measures are improving, indicating increasing revenue efficiency and a focus on reaching profitability.

  • Revenue Growth: Revenue has grown substantially in the past several years, showing high demand for their platform. Their full year revenues for 2022 totaled 1.39 billion, representing 25% year over year growth. The growth has also been consistent as shown by revenue for 2021 being 1.1 billion, in 2020 it was at 0.77 billion and in 2019, 0.59 billion. This has been driven both by growth in the core “Create Solutions” business and by the continued success in monetization of their platform using the “Grow Solutions”. While still not profitable, these revenue increases indicate a strong market position and a product that developers still want to use.

  • Margins: Unity’s non-GAAP gross margins have remained high, consistently above 70%. However, even after adjusting for non-cash expenses and non-operating income and expenses, the company is still unprofitable at the net income level. This indicates that the company has excellent and solid pricing power but struggles with the other aspects of the company, such as growth and R&D.

  • Profitability: Unity is not yet profitable on a GAAP basis. Net losses continue in the hundred million to low billion level. While non-GAAP profits are improving, the company still has a ways to go to reach GAAP profitability.

  • Cash Flow: Operating cash flows continue to fluctuate, and often have been negative, indicating the business is still not self-sustaining without financing and has large ongoing operation costs.

  • Balance Sheet: Unity has a reasonably healthy balance sheet. As of December 2022, it held 1.6 billion in cash and cash equivalents, which provides enough of a buffer to run their business and to wait for the company to become profitable. Intangibles are also high, but because the company is a tech firm, it’s expected. However, the intangibles have been growing from $1.1 billion in 2020, to $1.7 billion in 2021 and then over $2 billion in 2022, which could indicate lower earnings if they start to take impairment charges. The main issue is that the company’s liabilities remain high, and while interest rates have been low during their period of high growth, those interest payments could start eating into the bottom line.

  • Recent Concerns/Controversies:

    • Unity faced significant backlash for their decision to change their business model which resulted in the charging of runtime fees for developers based on game installs. The decision was met with major negative feedback, resulting in management having to amend and partially undo the decision within only a few weeks. This has revealed weakness and a lack of a long-term view by the leadership at Unity. It has also made investors question the long-term leadership of the company, as their judgement was questionable. *The company’s management has also mentioned that, during their Q1 2023 earnings call, they have experienced a high volume of negative feedback from customers, which has made them reduce investments in some areas.

Moat Assessment

Unity has a narrow moat rating of 2.5/5. The company benefits from some powerful network effects and high switching costs. They also have a very strong brand name with most of their customer base.

  • Intangible Assets: Unity’s brand is well-known within the game development community but has less weight in other areas. Their assets are also susceptible to disruption and may not have staying power.
  • Switching Costs: As the platform has a lot of embedded tools, and developers have a lot of training on their platform, this makes switching to competitors costly in terms of time and effort. While it does have switching costs, competitors can slowly entice developers to use a new platform with enough offerings that appeal more than the hassle of switching over.
  • Network Effects: There is some evidence of network effects as the platform gains more integrations and better resources from its developer base. The larger the platform becomes, the more useful it is. However, this is still not a truly strong network effect compared to other businesses.
  • Cost Advantages: They do not have any significant cost advantages, despite the high margins.

The moat of a software company can also be easily disrupted due to technology disruption or other changes. The video game software landscape has rapidly changed over time with new technologies and techniques becoming common seemingly overnight, creating a threat for a business that might struggle to change its systems.

Risks to the Moat and Business Resilience

  • Competition: The main risk to Unity’s business model is the increasing competition in the game engine market. Unreal Engine and other newer and established players are vying for the same market, so there is a threat of having their market share slowly erode over time.
  • Technology Disruption: The rapid pace of technology change is a constant threat, as well as a double-edged sword for the company. Innovations might help, but they also may cause the company’s technology to become obsolete.
  • Changing User Preferences: The preferences and methods of the users of Unity’s platform might change, requiring further shifts and changes in the business. It’s imperative to keep a finger on the pulse of the client base and their needs to continue to keep the moat alive.
  • High Operating Costs: Despite high gross margins, the company does need to control expenses more as it’s currently unprofitable. Their R&D spending is very high and, if not properly managed, could lead to a huge source of unprofitability over time. Their acquisitions may have a similar effect if not properly managed and integrated.
  • Macroeconomic Conditions: Emerging markets are large catalysts for high growth for gaming, and any downturns may negatively impact their ability to achieve continued growth as well as profits.

Unity has proven resilient so far as they continue to lead the market, however the increased competition and the changes in the space make it a business to be carefully watched. They are still a core pillar in the gaming space and seem unlikely to change course, despite some mishaps in leadership recently.

Understandability Rating

3 / 5: Unity’s business is fairly easy to understand on the surface. They provide tools for creating games and other interactive experiences, and monetize through subscriptions and revenue sharing. However, some of the nuances in their business model and its interplay with tech advancements, and emerging tech trends, particularly as they relate to metaverses, and other complex issues, makes it slightly complicated. Understanding the tech industry and game engine space also require more specialist knowledge.

Balance Sheet Health

4 / 5: Unity has a healthy liquidity position as they hold significant amount of cash, However, their debt is also high, and interest coverage is on the lower side. The company’s capital structure makes it fairly prone to shifts in borrowing conditions. So it’s important for the company to focus on long-term profit generation.