This gaming company's stock has doubled in its first few months on the public markets, but how does it make money, and should you buy?
Dec. 12, 2020
Unity Software (NYSE: U) has had an impressive start to life on the public markets. It recently reported its first results as a publicly-traded company in Q3 with some impressive numbers. Before investing, let's take a look at how this company makes money and whether it is a worthy investment.
What is Unity Software?
Unity Software is a cross-platform game engine that operates as a development platform rather than as a developer like Electronic Arts or Activision Blizzard. It facilitates the creation, operation, and monetization of video games with a mission to enable everyone to create content. The company was founded in Denmark in 2004 as Over the Edge Entertainment before changing its name in 2007. It started as a simple platform in 2005 on Mac OS and Microsoft Windows but has since expanded and become "the world's leading platform for creating and operating interactive, real-time 3D content" with 2.5 billion monthly active end users across several platforms.
Unity Software's Business Model
Unity serves customers of all sizes, with over 50% of mobile, PC, and console games created using Unity software. Its business model has enabled developers to create content and monetize users as the gaming industry has evolved from one-off purchases to in-app and advertising. Currently, 94 of the top 100 game development companies by global revenue are Unity customers.
Two key revenue generators are "Create" and "Operate" solutions. Create solutions allows developers to develop real-time 2D and 3D games and applications, while Operate solutions is a portfolio of products that enables content developers to grow and monetize users. It is trying to position itself as a platform to enable Augmented and Virtual reality. Unity's business model has expanded beyond gaming and is now being used by Fortune and Global 500 companies in architecture, engineering, automotive, and film to name but a few.
How does Unity Software make money?
Unity is free to use for anyone who has less than $100,000 in annual turnover. The number of customers spending greater than $100 thousand has increased by 70% to 739 in Q3 2020. Large enterprises make up the majority of revenue, and Unity continues to attract and retain customers with a dollar-based net expansion rate of 144%. Revenue increased by 53% year-over-year to $200.8 million, with high gross margins.
Operate solutions have some exciting product offerings such as Unity Ads, which enables developers to host ads on the game, and Unity will get a percentage. Operate solutions are also available to other developers that have not used the app to build their game which broadens the market opportunity. Operate solutions made up just under two-thirds of revenue in Q3 at 60%.
Create solutions generates subscription revenue on one to three-year subscriptions. This segment accounts for 31% of revenue and has been used beyond gaming by companies such as Toyota. It also makes money from fixed fees, royalty, and strategic partners, albeit to a lesser extent and accounted for 9% of revenue in Q3.
This unique position enabling content creations means that as games made on its platform take off Unity will make money and is not reliant on any single developer.
What's next for Unity Software?
Unity, according to its S-1 filing, estimates its total addressable (TAM) to be $29 billion across gaming and other industries. It believes that there are more opportunities beyond the current use cases and that will be a much bigger TAM than today. Continued growth in areas such as AR and VR content creation where Unity is already the leader and gaming should also fuel growth. However, Unity is spending heavily on R&D, spending over $450 million over the last two years alone, and will continue to do so to maintain its position as it eyes new opportunities.
Unity is well-positioned to benefit from secular tailwinds in the years to come and is growing at a fast pace. However, it is still operating at a loss that is expected to widen in the next quarter as it invests heavily in R&D. Unity appears to be an exciting investment. However, investors may want to wait for a quarter or two as it has recently gone public, and companies are often volatile during this period.
