Unity: A Double Edged Sword

One Pager + Deep Dive

Edited by Brian Birnbaum. 

One Pager (+ Full Deep Dive Below)

Note: from now on, I will be including a one-page summary at the top of every deep dive. Below, you can find the full deep dive. 

Unity leads a duopoly in the gaming engine market. Since gaming engines can be used to create any type of 3D content, as the world moves from 2D to 3D content Unity stands to harvest much of the resulting demand from content creators looking for the right tools. It occupies a privileged position in the internet´s value chain.

However, Unity´s financials are being dragged down by rising personnel costs, which trickle all the way down to the cash-flow statement. With $1.59B in cash and $2.7B in convertible debt, the balance sheet is not overly healthy. However, Unity has two potential inflection points coming up, which could change its financials rapidly:

1. Generative AI: will enable the conversion of natural language to code, democratizing access to the platform and potentially reducing CAC (cost of customer acquisition); and will also make games more engaging, contributing to a higher LTV too.

2. Vertical integration: via the merger with ironSource, Unity is converting itself into a network, which should over time translate into a higher LTV. It also positions Unity at the core of the Industry 4.0 value stack.

The combination of a lower CAC with a higher LTV could meaningfully improve Unity´s unit economics and ultimately, free cash-flow per share. There is no limit to the volume of 3D immersive environments that can be created on the internet going forward, so the runway ahead is long. At a P/S ratio of 8.5, it is possible to frame a hypothetical investment asymmetrically.

However, Unity´s management seems somewhat opaque to me and I have spotted instances of cultural dysfunction in the merger integration: with process taking over content. Unity is going from being focused on delivering content creation tools, to distribution and monetization tools as well. Management seems to be filling the company with new rules that are overwhelming employees.

Nonetheless, in Q1 2023, management took some steps to address this issue, ultimately reducing the number of managerial layers. Doing so reduces the process burden within the organization and enables employees a greater degree of creative and executive freedom. While this is a step in the right direction, I need to see more from management on this end.

If Unity manages to successfully integrate ironSource, which judging per the recent inflection point in adjusted EBITDA is not out of the question, the company has great upside ahead.

Full Deep Dive

1.0 Introduction    2.0 The Pursuit of Synergies

3.0 Beyond Gaming    4.0 Organizational Properties

5.0 Financials    6.0 Conclusion

1.0 Introduction

Unity has high odds of becoming the default content creation tool for the next generation of the internet.

As the world´s content evolves from 2D (flat on a screen) to 3D (immersive), Unity occupies a privileged position that sets it up for a future in which it becomes the internet´s key provider of immersive virtual spaces. Unity is currently the world´s leading cross-platform game engine and provides developers with a comprehensive suite of tools and services which enables them to build and operate any kind of 3D space.

Unity exists in a duopoly with Epic Games (the creators of Unreal Engine), and thus it stands as one of the probable key beneficiaries of the evolution of the internet. We all spend countless hours on the internet, staring at screens, many of us unaware that we are actually in constant pursuit of more natural interfaces. Naturally, the next step is to immerse ourselves in the virtual world. Developers looking for tools to satisfy this demand will not find many choices.

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Unity has a process moat, whereby the cost of effectively developing each incremental iteration takes years of relentless focus and specialization. On this basis, and with the world now moving towards 3D content, as suggested by the release of Apple´s Vision Pro, Unity approaches two major–yet only potential–inflection points:

1. Generative AI: this technology will enable the conversion of natural language to code, which will likely democratize access to the platform for less technical folks (the majority of the population). This may translate into a lower CAC (cost of user acquisition).

2. Vertical integration: in November 2022, Unity completed its merger with ironSource, a platform that essentially enables developers to turn their apps into successful businesses. In the case of successful integration, Unity will be able to offer a whole additional stack of services to developers at a marginal cost, which should ultimately increase LTV (lifetime value).

   1. Note: this operation came with a dilution of approximately 26% for Unity shareholders. Also, a lower CAC with a higher LTV tend to equate to better unit economics and, in time, higher operating leverage and free cash-flow per share.

   2. According to management, the apparent inflection point we are seeing in adjusted EBITDA is the result of the integration of the merger doing well thus far, with ad mediation accounting for a lot of this delta. ironSource brings a number of platforms under its belt, one of them being LevelPlay, which lets app developers manage and optimize multiple ad networks with just one SDK. More about this in Section 2.0.

   3. Although the graph below is aesthetic, the underlying drivers of the financial performance are slightly amiss. See Section 4.0 for more.

      

      
      

At a P/S ratio of 8.5, Unity presents a potential asymmetric scenario in which the two levers outlined above combine to yield meaningfully improved financials. The opportunity is particularly attractive when you consider that it works in a world in which 3D content either does or does not become the norm. Absent bad management and/or corporate culture, if the world moves to 3D content the two levers should produce outsized results, with all creators ultimately needing a 3D engine. If 3D does not, however, become the default content format, the two levers should still create appealing financial deltas over time–so long as gaming continues to increase in popularity, which is not a far-fetched assumption. Naturally, the latter scenario is not what we want.

Note: I have concerns regarding Unity´s management and corporate culture, which I will analyze in depth in Section X.

Further, generative AI may meaningfully strengthen Unity´s moat going forward, making it harder for competitors to catch up. Unity´s engine is a generator of unique data, which can in turn be used to train singular AI models. Every time:

1. a developer works with the platform to develop something, a specific creation comes to life within an infinite set of potential creations.

2. an end user plays a game, a specific outcome within an infinite amount of potential outcomes takes place.

The above datasets should over time translate to AI models that:

1. make the development of virtual immersive environments easier for creators,

2. make gaming much more engaging and realistic for end users.

The same concept applies to all gaming engines in the market, but thanks to its leading position, Unity stands to generate higher volumes of data (because it has more developers and end users) and, thus, it is statistically poised to train the best AI models in the space. This may yield a flywheel, by which more data translates into better AI models, which translates into better distribution/retention, which generates more data, and so on. Continuing to generate more data than competitors will likely give Unity an exponential advantage going forward.

Unity´s moat also gets stronger as its developer community grows. I am not a game developer myself, but I have gotten a quantitative feel of how much more liquid Unity´s asset store is than that of its nearest competitor. There are also a lot more resources for new developers to use to learn the platform and, in all, this drives further adoption.

The above is the mental model that synthesizes my view of Unity. Moving forward, I dissect key components of the model in depth. In the next section, I review the implications of the merger with ironSource and potential problems that may come along with it.

2.0 The Pursuit of Synergies

With the ironSource merger, Unity is turning into a network. This will enable it to get smarter, fast(er).

Unity´s ultimate goal is to delight end users of the virtual environments created via its engine. It has thus far succeeded in doing so by giving developers the tools to create the best games possible, accumulating more than 3 billion end users. As a result, it has captivated the minds of developers and via the merger with ironSource, it is seeking to aid them in:

1. distributing their creations

2. and monetizing them

The end goal is to create a one-stop shop where developers can satisfy all of their needs.

The ironSource platform has a number of components that I identify as very promising:

1. Aura: is a Digital Turbine competitor that operates 1B+ smartphones. It helps OEMs make money by pre-installing the apps of third parties into their devices. This is prime real estate for any kind of software developer.

2. LevelPlay: a mediation platform that enables developers to make money by selling ad spaces inside each respective app, which engenders in-app bidding. Ad-networks bid on ad placements in real time, ensuring that the highest paying ad gets served.

3. Supersonic: is a platform for mobile app developers to grow and monetize their user base through a combination of in-app advertisements, video ads, and more. Before the merger, it had 550m+ unique users worldwide.

   1. Mobile Ad Mediation: Supersonic has a mobile ad mediation platform that allows app developers to manage different ad networks from a single location.

   2. User Acquisition: Supersonic also helps with user acquisition, providing app developers with the tools to promote their apps to targeted users, with the goal of increasing downloads and active users.

   3. Playable Ads: As part of their creative strategy, Supersonic is known for its playable ads, which are interactive ads that allow users to try out a game before downloading it.

Bringing the above components into the Unity platform potentially creates a flywheel similar to that of Roblox, which helps creators both develop games and put them out into the world with decreasing levels of friction. In effect, it turns Unity into a network in which its creators can place ads programmatically to grow their communities without having to go anywhere. At maturity, the ironSource merger makes Unity quite similar to Roblox, except the latter brings end users together under one culture and the former does not. 

As Unity evolves into a network, it has the opportunity to compound intelligence much faster than otherwise, for all sorts of applications, because the information that it sends out circles back to it: for example, it can now learn what distribution and monetization efforts work for developers.

“The strength we are getting out of neural networks, an AI tool and the system we have been using for a couple of years now on the Unity side is being applied network-wide”. - John Riccitiello during Q1 2023 ER.

A rather fascinating example is project Barracuda, which Unity has been working on for some time now and is a tool that enables an inference engine to be “run on the handheld device or a computer or a PC or console”. This enables Unity to deploy LLMs (large language models) on your smartphone so that they can bring characters in a video game to life, gifting them with intelligence.

By spreading out LLMs over 1B phones and running them locally, instead of running them all from a centralized server, Unity can achieve a level of realism in games that would not be possible in a non-distributed computing format. Naturally, this also enables Unity to harvest plenty of data about how end users interact with the LLMs deployed in their devices, creating the below flywheel.

Unity´s evolution along the guidelines that I have explained above have two considerable implications going forward:

1. It positions Unity close to the foundation of the value chain for enterprises in any sector. More about this in Section 3.0.

2. Unity has traditionally been focused on enabling the best tools for 3D content creation and by now tackling content distribution and monetization too, it is at risk of losing focus: especially with seemingly sub-optimal organizational properties prior to the merger. More about this in Section 4.0.

3.0 Beyond Gaming

Unity´s evolving tech stack positions it close to the foundation of the Industry 4.0 value stack.

Companies are essentially optimization functions, in which the goal is to minimize inputs and maximize outputs over the longest period of time possible. To this effect, digital twins (a digital 1:1 copy of a company) enable organizations to understand what is going on within and around them much better and, thus, make optimal decisions to achieve their goals. Once a digital twin gets embedded into an organization, over time it becomes its core asset, since it eventually holds all of the organization´s intelligence (data + AI models).

While I do not see any evidence of Unity having a competitive advantage at the foundational level of digital twins (aggregating siloed data and then performing operations on it), it seems strongly positioned to:

1. provide 3D visualization for the data contained within digital twins, creating a persistent environment subject to the laws of physics and other laws that may be programmed via the engine.

2. run simulations by distributing computing power throughout the organization (Barracuda, Section 2.0) and while outputting the result of simulations during runtime.

   1. Note:”pure” digital twin players (like Palantir, or third parties of their choosing) will also be able to run simulations, since they are the gatekeepers of the data in the first place. I expect a degree of overlap in this region of the stack.

A consolidation of the emerging Industry 4.0 value stack, for the purpose of this post.

The combination of simulations and visualization at runtime give life to digital twins. It should be quite a powerful tool for enterprises across any industry. But this is far removed from Unity´s nature today. To get to this point, Unity must successfully integrate the ironSource acquisition and transition from being a platform to becoming a network. In the next section, I will address the qualitative data points that worry me on this front.

4.0 Organizational Properties

Management seems opaque, lending to the idea that it’s not handling the merger well from a cultural standpoint. In Q1 2023 Unity took some steps forward to fix this, however.

In quarterly conference calls, management talks about digital twins as if the first two blocks in the above diagram are of little significance. Analysts do not ask either - remaining, as ever, overly focused on financials over tech and direction, but management is not forthright in explaining how their many alleged digital twin customers implement their data for visualization. Fixing data silos in an organization is complex, but exponentially more so when the industry in question is highly regulated. I sense from management a level of opacity that I do not appreciate.

In the Q3 2022 ER I spotted an instance in which analyst Tim Nollen asked management for ironSource stand-alone revenue in Q3 The merger had closed two days before the call. Management declined without reasonable motive:

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Further, a high level of complexity lies within the process of converting Unity from a platform focused on simplifying the creation of games to a vertically stacked network focused on 3D content creation, distribution, and monetization. Reading through reviews on Glassdoor, it seems that, before the merger, Unity was a place where creativity came before process and after the merger, the situation has been reversed, presumably to deal with the complexity of this transformation.

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Whenever I spot a company in a privileged position, under the hood I tend to find a culture and generally a set of organizational properties that encourage risk taking and creative freedom, but that also preserve accountability. In turn, these firms die when they drown their talent in piles of rigid process. There is much to be learned by studying Netflix and, specifically, the story of its co-founder Reed Hastings: his first company failed because it became riddled with process, and he vowed not to repeat that same mistake.

Naturally, Glassdoor may be portraying a skewed version of reality, since employees often get upset with the changes that come with mergers. However, I’m getting a bad feeling, and the correlation across datapoints is high. Adjusted EBITDA is advancing suspiciously well, with morale seemingly coming down just as fast. For Unity to really succeed going forward, it must stay content over homogeneous process. It’s worth watching out for signals on this front over the coming quarters.

In Q1 2023, however, Unity took steps to reduce the number of managerial layers, firing 8% of its workforce. They plan to reduce the number of offices going forward and concentrate people geographically.

5.0 Financials

Personnel costs are dimming Unity´s financials.

Income Statement

Since September 2020 (as far back as I can see), gross margin has been trending down with revenues trending up. Cost of revenue has been rising faster than revenue mostly due to personnel costs (which include salaries, benefits and stock-based compensation) increasing rapidly. This seems to have a cascading effect on Unity´s income and, structurally, is something that I do not like to see.

$U Revenue, $.

$U Gross Margin, %.

While the operating leverage inflection points analyzed in Section 1.0 can quickly change the situation, I am concerned about the qualitative drivers (and their likely persistence of time) that I suspect have led to personnel compensation eroding the financials. Meanwhile, neither SG&A and R&D expenses exhibit anomalous behavior, but with the decreasing gross margin due to personnel expenses, operating income has been trending down despite revenue going up.

$U Operating Income, $.

What is strange is that Unity accounts for personnel compensation in cost of revenue and R&D and SG&A expenses, but personnel compensation only seems to be spiking on cost of revenue: and they do not explain why. In their 2022 10-K (page 55), Unity states that cost of revenue rose in 2022 “primarily due to higher personnel-related expenses associated with increased headcount” and uses the same phrase for R&D and SG&A, with no additional explanations.

With the ironSource merger, I would expect to see plenty of new employees on the tech and sales sides, which should be accounted for in R&D and SG&A respectively.  Thus, the question is, what are they accounting for in cost of revenues exactly? Cost of revenues jumped from $248.2M to $439.3M from FY2021 to FY2022, with only $44.6M of the $191.1M delta due to amortization of intangible assets and $18.8M in hosting expenses: $127.9M of the cost of revenue increase remains a mystery to me. This sort of accounting is confusing and correlates to the observations in Section 4.0, with no clarification from management. 

$U Cost of Revenue, $.

Cashflow Statement

The personnel costs trickle down into the cash-flow statement too, despite adding back some rather frothy looking amortization and SBC levels which obviously contribute to further dilution: 21.9% (amortization) and 32.5% (SBCs) of revenue in Q1 2023, respectively. Free cash-flow is considerably negative, coming in at ($153M) and ($116M) for FY 2021 and 2022 respectively, although approximately half of the negative free cash flow stems from Unity buying property and equipment.

$U Cash from Operations, $.

$U Depreciation and Amortization, $.

$U SBCs,$.

Balance Sheet

Unity ended Q1 2023 with $1.59B in cash and $2.7B in convertible debt. Not a terrible situation, but not optimal considering negative cash-flows.

6.0 Conclusion

Great potential, but with some notable issues at present.

Unity has achieved success by focusing on one thing: helping developers delight end users. It so happens that, as a result, they own and operate the world´s top (commercially speaking) 3D content creation engine–and now the world is moving in that direction. In the abstract, there is no limit to what the company can achieve.

However, there’s a hitch. By merging with ironSource:

1. Unity can indeed become a much more relevant and strong company,

2. but it is also at high risk of losing focus and requires a managerial improvement.

If it succeeds with the latter, Unity is positioned to grow exponentially as the internet evolves to a more immersive format. But at present the company´s financials are tainted with what seems like excessive personnel compensation, which ultimately translates into negative cash-flows that dilute an already a debt-burdened war chest.

For now, I choose to remain on the sidelines. But I will be watching closely to see how management evolves over the coming quarters. I am pleased about the actions taken in Q1 2023 to streamline operations and reduce the process burden. For the time being, I believe management is moving in the right direction.

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Disclosure

These are opinions only of the individual author. The contents of this piece do not contain investment advice and the information provided is for educational purposes only and no discussions constitute an offer to sell or the solicitation of an offer to buy any securities of any company. All content is purely subjective and you should do your own due diligence.

Antonio Linares makes no representation, warranty or undertaking, express or implied, as to the accuracy, reliability, completeness or reasonableness of the information contained in the piece. Any assumptions, opinions and estimates expressed in the piece constitute judgments of the author as of the date thereof and are subject to change without notice. Any projections contained in the Information are based on a number of assumptions as to market conditions and there can be no guarantee that any projected outcomes will be achieved. Antonio Linares does not accept any liability for any direct, consequential or other loss arising from reliance on the contents of this presentation. Antonio Linares is not acting as your financial, legal, accounting, tax or other adviser or in any fiduciary capacity.