-Andrew Macken
Video games are increasingly developed on one of only two games engines: Unity or Unreal, owned by Epic Games. These provide a set of software solutions for developers to create, run and monetise interactive, real-time 2D and 3D content for phones, tablets, PCs, consoles, and augmented and virtual reality devices. The scale, complexity and developer communities associated with each of these engines have become so great that it is simply not viable to build and maintain an independent engine – even for the world’s largest gaming publishers. (Over half of Nintendo Switch titles are made with Unity, for example).
Unity is the undisputed global leader in mobile gaming – which itself, is becoming universal. Whether you are 80 years old or 8, you are using your mobile for entertainment, spending approximately three hours per day on your smartphone (based on US statistics). Games made with Unity account for 71% of the top 1,000 mobile games (Q4 of 2020).
Unity generates most of its revenue in two key ways:
- Create segment (approximately 30% of revenue) – revenue per developer seat to access the engine: Unity Pro is US$150/seat/month. Importantly, however, the overwhelming majority of the 1.5M monthly Unity users from more than 190 countries around the world use Unity Personal which provides nearly all the functionality of Unity Pro but is free. Indeed, 77% of Unity’s total revenues stem from just 793 customers today.
- Operate segment (approximately 60% of revenue) – revenue from at least a dozen solutions offered to developers to help improve the growth and value of their game (including advertising, in-app purchases (IAP), analytics, multiplay and cloud solutions). Advertising accounts for approximately 80% of this segment today. And while Unity’s ad business will face headwinds associated with Apple’s proposed changes to user tracking across apps, we believe it will fare relatively better than alternative networks, given its large-scale, unique dataset on the contextual behaviour of most of the 2.7 billion players of Unity games each month.
Unity is drastically under-monetising its gaming engine today – an intentional strategy to drive adoption, solidify further its world-leading ecosystem and strengthen its data advantages. In a global gaming industry that generates approximately US$250B in annual revenues (and growing), it is striking that Unity, as an entrenched duopolistic mission-critical platform for games development, generates less than US$1B in annual revenues today.
Here’s what CEO, John Riccitiello, had to say about Unity’s monetisation recently:
“Our take rate in gaming overall is not high. It’s about 0.4%. When I talk to people in the industry, they have a mental picture and it must be at least 2%, 3%, 5%, 10%. I don’t think they are wrong… I believe we can increase our business in gaming as much as 10X and that’s what we’re after. So for clarity, I 100% agree with the sentiment and I want to get there one brick at a time over the course of the next handful of years…”
One logical opportunity lies in IAP, for example. IAP typically accounts for 60-70% of total publisher revenue. And yet, Unity typically does not share in this revenue today (Epic Games does, on the other hand). This will no doubt change over time and represent a larger, higher-margin opportunity than advertising for Unity.
Unity’s market value today is approximately 30x its revenue. Such a multiple is usually considered very high and likely overvalued. But in the context of a business which is so drastically under-monetising today, its multiple of future revenues is very much lower. We believe this business is undervalued today – and likely materially so, given its three big long-term opportunities.
Unity is a high-probability winner in at least three big long-term opportunities
Opportunity #1: Virtual Reality (VR)/Augmented Reality (AR) in gaming
Unity is a near-monopolist in AR/VR content creation: approximately 70% of all global AR content and 90% of all global VR content is made by Unity. Indeed, one of Unity’s core advantages loved by its developer community is the ease with which content assets can be converted between platforms – including VR and AR. It is, therefore, almost certain that Unity will continue to be a long-term winner in the VR/AR gaming space.
Over the course of this decade, it is highly-probable that VR/AR will become significantly more ubiquitous. Indeed, Facebook – owner of Oculus – is making sure of this: approximately one fifth of all Facebook employees today – or 10,000 employees – are currently working on Facebook’s VR/AR efforts.
Last year, Oculus launched what is unquestionably the best value-for-money VR headset: Oculus Quest 2. Priced at just US$300, it sold 1.1 million units in Q4 last year and approximately 3 million in total to date. Facebook views 10 million units as the approximate installed base required to accelerate developer VR content generation (substantially all of which will be built on Unity’s engine).
Viewed as a gaming console, there is no reason why Oculus could not repeat the success of Playstation or Nintendo Wii (each selling approximately 100M units over time). If Facebook achieves this success, they believe their learnings and user-data-enabled machine learning will be instrumental in solving the many more complex engineering problems associated with AR. And it is in AR that Facebook believes a successful frictionless device could one day surpass the smartphone, with an installed base of billions of devices over time.
This is a space also being actively pursued by Apple, though they are typically more secretive about new products. Regardless of who wins long-term in hardware, Unity is the mission critical VR/AR content generation engine required to generate substantially all content. This is an extraordinarily privileged position.
Opportunity #2: Real-time 3D (RT3D)/AR/VR in non-gaming
Given Unity’s privileged position in RT3D/VR/AR content generation in gaming, it is not surprising that it carries a privileged position in content generation in non-gaming verticals. Indeed, Unity’s competitive position in non-gaming is arguably even stronger (an effective monopolist) given Epic Games is not seriously pursuing non-gaming applications for its content generation capabilities.
Unity is pursuing this opportunity seriously, though it remains early days and requires continued training and experimentation on the part of industrial clients. Successful use cases to date have been demonstrated in autos, architecture, ecommerce, medical and entertainment. From AR/VR show rooms, to ads, to 3D videos: it is difficult to foresee a future that is not dominated by this high-quality content, especially in the world of digital marketing. As Unity puts it explicitly: “The world of content is in the early stages of transition from linear 2D content to RT3D content.”
Another important non-gaming use case for Unity’s engine is the definition of complex 3D worlds, with in-built physics defined, used for the rapid training of real-world automation AI models. From automated driving to the training of Google’s Deep Mind AI models. There is a reasonable probability that Unity also becomes mission-critical in many AI training processes – itself a powerful long-term structural trend that remains in its early days.
Opportunity #3: Democratisation of 3D/VR/AR content creation
We believe that Unity’s engine will become easily usable by mass consumers over time to generate high-quality 3D/VR/AR content creations. The long-term opportunity here is orders of magnitude larger than Unity’s user base today.
Today, serious users of Unity’s engine are primarily technically-skilled developers. In the future, all of us will likely be able to create high-quality 3D/VR/AR content easily. Unity continues to build out its low-code/no-code user interfaces on its engine, increasingly enabling non-technical users to create content. As Minecraft and Roblox have demonstrated, there is enormous demand for low-code/no-code opportunities to generate such content.
Unity has 1.5M monthly active creators today. Over time, this could grow to “hundreds of millions” according to CEO, John Riccitiello:
“I believe in the fullness of time there will be hundreds of millions of people using Unity on a monthly basis, and a significant complement of them will be consumers. Consumers wanting to express themselves with better videos on TickTok or an Instagram or a Facebook where real time 3D makes a difference and a positive difference to help them drive more eyeballs and more users. We recognize that opportunity.”
The potential upside in our Unity investment far outweighs the potential downside
We believe Unity’s current value of less than US$30B fails to appropriately appreciate (i) Unity’s true TAM, which is likely significantly higher than its disclosed TAM; (ii) Unity’s extreme under-monetisation today, which implies much higher future revenues and earnings; and (iii) Unity’s privileged economics associated with its platform business model, built in software, with very strong network effects and data advantages from its large and growing ecosystem.
When Unity listed on the NYSE last year, it disclosed a TAM estimate of US$12B for gaming based on 15M potential creators; and US$17B for non-gaming. These estimates are very conservative, in our view. Tim Sweeney, founder of Epic Games, believes we are moving towards an expansive virtual world in which every company has a real-time, live 3D presence. This “metaverse” will be a multi-trillion dollar economy, in his view. Such scale would render Unity’s TAM estimates as laughable.
Furthermore, we need not look further than Adobe for a reference point in terms of both absolute TAM for content creation software; and trajectory of TAM estimates during the early years of adoption. In 2015, Adobe estimated its three-year-forward Creative Cloud TAM at US$17B. Today, it estimates its three-year-forward Creative Cloud TAM at US$41B.
We believe the significant mismatch between Unity’s revenue and the revenue generated by its content will gradually narrow over time. For context, Epic Games takes a five percent royalty on all gaming revenues over and above a certain threshold today. We believe Unity will evolve its offerings over time to converge on a similar take rate – representing a new effective take rate multiples higher than where it is today.
The economics of Unity’s software-based platform business model with strong network effects and expanding data advantages are highly privileged. Unity operates with gross margins of 78% today and requires relatively little sales and marketing to grow, at just 28% of revenue. This allows Unity to invest in R&D to the tune of 52% of sales. This is unusually high and represents a moat-strengthening advantage. Yes, it is true that R&D is expensed and reduces reported earnings. But for Unity, this spend is true business-enhancing investment and should be viewed as such.
On the basis of Unity’s unique competitive position, multiple big future growth opportunities and its privileged economics, we see the long-term upside of our investment in Unity as being very substantial. At the same time, it is difficult to foresee a scenario in which Unity’s long-term value is materially less than where it is today. This is an attractive proposition, though it is clearly a long-duration investment suitable only for investors with a long-term horizon. As you know, we have structured Montaka to enable us to make such long-duration investments on your behalf.
Andrew Macken is the Chief Investment Officer at Montaka Global Investments. To learn more about Montaka, please call +612 7202 0100.
