Unity has been shuffled around between LTBH and the Momentum portfolio. We’ve felt at times the valuation was a risk considering the majority of its revenue right now comes from ads and ad-tech trades at a lower valuation than cloud. Meanwhile, we were very early to cover the AR/VR story for Unity with pre-IPO coverage and we certainly have a positive and bullish outlook on the company long-term.

Similar to Path, Unity has immense potential and a future spot in LTBH. However, the public markets are being offered innovation in earlier stages and we think Unity could need more time for its real thesis to materialize. We could be wrong on the timing which is why the company is in the Momentum category. We feel our Members can benefit from our early and often unwavering conviction in a thesis like Unity regardless of the exact positions that the I/O Fund holds.

Please note, we are often covering earnings or other key reports on the forum, such as my update on Fubo, Bradley’s update on Magnite and also Snap post-earnings analysis from me, and also analysis from Bradley.

Unity’s Staggering Penetration

Central to the Unity thesis is the company’s staggering penetration. As discussed in our original write-up, Unity has been installed more than 33 billion times over the course of 12 months in 2019. The real-time development platform reached 3 billion devices. The company has 1.5 million developers and is used to build 50% of the games on the market. Of the top 1,000 games, 53% use Unity and 93% of the top 100 game development studios by global revenue in 2019 were Unity customers. At the time, we had stated: “This kind of penetration can create a defensive position against competitors due to universal training and skills as learning a new platform is time consuming and less effective for recruitment and also lengthens time to market. To be clear, Unity does not have a moat but does occupy substantial space in a duopoly with Epic’s Unreal. As of 2018, Unity had 45% of the market and Unreal had 17% of the market.”

Part of Unity’s substantial presence is the free tools it offers game developers who earn less than $100,000 annually, and for the most part they capture any developer between the indie (small) stage and up to AAA studios although many of these studios prefer to use their own in-house game engine. The company has especially found its stride on mobile. 

Create Solutions is where games are built and Operate Solutions is how games are monetized through ads and in-app purchases. There are also analytics offered through DeltaDNA, which collects information on end-user engagement and behavior.

The Create Solutions is what can be leveraged now for other industrial purposes while Operate may have a bigger role for the Metaverse in the future. In other words, growth in the Create category will help us gauge where we are in terms of the Metaverse generating real revenue while Operate could have a sizable catalyst in the future (not near-term).

Where Unity could do quite well with Create is that the groundwork has already been laid to help developers assemble graphics, sounds and animation in the development environment (IDE) and creators are able to direct assets from the code. Unity’s IDE saves steps by allowing drag and drop code scripts to the object/character and also the ability to drag game objects onto the character. There is an Asset Store with 50,000 pre-designed assets available including 3D models, 2D/3D animal renders, tutorials and how-to’s.

Developing games on Unity is low code and sometimes no code, which is ideal for 3D creators who are not necessarily developers. This lends itself well to the creator community that is most likely to drive forward the Metaverse, or Web3, and also the various industries that can benefit from 3D or AR/VR right now. The Create Solutions and tools are also great for prototyping, which speeds up the time to deployment. Unity is frequently acquiring tools and plugins to lower the barrier of entry for developers and creators. For example, Bolt2 helps developers implement logic without knowing how to code.

Last year, Unity developed a new architecture that provides native APIs to third-party providers and offers a high-level managed API to Unity developers. The new architecture fundamentally improves how Unity delivers and manages SDKs for XR platform integrations.  

The main thing to know about Unity’s products is they offer 3D creation for everyone, i.e., democratizes the process. This was initially intended for the gaming industry yet there is natural affinity for gaming tools, IDEs, chips, etcetera, to be used for virtual worlds and the Metaverse.

When I think of Unity, the word “authentic” comes to mind as they’ve been in the trenches of game development for a long time (2004). I liked this statement from the company in the earnings call to help distinguish Unity’s positioning: “So headline number one is, my expectation is the use of real-time 3D interactive technology is going to expand many fold. I’ve said this dozens of times from prior to our IPO to now. It’s — some people call it a metaverse.” What I like about that statement is the company is essentially saying – we are just doing what we do – and some people are now calling what we do the Metaverse. Similar to Nvidia’s professional visualization segment, we can track Unity’s progress through the Create segment growth. Unity is also rare in that it’s a public company participating in Web3 right now with NFT-centric games being built on its engine.

What’s key for investors to understand as Unity is not launching a big marketing campaign or drastically changing its vision and operations to capture a trend. When we first covered Unity, the word Metaverse hadn’t been introduced yet to the market and headlines. Unity calls this 3D although AR/VR or XR are other terms that are interchangeable. What has changed is not the technology rather the marketing around the technology. I think that’s a key point to determining what is authentic and what is hype – and there is a lot of hypea lot of hype right now.

Unity: Key Things (Bullish) to Watch For

Catalyst: Non-gaming business

I think there are a few reasons the market is excited about Unity’s most recent earnings report. The first is the non-gaming business grew 70% year-over-year in 2021, which could mark the start of the Metaverse driving real revenue. Note: we need to see a bit more before we can proclaim the Metaverse moment has begun. There could be a few anomalous revenue segments such as Unity’s Create and Nvidia’s professional visualization. Will update as we go along.

The variety of industries the company now serves helps us envision a time when Unity software will no longer be known as only a gaming company.

For example, the game engine deploys games across Windows, Mac, iOS, Android and other consoles, and this is leveraged to also deploy industrial, non-gaming projects across many platforms. With Unity Pro, real-time 3D, AR and VR content can also be deployed on HoloLens and Oculus. The Unity Pixyz Plugin works with manufacturing software like AutoDesk to further industrial uses, such as automotive. Additionally, Unity does not compete with creators and is royalty-free.

“Our non-gaming business is growing even faster [than our gaming business]. As we add customers across multiple industries. We believe there is significant upside as we have embedded structural advantages. With unity, creators develop once and deploy to many platforms and other — unlike other companies, we don’t compete with our customers.”“Our non-gaming business is growing even faster [than our gaming business]. As we add customers across multiple industries. We believe there is significant upside as we have embedded structural advantages. With unity, creators develop once and deploy to many platforms and other — unlike other companies, we don’t compete with our customers.”

Regarding Unity’s gaming penetration, in our original write-up, we had stated the following in terms of future catalysts nearly 16 months ago before the company went public: “Because Unity is nearly ubiquitous and has a strong reputation for dominating the game development industry, it could be hard to see areas for future growth if not for VR/AR application development. I can’t think of any other platform best suited to own this market and I see this as the primary reason to keep Unity on our radar.”

We then published some statistics that support our understanding of Unity’s future markets, including “the AR and VR market growing substantially when you extend the outlook to 2025 and include global automotive with some reports estimating the market to grow from $213 million in 2017 to $673 billion in 2025.” Perhaps most compelling of all is the 175%+ CAGR we cited for AR/VR in our original report for onsite assembly/safety and industrial maintenance.

According to comments on the recent earnings call, Unity sees the largest opportunities in real-time 3D coming from games, film, animation and advertising. In terms of serving other industries outside of gaming, here is what Unity said in the S-1 filing a year ago:

“The dramatic growth of end-user demand for interactive content is driving industries beyond gaming to embrace the advantages of real-time 3D content. Creators are leveraging our platform to provide faster content creation and efficient deployment across formats and use cases. Today, Fortune and Global 500 companies in industries such as architecture, engineering, construction, automotive, transportation, manufacturing, film, television and retail are using Unity across many new use cases, including automobile and building design, online and augmented reality product configurators, autonomous driving simulation, and augmented reality workplace safety training.:Today, Fortune and Global 500 companies in industries such as architecture, engineering, construction, automotive, transportation, manufacturing, film, television and retail are using Unity across many new use cases, including automobile and building design, online and augmented reality product configurators, autonomous driving simulation, and augmented reality workplace safety training.:

Unity also recently launched Unity Forma, an automotive and retail solution tool for the creation and delivery of custom real-time 3D marketing content. Shortly after the Unity Forma launch, Unity acquired RestAR to power real-time 3D product capture.  

Core Business: Contextual Ads

The second reason to be excited about Unity is the contextual ads that Unity serves, which insulates the company from IDFA issues. Contextual means that instead of behavioral targeting, advertisers find enough value in the audience segment being “gamers” to use that category as the primary means for targeting. An example would be if you’re reading about Apple’s earnings and you see an advertisement for a Fidelity product, then Fidelity likely targeted you based on your interest in the category of finance or stocks. It is by the context of the content you are consuming that advertisers purchase the ad spot.

This approach has been around for ages, it’s how magazine ads or the Superbowl ads garners high revenue. If you watch the Super Bowl, contextually you are likely to drink beer and so Budweiser buys the spot. If you’re reading Vogue, then a makeup brand like Loreal will target you by context. The same applies to Unity Ads where advertisers know they want to target gamers first and foremost. Things like age and average in-app spend is also available to help further narrow down an audience segment.  

It's important Unity investors understand the contextual ads piece because it does separate Unity from other ad-tech players.

Here is what we said previously:

On a contrarian note, because Unity has a very specific content type (gaming), there’s a chance the company is very resilient through the iOS 14 changes as targeting can occur through content type (i.e. Gaming, Financial News, Beauty & Health, etcetera). Previously, Unity Ads have been known to be more effective because the audience type and interests are narrow. There’s also a possibility that Unity is stronger with the IDFA changes as they own the game engine whereas their competitors are using third-party data only for targeting. These competitors include Vungle, AdColony, Facebook’s Audience Network, MoPub, Leadbolt, TapJoy, etcetera.Unity has a very specific content type (gaming), there’s a chance the company is very resilient through the iOS 14 changes as targeting can occur through content type (i.e. Gaming, Financial News, Beauty & Health, etcetera). Previously, Unity Ads have been known to be more effective because the audience type and interests are narrow. There’s also a possibility that Unity is stronger with the IDFA changes as they own the game engine whereas their competitors are using third-party data only for targeting. These competitors include Vungle, AdColony, Facebook’s Audience Network, MoPub, Leadbolt, TapJoy, etcetera.

So, why did I close Unity going into the IDFA changes? I simply wanted to take risk off the table and I felt Unity’s core thesis of Industrial 3D Development was a ways off to where I could re-enter if needed. There was no perfect decision here other than to have a longer mindset than one earnings result. I still believe the changes to the IDFA is one of the biggest shifts to ad dollars that the public markets have had to grapple with. In other words, the effects are not done yet. The other big shift was when the walled garden went up. If you got that shift right, you made a lot of money as it led to the sustained rise of Google and Facebook.

Here is what Unity said on the call regarding contextual:

“So, our contextual approach provides numerous advantages. Even the largest game companies out there have a few 100 millions to use or so. We reach more than 3 billion devices. And unlike any other ad tech companies, the majority of mobile games out there are made with Unity, using our engine and our game services. That’s not quite the same as an ad tech company claiming a 3 billion reach. So let’s quickly address first-party data. Let’s assume we’re talking about first-party games data. First-party data is not bulletproof. First games are a hit driven business and even the best of games have a decay curve. So you really have two choices, if you’re in that business, either you create the next hit game, which we all know it’s pretty hard to do or you spend by studios that are producing them and that’s hard to sustain. The second thing is being end-to-end with first-party in this ecosystem is nearly impossible. So no matter how many companies anyone acquires, contextual data scales in a much more unlimited way. Well, first-party is limited to users only coming to your own and operated game.”Even the largest game companies out there have a few 100 millions to use or so. We reach more than 3 billion devices. And unlike any other ad tech companies, the majority of mobile games out there are made with Unity, using our engine and our game services. That’s not quite the same as an ad tech company claiming a 3 billion reach. So let’s quickly address first-party data. Let’s assume we’re talking about first-party games data. First-party data is not bulletproof. First games are a hit driven business and even the best of games have a decay curve. So you really have two choices, if you’re in that business, either you create the next hit game, which we all know it’s pretty hard to do or you spend by studios that are producing them and that’s hard to sustain. The second thing is being end-to-end with first-party in this ecosystem is nearly impossible. So no matter how many companies anyone acquires, contextual data scales in a much more unlimited way. Well, first-party is limited to users only coming to your own and operated game.”

Unity is stating they have a material advantage over supply side platforms as the games are developed on their engine with analytics, which is unique to Unity.

Acquisitions

In previous write-ups, we focused on Unity’s acquisition spree and high R&D spending that we believe will help to solidify Unity’s place as a picks and shovels provider for Web3 and the Metaverse. Unity agreed to buy Weta Digital VFX for $1.62 billion in exchange for the design tools, assets and data platform that drove film creations such as Lord of the Rings, Avengers, Avatar and Game of Thrones. The goal is to bring the magic of film assets to the individual creator on Unity’s platform.

The Weta Digital acquisition helps Unity remain defensive against Epic’s Unreal Engine, which was used on virtual sets, such as Star Wars The Mandalorian. It also helps Unity build a Metaverse asset library, such as stadium scenes, character movements, large crowds, fantastical characters and backgrounds, etcetera, which can help the workflow for content creation for the metaverse. With that said, the more near-term opportunity for these acquisitions is for Unity to turn Hollywood into a customer.

Here's what they said on the call – ILM being Industrial, Light & Magic, a motion picture visual effects company founded by LucasFilm:

“We just liberated one of the coolest assets that existed all of art and all of technology and all of content creation, the [Weta] tool set. The number of companies that are knocking on my door to say, we want to be your pilot customer, because we want out those tools. It is pretty substantial. And so it’s — I can’t really overstate how much interest there is an engaging now that the tools aren’t captive of a single company that’s got, if you will, ILM does not want to use tools from Weta they compete. ILM now wants to use tools from Unity.ILM does not want to use tools from Weta they compete. ILM now wants to use tools from Unity. Now, I’m using ILM as an example. I’m not going to point to them. So let me take that last part about the naming of them. But the notion of it is pretty clear.”

Unity also acquired Ziva Dynamics, which is film software for creating digital humans in Marvel movies, Hellblade, Jumanji and Godzilla vs King Kong. Similar to the Weta Digital acquisition, the tools for anatomical simulation will be democratized for individual creators on Unity’s platform.Similar to the Weta Digital acquisition, the tools for anatomical simulation will be democratized for individual creators on Unity’s platform. According to a statement from the company, “One of the most fundamentally revolutionary changes that Ziva brings is it allows a huge improvement in how creators can achieve believable, life-like character creation.”

Even if we don’t see millions of creators begin to work with Metaverse assets immediately, Unity is paving the way for when this happens.

Regarding Industrial, Pixyz Studio is the company that created a plugin for AutoDesk and other manufacturing software providers. The company specializes in optimizing 3D data and helps developers import the data into Unity, and its also used for industries such as the manufacturing of cars, appliances and buildings. The plugins and software products work with Nvidia, Microsoft, Autodesk and across the auto industry, to name a few.

Financials

By Bradley Cipriano

Unity is a leading ad-tech for those that have reported Q4 with 41% growth excluding Weta FX’s licensing fees. Revenue for the full year was $1.1 billion, for an increase of 44% compared to the initial guidance of 23% to 26%.

The company is guiding for growth of 35% at the midpoint for the current Q1 quarter, for revenue of $315 million to $320 million. For the full year 2022, Unity is guiding for $1.495 billion at the midpoint for growth of 35% year-over-year. One of the more important statements in the call was Unity’s assurance that they are providing a conservative forward outlook, and in the event that more tailwinds materialize, this outlook will move upward. The company has provided 6 consecutive beats on their guidance on both the top line and bottom line, so confidence in the management team is quite high. Guiding correctly during IDFA likely increased the confidence the Street has with this management team.

Here is what the company is guiding for long-term: “So what can you expect from Unity going forward? So in terms of revenue growth, now, as we just said, you can expect us to grow between 34% and 36% in 2022 and then at least 30% thereafter. So we will continue to drive that this driver which is critical for us.”So what can you expect from Unity going forward? So in terms of revenue growth, now, as we just said, you can expect us to grow between 34% and 36% in 2022 and then at least 30% thereafter. So we will continue to drive that this driver which is critical for us.”

Operate Q4 sales grew 45% year-over-year to $195 million and increased 51% YoY to $709 million for the full year. As stated above, Operate is the advertising business and there were quite a few questions on the earnings call about the health of this business, particularly its contextual advertising strength.

The net retention rate continues to be a feather in Unity’s cap. The DBNRR was at 140% compared to 138% in the year-ago quarter. Enterprise-level customers are helping the DBNRR metric with 85% of revenue coming from the >$100,000 segment compared to 80% last year. This trend correlates with DBNRR and highlights that customers are increasingly spending more with the company. Furthermore, >$100,000 customers increased 34% YoY to 1,052 customers, and customer growth has expanded beyond gaming. As mentioned above, the addition of Weta FX expands Unity into Hollywood, and the company has also been strong with industrial customers, leading to 70% year-over-year growth in non-gaming revenues.

Continuing down the income statement, Q4 gross margin improved 200 bps YoY to 80% and adjusted loss from operations was $12 million, or -4% of quarterly sales. For the year, gross margin was up 100 bps YoY to 80%, and adjusted operating loss was $51 million, or -5% of annual sales. Looking forward, Unity guided for an improvement in its operating margin and expects to report an adjusted operating loss of $40 million for the upcoming year, or -3% of sales (at the midpoint). However, expenses will be frontloaded to the beginning of the year as Unity expects Q1 2022 adjusted operating losses to be $23 million, or 7% of quarterly sales. The company stated they expect to break even sometime in 2023.

For the year, free cash flow was an outflow of -$153 million, down from -$20 million in 2020. Free cash flow included a one-time charge of $50 million to terminate its lease in San Francisco. Going forward, the margin improvements are expected to flow to free cash flow. CFO Luis Visoso stated on the Q4 call that “I would expect free cash flow to follow very much in line with our non-GAAP operating margin improvements”. He added that in FY2022, Unity’s free cash flow will be positive, which includes a lump-sum payment for four years of license fees from the recent Weta FX acquisition. We should expect Unity to be sustainably free cash positive post 2023, when they break even on operating margins.