Unity Inc (U - Full Stock Analysis): Metaverses and more

Jan 16

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U at a glance

U is primarily known for its gaming engine which is used in over 50% of all video games (source). A gaming engine is a tool that streamlines that creation of games with tools such as easy creation of 3D worlds, built in physics engines, lighting and camera functions, and more. Basically, it takes all the complexity out of creating 2D or 3D worlds for your game and allows you to focus on the uniqueness of the game itself. However, U is very quickly transforming itself from just a video game company to capture the requirements of the metaverse, virtual reality (VR) & augmented reality (AR), and other enterprise applications. As 3D environment rendering becomes more mainstream outside of the video game industry, U wishes to capture this emerging market with its current expertise.

U contains the following business offerings:

Unity Pro: their primary engine for 3D world creation and rendering for any 3D experience.
Unity Industrial Collection: an AR/VR visualization tool specialized for CAD models
Unity Ads: features to automatically implement ad monetization within their Unity suite of products
Unity Enterprise: custom development and services for enterprises needing 3D experiences not offered through any off-the-shelf products
Unity MARS & Unity BIM: an AR-specific engine. MARS focuses on general use cases while BIM focuses on industrial CAD mapping onto AR overlays.
Unity ArtEngine: an AI-powered texturing tool to streamline the 3D world creation process

The 3D modeling industry

The game engine industry

U’s current primary industry is the video game engine. The global game engine market size was valued at just over $2B in 2019 and is projected to grow to $6B by 2027 with a CAGR of 13.6% (source). This growth is driven by several factors:

The growing trend of AR/VR applications both for entertainment and enterprise
The gamification of applications across various industries for enterprise purposes
The boom in gaming popularity due to Covid-19 estimated to be an increase of 50% from previous popularity numbers (source)

The metaverse industry

Building out 3D worlds will be paramount in any metaverse where the entire digital universe is but a 3D rendering. While this industry is still on the bleeding edge, initial estimates have the metaverse industry growing to be worth $900B by 2028 with a CAGR of 44% (source). This bold prediction encapsulates the current gaming and AR/VR markets. It forecasts an entirely new world for advertisements (source) as well as what will be enabled in this world with the onset of blockchain-based NFT marketplaces and decentralized finance (source).

Currently, there is ongoing debate over the viability of a metaverse and even whether it is a good thing or not. Proponents of it sees it as an embodiment of the internet, creating a true level of experience and connectedness currently impossible (source). Opponents of it see it as best a marketing scheme much like how every company touted the term “AI” a few years prior and at worst a sci-fi dystopian tool about disconnecting entirely from reality (source).

The financials

Income statement

U is not a profitable company. While this is usually okay for a company still in their growing phase, U already controls 50% of the gaming market which is their main line of business. It is a bit worrisome that they have not been able to create profits despite this market dominance.

Moreover, their operating income loss is outpacing their growth in revenue. Year over year, their operating margins decrease further into the negative indicating that they are actually getting further from profitability than closer. Once more, this is okay for an aggressively expanding company, but not okay for a company with U’s level of market dominance.

Balance sheet

U has a very healthy balance sheet as of 2020. 2021 is a different story, but we’ll get to that later. They maintain a great ratio between current assets and current liabilities indicating that they are financially capable of meeting their short-term debt obligations.

However, in 2021, U acquired Weta, a VFX firm famous for creating the visual effects in Lord of the Rings (source). In order to do this, U offered $1.5B of convertible notes which is a debt obligation (source). So far, they have not published their 2021 Q4 balance sheet but given what we can see in their 2021 Q3 balance sheet which is very similar to their 2020 numbers, these convertible notes will bring their total liabilities near equal to their total assets. Thus, they introduce major balance sheet risk.

Statement of cash flows

U continues to expand their business through strategic acquisitions. This is reflected in their investing cash flow. In 2020, they financed these acquisitions through a stock dilution. In 2021, they financed it through convertible notes (debt). In both cases, they are able to stabilize their free cash flow to ~-100M per year (these numbers are in thousands).

At this rate of cash burn, and taking into account the debt they have just picked up from the Weta acquisition, U is likely to need additional financing for their operations soon.

Where U stands

The bull case

U is very deliberately diversifying its business so that it does not solely rely on gaming as a source of income. To do this, they must spend money on both R&D and marketing, which is why their current finances are not optimal. However, with the expansion of gaming due to COVID19, and with the onset of the metaverse, U is extremely well positioned to ride both these tailwinds into revenue opportunities. 94 of the top 100 game development companies use Unity (source). Already, some of the metaverse investments are coming to fruition as Unity has partnered with Meta in order to offer advertising within Meta’s metaverse (source).

U is also betting on the expansion of AR/VR applications. For example, Pokemon Go was made in Unity (source). Finally, U has recently launched its sports and live entertainment platform with the promise of eventually being able to provide viewers a full 3D experience of any show and from any angle (source).

As enterprises begin finding more use cases for AR/VR, as gaming and live entertainment continues to evolve, and as the metaverse expands, U will have a solid opportunity for market dominance in all of these sectors just as it is in gaming.

The bear case

U has a profitability problem. Already, they posted later-than-expected profitability of 2023 (source). Moreso, looking back at their financials, you’ll see that their numbers are continuously devolving instead of improving. Furthermore, digging deeper into their revenues, you’ll see that in 2020, 60% of their revenues came from their Operate Solutions segment (ad monetization within games) (source).

This indicates that their revenues are not diversified and are susceptible to major risk catalysts such as Apple’s new privacy policy affecting their ad monetization business (source). Lastly, U is very heavily investing in itself to diversify its business. This is great only if the investments pay off and instead of focusing on specific segments, U is targeting everything at once from sports to the metaverse to VFX. It will be difficult to balance their investment strategy if they try to expand everywhere all at once.

The verdict

Currently, Unity are experiencing several tailwinds such as the rise of gaming, VR, and the metaverse. If these industries truly come into fruition as industry experts expect them to, then U will be extremely well positioned for them. Even beyond these big three, their acquisition of Weta allows them to use their engine for movies. I really like how they are trying to position their already created assets and expertise into additional industries outside of gaming. While their finances are not great, there is no indication that their core business is in jeopardy and very little risk of insolvency. For this reason, I believe their financial risks are outweighed by the potential benefits of their current investments in themselves.

Positions Disclosure: No position.

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