Unity: Platform Is A Competitive Moat, In The Midst Of A Turnaround

Summary:

• Unity Software’s stock has declined by over 50% due to slowing revenue growth and pricing controversy, but its game development engine remains dominant.
• Unity’s Q1 2024 results showed flat revenue overall, with a focus on core business offerings and cost reduction efforts.
• The company is exploring new revenue sources through partnerships like Mazda, AR development, and improving monetization solutions.

Unity Software’s stock (NYSE:U) has seen its value decline by more than 50% in the past few months. Slowing revenue growth and last year’s controversy over the changes in pricing have contributed to the negative sentiment. However, Unity’s game development engine is still dominant in the industry and represents a competitive advantage for the company.

As a software platform, there are many paths the company could take to re-ignite growth. Improving growth and a focus on profitability should be the key tasks for the company’s new CEO. Unity could be at the inflection point of a turn-around.

Unity’s Q1 2024 Results Show Improvement

Looking at Unity’s most recent Q1 2024, we can see that the company achieved relatively flat results. Total revenue for Q1 2024 was $460 million which is 8% lower than the $500 million reported at the same time last year. However, the declining revenues should be interpreted within the context of Unity’s entire business. Beginning last quarter the company has begun to streamline and restructure its operations to focus on its core businesses referred to as the “Strategic Portfolio”. This means beginning to wind down activities that are not part of Unity’s core business offering such as Professional Services. This explains the rather large decline in top-line revenue of 8% year over year. Unity’s non-core revenue in Q1 2024 is approximately $34 million. Therefore I expect to see the winding down and consolidation of these business lines to continue to drag down top-line revenue.

Looking at Unity’s core business offerings i.e. the “Strategic Portfolio” top-line revenue results were largely flat. The Strategic Portfolio consists of three components. The first is the Unity Engine, the company’s flagship game development platform. The second is Unity’s Cloud offerings. Finally, Monetization consists of tools to help game developers further monetize their products with things like in-app advertising and in-app purchases. Revenue generated specifically by Unity’s strategic portfolio was up 2% year over year at $426 million. These results were on the high end of the company’s guidance of $415 to $420 million.

The company reported a Net Loss of $141 million for the quarter once adjusting for one-time losses for restructuring and one-time gains. This is much less than the GAAP loss excluding a restructuring charge of $240 million the year prior. The company’s adjusted EBITDA was $79 million which was an improvement of 172% compared to the same time last year. This demonstrates that the company’s cost reduction efforts are bearing fruit however much more needs to be done to get the company to profitability.

Unity has a Dominant Position in the Game Engine Industry

Unity’s development engine is already one of, if not the leading engine for game developers. According to the data research firm 6sense, 29.6% of all games are built using the Unity game development engine. For reference, the other popular game engine for triple-AAA games Unreal has a 16.6% market share. Unity is in a unique position as its game engine is popular with a variety of videogame developers ranging from massive triple-AAA companies to one-man indie game studios. In other words, Unity’s game engine is already an established and mature product.

Given the already dominant market share of Unity, in my view, the company has to explore other means to increase revenue growth. This is especially in light of slowing videogames sales last year. The total dollar amount spent on games in 2023 was $57.2 billion which was only a 1% increase compared to 2022. I expect Unity to continue to maintain its dominant position in the market with the expected release of the next-generation version of its game development platform, Unity 6.

There was major controversy late last year when the company experimented with changes to the pricing model for its main game engine. This led to a massive blowback and high volume of negative customer feedback including boycotts and a slowdown in overall customer demand. Unity’s stock has cratered since that time as at the beginning of September last U stock was trading at $39 and now it is $16. However in my opinion the risks from this controversy have been blown way out of proportion given Unity’s dominant market position.

At the end of the day, Unity had some productive conversations with customers and adjusted its new pricing model. It was all a knee-jerk reaction from the gaming community in my opinion and things have cooled down. The truth of the matter is Unity still remains cheaper to develop for than Unreal and all management had to do was communicate that value. Looking at the revenues from the game platform side this Q1 2024 saw an increase of 17% year over year indicating no lasting long-term damage from last year’s controversial move. According to management ;

we are seeing customers who were a bit ruffled at the end of last year, feeling much more confident with us. We’ve gone from what and why of runtime fee to I think a recognition that the industry wants to make sure that we invest in the runtime. And so it’s a matter of how and let’s kind of work through that.

So we’re having super productive conversations with our large customers. We had a phenomenal GDC, really, really great engagement across the board. So also it makes me feel good about our relationships with developers and where those are moving.

Other Potential Sources of Revenue

As mentioned earlier, Unity is looking at other avenues to grow its revenue base. The first of these initiatives is targeting new customers who may be interested in its engine’s 3D rendering capabilities. The most recent of these partnerships is with car manufacturing company Mazda where Unity will assist in improving the in-cabin car experience. Basically, Mazda will be building its next generation of digital screens and infotainment systems with the Unity platform as its core. According to the press release;

Unity Industry and Runtime will be used to support Mazda’s human machine interface (HMI) and graphic user interface (GUI) development, including integration into in-car operating systems. Leveraging Unity for HMI/GUI development enables seamless integration of diverse digital tools used across various phases of automotive development, from design to engineering, reducing rework and enhancing operational efficiency. By embedding applications created with and optimized through Unity into in-car devices, Mazda expects to advance high-performance capabilities that are more attractive and intuitive for its customers.

Another potential use case for Unity’s development platform is in the field of augmented reality (“AR”). Just early this year Unity announced support for Apple’s (AAPL) visionOS to enable developers to create applications and experiences for Apple Vision Pro. In the recently concluded Augmented World Expo (“AWE”), the company showcased the transformative effect of virtual and augmented reality on industries ranging from retail to manufacturing. While AR becoming mainstream could still be years away, it is good to see Unity already planting the seeds for what could be a potentially large market.

The second source of revenue growth is improvements in the performance of Unity’s monetization solutions, particularly advertising revenue. Having ads in videogames (particularly free to play) is nothing new and has been part of the Unity platform. However, the company has not been able to fully maximize the benefits of its game development platform when it comes to delivering ads. In fact, in Q1 2024, Unity’s monetization business was down 4% year over year.

One of management’s initiatives in increasing revenue growth for the monetization business is to improve its data usage to improve the efficiency of the company’s models. Ultimately this will deliver the appropriate return on ad spend for its customers. According to management in the latest earnings call;

We expect the second half acceleration to be driven by improvements in performance in our monetization solutions, and better usage of data to train our models and deliver that return on ad spend for our customers. And very importantly, we continue to make progress on something we talked last quarter, which is to integrate Create and Grow to better serve our game customers more holistically, which is something that Unity can uniquely do better than anybody else.

Conclusion

Ultimately, I expect Unity’s revenue to stabilize at these levels. The company has a pathway for rapid growth from its new businesses and monetization solutions. However, these may take some time to bear fruit. The company’s stock is trading at an Enterprise to Sales value of 3.6x which puts it close to the median for its industry group. I believe that Unity is a buy at these levels.

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Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, but may initiate a beneficial Long position through a purchase of the stock, or the purchase of call options or similar derivatives in U over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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