Perhaps one of the most hotly debated stocks in the market, Unity Software – the leading game engine developer and also a growing monetization solutions provider for gaming companies across the world has been at the center of a lot of criticism in the past few months. The stock has nosedived 86% from its 2021 peaks and is 16% down in the last 1 year. Yet, it is also one of the most promising stocks out there due to its product leadership in the industry, wide range of use cases and futuristic solutions which can generate revenue from not just gaming but augmented & virtual reality (AR, VR) applications outside gaming. Let’s find out what’s happening here and what you as an investor or someone looking to invest should do. We’ll start with what the recent controversies are about and then move to the company’s latest quarterly earnings report & leadership transition updates.
Pricing, “Run Time” Revenue Model Controversies
The controversies primarily started on September 12 when the company introduced changes to its pricing plans by implementing run-time fees, aka fees charged on a per-install to game developers and was a big reason that led to the retirement of Unity’s (now-ex) CEO John Riccitiello. The changes announced to its pricing prompted an immediate, overwhelmingly negative reaction from developers. They were outraged that new fees were being introduced at short notice, levied on top of existing charges and implemented retroactively. Many developers loudly protested online, saying the fees were not what they agreed to when signing up. Some developers even vowed to drop Unity for future games. In response to the backlash, Unity reassessed their proposed pricing model and made several amendments. These changes included raising the revenue threshold for games subject to the per-install cost and offering alternative payment options for developers. However, despite some clarifications, no one celebrated this move. It was seen as deeply backward, and there remained a flood of developers who fled the platform to Unreal or other engines in order to avoid this kind of install fee-based model.
It is worth noting as well that in Q3’s earnings report, Unity acknowledged that they “expect the impact of this business model change to have minimal benefit in 2024”. Business model change here refers to the new revenue model; but it seems like the company has not learnt from the misstep and the lacklustre impact to its metrics despite the change. What would have helped: an acceptance that their strategy is wrong, and a course correction plan to change the revenue model.
Interestingly, if you visit Unity’s pricing updates page here and go through the FAQ’s on the new fees, you’ll understand the issues with their strategy. There is simply no consistent way to measure, report and ensure that developers are submitting the right metrics and accurate data. The pricing updates also come with many different exclusions attached which makes it all the more complicated for developers to report the cut they have to pay despite them being applicable for mid-large sized companies.
Q3 Earnings Report, Analysis
Unity reported $544M of revenues in Q3’23 which was within management’s guidance of $540-550M but slightly below analyst’s expectations of $554M. This represented a 69% YoY increase, but one thing to note here is that this number includes the revenues they earned from their acquisition of ironSource. They had spent $4.4B to acquire ironSource in an all-stock deal in 2022, and ironSource seems to be pulling in ~$195M out of their $554M latest quarter’s revenue (i.e. 35% of revenues). Without including ironSource, Unity would have only grown 8% YoY, a starkly different story and definitely not something any growth investor would like to hear.
The real concern in our opinion is that the core of the company, i.e. their gaming engine which is housed under the “Create Solutions” division has been showing consistent signs of stagnation. It contributed $189M in revenue in Q3, compared to $193M in Q2 and $187M in Q1. In Q3’s ER, Unity blamed a slowdown in the Chinese gaming market along with a reduced focus on professional services for this slowdown. While these reasons are not completely invalid, they do not fully explain why a product portfolio as strong as Unity’s is unable to grow faster.
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It is also a good sign that the ironSource merger has (atleast so far) been accretive to the company’s business as M&A can be tricky and many acquisitions fail. Going by the trend, despite the relatively weak ad industry, the Grow Solutions division which houses the ironSource merged entity along with Unity’s ad platform was up by 166% YoY and 12% (excluding ironSource’s contribution).
Coming to profitability metrics, the adjusted EBITDA margin hit a record high of 24% and net margin also hit a record high of (-23%), both vastly better both on a QoQ and YoY basis. The company also generated a record $104M in free cash flow in this quarter but still posted a net loss of (-$125M).
All these beget the question – if the growth is slowing down, where will the profitability come from? Well, for starters, the company has to: (1) further reduce costs in terms of both manpower & office space, (2) discontinue products that are not finding product-market-fit and/or sustainability. Unity has mentioned both of these will be happening soon as per their Q3 shareholder letter.
However, this might not suffice. Looking at their Q3 expenses, stock based compensation (SBC) accounted for almost 30% of their revenues (~$147M in absolute terms). This is extremely high, and the company strongly needs to implement better controls here if it really wants to act in the interest of shareholders. Case in point, their Chief Legal Officer (Anirma Gupta) owns $13M in stock despite having spent just 1 year at the company. This should be a slight red flag for any shareholder.
The gross margins of Unity are strong at 72% in Q3 (up from 65% in Q3’22) but the operating expenses are so high that the company continues to operate in losses despite all the revenue growth. The company has slightly moderated its R&D spend this year, but the sales & marketing expenses are still extremely high (36% of revenues, up from 34% in Q3’22) especially considering the slow growth it is experiencing. Granted, a portion of this could be due to the ironSource acquisition but such a large contribution of sales & marketing expenses makes it harder to align with the picture of Unity being a strong product – the company definitely needs to think how to more efficiently carry out marketing activities especially in the light of slowing revenue growth from its core game engine portfolio.
Leadership Transition, New Interim CEO
With John Riccitiello’s retirement due to the pricing controversy, Unity announced an interim CEO to helm the company – James Whitehurst. Whitehurst was previously the CEO of Red Hat, serving for 10+ years until Red Hat was acquired by IBM and has also served in leadership roles at Delta Airlines, BCG and was a special advisor to Silver Lake, the PE firm which owns a 9% stake in Unity and is the second largest institutional shareholder after Sequoia Capital. It is no surprise how this introduction happened, and the new CEO could be a blessing in disguise atleast temporarily, since Unity is still searching for a permanent CEO and is still not out of the controveries it got into with game developers.
It remains to be seen whether the board will get someone new after Whitehurst or whether Whitehurst’s performance would be good enough for the board to continue on with him for a longer term. As a shareholder though, one would wish that if Whitehurst does not perform well, he proves so quickly so the decision for the board is clear and does not hang in uncertainty.
Conclusion
Unity is operating in a relatively hard to enter industry (due to the vast amount of technological knowhow & investment needed) with a strong product, industry leading gross margins and has the who’s who of the gaming industry as its clients. It has also done well to start building an ecosystem around its product offerings with expansion into monetization and growth platforms which have gained rapid adoption from their customer base aided by its ironSource acquisition. However, it strongly feels like the company needs a turnaround – gaming engines and development processes are due for a shakeup with the rapid proliferation of AI tools in all aspects & workflows whether it is programming, art generation, music/sound effects and more.
Unity is yet to prove how much its R&D investments, which form a considerable portion of expenses are focused on AI and how powerful those features can be to enhance their customer’s software development lifecycle and speed to market. On top of this, despite having implemented strong cost cutting measures, the company is not completely out of the woods yet as it is still incurring losses and spending a very large amount of money on sales & marketing and stock based compensation.
There is need for a stronger control on expenses, rapid product innovation with AI features, closer integration between their gaming engine & monetization platforms and a clear signal to its customers that it cares for them. Courting controversies and not fully addressing them will not make things easier, it will only serve to further isolate its community which has been one of their biggest strength as a company.
At the same time, the opportunities ahead of the company are tremendous. Let’s not forget that Unity is the primary engine of choice for developers working on spatial computing apps for Apple Vision Pro’s visionOS, a space which is completely untapped and has massive potential for revenue growth. Unity also has the financial strength and a strong team backing it to make the right investments and further strengthen its competitive advantage – but it needs leadership to execute fast. It remains to be seen whether the new CEO Whitehurst can accomplish this. Some other tailwinds that could act in favour of the company would be a pickup in the advertising industry and softened gaming regulations in China, both of which could pan out in 2024 or 2025.
Overall, we’re positive on the company but still retain a “monitor” view to assess how their growth plans fare over time. We would prefer to hold and continue adding onto the position if and when pullbacks present an opportunity.
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