If you still click the tweet T+N days after Unity S-1 was filed, I bet you have already checked Fintwit threads and relevant information on the stock so I would just skip S-1 summaries, comp table/chart on SaaS metrics, or historical financials. If you haven’t checked those information, I collect stuff I believe informative in Notion page.
This post primarily focuses on the conceptual runway of game engine. Math-related exercises like market sizing and adoption trajectory pattern matching are left for specialists with incentive.
Investors who have skimmed the game engine business should have an impression that the industry has a long runway. Instead of doing modeling with long time horizon that looks funny, investors might just assign a premium on the multiple.
This post intends to be funny. Here, the long runway for game engine industry means the growth stage the industry enjoys is abnormally long and the market leader would enjoy even longer growth stage. Let’s be more specific, I assume a market leader in game engine like Unity can have 25-year CAGR of 20%😵.
Let me save your time on doing compounding. First, annualize Unity’s revenue of six months ended in June 2020 which is 2 x $350M = $700M in CY2020(E). And then compound $700M for 25 years at 20% which gives us $66.8B (for reference, Unity currently estimates its addressable market is around $29B in S-1🤣 ). For comparison, the revenue of Alphabet, Microsoft and Facebook in latest fiscal year as of this writing were around $162B, $143B, $71B, respectively. Don’t worry, $700M compounds at 20% for 25 years still can’t eat the world economy😏.
User Base Compounding & Potential Revealed when Doing Comps
Metrics and Risks
On a side note, Epic Games’ Unreal Engine has a community of 11 million users as of August 2020 (Declaration of Nicholas Penwarden In Support of Plaintiff’s Motion for Temp — Document #17, Attachment #7). Be aware that the Unreal Engine’s community user metric is not comparable to Unity’s Create Solutions 1.5M MAU. Revenue of Create Solutions for 3 months ended in June 2020 was around $55M so the average revenue per user (ARPU) for Create Solutions was around $12/MAU/month. The low ARPU is due to non-paying creators comprising the substantial majority of creator base. While Unity reports financial-related metrics as key metric (number of customers > $100K of revenue; % of revenue represented by customers > $100K of revenue; dollar-based net expansion rate), the most important metrics for a game engine are user/community related metrics even though the freemium model and the long tail of users might make contribution directly from the core product less significant. Revenue concentration in Operation Solutions is not a risk but the under-investment or poor management on the core product.
Some might argue going public would make the company short sighted and eager to please capital market so it would allocate more resources on the segment that is easier to monetize and generate growth. On the other hand, there’re positive impacts from public capital raising and floating the shares. New capital, if allocated thoughtfully, and the public status of the company will kick in the loop shortly after IPO. The reinforcing loop might eventually change the competitive dynamics. The discussion above raises two issues: 1) management/entrepreneurship/control ; 2) how strategic decision potentially impacts competitive dynamics.
Management & Control
When an investor has concern about resource allocation or strategy of the company, he/she is actually concerned about the management team. Does the team have the vision and the leadership to drive the company, especially when the investor believes the business has a very long runway. Everything being equal, I would prefer a company with founder CEO who has meaningful control or influence even though it might be a double-edged sword. For example, Epic Games’ founder CEO is fighting in digital distribution space where he brings in more competition in PC game distribution market and tries to unlock the mobile app distribution market and in-app payment processing market. While the competition generally benefits consumers, the battle between Epic Games and Apple / Google makes mobile gamers not being able to get access to the Fortnite and drags developers using Unreal Engine to develop or support their products on Apple’s OS into a “legal limbo” (I learned the phrase in Epic Games and Improbable’s joint announcement). It’s quite likely Epic calculated the potential harm to its game and game engine businesses before it made the strategic move which led to retaliations and legal battles. The decision brings risk and uncertainty but maybe it is this kind of person who is willing to take this type of self-inflict risk can envision something has enormous value, then create the value and eventually capture the value in the long term.
Let’s look at Unity’s management and shareholding. John Riccitiello, Unity’s President, CEO and Executive Chairman, has roughly 3.4% of Unity before the offering. He was the CEO of EA and co-founded a private equity firm where he served as a Managing Director. Sequoia’s affiliated entities (venture capital funds) and Silver Lake’s affiliated entities (private equity funds) own 24.1% and 18.2% of the company, respectively. Co-founders of Unity, Joachim Ante (CTO of Unity) and David Helgason (Non-Executive Officer Director) own 8.2% and 4.4% of the company, respectively.
My thoughts on management and shareholding: 1) Unity feels like a typical corporate even though one of the co-founders still serves as CTO; 2) CEO previously co-founded a private equity firm and Silver Lake owns 18.2% before IPO? I won’t be surprised if there’s an management buyout in the future; 3) in terms of organization, it’s hard to bet beyond first-rated management and good corporate governance.
Strategic Moves Change Dynamics
It seemed Epic Games’ Unreal Engine was a better bet a month ago if investor had the investment opportunity in both game engines in private market. However, competitive dynamics has changed in the past 30 days as results of strategic decisions. Without those impacts, simple prediction of the competition between two game engines might be: 1) they will not only keep building tech but will do tech roll-up within their ecosystems; 2) both will keep deepening their primary categories in gaming and fighting in use cases beyond gaming; 3) eventually both game engines will try to expand categories to where their game engines are less adopted. The goal is not only to be cross platform but also getting the game engine widely adopted by developers on different platforms.
I would guess the game engine market won’t be a winner-take-the-most in steady state but a concentrated market with dominant players sharing the majority of the market. While path dependency is driving the development of market structure, sometimes strategics move might change the status quo so dramatic that the outcome universe and the probability distribution for each node get updated.
Apparently, Epic Games’ strategic move has changed the “global” status quo. Temporary restraining order only preserves “local” status quo in the short term which is still a limbo for third party developers. While third party developers are probably lock-in in the short term, the switching costs might not be insurmountable in the intermediate term for them. I don’t know how robust Epic Games’ ecosystem is but its recent/on-going dispute with mobile OS platform holders favors Unity. The Unity’s decision to go public should improve its competitive position as well. These events probably won’t change the market sharing characteristic of game engine market but they help right shift the probability distribution of Unity’s market share in steady state.
Unity Runway Summary
- Professional: first 10 years post IPO
- Replacing proprietary game engines
- Incorporating other third party game engines
- Industry expansion
- Use case expansion
- Tech roll-up / adjacent markets
- Casual / Consumer: last 15 years in 25 years runway
- App / Content
Whether the game engine is for professionals or consumers, low entry barrier, smooth on-boarding, gentle learning curve and strong official/community support are keys to adoption of the tool. While the process might take a very long time, increasing user base will eventually get network effect kick-in and the optionality get larger. At some point, game engine might see boost in adoption and user growth acceleration.
A Scenario for Consumer Adoption
Maybe at some point, there will be a consumerization of game engine which drives the adoption beyond professional use case.
To achieve this, the engine needs to lower the entry barrier, flatten the learning curve, build a smooth on-boarding experience, lay out a roadmap for self-learner, make the experience engaging for casual users, cultivate a vibrant community to support them or even create incentives (financial/non-financial) for them to stay.
A scenario to acquire consumers for game engine is via an application that have user-generated-content feature which leverages the game engine. Game is particularly good application to acquire a user base with favorable demographics. In addition, a game has its own economy which might provide financial incentive to keep gamers using the tool.
For example, players use UI or dedicated tool (it’s the game itself) in Animal Crossing to create their own island. What if a similar game not only provides an easy to use UI to create but provides an option to further enhance the possibility or quality of what gamer can achieve if he/she is willing to learn some features from game engine. As long as the game is engaging and game economy is built to support creation (game engine might take a royalty cut on transaction of UGC), gamers or even younger ones are likely to try the tool. Since the tool is not game/app/use case specific, it becomes a tech platform that connects end-users and game/app/use case and has direct & indirect network effect characteristics. Unlike Epics Games, Unity doesn’t develop games but at least this a path to get adopted by consumer or Unity might acquire a game developer in the future.
Currently, real-time 3D content is created by professional. Maybe in ten years some consumer will start making those content casually because the adoption of game engine has reached something like Microsoft’s Office.
Basically, the thesis is based on game engine will play an important role as a tech/tool platform in society in the future. It’s a bet on the long term development of technology and society.
To value the opportunity, people use comps (Public Comps is a convenient tool), add imagination and borrow ideas delivered through excellent story telling. In addition, Unity is a rare listed pure play for those who wants to get exposure (or they can get some exposure on Epic Games via Tencent). Thus, the stock is a good candidate for a boom-bust pattern. If the stock price busted for whatever reason, my bet is it would be acquired by strategic buyers (they don’t even have to wait for the bust) or be took private by PE firms (the company might already have one potential buyer in-place😏). While I assume the company has 25 years runway, I even doubt the company will still be a standalone or public company in 5-10 years.
For those who want to pick a reference adoption pattern, maybe check Carlota Perez’s Technological Revolutions and Financial Capital to come up with broader theme or doing comps on tech products to decide which one shares similar characteristics. I’m more interested in the adoption of English being taught in curriculum in Non-English speaking countries. Not sure whether my human language analogy makes sense🤪.
Next post: Unity – IPO Note