JFrog – Quick Cal.

💡 Intellectual exercise only. Don’t take the projection seriously.

JFrog recorded accounting profit in the last quarter. The company has been cashflow positive for a while. The business is a typical software business which enjoys high gross margin. Once the business breaks even, the operating leverage might kick in faster than consensus expects because people are not good at predicting something non-linear like operating leverage.

The product seems mission critical but I’m thinking that even without competition, is the TAM large enough to support 10x top-line growth for JFrog which has ~$160M revenue run-rate currently?


2020/9/14

(Reuters) – The company said it now expects its IPO price between $39 and $41 per share, up from between $33 and $37 per share expected earlier.

Unity – IPO Note 2

Unity filed S-1/A yesterday so now we have a better grasp on pricing. I’m not going to do a sensitivity analysis table which shows the relationship between market capitalization, estimated revenue / revenue growth and the multiple since FinTwit has done a great job.

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@jaminball

Since it’s typical for IPO stock to pop, what you would like to do is extending the table to X dollar per share and check whether the corresponding multiple for the traded share makes sense to you. Jamin has done a great work on the SaaS valuation comp categorized by the growth.

Unity: Benchmarking the S1 Data by Jamin Ball at Clouded Judgement

I talked about the runway and opportunities. By being very long-term oriented and aggressive (or naive), the posts probably make most readers identify more execution risks than opportunities on the business fundamental. Now let’s look at risk of paying too much or what might make the share drop.

  1. Category Change
    If Unity is trading at a multiple of high growth category, it might face de-rating when it’s not able to consistently deliver that high growth or when investors realize its fundamental actually has lower growth (sentiment change).
  2. Overall SaaS Multiple Contraction
    The SaaS multiple has expanded significantly since April, it’s difficult to predict whether it will expand further, stay within a band or even contract in the future.
  3. The Robustness of Operate Revenue Growth
    Operate revenue (~60% of total revenue for the six months ended June 30, 2020) is primarily generated by Unity’s advertising product at the moment. If the advertising revenue growth derailed, Unity might experience severe revision on valuation.
  4. Market Might Not Be Willing to Attach SaaS Multiple on Operate & Others Revenues
    Create Solutions revenue is subscription-based which is recurring. However, Operate Solutions and Others revenues are more like re-occurring revenues which might not be suitable to be valued as SaaS business. More investors using sum-of-the-parts (SOTP) on Unity will depress the share price. While I fine with a stretched revenue-based multiple, it’s still difficult for me to swallow valuation method mismatch. Be careful when you know your counter-party is very savvy.

Two tweets about Peloton after earnings release might be related point 4 above. To me, Peloton is a software-in-a-box. It generates revenue streams and contribution profits from boxes (Peloton’s bikes and treadmills are actually lucrative) and software (subscription). Hardware contributes large portion of total revenue and this revenue stream is re-occurring by market penetration, product penetration (offering market more products or selling existing users different product. For example, a bike user might further purchase a treadmill) and long-cycle product replacement (how many bike you need in your lifetime?). Software contributes smaller portion of total revenue at the moment and its monetization is subscription which is recurring.

Lastly, market is willing to put premium on valuable strategic asset (game engine). Sellers will definitely take advantage of that.


Previous posts on Unity:

  1. Thoughts on Unity and Game Engine before Unity IPO
  2. Unity – IPO Note

Unity – IPO Note

💡 This note is NOT an advice for making any investment decisions. Data in this note is hand-collected so it’s recommended to double check your data provider and S-1. The content here is my intellectual exercise so it might deviate from reality substantially and should be different from typical S-1 tear-down or IPO snapshot (hopefully in a positive way). If reader is not familiar with the company and hasn’t read the S-1, the content here might be toxic. If you haven’t read the S-1 or something like S-1 tear down / Fintwit thread, you should check this Notion page. Google Sheet for model data below. Previous post: Thoughts on Unity and Game Engine before Unity IPO. Next post: Unity – IPO Note 2.

Unity – Product Offerings

Unity has two distinct, but connected and synergistic sets of solutions. The Create Solutions and Operate Solutions are two suites of software used by content creators and customers who want to acquire/retain end-users, run the content or monetize the content. In gaming vertical, Unity’s business is something like game-as-a-service enabler which covers a value chain from content creation to live ops.

Apparently, a job can be done by a suite of software or by a software encapsulating all needed features. While there might be some connection / integration among software within / across suite(s), the integration level or ease of use of software suite is generally inferior than that of the all-in-one software or software platform. Due to broad adjacent market, fragmented use cases / scenarios / workflow and limited resources, it’s understandable a company is unlikely to build every software / features in-house even if they have a platform mindset. However, what the company can do is buying stuffs which are complement to the exiting offerings and then try to integrate them into a software platform or make it as a standalone offering while still being connected to other offerings. There are few implications below:

  • The acquisitions need capital and/or shares.
  • The acquired products and teams need to be integrated into company. While sometimes it’s better to leave the acquired asset alone. e.g. the asset is a disruptive technology / business model to the acquiring company.
  • Product distribution, cross-sell opportunity and complement to existing products are typical synergies to justify the acquisition.
  • The growth in the future won’t be all organic.

Acquisition is one of growth strategies of Unity. This kind of tech roll-up is not buying revenue but creating revenue and hopefully making the customer even more captivated. One benefit of being an active buyer is that it might fuel the innovation in the ecosystem

Another implication of this strategy on financial modeling is that the company might not be generating positive cash flow (free cash flow – cash used in acquisition) or even keep consuming cash for an extended period. My prediction is that Unity accumulates zero internal cash over the next ten years and if they aggressively pursue this strategy, they might need additional financing in the future.

Revenue Streams & Underlying Driver

Quarterly Revenue Breakdown

Create Solutions

The core product in Create Solutions is a software development engine which is offered to customer in tiered subscription plans. The user of the engine is called creator here in case of confusion because Unity through its products has business relationship with various participants in the ecosystem.

As of 2Q20, the engine has 1.5M monthly active creator. The majority of creator is using free plan which leads to an annualized average revenue per creator of $147. It’s critical to keep the entry barrier of financial / learning as low as possible for potential creators to drive long term adoption and diffusion of the technology. At current stage, the churn on new adopters might be high because the majority of new adopters are hobbyists, students… even though there are free official / third-party learning content and community support. The journey to get reward from this tool via creation is still too long for most adopters at the moment. Thus, in the short to intermediate term, the subscription revenue growth primarily comes from expansion of enterprise creator base and expansion of revenue contribution from each paying creator.

In my last post, I naively assumed Unity can grow at 20% CAGR for 25 years. Below is my growth pattern to generate that CAGR on creator base and subscription revenue.

What’s the meaning of 20% CAGR? The stuff just grows at 20% every year? Nope. The key of this forecast exercise is that it needs to capture concept of adoption / diffusion. The growth pattern below assumes an accelerated adoption over next 20 years and there will be a breakthrough after 15 years. The overall CAGR is around 19.4%.

Use current 1.5M creators as base, the chart for creator over next 25 years looks like below:

The growth pattern of average revenue per creator assumes that revenue from expansion in enterprise creators can offset relatively low growth in creator base. This leads to an expansion in average revenue per creator in first 10 years. The higher growth rate in creator base from year 11 to year 20 results in flat to decline of average revenue per creator. Starting from year 20, the company is able to convert non-paying creators into a subscriber effectively. This slows the decline trend of average revenue per creator.

Then apply the growth pattern to current annualized average revenue per creator.

Finally, we have revenue projection of Create Solutions for the next 25 years. Well, it’s a $20B business in 2045.

Operate Solutions

This is a suite of software products and services that help customers acquire / retain end-users for the content and run / monetize the content. There’re two monetization methods: revenue-share model and usage-based model.

  • Revenue-share model (primarily advertisement)

    This model generates a substantial majority of Operate Solutions revenue. Unity facilitates advertising on applications via its monetization solutions including Unified Auction which allows publishers to sell the available advertising inventory from their mobile applications to advertisers on a cost-per-install basis or cost-per-impression basis. Unity retains a share from the transaction as advertising revenue. While Unity has Unity IAP to facilitate in-app purchase, it typical does not retain a share of the revenue generate through Unity IAP (how does Unity monetize this product? is it a bundled product?).

    The performance of this business is linked to overall app economy, in-app advertising market, expansion of customer base, the success of customer’s app and expansion of its app portfolio, and the effectiveness of Unity’s products that create measurable value for advertisers. As Unity provides tools that create content, the synergy between monetization and creation businesses is obvious especially when monetization happens within the content. The adoption of the software development engine for content creation will expand the overall economy of this type of content and Unity is a key player that fuels the expansion.

    What’s the impact of Apple iOS privacy change on the advertising revenue? Maybe wait for 3Q20 result?

    We don’t know what will be the next emerging platform for consumers to consume content but at least the risk of AR / VR replacing in-app content consumption on mobile is mitigated since Unity is a leading player in that space.
  • Usage-based model

    This includes cloud-based solutions and enterprise hosting services to developers that develop and operate multiuser / multiplayer content (games or applications). These services are primarily sold on a fixed fee or usage-based model with fixed fees billed monthly in advance and usage fees billed monthly arrears. The performance is linked to the growth of customer base and their business success as well as macro drivers mentioned above.

Follow the 20% CAGR and the engine adoption assumptions, below is the growth pattern for Operate Solutions which has a CAGR of 20.5%.

Based on the annualized Operate Solutions revenue for 2020 and growth pattern above, the projection of Operate Solutions revenue for next 25 years is shown below.

Strategic partnership and Other

These are strategic contracts with owners of hardware, operating system, device, game console and other technology providers to customize Unity’s software licenses to enable interoperability with those platforms. Unity generally provides services in those contracts: (i) development and customization of our software to integrate with the customer’s platform and (ii) post-integration ongoing support and updates.

Unity also recognizes revenue for sales-based royalties based on the sales of games on the strategic partner platforms that incorporate Unity’s customized software.

This revenue stream didn’t show growth pattern in the last few quarters and the contribution is not material at the moment or maybe going forward. The forecast is based on annualized number of this year and then grow at 3% per annum for the next 25 years.

Margin Profile and Cash Flow

Quarterly Margin Profile

Annual, Semi-annual Margin Profile & Cash Flow

Forecast on Margin, Capex, Acquisition and Cash Flow

Valuation

Market Valuation at IPO

Jamin Ball has an excellent Unity S-1 review at Clouded Judgement. He predicts Unity will trade at $12B out of the gate based comp analysis and his forecast. You can check his newsletter or use Public Comps to do your own analysis.

I’m lazy and not good at logical reasoning so here’s my approach. Unity was valued at $6B in July 2019 which was a follow on at late stage by savvy investors. The visibility of exit event and the strong performance of SaaS in public market make 100% IRR target look fine. Series E should crystalize a 100% IRR in private market and further enjoy 25% public market premium. The market valuation can reach $15B ($6B x 2 x 1.25) during IPO before more market participants start processing information. (We have a drawdown today, Sep. 4, so maybe sentiment might change significant at IPO 😛)

Discounted Cash Flow (DCF)

Since we have free cash flow projection, it’s easy to comp up with valuation based on DCF. I discount the post acquisitions free cash flow at 10% discount rate and assume the terminate value trades at 20x post acquisitions free cash flow in year 25. Note that in my projection the top line and cash flow haven’t reached steady state in year 25 as they still grow at 20%.

The estimated enterprise value (present value of DCF) is around $57B. Assuming net debt is zero, equity value is therefore $57B. (I thought I can easily get a present value larger than $100B😅)

Multiple

A model can spit out anything you need. If you’re buying Unity at $15B enterprise value, you’re buying at 16.7x 2021 revenue or 8.1x 2025 revenue or 0.5x 2040 revenue…🤪

Final Thoughts & Reminder

In the beginning of this writing, I was about to write something more conceptual like increasing return, lock-in/switching cost, competition… but I notice those issues were mentioned in previous post or other places. This note turns out to be a forecasting exercise.

This exercise is not meant to be accurate but to provide a thesis-driven reference to track the performance of the company when the share might be trading at a multiple that is difficult to understand (e.g. 20 times 20xx revenue?). Maybe there’s a component in risk appetite called willingness to pay for an aggressive scenario in the distant future.

There’s no top-down market sizing here. Not sure if any PDIE material or broker’s coverage initiation has done that type of exercise.

The risk of IPO stock is high. High volatility and drawdown might lead to temporary loss of purchasing power or even permanent capital loss. Think twice before investing / trading stock with limited track record in public market. This note is just an intellectual exercise, NOT an advice for making any investment decisions.

Finally, the edge from having industry knowledge might be much more valuable than doing this kind of modeling.

Thoughts on Unity and Game Engine before Unity IPO

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%😵.

Topline Compounding

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

In terms of user base, in CY2Q20 Unity has 1.5M monthly active creators which include non-paying creators and paying creators (the metric is basically monthly active user, MAU, so I use MAU to refer to the user base of Unity Create Solutions). If Unity’s current MAU of 1.5M grows at 20% CAGR for 25 years, MAU will be around 143M. For comparison, Microsoft 365 (renamed from Office 365) had over 200M MAU in CY3Q19 and Minecraft had 132M MAU in CY2Q20. In terms of user base scale, MAU of 143M for a game engine and beyond in a quarter of century later looks not so ridiculous. There are implications from Office 365 and Minecraft I pick for comparison. First, the adoption of Microsoft 365 is cross industry and beyond commercial use. Second, Minecraft is a “user generated content” “game”. What if a tool for making real-time 3D content becomes so accessible or widely adopted that gamers have the option to generate their own 3D content in a game? What works need to be done to reach this consumerization stage? In gaming, game engine as tech platform might not just help developers make games but enable gamers create content in the games they’re playing. Besides, in AR / VR space where game engine might play as a key tech enabler for apps (content) on the platform and the platform. The product or service enabled by tech platform of game engine has potential to be ubiquitous. (Good stuff: Mark Zuckerberg’s VR / AR strategy and One)

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
    • Consumerization

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