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.

Pinterest – Initial Model

Pinterest (PINS.US)

[October 19, 2019]

Initial Model

Download the work-in-progress model in excel here to play around 🙂

It’s been a while since I put together initial analysis and deck skeleton on Pinterest. However, I have some difficulties to convert my thesis (particularly business development and competition) into numeric assumptions and found it’s not easy to validate those assumptions. So I just built an initial model and decided to wait and see.

More detective works required to build up conviction and to determine margin of safety.


 

58.com – Initial Thoughts

58.com (WUBA.US)

[August 23, 2019]

* Initial Thoughts *

Background

I came across this stock when trying various online stock analysis tools. I listened to its 2Q2019 earnings conference call and briefly reviewed most recent company presentation. I found 58.com interesting because of its business model and new business initiatives such as 58 Town and Zhuan Zhuan (used goods marketplace) since they are to some extent related to my Pinterest analysis.

Business models

58.com and 58 Town are classifieds focusing on cities and rural areas respectively. One of the key concept for this type of platform is liquidity / density on each category / vertical. Eventually, the platform tends to concentrate on certain categories (58.com as example: jobs, real estate, used goods, automotive, and yellow pages and local services). Another concept is that certain verticals in the horizontal marketplace might be better served with dedicated products – described as unbundling / rebundling craiglist.

Unbundling

unbun

Source: The Gong Show by Andrew Parker

Rebundling

dead-unbundle

↓↓↓

rebun

Source: A CROWDED SPACE by Josh Breinlinger

What 58.com is doing

58

Current challenge and opportunity

  • Macro headwind has negative impacts on certain categories such as housing and jobs.
  • There are some progress on 58 Town and Zhaun Zhuan. 58 Town has shown trajectory similar to 58.com in early stage per management team. The go-to-market strategy of 58 Town is social graph-based and has a an official “node” on each “town”.
  • 58.com’s business models are well-understood and not very exciting. The company faces competition at different degree on each vertical / category. The entry barrier is not from technical side but from indirect network effect. Experience in execution and traffic / brand of 58.com are asset for vertical player incubation.

Next Steps

  • Some initial analysis and talk to management team next week if possible
  • Revisit Mercari (Japanese used goods C2C marketplace player)
  • Pinterest business model analysis on parallel

Pinterest – Initial Analysis

Pinterest (PINS.US)

[August 14, 2019]

Initial Analysis

[0] Analysis Background | Approach Selection

While Pinterest has been a listed company since April this year, it is still in early stage and is more like a pure play of something. If you think runway left is enormous, a bottom up approach to follow the company increases the conviction for a long term bet.

[1.0] How Pinterest Describes Itself and Its Vision

Pinterest is the visual discovery engine to bring everyone the inspiration to create a life they love

[1.1 ] Business Model

Pinterest is an image/video-oriented user generated content site (UGC) with visual discovery engine as key feature for its users to get ideas/inspiration created by other users.

Users generate content by Creating a Pin or by Saving others’ Pins and they can organize their Pins by creating Boards.

create_pin

create_pin2

There’re two interesting features on adding content page 1) Add a destination link; 2) Save from site. Pinterest not only helps users to find ideas/product but also encourage content creators to show where the ideas/products come from. Pinterest help content creators leverage its discovery engine to direct traffic to their sites.

Below is the content of a Pin. Blue circle shows Pinterest’s priority is to encourage to save a pin (engagement and content creation). It also shows which user saved the pin, how it categorizes the item (it’s under “quilted tote bag” board) and how many time it’s been saved. Commercial intent of user can be satisfied as destination link shows this product appeared on Etsy, an e-commerce marketplace. User can follow the link to find the product or similar products available for sale and the shop/person who made the product.

pin1.PNG

While Pinterest has social features that allow users to view other Pinner’s profile, follow them, follow their boards and leverage users’ social graph on Facebook to send message to friends and see their activities on Pinterest… It seems those features were not emphasized when I tried the product on web browser. Apparently, core value of Pinterest is not social networking, news feed based on social graph or communication tool. New user doesn’t need to have a friend on the platform to start experiencing the product. This is important when making comparison between products that have social elements: Facebook, Instagram, Twitter, Pinterest, Whatsapp, Snapchat… Different products have different user behavior which reflects in metric. If someone wants to gauge user engagement by DAU/MAU (number of daily active users divided by number of monthly active users), Pinterest might rank lowest on this metric. This is normal because you would not expect Pinterest’s users to visit the site on a daily basis given current product offering. Higher DAU/MAU might be good and being low might not be a problem.

I feel the core of Pinterest is a crowdsourced visual database where data is either originally generated or saved from internet by users. Users add information or “curate” by adding title and description to each Pin and creating relationship among Pins via organizing Pins under Boards. Those curation help text / visual data science on discovery engine and other features. It’s important for Pinterest to reduce the friction of generating / organizing content, coming up with use cases and finally monetizing traffic and intent on the platform. Maybe Pinterest is a Google in a visual-dedicated user-curated universe.

Theoretically, this platform has direct network effect while it is not as strong as products based on social network.

[2.1] Products (Pinterest website) / Features / Function

product1product2product3

[2.2] Ad Formats (Pinterest website) – Monetization

product4product5

[3.1] Traction and Metrics

Pin_MAU

Pin_MAU_Add

Pin_Rev

Pin_QRev

Pin_SRev

Pin_US_arpu1Pin_US_arpu2Pin_G_arpu1Pin_G_arpu2.PNGPin_Int_arpu1Pin_Int_arpu2

[4.1] Geographic Exposure and Demographic 

Around 28% of Pinterest users come from US and the company doesn’t provide further breakdown on international users. Pinterest has penetrated around one third of social networking population in US. The primary Pinterest users demographic in US is female. Currently, US MAU shows saturation. To further penetrate US market, Pinteret might foster categories or come up with use cases appealing to potential male users.

The majority of revenue is generated from US market because its the first market Pinterest choose to monetize. The company also starts monetization initiatives in Canada and some Western Europe markets. Among international markets, I think Japan has huge potential to become a major revenue contributor.

[5.1] Competing Products

Basically, the technical entry barrier is low and Pinterest is competing with large companies that can offer similar features in their product. The moat, if any, comes from Pinterest having what users want and users being able to find what they want or get inspired. Pinterest needs to keep flywheel running fast: User Generated Content – User Curation – Search/Recommendation.

competitor

[6.1] Other Info for Pinterest.com

Pin_websitePin_CompetitorPin_Mkt_ChannelPin_social

[7.1] Reference Model and Benchmark

Pins_SN_userWebsite