It’s management team’s job to maximize the valuation for existing stockholders. By withdrawing from IPO and then raising a private round, Roblox as a company got the liquidity it wanted and its existing shareholders got a valuation they thought satisfactory. In addition, direct listing will increase the likelihood that existing shareholders can timely capture the attractive valuation since none of their shareholders are party to any contractual lock-up agreement or other contractual restrictions on transfer.
No doubt this setup is great for selling shareholders. The series of transactions will be considered as one of the best trades in this run and be written as case study. As a potential buyside of the share in the first trade, you are providing liquidity at a valuation with interesting trajectory to existing shareholders who are long-term, savvy and informative.
In current environment, it’s unwise to suggest avoiding any stock. That being said, you can avoid the disadvantage setup by not being the first trade. Sometimes patience and discipline pay off but stonks might only go up. I don’t know ¯\_(ツ)_/¯.
Roblox Corp. delayed its planned IPO after company officials decided that the gravity-defying performance this week of Airbnb Inc. and DoorDash Inc. made it too difficult to determine the right price for the videogame company’s shares.
It’s very common that hot IPOs have massive pop at their debut. The pros and cons between different going public mechanisms have been widely discussed and it’s understandable that companies decided to do last minute market timing for their stakeholders’ interests.
The impact on sentiment from these signaling might change the price behavior of certain “high-valuation” stock. It might take time to digest the impact or the impact might be permanent for those already listed stocks. It will be very interesting to see how these market timing activities end up (how successful they capture the money left on the table? don’t worry, there will be someone to do the math lol).
The moment you think your stock is underpriced, participants start thinking your stock is overpriced. The sentiment might stay for an extended period after listing. The setup becomes not very attractive at the moment.
I just skimmed Roblox S-1. As there will be many S-1 teardown and takes on the internet, I only write down high-level thoughts that I still remember without checking the document again. I might put together a simple model and charts later.
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[November 22nd, 2020]
What is Roblox?
Roblox is a User-Generated Content (UGC) platform holder that provides proprietary tools for developers/creators to design, build, distribute/publish, operate, monetize, and analyze applications (called experiences)/digital items compatible to the platform. Roblox is a multi-sided platform that connects users, creators/developers and other stakeholders (influencers, brands… the scope of this depends on the future development of the platform).
With social features, the platform and the experiences on top of it have the potential to enjoy direct network effect. In terms of relationship between users and developers/creators, the platform might have indirect network effect. I have a feeling that those network effects are kicking in but still in the very early stage because the growth is not exponential enough and it’s driven by extreme external event. In addition, we don’t have enough time to confirm the pattern. Even if we confirm the platform is enjoying network effects, its growth pattern might be different from those of carefully selected comps because platforms are not created equal and dynamics nature play important role in real world.
Roblox runs on top of several device-OS-App Store platforms like iPhone-iOS-App Store platform.
Focus on the Supply Side
Since Roblox is a UGC platform, its success is aligned with third party developers/creators. Technology trajectory will follow sustaining technology path. Everything is to assure that it’s easier for developers/creators to thrive on the platform. Investment in supply side ecosystem is indispensable. These investments in technology and supply side ecosystem is like content creation that will eventually attract users so it’s relatively difficult to distinguish this investment from user acquisition cost. Roblox claims their growth primarily comes from organic channel, earned channels and word of mouth. I didn’t notice they mention other additional user acquisition initiatives in the prospectus so I would assume their go-to-market will be as-is.
There’s no contractual restrictions that prevent developers/creators from multi-homing but even if they can make their experience/content cross-platform, their experience/content might not be economically viable as a standalone application outside of Roblox platform. In terms of content distribution, Roblox owns large enough dedicated user base for its developers/creators.
However, if developers/creators can create a well-recognized IP, then it might be easier to make the IP reach other platforms.
It is Roblox that is partially cross-platform (it’s not on Sony PlayStation or Nintendo Switch probably because Roblox doesn’t have much audience on console), not the experience or content on the Roblox platform.
The Business Model
Roblox in aggregate monetizes users via microtransaction on digital content at this moment. Users need to purchase virtual currency, Robux, from Roblox to spend on experiences, enhancements in those experiences or other digital items sold by developers/creators. Users can purchase Robux via one-time purchase or via monthly subscription. Roblox takes a cut when developers/creators exchange Robux for real money with Roblox. The time difference between Robux purchased, spent and exchanged might generate cashflow for Roblox. Generally speaking, this type of business generates attractive cashflow at scale especially when there’s no large spending on user acquisition.
From developers’ perspective, the monetization is not limited to microtransaction. They can adopt other monetization methods depending on the business model of their experience. One interesting thing is that while Roblox takes a cut on digital item transaction but it might not rake monetization method like advertising within experience.
Power law applies to both user side and supply side on Roblox platform. The conversion rate of user base by my estimation is around 1.0%-1.5% and roughly 0.14% of developers/creators earned more than 10K on Roblox platform for the twelve months ended September 30, 2020.
Apparently, expansion in age demographic and international markets are most attractive sources of growth. The user base looks relatively small compared to other leading global social utility providers. If the vision of Roblox is to become a utility, infrastructure or metaverse, then it has a very long runway. However, Roblox doesn’t disclose much information about go-to-market. Roblox has a JV with a subsidiary of Tencent in China but I don’t expect this initiative to take off even though they must spend lots of effort on how to moderate UGC. Roblox reports its doing well in South Korea so maybe Roblox can try more in Japan. I remember Minecraft does quite will on Nintendo Switch in Japan (over one million physical sell-through).
Improvement in monetization is another way to create growth in financial. It can come from improvement in conversion, average booking per DAU, average revenue per DAU (this means Roblox find other revenue streams such as ads…) or collaboration with brands, merchandize…
Everyone company that competing for users’ time and developers/creators is Roblox’s competitor. Therefore, Roblox lists many well-known companies as its competitors. This indicates it has very large TAM (maybe so large that Roblox doesn’t even mention it in S-1).
Simply put, I would say Roblox platform is a combination of software operating system and digital app store (storefront/marketplace) dedicated to a specific category (Roblox calls it human co-experience) on top of existing device-os-app platforms.
If you look at competitive landscape, there are many “games” trying to become a social platform or metaverse. It seems the space is getting more crowed but there’s always a room for an experience platform that successfully leverages cultural or art style stuff (for example anime).
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.
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.
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.
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).
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.
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.
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.
💡 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
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.
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.
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
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😅)
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.