💡 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.
- 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
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.
💡 This note shows some Free Fire user metrics disclosed in Sea’s filings and earnings calls. Combined with financial data in Free Fire – Preparation Revenue Estimation, one monetization metric, average adjusted revenue per daily active user, is also calculated. I fill the note with my murmur.
Since 2018, Sea has disclosed various Free Fire user metrics to help public investors gauge the traction of Free Fire. The disclosure is not very consistent as some metrics were disclosed at milestones only and some were missed (wonder why s-s analysts didn’t ask for peak 2Q19 and 3Q19 DAU numbers. Maybe they rely more on timely data from third party analytics. The reason why numbers were not disclosed in those two quarters is that Free Fire might experience drawdown in peak DAU).
The company doesn’t disclose the number of cumulative downloads which is fine for me. Number of cumulative downloads is noisy and only goes up (vanity metric) while it’s useful to gauge initial performance at launch or on-going game operation / product iteration. Since this metric is top of the funnel, if a new game flops on this metric, it would take lots of efforts to turnaround. We can find the metric used in a time-aligned comparison among games having similar genre, leveraging the same IP or even being under the same developer, publisher or IP stakeholder (basically, any cumulative metrics can be analyzed this way). For example, few days later, the first month performance of Pokemon Unite might be compared to other MOBA, other mobile games from Timi (developer), Tencent (publisher), The Pokemon Company (IP holder) or even Nintendo (IP stakeholder).
Once the game is downloaded and installed on the device, users need to open the game, register and start playing (activation). The game engages user in different ways (engagement) in addition to pure gameplay after an user is activated and before she/he is churned (retention).
Depending on the nature of the product, metrics for user base estimation are different. A marketplace might choose MAU (Monthly Active User), a productivity tool might choose WAU (Weekly Active User), and a messaging app or a mobile game might choose DAU (Daily Active User).
Sometimes user base in a shorter timeframe divided by user base in a longer timeframe such as DAU/MAU can be used a proxy for engagement. If MAU is very close to total active user base, then the ratio means that how many active user uses the product everyday.
Every company has their own way to calculate MAU/WAU/DAU but these metrics generally have average in their calculation because the timeframe of interest for the specific metric is generally longer than unit timeframe in the metric. We might be interested in a DAU on a specific day but it’s more likely we look for DAU of last month or last week. For example, the number series of active user for last seven days looks like: [25, 16 , 13, 20, 13 ,3 ,1]. DAU for last seven days is 13 (average of the number series) and the peak DAU is 25 (max of the number series). The difference between average and max of the number series is significant because the pattern in number series indicates the product might have specific behavior. The number series might come from an office productivity tool so it’s more often used on weekdays rather than weekend. One way to avoid this pattern is to use metrics with longer timeframe. The WAU for this product in this seven days might be 27 (the reason why it might be larger than peak DAU is we’re counting the total unique user during the week). There two observation from the exercise above: 1) peak DAU is generally larger than DAU; 2) the difference between two might be significant especially when there’s an event that drives product usage on specific day. Peak DAU looks better but it’s more aggressive and might be misleading. Maintaining a growing peak DAU is difficult than maintaining a growing DAU even though the overall user base is expanding and the engagement is increasing because peak DAU might be event-driven. What would you do if you find your peak DAU doesn’t grow but you know the underlying is still healthy. Probably you stop disclosing and wait for the overall user base catching up. Sea took a break for two quarters from 2Q19 to 3Q19. This is not a problem for investors as long as they can get third party data.
Sometimes, once the lifetime number of downloads/installed/registered users have reached certain level, it will become more difficult to interpret due to the nature of app user lifecycle (acquisition→activation→churn→reactivation if any→… how do you define those being churned and how do you measure them if you get them reactivated?), on-going update/iteration of software and on-going game operation. The metrics derived from these cumulative numbers get noisier and noisier as time goes by.
Free Fire User Metrics
- Free Fire reached 100M MAU and 40M peak DAU in 4Q18. It had 80M peak DAU in 1Q20. If the engagement relationship hasn’t changed a lot, Free Fire might have ~200M MAU in 1Q20 (probably not reached yet because the company might have reported this milestone if it had reached)
- The company has been reporting peak DAU since 2Q18 (from call transcript 3Q18). The reporting was suspended in 2Q19 and 3Q19 but resumed in 4Q19.
Combining Adjusted Revenue and User Metric
The company generally doesn’t disclose number of paying users for specific game.
In April 2020:
- Free Fire had record high monthly paying user which more than doubled yoy (since the peak DAU only grew 60% yoy, the conversion probably improved)
- In India, monthly paying users/monthly active user > 10%
We use peak DAU to calculate a monetization metric, Average Adjusted Revenue per Peak DAU (AARpPKDAU).
Fire Fire Adj. Rev. has been driven by expanding user base, improving conversion (paying ratio), and increasing monetization. As long as you build, grow and sustain a large user base, you always can find/try various monetization methods. While Free Fire focuses more on the monetization now, keep growing and sustaining a healthy user base is one of the keys to turning a game into a platform (key words: engagement, community, ecosystem…). Sea’s current goal for Free Fire is to make it a social platform so the company might try more monetization initiatives to bring in new revenue streams.
The monetization metric – AARpPKDAU – is not accurate but still provides a snapshot on monetization trajectory. The metric is driven various factors so a jump might not be good and a decline might not be bad. For example, a jump in Average Revenue per User (ARpU) might come from more aggressive initiatives which might sacrifice overall user experience and churn light users who might be converted into a paying users. A decline in ARpU might be due to new market penetration that expands the user base but hasn’t brought in revenue yet. If there’s a jump in user base proxy along with a decline a ARpU, I tend to interpret it more positively.
💡 This note tries to understand the traction of Free Fire. Generally, I would start with metrics which are more top of funnel such as downloads, number of active users, conversion, number of paying users or even engagement metrics. However, I was triggered by a Sensor Tower blog post the other day which mentioned Garena Free Fire revenue in 1H2020. I was confused by my back of the envelop growth rate calculation because I only had some rough ideas on how well Garena Free Fire performed financially before putting together this post. The confusion probably came from that there’re few financial metrics available in the market – revenue from third party analytics, Non-GAAP adjusted revenue from Sea’s Digital Entertainment, and GAAP revenue from Sea’s Digital Entertainment. It seems I encountered some difficulties when collecting those data to understand Garena Fire Fire financial performance. This post shows the traction of price-driving metric – adjusted revenue and digs out the history of a parameter which is key to determine Garena Free Fire adjusted revenue but not being disclosed anymore.
Announcement from Sea Limited
As of the end of October 2019, Free Fire had recorded a total cumulative adjusted revenue of over US$1 billion since launch.6-K Reports Third Quarter 2019 Results
Estimation: Free Fire’s Contribution to Adjusted Revenue in Sea’s Digital Entertainment (DE)
- Launched on Dec 4, 2017
- Accumulated $1B adjusted revenue (adj. rev.) by Oct 31, 2019 → roughly 23 months since launch or average $43.5M per month
1st Attempt to Estimate Garena Free Fire Adjusted Revenue Contribution
- As of Oct 31, 2018, Garena Free Fire’s lifetime adj rev. contribution to Sea’s Digital Entertainment since its launch was estimated to be ~60% (see estimation in Window Matching and Accumulated Adj. Rev. in the Window toggle lists below).
- Window Matching (Notion)
- Accumulated Adj. Rev. in the Window (Notion)
Filing Walk-Through to Gather Additional Info
- Started monetization in January 2018
- Ramped up monetization in June 2018
- Garena Free Fire adj. rev. contribution as % of Sea’s Digital Entertainment disclosed in the earnings call (see Filings & Transcripts toggle list below)
- 13% in June 2018
- 22% in 3Q18
- 44.5% in 4Q18
- 50%-60% in 1Q19
- Stop disclosing in earnings call since 2Q19
- The accumulated Garena Free Fire adj. rev during 1Q18-3Q19 + 1/3 of 4Q19 above was $1,024M which is close to the announced $1B lifetime adjusted revenue as of Oct 31, 2019.
- Approximately, Garena Free Fire contributed ~48.6% of Sea’s Digital Entertainment adjusted revenue during 1Q18-Oct. 2019.
- Garena Free Fire’s 65% adj. rev. contribution in 4Q19 looks reasonable and can be bridged to current 70% estimated by s-s analyst.
Third Party Analytics – Senor Tower
Cross Check with Official Data
- Numbers from third party analytics are more timely and detailed but we need to check the relationship between the reported numbers from analytics firms and numbers from the company. Sea discloses two top-line metrics: 1) GAAP revenue 2) Non-GAAP adjusted revenue which takes the changes in deferred revenue in the period into account. Sea believes that the Non-GAAP measure can better represent the performance of the business.
- If there’s wide difference and inconsistent between numbers from analytics firm and the company, the third party number might be less informative while it’s still an estimate to gauge the underlying performance. The difference and inconsistency might come from measures adopted, coverage difference, my mistake in merging/inferencing data from different sources. For example, I calculate Garena Free Fire 2Q19 revenue in Senor Tower by deducting cumulative revenue 1Q18-2Q19 by cumulative revenue 1Q18-1Q19.
- Senor Tower has reported Garena Free Fire revenue several times.
- From the charts below, it seems the discrepancy between Senor Tower and Garena Free Fire adj. rev. expands in tandem with discrepancy between GAAP and Non-GAAP numbers.
- Sensor Tower’s 1H20 number implies a 11.5% yoy growth which is difficult to reconcile with Garena Free Fire adjusted revenue trajectory as the gap between GAAP/Non-GAAP expands when game with large user base stated to ramp up monetization.
- A quick guesstimate on Garena Free Fire adj. rev in 2Q20 by observing the pattern is $375M (+$30M from 1Q20 which is based the assumption of 67.5% contribution) or around 41% yoy growth which implies yoy growth around 50% in first half of 2020. I believe adj revenue has more impact on price. While third part analytic is more timely, it’s too difficult for me to interpret.
Stick with Price-driving Metric, Focus on Long Term, and Believe Platform Brings in Optionality
So for this game, we’ll not look at any quarter-on-quarter or month-to-month or even year-on-year short-term performance, but we are really looking to build it into a long-term IP franchise.3Q19 Earnings Call