U: Building the Metaverse Infrastructure, a Long-Term Growth Play

1. Executive Summary

Unity Software (U) presents a compelling investment opportunity based on its dominant position as a leading platform for creating and operating real-time 3D (RT3D) content. The company's two main revenue streams, Create Solutions and Operate Solutions, cater to diverse industries, from gaming to automotive to architecture. While recent challenges, including pricing model adjustments and internal restructuring, have created volatility, the underlying demand for RT3D content continues to grow exponentially, driven by trends like the metaverse, augmented reality (AR), and virtual reality (VR). Unity is well-positioned to capitalize on this demand, making it a long-term growth play.

We believe Unity's extensive ecosystem, developer loyalty, and ongoing innovation create a sustainable competitive advantage. The company's recent strategic pivots to focus on profitability, streamline operations, and improve customer relationships are positive signs. While acknowledging the risks associated with execution and competition, we initiate coverage with a "Buy" rating and a 12-month price target of $45, reflecting our confidence in Unity's long-term potential to become the ubiquitous platform for RT3D content creation and operation. This target is based on a discounted cash flow (DCF) analysis incorporating assumptions of moderate revenue growth acceleration over the next 5 years and improved profitability.

2. The Business Model

Unity operates through two primary segments: Create Solutions and Operate Solutions.

• Create Solutions: This segment provides a software platform for creating interactive, real-time 2D and 3D content. It’s essentially a subscription-based service, allowing developers to access and utilize Unity's powerful tools for design, development, and asset creation. Revenue is derived from subscriptions to the Unity Editor and other related services. This segment is crucial for attracting and retaining developers within the Unity ecosystem. The quality and comprehensiveness of the tools determine the attractiveness of the platform.
• Operate Solutions: This segment provides services that enable customers to operate and monetize their created content. These services include advertising, in-app purchases, cloud diagnostics, and multiplayer networking. The revenue here is generated on a usage-based model, directly linked to the success of the content created on the Unity platform. As content built with Unity becomes more popular, Unity's Operate Solutions segment benefits.

The synergistic relationship between these two segments is key to Unity's business model. Create Solutions brings developers onto the platform, while Operate Solutions allows those developers to monetize their work and incentivize continued use of the Unity ecosystem. This creates a flywheel effect, fostering growth and solidifying Unity's position in the market. Unity also provides access to the Unity Asset Store, a marketplace where developers can buy and sell pre-made assets, further enhancing the platform's utility and value. A smaller "Strategic Partnerships" segment contributes by offering professional services and strategic alliances with key players in different industries.

3. Market Opportunity

The market opportunity for real-time 3D content is vast and growing rapidly. The total addressable market (TAM) is estimated to be hundreds of billions of dollars, encompassing gaming, architecture, engineering, construction (AEC), automotive, media and entertainment, and various enterprise applications.

• Gaming: The gaming industry remains Unity's core market and a significant growth driver. The increasing demand for high-quality, immersive gaming experiences on various platforms (mobile, PC, console, and VR/AR) fuels the need for powerful development tools like Unity. The rise of indie game development also contributes, as Unity offers accessible tools for smaller studios.
• AEC (Architecture, Engineering, and Construction): Unity is increasingly being adopted by AEC firms for visualization, simulation, and collaboration. Real-time 3D models allow for better design review, construction planning, and client communication.
• Automotive: Automakers are leveraging Unity for design visualization, virtual prototyping, and creating in-car infotainment systems. The adoption of electric vehicles and autonomous driving technologies further drives the demand for advanced digital interfaces.
• Media and Entertainment: Film studios and broadcasters are using Unity for pre-visualization, virtual production, and creating interactive experiences.
• Metaverse: The development of the metaverse presents a significant long-term opportunity for Unity. As the leading platform for creating interactive 3D content, Unity is poised to be a key enabler of metaverse experiences. This includes creating virtual worlds, avatars, and interactive elements.
• AR/VR: The growing adoption of augmented and virtual reality technologies is creating new opportunities for Unity. The platform's tools are well-suited for developing AR/VR applications for gaming, entertainment, education, and enterprise use cases.

Key growth drivers include:

• Increasing demand for immersive experiences: Consumers and businesses are increasingly seeking engaging and interactive experiences, driving the adoption of real-time 3D content.
• Advancements in hardware: The development of more powerful and affordable hardware (GPUs, AR/VR headsets) is making real-time 3D content more accessible.
• Cloud computing: Cloud-based platforms are enabling developers to create and operate real-time 3D content more efficiently.
• Democratization of content creation: Platforms like Unity are making it easier for individuals and small teams to create high-quality content.

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4. Competitive Moat

Unity possesses a strong competitive moat based on several factors:

• Developer Ecosystem: Unity has cultivated a massive and loyal developer ecosystem. This is arguably their strongest moat. Once developers learn Unity and build their workflows around it, switching to a competing platform becomes costly and time-consuming. The vast library of assets available on the Unity Asset Store further strengthens this moat.
• Network Effects: The more developers use Unity, the more resources (tutorials, assets, community support) become available, making the platform even more attractive to new developers. This creates a positive network effect.
• Switching Costs: As mentioned above, the learning curve, workflow integration, and existing asset libraries create significant switching costs for developers. Re-training teams and rebuilding projects on a new platform is a substantial undertaking.
• Breadth of Functionality: Unity offers a comprehensive set of tools and services for creating and operating real-time 3D content. This breadth of functionality reduces the need for developers to rely on multiple platforms or third-party tools.
• Continuous Innovation: Unity is constantly investing in research and development to improve its platform and add new features. This ongoing innovation helps to maintain its competitive edge and attract new developers.
• Partnerships: Unity has established strategic partnerships with leading hardware and software companies, further expanding its reach and capabilities.

5. The Quality Scorecard (1-5 Scale)

• Network Effects: 4 - A strong network effect is present due to the vast developer community and asset marketplace.
• Recurring Revenue: 4 - A significant portion of Unity's revenue is recurring, primarily from Create Solutions subscriptions and Operate Solutions usage-based fees.
• Scalability (Gross Margins): 3 - Gross margins are decent, but there is room for improvement with greater operational efficiency.
• Financial Strength (Cash vs Debt): 3 - The company has a reasonable cash balance but also carries some debt. The focus on profitability should improve financial strength.
• Innovation: 5 - Unity demonstrates a strong commitment to innovation, constantly updating its platform and exploring new technologies.

6. Valuation & Scenarios

Current Valuation: Analyzing current valuation multiples (Price-to-Sales) can be misleading given the company's historical growth stage and recent turbulence. A more appropriate approach is a Discounted Cash Flow (DCF) analysis.

DCF Analysis Assumptions:

• Base Case (50% Probability): Revenue growth averages 15% per year for the next 5 years, driven by continued adoption in gaming and other industries. Operating margins improve to 15% by year 5 due to cost-cutting measures and operating leverage.
• Bull Case (25% Probability): Revenue growth averages 25% per year for the next 5 years, driven by faster-than-expected adoption in the metaverse and enterprise sectors. Operating margins improve to 20% by year 5 due to strong operating leverage.
• Bear Case (25% Probability): Revenue growth averages 5% per year for the next 5 years, due to increased competition and slower adoption in key markets. Operating margins remain stagnant at 5%.
• Discount Rate: 10% (reflecting the risk associated with growth companies).
• Terminal Growth Rate: 3%

Price Targets:

• Base Case: $45
• Bull Case: $65
• Bear Case: $30

The current stock price suggests the market is pricing in a scenario closer to the bear case. We believe this is overly pessimistic given Unity's strong market position and growth potential.

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7. Key Risks

• Execution Risk: Unity's ability to successfully execute its strategic plan, including improving profitability and streamlining operations, is a key risk. Missteps in product development or pricing changes could negatively impact developer adoption.
• Competition: The real-time 3D content creation market is competitive, with companies like Epic Games (Unreal Engine) posing a significant threat. Increased competition could lead to pricing pressure and reduced market share.
• Macroeconomic Conditions: A slowdown in the global economy could negatively impact demand for real-time 3D content and advertising revenue.
• Reliance on Key Industries: Unity's revenue is heavily reliant on the gaming industry. A significant downturn in the gaming market could negatively impact its financial performance.
• Technology Obsolescence: The technology landscape is constantly evolving. If Unity fails to adapt to new technologies and trends, it could lose its competitive edge.
• Integration Risk: While unlikely in the short term, future acquisitions could pose integration challenges and distract management from core operations.

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8. Conclusion

Unity Software presents a compelling investment opportunity for long-term investors. The company is a leader in the rapidly growing real-time 3D content creation market, with a strong competitive moat and significant growth potential. While acknowledging the inherent risks associated with a growth stock and the challenges the company has faced, we believe the market is undervaluing Unity's long-term prospects. The shift towards profitability and the company's pivotal role in enabling the metaverse, AR/VR, and other innovative applications make it an attractive investment. We initiate coverage with a "Buy" rating and a 12-month price target of $45. We recommend investors consider a position in U as part of a diversified growth portfolio.