In this episode of Industry Focus: Wildcard, Jason Moser and Motley Fool analyst and lead advisor Tim Beyers take a deep dive into the real-time 3D development platform Unity Software (NYSE:U). They talk about how Unity helps game developers and creators develop robust solutions efficiently, and how they are making inroads into new segments. They also discuss all the different ways the company generates revenue, its financials, the management, future growth potential, and much more.

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This video was recorded on Oct. 14, 2020.

Jason Moser: It's Wednesday, October 14th. I'm your host Jason Moser, and on this week's Wildcard Wednesday show we're digging into a recent IPO in Unity Software to get a better grip on the business and the opportunity for investors. Joining me today it's our Lead Advisor for our Cloud Disruptors service, among other things, it's Mr. Tim Beyers. Tim, how's it going?

Tim Beyers: All right, Jason, how are you, man?

Moser: Doing great. Thanks so much for taking the time to join this week. I know that you like all things tech and software, and given the nature of the service that you're running with Cloud Disruptors, I've been really excited to sit down and talk about this business with you, because it has a lot of the elements that we look for certainly in Foolish investments. And so, hopefully, we'll be able to give a little bit of a better idea for listeners as to what the company does, what competitive advantages it may possess, and ultimately, is this an idea that investors need to have on their radar?

Let's start, first off, here just talking about actually what the company does. Unity Software, they operate a real-time 3D development platform, don't they?

Beyers: Right. So, it's a series of tools, and there's a whole bunch of tools here, Jason. And essentially, they call them, they have two segments in their business called create solutions and operate solutions. It's to create solutions, the products, and there's I think 15 or 18 different products for actually building out any kind of 3D interactive environment. So, the best way to think about it, I think, Jason, is like, the stuff they used to do in hardware. So, say you were making a video game and you wanted to make it realistic and you were going to render, like, characters and how they walk around and how they interact with the environment, all that stuff used to be done basically with what we would call physics processing, and they were really specialized environments, real specialized hardware, and that was built up and it was very expensive, really specific. And Unity has built an environment to actually take a lot of that work and run it inside of a Unity Engine. And there's another engine there called the Epic Games Unreal Engine, this is what we're talking about in terms of the duopoly. And the Unity Engine is incredibly popular. Just for perspective, if you tuned into the Apple event yesterday, and they were talking about, you know, the new iPhone and just some ways that it could be like a gaming phone, do you know what the new phones come preinstalled with, JMo, did you hear about this?

Moser: Is that the lidar [Light Detection and Ranging] you're talking about?

Beyers: Well, not the lidar, but there's a game that's preinstalled in the iPhone.

Moser: Oh, yeah, I'm not a big gamer, but I saw the name of it, I think, what's it called?

Beyers: It's League of Legends, it's the latest League of Legends that is preinstalled here on the iPhone. So, what does League of Legends run on? It does run on the Unity Game Engine, like, it's built with the Unity Game Engine. So, there are a lot of these games, and there are other things. But let's just call this primarily a gaming company.

When you're building out a game, you want to make it look realistic, you want it to be an immersive experience, you want it to have 3D characteristics. Very often those game developers will work with the Unity Game Engine.

Moser: Yeah. I'm glad you mentioned that, because it seems like a time ago, like you said, this was a very specialized service that was was difficult, it was expensive, it required a lot of equipment and, clearly, technology, the internet everything, we've seen a lot of disruption here in the way we do things. And so, Unity is obviously capitalizing on that advantage and really focusing on not only mobile with phones and tablets, but they're putting software out there for PCs, for consoles, the immersive technology side with augmented and virtual reality devices. I mean, this is a company that really seems to do, I don't want to say everything, but it sure feels that way.

Beyers: Yeah. And look, as we have more software for interacting with the world, and more ways to interact with the world in software, and there are just a number of use cases here, games are going to get more sophisticated, we're isolated right now, so we're gaming a lot more. So, that means -- right, I mean, that does mean that we're going to have more interactive, more specialized games. The market for it is clearly growing. It's also a social platform; you know, our friend and colleague John Rotonti really pounds the table on this idea that gaming is a social platform. And you know, it becomes more social when it looks more realistic and you can interact with your friends in real-time. And so, you need some of this technology.

I'll just say one other thing here, to the degree that you could make the digital environment more realistic, there are more things you could do. So, prototyping is a really good example. Like, you can build out some very realistic models for prototyping in digital using something like a Unity. So, they're trying to expand a little bit beyond where they've been, but for sure. I mean, the demand for this is only increasing and it probably is going to increase exponentially. And there are some ways that Unity kind of wins in this area, where its primary competitor Epic will not.

Moser: Yeah, I think that's a good point. You know, in some of the interviews and the folks that I've spoken with throughout the year-and-a-half or so that we've had the Augmented Reality and Beyond service open, it became clear that while Unity was primarily known as a gaming engine, really it is become known more as a creation engine, because to your point there, it does go beyond games. I mean, there are companies that are creating all sorts of different things with this engine and we'll talk a little bit more about that.

But before we do, let's talk a little bit about how this company makes money. You mention the create solutions and the operate solutions there. And I think the neat part about this business, it gives you a couple of different ways, it makes money through subscriptions and also through a usage-based business model. And so, it does look like -- you have the operating solution, which essentially represents about 70% of total sales, whereas create represents about 30% of total revenue.

Talk a little bit about the difference between the two segments there. We dove into that a little bit in the intro here, but it sure sounds like create, that sort of is the obvious one there, it's for folks looking to create with that platform; whereas operate, maybe that's a little bit more of an ongoing maintenance basis.

Beyers: Yeah. So, the create solution is, if you are building something, whether it's games, whether it's some kind of app, you are going to buy a subscription. So, primarily these are subscriptions. You're going to buy access to different Unity Games tools and you're going to use those tools to build something, create, right? So, create solutions.

The operate solutions business, I looked at the 2019 numbers, I had it at 54% of revenue, but it does appear to be growing. And I think we should expect that 70/30 breakdown that you had, JMo, I think it's probably going to -- and it may be 30/60 with 10% from strategic partnerships. But overall, I think operate solutions are going to be the vast majority of revenue moving forward. It may even get to, like, 80% or even 85% at some point; we don't know.

Because there are three ways this company makes money. So, the create is you buy access to the subscriptions, you buy the ability to create inside Unity. Operate is a couple of things. One is I want to host my game on the Unity platform and let it run there. I'm going to pay for the privilege of doing that. Another is, I'm going to run on your platform and there's going to be some revenue share here. As I sell it, as people start accessing my game through the Unity marketplace, I'm going to share revenue with you, so that's another way that they earn money. And then the third is the strategic partnerships, which is, on a particular device, it's maybe optimized for the Unity Game Engine and there's some one-time revenue that hits here. Also, it's very interesting that you can have some add-ons, some little plugins to either your game or an environment or some other thing. And there's, kind of, this app store that exists inside Unity, and when you're selling through there, Unity gets a cut basically like the -- you know, wait, who else does that sound like? That sounds like Apple, right?

And so, here was the thing I wanted to point out about Epic, and I like these comments that we're hearing for some folks who are tuning in with us in real-time as we're recording this, JMo. We had Mike Migliore say, there was a comment about how Epic is a better experience, and then Musketeer Jabba saying that, frankly, it's a different market and maybe there are some mobile games on the Unity Game Engine. But Unity may be made for, kind of, lots of volume, lots more games, and Epic may be operating at the higher end.

Here's another big difference, Unity is not fighting with Apple [laughs] but Epic is ...

Moser: [...] Yeah, I was going to no antitrust risk there and no Apple wars; at least not yet, right?

Beyers: Right. And here's the thing. What makes Unity so interesting to me is that Epic is fighting Apple because of the share inside the app store, while Unity is actually printing money by having an app store of its own, it's a very different environment. And I like that a lot; I think there's room for both of them and both could very easily succeed. But they are different companies, and I really want to point that out.

Moser: Yeah. And I appreciate you doing that; I think that's important to note. And I really do like, because, you know, we talk about that -- man! You know, wouldn't it be neat if there's another app store where you didn't have to necessarily rely on Google [Alphabet] or Apple to be the gatekeeper, so to speak? And here you go with Unity, kind of, doing their own thing. And it certainly does seem to be working. And you know, the other thing when we talk about Epic's Unreal Engine, I mean, we can't mention that without also noting the fact that Epic -- I mean, let's remember, Epic, there's about a 40% interest there -- Tencent owns about 40% of Epic Games. And so, that just goes to show you that with Epic, clearly, they have a lot of resources at their disposal given that ownership interest from Tencent, which I think, arguably you could say that Tencent is the biggest gaming company in the world.

Beyers: Yeah, I think that's 100% right. And it is a really good way, so the ticker for Tencent is, at least if you're going to buy it here in the U.S. on the pink sheets, it's TCEHY; so, that's Tencent Holdings. So, if you want a piece of Epic, you can get it, but you're going to get it through Tencent Holdings. And buying both -- I mean, JMo, you are the master of baskets, so it could be a really interesting basket, right?

Moser: I think we could have, like, an umbrella brand for these baskets, like, duopoly baskets. [laughs] This could be the first duopoly basket. I actually like that idea a lot. Well, I mean, to your point there, both businesses are witnessing a lot of success. And there's a datapoint here that I found in regard to Unity that I thought was just really fascinating and I think it really is a testament to the success that the business is having. And if you look at customers that contribute greater than $100,000 in revenue annually. You go back to quarter one of 2018, that was 389. And as of the second quarter of this year that number is now 716. So, that I think is just another metric. You know, we talk about metrics that matter, and that's certainly one that matters, because it does show that they're doing something that their customers like, and that customers are not only willing to sign up but also willing to spend more with the company as that relationship evolves.

Beyers: Yeah, and they account for that same cohort, they account for 74% of total revenue, all revenue; so, those 716 customers. And they report in their prospectus that the gross retention rate on that customer base is 99%. So, when they commit to Unity, they stick. They stick around. And you know what, that makes sense.

Moser: It does. And you know, I mean, that is -- we talk about competitive advantages and, sort of, the signs that you're doing something right. I mean, that willingness, that loyalty, that stickiness, that is a big deal, because over time, I mean, those switching costs do start to grow over time. And when you get those switching costs, there's a little bit of pricing power that often can come with that. But you know, let's talk about those customers for a little bit here. Because we talked about at the very beginning of the show, this is primarily seen by a lot of folks as a gaming company, but if you just do a little research and you just go to Unity's website and look at the actual cross-section of customers that they cover, I mean, it's so far beyond games. I mean, they have case studies in architecture, engineering, construction, automotive, film, education, I mean, the list goes on. I mean, it spoke to me in that, this is really a creation engine and not just a gaming engine anymore.

Beyers: Right. So, all of those sectors that you just talked about, there is some degree of either planning, prototyping, some kind of structural analysis, where I can take an element of the real world and I can stress-test an idea inside a digital environment. And Unity does that heavy-lifting for me because it does such a good job because it is a 3D virtual environment and an augmented reality environment that you can stress-test, say like, the structural integrity of a building looking at a certain design, for example, or stress-test the output of a certain engine or some kind of machine based on the known factors that you're plugging into the Unity Engine. That is way cheaper than doing real world prototyping and actually building out big models.

So, there's definitely something here, and they're talking this up a lot. I mean, if you read their prospectus, they really are talking about, it's actually in John Riccitiello's letter, and he talks about, we were just a gaming company, but what we found is that the applicability of what we've built in Unity stretches way beyond gaming. And you know what, simulating an actual physical environment does have a lot of benefits for a lot of different industries.

Moser: It does, and I'm glad you mentioned that word "simulation" because, you know, we talk about the duopoly here, and I agree, I think to an extent it probably is. There is another business that some listeners I'm sure will be familiar with because I've talked about it before, but it's a business that is very much in the simulation market there, and it's a company called ANSYS, one that I've followed for a while, one that I actually own shares in myself, it's just done very well for a long period of time, it's because of that argument that you just made there.

Being able to simulate any type of environment, whether it's gaming or a building or an airplane, you save so much time and so much money and you ultimately end up with a better end result anyway. So, maybe ANSYS is kind of another, sort of, player in the sandbox, maybe not a direct competitor, so to speak, but certainly one benefiting from that move to simulation. And I mean look, when you look at the actual numbers of people that Unity is reaching, at the end of June this year they had a global reach of over 2 billion, that's with a "B," monthly active end users. I mean, there are a lot of people, you probably don't realize it, but you're interacting with a Unity product.

And, you know, you talked about the Apple phone event that just came out yesterday, it's worth noting that lidar that I spoke to, that's a key point to the augmented reality functionality of those phones. And so, when you see more immersive technology coming into play in the devices that we own, that's just going to be more opportunity for a company like Unity to really continue to grow that network of creators that is already growing so quickly.

Beyers: I would say it might even blow your hair back a little bit to hear that, you know, ANSYS is actually using Unity. Now, I don't know that that's true, but would it surprise you at all if they were using that engine to power simulations. It would make a lot of sense, in fact.

Moser: Yeah. And you do see a lot of partnerships in this market, I mean, you see all sorts of partnerships with these companies, and it's nice to see that, because I think, like most things, when we work together, we tend to get better results and more people benefit. So, yeah, that's a really good point.

You mentioned CEO John Riccitiello, and I want to talk a little bit about management here, because one of the things that attracted me to this business and, you know, it's not a reason to invest, mind you, but it is something that I think investors like to see, as I know we certainly like to see it, is there is involvement there still with co-founders of the business.

Beyers: Rightf. And you have to go searching for it, because it looks like the two big co-Founders, Joachim Christoph Ante and David Helgaso, Helgason is on the Board, but these two combined, they actually made an entity where they put their combined shares that they vote for Unity into -- it's kind of a financial entity, it looks like they own zero shares, that is not true, don't believe that, that is just a function of SEC filings. They own roughly 11% of the business and they have a lot of voting power in the business. And Helgason is actually on the Board of Directors.

So, Riccitiello has been with Unity for about six years. Prior to that he had about six years at Electronic Arts, so he's been in the business. But these co-founders are still around and they're still overseeing the business. And more importantly, they got skin in the game and that matters.

Moser: Yeah. And there is a VC interest there, but one point I noted in the S-1 that I thought was really encouraging, at the end of June 2020, when you base it on the IPO and the offering, the number of shares that were being offered, it was the executive officers, directors and greater than 5% shareholders in the aggregate owned approximately 62% of the outstanding stock. So, yeah, to your point, there is significant ownership there. And, yeah, again, maybe not a reason to invest, but certainly something that works in the favor. Because as we talked before, that aligns their interests with ours in most cases as longer-term shareholders, and they certainly seem to be building this business with that mindset.

Beyers: And one thing I want to mention very briefly before we move on here, because I think it's important, there were some allegations of sexual misconduct, sexual assault or something like that, I don't have the exact data here, but there were charges leveled against Riccitiello, nothing has been proven here, but there are some comments online, you should look them up if you're interested in investing in this business. Because we haven't really heard a resolution here, and so we don't know. And if that matters to you, and there are good reasons for that to matter for sure, pay attention, go take a look, we don't have anything definitive here yet, but it is out there. And so, I just want to make sure that it is noted. We haven't really heard from women yet on this in a way that, sort of, has settled this case definitively, so just bear that in mind.

Moser: Yep. Always worth remembering, I mean, there are risks, there are personal risks that come with managers, with leaders. And Riccitiello has been CEO of this business since October of 2014, so clearly, he has helped build this business to what it is today. [laughs] I wouldn't call this the Buffett-style ham sandwich business, right, I mean, I don't think a ham sandwich [laughs] could necessarily run this business. By the same token, it does look like they have a lot of talent there that would be able to keep this business moving forward and being successful, if something came of this, but I think, you know, to the greater point there of culture, you always have to keep that stuff in mind, because you want to make sure that there's a culture, in the businesses that we invest in, there's a culture that fosters inclusion, and success, and productivity, and respect. And so, yeah, that's absolutely a headline worth keeping in mind and one that we'll continue to follow to see if there's any kind of resolution there.

Tim, we've talked a lot about this business, we've talked about the competitive landscape. At the end of the day, have you developed an opinion on this stock, is this a company that you feel like belongs on people's radars? Do you feel like this is a business you'd rather wait and see, kind of, how things progress? I mean, it feels to me like this is a business that already -- even though it's newly public, I mean, it still has a pretty respectable track record of success as a business.

Beyers: It does. And it's definitely worth a closer look in my opinion. I would say, you know, recognize that you're going to pay a premium for it. I mean, today, this is an unprofitable company that is trading for 39X revenue, and its revenue growth rate is about 39%. So, there are companies that are trading at that level that are growing much faster than Unity is. That's one of the downsides, so bear that in mind. Having said that though, this is a company with scale, with some advantages. So, we talked a little bit about that operate solutions business, as that operate solution, that is an unbounded opportunity. As gaming grows, that segment will grow. And it will come to dominate, probably, a greater share of the overall revenue pie, so there's some upside there. And just for perspective, from 2018 to 2019, that segment grew 59%. It is still an incredible growth story there.

So, it's priced at a premium, is it worth taking a look at? Yeah, no doubt. It's probably not going to be cash flow positive very soon, but it does have a decent balance sheet just by virtue of going public, and there's some optionality in the business. And by virtue of its competitive advantages, the fact that it has roughly a duopoly here, it's unlikely to be dramatically disrupted anytime soon. So, that's worth a little too. So, I would say, for me personally, JMo, I would go, if I were to invest in this business -- and I haven't shut up about it, so the odds of putting real skin in the game is very unlikely. So, don't read anything into that. If I don't buy shares, it means that I probably just stopped out of it, I just can't.

Moser: We have trading guidelines that we all have to adhere to, and that's something we, you know, make sure that listeners and everyone, they do know that. I mean, we do have trading guidelines, I mean, these companies we talk about, we can't just go buy and sell whenever we want, you know, time has to pass by before we can make purchases or sales based on the companies that we're talking about.

Beyers: Right. But if I did have the option today, I would be the kind of judicious buyer that would be like, all right, I'll buy two to five shares here, like, I would not make a big bet on it. I would make a very, very small bet, and say like, all right, this is interesting to me, there's clearly optionality here, the moat is big enough that it's unlikely to put my capital at a risk of permanent loss, I'm willing to make a very small bet. That's kind of where I land on the stock.

Moser: Yeah, I think you're right. And obviously, valuation being one of the bigger risks, and that's for a number of different reasons, but for all of the points that you just mentioned. I mean, the fact that they look at the total market opportunity today somewhere in the $30 billion range, all-in, right, not just gaming, but all of those different markets. I mean, they're going to chalk up about $750 million in revenue this year for 2020, so that just gives you an idea of what the company is making versus the opportunity that exists out there.

And so, yeah, I think I'm with you. I mean, this is a wonderful time to be an investor for so many reasons, you know, [laughs] one of those reasons, I mean, the commission costs have essentially disappeared, which means you can invest [...] and take advantage of that when you can. Because I agree with you, this strikes me as that type of a business, and so I'm right there with you.

Beyers: Yep. 100%. You know, kind of, to put a bow on Unity here. This is one, we're taking a look, kind of, from the bottom-up here. I think the one thing that's not in dispute, and with a company like this, when you're doing stock from scratch bottom-up analysis, one of the places you want to start is like, does this solve a migraine-level problem, you know, like a migraine-level problem where people are willing to pay up? And the answer is, yeah. I mean, there is a lot of proof that they are absolutely doing that and that's a great place to start. Like, if you can answer that definitively, you've got a place to go with a technology company; if you can't, you know, you want to be really careful.

Moser: Well, there you go. Tim Beyers, thanks so much for joining us this week. Appreciate it.

Beyers: Thanks, Jason.

Moser: All right, folks, that's going to do it for us this week. Remember, you can always reach out to us on Twitter @MFIndustryFocus, or you can drop us an email IndustryFocus@Fool.com. If you have an opinion on Unity, hey, let us know, we'd love to hear it.

As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear.

Thanks, as always, to Tim Sparks for putting the show together. For Tim Beyers, I'm Jason Moser, thanks for listening and we'll see you next week.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.