For a long time, investing in the gaming industry was something that I was not comfortable with. If a company relies on just two or three popular games, it can face incredible revenue concentration, and since video games are not popular forever, companies consistently have to come up with the next big hit to remain successful.
Unity (U 1.15%), however, is different. The company does not develop games directly, but rather sells tools to allow individual developers to create their own games. This pick-and-shovel approach is much more appealing: It gives Unity a stable, consistent revenue stream while allowing it to take advantage of the fast-growing gaming industry. The company has been furthering its dominance as one of the top development platforms, and considering that its stock is down more than 50% from its all-time high, it was the right time for me to finally add this company to my portfolio.
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1. Its opportunity is massive
Unity is a market leader in its space, with over 1.5 million active creators monthly using its platform. The company has tools for developers to manage everything from building a game to monetizing it. A lot of Unity's developers are independent and might not have the connections to scale and maximize their game's cash generation, but Unity helps them do that.
The company had over 1,000 customers spending more than $100,000 annually at the end of 2021, and its existing customers from fourth-quarter 2020 spent an average of 40% more in Q4 2021. This reliance on the platform has helped it become one of the leaders in the game development space. It now operates in a duopoly with Epic Games' Unreal engine, with the only other major competition being from developers that decide to build their games in-house.
The gaming industry is expected to be worth $340 billion by 2027, representing major growth from 2021 when it was worth just under $200 billion. Considering Unity made $1.1 billion in revenue last year, it has a lot of room to run. The gaming industry is not the only industry the company operates in, however. Its tools can also be used to simulate, experiment, and test things in the automotive, aerospace, and construction industries.
The company even has the potential to capitalize on the metaverse, which some believe could be worth $800 billion by 2024. Since Unity's platform allows people to easily build a video game, the opportunity to develop a personalized metaverse is not out of the realm of possibility. If the world becomes one where individuals have their own digital worlds, Unity could see jaw-dropping adoption.
2. Unity is extending its lead
While many investors would be fine with Unity remaining in its duopoly, the company is investing heavily to stand out from the pack. It has made two acquisitions recently to improve its graphics capabilities, the first being Weta Digital, which closed in December 2021. This acquisition will allow Unity developers to have access to some of the best graphics and content tools on the market, which helps Unity become the go-to developer for those looking to have the gold standard of 3-D art and visual effects in their games.
The company also acquired Ziva Dynamics in January 2022. Ziva specializes in creating digital characters that can emulate human emotion, language, and expressions by using complex deep-learning tools. This acquisition of Ziva furthers its lead on the graphics front by opening up world-class technology and character creation capabilities to anyone on Unity, regardless of skill level. These will likely have an effect on the company's adoption over competitors, and it could also open the door for potential pricing power in the coming years.
One risk that remains
The major risk for Unity is its unprofitability. It lost over $533 million in 2021, which represented 48% of revenue. What's more concerning, however, is its cash burn. Unity's free cash flow burn was $153.5 million in 2021, and that increased substantially from a burn of $20 million in 2020. The company has more than $1.7 billion in cash and securities on its balance sheet to fuel this, but investing in free cash flow negative companies can be risky, especially when they're trending in the wrong direction -- like Unity is.
That being said, the company's competitive advantages and the success it has seen so far are incredibly appealing. Its optionality among industries and revenue diversification between video games make me believe that Unity has found a stable way to capitalize on this large market. Shares have been crushed recently, and they now trade at 25 times sales at the time of this writing -- a high but more reasonable valuation than it has been over the past year. With all of these things going right for the company today, I decided to invest, despite its tricky cash flow situation.
