MTTR - Unity's Unique Competitive Advantage Explained

2023-07-07 09:53:24 ET

Summary

• We believe we're on the verge of early majority adoption of the spatial computing platform, and Unity is well-positioned as a critical component of the software stack.
• In this article, we go in-depth to explain Unity's business model and unique competitive advantages.
• We have a $130 price target and outline our trading strategy in this article.

Introduction

We have been following Unity ( U ) throughout the Metaverse hype and we think it is finally time to share our conviction in Unity with you. We officially bought into Unity at about $38 per share after Apple's ( AAPL ) announcement of the Apple Vision Pro. Now, Unity represents about 50% of our investment portfolio exposure.

This article will detail our key takes on Unity from competitive advantages to growth drivers, to our trading strategy.

More importantly, we want to shed light on Unity's path to $1bn EBITDA by 2024.

Unity's Synergistic Business Model Explain

We believe Unity's competitive advantage lies in the ecosystem around its platform and synergistic revenue model.

Unity's Ecosystem Competitive Advantage

Unity positioned itself as a platform for creating and operating real-time 3D (RT3D) content. Unity aims to become the ultimate end-to-end solution for creating and operating RT3D content. This is evident through a series of strategic acquisitions like ironSource , Weta , Ziva , SpeedTree , and others that can complete the processes and pipelines of developing RT3D content with Unity. This gives Unity a competitive edge over competitors.

Unity not only competes with engines like Unreal, but Unity also competes with companies such as Matterport ( MTTR ) which offers AR/VR/XR products and services. But Unity as a platform for RT3D content creation has a unique competitive advantage compared to companies like MTTR in terms of its position in the AR/VR/XR software stack.

As a platform, Unity can expand both vertically and horizontally to develop key infrastructures that enable RT3D technologies and applications to serve the industry's needs.

This may be the reason why Unity's digital twin solutions can be applied to architectural, manufacturing, automotive, airports, and other applications, but MTTR's digital twin solution only focuses on real estate.

Moreover, It is also likely easier for Unity to expand into real estate than MTTR to expand to broader digital twin applications. Furthermore, Unity's partnership with AAPL provides Unity with direct access to AAPL's large registered developer base which is relatively untapped. In this case, it is more likely for AAPL's registered developers to use Unity's digital twin solutions than to switch platforms to MTTR's altogether.

This showcases a unique competitive advantage of Unity compared to other competitors in the RT3D space.

Unity's Synergistic Revenue Model

Unity monetizes its services in three ways: Ads (under the Unity Grow segment), Developer Seats (under the Unity Create segment), and Cloud Services (soon). Hence, we simply Unity's revenue model as follows:

Revenue = Games*Players*Ads + Fees*Developer Seats + Cloud Service + Marketplace

We further categorize Ads and Cloud Services under Usage Revenue, and Developer seats (including subscriptions to the Plus/Pro plan and other tools such as the industry tools and artistry tools) as Subscription Revenue. We find this method of viewing Unity's revenue model to be accurate because about 2/3 of Unity's revenue is derived from usage.

Grow, Create, and Cloud complement one another to help Unity to monetize its platform adoption at different levels.

We interpret Grow as a way to monetize Unity's large free-tier userbase and Create as a way to monetize its professional userbase. Unity directly monetized its professional users (developers) through subscriptions (Unity Plus Plan, Unity Pro Plan, and other professional tools such as Artistry and Industry tools). On the other hand, Unity can monetize its free-tier users through Grow.

But Unity's Cloud Services can monetize both professional and free-tier user bases.

Firstly, Unity expects a lot of AI work and rendering to be done on Unity's servers which will provide opportunities for more growth. Products and services such as Digital Twins, Unity Muse, Weta tools, and SpeedTree will be served through Unity Cloud services.

Almost all AI work that's cross-platform is going to end up being done on the server side. And that's expensive for our customers.

"Expensive" implies a high-margin growth opportunity for Unity. But what can justify developers using Unity's "expensive" AI cloud service?

We believe it is the training data and workflow. Here's our take as scientific researchers specializing in AI in vision and algorithm trading (with AI publications over 9.0 impact factor).

We think that the game engine is required to generate the desired game scenarios (training data) to train the AI models. Generating game scenarios is very different from generating text, and images. and videos. This is because, in addition to the images and sounds, game scenes also require input data (keystrokes), game mechanics, game physics, lighting, and data not available anywhere else other than the game engine the game is built on.

Moreover, these game scenarios are highly unique and vary from game to game, which means generating the desired game scenarios is extremely difficult outside of the game engine. Unlike text data where there are large libraries of text corpuses available to train natural language models, codes, engine, and runtime rendering are all required to generate the desired data (similar game scenarios) to train the AI. Hence, we can say that generating similar in-game scenarios is almost impossible, if not impossible, anywhere other than the platform the game is built on.

Furthermore, Unity owns a large library (through acquisitions like Weta) of world-class digital assets, intellectual properties, and tools that could be further integrated to provide differentiated and much superior AI services than competitors.

Therefore, the AI services offered by Unity as an end-to-end RT3D platform is very unique and not easily found anywhere else. Unity is very well-positioned to monetize its high-margin AI and cloud services.

For these reasons, we believe that Unity's revenue model is highly synergistic and that it can monetize its competitive ecosystem effectively.

Near-term Growth Drivers to Surpass the Guided $1bn EBITDA

Unity guided a $1bn EBITDA by 2024, but it is not until AAPL's partnership that we saw a clearer path to surpass the guidance which prompted us to invest. We believe that this partnership will be a major catalyst for growth.

Firstly, AAPL's partnership gives Unity access to over 34mil registered developers . We think that this is a relatively untapped addressable market for Unity. For instance, if 10% of AAPL's registered developers subscribe to Unity's Pro plan (which costs $2,040 per year), this presents Unity with additional $7bn annual revenue from developer seats alone.

AAPL's new cloud computing platform also introduces an addressable market for Unity's ads segment (Grow). With more affordable AR/VR/XR headsets planned , we think that the spatial computing platform is on the verge of early majority adoption. More AR/VR/XR users imply a larger addressable ads market.

We expect it'll take Unity 1.5 years to begin reflecting the growth in developer seats which coincides with the official launch of the Apple Vision Pro. We also expect it'll take Unity 3-5 years to begin reflecting the growth in ad revenue related to AAPL's spatial computing platform. This coincides with the time taken for the iPhone to see early majority adoption.

Other growth drivers are also already at play.

Unity increased its Create subscription prices on 13th October 2022. Since these subscriptions are mostly annual, the revenue growth from the price increase isn't fully reflected yet. A third of Unity's revenue ( $187mil in 2023Q1) is derived from Create.

We estimate the price increase will add about $150mil in annualized revenue based on 2023Q1 figures. In addition, new product offerings such as Weta are expected to further boost subscription revenue and cloud revenue. Speaking of cloud revenue, Unity stated that Unity will realize start to realize the ratable cloud revenue from its digital twin segment.

Table 1. Unity subscription price rises from 13 October 2022 onwards

Source: cgchannel

Two-thirds of Unity's revenue is derived from Grow (ads segment), so the overall ads market is crucial to Unity's growth prospect. In the short term, we do not expect the overall ads market to be a growth driver for Unity. Even though Unity reported market share gains through Unity LevelPlay, the overall ad spending is expected to remain relatively flat (low single-digit growth of 3%-5% annually) between 2023 and 2025, according to Dentsu . In addition, the potential recession further adds to the ad market headwind. Nevertheless, these market share gains will greatly benefit Unity when the ads market recovers.

Where we expect ad revenue growth to be realized is from a more optimized ads mediation through deeper integration with ironSource. Unity quantified its attained synergy with ironSource to be about 25% in terms of EBITDA ramp. Hence, the remaining 75% is still room for growth.

In the long term, we believe there is much growth to be realized from the unique competitive advantages of Unity's AI product offerings (discussed in the previous section) and its resulting ratable cloud revenues.

Our Trading Strategy and Closing Remarks

In this article, we discussed Unity's business model and competitive advantage in great detail. We have identified several growth drivers to surpass the guided $1 billion EBITDA in 3-5 years. At 15x 2024 expected EBITDA, Unity presents us with substantial upside potential. Unity to us is as AAPL to Berkshire Hathaway ( BRK.A ) ( BRK.B ).

Our trading strategy considers both the upside potential and volatility.

We estimate Unity to achieve around $2bn (conservative) net income in 3-5 years. This is feasible considering Pro Plan subscription from 5% of total AAPL's registered developers is sufficient to add $3.5bn in annual revenue. Based on Seeking Alpha's sector average 25x earnings, a $2bn net income can justify a $50bn market cap or $130 per share, which implies a 230% upside.

At the time of purchase, Unity's long-dated call options have about 65% implied volatility. We think Unity's implied volatility will spike when the launch of the Vision Pro draws near. We expect news related to the adoption of Vision Pro or Unity's platform to pick up and become a catalyst for higher implied volatility. We've seen Unity's implied volatility crossing the 100% mark.

Therefore, we invested in long-dated (~600 days) slightly in-the-money (Strike $35) call options (each for $13.75) instead of Unity's shares. We estimated that 600 days is enough to test our thesis on Unity.

We expect the Vision Pro to be launched within the next 365 days. We allocated another 135 days for the market to digest the anticipated positive news and the price to react. Hopefully, the price will realize at least half of our price target ($75).

Then, we'll short the at-the-money call to form a vertical and collect the initial premium paid. At $75 per share (half of the price target), 85% expected implied volatility, and 100 days to expiration, the theoretical price of the at-the-money call options is about $13.2.

This trade will still yield about 200% return even though the full price target isn't realized and less capital is risked. If Unity realized our full price target, we could see a return as high as 600%.

So this article detailed our conviction in Unity. We give Unity our "Strong Buy" rating.

What's your take on Unity? Let us know in the comment section.

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