Why Unity Software’s Business Model Has Market-Beating Upside Built In

Not all business models are created equal, and Unity Software (NYSE:U) has a pretty interesting one. Put simply, the company empowers creators to start their journeys and then profits only as these creators succeed. It costs Unity little to do this but allows it to capture the upside.

In this video from Motley Fool Backstage Pass, recorded on Oct. 11, Fool contributors Jon Quast and Jose Najarro along with analyst Sanmeet Deo go into more detail explaining how this business model works in Unity’s favor.

Jon Quast: This is a company that I don’t know much about and I’ve been looking forward to somebody like you breaking it down like that. I very much appreciate that.

One thing that I wanted to point out, I did do a little bit of homework before we came on the show today, and I just wanted to point out, you pointed out the different revenue segments there for Unity. And the operate segment, so that’s once a game or whatever it may be has been launched, they’re providing that service to those developers on an ongoing basis from there, that’s actually the biggest part of the business in the second quarter of 2021. I just did the math on it, 67% almost of their revenue was from the operate segment.

What I also thought was very interesting was that the operate solutions, according to the S-1, they generate revenue primarily through usage-based models. Whereas the creative segment of the business is a subscription, the operate segment is a usage-based model, which I find very interesting when you think about it from a potential upside perspective. We’ve talked on the show before about how mobile gaming is the only part of the video game industry that’s actually growing. So by being a usage-based model, Unity is empowering these game developers, and once one of these becomes a hit, that’s just pure upside for Unity. They’re not capped by the set subscription that they on-boarded them with, they can onboard many, many game developers and potentially benefit from any of those that wind up being a runaway mobile game hit.

I just thought that was an interesting aspect. I don’t know if that’s the correct take or not. That was my take on it.

Jose Najarro: Definitely, Jon, and I think that’s one thing the CEO mentioned. It creates this one, that both the designer, both the creator of the game and Unity have the same goal. If their game does well, Unity is going to benefit and so is the game developer. That’s what pushes Unity to, “Hey, make sure we have the best products for you, make sure that we’re able to provide the best services for your customers, because if your game does well, then we’re going to do well, you’re going to come back you’re going to make another hit game, that hit game is going to do well and we’re going to see that kind of growth.” That’s a great point you made there, Jon.

Sanmeet Deo: Unity is definitely one that I’ve looked at and I really like as well. It’s one that I own personally myself, from one I’ve been following along.

One of the things that I’m really excited about with this business is the optionality in terms of, right now it’s primarily a gaming engine and it’s making most of its money and business off of mobile gaming and the creative solutions and also what Jon was saying was, the usage-based model, which gives them so much upside as they grow.

But they’re breaking into these other verticals of architecture, automotive, film. I like to liken Unity as it’s almost the software, the operating system for AR, VR, and the metaverse. It’s anything you want to create in terms of those things. Right now it’s almost a duopoly between Unity and Unreal. For people that may not know, Unreal Engine is made by Epic Games, which is the creator of Fortnite.

One thing that I came across with my research in terms of the competition…that advantage of Unity is that it’s low code and it’s easy to learn and it’s used a lot in the smaller, the mobile games, while Unreal, it’s a little more challenging to learn, it’s a little more complicated. It’s also been used for a lot of what they call the AAA game titles, which are the big game titles that we think of.

The interesting thing about Unity is they offer their software subscription plan for free for anyone less than $100,000 in revenue, so students and young people or young creators, or developers are looking to learn off software like Udemy where you can learn how to use it and then you can just get the software yourself and start creating. Unity really wants to capture that developer from the time they get interested and start, to the time that they might actually potentially become their own developer or developer team or create their own developer business.

It’s very content economy-focused and empowering the content, or I should say more in this sense, the developer community, empowering them to learn their software, to use their software, to expand with their software, and they both expand together. Very interesting there in terms of how it’s structured versus Unreal and how its strategy differs a little bit about it.

This is a huge market. I think Dave said that it’s about a $29 billion TAM [total addressable market] and growing. Like we’ve said, mobile gaming is the fastest-growing segment of gaming.

One thing I like about this company too is as we’ve been talking a lot about, again, I keep saying the convergence of movies and gaming and all of the stuff. It’s all going to come together, what are you going to use to make it come together? Something like Unity, it’s like the operating system for all of those things.

I don’t know if you guys know too that Zuckerberg, of Facebook fame, [laughs] wanted to buy Unity in, I think it was 2015. Because he saw it as a key platform or core technology for the metaverse. He actually wrote a memo that has recently been available of why he wanted to buy Unity, and where it’s going. If I can find that I’ll definitely pass it along. But it says a lot when Mark Zuckerberg was interested in buying you and now given the fact that Facebook is watching their own metaverse initiative and focus. It’s a definitely exciting company. Thank you for presenting that. Any other questions on Unity or?

Quast: I just wanted to underscore something that you just said Sanmeet, and that is how they onboard new developers. There’s no charge under a certain amount of revenue. This is a company with 79% gross margins. I talked about on The Rank earlier today that optionality is best when the greater the asymmetries. What I mean by that is when there’s little downside to do something, but great potential upside, that’s an asymmetry of optionality that is investors’ favors. With 79% gross margins, this is a low-cost thing to offer this to somebody. But since it is a usage-based model, the asymmetry to the upside is very much in investors’ favor. I really like that about the business model.

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.