Rising Open-Source Threats And Regulatory Pressure Will Weigh On Margins

Key Takeaways

• Increased competition and regulatory challenges threaten Unity's market share, pricing power, and ability to monetize across gaming and new sectors.
  
• Heavy investment needs amid weak profitability cloud the outlook for revenue expansion, margins, and long-term earnings growth.
  
• Adoption of AI-driven products, expanding non-gaming markets, and a stronger subscription base are positioning Unity for diversified, stable growth and improved profitability.

Catalysts

Operates a platform to create and grow games and interactive experiences for mobile phones, PCs, consoles, and extended reality devices in the United States, China, Hong Kong, Taiwan, Europe, the Middle East, Africa, the Asia Pacific, Canada, and Latin America.

• The accelerating rise of open-source and lower-cost development tools is likely to erode Unity's pricing power and increase customer churn over time, pressuring long-term revenue growth and making it increasingly difficult to sustain high average revenue per user or retain competitive gross margins.
  
• As regulatory scrutiny intensifies globally around data privacy in digital advertising and monetization, Unity will face significant challenges in leveraging its large-scale data advantage across its ad networks, potentially forcing fundamental changes to its core monetization strategies and reducing future ad revenue streams.
  
• Escalating competition in the game engine sector from Unreal Engine and emergent specialized or proprietary tools will likely result in continued market share erosion for Unity in both existing gaming markets and new industries, increasing the risk of long-term stagnation or decline in its core revenue base.
  
• The growing adoption of alternative real-time 3D technology frameworks outside Unity's ecosystem, such as proprietary in-house engines or rival cross-platform solutions, could sharply reduce Unity's relevance among large studios and new, fast-growing segments like VR, AR, and industrial digital twins, limiting expansion and capping total addressable market, which will constrain future revenue and margin growth.
  
• Continued high investment requirements in AI, cloud infrastructure, and R&D to keep pace with market expectations, alongside ongoing difficulties achieving profitability at scale, will exacerbate net margin pressure, elevate execution risk, and ultimately undermine prospects for earnings growth and sustainable positive free cash flow.

Unity Software Future Earnings and Revenue Growth

Assumptions

• This narrative explores a more pessimistic perspective on Unity Software compared to the consensus, based on a Fair Value that aligns with the bearish cohort of analysts.
• The bearish analysts are assuming Unity Software's revenue will grow by 6.7% annually over the next 3 years.
• The bearish analysts are not forecasting that Unity Software will become profitable in next 3 years. To represent the Analyst Price Target as a Future PE Valuation we will estimate Unity Software's profit margin will increase from -25.2% to the average US Software industry of 13.2% in 3 years.
• If Unity Software's profit margin were to converge on the industry average, you could expect earnings to reach $287.3 million (and earnings per share of $0.6) by about August 2028, up from $-450.7 million today. The analysts are largely in agreement about this estimate.
• In order for the above numbers to justify the price target of the more bearish analyst cohort, the company would need to trade at a PE ratio of 32.6x on those 2028 earnings, up from -31.3x today. This future PE is lower than the current PE for the US Software industry at 40.4x.
• Analysts expect the number of shares outstanding to grow by 4.75% per year for the next 3 years.
• To value all of this in today's terms, we will use a discount rate of 8.88%, as per the Simply Wall St company report.

Unity Software Future Earnings Per Share Growth

Risks

• Rapid adoption and strong early performance of the Vector AI-powered ad platform are already lifting advertiser returns by 15 to 20 percent, leading to increased advertiser spend; if this trend persists, Unity's advertising revenues and gross margins could see sustained growth.
  
• Double-digit year-over-year expansion in high-margin Create segment subscriptions, with 80 percent of Create revenue now driven by subscriptions and further pricing improvements planned, suggests a foundation for stable and expanding recurring revenue and improving net margins.
  
• Unity's continued penetration into industry verticals outside gaming-including healthcare, manufacturing, and architecture-has resulted in nine consecutive quarters of sequential revenue growth in these segments, broadening the company's addressable market and supporting long-term revenue diversification.
  
• Significant investment in AI and data-driven insights is laying the groundwork for enhanced customer value, cross-segment synergies, and future product offerings that could increase average revenue per user and drive platform stickiness, positively affecting earnings and customer retention rates.
  
• The company's strong balance sheet, recent debt refinancing extending maturities into 2030, and ongoing cost discipline resulting in expanded EBITDA margins and increased free cash flow position Unity to invest in growth opportunities without immediate financial strain, potentially supporting long-term earnings growth.

Valuation

• The assumed bearish price target for Unity Software is $15.23, which represents two standard deviations below the consensus price target of $27.57. This valuation is based on what can be assumed as the expectations of Unity Software's future earnings growth, profit margins and other risk factors from analysts on the more bearish end of the spectrum.
  
• However, there is a degree of disagreement amongst analysts, with the most bullish reporting a price target of $44.0, and the most bearish reporting a price target of just $15.0.
  
• In order for you to agree with the bearish analysts, you'd need to believe that by 2028, revenues will be $2.2 billion, earnings will come to $287.3 million, and it would be trading on a PE ratio of 32.6x, assuming you use a discount rate of 8.9%.
  
• Given the current share price of $33.94, the bearish analyst price target of $15.23 is 122.9% lower. Despite analysts expecting the underlying buisness to improve, they seem to believe the market's expectations are too high.
  
• We always encourage you to reach your own conclusions though. So sense check these analyst numbers against your own assumptions and expectations based on your understanding of the business and what you believe is probable.