Unity is caught in a mess of Mergers & Acquisitions

Unity (U) is one of my highest conviction holdings and I have been buying the stock heavily throughout the year. Lately, the stock has amassed attention as it found itself in a confusing mess of now several merger and acquisition bids. Shortly after closing their first major acquisition of Weta Digital – a $1.625 billion deal – Unity made another bid to merge with ironSource (IS) for $4.4 billion and subsequently received an unsolicited counter-offer from ironSource competitor AppLovin (APP) just a few days ago.

What is AppLovin trying to achieve?

Originally this post was just meant to share my in-depth thoughts and analysis on the ironSource merger but given the complexity added to the situation by the offer from AppLovin, I feel I must address this as well. Both ironSource and AppLovin are in the business of app monetization – primarily through optimizing the integration of ads and streamlining the installation process. AppLovin is the much larger player here, with a market cap of $13.55 billion in comparison to the $4.4 billion Unity offered ironSource for their full inclusion into the company. Interestingly though, Unity stock closed this week at $58.49 per share, making Unity the largest of all three companies with a market cap of $17.5 billion. This not only makes AppLovin’s bid to acquire them quite misleading, as they would in actuality end up the smaller part of a merger – it also makes it completely uninteresting in terms of profiting from the deal as a Unity shareholder. AppLovin’s bid sits at $58.85 per share, only a few cents off Unity’s current valuation, meaning shareholders of the stock likely will not let them off that cheap.

A merger between Unity and AppLovin would propose current Unity CEO John Riccitiello stay in his role for the combined entity. Further, accepting the deal would leave ironSource in the dust as Unity would have to cancel current plans of completing their merger. These two things make the deal come off as a desperate move by AppLovin fearing a combined Unity + ironSource. This whole ordeal has made me more supportive of the original merger, as it affirms that there may be some real potential in ironSource, spawning a reaction from a direct competitor.

ironSource would be pushed out of the new entity in a potentially combined Unity & AppLovin.

Riccitiello acknowledged AppLovin’s acquisition bid on Unity’s latest earnings call but refused to comment further on it – probably because it was made earlier that very same day. But in a combination of Unity reiterating its commitment to ironSource several times throughout this earnings call and seeing the share price move up to near the same level as offered, I have pretty much written off the possibility of a deal between Unity and AppLovin. However, the ironSource merger has certainly not been without its caveats and controversies, so we will have to go through those in this post as well.

Unity faces backlash over ironSource deal

Unity’s announcement to merge with ironSource was met with harsh reactions from the developer community. Throughout social media, game developers voiced their concerns over the direction Unity is currently heading. Among unfinished tools and features, abandoned projects, and letting go of around 4% of their workforce, spending 4 billion on an app-monetization company simply did not sit well with many people. As a game developer myself, I understand where they are coming from: To many, it can sound like the company is completely abandoning its roots and losing itself. Company focus oftentimes shifts dramatically when going from private to public, and this is no different for Unity – a change many long-time users and fans are struggling adjusting to. On top of that, before leading Unity, CEO Riccitiello led Electronic Arts (EA) – one of the single most disliked companies in the industry. While massively successful in terms of doing business, EA is also known for squeezing customers out of every last cent through devious monetization schemes and squeezing everything out of their developers through massive crunch-time (working extra hours for extended periods of time in order to finish a project).

John Riccitiello joined EA in 1998 serving as President and COO until 2004. He later rejoined the company as CEO from 2007 to 2013 before joining Unity in 2014.

Fueling the fire of developer backlash, PCGamer published an article just a day later, painting ironSource as a malware company. For a few days, the internet ran wild with damning headlines, accusations, and predictions of the death of Unity. In an act of poor judgment and probably fed up with all this, Riccitiello said this in an interview with pocketgamer.biz about developers not looking at a monetization strategy from the beginning:

‘…they’re the most beautiful and pure, brilliant people. They’re also some of the biggest fucking idiots.’

John Riccitiello, Unity CEO, 2022

This of course, only made things worse and was quickly followed by a half-assed apology tweet. In reality, I believe Riccitiello means well, although is not great at articulating it: Game development is indeed both creative and hard work. It is an art – but if chosen as a means of living, you better make sure to monetize your game too. Time and time again it has been proven that implementing ways of monetizing your game after the fact, never quite works out and that the most beloved games have had monetization figured out from the get-go. And that is exactly what ironSource can offer developers – Doing all the hard work related to monetization so that developers can focus exactly on what they are good at and enjoy the most: Developing games.

Is ironSource really a malware company?

The accusations that led to headline-grabbing news all come from a past long gone related to ironSource’s first product called InstallCore – an open-Source SDK for cross-platform installations. The program bundled software together, sometimes not letting people know what they actually installed, and even disguised some software for others. It was observed to avoid detection by anti-virus and ultimately, this SDK eventually landed on a list of potentially unwanted software and was ultimately blocked by Microsoft Defender in Windows. So yes, ironSource is responsible for supposed malware – a piece of software that did not quite work out the way they had wanted, but what all the headlines forget to mention is that this product was discontinued in 2020 and has not been supported by the company for years. As of 2022, the business that Unity is acquiring is in no way reliant on any aspect of InstallCore. In fact, in 2015 ironSource itself merged with Supersonic and the tools acquired here are actually what make up most of their revenue today. Had the new entity back then decided to continue business under the name Supersonic rather than ironSource, these headlines would likely never have seen the light of day.

What is ironSource then?

Okay, so that was a lot of bad… By now you may be thinking to yourself – what is left to like? Well. it turns out… a lot! Let us first cover the basics: ironSource is an Israeli-based company founded in 2010. It employs around 1.000 people in offices all over the world and went public in June 2021 with a valuation of $11.1 billion. Since then its valuation has dropped more than 80% – not unlike Unity, which is also currently trading below IPO price and at one point had shredded 85% of its valuation from all-time highs (from $210 to $30). But unlike Unity, ironSource is already a profitable company. they have a very good balance sheet and good margins.

From ironSource latest Q2 earnings release.

As you can see ironSource brings in $183 million in revenue, with a 35% YoY growth rate (particularly impressive considering a comparison to a lockdown quarter). It has solid software margins and an awesome retention rate. After having looked through their last few earnings and generally given the stock a proper look, I have come to the conclusion that ironSource may have been significantly undervalued. I believe Unity made a smart move here, took advantage of the bear market, and picked up a great business at an attractive price. Someone even reached out to me on Twitter about my thoughts on ironSource just a few weeks prior to the deal, exactly because I cover Unity stock. It is an obvious fit.

Original Tweet in Danish, translated to English using Google Lens.

I myself initially struggled a bit with making sense of exactly what it means to be in the business of app monetization. But what it means in the case of ironSource is letting an app through their service to maximize revenue and drive effective user acquisition. Once your app is integrated with the ironSource SDK, you can choose exactly where and what apps should appear. Listed in the company’s own documentation from a few quarters ago they view Unity as both a partner and a competitor – and most of their customers today are already game developers. App monetization is a growing business overall and one that Unity is betting on as well. Once you build a game in Unity, you should have tools available to monetize – whether it be through in-app purchases or advertisements. And as long as developers use Unity’s own first-party tools, they too can be part of the success of the application, beyond reoccurring subscription license fees for development.

From Unity Gaming Services page. Unity can help developers from beginning to end and both stand to benefit from this relationship.

Making sense of it all

One area where this merger makes immediate sense is when you look at just how concentrated ironSource’s customer base is. 95% of revenues come from customers contributing more than $100.000 over the last year. These customers actually only count in the few dozen or so – a number which can be greatly expanded with Unity’s reach and 90%+ market share in mobile games. Also interesting is how around 18% of ironSource’s current customers come from outside of gaming. Regular readers will know, that the big opportunity I see for Unity actually lies beyond games. Unity recently disclosed that 40% of their revenue from Create now comes from non-gaming related customer projects. This is massively positive for the long term case and I am glad to see more of it. While it would have been nice to see a number higher than just 18% this is also a testament to just how aligned the two businesses are. Through this move, Unity is not only absorbing a healthy profit-generating asset but in many aspects, a competitor too.

The numbers also speak further to why ironSource is such a good fit. It is a really good thing that ironSource is not as large as AppLovin. While I believe the monetization part of the business to be important – it should not become its core. Unity is a tool for creating incredible real-time 3D applications and simulations first and foremost and that should continue to be its primary objective. Because this deal is an all-stock trade however, it also means that Unity shares will be diluted by 29% as a result. That is quite a lot and another good reason we should be happy ironSource is not trading at the market cap of AppLovin. Strangely, it seems management will try to counter the dilution through a share buyback program over the coming years. I am not sure what to think of this – on one hand, I am happy they are considerate of their shareholders when doing a disruptive deal like this, on the other, I am not convinced this is the right time to do it. Unity itself is still losing money, at least until later this year, and as a committed shareholder, I have little issue with share dilution as long as it supports the long-term mission.

While some have speculated that the ironSource deal was merely a quick, expensive solution to the troubles Unity Monetization faced earlier this year, having trained its algorithm on bad data, Q2 earnings revealed this to not be the case. This issue, which caused Unity stock to drop 35% following Q1 earnings, is already fixed. I described this drop in share price to be a massive overreaction and nothing but a short-term challenge. Over the last couple of months, I have purchased Unity shares hand over fist, and put my money where my mouth is. For that, I have seen nearly 100% return on my shares purchased back in May following QQ earnings. In this post, I reiterate my belief that Unity trading under $100 is a great deal in the long term, and I stand ready to deploy more cash into the stock once we have confirmation that the AppLovin deal is dead and gone. While I did not know what to make of the original merger deal initially, I am now in full support of the inclusion of ironSource – however, the last few weeks have revealed weakness in Unity’s ability to communicate, which does include the risk of alienating core users. Despite it, I remain extremely bullish on the company.

This is Unity’s stock performance since inception. Every blue dot on the graph represents a purchase from me – including on the day of IPO. As high as $116 and as low as $32 per share. Even I did not buy shares when the stock traded in the 200s, but I expect we will see it again sooner than later.

Finishing off all this talk of mergers and acquisitions, Unity made a commitment to leading the RT3D space through their previous deal with Weta Digital – which I have attested to being a huge fan of. On their latest earnings call, we finally got to see progress on translating Weta’s tools from VFX to a real-time pipeline. This is a huge deal in my opinion and once the work is finalized and all their tools translated, it could well move the industry significantly forward and allow Unity to rival Unreal Engine, in key aspects of the high-end.

Unity’s Lion demo showcases their new fur tools, acquired from Weta and translated to real-time – along with other Unity first-party tools such as Ziva and SpeedTree.

Disclaimer: I am not a financial advisor, the opinions expressed in this article are entirely my own – always invest at your own risk.

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