AppLovin And Unity: Not Lovin' This Unity

Aug. 11, 2022 6:09 AM ETAppLovin Corporation (APP), UIS56 Comments
James Emanuel profile picture
James Emanuel


  • Unity Software is in the process of acquiring ironSource.
  • AppLovin, a competitor of ironSource has tabled a merger proposition that would scupper the ironSource deal.
  • Should Unity Software accept the AppLovin terms or proceed with the ironSource acquisition?
  • I dig into the data and urge Unity to marry ironSource and to politely decline the loving approach from AppLovin.

Young couple kissing using smartphones, creative collage

Prostock-Studio/iStock via Getty Images

I hadn't looked at AppLovin (NASDAQ:APP) until it approached Unity (NYSE:U) with a bid to merge the companies this week.

I am a shareholder in Unity and so this caught my attention, so I decided to do some digging into the data.

What is Unity Software?

Unity is the world’s leading platform for creating and operating interactive, real-time 3D content.

Unity’s platform provides a comprehensive set of software solutions to create, run and monetize interactive, real-time 2D and 3D content for mobile phones, tablets, PCs, consoles, and augmented and virtual reality devices.

The really exciting part is that we are moving into an era that will see the gamification of the internet, something that people refer to as the Metaverse. Essentially, until now, the internet has been nothing more than a collection of pages that contain information (and the occasional embedded video or animation). However, that is all changing. The internet is tending towards becoming an immersive 3D experience.

3D Immersive Experience Unity Software

3D Immersive Experience (Unity Software)

Unity is the go-to solution for creating world-class interactive and immersive real-time experiences that bring products and ideas to life. As such, Unity is likely to be the primary beneficiary of this evolution of the internet.

By analogy, think about the Californian gold rush of 1848 to 1855. Sure, the odd prospector got lucky and struck gold making untold riches (the equivalent of winning the lottery back then), but most people lost more than they gained. However, the companies that sold picks and shovels, plus companies such as Levi Strauss, made a killing. The smart thing to have done back then was not go prospecting for gold, but to invest in those selling the tools that were needed for prospecting.

Unity is the company selling the picks and shovels, and the denim, for the 21st Century gold rush that is the Metaverse. That's why I'm invested. Better still, other than EPIC Games which is not a public company but is majority owned by Tencent (OTCPK:TCEHY), there is little or no competition for Unity. It has a huge moat.

See this video for demonstration of the power of Unity Software

It is estimated that Unity powers in excess of 70% of app based games, but it is also pushing into industries beyond gaming. These include the automotive industry, architecture and the movie business to name just three. The beauty of this business is that it is a set of very powerful tools that developers need. There are more than 1.5 million active Unity developers worldwide, but it is estimated that over 2 billion people use apps that run Unity real time 3D content.

Unity Software: The World Engine

3D Immersive Experience (Unity Software)

That is a huge market audience for monetization purposes. Most app developers are great at creating apps but not very adept at monetization. This is a huge opportunity for Unity to add value.

It is for this reason that it intended to acquire ironSource, an app monetization platform (more on this later).

AppLovin is a competitor of ironSource.

What Is AppLovin?

AppLovin's Palo Alto business helps app developers monetize their software. AppLovin also has its own portfolio of mobile games.

It derives significant revenue from the distribution of apps through third-party platforms and almost all of its in-app purchases are made through the payment processing systems of these third-party platforms.

The company plans to grow aggressively, apparently through acquisition. These include German app marketing company Adjust, mobile game developer Machine Zone Inc, software development kit-management platform SafeDK and in-app header bidding company Max Inc.

If you strip out the growth that flows from acquisitions, organic growth at AppLovin is insignificant. More particularly, it seems to be paying way too much for top line growth.

The cash flow statement reveals that since 2018 it has spent approximately $4.5bn CAPEX on acquisitions plus another $4bn in OPEX to grow the top line from $483m to $2.8bn.

While its asset base has ballooned (mostly Goodwill and Intangibles) the Return on Assets has collapsed from near on 50% to 0.6%. Asset turnover has halved from 0.90x to 0.46x.

Adept capital allocation this is not.

Let's delve deeper into management competence.

AppLovin Management

Long term debt at AppLovin has increased substantially from $796m to $3.2bn (net debt from $520m to $1.7bn) in the 2018 to 2022 period. The debt to equity ratio stands at 150% so this is a company that is very leveraged. Debt at 6.5x EBITDA makes me feel uncomfortable and the business is still pushing ahead with new mergers and acquisitions!?!

Add to that a need to fund an increasing negative working capital position and I am starting to feel uncomfortable about the profligacy of the AppLovin management. Said differently, this is not a prudently run business.

Given the current macroeconomic situation of high inflation and rapidly climbing interest rates, this makes for a precarious situation.

The other thing I find telling about the management of this business is its attitude to stock based compensation. Operating income for the year ended 2021 was $166m falling to $41m on an LTM basis. Against this backdrop it saw fit to award $133m and $148m of stock based compensation respectively in each of those years. In other words, the business is not operating for the benefit of the shareholders.

Silicon Valley tech types seem not to grasp fundamental corporate economics. They seem not to understand that running a public company is about acting in a fiduciary capacity for and on behalf of shareholders.

Why do I want to invest in that kind of a business set up?

AppLovin Valuation and Unity Offer

AppLovin, backed by KKR, enjoyed an IPO in April 2021 raising $2bn and valuing the company at $28bn. This was at the time when, post pandemic, the market lost its head in relation to realistic tech valuations. Bear in mind that KKR became involved in AppLovin back in July 2018 with a $400m investment which valued the business at $1.4bn. This followed the collapse of an acquisition by Chinese private equity firm Orient Hontai Capital which also valued AppLovin at $1.4bn, so we can assume that was a fair valuation back then. However, the IPO valuation of $28bn implies more than 111% CAGR over four years that followed.

AppLovin's IPO

AppLovin IPO (Nasdaq)

Does that increase in market cap match the intrinsic growth of the company? Here is the evidence. Top line revenue grew from $483m to $2.8bn (55% CAGR), but that was mostly driven by costly acquisitions and huge increases in OPEX. Said differently, AppLovin appears to have bought top line growth by sacrificing margins. Operating margins in 2018 were a healthy 48%, but these fell sequentially in the years that followed and today they stand at a paltry 1.5%.

The price to sales multiple in 2018 was 2.9x, but by 2022 it had ballooned to 10x. This makes no sense when profit margins have collapsed.

Perhaps this is why the market cap has since corrected somewhat. Today it stands at $13.6bn at a sales multiple of 4.8x, but on a 1.5% operating margin that is still way too high.

So I think it fair to conclude that AppLovin is hugely over priced in the market and it wants to use its over inflated stock as currency to buy in to Unity in an all-stock deal worth an implied value of $17.54bn, but if AppLovin is still 10x overvalued, then it is really buying into Unity at closer to $1.75bn (it's easy to see why this works for AppLovin).

Unity, Just Say No

For the same reasons that this works for AppLovin, it should be refused by Unity.

To make matters worse, if the AppLovin deal goes through then that will scupper the Unity acquisition of Israeli company ironSource (IS).

IronSource Unity acquisition

IronSource IPO ('CNBC')

ironSource and AppLovin are competitors.

Why would Unity merge with AppLovin and be left with only 55% of the joint enterprise, when it could merge with ironSource and own 73.5% of the joint business?

Both Unity and ironSource have much stronger gross margins than AppLovin which means that an ironSource marriage will not dilute gross margins for Unity whereas an AppLovin marriage likely would.

More particularly, ironSource is growing its top line, maintaining its 82% gross margins, generating 15% operating margins and 10% net margins.

The balance sheet is clean with no long term debt. In short, ironSource is a better managed business and a far better fit for Unity.

Summing It Up

Unity's business is split into:

  1. Create Solutions (consisting of Unity Engine subscriptions and other professional services)
  2. Operate Solutions (consisting of Unity Ads, Unity In-App Purchases, and other tools, which was newly established in 2015)
  3. Strategic Partnerships (which have included ventures with Apple, Google, Alibaba and Facebook amongst many others).

Unity has a huge moat around Create Solutions and that is its core competitive advantage and its engine for growth.

However, Operate Solutions is a key to unlocking value and this is where it needs to bolster its offering (hence the appeal of service providers such as ironSource or AppLovin).

Why is this key?

Most developers are great at creating engaging apps, but they are not expert in commercialization or monetization. Since they already use Unity for the creative element of their app, they will invariably also use it for the monetization aspect if that is on offer. So the power of the suite of tools offered by Unity is quite incredible and in this way, creative developers become ever more dependent on these tools. Unity is effectively creating an eco-system of tools for the virtual world in the same way that Alibaba (BABA) successfully created eco-systems for commerce.

Said differently, by monetizing the apps of its customers, Unity is monetizing its own business on complimentary horizontals and verticals.

Unity advertising enables developers to monetize their game by selling ad-space to advertisers, or for a game studio to acquire more users by advertising its own products. Unity Mediationᴮᴱᵀᴬ solutions enable publishers with the tools to easily expand their ad-demand by driving more competition for their inventory.

Then there is Metaverse monetization. This requires blockchain technology because virtual assets will only have a value if they take the form of non-fungible tokens (NFTs). Unity has secured several key partnerships with blockchain technology providers such as Venly (formerly Arkane Network). With the release of the Arkane blockchain gaming SDK for Unity, developers can publish in-game items from within Unity straight to blockchain without requiring deep knowledge of blockchain, smart contracts or transaction handling.

NFTs, just like crypto-currencies, are stored in a wallet and transferred via a blockchain. However, in the context of a Unity based game, the concept of a ‘white label’ wallet is key to the whole process. A white label wallet is owned by the app not by the user which means that the app can add to, and remove from, this wallet with ease. In this way, a user of the app will have an "inventory" of assets that can be traded within the game creating a virtual world without complicated third-party dependencies.

Unity is currently pre-profit and expected to break into the black in 2023. It has been investing very heavily in entrenching its position as the dominant player in virtual and augmented reality. So while earnings are still negative, the intrinsic value of the business is going from strength to strength.

By way of example, Unity is expanding its capabilities both organically and by acquisition. Recently it has acquired the tools and award-winning engineering talent of WETA Digital. These tools were foundational in screen content including Avatar, Black Widow, Game of Thrones, Lord of the Rings, Planet of the Apes, Wonder Woman, The Suicide Squad, and more.

Pre IPO acquisitions included Applifier (mobile service provider), Playnomics (a data analysis platform for developers now Unity Analytics), Tsugi (continuous integration service no known as Unity Cloud Build), Multiplay (multiplayer server game hosting), Vivox (cross-platform voice and text chat used in games including Fortnite and League of Legends, which is noteworthy because both games use EPIC Games’ Unreal Engine, but still Unity has a stake in those games via Vivox), deltaDNA (game analytics), ChilliConnect (live game management platform), Obvioos (3D application streaming), Artomatix (developer of AI-assisted material creation tool called Art Engine), Codice Software (distributed version control system Plastic SCM) and Finger Food Advanced Technology Group. While many of the gaming applications have the ability to be applied to industries outside of gaming, there have also been non-game sector acquisitions including Digital Monarch Media (virtual cinematography).

Since its IPO in Sept 2020, acquisitions have included:

- Parsec (planned acquisition announced Aug 2021) desktop streaming software

-SpeedTree (July 2021) is the leading vegetation modeling and environment creation tool, allowing filmmakers, architects, artists and game designers to build lush digital worlds.

- PiXYZ (June 2021) provides 3D preparation and optimization software, allowing engineers to import 3D data such as cars and planes and optimize/develop these models with VR capabilities.

- VisualLive (March 2021) is a tool for architects/contractors to overlay CAD/BIM models onto a physical jobsite in AR within minutes, integrating directly with Autodesk.

- RestAR (December 2020) empowers fashion brands, online retailers and marketers to scan physical objects with a mobile phone and render a digital twin.

- MLAPI (December 2020) a multiplayer networking framework

The final piece of the jigsaw is the monetization piece which either ironSource or AppLovin can bring to the table. Unity has already approved the merger with ironSource and the deal was due to conclude later this year. So the question that we now need to ask is whether or not AppLovin is a better deal.

On the basis of the evidence in this article, I think not.

However, the approach by AppLovin, which values Unity stock at over $58 indicates that the business is worth far more than the price ascribed to it by the stock market in recent months.

In my humble opinion, Unity in future will be as ubiquitous, and as successful (if not more so), than the likes of Adobe. This is a business that is really only just at the start of an epic journey. Given the recent tech stock sell off, Unity is also available at bargain prices in the market so I am increasing my position substantially. This will surely be a multi-bagger stock and one of the best performers of the next decade.

This article was written by

James Emanuel profile picture
Author of top selling investment book "Success in the Stock Market", James is the CIO of the investment partnership Rock and Turner, website: James has enjoyed a 25 year career in the finance and banking industry. He has worked at tier one banks including Citigroup Inc and Deutsche Bank Wealth and Asset Management. The book, Success in the Stock Market is available on Amazon:

Disclosure: I/we have a beneficial long position in the shares of U either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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