Unity Technologies is one of our favorite companies. They are an important part of the gaming ecosystem, and we like games. They went public last month and reported their first earnings yesterday. We probably should have done a write-up for their IPO, but by just covering the earnings we save us (and you) from a 30-page Initiation report.

Unity makes tools for software developers building applications that use a lot of graphics. We phrase this obtusively for a reason, but in plain English, they make tools for game developers.

They started life designing “physics engines” for games. Coding gravity into a game is boring, most developers would rather spend their time designing guns and armor and outfits. Unity solved this by writing the code that makes games seem like they have coherent laws of physics. And then they added all kinds of other things of top of that. Developers take those tools and build their own designs and game logic on top. They are a tremendous time saver. Today, Unity is the most widely used gaming tool suite for mobile applications. Over 5 billion apps with their code inside get downloaded every month. They are strongest in mobile games, while their competitor Epic Games, has an equally formidable share in console and PC games.

Unity operates two main business lines – “Create” and “Operate”. Create are tools that help developers build games. Operate are tools that help developers monetize – mostly tools that help developers monitor user behavior and sell ads accordingly (yes, we are oversimplifying). The Create business charges on a usage basis, Operate operates largely through a revenue share model.

The Unity story is really fascinating. Their strategic premise holds that we are moving ever more communications online to digital formats and companies will increasingly need advanced, “3D” graphical tools to communicate more effectively. Unity has created that platform, and has distributed it incredibly widely to developers. They are now attempting to expand their accessibility to other customer pools. In their investor materials they talk a lot about how non-gaming customers are using Unity to design things like construction blueprints and cars. And on the call, they talked about eventually making these tools widely usable for the average consumer looking to beef up their TikTok videos and other social posts. We find this a truly compelling vision. This could be an incredibly important platform for the future.

But then there are the numbers. For the quarter, they reported a loss per share of ($0.09) on $201 million of revenue, comfortably ahead of expectations of $187 million and ($0.15). They guided to revenue of $202 million and a loss per share that we (roughly) calculate at ($0.13), this is slightly better than consensus of $196 million and ($0.16). Good results, but not a blow-out.

The bigger question is why aren’t they making more money. This is a company that is so deeply embedded in the mobile gaming ecosystem that Apple demonstrated its latest chip with a demo showing it running Unity. (And probably more significant, it means that Unity got to see Apple silicon long in advance of almost anyone else. Apple doesn’t lift the veil for many.) But in their 14 years of existence, they have never generated a profit, or even positive cash flow.

There is a perfectly reasonable explanation for this. If the opportunity is as massive as the company paints it, then they should absolutely be investing to capture as much of that potential for as long as the capital markets will tolerate. And with the stock trading at 40x Revenue that tolerance is pretty close to infinite right now.

So the question is how do they get to profitability. And here is where a few more doubts seep in. Their revenue is growing nicely, and they just raised prices a bit, but on the call expressed a deep unwillingness to raise prices again. We suspect that they can raise prices a bit, but only to a point. They are already capturing a large share of developers. So to grow their value they have to either get more non-gaming customers on board, or find more ways to capture value with additional services to existing customers.

On the call, an analyst asked about all this – why is Unity’s “take rate” so low. The analyst implied that this is a common question among many investors. Their answer was that they have a strategy to increase this monetization per customer, but that it will take many years to build.

The good news is that investors will be able to track some of this. The company gives out a fair amount of information about its number and monetization of customers. We will not get into all of these now, but can revisit them in the future. The bad news is that this remains a fairly intangible solution to a tangible reality.

Our take is that the stock is actually a buying opportunity for the short term, the near-term trends continue to work in its favor. However, the longer-term question remains open.

We have followed Unity for a long time and really like their story. We play a lot of their games. And we buy into the strategic vision of a more graphical future. That being said, there a lot of worries beyond that fundamental under-monetization – competition, gaming platform power and the very unproven notion that non-gaming customers will adopt Unity’s technology.

Deep down in our hearts, we want to believe. But in our heads, we are not quite there yet.