Summary

• Unity Software's stock, despite past struggles, is set for a comeback in 2025.

• Unity's graphics engine dominates the mobile game market and is having increasing success in consoles, PC games, and AR/VR, offering developers ease of use and interoperability.

• The gaming industry is stabilizing, and Unity's focus on its core business and reduced costs will drive sharply improved profitability.

• Unity's competitive moat, asset store, and market position make it a strong investment candidate within the gaming industry.

Looking for software companies that could deliver outsized returns in 2025? I believe Unity Software fits that description. While the company's stock has been stuck in a brutal downtrend for years now, the firm's operating results have recently turned in a positive direction, and it should be just a matter of time until the stock price begins to reflect the improving outlook:

Data by YCharts

For those unfamiliar, Unity Software operates a game engine, also called Unity, and has done so for 20 years now.

The Unity game engine serves as a sort of operating system for a video game. Unity's engine allows developers to build the core game loop, scene building and switching, UI & controls, AI/NPC controls and functionality, in-game physics, sounds, saving and user authentication, and so on.

Historically, major game studios built their own proprietary graphics engines. However, Unity saw an opening in the market with the rise of casual games. As properties such as Farmville, Angry Birds, and Candy Crush took off, it made potential developers realize there was money in simpler games aimed at mobile audiences. Unity allowed smaller or independent development studios to quickly build casual games and monetize them with ads and in-app purchases.

Unity rapidly got to more than 50% market share for game engines within the mobile space, and it retains a dominant position in that market today. Over the years, Unity has been able to build on that, and it has now broadened its reach into consoles, PC games, and even virtual and augmented reality applications. Unity's interoperability makes it easy for developers to build a game for one channel, such as PC, and then port it to mobile and consoles if desired.

Unity was in a perfect position in 2020. With folks stuck at home and having plenty of free time and extra disposable income, the gaming market positively skyrocketed. Developers poured tons of money into new game projects, and the market embraced it at scale. The casual market in particular took off, attracting new demographic groups into the gaming hobby.

Why Unity Shares Crashed

Investors extrapolated out Unity's rapid revenue growth from that period and assumed the sky was the limit. However, as the economy started to reopen, the gaming boom turned to bust. Over the past two years, we've seen record layoffs across the industry, with some analysts pointing to the current gaming bust as being the worst since the Atari crash of 1983. It's grim times out there. Almost every month, we hear reports of another major development studio engaging in mass layoffs or shutting down completely.

Unity has had its own company-specific problems as well. Under former CEO John Riccitiello, Unity attempted to push through a dramatic fee hike to developers, with the intention of charging based on the number of times a Unity game or app is downloaded. Developers protested and started to move to rival engines, such as Unreal and Godot, in large numbers. Unity eventually walked back the runtime fee hike, and Riccitiello left Unity following that incident.

Under Riccitiello, Unity engaged in what some viewed as empire-building. Unity made a number of M&A deals, with purchases such as Weta Digital and IronSource, that appear to have been major misallocations of Unity's capital. In the case of Weta, for example, Unity paid $1.6 billion for the digital effects company only to shut it down entirely several years later.

While Unity is the engine behind a large number of leading mobile, console, and PC-based video games, it remains heavily reliant on mobile advertising to drive revenues. This has been an issue as Unity's ad solutions package has fallen well behind rival AppLovin (APP) and thus U stock has gotten left in the dust while APP shares have soared.

Unity's Long Turnaround Is Finally Working

It's understandable why investors have largely thrown in the towel on Unity stock. The company has endured a variety of self-inflicted errors and its industry, gaming, is going through arguably its worst downturn in 40 years.

However, Unity has made the tough moves necessary to get the company back on track. It has endured multiple rounds of mass layoffs, including one wave that cut 25% of the workforce earlier this year. This was a necessary move, as Unity's workforce dramatically bloated from the IPO onward. The company didn't historically need a large labor team to manage its core Unity graphics engine, but it hired extensively for a variety of non-core projects, along with taking in lots of employees from its various M&A endeavors.

It seems like Unity had been operating with an Alphabet (GOOGL) sort of model, where the company was investing significant resources in other projects that were far afield from Unity's core business. That works for Alphabet because businesses like Search have such robust cash flows. Unity, by contrast, is a less mature operation and simply didn't have that sort of discretionary resource pool to throw at unproven projects that might pay off in 5–10 years or never pan out at all.

Unity slashed its non-essential businesses, leading to a dramatic 84% year-over-year drop in revenues from its non-strategic portfolio. This is where the positives start when analyzing the company today.

Unity is on pace to deliver a roughly 18% decline in revenues for full year 2024 as compared to last year. But in Q3, revenues from the core business surprised to the upside. The winding down of the non-strategic portfolio is making the top-line results look poor, whereas core units such as the ad business have seen improved performance sequentially. Meanwhile, the cost base is now much lower thanks to all the staff reductions.

Additionally, Unity experienced significant one-time charges related to all the layoffs over the past year. The company will enjoy much stronger comps in 2025 as it doesn't have similar severance expenses going forward, and its revenue picture will be clearer once the shuttered non-core businesses are no longer reflected in results.

Meanwhile, the overall gaming industry appears to have stabilized. Analysts expect full-year 2024 results to be roughly flat or perhaps up marginally. And the industry should return to growth in 2025.

Unity: Taking A Growing Share Of An Expanding Market

The global game market generated about $184 billion in 2023, and analysts see that growing to around half a trillion dollars annually in 2033. Global movie box office revenues were just $34 billion by comparison in 2023 (down 20% from 2019).

Meanwhile, Spotify Technology (SPOT) is doing $16 billion annually in revenues, and Netflix (NFLX) is around $37 billion annually. Spotify currently has a $90 billion market cap, and Netflix's is about $400 billion. Needless to say, if and when Unity can carve out a $10 billion chunk of annual revenues from gaming, the stock will have tremendous upside from here and today's $10 billion market cap for Unity will look like a tremendous bargain in hindsight.

I believe Unity has the potential to be a dominant player in gaming, in the same way Spotify and Netflix have carved out large chunks of the music and video streaming markets.

That's because there are only two major independent game engines out there, Unity and Unreal. Unreal produces better graphics and is best for high-end games. But it has a reputation for being rather finicky, not easy for developers to use, and not running well on lower-end consoles and PCs. And competitions at the other end, like the Godot engine, are fine for smaller projects but struggle to hold up to the needs of higher budget games.

From my understanding, Unity strikes a happy balance of producing good enough graphics while being easy for even novice developers to master.

Unity's asset store is also a major benefit. Its unrivaled supply of prebuilt characters, buildings, units, scenery, and so on makes it easy for developers to get assets that they can plug and play into their games. This makes the game development process easier and faster, particularly for smaller studios that don't have a large art team. And Unity earns a cut on everything sold through the asset store.

These factors help give Unity a competitive moat, and this was proven during the recent runtime fee controversy. There was a widespread movement to boycott or move away from Unity at that time. However, many developers tried Godot or other alternatives and ultimately ended up returning to Unity due to its ease of use, asset store, and platform interoperability. While Unity's prior attempt to raise prices was tone-deaf, I believe that incident highlighted the underlying value of Unity's engine and ultimately enhanced its competitive positioning.

Speaking of which, I expect Unity and chief rival Unreal to earn a larger market share going forward. That's because so many large game development studios have consolidated operations and shrunk their headcounts during the recent industry bust.

As a result, there is less interest and financial willingness to keep paying for the development of proprietary game engines, as the IRR on these sorts of investments is not certain. Additionally, developers have increasingly realized that their employers may fire them at any time and thus are less willing to do work within a proprietary engine that would have little value on a resume if they were to get laid off. Long story short, I believe much of game development will move from proprietary engines to either Unity or Unreal going forward, giving Unity a growing slice of a rapidly expanding total addressable market.

Unity's Bottom Line

The company's Q3 results were ahead of expectations and the company raised guidance going forward. It seems clear that the worst has passed for Unity, operationally speaking.

Analysts already see Unity being solidly profitable on an adjusted earnings basis, with the stock at around 29x projected forward earnings. I would caveat that, however, with the fact that there are significant costs such as stock-based compensation at play and the company is still not profitable on a GAAP basis. Regardless, profitability will look a lot better in 2025 thanks to the much reduced cost base and the fact that one-off costs such as severance expenses that the company paid in 2024 should not reoccur going forward.

Over time, gaming will likely continue to take more mindshare away from alternatives such as cable TV. Demographics will also assist here, as young gamers get older, they will have more spending power and help the industry continue to become more mainstream.

Historically, it's been somewhat challenging to invest in the gaming industry due to the lack of an obvious category leader such as Netflix or Spotify. Buying individual game developers, for example, is often quite risky as they are always just a few failed game releases away from seeing their share prices tank. Just ask shareholders of Ubisoft Entertainment (OTCPK:UBSFY) or Embracer Group (OTCPK:THQQF) if you don't believe me.

By contrast, Unity has established itself as a neutral vendor to an increasingly large chunk of the overall game development industry. Unity is independent and not biased toward any of the major studios. Thus, it is well-positioned to attract businesses running the gamut from small indie shops up through triple-A development studios. Unity will return to growth in 2025, it has fixed its cost bloat, the overall gaming industry is coming out of its slump, and Unity is set to get a larger chunk of the pie as competition from proprietary game engines diminishes.

The Unity turnaround is starting to pay off, and following the company's Q3 earnings beat and raised guidance, shares are set to move higher in 2025.