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Unity Software Inc(U-N)

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Unity's CEO Is Out After "Runtime Fee" Train Wreck

Motley Fool - Tue Oct 10, 2023

Game engine developer Unity Software(NYSE: U) has built a popular platform for game development and other graphics-intensive tasks, but it's failed to translate that popularity into profits. The company generated $533 million in revenue during the second quarter, along with a $193 million net loss.

Unity generates revenue from subscription plans. While the platform is free to use for those who don't meet certain revenue thresholds, those who do need to shell out at least $2,040 annually for the Unity Pro plan, or much more for an Enterprise plan. The company also offers a variety of services, including in-game advertising.

This subscription business model with a generous free tier ensures a healthy pipeline of potential customers, and those who commit to using Unity's platform are unlikely to jump ship in the middle of video game development. There's a bit of a network effect that benefits the company. The more popular Unity is for game development, the more likely a developer is to choose Unity for a new game. A larger developer base means more resources and more support to help new developers get going.

Nickel and diming

Last month, Unity rolled out a new fee layered on top of its subscription plan in a ham-fisted attempt to boost revenue. The company isn't growing very fast anymore -- pro forma revenue rose just 11% year over year in the second quarter, and the dollar-based net expansion rate fell to just 106%. By attempting to charge developers a fee each time a game using Unity is installed, the company aimed to benefit financially from each game's success.

There were myriad problems with Unity's plan. First, many details were left to the imagination. How would game subscription services, where a game could be downloaded many times, work? Would free-to-play games that generate little revenue per user even be feasible under the new model? Second, Unity planned on charging this "runtime fee" to those on the free plan. This risked killing off the pipeline of free users that could later convert to paid users by pushing them to alternatives. Third, Unity was angling to apply this fee retroactively to games that had already been released, not exactly a customer-friendly move.

The backlash was swift, and within about a week, Unity had largely rolled back its plans. The free plan would remain entirely free, there would be a cap based on revenue for the runtime fee, games built with older versions of the Unity engine would be spared, and both revenue and installs would now be self-reported by developers.

While Unity staved off an immediate crisis, its brand, its reputation, and the trust it's built with developers over the years all took a hit.

Changing course

Unity announced this week that CEO and President John Riccitiello would retire from both positions effective immediately. Riccitiello has been leading the company since 2014, guiding it through its initial public offering and its transition from perpetual licenses to subscriptions. But the runtime fee fiasco was a big enough black eye to prompt a leadership change.

For the time being, former Red Hat CEO James Whitehurst will take the reins as interim CEO and president as the company searches for a permanent leader. While Unity is unlikely to make any big strategic changes before settling on a new CEO, Whitehurst brings plenty of experience building and running a subscription software company.

Once Unity finds a new CEO, he or she will face the challenge of accelerating the company's growth and moving toward profitability without upsetting its developer base. That's a tall order, and it may ultimately require significant cost-cutting to make it work. Unity has already laid off hundreds of employees this year.

Shares of Unity have tumbled 85% from its all-time high reached during the pandemic. With a market capitalization of just over $11 billion, the stock still trades for more than 5 times full-year revenue guidance. That looks too expensive given the challenges the company is facing.

Unity must thread the needle with any new strategy or monetization model, being careful not to further damage developer relations. This constraint limits the company's ability to boost growth and turn a profit, and it makes the stock a risky investment.

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Timothy Green has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Unity Software. The Motley Fool has a disclosure policy.

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