Game Development Software: Picks and Shovels for the 3D Rush
Gaming is an undeniable long-term growth opportunity. Games like Fortnite have become a growing part of pop culture, game streamers are taking young audiences away from mainstream and YouTube content, and esports has emerged as an exciting way for gaming fans to watch the best gamers in the world compete. Underpinning the emergence of gaming across multiple verticals is game development software. In some ways, these platforms from Unity and Unreal Engine are the unsung heroes of gaming. The tools these platforms provide game developers enable them to build new and richer experiences at a faster rate than building the core software in-house. Without these platforms, gaming would not be the growth opportunity it is today. As the foundation of gaming, we view game development software as a great long-term growth opportunity for several reasons.
The Gaming Market Continues to Grow
As gaming becomes a larger component of popular culture, the market continues to grow. More people are playing games every year. Nvidia’s CEO Jensen Huang said it best: “I’ve always believed that the video game market is going to be literally everyone. In 10-years’ time, 15-years’ time there’s going to be another billion people on earth. And those people are going to be gamers.”
Newzoo estimates that the overall gaming market was $148.8 billion in 2019, up 7.2% y/y. This breaks down into three core gaming formats: mobile ($68.2 billion of the market total in 2019), PC ($35.3 billion) and console ($45.3 billion). To estimate the amount spent on game development software, we analyzed the research and development budgets of the three major game publishers: EA, Activision, and Take-Two. Those three companies spent an average of 17% of their net revenue on R&D in CY18/FY19, which we think is a fair representation of the overall industry. Applying the 17% R&D estimate on an overall $149 billion industry implies $25.3 billion in R&D spend in 2019. We estimate about 12% of R&D budgets are spent on software tools and licenses, thus the overall game development software market was around $3 billion in 2019. We expect the market to grow roughly in-line with the overall gaming market.
Gaming Is Becoming a Core Component of Social
Games like Fortnite, Minecraft, and Roblox are more than just games, they’re social platforms. Fortnite, developed by Epic Games and built on Unreal Engine, has become a “third place” for younger users to spend time with their friends. This digital third place is reminiscent of the third place that Starbucks has long prided itself on creating — a place where people can gather and “deepen human connection.” Fortnite fosters the third place atmosphere for its users through curated experiences and content. Fortnite has hosted a Marshmello concert, sold digital Jordan content, and done multiple crossovers with movie franchises including The Avengers, Batman, John Wick, and Deadpool.
We’ve hypothesized before that the next major social network might be a video game, In short, all meaningful social internet platforms are worlds that merge elements of identity and reality so users can interact in a compelling way. Fortnite as a world merges an avatar you play with your real identity with a purely digital world. You can squad up with friends to hang out in the digital world, and you can interact with others by trying to beat them at the game.
In hindsight, if social internet platforms as worlds is axiomatic, it was inevitable that social networks and games, which are virtual worlds, would intersect. The simple liking and favoriting mechanics of Facebook and Twitter are only indirectly game-like, but Snapchat leverages streaks, a direct game mechanic, to great success. TikTok is a world of users playing IRL games. Fortnite is a game.
As digital third places continue to emerge, many will be built on game engines as we move beyond traditional text- and video-based social media. These platforms allow developers to focus on what matters, designing and creating compelling virtual worlds for their users.
Game Development Software Is Being Used in More Non-Gaming Applications
Aside from game developers themselves, game development software is now used by several other industries, including:
Automotive, Transportation, & Manufacturing. Automotive companies use game development software to design and engineer vehicles, as do manufacturing companies for physical products. Developers build designs into 3D experiences to allow internal teams to refine products prior to production and external customers to experience products before making a purchase.
Film, Animation, & Cinematics. Game development software is also used by CG content creators to develop short-form, episodic, and feature-length stories. These tools can expedite traditional development time because they are a real-time platform, meaning all departments (editing, animation, lighting, camera, sound, etc.) can begin working on a project at the same time and constantly iterate. Most notably, Disney and Jon Favreau used Unreal Engine and LED walls to film The Mandalorian.
Architecture, Engineering, & Construction. Architects and construction professionals use game development software for real-time rendering and 3D display of building environments. This allows clients to experience construction projects in VR before they are built, enabling faster iteration and lower build costs.
While the gaming market will provide stable growth for game development software, expanding into markets outside of gaming should drive consistent mid-teen y/y growth for several years. We view Autodesk and Adobe’s subscriber bases as reference points for this expansion. Autodesk had 4.3 million total subscribers in FY19. We estimate Adobe had over 13 million at the end of 2019. Assuming a 30% overlap, that would mean 16 million total subscribers across those software platforms. If we assume a quarter of those subscribers could benefit from leveraging game development software, there’s a market opportunity of 4 million total subscribers. A blended average ARPU of $1,500 would suggest a $6 billion long-term revenue opportunity in the non-gaming markets.
Game Development Software Is Critical for AR/VR Applications
AR and VR remain potentially transformative technologies and provide long-term optionality to 3D software platforms, as the emergence of both technologies will create an acute demand for rich 3D experiences. Pokemon Go, the well-known AR game that is built on Unity, eclipsed $900 million in revenue in 2019 despite no longer being the social phenomena is was a few years ago. More of these success stories will come as AR adoption increases, and game development engines will power the majority of them.
According to IDC, worldwide spending on augmented and virtual reality will be $18.8B in 2020, an increase of 78.5% over $10.5 billion in 2019. We’re more cautious than IDC in our expectation for AR/VR uptake and see total revenue from the segment reaching $103 billion by 2025. If we apply the same framework we used for the gaming market — R&D as 17% of revenue and 12% of R&D to software tools — the AR/VR opportunity could generate $2.2 billion in development software spend by 2025. We assume a little less than half of that spend overlaps with gaming, thus AR/VR could generate about $1.1 billion in development spend incremental to gaming in 2025. While $1.1 billion may not seem an excessively large number, we believe it is a true market estimate of revenue that will in large part end up allocated to Unity or Unreal Engine.
Unity Is the Best Opportunity for Investors
The 3D game engine market is essentially a duopoly between Unity and Epic Games’ Unreal Engine. The primary difference between the two engines is that Unity focuses on broad market appeal via ease of use while Unreal focuses on creating the most realistic high-quality graphics. This makes sense because Epic is also a game developer. The company has created popular titles like Fortnite, Gears of War, and Unreal Tournament.
Unity CEO John Riccitiello has said, “It’s easy to make powerful tools that no one can figure out how to use, but what’s hard is making insanely powerful tools that are easy to use.” An example of the ease of use vs power philosophy is Unity’s focus on using the C# scripting language compared to Unreal Engine’s use of C++. C# is easier to learn, while C++ is more powerful and efficient. Unreal Engine has around 7 million registered developers vs Unity’s 9 million at the end of 2019.
We see offsetting competitive advantages between the two companies. Epic’s lucrative gaming business can help fund the development of Unreal Engine. Fortnite generated $2.4 billion in revenue in 2018 and $1.8 billion in 2019. Epic will likely continue to innovate as a premium engine that serves its own needs. However, the tradeoff of using a more powerful scripting language as the basis for developing with the engine, C++, will always mean a higher degree of complexity. Unity, on the other hand, will continue to serve the mass market.
Given this tradeoff between powerful complexity and simple usability, the 3D software development market isn’t likely to be winner-take-all. Both Unity and Unreal Engine can continue to serve their core customer bases with occasional overlap. We prefer the competitive position of Unity given the market dynamics. Since Unreal Engine caters primarily to AAA developers, it only addresses about a quarter of the overall gaming market described above, and many AAA developers build proprietary engines. Unity serves the other 75% of the market. When it comes to non-gaming applications, including those in AR/VR, non-traditional developers are likely to put a premium on ease of use when choosing between the platforms, favoring Unity.
We’ll explore the several tailwinds behind game development software over the coming weeks.