Soul-searching question, has Unity's "bottom" been reached?

Hello everyone, I am Dolphin Jun!

After the US stock market closed on November 7th, Eastern Time, the leading game engine company $Unity Software(U.US) released its Q3 2024 earnings report. Although the announcement in September to cancel Runtime fees has led to a nearly 30% surge in stock price, Dolphin Jun still believes that the core issue supporting a solid valuation return lies in when the Grow business will rise from its current stagnation due to more damaging competitive issues.

Regarding this issue, does the Q3 report reflect signs of business recovery? Let's first take a look at the financial report.

Unity is still at a critical turning point, but during this period, most financial indicators lag behind changes in the company's strategy and operations, while operational information is mainly discussed in the conference call. Therefore, after carefully reading the shareholder letter and the conference call content, Dolphin Jun will share specific thoughts on this earnings report.

Let's go through the financial performance via several key operational questions:

1. Repeated turmoil, the engine still has a user base: In the past year, as Unity's pricing model has been in turmoil, there have been voices in the industry abandoning Unity for Unreal/Cocos. Although the cancellation of Runtime fees shows a certain degree of concession from Unity, the stable growth of core subscriptions indicates that Unity still holds irreplaceability in the eyes of its "die-hard fans."

In Q3, according to the disclosure of the Strategic portfolio, Create grew by 5.6%, showing a slight recovery quarter-on-quarter, while the major engine subscription revenue continued to maintain a healthy year-on-year growth of 12% (the growth rate for the previous two quarters was 13%).

The company explained that this growth mainly relies on an increase in average revenue per user. On one hand, it is driven by price increases every 1-2 years, and on the other hand, it is promoted by users shifting from lower-priced packages to premium packages. For example, after canceling Runtime, Unity plans to raise prices for Pro and Enterprise by 8% and 25%, respectively, starting January 1, 2025.

However, Dolphin Jun is more concerned about whether the "subscription customer base " is continuously increasing. This metric reflects how many customers lost due to Runtime fees have returned due to the company's strategic adjustments, and if Unity is to maintain its growth attributes, expanding its customer base is a fundamental prerequisite.

Unity 6 was released in early October, and during the conference call, management expressed satisfaction with the current customer adoption (over 500,000 downloads). Management is very confident about the subsequent adoption of Unity 6, as it has changed the original iterative update method by providing a powerful testing environment to offer customers real-time experiences of new features, thus achieving timely improvements and product feature launches Therefore, for Unity 6, the company believes that this generation of the engine will become the main driving force for subsequent growth.

2. Advertising share is still being encroached upon: Although the engine's user base is relatively stable and recovering, Dolphin has repeatedly mentioned that the performance is putting pressure on valuations, and more importantly, the Grow business has been struggling for a long time.

In the third quarter, the Grow business in the Strategic portfolio declined by 5% year-on-year, while the overall industry performance during the same period was quite good, as evidenced by the impressive results of advertising stocks in Q3. However, compared to peers, Unity's performance remains weak, and the unexpectedly explosive results of direct competitor Applovin have made Unity's struggles painfully visible.

In the last quarterly report, management mentioned the adjustments they are working on:

1) They have brought in two experts to adjust the advertising business, one of whom is Jim Payne, a co-founder of the mobile advertising marketing platform MoPub, who later founded Max advertising systems. This Max platform was launched after integrating with Applovin and is one of Applovin's core advertising technologies, indicating that Unity has directly invited back a "core backbone."

2) They are increasing investment in machine learning and data stacks to repair the advertising technology that has been hurt by IDFA.

Dolphin believes that the above two actions will not lead to immediate repairs in advertising, especially since competitors have more mature and advanced technologies. Therefore, it is likely that due to the uncertainty in the pace of adjustments in the advertising business, management has not significantly raised the full-year revenue guidance, only increasing the portion that exceeded expectations in Q3.

3. Leading indicators are caught in a "dilemma": Several leading indicators that hinted at hope in the last two consecutive quarters showed signs of stagnation in improvement in the third quarter. Only (1) deferred revenue is still increasing quarter-on-quarter; for other items:

(2) New contracts decreased quarter-on-quarter; (3) Number of large clients experienced a net loss quarter-on-quarter (though the number of large clients in existing business increased quarter-on-quarter, possibly reflecting a return of clients after the cancellation of Runtime fees); (4) Remaining un-cancelable contract amount (including deferred and unpaid backlog) has accelerated its decline quarter-on-quarter; (5) Net expansion rate continues to deteriorate, dropping to 94% in the third quarter, which is also below market expectations.

Looking at indicators <1-5> together, it is evident that the short-term pressure on Grow has increased again: Deferred revenue mostly comes from engine subscriptions (at least signed for 1 year), and the quarter-on-quarter growth in deferred revenue confirms the stable growth of core subscription revenue in the engine business.

However, overall, customer demand has not shown a significant positive increase. Dolphin believes that aside from the expiration of the WETA partnership without renewal and the proactive optimization of Professional services and other businesses, the main issue lies within the Grow business

Combining the relevant descriptions from the management's conference call and the performance of peers like Applovin, Dolphin believes that this year is unlikely to see any significant improvement in the Grow business. Whether it’s talent acquisition or technological investment, ultimately, the results will have to be seen in next year's performance.

4. "Technological Investment" Offsets "Layoff Benefits": In the third quarter, there were still effects from layoffs (Q3 GAAP operating expenses decreased by 11% year-on-year, with SBC stock-based compensation down by 28.5%), but as Dolphin judged last quarter, the necessary investments made to repair advertising technology (machine learning, data stack) have offset the benefits from layoffs, slowing down the improvement in profitability (the operating loss rate in Q3 showed stagnation in improvement).

In the third quarter, there was also a sequential weakening of gross margin due to business structure. The weakness in the Grow business may have led to an increase in the revenue proportion of the low-margin Create business, slightly lowering the overall gross margin compared to the previous quarter. Ultimately, operating losses were reduced to 127 million, flat year-on-year, with adjusted EBITDA at 90 million, exceeding the company's guidance and market expectations.

From the conference call, the management repeatedly emphasized the pursuit of efficient investment, and given that the advertising technology investments are relatively easy to monetize, Dolphin believes that profits are not expected to be long-term weakened, of course, this is based on the assumption that Unity's Grow business can ultimately achieve steady recovery.

5. Performance Indicators Overview

Dolphin's Viewpoint

Compared to expectations, the overall performance in the third quarter is a beat. However, key forward-looking indicators also reveal some short-term pressures. The addition of the Max founder last quarter and the cancellation of Runtime head fees in September led the market to overlook short-term performance pressures and to celebrate prematurely.

By business segment, the Create engine business continues to recover, especially with a sequential increase in the number of large clients in "existing businesses" in the third quarter, reflecting positive feedback from clients after the cancellation of Runtime fees.

However, the Grow advertising business still faces the dilemma of losing market share to peers (the slowdown in Q3 was driven by an overall industry recovery). The problem is that Grow is precisely the core driver of profitability in the short to medium term. The bearish assumption is that if investments in machine learning and data stacks are made while advertising technology has not yet been repaired and shown results, the short-term pressure on profits will further increase under this expectation.

Therefore, consistent with the judgments made this year, Dolphin still believes that even if Q3 beats expectations, whether it’s the Create business starting to benefit from price increases next year or the potential recovery of market share in Grow's advertising under technological repair, a truly solid performance rebound and valuation reversal may still have to wait until next year. However, considering the situation in September of the last quarter, if the market still has the willingness to rush ahead, how much reasonable upward space is left for Unity's short-term valuation? Here, Dolphin attempts to make a "neutral to positive" assumption.

Combining the management's guidance for 2024 and market expectations, simply looking at the market capitalization of $8.8 billion as of the close on the 7th implies a valuation of 4.5x P/S (corresponding to 2025, with low single-digit year-on-year growth). If placed among advertising stocks, given the current state of Unity's advertising business, this valuation is relatively high.

However, Dolphin also believes that a key change in the third quarter is— Unity's shift in attitude towards customers, including the cancellation of headcount fees and the new iterative approach to real-time testing adjustments in Unity 6. For market funds, when it was announced in September that Runtime would start charging again, returning to the familiar growth path of "traditional software price increases," funds would have a much clearer view of Create's growth prospects. The stable growth rate of core subscriptions in the third quarter also continues to confirm the relatively solid user base of Unity's core engine.

This means that as Create gradually digests the impact of restructuring and returns to a double-digit growth channel, based on the original valuation center (7x P/S for 2025), with the advertising segment at 4x P/S, overall, before the performance shows a reversal, if the adoption rate of Unity 6 progresses well, or if market liquidity improves and sentiment is positive, there is still hope to continue to reach $10 billion. However, to go further up, Unity needs to quickly regain the market share it once lost in the advertising market. At least in the current situation where competitors have a technological advantage, the difficulty is still considerable.

The following is a detailed analysis

1. Basic Introduction to Unity's Business

Unity incorporated IronSource's operating conditions in the first quarter of 2023 and also adjusted the scope of its segmented business. Under the new disclosure structure, the segment business has been condensed from three (Create, Operate, Strategy) to two (Create, Grow).

The new Create solution includes the products originally under Create (game engine) and also incorporates the UGS revenue (Unity Game Service: a full-chain solution for game companies that helps solve game development, publishing, and customer acquisition operations) originally confirmed in Operate, as well as revenue from the original Strategy; however, starting in 2023, it will gradually close Professional service, Weta, and other product services;

The Grow solution includes the advertising business from the original Operate, as well as the marketing from the merger with IronSource (mainly Aura, Luna will close in Q1 2024) and game publishing services (Supersonic). Revenue contributions come from the subscription income of the game development main engine, and income from the advertising platform responsible for facilitating bidding, game publishing income, and so on

2. Create growth is clear, but Grow's prospects remain uncertain

In the third quarter, Unity achieved total revenue of $4.5 billion, a year-on-year decline of 18%, slightly above guidance and market expectations. Excluding the impact of restructuring, revenue from the Strategic Portfolio declined by 2% year-on-year, showing a moderation in the decline compared to the previous quarter.

Looking at the segmented business, the strategic partnerships and professional services within the Create business are still actively contracting, but core engine subscription revenue grew by 12% year-on-year, consistent with the 13% growth in the first and second quarters. On the other hand, Grow continues to be affected by competitors in mobile marketing capturing market share.

However, from the perspective of forward-looking operational indicators, overall, the positive momentum stagnated in Q3. Considering that core subscription growth is at 12%, stable compared to Q1 and Q2, along with the fact that deferred revenue, which reflects subscription demand, is indeed growing quarter-on-quarter, and the number of large clients in existing businesses is still increasing, it indicates that the short-term pressure is mainly on the Grow business :

(1) Net expansion rate

The net expansion rate is a growth indicator that the market generally pays attention to. The net expansion rate in Q3 is expected to continue to decline to 94%, a figure that represents a year-on-year decline in total revenue from existing customers over the past 12 months, indicating that existing customers paid less compared to the previous year.

This may be due to a. Unity actively shutting down some businesses, b. existing customers reducing the number of accounts or downgrading accounts, and c. direct loss of existing customers.

The net expansion rate has continued to decline to below 100% over the past year, which should also include the impact of existing customers being dissatisfied with the Runtime charging model and not renewing. However, after passing through a base period in Q3 and announcing the cancellation of the Runtime charging model in September, Q4 is expected to stabilize or even rebound in the net expansion rate with the return of engine customers.

(2) Number of large clients (annual payment exceeding $100,000) The number of large customers generally refers to clients in the engine business (with at least a one-year contract), so the changes in customer numbers over the past year have mainly been influenced by business restructuring. For example, some clients from Weta, professional services, or Luna have been lost after the company closed those businesses. Additionally, there has been a "downgrade in consumption" among customers on Unity, with annual payments dropping to less than $100,000.

In the third quarter, the number of large customers was 1,242, a decrease of 12 from the previous quarter. However, in terms of comparable ongoing business, the year-on-year figure was 1,230 last year, and 1,227 in the previous quarter (which was still declining quarter-on-quarter), indicating that some customers returned due to the cancellation of the Runtime model or that new customers were attracted. For instance, during the conference call, management mentioned new clients in non-gaming sectors, such as KLM Royal Dutch Airlines (VR cockpit training) and the German national railway operator.

(3) Remaining Contract Amount & Deferred Revenue

In the third quarter, the remaining contract amount declined year-on-year by 7.1%, and there was also a quarter-on-quarter decline, but this more reflects the deferred revenue from engine subscriptions, which net increased by 2.1 billion quarter-on-quarter. The two indicators show opposite trends, one good and one bad, which not only reflect the impact of business restructuring but also further indicate the drag of the Grow business on overall performance.

(4) New Contract Amount

The new contract amount indicator recalculated by Dolphin has declined quarter-on-quarter in the third quarter, halting the warming trend since the beginning of the year.

Marginal new additions often represent changes in customer attitudes towards cooperation with Unity. The quarter-on-quarter decline in the third quarter was influenced by the further closure of professional services, Weta, and other businesses (the revenue from the Strategic portfolio increased as a proportion of total revenue in the third quarter, reflecting further closures of other businesses).

Additionally, based on some public news reports, Dolphin believes that some customers in the third quarter may have been waiting to see the performance of the Unity 6 product launched in October before deciding whether to continue their subscriptions. Some customers also reported that they chose not to renew immediately in the third quarter because they had learned in advance that Unity might adjust its pricing model and preferred to wait for an official announcement.

As for whether there will be negative impacts from the price increase (Pro and Enterprise prices will increase by 8% and 25%, respectively, starting in January next year), Dolphin believes that while short-term impacts are theoretically unavoidable, compared to the positive feedback from the cancellation of Runtime, it is currently difficult to accurately assess the overall impact on Unity, and further observation of the Q4 situation is needed

Overall, the company's customer demand has not shown a significant positive increase, and there are still fluctuations in the short term. Dolphin believes that, in addition to the expiration of the WETA cooperation without renewal and the proactive optimization of Professional services and other businesses, the main issue lies in the Grow business.

Combined with the relevant descriptions from the management's conference call and the performance of peers like Applovin, Dolphin believes that it can be said that this year there is unlikely to be a significant improvement in the Grow business. Whether it is talent acquisition or technological investment, the true results will only be seen in next year's performance.

Management's clear guidance:

In the fourth quarter, both revenue and adjusted profit exceeded expectations, and due to the better-than-expected Q3, although the full-year guidance was raised accordingly, it was still based on cautious considerations regarding the advertising business, the management's upward adjustment of guidance is not substantial.

(1) The fourth quarter is expected to see Strategic Portfolio revenue between 422 million and 427 million, with a growth rate almost flat (-0.5%-0.7%), continuing to warm up compared to Q3, and the median of the guidance range is above market expectations.

(2) The expected full-year Strategic Portfolio revenue for 2024 is between 1.703 billion and 1.708 billion, which is an upward adjustment of 1.5% from the Q3 expectations. Although the warming trend remains unchanged, the upward adjustment of the full-year guidance implies that it only adds to the part that exceeded expectations in Q3, and the guidance for Q4 has not been raised in sync with the performance of Q3.

Dolphin believes that, as we judged last quarter, this is also a relatively cautious and conservative forecast from the management, reserving potential beat space brought by improvements in advertising technology and adjustments in the advertising department.

3. Short-term recovery with the industry, but still losing market share

Although Unity's growth and valuation focus mainly on non-gaming industrial scenarios, revenue from the gaming market still accounts for the vast majority of overall engine subscription revenue, so Dolphin generally also looks at the gaming industry situation.

According to Sensor Tower data, global downloads and in-app purchase revenue continued to rebound in Q3, reflecting an increase in player demand. Last quarter we mentioned that, based on the trend of the base cycle, the second half of the year is expected to continue to warm up.

The overall advertising industry in Q3 was also good, and Unity indeed followed the broader environment, showing some recovery in performance, especially reflected in the Grow business, which currently has relatively weak technological competitiveness, showing signs of month-on-month warming in the short term.

However, the issue of competition seems to remain unresolved. Unity's number one competitor—Applovin—has been aggressive and has shown no signs of slowing down during Unity's sluggish year. In Q3, the revenue from the software platform providing advertising matchmaking services grew by 66% year-on-year, which is the main contributor to Applovin's performance surge over the past two years Two years ago, Applovin attempted to acquire Unity to strengthen its mobile marketing landscape and fill the gap in its business chain with upstream game developers.

However, in the second half of 2023, with the widespread application of AI large models, Applovin integrated AXON technology, significantly enhancing the ability to precisely match advertisers with advertising platforms, compensating for the impact of Apple's privacy policy IDFA on ad tracking and targeted delivery.

During the same period, Unity had just acquired IronSource, but the integration process was extremely slow. Coupled with numerous management issues from the original leadership team, the issuance of additional shares to premium acquire was already highly questioned. In Q3 2023, Unity pushed for Runtime fees against customer wishes. The focus was wasted on how to inflate superficial financial metrics, further neglecting the improvement of technology to reduce the impact of IDFA.

Therefore, the current performance pressure is a backlash from past inaction. Withdrawing the unpopular charging method and increasing investment in technology, focusing on the repair of the product itself, is at least a step in the right direction. Although there may be income pressure and increased investment affecting the pace of loss reduction, as long as the investments are not ineffective, wasteful, or benefit transferring to employees, loss reduction is not the key issue at this moment.

In fact, Unity also has advantages relative to Applovin—Unity possesses an end-to-end full industry chain business. Under this influence, at least in the mobile game marketing field, as long as the advertising technology is patched up, there will still be the confidence to compete.

4. New technology investments offset the benefits of layoffs

In the third quarter, there were still effects from layoffs, with GAAP operating expenses declining by 11% year-on-year, and SBC equity incentives decreasing by 28.5%. However, as Dolphin Jun assessed last quarter, the necessary investments made to repair advertising technology (machine learning, data stack) have offset the benefits of layoffs, slowing the improvement of profitability, reflected in the stagnation of the operating loss rate improvement.

Additionally, in the third quarter, the gross margin may have been affected by the weak Grow business, leading to an increase in the revenue proportion of the low-margin Create business, slightly lowering the overall gross margin compared to the previous quarter.

However, the market has conservative expectations for the Grow business, leading to lower profit expectations. Ultimately, Unity's operating loss in the third quarter decreased to 127 million, flat year-on-year, with adjusted EBITDA of 90 million, exceeding company guidance and market expectations.

Management expects Q4 adjusted EBITDA to be in the range of 79 to 84 million, with full-year guidance between 363 to 368 million. Compared to the revenue increase, the profit increase is more significant, implying that the Grow business will further recover, driving an overall improvement in profit margins

In the third quarter, due to the arrival of several new executives, the newly granted options significantly increased quarter-on-quarter, which also raised the potential impact of equity dilution. It is very likely that the previously guided 2% equity dilution ratio by the management at the end of the year may also need to be adjusted upwards.

5. Cash Flow: Free Cash Flow Continues to Improve

There are currently no major issues with cash flow changes in the third quarter. As of the end of the third quarter, the company's cash on hand was 1.42 billion, an increase of 130 million compared to the previous quarter, mainly due to improvements in operations and maintaining a low level of capital expenditures.

The company has no interest-bearing debt, and financing relies on direct stock issuance or convertible bonds. As of the end of the third quarter, the total face value was 2.2 billion, with no redemptions or new issuances this quarter. As performance gradually moves past the worst stage and cash flow stabilizes, there is currently no need to worry about the impact of financing needs on equity dilution.

Dolphin Investment Research "Unity" Related Reading:

Earnings Season (Past Year)

August 10, 2024 Conference Call: Unity: Discussing Goals Too Early, Execution is the Top Priority Right Now (2Q24 Conference Call Summary)

August 10, 2024 Earnings Review: Surge Without Reason, but "New" Unity is Promising

May 10, 2024 Conference Call: Unity: Improvement in Customer Communication, Operational Improvement in the Second Half of the Year (1Q24 Conference Call Summary)

May 10, 2024 Financial Report Review: Unity: Is the Painful Healing Nearing Its End?

February 27, 2024 Conference Call: Unity: Lightening the Load, Focusing on Software

February 27, 2024 Financial Report Review: Unity Plummets? Poor Management, Terrible Moves

November 10, 2023 Conference Call: Unity: More Streamlined, More Focused (Unity 3Q23 Conference Call Summary)

November 10, 2023 Financial Report Review: Constantly Shaky Moves, Unity Weathering the Storm

August 3, 2023 Conference Call: AI and VR, Significant Progress Expected in the Next Two Years (Unity 2Q23 Earnings Conference Call Summary)

August 3, 2023 Financial Report Review: Unity, Repeatedly Speculated, Still Delivers Results

May 11, 2023 Financial Report Review: Unity: Financial Report Beat, Taking Off from Wuhu? Let's Wait and See…

February 23, 2023 Conference Call: Management: Currently in a Recession, Focus on Recovery Timing (Unity 4Q22 Conference Call Summary)

February 23, 2023 Financial Report Review: Unity: Strong Partnership with IronSource, Yet Hard to Resist Industry Winter?

In-depth

On October 12, 2022, "The Winter of Gaming Has Arrived, Where Is the Warm Spring?"

On April 1, 2022, "Several Interesting Points in the 'Unity 2022 Global Game Report'"

On March 17, 2022, "Can Valuation Be Boosted by the Imagination of the 'Metaverse'? Unity Says It Can"

On March 9, 2022, "The Unclear Metaverse, the Clear Unity"

Risk Disclosure and Statement of This Article: Dolphin Investment Research Disclaimer and General Disclosure