Unity: Customer Relationships, Product Quality, and Execution (3Q24 Earnings Call)

The following is the summary of the Q3 2024 earnings conference call for $Unity Software(U.US). For financial report interpretation, please refer to "Soul Searching: Has Unity's 'Bottom' Been Reached?"

1. Overview of Key Financial Metrics

2. Management Report

1) Key Actions in Q3

When we gathered last quarter, we announced our plans to make meaningful changes at Unity. We stated that we wanted to prioritize execution and discipline to drive faster product innovation and restore our strong and genuine connection with customers and the community. Over the past 90 days, we have achieved these goals in various ways, and we have felt the impact of this positive momentum both internally and externally.

First, we eliminated the Runtime fee and reverted to a traditional subscription model, implementing price increases in a way that customers understand. This change has helped us streamline the renewal process and re-establish our connection with the customer community.

Subsequently, we delivered Unity 6, which is our best-performing and most powerful version ever. Unity 6 marks a fundamental change in the way we will approach our development cycles in the future. At launch, we introduced a new upgrade philosophy, aimed at allowing customers to leverage new features over time through significantly enhanced testing and real production environments, while minimizing sacrifices to stability. Maintaining a better and more consistent feedback loop will help ensure that the tools we provide deliver tangible changes for customers every day. The combination of new methods, new pricing, and new software is at the core of our strategy.

When developers choose Unity, they may be building a business on our platform that can last for decades, and we are committed to making that choice a reality. In non-gaming sectors, we have also seen positive momentum. In Q3, industry growth remained strong and continues to be our fastest-growing subscription business. Major new customers this quarter include KLM Royal Dutch Airlines, which is building a VR cockpit training application. The German national railway operator Deutsche Bahn is building a series of systems and training simulations in Unity.

2) Technical Investments

We also discussed last quarter how we are fundamentally rebuilding our machine learning stack and data infrastructure, and using artificial intelligence to enhance the return on investment we can provide to advertisers We are pleased to report that significant progress has been made on this work, which has been tested on real-time data. We are very encouraged by the early results we have seen. Game monetization will not be a winner-takes-all market, and I can confidently tell you from personal experience that customers do not want such an outcome.

Unity has unique insights into how to maximize the lifetime value of game consumers and navigate the challenges of cross-platform game development and real-time operations. Our motivation for working at Unity every day is to unlock these insights and improve the gaming industry for developers and consumers.

3) Team Building

We have also made significant progress in building a new leadership team this quarter. Attracting experienced leaders to make meaningful positive changes is crucial for sustaining long-term growth. At the end of October, we hired Steve Collins as our new CTO. Steve has decades of experience as CTO at King, the studio behind popular games like Candy Crush, and is a co-founder and CTO of the pioneering physics engine Havok that helped define modern gaming.

Today, we are equally pleased to announce that we have hired a new CFO, Jared Gas, who will start full-time on January 1, 2025. Jared joins Unity from Shutterstock, where he served as CFO for the past five years, helping to drive the company's portfolio expansion, data monetization, and digital advertising while emphasizing revenue growth and profitability.

In summary, we are excited to make progress on our transformation strategy while achieving quarterly results that exceed expectations. Our vision for Unity is clear. We believe we play a key role in driving the gaming industry into the next phase of growth. We are the only company in the world that can provide a platform to support the entire development cycle, from prototyping to real-time service management, to user acquisition and monetization. This enables us to drive fundamental improvements in the economics of successful games. In production, AI-enhanced tools will accelerate the development process and enable greater innovation. In real-time operations, advertising, and monetization, we will be able to provide insights that customers cannot obtain elsewhere.

We believe that the 3 billion downloads per month of products developed by Unity represent opportunities to provide value to developers and players with each download. Regarding follow-up work, we still have much information to share and announce. Our team is working together energetically to realize this vision while also focusing diligently on continuously improving our business every day.

3. Key Financial Performance for the Quarter

In the third quarter, total revenue and adjusted EBITDA both exceeded expectations. Revenue from the strategic portfolio was $429 million, a year-over-year decrease of 2% and a quarter-over-quarter increase of 1%, better than our guidance of $415 million to $420 million

In the third quarter, revenue from Create solutions in the strategic portfolio was $132 million, a year-on-year increase of 5% and a quarter-on-quarter increase of 2%—driven by growth in our subscription revenue, which increased by 12% year-on-year.

In the third quarter, revenue from Grow solutions in the strategic portfolio was $298 million, a year-on-year decrease of 5% and a quarter-on-quarter increase of 1%, showing quarter-on-quarter improvement.

In the third quarter, the company's overall adjusted EBITDA was $92 million, compared to expectations of $75 million to $80 million. In the third quarter, our free cash flow was $115 million, an 11% increase from $104 million last year. Cash and cash equivalents at the end of the quarter were $1.4 billion.

Guidance:

(1) Q4: The guidance for the fourth quarter is $122 million to $427 million, with adjusted EBITDA for the fourth quarter expected to be $79 million to $84 million. The fourth quarter guidance reflects our continued caution regarding the recovery trend of growth business revenue, as well as expectations of some additional costs related to training new employees.

(2) Full Year: The full-year guidance for the strategic portfolio has been raised from the previous $1.68 billion to $1.69 billion to $1.73 billion to $1.78 billion. Adjusted EBITDA has been raised from the previous $340 million to $350 million to $363 million to $368 million.

4. Analyst Q&A

Q1: How do you view the growth levels for the next 3 to 5 years?

A: We are very optimistic about Unity's long-term value. We are in a very unique position in a very large and vibrant market. The creation of 3D content in interactive entertainment will grow. As a tool provider, we are in an excellent position to fundamentally change the way the next generation of content is created.

Similarly, as someone who has been in game development for a long time, I can tell you that when you consider starting a new project and how much you can invest, that calculation directly depends on how many people and how much time you have. As a tool provider and platform provider, we have the opportunity to fundamentally change how people think about creating interactive content. If they can be more efficient, they will create more. When customers have more creative demands, we will also see growth.

We are the only company that can act as a platform throughout the entire development lifecycle, from prototyping to operating real-time services, to monetization and advertising in the U.S. We can share insights gained as a platform with our customers, fundamentally providing insights that we believe others cannot offer over time.

We still have a lot of work to do. But we know what needs to be done and what is feasible. From customer feedback and the results of some early investments we are making, we see and feel the strength behind us. Therefore, this is a business that excites us immensely

Q2: Considering the long-term value of Unity in the gaming market and the development of Create in non-gaming areas, do you think Unity's future growth rate can exceed that of the mobile gaming industry?

A: Yes, what I want to say is that we have a lot of room for growth in this market, especially in terms of monetization. We believe that as our products, tools, and insights improve, this opportunity will be quite significant.

Q3: You mentioned that you are currently conducting real-time testing. Can you help us understand what the roadmap for release and development might look like—could you specifically describe the performance and effects of the activities you are seeing?

A: I can describe the process of building, testing, and validating the platform. You may not be surprised that it is highly iterative. The testing data I mentioned at the beginning, we have built new machine learning models in the new neural network. It has been launched, and we are testing on real-time data. Obviously, you want to see the new models perform better than the old ones, and you want these new models to show significant improvements under various weather conditions, types, regions, and market conditions. Validating this work takes time.

We will continue to build this capability, continue to validate and test, and launch when we are ready. I can't go into specifics right now, but I want to say that we are very satisfied with the current situation and the impact we hope it will have.

Q4: I see the rapid changes you've made in a short time, but I'm curious about the impact of introducing the Runtime model previously. Although I think relatively few customers have used this paid method. In other words, how do you plan to repair customer relationships that have been damaged due to Runtime in the future development process? What is your top priority?

A: As you mentioned, we made the change to abolish the Runtime fee, which is as important as the abolition itself, meaning our relationship with customers and the care we hope to maintain. Many of them are our long-term partners and are expected to continue a cooperative relationship for decades.

In the future, as we monetize the platform (whether through advertising or the engine), if there is an opportunity to continue expanding our cooperation with customers, we will do our best to seize that opportunity, prioritizing long-term partnerships with customers. I think, as you said, in some previous pricing thinking, we somewhat detached from that interpersonal relationship and became a bit abstract.

In the long run, we must ensure customer satisfaction and provide value that changes in the same direction as the customer's contributions. This is crucial for any long-term relationship. Therefore, we are deeply involved in collaborating with customers, testing different ideas, and soliciting their feedback, which is very important for resetting our position in the market. As you said, in the long run, we are very optimistic about the opportunities to expand our relationships with these customers and others.

The opportunities for selling consumption-based products, whether it’s multi-user tools, real-time operational services, data management tools, asset management, consumption-based AI-enhanced tool pricing, or anything else, these are all products of platform adoption and customer relationships. The concept I mentioned at the beginning about fundamentally thinking differently about how we develop products is a sister concept here.

So in the past, we have created many such products and acquired some of them, but not always validated our work with real customers in a real production environment. What I mean is, simply sitting down with customers to design tools that provide the value they need and want, so we can abstract these solutions and sell them to more customers. Therefore, over time, the opportunity to expand these relationships is crucial for us, and finding the right space in pricing is also essential—ultimately, I want to say that we are very satisfied with our current pricing setup, which not only maintains good customer relationships but also shows continuous growth.

Q5: How is the progress of the team adjustments? Are the effects meeting expectations?

A: We are very satisfied with this. We have done well in team building. We have rich experience, are very focused on operations, and have a very specific understanding of the markets we operate in. Moreover, there is a real connection in terms of vision, and we remain aligned around the goal of changing culture and delivering value to customers.

So I want to say that we are very pleased with the speed of this change, and we have the ability to attract the right talent. Many talents actually come from within our organization, although some key positions we discussed today, such as CFO and CTO, are externally hired.

But Unity has a very strong and smart talent pool, and we are able to promote them. They not only provide us with the capability for transformation and progress but also have a deep understanding of the company's history. So I think we are in a pretty good position. As you said, you always want to bring in world-class talent when possible, but we are satisfied with our progress and position in this process.

Q6: How do customers view the cancellation of Runtime fees and the release of Unity 6? How do you assess the trends in adoption rates and other key metrics?

A: The price increase is linked to Unity 6; if you don't want to subscribe at the new price, then you just don't upgrade. This dynamically optional pricing model has received positive feedback from customers. We hope customers can hear our voice—what is most important from our perspective for the future is stability and comprehensive support, ensuring that people can use our platform for many years without having to compromise between adopting features and stability. We have spent a lot of time—of course, we always talk about some exciting new things coming up.

But most of what we talk about is how we can help now. How can we better collaborate with partners? We have documented the impact of all these changes. Unity 6 has now been downloaded over 500,000 times, which is a very fast and quite significant number for a product that has just started, and it is favorable compared to some of our historical numbers in this regard

We also see that it has impacted the renewal speed and other key KPIs. So these things take time to take effect. I will spend time making an impact on our numbers. However, we have indeed implemented very significant price increases. Therefore, these conversations will take some time. That said, we feel we are in a very good position.

Q7: How to drive a stronger growth flywheel effect between the Create and Grow businesses?

A: A few months ago, the first thing we did was merge Louise into an independent department responsible for producing other products—we call them Game Service products. This department is separate from the team that develops our editor. The first thing we did was recognize that the greatest value we can provide is to deeply integrate these new products with the core etiprate. Therefore, bringing together the product designers and engineering teams for these two products was the first and very important step in understanding how to deliver better products.

The second step is to ensure that we design products and adjust our roadmap based on actual production conditions.

The third thing we did, which we are very pleased about, is that we promoted a new product lead and a new engineering lead, both of whom have very strong backgrounds in game development, have worked with game developers, and have a very intuitive and real understanding of what needs to be provided to bring change to customers. All these factors combined, along with some modifications to our marketing approach, have been very useful. Therefore, we also merged the sales teams, who will be responsible for selling our core engine and editor as well as the game services we have promoted in various ways in the past. So, once again, perhaps some insider information, perhaps not the most exciting, but how to bring these products to customers in the right way, integrate them correctly, and price them appropriately is indeed very important for achieving success.

Q8: The development speed in non-gaming areas is slower than the market expected. What excites you in the current business and what are you trying to drive for future growth?

A: I think what’s most exciting is truly understanding the products being developed to recognize how interesting and impactful they are, as well as how broadly applicable they can be. Oil retail and manufacturing can really drive the development of Unit every day.

As I mentioned, KLM Royal Dutch Airlines has developed these cockpit training applications that allow pilots to practice and hone their skills and improve their situational awareness. Deutsche Bahn has used Unit to help train train dispatchers with system simulations. We have also seen incredible and touching products launched in healthcare, such as a free 3D model for pediatric care from Charles Hospital, where the software allows clinicians anywhere in the world to interact with virtual 3D reconstructions of patient anatomy.

Not to mention that most global automotive companies are using Unity as the new machine interface for cars, and the adoption of Unity is very widespread. Therefore, part of the reason for the slow growth is the lack of visibility into more new industries I think the second issue is "execution." I believe we allow our enthusiasm to make us more ambitious than strictly speaking, which is ideal. There is a real difference between investing heavily in the 3D visualization layer, importing 3D assets, manipulating those assets, and building applications on top of them that can be distributed through our runtime on any device. This will be our core business, but it is unlikely for us to delve deeply into the industrial technology stack of digital twins and conduct nuclear reactor simulations in the short term.

Therefore, focusing on where our strengths play a role in the technology stack, we can continuously find customers and help them truly understand this business, which is really important.

The third point is to market in a more disciplined manner and establish the right relationships with system integrators and solution providers, so that when working more deeply with large industrial clients, these partnerships are needed to penetrate these markets, which is quite common. Doing this in an orderly manner can really provide us with some real benefits.

What we are really lagging behind is this—core business execution requires the capability configuration we need.

Q9: Is it still going to take about a year for most customers to adopt the new pricing subscription, and will this positively impact performance in the fourth quarter of next year?

A: Our price increases tend to unfold slowly over time, as they are related to upgrade cycles and update cycles. Therefore, I think it is correct to view this as an advantage and that we will start to see the effects of this, but we will see this and the impact of our other price increases over time.

Q10: Regarding the Gen AI issue. There are currently many startups creating tools for asset creation for games, and even the entire environment has changed, such as Google DeepMind launching something called Genie a few months ago, which tends to include elements of the Create stack. Undeniably, many of these are still quite poor. But if you look at the speed of improvement in diffusion models and AI, it will soon become very good. So I want to ask, as you look at this industry, how do you see—how will your customers integrate Gen into their workflows? How do you think this will affect your business, both from a pricing and cost perspective? How do you see all of this integrating in the coming years?

A: This is a very important question. Look, we know that AI plays a fundamental role for our customers, as I mentioned earlier, it makes the process of building video games faster, easier, more engaging, and innovative. We are the platform and assembly point for games and other applications. Therefore, our scalability is indeed our greatest advantage.

Thus, we feel fully capable of helping developers integrate these tools. From our perspective, we do not know where and how customers create their 3D assets. We will become an assembly point, providing tight control, the pipeline you need to build, and ultimately achieving cross-platform distribution at runtime Therefore, from our perspective, if the explosive growth of Gen AI can help our customers, then we will integrate the best first-party and third-party AI features into the Unity editor and provide these features to our customers. So we are very excited about this, and we are not opposed to it at all.

The second point is that our focus should be on using AI to handle some of the complexities in our tools, helping our creators use our engine more easily and quickly. For game companies, they need to recalculate the formulas for game investment and returns (cash flow, profit margins, investment ROI, etc.). The more efficient and faster they can produce games, the more we can benefit in sync.

So, I believe this is the core of the next phase of growth in our industry. We hope to play a very important role in this. Finally, I want to say that DeepMind, which you mentioned, is also a customer of Unity, and most of its work utilizes our technology. Therefore, we do play a very important role in the entire ecosystem. I believe that over time, we can become smarter and better in this regard, and we have invested a lot of time in this area.

Q11: Talk about price increases, and how many customers have adopted the new pricing? Can future growth reach double digits? Can bundling help achieve the effect of price increases?

A: Regarding price increases, as we discussed, we believe this indeed provides us with the opportunity to drive double-digit growth. It is important to remember that the price increase will take effect on January 1. Therefore, as customers begin to renew or upgrade at their current levels, this will be implemented starting in 2025. Thus, as we complete the renewal cycles for our customers, we believe this will impact us in the coming years. Then we talked about the future, mentioning that we will restore a more consistent annual price increase practice, which again helps us drive the double-digit growth we are seeing.

Regarding bundling to achieve price increases, we haven't spent much time seriously considering how to incentivize customers to switch to our growth solutions. The reason is that the best incentive you can offer customers is outstanding performance. So our job is to ensure we provide a return on investment. When we provide a return on investment, customers will switch. The return on investment and your user acquisition are the lifeblood of the vast majority of mobile games in the world. So I think we don't need to think too much about innovative business models in this regard. I believe product innovation is the key to achieving growth over time.

Q12: How do you view the importance and effectiveness of pricing under different mechanisms? How do suitable pricing models and high-quality teams combine to validate Unity's strategic importance in this ecosystem?

A: The reason I came to Unity is that I can clearly see the company's importance in the ecosystem, as you described—within a huge and vibrant market. The question we just raised is artificial intelligence, and we can carefully examine these issues and think about our role and position in the ecosystem

From my perspective, the only things we lack are execution and discipline, as well as customer engagement and partner involvement. Maximizing this position is not about business model innovation or bundling sales, but about building quality relationships with customers and providing high-quality products and services as a platform provider to achieve our rightful position.

So these two things are fundamentally connected, and what we need to do is integrate the product, product quality, platform nature, and the relationships within the ecosystem to understand how we will deliver value and how we will be compensated. And we need to do this in a thoughtful, orderly, and meticulous manner. I believe this is the only barrier to becoming one of the greatest companies in this field. It will take some time. As I said, we want to work in an orderly manner, but this is the greatest value creator we can provide for the company so far.

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