Pressed too long by Applovin? Unity hasn't started to party yet!

Hello everyone, I am Dolphin Research!

After the U.S. stock market closed on February 20th, Eastern Time, the leading game engine company $Unity Software(U.US) released its Q4 2024 earnings. The Q4 performance was solid, with core financial metrics mostly exceeding expectations. However, the disappointment came from the Q1 guidance, where both revenue and profit missed expectations.

In my earlier comparative study of Applovin and Unity at the beginning of the year, I emphasized: Unity in 2025 is waiting for a turning point. Due to the difficulty of quickly reflecting internal technological progress in performance, the management's statements during the conference call became even more crucial.

Therefore, the "gold content" is all in the conference call. The management highlighted the specific progress of the advertising algorithm model, which was slightly better than expected, and explained that the weak Q1 guidance was due to the impact of algorithm migration, which was given out of caution, alleviating some concerns. Coupled with the fact that Applovin was also heavily shorted by Bear Cave, Unity's stock surged nearly 30%.

However, stock prices are influenced by emotions (especially for a company like Unity, which has a small market cap, fluctuating performance during a turning point, and has previously been labeled a meme stock, making it more susceptible to short-term trading factors). If we step out of the emotional context and look at it from a rational perspective, has the fundamental turning point for Unity really arrived? Additionally, I will briefly discuss the issue of Applovin being shorted again last night (is it just a coincidence that the timing aligns?).

Let's go over the key points of the earnings report:

1. Unity steadily penetrates, customer migration progress at 38%: In Q4, under the Strategic Portfolio metric, Create grew by 8.6%, continuing to recover, while core engine subscription revenue increased by 15% year-on-year, showing a rebound from 12% in the previous quarter, with subscription growth in non-gaming industries (mainly automotive and retail) reaching 50%.

What surprised me was that this time the growth in engine subscriptions was no longer solely reliant on price increases (including direct price hikes over 1-2 years and the passive switch from Plus to Pro packages, which led to an increase in average transaction value). The management emphasized that the growth mainly came from an increase in customer scale and renewals from existing customers, further indicating customer recognition and confidence in Unity's products The Unity 6 launched last October has received positive feedback, with 38% of existing customers having completed the migration. Jefferies' research shows that two-thirds of surveyed Unity customers indicated they would adopt Unity 6, and customer penetration conversion is still ongoing.

The technological upgrade can naturally enhance customers' willingness to accept price increases. Starting January 1st, the two paid versions of the Unity engine, Pro/Enterprise, will increase in price by 8% and 25%, respectively. This is also a major growth highlight and investment logic for the Create business this year.

2. The new advertising system is progressing faster than expected: In the fourth quarter, the Grow business in the Strategic portfolio finally returned to growth, with a year-on-year growth rate of 2%. Although this is significantly weaker than the top competitor (indicating that market share erosion is still ongoing), disregarding horizontal comparisons, this growth trend without an upgraded algorithm model also represents that Unity is emerging from the trough.

Last quarter, management mentioned that the company is currently developing a new advertising system platform (new model development) using AI—Unity Vector. Therefore, when the Grow business will emerge from the bottom this year primarily depends on the progress and implementation of this new model.

Since internal technological progress is difficult to reflect in performance, how management describes the model development progress during the conference call is crucial for expectations and sentiment.

Indeed, management revealed some positive information, which was key to the post-earnings surge:

(1) Accelerated pace: The first phase of the new model will be deployed starting in Q1 and completed before Q2. This is faster than previously stated, which indicated it would not be implemented until mid-year and deployed in the second half.

(2) Cautious Q1 guidance has special reasons: Due to changes in system effects and functions during the new model switch, customers will have an adaptation process in the short term, which is also the reason for management's weak/cautious Q1 guidance.

This not only alleviated market concerns about a Q1 guidance miss but also provided a positive signal regarding the progress of the advertising model exceeding expectations. Therefore, even though performance has not yet reflected this, sentiment has improved, and the stock price has surged!

3. Leading indicators are still "repeating": Several leading indicators that Dolphin Research has been monitoring show that signs of recovery can only be described as faint, and at least they do not reflect the optimism suggested by the significant stock price increase. Of course, this is also due to the new model not yet being deployed:

(1) Deferred revenue decreased month-on-month, with not many new contracts added during the period;

(2) Net expansion rate slightly rebounded to 96%, but below market expectations.

(3) Number of large customers increased month-on-month, mainly reflecting the renewal of old customers and the return of temporarily lost customers, but the extent was weaker than the market anticipated;

(4) Remaining contract-related indicators were not disclosed in the financial briefing or conference call this quarter and will need to wait for the annual report;

Looking at indicators <1-3> together, it can be seen that the Grow business still faces short-term pressure, which aligns with early-year advertising client survey information—namely, that the advertising conversion effect ROAS of Unity Ads has not yet shown improvement, with only some advertisers beginning to test IronSource ads. However, under the statement about the new model's progress exceeding expectations during the conference call, the outlook has been raised, making the short-term pressure in Q1-Q2 less significant.

4. Profit side also benefits from layoffs: In the fourth quarter, there will still be effects from layoffs due to the divestiture of inefficient businesses, with Q4 GAAP operating expenses down 23% year-on-year, and SBC equity incentives down 39%.

Among the three expenses, the decline rate is accelerating, with the most significant contraction in management expenses. Recently, Unity has initiated a new round of employee optimization, which may not be due to business divestiture but rather related to internal cost reduction and efficiency improvements brought by AI.

Ultimately, GAAP operating losses decreased to 124 million, continuing to reduce losses quarter-on-quarter, with adjusted EBITDA reaching 106 million, a profit margin of 23%, significantly exceeding the company's guidance and market expectations.

5. Performance indicators overview

Dolphin Research's viewpoint

In simple terms, this surge is an outburst after a long period of emotional suppression. In 2025, the positive investment logic for Unity is clear, but given the past trust crisis with the management, the real turning point needs to be judged by the market itself.

Although Q4 performance did not reflect a turning point, the better-than-expected Q4 results deserve a reward of 5-10%. The subsequent positive statements about the new model during the conference call (including explanations for the weak Q1 guidance), along with Applovin being targeted by short sellers, are key factors that led to the 10%-30% increase.

Therefore, it can be said that Unity is currently in a state of "premature excitement." On one hand, competitors like Applovin have been thriving while Unity is in turmoil, and many funds are waiting for Unity's turning point under high valuations; on the other hand, Unity is also attracting attention from Meme stock investors, making short-term "emotional highs" likely to occur.

Achieving a turning point in actual performance may wait until the Q2 earnings report releases Q3 guidance, as it remains uncertain how much the new model can truly improve ROAS, and this conference call did not reveal any quantitative figures.

However, the sentiment has improved, and based on expectations of replicating Applovin's success, Unity's valuation is unlikely to revert in the short term. For example, in the early year comparison study of Applovin and Unity , Dolphin Research estimated a pessimistic value. During the last quarter's Q3 earnings report, Dolphin Research also emphasized the issues of sentiment improvement and the rush effect brought by Meme stocks, believing it could maintain a relatively positive outlook below a valuation center of 10 billion. **

At present, due to the faster-than-expected progress of the advertising model and the switch to the 25-year performance forecast, the central valuation (based on EV/Sales, Create 10x, Grow 5x) can be raised to USD 12 billion (mainly based on sentiment, increasing the valuation multiple, but since there is no specific quantitative data on ROAS testing, the revenue forecast has not been significantly increased). Before the performance shows a turning point, it is advisable to actively monitor the testing effects and customer feedback of the new advertising model Unity Vector. If the response is indeed good and the return rate is comparable to leading platforms like Applovin and Meta, there is hope to regain market share and initiate a true, sustained Davis double.

Finally, let's talk about the short report released by Bear Cave on Applovin last night. Applovin has been targeted by short sellers more than once, with the core points being its high valuation and the fact that Applovin's approach in the gaming market contradicts traditional advertising methods (inefficient ad conversion, but in the gaming field, advertisers and publishers may be the same type of developers, resulting in a small-scale zero-sum game where Applovin becomes the biggest winner), and this approach may not work in the e-commerce sector, potentially affecting this year's e-commerce advertising narrative logic.

Regarding the second point, Dolphin Research does not deny this. The short-selling logic of Lauren Balik, who announced a short on the app in January, and this time's Bear Cave, both focus on this issue—questioning whether Applovin has advertising effect fraud, namely frequent ad bombardment, inducing users to mistakenly click ads, and gambling-type incentive ads, while peers have implemented certain compliance restrictions on these issues.

However, we also say that game developers are not completely unaware of this issue; Applovin is just the optimal choice within a limited scope. Especially when the CPM of Meta and Google continues to rise and Unity struggles to gain traction, Applovin's high ROAS has even attracted some game developers to list it as a top choice.

As for the e-commerce advertising narrative, Dolphin Research believes that there are not many issues in the short term (1-2 quarters) that can keep Applovin's performance strong, but potential pressure may come later, based on the logic that:

(1) Applovin has just entered a market several times larger than game advertising, and due to its reputation for high ROAS, the user profile characteristics of older women + user scale and engagement will attract small and medium-sized businesses to try (consistent with early-year research findings). Therefore, short-term customer acquisition and realizing some incremental growth is not difficult.

(2) Subsequent ROAS may be pushed up with bidding (Applovin has revealed that it does not plan to increase ad inventory for the time being, so increased demand will lead to higher bidding), and the actual conversion effects of e-commerce (especially at the transaction level) may begin to be affected.

**In this process, the first demand to spill over will be from small and medium-sized game developers who are sensitive to high bidding, followed by some merchants who focus on transaction conversion. Market expectations may very likely exaggerate subsequent performance due to the strong performance in 1-2 quarters, which will undoubtedly increase the difficulty of beating expectations Once a high valuation misses, it will face significant selling pressure, which requires Applovin to demonstrate stronger technical capabilities to cope.

The following is a detailed analysis

1. Basic Introduction to Unity's Business

In the first quarter of 2023, Unity integrated the operations of IronSource and adjusted the scope of its segmented business. Under the new disclosure structure, the business segments have 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 previously recognized in Operate (Unity Game Service: a full-chain solution for game companies that helps solve game development, publishing, and customer acquisition operations), as well as revenue from the original Strategy; however, starting in 2023, it will gradually shut down 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 be shut down in Q1 2024) and game publishing services (Supersonic). The revenue contribution comes from subscription revenue for the game development engine, advertising platform revenue responsible for facilitating bidding, and game publishing revenue.

2. What does the cautious guidance reveal?

In the fourth quarter, Unity achieved total revenue of $457 million, a year-on-year decline of 25%. Excluding the impact of Weta's divestiture, the decline was 20%, still within the impact cycle of business restructuring. If we completely exclude the restructuring impact, looking solely at the Strategic Portfolio, revenue grew by 4% year-on-year, clearly exceeding market expectations.

In terms of segmented business, the strategic cooperation and professional services within the Create business are still actively contracting, but the core engine subscription revenue grew by 15% year-on-year, rebounding from the 12% growth in the third quarter. Although Grow is still losing market share to competitors, its own trend is warming up; under the Strategic Portfolio metric, the fourth quarter also returned to growth, with a year-on-year growth rate of 2.4%.

From a forward-looking operational indicator perspective, overall, the positive trend is relatively slow, and pressure still exists in the Grow business. Before the new model is fully deployed, the trend will continue to fluctuate: (1) Net expansion rate

The net expansion rate is a growth indicator that the market generally pays attention to. In the fourth quarter, the net expansion rate climbed to 96%, but the pace was slightly slower than market expectations. This figure represents a slight 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, as well as 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. Currently, Unity's relationship with game customers is continuously improving, while non-gaming industry customers saw subscription revenue grow by over 50% year-on-year in the fourth quarter, indicating strong demand for Unity 6, especially in the automotive and retail sectors.

Therefore, as the business continues to stabilize and improve, it is natural for the net expansion rate to rise above 100% as Create stabilizes and Grow emerges from difficulties.

(2) Number of large customers (annual payment over $100,000)

The number of large customers generally refers to customers of the engine business (at least signed for 1 year), so the changes in customer numbers over the past year have mainly been affected by business restructuring. For example, some customers from Weta, professional services, or Luna lost their accounts after the company shut down operations. Additionally, during the pressure on the gaming market in the past two years, some customers downgraded their spending on Unity, with annual payments falling below $100,000.

In the fourth quarter, the number of large customers was 1,254, an increase of 12 from the previous quarter. In addition to recovering some lost customers by canceling Runtime, the estimated main increment also comes from non-gaming industry customers whose subscription revenue grew by 50% (or who purchased more services, resulting in "upgraded consumption" in annual payments).

(3) Deferred revenue & remaining performance obligations

Deferred revenue declined quarter-on-quarter in the fourth quarter, which indirectly indicates that the improvement at the operational level is still relatively slow. However, this quarter, the financial briefing and conference call did not disclose the remaining performance obligations (RPO). Dolphin Research estimates that there is likely to be a trend of improvement, but it may not recover growth quickly; it is recommended to wait for the complete annual report to take a look.

Similarly, Dolphin Research's secondary calculation of the contract new indicators based on RPO cannot be updated for the time being.

Back to the management's quantitative guidance on short-term performance:

In the first quarter, both revenue and adjusted profit missed expectations, with the strategic portfolio revenue guidance expected to be between 405 million and 415 million, a year-on-year decline of 9% to 12%.

However, during the conference call, they slightly explained the reason for the conservative guidance—impact from the migration to a new advertising algorithm, which somewhat alleviated market concerns. Looking back over the past year, since the complete overhaul of the management team, the management's guidance style has leaned towards caution, leaving themselves more room for flexible adjustments and exceeding expectations.

2. When will the loss of market share stop?

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, as well as the main advertising revenue in the Grow business, so Dolphin Research generally also looks at the gaming industry situation.

From Sensor Tower's data, the decline in global downloads in the fourth quarter has slowed, and the growth rate of in-app purchase revenue has slightly decreased but remains stable. Although Unity is experiencing a slow recovery, compared to its peer Applovin's advertising revenue growth of 73.5% year-on-year (excluding about 500 million to 1 billion in e-commerce and other non-gaming increments, the growth rate is still 60%), it is clear that Unity ads are still losing market share.

Currently, changes in the competitive landscape will still need to wait for the launch of the new advertising system Unity Vector and the testing of advertising conversion effects. Additionally, Applovin's increase in e-commerce advertising demand without a corresponding increase in advertising inventory may potentially reduce bidding advantages, spilling some demand to Unity, Ironsource, and other small to medium platforms.

3. There are still layoffs benefits on the profit side

In the fourth quarter, there were also layoffs resulting from the divestiture of inefficient businesses, with Q4 GAAP operating expenses down 23% year-on-year, and SBC equity incentives down 39%.

Among the three expenses, the rate of decline is accelerating, with the contraction of management expenses being the most significant. On the news front, Unity has recently initiated a new round of employee optimization, which may not be due to business divestiture but rather related to cost reduction and efficiency improvement brought about by AI. The final GAAP operating loss decreased to 124 million, continuing to reduce losses quarter-on-quarter, with adjusted EBITDA reaching 106 million and a profit margin of 23%, significantly exceeding the company's guidance and market expectations.

There are currently no major issues with cash flow changes in the fourth quarter. As of the end of the fourth quarter, the company's cash on hand was 1.53 billion, an increase of 100 million compared to the previous quarter, mainly due to improvements in operations and maintaining a low level of capital expenditure.

Dolphin Research "Unity" Related Reading:

Earnings Season (Past Year)

November 9, 2024 Conference Call: Unity: Customer Relationships, Product Quality, and Execution (3Q24 Earnings Conference Call)

November 9, 2024 Earnings Commentary: Soul Searching, Has Unity's "Bottom" Been Reached?

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

August 10, 2024 Earnings Commentary: Surge is Absurd, 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 Minutes)

May 10, 2024 Earnings Commentary: **[Unity: Is the Bone Scraping Treatment Nearing Its End?](https://longportapp.cn/zh-CN/topics/21009531? invite-code=032064)》

February 27, 2024 Conference Call《 Unity: Lighten the Load and Focus on Software》

February 27, 2024 Earnings Report Review《 Unity Plummets? Poor Management and Terrible Moves》

November 10, 2023 Conference Call《 Unity: More Streamlined and Focused (Unity Q3 2023 Conference Call Minutes)》

November 10, 2023 Earnings Report Review《 Constantly Stirring the Pot, Unity Faces Turbulence》

August 3, 2023 Conference Call《 AI and VR Will Make Significant Progress in the Next Two Years (Unity Q2 2023 Earnings Conference Call Minutes)》

August 3, 2023 Earnings Report Review《 Unity, Repeatedly Speculated, Performs Well》

May 11, 2023 Earnings Report Review《 Unity: Earnings Report Beat, Will It Soar? Let's Wait and See…》

February 23, 2023 Conference Call《 Management: Currently in a Recession, Focus on Recovery Timing (Unity Q4 2022 Conference Call Minutes)》

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

In-depth On January 10, 2025, "Can Unity replicate Applovin's 'cash ability' by following the model?"

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 Unity's valuation be boosted by the imagination of the 'metaverse'?"

On March 9, 2022, "The unclear metaverse, the clear Unity"

Risk disclosure and statement of this article: Dolphin Research disclaimer and general disclosure