Unity: The Rebounding Bubble—Can It Keep Inflating?

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After the US stock market closed on May 7th, Eastern Time, the leading game engine company $Unity Software(U.US) released its Q1 2025 performance. Although the last quarter provided a conservative guidance, the management mentioned during the conference call what the market wanted to hear the most at that time—about the new advertising model expected to be deployed a quarter earlier, hence the conservative Q1 performance guidance considered the impact of the transition between the new and old models.

As a result, the stock price immediately soared. However, Dolphin Research also mentioned in the commentary, it is still early for implementation, and the surge is completely "premature excitement," although from a long-term perspective, it can provide more expectations (long-term valuation), this indeed helps to elevate the bottom valuation in the short term, but there is no need to rush to chase high, after all, the feedback from internal testing is still non-existent.

So, a quarter has passed, how is the real effect of Unity's new model? Before discussing the actual customer feedback, let's first take a look at the Q1 performance and see if there are any clues for judgment:

1. New model effects are still early: Q1 revenue exceeded expectations, mainly driven by the Grow business. In Dolphin Research's view, this is quite good, especially considering the market's cautious expectations based on the latest macro and industry environment (advertising expectations are cautious, game developers' monetization tendency shifting from "advertising" to "in-app purchases"), at least it won't trigger further market concerns about this business itself.

However, from the revenue guidance, the new advertising system Vector, which integrates the new model, is not expected to have a significant positive impact on the business in Q2. There is little information available in the market regarding the testing effects of the new model, and Unity itself has not disclosed much progress, so this conference call remains crucial.

2. Engine revenue below expectations, but trend direction unchanged: Create declined by 8% year-on-year, slightly below market expectations, but Dolphin Research believes this is not a big issue, and the warming trend remains unchanged. Looking solely at core subscription revenue, it grew by xxx% year-on-year, driven by both volume and price.

Since the launch of Unity 6, market feedback has generally been positive, gradually erasing the negative image caused by the "Runtime charging model." Recent research by Jefferies shows that the percentage of customers willing to adopt Unity 6 has risen from 66% at the beginning of the year to 81%, reflecting a smooth customer penetration conversion.

3. Operational indicators improved, but not significantly favorable:

(1) Deferred revenue remained flat quarter-on-quarter, indicating that current cash flow is still declining year-on-year;

(2) Net expansion rate slightly warmed to 97%, but below market expectations.

(3) Number of large customers increased quarter-on-quarter, mainly reflecting the renewal of old customers and the return of short-term lost customers, but the extent is weaker than the market anticipated; (4) Remaining Contract-Related Indicators The financial briefing and conference call did not disclose this quarter's information; we need to wait for the complete financial report. The new contract amount in the fourth quarter is looking good;

Looking at the indicators from <1-4> together, it indicates that the Grow business still needs to hover for at least one more quarter in the short term. However, most market expectations regarding the turning point are similar, needing to wait until the second half of the year.

4. Internal Efficiency Improvement: The first quarter still has effects from personnel adjustments due to business integration, with operating expenses down 35% year-on-year and down 3% quarter-on-quarter, among which SBC equity incentives decreased by 42%, further expanding the optimization compared to the previous quarter.

Among the three expenses, management expenses showed the most significant decline. Ultimately, GAAP operating loss was 128 million, with adjusted EBITDA achieving 84 million, a profit margin of 19%, exceeding the company's guidance (60-65 million) and market expectations (65 million).

5. Performance Indicators Overview

Dolphin Research's Viewpoint

Before the second half of the year, when a real examination is needed, Unity's short-term catalysts completely depend on how the management guides.

Unlike last quarter, Dolphin Research believes that if the management provides a qualitative guide without data again this time, the market is likely to experience aesthetic fatigue, making it difficult to inflate a bubble like last quarter.

However, we also mentioned last quarter that based on the expectation of a turning point in "turnaround" and the already stable engine business providing a "bottom line," even if the integration of the new model does not progress quickly, the market will not value Unity down to a 6 billion market cap, which at that time implied only a 4x EV/Sales valuation level.

In the long term, although Dolphin Research believes Unity still has hope to reach 12 billion, this process may take longer than the market expectations after the management's "hints" last quarter. If there is an opportunity to adjust below 4x EV/Sales (implying 7.6 billion), the safety cushion will be relatively high:

On one hand, the initial progress of Vector is not astonishing but rather a process of ROAS improvement that is within expectations. In the article "Can Unity replicate Applovin's 'cash ability' by following the model?," we previously stated that this year is Unity's 2020 moment for doing Applovin, but based on the advantages of being a "follower," the time to reach the turning point can be shortened; for example, it may not take two years, but only one year to see a reversal in financial data—returning to growth.

However, Unity's turnaround cannot be directly compared to Applovin's rise. This is because Unity needs to reclaim its previous market share from Applovin, not seeking to surpass ROAS but at least to barely keep pace with Applovin Otherwise, in the eyes of game advertisers, they will still prefer Applovin.

One of the factors delaying the turning point is the current macro and industry environment dragging down performance. Under pressure from the macro environment, advertisers' willingness to test new channels will decrease, tending to concentrate limited budgets on platforms with high ROAS, such as Google, Meta, and Applovin.

In the gaming industry, advertising is not the only monetization channel for developers. Since the beginning of the year, there has been an increasing number of products/manufacturers shifting towards in-app purchases, as the resilience of paid options is higher than advertising in the current macro environment. This will lead to a contraction in supply (advertising space), thereby pushing up unit prices and overall weakening the industry's ROAS. At this time, the impact of the first factor can be further strengthened, which manifests as a greater concentration of market share at the top, increasing the demand for Unity to quickly refine its system in the short term.

The following is a detailed analysis

1. Basic Introduction to Unity's Business

In the first quarter of 2023, Unity incorporated IronSource's operating conditions 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 under the original 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) previously confirmed in Operate, as well as the revenue from the original Strategy. However, starting in 2023, it will gradually close 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 closed in Q1 2024) and game publishing services (Supersonic). The revenue contribution comes from the subscription income of the game development engine, advertising platform income responsible for facilitating bidding, and game publishing income, among others.

2. The Advertising Turning Point Is Not Coming Soon

In the first quarter, Unity achieved total revenue of $435 million, a year-on-year decline of 5.5%, exceeding the company's guidance and market expectations From a segmented business perspective, the strategic cooperation and professional services within the Create business are still actively contracting, while the core engine subscription revenue has increased by 13% year-on-year, with growth stabilizing. Although this is below expectations, the negative impact brought by the Runtime charging model has gradually diminished.

Although Grow is still losing market share to competitors, its own trend is recovering, with a 4% decline in the first quarter, which is the main area exceeding market expectations.

From the perspective of forward-looking operational indicators, overall, the positive trend is relatively slow, and there is still some stagnation in the short term:

(1) Net expansion rate

The net expansion rate is a growth indicator that the market generally pays attention to. In the first quarter, the net expansion rate climbed to 97%, but the speed is still slower than market expectations, with over 100% being a healthy growth state for existing user expansion. This figure indicates a slight decline in total revenue from old customers over the past 12 months, meaning that the payments from old customers have decreased year-on-year compared to the previous year.

Similar to previous quarters, 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 old customers.

The net expansion rate has continued to decline to below 100% over the past year, which should also include the impact of a few old customers who are dissatisfied with the Runtime charging model and have chosen not to renew. Fortunately, Unity 6 has received a good response, and the adoption rate or the proportion of customers intending to adopt it has been increasing quarter by quarter. Currently, the relationship between Unity and game customers is continuously improving, and customer attrition has stabilized. Non-gaming industry customers, on the other hand, continue to penetrate the market.

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

The number of large customers generally refers to customers in 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 have been lost after the company closed those businesses. 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 first quarter, the number of large customers was 1,260, an increase of 6 from the previous quarter. The main increase should still come from non-gaming industry customers, but the extent is weaker than the market expected;

(3) Deferred Revenue & Remaining Performance Obligations

Deferred revenue in the first quarter remained flat quarter-on-quarter, showing a slight improvement compared to the previous quarter. The RPO scale disclosed in the complete financial report for the last quarter increased slightly quarter-on-quarter, mainly reflected in the remaining long-term performance obligations. Dolphin Research generally combines RPO with secondary calculation indicators for new contracts, which showed significant additions in the last quarter. Dolphin Research believes the trend will remain unchanged in the first quarter, with specific data to be updated after the complete financial report is disclosed.

Regarding Management's Guidance on Short-Term Performance:

Revenue and adjusted profit for the second quarter both missed expectations—expected revenue guidance is between $415 million and $425 million, a year-on-year decline of 5.3% to 7.5%; expected adjusted EBITDA is between $70 million and $75 million, lower than the market expectation of $81 million.

In addition to the friction caused by the switch between new and old advertising algorithms, the engine business also faces revenue contraction impacts outside of the Strategic portfolio, leading to a slight decline in guidance, which is slightly below market expectations. However, Dolphin Research has reviewed the past year, and since the complete overhaul of the management team, the management's guidance style has tended to be cautious, leaving more room for flexible adjustments and exceeding expectations.

3. Internal Efficiency Improvements Are Ongoing

The first quarter still falls within the efficiency improvement period of business restructuring, with GAAP operating expenses declining by 35% year-on-year, of which SBC equity incentives decreased by 42%, further expanding the optimization range compared to the previous quarter, indicating that personnel optimization is still ongoing. As of the end of last year, Unity had 4,987 employees, nearly half of the peak scale of over 8,000.

Among the three expenses, the contraction in management expenses is the most significant. Ultimately, GAAP operating loss was $128 million, with adjusted EBITDA achieving $84 million, a profit margin of 19%, exceeding the company's guidance ($60 million to $65 million) and market expectations ($65 million).

Cash flow in the first quarter decreased significantly quarter-on-quarter, partly due to seasonal performance impacts and partly because a portion of convertible bonds was redeemed during the period (similar to 1Q24). As of the end of the first quarter, the company's cash on hand was $1.55 billion, an increase of $20 million compared to the previous quarter, indicating a relatively stable trend of improving cash conditions

Dolphin Research "Unity" Related Reading:

Earnings Season (Past Year)

February 21, 2025 Conference Call: Unity (Minutes): "Windfall" of the New Model

February 21, 2025 Earnings Review: Pressed by Applovin for Too Long? Unity Hasn't Started to Party Yet!

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

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

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

August 10, 2024 Earnings Review: Surge is Absurd, but "New" Unity is Promising

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

May 10, 2024 Earnings Review: Unity: Is the Bone Scraping Treatment Nearing Its End? 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 Weathering the Storm

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

January 10, 2025: [Can Unity Copy Applovin's "Cash Ability" by Following the Model?](https://longportapp.com/zh-CN/topics/26553047? invite-code=032064)》

October 12, 2022《 The Winter of Games Has Arrived, Where Is the Warm Spring?》

April 1, 2022《 Several Interesting Points in the "Unity 2022 Global Game Report"》

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

March 9, 2022《 The Unclear Metaverse, the Clear Unity》

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