Crazy Roller Coaster, Does Unity Really Have a 'U' Turn?

Hello everyone, I am Dolphin Research!

On August 6th, after the U.S. stock market closed, the leading game engine company $Unity Software(U.US) released its second-quarter 2025 earnings.

Regardless of the performance, the pre-market fluctuations were another drama of expectations versus counter-expectations.

Overall, the performance (especially the guidance) basically met the expectations of the sell-side, but the pre-earnings surge certainly fell short of the buy-side expectations with pricing power. The good news is that the operational turning point is basically clear, and the positive trend is slowly becoming apparent:

1. Vector contribution to be seen next quarter: Grow's second-quarter revenue declined by 3.8%, with the rate of decline slowing down. The guidance for next quarter indicates single-digit sequential growth, implying accelerated improvement in advertising. In the second quarter, Unity Ad Network revenue already accounted for half of Grow, showing strong performance.

However, Dolphin Research believes that the Q2 performance was mainly driven by the recovery of the casual gaming industry, leading to endogenous growth. Vector was fully launched in the second quarter, and by the end of the quarter, customers had clear positive feedback, with channel feedback indicating a 10-20% improvement in ad conversion rates sequentially.

2. Engine subscription stability: Create grew by 2% year-on-year, with a one-time licensing revenue of $12 million. The main growth driver for the engine business is Unity 6 and price increases. Last quarter, 43% of old customers had upgraded to Unity 6.0, and it is expected to exceed 50% in the second quarter, with the previous official target being 70% by the end of 2025. Pay attention to the discussion of related progress in the conference call.

Third-quarter guidance shows a slight sequential decline, implying year-on-year stability or slight increase, but buy-side expectations may be higher. However, this is not a big issue, as management often leaves room in guidance for operational fluctuations since the company's restructuring.

3. Operational indicators may improve: (Complete operational indicators will be supplemented after the full financial report is disclosed) Here, we can only look at the deferred revenue situation. In the second quarter, deferred revenue increased by $30 million sequentially, with several new multi-year cooperation orders from medium and large customers, where SaaS subscriptions are the main component.

4. Short-term expense optimization slows: Second-quarter EBITDA profit margin slightly increased by 1 percentage point, reaching 20.5%, with guidance for next quarter implying continued slow improvement in profitability.

Currently, it is still in the critical period of new product launches like Vector, and although the three major expenses are still declining year-on-year in the second quarter, it is expected that apart from management expenses and the benefits of restructuring and downsizing cycles, other short-term optimization space is limited.

Future profit margin improvement will rely on the release of advertising monetization to naturally enhance the company's overall profitability.

5. Performance indicators overview

Dolphin Research's View

Undoubtedly, the progress of Vector is currently the biggest factor that can drive Unity's substantial rise, followed by the adoption rate of Unity 6. Other information can only cause some temporary small fluctuations. For example, the short article about Apple's acquisition in early June quickly returned to its original state after a sharp rise.

Unity 6 is not controversial. Since its release last year, the migration rate of existing customers has increased quarter by quarter, including the adoption rate of three AI features (Muse, Sentis, AI Navigation2.0), which is also improving, driving engine subscription revenue to maintain double-digit growth.

Vector is the main focus. After the intensive channel research by institutions in July, Unity finally ushered in a meaningful revaluation—according to feedback from participating customers, the ad conversion rate of the Vector system has indeed improved as management stated. However, the ROAS improvement is not consistent, with some saying a 10-20% increase, while others say it is only a "slight improvement."

Of course, it is still difficult to quantify this into revenue, coupled with the existing IronSource and Levelplay still "dragging down," with these two products accounting for about 20% of Grow's revenue. But Unity's operational turning point is clear, and it is reported that the company is using accumulated engine data to optimize the Vector model.

So, in the early stages of the turning point, when performance cannot be realized, how to judge Unity's value?

Dolphin Research believes that it is necessary to first understand the optimization logic and improvement details of Vector.

In the previous "App vs U Comparison Study", Dolphin Research mentioned that Applovin's Axon model is advanced in: 1) data advantage; 2) full-stack advertising technology (from SSP to Exchange matching to DSP, conducive to building a high-barrier closed ecosystem).

In contrast, Unity lacks these two points.

On one hand, there is no similar 1P game and Adjust to provide real-time, detailed ad conversion effect data. On the other hand, lacking a full-channel DSP platform means being too far from the actual payer in the industry chain, unable to act as both referee and player like Applovin, using information advantages to directly offer more favorable quotes, nor can it build a closed-loop ecosystem like Applovin to capture the most core value in the industry chain.

The focus of building the Vector model is to solve the first "data" problem, but it also has differences from Applovin, with a sense of taking a different path—Vector's effectiveness is to train AI models using in-game data obtained through the engine (player data, scene data, content data) to achieve more accurate bidding and ad formats.

To illustrate this process, Dolphin Research gives a few examples, such as in the following scenarios where players' attention is relatively concentrated (implying potential ROAS), Vector will automatically increase the bidding for ad slots, improving the monetization of ad slot providers. Conversely, in low-traffic scenarios, ad slots will reduce bidding, saving costs for ad buyers.

Under this optimization, although Unity provides more accurate bidding, theoretically benefiting both buyers and sellers, it is clearly more beneficial to sellers, which is also the result of Unity lacking a true DSP.

For this reason, we believe that although Vector will attract some advertisers' budgets (after all, multi-channel placement is a consistent practice of developers), it will slowly regain some market share. But it is still difficult to scale rapidly like Applovin.

Considering Unity also has a relatively stable advantage in the engine business, and investment sentiment is also positive (whether it is targeted by shorts due to data privacy issues, Roaring Kitty's preference), Dolphin Research believes:

(1) Before the improvement effect of Vector is reflected in the financial report, it is necessary to truly review and examine (we believe the market will especially focus on the 4Q25 financial report, where the 2026 guidance is key), in the next 1-2 quarters, Unity's valuation will still be mainly driven by sentiment (that is, dry valuation multiples, reflecting the sustainability of Unity Ads improvement), market sentiment will be influenced by management guidance (earnings conference call), channel research (especially changes in advertisers' budget allocation share to U), and other factors causing stock price fluctuations.

Compared to the neutral valuation of $12 billion given last quarter, we expect the short-term valuation range of the Grow segment can be raised, under optimistic sentiment: Horizontally comparable to the still high-growth Applovin (currently corresponding to 26-year EV/EBITDA 22x, combined with growth performance, valuation can be given 25x-30x).

Unity Grow's EBITDA profit margin is lower than Applovin's 70% (pure advertising) because it also includes services other than advertising, such as real-time operational technology platforms, cloud services, etc. Therefore, assuming Grow's overall EBITDA profit margin is 40%, a discount is applied to the valuation, giving 20-25x. Create, due to its low profitability, still uses 8x P/S for calculation.

Finally, Unity's valuation = $10.4-13 billion (Grow) + $5.3 billion (Create), totaling nearly $16-18.3 billion. Before the Q4 performance needs to be verified and realized, it can maintain moderate positivity, and everyone can evaluate the risk-reward ratio themselves.

(2) Approaching the Q4 financial report period, if the valuation is high, caution is needed, to prevent the 2026 guidance from not reflecting the strong high-growth trend priced in the valuation.

Below is the detailed analysis

I. Basic Introduction to Unity's Business

In the first quarter of 2023, Unity incorporated IronSource's operating conditions and adjusted the scope of segmentation of its business. Under the new disclosure structure, the segment business was condensed from the original three (Create, Operate, Strategy) into two (Create, Grow).

The new Create solution includes the products under the original Create (main game engine) and also incorporates UGS revenue (Unity Game Service: a full-chain solution for game companies, helping solve game development, distribution, customer acquisition, and operation) previously confirmed under Operate, and Strategy revenue, but gradually closed Professional service, Weta, and other product services starting in 2023;

While the Grow solution includes the advertising business under the original Operate, as well as the marketing (mainly Aura, Luna closed in 1Q24) and game distribution services (Supersonic) merged from IronSource. Revenue contribution comes from seat subscription revenue of the main game engine, and advertising platform revenue responsible for bidding matching, game distribution revenue, etc.

II. Establishment of Operational Turning Point

Unity achieved total revenue of $440 million in the second quarter, down 2% year-on-year, exceeding company guidance and market expectations.

Looking at the segmented business:

(1) Create business still has restructuring impact, but the core engine subscription revenue maintains double-digit year-on-year growth, with stable growth compared to the situation in the past year. Several large partners signed new contracts during the period, such as Tencent and Scopely. Some of these contracts are pre-confirmed as revenue, but most are traditional subscription revenue based on SaaS, recognized over time.

In the conference call, the company specifically mentioned the revenue progress in the Chinese region. The mobile game market grew by single digits year-on-year in the second quarter, but excluding the 20% growth in the Chinese region, other regions can only be said to be stable. Therefore, Unity's bundling with Chinese customers helps it quickly emerge from the mire.

(2) Grow's second-quarter revenue declined by 3.8% year-on-year, with the downward trend slowing compared to the first quarter. The company revealed that advertising revenue, which accounts for half, grew strongly in the second quarter, increasing by 15% sequentially from Q1, and this momentum will continue. Jefferies' quarterly channel research also shows that Unity's advertising market share has stabilized in the second quarter.

However, Vector, which was fully launched in May, is clearly not the main factor contributing to advertising, but rather the cyclical recovery of the casual gaming market and strong growth in the Chinese market (mini-games, etc.). The company's growth guidance for the third quarter is "mid-single digits," with double-digit growth in advertising revenue and stable non-advertising revenue, estimated to be flat year-on-year.

(3) From the perspective of deferred revenue, the operational situation is also in an improving trend.

Deferred revenue in the second quarter remained flat sequentially, showing significant improvement compared to the previous quarter, with a net increase of $30 million, mainly reflecting the addition of several medium and large customer contracts for engine subscriptions. Other operational indicators will be supplemented after the full financial report is disclosed.

Regarding management's guidance on short-term performance:

Third-quarter revenue and adjusted profit basically meet expectations—revenue guidance is expected to be between $440 million and $450 million, basically flat year-on-year; adjusted EBITDA is expected to be between $90 million and $95 million, with market expectations at $92 million, also within the guidance range.

Since the stock price had already surged nearly 50% before the financial report, buyers may not be completely satisfied with this guidance. However, Dolphin Research reviewed the past year, and since the complete change of management, the guidance style has been cautious, leaving more room for flexible adjustments and exceeding expectations.

III. Short-term expense optimization slows

The second quarter is still within the efficiency cycle of business restructuring, but apart from management expenses, sales and R&D expenses need to slow down the pace of short-term optimization due to the launch of new product Vector and its gradual contribution to revenue. Future profit margin improvement will mainly rely on the growth of high-margin advertising revenue to naturally drive it.

GAAP operating expenses decreased by 5% year-on-year, with SBC equity incentives increasing by 20% year-on-year, mainly driven by the increase in market value (Unity's market value increased by nearly 50% in the second quarter). Ultimately, GAAP operating loss was $118 million, and adjusted EBITDA achieved $91 million, with a profit margin of 21%, exceeding company guidance ($70-75 million) and market expectations ($76 million).

Second-quarter cash flow changes increased significantly sequentially, including the reduction of losses during the period and the prepayment of new contract revenue. As of the end of the second quarter, the company's cash on hand was $1.7 billion, an increase of $150 million compared to the previous quarter, with a relatively stable trend of cash situation improvement.