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Non-stop exciting moves, Unity in the midst of ups and downs

Hello everyone, I am Dolphin Research!

After the US stock market closed on November 9th, the leading game engine company Unity released its third-quarter performance for 2023. Unity's current performance itself fell slightly short of expectations in terms of overall revenue, mainly due to a significant miss in Create revenue, but the profit exceeded expectations due to cost control.

However, the 12% drop in the stock price after the market indicates that the market is very dissatisfied with this earnings report. The reason is that the forward-looking indicators are weak, and the management's lack of guidance has led to pessimistic expectations for the future. In addition, the management's instability and the large-scale reduction in holdings by senior executives before the earnings report have cast a shadow over the stock price.

Since the introduction of the new charging policy, Unity seems to have entered a period of "chaos". Although adjustments were made in a timely manner, the performance in the third quarter was completely different from that in the second quarter. Some forward-looking indicators in the second quarter were good, indicating that there should be no major problems in short-term growth, and there may even be surprises. However, the actual performance in the third quarter was not as expected, especially in the Create business. In addition, the forward-looking indicators for Q3 revealed more short-term pressure, indicating that the problem occurred in the third quarter. The management's actions caused the loss of existing customers and increased the difficulty of acquiring new customers.

Although the new charging policy has made some adjustments in details, developers still have complaints, which puts pressure on the short-term growth of Create. In terms of management issues, until the new leader of Unity is determined (James M. Whitehurst is only temporarily serving as CEO), the period of chaos may continue, so it is also inevitable that some executives will continue to unscrupulously sell stocks.

In short, during the most confusing period in the market, the new management of Unity failed to provide clear performance indicators, which undoubtedly increased market doubts about Unity's prospects, resulting in a significantly undervalued valuation for Unity in the medium and long term (we believe that Unity's product competitiveness is still relatively high, and short-term customer dissatisfaction will gradually be resolved). Despite this, Unity still faced such a large sell-off punishment.

The current after-hours price is approaching our conservative expected valuation, but the headwinds in short-term performance are likely to continue to drag down the stock price performance (excluding the period of speculation in AI and VR), unless the management provides a relatively clear or slightly positive guidance during the conference call.

The following is a detailed analysis:

1. Overview of Unity's business

Disclosure structure adjustment: The current performance has been incorporated into the operating conditions of IronSource, so looking at the year-on-year growth rate is relatively distorted. Moreover, due to the adjustment of the division of sub-businesses, it has also increased the difficulty of comparing with previous periods.

Under the new disclosure structure, the business segments have been condensed from the original three (Create, Operate, Strategic) to two (Create, Grow).The new Create solution includes the products from the original Create, such as the game engine, as well as the previously confirmed UGS revenue in Operate (Unity Game Service: a comprehensive solution for game companies that helps with game development, publishing, and user acquisition), and the revenue from the original Strategy.

The Grow solution includes the advertising business from Operate, as well as the merged marketing (Aura, Luna) and game publishing services (Supersonic) from IronSource.

The revenue contribution comes from seat subscription revenue for game development main engines, as well as advertising platform revenue and game publishing revenue generated through bid matching.

Looking at Unity's business structure in the past few years, although Unity gained fame for its absolute monopoly in the mobile game development engine market, the Create solution does not contribute the highest percentage of overall revenue. With the rapid growth of incentivized advertising games, the advertising revenue from Grow (Operate) has also increased rapidly, playing a larger role in supporting Unity's revenue, especially its profits.

Looking back at Unity's performance in the past two years, Create revenue has maintained a growth rate of around 30%-50%, which is in line with the performance of a relatively stable SaaS platform in a development phase. This means that the user penetration rate has reached a ceiling, but there is a high renewal rate due to high stickiness. Annual revenue growth relies on users using more tools or platform price increases.

For a SaaS platform, after going through the customer acquisition phase, the profit margin continues to increase, and the platform's value will be realized. This is also one of Unity's medium to long-term logics.

Currently, although Unity is still operating at a loss, this is mainly due to the lower monetization rate of the main engine compared to its peers. The profit model of Create has not yet been fully implemented, and the company has been continuously investing in non-gaming areas in recent years.

Before the main business becomes profitable, Unity is not hesitant to invest in new markets. This is an early exploration of its new growth drivers, as mentioned in several management speeches. The company's current strategic focus is to seize more market share. However, this has also raised concerns in the market about the profit model and the company's cash flow.

The merger with IronSource is based on medium to long-term logic. On one hand, it can provide Unity with the ability and resources in the distribution segment of the game industry (primarily casual games) to earn a larger share of game revenue. On the other hand, it helps Unity increase its penetration rate among independent game studios, which is beneficial in the era of the metaverse when Unity's "shovel" influence can be exerted.

2. Falling into negative growth, unexpected slowdown in Create

In the third quarter, Unity achieved a total revenue of $54.4 billion, a year-on-year growth of 69%. Excluding the impact of the merger with IronSource, the year-on-year growth was nearly 8%. Although the overall revenue was within the guidance range, it was slightly lower than market expectations. What disappointed the market even more was the performance of Create.

In the third quarter, Create's revenue decreased by 0.15% compared to the same period last year, breaking the trend of recovery in the previous quarter, which was quite unexpected. Although forward-looking indicators such as net expansion rate, remaining performance obligations, and the number of large customers spending over $100,000 did not show a significant decline in the short term in the previous quarter, it indicates that the problem mainly occurred during the third quarter.

The company's explanation for the pressure on Create's growth is: high base of UGS, game policy restrictions in China, and a reduction in professional services. The impact of reducing professional services can be understood, as it has been mentioned since Q1 of this year, and the impact of the year-on-year base has not been fully digested. However, the reason of "game policy restrictions in China" seems a bit far-fetched. Since the resumption of game approvals in April 2022, although there may be occasional fluctuations, the overall approval pace has been stable. Therefore, the industry's expectations for policies are not expected to change significantly, which clearly cannot be the reason for the pressure on Create.

On the other hand, the forward-looking indicators in the second quarter did not reflect any significant changes in China's game industry policies. Therefore, Dolphin Research still tends to believe that the new charging policy has had some impact on Unity's reputation in the short term and has led some game developers to choose alternative products.

Therefore, at this moment, the market is in great need of the management team to provide a relatively clear blueprint and direction. However, Unity has unprecedentedly not provided Q4 guidance this time, citing that the monetization effect of the new charging policy is not yet clear, and therefore cannot provide forecast numbers. This move undoubtedly increases market concerns.

Since the company has not provided a guidance range, we can only look at some indicators to make a directional judgment:

(1) Net expansion rate

In the third quarter, the net expansion rate did not stabilize and continued to decline to 102%, which often represents the growth of payment from existing users in the past 12 months. As it is the average growth rate of the past 12 months, a continuous decline in this number indicates a worse performance in the current period.

(2) Number of large customers with TTM>100,000 USD

The number of large customers in the third quarter also decreased compared to the previous quarter, from 1,330 in the second quarter to 1,324. Either existing customers are leaving at a faster rate or new customer penetration is slowing down. However, this situation is clearly not optimistic for Unity, especially when the gaming market is clearly improving.

(3) Remaining Performance Obligations (RPO)/Deferred Revenue

The overall RPO in the third quarter was 56.6 billion, a decrease from 62.4 billion in the previous quarter. The decrease mainly comes from long-term RPO, while short-term contracts did not increase significantly. This indicates that there were not many new contracts in the third quarter, but rather a consumption of existing contract amounts, transitioning from long-term to short-term over time.

So, is the poor short-term growth prospects for Unity due to the industry? Obviously not, at least not in the gaming market.

Looking at the performance of the global mobile gaming market in the following chart, the industry is experiencing a recovery as we expected at the beginning of the year, both in the Chinese market and other regions.

Although global mobile game downloads reversed their direction and declined in September, contrary to the change in revenue, it does indicate some issues, such as the possibility of fewer new games and the market recovery being driven mainly by the performance of existing games. If this trend continues, it may have a certain impact on Create's customer acquisition. However, in the first two months of the third quarter, July and August, the download volume showed a positive trend, and historically, download volume has always fluctuated significantly. But Create's historical revenue did not show such a large fluctuation in this quarter.

Therefore, Dolphin Research still tends to believe that the new fee policy introduced in September has changed some customers' choices of development engines.

3. Cost control squeezing profits, only a consolation

The performance on the profit side in the third quarter may be the only thing worth celebrating. However, with such lackluster revenue, the profits achieved through cost control can only console some long-term investors. After all, while profits are important at present, they are not the most important.

Unity's GAAP operating loss in the third quarter was 520 million, with a convergence rate of 12 percentage points. Research and development expenses played a major role in the convergence of expenses, followed by sales expenses.From the perspective of SBC, the decrease in R&D expenses may be mainly due to the reduction in expenditure on research and development personnel. Sales expenses may not be directly related to layoffs, but more likely to be associated with a decrease in marketing and promotion expenses.

Excluding all employee stock incentive expenses, the non-GAAP operating profit margin in the third quarter reached 24%, exceeding the guidance range of 17% to 18% given in the previous quarter.

In addition, according to previous research information, the company also has plans to further reduce SBC. Therefore, the annual dilution ratio of equity is expected to decrease from the previous years' 5% to 2%-3%. In the third quarter report, the management guided that the overall shareholding at the end of Q4, including potential diluted equity, is 480 million shares (slightly lower than the guidance of 488 million shares given in Q2), with a YoY increase of only 1.24%, which is lower than the previous expectation of 2-3%. This increase in friendly terms is beneficial to small and medium shareholders.

Third, cash flow is not a major issue and is not the focus of current attention.

With the improvement in profitability, the company's free cash flow continues to increase. However, due to increased investment and repayment of some debts in this period, the cash on hand has decreased MoM. As of the end of the third quarter, Unity had approximately 1.52 billion in cash and investments, a decrease of 130 million MoM.

The company has no interest-bearing debt, and financing is mainly through direct issuance of stocks or convertible bonds. Currently, the main convertible bonds issued in 2021 have a face value of 1.725 billion and will mature in 2026.

However, due to the high conversion price, the stock nature of the convertible bonds has basically disappeared, and they may need to be repaid upon maturity.However, as the company's free cash flow has turned positive and is expected to continue accumulating cash in the future, there is no immediate need to be overly concerned about potential financing risks. For small and medium-sized investors, the end of Unity's darkest period and the potential recovery of revenue growth are more important.

Recommended readings from Dolphin Research on "Unity":

Earnings Season

August 3, 2023 Earnings Call Summary: "AI and VR, significant progress expected in the next two years (Unity 2Q23 Earnings Call Summary)"

August 3, 2023 Earnings Report Review: "Unity, which has been repeatedly hyped, also delivers on its performance"

May 11, 2023 Earnings Report Review: "Unity: Beat the earnings, but let's wait and see..."

February 23, 2023 Earnings Call Summary: "Management: Currently in a downturn, focus on the timing of recovery (Unity 4Q22 Earnings Call Summary)"

February 23, 2023 Earnings Report Review: "Unity: Joining forces with IronSource, but still struggling in the industry's winter?"

November 10, 2022 Earnings Call Summary: "Unity's Q4 guidance may not greatly exceed expectations (3Q22 Earnings Call Summary)"

November 10, 2022 Earnings Report Review: "Unity: Is the steep decline becoming a habit? Performance is not as bad as it seems, but not as good either"

August 10, 2022 Earnings Call Summary: "Unity: Significant recovery in proprietary technology, but short-term macro pressures ahead (Call Summary)"

August 10, 2022: "Unity's frenzy of capital operations, with miHoYo entering the game, difficult to resolve short-term hidden concerns"May 11, 2022 Conference Call: "Unity: Second Quarter Guidance Affected by Internal Issues, Long-term Impact Not Seen" (Summary of Conference Call)

May 11, 2022 Earnings Report Review: "Unexpected Thunder, Is Unity, the Shovel Stock of the Metaverse, Also Crumbling?" (Review of Earnings Report)

In-depth

October 12, 2022: "The Winter of Gaming Has Come, Where Can We Find a Warm Spring?" (Article)

April 1, 2022: "Several Interesting Points from the 'Unity 2022 Global Gaming Report'" (Article)

March 17, 2022: "Imagining Valuations with the Power of the Metaverse? Unity Says It's Possible" (Article)

March 9, 2022: "The Unclear Metaverse, the Clear Unity" (Article)

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