Unity's sharp drop? Poor management, lousy moves.

Hello everyone, I'm from Dolphin Research!

After the U.S. stock market closed on February 26th, the leading game engine company Unity Software released its fourth-quarter performance for 2023. In a nutshell, it's a mess left by the former CEO, and the new team has to continue cleaning up the mess.

Before diving into the specifics of the Q4 performance, let's first review the issues Unity faced in the previous quarter. In terms of performance, Unity slimmed down in the third quarter (closing Professional Service), leading to a negative revenue growth. Additionally, they faced operational challenges caused by customer dissatisfaction due to changes in their payment policies. Although this issue didn't show much impact in the Q3 performance, the three leading indicators pointed to worrisome short-term trends.

By not providing performance guidance, the market was left puzzled about the actual development of the company, leading to an immediate drop in the stock price after the performance release. The subsequent rebound was purely driven by market liquidity and speculation on VisionPro and AI, as the 3D engine revenue on VisionOS had not significantly contributed to the company's performance.

In early January, the company announced another round of layoffs of 1800 employees (25%), which completely reversed the stock price. This one-time large-scale layoff (instead of a continuous rolling layoff to ensure business stability) cannot simply be seen as a cost-saving measure, but rather indicates significant changes in the company's strategy or operational status in the short term, causing increased uncertainty and potential capital flight. Unity's bloated organization is a harsh reality, as the former CEO's expensive acquisitions were not followed by timely departmental restructuring and personnel integration, resulting in an annual revenue of only 2 billion with over 7,000 employees.

In this scenario, the Q4 performance is crucial in guiding when the company can emerge from the restructuring shadows. However, due to changes in disclosure structures and some forward-looking indicators not being presented in the flash report, judging the short-term outlook has become more challenging. The company expects to complete the restructuring by the end of the first quarter, which may then reveal the turning point in Unity's fundamentals.

Specifics of the Q4 performance:

1. Excluding incidental factors, both revenue and profit missed expectations: At first glance, it may seem like revenue and adjusted EBITDA beat expectations, but in reality, this includes a one-time permanent license revenue of 99 million due to terminating the original cooperation framework with Weta at the end of November.If we completely exclude this impact, in fact, Unity's revenue of 510 million and adjusted EBITDA profit of 84 million are both significantly below market expectations.

2. Failure of forward-looking indicators leading to negative growth: Following the cancellation of guidance in the previous quarter amidst significant changes in the company's development, the market hoped to see performance guidance in Q4 that could at least shed light on the current operating status of the company.

Although guidance for 1Q24 and 2024 has been provided, the management has redefined a disclosure criterion - the "Strategy Portfolio" to represent the core businesses they will focus on in the future, including engines, cloud, and advertising. The gradually exiting and closing of Weta, professional services, and Luna (formerly IS business, cross-channel marketing planning for independent studios and small game factories) are no longer disclosing specific revenue and profit. This will mainly render some forward-looking indicators that Dolphin Research pays attention to ineffective, as they cannot be traced back to previous periods (and this time has not been disclosed, awaiting the complete financial report).

However, looking at deferred revenue, long-term deferred revenue has decreased by 90%, indicating that a significant portion of the deferred revenue previously came from Weta, and there may also be customer contract losses due to payment adjustments.

Taking a direct look at the company's disclosed "Strategy Portfolio" revenue (/guidance) for 2023 and 2024, a bleak outlook of increasing negative growth can be seen. Only with the loss-making businesses removed, the profit will appear better.

3. Bulky and inefficient structure still needs optimization: Despite announcing layoffs of 1,800 people in January and previously laying off over 250 people in the Weta business in November, for an organizational structure of around 7,000 people generating 2 billion in revenue, Unity appears very bloated and inefficient compared to other software companies in the industry.

The most direct manifestation is the high operating expenses. Unity's three expenses often exceed 100% of revenue, with equity incentives accounting for 30% of that. The operating expense ratio in Q4 was 99.6%, an increase from the previous quarter, coupled with the high cost of Weta revenue recognized in the period, resulting in a net loss of 250 million USD and an operating loss of 260 million USD.

The company revealed that after laying off 1,800 people, it is expected to bring in 250 million in Non-GAAP operating expenses for the full year. If 30% is added for equity incentives, the operating expenses will amount to 330 million, showing a significant optimization effect.

4. Despite dismal performance, cash flow is temporarily secure: At the end of the fourth quarter, the company had 1.6 billion in cash on hand. Although the net loss has significantly widened, the free cash flow can still net in 72 million. After swiftly cutting more loss-making businesses, the pressure on cash flow will further decrease. Short-term layoffs will incur some compensation expenses, but 30% of employee compensation is in the form of stock options, which can actually save some cash outflow. The market anticipates that the two rounds of layoffs will require approximately 100 million in compensation expenses.

5. Current Performance Overview

Dolphin Research Insights

In short, Unity is currently in a period of chaos.

On one hand, the stable leadership team (especially the final CEO) has not been confirmed yet, indicating the current difficulty for the company to formulate medium to long-term strategies. James, appointed as the interim CEO by Silver Lake, may prioritize profitability from the perspective of this major shareholder. Therefore, he is aggressively cutting various loss-making businesses.

Dolphin Research believes that instead of cutting innovative businesses, Unity may need to address operational efficiency issues first. After all, the former CEO was involved in numerous acquisitions, but after each acquisition, there seemed to be no significant personnel integration or lack of business synergy, resulting in a continuous bloated workforce. While cutting businesses may show immediate results, it may also eliminate some of Unity's growth potential.

On the other hand, the slowdown in casual game growth, Apple's privacy policies, and significant strategic changes, are causing Unity's old business performance to continue to linger at a "low point" for some time. The market hype around VR has not significantly contributed to VisionPro yet (due to technological adaptability, competition with Apple's proprietary engine, and limited developers).

The company has stated that accelerated growth will be seen in the second half of 2024 (due to a low base + Visionpro 3D engine + cooperation with Meta on H5 mini-games), but the full year is still expected to be in a negative growth state. However, with the leaner Unity post-restructuring, whether its future growth can still support the current valuation (24eEBITDA 27x), the dependence on VR or AI may only increase.

Detailed Analysis:

I. Overview of Unity's Business

Disclosure of major structural adjustments: The current performance has been incorporated into the operating conditions of IronSource, making the year-on-year growth rate relatively distorted. Moreover, due to the adjustment of the division range of segmented businesses, it has 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, Strategy) to two (Create, Grow).

The new Create solution includes the products originally under Create (game engines), as well as the UGS revenue (Unity Game Service: a comprehensive solution for game companies that helps with game development, distribution, and user acquisition) previously confirmed under Operate, and the revenue from the original Strategy segment;

While the Grow solution includes the advertising business originally under Operate, as well as the merged marketing (Aura, Luna) and game distribution services (Supersonic) from IronSource.The distribution of revenue contributions comes from the seat subscription revenue of the game development main engine, as well as the revenue from the advertising platform responsible for auction matching, game publishing revenue, and so on.

Looking at Unity's business structure over the past few years, although Unity has gained fame for its absolute monopoly in the mobile game development engine market, the contribution of the Create solution business to overall revenue is not the highest. With the accelerated growth of incentive advertising games, the advertising revenue of Grow (Operate) has also rapidly increased, playing a greater role in supporting Unity's revenue, especially profits.
Reviewing Unity's performance over the past two years, Create revenue has basically maintained a growth rate of 30%-50%, in line with the performance of a relatively stable SaaS platform in development. This indicates that the user penetration rate has reached a plateau stage, but high stickiness and renewal rates are guaranteed. Annual revenue growth relies on users using more tools or the platform raising prices.

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

Currently, although Unity's operating losses are relatively large, mainly due to the lower monetization rate of the main engine compared to peers, the profit model of Create has not yet taken off, and the company has been continuously increasing investments in non-gaming areas in recent years.
Before the core business becomes profitable, Unity is not hesitating to invest in new markets. This is an early exploration of additional growth drivers for the company, as mentioned in several management speeches. The current strategic focus of the company 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 supplement Unity's ability and resources in the distribution link of the game industry (leaning towards hyper-casual games), earning more revenue share from game flows. On the other hand, it helps Unity expand its penetration rate in independent game studios, which is beneficial for Unity to exert its "shovel" influence in the era of the metaverse.

II. Restructuring Loss-making Businesses, Create is the Hardest Hit Area

Unity achieved a total revenue of $6.09 billion in the fourth quarter, a year-on-year increase of 35%. However, this figure includes one-time revenue from Weta. Excluding this impact, the actual revenue is only $5.1 billion, a 2% year-on-year decline. As a growth stock relying on high growth, this performance is very unattractive.

Of course, this is related to the company's ongoing business restructuring, where professional services, Weta, multiplayer game hardware component development, independent developer professional art creation tools, and Luna will gradually exit. The reason is that profit is currently the top priority, and these businesses are all loss-making.In the businesses that are about to close mentioned above, except for Luna (a cross-channel marketing plan for independent developers), all belong to the Create business category. Therefore, the overall revenue decline is mainly due to the drag from Create (excluding the situation with Weta).

The Grow business also experienced a high base due to the acquisition of IS starting from Q4, with the growth rate slowing down from 166% in the previous quarter to 26%.

The continued decline in Create in the fourth quarter is actually not surprising. In the previous quarter, we already saw some growth pressure in terms of Net expansion rate, number of major clients, and remaining performance contracts/deferred revenue, three forward-looking indicators. However, because two forward-looking indicators were not disclosed in the flash report for this quarter, it is temporarily impossible to compare with the previous quarter.

However, from the disclosed deferred revenue and the revenue guidance provided by the company, the growth pressure on Unity in 2024 is still significant, especially in the first half of the year. The second half of the year may see a rebound due to the low base, VisionPro, and the cooperation with Meta on H5 games. By the end of 2024, Unity 6 will be released, incorporating a new Runtime subscription model, which is expected to boost the old business.

Although Unity's growth and valuation focus mainly on non-gaming industrial scenarios, game market revenue in Q4 still accounts for 67% of the overall engine subscription revenue. Therefore, it is necessary to also consider the industry situation.

Looking at the trend, the continuous warming trend before January is evident, but the download volume has been declining since the fourth quarter, which may also be related to the strong rebound in offline activities as the Chinese market opens up from the epidemic.

Therefore, we expect an easy recovery of the low base dividend in the first half of the year, but the second half of the year will truly return to normal disruptions caused by the epidemic. Overall, the year may seem a bit flat, and more developers need to participate in new product development to stimulate industry prosperity (the following data does not include the Chinese Android market).

Analysis Report: Unity Needs Optimization in Bloated and Inefficient Structure

Despite announcing layoffs of 1800 employees in January and previously cutting over 250 jobs in the Weta business in November, Unity's current organizational structure, with around 7000 employees generating revenue of 2 billion, appears bloated and inefficient compared to its peers in the software industry.

The most direct manifestation is the high operating expenses. Unity's operating expenses often exceed 100% of its revenue, with equity incentives accounting for 30%. In Q4, the operating expense ratio was 99.6%, expanding from Q3. Coupled with the high cost of Weta's revenue recognized in the period, this led to a net loss of 250 million USD, with an operating loss of 260 million USD.

After excluding expenses such as goodwill impairment from the dissolution of Weta and employee stock option incentives, the EBITDA profit margin increased to 30.5%. However, without considering Weta, the profit margin would be only 16.5%. Nevertheless, due to the gradual exit from high-loss businesses, the company's Q1 performance and profit guidance exceeded market expectations. Although there was a significant drag on revenue for the year, the profit and loss were slightly better than market expectations.

Following the disclosure of the 1800 job cuts, the company expects to bring in 250 million in Non-GAAP operating expenses for the year. If we add 30% for equity incentives, the optimization effect would be significant, totaling 330 million in operating expenses.

Cash Flow Situation: Unity Temporarily Unconcerned

With pressure on growth in the old business in the fourth quarter, the company has been cautious in cash outflows. The Q4 free cash flow netted 72 million, but due to increased investments and some borrowing, the cash on hand increased slightly. As of the end of the fourth quarter, Unity had approximately 1.6 billion in cash and investments, a decrease of 70 million compared to the previous period.The company has no interest-bearing debt, and financing is mainly through direct stock issuance or issuing convertible bonds, with a total face value of 2.7 billion at the end of the fourth quarter, with little change from the previous quarter. The main issue was in 2021, with a face value of 1.725 billion, and the convertible bonds due in 2026 may need to be repaid upon maturity due to the disappearance of stock characteristics as the conversion price is too high.

However, as the company's free cash flow has turned positive, it is expected to continue to accumulate cash in the future, so there is currently no need to be particularly concerned about potential financing risks. For small and medium investors, when Unity's darkest period will end and whether revenue can return to high growth are still more important.

Dolphin Research on "Unity" Related Readings:

Earnings Season

November 10, 2023 Conference Call "Unity: More streamlined, more focused (Unity 3Q23 Conference Call Summary)"

November 10, 2023 Earnings Report Review "Continuous shenanigans, Unity in turbulence"

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

August 3, 2023 Earnings Report Review "Unity, repeatedly hyped, also performs well"

May 11, 2023 Earnings Report Review "Unity: Beat the earnings, ready to take off? Let's wait and see..."

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