Unity: Is the bone-setting therapy coming to an end?

Hello everyone, I am Dolphin.

After the US stock market closed on May 9th, Eastern Time, the leading game engine company $Unity Software(U.US) released its first-quarter performance for 2024. Overall, the Q1 performance was mixed, with revenue beating the market's relatively conservative expectations, but the lack of an upward revision in the full-year guidance disappointed the market. On the profit side, restructuring one-time costs increased losses, but excluding this factor and depreciation, non-GAAP figures actually exceeded expectations.

As Unity was still in a restructuring phase in the first quarter (with businesses such as Weta, Professional Service, and Luna still in the process of closure, and the restructuring work was basically completed by the end of the first quarter), Dolphin is more concerned about this financial report in terms of:

(1) Company guidance: Helping to determine the inflection point of performance reversal and when valuation will truly rebound.

(2) Operating indicators: Helping to determine the inflection point of operations and the lower limit of valuation grinding.

Specifically:

1. A turbulent year, what happened?:

Over the past year, there have been significant changes in Unity's business structure, so it is necessary to "review the past" before the financial report.

At the beginning of 2023, Unity officially completed the merger with IronSource, directly boosting Grow revenue. At the same time, with IS's over 2,000 employees and several hundred employees from the previous year's merger with Weta, the massive organizational structure of nearly 8,000 people became a core reason for the group's increased losses in 2023 under the industry headwinds (the global gaming industry saw almost no growth in 2023).

The growth pressure downstream quickly transmitted upstream, and global game companies began optimizing their workforce. As a result, Unity's engine business, based on a subscription-based business model, felt significant pressure after the dividend period from the IS merger, as the number of developer professionals decreased.

To alleviate the growth pressure, the management introduced a new fee structure based on Runtime fees, which was full of negative feedback, attempting to push the pressure back to downstream customers. This sparked a united backlash from game developers, further accelerating the deterioration of Unity's operating indicators.

Therefore, starting from 3Q23, the company entered a period of chaos. Not only did they cancel the short-term guidance for 4Q23, but they also announced layoffs at the end of 23 and the beginning of 24. If the layoff of 265 people at the end of 23 was interpreted as cost reduction and efficiency improvement in existing businesses, the layoff of 1,800 people (25% of the workforce) announced in January 24 was a survival move. The significant changes in the business directly led to market confusion and uncertainty about Unity's growth expectations, both in the short and long term (the hype around VisionPro and AI themes is confusing).Therefore, the situation reported in the first quarter is actually the process of the company's "restructuring", so the financial indicators obviously cannot simply be compared to the past situation (not to mention that the base number of 1Q23 is still "inflated"), the year-on-year and quarter-on-quarter significance is not significant (the comparable growth disclosed by the company in the same business is still crucial), in addition, one-time expenses incurred during the company's restructuring will also cause short-term profit indicators to collapse.

Moreover, the past turbulence has long been anticipated, and most of it has already been priced into the stock price. However, some non-financial operational indicators disclosed in the first quarter report are often more forward-looking and can be somewhat helpful for us to judge the turning point.

Clear financial turning point, but guidance lower than expected

The turning point in performance is not in Q2, and the data warming in Q4 is expected to be more pronounced. According to the company's guidance, the second quarter is expected to have Strategy Portfolio revenue between 420 million to 450 million, with a comparable decrease of 6%-7%, significantly worse than the 2% growth in Q1 due to the high base number, with the midpoint of the range slightly below market expectations. However, the company expects the adjusted EBITDA for the second quarter for Strategy Portfolio to be 75 to 80 million, with a profit margin of around 18%, showing a significant improvement quarter-on-quarter.

The company expects full-year revenue in 2024 to be between 1.76 billion to 1.8 billion, with a year-on-year growth of 2% to 4% (unchanged from the guidance given in the previous quarter), but lower than market expectations. With a 2% growth in the first half of the year, indicating an 8% growth in the second half of the year. In addition, the fourth quarter of last year was the period when the company began its restructuring, and the base number itself has already decreased, so the rebound in Q4 data should be more certain.

Furthermore, according to the company's plan to release Unity 6 by the end of the year, as well as the expectation of releasing several functional components in the third quarter, and the potential industry cycle recovery, this will also help the financial data to truly turn around in Q4.

A glimmer of hope revealed in the operational aspect: According to the "Strategy Portfolio" business scope disclosed by the company in the previous quarter (including engines, cloud, and advertising), the comparable growth created in the first quarter is 17% year-on-year and 4% quarter-on-quarter, reflecting the recovery of growth in the core Create business.

Several forward-looking operational indicators that Dolphin Jun has always been concerned about have mixed performances, but the new contract indicators unaffected by business integration reveal growth prospects.

(1) Net expansion rate, number of large customers, and remaining non-cancelable contract amount (including deferred and unpaid backlog) have deteriorated quarter-on-quarter, but may be related to closed businesses.

(2) Indicators such as new contract amount calculated by Dolphin Jun for the second time are starting to show quarter-on-quarter growth.

As more game companies globally have started layoffs in the first quarter of this year, excluding the possible impact of industry environmental changes, the increase in contract amount in the first quarter can be seen as a positive signal that the company is regaining customersCash Flow: Free cash flow turns negative, redeeming part of convertible bonds

At the end of the first quarter, the company had 1.2 billion in cash, which was 400 million less than the end of last year, mainly used to redeem part of the convertible bonds. Due to the one-time increase in restructuring and severance costs, operating cash flow turned negative for the period. Although capital expenditures were halved compared to the past, free cash flow still fell into negative territory in the short term.

Performance Indicators Overview

Dolphin's Viewpoint

What is the market worried about? Although the turning point in performance in the second half of the year is clearly visible, the market feedback remains flat when the financial report is released. Combining the conference call, we found that the biggest concern in the market is still some doubts about Unity's medium to long-term growth. For example, during the conference call, analysts repeatedly asked about the growth drivers, Unity's product competitiveness, especially for the lagging Grow business in the past two years. After the dividend period of merging with IronSource, what will drive growth?

Dolphin believes that the fundamental reason for the market's lack of confidence in Unity's growth lies in the short-term unfavorable industry environment for Unity and the lack of trust in the management's capabilities. During the turbulent period, Unity's performance lags behind its peers, raising doubts about its competitive barriers. Although the previous CEO was the main scapegoat, it is uncertain whether the new CEO who will take office next Wednesday will repeat the same mistakes.

However, we also mentioned that the sequential growth in new contracts in forward-looking indicators has shown signs of recovery. Coupled with the approaching turning point in performance, although lower than expected, at least it will not fall into a bottomless pit of continuous decline. Therefore, in the current chaotic performance and the market's uncertain growth expectations, it is more crucial to find a safe position by probing.

Combining the company's guidance and market expectations, assuming Unity achieves 20 billion in revenue in 2025 (+11% yoy), with Create growing significantly faster than Grow, conservatively ignoring the uniqueness of Create's growth, and valuing the overall company at 4x to 6x forward PS (Snap 4x, Applovin 6x), the estimated bottom valuation is around 80 to 120 billion. As of the closing market value on May 9th, which is 97 billion, it falls within this range. However, until more reversal signals are released and the market's confidence in its growth is restored, Unity may continue to oscillate near the bottom.

Detailed Analysis Below

I. Introduction to Unity's Business

In the first quarter of 2023, Unity merged with IronSource and adjusted the division of its business segments. Under the new disclosure structure, the segment business was condensed from the original three (Create, Operate, Strategic) to two (Create, Grow) The new Create solution includes the products originally under Create (game engine), as well as the UGS revenue confirmed in Operate (Unity Game Service: a full-chain solution for game companies, helping with game development, distribution, and user acquisition), and the revenue from the original Strategy. However, starting from 2023, there will be a gradual shutdown of Professional service, Weta, and other product services;

On the other hand, the Grow solution includes the advertising business from Operate, as well as the marketing (mainly Aura, with Luna closing in 1Q24) and game distribution services (Supersonic) from the merger with IronSource. Revenue contribution comes from seat subscription revenue of the game development main engine, as well as revenue from the advertising platform responsible for auctioning, game distribution revenue, etc.

Excluding the impact of restructuring, Create's growth is recovering

Unity achieved a total revenue of $4.6 billion in the first quarter, an 8% year-on-year decline, slightly higher than the market's relatively conservative expectations. Excluding the impact of restructuring, looking solely at the Strategy Portfolio, revenue grew by 2% year-on-year. Among them, Create grew by 17% year-on-year, showing signs of recovery, with engine subscription revenue growing by 13%. This growth is not easy to come by amidst the wave of layoffs in the gaming industry.

On the other hand, the Grow business in the strategic business portfolio is under short-term pressure, with a 3% year-on-year decline. Compared to the strong double-digit growth of peer Applovin in Q1, it is hard not to have doubts about Unity's own product strength. Dolphin believes that this may be due to the negative feedback from customers since the introduction of the Runtime-based pricing model last year, leading to some churn.

Looking at forward-looking operational indicators:

（1）Net expansion rate

The net expansion rate in the first quarter is expected to continue to decline to 101%, indicating that the total revenue contribution from existing customers over the past 12 months has almost stopped growing, which is largely related to Unity's closure of certain businesses

（2）Number of Key Clients

Due to business restructuring, the number of key clients is also a similar affected indicator. In the first quarter, there were 1,243 key clients, with a decrease of 61 compared to the previous period.

（3）Remaining Unfulfilled Contract Amount & Deferred Revenue

In the first quarter, the remaining contract amount continued to decrease by 7% compared to the previous period. Specifically, the main loss came from long-term contracts, which we believe may be related to the closure of Weta. Short-term contracts related to games saw a slight increase compared to the previous period.

Deferred revenue, reflecting a similar operating situation, also continued to be impacted by the restructuring in the first quarter, with an absolute decrease compared to the previous period. However, similar to the remaining contract amount, the rate of decline has significantly slowed down.

（4）New Contract Amount

In terms of marginal contract additions, Dolphin Jun found that the contract amount signed in the first quarter increased by 8% year-on-year, with a significant increase compared to the previous period. Marginal additions often represent changes in customer attitudes towards Unity's cooperation. Therefore, from this indicator, it indicates that Unity's series of retention actions after last year's turbulence have somewhat eased customer relationships.

The forward-looking indicators (1)-(3) mentioned above are all affected by business closures, making it difficult to separate the situation of the Strategy Portfolio. However, (4) is more of a marginal indicator, thus able to reflect the latest operating trends.

Despite signs of marginal recovery in operations, the actual turning point reflected in financial indicators is estimated to be in the second half of the year, especially in the fourth quarter, where certainty will be higher. However, there may still be some pressure in the short term in the second quarter.

According to the company's guidance, the second-quarter revenue from the Strategy Portfolio is expected to be between 420 million to 450 million, with a comparable decrease of 6%-7%. This is significantly worse than the 2% growth in Q1 due to a high base. The mid-point of the range is slightly below market expectations. However, the company expects the adjusted EBITDA for the Strategy Portfolio in the second quarter to be between 75 to 80 million, with a profit margin of around 18%, showing a significant improvement compared to the previous periodThe company expects full-year revenue in 2024 to be between 1.76 billion to 1.8 billion, with a year-on-year growth of 2% to 4% (unchanged from the guidance given in the previous quarter), but lower than market expectations. With a first-half growth of -2% in guidance, indicating an 8% growth in the second half of the year. Additionally, as the company began restructuring in the fourth quarter of last year, the base has already been lowered, so the rebound in Q4 data should have higher certainty.

Furthermore, based on the company's plan to release Unity by the end of 6 years, as well as the expected release of several functional components in the third quarter, and the potential industry cycle recovery, this will also help in the turning point of the financial data in Q4.

II. Industry Environment Hampers Short-Term Recovery

Although Unity's growth and valuation focus mainly on non-gaming industrial scenarios, gaming market revenue still accounts for the vast majority of overall engine subscription revenue, so it is necessary to also look at the gaming industry situation.

Apart from the high base, the industry environment may be the main factor causing pressure in Q2. According to Sensor Tower data, global game spending and game downloads continued to decline in the first quarter, and at the beginning of the year, global game companies successively announced layoff plans, thus bringing significant drag on Unity's engine subscription revenue based on headcount in the short term.

III. Rapid Layoffs, Significant Cost Reduction and Efficiency Improvement

With 1800 layoffs in January, the effects are already evident in the first-quarter financial indicators. In addition to the several rounds of layoffs in 2023, if strictly implemented in the first quarter, it is expected that the number of employees at the end of Q1 will be less than 5000, a 37% decrease compared to the end of 2022. Adjusted EBITDA for Q1 is 78.5 million, exceeding market expectations (50 million).

Due to the disruption of layoff costs on GAAP profit performance, we mainly look at the profit situation after adjusting for restructuring costs, employee stock incentives, depreciation, and amortization expenses.

The company's guidance for the second quarter (75-80 million) is slightly lower than market expectations (88 million), and the full-year profit guidance (400-425 million) is in line with expectations. During the conference call, the company mentioned that it will moderately reinvest in core business later on, but will focus on efficiencyHigh SBC expenses, although showing a year-on-year decline, still account for a high proportion of revenue, at 30%, and nearly half of the overall expenses. This is one of the key areas that can be optimized in the future.

SBC expenses do not involve cash inflows and outflows, but can lead to share dilution when employees sell off shares after the lock-up period. The company expects the total shares outstanding, including potential dilution, to reach 492 million shares by the end of 2024, an increase of nearly 3% compared to the end of last year.

Cash Flow: Negative Free Cash Flow, Partial Redemption of Convertible Bonds

At the end of the first quarter, the company had 1.2 billion in cash, a decrease of 400 million from the end of last year, mainly used for the redemption of some convertible bonds. The one-time restructuring severance costs increased during the period, dragging down operating cash flow into negative territory. Despite capital expenditures being halved compared to the past, free cash flow remains negative in the short term.

The company has no interest-bearing debt, and financing is done through direct stock issuance or issuing convertible bonds. At the end of the first quarter, the total face value of convertible bonds was 2.2 billion, with the redemption of convertible bonds due in 2026 (with a face value of 480 million). The conversion price of these convertible bonds is as high as $309, which can be considered as debt to be fully repaid upon maturity.

End of Translation

Dolphin Research "Unity" Related Readings:

Earnings Season

February 27, 2024 Conference Call "Unity: Lighten Up and Focus on Software (Unity 4Q23 Conference Call Summary)"

February 27, 2024 Earnings Review "Unity Plunges? Poor Management, Bad Moves"

November 10, 2023 Conference Call "Unity: More Streamlined, More Focused (Unity 3Q23 Conference Call Summary)"2023 年 11 月 10 日财报点评《骚操作不断，Unity 颠簸风雨中》

2023 年 8 月 3 日电话会《AI 和 VR，今明两年会有明显进展（Unity 2Q23 业绩电话会纪要）》

2023 年 8 月 3 日财报点评《被反复爆炒的 Unity，业绩也争气》

2023 年 5 月 11 日财报点评《Unity：财报 Beat 芜湖起飞？先等等…》

2023 年 2 月 23 日电话会《管理层：目前处于衰退期，关注复苏时点（Unity 4Q22 电话会纪要）》

2023 年 2 月 23 日财报点评《Unity：与 IronSource 强强联手，还是难抵行业寒冬？》

2022 年 11 月 10 日电话会《Unity 的 Q4 指引可能并未大超预期（3Q22 电话会纪要）》

2022 年 11 月 10 日财报点评《Unity：暴跌成习惯？业绩没那么糟也没那么好》

2022 年 8 月 10 日电话会《Unity：自有技术问题显著恢复，当下会面临短期宏观压力（电话会纪要）》

2022 年 8 月 10 日《Unity 疯狂资本运作，米哈游入局难解短期隐忧》May 11, 2022 Conference Call "Unity: Headwinds in Q2 are caused by internal issues, long-term impact not seen (conference call summary)"

May 11, 2022 Financial Report Review "Unexpected Thunder, Metaverse Shovel Stock Unity also Crashes?"

In-depth

October 12, 2022 "The winter of games has come, where is the warm spring?"

April 1, 2022 "Several interesting points in the 'Unity 2022 Global Gaming Report'"

March 17, 2022 "Imagining valuation with 'Metaverse'? Unity says it's possible"

March 9, 2022 "The unclear Metaverse, the clear Unity"

Risk disclosure and statement of this article: "Dolphin Research Disclaimer and General Disclosure" 海豚投研免责声明及一般披露