Rapid and irrational surge, but the future of "new" Unity is promising

Hello everyone, I am Dolphin Jun!

After the US stock market closed on August 8th, Eastern Time, the leading game engine company $Unity Software(U.US) released its second-quarter 2024 performance. Overall, the performance in Q2 exceeded expectations, but the Q3 guidance missed expectations and further lowered the full-year guidance.

Normally, a guidance downgrade is a very negative signal, so why is the market reacting so positively? Unity's stock surged 8% at the close yesterday. Is it because the market hopes that Unity can turn the situation around after the restructuring, or is it just pure trading volatility? What subtle operational changes are reflected in the Q2 financial report?

At such a critical turning point, the vast majority of financial indicators lag behind the company's strategic and operational changes, and operational information is mainly discussed during conference calls. Therefore, after carefully reading the shareholder letter and conference call content, Dolphin Jun will discuss in detail with everyone how to interpret this financial report.

Let's first go through the performance of the core financial indicators:

1. Engine business effectively retains customers?: In the disclosure caliber of the Strategy portfolio, the growth rate of Create has slowed down due to the active contraction of business such as strategic cooperation and professional services. The subscription revenue of the main engine still maintains a healthy growth of 13%.

The company explains that this is driven by both volume and price. On one hand, price increases and users transitioning from lower-priced packages to premium packages, and on the other hand, the number of subscription users is also increasing.

Compared to the former, Dolphin Jun pays more attention to the latter, which is the increase in the number of subscription customers. This is not only because acquiring customers with high retention rates in the Tob business is crucial, but also because the announcement of charging based on Runtime in September last year led to customer dissatisfaction and even loss, so the main task of the new CEO after taking office is to retain the previous game customers.

Although the management claimed that the number of subscription customers increased in both Q1 and Q2, it was not evident in the actual indicators in Q1. In Q2, the number of large customers increased by a net of 11 compared to the previous quarter. Although the increase is not significant, it finally corroborates the management's description of "customer sentiment turning around."

Unity 6 will be released in the next quarter, and the new payment model based on Runtime charging will be officially launched. Therefore, subscription users who are willing to renew at this time can be seen to some extent as accepting this charging change. The management is confident in Unity 6, believing that this generation of engine will be the main driving force for future growth.

2. Advertising is still in decline: However, as we all know, the engine business is Unity's core competitiveness, and the real reason the company has been under pressure for so long is that the Grow business, which is mainly advertising-based, has encountered problems.

In the second quarter, the Grow business in the Strategy portfolio declined by 9.5% year-on-year, further accelerating from the previous quarter. Although there are industry factors (leading company Applovin's revenue miss), the slower growth compared to peers reflects that Unity's market share is being further squeezed Currently, Unity has brought in two experts to adjust its advertising business. Jim Payne, one of the co-founders of the mobile advertising marketing platform MoPub, later founded Max advertising systems, making him a seasoned expert in the field of mobile marketing.

However, the management also acknowledges that it will still take some time to fix the advertising business. Due to the uncertainty in the pace of adjusting the advertising business, the management has prudently lowered the full-year revenue guidance.

3. More "Hope" Revealed by Quantitative Operational Metrics: In the last quarter, among several forward-looking operational indicators that Dolphin Jun pays attention to, only the growth in new contracts on a month-on-month basis increased. This was seen as a "glimmer of hope" by Dolphin Jun because the new contract amount was not affected by the restructuring.

Looking at the second quarter, there seems to be more hope in the operational indicators: (1) New contracts continue to expand on a month-on-month basis; (2) Number of large customers has a net increase on a month-on-month basis; (3) Deferred revenue has a net increase on a month-on-month basis; (4) Remaining non-cancelable contract value (including deferred and unpaid backlog), although still declining on a month-on-month basis, the rate of decline has further narrowed.

The only regret is that (5) Net expansion rate is deteriorating, dropping to 96% in the second quarter. This means that the payment from existing customers in the past year decreased compared to the previous year. This could be due to reasons such as customer churn, reduction in the number of accounts or downgrading of accounts by existing customers, as well as Unity's proactive closure of some businesses. Considering the layoffs by many game developers at the beginning of the year, Dolphin Jun believes the latter two reasons are more likely.

4. Cutting Employees for Efficiency, Lowered Profit Guidance Indicates Approaching New Investments: The significant layoffs mentioned by Unity at the beginning of the year finally materialized in Q2 - operating expenses decreased by 17% year-on-year, mainly from the significant reduction in research and development, sales expenses, and a 28% year-on-year decrease in SBC expenses. The gross profit margin returned to a high level of 76% due to adjustments in the product portfolio, discontinuation of low-margin professional services and Weta collaboration. As a result, operating losses decreased by 32% to 129 million, and adjusted EBITDA reached 114 million, exceeding guidance and expectations.

Although Q2 profits exceeded expectations, the company also lowered its profit guidance for Q3 and the full year, with the reduction exceeding the revenue. This indicates that the cost-cutting and efficiency improvement measures are nearing completion, and moderate new investments are expected to come.

This was partially confirmed during the conference call. The management pointed out that to strengthen the competitiveness of the advertising business, more infrastructure needs to be built, so there will be some investments in machine learning, data stack, and other areas in the future.

5. Performance Metrics Overview

Dolphin's Viewpoint

The biggest controversy in the second quarter performance is the issue of guidance downgrade. At first glance, it is a negative message for short sellers. However, after reading through the financial reports, shareholder letters, and conference calls, Dolphin believes that the downward revision of guidance is most likely as the management team stated, "out of cautious and conservative considerations," to provide the newly formed team with more room for trial and operation.

With the departure of the original CFO and the introduction of two industry veterans to readjust the advertising business, the new team under Unity has a sense of starting anew. Of course, in terms of financial indicators, it is difficult to see rapid changes in the short term.

In the Q1 review, Dolphin believed that the turning point in financial performance would be earliest at the end of the year, mainly based on the performance of Create: 1) Unity's release in the fall of 6; 2) the formal completion of the restructuring cycle by the end of the year; 3) the recovery of the gaming industry, among other considerations.

The Q2 financial report did not completely meet Dolphin's expectations (forward-looking indicators indicate that the improving trend of Create has not changed, and non-gaming market revenue is still growing rapidly, with a growth rate of nearly 60% in Q2). However, it must be acknowledged that the advertising business has indeed faced some twists and turns in the short term, and according to the guidance, Q4 is probably still catching its breath. The key to advertising adjustment lies in how Unity can win back customers from competitors like Applovin.

The management has provided some directional guidance - the introduction of talent, improvement of high-tech infrastructure, faster product innovation, and leveraging existing ecosystem advantages and positions to drive business recovery and expansion trends.

These actions are not immediate, nor can they bring about immediate changes in performance in the short term. But the new team has chosen the right direction - polishing products to enhance competitiveness, rather than relying on commercial means to force customers to make choices that are detrimental.

Therefore, Dolphin believes that although Unity is still in an adjustment period in the short term, the guidance downgrade and the decline in advertising market share are still somewhat negative news for most funds. However, in the medium to long term, Dolphin is relatively optimistic and hopes that Unity can return in a simpler, purer manner.

Looking back at yesterday's counter-trend surge, it cannot be ruled out that some funds are betting on the new team or preemptively buying into the operational turning point, as the current valuation is indeed low. However, Dolphin believes that it is mainly due to trading factors, and the short-term fundamentals do not support such a degree of increase. Only when there are clear signs of resolving the advertising issues will there be truly sustained and powerful value restoration.

Detailed Analysis Below

I. Introduction to Unity Business

In the first quarter of 2023, Unity merged with IronSource's operations and also adjusted the scope of segmentation of its business. Under the new disclosure structure, the divisional business has been 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 previously confirmed in Operate (Unity Game Service: a full-chain solution for game companies, helping to solve game development, distribution, and user acquisition operations), 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 originally in Operate, as well as the merger of IronSource's marketing (mainly Aura, Luna to be closed in 1Q24) and game publishing services (Supersonic). Revenue contribution comes from seat subscription revenue of the game development main engine, revenue from the advertising platform responsible for auction matching, game publishing revenue, etc.

II. Create maintains stable growth, while Grow faces worsening issues

Unity achieved total revenue of $4.5 billion in the second quarter, a year-on-year decrease of 15.8%, slightly higher than guidance and market expectations. Excluding the impact of restructuring, looking solely at the Strategy Portfolio, revenue decreased by 6.5% year-on-year.

On one hand, strategic partnerships and professional services in the Create business are still actively shrinking, with engine subscription revenue growing by 13% year-on-year, remaining stable compared to Q1; on the other hand, Grow is still affected by the competition from peers in mobile app marketing.

Looking at forward-looking operational indicators, overall Q2 trends continue to improve:

(1) Net expansion rate

The net expansion rate in the second quarter is expected to continue to decline to 96%, which represents a year-on-year decrease in total revenue from existing customers over the past 12 months, indicating a decrease in payments by existing customers compared to the previous year.

This may be due to a. Unity's proactive closure of certain businesses, as well as b. reasons such as existing customers reducing the number of accounts or downgrading accounts, and c. reasons for customer churn. Considering the layoffs by many game companies earlier this year, Dolphin believes that the former two reasons (a/b) are more likely

(2) Number of Major Clients

Due to business restructuring, the number of major clients is also an indicator that may be affected. However, in the second quarter, the number of major clients reached 1254, with a net increase of 11 compared to the previous quarter, which is a positive signal worth continuing to monitor.

(3) Remaining Unfulfilled Contract Amount & Deferred Revenue

In the second quarter, although the remaining contract amount decreased by 1.4% compared to the previous quarter, the decline has slowed down compared to Q1. Reflecting a similar operating situation, deferred revenue in the second quarter also showed signs of recovering from the impact of restructuring, with a net increase of 680 million.

(4) New Contract Amount

The Dolphin's second calculation of the new contract amount indicator was the only positive signal in Q1, and in Q2, with improvements in other forward-looking indicators, it naturally continued to show a positive trend: the new contract amount in Q2 continued to expand.

Marginal additions often represent changes in customer attitudes towards Unity, so from this indicator, it once again illustrates that Unity's series of retention actions after last year's controversial operations have somewhat eased customer relationships, which is also corroborated by relevant statements from management during the conference call.

The above forward-looking indicators (1)-(3) have been affected by business closures. Although it is difficult to separate the impact of the Strategy Portfolio, the overall trend is showing a continuous recovery. Indicator (4) is more marginal and can better reflect the latest operating trends, indicating that the operating situation has not deteriorated.

Of course, financial indicators always lag behind changes in operations, and due to the cautious considerations in the advertising business, management has slightly lowered the revenue guidance for Q3 and the full year.

According to the company's guidance, the Strategy Portfolio revenue in the third quarter is expected to be between 415 million and 420 million, with a comparable decrease of 4%-6%, slightly better than the second quarter, and the midpoint of the range is below market expectations.

In addition, the management expects the full-year 2024 Strategy Portfolio revenue to be between 1.68 billion and 1.69 billion, a year-on-year decrease of 2% to 3%. Compared to the previous quarter, it has been revised downwards, but the new guidance still implies an expectation of revenue recovery in the fourth quarter.

Unity 6 is also set to be released this autumn, and it is expected that the management will be able to see feedback from Unity 6 customers in the third quarter. Therefore, as long as there are no major disruptions in the advertising business, the turning point in performance by the end of the year is relatively clear.

II. Industry Recovery, Why is Unity Not Benefiting?

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

According to Sensor Tower data, global game revenue rebounded significantly in the second quarter, and following the trend of the base period, the second half of the year is expected to continue to recover.

In theory, Unity should also follow the recovery, so why is advertising revenue declining instead of increasing?

Dolphin believes that, first of all, it cannot be denied that Unity is indeed losing market share in the mobile marketing market. On the one hand, Runtime fees have angered many, leading to the cancellation of marketing partnerships, and on the other hand, the integration with IS has not yet been effective, as well as the fact that Unity's ad tracking technology has not been optimized in a timely manner under Apple's privacy policy, all contributing to this situation.

However, Dolphin also found that Sensor Tower's industry data is based on actual consumer payment revenue, but does not include casual games that primarily monetize through in-app advertising. In addition, while global payments are growing, game downloads have not recovered synchronously, indicating to some extent that the incremental revenue from games mainly comes from existing games, and not many new games are benefiting from the industry recovery.

Given the above two reasons, the situation of casual games closely related to Unity's advertising revenue is not reflected. In fact, after several years of high growth during the epidemic, casual games are currently in a period of stagnation. At the same time, with few new games available overall, Unity's promotional revenue is also unlikely to show significant growth.

III. Staff Reduction for Efficiency, but Investment Will Return

At the beginning of the year, Unity mentioned significant staff reductions, which finally materialized in Q2 with a 17% year-on-year decrease in operating expenses, mainly from the significant decline in research and development and sales expenses. The 28% decrease in SBC also clearly indicates that the decline in expenses mainly comes from the reduction in team costs.

In addition, due to the adjustment of the product mix, the gross profit margin of professional services with low gross profit margin and Weta cooperation were terminated, and the gross profit margin was also returned to the high level of 76%. Final operating loss was reduced to $129 million, down 32% year-over-year, adjusted EBITDA was $114 million, and profit margins reached 25.3%, exceeding guidance and expectations.

Although Q2 earnings exceeded expectations, due to the decline in revenue, the company's earnings guidance for Q3 and the whole year was also lowered, and the adjustment was higher than the income, indicating that this round of cost-reduction and efficiency throttling operation will also come to an end, and moderate new investment will arrive:

Management expects Q3 adjusted EBITDA to be in the range of $75 million to $80 million, and full-year guidance to be in the range of $340 million to $350 million, down 15% from the previous range of $400 million to $425 million, both below market expectations.

That was partly true on the call. Management pointed out that in order to strengthen the competitiveness of the advertising business, more infrastructure needs to be built, so it will start to make some investments in machine learning, data stack, etc.

Regarding the impact of SBC on equity dilution, Unity has been consistently criticized in the past. However, it has been greatly alleviated since Q4 last year, although the company's research and development investment will increase in the future, the total shares of the company's guidance by the end of 2024 is expected to reach 488 million shares after potential dilution, which is further decreased compared with the 492 million shares of the previous quarter, and the implied annual equity dilution rate is only 2%.

IV. Cash flow: Free cash flow returns to positive inflow

There were no major issues with the cash flow changes in the second quarter. By the end of the second quarter, the company had cash on hand of 1.28 billion, an increase of 100 million compared to the previous quarter, mainly due to the improvement in operations and the maintenance of low capital expenditures.

The company has no interest-bearing debt, and financing is done through direct issuance of shares or issuance of convertible bonds. At the end of the second quarter, the total face value was 2.2 billion, with no redemption or new issuance actions this quarter.

Dolphin Research on "Unity" for Further Reading:

Financial Reports (Past Year)

May 10, 2024 Earnings Call "Unity: Customer Communication Improving, Operational Improvement Expected in the Second Half of the Year (1Q24 Earnings Call Summary)"

May 10, 2024 Financial Report Review "Unity: Is the End of the Tough Times Near?"

February 27, 2024 Earnings Call "Unity: Streamlined Focus on Software"

February 27, 2024 Financial Report Review "Unity Plunging? Poor Management, Bad Moves"

November 10, 2023 Earnings Call "Unity: More Streamlined, More Focused (Unity 3Q23 Earnings Call Summary)"

November 10, 2023 Financial Report Review "Continuous Controversies, Unity in Turbulent Times"

August 3, 2023 Earnings Call "AI and VR, Significant Progress Expected in the Next Two Years (Unity 2Q23 Performance Earnings Call Summary)"

August 3, 2023 Financial Report Review "Unity, Subject to Repeated Hype, Shows Strong Performance"

May 11, 2023 Financial Report Review "Unity: Financial Beat, Ready to Soar? Let's Wait and See..." 2023 年 2 月 23 日电话会"Management: Currently in a downturn, focusing on the timing of recovery (Unity 4Q22 conference call minutes)"

2023 年 2 月 23 日财报点评"Unity: Joining forces with IronSource, still struggling in the industry winter?"

In-depth

2022 年 10 月 12 日"Game winter is here, where is the warm spring?"

2022 年 4 月 1 日"Several interesting points in the 'Unity 2022 Global Gaming Report'"

2022 年 3 月 17 日"Can imagination based on the 'metaverse' boost valuation? Unity says yes"

2022 年 3 月 9 日"The metaverse that is unclear, the Unity that is clear"

Risk disclosure and statement of this article: Dolphin Research Disclaimer and General Disclosure