Unity: Is a sharp drop becoming a habit? The performance is not as bad as it seems, nor is it as good.

Hello, I'm Dolphin Analyst!

After the US stock market closed in the morning of November 10th Beijing time, the gaming engine leader $Unity Software(U.US)nity Software.US released its Q3 2022 performance. Amid the global game slump and the consecutive slump of advertising stocks, I have some concerns.

From the final results, it's not as bad as expected, but there are still hidden worries:

(1) The total revenue meets the target, but the loss is expanding. The main reasons are the weakening of gross margin due to changes in revenue structure and the increase in employee compensation burden.

(2) The revenue guidance for Q4 looks good, but we think it may not exceed expectations. Mainly because the Q4 guidance includes the revenue of IronSource for two months. As the acquisition was just completed on Monday, the market expectations have not had time to adjust yet. If the revenue of IS is removed, Unity's Q4 revenue guidance may be lower than expected.

In the Q2 earnings call, I mentioned that I was not satisfied with some of the operating indicators. But at that time, the real feedback from the market on the financial report was actually obscured by Applovin's premium acquisition letter. Looking at this quarter, these indicators that I care about have not improved. We believe that the fundamental reason is the downward trend of the game industry in the short term.

Recently, Unity has fallen for several consecutive days. Although the current quarterly performance has met the target, whether the guidance is truly better than expected remains to be seen. In addition, I think the decline may also be related to the current market's greater focus on corporate profitability. Although the Non-GAAP operating profit disclosed by the company is better than market expectations, it is still a "excessive" loss under GAAP. The difference between the two comes from the further increase in the proportion of employee stock incentives. Considering that high stock incentives are an important component of Unity's employee compensation, it can be regarded as a recurring expenditure related to the main business, so Non-GAAP operating profit over "beautified" the actual profit situation.

Returning to the highlights of this financial report:

1. Revenue meets the target and internal technical tools have seen repairs: The total revenue in Q3 is CNY 32.3 billion, which is consistent with market expectations and within the company's guidance range. The growth rate of the Create business has slowed down slightly on a month-on-month basis, but the overall is still relatively strong. The Operate business, which mainly consists of advertising revenue, is weaker than the market expected, mainly due to the decline in the game market prosperity. However, compared with the previous quarter, the internal technical problems (Audience Pinpointer) of the company have been significantly repaired. The strategic cooperation revenue has also rebounded significantly this quarter.

2. The burden of employee stock options suppresses profitability: The Non-GAAP operating profit that the company focuses on is a loss of CNY 37 million with a negative rate of 11.6% in Q3, which is slightly better than market expectations. However, as to whether employee stock incentives need to be adjusted, I think that paying attention to the GAAP operating profit may better reflect Unity's profitability. Apart from the overall gross profit margin decline caused by the income structure, the main reason for the loss in Unity's main business under this indicator is poor expense control. Although there are more stock incentives for Mindkick employees who have merged, overall operational efficiency still needs to be accelerated.

In addition, there are two potential risks worth noting for employees with high proportion of stock options. On the one hand, frequent selling of stocks by executives to raise personal funds often occurs, and on the other hand, the stability of employees is also affected during the process of continuous stock price decline.

3. Some operating indicators have not yet rebounded: In several operating indicators that Dolphin Analyst pays attention to and can reflect short-term growth trends (deferred income, remaining contract amount, number of large customers, etc.), they did not improve in the third quarter. Although the revenue guidance for the fourth quarter is good, there will still be some growth pressure in the short to medium term, mainly due to the industry's winter.

4. Guidance is a "superficial" highlight: The revenue guidance for the fourth quarter is 425-445 million US dollars, higher than the market consensus forecast (~379 million), and the non-GAAP operating profit guidance interval is 5-15 million US dollars, which is also higher than the market expectation. However, note that this indicator includes the income from the last two months of IS, and the market expectation has not been adjusted in time. Dolphin Analyst roughly estimates that it is very likely to be lower than expected.

5. Cash is being consumed, but the pressure is not great for the time being. At the end of the third quarter, the company held cash-like assets (cash, restricted cash, and securities) of approximately 1.7 billion yuan, and the free cash flow in the third quarter was a net outflow of 81 million yuan, mainly due to the increase in losses dragging down operating cash flow. Currently, the cash pressure is not great. However, Unity's investment actions are quite active, and it is necessary to closely monitor its investment needs for situations where large amounts of cash are consumed.

There is not much discussion on the above issues in the performance briefing, and it is recommended that investors pay attention to the management's answer during the conference call. Dolphin Analyst will publish the minutes of the conference call to the Longbridge app community platform or research group as soon as possible. If you are interested, you can add the WeChat account of "dolphinR123" to join the group and obtain the minutes.

Dolphin Analyst Viewpoint

In Dolphin Analyst's view, Unity's third-quarter performance is a mixed bag, but the issue of market concern over the increase in losses is not our main concern. However, Unity's cost control ability does need attention. However, from a medium- to long-term perspective, Dolphin Analyst is more concerned about Unity's own growth potential and competitive barriers. In the article "Can Unity rely on the imagination of the metaverse to increase valuation?" we mentioned that Unity's pricing is not high from the perspective of final realization rate. Therefore, as long as it can maintain its competitive advantage, improving the realization rate is a matter of course. Therefore, the revenue guidance for the fourth quarter is the only bright spot that we believe.

The Dolphin Analyst is concerned about the end of the game winter in this financial report. Q4 guidance can reflect the industry's chilliness. Looking at the number of important customers of Unity, there was a loss for the first time in the third quarter. However, combined with the strong performance of Create and the low performance of Operate, the Dolphin Analyst believes that the main reason is the decline in industry prosperity, rather than the loss caused by increased competition. According to the game data disclosed by Sensor Tower, the global mobile game market has continued to decline for three consecutive quarters and the magnitude is increasing. When it will hit bottom and return to growth, it is probably more worthy of investors' attention than competition among peers.

It is recommended that everyone pay attention to Unity's conference call and see how the management explains the reasons for customer loss and the outlook for the game market. The Dolphin Analyst will also release the meeting minutes in the Longbridge app or investment research group as soon as possible. If you are interested, you can add the WeChat ID dolphinR123 to get it.

This financial report season, the Dolphin Analyst's deepest feeling is that the current market environment demands more stringent profitability for companies, which is naturally not the main venue for Unity, a company with huge losses. However, after this valuation killing, it is suitable to find gold that has been wrongly killed. Therefore, for Unity, focusing on its own growth and moat advantage is more important in the medium and long-term investment cycle.

Overview of Unity Business

Unity consists mainly of two businesses, Create and Operate solutions, with revenue contributions coming from seat subscription revenue for game development main engine, and advertising platform revenue responsible for bidding and matching.

1. Looking back at Unity's business structure over the past few years, although Unity's reputation lies in its absolute monopoly in the mobile game development engine market, the contribution of Create solution business to overall revenue is not the highest. And with the accelerating growth of incentive advertising games, Operate's advertising revenue has also risen rapidly, playing a greater role in supporting Unity's revenue, especially profits.

2. Looking back at Unity's performance over the past two years, Create revenue has basically maintained a growth rate of 30%-50%, which is in line with the performance of a relatively stable SaaS platform in development, that is, user penetration rate has reached the ceiling of the stage, but high stickiness and renewal rate is guaranteed, and annual revenue growth comes from users using more tools or platform pricing effects.

For SaaS platforms, after experiencing the expansion period, the profitability will continue to increase, and the platform value will be realized. This is also one of the medium and long-term logics of Unity. 3. Currently, although Unity's main engine has a relatively low monetization rate compared to its peers, and Create's profit model has not yet been launched, the company's losses are still relatively large. In the past few years, the company has continuously increased its investment in non-gaming areas.

1. Before the main business is profitable, Unity is investing heavily in new markets. This is to seek new growth drivers in advance, as mentioned in several management speeches. The company's current strategic focus is to seize more market share. However, this also brings concerns about the profit model and cash flow of the company.

2. The merger with IronSource is based on medium-to-long-term logic. On the one hand, it can supplement Unity's capabilities and resources in the publishing link of the game industry (leaning towards hyper-casual games) and earn more revenue from game streams. On the other hand, it helps Unity expand its penetration rate in independent game studios, and helps Unity's "shovel" influence to be exerted in the era of the Metaverse.

Detailed analysis of this financial report:

1. Bright revenue guidance, invisible pressure brought by the cold winter of the game industry

2. Overall situation: In the third quarter, Unity's overall revenue was 323 million yuan, an increase of 12.8% year-on-year, which is consistent with market expectations. The company's guidance for the fourth quarter is between 445 million yuan and 425 million yuan (the annual revenue is in the range of 1.365-1.385 billion yuan), which is higher than the market expectation of 380 million yuan. However, this includes the revenue of the last two months of IronSource.

3. Since the completion of the merger on November 7, Q4's guidance includes the revenue of IronSource in the past two months. If IS has a revenue of 180 million yuan for three months, corresponding to 120 million yuan for the first two months. That is, the revenue of the original Unity for 2022 is between 1.245-1.265 billion yuan. Excluding the first three quarters, the fourth quarter guidance of the original Unity corresponds to 305-325 million yuan.

4. Note that since the completion date given by Unity before was only vague in Q4, the market's unanimous expectations may not include the revenue of IS for two months, or at most one month. Therefore, if this impact is excluded, Unity's original guidance is very likely not as much higher than expected as it seems, but lower than expected.

5. Although the company's management also stated that the guidance for the fourth quarter here includes the company's best estimate of the impact of the economic environment (that is, slightly conservative), the Dolphin Analyst believes that in the headwind period of the industry, we still need to be cautiously optimistic.

In addition, the company has also given a long-term sustainable growth rate of 30%, but there is greater pressure in 2023. Considering the current situation, the growth rate in 2023 may be lower than 30% until the environment improves. However, the Dolphin Analyst believes that this is not related to the expected industry recovery. In the second quarter, Unity's Audience Pinpointer algorithm model was fed with problematic data, resulting in a significant decrease in accuracy. At that time, the management promised to completely solve this problem before the end of this year. Judging from the situation in the third quarter, the repair effect has already appeared. Therefore, the rebound in the fourth quarter is still due to Unity's own problems being partially solved and returning to the original growth track.

However, the industry's coolness and the sluggish macro-economy have also brought visible pressure to Unity. When the game industry hits bottom is the key factor for Unity and IronSource, which has already completed the merger, both of which are companies that rely too much on the gaming industry in the short term to grow securely.

1. Business Segmentation

In terms of revenue structure, the impact of the Operate business on total revenue is still the heaviest, but the Create business is accelerating to catch up. Although the Operate business has slowed down this quarter due to technical repairs, it is still different from market expectations. The Operate business includes in-app advertising and some cloud services that cater to gaming client needs, with advertising being the main driver.

Whether it is advertising for gaming clients or advertising for other sectors, the marketing budget has been adjusted due to the macro economy and industry outlook. Therefore, the Operate business may continue to be affected by the drag of the industry.

Unity's monopoly advantage mainly comes from the Create business. Although its growth rate has slowed down in the third quarter, it can still maintain a slightly higher growth rate than market expectations in the underperforming gaming environment. In addition to its stable position in the gaming industry, its expansion in non-gaming fields should be good as well.

In addition, the income of strategic cooperative clients rebounded this quarter, which may also be brought by the expansion of new businesses.

1. Several operating indicators with hidden concerns

In addition to guidance, the Dolphin Analyst was also dissatisfied with the trend of some operating indicators in the previous quarter. Generally speaking, these operations often demonstrate the growth situation that Unity may encounter in the future.

Looking at these indicators again in the third quarter, there is no improvement for the time being. The combination of these three indicators depicts a rough picture of the behind-the-scenes business changes:

1. The current new contract amount is weaker than the previous period, and overall customer demand is weakening. <2> In the case where the overall contract amount is decreasing, there has been a month-on-month increase in short-term contracts. This is either due to customers prioritizing short-term contracts under industry uncertainty in their long-term demand, or because new customers in non-gaming industries are temporarily favoring short-term contracts.

The Dolphin Analyst believes that the latter possibility is more likely. Generally speaking, there are discounts for signing long-term contracts, and there is no need to pay in advance before invoicing. Although the gaming industry is in a slump, the development cycle of a game is usually more than one year. In comparison, it is more reasonable for new customers in non-gaming areas to choose short-term contracts for experimenting and trying out.

<3> The decrease in long-term deferred revenue leads to a decrease in deferred revenue on a month-on-month basis. If the deferral decreases but the computed revenue increases, it may indicate that the current usage by customers is slowing down.

<4> Unity has continued to expand its new customers in non-gaming areas, and progress is still good.

<5> Currently, the KA customers are mainly in the gaming industry, and the loss of KA customers in the gaming industry is higher than the increase of KA customers in non-gaming areas.

From the Dolphin Analyst's attribution results, it seems that the problem still lies in the gaming industry, and the root cause goes back to the gaming prosperity issue we have repeatedly mentioned above. However, this attribution result is only the Dolphin Analyst's interpretation, and it is best to verify the real reason based on the content of the telephone meeting.

(1) Deferred revenue

Deferred revenue in Q3 continued to decrease on a month-on-month basis, mainly reflected in the reduction of long-term deferral (more than 12 months). After calculating the revenue value, Q3 has increased slightly.

(2) Remaining compliance contracts

Remaining compliance contracts often represent a portion of the revenue that can be confirmed as binding in the future. The remaining compliance contract amount decreased from the previous quarter, and the company expects the proportion of short-term contracts that can be confirmed as revenue within the short term to increase to 40%.

From the perspective of new contract amounts, there has been a month-on-month weakening in the increase of new contracts in Q3.

(3) Changes in customer structure

Finally, looking at the distribution of new and old customers, the proportion of revenue for old customers calculated based on the 12-month old customer revenue expansion rate (net expansion rate) continued to decline on a month-on-month basis, while the proportion of new customers is increasing. This probably reflects the expansion of new customers in non-gaming industries, but mainly for old customers in the gaming industry whose demand is weakening. Another indicator that corresponds to this situation is that the customer data who spent over $100,000 in the past 12 months has decreased for the first time compared to the previous month, which should be mainly due to the loss of KA customers in the gaming field or a decrease in spending below $100,000.

Two

Profit: high employee salaries dragging down overall profitability

Aside from developing engine Create, Unity's Operate provides an advertising bidding platform, mainly playing an agent role and cannot actively control ad inventory and delivery. Therefore, when confirming income, after receiving a certain proportion of the share, most of the revenue is calculated net, so the gross profit margin of the Operate business mainly based on advertising revenue (about 80%-90%) will be much higher than the current Create. The strategic cooperation business itself is more for the purpose of expanding customers, with no profit requirements. Therefore, there are more customized projects, and the gross profit margin is the lowest.

In addition, with the rapid growth of cloud service revenue in Operate and the trend of Create's gross profit margin itself optimization, the gap between the two sides will gradually narrow in the future.

In the third quarter, the proportion of Operate and Create business revenue has declined slightly, but the proportion of strategic cooperation business with the lowest gross profit margin has increased by 1%. Therefore, the change in revenue structure has led to a weakening of the overall gross profit margin.

However, according to the revenue proportion of segmented businesses, while the gross profit margin of Operate is obviously weakening, it can be deduced that the gross profit margin of Create in the second quarter continued to increase significantly compared to the previous quarter.

In the third quarter, expenses began to rise again, among which the increase in employee salaries should be the main reason. In the third quarter, the company granted some equity to the employees of MindKick, which was acquired in January this year, which may have boosted the season's expenses.

Although from the results of Non-GAAP operating profit, the impact of the above equity incentives was removed. However, in Unity's employee salary structure, equity incentives have always been a very important part, accounting for nearly 30% of the total cost. Therefore, when paying attention to the main business operation and profitability, it is not suitable to be regarded as non-recurring expenses and removed.

Therefore, although the company disclosed its Non-GAAP operating losses are slightly better than market expectations, it is somewhat distorted. Since there are not many other non-recurring expenses in the season, and there is not much change compared to usual, the GAAP operating profit is more reflective of Unity's current profitability. From the perspective of GAAP operating profit, the increased losses and higher loss rate compared to the previous quarter is the most concerning issue for the market. **

Three

Normal business cash flow pressure not high

Although the management team previously set a target that Non-GAAP operating profit will turn positive at least in Q4 this year, cash flow is still a very important operational indicator for tracking short-term Unity's performance due to the uncertain profit model and the unfavorable environment.

As of the end of the third quarter, the company's total cash on hand (cash and cash equivalents, restricted cash) was US$1.25 billion, a slight increase from the previous period. In addition, there were approximately US$450 million in marketable securities, which have been sold off compared to the previous quarter and can be quickly cashed in to ease cash flow pressure during critical times.

The net cash outflow from operating activities in the third quarter was RMB 69 million, and the free cash flow after capital expenditures was a net cash outflow of RMB 81 million. Although cash flow has not turned positive, the current cash can still support the normal operation of the company.

In addition, the integration and consolidation of the acquired Iron Source has not yet been completed in accounting. Iron Source has a higher profit margin (GAAP net profit margin of 13% in the second quarter of 2022) because it mainly relies on advertising monetization. The free cash flow is more than RMB 20 million per quarter under normal circumstances, and there is still more than RMB 200 million in cash on hand, which can help Unity alleviate the pressure on cash flow after the merger.

Related reading on Dolphin "Unity":

Financial report season

August 10, 2022 telephone conference call "Unity: self-owned technology issues significantly recovered, currently facing short-term macro pressure (conference call summary)"

August 10, 2022 "Unity crazy capital operation, miHoYo's entry into the game is difficult to resolve short-term hidden dangers" 2022 May 11 Telephone Conference Call - "Unity: Second Quarter Guidance Against the Wind Due to Internal Issues, No Long-Term Impact Seen (Conference Call Summary)"

2022 May 11 Financial Report Review - "Unexpected Thunder, Did Unity, the Shovel Stock of the Metaverse, Collapse Too?"

Depth

2022 October 12 - "The Winter of Games is Coming, Where is the Warm Spring?"

2022 April 1 - "Several Interesting Points in the Unity 2022 Global Gaming Report"

2022 March 17 - "Can Unity's Valuation be Lifted by the Imagination of the Metaverse?"

2022 March 9 - "The Invisible Metaverse, The Visible Unity"

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