Unity's Q4 guidance may not have exceeded expectations by much (3Q22 conference call minutes)

The following is the summary of incremental information for the Q3 2022 earnings call of Unity Software US, which can be reviewed in the financial report interpretation article "Unity: A Habitual Slump? Mixed Fortunes in Performance."

Management Outlook on the Gaming Market

1. Gaming Advertising Market

In the gaming advertising market, the overall performance is currently weak.

In 2021: Apple adjusted its user privacy plan starting in 2Q21, and the spending ratio of iOS and Android changed. However, due to increased user engagement during the pandemic, the overall advertising market performed well in 2021.

In 2022: The game advertising department performed strongly in 1Q22, with double-digit year-over-year growth; estimated to grow by about 10% in Q2; slowed down to low single-digit growth in Q3; and stays the same year-over-year in Q4.

2. User Stickiness

Regarding user stickiness, compared with the high levels based on the pandemic in 2020 and 2021, the overall player engagement was weak in 1H22. However, compared with before the pandemic, user engagement has been steadily rising for three years in a row, with Q3 DAU (Daily Active Users) increasing year-over-year. Despite the poor market conditions, users are still downloading and playing games, demonstrating the stickiness of this field and the game industry's long-term resilience.

Starting from Q3, when interest rates rise, and during an economic recession, CPM is also suppressed. Advertisers are cautious about spending and unwilling to bid to increase CPM.

Nevertheless, the company remains confident. The advertising market is currently in a period of decline. Although it is uncertain when it will end, we believe that the powerful user stickiness will revive the advertising market.

3. Create

The core Unity engine for Q3 is primarily strong in new areas such as digital twinning and film and art.

(1) Games: Working with SecondDinner to develop the "Marvel: Snap" game; working closely with Software Engineering.

(2) The two tools, Parsec (remote desktop tool) and SyncSketch (synchronous real-time collaboration tool), were acquired and jointly formed our Create Anywhere business, with Parsec's largest customer order spending over $1 million a year. For the Create Anywhere business, we currently have more than 25 customers with annual spending exceeding $100,000.

(3) HBO Max's program, "Raised by Wolves," used SyncSketch to solve the synchronous collaboration of a team distributed across various regions and to handle about 3,000 complex visual effect shots. (4) Last quarter, we announced a price increase for our main engine (Unity Pro, Unity Enterprise, Unity Industrial Collection), ranging from 13% to 24%. This is the first price change in the past three years, mainly due to the enhanced features of our products, which provide better services to our customers. In the future, we will continue to provide better services by improving our product features, so that customers are willing to pay higher fees.

(5) We are also continuing to think about a cloud service transformation. This quarter, we released a digital twin cloud service solution (alpha testing phase), providing an end-to-end development function that includes the use of real-time, interactive, and 3D digital twin technology in any field. More details will be disclosed as progress is made.

4. Operate

Operate increased by 8% quarter-on-quarter. This quarter, we continued to enhance the competitiveness of our core products and gained more market share from the largest advertisers.

2022 is undoubtedly a challenging year. From 2019 to 2021, the Operate team achieved rapid growth at a CAGR of 55%. We did benefit from the pandemic, and we encountered some challenges and issues in 2022, which we have already resolved and started to recover our market position and market share.

5. UGS (Unity Gaming Service)

After being launched this summer, UGS has developed satisfactorily. This suite of services (including more than ten forms of analysis tools, cloud orchestration, embedded voice and multiplayer gaming functions) is priced based on usage, so customers only need to pay when they use it. Success of their products means that our revenue will also increase.

UGS has also unlocked synergies between our different products. Create, Operate, and UGS work together to solve more important problems for our customers. The development of the game "SecondDinner" demonstrated the flexible application of this feature.

In September, we launched Multiplay and Matchmaker tool services. The mobile gaming market is shifting towards multiplayer games such as PvP, which have proven to be popular among players. Our tool technology can help game companies easily accomplish this function.

4. Future Outlook

With the merger of IronSource, Unity has become a leading end-to-end platform that supports developers throughout the development cycle. Therefore, the company's positioning is to lead the market and become the main beneficiary of the market recovery.

Although the market is challenging, the company has unique opportunities. Once macro conditions improve, we can gain market share and achieve rapid growth. Unity's end-to-end platform will become a key factor in helping creators grow and ultimately increase the overall market through more successful game development. LevelPlay will become a Unity aggregate product, providing creators with outstanding services to help them enter the global player network with over 3 billion Monthly Active Users (MAU). Unity LevelPlay will integrate with Unity Editor plugins and provide services for Unity Ads and IronSource advertising networks, while Super Sonic will provide crucial publishing capabilities to help more developers launch games and expand their influence. The company is confident that the new Unity platform can substantially surpass the industry and gain market share based on its ability to achieve success for its customers.

The company will begin disclosing its performance after merging with IronSouce next quarter (Q4 2022). We hope that the company can achieve a sustained growth trajectory of 30%, and we will provide guidance on 2023 during the annual conference call. Based on the current situation we understand, it is expected that sustained growth may be lower than the 30% target until there are signs of improvement in the macro environment and industry.

Analyst Q&A

I. Operate Advertising Business

Q: Views on the mobile gaming industry and advertising prospects

A: (1) Mobile gaming

User stickiness is actually increasing. Based on the revenue growth of Unity's in-app purchase business, the average growth rate of the top 5 mobile game publishers in Q3 was 4%.

During the 3-year pandemic period, Unity has achieved growth beyond this time frame. Therefore, gaming is a very healthy industry.

(2) Advertising

In terms of what data types can be obtained in the expected way from users, purchase is an important component of the ROAS (Return On Ad Spending) model. Advertisers are now more cautious and pay more attention to the balance between short-term and long-term returns. A year ago, publishers tended to make long-term investments, but when this year is spending and next year is return, the market return seems to be inconsistent with what publishers expected, so ROAS declined.

The decrease in eCPM (effective cost per mile) put pressure on Unity in the short term, and it is expected to remain flat in Q4. The Q4 guidance does not assume that eCPM will recover. Although eCPM will increase during Thanksgiving and Christmas, the company is still cautious based on observed customer sentiment. It is expected to start to recover to some extent at some point in 2023, and the company will have better revenue and profit performance.

Overall, Unity's current aggregation capability is rising, and its market share is also increasing.

Q: How much market share did IronSource bring to the company? A: Not quite sure.

Merging IronSource strengthens the overall situation:

In terms of team, it is beneficial for the company to develop as excellent teams led by Tome and Ingrid have been introduced for Unity. Currently, the data provided by LevelPlay supports the operation of 2 networks, and the corresponding teams are being integrated within the company.

In terms of business, the tools owned by IronSource can help users develop more high-performance games and applications, which can further promote the development of the company's other businesses. This is because people will not advertise for products with low user stickiness, nor will they rent multi-person servers without a user base. However, after helping users succeed, they will naturally use other services provided by the company more often.

Q: Regarding the merger with IronSource, is the company integrating and optimizing all parts of both sides to build an overall solution, or is it simply repackaging and combining businesses?

A: In terms of team, the views on the development of the Create and Grow teams are very consistent.

In terms of business, Unity's actions in the new Marvel game ranking will also be replicated in IronSource in the future. In addition, LevelPlay will be added to the editor. The company has significant advantages in UGS and multiplayer mode, and users are more likely to test games on Unity than to develop games on Unity, which will also promote development. This is mainly in the mobile field, where the company has a market share of over 70%.

Overall, the merger is to make up for the gaps in aggregation.

Q: What is the proportion of non-game customers in advertising revenue?

A: The proportion is very small, currently in the single digits.

Currently, the focus is still on games, but opportunities outside the gaming sector are being actively cultivated and innovated.

In terms of games, Unity's MAU exceeds 3 billion. On the one hand, this is something other pay media platforms cannot achieve; on the other hand, it helps advertisers win the eCPM game.

II. Create Game Engine Business

Q: The contribution effect of the Create game engine business price increase in Q3; will price increase become a normal business practice?

A: In terms of financial performance, since the price increase plan was launched at the end of Q2, it will take some time to obtain new contracts with price increases, so attention should be paid to the impact on 2023 performance rather than on 2022 performance. So far, there has been no financial impact from the price increase.

In terms of products, digital twinning meets the user's cloud solution needs and has lower costs. Digital twinning supports a series of work such as data calculation, each of which is very expensive. Today, Unity integrates them together, solving problems for users and saving costs.

Q: If the game industry enters a recession, will the growth of Create be sustainable?

A: First of all, the company firmly believes that growth will reach billions of dollars, not just tens of billions of dollars. Although games are the company's main business, it is also exploring opportunities outside of the gaming industry, hence its investments in ProArt and Anywhere. Great synergies can be generated between gaming and non-gaming businesses, driving the company's growth in the long term. Digital twinning is a huge investment, helping the company build a scale advantage and increase future development speed.

Secondly, the company prefers usage-based billing to SaaS model and expects the former to generate more revenue in the future.

The Internet will enter the real-time, 3D era with persistence, interactivity and sociality, requiring game engines or similar things. Unity is in a leading position in this field.

Q: What is Unity's business positioning in macro data processing for terminal clients? How to enhance the client's dependence? The impact of the self-service launched by the company on incremental cross-selling and adoption?

A: There is a significant trend in gaming towards self-help pairing and multiplayer gaming, which poses challenges for developers. Competition in PVP and other multiplayer mobile games is mainly from single-person games or synchronized single-person games (matching based on other players' scores; the user stickiness of this type of single-person game is higher than that of simple single-person games, but not as much as that of multiplayer real-time games). Personally, I believe that multiplayer games will become the mainstream trend in the next few years. User stickiness essentially represents revenue; the higher the user stickiness, the more revenue is generated.

Unity benefited greatly from providing self-service on UGS.

Unity started experimenting with clients outside the gaming industry (such as automotive, architecture, and fashion) about 3-4 years ago, initially providing designs for them and gradually moving on to large-scale projects. The establishment of digital twinning is based on the real needs of customers, such as visualizing the manufacturing of large buildings, which is similar to meeting the real needs of game developers with multiplayer self-service.

Currently, the company is conducting close testing with customers, and digital twinning is expected to account for the largest proportion of revenue in the future. Frankly speaking, the tools for rendering, animation, data transmission, and other parts of the business that are integrated with Unity are far more numerous than those that are paid for by seat, so the company is very excited about the development of this part of the business. Currently, games and digital twinning are in different stages of development, but the latter is developing very fast, and many customers are very interested in it.

Q: Views on the monetization of digital twinning; Timeline from alpha to beta testing for digital twinning

A: (1) Revenue proportion of digital twinning

At present, the revenue proportion of digital twinning is 40%, which is ahead of the plan set by the company about 2 years ago when it IPOed, which was to achieve a revenue proportion of 50% within 5 years.

(2) Development process of the digital twinning platform

Internal testing will be conducted around the first half of 2023.

(3) Difficulties of the digital twinning platform

The digital twinning platform is a universal platform for calculating and moving data, with the difficulty being the communication of data. This is not limited to a particular industry. To be more easily understood, the vertical field within the architecture industry, for example, requires customers to perform complex synthesis and then transfer these images to buildings and production lines. III. Overall Performance

Q: IronSource performance for the quarter; after fixing the internal technical issue (Audience Pinpointer) in Operate advertising business, has the company regained market share? Can market share be increased through IronSource's aggregation platform?

A: (1) IronSource performance for the quarter

As the acquisition and merger transaction has just been completed, IronSource was not included in the Q3 financial report, but Q4 performance guidance includes IronSource. Compared to the previous revenue guidance for the merged companies, it has been lowered by RMB 60 million.

Dolphin Analyst: As the acquisition was completed on November 7th, Q4 guidance includes IronSource's revenue for the past two months since then. If IS performs similarly to the second quarter, with revenue of RMB 180 million for three months, then 1-2 months correspond to RMB 120 million. That is to say, the 2022 revenue of the original Unity entity is RMB 1.245-1.265 billion. Deducting the first three quarters, the Q4 guidance for the Unity entity is RMB 305-325 million.

Note that because the completion date of the merger given by Unity before was just a vague Q4, the market may not expect to include IS's revenue for the past two months, or at most one month, so if excluding this impact, Unity's original guidance is very likely not to be as much higher than expected as it seems on the surface, but lower than expected.

But the company's management also expressed that the Q4 guidance here includes the company's best estimate of the impact of the economic environment (i.e., more conservative).

(2) Create game engine business performance

In the third quarter, Create grew strongly, with a growth rate of 54%. Among them, the recently launched digital twins performed outstandingly, bringing incremental shareable revenue to the company.

(3) Operate advertising business performance and market share

It is expected to slightly increase compared to the same period last year in Q4, that is, market share will increase year-on-year.

1. In terms of team, the company and IronSource management team have merged very well with obvious synergies.

2. In terms of product complementarity, the biggest gap between the company and IronSource is in the aggregation platform. Through the merger, the company now has a leading advertising aggregation platform LevelPlay. At the same time, IronSource's SuperSonic game publishing can bring incremental advertising revenue, although it is an independent business, it can also generate profits.

Aura has a strong position in the industry and is growing well.

Some people are worried about Apple's entry into the advertising field, but Luna is one of the few partners, so this is more of a growth opportunity for the company than a threat.

Q: Prior to the slowdown in the mobile advertising market, Wall Street investment banks did not expect Unity and IronSource's merged 2024 EBITDA to reach $1 billion, and the company management holds the same view. A: Yes.

But it needs to be clarified that the company's guidance is not for the full year of 2024, but for the ability to achieve an annual EBITDA of $1 billion by the end of 2024.

The company is confident in the prospects of its business development:

In the Create game engine business, ProArt, digital twins, and the development of the gaming industry are all doing well; under the Everywhere strategy, the company's remote hybrid mode is also performing well on the user side.

In the Operate advertising business, the company can almost gain market share in any market, and the aggregation platform that bridges the gap with the network plays an important role here. Digital twins are a new form that brings benefits to the company and users, and there is no reason to give up.

Guidance will be given at the beginning of 2023, and there will be more definite data then.

Q: Share repurchase plan

A: The board of directors has approved a $2.5 billion share repurchase plan, which will be executed at an appropriate time.

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