Unity: Strong Partnership with IronSource, or Hard to Resist Industry Winter?

Hello everyone, I'm Dolphin Analyst!

After the U.S. stock market closed this morning, Unity, the game engine leader, released its Q4 2022 results. Due to the official merger with IronSource this quarter and the adjustment of business disclosures, the performance of this quarter is not comparable to previous years. However, from the operating indicators, we can still see the chill in the mobile game market.

Compared with market expectations, the current performance is good, but the company's guidance for the next quarter is significantly below expectations, and the expectation for the whole year is basically in line with the upper limit of the guidance given by the management.

However, combined with the full-year guidance given by the company, some imply a trend of gradual warming up of the game market this year.

Specifically:

The adjustment of the merger with Ironsource (details can be found in the main text) may account for part of the outperformance: Q4 total revenue of 45.1 billion yuan significantly exceeded the upper limit of guidance (44.5 billion yuan) and market expectations (43.6 billion yuan). From the business segment, the excess part is mainly in non-engine business Grow (formerly Operate).

After the merger, the Operate revenue not only includes Unity's original advertising business, but also the entire IS income. Through calculation, the Dolphin estimates that the income of October, which was not merged in Q4, was about 6.8 billion yuan, which did not show a particularly large decline compared to the average monthly level of more than 6 billion yuan in the previous three quarters.

However, Applovin's growth rate in the second half of last year was in a fast collapse rhythm. The Dolphin guesses that the difference between the two may not be related to advertising performance, but to IronSource's SuperSonic publishing revenue.

The slowdown in revenue growth of the main engine Create is significantly related to customer churn and the chill in the game market: Although the Create revenue in Q4 met expectations, the growth rate on a month-on-month basis still slowed down significantly, with a year-on-year growth rate downgraded from 54% in the previous quarter to 42% in this quarter (original disclosure caliber). In theory, Create is currently expanding its non-gaming customers and should be able to maintain stable high growth.

However, looking only at the major customers of Unity's original business, its net expansion rate still has not rebounded (down 2pct), with a continued loss of customers (19 fewer compared to the previous quarter), but the downward trend has slowed down. Although Unity is continuously penetrating into non-gaming fields and expanding its TAM, it is still unable to resist the negative impact brought by the low tide of the mobile game market, which has a higher revenue share.

From external data, the payment heat of mobile games in Q4 still declined year-on-year, but the monthly performance was basically on a trend of gradual recovery.

The Dolphin predicts that the impact of last year's stay-at-home dividends and insufficient market supply on the gaming market is expected to see some relatively obvious improvements in the second half of this year. The change from strict supervision to normalcy of China's game regulation can also give Unity some unique advantages while revitalizing the market. 3. Profit is higher than expected after adjustment due to short-term increase in merger and reorganization costs:

The operating loss under GAAP intensified in the fourth quarter, but the rapid increase in the amortization of intangible assets after the merger resulted in short-term damage to profits. Adjusted operating profit was 13 million, which is higher than the market's expected 9.72 million.

In terms of costs, except for the slight exaggeration of sales expenses, research and development and management expenses were relatively stable, and the research and development expense ratio decreased slightly. The proportion of equity incentives, which are relatively high in the employee salary structure, remained basically stable compared with the previous quarter in absolute value, but due to the recent merger of IS, the stock options for IS employees in the fourth quarter may not have been fully distributed, including possible compensation related to the subsequent downsizing in the next quarter, so there is still a possibility of seasonal increase in expenses in the future.

The high proportion of employee stock options has always been a point of concern for Unity's profitability, in addition to the long-term risk of equity dilution, there are two other problems: on the one hand, executives often sell stocks frequently to mobilize personal funds, and on the other hand, in the process of consecutive stock price declines, it will also affect employee stability. Of course, in order to alleviate the impact of equity dilution, the company also conducts intermittent repurchase.

Unity announced a 300-person layoff in January this year, but considering that the company merged with multiple companies last year, and with the addition of nearly 1,500 people from IS at the end of the year, the total number of employees is now close to 8,000, so this layoff ratio is not high, less than 5%.

Considering that high equity incentives are an important component of Unity employee compensation, it can be regarded as a regular expenditure related to the main business. Therefore, if we only look at the Non-GAAP operating profit, we may overlook the true profit situation.

4. With new financing and positive cash flow from IS, the cash position is expected to continue to improve. At the end of the fourth quarter, the company held cash assets (cash, restricted cash, securities) of approximately 1.6 billion, with a net outflow of free cash flow of 64 million, but the main drag is still the loss, and the cash pressure is not particularly high at present. However, Unity's investment actions are quite active, and we need to monitor its investment needs for large cash consumption.

The performance report provides few details on guidance and business restructuring. It is recommended that investors pay attention to the management's answers during the conference call. Dolphin Analyst will first release the conference call summary on the Longbridge app community platform or investment research group. If interested, you can add the assistant's WeChat account "dolphinR123" to join the group to obtain the summary.

Dolphin Analyst's View

Unity's fourth-quarter performance looks good, but the implied short-term guidance still faces the impact of industry headwinds. Therefore, for Unity, what Dolphin Analyst is most concerned about in the short to medium term is when the game winter will end. From Unity's operating indicators and external data, we believe that the overall market may have passed the most difficult period, and the decline in the scale of paid games has gradually slowed down month by month. At the same time, in the second half of this year, it is expected to digest the negative impact of the decline of staying at home bonus that occurred in the first half of last year. The supply problem of games can also be improved.

From a medium to long-term perspective, Dolphin Analyst is still mainly concerned about the growth potential and competitive barriers of Unity itself. As we mentioned in "Can Valuation be Imagined by" Metaverse "Powered by Unity" on Dolphin, Unity's pricing is not high from the perspective of final monetization rate.

Therefore, as long as it can maintain its competitive advantages, improving monetization is a matter of course. For example, last October, it raised the price of engine subscriptions by 15%-25%, but it will still need some time to reflect this in its financial report, as most of Unity's customers are annual subscribers.

In addition, the generative AI technology revolution sparked by ChatGPT is either more beneficial (improving platform tools) or more negative (competitive replacement) for Unity, depending on the company's strategic direction in the future.

From a valuation perspective, the current market value is basically based on some long-term pricing for operations, such as the company management's outlook and guidance, which also correspond to the pessimistic to neutral valuation range (26 US dollars to 41 US dollars) previously given by Dolphin Analyst.

However, in a high-interest and countercyclical environment, companies like Unity that may need to borrow for financing (acquisitions) and have stylish but loss-making businesses may experience high volatility during the holding process. In addition, there may be periodic equity dilution, requiring a higher safety margin to offset potential risks.

But on the other hand, the recovery of the mobile game market may also be on the horizon, and it is recommended to pay close attention to it. For Unity, you can wait for a relatively safe price.

We recommend paying attention to Unity's conference call, see how management expects the gaming market to recover, and evaluate AIGC and how it will be combined with the company's business in the future. Dolphin Analyst will publish the conference summary on the Longbridge app or research group as soon as possible, and you can add WeChat ID dolphinR123 to get it if interested.

Unity Business Overview

Disclosure structure overhaul: Q4 performance included two months of IronSource operations, so the YoY growth rate is relatively distorted, and the division of segmented businesses has also been adjusted, making it more difficult to compare with previous periods.

Under the new disclosure structure, branch businesses have been condensed from the original three (Create, Operate, Strategy) to two (Create, Grow).

New Create Solutions includes the original products under Create (game engine), and also includes UGS revenue (Unity Game Service: full-chain solution for game companies, helping to solve game development, distribution, customer acquisition, and operation), and original revenue from Strategy under Operate. While Grow's solution contains the advertising business from the original Operate, as well as the merged marketing (Aura, Luna) and game publishing services (Supersonic) of IronSource.

Revenue contribution comes from seat subscription revenue for game development main engines, as well as advertising platform revenue responsible for matching bids, game publishing revenue, etc.

Looking at the business structure of Unity in the past few years, although Unity rose to prominence because of its absolute monopoly in the mobile game development engine market, the contribution rate of the Create solution business to the overall revenue is not the highest. And with the accelerated growth of incentive ad games, the advertising revenue of Grow (Operate) also rapidly rose, which has a greater supporting role for the revenue of Unity, especially the profit.
Looking back at Unity's performance in 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, the penetration rate of users reaches the stage ceiling, but the high stickiness renewal rate is guaranteed, and revenue growth every year depends on users using more tool software or platform pricing effects.

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

At present, although Unity's operating losses are still relatively large, this is mainly due to the lower monetization rate of the main engine compared with its peers, and the profit model of Create has not yet taken off. Furthermore, the company has continued to increase investment in non-game fields in recent years.
Before the core business is profitable, it is not hesitant to invest money in new markets. This is to dig its own new growth drivers in advance. This has also been mentioned in several speeches by the management. The company's current strategic focus is to capture more markets. But it also brings concerns from 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 the one hand, it can provide Unity with the ability and resources of the distribution link in the game industry chain (leaning towards casual games) and earn more revenue from game traffic. On the other hand, it can help Unity increase its usage penetration rate in independent game studios, which is helpful for Unity's "shovel" impact to be exerted in the era of the metaverse.

Detailed interpretation of this financial report

1. Guidance was missed

In the fourth quarter, Unity's overall revenue was 451 million yuan, with a year-on-year growth rate of 42.8% (including the contribution of IS's revenue in the past two months of the merger), which exceeded the market expectation of 4.36 billion yuan. The company's guidance for the first quarter of this year is 470-480 million yuan (annual revenue in the range of 2.05-2.2 billion yuan). The guidance for the first quarter was noticeably weaker than expected.

Breaking it down, the fourth quarter exceeded expectations mainly because of the judgment on IronSource, and although the Create revenue from the engine was in line with expectations, there was a significant slowdown in growth.

Dolphin Analyst believes, the main reason is the drag of the global game winter. Unity is highly related to the game market, and while it is also expanding into non-game fields, both the original revenue focus and the newly merged IronSource are directly linked to the prosperity of the mobile game market.

Since the lifting of the global ban last year, the game has been affected by the impact of offline entertainment. Of course, in 2020 and 2021, the game market was booming, which also raised the base. In addition, China, which is always in the top three of the game pay market, stopped issuing version numbers from the second half of 2021, and has continued until the second quarter of 2022. In addition, the preparation time for game companies' own product launches, the third quarter of 2022 is basically a situation of soft demand decline and hard supply shortage.

It wasn't until November that the slide in the game market slowed down. But it is also the trend of continuous improvement for three months since January, plus China's regulation has basically become normal, so Dolphin Analyst believes that the worst moment for mobile games may have passed.

In addition, it is also recommended to pay attention to the progress of Unity's Audience Pinpointer algorithm issue resolution and whether the current guidance includes the incremental improvements brought about by itself.

2. Create growth slows down, is it due to the headwind in the game industry or the bottleneck in non-game expansion?

In terms of revenue structure, after the old Operate business merged with IS income, its impact on total revenue increased in absolute value. Operate includes in-app ads and some cloud services that are more inclined to game customer needs, with ads being the majority.

Both game clients' and other industries' advertisers have lowered their marketing budgets due to macroeconomic and industry prospects. Combining with the Q1 guidance, Operate business may continue to be dragged down by the industry in the short term, but as mentioned above, from the perspective of game payment heat, the darkest moment has passed.

Unity's monopoly advantage comes mainly from the Create business, which continued to slow down on a quarter-on-quarter basis in the fourth quarter. It is necessary to pay attention to whether it is due to game industry customers or non-game field expansion affected. **Although currently Unity's valuation is mainly influenced by the gaming market, the potential market space in non-gaming areas is the driving force for further increasing the valuation.

In addition, the revenue growth rate of strategic cooperative clients this quarter is also declining, which may imply problems with the penetration bottleneck in non-gaming areas.

3. Several operational indicators with hidden concerns

Following Dolphin Analyst's concerns about some of Unity's operational indicators last quarter, there are also some issues this quarter that may indicate the short-term outlook for Unity's operations.

Unity in Q4, excluding the impact of IS:

<1> Loss of large clients, with the number of large clients paying more than 100,000 yuan for 12 months in Q4 decreasing by 19 compared to the previous quarter, to a total of 1056 clients.

<2> Contract amount data related to engine business was not disclosed in the performance briefings, but we can pay attention to long-term and short-term deferred revenue as a substitute index when the detailed quarterly report is released. However, in terms of these two indices, there was no significant growth in Q4. In fact, deferred revenue even declined, indicating that short-term demand is still weak.

<3> Currently, the KA clients are mainly in the gaming field, and after merging with IS, the contribution of long-term clients' revenue is increasing as well.

However, if we exclude IS and only look at Unity, the expansion rate continued to decline to 109% in Q4, but on the bright side, the rate of decline has slowed down.

2. Short-term restructuring and merger of employees bring additional costs and high equity incentives

In addition to developing the Create engine, Unity's Operate provides an advertising bid matching platform that mainly plays a brokerage role and cannot actively control the advertising inventory and delivery situation. Therefore, when confirming income, it is collected based on a certain proportion after commission, and most of it is collected according to the net amount method, so the gross profit margin of the Operate business dominated by advertising revenue (accounting for about 80%-90%) is much higher than that of the current Create business.

The Strategy business itself is more aimed at expanding customers, and profitability is not required. 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 optimization trend of Create margin itself, the gap between the two parties will gradually narrow in the future.

In the fourth quarter, due to the relationship of merging IS (high-margin advertising), the overall gross margin has increased to a certain extent month-on-month, but it is much weaker than the market expected.

However, according to the proportion of revenue from segmented businesses, assuming that the gross margin of Create continues to significantly improve on a month-on-month basis while Operate's gross margin remains unchanged or declines, Dolphin Analyst estimates that it has likely optimized by 4 percentage points compared to the third quarter.

In terms of expenses, there are factors of merging and restructuring in the fourth quarter, leading to a short-term rapid increase. However, since the additional mainly includes the amortization of intangible assets of IS and employee stock incentives, most of them need long-term financial commitment. Therefore, to expand the profitability, it is necessary to increase the realization ability of income.

From the result of Non-GAAP operating profit, the above-mentioned impact of restructuring, amortization of intangible assets, and stock incentives have been excluded. But in Unity's staff compensation structure, stock incentives have always been a very important part, accounting for nearly 30% of the total cost. Dolphin Analyst believes that when paying attention to the main business and profitability, it is not suitable to be regarded as non-recurring expenditure and excluded.

Therefore, although the company's disclosed attention to Non-GAAP operating loss is significantly better than market expectations, caution still needs to be maintained. Since there are not many other non-recurring expenses in the quarter, and the change is not significant compared to usual, the GAAP operating profit in the third quarter can better reflect Unity's current profitability. Looking at the GAAP operating profit, the increase in losses and the new high loss rate on a month-on-month basis is also the area that the market has been concerned about.

Third, the cash flow pressure from normal operations is limited.

Although the management has been giving guidance on Non-GAAP operating profit, since the current profitability model has not yet emerged and the environment is also facing headwinds, for short-term Unity, cash flow is also a very important operating situation tracking indicator.

As of the end of the fourth quarter, the company's total cash on hand (cash and cash equivalents, restricted cash, and short-term investment) was $1.6 billion, a slight decrease month-on-month, mainly due to a decrease of nearly $350 million in short-term investments, but the merger of IS also increased by nearly $200 million.

In the fourth quarter, the net cash outflow from operating activities was RMB 49 million. After capital expenditures, the free cash flow was a net outflow of RMB 64 million. Although the cash flow has not turned positive, the current cash assets can still support the normal operation of the company's business.

Readings on Dolphin "Unity":

Earnings Season

November 10, 2022 Conference Call - "Unity's Q4 guidance may not significantly exceed expectations (3Q22 conference call minutes)"

November 10, 2022 Earnings Review - "Unity: The habit of plummeting? The performance is not as bad as it seems"

August 10, 2022 Conference Call - "Unity: Significant recovery in proprietary technology, short-term macro pressures currently being faced (conference call minutes)"

August 10, 2022 - "Crazy capital operation of Unity, MiHoYo joins amid short-term concerns"

May 11, 2022 Conference Call - "Unity: The second quarter guidance and headwinds are caused by internal issues, no long-term impact observed (conference call minutes)"

May 11, 2022 Earnings Review - "Unexpected thunderbolt, is Unity, the stock of the shovel for the Metaverse, also collapsing?"

In-depth Analysis

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

April 1, 2022 - "Interesting points from the "Unity 2022 Global Gaming Report""

March 17, 2022 - "Can valuation be boosted by the imagination of the Metaverse? Unity says it's possible"