Unity Software Inc. Q2 FY2023 Earnings Call

Welcome to Unity's Second Quarter 2023 Earnings Call. After the close of the market today, we issued our Shareholders Letter. That material is now available on our investor website at investors.unity.com. Today, I'm joined by John Riccitiello, our CEO, President, and Chairman; and by Luis Visoso, our CFO. Before we begin, I want to note that today's discussion contains forward-looking statements, including statements about goals, business outlook, industry trends, market opportunities, expectations for future financial performance, and similar items, all of which are subject to risks, uncertainties, and assumptions. You can find more information about these risks and uncertainties in the risk factors section of our filings at sec.gov. Actual results may differ, and we take no obligation to revise or update any forward-looking statements. As in prior quarters, we will be providing both GAAP and non-GAAP financial measures. And unless otherwise noted, we will be speaking to the non-GAAP financial measures when describing our results. The Shareholder Letter and our filings on sec.gov include full GAAP to non-GAAP reconciliations. Okay, thank you very much. So, as we did last time, let's start off with two brief questions before we open up to regular Q&A. So, for John, you've seen a lot of trends and cycles over your career. What are you most excited about when you think about where Unity is today and where we're headed?

Well, first off, I want to congratulate my colleagues on delivering strong execution and a great quarter in our second fiscal quarter. I really appreciate it. Great work. Congratulations. Now, when I look at Unity today, I really feel fantastic about the company and where it's heading. There are a number of factors that make me feel great about Unity, both near term and long term for revenue growth and profit growth in a way that's super healthy, and I believe we'll deliver in huge ways for our customers and our shareholders. First, you've heard about Unity PolySpatial. It was great to be on stage with Apple at WWDC. Since then, we've seen substantial interest from our developers in the PolySpatial platform. I think it represents another reason for developers to look to Unity as the go-to platform for all real-time 3D development. We cover the platform better than anyone, and we cover them spectacularly well with new platforms as they come out. A great example of that is what Apple just announced recently. The second is the Unity Cloud. We put that in market in a closed beta recently. We expect to go general availability later this year. This is a platform that connects all of our services to our product. If you want to think about this in a way, the go-to-market motion just collapsed from people getting in a plane, taking a cab or an Uber, knocking on a door, to a click inside the editor. We like that. It makes it easy, makes it simple. We think it's going to drive increased adoption. For us, this is substantial. It's going to lead to increases in consumption and ratable revenue in addition to subscription, the artist seats, and usage, and all that goes with that. You've seen lots of announcements from us recently on Weta, Ziva, Speedtree. We expect that to continue to drive increased artists picking up the platform, and again, net new revenue, net new SaaS revenue, net new consumption revenue. Digital Twins acceleration is really important. I hope you'll listen carefully. We're getting great traction in the market, and we're now focused on delivering repeatable solutions, high-margin solutions that deliver ratable revenue streams and consumption revenue streams. We've made a decision to deemphasize our growth on the Professional Services side and lower margin business, and we're thrilled to be able to rely on partners like Capgemini and Booz. This is a great move for Unity. It adds significantly over time to our bottom line. A little bit less Professional Services growth, but it's a good strategic trade for the margin and for the business on a strategy perspective for how we're going to build our position in the marketplace. The One platform is the synergy story. This is why Unity Create and Unity Grow are together in a way that delivers better for our customers and better for our investors. Here, we're getting deep integration between advertising, mediation, publishing, and UA tools inside the editor. We're working through some really important incremental synergy programs and we'll be sharing more about that later in the year. You should start thinking about with all the synergy we're already getting, there's more to come. There's an advantage in being the place where our customers build their product and monetize their product. I couldn't be more excited about the two AI products that we announced some weeks ago, a huge amount of interest from our customers. We're there on the creation side and the operation side for applications with Muse and Sentis. We'll be looking at a business model for these much like what Microsoft has announced with some of their AI products. Incremental revenue around SaaS and incremental revenue around consumption. We have a particularly specific set of opportunities because people forget that Unity has a large number of free users. These users will want to use AI, because it will significantly expand their ability to build what they have in their mind's eye, to get it on the screen and into the hands of their customers. We're super excited about that. So, the handful of reasons, all product innovation driven will put us in a great position for growth both on the top and bottom line.

Thank you very much. Luis, as we reach the midpoint of 2023, it would be helpful to discuss how the first six months have unfolded as we look ahead to the remainder of the year.

Yeah. Thank you, Richard. We are actually very happy with our results. If you look at it, and I'm sure everybody has read our Shareholder Letter, we had a record quarter. We were ahead of expectations, and as John just mentioned, we're bringing a ton of innovation to the market which we believe will position us well into the future. So, we're very happy overall. Just to go a bit deeper, what we've committed and talked to several of you about is creating shareholder value by driving three things: One is revenue growth; expanding margins; and efficient use of cash. On revenue growth, we accelerated growth to 11% this quarter, a great improvement quarter-over-quarter. We're winning with customers in games and in industries. And frankly, I would say, this is still in a challenging economic environment. Some of our game customers are not adding headcount; some of our sales cycles in industries are still a little bit longer as we need to prove value. The China Create market continues to be soft overall. The ad industry has been relatively stable with not much seasonality so far this year. Very importantly, we're winning in this environment, and we estimate that we're growing faster than the markets in which we compete. On the profitability side, we're delivering all this acceleration while significantly improving our profitability, with strong progress on a GAAP and non-GAAP basis. EBITDA was $99 million. We need to get a few hundred thousand more to get to $100 million, but we're very close. An 18.5% margin is a good place to be, particularly when we look at where we were just four quarters ago. In Q2 of last year, we were minus 13%. So, from minus 13% to almost 19% in just a year, driven by choices we've made. There are portfolio choices we've talked about before. We're reducing hierarchy, driving cloud efficiencies, and reducing our office footprint. Just a lot of decisions we've made to become a sustainable and profitable company. As John mentioned, we're reducing our reliance on Professional Services as we build scale to be a profitable business. Third, on cash flow, we are now positive. We delivered $33 million in the quarter. More importantly, we're now where we believe to be sustainably on the positive side of cash generation. Obviously, there will be normal quarterly fluctuations based on payment schedules and those types of things, but we're clearly now on the positive side. With all this, I'm actually very optimistic about the year. If you look at where we guided at the beginning of the year for the midpoint of our revenue guide, that number was $2.1 billion to $5 billion. Last quarter, we added another $15 million, and now we're adding another $20 million. We're now guiding the midpoint of our revenue guide at $2.16 billion. So, we're making progress. We're feeling more confident about where we are in the full year, and that's encouraging. Just to highlight Create and Grow: One key number on Create is our core subscription growth, excluding China, is 22%. That is a very healthy number. Our actions are working. Our price increase has been clearly flowing through. I’m very happy with our core subscription, excluding China. The Industries segment is now 30% of total Create despite our reduction of our reliance on Professional Services. There is just a lot of innovation going on, which gives us confidence that we will be able to sustain this growth for the foreseeable future. Grow is just as exciting. We're seeing industry leaders, such as Supercell, Sega, joining LevelPlay. They're making the choice to move to LevelPlay because they believe that's a better play for them. Supersonic continues to do very well. We're adding new titles to our portfolio. Keep in mind, Supersonic has published some of the most downloaded games in the U.S. and key markets. Very, very strong performance there. AI within Create is also helping us on Grow. We're using AI and machine learning to strengthen our algorithms to deliver better ROI for our customers. We believe we're just getting started. There is more to come and more synergies to come over the next few quarters and years. Overall, the integration between ironSource and Unity is going well. If I had to summarize an answer to your question, I'd say we're very happy with where we started this year, and we look forward to a strong Q3 and Q4.

Great. Thank you very much. As we did last time, remember, we'll promote you to panelist, raise your virtual hand, and we will unmute you and call on you. We'd ask that you unmute yourself and turn on your video, if possible. We'll do some Q&A for about 20 minutes here. So, at this point, we'll see who's in the queue and we can pick whoever wants to talk first and ask a question. So, Thomas, do we have our people here that want to ask questions?

Clark, go ahead.

There we go. Thank you, Clark.

Hey, guys. Good evening. I've got two questions. The first one is for John, the second one for Luis. John, I'm going to pull us back a bit and talk about AI. As we think about some of the tools that you announced intra-quarter being commercialized, are those designed for the lower end of the market that may not monetize as you were talking about earlier? As these tools start to permeate the market, how do you think about either potential growth in the developer community overall or the volume and velocity of creation impacting the market and some of your existing customers? Luis, I wanted to clarify, I guess, on the cost-cutting trajectory. Last quarter, we talked about, I think, half of the cost synergies you initially identified being realized. Could you give us a rough update on where we are today? Thank you.

Thanks for the questions. Let me try to address them. First off, on AI, we've introduced products focused on two areas. One helps people create content, and the other is called Muse. The second product we launched is Sentis, which enables games and real-time applications to achieve things that were previously impossible, making non-player characters in games feel alive, similar to having their own ChatGPT-like interactions. This also extends to digital twins, where an agent within a digital twin can predict future outcomes or run scenarios and simulations. We are very optimistic about this; it's a source of recurring revenue. Muse for content creation targets three audiences. It allows users to draw on touch devices, with the engine interpreting their drawings as professional art. It also accepts word prompts, functioning like a large language model for generative art. This offers significant value to users, saving them time, which makes them willing to pay. The final group consists of potential users who currently find Unity too complex. We see thousands of new users daily downloading Unity and exploring the editor, only to perceive it as complicated. They need assets or scripts, and can now simply request them. This will streamline the process and attract new users to the platform. While I don't anticipate an immediate surge in new users from AI, I believe that over time, we will capture a larger share of those experimenting with the platform for the first time. We see this as an opportunity to engage a wide range of potential creators who previously found the platform daunting.

Hey, Clark, to the second part of your question, we've captured about two-thirds of the benefit in Q2. You should expect a little bit more to come. Just keep in mind that we also had a merit increase and a few other things. So, it's not as easy and straightforward to do the forecast. But to answer your question directly, it's about two-thirds of the benefits are in Q2.

Great. Thanks. Okay, we have one of our newer analysts covering us, Brian Fitzgerald. We'll pop you in here.

Thanks, guys. It looks like the Industry grew in line with the broader Create segment. I'm curious about how you're defining industry, given you only recently introduced the Industry SKU, and whether that definition may change? Also, any early read on the adoption of Industry by online customers since its launch or new emerging use cases you're beginning to see traction with?

Let me step back a little bit, and Luis, feel free to add on. In general, we generate revenue in digital twins from three activities. Revenue generation from Professional Services, which enable customers to get a real-time digital twin, could be an airport, city, manufacturing facility, or retail. We're seeing strong demand from the sectors I mentioned. The first step for many is to get up and running on Unity, often through Professional Services. The second component is the seats they consume. We've done with our Industry SKU that marries many tools that they would need for their specialized use cases. The third and more nascent piece is ratable revenue, once they've got their digital twin up and running, whether using us for simulation or rendering. Where we are right now, our largest revenue stream is Professional Services, our next largest revenue stream is seats, and our third, more nascent, is ratable. We brought partners like Capgemini and Booz to scale more rapidly. This will result in less Professional Services revenue, more seats, and at some point, more ratable revenue streams. We’re transforming our business to ensure our scaling makes a lot of sense longer term. In terms of demand, frankly, we've been supply constrained—not pushing much for demand—certainly keen on government, manufacturing, and architecture engineering construction.

Hey, Brian, just to add a few points for clarity. If you think about Create, we're splitting it into two segments: games and Industry. Whenever we talk about Industry, we're referring to everything not related to games. This produces 30% of total Create, and the Industry SKU is specifically defined for these customers. As you saw in the letter, it's the fastest SKU ever, and it's a little over two times the price of the game's equivalent SKU.

Great. Thank you. We'll go to Tim Nolan.

Great. Can you hear me?

Yes.

There we go. Thanks very much. Two questions: both clarification or a bit more color on some previous points you've made. John, I heard what you were explaining about the shift away from professional toward more seats and more ratable services. I'm wondering how much the AI marketplace and Unity Cloud are significant upsell opportunities. Can you charge incremental fees for these? Is it like incremental charge points that you can add on to your subscription levels? And another question for Luis: I heard your comments around the Grow business. You had a pretty good swing from minus 7% in Q2 to plus 9% pro forma in Q3. Could you talk about where this is coming from? Is it volume, price, market share gains, or growth beyond gaming?

On the AI side, what I addressed so far is subscription plus ratable for the tools we make, Muse and Sentis. Muse will likely be more subscription-oriented but will also generate ratable revenue because there will be volume levels when you charge more. Sentis will mainly result in ratable revenues. The marketplace connects the large universe of real-time 3D creators with AI tool developers, and for us, these are mostly revenue share deals. If the partner is working on a per-seat basis, then it's a revenue share for a defined period, typically negotiated. We expect that to continue in the long term.

Regarding your second question, first of all, Q1 of 2022 was huge, right? That’s still when eCPMs were very high. We're comparing against a very strong Q1 of last year when looking at that minus 9% for Grow for Q1. Quarter-over-quarter growth, which is about 13%, is a much more important metric. Based on our analysis, we're growing faster than the market, with greater units despite a difficult eCPM environment.

Great. Thank you. We have a quick question from Dylan Becker.

Hey, hopefully, you guys can hear me? John, I wanted to ask about the Luna offering and the importance of creative management, automating within the creation tool itself, and how AI can augment the capability to provide more tailored experiences and engagements for campaign management. Thanks.

As you know, we don't break out Luna. It's a relatively small business. We're very pleased about a couple of aspects strategically with Luna. For those who don't know, it's a user acquisition platform that developers can use to identify opportunities not only within gaming inventories but also within social networks and app stores. It allows a developer to test creatives against specific audiences in and outside of game inventory. It's sort of like a more strategic version of a DSP, primarily serving game developers. Part of the business model means we get paid by the targeted media. This tool helps add new ad inventory over which we generate revenue share. The noise in the marketplace creates challenges in discerning the trajectory of movement, but Unity's visibility combined with ironSource's data allows us to target users better, creating high-value installs.

Great. We'll switch over to Brent Bracelin.

Hey, how are you? Can you hear me okay?

Yes, now we can.

I wanted to start with Luis. Grow showed significant sequential increases. How much of that do you believe is due to an industry recovery? Are you noticing signs of gaining market share?

We're definitely growing faster than the market. Key customers are moving to LevelPlay, which bodes well for our growth. We can see mediation and LevelPlay performing strongly. The AI efforts we've implemented are driving better returns for our customers' investments and are just getting started.

If you recall, we said when we did the acquisition with ironSource that the combination of Unity and ironSource would lead to market share growth, and that's exactly what's happening.

Maybe, John, for you. Just double-clicking into large studios like Sega, what's driving their interest?

There's a strategic argument here. A lot of noise in this marketplace for movement toward one platform or another. I think the trend toward Unity, especially among larger games, is due to the strong ROAS toolset that comes from pulling together data from Unity and ironSource. This allows better visibility into targeting users both on ad campaigns and in app purchases, which developers want to target. Our customer base recognizes this strategic value, as we consistently remind them, show them data and case studies supporting our performance. We believe we're on a long-term trend line favorable for Unity.

Great. Gili at Goldman.

Hey, guys. Thank you for taking my question. Congrats on the quarter. John, can you elaborate on the flywheel between Create and Grow and how that's trending? Are you seeing more customers leveraging both sides of your platform?

First off, we've achieved a lot in synergy, and I would say we're just scratching the surface. There's something chocolate and peanut butter about having the content creation platform and the data that spreads off. We're trying to sell UGS before the Cloud platform, it required appointments and demos. Now it can literally be a checkbox. We've been pressing on this for years. We're seeing customers come to the platform because of the combination as they transition between Grow and Create services.

Super helpful. I appreciate the response. One for you, Luis, around the full year guide. Given the strength this quarter and the potential upside from new products, how much revenue growth are you currently incorporating in your full year guide from these services?

Not too much. I think these products can make a significant difference for us, but they will ramp in 2024. I don’t have too much in 2023, but we should get some traction. As John mentioned, customers love them, particularly Muse and Sentis.

We are giving more visibility on things that did look like two-year revenue ramps, now are available. We are in a great spot where we have good reason to believe in the tailwinds, more than in years past.

Great. Thank you very much. For the closure here, we'll connect with all of you with additional questions subsequently. If Matt Cost, you're available, we'll let you come in and close the session.

Hey, Matt.

Matt, you may need to unmute yourself, perhaps.

Okay.

Can you hear me now?

There we go.

Got it. I pulled it out of the fire and I'm here to close. I guess starting on the Pro Services side, you talked about how there's a margin differential between Pro Services and the rest of the Create business. What is the strategic reason? Why is it operationally better not to do Pro Services? Will that continue to weigh on Create growth?

I never intended to scale Professional Services into a large business; it was a necessary phase. I find that as we transition our business model, I believe that SaaS and ratable revenue can scale faster than hiring for low-margin projects. It's a huge managerial undertaking to manage those projects. We did rearrange our Pro Services business, anticipating this, and yes, we could have delivered more revenue this quarter if we hadn't done that. However, as we navigate 2024, I anticipate more revenue from this decision, not less.

We're not walking away from Pro Services; we’re reducing reliance on it and still see it as strategic, particularly for customers needing help to create a digital twin. What we need to do is ensure that these customers become subscription customers with consumption elements.

Great. That wraps up the Q&A session. John, if you want to close, I appreciate it.

Thank you for listening. We appreciate it. We're very pleased with the quarter. We're happy to see strong margin growth, hitting 18.5% EBIT margins in the second quarter. This is ahead of most expectations. We like our print, our guide, our future, and we genuinely love a world with more creators in it, and it's our job to deliver for them.

Thank you, everyone.