Unity Software Inc. (U) Earnings Call Transcript

Ladies and gentlemen, thank you for joining us, and welcome to the Unity Technologies Q2 Earnings Call. [Operator Instructions] I will now hand the conference over to Alex Giaimo, Head of Investor Relations. Alex, please go ahead.

Thank you. Good morning, everyone. Welcome to Unity's Second Quarter 2026 Earnings Call. Today, I'm joined by our CEO, Matt Bromberg, and our CFO, Jarrod Yahes. Before we begin, I want to note that today's discussion contains forward-looking statements including statements about goals, business outlook, industry trends and expectations for future financial performance, all of which are subject to risks, uncertainties and assumptions. You can find more information 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. Finally, during today's meeting, we will discuss non-GAAP financial measures. These non-GAAP financial measures are in addition to and not a substitute for or superior to measures of financial performance prepared in accordance with GAAP. A full reconciliation of GAAP to non-GAAP is available in our press release and on the sec.gov website. And with that, I will turn it over to Matt.

Thank you, Alex. Good morning and for everyone on the phone, thank you for joining us this morning as well. It is, as always, a distinct privilege for us to be able to represent the fine work of the Unity team from around the world. Two years ago on this call, we told you that a rededication to our customers' needs, more disciplined execution and sharply accelerated product velocity would transform our company. Although we were in a difficult moment, we believe we had everything we needed to bring Unity all the way back, and we did. One year ago, we [indiscernible] Unity hit an inflection point in that transformation and that our efforts will translate to a markedly improved and sustainable series of business results, and they did. Today, after what was arguably the best quarter in Unity's history as a public company, we're done looking backwards. The flywheel we're constructing is spinning up, and we expect it to power us into the rents of the most consequential companies of the AI era, and it will. Why? Because AI has already become the most crucial driver of our product velocity and quality, it is also well on its way to becoming our most crucial driver of demand. To remind everyone how this AI-powered flywheel works at Unity, as game creation becomes more efficient, more games are being released. More games drive more usage of our integrated authoring platform and also make new game discovery more challenge, accelerating our ad business. Games, more platform usage, more discovery, all driven by the unique understanding that we derived from approximately 3 billion people each month plan a game on the Unity run time and understand it which we use in turn to help creators build better games to help them acquire new users and to help them operate successful live services. With that as an introduction, let's turn to this quarter's results, beginning with Unity Vector. In performance marketing, we only win what our customers win. Advertised are laser-focused on the direct return of their aspect and our technology must empower them to hit and exceed their return targets at maximum scale. Through continuous product enhancement higher-quality data and compounding model improvements. We are now driving significant gains for our customers across every campaign type, genre, geography and platform and it's having an exceptionally positive impact on our business results. Our expectations for growth in Vector in Q2 were a robust 12% to 13% growth quarter-over-quarter. Instead, our team delivered nearly double that, racking up 23% quarter-over-quarter growth and establishing an accelerated momentum that is carried over to elevated results in Q3. Keep in mind, 6 quarters ago, the Unity Vector product didn't exist. It is now at substantially over $1 billion in annual run rate, 2 quarters earlier than expected. And yet, we still consider ourselves to be in the very early stages of product development. Our astounding performance is fueling a 63% year-over-year increase in our strategic grow business with our third quarter outlook pointing to an even stronger 70% growth rate. Overall company EBITDA margins are approaching 30% for the first time ever. We don't know of many companies at our scale growing revenue at this velocity while simultaneously expanding margins 800 basis points year-over-year. In the second quarter alone, the Vector team successfully executed over 20 major updates, advancing the capabilities and intelligence of our AI prediction platform, bringing new run time data online and transforming how we identify, understand and value gain retention. This incredible rate of change enabled Unity to optimize real-time bidding precision for our advertisers to a degree that was formally impossible. One of the most impactful updates in Q2 has been our Day 28 return on advertising spend capability for both in-app advertising and hybrid campaigns, a companion to the in-app purchase product that was released in the first quarter. As the name suggests, Day 28 ROAS enables our partners to measure their return over a longer period than our standard 7-day ROAS product. Initially released at the end of Q1, the full rollout has now seen Day 28 campaign spend growing nearly 3x from the first quarter. Over 25% of our advertising base has adopted this new campaign strategy, and the demand is scaling rapidly as a result of our delivering extremely strong performance. Q2 also contains another transformational milestone. We are speaking of course, about the first incorporation of runtime data into the Vector platform. As we have emphasized many times, there are currently over 3 billion consumers each month playing a made with Unity game and the connection with those billions of players through our run time has been an untapped capability that we have long believed should deliver unique value across our platform. Towards the end of the second quarter, we began for the first time in our history to unlock this advantage by incorporating signals from our run time directly into our Vector AI models. While this effort remains very real, the results are extremely encouraging, and we gain more and more confidence each day that run time represents a deep and sustainable competitive advantage for Unity. Let's transition now to the Create business. The future of game creation no longer belongs only to those who can marshal the most resources. But rather, to those who can best use the technology to amplify the resources they have. Two weeks ago, at our Ignite conference in Seoul, we announced the release of Unity 7, a new generation of our software designed for this future and open collaborative platform where developers, artists, producers and coding agents work together across the full development life cycle. We've made our MCP free and opened our API which enables developers to use the command line and coding agents to control Unity directly from inside their own workflows. What this all means is that you no longer have to know all of the intricacies of our application to access the power of our full offering platform. What's even more exciting is that this platform, including the downstream revenue enabling services Vector, our commerce solutions and our live game operations services are all now configured automatically on day 1. There are no instructions, there are no SDKs, there's no engineering time required. Remember what I referenced slightly earlier, remember our flywheel, more games, more platform usage, more discovery, all driven by run time and Vector AI. We believe Unity 7, which will launch in beta in Q4 of 2026 and the full release in Q1 of '27, holds the potential to be the most exciting and impactful release in our history and that it points the way to a fundamentally different future, one where the top of the funnel gets bigger and bigger to accommodate the increased interest and the creation of interactive entertainment. Before leaving [indiscernible], I did want to highlight a new partnership Unity consummated in Q2 with Netflix. We're so thrilled about it. And I want to highlight because it exemplifies the kind of innovation we live to help support. The partnership calls for us to comprehensively support the Netflix multi-platform games, ecosystem with the Unity engine in the years ahead. Netflix has launched something potentially revolutionary, presenting a social game experience for consumers on the biggest screen in the house, instantly without asking them to download, register or buy anything, with the potential to add an entirely new agent path for their customers. This is the kind of advancement that Unity exists to support. Consumer habits are changing, distribution platforms are evolving and will continue to evolve, but Unity's role remains straightforward and constant, make it easier for studios to build great games and get them in the hands of players wherever they are. We're proud that Netflix has chosen to do that work with us. Thank you again very much for taking the time to be with us this morning. We are incredibly proud of Unity's performance in Q2. The continued acceleration of Vector, coupled with our robust product roadmap has us more excited than we've ever been about our future. I'll now pass the call over to Jarrod for a deeper discussion of our financials. Jarrod?

Thanks, Matt, and good morning, everyone. Unity delivered a truly exceptional second quarter with strategic revenue growth of 38% and adjusted EBITDA growth of 77%, along with record margins. Strategic grow revenue was $329 million, up 63% year-over-year. Growth accelerated both quarter-on-quarter and year-over-year based on tremendous momentum at Unity Vector. Of note, the sunsetting of the ironSource Ads Network had a negligible positive impact on Vector growth in the quarter with only $3 million in Q2 vector revenue growth from ironSource customers as a result of the shutdown. In Create, strategic revenue was $157 million, up 14% year-over-year when excluding the impact of a onetime revenue item in the prior year. Create momentum continues to be driven by ARPU growth, supported by price increases and minimum annual customer commitments as well as strong growth in China. Ultimately, these results are the direct outcome of products that deliver the innovation and performance our customers demand, steadily enhancing Unity's core value proposition. Shifting from revenue to profitability. Adjusted EBITDA in Q2 was $160 million. Adjusted EBITDA margins were 29% with margins expanding 800 basis points year-over-year. Rapid revenue growth, high gross margins and disciplined cost management resulted in significant operating leverage. This operating leverage is the primary reason why adjusted EBITDA grew 77% year-over-year, more than 2x the growth rate of strategic revenues. We experienced operating leverage across all major expense lines in the second quarter. In addition, adjusted sales and marketing and adjusted G&A were down not only in percentage terms, but in dollar terms. We're making strong progress in optimizing our cost structure and simplifying our business and using that freed up capital to reward high-growth businesses like Vector while aggressively investing in our product road map. Rapid growth in adjusted EBITDA is converting into exceptional free cash flow. Unity had $202 million in free cash flow in the second quarter, an increase of 59% year-over-year. This brings our cash balance to $2.36 billion, with Unity flipping from a net debt position to a net cash position this quarter. Our near-term capital plans center around delevering our balance sheet and we expect to pay off our 2026 convert in November. Longer term, the record cash generation we are experiencing combined with the delevered balance sheet opens up tremendous flexibility from a capital allocation standpoint. Outside of cash expenses, the disciplined approach we're taking to equity resulted in stock comp expense down 25% year-on-year. Stock comp expense was 14% of revenues for the quarter, its lowest level ever. Before moving on to guidance, I'd like to provide 3 recent strategic updates. Firstly, during the quarter, we made a strategic investment in mobile measurement leader, AppsFlyer, along with investment partners, Meta, Google and Moloco. This was a unique opportunity to invest in a market-leading asset while simultaneously allowing AppsFlyer to preserve competition, choice and innovation in the mobile attribution and measurement ecosystem. Secondly, we're pleased to report that we closed on August 4, the sale of Supersonic to Tripledot Studios. With this transaction, Supersonic finds an outstanding home with Tripledot, one of the largest and most successful mobile game publishers in the world. And lastly, during the quarter, we substantially completed the closure of our ironSource Ads Network effective April 30. The sale of Supersonic and the sunset of the ironSource Ads Network will benefit our margins in the second half of the year. With these actions, Unity becomes a more focused company, positioned for faster revenue growth and dramatically higher levels of profitability. With that, let's now turn to our guidance for the third quarter. For the third quarter, we're guiding to strategic revenue of $540 million to $550 million, implying year-over-year revenue growth of 44% to 47%. This represents a material acceleration from the growth rates we saw in the second quarter. In strategic growth, we expect year-over-year revenue growth of 68% to 70% driven by continued exceptional performance in Unity Vector. Our guidance assumes 19% to 21% sequential growth rates for Unity Vector. In Strategic Create, we expect 7% to 10% year-over-year revenue growth driven by continued ARPU growth and strength in China. And we expect $20 million in nonstrategic revenue in the third quarter driven primarily by the July contribution of Supersonic. We're guiding to third quarter adjusted EBITDA of $185 million to $190 million, implying adjusted EBITDA margins of 33% and adjusted EBITDA growth of 69% to 74%. The third quarter is expected to be our sixth straight quarter of adjusted EBITDA margin expansion with margins up 400 basis points from the second quarter alone and up 1,000 basis points year-on-year. Expected margin expansion is a function of additional operating leverage amplified by cost reductions enabled by our strategic actions, resulting in a structurally more profitable business. Lastly, we're pleased to report that we're pulling forward our expectation for achieving GAAP net income profitability from the fourth quarter of 2026 to the third quarter of 2026. In closing, we are incredibly pleased with Unity's second quarter financial results and outlook for the third quarter. Unity has now entered a new chapter of structurally faster revenue growth, combined with enhanced profitability, powered by a flywheel of more games, more platform usage and more discovery, all driven by run time and Vector AI. And with that, I'd like to thank you for joining us on Unity's Second Quarter 2026 Conference Call. I'd now like to turn the call over to Alex so that we can take your questions.

Thank you, Jarrod. Operator, we're ready for questions.

[Operator Instructions] Your first question comes from the line of Matthew Cost with Morgan Stanley.

Matt, there are some comments in your prepared remarks that sort of alluded to a positive feedback loop between Vector and the Create business. And it sounds like maybe even more specifically Unity AI. So I was wondering if you could expand a little bit more on exactly how that works and what benefits we could expect the 2 businesses to drive for each other? And then secondly, for Jarrod. It sounds like the runtime fee rollout kind of came towards the end of the quarter, B-28 was the big driver of strength for Vector in the quarter. What's run time fee a material contribution or relatively small? And then based on what you've seen so far, what does it tell you about what you can [indiscernible] to contribute in the coming quarters?

Thanks, Matt. Thank you for the question. We were incredibly excited obviously about the performance of Vector in the quarter. We've now had 4 straight quarters, 15% growth, which then stepped up to nearly 23% growth from the second quarter, and we're really excited looking forward as well. It's incredibly important that what we've been able to do through continuous product enhancement, improving the quality of our data and compound our model improvements that we've been able to drive significant gains for customers, which therefore drives our business. We're really, really pleased about that. I mentioned one of the product enhancements in the prepared remarks, our Day 28 ROAS product, there were many, many more. And to your point, we did call out run time, which was, as I mentioned, a historic achievement for us, something that's been long discussed, we have always believed that this will be the primary strategic advantage for us going forward in this business. Every major participant in this world has an approach. If you are Meta, you own your apps. If you're us, you have access to the 3 billion people planning to meet with Unity game, and that's going to put us in a really good spot over the long term. So we began implementing signals from the run time into Vector towards the end of the second quarter. We're super pleased with what we're seeing. We are having continued success around customers continuing to opt into our data development framework, which sits underneath all these efforts in run time. That's going to continue. Although it's still very early, we're just -- we're very, very excited about what we're seeing. The -- I don't know if there's any analytical value for anyone to single out the impact of run time [indiscernible]. Our performance, as we've noted, is the sum of the impact of all the product enhancements, the higher quality data and the compounding model improvements. And these impacts are self-perpetuating as our system continues to learn in real time. So we expect it to be a driver of success over the long term. And as you guys remember, there are many, many times I said that look, what we're going to see is solid incremental growth followed occasionally by step change functions. And so -- and that's exactly what we experienced and that's exactly what we expected. Finally, to your point about the flywheel. I did want to spend some time on it in our opening remarks because I do think that historically, folks have thought about our businesses as separate. And of course, we report in segments. But as a matter of strategy and at the level of product usage and how we connect with customers, these businesses are not separate. And what we're really excited about is that we can see the fundamental value of our platform really coming into play. So if you think about it this way, as we open up early as we have with Unity 7 and has more games are created and more creators coming to the market and game creation becomes more efficient, there are a lot more games that get released. We are thrilled about that dynamic. We don't care how people access the Unity UI, the application itself. The application layer is just the surface piece. What's really important is we drive as many people as possible into our full integrated offering platform, which helps creators deploy and monetize and grow their experiences at scale. As more games enter this platform, we benefit because we're able to deliver Vector, our commerce solutions and our live service solutions. And then finally, as more and more games come on to our platform and become successful and go into the marketplace, the need for discovery becomes ever more important because it's harder and harder for consumers to figure out what is the next game they want to play because they're so many more games in the market. And our ability to help our customers predict which one of those consumers are going to install their game accelerates our ad business. So that's the flywheel. Folks historically are very focused on the Unity application, and it's just not how we think about it. It's not how it works. More folks created an active entertainment, more folks on the platform, more need for advertising. And this process is one that is still at the relative beginning. As I've noted before on the call and I think we've discussed before, AI is going to make the creation of interactive entertainment much easier over time. And so you're going to see a massive expansion of TAM for the interactive creation, marketplace. And so although we haven't talked about that a lot today, it is very much on the horizon for us and very much something we're thinking about. Then we'll probably end up talking about that a lot more in the future. So thanks for your question.

Your next question comes from the line of Alec Brondolo with Wells Fargo.

I appreciate the question. Perhaps I'll ask 2. Unity AI, I would love to get a sense from you as to how you balance the need to kind of preserve margin and unit economics relative to the amount of credits you include in each of the subscription tiers? How do you think about finding that balance, delivering enough value to the customer while protecting the bottom line. That's the first question. I think the second question is on payments. You announced Unity Commerce last October. IAP SDK 5.4 released several weeks ago. It includes most of the functionality you talked about wanting in the product when you announced the initiative. Since that initial announcement last year, how have your thoughts in terms of the addressable customer or customer needs evolved in payments?

Thank you so much for the question. So let me take Unity AI first. Our Unity AI product went into open beta in May, just so everyone is on the same page. It's an integrated agent that's tuned specifically for Unity game development. It's still very early. Just still in beta, but the results have been really encouraging. For many tasks because the harvest we've built, we've been able to go with our unique insight into our software, Unity AI is very often more effective than outside frontier models and virtually always more efficient, which is key than frontier models. So the product really helps our developers leverage the full power of Unity. And our goal and our strategy here is to give developers a choice. You can use our bespoke AI or use your own. We don't care. Our primary goal is to maximize the usage of the authoring platform that I was just describing to Matt. So we're not looking to restrict our customers, and which is why we opened up both our CLI and our API in Unity 7. I also want to let you know that we are really currently just seeing a fraction of the functionality that we have planned in Unity AI. And so we're just really excited about the future of the product. And ultimately, our ambition is to use Unity AI and our run time data to offer a complete tool set for game development. And what I mean is we call it -- Unity AI is useful for developers, not just in [indiscernible] system, but ultimately, it's going to enable real-time personalization of content creation and scale so that customers can change the way they build games to optimize experiences for players at an individual level. There's so much more interesting going on here than just honing in UI assistance where the product is currently as happy as we are about it, it's really still very much at the beginning. On the [indiscernible] product, we're really pleased to announce that the product went through general availability on June and June 30. This is an amazing opportunity for us, the opening of commerce opportunities and things are moving really fast. A lot of estimates are showing the direct-to-consumer modernization within real gaming is already around 15% of the overall market. Just to remind everybody, our product is completely free to developers. We're really pleased with the early feedback. We're actively onboarding new partners. We recently published an example of a new partner, a terrific game publisher in Hutch, who is using the Unity IIP product to add direct-to-consumer purchasing for the top games, top drives. Like many customers, they were able to achieve this without any added complexity or the need to manage multiple or separate SDKs or stores. It's sort of the perfect example of how our platform can provide more value in games ecosystem over the long term. There are 3 main benefits to the commerce product. It exploits and simplifies the process for publishers to certain [indiscernible] fees. It gives us visibility into the rich purchase behavior data, which first further optimizes our ad models. And there is some small economic benefit to us as well, which scales over time. So the product has been really well received. This is a long-term growth opportunity, and we're really pleased to be able to how successfully integrate it into our offering.

Your next question comes from the line of Clark Lampen with BTIG.

Can I get all 3 unmuted here? Can you guys hear me?

Yes, we can hear you.

Okay. All right. Perfect. Vector growth, 23% in the quarter, you're guiding 20% in the forward quarter. Maybe I've missed this in the past, but I don't think -- I've heard you guys sort of call out sort of step function model improvements on a quarter-by-quarter basis. Has that been a driver sort of historically or something that we should think about as a potential future opportunity? I'm just thinking about the sort of range of product releases and evolution that you've talked about on this call and on recent ones, I'm wondering if that's something that could drive accelerating or sort of improving momentum from a development standpoint.

Thank you for the question, Clark. The short answer is yes. So we -- in my prepared remarks when I noted that AI is a real driver of product velocity and quality, this is one of the areas that I was thinking. As I noted, we delivered more than 20 product enhancements to Vector during the second quarter. It's just an incredible rate of progress. And the way I would think about this business is that progress comes across all 3 of the important elements of our performance model. So you need continuous product enhancement, which -- we are accelerating -- the velocity of which is accelerating and which we feel we have lots more to do. Now every quarter won't be as busy as this quarter in terms of product enhancements, we have now 20 product enhancements in every quarter. But we are going to continually enhance the product as quickly as we possibly can. But [indiscernible] just one leg of that stool. The second line of the stool is higher quality data, better signal. That's what I'm referencing when we talk about the long-term benefits of run time as an example, but there's also lots of other routes for us to improve the quality of our signal and the depth of our signal. And then when you have product enhancements and you have high-quality data, you also [indiscernible] model the opportunity to learn and improve. And two, itself as a [indiscernible] and each time we make product improvements, it improves data, the model has an opportunity to get more efficient. It's all 3 of those drivers that are driving significant gains for our customers. And we just look very confident that we're going to be able to continue that process over time as we continue to benefit [indiscernible] is a long-term strategic moat we have around run time.

Okay. That makes sense and it's really helpful. Maybe as a follow-up here, I wanted to ask a question related to the sort of Netflix partnership. And the very basic question is to the extent you're sort of comfortable sharing more detail around the scope and potentially even the economics of this how is, I guess, the initial sort of working relationship taking shape? Or how is it going to affect your customers?

Yes. As I mentioned upfront, what -- what we learned about the Netflix relationship is that it's emblematic of the kinds of significant platform relationships we have with virtually all of the major gaming platforms in the world. So it's very rewarding, and we're really pleased that Netflix chose us. It's an important multiyear deal that caused for us to invest in support of their gaming initiatives on their platform and ensure that those games work well, that our developers can easily build games that function on the Netflix platform to which helps us expand the opportunities for our developers. This is what we're all about. And expand access to games for a new set of consumers that might not have played before or that haven't had the opportunity to play on that platform. What's interesting and exciting about Netflix is that -- it's important to remind folks that there are always new platforms developing and that interactive entertainment is a fundamental human desire. Consumers love and will always love playing games. And platforms, rise and fall, they grow and shrink, there's all sorts of cycles, but new platforms and innovation always come to the fore, and players will always love playing games. And we are really excited to be in a position to help platforms and in all platforms be optimized for Unity because Unity is by far the leading platform for game making in the world. And that's what we're so excited about.

Your next question comes from the line of Vasily Karasyov with Cannonball.

Matt, I wanted to ask you to -- to go into more detail, please, if you can, on Unity 7. I know you said in your prepared remarks that it's sort of a new frontier product for you. But can you explain to us in simple terms, please, how it's different from the previous generation and how you see it supporting growth in both of your segments?