ZH - Zhihu: A Tricky Balancing Act

2023-08-24 17:48:21 ET

Summary

• ZH's Q2 2023 revenue and reported operating loss fell short of analysts' expectations, and the company's share price dropped by -9.4% on the day of the results announcement.
• It is tough for Zhihu to strike a delicate balance between growing the company's top line and improving its profitability.
• I deem ZH's shares to be deserving of a Hold rating, considering both its tricky balancing act and its undemanding valuations.

Elevator Pitch

I continue to have a Hold investment rating assigned to Zhihu Inc. ( ZH ) [2390:HK] stock. I previously performed a preview of ZH's financial results for the second quarter of this year in my June 9, 2023 update .

With the latest article, my focus is on the review of Zhihu's most recent quarterly financial performance and an evaluation of the company's outlook. My analysis leads me to the conclusion that it will be very difficult for ZH to maintain a balance between profitability and top line growth. On the flip side, Zhihu is already trading at its lowest price-to-sales valuation multiple since listing, which implies that negatives are priced in to a large extent. In that respect, I choose to maintain my Hold rating for ZH.

Stock Price Underperformance And Valuation De-Rating Post Q2 Results Announcement

ZH released the company's Q2 2023 financial results on August 23 before trading hours . Investors had a negative view of Zhihu's financial performance for the most recent quarter, as seen with ZH's share price performance and the de-rating of its valuations.

Zhihu's stock price fell by -9.4% from $1.09 at the end of the August 22 trading day to $0.99 as of August 23. This was the first time that ZH's shares have closed below $1 in the past three months.

Also, ZH traded at a consensus forward next twelve months' price-to-revenue valuation multiple of 0.84 times (source: S&P Capital IQ ) based on the company's closing price of $0.99. This represented a new historical trough price-to-sales ratio for Zhihu. Since the stock's public listing on the NYSE in March 2021 , the market has valued Zhihu at a price-to-revenue multiple as high as 14.1 times, while ZH's historical mean price-to-sales metric was 3.8 times.

In the subsequent sections of the article, I highlight why ZH's post-results share price drop is justified.

ZH's Revenue And Headline Operating Loss Were Below Expectations

Zhihu revealed its financial performance for the second quarter of the current year with a press release issued on Wednesday (August 23) morning. With my earlier June 2023 write-up, I cautioned that "there is a low probability of positive surprises or results-related catalysts with ZH's second quarter financial performance", and I turned out to be right.

The company recorded a revenue of RMB1,044 million for the recent quarter. This implied that ZH's YoY top line expansion had moderated significantly from +31.0% for Q2 2022 and +33.8% for Q1 2023 to +24.9% in Q2 2023. Furthermore, Zhihu's actual second quarter top line came in below the sell-side analysts' consensus sales projection of RMB1,048 million as per S&P Capital IQ data.

Marketing services were a drag on ZH's revenue in the second quarter of this year. In specific terms, Zhihu's marketing services revenue declined by -14% YoY from RMB478 million in Q2 2022 to RMB413 million for Q2 2023. At the company's Q2 earnings briefing , Zhihu explained that it had "phased out some low-margin marketing services and products", and this hurt its top line.

ZH's reported or GAAP operating loss widened QoQ from -RMB217 million for the first quarter of this year to -RMB327 million in the most recent quarter. Prior to the company's actual Q2 2023 results release, the market had anticipated that Zhihu will achieve a relatively narrower net loss of -RMB317 million (source: S&P Capital IQ ).

ZH noted that its vocational training business is "still in the investment stage" and also highlighted its "newly initiated investment in generative AI technology" at its second quarter results call. These are likely to have been key factors contributing to Zhihu's wider than expected reported operating loss for Q2 2023.

It Will Be Tough To Strike A Balance Between Growth And Profitability

Zhihu emphasized at its Q2 2023 results briefing that its goal is to "advance our progress in terms of our profitability while prioritizing healthy and sustainable (revenue) growth."

I am of the view that Zhihu will be faced with a difficult balancing act for the foreseeable future. ZH is currently in transition mode. On one hand, the company needs to optimize its expenses and investments to achieve positive earnings as soon as possible. On the other hand, Zhihu has to allocate sufficient capital to support its new growth initiatives in areas such as vocational training and generative AI.

It is noteworthy that ZH didn't provide a specific answer in response to an analyst's question at the Q2 earnings call on whether there is "any update on reaching breakeven timetable" for the company. Specifically, Zhihu stressed at the most recent quarterly results call that its "loss reduction strategy is on track."

Based on the current sell-side consensus financial forecasts taken from S&P Capital IQ , Zhihu is only expected to generate positive normalized non-GAAP earnings in FY 2025 and deliver positive GAAP net profit by FY 2026. Separately, the consensus financial figures point to ZH potentially suffering from revenue growth deceleration for three consecutive years during the FY 2024-2026 period. These numbers support my opinion that Zhihu will find it challenging to strike a balance between top line expansion and profitability improvement.

Concluding Thoughts

ZH's shares don't warrant a Buy rating, as the company faces a tricky balancing act considering its target of achieving both strong revenue growth and positive earnings. But it won't be right to award a Sell rating to Zhihu, as its valuations are already very depressed based on the price-to-revenue metric. Therefore, I have decided to retain a Hold rating for Zhihu.

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