ZH - Zhihu Could Stay Cheap Without Catalysts

2023-06-09 06:52:07 ET

Summary

• I think that Zhihu's Q2 2023 results will be inferior to that of its performance for Q1 2023, as per what the analysts are currently forecasting.
• But ZH's attractive P/S and EV/EBITDA valuations have already largely factored in negatives associated with its lackluster short-term outlook.
• I keep my Hold rating for Zhihu, as there aren't any catalysts in the near term to drive a positive re-rating of its valuations.

Elevator Pitch

I rate Zhihu Inc.'s (ZH) [2390:HK] shares as a Hold.

In my earlier write-up for ZH published on February 15, 2023, I attributed Zhihu's good share price performance in the early part of this year to the company being recognized as "a play on the AI chatbot investment theme." But I also cautioned in the article that "the AI chatbot bubble in China might burst" at any point in time, and ZH's shares actually fell by -40% (source: Seeking Alpha price data) after my prior article was written.

My attention turns to Zhihu's near-term financial outlook and current valuations with this current update. Zhihu's shares are pretty cheap based on the price-to-sales and EV/EBITDA valuation metrics. But my preview of ZH's Q2 2023 financial performance suggests that it is unlikely that there will be any catalysts relating to positive second quarter results surprises. In the absence of catalysts, Zhihu's shares could stay cheap, which explains why I have stuck with a Hold rating for ZH.

ZH's Q2 2023 Results Announcement Won't Be A Catalyst

Zhihu didn't offer any specific quantitative guidance for Q2 2023 or full-year FY 2023, when the company released its first quarter results on May 24. But the current sell-side analysts' consensus financial forecasts suggest that Zhihu's Q2 2023 financial performance won't be as good as what the company achieved in Q1 2023.

Specifically, the analysts see ZH's top line growth moderating from +33.8% in Q1 2023 to +26.6% for Q2 2023 on a YoY basis in local (or RMB) currency terms. The sell side also expects Zhihu's normalized net loss to almost double QoQ from -RMB120.2 million for the first quarter of this year to -RMB239.8 million in the current quarter.

I am of the view that the market's current consensus second quarter financial estimates for Zhihu are realistic, which suggests that ZH is less likely to deliver a better set of financial results in Q2 2023 vis-a-vis Q1 2023.

In terms of the top line, Zhihu's marketing services revenue stream is expected to be the weak spot for the company. ZH's revenue derived from marketing services contracted by -11.7% YoY to RMB444.1 million in Q1 2023. In contrast, ZH witnessed positive YoY growth for its other revenue streams such as paid memberships and vocational training in the most recent quarter.

Looking ahead, it will require a great deal of optimism to expect a strong recovery in ZH's marketing services revenue for Q2 2023 in YoY terms. At the company's Q1 2023 results call on May 24, Zhihu revealed that the growth in advertising demand is limited to the "e-commerce and 3Cs (Computers, Communications, and Consumer Electronics)" industries for now, and noted that "faster recovery" for advertising is only expected in 2H 2023.

ZH's recent management commentary implies that the current recovery for advertising services in China is uneven across industry, and more time is needed for a return to robust growth for advertising demand. Zhihu's management views are aligned with the latest economic data coming out from Mainland China, as both China's official PMI and exports for May 2023 fell below the market's expectations.

At its first quarter results briefing, Zhihu declined to provide specific gross profit margin guidance, and ZH also didn't want to commit to a specific timeline for the company to achieve breakeven. This points to uncertainty regarding the company's future profitability which could be influenced by various factors as detailed below.

One factor to note is operating leverage. As discussed above, Zhihu's near-term revenue growth prospects are dependent on the health of China's economy, and recent economic indicators aren't that favorable. Assuming that ZH's actual sales expansion is slower than expected, the company's bottom line could potentially be adversely affected by negative operating leverage.

Another factor to watch is Zhihu's research & development or R&D spending. ZH acknowledged at its Q1 2023 earnings call that it is planning for "new investments" relating to "the development for our large language model (LLM) training" which it expects to have "some impact on our P&L (Profit & Loss)."

Zhihu is expected to report the company's Q2 2023 financial results in late-August . Based on my analysis, I think that there is a low probability of positive surprises or results-related catalysts with ZH's second quarter financial performance.

Zhihu's Valuations Have Become Enticing After Major Pullback

As I mentioned earlier in this article, ZH's share price dropped by -40% since the publication of my earlier February 15 write-up, and the stock's valuations have become even more attractive.

Zhihu is now valued by the market at 3.9 times consensus forward FY 2025 EV/EBITDA as per S&P Capital IQ's valuation data. Of course, this assumes that ZH turns EBITDA positive by FY 2025.

For investors who are less confident in ZH's ability to improve its profitability, they can consider revenue-based valuation metrics instead. Zhihu's current consensus forward next twelve months' price-to-sales or P/S multiple of 0.96 times is just slightly higher than its historical P/S trough of 0.86 times recorded on May 19, 2023.

Closing Thoughts

Zhihu's Q2 2023 outlook is unfavorable with expectations of its net losses nearly doubling QoQ in RMB terms. As such, even though ZH's valuations are appealing, the stock doesn't deserve a Buy rating. In that respect, I have decided to maintain my Hold rating for Zhihu.

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