ZH - Zhihu: Risk-Reward Is Balanced

Summary

• Zhihu's shares have outperformed the broader market in this year thus far, as it is seen as a play on the AI chatbot investment theme.
• On the positive side of things, ZH might be acquired by Chinese technology giants considering the content it has and its current valuations.
• On the negative side of things, AI chatbots could compete with Zhihu for online users, while the "AI chatbot stock bubble" might burst in China due to regulatory forces.
• My rating for ZH is a Hold; there are both risks and rewards for Zhihu relating to the emergence of AI chatbots.

Elevator Pitch

I have a Hold rating for Zhihu Inc.'s ( ZH ) [2390:HK] stock.

With my earlier December 6, 2022 update for Zhihu, I wrote about how ZH is prioritizing profitability over top-line expansion as evidenced by the company's Q3 2022 metrics. My latest article discusses about what drove Zhihu's recent share price outperformance and highlights the key risks and rewards relating to the company's outlook.

AI chatbots could be either a blessing or curse for Zhihu. ZH's shares have already run up on positive investor sentiment relating to AI chatbots, and there is no certainty that Zhihu can sustain the current share price momentum. I deem the current risk-reward for ZH to be fair, which supports a Hold rating for Zhihu.

Recent Stock Price Performance Driven By AI Chatbot News Flow

In 2023 year-to-date, Zhihu's share price surged by +27.9% , which was way better than the S&P 500's +8.2% rise in the same time period. It is worthy of note that ZH's stock price went up by +21.4% and +31.7% on the January 4, 2023 and February 7, 2023 trading days, respectively.

On January 4, 2023, Seeking Alpha News reported that Microsoft ( MSFT ) plans to introduce a new "version of its Bing search engine that uses the artificial intelligence software behind ChatGPT." A Seeking Alpha News article published a month later on February 7, 2023, noted Chinese search giant Baidu's ( BIDU ) announcement that the company will "launch its ChatGPT-like bot (named as Ernie) in March" this year.

It is clear that Zhihu has attracted significant investor interest as the AI chatbot investment theme gains prominence, which led to ZH's shares rising substantially since the start of this year.

Potential Rewards Relating To A Potential Takeover

A recent February 13, 2023, Seeking Alpha News commentary cited a research report from Hedgeye highlighting that Zhihu's "moat in the knowledge sharing space."

In my September 26, 2022 initiation article for Zhihu, I had described ZH as China's Quora. Zhihu revealed at the company's Q3 2022 earnings briefing that it had 485 million of Q&As (Questions and Answers) in its database as of September 30, 2022. With the significant amount of content that it possesses, ZH claims that it is among the five biggest "online content communities" in China.

Mainland Chinese research firm BOCI Research recently issued a research report (not publicly available) on February 6, 2023, with the title "ChatGPT and China AI." In its report, BOCI Research listed technology giants like Baidu, Huawei, Alibaba ( BABA ), and Tencent ( TCEHY ) ( TCTZF ) as Chinese companies who are "working on large AI models since 2019" and could possibly introduce their own versions of AI chatbots in the future. Also, as per ZH's most recent 20-F filing , Tencent, Baidu, and Chinese livestreaming company Kuaishou ( KUASF ) ( KSHTY ) are existing shareholders of Zhihu. As such, it is reasonable that one or more of these Chinese technology companies could have the intention to do a complete takeover of Zhihu to utilize ZH's content for relevant AI applications.

Zhihu's current valuations also imply that a potential acquisition of ZH will be a pretty good deal. The market currently values Zhihu at just 0.31 times consensus forward next twelve months' Enterprise Value-to-Revenue according to S&P Capital IQ valuation data. Separately, ZH is only expected to turn EBITDA positive in fiscal 2026. Based on Zhihu's current enterprise value of $240 million and its consensus FY 2026 EBITDA of $37 million (source: S&P Capital IQ ), ZH's consensus forward FY 2026 EV/EBITDA multiple of around 6 times is rather undemanding.

But the emergence of AI chatbots isn't totally positive for Zhihu as discussed in the next section.

Downside Risks Shouldn't Be Ignored

In the US, the spotlight is on the potential disruption threat that Microsoft's new ChatGPT-powered Bing poses to Alphabet's ( GOOGL ) ( GOOG ) Google Search. Thinking along the same lines, it is natural to be worried that Baidu's Ernie or other AI chatbots introduced by Chinese companies could potentially lure users away from Zhihu's platform and community in time to come.

In other words, the increased popularity of AI chatbots might invite new competitors for Zhihu, rather than bring in a prospective acquiror of the company's shares.

Separately, the AI chatbot "bubble" in China might burst sooner than one would expect, and regulatory issues could possibly restrict the development of AI chatbots in the country.

On February 10, 2023, Zhihu's shares experienced a meaningful -11% price correction. This came about as "Chinese state media" warned "against risks in chasing local ChatGPT-concept stocks" as reported by Reuters on February 9, 2023. Assuming that China's policymakers come up with new rules to regulate the Chinese AI industry in the months ahead, it is likely that Zhihu might give up most of its earlier share price gains, as a potential takeover of the company becomes less likely if interest in AI chatbots cools.

Concluding Thoughts

AI chatbots offer both rewards and risks for Zhihu. Positives have been priced in for ZH judging by its recent share price performance, indicating that a Hold rating for Zhihu is justified.

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