I still rate Zhihu Inc. (NYSE:ZH) [2390:HK] stock as a Hold.
I have a Neutral view of ZH’s Q2 2024 results. Although Zhihu’s losses narrowed substantially in the second quarter, the company paid a hefty price in the form of a bigger drop in its top line. I think that ZH has yet to reach an inflection point that will spark a re-rating of the stock’s valuation. If and when Zhihu comes closer to achieving both positive top line expansion and positive operating income, I will be willing to upgrade my rating for ZH to a Buy.
The spotlight is on ZH’s latest second quarter performance in the current write-up. I previously reviewed Zhihu’s Q1 results in my June 13, 2024 article. Chinese media publication South China Morning Post describes ZH as a company that operates a “Quora-like question-and-answer service” in China.
Q2 2024 Bottom Line Performance Was A Significant Improvement
Zhihu’s operating loss and normalized net loss improved by 44% YoY and 80% YoY to -RMB 184 million and -RMB 45 million, respectively in Q2 2024 as per the company’s quarterly results announcement.
The company’s actual second quarter loss from operations and non-GAAP adjusted net loss turned out to be 7% and 59% better than the analysts’ consensus operating loss and bottom line forecasts of -RMB 199 million and -RMB 109 million, respectively. The consensus financial estimates were obtained from S&P Capital IQ.
In its Q2 2024 results announcement, ZH highlighted that it “maintained disciplined spending while achieving a high ROI (Return On Investment) across all business lines.” Zhihu’s operating costs declined by -17% YoY to RMB 740 million in the second quarter of this year. This means that ZH’s operating costs-to-sales metric improved from 85% in Q2 2023 to 79% for Q2 2024.
ZH’s second quarter analyst call commentary indicates that the company will likely become more aggressive with its cost optimization efforts in the coming quarters. Specifically, Zhihu emphasized at its latest results briefing that it will step up on its “loss reduction work” in Q3 and stressed that the substantial Q2 bottom line performance improvement was made possible with just “a single quarter of adjustments.”
Moving ahead, Zhihu guided that the company can record a positive normalized net income in the final quarter of the current year as per its Q2 2024 analyst briefing disclosures. ZH’s Q2 2024 non-GAAP adjusted net loss of -RMB 45 million was its best quarterly bottom line performance since its March 2021 public listing on NYSE, and the company has never been profitable in any single quarter or year. As such, it will be a key milestone if Zhihu does achieve positive earnings in Q4 2024 based on its guidance.
But Revenue Contraction Got Worse In Recent Quarter
There is a significant price to pay with ZH’s lower costs and smaller losses. Zhihu’s revenue fell by -11% YoY to RMB 934 million in the second quarter of 2024, which was inferior to its Q1 2024 top line decline of -3% YoY.
Although ZH’s actual Q2 top line in local currency or RMB terms represented a +2% beat as per S&P Capital IQ data, the market anticipates that the company’s revenue contraction to get worse in the second half of the current year. Specifically, S&P Capital IQ’s consensus data points to expectations of Zhihu’s top line decreasing by -17% YoY and -27% YoY for Q3 2024 and Q4 2024, respectively.
In the most recent quarter, Zhihu’s pay membership revenue and vocational training revenue decreased slightly by -4% YoY and -7% YoY, respectively, But the company’s marketing service revenue, which accounted for 37% of Q2 2024 top line, dropped by -17% YoY for the latest quarter.
ZH explained in its results announcement that its marketing service revenue stream has taken a big hit from the “ongoing refinement of service offerings to strategically focus on margin improvement” in Q2 2024. It is clear that Zhihu is prioritizing the narrowing of losses over top line expansion. As such, ZH’s revenue decline might possibly widen in the quarters ahead, as boosting profitability becomes a key near-term priority to support the company’s Q4 2024 positive operating income target.
I am of the view that ZH’s above-expectations second quarter bottom line was a “low-quality beat”, as the smaller losses for the recent quarter weren’t accompanied by positive revenue growth.
Concluding Thoughts
Zhihu is now still trading a depressed consensus next twelve months’ price-to-revenue valuation multiple of 0.58 times. This is low in absolute terms and also represents a big discount to ZH’s historical three-year average consensus forward price-to-sales or P/S ratio of 2.0 times according to S&P Capital IQ data.
Based on data taken from S&P Capital IQ, ZH’s quarterly bottom line was better than the consensus estimate by at least 20% for the past three quarters between Q4 2023 and Q2 2024. But Zhihu’s P/S multiple has continued to de-rate despite the company’s bottom line beats, as investors penalize the stock for its negative revenue growth in both Q1 2024 and Q2 2024. As a reference, ZH’s consensus next twelve months’ P/S multiple was a higher 0.80 times at the beginning of 2024.
In my opinion, the company has to return to positive revenue growth before the market is willing to assign a higher valuation multiple to the stock, notwithstanding its narrowing losses. ZH’s rating remains a Hold, until the company can achieve a good balance between revenue growth and operating profitability enhancement.
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