Zhihu Stock: Watch Trade-Offs & Investor Sentiment (NYSE:ZH)

Elevator Pitch

My rating for Zhihu Inc.’s (NYSE:ZH) [2390:HK] shares is a Hold.

I evaluated ZH’s valuations and financial outlook in my prior write-up for the stock published on September 26, 2022. In the current article, I analyze how Zhihu is sacrificing growth in exchange for cost reduction.

The trade-offs that Zhihu is making haven’t impressed analysts, as the sell-side has continued to cut 2023 top line estimates and price targets for ZH in the past few months. Zhihu’s shares only warrant a Buy rating, assuming that the company is able to deliver both strong revenue growth and improved profitability. For now, ZH stays a Hold-rated name in my opinion.

ZH Achieved Narrower Losses In Most Recent Quarter

In the current market environment where investors are placing a stronger emphasis on profitability rather than growth, many fast-growing technology companies have chosen to engage in cost cutting to boost their bottom line. Zhihu falls into this category of companies.

In the third quarter of this year, ZH’s losses were narrower, and came in better than what the sell-side analysts were forecasting.

Zhihu’s Q3 2022 loss from operations was -RMB279 million as indicated in its recent earnings report, which compares favorably with the company’s operating loss of -RMB461 million in the second quarter. The company’s actual third quarter loss from operations was also superior to the market’s consensus operating loss estimate of -RMB491 million based on S&P Capital IQ data.

The company’s net loss attributable to shareholders narrowed from -RMB487 million in Q2 2022 to -RMB300 million for the most recent quarter. It is worthy of note that the sell-side had earlier projected a substantially wider Q3 2022 net loss of -RMB545 million for ZH.

It was Zhihu’s cost management efforts which paid off in the form of an improvement in the company’s bottom line. ZH specifically mentioned about “rigorous cost control and ongoing efficiency improvement” at its Q3 2022 results briefing, and this is reflected in its financial numbers.

ZH’s selling and marketing costs (S&M) declined by -10% QoQ to -RMB478 million in Q3 2022, while its research and development (R&D) costs fell by -28% QoQ to -RMB161 million in the recent quarter. The company managed to lower the proportion of S&M expenses as a percentage of revenue from 63% in Q2 2022 to 52% for Q3 2022, and its R&D expenses-to-revenue ratio also decreased from 27% to 18% over the same period.

But Zhihu Saw A Decline In Users And Slower Revenue Growth

Everything comes at a cost, and there are always trade-offs that companies have to consider in making business decisions. ZH might have delivered a better-than-expected bottom line in the third quarter of 2022, but the cost savings could have had a negative impact on the company’s growth in the same time frame.

The monthly average users or MAUs for Zhihu contracted by -4% YoY from 101.2 million for the third quarter of 2022 to 97.0 million in the most recent quarter. Based on my calculations, ZH’s average revenue per paying user also decreased by -3% QoQ to approximately RMB10.3 in Q3 2022.

In local currency terms, ZH’s YoY top line expansion also slowed from +55% in Q1 2022 and +31% in Q2 2022 to +11% for Q3 2022. More significantly, the analysts’ consensus financial projections taken from S&P Capital IQ suggest that the market sees Zhihu’s revenue growth decelerating further to +6% YoY in the final quarter of this year on a YoY basis.

Zhihu attributed the slower Q3 2022 top line increase to “the COVID situation and the weaker economic environment” in China at the company’s recent third quarter earnings briefing. However, it is reasonable to assume that ZH’s cut in S&M and R&D costs have also contributed to the decrease in its MAUs and its top line growth deceleration.

Investor Sentiment Is Still Weak

It takes a meaningful shift in investor sentiment for a stock to experience a positive re-rating. In that respect, investor sentiment towards Zhihu appears to remain weak judging by the change in consensus forecasts and price targets.

According to S&P Capital IQ data, the analysts’ consensus FY 2023 top line estimate for Zhihu has been reduced by -3% from RMB5,101 million at the end of September to RMB4,939 million now. Similarly, the sell-side’s consensus target price for ZH was lowered by -3% in the same period.

If the market was impressed by the trade-offs that Zhihu had made to improve its bottom line, the sell-side analysts would have raised the company’s forward-looking revenue forecast and price targets. This wasn’t the case as outlined above.

Moreover, the company’s management remains very cautious about the outlook for 2023, which also explains why investor sentiment for ZH’s shares is weak. Zhihu stressed at its most recent quarterly results call that “we are not able to make an accurate prediction as to what will happen next year.”

Closing Thoughts

I am still rating Zhihu’s shares as a Hold.

It will take more time for Zhihu to achieve a good balance between revenue/user growth and profitability. I will only consider upgrading my rating for Zhihu to a Buy, when I see signs of that happening.