Zhihu: Earnings improvement comes at the expense of a larger revenue decline (NYSE:ZH)

I still rate Zhihu Inc. (NYSE:ZH) (2390:HK) stock as a hold.

I have a neutral view on ZH’s Q2 2024 results. Although Zhihu’s losses narrowed substantially in the second quarter, the company paid a heavy price in the form of a larger drop in its upper line. I believe that ZH has not yet reached an inflection point that will trigger a reassessment of the stock’s valuation. If and when Zhihu comes close to achieving both positive top line expansion and positive operating income, I will be willing to raise my rating on ZH to Buy.

The focus is on ZH’s latest Q2 performance in the current article. I previously reviewed Zhihu’s Q1 results in my article dated June 13, 2024. Chinese media publication South China Morning Post describes ZH as a company that operates a “Quora-like question and answer service” in China.

The final performance of Q2 2024 was a significant improvement

Zhihu’s operating loss and normalized net loss improved 44% YoY and 80% YoY to -RMB 184 million and RMB 45 million, respectively, in Q2 2024, according to the company’s quarterly results announcement.

The company’s second-quarter actual loss from operations and non-GAAP adjusted net loss came in 7% and 59% better than analysts’ consensus operating loss and trailing forecasts of -199 million RMB and 109 million RMB, respectively . Consensus financial estimates were obtained from S&P Capital IQ.

In its Q2 2024 results announcement, ZH emphasized that it “maintained disciplined spending while achieving high ROI (Return On Investment) across all business lines.” Zhihu’s operating costs fell by -17% year-on-year to RMB 740 million in the second quarter of this year. This means that ZH’s cost-to-sales ratio improved from 85% in Q2 2023 to 79% for Q2 2024.

ZH’s second quarter analyst 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 would step up its “loss reduction work” in Q3 and pointed out that the substantial performance improvement in Q2 was possible with only “a single quarter of adjustments.”

Going forward, Zhihu indicated that the company may post positive normalized net income in the fourth quarter of the current year, according to its Q2 2024 analyst briefing disclosures. ZH’s Q2 2024 non-GAAP adjusted net loss of -45 million RMB was its best quarterly performance since its March 2021 public listing on the NYSE, and the company has never been profitable in a single quarter or year. As such, it will be a key milestone if Zhihu achieves positive earnings in Q4 2024 based on its guidance.

But the revenue contraction worsened in the last quarter

There is a significant price to pay with ZH’s lower costs and lower losses. Zhihu’s revenue fell -11% YoY to RMB 934 million in Q2 2024, which was lower than its top-line decline in Q1 2024 of -3% YoY.

Although ZH’s actual top line in Q2 in local currency or RMB terms was up +2% according to S&P Capital IQ data, the market expects the company’s revenue decline to worsen in the second half of the current year. Specifically, S&P Capital IQ consensus data indicates that Zhihu’s top line is expected to decline by -17% YoY and -27% YoY for Q3 2024 and Q4 2024, respectively.

In the most recent quarter, Zhihu’s paid subscription revenue and professional training revenue fell slightly by -4% YoY and -7% YoY, respectively, but the company’s marketing services revenue, which accounted for 37% of the top line from Q2 2024, down -17% YoY for the last quarter.

ZH explained in the results announcement that its marketing service revenue stream received a big hit from “continuous refinement of service offerings to strategically focus on margin improvement” in Q2 2024. It is clear that Zhihu is prioritizing the reduction losses from the top line. expansion. As such, ZH’s revenue decline could extend into the coming quarters as increasing profitability becomes a key near-term priority to support the company’s positive operating income target for Q4 2024.

I think ZH’s second-quarter profit beat expectations was a “low-quality beat” because the lower losses for the last quarter were not accompanied by positive revenue growth.

Closing thoughts

Zhihu continues to trade at a low consensus trailing twelve month price-to-earnings multiple of 0.58x. That’s low in absolute terms and also a big discount from ZH’s three-year consensus historical average price-to-sales ratio, or P/S, of 2.0 times, according to S&P Capital IQ data.

Based on data taken from S&P Capital IQ, ZH’s quarterly result beat the consensus estimate by at least 20% for the last three quarters between Q4 2023 and Q2 2024. But Zhihu’s P/S multiple continued to fall, despite the company’s bottom line taking a beating as investors penalize the stock for negative revenue growth in both Q1 2024 and Q2 2024. For reference, ZH’s trailing twelve-month P/S multiple was 0.80 times higher in early 2024.

In my view, the company needs to return to positive revenue growth before the market is willing to assign a higher valuation multiple to the stock, despite narrowing its losses. ZH’s rating remains a Hold until the company can strike a good balance between revenue growth and operating profitability growth.