Zhihu Answers Investor Doubts With Improving Margins

Key Takeaways:

• Zhihu’s revenue fell 3.3% in the first quarter, marking its first-ever decline since its New York listing
• The company, often called the “Quora of China,” boosted its gross margin by more than 5 percentage points, and said it expects to achieve non-GAAP profitability by year-end

By Doug Young

Who knows when Zhihu Inc. ZH will finally turn profitable?

Top brass at the company often dubbed the “Quora of China” seemed to think they knew that answer, reiterating on Wednesday they were aiming to achieve a non-GAAP profit, which typically excludes stock-based employee compensation, by the end of this year. Investors weren’t too impressed, bidding down Zhihu’s stock down by 2.5% after the company reported its first-ever revenue decline in its latest quarterly results.

The Wednesday selloff means Zhihu shares have lost nearly 40% of their value this year, and are now down more than 95% from their IPO price during headier times when the company made its New York listing in 2021. Notably, Zhihu’s shares have been left behind in a recent rally that has lifted most U.S.- and Hong Kong-listed Chinese stocks this year, reflected by a 16% rise for the iShares MSCI China ETF (MCHI.US) from a February low.

Remarks by founder and Chairman Zhou Yuan calling the first-quarter results a “solid financial and operating performance” to start the year might leave some scratching their heads. After all, a first-ever revenue decline is hardly something to brag about. But a closer examination shows Zhou was probably referring to the company’s gross margin, which improved by more than 5 percentage points to 56.6% in the first quarter from 51.5% a year earlier.

Unfortunately, the improving margin didn’t trickle down to Zhihu’s bottom line. Its net loss for the quarter improved slightly to 165.8 million yuan ($23 million) from 179 million yuan a year earlier. But its adjusted non-GAAP loss – the metric it’s eying for breakeven by the end of this year – actually widened to 135.7 million yuan from 120.2 million yuan a year earlier. Clearly, the company has lots of work to do during the rest of the year to reach its breakeven target.

While investors love a profit, they aren’t exactly too excited about a shrinking company. That’s reflected in Zhihu’s anemic price-to-sales (P/S) ratio of just 0.58, which hardly looks like what you’d expect for an internet company that’s a leader in its space.

By comparison, search giant Baidu BIDU, which also hosts numerous similar user communities, trades at a P/S of 1.78, and China Literature (0772.HK) trades at 3.48. Then there’s U.S. powerhouse Reddit RDDT, which trades far higher than its Chinese peers at 11. Such a China discount within this group owes at least partly to the Chinese companies’ huge volumes of user-generated content, which is highly sensitive in China and poses a big risk from potential government clampdowns.

Still, Zhihu is the only one of its China peers that has yet to find profits, which explains why it’s valued so low even among that sub-group. Four analysts polled by Yahoo Finance aren’t saying whether they expect Zhihu to become profitable by the fourth quarter, though at least one believes it will become profitable next year. Despite the lack of profits, eight of nine analysts polled by Yahoo Finance in May rated Zhihu either a “buy” or “strong buy,” showing at least the analyst community hasn’t given up on the company just yet.

Shrinking revenue

Next, we’ll take a deeper dive into Zhihu’s financials that do seem to show why the company’s margins are improving at the expense of revenue growth. As we’ve noted already, Zhihu’s revenue fell 3.3% to 961 million yuan in the first quarter from 994 million yuan a year earlier.

While the decline represented a dubious first for the company since its listing, it certainly wasn’t a huge surprise. That’s because Zhihu’s revenue growth was slowing rapidly throughout last year, ending 2023 with just a 2.2% increase in the fourth quarter after starting off the year with a 33.8% year-on-year quarterly gain.

While the revenue slumped, Zhihu’s cost of revenue fell by an even larger 13.4% year-on-year to 417 million yuan as it downsized or discontinued less-profitable services that were dragging down its margins. All of its major user metrics were also down, led by a slightly alarming 13% drop in average monthly active users to 89 million. The more important metric of paying subscribers also fell, though just slightly, to 14.8 million from 14.9 million a year earlier. That shows that Zhihu is focusing less on freeloaders that bring it big user numbers but relatively little value, again highlighting the focus on reaching profitability.

Revenue for two of the company’s three main categories also fell, led by a 16% decline in its marketing services revenues to 331 million yuan as it retired some lower-margin products. Its biggest breadwinner, paid memberships, also fell, though only slightly to 450 million yuan from 455 million yuan a year ago.

The company’s lone bright spot, at least from a growth perspective, was its vocational training services, which recorded a 36% gain to 145 million yuan. That part of the business is still the smallest of its three major categories, but has grown over the last year to its current 15% of total revenue from 11% a year earlier.

Zhihu hyped up its various AI initiatives on its earnings call, though such hype has become standard fare for just about any content-centric internet company these days. While it’s true that such content could ultimately revolutionize the field, it’s far less clear who has the best technology and can find ways to harness and monetize it.

Zhihu’s march to profitability isn’t consuming too much money, which should give the company plenty of time to reach its profitability goal. It had 5.2 billion yuan in cash and short-term investments at the end of March, down just a tad from three months earlier and not too far off the 6.3 billion yuan it had at the end of March last year.

At the end of the day, Zhihu looks like quite the mixed bag for any investor interested in its Q&A story: On the one hand it’s a leader in its space and is likely to become profitable in the not-too-distant future. On the other, its revenue has begun to shrink and may not return to growth for a few years more.

This article is from an unpaid external contributor. It does not represent Benzinga's reporting and has not been edited for content or accuracy.