I assign a buy rating to Zhihu (NYSE:ZH) with a base-case target price of $4.73/share, implying an upside potential of approximately 180%. My recommendation is based on a residual earnings framework, with EPS analyst consensus forecast, 11% WACC and 3.28% TV growth rate. Personally, I feel the market underappreciates Zhihu’s massive MAU and highly engaged online community. The negative sentiment against China-based equities certainly added to a considerable headwind for the share price performance in the past 12 months, and resulted in a -80% price-depreciation for Zhihu’s share price. Long-term investors might want to take a chance on this speculative play and accumulate < $2 / share.
Zhihu Inc. (ZH) is a leading online content community in China. The company operates Zhihu, a social platform vary similar to Reddit and Quora. As of Q4 2021, Zhihu is China’s largest Q&A-themed online community, and one of the top five online content communities in China, not only in terms of average mobile MAUs but also revenue. On Sept 16, 2021, Zhihu announced that its average MAU surpassed 100m. The company went public in March 2021 at a price of US$9.5. Since a few weeks the company is also listed in Hong Kong (ticker: 2390) The company self-description reads as follows:
Zhihu is a leading online content community where people come to find solutions, make decisions, seek inspiration, and have fun.
The Case for Zhihu
Zhihu’s business model is very similar to other internet content platforms whose primary revenue source are advertising (1), membership subscription (2) and ecommerce (3). However, there are multiple aspects to like: Firstly, Zhihu attracts a highly engaged user base. Zhihu’s users are-generally speaking-highly educated youngsters, who are regarded as the future of China’s consumption power. This makes the platform highly interesting for advertisers. Secondly, the company’s success is hard-to-replicate by competitors, as network effects make the business model highly defensible. Third, Zhihu has structured quite a unique and differentiated value proposition. Forth, once the company has reached its growth target, management will have multiple monetization and revenue sources-including advertising, subscription fees based on a premium content library and ecommerce transaction opportunities. Finally, Zhihu is backed by a strong strategic shareholder base, which includes Tencent (11%), Kuaishou (7%) and Baidu (2%).
Investors should pay attention to the enormous market size of China’s online content communities. The market is expected to increase to $203 billion in 2025, representing a CAGR of 30.3% from 2019. In addition, China’s market for online content communities is still at a very early stage of monetization–with diversified monetization potential, including online advertising, paid membership, content-commerce solutions, content e-commerce, virtual gifting in live streaming, online games, IP-based monetization, and online education. For reference, revenue per user in China’s (total revenue of online content community market divided by total number of users) is approximately $60 per user, only one third of the same metric in the United States.
Despite a horrendous year for Zhihu shareholders, the company has actually delivered a strong FY 2021. In fact, total revenues reached US$464.4 million in 2021, representing an increase of 118.9% as compared to 2020. The increase was not only driven by MAU expansion but also by an increase of average revenue per user. For reference: Advertising revenue was US$182.2 million in 2021, which represents an increase of 37.7% compared to 2020. Paid membership revenue was US$104.9 million in 2021, increasing 108.6% year over year. Content-commerce solutions revenue was US$152.8 million in 2021, representing a x7 increase as compared to 2020.
Moreover, Zhihu’s user metrics have been growing strongly. Average monthly paying members increased to 6.1 million in Q4 2021, representing a growth of 102.0% year-over-year. As of Q4 2021, total time spent on the platform was 14.4bn mins. In addition, the accumulative pieces of content on Zhihu’s platform had reached 419 million, representing a year-over-year increase of 39%. However, despite the strong topline growth, the company is writing losses. Net loss for the FY 2021 was recorded as $-203.8 million. Future loss-making is cushioned by cash and cash equivalents of $1.132 million.
While it is challenging to value a loss-making growth company, as there is considerable speculation built into the future financial estimates, I have structured a Residual Earnings framework to value Zhihu. For your reference, I used the analyst consensus forecast for EPS, applied a WACC of 11% and a TV growth rate equal to GDP growth. Given these metrics, my valuation estimates a fair share price of $4.73 / share, implying considerable upside potential from Zhihu’s current price level of $1.71 per share.
For investors who want to challenge my assumptions and consider different scenarios, I structured a sensitivity analysis based on varying WACC and TV growth combination. For reference, red cells imply an overvaluation, while green cells imply an undervaluation as compared to Zhihu’s current valuation.
Needless to say, the table looks very favorable in terms of risk/reward. Alternatively, investors could also apply multiples to value Zhihu. I suggest using a 30% discount to Weibo’s x3 P/S multiple for 2023E numbers, resulting in a 3.16/ share valuation; or 2023E x10 EBITDA, implying a share-price of approximately $3.48 / share
Investing in Zhihu is a speculative play and there are a few risks top note: 1) intensifying competition for time and attention with other Internet platforms; 2) failure to successfully monetize the company’s business operations. Currently the market expects Zhihu to break-even in 2023. Notably, the company has a track-record of loss-making operations; 3) regulatory headwinds; and 4) macro uncertainties may impact spending for ads.
On the upside, I see the following catalysts for price appreciation: 1) Zhihu’s MAU increases faster than expected (2) and the company finds strong monetization opportunities; 3) sentiment towards risk-assets and China-based equities improves.
While the short/medium outlook remains challenging for Zhihu, I expect the company will be a long-term winner. China’s market size for online communities is expected to grow more than 30% CAGR until 2025 and grow Zhihu is well positioned to ride the tailwind. In my opinion, investors currently underappreciate Zhihu’s massive and highly engaged MAU, which topped 100 million users in 2021. Notably, Zhihu’s revenue-per-user metric (approximately $6) is considerably lower than the same metric for comparable companies, implying significant room for monetization potential. Once the current negative sentiment surrounding China equities subsides, Zhihu might see significant buyer interest and price appreciation. My base-case price target is $4.73 / share, implying an upside potential of 180% from current levels. Investors, however, should be aware that this is a speculative play. There is lots of uncertainty surrounding not only China, but also Zhihu’s business operations. Investors should be able to withstand considerable price volatility.