Zhihu: Impressive Growth, Improving Margins And Ready To Take Off
- Zhihu recently debuted on NYSE at an IPO price of $9.50/ADS. Shares currently trade at $9.19/ADS.
- Investors haven't yet paid enough attention to the hyper-growth company, which has also seen improving margins and diversifying sources of revenue in past quarters.
- I believe Zhihu is a strong buy at its current price. Growth investors should scoop up some shares amid the recent decline of valuation multiples for Chinese tech companies.
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Zhihu (NYSE:ZH) made its debut on NYSE at an inopportune time—overall decline of interest in tech stocks over valuation and interest rate concerns, tightening regulation from the CCP over internet companies in China, the quick tumbling of blockbuster e-cigarettes IPO RLX, and the disastrous explosion of Archegos, which witnessed massive sell-offs in Chinese tech stocks such as GSX, VIPS, and TME and caused serious chain reactions and losses for major financial institutions. Zhihu debuted on NYSE last Friday, backed by Chinese tech giants Alibaba (BABA), Tencent (OTCPK:TCEHY), Kuaishou (1024.HK), and prestigious Chinese PE firms such as Sinovation Ventures, Qiming Venture Partners and Capital Today. Nevertheless, amid confusion and panic over steep declines in Chinese equities, Zhihu started trading at $8.05, well below IPO price of $9.5, sank to $6.81 during the day, and ended the day at $8.5, which gave the company a valuation of $4.8b. In this article, I argue that ZH is currently underpriced and its current valuation offers a golden entry opportunity. I will substantiate my thesis in three parts: the macro—total addressable market, or TAM, is enormous, which offers ZH a great runway into the future; the financials—improving operating efficiency and diversifying sources of monetization lay out multiple paths to profitability; the company—ZH’s reputation as a community for the learned and as a reservoir of authoritative knowledge and eclectic contents provide huge moats over its competitors.
Zhihu reports its financials in RMB. For readers’ convenience, all of the financial data is converted to USD using a constant exchange rate of 6.5RMB to 1USD.
Zhihu—A Brief Introduction
Zhihu was founded in 2010, one year after the founding of Quora. However, Zhihu didn’t start its monetization efforts until 2016, when it introduced online advertising on its platform. For the year ended in 2020, Zhihu has 76 million monthly active users (MAU), 43 million cumulative content creators.
In its IPO filing, Zhihu describes itself as the “largest Q&A-inspired online community and one of the top five comprehensive online content communities in China." For investors who do not read Chinese, here’s a brief overview of the web version of Zhihu’s service.
A typical Q&A page looks like the following:
I marked a few important functions/sections in red numbers. 1 is Zhihu’s paying membership program, which I’ll explain in a later section. 2 is Discover, through which one finds trending topics and participates in online roundtable discussions. 3 is the search box where you enter questions or keywords. 4 is the answer section, where users write answers to the question raised. 5 is the community interaction section, where users interact using upvotes, downvotes, comments, share posts, add to favorites, and send likes. 6 is an ad block, through which companies market themselves to Zhihu users. Zhihu makes the bulk of its revenue through online advertising services.
The user interface does remind one of its U.S. peer, Quora. For a long while, Quora was unable to generate any revenue until it added ads to its content platform. The same is true for Zhihu. Having long established itself as the leader of premium written contents, Zhihu’s initial monetization efforts were unsuccessful, partly due to an immature market environment for paid contents, partly due to its zealous users’ vision for Zhihu to be a pure and scholarly platform of crowdsourced knowledge. Nevertheless, since 2016, with the help of experienced private investors, the companies have laid out four successful and fast-growing major revenue paths. All of these sources of revenue compete in fields with enormous total addressable markets (TAM).
Attractive TAM, great potential
Zhihu made its revenue through four major paths—online ads, membership fees, content-commerce solutions, and other (mainly consisting of online education and e-commerce). In FY2020, the company reported a revenue of $207m, of which 62% is from advertising, 24% from membership fees, 10% from content-commerce solutions, and 4% from other.
(source: Zhihu's F1/A filing)
A mature growth runway—online advertising
According to an industry report prepared by CIC, an independent research firm, China’s online advertising market in terms of revenue has grown from $33.6B in 2015 to $102.4B to 2019, and is expected to grow to $283.6B in 2025, at a CAGR of 18.5%. In the specific area of advertising through online content communities, revenue reached $16.8B in 2019 and is expected to increase to $78.5B in 2025 at a CAGR of 29.2%. Zhihu made $129M of advertising revenue in 2020, representing a meager 0.53% of the TAM in online content communities advertising.
(source: Zhihu's F1/A filing)
Gaining momentum—membership subscriptions
Zhihu generates revenue when users pay subscription fees to access premium content. The broader online content market has seen a drastic increase in paying members as a percentage of total users, which grew from 5.8% in 2015 to 17.3% in 2019 at a CAGR of 31%. Similarly, China’s paid membership market has reached from $16.2B in 2019 and is expected to reach $50.5B in 2025. Paid membership revenue generated from online content communities in China is expected to grow from $2.7B in 2019 to $13.9B in 2025 at a CAGR of 31.6%. Zhihu made $49M in paid membership in 2020, representing 1.84% of the TAM in online content community paid membership.
Expect further growth in content-commerce solutions
Content-commerce solution is a pretty new industry in the Chinese internet scene, in which the solution provider offers a tool to help businesses reach their target users with efficiency. Zhihu launched its content-commerce solution platform, Zhi+, in early 2020. This business has seen tremendous growth, bringing in $20.8M in revenue for the company last year. I’ll explain the advantages of Zhihu’s solution platforms over its competitors in a later section.
China’s overall content-commerce solution market size has grown from a negligible $0.3B in 2015 to $1.8B in 2019, and is expected to grow at a CAGR of 46.4% to $17.3B in 2025. Zhihu currently makes $21M from this section of business, representing 1.19% of the overall TAM.
E-commerce, live streaming, and online games, IP-based monetization, and online education
Zhihu makes the rest of its revenue, roughly about 4%, from content e-commerce, live streaming virtual gifts, online games, IP-based monetization and online education. The company does not disclose the size of each business in its 8-K, but CIC research suggests these runways expect CAGR of 60%, 25.1%, 28.5%, 15%, 22.8%, respectively into 2025. All of these runways are multi-billion dollar industries in China, which can provide additional growth and huge upside potential in Zhihu’s future business expansion.
To put everything together, if we do not take “Other” into account, Zhihu currently operates in a market size of $31B in terms of revenue. With a revenue of $207M in 2020, Zhihu has captured only 0.66% of its TAM. The company’s TAM is expected to grow to $110B in 2025. A 1% and 2% market share would bring in revenue of $1.1B and $2.2B, representing a CAGR of 40% and 60%, respectively.
Diversifying Business, Impressive Growth and Improving Margin
Since 2019, Zhihu has diversified its sources of revenue to include membership fees, content-commerce solutions, and others. Zhihu is a growth monster when we look at the revenue. The company reported a revenue growth of 102% for FY2020, in which online advertising grew 46%, membership fees grew 264%, content-commerce solutions grew to a combined $28M from negligible amounts.
Concerns for potential investors include that Zhihu’s ad revenue growth doesn’t seem impressive given its current size, and that Zhihu’s cash burn might not bring the company to profitability in the foreseeable future. However, we get a different picture when we take a closer look at the quarterly results:
(source: author, with data from Zhihu's F1/A filing)
As is obvious in the quarter-by-quarter breakdown, Zhihu’s advertising business was greatly hampered by COVID-19 during the first half of 2020, when most businesses cut their sales and marketing budget. However, revenues quickly rebounded and growth accelerated during the second half. For the whole year, YoY revenue growth is 22.3%, 22.9%, 51.1% and 71.9%, respectively. Rather than decelerating, Zhihu’s revenue from ads is actually growing at an accelerating rate. It is not an overstatement to say that if it weren’t for the impacts of COVID-19, Zhihu’s ad business would grow at 60% to 80% for FY2020.
Average ad revenue per MAU is $1.88 for FY2020, a slight increase from $1.85 in 2019. As Zhihu attracts more active users, however, it fails to extract further value from each user in advertising. This should be a metric to take notice for potential investors. We should note that ZH’s monetization effort is still at an early growing stage, especially so when we compare to that of Facebook’s (FB) operation in the area. For FY2020, Facebook has 1.2 billion MAU in Asia-Pacific. The majority of FB’s MAU in this area are located in India, yet FB still manages to extract a staggering $16.55 from these users.
(source: author, with data from Zhihu's F1/A filing and Facebook's 10-K)
Another point that draws my interest is the continuous high growth in paid membership revenue. Membership fees have grown at triple-digits YoY for all reported periods, the most recent of which witnessed a revenue increase of 193% to $16M. It is worth noting that Zhihu’s percentage of paying MAU for 2020 reaches 3.45%, a 188% increase over 1.2% from last year, but still significantly lower than the figure of Bilibili (BILI), a leading Chinese online content community focusing on videos, which reported that paying MAU reached 8.86% for FY2020.
(source: author, with data from Zhihu's F1/A filing and Bilibili's most recent 6-K filing)
Zhihu’s content-commerce solution, branded as Zhi+, has witnessed continuous quarterly growth as well, increasing from $0.17M in Q1 to $11.77M in Q4. The quarter-by-quarter growth rates for this segment of business have been 83%, 1055%, 258%, 68%. So far we do not know what slowed down Zhi+’s revenue increase. Investors should pay attention to the upcoming quarterly result to determine the value, sustainability, and potential of this part of Zhihu’s business.
Moving on to expenses. Except for China’s COVID-plagued 2020H1, Zhihu’s gross margin has seen great quarterly improvements. For the latest quarter, Zhihu reported a gross margin of 64.1%, a significant improvement over that of 29.6% reported in 2019Q1. Operating efficiency has also improved, where SG&A as a percentage of revenue has seen impressive decreases in all reported quarters, dropping down from 168% in 2019Q1 to 68% in 2020Q4. This brings operating margin to -20.1% for the latest quarter, also a huge positive to Zhihu given that the company burned 3x cash to earn 1x revenue in 2019Q1. If operating efficiency continues the current trend upward, Zhihu might see positive operating margin in a few quarters. The company spent a mere 15.8% of revenue on R&D, which is quite low for a growing tech company of Zhihu’s size.
Deep moat as the company grows into Quora + Wikipedia in China
Zhihu is a household name in China. It is especially popular among the younger generation. In its IPO filing, Zhihu reports that 78.7% of its MAU are under 30 years old as of December 2020. Moreover, users in tier-1 and tier-2 Chinese cities make up a total of 72.8% of Zhihu’s MAU. These users are usually well-educated young people who have the desire and the financial capability to learn and to spend on value-added services.
(source: author, with data from Zhihu's F1/A filing)
Many investors consider Zhihu to be a peer to the US-based Q&A platform, Quora. However, I believe the view is only partial. Instead, I see Zhihu as a combination of both Quora and Wikipedia. For one thing, Chinese internet users do not have their own authoritative go-to website for knowledge. Wikipedia is banned in China and Baidu’s encyclopedia is nowhere comparable to Wikipedia in terms of content quality and comprehensiveness. Since 2010, young people searching for answers are turning to Zhihu, where they can find quality answers written by other users in topics ranging from love to finance to quantum mechanics.
Zhihu has built an extensive reservoir of knowledge for its users. The company reports 315 million cumulative Q&As as of FY2020. As more users contribute to the space, more quality answers in more topics will be available, attracting a wider range of people to the platform.
The massive readership of Zhihu and Zhihu’s recent ventures make me feel necessary to talk more about Zhi+, its content-commerce solution platform, through which businesses market their products to Zhihu users. Zhi+ is unique in that it integrates ads into its Zhihu’s contents—marketers can use Zhi+ to find trending topics, integrate their marketing materials into answers and pay for initial promotion. In this way, the ad stays forever—so that as long as the marketers manage to find a smart way to write useful and helpful answers to the appropriate and relevant question, the answer would get plenty of upvotes and thus always pops up when users search for relevant keywords in the future at no further costs. This long-lasting advertising effect offers an enticing alternative to traditional advertising, where businesses pay for each display, click or chunk of display time. Zhi+ currently offers competitive price advantages over established content-commerce platforms and is relatively unknown in the mainstream space of content-commerce. I believe we can expect strong growth in Zhihu’s content-commerce solution revenue as marketers make use of Zhihu’s massive traffic and attractive pricing.
All that said, risks remain for investing in Zhihu. For one, the company has only seen two to three years of significant revenues. We cannot get a reliable estimate of its future revenue growth. Moreover, there is a significant risk of outflow of quality writers to competing platforms, notably Bilibili, which has so far done a better job at financially rewarding for their content contributors. Also, we cannot predict the impacts of Zhihu’s monetization efforts on Zhihu’s users—further introduction of ads and content promotions might undermine the quality of Zhihu’s contents, slowing down future user acquisitions. Finally, it would be more useful if Zhihu provides more comparative statistics, as used by its competitors, such as average time spent each day, user retention rate, etc.
Valuation and Conclusion
As of the completion of this article, Zhihu’s stock price is $9.19 per ADS, which gives the company a market cap of $5.06B. The company currently trades at 24x its 2020 revenue, which is similar to the competing Chinese growth monster Bilibili's multiple of 23. However, Bilibili's gross margin for FY2020 is 23.67% as compared to ZH’s 56.04%. Given Zhihu’s diversifying business model, its triple-digit growth rate in terms of revenue, its improving margins, and its list of influential backers, I believe Zhihu is currently a Strong Buy. Growth investors should scoop up some shares in the midst of the recent meltdown of Chinese stocks.
This article was written by
Analyst’s Disclosure: I am/we are long ZH. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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