The Moat Show Ep. 1: Meta Platforms with Ali Mogharabi

Chelsea Cines: Hello and welcome to the premiere of the Moat Show. In this series, we uncover the companies with economic moats one stock at a time by bringing on analysts from Morningstar to share their in-depth insights with you. In today's discussion we'll dive deeper into Meta Platforms. For the latest VanEck Morningstar Wide Moat ETF holdings on Meta platforms, go to vaneck.com/moat.

In this episode, we're thrilled to welcome Ali Mogharabi, a senior analyst at Morningstar.

Ali, take us back in time to 2012 when Meta, formerly Facebook, IPO'd and was given a wide economic moat rating, which is the most exclusive rating a stock can receive from Morningstar. Why did Morningstar assign that rating at the time? And what about Meta's core business model made it that compelling?

Ali Mogharabi: Yeah, sure, Chelsea. Well, simply put, let's start with the second part of your question. Simply put, Meta generates nearly all of its revenue from advertising as it sells ad inventory on its Facebook and Instagram apps to various advertisers. Now, in our opinion, Meta's primary economic moat source is the network effect. It's actually a two-sided network effect. You know, as more users joined Facebook and Instagram back then, the apps became more valuable to their current users. So more content was posted by the users and their interaction and engagement increased, which then, of course, attracted more users to the apps, which again increased the value to current users, increased content and engagement, attracting more users, pretty much creating a flywheel. Now, on the other side of the network effect are actually the advertisers. In this case, it's an indirect network effect. With advertisers, benefit more from the users and not necessarily from their fellow advertisers. As the number of users increase, as you know, as the number of eyeballs increase, as they spend more time on the apps, demand from advertisers increases, which of course results in more ad spending and therefore revenue for Meta. Now, in addition to the network effect, we think Meta has an intangible asset moat source, and that's data. It's first party data regarding users. Meta can actually utilize that data to help increase ROI on its ads that the advertisers purchase, and certainly that makes the ads overall much more attractive to the advertiser.

Chelsea Cines: Would you say it's pretty rare for Morningstar to assign a wide vote rating for companies that recently IPO'd?

Ali Mogharabi: I would say yes, it is pretty rare. And actually, it's the entire coming up with the entire moat rating, that entire process where the analysts actually have to sit and make their pitch, debate and argue in front of the moat committee. That in itself makes it much more difficult. And of course, we have to get into details about the company's products, about the company's competitors and so forth, and how they may actually continue to perform in the long run. So with that in mind, if you think about it, when there's an IPO, there's to a certain extent some limited information available about the company. So that makes it even more difficult. But to answer your question, absolutely. It is very difficult.

Chelsea Cines: Ali, equally as important as your economic research is your valuation research. Can you walk us through your cash flow model for Meta? I’m also curious about the broader macro environment and how that influences Morningstar’s moat valuation process. For example, given that tech stocks are frequently views as long duration assets that have a higher sensitivity to interest rates, do these factors play a role in Morningstar’s valuation methodology?

Ali Mogharabi: Sure. Sure. I mean, as you mentioned, it is a discounted cashflow. Our valuation is based on a three-stage discounted cashflow model. Stage one is basically my explicit forecast. In the case of Meta, I have a five-year explicit forecast. Stage two is pretty much a fade stage where we're actually assuming that the return on new invested capital is going to gradually decline towards the cost of capital. But we are assuming that excess ROIC will still be generated for at least the next 15 years.

After that explicit stage or stage one and in stage two and in stage three. In stage three, we've got the perpetuity stage. So now remember, we have given Meta a wide moat rating, which simply means that we think it can generate excess ROIC for at least the next 20 years. Now while we think Meta will face margin pressure due to the deceleration and revenue growth as we think.

One, the transition to digital ad spending by advertisers is almost complete. The firm is also facing further competition, which will also keep capex higher than where it has been historically. And of course, possibly an economic downturn means less ad spending by businesses. So we do think that operating margin will average around 30% for the next five years, lower than the last three years, 34% plus average. In terms of free cash flow generated, in our model, we think that as a percentage of sales, it will average at around 24%-25% in the next five years, and we believe it'll gradually improve beginning probably next year in 2024. That's compared to actually 26% in the last three years, including of course a very, very weak 2022 or last year. And then there are also of course some things that may impact the valuation, but in our case it hasn't necessarily impacted it that much.

From a macro standpoint, higher rates haven't necessarily impacted my weighted average cost of capital assumption. When it comes to cost of equity, our approach is more forward looking and we try to minimize effects of recency bias, of false precision, of market noise. Just to give you a simple example, while the significantly lower risk free rate in 2021 actually implied a much lower cost of equity, my assumption was a lot higher and similar to what it is today.

So it is more forward looking and our overall weighted average cost of capital assumption right now for Meta is around 9%. And again, it was in the same area 2-3 years ago.

Chelsea Cines: Well, narratives seem to chase price shifts in markets, and it doesn't seem like it was too long ago when the mood around Meta was near an all-time low. The company appeared to be going through a bit of an identity crisis with its rebrand from Facebook and its pivot to the metaverse. It also had a bit of a beat down due to Apple's data privacy changes and lost market share for TikTok.

Ali, what made you maintain your conviction in the stock when everyone else seemed very bearish?

Ali Mogharabi: Sure, a few things. First, TikTok is certainly one of Meta's largest and most fierce competitors. We think that Meta can also benefit from that short form video or vertical video, I should say, that TikTok brought into the social media space. That new format actually helps create more advertising options for the advertisers. Now, we're not assuming that Meta is going to be the number one player on that front.

And we're also not assuming that TikTok is going to completely displace Meta. But simply put, we feel pretty comfortable that Meta is going to get us a piece of that growing pie, even if it's not the biggest piece that it has been historically. As you remember, Meta was confronted with new and innovative formatted content before. It was not the first mover regarding stories, which was actually introduced by Snapchat.

But in 2017, Meta started rolling out its stories and started monetizing them pretty effectively after a couple of years. Obviously, it's done pretty well on that front. So we think, you know, we think even though TikTok is a more formidable competitor than Snap was, we do believe while, again, while it's not the biggest piece, Meta is going to get its piece of that growing pie with its reels, which by the way, it actually began, only began, I think, monetizing late last year.

Now, the second thing is, from the beginning, we didn't think that Apple's policy would impact the effectiveness of ads on Meta's platforms. As you know, Meta has a significant amount of first-party data that it utilizes, and of course, the amount of time that users spent on that platform. Apple's policies impacted the measurement of the ads effectiveness more than anything else, which made the advertisers a little bit hesitant. And we thought that over time, Meta and the advertisers could actually make the necessary changes to improve that measurement. And it looks like that's slowly taking place.

And then the third thing, as I mentioned before, Meta's platforms are likely to keep attracting ad dollars given their huge user count. Even with the emergence of new competition, we haven't seen significant, or I should say, maybe consistent decline in its daily or monthly user count. And engagement certainly remains pretty stable. So those are the three main things that I think helped the stock recover.

But of course, in addition to those, you've got some geopolitical factors that have also helped it to recover. One is that the lawmakers are considering banning TikTok. You know, actually recently, Montana state lawmakers passed legislation doing just that. Even if that doesn't happen at the federal level, you know, the uncertainty may drive content creators to focus a little bit more on distributing and monetizing their content on non-TikTok apps, like Instagram's Reels, YouTube Shorts or Snap’s Spotlight. And then the other thing is that, you know, we, I don't think I've heard it being touched on in the press that much. But the other thing is that such a threat that TikTok represents to Meta actually weakens, in our opinion, weakens FTC's antitrust case against the company. So overall, we think the market has also begun to take some of these things into account and that's contributed to driving the stock up a little.

Chelsea Cines: In your opinion, do you think TikTok poses a serious threat with data privacy concerns, or do you think it's mostly a victim of these rising geopolitical tensions?

Ali Mogharabi: That's a good question. I actually think it's geopolitical. I think that geopolitical tensions have increased data privacy concerns specifically regarding TikTok. So to answer your question, it's both. But let's be straightforward here. As you're aware, all social media platforms continue to face data privacy concerns. So, and it's not just in the U.S. but also in the international markets. So again, it's not just TikTok.

It's also, of course, and it has been for a long time, Facebook, Instagram, YouTube, Snap, to a certain extent, maybe Pinterest, not as much though. But in TikTok's case, those geopolitical factors make the data privacy and data security issues even more worrisome.

Chelsea Cines: Ali, before we close, we got to talk about AI. It's the buzzword for 2023 with OpenAI's release of ChatGPT. What is your perspective on these new AI tools like ChatGPT? And can you shed some light on any AI projects that Meta is currently developing? And to steal a term from Google, are there any moonshot projects that Meta is working on currently.

Ali Mogharabi: Yeah, well, that's a very good question. Certainly expected. We always have to talk about AI. Now, regarding Meta, while it has its own large language model, which is pretty much basically what GPT and Google's Lambda is, by the way, Meta's large language model, one of them, is referred to as a LLAMA, a little bit similar to Google's Lambda, but LLAMA.

So it has its own large language model, but we don't think it's going to be using it on its platform soon. The company has actually said that it's made it available mainly to academic researchers, industry specific research labs and so forth. The firm certainly has other AI capabilities like image segmentation and actually animating amateur drawings that in my opinion, can help social media users create even more content and more engagement and interaction. But we don't think it's going to be focusing on using AI on the user side.

Now, there have been some reports where it appears that its current focus on providing AI capabilities is on providing AI capabilities to advertisers and their agencies, whether to further automate their ad deliveries on its different platforms or to actually help on the creativity front where they may help businesses actually design and create their ad campaigns.

So they're focusing more on providing those capabilities for the advertisers. Right now though, besides AI, I would say that the main moonshot remains the metaverse, which looks like the firm is a little bit less aggressive on, given the various factors, including the macro environment, overall slowdown and ad spending, and of course, increase in competition. So again, to answer your question, I think the main moonshot right now is metaverse. But on the AI front, they're certainly very aggressive to possibly utilize them on their social media platforms and of course with the advertisers themselves.

Chelsea Cines: Great, thanks so much for your time, Ali. Where can our viewers stay up to date with you and your latest research?

Ali Mogharabi: Well, at Morningstar.com, at Morningstar, we publish our research in a timely manner, very objective, very independent. And yeah, you can always find that information on our website. And of course, through VanEck, as you mentioned before, Meta, the company has a wide moat rating and it's currently in the Moat ETF.

Chelsea Cines: Great. Thank you all for joining us on the Moat Show. Don't forget to like and subscribe to our channel for VanEck's latest investment insights. To receive the latest Moat investing research right to your inbox, go to vaneck.com/subscribe to subscribe to Moat investing.