Investors Dig Into AppHarvest

As one of the newest businesses at the forefront of Agtech, AppHarvest (APPH) has the ambitious goal to revolutionize the way the United States supplies its produce. In this episode of Industry Focus: Wildcard, join Motley Fool analysts Clay Bruning and Emily Flippen as they present their bullish and bearish theses for the business and discuss if the risks are worth the reward.

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This video was recorded on August 4, 2021.

Emily Flippen: Welcome to Industry Focus. Today is Wednesday, August 4th, and I'm your host Emily Flippen. Today I'm joined by Motley Fool analyst Clay Bruning as we talk about the vertical farming innovator AppHarvest. Hey Clay, how's it going?

Clay Bruning: It's going well. Thanks for having me on and I'm excited to talk about the future of agriculture today.

Flippen: Yeah, I love it. Thanks so much for joining. I'm actually suspecting that a lot of our listeners are probably already pretty familiar with AppHarvest. One of the other Industry Focus hosts, Jason Moser, hosts our financial show on Mondays. He has had both the AppHarvest President, David Lee, as well as the AppHarvest CEO and Founder Jonathan Webb on the show in prior, I believe prior months this year for interviews. If you haven't given that a listen, I definitely encourage all of our listeners to go back, checkout those interviews because they're very informative. But also, I think you can hear the passion that both the president and co-founder have for this business, which is always fun to hear that straight from the horse's mouth, so to speak. But I was thinking that we could spend the bulk of today's show doing a bull versus bear debate on AppHarvest, probably overstating our opinions on it. 

Clay, I know you're a big fan, but I have to say I'm a little bit of a skeptic myself. I spend a lot of my time actually looking at can harvest companies and those businesses just have razor thin margins because of how challenging it is to take a commodity and make it something that is investable for shareholders. It's really not fun. When I think about AppHarvest, I get excited about their mission. Obviously, the landscape for vertical farming is the future rate, call them an AgTech business, the future of agriculture. But I can't quite get over the investing side of it. I'm hoping that you can change my mind here. For full transparency, that might be challenging, but at the very least, I hope you can maybe give some of your opinions for our listeners, maybe change their minds about the business. That was a lot. Sorry for talking all there. Before we get into today's show though, for people who haven't listened to these prior episodes, can you just give us, I guess, a quick synopsis of what AppHarvest is when we talk about AgTech, what does that mean?

Bruning: Yeah, absolutely. AgTech is just agriculture technology and AppHarvest specifically is focusing on feeding the future in a sustainable manner. They have paid off the Dutch idea of circular agriculture, which is the concept of minimizing your inputs while also being able to maximize your output. Think about those inputs as sunlight, water. In a lot of conventional methods, pesticides or chemicals and things like that. They do this by having what's called CEA or controlled environment agriculture or vertical farming where you are growing more in less acreage. Right now AppHarvest only has one operational facility that harvested their first set of tomatoes in the first quarter. They have four more under construction, and they have a goal of having 12 by 2025. Off to a slow start, but it's going to be a long-term vision for this company. Like I said, first harvest in the first quarter of 2021, they sold just under four million pounds of tomatoes that generated just over $2 million in sales. Very early, early on in the story of this company.

Flippen: It's an interesting choice for AppHarvest to go to the equity markets. This was a business that went public via SPAC structure, preferring to tap the equity markets as opposed to the debt markets to fund its expansion. Historically speaking, when we look at, I won't say AgTech businesses, because this is a really new space for a lot of investors and a lot of businesses. I will say though traditional greenhouses, these business models tend to go to debt markets before they go to equity markets and the handful of businesses that have been competing in the [...] space that are on the equity markets, I think Village Farms comes to mind, have always had a challenging time. I think explaining to investors why they deserve to be publicly traded, like why they're going to result in a return on your investment as a shareholder. But AppHarvest, flip that model on its head. I think they're really making the argument that you can be a business that is trying to do good things in the world, so increase the sustainability of food while also being a good investment. It's that second part I struggle with, so maybe tell me why you think this is a good investment. Give me your bull case here.

Bruning: A forewarning, this is a super-spec litter investment. Like I said, they had their first dollar of sales in the middle of the first quarter, which was also the first quarter of ever harvesting produce. By no means is this one of my highest conviction companies that I've looked at. It's just me thinking about a vision of what the future of not only agriculture, but the food supply chain as a whole looks like. I had to get that disclosure that this is a super speculative investment. I'm looking at this company not in five-years, but more so decades. The first thing that gets me excited about this company, is that there is ESG focused in everything they do. They're certified B Corps, meaning to have third-party people look through their entire company to ensure that they are sustainable in things like environmental impacts, how they treat employees, how they treat their communities, and how they treat their customers. They are actually just one of four public certified B Corps in the world. 

Then on top of that, they are really focusing on improving and solving a lot of problems not only here in the U.S, but in the world. The UN forecast that by 2050, the population is going to grow about 30 to 10 billion people. That's going to create 50 more food demand across the globe. Then you think about how much freshwater is dedicated to agriculture already. That's 75% of all freshwater in the world is already dedicated to agriculture. Something has to change there because the demand is going to far surpass the supply if conventional agriculture stays as the main source of food. Then I think about just today or last night, you think about California instituting an emergency response to the drought. They are going to limit certain farms in a couple of weeks to using freshwater because the drought is so severe. Some people even say California has been in a drought for 20 years. 95% of Western states as a whole are in a drought. The Western states are typically the hub for a lot of agricultural produce. Those are a couple of things in terms of the problems they're solving and as land degradation is whole, another thing. 33% of the world's soil has degraded to an extent which will lead to unharvestable conditions moving forward. 

You think about the lack of water and lack of land continuously getting worse every year and every decade. Something has to change there. Then something the CEO said with Jason, one of those interviews you mentioned really stuck with me the idea that sustainability is profitability. They are focusing on minimizing inputs, they use 100% recycled rainwater. They only use 1.8 gallons of water per tomato, which is 92% less than the global average within one day's drive of the entire U.S. population, which not only decreases transportation costs, but should decrease waste. Forty of all produce is wasted so that's a big way to reduce waste, reduce costs. They also use natural sunlight to grow when weather is applicable. Then they also use autonomous robots to harvest a lot of their produce, which is pretty early innings. They just acquired a company called Root AI that has a robot that can autonomously sense when a plant is ripe and ready for picking. They use that to decrease some of those costs, and in theory increase some of their operating leverage in way down the line there, hopefully, their profitability.

Flippen: I love that quote, sustainability is profitability. I'm going to push it though. I'm going to agree with that quote but I don't think that profitability equals investability. I don't think just because the business can be profitable that it's going to be a good return on shareholders' money and I think that's where I get hung up. When I think about other vertical growers, Revol Greens, Little Leaf, Gotham Greens. Vertical farming has been in development for decades and AppHarvest isn't the only business that is working in the business of vertical farming. It's been around a while. But these other businesses have really focused on essentially only the produce that can be grown consistently and economically, which tends to be these baby greens. You think arugula, for instance, tiny lettuce heads these things that they can grow really economically in a vertical farming environment and they're fine businesses, they're profitable businesses, I think all of them. Again, I went to those markets to finance because they could make these payments, but they're not necessarily great investments. I'm curious, what do you think makes AppHarvest different than all these other vertical growers that are competing, I suppose, for the same placement in grocery stores or with suppliers?

Bruning: I think the first thing and something management really stresses is their proximity. Like I said, they are within a day's drive of 70% of the U.S. population and they are headquartered in Appalachia, which is for them at least in Kentucky, Appalachia is a region in the middle of the Eastern Coast. But Appalachia has actually had three of the wettest years over the last 10 years in Kentucky's history. You think about using that recycled rainwater, rain doesn't seem to me much of an issue. Whereas California, Arizona, and a lot of other Western states where vertical farming is beginning to be adopted or has been adopted for some time now, they struggle to actually get that water and they probably have to use a lot of fresh water. I think the proximity is a big thing for them. They also have some impressive distribution agreements. The most important one is Mastronardi, I think this is how you pronounce it. They have access to grocers and food chains like Wendy's, Walmart, Target, all the Kroger, you name it in there. That works. Our target is really focused on the growth rather than the logistics of how are we going to sell all of these millions of pounds of produce that we have. That I think takes a big burden off of management to just have the peace of mind knowing that, we're going to focus on growing and then they're going to handle just about everything else. 

Then on top of that, food is the ultimate recurring revenue source for any company. Everyone eats food every day, three times a day. I don't necessarily think that it's going to be a winner take all market. I think there's a lot of room for multiple companies to have a decent market share. I don't think necessarily they are going to be the top dog or for that matter a top producer. But I think it's the ethos of this company, the idea that they are helping to revive Appalachia which was a huge coal mining industry. They're helping a lot of those coal miners pivot and work in a new and emerging technological industry. I just really enjoy the ethos and the whole idea of not only eventually gaining some profits, but helping people benefit where they work as well.

Flippen: To be frank, I'm still getting hung up on the same spot with this investment though, which is again a great business. Clearly, we all need to eat, but just because we need to eat and they sell us tomatoes doesn't necessarily mean that it's good to invest in the tomato grower and I think if you look at produce businesses to this point. If you look at necessarily businesses that supply what is supposed to be a really critical input into everyday life tend to be some of the worst performing investments because they get commoditized. I'm brought back to Village Farms, which is a really interesting Canadian produce grower turned joint venture cannabis company. They had decades of experience growing specifically the same type of tomatoes that AppHarvest is looking to grow that's on the vine, beefsteak tomatoes. In addition to things like peppers, and their management for decades every single time you get on the earnings call with them, it was, oh man, weather in Florida was a little bit wetter this year so our competitors were able to get to market a little bit before us or a little bit after us and that resulted in these tiny basis-point changes in their margins; which led to huge movement in terms of the businesses profitability for these little things that they had no control over and they had master growers on their team. In fact, a large number of the growers at AppHarvest actually were poached from Village Farms. 

The experience on the team is the same but Village Farms realized this was just a really hard industry with razor-thin margins, which is why they even tried to get into cannabis. It's a different story. But I'm brought back to this comment that management made on their May call. I'm going to read this quote out, I want to hear your take on it. The quote is "The pricing environment in the tomato market had a swung from one extreme to the other as elevated prices of last year due to high at-home demand have given way toward the lowest pricing methods with tomatoes, specifically the commodity tomatoes, like tomatoes on the vine or beefsteak varieties that we've seen over the past 10 years. As a result, although our volumes were up driving a nine year-over-year increase in produce sales, our gross adjusted EBITDA was down 50 year-over-year." That quote perfectly describes the produce market. Which is, you can have demand for tomatoes but the economics of selling produce is just so challenging. Maybe talk me through what the economics for, they're selling tomatoes right now that may expand in the future, but talk me through what the economics look like for the tomatoes currently and what you think it may look like in say five years?

Bruning: Like I said, they had, I think $2.3 million or so in sales on just under four million pounds of tomatoes in the first quarter, which equates to about $0.60 of sales per tomato, which seems pretty low when you consider the average sales price according to the Federal Reserve is about $1.80 for tomatoes right now and I'm sure Mastronardi is taking cut of that by taking over the distribution agreement. But it does expand beyond tomatoes. They have one facility under construction right now for strawberries. Looking at the specific brand, they are sold under the Sunset brands by Mastronardi on Kroger and Harris Teeter. I think those sell from 3-4, $50 a pound. There is somewhat of a premium for organic local produce there. But it is interesting. This is a question mark for AppHarvest, is the idea of once they have a sustainable brand, are they going to leverage that brand for pricing power? Because like I said, they are very local, they are sustainable in terms of how they grow. But there are public benefits [...] so they are supposed to benefit everyone, including their employees, their customers, and management has specifically said they don't plan on raising prices, at least substantially. They want to remain in line with other comparable products. But in terms of some of those unit economics, long-term, the company is forecasting 12-16 EBITDA margins on tomato specifically. They haven't grown anything else, so they haven't provided any forecasts on their berries, their leafy greens, their cucumbers that are all products that they expect to grow in the future. It's worth noting that 12-16% EBITDA margin for tomatoes was before they acquired the autonomous harvesting robot, Root AI company. I expect that it'll probably be in the top half of that 12-16% range, if not even a little higher, from some cost synergies that we'll let these robots harvest rather than having manual labor pick these tomatoes on a quarterly basis. It will require some oversight from these cultivators, but it will allow them, management has said, it's going to free up some of their time so they can focus on more complex tasks that these robots aren't quite ready for or so.

Flippen: I think that the Root AI ideal is by far the most interesting thing about AppHarvest. I even find myself scratching my head and wondering what the thesis was for AppHarvest before they made the purchase of Root AI. Because if management isn't planning on increasing the costs associated with buying their specific tomatoes, then the only way they're better than any other produce seller on an economic basis again, are all these moral bases as you can make many arguments. But on soliciting investor money, the only way they end up better is that they have lower costs. It's challenging when you're going up against these very ingrained producers that are producing at very low cost and regions of the world that have year-round growing seasons. Without the Root AI system, I was a little confused about; if you're not going to sell the higher price points and you're not going to lower costs, then you don't really get anywhere at this. I think the Root AI system has the opportunity to lower those costs. I wish they provided more information about that deal in particular. Because since this is a business that went public via SPAC, we don't have any audited 10-K to go off a year and a lot of the information that we're getting is just based on what the company itself is reporting or Root AI reported pre-acquisition. 

In fact, in our notes, I was under the impression that Root AI I was only for tomatoes. It was so hard to find any information, but you corrected me. You linked to a video where you can see the Root AI system picking strawberries and cucumbers as well. If that's something that can lower labor costs, that will be really interesting in my opinion. I will say, "I'm a little bit nervous. The labor costs associated with growing produce and the areas of the world where large producers are currently growing are very low." When I think about the technological expertise that needs to go into somebody who is managing and developing these systems, I do wonder if that ends up being deceptively costly. But you make an interesting argument that the Root AI system could potentially be licensed and this is where I get excited. I hear the word licensing and I think to myself, "Oh, that's something proprietary that they can then sell at a really high margin to other vertical growers." All of those competitors that I just mentioned are growing vertically, maybe specific things again, these baby greens. This is maybe an opportunity for them. But I don't believe they have any license in place. It just made these acquisitions. I'd be surprised if they did.

Bruning: Yeah and again, you mentioned it, no 10-K and I have to just plug in again, it's a super speculative investment not for the fun part, in terms of day-to-day price changes, which I advise all listeners to tune out. But yeah, no license agreement I am aware of. Management has mentioned that there is a potential new revenue stream that they can bring in and like you said, very high-margin. In terms of cost reductions, this was something management talked about. On a 60-acre tomato farm, they said they would have about $15 million of adjusted EBITDA. Again, I'll say adjusted there, which isn't what I would love to hear from management. I would prefer that just GAAP EBITDA margin there. But after the Root AI deal, they increased by about 50%. From $15 million on a 60-acre farm, they jump that up to about $23 million to recognize some of those cost savings and improved leverage within the harvesting business. The Root AI deal is honestly what really got me excited when I was doing my research, watching some of those videos, reading the call with management from Root AI, and they've brought the whole team, I think they had 15 members. T

heir AppHarvest CTO is the former CEO of Root AI and he is going to be completely focused on Root AI, and innovating in that space. It won't necessarily recognize immediate cost benefits because it is pretty early in their robot [...] life cycle. But you can go a lot of different places when you think of an autonomous rollout in the produce industry. I mean, I was just baffled a couple of weeks ago when I was in California. I was passing strawberry fields and there were 50, 60 workers in the fields manually picking the strawberries. I was just shocked there were no autonomous systems to do that. Then, of course, I read about Root AI and I got so excited. Root AI is really exciting in terms of cost synergies and additional revenue streams, and optionality in terms of where they could take this technology and expanded use cases for it moving forward.

Flippen: If you're at irritated by the adjusted EBITDA margins, then I don't know what to call myself when I saw the fact they were guiding for what they call free cash flow before growth spins, which is a fairly their free cash flow excluding all the money they would need for development of new facilities in the future, which is a lot of money to put it bluntly. This is a business that I think we both recognize it's growing. It's very small right now. They're going to need to raise capital. They're pretty well capitalized after raising money by going public. But at their current spend rate plus all of their planned developments, they will need to raise money in the future. But I think another area where I get hung up on again, is building away from tomatoes and into their leafy greens. Their own projections have by 2025, leafy greens still accounting for less than 10% of their total revenues. Even if those end up being higher-margin than their vine crops, their tomatoes, then it's still very marginal in terms of what it's actually doing for their bottom line and top line, since it's responsible for such a small portion of their revenue. They seem heavily focused on tomatoes right now. Given the fact that, as Village Farms says, we're in one of the worst pricing environments for tomatoes that we've seen the last two decades. I don't know, it's hard to get excited about whether or not there really is optionality here in terms of their product line.

Bruning: Again, this is a decades-long game. They're not going to have another facility operational until next year, I believe, which will be they have one strawberry farm operational in the second half of next year as well as one leafy green farm in the second half of next year. But like you said, it's going to take a lot of money to create these and construct these facilities. I actually have a whole section in my research document in terms of management's promises and what they expect years in advance to ensure that they are hopefully meeting those expectations. The most important one to me is, they've said they are going to acquire attractive, non-dilutive financing for all 12 of their facilities that they have for 2025. So far, they have done that for five of them. 

They recently had a $90 million financing with some private investors in terms of tapping those debt markets. In terms of expanding their construction facilities, they have essentially guaranteed which, again, if they have to dilute shareholders to construct these facilities, that changes the complexion of this company for me because that's management essentially not making or keeping up to their word. But when you think about operations, they haven't mentioned anything about that. You think they are probably going to be diluting shareholders, which is of course a risk and decreases your stake in a company with, I think, about a $50 million quarterly burn rate and I think they have $300 million in cash or so. It's not a matter if it's a question of when they're going to eventually tap the equity of debt markets for operations. That's something as a shareholder I'm willing to take. Again, this is like a need for those companies for me. I want to help them support growth and disrupt the agriculture industry for the better. But that is 100$a risk in terms of just diluting shareholders over the longer-term. But I'm at least encouraged that they've been able to acquire attractive financing for five or six facilities at this point like they've promised.

Flippen: Well, I'm definitely interested in AppHarvest. I think it's an interesting business. I've done some research into other businesses that are similar. I think AgriFi comes to mind. It's interesting. [laughs] I'm saying the word interesting a lot and that's where I find myself. It is a cool business that's doing something important. I'm still not convinced that they're ever going to be able to raise prices because of their certified B corp status, the public benefit corporation aspects that may prevent their pricing power from ever being expressed. For that reason, plus not having any data to show that they can actually produce at a lower cost, they have negative gross margins right now, for all those reasons, I think I find myself still wanting to sit on the sidelines, but I can respect this as a speculative investments playing on an industry that is increasingly important that needs to be disrupted. I appreciate the work that AppHarvest is doing to attempt to disrupt it. Also love the passion you have for the business and the research you've done for the space as well.

Bruning: If you want to see some passion, there are a couple of interviews with the CEO. There is one that comes to mind when, I think it's Andrew Sorkin on CNBC where he's with Martha Stewart and he is in one of these facilities. He is going crazy at the end [...] at the end of the interview, saying this is the future of agriculture. It's really entertaining. If you have some time, look up at the AppHarvest app, it's pretty there.

Flippen: Oh, my gosh. I don't know how this entire episode has gone without mentioning the fact that Martha Stewart sits on this company's board. That's correct, right? I'm not the biggest fan of Martha Stewart, either as a person or as an investor, especially. So I'm going to refrain from my opinion there other than to say, I would prefer I think quite literally anybody else to be sitting on the board of this company over Martha Stewart. I think she has thrown her name around the number of work positions in companies that she provides very little value to. If they can get value out of a Martha Stewart branded tomato, then more power to them. I don't know if I see it happening. Gosh, I just hate that involvement. I love the founders team, and I hate Martha Stewart's involvement.

Bruning: Fair enough.

Flippen: I won't go on my Martha Stewart rant, I think I've done it before this show, so I'll stop it there. But Clay, thank you so much for coming on, and providing your insights and your thoughts. I know this is a business you've done a ton of research on.

Bruning: Yeah, thank you for having me.

Flippen: Listeners, that does it for this episode of Industry Focus. If you have any questions or just want to reach out to say "Hi," don't be afraid to shoot us an email at [email protected] or tweet at us @MFIndustryFocus. As always, people on the program may own companies discussed on the show and The Motley Fool may have formal recommendations for or against any stocks mentioned, so don't buy or sell anything based solely on what you hear. Thanks to Tim Sparks for his work behind the screen today. For Clay Bruning, I'm Emily Flippen. Thanks for listening and Fool on.