By Carleton Hanson

July 28, 2021

Summary

• AppHarvest is a vertical farming company that is ramping up its operations.

• AppHarvest's management has rosy projections for profitability and growth, but the market is skeptical about the company's future.

• If management's estimates are accurate, AppHarvest looks appealing on a future cash flow basis.

• AppHarvest has meaningful downside risk.

• I am considering starting a small, "coffee can" position in the company.

I look for companies that generate consistent free cash flow and that can reinvest cash at a high rate of return. AppHarvest (APPH) does not fit the bill in its current state. The company only started to generate revenue in 2021 and is years away from generating free cash flow. APPH's management projects appealing unit economics and a long runway for future growth. If management's projections are accurate, in five years APPH will be generating over $100mm in annual free cash flow and be able to reinvest 100% of that cash at a rate of return over 15%. APPH's business model is unproven but I would be excited to own shares in a company with their projected return profile.

What is AppHarvest?

APPH is an indoor farming company based in Appalachia. The company grows tomatoes in a 60-acre indoor farm located in Morehead, KY. By growing their produce indoors, APPH is able to avoid using pesticides, recycle water, and optimize the controlled environment for higher crop yields. APPH can grow 365 days a year and crops are protected from adverse weather events. The company reports that it can produce yields as high 30x those of conventional outdoor farms while using 90% less water and a fraction of the soil and fertilizer. APPH sells exclusively to Mastronardi Produce Limited, another indoor farming company that has an extensive distribution network across the United States.

APPH is a new company, and only began harvesting from their Morehead facility this year; there isn't much data yet on their operational metrics. As of Q1, the company had about $300mm in cash on their balance sheet, but APPH is investing heavily into building additional farms. There are two farms currently under construction in KY and six additional sites have been identified as future farm locations. APPH's goal is to have 12 farms completed or under construction by the end of 2025. A standard 60-acre facility costs about $120mm to build and APPH estimates that a fully functional farm can bring in annual revenues above $40mm with gross margins as high as 40% and EBITDA margins around 35%.

(Source: Analyst Presentation)

Management raised facility EBIDTA estimates to over $23mm on the Q1 conference call, with the excess coming from increases revenue and lower input costs. Some of this upward revision is also due to the acquisition of robotics company Root AI, which management expects to improve farm efficiency and automation in the future.

Putting together the farm unit economics and the target number of farms, five-year projections look like this:(Source: Analyst Presentation)

APPH has a market cap of $1.2 billion. If the projections above are accurate, APPH will be generating more than $100mm in free cash flow by 2026 and have a proven, profitable model that they can leverage to build more farms with an expected cash return above 15%. $1.2 billion is a cheap enough price to pay for a company with that return profile.

Let's Take Management's Projections at Face Value; How Much Should We Pay For APPH?

The big question is: Are management's estimates accurate? I will talk more about this risk later in the article, but for now let's say that the future plays out exactly as management projects. In this scenario, what would be a fair price to pay for APPH shares today? Using company estimates, we can put together a rough 5-year DCF. I am going to use a 15% discount rate in my equation. This might be controversial, but there are a number of other companies that I own that I expect to return at least 15% a year. If I am going to tie up capital in APPH while I wait for management to execute their plan, I am going to treat the opportunity cost as 15% a year. The results look like this:



The netted cash amount is inconsequential for just five years. In the scenario where management's estimates have been accurate, the company would be in a great position at the end of 2026. They have a proven business model, are generating ample free cash flow, and could continue to expand their operations by building more farms. I think a multiple of 25-30x FCF is reasonable in this scenario, resulting in a market cap of between $1.4-$1.6 billion and a share price between $14-$16. Due to a fairly steady decline in APPH's share price over the last month, a $14 price target is a 16% premium to the current price and $16 would be a 33% premium. For this scenario, I'll split the difference, slap a $15 price target on the stock, and estimate the company is undervalued by 25%.

The Market is Skeptical

Using management's estimates and my DCF assumptions, my "base case" price target for APPH is around $15/share. Despite some initial excitement about the company when it came public via a SPAC, the market is skeptical about this base case:(Source: Seeking Alpha)

APPH is trading more than 70% below its 52-week high and has significant short interest; why might the market be pessimistic about APPH's future? I think the market has two main concerns. First, APPH is only just beginning their operations; the unit economics and long-term growth plans presented by management are just projections at this point. Perhaps the farms will have higher maintenance costs than expected or produce a lower yield over a prolonged period. Interest rate changes could make future expansion projects more expensive. APPH might incur greater than expected SG&A costs. With no operating history, investors are forced to rely on management estimates or make their own projections with limited information. In this case, uncertainty about the future works against APPH's share price in the short term.

Secondly, despite their advanced indoor farm technology and investments in artificial intelligence software, at the end of the day APPH sells commodity products (tomatoes and eventually other produce). It is hard to find a convincing competitive advantage that is unique to APPH that will help them stand out in the market place. There are dozens of other indoor farming companies in various stages of development and production, so APPH's technology isn't unique. Companies like Plenty, AeroFarms, and Local Bounti come to mind, but there are many others as well. APPH's location (Kentucky), cited by the company as a large competitive advantage, will be diminished by the growth in indoor farming. Kentucky might be closer to New York than Mexico or California, but if other companies have the ability to start up small urban farms (like Plenty), then in not too many years I could see more farms popping up closer to major urban areas and reducing APPH's location advantage. SA author Jamie Louko recently did a deeper dive on APPH vs the competition in this article, and I think he brings up good points, especially around APPH's scale and progress in building their farms and securing funding for future work. I'm not sure the market is convinced these advantages will be enough, especially in today's market where traditional farming remains the primary competition.

Investment Thesis (and Risks)

Is the market right to be skeptical about APPH's future, or is the market being short-sighted and creating a favorable investment opportunity? I think the answer to both questions is yes. On the one hand, it is reasonable to remain cautious about APPH's unit economics until the company has been operating multiple farms for multiple years. Without a strong unit economic base, I see limited downside protection for investors. APPH still has a sizable cash position on their balance sheet and owns their one operating farm, but much of the cash is already allocated to completing their two in-progress farms, and their existing farm won't be of much value if the unit economics end up being a lot worse than anticipated. APPH needs to complete more than three farms to overcome their overhead costs, so their long-term success is going to be dependent on a successful progression of new farm construction. New farm construction will be impacted by the future availability of credit and/or the company's share price (if they decide to an equity raise). Finally, APPH would be negatively impacted by short-term drops in vegetable commodity pricing. Tomato pricing has been relatively stable over the last 15-20 years, but swings of 15-25% or more have happened regularly and will likely continue to happen. An APPH investment has real risks that the market is keenly aware of.

On the other hand, I see a lot to like about the company if management is able to execute on their plans. In this scenario, APPH is only a few years away from consistent cash flow generation and will have a long runway for reinvestment at high rates of return. It is rare to find a company today that can reinvest 100% of their free cash flow to grow their business; often companies resort to paying a dividend or buying back shares with excess cash. These outcomes are "fine" for investors, but aren't going to generate the same 15-20% ROI that APPH would be able to get from additional farm construction. The most optimistic outlook makes me think of investing in Walmart or McDonalds in their early stages, when they were building new stores or opening new franchises at a brisk pace and reaping solid returns on those investments.

I can also envision scenarios where APPH makes an unexpected leap forward and expands into an adjacent industry. Company president David Lee made a comment on the Q1 conference call that suggested he sees the potential of their in-house AI and robotic solutions to be licensed to other companies. This would provide another source of high-margin revenue. He even went as far as to say that APPH's solution could be what "AWS is to Amazon" (source). APPH's investment in Root AI shows their commitment to solving technological problems presented by indoor farming and to continuing to optimize their day-to-day operations. If APPH expands into a true tech-focused company that is able to build a platform of tools that other future companies will want to use, that would be a huge and unexpected win for the company. I would take this projection with a huge grain of salt and say it is unlikely to materialize, but I think APPH's technology has value and at least has the potential to be monetized in the future.

Conclusion

An APPH investment is a departure from my usual style; I tend to focus more heavily on protecting against the downside than shooting for home-run returns with a favorable risk/reward ratio. That being said, I see APPH as an intriguing opportunity. APPH's potential to invest 100% of ample free cash flow at high rates of return is the most appealing part of this equation, and after the slow fall of the company's share price I think today's market cap looks fairly reasonable. Even with a 15% discount rate APPH is trading slightly below "fair value", assuming management estimates are close to reality. If I were to invest in APPH, I would make it a small portfolio position and plan on holding it "forever" to let the long-term investment thesis play out.