The Bengal Bite | Longform

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The following is not exactly a short report on Agrify (NASDAQ:AGFY) because we do not have any short position in it, nor any similar synthetic economic position through the use of options. Probably a more accurate description for this report would be "public service announcement."

In our opinion, companies like Agrify take air out of the room from others much more deserving of investment, and it is past time for the cannabis industry to begin to grow up and become more institutional-class in its transparency, disclosure, and governance.

Agrify: A "Short" Report on a Stock We Are Not Short

Canadian cannabis companies were notorious a few years ago for flowery projections of production and revenue that we thought landed just on the inside of securities laws (now they inflate expectations in other, more subtle, ways). We at Bengal thought that the cannabis industry maybe had progressed past that capital markets toddler stage - the one where a company seems to just throw out eye-popping future revenue and profitability numbers. But recently we were reminded that there is truly nothing new under the sun when it comes to treating a company’s stock as its main product to be sold.

Witness Agrify, a NASDAQ-traded cannabis ancillary company that holds the current crown for what can only be described as unabashed tall tales of operational prowess packaged in a way that one wants to believe the hype. Agrify has recently purchased a few businesses (discussed more below), but its crown jewel is its “VFUs” - vertical farming units which are self-contained cannabis growing pods that can be stacked on top of one another. More canopy, and more efficient canopy, in the same floor space is Agrify’s main selling point for its VFUs. Oh, and of course, more quality as well, which ties to how much better they must be at science and economics than the rest of the industry.

Agrify’s first line of business seemed to be outright selling of its VFUs to customers, but recently there’s been a marked shift in Agrify’s strategy to what they call a “Total Turn-Key Solution” (“TTK”). TTK shifts the business model of Agrify significantly: instead of selling VFUs, Agrify now will finance up to 100% of the cost of installing the VFUs and the TTK client will pay Agrify fees. A skeptic might note that when you can’t convince customers to buy your product, one option is to fully finance their purchase; this is something that seems to really resonate in an industry in which the federal regulatory environment continues to keep a lid on capital raising for small companies.

And these are not insignificant fees - Agrify lists $600/lb as its production “success fee” in its materials, and then layers on an additional $200-300 per month per VFU for access to its “Agrify Insights” monitoring software. For an intuitive gut check, we believe strong cultivation operators in mature markets produce quality flower for approximately $600-800/lb all in, and this is by necessity, as they won’t be profitable with costs too much higher than that.

The TTK strategy is the linchpin of Agrify’s investor marketing - it’s what turns a company that sells boring cannabis growing containers with lights into a recurring revenue and even Software as a Service machine (great buzzwords for investors). Agrify discloses plenty of information regarding what it expects from its TTK and VFU arrangements, and it does not take long for problems and absurdities to become apparent. For one, Agrify’s assumptions on what prices its TTK clients will receive per pound of product seem wildly optimistic considering the best proxy for a “national” cannabis price is already lower than their 10 year forward average pricing assumption.

The US National Average Spot Price Is AlreadyLower than Agrify’s Average Projected TTK Customer Revenue Per Pound Over Ten Years

Agrify provides a representative example of its expectations for its TTK partnerships in its investor presentation materials:

(Source: Agrify Q4 2021 Earnings Presentation)

Charitably, we assume that all of Agrify’s projected 20,720 lbs of production is grade A flower. A bit of simple math reveals Agrify’s cannabis pricing assumptions:

So, the price Agrify assumes its TTK customer will get on average over 10 years is already higher than Cannabis Benchmark’s best estimate national “average” price. Many mature and rapidly maturing cannabis markets like Washington, Oregon, and even Michigan, already have average wholesale prices for indoor cannabis lower than $1,700. Previously insulated states are also starting to see significantly more price competition - Florida and Pennsylvania have seen significant average price declines. When pricing pressure comes to markets, history has shown it is not gradual, but instead sudden and drastic - Michigan’s wholesale prices went down 23% in the last year (Source: Leaflink Wholesale Pricing Guide 2022), and Washington had >40% falls in wholesale pricing in one year as its market matured. To project a 10 year average price above the best guess national price today seems absurd to us. To the extent that Agrify believes that national cannabis legalization will lead to an extended period of higher wholesale pricing, they would be the only ones in the US cannabis industry to do so (our instincts are that eventual interstate commerce is deflationary).

But, not to miss a chance to lean into the absurdity, Agrify uses its inflated pricing assumptions from TTK engagements to then create a $313mm “pipeline” of revenue - the majority of its pipeline in the next three years:

(Source: Agrify Q4 2021 Earnings Presentation)

We interpreted Agrify’s illustration as indicating that the $184mm Agrify earns in fees is paid out of the $355mm its TTK customer earns in revenue, but potentially what Agrify is saying here is that the numbers should be combined. That is, that the customer will sell $539mm ($355mm plus $184mm) of cannabis, and then pay $184mm in fees to Agrify, in which case the average selling price per pound over 10 years for the TTK client would be $2,600 - an even more ridiculous number than the $1,700 we infer above.

Why do we think Agrify would make these absurd projections? Because they are convenient and necessary to support a technology solution that was far from market ready, let alone validated, yet checks all the boxes of what an uninformed cannabis investor would want to see (having sat through this leadership teams’ presentation, we can do nothing but tip our hats as to how good they are at the narrative; we really wanted to believe). As explained in the section below, under even a minimally realistic view of pricing pressure a TTK client is uncompetitive and Agrify’s TTK revenue and fee projections break down.

Agrify’s TTK Fees More than Double a TTK Client’s Costs

Simple math based on Agrify’s slide above allows us to see what Agrify is projecting to collect in fees per every pound produced by its TTK client over 10 years:

To put into perspective how absurd this level of fees is: the most mature cannabis markets in the US, which we believe are indicative of what many individual state markets and any potential future national market will look like in much less time than 10 years, have had (at their bottoms) indoor cannabis wholesale prices that were lower than the $888 in fees Agrify plans to charge per pound.

Agrify claims that its VFUs lead to lower operating costs per pound than “traditional competitors,” but combining their productivity and efficiency numbers at face value (which we, as described in another section below, do not do and suggest to others that they please do the same) and combining with some reasonable estimates based on our industry experience continues to lead to absurd results:

(Source: All figures based on Agrify’s Q4 2021 investor presentation, Agrify’s January 2021 S-1, and FY 2021 10K except estimated additional operating expenses which are Bengal estimates.)

A TTK customer’s cost of goods sold (“COGS,” $1,215/lb) is nearly 3x that of a “traditional” competitor, and already above the average price of multiple mature cannabis markets before we add in non-COGs expenses. When adding those in, and being extremely charitable to Agrify by giving it an advantage in these costs over a traditional competitor as well, Agrify’s TTK client is significantly disadvantaged against its competitors, and would already be unprofitable in many cannabis markets we see today. Again, we are being charitable to Agrify here - as we stated before, the solid “traditional” operators we have come across in indoor cannabis production are able to manufacture at an “EBITDA” cost of ~$600-800/lb.

Because a TTK client presumably needs to make at least some reasonable profit in order to have an incentive to keep working, the true minimum selling price of a TTK client is roughly $1700/lb - conveniently, the exact price that Agrify projects..

When Prices Fall, Agrify Will Inevitably Have To Cut Fees

A TTK client must pay its workers, its salespeople, its electricity, its water, etc., because those are real costs, and with costs already as low as we estimate above, it will not have much room to lower them as prices come down. Agrify, however, projects that it will earn 80-100% gross margins (source: Agrify CEO Raymond Chang on Agrify’s Q4 2021 earnings call) on its TTK fees, and so those fees will be the natural starting point to trim back as prices fall and TTK clients become increasingly uncompetitive and Agrify needs them to remain in business to earn any fees at all.

There are other cannabis lenders which are publicly traded on NASDAQ, but we find them to be generally honest about what they are and how they work. More troubling in Agrify’s case is the high level of related party relationships - it seems that Agrify shareholders are financing Agrify insiders. Agrify’s largest reported TTK client, with over $11mm extended by Agrify so far, is related party Greenstone Holdings in Colorado (again, not a market known for consistently high prices) - about 50% of the total capital Agrify has extended in loans as of its last reported financials ($22mm). Revenue from related parties was 49% in 2020 and 53% in 2021. We see flashing red lights when capital providers have to create their clients and in this case, Agrify is both a capital provider and infrastructure provider financing its own equipment.

The picture of Agrify coming into focus is that of a company giving its insiders shareholder money for them to effectively buy lottery tickets, with the insiders keeping the winnings and Agrify maybe getting paid back for the cost of the tickets. CEO Raymond Chang offloaded over 60,000 shares at prices above $30/share for over $2mm in proceeds in the summer of 2021 while the stock was at its height - it trades at under $4 today. Looking at the history of Agrify, it does not appear to be a company in which the CEO has toiled away for years, building and grinding as an entrepreneur for under-market compensation.

A short report by Bonitas Research recently delved into the various related party relationships inside Agrify (https://www.bonitasresearch.com/company/short-agrify-corp-nasdaq-agfy/). It makes for interesting reading, but Agrify’s more fundamental problems are in plain sight: Agrify’s numbers do not pass very simple smell tests.

Agrify’s Technology Is Unimpressive Compared to Traditional Indoor Growing Methods  

(Source: Agrify S-1, pg. 5, filed January 26, 2021.)

As an initial note, Agrify’s revenue and EBITDA estimates in its S-1 for all of the facilities are facially ridiculous at $3000/lb and >=80% EBITDA margins. Trulieve at the height of its profitability powers was only generating 80% gross margins.

Going a different way when it comes to production yields and cost metrics, Agrify does not seem so much to give rosey projections about its own VFUs so much as give unrealistically negative assumptions about the performance of “conventional” methods to make its VFUs’ performance seem better than it is.

Agrify has provided various breakdowns of how its technology compares to “conventional” setups, such as the image above from Agrify’s S-1 filing in January 2021. Agrify continues to refer to this same hypothetical in its most currently filed financial statements as well, so we use this to back into Agrify’s productivity and cost metrics as they compare to other facilities that we on the Bengal team are familiar with.

Grams per square foot is a widely used production efficiency metric in the cannabis industry. Agrify makes the claim that not only can you get more growing room in a facility by stacking VFUs, but that its VFUs are more productive than traditional growing methods using overhead lights, benches, etc. All product comparisons are ultimately meant to make the product someone is trying to sell look good, but the numbers Agrify provides, again, do not pass simple smell tests for anyone familiar with decent conventional indoor cultivation facilities.

Below is a comparison of the Agrify hypothetical above (which they continue to repeat in their most recent financials), with two real world facilities which we at Bengal are familiar with. Both of these facilities are largely high pressure sodium (“HPS”) lighting, or what Agrify would ballpark as a 191 g/sqft facility (note: we assume that the production metrics provided by Agrify refer to flower only, so we have normalized the numbers by adding 30% trim weight for a total grams per square foot number).

The first real world facility had raw performance and performance per dollar of cost close to Agrify’s projected performance seven years ago (roughly 19% higher costs per gram of yearly production with yields within 10% of Agrify’s stated yields), and the second facility, built over half a decade ago, is significantly better than Agrify’s (presumably best-case) projections (36% cheaper on a cost per gram of yearly production basis, and marginally more productive in absolute terms as well).

The real world facilities we are comparing to here are likely better than average, but we believe that advances in knowledge sharing and technology mean that the baseline conventional facility built today is significantly more productive than Agrify’s estimates for “conventional” facilities, and likely much cheaper on a cost-to-yield basis than an Agrify facility. Facilities like these will be TTK client’s competitors, which does not bode well for TTK clients given their inflated breakeven prices.

Ironically, decent operators will not be attracted to the middling performance of Agrify’s VFUs, but it is exactly these decent operators that Agrify needs to attract. Instead, Agrify’s TTK program has set up a series of incentives that lead to the natural flow of potential TTK clients being poor operators, opportunists to whom Agrify funnels shareholder money in the hopes of it coming back as fees, and (of course) to insiders.

Our Informal Industry Checks Were Unanimous: Agrify’s VFUs Do Not Work As Advertised

Sometimes informal checks with friends and contacts in an industry reveal a business that is better than its financials suggest, but not so in Agrify’s case.

Up to now, we have largely taken Agrify’s numbers regarding its technology at face value, but at this point in our story, we will no longer do so. We have informally asked those who have had experience with Agrify’s technology about its performance and potential. The result, on background, has been unanimous: Agrify’s VFUs are not as efficient or cost effective as traditional indoor cannabis growing - they just don’t work very well.  These informal checks also produced another troubling allegation: Agrify had vastly overstated the installed base and performance of its VFUs in its S-1 IPO filing and investor roadshow.

To balance out the significant problems we note above, we would have needed to hear at least some praise for Agrify in our private conversations, but we heard none.

Agrify’s TTK Shift Was Likely Made Because No One Wanted to Buy VFUs - And Now It’s Buying Other Businesses To Hide Future TTK Disappointments

So, to recap: Agrify predicts unrealistically high revenues for its TTK clients over 10 years and ignores that its fees will be drastically reduced as TTK clients struggle to be cost competitive while its own data on the productivity of its VFUs shows that the VFUs do not offer any advantage over our informed perspective on “conventional” indoor cannabis growing methods either in cost or productivity.

When Agrify sold a VFU, it generally sold a VFU and collected money for it (for however few they actually sold anyway), but now Agrify’s TTK program, which is billed as a farsighted strategic shift by management, changes the equation drastically: Agrify is now actually much more at risk if its own VFUs don’t work as advertised (which they likely don’t) because they have financed all or much of the initial investment in equipment, construction, etc.

A cynic may be tempted to conclude that Agrify’s TTK shift was not the genius corporate move it’s portrayed as but instead a necessary shift to deal with the fact that no one wanted to buy VFUs, and we at Bengal have been known to be a cynical bunch, particularly when confronted with charismatic and believable promoters.

Likely to hedge against what they know will be future underperformance, Agrify is on an acquisition spree, and seems to be buying legitimate companies that have long supplied the cannabis industry with equipment, like extraction technology, for years. The point here seems to be to buy enough businesses that you can pivot the story enough times so that investors hopefully forget the first story they were told. Agrify is starting to recast these businesses as an extension of its TTK offering (CEO Raymond Chang, Agrify Q4 Earnings Call, “We are very, very close to signing our first extraction TTK deals”). This is, again, an attempt to put a stylish spin on a very sedate business: selling cannabis companies durable extraction equipment which will last for years at ~30% gross margins with minimal recurring revenue.

Investors should not be fooled; the core of Agrify’s entire company is on its untenable TTK program, and these otherwise decent companies are now part of an uninvestable package, in our opinion.

Boston Chicken Redux

Some of you may remember with fondness the Boston Market chain that proliferated in the 1990s. What may not be as memorable to some of you, but was memorable to one member of the Bengal team who was around to see it, was the Boston Market capital markets debacle that occurred at the same time - and the entire episode reminded him a lot of Agrify.

Boston Market (then called “Boston Chicken”) IPOed at $10 per share in 1993, rising a then unheard of 140% on its first day of trading. The stock stayed high as more Boston Markets opened and retail investors were largely responsible for driving the stock to $40 per share by 1996. Management used the hubbub around the stock to continue to go back to the markets to raise increasing amounts of cash - more than $1.5B raised by selling stock from 1993 to 1996 (about $3B in today’s dollars adjusted for inflation). But, Boston Market’s SEC disclosures were not a model of clarity, and few investors truly took the time to get behind the byzantine accounting Boston Market was employing to hide one very simple fact: its restaurants were losing money (one reason why seasoned hospitality investors frequently refer back to the economics of one location – unit economics).

How was this difficult to see? Boston Market would raise money, then loan that money to area developers (only up to 80%, not the 100% Agrify does for TTK clients), which would then go and build/operate Boston Market restaurants, and pay back Boston Market the loans, royalty fees, etc. Also, Boston Market’s loans to its area developers contained conversion provisions so that even if the loan were in default, Boston Market could just convert it into equity and not report to shareholders that there had been any kind of loss. The end result was that the Boston Market public company showed royalty fees and debt payments impressively coming into the company, while not showing the mounting operational losses of the underlying franchisees it relied on to actually pay the loans and royalties back - a ticking timebomb which eventually exploded and hurt a large number of individual investors who had held the stock.

When taking a small step back, the similarities between Agrify and Boston Market are staggering: the inherent comfort with overly-aggressive projections, the loans-to-franchisees type operation of TTK, and that TTK clients’ financial performance is hidden from Agrify investors. Ultimately, it’s the unit economics that matter in both cases.

Without diving into byzantine accounting rules, Agrify notes in its financials that its related party and largest TTK client Greenstone’s financial results would normally be required to be consolidated with Agrify’s because Agrify exercises sufficient control and benefit/loss from the underlying operations of Greenstone. Agrify, however, does not consolidate because of an exception to such instances where Agrify is not the “primary beneficiary” of the underlying entity. Given the structure of the TTK relationship as described by Agrify, this seems strange to us, but we leave it to those more schooled in accounting to pass judgment. The fact remains that the performance of Greenstone, like the performance of all those Boston Market area developers, remains hidden to investors.

Why are We Writing This?

It’s a fair question: why are we writing what amounts to a short report on a stock we are not short? Cannabis capital markets have been dislocated from the beginning because of federal law, which forced US operators to flee to Canada for financing. The Canadian finance world feasted on fees generated by questionable projects sold either to retail investors who were looking for the next hot thing or hedge funds that were looking to make money off of retail investors with barely a care as to the underlying business they were investing in. This environment had consequences, and led to capital being directed towards companies that squandered it.

This is commonly referred to as greater fools investing. While many folks get rich if they get the timing right, particularly if the narrative or storyteller is compelling, our strong bias is to business fundamentals. And we’re cannabis investors, so we don’t ignore blue sky, we’re perfectly happy looking out into the distant future to see fundamentally driven cash flow (and we’ll pay a high multiple for growing, sustainable cash flow).

It’s time for cannabis markets to grow up, and investors to start realizing some of these companies for what they are. Every dollar directed towards Agrify is a dollar not directed towards another company - a company that could take that dollar and convert it into jobs and happy customers, not loans directed towards company insiders. There are solid companies in the sector that are unloved and building businesses, not just trying to get rich quick on the greater fool’s speculative wager.

So, in that vein, we suggest investors take their dollars elsewhere, preferably within cannabis.


Disclaimer: This material is provided for information purposes only and is not a recommendation or investment advice. As of the initial publishing date of this post (4/20/22), we currently have no short position, or its economic equivilant, in Agrify, but we have no obligation to update such information should we enter into such a position in the future. Our views above are based on our analysis of Agrify's public filings and earnings calls, combined with confidential informal conversations with other industry members, our knowledge and experience given our years of working in the US cannabis industry, third party sources (such as Leaflink) and other available information which we believe to be reliable - we may be wrong or have misinterpreted something.

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