Editors note: I wrote an article on the potential return of Baupost’s investment in Ontario, which can be found here. This article deals more with the risks regarding the investment:
By Kim Palacious
Hedge fund stock buying strategies are generally straightforward: buy equity in an undervalued company at the right time, hold it for a wise period, then sell it at a steep profit. Yet, the rumored stake taken by Seth Klarman’s Baupost Group in Canadian quarry outfit, The Highland Companies, flouts the rule, exposing Baupost investors to an uncommon degree of risk. Baupost-worthy profits hinge on the setback-free development of a “mega-quarry” north of Toronto—one so early-stage that more questions than answers hamper prediction of its success.
Consider the math: the more variables at play, the lower the probability they will all occur together (e.g., if A and B and C must all happen in order for an investment to be successful, and each only has a 50% chance of happening, the chance that all three will happen is only 12.5%). Now, consider the investment in question: in addition to the numerous project approval roadblocks that must be removed for the quarry effort to come to fruition, Baupost is also betting on overall industry potential, wagering on buyers aplenty when the quarry enters the market.
Bet #1: Highland Can Cut Through Regulatory Red Tape and Other Government Approvals
After five years of preparation, Highland did not submit its application (rumored to number 3,100 pages) until spring of 2011. In addition to the requisite bureaucracy that comes with any government approval, the project carries a significant roadblock: as the quarry would extend below the water table, some 600 million liters of water per day would need to be pumped into the mines in order to prevent the space from becoming a lake. It would also compromise well levels among local residents and impact the Nottawasaga and Grand River systems, causing collateral damage to the greater population.
Also of concern is a land use issue. The soils beneath which billions of tons of limestone deposits lie is among the most prized soil in the region. The land is not only highly arable, but the soil quality is so high as to make a case to keep its usage agricultural. In addition to core elements of the proposal, these water and land use issues must be discussed, and resolved, before the project can move forward.
Bet #2: The Effort Will Survive Local Resistance
If Highland didn’t want to get off on the wrong foot with the local community, it probably shouldn’t have spent three years buying up land under the auspices of continuing the local potato farming legacy. By 2009, the company came forward and admitted that suspicious digging had not, in fact, been for the irrigation wells that it had originally reported, announcing plans for the mega-quarry at that time.
In addition to heartburn over subversive land infiltration (which included the destruction of 30 farmhouses, some dating back to the 1800s), locals cite environmental and quality of life concerns, including increased truck traffic, the aforementioned water supply issue, and the likelihood that the quarry would ultimately benefit local (vs. foreign) interests. The company’s agreements to purchase a rail line and water management technology have done little to mollify locals and environmental groups, nor has the company’s promise that Quarry output will serve only the Ontario market.
Bet #3: The Market Has Been Sized Appropriately
In order to be considered a “mega-quarry,” a property must have mineral deposits of 150 million tons. The Highland mega-quarry far surpasses this with upwards of 1 billion tons in reserve. Highland is banking on the idea that the limestone deposits (a key component in concrete, among other building materials) will meet demand in a growing construction market. Yet, not everyone is bullish about the growth potential in this Canadian sector.
Whereas industry publications including the Journal of Commerce (a Canadian construction newspaper), and Price Waterhouse Coopers projected astronomical Ontario market growth, outlets including The Toronto Star cited slowdowns and said that growth would be difficult to predict. Independent bloggers were also skeptical about sensationalistic claims about Ontario’s growth potential, mentioning further nuances in the construction arena that call into question demand for limestone derivatives (e.g., commercial vs. residential, new construction vs. renovations, etc.).
The Upside if All Bets Pay Off
If all goes as planned, the mega-quarry could generate more than $18M in aggregate per acre (at current market rates). Multiply that by the planned 2,400 acres of aggregate extraction conducted in eight tranches of 300 acres, total revenues could fall around $43.2B. Though it’s difficult to predict revenues after costs, or to know what Baupost paid, it is rumored to own a 16% stake. With gross revenues in the double-digit billions, however, if all goes as planned, the returns could be impressive.
The Consequences If All Bets Are Off
Even if Bet #3 is correct, and Bets #1 and #2 are achievable, a significant variable still stands to impact Highland’s potential for success. That factor is timing. If Highland is not poised to get online and sell product during Toronto’s primary growth years, it will be stuck finding new customers for the lion’s share of its product, and even more hamstrung if it intends to make good on its “sell local” promise. Any delay in the ability to win Bets #1 and #2 will delay all profits and limit total potential upside. This will severely erode profits for the high-flying Baupost, and other investors.
Also of concern is competition—new and existing players will undoubtedly jockey for a share of the market; though the Highland reserve is substantial, limestone is among the most abundant minerals on earth. With an unsecured project, even if Highland comes online in time, price competition may drive profits down.
A final risk to profits is Highland’s current behavior: to throw money at every potential roadblock. Thus far, it has responded to arguments from its opponents by promising to reach into its own pockets to fund solutions. Too many operating decisions made in that spirit will certainly lower the bottom line.
Highland (and Baupost) will win only if deal-breaking approvals can be secured expediently, and if the Ontario market turns out to be as promising as optimistic speculators purport.