Reading The Tea Leaves

They usually appear around this time of the year for companies that have their financial year ending in December. They are thick and heavy and when you read them, you fall asleep. If you have a portfolio of stocks, you would likely receive a stack of them. Few would read them, most would throw them away. But before you dump your Annual Reports into the bin, read this blog article first. Annual Reports contains a wealth of information about the company you are vested in.

We will take a look at Fragrance Group Limited to understand how to read the tea leaves from its 2011 Annual Report. Fragrance Group owns hotels and sells private properties in Singapore.


Chairman’s Message (Page 2-3)

This is the part of the Annual Report where the Chairman or CEO round up the year. Usually the good stuff is amplified and the bad stuff is chucked away. The message is not too long and if you read enough of them, you can read between the lines quite easily.

Fragrance did well in Year 2011, its profit rose as tourist packed its hotels and properties were snapped up like hotcakes. The message didn’t tell you much about the impact of the government’s measure to bring down property prices nor did it tell you that rising jet fuel prices would raise air fares impacting tourism.

Shareholders have reasons to be pleased. If you were to own 1,000 shares of Fragrance, you would now own 2,000 shares due to the 1-for-1 bonus issue during the year. You will get 0.5 cents in dividend in April this year in addition to the 0.6 cents (3Q11) and 0.5 cents (1Q11) declared earlier in the year.

The biggest news in the message is Fragrance is going to spin off its hotel business. The outcome would depend on whether Fragrance can get a good price at the right time. The question to ask is why would a company sell off part of a profitable business?

Operations and Financial Review (Page 10-16)

This is the meat of the Annual Report. It tells you what’s going on in detail.

The hotel business is doing well but with new hotels coming online both by Fragrance and its competitors, supply has increased while demand for rooms could be affected by a slowing global economy and higher oil prices. This could bring down room rates and affect the bottom line.

Property development is a risky game. Fragrance is playing the game well, for now. Fragrance have to bid for land at high prices, paying it with debt and hope to sell the property off at a higher price even before a single pile is driven to the ground. Land prices have become so high Fragrance has to partner its competitors to jointly bid for land. Parc Rosewood  is a good example. The story may change once interest rates starts to climb and property prices starts to fall.

Corporate Governance Report (Remuneration) (Page 21)

If you have problem falling asleep, try reading the Corporate Governance report. We‘ve all heard of Enron and Lehman Brothers. Even with a Board of Directors and external auditors, things can and have gone wrong. Corporate Governance is like having highly-paid security guards to safeguard your investment. The problem is no matter how much money you pay these security guards, they cannot guarantee that nothing will go wrong.

The only interesting part of the report is how much the security guards are paid. The Chairman who happens to be also the CEO is paid around S$6.5 million in FY2011. Fragrance made S$113.7 million in FY2011. His remuneration was 5.7% of the company’s profit. It is interesting to note that in Year 2010, the CEO and Managing Director of Wheelock Properties, a company also in the hotel and property industry of similar size, was paid about S$4.5 million, which was 1.4% of FY2010 profit of S$316.2 million.

Personal interest against shareholders’ interest is probably why Corporate Governance is so difficult to achieve despite layers of internal and external controls.

Notes to the Financial Statements (Investment Property) (Page 68-70)

Most of us who are not finance trained would not understand the notes to the financial statements. Laziness turns investors into speculators. While company profit fluctuates in the short term, the value of land or the property which it sits on appreciates gradually in the long run. The reason being, God don’t make land anymore.

Fragrance’s chain of hotels sits mainly on freehold land. This means it doesn’t have to depreciate it, lowering the cost of operating the hotels and the value of the freehold land rises over time.

A good time to look at companies that hold freehold land is during a financial crisis when all stocks good or bad get sold down. This is a time when you can own freehold land at a fraction of its price.

Shareholding Statistics (Page 83-84)

He who has the gold makes the rule. The CEO and his wife own 84.18% of Fragrance. This means that they have majority voting rights. When you buy into a company where the largest substantial shareholder is also the security guard, odds are the security guard is unlikely to doze off because he owns most of the company.

He also decides whether to sell the company when the price is right. At least for now, Fragrance’s hotel business is in the process of being spun-off in a IPO.

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