Summary Just Energy is an energy reseller. The business model has many questionable elements. Several factors could cause the earnings to decline in FY2016. Just Energy (NYSE: JE ) is a Canadian retailer of energy across select regions in North America and the UK. The company has a long rap sheet of customer complaints, fraud charges, and consumer watchdog warnings. Investors have bid the stock up in recent weeks on a swing to profitability in the first quarter. That profit is based on a one-time item. Beneath the surface, Just Energy is a company with lengthy legal concerns, a declining customer base, and an inherently flawed business model. Flawed Business Model One of my favorite financial quotes is from famed investor Jim Chanos. “A business model that relies on deceiving customers is an inherently flawed model.” No sentence more accurately describes Just Energy. The services offer no value to consumers. In fact, one study found that the average JE customer pays more for their utility service than those who pay for their utilities through a traditional utility provider. If your business model is built on saving customers money by switching them to your service, shouldn’t your service actually be less expensive? It appears that in 98% of cases , it is not. According to a lawsuit in Illinois, “there is no reasonable person who could market this product by suggesting that a customer would ‘save’ money.” The lawsuit also noted that “almost all of [Just Energy’s] plans have cost customers far in excess of what [utilities charge].” This could partially explain the aggressive sales practices. If your services cannot deliver as promised, why not just bend the truth? The company’s profits rely on selling long-term contracts to customers at rates higher than can be achieved in the marketplace. Essentially, the company locks customers into 5-year contracts and hopes that energy rates decline. The only way it makes a profit is by overcharging customers. Again, a business model marketed as a less expensive alternative to utilities that can only make a profit when it is, in fact, more expensive, is deceptive and fundamentally flawed. Legal Concerns There is a litany of formal complaints filed against the company, so many in fact that it has had to change its name and buy new brands in an apparent attempt to hide the past misdeeds. Among the most notable concerns are lawsuits brought by the Attorneys General of Illinois, Massachusetts, Ohio and New York. Complaints filed by the Canadian Energy Board and consumer watchdog groups have also caused reason for concern given the repeated allegations of misconduct. The company has an almost unheard of F rating by the Better Business Bureau . The BBB cited “a large volume and pattern of complaints concerning misleading sales practices.” (click to enlarge) Source: Internet review websites Just Energy could arguably have received more complaints per customer than any other publicly listed company in North America. The Illinois Attorneys General lawsuit found that the company received about 30,000 complaints annually in the state of Illinois alone. So what caused so many formal complaints against the firm? As most lawsuits describe, the company’s sales team goes door-to-door soliciting homeowners to purchase energy contracts. It also utilizes telemarketers in its sales process. The fraud complaints stem from thousands of sales reps purposely lying about rates, and in some cases, signing up customers without their permission. Source: News articles The unbelievably poor compliance at JE is a cause for future concern, as the practices are systemic of the organization and do not seem to have been curtailed. In fact, they are getting worse. In July 2015, Just Energy partnered with an alleged pyramid scheme to distribute its products. Lyoness is a MLM firm with a long history of pyramid scheme accusations. Think Herbalife (NYSE: HLF ), but worse. If the company’s former sales team was so inadequately trained that hundreds had to be laid off after defrauding clients, why would the distributors for a company under numerous fraud investigations be any better? According to an Australian regulator, Lyoness’ distributors “lie about every aspect of the business they are promoting.” These people will now be the face of Just Energy. Cue the forthcoming onslaught of Attorneys General investigations that are likely to emerge. Declining Customer Base While the company has largely weathered the past concerns, that luck seems to be eroding. As customers are coming out of their five-year contracts, they do not seem to be re-enrolling. Additionally, the company is failing to find new customers. Perhaps the years of negative reviews, multiple fraud investigations, and bad press coverage have dissuaded customers from trying out the company’s service. Or perhaps they can just do math and do not want to pay more for a service they already receive. For the first time in years, the company had a net loss of customers in the most recent quarter. Additionally, the number of new customers was the lowest since 2012. In red below, we can see that new customers are down 31% from Q1 2015 and down 15% from Q1 2014. The company is not growing the customer base enough to offset those leaving the business. (click to enlarge) Source: Investor presentation (with Q1 info added by author) How This Will Impact Earnings With a clear downward trend developing, investors should prepare for a future decline in sales. The average Just Energy contract is 3.5 years. The decline in new customers is not directly felt on the income statement just yet. As customers leave (about 1.15 million per year), the inability to replace those customers will cause revenues to decline. For the first time in years, JE is losing more customers than it is gaining. Customers leaving today locked into a temporarily low point in natural gas prices, thus new customers that replace the customers being lost are “higher margin.” While management has spun this as a positive, in reality it is a massive headwind. As noted, the average customer contract is 3.5 years. In early 2012 (exactly 3 ½ years ago), natural gas prices bottomed at nearly $2. So yes, the customers leaving are being replaced by new customers with higher margins, but it is short lived. In the coming quarters, as more customers leave, the new customers will be lower margin than those customers lost. Source: NASDAQ The next two years are going to be a massive headwind as the company loses customers that signed up under much higher natural gas prices than today’s prices. Recognizing this impact, the company began diversifying the portfolio over the past several years. In 2009, debts were zero. Today, debts are in excess of C$677 million. The decision to buy electricity suppliers has cost the company in a time when profits and margins are going to begin eroding. Impact On The Stock Predicting JE’s EPS is a challenge. The company often swings between massive losses and equally massive profits. Over the past three years, the company has posted net profits from C$602 to losses of C$579. With customer attrition likely to increase over the next year, it will be virtually impossible to produce a net income. While Q1 saw an EPS of C$0.67, that figure was due to asset sales. That is not a long-term means of growth. Had the company not sold off a unit for C$505 million, it would have posted a loss for the quarter. For FY2016, expect a significant loss (unless JE continues selling off assets). While management is correct that margins are improving, that effect will fade in Q2 and reverse in Q3. New customers will begin to constrain margins beginning in November. That is because 42 months ago (3.5 years) natural gas prices fell to levels below current levels. That lasted from December 2011 to June 2012. Every customer who signed up after June 2012 is a higher-margin customer than the ones the company is acquiring today. JE requires volatile gas prices for profits. In 2015, natural gas has been flat. In order to turn a profit, gas prices would need to drop. At $2.7 today, that seems unlikely. With all of this in mind, the company could post continuing revenue growth, but will still report losses. Management does not provide earnings or revenue outlook, instead it only focuses on EBITDA outlook. For FY2016, the company expects C$193-C$203 million in EBITDA. The excessive focus on EBITDA is alarming from an investor’s standpoint. Multiple forensic accounting firms have highlighted red flags in relation to how JE calculates its EBITDA. Additionally, it is always alarming when a company with no tangible cost structure (JE does not own any hard assets) only points to EBITDA. In 2015, the company generated sales of C$831 per RCE (residential customer equivalents). This is the non-GAAP figure used to calculate the number of customers. The actual number of customers is around two million. The C$831 per RCE is higher in 2015 because margins are increasing. As margins decline (as I have suggested will be the case in the second half of FY2016), the revenue per RCE should normalize to figures from previous years. About ⅓ of Just Energy’s customers leave each year. In past years that decline was offset by adding more customers, creating a net gain. That trend reversed in Q1. If the rate of decline experienced in Q1 continues throughout FY2016, total RCE will decline to 4,390,000. Using the C$831 figure (which I feel is very generous), total revenue for the year will come to C$3.6b, a 7.7% decline from 2015. RCE Sales per RCE Sales (in millions) Q1 4,609,000 C$202.4 C$933 Q2 4,535,000 C$202.4 C$918 Q3 4,462,000 C$202.4 C$903 Q4 4,390,000 C$202.4 C$889 Total – – C$3,643 Source: 10-Q The exact nature of any declines are subject to a number of factors including the timing of margin contraction, the severity of the contraction and the ability of the company to aggressively increase marketing to obtain new customers. All of these factors could impact the above calculation. At the end of the day, things do not look good for Just Energy. It is hard to imagine how the company will grow EBITDA by 5.5% (as it predicts) when the business is facing declining customer growth, increasing attrition and declining margins for 2016. Long term, there are too many headwinds to keep this electricity and natural gas reseller from being an attractive investment. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.