Tag Archives: utility

Just Energy Is In Hot Water

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.

IFRS Vs US GAAP In Utility Analysis And The UIL Merger

Summary Iberdrola USA filed an S-4 with the SEC related to its acquisition of UIL. Previously IUSA financials were based on IFRS, but the S-4 used US GAAP. This creates a unique opportunity to examine how accounting standards impact utility results. Accounting issues appear to make a noticeable difference when comparing US and international utility companies. IUSA Income under US GAAP was $20M lower than under IFRS; don’t be surprised if guidance for the combined company is eventually lowered. Iberdrola USA’s ( IUSA ) purchase of UIL Holdings (NYSE: UIL ) was announced back in February. The parties have been progressing through the various requirements to complete the merger, and they are still on track to complete it by the end of the year. IUSA financials were previously done under IFRS , because they were a fully owned subsidiary of Spanish utility Iberdrola S.A. (OTCPK: IBDSF ) After the completion of the merger, the combined company will be publicly traded on the NYSE, and will be required to provide financials under US GAAP. The recently filed S-4 IUSA restated their 2014 financials using US GAAP , providing a unique opportunity for investors to see how accounting standards impact utility results. This article provides a side to side comparison of the two financial statements under the two standards. This information should be particularly useful when comparing American utilities to those elsewhere in the world. These issues should also be in investors minds when comparing utility ETFs like (NYSEARCA: XLU ) that are US focused to ones with a bigger international component, like (NYSEARCA: JXI ). Balance Sheet Assets The first thing that jumps out when reviewing IUSA’s assets on the balance sheet is that the two methods come up with different values for cash. Now you would think cash is cash, but somehow the accountants have come up with a way to make it different, with US GAAP showing $18M more in cash than IFRS. Another noticeable difference between the two methods is that no deferred tax assets show up in the US GAAP books. These assets have not disappeared, but they have just been netted against the deferred tax liabilities on the other side of the balance sheet. The US GAAP books show almost $900M more in total assets than the IFRS books, but since the deferred tax assets have just been moved to offset the liabilities, the “real” difference between the two methods is closer to $3.3B. The biggest driver of this difference is regulatory assets. IFRS actually does not allow companies to put regulatory assets or liabilities on the balance sheet, but US GAAP does. This is really a big deal for utilities, which have constant dealings with regulatory authorities. While regulators do sometimes change their minds, if a state public service commission says that a utility can collect $100M from customers to cover certain costs, it is very likely the utility can expect to get that money. IUSA has almost $2.5B in current and non-current regulatory assets. These represent promises from regulators that IUSA should expect to receive. These promises will be an asset that helps support the business going forward, and should be recognized on the balance sheet. Balance Sheet Equity and Liabilities (click to enlarge) IUSA’s equity under US GAAP was $1.9B higher than under IFRS. A big reason for higher equity was from regulatory assets and liabilities. There are almost $1.4B of current and non-current regulatory liabilities which partially offset the $2.5B of regulatory assets discussed earlier. Another driver for the increased equity is a decrease in environmental remediation costs and in asset retirement obligations. These items were included in the “other provisions” line under IFRS. Note 18 of the IFRS books shows an $845M liability between these two items, while it is only $518M in US GAAP. IFRS requires the use of the mid-point of a range of estimates if no best estimate is available. US GAAP uses the low end of the range. So it seems likely that IUSA is at risk to higher environmental costs than are shown in the latest balance sheet. Deferred income also contributed to the change in equity, with US GAAP showing a $300M smaller liability than IFRS. Another area that is important to understand with IUSA is the special financing they have used for their wind projects. Under IFRS these are “Capital Instruments with Debt-Like Characteristics” and have a balance of $344M. US GAAP calls them “tax equity financing arrangements”, and has a current balance of $124M, and a non-current balance of $277M. These are very complicated instruments where investors contribute money to IUSA’s wind projects, and are paid back with cash and tax benefits. At first these investors may receive the majority of a project’s returns, but over time the majority shifts back to IUSA. There is also an interest component to these payments, but how much of the payment should be allocated to interest vs. repayment of principal, or another category is difficult to determine. This difficulty is likely part of the reason there is a current liability for this category under US GAAP, but there is only a noncurrent liability under IFRS. It is interesting to see that US GAAP seems to think that they are a bigger liability than IFRS, though both methods say they should not be considered “true” debt. However, while it may not be “true” debt under either method, it is still similar and it is significant. When thinking about IUSA’s debt and interest ratios these values should be considered in the calculation, but most people likely ignore. Statement of Cash Flows (click to enlarge) The statement of cash flows shows the total change in cash during the year to be the same under both methods. However, some of the cash was categorized differently. As many people know, followers of IFRS have the option to run interest expense through the financing instead of operations, but that was not one of the differences in this instance. One of the big items to stand out is capital expenditures. These are $155M lower under US GAAP, which makes up the majority of the difference under investing activities. It is likely that some of this is differences in how major maintenance spending is capitalized. IUSA also has some investments that were proportionally consolidated on a 50% basis under IFRS, while they received equity method treatment under US GAAP. It is possible CAPEX at the proportionally consolidated subsidiary disappeared using the equity method in US GAAP. Under operations, depreciation and amortization was almost $100M higher under IFRS. This would likely be consistent with the CAPEX numbers discussed in the investments section. If more expenses were capitalized it would make IFRS PP&E higher (and it was $300M higher on the balance sheet), and therefore depreciation would be higher as well. Regulatory assets and liabilities also played a big role in cash flow from operations. Under financing, the “Changes in borrowings from affiliates” line item disappears under US GAAP. It seems likely that some of this was netted against “repayment of long-term debt and related interest” under US GAAP, but this would seem to be important information that investors would want to know about. Another item of note is that the Aeolus debt and the tax equity financing are basically the same thing, but there is a slight difference in the value recorded. This slight difference is probably reasonable considering the difference discussed earlier on the balance sheet. Income Statement (click to enlarge) IUSA’s net income was $22M lower in 2014 under US GAAP than under IFRS. This seems consistent with what we’ve seen on the other financial statements. Moving spending from capital to expenses would lower income. Including regulatory assets in the financials would lower income as well. Under IFRS, the cash recovery of these regulatory assets would likely go to income, while under US GAAP the incoming cash would match up against a decrease in the regulatory asset account. Implications for UIL/IUSA Merger Assuming the merger is completed, this analysis implies that there is a risk that the new company will reduce its combined guidance. According to last month’s S-4 filing, the IUSA forecast used in evaluating the merger was based on the IFRS $446M of net income in 2014. With the biases discussed in this article, it seems like IUSA’s starting point was actually too high, and it makes sense that these biases would have continued in their forecasts. It might be appropriate to reduce the combined 2016 forecast of $700-730M to $680-710M based on these factors. When analyzing the new entity with other metrics, like EBITDA, this accounting review shows that there are a lot of uncertainties created by their tax equity financing arrangements. How much of the payments to these other entities should count as interest and how much as a reduction of the outstanding balance? Should these be considered debt? If the accounting standards cannot agree on how this should be handled, how can investors be consistent when they are comparing different companies on these metrics? While there are no clear answers to these questions, investors cannot forget these issues when analyzing the company. Implications of Analysis of International Utilities This article also shows that the different accounting methods can create significantly different results, with IUSA having a 5% reduction in earnings under US GAAP. Investors should think about this when comparing US utilities to those elsewhere around the world. The different treatment of CAPEX, and especially regulatory assets, would seem to create a bias that would increase international utilities earnings vs. the US. Obviously each case is different, and there are potential factors that could move results the other direction, but this example should be a wakeup call to US investors considering international utilities. Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks. 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.

VDADX: A Great Mutual Fund That Is Remarkably Low On 2 Key Sectors

Summary VDADX offers investors a great start to building a dividend portfolio. The fund is missing almost all exposure to the utility sector and to oil and gas. The expense ratio is exceptionally low, and the historical volatility has been better than that of the market. Investors should be seeking to improve their risk-adjusted returns. I’m a big fan of using ETFs to achieve the risk-adjusted returns relative to the portfolios that a normal investor can generate for themselves after trading costs. Despite my frequent use of ETFs in my personal investing, many retirement accounts still use mutual funds as a major source of their investing. When it comes to assessing the mutual funds, one of my earlier favorites is the Vanguard Dividend Appreciation Index Fund (MUTF: VDADX ). Largest Holdings I’m starting the analysis by looking at the largest holdings in VDADX. As you can guess from the name, there is a heavy emphasis on receiving dividends from the portfolio. (click to enlarge) The holdings are a little on the heavily concentrated side with several holdings over 3%, and it is interesting that the fund opted to include heavyweights on both Coke (NYSE: KO ) and Pepsi (NYSE: PEP ). However, I don’t see any real disadvantage to holding both for better diversification since the investor won’t be stuck paying trading costs to buy each individually. The thing that really stands out to me is that there is no Exxon Mobil (NYSE: XOM ) or Chevron Corporation (NYSE: CVX ) in the top 10. XOM is yielding over 3.5% and CVX is up near 5%. That really concerns me. Though I did not chart the rest of the top 100 holdings, I did scan through them looking for Exxon or Chevron. Neither was included anywhere in the top 100 holdings. Granted oil prices are plummeting and oil stocks may seem “risky”, but a small inclusion would be entirely appropriate for a portfolio focused on dividends. The yields are high, and the companies would benefit from higher gas prices while many parts of the economy would be disadvantaged by high fuel prices. For diversification purposes, it is very strange not to have them included. On the other hand, Vanguard is including quite a few other holdings that I wouldn’t put at the top of the list for a fund focused on dividends. For instance, Costco (NASDAQ: COST ) is included in the portfolio despite having a yield of only 1.09%. There is nothing wrong with Costco as a company from my perspective, but the portfolio already has quite a bit of retail exposure and is lacking in the big gas companies. Diversification Benefits The correlation to SPY is just under 97%, so diversification benefits are not very substantial. However, the volatility on the fund is materially lower at only 87% of the level on SPY, which is nice for investors who would prefer more stability in their portfolio values. Yield & Taxes The SEC yield is 2.19%. Again, this feels fairly low for a dividend portfolio and brings me back to the question of why companies like Chevron were not given a prominent weighting in the portfolio. Expense Ratio The mutual fund is posting an expense ratio of .10%. I want diversification, I want stability, and I don’t want to pay for them. An expense ratio of .10% is absolutely beautiful and makes VDADX a solid choice for investors. Sector Allocations To go a little deeper into the absence of the major oil companies I like to see included in a dividend growth portfolio, I grabbed a chart of the sector allocations. (click to enlarge) As you can see, the oil and gas sector was only 1.3% for the fund. That matches the index that the fund is tracking; however, I find it interesting that the index was designed to limit the exposure to oil and gas. If I were establishing a dividend index for a fund that could be used as a major portion of an investor’s portfolio, I would want to increase the oil and gas weightings to around 10%. The other interesting factor is that utilities are also mostly absent. Unless the investors are buying utility companies themselves, the ideal allocation, in my opinion, would include a higher weighting for utilities in the 10% to 15% range. Conclusion For investors looking at the very long-term picture, the extremely low expense ratio is beautiful. Vanguard has been one of the best in the business at creating low-fee mutual funds. I don’t think a fund should be chosen purely for the expense ratio, but I do believe investors should be very aware of it. When I’m putting together hypothetical portfolio positions, one of the things I include is the expense ratio on the individual positions to track the overall expense ratio on the portfolio. The overall portfolio looks solid with the exception that oil and gas is largely absent and the utility sector is strangely underrepresented despite several utility companies having strong yields. If I were using VDADX as a core holding in my retirement accounts, I would want to complement it with specifically increasing allocations to large-cap oil and gas companies and a geographically diversified group of utility companies. 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. Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.