A quality UK stock heading on the right track

Britain used to lead the way on rail. But systemic funding and planning issues, combined with the fragmented management of the network, has tipped the modern domestic system into a state of chaos. Industrial action has caused misery for travellers already facing rising prices. The scrapping of the northern leg of HS2, meanwhile, has highlighted the expensive nature of public infrastructure and the transport inequalities at play across the country.

Tip style

Growth

Risk rating

Medium

Timescale

Medium Term

Bull points

Strong international outlook
Techno-regulatory barriers to entry
Customer growth
Big capital returns potential

Bear points

Residual GBR risk
Lower UK rates and passenger volumes

The struggling rail network doesn’t seem to have derailed Trainline (TRN), however. When it publishes half-year numbers next week, investors have been told to expect that group-wide revenues will rise 19 per cent, backed by double-digit growth in all three of the ticketing platform’s divisions. A recent trading update also put net ticket sales up 23 per cent to £2.65bn in the period, while the company’s recent swing to profit has been sufficiently strong to justify a £50mn share buyback programme, as part of a new capital allocation framework.

Rail system uncertainty and competing political priorities also make the delivery of the proposed state-backed body Great British Railways (GBR) less likely. Trainline's share price cratered back in 2021 after the government’s William-Shapps Plan for Rail said that GBR would “simplify the current confusing mass of tickets, standardising mobile and online ticketing” under a centralised system. As well as the core ticketing franchise, investors feared that Trainline’s technology solutions division – which provides booking services for employers and travel companies, as well as white-label sales platforms for rail companies – could soon face a significant external threat.

The project remains a key risk, but a much reduced one. Having already been delayed, reports earlier this year suggested plans for GBR had been “quietly scrapped” by Downing St. To Stifel analyst Mark Irvine-Fortescue, it may be that the notion of “a 'level playing field' is being upheld, which raises some doubt as to whether a new state-backed digital ticketing platform could be developed and run as a credible competitor without being seen as advantaged”.

That doesn’t mean investors totally buy Trainline’s investment case. The shares, for one, are a third down on the level they priced at in 2019, although the big knocks – a pandemic and GBR – have been outside management control. We have been bearish on the company in the past ^[1], but now we are on the other side of Covid-19 and regulatory risks have moderated, we believe that tailwinds now outweigh headwinds. Growth rates are attractive, margins are improving, and things are looking up for capital returns. The company enjoys strong brand equity, boasts a dominant market position in the UK, and is benefiting from regulatory developments in Europe.

Improving market sentiment is reflected in short positions. Trainline was at one point the second-most shorted share in London, but now there are only two managers with relatively small bets against the stock, according to FCA data.

The business model

Trainline's three divisions are UK consumer (which sells tickets from all domestic rail companies and bus tickets from National Express), international consumer (which sells tickets from key European rail and coach companies), and the Trainline solutions arm. UK consumer and Trainline solutions together can be thought of as the core business and this contributed 86 per cent of revenues in the latest financial year. The solutions business is also the most profitable, having recorded a gross margin of 91 per cent in the 12 months to February.

The company's business-to-consumer revenues come from the commission and fees it takes when customers buy tickets on its website or app. It also takes some sales on additional services such as travel insurance and foreign exchange. Business-to-business ticket sale revenue comes under Trainline solutions.

As well as the GBR project, the company also faced a regulatory risk from commission rate discussions with industry body Rail Delivery Group. These have now concluded, albeit commission on UK ticket sales will fall from 5 per cent to 4.5 per cent. European commission rates are far higher, at 8 per cent.

Another risk comes from the combination of the remote working trend and cost of living pressures. The company's model, obviously, depends on people using the railways. According to the Office of Rail and Road, 389mn rail journeys were made in Britain in the first quarter of this year, which represents 88 per cent of the pre-pandemic figure. But this looks like less of a concern given the company’s reaffirmation of guidance, the surprisingly resilient nature of the UK consumer, and a 58 per cent increase in active customers from pre-pandemic levels.

Operations are supported by a manageable balance sheet which doesn't contain any unpleasant surprises. At the end of the latest financial year, the company had cash of £57mn. A revolving credit facility of £325mn provides appropriate financing. Net debt, which contains convertible bonds and lease liabilities, equals around a third of shareholder equity, and less than this year’s expected cash profits of £109mn. With operational gearing starting to emerge in the income statement, profits should climb as leverage falls.

There isn't the need for a lot of cash in the business and this supports a more bullish outlook on capital returns. Canaccord Genuity analyst Ken Burns argues that Trainline could generate cumulative free cash flow of over £500mn over five years, with compounded EPS growth of over 38 per cent if it buys back shares.

It's also important to note, for investors who factor this into their decision making, that Trainline has some strong environmental credentials. This is fair enough given that its model is to convince people to use train travel (which has lower carbon emissions) rather than drive or fly. Regardless of the ESG stakes, this should also make for a strong secular growth story, as both the UK and the European Union push rail travel as a key means of reducing the reliance on fossil fuel reliance in the transport sector.

Growth drivers

Trainline is fundamentally a technology company. It has invested around £200mn in its platform over the past decade and boasts around 500 tech-focused engineers. This puts it in a very strong position to benefit from market trends such as digitalisation, as more tickets are booked through the company’s app and consumers continue to move away from paper tickets. The company has the resources to use reams of data and artificial intelligence to its advantage.

Peel Hunt analysts argue that technology capabilities will allow the company to “expand its remit to be the tech provider of choice for rail as [Spanish software business] Amadeus is for air”.

Technology underpins international expansion, as well as domestic dominance, as the network effects it has built up in the UK give it what it needs to invest overseas. The company’s inroads in European markets look very enticing. The international consumer division hit €1bn (£871mn) in net ticket sales in the last financial year and management guidance is for it to hit break-even this year on an adjusted cash profit basis. Analysts expect the division to post the most rapid growth in the coming years.

Growth potential has been boosted by the EU’s liberalisation of rail markets. The EU’s fourth railway package came into effect in 2020 and this opened domestic markets to external competition. The Italian and Spanish markets have been particularly fruitful for the company, taking around two-thirds of international revenues, with France contributing the remainder. Trainline’s market share in Europe is still in single digits, meaning that it is operating from a low base with significant potential to expand, and this in a market where the overall opportunity is bigger than in the UK.

European growth potential is a key reason why Stifel upgraded its recommendation on the stock to a buy earlier this year, arguing that the company “is in a strong position to capitalise on this opportunity, having invested £40mn in its single global platform” since regulatory changes in 2016.

Valuation

The shares trade hands at 21 times consensus forward earnings. While this isn’t at the cheap end of the scale, the rating is significantly lower than the five-year average, which in any case has been obscured by a lack of profits. Measured against sales, the stock is as cheap as it has ever been. As such, we don't view the valuation as too demanding, given the strengths of the business model and the growth opportunity on offer.

City analysts agree that the company's prospects have turned a corner in the aftermath of the pandemic. Of the brokers who cover the company on FactSet, the majority currently have the stock on buy. And this comes with a mean target price of 362p, suggesting significant potential upside for investors who take the plunge now.

The shares have been through a rough ride since the IPO. But the fundamentals are strong at Trainline, and it looks set to go from strength to strength with its tech capabilities and increasingly attractive overseas offering.

Company Details Name Mkt Cap Price 52-Wk Hi/Lo Trainline (TRN) £1.14bn 239p 354p / 216p Size/Debt NAV per share* Net Cash / Debt(-) Net Debt / Ebitda Op Cash/ Ebitda 62p £96.2mn 1.4 x - Valuation Fwd PE (+12mths) Fwd DY (+12mths) FCF yld (+12mths) EV/Sales 21 - 7.1% 3.7 Quality/ Growth EBIT Margin ROCE 5yr Sales CAGR 5yr EPS CAGR - 6.4% 12.9% - Forecasts/ Momentum Fwd EPS grth NTM Fwd EPS grth STM 3-mth Mom 3-mth Fwd EPS change% 25% 21% -14.7% 7.8% Year End 28 Feb Sales (£mn) Profit before tax (£mn) EPS (p) DPS (p) 2021 67 -70.8 -19.1 nil 2022 189 -3.3 -0.8 nil 2023 327 41.1 7.7 nil f'cst 2024 381 60.4 10.2 nil f'cst 2025 419 73.6 12.4 nil chg (%) +10 +22 +22 - source: FactSet, adjusted PTP and EPS figures NTM = Next 12 months STM = Second 12 months (ie one year from now) *Includes intangibles of £488mn, or 105p per share

References

^{^} in the past (www.investorschronicle.co.uk)