Virgin Trains USA (Nasdaq: VTUS) is planning a $500M IPO this week to become something of a private force in the build-out of private train systems in parts of the US. The company has a small and successful train service in Southern Florida that it plans to expand to the central part of the state. Management is also planning to construct a brand new route between Los Angeles and Las Vegas. There's a lot of history to draw on when looking at this deal.

Despite having more miles of railroad tracks than any other country in the world the US is very low in terms of train ridership. There are lots of reasons for it including the fact that the tracks are mostly owned by freight companies, most were built during the "golden age" of US train travel in the 1800s, and the US is sparsely populated in most places. Cars and planes took over from trains for passenger travel in the US.

Yet somehow the opportunity remains for train travel to have a greater role in the US. France has only 20% of the US population but has nearly 50x the number of train journeys per day, hundreds of them on very high-speed lines connecting most cities.

Track ownership is a huge problem because it means that Amtrak has little control over when their trains arrive. Companies like Union Pacific own the tracks and give priority to their own trains. In contrast, the railroads in countries like France and Germany own all their own track.

The key ingredient for any successful high-speed rail option is money and lots of it. Amtrak is stuck because they have little money to spend on improvements so their trains and customers suffer. Whereas in France the taxpayer supplies about 1/2 of the funding which allows them to make the needed investments for great service while keeping prices low.

Virgin Trains USA isn't suggesting they are going to change the USA when it comes to train travel. But they have identified two specific areas where they believe they have a strong case for investors.

Florida

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Florida is the current home base for Virgin Trains USA. It started as the "Brightline" serving Miami, Ft Lauderdale, and West Palm Beach. People love the service. On TripAdvisor, 89% of the reviews are 5 starts with expressions like "loved it, awesome, impressive, great experience, fast & clean, superb service and convenient." Based on the success of the current but rather short line they are extending the line over 100 miles north to Orlando. This part of Florida has the right characteristics to support a profitable private rail line:

1. Florida is a big state with a number of cities with a high population density.
2. Major tourism to Orlando, Miami and warm weather. Annual visitors are 4x population.
3. Hub of activity for the cruise industry with very large ports which drive major demand to/from cities and airports.
4. Miserable driving experience with just one large highway (Route 95) that has is nearly always backed up with traffic.

Although the Brightline provides a luxury experience they target the middle-class passenger in terms of pricing. They also offer commuter "packs" at a discount and monthly passes. For example, a monthly pass between two cities starts at $350 and an all-access pass starts at $450. Monthly parking is also available with car-ride service credits coming soon.

In short, Florida is a great fit for VTUS and since it's already operating the lowest risk part of the story. The current run rate for the Florida system is about 1 million passengers a year and it's growing at 50% per year. The company estimates that when they reach "stabilization" in FL they will be moving 9.5 million passengers and generating over $800M in revenue and $567M of EBITDA at their "target margin" of 70%. (This seems rather high so we'll come back to that.)

Vegas

As a young man, I've driven the road from LA to Vegas a few times. My college friends and I would take a "road trip" there for a few days at a time. There is one very long, very straight road that connects from just outside of LA to Vegas. I-15 runs 185 miles through the featureless desert. There's a place or two in the middle (Barstow or Baker) where most people stop for gas and fast food, then on to Vegas or home.

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The LA-Vegas route is a bit of a one-off. But the addressable market according to the company is 56 million trips which today require a three-hour drive along an increasingly congested I-15. The Virgin Train USA service aims to cut that travel time to 90 minutes and offer it at $60 with free parking at the station.

Most visitors don't need or want a car in Vegas. Most attractions in the city are walkable and there is a monorail that links much of the city. It's easy to get around. This makes taking the train a good option for many people. Given the character of most visitors to Vegas the ability to relax on the train and enjoy the bar and food service on the way will also be a major attraction. (It's likely that many passengers on this line will spend more at the bar then what they paid for their ticket.)

Virgin also owns 38 acres of land adjacent to the center strip clustered between the Bellagio and the new Raiders stadium. It's fully entitled to gaming, hotel, residential and retail which are part of their "development master plan."

The company puts the LA/Vegas business as roughly equivalent to Florida when they reach "stabilization." Their estimates for LA/Vegas are $863M in revenue and $600M of EBITDA to bring the total for both to $1.67B in revenue and $1.17B in EBITDA.

But the LA/Vegas operation doesn't exist and has to be built out. VTUS did buy the failed XpressWest which had development rights and plans for the route. But XpressWest was relying on a $5.5B government loan which wasn't forthcoming so they were not able to proceed with their own plans.

It's worth noting that VTUS believes they can build this project for much less, $3.6B, and still make the originally scheduled date of service in 2022. We believe that the management team is top-notch (see below) but delays and overruns in any complex project are the norms. (As an aside we recommend that management consider using some advanced risk-management software like Aptage).

There's one final fly in the ointment for this project - the train doesn't go to LA, at least not initially. It's really between a town outside of LA called Victorville. Victorville is about 85 miles outside of LA and most residents will say that's where the traffic problem is, not the Victorville to Vegas leg. Critics have raised this as a risk and believe that after fighting traffic for over two hours to get to Victorville people are not going to want to park their car and board a train for the "easy" part of the trip.

We think over time management can create some "feeder" transport links between coastal cities in Southern California to overcome some of these obstacles but it may result in a slower-than-expected ramp up in terms of revenues.

Puts and Takes

+ Ride-sharing services like Lyft and Uber help to make private train travel more viable since consumers can solve the "last mile" problem much more easily than they ever could in the past.

+ This is a great management team with major accomplishments in terms of building infrastructure, hospitality, casinos, project and operations management, trains, finance, and business development. If anyone can do it, these guys can.

+ Air travel continues to worsen thanks to increased security, delays and continued cost pressure at most major airlines.

+ Operational line in Florida is a known quantity demonstrating high customer satisfaction and rapid growth. This will only improve further with the addition of Orlando which is a very key market.

-- LA/Vegas expansion plan has yet to be developed and we know that overruns and/or delays are likely. There are also questions about whether passengers will opt to shift from driving to the train after they have done the "hard part" in getting to Victorville.

-- Management seems to be setting profitability targets/expectations rather high at 70% EBITDA. This compares to the current industry leaders Eurostar (61%), .italo (57%), Acela (47%) and even Virgin Trains UK (55%.) We're not saying they can't get there but nobody else has.

-- Heavy debt financing will be needed for the build-out. The current environment for debt financing is very favorable but it may not be so in the future. In addition, if delays or overruns occur additional financing (debt or equity) may be required.

Investment Conclusion

At the IPO mid-point of $18, the market capitalization of VTUS will be $3B. The company expects to incur a debt of $2.3B to support Florida. If we include Vegas there is an additional $3.6B of debt and equity. That brings the EV to about $8B.

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We put a small group of comparable transportation companies together to illuminate what an appropriate multiple of EBITDA should be for VTUS. Looking at the table they are in a fairly tight range with an average of 10.4x. It should be noted that the railroad stocks are trading at significant new highs. For example, CSX was trading at 1/2 their current 11.1x multiple less than two years ago.

If we take the 70% EBITDA target as a given and accept the "illustrative financials" provided by management then EBITDA at "stabilization" is $567M for Florida and $604M for Vegas for a total of $1.17B.

Considering that Vegas doesn't open until 2022 at the earliest we can start with Florida which should reach their target of 9.5 million passengers by 2023 with a resulting EBITDA of $567M. Putting a 10.4x multiple on that the EV of VTUS should be $5.9B. Without Vegas, the current proposed EV is $5.3B. And remember we haven't applied any present value adjustments to this.

We could factor in Vegas but it wouldn't change the overall picture. Sure it would double EBITDA at some point - let's say 2028 but it brings the current EV to $8B. In 2028 we would expect the EV to reach $11.6B. But that's in 10 years.

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This little table drives the point home. If we project an EV on each business based on the build-out and aggressive ramp and then discount that at a conservative 10% we see that the current proposed EV under any scenario (just FLA shown in green, both FLA and Vegas in blue) the deal is overvalued by about $1B. In summary, the numbers at the current valuation of $18/share are not very enticing. It's already "pricing in" the full ramp of the Florida system over the next few years and a major chunk of the yet-to-begin and be tested Vegas expansion.

In the very long term, there are more assets to be developed including gaming, retail, hotels, and related services but it's hard to pay up for these today. We're more likely to watch this one and see how this one trades after all the IPO hype and excitement die down. With eight banks on the cover and leads that include J. P. Morgan and Morgan Stanley, there will be plenty of table pounding out of the gate.