OTC Markets Group — Q421 was another beat, 2022 is more uncertain

The purchase of the National Quotation Bureau (NQB) by current CEO R Cromwell Coulson and a group of investors in 1997 began the process that led to the creation of OTCM in its current form. With a history dating back to 1913, NQB published the ‘Pink Sheets’, a printed list of broker-dealer quotes for securities traded off-exchange. Following the purchase of NQB, the new management team progressively applied technology to the task of aggregating liquidity and increasing transparency in this over-the-counter market.

A platform providing real-time quotes was launched in 2003 and evolved into the current SEC-regulated alternative trading system, OTC Link ATS. Another platform, OTC Link ECN, was launched in 2017, providing dealers with complementary features including an anonymous order-matching engine with an order routing capability – as opposed to OTC Link ATS, where attributable quotes are displayed and messages delivered, enabling direct trades between dealers. OTC Link ATS carries quotes in more than 12,000 securities and has 86 active broker-dealer participants, while OTC Link ECN has expanded its subscriber base and trading volumes rapidly since launch. At end 2021, it had 93 subscribers, compared to 53 in 2019 and 41 in 2018.

These two existing platforms are complementary. OTC Link ATS provides a network to publish quotes and facilitate trades between subscribers and OTC Link ECN operates an anonymous matching engine and acts as an order router, functioning as the execution party on an agency basis.

OTCM launched its third alternative trading system in Q321, OTC Link NBQ. It operates in the same way as OTC Link ECN but with full disclosure rather than anonymity and allowing distribution of the full depth of book data rather than top of book alone. Management has stated that it is unable to gauge the financial impact or how successful this new IDQS will be. However, we believe the launch of NBQ will be an attractive proposition to clients and thus should be a positive for OTC Link’s revenue in the medium term.

To help investors assess risk exposure, OTCM organises the companies on its markets into tiers, with membership of each subject to the adequacy and timeliness of disclosure, financial criteria and adherence to governance standards:

For corporates, OTCM’s premium markets, OTCQX and OTCQB, provide access to public trading in the United States at a cost-effective price, compared with a listing on a registered national securities exchange such as Nasdaq. As shown in Exhibits 1 and 2 below, both OTCQX and OTCQB have a substantial number of international corporate clients, notably from Canada.

The group’s activities are organised in three divisions: OTC Link (trading services), Market Data Licensing and Corporate Services (OTCQX, OTCQB and other services), which in FY21 accounted for 29%, 33% and 38% of gross revenues respectively. Exhibit 3 gives examples of how revenues are generated in each division.

While OTC Link revenues are largely transaction-related, subscription-based revenues feature in many activities and in Q421 accounted for about 80% of the group total, providing a measure of revenue resilience against the background of equity market volume fluctuations.

Exhibit 4 shows the long-term development of OTCM’s gross revenue by division and its operating margin. Total gross revenue grew at a compound annual rate of 13% between 2009 and 2021. Within this, Corporate Services has contributed the fastest growth at 25%, mainly due to the development of the premium OTCQX and OTCQB markets, both in terms of the number of corporate clients subscribing and the level of fees charged. Market Data Licensing’s and OTC Link’s CAGRs were 10% and 9%, respectively.

The operating margin increased significantly between 2013 and 2015 as the scale of the business grew but was then flat between 2015 and 2018 as investment was made in people and systems to support the sustainable growth in the business. In 2019, the company further invested in staff and IT infrastructure and moved to a new office in New York, resulting in a reduction in margin. The operating margin has risen in the last two years, especially in 2021 when it reached a record 38% (versus 31.3% in FY20), due to business growth and an increase in service prices.

OTCM’s management takes a long-term view of the development of the business and has a consistent mission statement, which is to create better informed and more efficient markets. Flowing from this is a threefold strategy, set out as follows:

This focus has contributed to the long-term growth in the group set out above and the goals appear to fit well with the requirements of corporates, investors, broker-dealers and regulators involved in the OTC market.

SEC Rule 15c2-11 came into effect on 28 September 2021. The rule sets minimum disclosure standards for companies to be quoted on broker-dealer networks such as the ones OTC operates. It also recognises OTCM as a qualified IDQS operator, which increases transparency in these markets and increases the number of quoted companies. The rule allows OTCM to carry out initial reviews that streamline the new securities onboarding process. The increase in Corporate Services business during the second half of 2021 was boosted by companies seeking to comply with the rule.

With regard to potential acquisitions, OTCM has been clear that it is not seeking a high-risk transformative transaction but continues to monitor opportunities for purchases that will provide complementary capabilities.

OTCM continues to work towards further regulatory recognition for its two premium markets, including extending the list of states that grant exemptions under state Blue Sky laws governing secondary trading. The list currently includes 37 states for OTCQX and 33 for OTCQB, providing population coverage of nearly 58% and more than 53% respectively. Blue Sky recognition is not directly linked to revenue generation but progress towards 100% coverage should be increasingly positive reputationally, helping to attract a broader range of corporate clients to OTCM’s premium markets. OTCM is also seeking recognition for OTC securities on its OTCQX and OTCQB markets for the purposes of federal regulations dealing with margin eligibility and employee stock ownership plans.

A summary of the quarterly progress in OTCM’s profit and loss figures is given in Exhibit 5. We highlight the key points below (the comparisons are year-on-year unless stated):

Our next table summarises the change in operating expenses with commentary on year-on-year changes. Compensation and benefits remain the most significant driver of costs and the increase was driven mainly by cash awards. IT costs grew substantially to support the growth of the OTC Link ECN business. There were also cost increases driven by implementation of Rule 15c2-11, as well as system security and workstation updates relating to the Virtual Investor Conferences (VIC) business.

Exhibit 8 shows changes in operating data and related revenue data. In OTC Link, trading volumes in US$ terms in the OTCQX and Pink segments was sharply up year-on-year in Q421 at 51% at 27%, respectively. Both were off the peaks of Q121, but volumes remain at elevated levels. Conversely, OTCQB volume was down 47% year-on-year, although flat on the previous quarter.

The number of OTC Link ATS participants (86, +2% y-o-y) and ECN subscribers (93, +27% y-o-y) continued to increase and ended the year on a record high.

Corporate Services also showed very strong year on-year increases across the three segments: OTCQX (24%), OTCQB (27%) and Pink (111%). Revenue per client grew 3%.

Market Data Licensing saw a 24% year-on-year increase in total users. This included a 36% y-o-y jump in non-professional subscribers, although these numbers fell 3% on the previous quarter. These subscriber numbers are typically more volatile than the number of professional subscribers, so may decline if the market proves choppy in 2022. Professional users grew 13% year-on-year. Revenue per terminal fell by 4%, presumably affected by a higher number of non-professional users, which are typically lower revenue.

The most significant regulatory development highlighted by OTCM in 2021 was the amendment to the SEC’s Rule 15c2-11, which came into effect on 28 September 2021. The rule deals with information requirements before quotes may be published on interdealer quotation systems such as OTC Link ATS. On a positive note, the amended rule recognises OTCM’s disclosure standards and OTC Link ATS will be permitted to act as a qualified IDQS, reviewing disclosure to determine whether a security is eligible to be quoted publicly. This will enable it to streamline the onboarding of securities to its markets, removing the risk and administrative burden of certifying the suitability of securities for quotation from broker-dealers, which in turn will allow them to focus on their financial advisory role. For companies that do not meet the information requirements, there is the potential for an expert market exemption allowing sophisticated or professional investors to continue to trade in the securities. OTCM has already established an Expert Market and is continuing to engage with the SEC with the aim of refining implementation of the amended rule to provide well-informed markets for its corporate clients, broker-dealers and investors.

Economic and financial markets have clearly become more uncertain. Inflationary pressures have been building up and inflation has exceeding expectations (Exhibit 1). This in turn had led to rising interest rate expectations, which is often a headwind for equity markets. At the beginning of December 2021, the market was pricing in just under two rate hikes (of 25bp each) by the end of 2022. Just two and a half months later, the market is now forecasting seven hikes (we include the 17 March hike in this number) and a US Fed Funds Rate of 1.8% at that time. The current war in Ukraine has aggravated the inflation problem, mainly through higher energy prices due to sanctions against Russia.

It is encouraging that COVID-19 fears and risks have receded for now and the market is forecasting strong economic growth this year (US consensus is 3.6%, Europe 4.4% according to Bloomberg-collected consensus). However, higher rates and inflation could reduce economic growth and earnings estimates and affect the markets.

The cryptocurrency boom has been a major factor in rising volumes in OTC (since crypto-related stocks are among the most traded stocks on OTC markets) and this may continue, but it may also be volatile.

These macroeconomic concerns and uncertainty have contributed to relatively weak equity markets over the last six months. Smaller stocks, usually riskier and more volatile, have fared worse. This is reflected in the performance of OTCQB and S&P TSX Venture Index.

The State Street Investor Confidence Index tracks changes in institutional investor holdings in risky versus safer investments. Exhibit 12 shows that confidence is higher than during the pandemic in 2019–20 as well as in 2018. The confidence level rose after Omicron proved to be less dangerous than first feared. However, the index does not yet reflect the impact of the war against Ukraine or concerns about rising inflation.

Another indicator of the environment surrounding corporate decision-making is the Economic Policy Uncertainty Index shown below. The index component selected here reflects daily newspaper coverage related to economic uncertainty and clearly shows a spike in recent weeks.

2021 was a record year for IPOs on the Nasdaq, TSX Ventures and TSX exchanges, rising by 138% and 159% on Nasdaq and TSX Ventures respectively and by 12% on TSX.

We estimate that OTCM’s gross revenue will fall by 9% in FY22 on the basis that weaker financial markets and elevated macroeconomic and political uncertainty will lead to lower trading volumes. We forecast a 5% increase in FY23 revenue on the assumption that trading levels normalise and resume an upward trend. However, despite our continued caution, we have increased our revenue estimates by 6% to reflect the strong growth in the Corporate Services business.

Exhibit 16 shows details of our revenue assumptions. We forecast a 40% decline in revenue from the OTC Link business as this segment accounted for 29% of OTCM’s revenue in FY21 and is most exposed to a drop in trading volumes.

Trading volumes in OTC Link ECN (the key driver in OTC Link’s variable revenue component) are not reported monthly and the pricing structure is complex (variables include which investors are trading, lot sizes, securities trading and even the fact that different share prices have different trading costs). This complicates forecasts beyond the usual challenge in that trading volumes can be quite volatile.

We forecast a 6% decline in revenue from Market Data Licensing. While this segment is more resilient to weaker markets, but we would expect to see a decline as some users step back from trading in less favourable market conditions, especially non-professional users which had been the fastest growing segment.

Corporate Services is the most resilient of the three segments as it correlates more with economic activity than trading volume or market performance. Nevertheless, we cautiously forecast 12% growth in 2022 to allow some room for the possibility that an unfavourable economic growth shock later this year might lead to an increased number of companies ceasing to trade on the trading platforms and fewer new ones joining them.

12% year-on-year growth might be considered conservative given the assumed significant pullback from FY21 growth of 61%. The FY22 growth number is affected by the basis effect from significant client additions in 2021 and the subscription-based, recurring nature of revenue in this segment.

We expect OTCM to be able to control some of its costs to counter the forecast revenue decline. As a result, we estimate an 8% decline in compensation and benefits in FY22 from a smaller variable component in pay. Furthermore, management sees scope to reduce costs in some areas such as professional and consulting fees as well as marketing costs. Conversely, expenses in areas like IT and occupancy are less likely to be pared back. We estimate a 5% decline in total operating expenditure in FY22 followed by a 4% increase in FY23.

Exhibit 17 summarises the changes to our forecasts. We now forecast PBT of $35.6m in FY22. This is 2% higher than our previous estimate (which already assumed sharply lower trading volumes for FY22) and represents a 6% drop from FY21. We have upped the assumed tax rate from 19% to 22% following management guidance, and as a result our new FY22 EPS forecast is down 3% on our previous forecast and 9% below FY21.

OTCM’s balance sheet remains strong with no debt and a record level of cash at $50.4m, or $52.0m including restricted cash at the end of FY21. We assume that OTCM maintains its $2.16 dividend per share despite the decline in earnings. This would take the estimated dividend payout ratio for FY22 to 92%, which is easily covered by operating cash flow. We note that OTCM has a strong record of dividend distribution, with the 2019 payout ratio at 97%.

Exhibit 18 compares OTCM’s P/E ratios to a range of market information providers and global exchanges. OTCM is trading at a 12% discount on trailing earnings, about in line with 2022e and then a relatively small (16%) premium on 2023e. The premium is deserved due to OTCM’s strong growth track record, balance sheet and relatively high proportion of subscription-based revenues.

The sensitivity of our discounted cash flow valuation to different discount rates and long-term growth assumptions is shown in Exhibit 19 below. The model factors in our increased explicit forecasts for FY22–23, together with an assumption of FY24–25 cash flow growth of 10% and a terminal cash flow multiple of 16x. we obtain the valuation range of $42.4–66.3 per share by flexing the discount rate from 7% to 11% and assuming long-term growth (2026–32e) of 3–6%.