OTC Markets Group — Building the base for long-term growth

OTC Markets’ first quarter results showed gross revenues 7% ahead of the same period last year Expenses increased at a similar pace, allowing pre-tax profits to rise in line. Price increases were a factor in the 7% revenue increase for Market Data Licensing, while Corporate Services (+10%) benefited from the increase in corporate clients on OTCQB and the accelerated revenue from departing OTCQX companies referenced earlier. Encouragingly, OTC Link recorded a small increase rather than decrease in revenue, reflecting a pick-up in messaging-related revenue that offset the headwind created by the year-on-year contraction among broker-dealer subscribers. The tax rate was lower than we expected (at 18%) and diluted earnings per share increased by 19%. A quarterly dividend of $0.14 is to be paid, the thirteenth at this level. A P&L summary is shown in Exhibit 1 and more detailed revenue analysis in Exhibit 2. Other highlights from the quarter included:

Exhibit 2 shows a further revenue analysis based on OTCM’s discussion of percentage changes in some of the subsegmental components in the group. The inferred figures are approximate but give additional indications of trends and relative size. Looking down these figures we can see the benefit of the increase in messaging revenues within OTC Link ATS and the pricing, client count and accelerated revenue recognition effects as mentioned above for OTCQB and OTCQX.

Our next table collates operating and related revenue data by segment. For OTC Link ATS the number of broker-dealer participants has been unchanged for two quarters, suggesting that the erosion seen previously (reflecting consolidation, competitive conditions, margin pressure and regulatory costs) could be easing. The corporate client count was down modestly for OTCQX with contributing factors being a marked increase in the number of graduates to national securities exchanges, some increase in those downgraded for compliance reasons and a slightly lower retention rate for calendar 2018 (91% versus 93%). For Market Data Licensing both professional and non-professional users were down year-on-year, but sequentially there was a small increase in professional users, which may be a more positive indicator for the future. Non-professional users have increased over the longer term but have shown quarterly fluctuations, as evidenced in the periods shown.

The progression in the number of corporate clients for OTCQX and OTCQB since Q216 is shown in Exhibit 4. From the beginning of 2017 the number of OTCQX companies has been broadly stable, while the OTCQB number has shown a modest increase driven by stronger sales and fewer compliance downgrades. Clearly there is some offset between the move to raise the quality of the OTCQX market and the number of corporate clients or potential clients. Prospectively, achieving national Blue Sky recognition could more than compensate for this effect as it would be likely to substantially raise the profile of the market, attracting new US and overseas clients. In the meantime, OTCM has been able to implement price increases that have contributed to increase revenues.

As noted above, Connecticut granted Blue Sky recognition to OTCQX and OTCQB during the first quarter. This takes the total number of states to 30 for OTCQX and 27 for OTCQB. A further three states, Michigan, Oklahoma and Missouri, have rule proposals that could lead to recognition of both markets in due course. The sustained increase in the number of states recognising OTCQX since OTCM began working to this end is shown in Exhibit 5 (over the period between one and three of these states only recognised OTCQX).

We have updated our charts showing the number of IPOs on Nasdaq, the Canadian TSX and TSX Venture exchanges as an indicator of corporate activity levels in these equity markets. The run rate for Nasdaq and TSX Venture has been well ahead of the same period last year, although the TSX is running at a markedly lower level.

The one-year performance of the S&P 500, Nasdaq Composite, S&P TSX Venture and OTCQX Composite have all been positive with equity markets rallying from a period of increased volatility earlier in the year. US and global economic growth has also been sustained, suggesting the background for prospective corporate activity and IPOs should be broadly supportive.

OTCM’s corporate segment should benefit from this background with other more specific factors coming into play, including the number of international corporates seeking US market exposure and the traction of OTCM’s own marketing initiatives.

Within Market Data Licensing wider take-up of newer products such as compliance data, together with the continued benefit of price increases compared with the prior year period, should allow revenue progress even if the number of professional users remains at a similar level.

OTC Link ATS is likely to continue to be affected by the challenging background for its broker-dealer customers. However, development of OTC Link ECN and work on adding functionality to both the ATS and ECN should help OTCM’s competitive position and potentially generate incremental revenue.

On a longer view, OTCM’s relatively low cost for corporate clients should put it in a strong position to act as a venue for secondary trading of equities issued through online capital-raising (under Regulation A+ and facilitated by JOBS Act). OTCM has joined others in supporting legislation which, if enacted, would broaden the pool of companies that could employ this form of funding to those that are SEC reporting.

Among the sensitivities to consider for OTCM are the risk that a competitor adopts more aggressive behaviour, that there is an adverse regulatory development that could affect the number of broker-dealer participants and data licence revenue, and that the momentum in gaining Blue Sky recognitions slows. Conversely, a higher level of net new corporate client signings, paired with broader Blue Sky recognition, would help create the conditions for a virtuous circle benefiting all parts of the business and generating positive earnings surprises.

We have made limited changes to our estimates following the first quarter, with a marginal reduction in estimated revenue, modestly lower pre-tax profit numbers and essentially unchanged earnings estimates on a slightly lower assumed tax rate.

The end-March cash position, including $0.5m of restricted cash held as clearing collateral, stood at $23.4m compared with $24.4m at end 2017 and $23.7m for Q117. The first half tends to see weaker cash flows reflecting the incidence of bonus payments and other annual costs. Dividends and share buybacks and absorbed $2.6m (compared with $3.0m for Q117 and $15.4m for FY17).

Our comparative P/E table includes global exchanges and information providers, MSCI and Markit, as they can be seen as having something in common with OTCM’s subscription-based fees and market data income (Exhibit 9). OTCM continues to trade on multiples below or similar to the consensus averages for the exchanges and information providers. While OTCM’s relatively small scale in relation to these businesses could be seen as a reason for this rating discount, the flip side is the potential for the business to generate positive surprises if it continues to secure increased regulatory recognition and this feeds through into increased client wins.

Flexing our discounted cash flow model assumptions to match the current share price ($26.50, 25 May 2018), one combination producing this value is a discount rate of 10%, a long-term growth rate of 3.5% and a terminal operating cash flow multiple of 16.0x (compares with a current year value of 17.1x). These assumptions do not seem aggressive and, with broadly stable estimates at this stage, we maintain our fair value estimate at c $29. Exhibit 10 shows the sensitivity of our valuation to discount rate and growth assumptions.