OTC Markets Group — Clear focus on longer-term aims

OTCM reported revenues up by more than 7% for FY17 (Exhibit 1). The main driver was a near-18% increase in Corporate Services revenue reflecting good sales and reduced churn for the OTCQB Venture market, together with price increases at OTCQX Best market that more than offset a reduced client count as 91 companies were downgraded for failing to meet the market’s higher standards. The 5% decline in OTC Link ATS revenues resulted from the continuing contraction in the number of broker-dealer members, while the 4% increase for Market Data Licensing was the net result of price increases, sales of new products and a small reduction in the number of professional users.

Expenses for the full year grew at a slightly slower pace than revenues, allowing pre-tax profits to increase by 8%. Net income for FY17, benefiting from a lower tax rate, increased by 19%. The company announced a quarterly dividend of $0.14, the twelfth payment at this level and 37th consecutive quarterly dividend payment. Including the special dividend of $0.60, the total dividend for the year of $1.16 was also maintained.

Looking at the final quarter result compared with Q416, the trends in revenue in the three segments were in line with the full year comments above. For this period increased expenses reflecting headcount investment and bonuses driven by increased sales meant that pre-tax profit lagged revenues showing a 1% increase. Again, a lower tax rate resulted in 8% growth at the net income level.

On the tax charge there was a sharp increase (from 24% to 37%) between Q317 and Q417, which resulted from the negative impact on tax assets of the reduction in US corporate tax rates. Prospectively, the lower general level of corporate tax rates and continuing modest benefits from the federal Domestic Production Activities Deduction, and the lower rate available in New York State for Qualifying Emerging Technology companies, is likely to contribute to an effective tax rate put at between 22% and 24% by OTCM.

OTCM launched OTC Link ECN in December 2017 to provide broker dealers with an anonymous order matching and routing system as an alternative to the existing fully attributable quotation platform, OTC Link ATS. It is still too early to gauge the likely uptake of the ECN (Electronic Communications Network) and its impact on revenues. Nevertheless, the additional offering is one of the steps OTCM is taking to enhance the services it offers to broker dealers, which in turn helps to address competition, including Global OTC ATS. Global OTC ATS (a subsidiary of ICE/NYSE) began competing more directly with OTC Link ATS in May last year when it withdrew its quotations from OTC Link ATS. Global OTC ATS, like OTC Link ECN, operates a maker/taker fee model. In its annual report OTCM indicated that this development had a de minimus impact on revenue in 2017. Global OTC ATS data show that although the current market share of c 11% is above a low of around 7% recorded in May/June last year, it is still within the two-year range, which peaked at over 12% in 2016.

OTCM initiatives to improve the transparency of its markets and ease the experience of corporate clients include the Transfer Agent Verified Shares programme and the Issuer Direct and Canadian Stock Exchange alliances. The Transfer Agent Verified Shares programme makes public current information on share issuance making clear, for example, where there has been dilutive share issuance; there are 15 transfer agents participating. The Issuer Direct alliance gives corporates easy access to communications and compliance service. The strategic alliance with the Canadian Stock Exchange enables corporates to list on the CSE and then develop secondary trading in the US in a cost-effective manner through OTCQX or OTCQB.

The next chart shows the evolution of revenue since 2007, a period over which total revenue grew at a compound rate of 12%. As can be seen, the Corporate Services segment has expanded significantly, accounting for 41% of revenues in 2017 compared with 23% in 2014. This mainly reflects the development of revenues from the premium OTCQX and OTCQB markets, most of which derive from application and annual fees.

Exhibit 3 shows a summary of operating and related revenue data for the three segments. The figures for OTC Link ATS confirm the reduction in the number of active participants, reflecting consolidation and withdrawal from the market as broker-dealers face the challenges of increased automation, margin pressures and rising regulatory costs. Nevertheless, there appears to have been a tempering of this trend with the number of participants stable at 94 for Q317 and Q417.

Market Data Licensing has also felt some effect of consolidation and cost pressures among market users, resulting in a small contraction in the number of professional terminals during 2017. In contrast, the number of non-professional terminals saw a 15% increase, a gain that OTCM indicates mirrors increased retail participation in the US equity market.

The Corporate Services metrics show an 8% reduction in the number of OTCQX clients between FY16 and FY17, which was the net result of lower churn (non-renewal), higher new additions (83 versus 60) and increased compliance downgrades (83 versus 60). The number of OTCQB clients increased by nearly 8%, with new sales up (249 versus 227) and churn and compliance downgrades down (272 versus 351).

Not shown in the table below, but an important operating metric is OTCM’s achievement of a third year of 100% uptime in its core systems in 2017, validating the investment made in IT systems while supporting the company’s reputation and competitive position.

OTCM continues to work towards increased Blue Sky recognition for its premium markets and national recognition for OTCQX. Since the Q317 announcement a further two states, Louisiana and Tennessee, have granted recognition to both markets (see Exhibit 4 for full list) taking the totals to 29 states for OTCQX and 26 for OTCQB. The company notes that Michigan and Oklahoma both have rule proposals that could lead to recognition in due course.

As in previous notes, we include charts showing the number of IPOs on Nasdaq, the Canadian TSX and TSX Venture exchanges and AIM in the UK to give a flavour of the broader corporate activity levels in a selection of equity markets.

In all three markets there was a positive comparison between 2017 and 2016 despite an uncertain geopolitical background during the year. Factors likely to have contributed to this include the generally favourable economic background and positive market performances. One-year index performances to mid-March are shown in Exhibit 8 and these are still mainly positive, even after the correction seen in the current year. While questions continue to be raised over market valuation, absent a more sustained market correction the background for new issues appears to remain satisfactory.

This should broadly create a positive read-across for OTCM’s corporate segment. Activity in this area will also be affected by factors such as the appetite of international corporates for US market exposure and whether the higher new sales rate and lower churn seen in 2017 can be maintained. For OTCQB, the current year will benefit from an increase in the annual fee announced in October 2017 (20% for those paying annually and 8% on a quarterly basis).

Exhibits 9 and 10 show the trends in data users with OTCM users compared with figures for UTP (Nasdaq) users. OTCM professional users have fallen modestly and this trend may continue, although the decline is not steep and could be reversed if appetite for OTCM increases, allowing its modest market share versus UTP to increase (from 7.3% at end 2017). The number of non-professional users has been on a strong upward trend, as noted earlier, and we suspect this increased penetration could see noticeable positive or negative variation subject to equity market conditions.

We have noted the challenges faced by the broker-dealer participants in OTC Link ATS and the new OTC Link ECN and these seem unlikely to reverse. However, OTCM’s development of new products such as the ECN and prospectively new functionality on both the ATS and ECN should help customer retention and strengthen the competitive position of the business. Sensitivities for the business remain the risk that a competitor adopts more aggressive behaviour or that there is an adverse regulatory development that could affect the number of participants and data licence revenue.

OTCM has set out its five main objectives for 2018, demonstrating consistency and a clear focus:

Exhibit 11 sets out changes in our estimates including actual versus estimated for 2017 and fresh estimates for 2019. The variations for 2017 and 2018 in revenue and PBT are minor, while EPS for 2018 increases substantially reflecting lower prospective tax rate.

At the year end the cash position stood at $23.7m compared with $25.0m at end 2016. Operating cash flow was up from $15.7m to $16.5m with increased capital spending and returns to shareholders being the main offsetting factors. Capital expenditure and spending on intangibles for 2017 nearly trebled to $1.2m with the increase including $440,000 invested to re-platform the OTCM website and $100,000 for the launch of the OTC Link ECN. Returns to shareholders (dividends and share buybacks) increased by 5% to $15.4m. Otherwise there was a small allocation of cash ($0.5m) as collateral held at clearing organisations against obligations arising from the operation of OTC Link ECN, which acts as agent in transactions (OTC Link ATS is not an intermediary, instead transmitting messages facilitating trades between subscribers). OTCM indicates that even were the ECN to scale up considerably, the level of cash restricted is unlikely to increase proportionately. We have assumed small additional amounts are restricted in this way within our forecasts.

We have updated our comparative P/E table including global exchanges and information providers, MSCI and Markit, which can be seen as having some parallel with OTCM’s subscription-based fees and market data income (Exhibit 12). As in previous reports, OTCM trades on multiples below or similar to the consensus averages for the exchanges and information providers. On a longer view, success in OTCM’s mission to provide painless access to capital markets for new corporates, particularly those using online capital-raising techniques, could be a key driver of earnings and valuation. Potentially a medium-term source of positive surprise would be increasing reputation and traction with corporates as OTCM’s premium markets gain Blue Sky recognition from an increasing number of states.

Using a discounted cash flow model based on our current estimates and adjusting assumptions to match the current share price ($27.40, 20 March 2018), one combination producing this value would be a discount rate of just over 10%, a long-term growth rate of 4% and a terminal OCF multiple of 16.5x (compares with a current year value of 17.4x). A sensitivity table below shows how the DCF valuation changes with discount rate and growth assumptions. Reflecting the roll over to a new year since we last published and taking into account peer multiples, we increase our fair value estimate from c $26 to c $29.