OTC Markets Group — Focus remains on long-term value

A summary of Q420 and FY20 profit and loss figures is given in Exhibit 1 with comparative figures for Q419, Q320 and FY19 shown. We pick out key points below (comparisons are between FY20 and FY19 unless stated).

Exhibit 2 shows an indicative subdivisional analysis of gross revenue based on management commentary in the FY19 and FY20 reports. The most salient point is the jump in revenue for OTC Link ECN resulting from both the volatility in equity markets and a continued increase in participants. It accounted for 7% of gross revenue but netting off transaction-related expenses, which primarily relate to this activity, would leave its share of total net revenue after transaction costs at just over 3%. In Market Data Licensing, the revenue increase for professional user licences was the main absolute contributor to growth. Non-professional users generated a 35% increase in revenue, but this was from a substantially lower base, reflecting the lower subscription cost per customer. The main Corporate Services revenue components, OTCQX and OTCQB, were relatively stable against a challenging market background, although a lower average corporate client count meant OTCQB revenues were down 4%. This was more than offset by other activities, notably Virtual Investor Conferences, which recorded very strong growth, hosting 27 conferences in the year with 387 companies participating (prior year 18 and 213 respectively).

Exhibit 3 sets out the changes in operating expenses between FY19 and FY20. As noted, the main driver was the increase in compensation costs, which reflected a combination of base salary (4%), bonus (13%), share-based expenses (14%) and headcount increases (from 99 to 102 at the respective year ends). The increase in professional and consulting costs was mainly linked to OTC Link ECN clearing and regulatory costs.

Exhibit 4 collates operating and related revenue data showing year-on-year and quarter-on-quarter changes. Under the OTC Link heading, increases in trading volumes are substantial for each of the market segments with OTCQX most marked. For Corporate Services, the second-half pick up in new client sign-ups in the second half is evident in the quarter-on-quarter net increase in OTCQX and OTCQB client numbers. The rise in non-professional market data subscribers is striking and reflects the increase in retail investor activity seen in recent periods. Historically the number of subscribers has been quite volatile, and it remains to be seen whether the change in retail investor activity is part of a longer-term trend.

Turning to regulatory developments, the SEC’s final rule amending Exchange Act Rule 15c2-11 was published in September last year and has a compliance date of 28 September this year. As a reminder, Rule 15c2-11 deals with information requirements before quotes may be published on interdealer quotation systems such as OTC Link ATS. Positively, the amended rule recognises OTCM markets’ disclosure standards and OTC Link ATS is permitted to act as a qualified IDQS (interdealer quotation system) reviewing disclosure to determine whether a security is eligible for public quoting. This will enable it to streamline onboarding of securities to OTCM’s 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. OTCM notes that it does not expect the disclosure rules for companies on its OTCQX, OTCQB and Pink Current and Limited Information tiers will change materially. In a further development in December the SEC published a proposed exemptive order that would, subject to approval, allow OTC Link to operate an Expert Market for companies that do not meet the information requirements allowing sophisticated or professional investors to continue to trade in the securities. The group is focused on successful implementation of the amended rule ahead of the compliance deadline.

The initial phase of Consolidated Audit Trail (CAT) obligations for OTC trading began in June 2020 with subsequent obligations taking effect this year, beginning in April. The prospective costs for firms such as OTC Link LLC and other FINRA broker dealer members to fund the database of trading activity have yet to be established and there are also costs involved in building the capability to submit trade reports to meet CAT requirements.

OTCM reported that it filed with the SEC in late 2020 to operate a third ATS alongside OTC Link ATS and OTC Link ECN. The two existing platforms are complementary, with OTC Link ATS providing a network to publish quotes and to facilitate trades between subscribers, while OTC Link ECN operates an anonymous matching engine and acts as an order router, functioning as the execution party on an agency basis. The proposed new ATS, OTC Link NBQ, will provide alternative functionality to broker dealers enabling electronic matching and execution, but with full disclosure rather than anonymity and allowing distribution of full depth of book data rather than top of book alone as at OTC Link ECN. OTCM expects to launch OTC Link NBQ in the first half of 2021.

OTCM continues to work towards increasing regulatory recognition for its markets including the number of states granting Blue Sky recognitions for OTCQX and OTCQB (unchanged at 37 and 33 respectively).

Our first background table shows recent performance from a selection of equity indices (Exhibit 5). All have shown positive moves over all the periods shown, reflecting the recovery seen in markets as they have reacted to the development of the pandemic and the implementation of countermeasures. The OTCQX and OTCQB indices have shown strength relative to the S&P 500 and Nasdaq indices, perhaps reflecting a rotation towards smaller cap and more economically sensitive sectors; the TSX Venture market has shared in this relative strength.

In Exhibit 6 we show the readings from State Street Investor Confidence Index from just before the global financial crisis in 2008/09. This indicator tracks changes in institutional investor holdings of risky versus safer investments. On this measure, the level of confidence bounced following the financial crisis, later peaking in 2015 then declining to a lower level in 2018/19 coinciding with global trade tensions, followed by the pandemic in 2020. Confidence did recover quite sharply following the initial onset of the pandemic and then fluctuated until it was boosted by more encouraging news relating to vaccines that may curtail the impact of COVID-19.

The Economic Policy Uncertainty Index shown below is another indicator of the environment for corporate decision-making. The index component selected here reflects daily newspaper coverage related to economic uncertainty and shows the substantial impact of the pandemic compared with the global financial crisis, for instance. Reflecting the nature of its compilation, the index does show a more severe spike with the arrival of the pandemic than the investor confidence index. The index has moved significantly lower, but still remains at a relatively high level in relation to the history shown.

Next, we show the trends in numbers of IPOs on the Nasdaq, TSX and TSX Venture exchanges. In the third and fourth quarters of last year the number of IPOs on Nasdaq bounced strongly (Exhibit 8), up 156% and 184% y-o-y respectively. TSX IPOs in 2020 were up 32% by number and 328% by funds raised. The TSX Venture exchange saw a 46% drop in the number of IPOs, but a 134% increase in funds raised. For the first two months of 2021 the pattern for these markets was mixed with IPO numbers down 11% for TSX and up 29% for TSX Venture; in terms of IPO money raised the trends were reversed, with TSX up 134% and TSX Venture down 47%. The Nasdaq data points to a release of pent-up activity following equity market strength and growing anticipation of an easing of the pandemic. On the other hand, the TSX numbers suggest a more varied picture depending on company size and sectoral rotation in markets.

Looking at the trend in the number of corporate client additions for OTCM itself, Exhibit 10 sets out the figures since Q119 for both OTCQX and OTCQB. This shows the relatively subdued rate of new additions in the first quarter of 2020 as the pandemic took hold with a recovery in the remaining quarters. OTCQX client renewal is at the beginning of the calendar year while for OTCQB client renewal is annual or semi-annual, based on when companies originally signed contracts, and renewals are spread broadly evenly between quarters. Using the figures from the table, the rate of cancellations and downgrades in FY20 expressed as a percentage of opening client numbers was 19.7% for OTCQX and 25.8% for OTCQB, moderately below and above the figures for FY19. Assuming the rates of cancellations and downgrades remain close to the range seen in these years and market conditions allow the H220 improvement in new client additions to be maintained, then prospects for growth in the corporate client base will be good. Certainly, the current year has started well with OTCQX’s annual retention rate up from 92% in January 2020 to 94% for January 2021 and the company reports more broadly that it has continued to see an encouraging trend in terms of new sales and has a strong pipeline of prospects. The group has a particular focus on continued growth in the number of international issuer and community bank clients.

For OTC Link the high level of trading seen in FY20 and year to date may not be sustained, but on a longer view OTCM will continue to work on attracting new subscribers and adding additional functionality as exemplified by the proposed launch of OTC Link NQB.

Market Data Licensing is continuing to develop its product offering with a focus on compliance data including the Canari compliance tool and roll out of the Blue Sky compliance secondary trading data product, which was launched in September last year.

OTCM has highlighted its three strategic priorities for 2021 as:

Headline figures from our revised estimates are shown in Exhibit 11 with further detail in the financial summary (Exhibit 13). For FY21 our revenue estimate is increased by 5% including a 9% increase in the estimate for OTC Link, reflecting the high levels of trading activity that have persisted at the start of the year. We nevertheless allow for some normalisation of activity, assuming a year-on-year decline of 12% in revenue for the division with a further 7% reduction in FY22. For FY21 we expect Corporate Services to contribute the largest increase in revenue, reflecting price increases that come into effect together with the assumption of a better year for net corporate client additions, as mentioned earlier. Our revenue growth assumptions for Market Data Licensing (2% and 3% for FY21 and FY22) are tempered by the thought that moderation in market trading levels could affect subscription levels but may prove conservative. With expense assumptions little changed, our diluted EPS estimate for FY21 increases by 9%.

OTCM’s balance sheet remains strong with no debt and cash of $33.7m or $35.3m including restricted cash. Operating cash flow for FY20 was $26.0m, of which $1.0m was allocated to capital expenditure (IT infrastructure), $14.6m to dividends and $3.5m to purchases of treasury stock. In addition to the cash held, OTCM has an undrawn line of credit of up to $1.5m available.

An updated version of our comparative P/E table is shown in Exhibit 12. This includes information providers MSCI and Markit together with the average multiples for global exchanges. OTCM shares are trading on prospective P/Es similar to the average for exchanges and noticeably below those for information providers. To some extent the multiple applied to prospective earnings may be limited by the relative illiquidity of OTCM shares and to exposure to smaller companies through its venture market. Positively, an environment of economic recovery may favour some of the smaller company client base, and the group is financially strong and has a high proportion of subscription-based revenues.