OTC Markets Group — Gaining domestic and international traction

OTCM’s mission is to create better informed and more efficient financial markets. Sharing information on open networks creates transparency for investors, while investment in technology ensures that broker dealers are reliably connected, providing quotes on over 10,000 companies. For international and domestic corporate clients, OTCM’s markets are tiered by standards of disclosure (OTCQX, OTCQB and Pink) and provide access to public trading in the US at a cost-effective price, compared with a listing on a registered national securities exchange such as Nasdaq. Approximately 87% of OTCM revenues are earned on a recurring, contractual basis rather than being transactional in nature and include annual fees paid by corporate clients on the premium OTCQX and OTCQB markets, broker-dealer subscription fees and data fees for access to pricing and other information channelled through distributors such as Bloomberg. Between 2007 and 2017, revenues grew at a compound rate of 12%.

Comparing OTCM with global exchanges and leading information providers (given their subscription-based revenues), we note that it trades on slightly below the P/E averages for these peers for FY18 and slightly above for FY19, and well within the range of valuations for these periods. Based on our DCF analysis, assumptions giving a valuation in line with the current share price would include a discount rate of 10%, long-term cash flow growth of 4% and a terminal cash flow multiple of 17.2x. Taking our peer comparison and DCF model into account, we have increased our fair value from $31 to $34.

We have increased estimates for FY18 and FY19 modestly following a similar increase after the Q218 results. At the EPS level, the increases are 3.8% and 1.5%, respectively. In terms of revenue, the main driver for the current year increase is the better than expected outcome in the OTC Link division, where increased equity market volatility and increased traction for the OTC Link ECN have been the key contributors.

From a macro perspective, the economic background will have a positive or negative influence on equity market trends including: investor sentiment towards international and venture equities, the flow of venture company IPOs, corporate interest in accessing liquidity in the US market, and volatility and trading volumes. A range of micro factors apply specifically to OTCM and its sector, and points to consider here include the following:

OTCM began to take its current form in 1997 with the purchase of the National Quotation Bureau (NQB) by CEO R Cromwell Coulson and a group of investors. NQB published the Pink Sheets, which were an aggregation in printed form of broker dealer quotes for securities traded off-exchange. Following the purchase, the new management team began the process of applying technology to the task of aggregating liquidity and increasing transparency. A platform providing real-time quotes was launched in 2003 and evolved into the current SEC-registered OTC Link ATS. Another platform, OTC Link ECN, was launched in 2017, providing dealers with alternative features including an order-matching engine – as opposed to the ATS, where quotes are displayed and messages delivered, enabling direct trades between dealers.

OTC Link ATS carries quotes in over 10,000 companies and has 97 active broker-dealer participants. In order to help investors assess risk exposure, the companies are organised into three tiers, with membership of each subject to levels of disclosure differentiated in terms of timeliness, quality and quantity of information provided.

In Q318, approximately 87% of OTCM revenues were contract-based and of a recurring nature, reflecting the subscription model that applies in the majority of its activities. As examples, OTC Link earns monthly licence, subscription and connection fees from broker-dealers to use OTC ATS Link; Market Data Licensing distributes data through companies such as Bloomberg, Thomson Reuters and Interactive Data Corporation in exchange for end-user subscription fees; and Corporate Services earns annual subscription fees from companies that join OTCQX and OTCQB markets.

Revenues grew at a compound annual rate of 12% between 2007 and 2017, with the most rapid growth seen in Corporate Services, which accounted for 41% of the total in 9M18 (Exhibit 1).

In Q318, OTCM recorded gross revenue growth of 8.4% y-o-y. A stepping-up of trading volumes on OTC Link ECN, launched in December 2017, fuelled a near-25% increase in fees and rebates paid, which meant that net revenue growth was slightly lower at 7.7%. Cost growth was held to below 4%, allowing pre-tax profits to increase by 16%. The reduction in US corporate tax rate and a higher research and development tax credit claimed in respect of the 2017 tax year resulted in a lower tax rate of 18%. This left net earnings and diluted EPS more than 25% ahead of the prior-year period and 10% above the second-quarter level.

The quarterly dividend (40th consecutive payment) was maintained at 15 cents following an increase from 14 cents in the second quarter. A special dividend of 65 cents was announced, five cents above the prior-year level, an increase of 8%.

We have included the divisional analysis of revenues in Exhibit 2 and added subdivisional figures derived from management commentary in Exhibit 3. Apart from OTC Link ECN, the subdivisional revenue figures are based on figures given for absolute and percentage changes and are therefore indicative, given the potential for rounding errors.

As in the second quarter, OTC Link generated the fastest growth, at 16%, followed by Corporate Services and Market Data Licensing. As can be seen in Exhibit 3, the increase in activity on the ECN accounted for the majority of growth for the OTC Link division. Since launch, the ECN has enabled 29 existing OTC Link ATS subscribers and added seven new users. Otherwise, the division benefited from higher messaging volume associated with more active markets, reflecting volatility and interest in cryptocurrency and cannabis-related securities. The number of broker-dealer subscribers increased slightly, but this was offset by a reduction in the number of users of OTC Dealer software and individual connection fees.

For the Market Data Licensing division revenues (+5%), the main positive drivers were data licence and end-of-day pricing products, which both benefited from price increases and from new sales and higher reported users, respectively. These gains substantially outweighed lower advertising revenue following difficulties in integrating a third-party provider with the new OTCM website (this has now been largely resolved).

Corporate Services revenues increased by 9% including increases of 10% and 11% for OTCQB and OTCQX, respectively. Both markets benefited from a higher average number of companies, resulting from strong new corporate client wins. For OTCQB, a higher rate of client company retention and price increases for renewing subscribers at the beginning of 2018 were additional positive factors. OTCQX experienced a lower rate of compliance-related downgrades and also accrued accelerated revenues arising from M&A and when companies graduated to exchanges or cancelled for other reasons.

Exhibit 4 provides a summary of OTCM’s operating data and derived revenue measures. We highlight the following points:

OTCM has maintained its strategic emphasis on providing data-driven transparency in its premium markets. In addition to refining rules for its premium markets, it has taken steps to increase the availability of information for investors. These include its Transfer Agent Verified Shares Scheme, launched in 2016, that provides timely information on share issuance and share count, helping to alert shareholders to potential dilution of their interest. The number of agents participating has risen progressively and there are now 30 (22 at the time of the Q218 report), giving coverage of about 96% of companies on the OTCQX and OTCQB markets. OTCM also introduced stock promotion and shell flags recently and has added them to compliance data files that compliance departments can use to monitor risks. OTCM has now extended this by introducing a Small Cap Listed Compliance product, which provides a framework for monitoring data across both the listed and OTC small cap equity markets. The company reports that, at the beginning of October, 27 companies were subscribing to its compliance data or analytics products including many of the largest banks, custodian and clearing firms: an encouraging indicator that subscription to these services is becoming a default option for such companies.

The number of states that grant Blue Sky recognition to OTCQX and OTCQB has continued to tick up, with Missouri and Oklahoma added since the Q218 report, taking the total recognising OTCQX to 33 and OTCQB to 30 (see Exhibit 5 below). OTCQX coverage now includes states accounting for about 50% of the population in the US. Michigan is in the process of considering giving recognition and, were it to do so, this would increase the population coverage to 53%.

The North American Securities Administrators Association (NASAA) in July announced a model rule proposal for states to employ that would have the effect of granting OTCQX/OTCQB recognition. There was a period for comments that closed in August with only supportive submissions received. OTCM has noted that adoption of the model rule would be likely to facilitate a number of states moving towards Blue Sky recognition of its markets.

We start by considering the equity capital markets background as an indicator of the background for OTCM. While global economic forecasts have only seen small downward adjustments in recent months, commentators such as the OECD highlight increased uncertainty relating to trade tensions and normalisation of monetary policy, notably in the US. These factors are likely to have contributed to the recent correction in equity market prices, which is evident in the negative returns over three months for a range of indices, shown in Exhibit 6. Looking at the year-to-date figures, OTCQX and OTCQB indices have been significantly weaker than the broad US indices, which can be seen as reflecting a combination of the small- and mid-cap and Canadian components of its constituents: areas where weakness has been more marked. The strength of the US dollar in this period will also have been a factor influencing the US$ prices of international stocks in the OTCM indices.

We monitor the number of IPOs on Nasdaq, the Canadian TSX and TSX Venture exchanges as an indicator of corporate and market confidence and activity. For Nasdaq, the number of IPOs to end-September was 66% ahead of the same period last year, while on the Canadian exchanges TSX IPOs were just ahead and TSX Venture was running at more than double the number in the prior-year period. While these appear to be positive indicators, the increase in equity market volatility in October may mean corporate activity levels are more subdued in the near term and, arguably, this could also influence the timing of OTCM’s sales pipeline.

OTCM has highlighted success in winning international clients for its premium markets in the latest quarter. Its OTCQX and OTCQB markets can offer a complementary service facilitating cost-effective access to a US investor base and enhanced liquidity for international companies with primary listings elsewhere. The current geographical make-up of OTCQX and OTCQB indices is shown in Exhibits 11 and 12.

This shows the significant share of Canadian companies in both indices (helped in part by OTCM’s partnership with the Canadian Securities Exchange) and that international securities as a whole already account for 65% of the OTCQX index. For both markets there would seem to be significant potential to broaden the geographical breadth of the client base over time and the group is continuing to commit resources to international marketing and has announced that it will open a small office in London to provide a base for sales across Europe. OTCM is also very active in addressing markets in Asia and Australia.

On a medium- and longer-term view, OTCM sees potential benefits from the development of online or crowdfunded capital raising facilitated by Regulation A+ and Regulation Crowdfunding. The development of online funding could create a larger pool of companies that may be attracted to OTCM’s cost-effective market offering for secondary trading. In May, the passage of the Economic Growth, Regulatory Relief and Consumer Protection Act (S.2155) is set to extend the availability of Regulation A+ to SEC reporting companies; this section of the act largely reflected OTCM’s SEC petition for rulemaking. SEC rule changes that will influence the impact of the act are still awaited.

Next, we look at the trends in subscribers to market data; Exhibits 9 and 10 show figures for professional and non-professional users for OTCM and Nasdaq. Encouragingly, the number of professional users (the larger source of revenue for the Market Data Licensing division) has increased from the first quarter of this year, although it should be remembered that user numbers have tended to fluctuate on a quarterly basis, partly driven by audits of distributor subscriber numbers. The non-professional user numbers have risen y-o-y and significantly since 2012, albeit with variations, as shown in Exhibit 10. The small size of OTCM’s user base relative to Nasdaq underlines the opportunity to expand this source of revenue as the company continues to build its corporate client base and strengthens the reputation of its premium markets.

Other points we would highlight when considering the outlook for OTCM are as follows:

Exhibit 13 summarises the changes in key numbers within our FY18 and FY19 estimates following the Q318 result. There is a modest revenue increase, mainly reflecting the better than expected result from OTC Link. We have assumed the 18% Q3 tax rate increases to 20% in subsequent quarters, so the EPS estimate increase is more muted in FY19 than for FY18.

Cash available for operations at end-September stood at $26.1m compared with $25m at end-June and $23.7m at end-2017. This excluded restricted cash (held as clearing collateral) and including this total cash stood at $27.8m. For the year-end, we estimate cash and restricted cash of $22.7m following payment of the special dividend and an increase in capital spending related to the prospective office move. As mentioned in our last note in August, part of this cash together with borrowing could provide the means for a significant acquisition should a suitable opportunity arise in an area serving OTCM’s client base in small- and mid-cap corporates.

We have updated our comparative P/E table (Exhibit 14), which includes major information providers MSCI and Markit (in recognition of OTCM’s subscription-based fees and market data exposure), together with global exchange averages and values for the S&P 500 index. OTCM trades within the range for the information providers and is trading above the FY18e and FY19e average P/Es for the exchanges (although well within the range of multiples for these companies). Given OTCM’s potential to increase its penetration with both domestic and international corporates and to leverage its liquid balance sheet, there should be good scope for positive surprises in earnings over the medium to longer term, helping to justify the current rating.

Using our discounted cash flow model to determine a set of assumptions that would match the current share price, we find that a discount rate of 10%, long-term cash flow growth of 4% and a terminal cash flow multiple of 17.1x (arguably not excessive in comparison to the current year value of c 26x) would give a valuation in line with the share price at the time of writing ($32.40, 13 November 2018). A sensitivity table shows the variation in implied valuation with changes in growth and discount rate assumptions.

Taking into account the comparative valuations shown above and the potential DCF outputs on a range of assumptions, we see a fair value of c $34 as reasonable (previously c $31).