OTC Markets Group — Growing revenues and investing for the future

OTCM reported third quarter revenue growth of 8% compared with Q316, while operating expenses increased by 10%, in part reflecting increased investment in personnel and technology to support existing and new services for customers. This left the operating profit margin down one percentage point and profit before tax up 4% compared with the prior year period.

Key points from the results are highlighted below (comparisons with Q316 unless stated) with a summary of quarterly figures given in Exhibit 1.

Our next table (Exhibit 2) shows operating data for the three business segments. For OTC Link ATS the overall number of securities quoted was modestly higher but, more importantly, the number of broker-dealer participants has continued to contract either through withdrawal from the market or consolidation. This reflects an environment of lower volumes, margin contraction arising from increased automation and rising regulatory costs. Further, while the dollar value of trading increased compared with the prior year period, the flat daily fee per stock for quotation or messaging combined with a concentration of activity within a small number of stocks meant that revenues did not benefit. These factors combined to produce the 5% decline shown above for segmental revenues in the quarter.

Corporate Services data show the reduction in the number of OTCQX clients (8%) compared with last year, with the main factor here being the downgrading of 54 companies for compliance reasons. While negative for near-term revenues, OTCM sees enhancing the standards for its OTCQX market as important in increasing its reputation and recognition by state regulators. This should in turn be positive on a longer-term view. Sales have been stronger year to date with a total of 58 new companies added for the first nine months compared with 40 in the same period in 2016. OTCQB has continued to make net additions to its corporate client list (+6%) reflecting strong sales and reduced churn.

Within Market Data Licensing professional user numbers were down by 7%, which OTCM notes probably represents normal fluctuation due to user audits and numbers reported by redistributors. As in Q217, the number of non-professional users increased strongly against the prior year period. Sequentially, there was a marked reduction, suggesting this part of the user base may prove more volatile than professional users, but it accounts for less than 10% of segment revenues compared with over 50% for professional users.

In its Q3 release OTCM made a number of announcements that relate to its long-term aim to increase the reputation of its premium markets, and provide a range of services to its users, corporate or broker dealer. These included the addition of two further states that recognise OTCM markets for Blue Sky purposes, new participants in the Transfer Agent Verified Shares Program, the establishment of alliances with the Canadian Securities Exchange (CSE) and Issuer Direct Corporation (ISDR) and the expected launch of OTC Link ECN (Electronic Communication Network) before the end of the year. Further, confirming the continuing work to maintain the resilience of its system, OTC Link ATS recorded a further quarter of 100% uptime during trading hours, important given its status as a Regulation Systems Compliance and Integrity (SCI) entity.

Exhibit 3 shows the list of states with Blue Sky recognition for OTCM markets. During the third quarter two more states, Hawaii and Pennsylvania (the latter under existing law), joined the list. This brought the number of states where OTCQX securities were qualified for secondary trading at the end of October to 27 and for OTCQB to 24. There was also encouraging news in that the North American Securities Administrators Association (NASAA) is planning to issue a model rule recognising OTCQX and OTCQB markets under a manual exemption. While the model rule has yet to be issued and the impact of having it available is uncertain, it may encourage states where resources to deal with such issues are constrained to take the necessary steps to give recognition.

The Transfer Agent Verified Shares Program assembles data on share issuance, increasing transparency in relation to dilutive share issuance, for example. The number of participating share transfer agents has increased from 12 as reported at the Q2 stage to 15.

The strategic alliance with the Canadian Stock Exchange means that international corporates can seek a Canadian listing and raise funds through CSE and then develop secondary trading in the US through OTCQX or OTCQB in a cost-effective manner.

The alliance with Issuer Direct means that corporate clients of OTCM can more easily access the communications and compliance services offered by ISDR, helping to make being public “less painful”, particularly for smaller companies that may not wish to devote the resources that would otherwise be required to these functions.

The launch of OTC Link ECN will provide an additional option for OTCM’s broker-dealer subscribers by providing an anonymous trading platform with a matching engine and liquidity router for selected OTC equities. We assume broker-dealers with their own internal matching systems are unlikely to divert substantial business to the new ECN but will continue to seek the liquidity provided by market makers through the existing OTC Link ATS quotation platform. However, the ECN will provide an alternative for other participants. OTCM notes that the ECN has been created in a cost-efficient manner and that it has interest from some subscribers but notes that it is not possible to anticipate the rate of adoption. From a competitive perspective, Global OTC (subsidiary of NYSE) has recently adopted a fully attributable quoting model with maker-taker pricing under which incentives are offered to liquidity suppliers. This has yet to have a noticeable impact on Global OTC’s market share, which has fluctuated between 7.4% and 11.9% year to date (latest reading c 9%). It remains to be seen what pricing model OTC Link ECN will adopt.

We monitor IPO volumes for Nasdaq and the Canadian TSX and TSX Venture exchanges as indicators of the health of issuer activity in North America. As Exhibits 4 and 5 show, the first nine months (Nasdaq) and year to October (TSX markets) have shown a healthy trend with the number of IPOs on the Canadian markets already outpacing 2016 by a comfortable margin.

As with Nasdaq, in the UK the run rate for AIM is ahead of the prior year period (Exhibit 6). Despite geopolitical uncertainties globally, the economic background has remained positive and global GDP forecasts have followed an upward trend. This has probably underpinned the strongly positive market performances shown in Exhibit 7.

While this creates what would normally be seen as a positive background for new listings, there have been reports of a number of IPO cancellations seemingly reflecting a lack of investor appetite. Perhaps high valuations (for example in the US the cyclically adjusted price earnings ratio is standing 25% above its 10-year average) and unusually low volatility, as represented by the VIX, are restraining factors here.

Exhibits 8 and 9 set the recent data user figures in a longer-term context and also give figures for UTP (Nasdaq). This shows that OTCM still has a small share of the market compared with UTP (Q317 7.3% of professional users), suggesting the potential for gains assuming the premium markets can continue to broaden their client base and increase their profile.

For OTC Link ATS, the trading environment seems likely to remain challenging in the near to medium term as broker dealers continue to face unfavourable trading conditions. For the moment we have not factored in an explicit impact from the launch of OTCM’s ECN and the main near-term factor that could produce a marked uptick in this area would be a volatility-driven increase in trading levels.

More broadly, OTCM continues to work on making its markets more business friendly and transparent for investors. Efforts to encourage further states to grant Blue Sky recognition are being maintained. Even if there is no direct linkage to revenue generation there should be reputational benefits as Blue Sky recognition is extended. The company remains optimistic on the broadening of the universe of potential corporate clients as crowdfunding and online funding gain traction following the JOBS Act (including Regulation A+). To this end OTCM is encouraged that the House of Representatives passed the Improving Capital Access Act in September; the next step will be consideration of the bill by the Senate. Passage into law would allow SEC reporting companies to offer securities under Regulation A+.

There are only modest changes to our estimates following the Q317 results. Within revenues we have increased our estimate for Corporate Services for FY18, reflecting the implementation of a 20% fee increase for OTCQB companies. Against this we have adopted a slightly more conservative assumption for OTC Link ATS given the continuing reduction in the number of active participants. Operating expense estimates are marginally increased to allow for headcount and other spending to support new services. For FY17 our pre-tax profit estimate falls slightly but earnings per share rise, benefiting from the one-off tax reduction seen in Q3. FY18 sees a smaller benefit from ongoing tax savings. Our dividend assumptions are reduced to reflect the payments already announced for FY17 and hence a lower base for FY18.

We have updated our usual 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 11). As previously, OTCM trades on multiples below and similar to the consensus averages for the exchanges and information providers for FY17 and FY18 respectively. Changes in the level of trading activity prompted by market volatility could help near-term revenues for OTC Link ATS, but on a longer view the main potential drivers of positive earnings surprises and hence valuation would be a broadening population of potential corporate clients and progressive increases in the reputation and traction of the OTCQX and OTCQB markets, as discussed above.

Using a discounted cash flow model based on our current estimates and adjusting assumptions to match the current share price ($24.5 on 15 November 2017), one combination producing this value would be a discount rate of 10.5%, a long-term growth rate of 3.5% and a terminal multiple of 16.5x (compares with a current year value of 16.9x). A sensitivity table below shows how the DCF valuation changes with discount rate and growth assumptions. Given the limited change in estimates and the similarity of rating relative to peers, we retain c $26 as a fair value estimate.