OTC Markets Group — Keeping focus amid near-term uncertainty

Exhibit 1 puts OTCM’s 2019 results in a longer-term context. It shows the evolution of revenue by segment and operating margin since 2009. Key points to note here include the overall growth in revenues (CAGR 11%), the increase in contribution from the Corporate Services segment and an increase in operating margin, despite the recent reduction that reflected investment in people, IT and other costs. The 25% compounded growth in Corporate Services over the period reflects the successful development of the OTCQX and OTCQB premium markets with a larger number of corporate clients and increased fee levels. Market Data and Licensing (9% CAGR) has benefited from a rise in subscriber numbers and a continuous development in the range of products offered. While OTC Link revenues have shown modest growth (2% CAGR) against the background of challenging conditions for broker-dealers, the group’s investment in infrastructure and strengthening of its offering (including the launch of OTC Link ECN in 2017) has helped sustain the absolute level of revenue for the segment.

Exhibit 2 provides a summary of the Q419 and FY19 results compared with prior periods. As noted previously, the overall increase in revenue for FY19 was 6%, which was outpaced by a 13% increase in operating expenses, leaving net income down 8% year-on-year.

An analysis of operating expenses is given in Exhibit 3. A 6% increase in headcount (to 99) together with increases in base salaries, bonus awards, share-based payments and healthcare costs contributed to the overall increase of 13% in compensation costs (to $27m). The 15% increase in IT costs reflected support for the newly acquired activities of Virtual Investor Conferences and Qaravan (provider of web-based data and analytics to banking and finance professionals) together with the updating of data centres, security enhancements to meet regulatory requirements and support for other parts of the business. The benefit of persistent investment in the company’s IT infrastructure is evidenced by the fact that 2019 represented the fifth year in a row of 100% uptime for the core systems. The depreciation and amortisation charge was boosted by depreciation of investments in fitting out the new office in New York, capitalised costs of re-platforming the website and software assets acquired with Qaravan. The differential between one-off costs between the two years was modest.

Selected operating metrics are shown in Exhibit 4. For OTC Link, the number of active broker dealer participants was down modestly year-on-year and sequentially but the number of ECN subscribers continued to rise (to 53) and its revenue rose from $0.9m to $1.5m. OTC Link ECN continues to seek a higher market share (noting, as in previous periods, that this may entail more aggressive pricing).

The number of Corporate Services clients increased by 8% for OTCQX with particular success in adding international clients (69) and domestic and international companies in cannabis-related activities (at the beginning of March there were 68 such companies on OTCQX). The efforts to recruit additional international clients continue helped by the sales office established in London at the beginning of 2019. The retention rate for clients on OTCQX for 2020 was lower at 92% versus 94% last year but still above the 91% seen for 2018. The number of OTCQB corporate clients fell 3% in 2019, reflecting lower sales that were constrained by a further tightening of eligibility standards and a less active cannabis sector compared with 2018.

Market Data and Licensing saw the number of professional users increase by 4% over the year while the number of non-professional users, which has been more volatile, was down by 13%. Important contributors to revenue growth in the division were sales of compliance analytics and compliance data products. The number of market data compliance file users increased from 28 to 41 during the year.

On the regulatory front, the number of states granting Blue Sky recognitions1 stood at 36 and 33 for OTCQX and OTCQB respectively up from 34 and 31 at the end of 2018. There were no additions in Q419 but the Virginia legislature has passed legislation that would provide a pathway for OTCQX to gain exempt status. Among other initiatives, OTCM has advocated wider availability of employee stock ownership plans (ESOP) schemes and supports the recently introduced ESOP Fairness bill to enable companies, such as those traded on OTCQX, to offer employee stock ownership plans.

OTCM notes that the initial phase of Consolidated Audit Trail (CAT) obligations for OTC trading are due to take effect in April 2020. The prospective costs for firms such as OTC Link to fund the database of trading activity have yet to be determined and there are also costs involved in building the capability to submit trade reports to meet CAT requirements.

In October 2019 the SEC published a policy statement on market structure innovation for Thinly Traded Securities seeking proposals to improve secondary market liquidity. Potential changes mentioned by the SEC included termination of unlisted trading privileges (UTP) or exemptive relief from Regulation NMS with the intention of countering fragment of liquidity in thinly traded stocks across different trading platforms. In response, Nasdaq has submitted a proposal for a market tier for smaller, less liquid stocks traded on its platform where issuers can choose to trade on one exchange (terminating UTP for these stocks). OTCM has not formally commented on the proposal yet but sees itself as providing a leading venture market that is well placed to provide liquidity to smaller, micro cap or venture stage companies. As such, it does not think the suspension of UTP is the right direction to take but will provide a broader response in due course. Were the Nasdaq proposal to be implemented, it could increase competition for the listing of some of OTCM’s clients.

In our last note we discussed the Concept release on Exchange Act Rule 15c2-11 (dealing with information requirements before quotes may be published on interdealer quotation systems such as OTC Link ATS). OTCM has submitted comments to the SEC supporting the release’s recognition of OTCM’s disclosure standards and has already initiated an Expert Market for securities that are restricted from public quoting or are not suitable for non-professional private investors.

We set the scene by showing the recent performance of selected equity indices. This shows the marked impact of recent sharp falls in equity markets with the OTCQX Composite index showing performance of broadly the same profile as the S&P 500 and Nasdaq Composite indices. The venture indices shown (OTCQB and S&P TSX Venture) have generated significantly negative returns, which may reflect lower investor appetite for the potentially higher risk of smaller cap/low liquidity stocks. This was present before the coronavirus-related setbacks but has been accentuated by recent moves.

As indicators of corporate and market confidence and activity, Exhibits 6 and 7 show the trend in IPOs on Nasdaq and the Canadian TSX and TSX Venture markets. The Nasdaq and TSX number of new issues were resilient in 2019 but TSX Venture IPOs and, not shown, AIM in London (-65%) were both notably weak. Given a stable macro background there might have been some hope for an improvement in the venture markets this year but with the sharp falls in market levels year to date and uncertainty over the prospective coronavirus impact, there is likely to be a hiatus in activity.

For OTCM it is early to gauge the potential impact. As highlighted earlier, the high proportion of its revenues (over 80%) earned on a subscription basis provides a good degree of stability in periods of volatility such as that being experienced currently. Nevertheless, it is reasonable to expect an impact on levels of trading activity, which may increase initially but then subside. For a period it may also prove more challenging to sign up new clients for both Corporate Services and Market Data Licensing. On a longer view, the potential to expand the number of international corporate clients appears substantial and OTCM remains well placed to provide secondary trading venues to corporates raising capital through online funding or crowdfunding.

Changes to our 2020 estimates and the new estimates introduced for 2021 are summarised in Exhibit 8. We have made a modest overall adjustment to our revenue assumption for 2020, reflecting the subscription nature of most revenues. While this appears limited in the context of substantial equity market volatility, it is supported historically by the resilience of OTCM’s results through the 2008/2009 financial crisis and subsequently, although we note that fee increases have been a positive driver at various points in this period.

We have reduced our expectation for OTC Link such that growth in 2020 is only expected to be 1%. There are small reductions for the other two segments, leaving overall revenue growth at 4%. For the following year we assume market confidence will improve, even if there are still economic consequences from the pandemic. We are therefore assuming overall revenue growth of 6.5% for 2021. The 2020 assumptions feed through to a 5.6% reduction in estimated fully diluted EPS. As an illustration of a more pessimistic scenario, if 2020 revenues were unchanged from last year we estimate the somewhat higher cost base resulting from increased headcount, IT and other costs could mean earnings of between 1.17c and 1.21c compared with 1.25c for 2019.

OTCM’s balance sheet remains strong with cash of $28.2m at the end of 2019 or $29.8m including restricted cash.

We have updated our table showing comparative P/E ratios for information providers (MSCI and Markit) and global exchanges. Since our note in November, the 2020 multiples are all lower; OTCM’s prospective multiples sit below the exchanges and, more noticeably, the information providers, a similar relationship to that seen in November 2019.

The sensitivity of our discounted cash flow valuation to different terminal free cash flow multiple and long-term growth assumptions is shown in Exhibit 10. The model assumes a discount rate of 10%, factoring in our explicit forecasts for FY20/21, together with an assumption of FY22–23 cash flow growth of 5%, long-term growth of 4% and a terminal cash flow multiple of 15.5x, compared with c 17x for FY19 and 14x for FY20e. Reflecting the estimate reduction for FY20 outlined earlier, a new forecast for FY21 and the assumption of a lower terminal cash flow multiple (aligned with lower FY19/20 multiples), the resulting central value is $32.0 compared with $37.0 per share previously. Taking the current share price, based on our other model assumptions, this would be consistent with a terminal cash flow multiple of below 10x and long-term growth of 3%, which is likely to be seen as conservative once nearer-term macro concerns begin to ease.