OTC Markets Group — Update 19 April 2016

Company description: ‘Open, transparent and connected’ financial markets

OTCM’s strategy is to operate world-leading securities markets that give companies access to the large US investor base in a more cost-effective and less complex way than a traditional stock exchange listing like NYSE and Nasdaq. It has three sources of revenue: revenues from broker-dealer subscribers using OTC Link ATS; the sale of its market data directly or through redistributors; and companies joining its OTCQX and OTCQB markets or subscribing to premium services. It has a young but experienced management team. The company has successfully established the OTCQB Venture Market as the ideal public trading venue for emerging, early-stage and entrepreneurial companies.

Valuation: Upside to $23.7 per share

On a 2016 P/E basis OTCM trades in line with the S&P 500 but around 28% lower than that of market information service providers, MSCI and Markit, to whom its mostly subscription-based services can be compared. It has net cash ($23.9m at 31 December 2015) and no debt and has a progressive dividend policy. In the last two years it has paid special dividends and, barring a collapse in profits – which we do not anticipate – we expect it to continue to do so. It yields around 6.8% including the special dividend, c 3% excluding it on our 2016 dividend estimate.

Financials: Excellent growth in 2015, following that of 2014

Net income in 2015 rose 30% y-o-y, driven by a 77% rise in revenues from the corporate services business line, which benefited from more companies choosing to be included on the OTCQB Venture Market. In 2014 net income rose 40% and was driven by the company’s repricing initiative in the Market data licensing business line. The profit increases in both years were achieved after expenditure on updating its computer systems, raising compensation to remain competitive and increasing headcount. We anticipate that 2016 and 2017 will experience a slowdown in profit growth as the benefits of recent initiatives fade. However, longer term there is scope for profit growth to accelerate if online crowdfunding proves successful and the securities offered are quoted on its OTCQB market. OTCM’s business is cash generative. With $23.9m of cash on its balance sheet and no debt, we expect it to continue to pay generous dividends, including special dividends, in 2016 and 2017.

Sensitivities: Regulation, markets, technology

OTCM’s stated strategy is to operate a world-leading securities market by:

It has three sources of revenue: revenues from broker-dealer subscribers using OTC Link ATS; access to its market data directly or through redistributors; and companies joining its OTCQX and OTCQB premium marketplaces or subscribing to premium services. It believes the future of capital-raising and finance is online, data-driven and social and that its technology-based ecosystem, which has attracted broker-dealers, investors and corporations, is ideally placed to accommodate these trends.

OTCM operates three main markets:

The evolution of the number of corporate clients and the US dollar volume traded from 2013 to 2015 is shown in the following two tables.

OTCQX Best Market

The OTCQX market provides established US and global companies an informed and efficient US public trading market for their shares and ADRs without the cost and complexity of a national securities exchange listing. Companies pay a one-time application fee and annual fees on renewal; the fees are fixed and do not depend on the size of the company. The market is divided between OTCQX US and OTCQX International. At the end of December 2015 there were 424 companies traded on OTCQX Market of which 145 were from the US and 279 were international. By joining OTCQX, international companies can save money by opting out of the Sarbanes-Oxley Act and the filing demands of the Securities & Exchange Commission. Many large international companies are listed on OTCQX, including BNP Paribas, Allianz and Roche Holding. There are also a large number of small mining stocks from Australia and Canada listed on OTCQX International.

The OTCQX Banks segment is for US regional and community banks. At the end of December 2015 it contained 81 banks from 26 states (48 new banks added in 2015).

Both OTCQX US and OTCQX International have elite segments for the largest and most liquid companies (OTCQX US Premier and OTCQX International Premier).

OTCQB Venture Market

The OTCQB Venture Market provides a public trading venue for developing companies with standards that promote price transparency and facilitate public disclosure. OTCM’s ambition is for this to be the entry level market for small and start-up companies in the US and similar to other venture markets, such as TSX Venture in Canada and the AIM market in London. The eligibility criteria to be traded on OTCQB were changed on 1 May 2014 to improve the information available to investors. The changes included:

Pink Open Market

The Pink Open Market is organised into three categories based on the amount, quantity and timeliness of information made public by a company to its investors. These are:

OTCM generates most of its revenue from contract-based and recurring subscriptions. As we show in Exhibit 3 below, revenue has grown steadily since 2007 at a compound annual growth rate of around 15%. For a financial services firm operating in equity markets, this is an impressive performance. OTCM has three lines of revenue: OTC Link ATS revenue earned from fees charged to subscribing broker-dealers for access to the trading technology and usage fees based on levels of quoting and messaging; market data licensing revenue from selling market and company data to interested users; and corporate services revenues earned from companies that have their securities included on one of OTCM’s premier markets. While these lines are shown separately, it should be recognised that they are largely interdependent. For instance, a rise in the number of companies with securities quoted on an OTCM market increases the pool of potential corporate services clients and is likely to increase trading. This boosts OTC Link ATS revenues and increases the demand for data on trading and corporations, which increases market data licensing revenues.

OTC Link ATS

OTC Link ATS is operated by OTCM’s subsidiary, OTC Link LLC, a FINRA-registered broker-dealer that operates a SEC-registered Alternative Trading System (ATS). It connects a network of leading US broker-dealers who provide liquidity and execution services. It offers real-time price transparency and connectivity and allows broker-dealers to control trades and their choice of counterparty to enable them to provide best execution, attract order flow and comply with FINRA and SEC regulations. OTC Link ATS generates revenues by offering a suite of quotation and trade-messaging services.

OTS Link ATS revenue accounted for 24% of the total in 2015, which compares with around 36% in 2007. It is under pressure from a decline in the number of broker-dealers, who are suffering from lower dealing revenues and margin compression.

Market data licensing

Market data licensing revenues are earned from providing market, company and security data collected through the OTC Link ATS and Corporate services business lines to enterprise and professional and non-professional users. Most revenues are earned from sales through major financial data distributors, such as Bloomberg, Interactive Data Corporation and Fidessa. Bloomberg accounted for 12% of gross revenues in 2015 (2014:15%). This business line also generates revenue from enterprise licences with online brokerages including Etrade, Fidelity, Schwab, Scottrade and TD Ameritrade. They typically pay monthly licence fees, which vary with the type of licence (different layers offer access to different types of data and different uses such as internal only or to clients). Redistribution fees and rebates are paid to some distributors. Around 60% of revenue comes from professional licences. At the end of 2015 there were more than 20,000 professional users.

On 1 January 2014 OTCM implemented a price increase for the majority of its market data licence subscriptions. This was the first rise since 2009 and, according to management, brought fees in line with peers.

Corporate services

Corporate services revenues are generated from companies that choose to have their securities included on one of OTCM’s premier markets. All companies traded on the OTCQX and OTCQB markets pay one-time application fees and annual fees thereafter. OTCQX companies pay an application fee of $5k and a recurring annual fee of $20k ($15k until 1 January 2015); OTCQB companies pay an application fee of $2.5k and a recurring annual fee of $10k. Fees are fixed and do not depend on the size of the company.

Companies on OTCQX receive OTC Disclosure & News Service, Real-Time Level 2 Quote Display and the Blue Sky Monitoring Service, which enable companies to monitor their compliance with state Blue Sky laws. OTCQB companies acquire a package of services designed to promote price transparency and public disclosure. Pink companies pay fees only if they choose to subscribe to premium services.

As expected in a financial services technology company, the management team is young. Their average age is 40 to 50; the average for directors is 52. There is a reasonable balance between experience and fresh thought. In 1997, R Cromwell Coulson, president and CEO, led a group of investors in acquiring OTCM’s predecessor business, the National Quotation Bureau (NQB). He still owns 3.4m Class A shares (30.8% of the company) and 130k Class C shares. Beatrice (Bea) Ordonez joined as CFO in 2015 and has more than 20 years’ experience in the financial services industry, is a qualified chartered accountant (England and Wales) and for 13 years was COO and MD at Convergex Group, a global brokerage and trading-related services provider. Neal Wolkoff, former CEO of the American Stock Exchange, was named chairman of the board in August 2013.

OTC Link LLC, as well as its broker-dealer subscribers, is regulated by the Financial Industry Regulatory Authority (FINRA), the US SEC and various state securities regulators. Companies with SEC-registered securities are also regulated by the SEC. OTCM is neither a stock exchange nor a self-regulatory organisation (SRO). In 2013 the SEC designated OTCQX and OTCQB as ‘established public markets’.

FINRA QCF proposal

On 13 November 2009, FINRA filed a proposed rule change with the SEC to create a quotation consolidation facility (QCF) that would consolidate and disseminate quote data for the OTC equity market. OTCM believes adopting this could negatively affect its revenue as 17% of its gross revenues come from providing this data in its market data licensing and OTC Link ATS business lines. OTCM is considering legal action against the SEC and/or FINRA if the proposal is approved.

Regulation SCI

OTC Link LLC is designated an SCI entity. Regulation SCI, effective in November 2015, mandates, among other things, that SCI entities establish written policies and procedures to ensure their systems are capable of maintaining operations. Further, SCI entities are required to maintain certain books and records and to undergo an annual review of their systems by an independent firm. OTCM has invested in personnel and IT resources to meet its Regulation SCI requirements and it does not expect that its ongoing financial results will be materially affected by compliance.

OTCM’s business model has several competitive cost advantages over exchanges.

While not an exchange, OTCM is providing an alternative and to some extent competitive product to traditional exchanges such as Nasdaq and NYSE, as well as international exchanges. It is sensitive to their regulation as well as its own. Regulation of exchanges and their strategic direction could change the competitive environment. The more successful OTCM is, the greater the probability that a competitor will view its market as more attractive and look to establish ‘me-too’ markets backed by their infrastructure.

Technology is a key enabler for OTCM and is a core competency of the company. OTCM has to continually invest to ensure its IT and communications systems meet regulatory requirements and those of a continuing evolving customer base. Delivery of technology-based solutions that are elegant and cost-effective has been a key feature of OTCM’s strategy, and creates an effective barrier to entry. In 2015, the company achieved 100% uptime for its core systems.

The Jumpstart Our Business Startups Act (JOBS Act) was passed on 5 April 2012 and included goals to ease the burden on capital-raising for small and mid-sized companies with the aim that such companies would flourish and create new jobs. The act mandated that the SEC introduce new rules to achieve this goal and, in 2015, the SEC introduced revisions to the existing Regulation A framework and a new regime specifically aimed at crowdfunding. OTCM believes it is well positioned to become the trading venue of choice for companies created as a result of these initiatives, as its markets are more cost-effective for them and dealer-based venues are more suited to the needs of smaller companies. Exhibit 5 summarises some of the more important features of the rules.

The potential number of new clients that could be gained is large because of the size of the US economy and wealth of the investor base. There are six million small businesses in the US (excluding the self-employed) according to the US Small Business Association and private US wealth is estimated at $87tn (FED, March 2016). Only a small fraction of these are included on one of OTCM’s premier markets. OTCM believes it is creating a trading ecosystem around its markets that will modify investor and company behaviour, promoting increased price transparency and disclosure and providing entrepreneurial companies the public trading venue they need today to grow for tomorrow. An early success was Elio Motors, which raised $17m in a Regulation A+ (Tier 2) offering in February 2016 and is now quoted on the OTCQX Best Market. OTCM believes its dealer-based markets are more suited to small, illiquid companies than the traditional central limit order book-type exchanges.

The following table compares OTCM’s P/E ratio with the US market represented by the S&P 500 index as well as against two data providers, MSCI and Markit. We estimate around 80% of OTCM’s revenues are subscription based so we believe these two data providers provide a useful benchmark. OTCM’s 2016 P/E ratio is 3% higher than that of the S&P 500 and 28% lower than the average of MSCI and Markit.

We have also considered OTCM’s valuation using DCF. Net cash at 31 December 2015 was $23.9m and with c $14m of free cash flow in 2016 OTCM would be worth $23.7 per share (compared with $21.3m in November 2015) on a DCF basis if we assume a long-term growth rate of 3% and a cost of capital of 9%. The uplift arose because of an increase in our estimate of free cash flow in the first forecast year to $14m from $12m as 2016 is now the base year of our DCF calculation.

FY15 saw continued financial success for OTCM with gross revenues rising 18% y-o-y to $49.9m, largely thanks to a 77% increase in revenues from corporate services, as those from OTC Link ATS declined 2% and those from market data licensing rose by just 1%. The rise in corporate services revenues was driven by the growth in the number of OTCQB verified companies from 311 at 31 December 2014 to 942 at 31 December 2015 and reflects the success of its initiative to designate the OTCQB market as a premier market. Exhibit 7 below shows the growth of revenue from its various business lines during the year, with a clear uplift on corporate services revenues in Q215 as the initiative’s success became apparent, although growth q-o-q decelerated in Q4 to 4% from 33% in Q215.

Operating expenses in 2015 increased by 14% y-o-y, with compensation benefits rising 20% and IT infrastructure and information services by 13%. The former reflects an increase in annual pay to keep OTCM competitive in the market and bonus awards following the company’s good performance. The rise in IT and related expenditure reflects the need to comply with new regulatory requirements and maintain a high level of service for clients.

The net result for 2015 was a 30% increase in net income to $10.3m. Dividends declared in 2015 amounted to $1.08 per share, included a special dividend of $0.6 paid in December 2015. This was 32% higher than the dividend of $0.82 per share declared in 2014 and the company has paid 29 consecutive quarterly dividends. OTCM expects to fund its strategic initiatives from its operating cash flow. It had $23.9m of cash at the year end, up 18% y-o-y, and equivalent to 82% of operating expenses for 2015 (excluding depreciation) indicating a strong cash position. If its profits develop as we expect, we believe future cash flows will be sufficient to invest in its operations and pay dividends.

After the revenue success of recent years we anticipate a slower pace of growth in 2016 and 2017 as we expect it will take time for the Regulation A+ and Regulation Crowdfunding initiatives to work through to the profit and loss account. We anticipate gross revenue growth of 5% in 2016 and 4% in 2017. We do not foresee a jump in expenses as occurred in 2015 and look for expenses to rise 3% in both years leading to a 9% rise in net income in 2016 and 7% rise in 2017. Our detailed forecasts are given on page 11 and Exhibit 8 summarises the changes since our previous forecasts in November 2015.

We anticipate that OTCM will declare an ordinary dividend of $0.56 per share for 2016 and $0.6 for 2017 and a special dividend of $0.6 per share each year. It paid a special dividend of $0.5 for 2014 and $0.6 for 2015 and, if profits develop as we forecast in 2016 and 2017, we expect it to also make special dividend payments in those years. Previously we had speculated that a special dividend was possible for 2016 but had not incorporated it in our forecasts.