OTC Markets Group — Update 6 September 2016

OTCM began to take its current form after a group of investors led by CEO, R Cromwell Coulson, acquired the National Quotation Bureau (NQB) in 1997. NQB published the ‘Pink Sheets’ in paper form, which aggregated broker-dealer quotes for securities traded off exchange. Under the new ownership, the company adopted new technology to enable greater efficiency and improved transparency, beginning the transformational move to a real-time electronic platform for broker dealers to price and trade equities. Launched in 2003, this system evolved into the current, SEC registered OTC Link Alternative Trading System (ATS).

The OTCM ATS reported 112 active, broker dealer participants and carried quotes in nearly 10,000 securities at the end of Q216. To help investors properly price risk, companies are organised into three markets that are tiered based on the timeliness, quality and quantity of information they provide:

In addition to OTC Link ATS, which contributed 21% of revenue, OTCM has two other business lines: market data licensing (41% of revenue) and corporate services (35% of revenue). For access to OTCM Link ATS, broker dealers pay subscription fees, quote fees for Pink securities and messaging fees. Market data licencing provides access to real-time and historical pricing data, together with corporate financial information and compliance data. Market data is disseminated through over 50 distributors such as Bloomberg, Interactive Data Corporation, Thomson Reuters and Fidessa and via enterprise level licencing arrangements. Corporate services revenues are mainly generated from fixed application and annual charges to companies on the premium OTCQX and OTCQB markets. Pink companies may subscribe separately to disclosure, news and other services.

Revenues have grown at an annual compound rate of 14% between 2007 and 2015, with the most rapid growth seen in the Corporate services business segment (Exhibit 1).

OTCM produced a resilient second-quarter performance against a slow market environment, broadly continuing the trends seen in the first quarter. Compared with the second quarter last year, tariff changes, continued consolidation among broker dealers and lower quote and message volumes resulted in lower revenues at OTC Link ATS. Market data income was stable and corporate services revenue was materially ahead, reflecting a higher average number of companies signed up to OTCQB than in the prior-year period. Key points from the second-quarter results include:

In Exhibit 3 we have shown further analysis of OTC Link ATS and Corporate services revenues drawn from the management commentary (the numbers should be treated as indicative as they are mainly inferred from percentage changes and by deduction). Looking at the OTC Link ATS analysis, we can see the impact of fee changes made in July last year when quote fees were eliminated from the two premium markets. Even with an increase in fees on Pink, overall quote fees were down by nearly a third. Messaging fees were increased at the same time, resulting in a sharp increase in revenue in this area but, with continuing consolidation among broker dealers resulting in reduced participant subscriptions, the overall segment revenue was down 9%.

On Corporate services, as noted earlier, the higher average number of OTCQB companies during the period contributed to 18% growth in revenues, while OTCQX revenues were broadly flat despite a slightly lower average number of client companies. New companies joining OTCQX have been paying annual fees of $20,000 since the start of the year while existing clients will remain on the previous tariff of $15,000 until the beginning of 2017.

Staying with Corporate services, the company reports that the number of verified companies on OTCQB had fallen to 877 at the end of June, compared with 929 at the end of the first quarter and 955 at end June 2015. This reduction reflected a higher rate of compliance-related downgrades and non-renewals and OTCM expects this venture market to continue to see a higher rate of ‘churn’ given the relatively early-stage profile of these clients. For OTCQX, the number of companies has fallen from 424 at the year-end to 383 at end June, with a sluggish market background for new sales meaning they have failed to keep pace with the normal attrition of the client list. In the next section we review evidence of recent market trends and try to gain a sense of whether the environment is likely to become more favourable.

As an indicator of the general environment in equity capital markets, we have collated data for the number of IPOs on Nasdaq, TMX, TMX Venture and AIM. Looking first at Nasdaq and the TMX exchanges (Exhibits 4 and 5) we can see that the Nasdaq count has been on a downtrend since 2014 while the pattern for the TMX markets, with their significant commodity exposure, is different with an earlier decline but a stronger pro rata number of IPOs year-to-date.

In the UK, the AIM market (Exhibit 6) experienced a virtual halving in the number of IPOs last year but, despite the uncertainties surrounding the EU referendum, the run rate in 2016 to end July was actually ahead of 2015 (45 versus 37).

While the global macroeconomic backdrop has appeared uncertain and GDP growth estimates have generally been trimmed, equity markets have been surprisingly buoyant. In the year to date each of the indices for the markets discussed are up, to a greater or lesser extent (S&P/TSX Composite +12%, S&P/TSX Venture +51%, Nasdaq Composite +4% and FTSE AIM All-Share +7% at 1 September). Subject to a marked weakening in economic conditions, we would expect this resilience to be broadly supportive for the level of IPO activity prospectively and by extension for the potential number of new clients for OTCM’s premium markets. OTCM itself has indicated it will be sharpening its focus on retaining OTCQB companies following the substantial reduction in numbers that followed the introduction of new eligibility standards in 2014/15; it is also looking to expand the sales pipeline for both OTCQX and OTCQB.

The trend for contraction in and consolidation among broker-dealers has contributed to the decline in the number of active participants in OTC Link ATS (from 133 at the end of 2012 to 112 at the end of the second quarter). This might also be seen as putting some pressure on the number of professional market data users but over the same period this has risen (Exhibit 7), although there has been a flattening since 2014. However, as OTCM points out, its penetration of the potential market is still relatively small, so even if the overall market shrinks there should be scope to increase penetration. In Exhibit 7 we have shown professional users of UTP (Nasdaq) market data and OTCM’s users as a percentage of that number. This suggests significant upside, signalling the opportunity for a virtuous circle if OTCM is able to reinforce the reputation of its premium markets by securing further Blue-Sky manual exemptions, maintaining the record of platform uptime and enhancing transparency through the availability of corporate data and further third party research (Morningstar currently provides this).

Beyond the Blue-Sky exemptions noted above, there were no significant new regulatory developments affecting the business in the last quarter. The medium- to longer-term positive theme related to the Jumpstart Our Business Startups (JOBS) Act (including Regulation A+ and Regulation Crowdfunding) remains in place. So far one company has made a successful crowdfunding equity offering under Regulation A+ and began trading on OTCQX in Q116 (Elio Motors). Developing the use of online funding or crowdfunding could generate a rising population of companies that may be attracted to the OTCM offering, as it seeks to facilitate public trading of shares with less financial and administrative burden than a listing on a national securities exchange. OTCM aims to charge less than half the price of a Nasdaq listing for OTCQX and less than a quarter of Nasdaq’s lowest price for OTCQB.

Competitive pressures and regulatory risks remain factors to consider. Successful companies are likely to continue to ‘graduate’ to a national securities exchange from the OTC platform (60 did in 2015) but this is also a badge of success for OTCM. National securities exchanges (or new ventures) could seek to create trading venues to offer competing services for developing US companies: even if they did not gain traction, there could be negative pricing implications.

New regulations could impose higher costs (as was the case with Regulation Systems Compliance and Integrity) or affect revenues. In 2009 FINRA filed a proposed Quotation Consolidation Facility (QCF) with the SEC, which OTCM indicates could impact market data income by removing c 17% of gross revenues if it is approved. There have been no reports of new developments relating to this proposal in recent years, but OTC indicates it has submitted multiple letters in opposition.

In summary, while the economic backdrop is uncertain, markets have proven resilient and there are some signs of increased IPO activity that give near-term encouragement for OTCM. On a longer-term view, regulatory and competitive risks cannot be ignored, but OTCM should be well positioned to benefit by recruiting clients among companies employing disruptive online capital raising. Its increased focus on reliability through IT investment, and success in achieving additional state Blue-Sky recognition combined with the higher quality thresholds established for its premium markets should also widen the pool of potential corporate clients.

Following the second-quarter results we have modestly reduced our estimates as shown in Exhibit 8, primarily reflecting a slightly lower starting point, particularly within the OTC Link ATS business line where we have also allowed for further consolidation among active participants in the forecast years. Positive factors for revenue include the fact that from the end of this year a significant number of OTCQB companies will move from a promotional subscription fee of $7,500 per year to $10,000. At the end of the second quarter, 42% of companies were on the promotional rate. Similarly, for OTCQX, companies that were clients last year will move to the new fee level of $20,000 per year versus $15,000 at the beginning of 2017.

At the end of the second quarter, cash on the balance sheet was $23.3m and, on our estimates, is likely to be above $20m for end 2016 and 2017.

As an initial step in considering the valuation, we place OTCM in the context of two substantial US financial information providers, MSCI and Markit, together with average P/Es for global exchanges and the S&P 500 index. Given the differences in size of businesses and the business models, direct comparisons are difficult but the predominantly subscription-based revenues at OTCM mean that the information providers are relevant comparators while the exchanges include competitors and generally generate significant revenue from market data. On this comparison OTCM trades on multiples above the S&P 500 but on modestly lower P/Es than the exchanges and is noticeably below the average for the information suppliers. Positive news on further state Blue Sky recognition and evidence of success in building the corporate sales pipeline are among the potential catalysts for a rerating.

We have also refreshed our discounted cash flow model for OTCM and in Exhibit 10 show a sensitivity table for values at different discount rates and intermediate-term growth rates. Our unchanged central assumptions are a discount rate of 9%, cash flow growth of 3% and a terminal value multiple of 10x. The resulting indicative value is $18.7 compared with our previous central value of $19.2, reflecting the modest reductions in our estimates noted above.