OTC Markets Group — Progress continues

OTCM’s Q218 gross revenue increased by just over 7% versus Q217, in line with the growth reported for the first quarter. There was a slightly higher growth in fees and rebates, including those paid out for liquidity providers on the OTC Link ECN as it gains traction. Operating expenses also outpaced revenues, partly boosted by one-off costs related to a potential acquisition that did not proceed. This resulted in pre-tax profit growth of 3.3%, which, after a sharp reduction in the tax rate, translated into diluted EPS growth of 27.6% to 34 cents. The quarterly dividend (39th consecutive payment) has been increased from 14 to 15 cents (+7%).

Focusing on the revenue figures, we can see that OTC Link recorded the most rapid segmental growth. This follows three years in which revenues declined as the number of broker-dealer participants continued to contract in the face of difficult market conditions, which have prompted withdrawals and consolidation. Positive features in the quarter included a contribution of $0.2m from the ECN, which is already covering its direct costs. High transaction levels drove messaging income up, which more than outweighed a year-on-year decline in subscription revenues. We note that sequentially there was actually one additional participant following previous contraction and three quarters of stability (see operating data in Exhibit 2).

Market data licensing growth (6%) resulted from a combination of new sales of data licence products (including compliance products in particular), price increases and signing up new broker-dealer licences. Through development, compliance products appear to have reached a point of self-reinforcing acceptance among broker-dealers, banks and custodians. In the operating data, we can see that the number of professional users has risen for the second quarter in a row and now stands just above the average level for the period since the beginning of 2015.

Corporate services revenue increased by 7% with the main driver being OTCQB, where there was a slightly higher number of companies in the quarter versus Q217 and higher prices for subscribers that were implemented at the beginning of 2018. Sequentially, the number of OTCQB companies actually fell modestly, reflecting a weaker level of sales and higher churn. OTCQX revenue also made progress, benefiting from a higher number of companies both year-on-year and sequentially resulting from stronger sales. Churn among the OTCQX corporate clients generated accelerated revenue recognition, which also bolstered revenue.

Within an overall increase of 9% in expenses versus Q217, the main features were a 12% rise in compensation costs, a sharp rise in advisory fees, as noted above, and a reduction in depreciation and amortisation. The compensation cost increase reflected higher headcount, salary increases and incentive accrual, while depreciation was lower following full depreciation of leasehold improvements at the end of 2017.

The group incurred costs in the period arising from consideration of a potential acquisition, which did not proceed. While OTCM has not given any details on the possible purchase, it indicates that it is part of its strategy to look for opportunities to add businesses that provide products and services to its client base including, for example, the small- and mid-cap issuer area. We assume this could include targets that are larger than transactions that have taken place so far but would be subject to fit, integration risks and prospective return on capital. As an illustration, if we were to assume an acquisition with a consideration of $50m, at a revenue multiple of four times with an EBITDA margin of 30% and which is 80% financed by debt, then this could result in a debt/EBITDA multiple of 1.7x, interest cover of over 11x, remaining cash of $16m and an 8% increase in pre-tax profit before allowing for any cost or revenue synergies.

The list of states that grant Blue Sky recognition to OTCQX or OTCQB continues to grow with Minnesota added in the latest quarter, bringing the total number of states to 31 (see full list in Exhibit 3). In terms of population coverage, this takes OTCM to nearly 47%. There are a further three states in the process of considering giving recognition (Michigan, Missouri and Oklahoma) and if they were all to proceed this would increase the population coverage to 53%.

On this front, an encouraging development in July was the announcement by the NASAA of a model rule for states to employ that would have the effect of granting OTCQX/QB recognition. The period for comments ended 20 August and the NASAA is considering responses before deciding on any amendments or adoption. OTCM notes that adoption should facilitate a number of states moving towards granting Blue Sky recognition to its markets.

The continued increase in the number of states granting Blue Sky recognition to OTCM premium markets does not directly lead to revenue gains, but is helpful in terms of reputation with potential corporate clients, while every addition (and adoption of the model rule by NASAA) is likely to ease the process of winning over further states.

The passage of the Economic Growth, Regulatory Relief, and Consumer Protection Act (S.2155) in May is set to extend the availability of Regulation A+ to SEC reporting companies. (Regulation A+ allows companies to raise up to $50m in a 12-month period through a public solicitation with lower regulatory hurdles and costs.) The impact of S.2155 is dependent on the detail of SEC rule changes and the appetite of potential issuers. However, it may enlarge the pool of companies offering securities using Regulation A+ and would be likely to add more established companies and hence tend to improve the reputation of this route to raising equity capital. As with increasing Blue Sky recognitions, there is no direct benefit to OTCM from the change in legislation but any move that progressively raises the population of corporates likely to seek a cost-effective venue for secondary trading in their shares could be increasingly helpful.

There was further progress in the quarter in OTCM’s drive to enhance transparency and data availability for market users. The Transfer Agent Verified Shares Program (provides timely information on share issuance/share count) has continued to increase coverage with 22 agents now participating, representing 85% of US companies on OTCQX and OTCQB. In addition to the stock promotion flag introduced in Q118, a stock promotion data file was made available to market participants with the compliance data file also updated to include this and shell risk information, another flag introduced in the first quarter.

Following a correction in February, the broader equity market context has been generally positive over the past three and six months, although smaller cap/venture company biased indices and the two OTCM markets have shown some weakness (see Exhibit 4).

This would suggest a somewhat mixed background for corporate activity and hence for OTCM clients and potential clients. However, the read-across is not direct and looking at the new issuance activity levels for Nasdaq and TSX Venture exchanges in the first half (Exhibits 5 and 6), we can see that they have enjoyed a strong period for the first half of the year with the number of IPOs up 75% and over 150%, respectively, compared with H117. TSX activity has been more subdued (-5%).

Absent a significant spike in equity market volatility (the Cboe VIX remains at relatively subdued levels) and with economic activity in the US remaining robust, the conditions for corporate activity and for OTCM to recruit corporate subscribers to its markets appear satisfactory or favourable.

For OTCM itself, there are a number of specific considerations that may have a bearing on the outlook, including the following.

In the next section, we highlight changes in our estimates and comment on the group’s financial position.

Reflecting the performance year-to-date, we have edged up our revenue estimates for both years, with the main change being in OTC Link where performance has been ahead of our expectation, and we now assume a marginal increase next year rather than a decline.

Occupancy costs are set to rise in FY19 with the move to a new office in New York. We have allowed for an increase of 20% or approaching $0.4m in this area. Overall expenses, including depreciation and amortisation, are expected to increase by c 6% this year, partly affected by the M&A-related fees mentioned earlier, and by c 4% next year, assuming no M&A costs.

The net result is that our pre-tax profit estimate for this year increases by just over 1% and is virtually unchanged for next year. At the EPS level, our assumption of a slightly lower tax rate than before (20%, in line with Q218) produces modest estimate increases of 1.7% and 1.3% for this year and next. We continue to include special dividends in our estimates but note that significant investment in an acquisition (not in our estimates) could constitute an alternative use of funds.

The cash available for operations at the end of June was $25.0m compared with $22.7m at end-March and $23.7m at the end of 2017. This excluded $0.7m of restricted cash held as clearing collateral. Cash flow in the quarter was seasonally stronger following the normal incidence of bonus payments in the first quarter. Capital spending remained at a relatively low level but we assume that this simply reflects timing and that spending will be higher in the second half, potentially boosted by expenditure required ahead of the office move. Despite this and our assumption of a special dividend payment, we still look for year-end cash available for operations of c $26m.

Our comparative valuation table (Exhibit 8) includes information providers, MSCI and Markit, given the data/subscription emphasis within OTCM’s revenues as well as the average rating for global exchanges (which also generate significant data-related revenues). This shows that OTCM trades on prospective P/E ratios below both groups for FY18e and in line with exchanges and below information providers for FY19e.

As previously, we have adjusted the assumptions within our discounted cash flow model to match the share price at the time of writing ($29.00, 23 August 2018) and one combination that gives this value is a discount rate of 10%, a long-term growth rate of 4.0% and a terminal operating cash flow multiple of 16.0x (compares with a current year value of 19.0x). These assumptions do not appear aggressive and, with a small increase in estimates and encouraging developments within the business, we have increased our fair value estimate to c $31 from $29. The sensitivity of our valuation to discount rate and growth assumptions is shown in Exhibit 9.