OTC Markets Group — Q122 – net income up 11%, but costs start to bite

A summary of the quarterly progress in OTCM’s profit and loss figures is given in Exhibit 1. We highlight the key points below (the comparisons are year-on-year unless stated):

Our next table summarises the change in operating expenses with commentary on year-on-year changes. Compensation and benefits remain the most significant driver of costs and the increase was driven mainly by cash awards. The current pressure on wages in the United States, especially for IT personnel, has had an impact on compensation and benefits.

Exhibit 4 shows changes in operating data and related revenue data. Trading volumes fell sharply in the OTCQX both year-on-year (-53%) and quarter-on-quarter (-30%). The Pink segment’s trading was more resilient, down 17% y-o-y but up 6% q-o-q. OTCQB volume fell 82% from an unusually strong Q121 and was down 38% on Q421.

On the other hand, the number of OTC Link ATS participants (90, +10% y-o-y) and ECN subscribers (98, +20% y-o-y) continues to increase.

Corporate Services also showed very strong year on-year increases across the three segments: OTCQX (18%), OTCQB (27%) and Pink (101%). Revenue per client dropped by 2%.

Market Data Licensing saw a 12% year-on-year drop in the total number of users. However, the number of professional users (which generate more revenue) increased by 10%. As we expected, the weak financial markets had a significant impact on the number of non-professional users, which fell by 31%. Revenue per terminal rose by 24%, reflecting this change in user mix.

Blue Sky Data Corp provides equity and debt compliance data on state ‘blue sky’ securities rules and regulations. The deal enables OTCM to improve its value proposition and expand its subscriber base by allowing OTCM to provide ‘a comprehensive view of Blue-Sky secondary trading compliance data’ that is ‘delivered in an efficient format for broker-dealers, financial advisors, public companies, and regulators’. This will help these subscribers better understand compliance and state securities laws in the US. The deal is expected to bring approximately 30 clients, in addition to the synergies with the market data licensing business.

The purchase price is approximately $12m paid in cash and completed in May 2022. We note that OTCM had a net cash position of $45m (excluding restricted cash) at the end of 1Q22. The company hopes to largely complete the integration of Blue Sky Data by the end of June. A handful of employees are expected to be added to OTCM’s current headcount of 112.

US inflation and recession fears have been increasing and this has been resulting in weaker financial markets, including equities. Back in December 2021, the market was pricing a 0.5% Fed Funds target rate at the end of 2022. This had moved to 1.8% when we wrote our last note on OTC two months ago (Q421 was another beat, 2022 is more uncertain) and now the forecasts are for a 2.8% target rate for the end of 2022.

As the Citi US Inflation Surprise Index (Exhibit 6) shows, the market has been underestimating inflation for quite a while. It is clear much of the inflation is transient, driven by supply chain disruptions, consumers spending money saved during the lockdowns and the current war in Ukraine. However, much uncertainty remains regarding how much will be sticky and anchor into wage and inflation expectations.

The degree of the economic slowdown (US GDP growth was already negative in Q122) and the degree to which the Fed will have to apply the brakes to rein in inflation are all weighing on equity markets. Exhibit 7 shows that the pain in equities is broad-based both in larger and smaller companies, although smaller companies (which on average present stronger long-term growth potential as well as higher risk) are usually sold off more during downturns. The technology-heavy Nasdaq index (previously quite highly rated, and now one of the sectors more actively sold) is down 28% over the last six months compared to 16% in the S&P 500.

The cryptocurrency boom has been a major factor in rising volumes in OTC (since crypto-related stocks are among the most traded stocks on OTC markets) and currently cryptocurrencies are also contributing to slowing volumes.

The State Street Investor Confidence Index tracks changes in institutional investor holdings in risky versus safer investments. Exhibit 8 shows that confidence is higher than during the early stages of the pandemic in 2020. However, clearly the confidence is falling following the boost after Omicron proved to be less dangerous than first feared. With the index below 100, the mood is currently bearish.

2021 was a record year for IPOs on the Nasdaq, TSX Ventures and TSX exchanges, rising by 138% and 159% on Nasdaq and TSX Ventures respectively and by 12% on TSX. The first quarter saw 84 IPOs in the Nasdaq, which although less than a year ago (135) is still above the long-term average of 59.

We have slightly increased our revenue forecasts and now estimate that OTCM’s gross revenue will drop by 6% in FY22 (previously we expected a 9% decrease). The driver for this drop remains the same: weaker financial markets and elevated macroeconomic and political uncertainty will lead to lower trading volumes.

The forecast increase in FY23 revenue remains similar (5.5% vs 5.0% previously) but from a slightly higher FY22 forecast. We assume that trading levels normalise and resume an upward trend, but are still factoring in relatively difficult markets in FY23, which may prove to be excessively cautious.

Exhibit 11 shows details of our revenue assumptions. We forecast a 35% decline in revenue from the OTC Link business; this segment accounted for 29% of OTCM’s revenue in FY21 and is most exposed to a drop in trading volumes.

Trading volumes in OTC Link ECN (the key driver in OTC Link’s variable revenue component) are not reported monthly and the pricing structure is complex (variables include the type of investors that are trading, lot sizes, which securities are being traded and even the fact that different share prices have different trading costs). This complicates forecasts beyond the usual challenge in that trading volumes can be quite volatile.

We forecast a 4% decline in revenue from Market Data Licensing. This segment has been proving more resilient to weaker markets, but we would expect to see a decline as some users step back from trading in less favourable market conditions, especially non-professional users, which had been the fastest growing segment. The Blue Sky Data acquisition boosts OTCM’s offering in this segment and could provide potential upside. We do not have guidance on revenue from Blue Sky Data (or reliable historical data), but we have increased Market Data Licencing revenue growth for 2023 from 4% to 6%.

Corporate Services is the most resilient of the three segments as it correlates more with economic activity than trading volume or market performance. We have upped our FY22 growth forecast from 12% to 14% to reflect the good Q122 performance and raised FY23 growth from 4% to 5%.

We have raised OTCM operating expenses to factor in the cost pressure in staff compensation and IT costs (these two items account on average for about 80% of operating expenses). We have also factored in some costs from the Blue Sky Data acquisition. Our forecasts for operating expenses have been raised by 22% in FY22 and FY23, which has an adverse impact on the earnings forecasts.

Exhibit 12 summarises the changes to our forecasts. We cut our EPS forecasts by 19% and 17% for FY22 and FY23 respectively and the DPS by 20%. OTCM does not have fixed dividend pay-out guidance but usually the pay-out is significant (80–126% since 2014). We have assumed 90% and 86% for FY22 and FY23, within the 83–97% range of the last four years. We expect the quarterly dividends (excluding special dividends) to remain at $0.18 in FY22 and FY23.

Despite the $12m Blue Sky Data acquisition, OTCM’s balance sheet remains strong with no debt. We are forecasting a net cash position of $34.7m including restricted cash ($33.2m ex-restricted cash) at the end of FY22 (FY21: $52.0m with restricted cash, $50.4m ex-restricted cash).

Exhibit 13 compares OTCM’s P/E ratios to those of a range of market information providers and global exchanges. OTCM is trading at an 9% discount on trailing earnings, but at a premium to forward earnings. The premium is deserved due to OTCM’s strong growth track record, balance sheet and relatively high proportion of subscription-based revenues. Furthermore, its ratios are more comparable to the US-based peers with more subscription revenue, such as MSCI and S&P Global.

The sensitivity of our discounted cash flow valuation to different discount rates and long-term growth assumptions is shown in Exhibit 14 below. The model factors in lower explicit forecasts for FY22–23, together with an assumption of FY24–25 cash flow growth of 12% and a terminal cash flow multiple of 16x. We obtain a valuation range of $42.7–64.4 per share by flexing the discount rate from 7% to 11% and assuming long-term growth (2026–32e) of 3–6%. This compares to the previous range of $42.4–66.3.