OTC Markets Group — Revenue, profit and regulatory recognition increase

Before looking more closely at the detail of OTCM’s FY18 and Q418 results it is useful to set them in a longer-term context. Exhibit 1 shows the progression of gross revenue and operating margin since 2008. Over the period, group revenue has increased at a compound annual rate of 11%. The most rapid growth was in Corporate Services, where development of the premium markets, OTCQX and OTCQB, both in terms of corporate membership and the level of fees charged, generated a CAGR of 26%, with the segment accounting for 42% of FY18 revenue. As shown, Market Data Licensing has also seen strong growth (+8% CAGR). OTC Link has recorded growth (+3% CAGR) but faced the headwind of a progressive contraction in the number of broker-dealer participants in OTC Link ATS through a combination of competitive market conditions and consolidation.

The chart also shows how the operating margin has benefited from increased scale over the period, with the operating margin more than doubled from 16% to 35%. Compensation and IT costs account for 80% of total expenses and both fell initially relative to revenue, but the ratios subsequently rose modestly in the case of compensation or stabilised for IT as OTCM invested in people and its IT infrastructure to support the sustainability and development of the business. As evidence of this, OTCM recorded its fourth year of 100% uptime in its core systems in 2018, having concentrated its capital spending on network resilience and security in recent years.

Turning to the FY18/Q418 results, we have set out the P&L comparisons in Exhibit 2. We would highlight the following points from the full year figures compared with FY17.

Gross revenue was 8.5% ahead, with the largest absolute growth contributor being the Corporate Services business, where a combination of price increases implemented for OTCQB companies and a significant rise in the number of corporate clients at OTCQX contributed to an 11% or $2.1m revenue increase. Market Data Licensing saw the next largest absolute increase within which end of day pricing, data and internal licences were the main contributors, with price increases and higher usage the underlying drivers. OTC Link recorded the largest percentage gain, up nearly 11%, mainly because of a $0.9m revenue contribution from the OTC Link ECN, which was launched at end 2017. The segment also benefited from an increase in trading activity in US equity markets, which, from an OTCM perspective, fed through to higher messaging fees (+$0.3m).

After redistribution fees, rebates and transaction-based expenses, revenue was 8.2% ahead, slightly below the 8.7% increase in operating expenses. Within operating expenses, compensation costs were up 11%, mainly reflecting annual salary increases and incentive payments, and a continuation of the recent gradual uptrend in the number of employees (from 90 to 93). Occupancy costs saw a 19% rise as costs associated with the group’s new corporate headquarters at 300 Vesey Street, New York, commenced combined with overlapping costs on the existing building ahead of the move expected to take place in Q119.

As a result pre-tax income was up 7.7%, while diluted EPS increased by 29% as the effective tax rate fell sharply (18% versus 32%), mainly because of the reduction in federal tax rate.

The group announced an unchanged quarterly dividend of $0.15 giving a full year dividend of $1.23 (+6%). Adding the c $1m returned through share repurchases during the year gave a total returned to shareholders of $15.2m, following $15.4m in FY17.

In the next table we collate some of the key operating and related revenue data. Focusing mainly on the Q4 comparison with the prior year period we note:

During 2018 OTCM continued to pursue regulatory recognition for its two premium markets and five states were added to the list granting both markets Blue Sky recognition (including one in the final quarter). This takes the totals to 34 states for OTCQX and 31 for OTCQB (see Exhibit 4). This gives population coverage of over 53% and 51%, respectively. In July 2018 the North American Securities Administrators Association (NASAA) published a model rule proposal for states to employ that would have the effect of granting OTCQX/OTCQB recognition. There is no timetable for formal adoption but OTCM is hopeful that this could happen in the second quarter of the current year and has noted that adoption of the model rule would be likely to facilitate a number of states moving towards Blue Sky recognition of its markets. OTCM is also seeking recognition for OTC securities on its markets for the purposes of federal regulations dealing with margin eligibility and employee stock ownership plans.

The background in equity markets year to date has been more positive following increased volatility and marked weakness in Q418 and this is evident in the positive three-month moves across the market indices included in Exhibit 5, whereas all are in negative territory over six months. Macro factors such as global trade tensions remain a potential restraint on equity market and corporate confidence, but recent economic forecasts have only seen minor downward adjustments. If these expectations remain stable and equity markets sustain recent levels, this would be supportive of corporate activity and hence provide a more favourable background for OTCM corporate clients and potential corporate clients.

As an indicator of corporate confidence we track the number of IPOs on the Nasdaq, TSX and TSX Venture exchanges (Exhibits 6 and 7). As can be seen, the Nasdaq activity level in 2018 nearly matched the previous peak in 2014, while the TSX Venture exchange reached a level more than double the 2017 figure, helped by relative strength (until Q4) in the mining sector and activity in the rapidly developing cannabis sector.

Turning to OTCM itself, the group has set five main objectives for 2019:

On OTC Link ECN, the group notes that the market it is addressing is limited in size and while it expects to gain further share, it may have to compete more aggressively to achieve this. Given the maker-taker fee structure this could be evident in lower than expected revenues or higher than expected transaction-based expenses. More broadly the ECN provides additional functionality for OTCM’s trading participants including the ability to trade anonymously.

On the results call the group made clear that it is not aiming for a high-risk transformative acquisition but to add businesses incrementally that fit with the existing activities, are relatively asset light and are earnings accretive reasonably quickly. Examples of the type of strategic acquisition that the group has in mind are the purchases of assets related to Virtual Investor Conferences and the Qaravan business in January and February this year, respectively. Virtual Investor Conferences provide a time efficient way for corporates to engage with investors or potential investors, while Qaravan is a provider of risk and performance analytic services to the bank and financial sectors, in particular to private and community banks, an important corporate client segment for OTCM. Neither is expected to have a material impact on revenues in the short term, but are capable of development within OTCM and are set to further the aim of enhancing the client experience.

The continuing progress in regulatory recognition of OTCQX and OTCQB is encouraging and, if adopted, the NASAA model rule should facilitate recognition by further states. While there is no direct linkage to revenues from this, additional recognition should be increasingly helpful reputationally the closer OTCM moves to 100% recognition.

While not looking for a near-term benefit, OTCM sees long-term potential for the development of online/crowdfunded capital raising to increase the population of corporates that would be interested in using the cost-effective secondary markets the group operates. A positive development this year has been the introduction of an SEC rule at the end January effectively enabling SEC reporting companies to offer securities using Regulation A+. The amendments to Regulation A+ largely reflected OTCM’s SEC petition for rulemaking in 2016.

Changes in headline numbers from our forecasts are shown in Exhibit 8 and further detail of our estimates is contained in the financial summary (page 8). Our revenue estimates are modestly higher, mainly reflecting an increase in our assumptions for OTC Link. At the pre-tax level, allowance for slightly higher expenses leaves the estimate unchanged for 2019 but there is a 2.5% increase for 2020. EPS benefit from lower tax rate assumptions, particularly in 2019 where 100% allowance for capital spending will hold down the rate; as a result our estimates increase by 3.7% and 3.5% for 2019 and 2020, respectively (our 2020 estimate was previously unpublished but factored into our DCF model).

The largest contributor to expenses is the compensation and benefits line (65% of the total) and we have allowed for a modestly higher increase here. Occupancy costs are relatively small within the total (c 6% estimated for 2019) but are set to rise significantly in percentage terms in 2019 as OTCM moves into its new head office: the annual lease cost is c $0.6m higher and there are dual running costs until the move is completed.

The move will also have an impact on cash flow in 2019 with related capital spending put at $2m. Otherwise the group has highlighted that it expects a substantial increase in capital spending to replace servers and other equipment that is nearing the end of its life. This is likely to absorb a further $2m. This means there is likely to be a step up in capital spending to c $4m versus $0.5m in 2018, but subsequently the level of spending required should revert to a lower level (the five-year average historically was $0.9m and we have assumed $1.3m for 2020).

Cash available for operations at the year-end stood at $28.8m compared with $23.7m at end-2017. This excluded restricted cash (held as clearing collateral) and including this total cash stood at $30.5m. The group is therefore well positioned to finance acquisitions, to undertake capital spending to ensure its IT systems remain robust and to continue returning cash to shareholders through a combination of dividends and share repurchases.

Sensitivities for the group include macro factors that will influence equity market sentiment and the corporate environment; competitive pressures from Global OTC and national securities exchanges (particularly if they were allowed to be involved in trading non-SEC registered securities); and the continued reliability of key IT systems.

OTCM’s shares have enjoyed a period of marked strength with the price up 23% over three months compared with an average of +6% for global exchanges and +13% for the information providers. Following this our updated P/E comparison table (Exhibit 9) shows OTCM trading above exchanges for both years and just below and just above information providers for 2019 and 2020, respectively. The potential for OTCM to deliver good long-term cash-generative growth through greater penetration of international and domestic corporates and selective acquisitions helps justify this rating.

Using our discounted cash flow model to derive a set of assumptions that give a value matching the share price at time of writing of $35.50, one combination would be a discount rate of 10%, long-term cash flow growth of 4% and a terminal cash flow multiple of c 22x (which compares with the current year value of nearly 30x). A sensitivity table below shows how the value would change with discount rate and growth assumptions.

Balancing the peer comparison and outputs from our DCF model we increase our fair value from $34.00 to $37.00.