OTC Markets Group — Trading well and keeping its long-term focus

Exhibit 1 sets out a summary of the OTCM profit and loss for Q220, compared with Q219 and Q120. We highlight a number of points from this below, with comparisons made against Q219 unless stated.

Gross revenues increased by 9%, with the largest percentage increase arising in OTC Link, as elevated market volatility and increased subscriber numbers for OTC Link ECN generated raised transaction levels. The largest absolute revenue increase was in Market Data Licensing, where price increases for some products and higher numbers of data file subscribers were augmented by higher reported usage (via data distributors such as Bloomberg). Corporate Services revenue was down just 2%, with the OTCQB market client count down on a lower sales level, influenced by COVID19 and a slightly higher non-renewal rate. OTCQX revenue was stable (see also Exhibit 2).

Redistribution fees and rebates are paid to data distributors and increased (+11%) at a pace close to that of Market Data Licensing revenue (+13%). Similarly, transaction expenses are linked to the OTC Link ECN business, reflecting liquidity provider payments under the maker/taker fee structure; these more than trebled, reflecting the market background and expanded subscriber base. This left net revenues less transaction-based expenses up 6%.

Operating expenses increased by 5%, with the main driver being personnel expenses (see further detail below).

Pre-tax profit was 8% ahead, while net income was 19% ahead after a relatively low tax charge of 12% that benefited from the reversal of previous provisions for state tax.

Exhibit 2 provides an indicative subdivisional analysis of gross revenue based on management commentary in Q219 and Q220 reports. Key points here include: the large increase in OTC Link ECN revenue in both absolute and percentage terms; the impact of price increases and added subscribers for Market Data Licensing; and the 7% decline in OTCQB revenue where sales have proven more sensitive to COVID-19 effects, a point we discuss further in the background and outlook section. Also worth highlighting is the strong growth for Virtual Investor Conferences, the business acquired at the beginning of 2019. The service is particularly well suited to the current environment, but the group also sees it as a valuable part of its offering on a longer view, given corporates’ likely desire to reach an investor audience in an efficient online manner in combination with the cost-efficient transparency provided by OTCM’s premium markets.

An analysis of operating expenses with commentary is set out in Exhibit 3. Apart from the main change, which is in personnel costs, the other points we would pick out are the modest reduction in IT costs as prior year one-off costs dropped out, and the increase in professional and consulting fees arising from increased ECN clearing costs and one-time costs, which included acquisition evaluation costs. As a reminder, OTCM’s acquisition interest is centred on incremental purchases, which add adjacent services to enhance its offering to clients.

In Exhibit 4, we show the progression of operating data and related revenues. Under OTC Link, the dollar volume traded shows marked variations between markets and the periods shown. Swings in activity in hot sectors, as well as the broader impact of the pandemic have played a role here. Given that volume is in dollar-terms, market levels will also have had an influence on the numbers (notice on this front the negative move y-o-y for OTCQB), while sequentially (q-o-q) there was a strongly positive change. Also notable is the progressive increase in the number of ECN subscribers, as highlighted earlier.

Corporate Services data show that OTCQX client numbers were little changed over the periods shown, ending at 415, while OTCQB saw a 3.4% decline y-o-y to 885.

For Market Data Licensing, the number of professional users increased modestly, while the more volatile non-professional user number jumped substantially q-o-q, reflecting increased trading activity. This in turn diluted the total per-terminal revenue figure, given the relatively low fee attached to non-professional users.

On regulatory developments, the number of states granting Blue Sky recognitions regarding secondary trading increased by one (Virginia) for OTCQX to 37, with OTCQB standing at 33. While there is no direct linkage to revenue generation, progress towards 100% coverage should be positive reputationally and the group continues to work towards this. The North American Securities Administrators Association model rule proposal for states to employ that would have the effect of granting OTCQX/OTCQB Blue Sky recognition remains under consideration and is likely to be helpful, if adopted. In the meantime, lockdown and remote working have had the beneficial effect of encouraging engagement by some state regulators.

OTCM continues to work with the SEC on proposals affecting its markets, including the proposed amendments to the Exchange Act Rule 15c2-11 (dealing with information requirements before quotes may be published on interdealer quotation systems such as OTC Link ATS). OTCM has submitted further comments aimed at avoiding negative impacts for sophisticated investors, early-stage companies and broker dealers participating in the OTC market. OTCM also submitted comments urging the SEC to disapprove a National Securities Clearing Corporation proposal that would result in increased costs for participants trading OTC securities.

We have updated the market background indicators we include in our notes, starting with recent equity market index performance (Exhibit 5). The salient feature here is the positive performance of all the indices shown over the past three months, particularly for the OTCQB and TSX venture markets. This is in marked contrast to the negative performances seen in our last note in May, when the uncertainty associated with COVID-19 was having a more marked impact on markets.

The next two charts show the number of IPOs on Nasdaq and the Canadian TSX and TSX Venture markets as an indicator of corporate activity. For Q220, the number of Nasdaq IPOs was down 30% y-o-y following the 27% reduction seen in Q120. There were contrasting trends for the Canadian markets, with TSX showing a 22% increase in the number of IPOs in the seven months to end-July, while TSE Venture was down 58% (although money raised was up 47%). The pattern is varied between markets, but much equity capital markets activity year-to-date has been concentrated on further equity issues to strengthen balance sheets, allowing companies to weather the economic impact of COVID-19. As this subsides and businesses focus more on their longer-term plans, this should be helpful for OTCM.

In OTCM’s Corporate Services segment, sales were suppressed in the first and second quarters with the uncertain macro background compounded by the absence of in-person meetings. OTCQX corporate clients renew annually on a calendar basis and at the beginning of 2020 the renewal rate was slightly lower at 92% versus 94%. Q120 new sales were markedly lower at 9, compared with 30 for Q119, while Q220 saw a rebound to 19 (versus 30 Q219). A positive indicator that sales momentum may be returning is that 13 of these sales took place in June. For OTCQB, the renewal is annual or semi-annual based on when companies originally signed contracts and renewals are spread roughly evenly across the quarters. The voluntary non-renewal rate in April this year was 9%, followed by 6% and 7% in May and June, respectively, compared with an average of 6% in 2019. Based on the end-period client numbers, new sales and voluntary renewal figures provided, we have illustrated the recent evolution of OTCQB client numbers in the table below. Notable here is the improvement in new sales in Q220, both sequentially and compared with Q219. There was still a net reduction in clients but, as can be seen, a modest improvement in additions, non-renewals or compliance downgrades could generate a positive change in future quarters.

Looking ahead, OTCM notes that potential client companies are engaging more actively, following a period when their focus was internal, addressing the initial impact of the pandemic. This has resulted in a stronger pipeline than the group has seen for some time. Understandably, the group also warns that a material worsening of the economic background would be likely to mean decisions are deferred again and could lead to an increase in the non-renewal rate, particularly for OTCQB, where clients are typically smaller and more sensitive to economic fluctuations. Were the economic downturn to worsen, OTCM does see a potential longer-term mitigation as more companies might delist from exchanges, creating a larger pool of qualified companies for its premium markets.

For OTC Link, the current quarter has started with July and early August trading activity continuing at a high rate. The ebb and flow of news relating to the pandemic, macroeconomy and politics may mean equity market volatility and trading activity remains high, but it seems reasonable to expect a quieter period to follow in due course. The increased subscriber base and liquidity established in OTC Link ECN may nevertheless support transaction levels to a degree.

Market Data Licensing should continue to benefit, compared with last year, from the higher pricing levels established for some products and from the increase in subscriber base, particularly for compliance products. Looking ahead, subscription-based revenue should provide resilience, although a longer-term economic downturn would be likely to lead to lower subscription levels. Within the compliance data area, OTCM believes it has captured a large proportion of the potential market and future growth is likely to depend on new product developments, an area of focus within the business.

As we noted following the Q120 results, there is greater-than-usual uncertainty surrounding our estimates, given the continuing development of the pandemic and its economic effects. On this occasion, the main change we have made is to allow for the higher-than-expected level of trading activity that is continuing to benefit OTC Link. We still allow for a reduction in trading activity in FY21 (OTC Link revenue -8%), resulting in only a marginal change in estimates for the segment in that year. Otherwise, the variances in revenue assumptions compared with our previous estimates are small. We have allowed for higher transaction-based expenses in FY20, reflecting the OTC Link revenue strength. Redistribution fees and rebates are also higher reflecting the year-to-date level recorded. Operating expense assumptions are little changed. Otherwise, the only significant change is allowing for the lower-than-expected tax rate in the second quarter; we assume this will revert to 19% for the forecast periods. The net result is a 9% increase in our FY20 diluted EPS estimate and a near -2% increase for FY21 (see Exhibit 9 and the financial summary for further detail).

The balance sheet remains strong with cash at the end of Q220 of $25.0m or $26.7m, including restricted cash. During the second quarter, there was a cash inflow of $2.4m. This reflected a $4.1m inflow from operating activities net of modest investment spend and a dividend payment of just under $1.8m.

In Exhibit 10, we update our table with comparative multiples for information providers and global exchanges. OTCM’s share price is higher since our last note in May, but our earnings estimate has been increased as shown above. OTCM stands on lower multiples than both the information providers and global exchanges. As before, we see this as partly explained by the group’s exposure to smaller companies through its venture market and the relative illiquidity of its own shares. The group is financially strong with relatively sticky subscription base revenues and is well placed to benefit once the background improves, generating greater corporate and investor confidence and the potential for estimate upgrades.

The increase in our estimates modestly increases the values produced from our discounted cash-flow model. On unchanged assumptions (a discount rate of 10%, our explicit forecasts for FY20 and FY21, together with an assumption of FY22–23 cash-flow growth of 12%, allowing for a degree of bounce back, long-term growth of 4% and a terminal cash-flow multiple of 16x), the model would give a value of $30.4, compared with $29.5 previously. To match the share price at the time of writing ($32), assumption of a discount rate of 9% or alternatively a terminal cash-flow multiple of 18x would be sufficient. On our estimates, the cash-flow multiple for the current year is nearly 21x.