OTC Markets Group — A further estimate upgrade

The purchase of the National Quotation Bureau (NQB) by CEO R Cromwell Coulson and a group of investors in 1997 began the process that led to the creation of OTCM in its current form. NQB, with a history dating back to 1913, published the Pink Sheets, a printed list of broker-dealer quotes for securities traded off-exchange. Following the purchase, the new management team progressively applied technology to the task of aggregating liquidity and increasing transparency in this over-the-counter market.

A platform providing real-time quotes was launched in 2003 and evolved into the current SEC-registered alternative trading system, OTC Link ATS. Another platform, OTC Link ECN, was launched in 2017, providing dealers with complementary features including an anonymous order-matching engine with an order routing capability – as opposed to OTC Link ATS, where attributable quotes are displayed and messages delivered, enabling direct trades between dealers. OTC Link ATS carries quotes in more than 11,000 companies and has 82 active broker-dealer participants, while OTC Link ECN has expanded its subscriber base and trading volumes rapidly since launch; at end September it had 69 subscribers, an increase of 22 over 12 months.

In order to help investors assess risk exposure, OTCM organises the companies on its markets into tiers, with membership of each subject to the adequacy and timeliness of disclosure, financial criteria and adherence to governance standards:

From the point of view of corporates, OTCM’s premium markets, OTCQX and OTCQB, provide access to public trading in the US at a cost-effective price, compared with a listing on a registered national securities exchange such as Nasdaq. As shown in the charts below, both OTCQX and OTCQB have a substantial number of international corporate clients, notably from Canada.

The group’s activities are organised in three divisions: OTC Link (trading services), Market Data Licensing and Corporate Services (OTCQX, OTCQB and other services), which in 9M20 accounted for 21%, 40% and 39% of gross revenues respectively. Exhibit 3 sets out examples of how revenues are generated within each division.

While OTC Link revenues are largely transaction-related, subscription-based revenues feature in many activities and for 9M20 subscription-based revenues accounted for 84% of the group total providing a measure of revenue resilience against the background of equity market volume fluctuations. The diversification of revenue streams is also helpful in this respect; in the current year the pandemic initially created difficult conditions for recruiting corporate clients while market volatility caused a jump in transaction levels for OTC Link. It may be that a normalisation of trading activity in due course will coincide with an improving macroeconomic outlook and hence a stronger period in Corporate Services.

Exhibit 4 shows the long-term development of OTCM’s gross revenue by division and its operating margin. Total gross revenue grew at a compound annual rate of 11% between 2009 and 2019. Within this, Corporate Services has contributed the fastest growth at 25%, mainly as a result of the development of the premium OTCQX and OTCQB markets both in terms of the number of corporate clients subscribing and the level of fees charged. Market Data Licensing CAGR was 9% and OTC Link 2%.

The operating margin increased significantly between 2013 and 2015 as the scale of the business grew, but was then flat between 2015 and 2018 as investment was made in people and systems to support sustainable growth in the business. 2019 saw further investment in staff and IT infrastructure together with a move to a new office in New York, resulting in a reduction in margin. The current year has seen a small increase in margin.

OTCM management takes a long-term view of the development of the business and has a consistent mission statement, which is to create better informed and more efficient markets. Flowing from this is a threefold strategy set out as follows:

This focus has contributed to the long-term growth in the group set out above and the goals appear to fit well with the requirements of corporates, investors, broker-dealers and regulators involved in the OTC market.

On acquisitions, OTCM has been clear that it is not seeking a high-risk transformative transaction but continues to monitor opportunities for purchases that will provide complementary capabilities. An example is the acquisition of certain assets of Virtual Investor Conferences in January 2019, which has been developed with further investment and has seen strong demand in the current year when in-person meetings have not been possible. The business arranged 19 virtual conferences in 9M20 involving 232 companies and reaching over 18,000 investors.

OTCM continues to work towards further regulatory recognition for its two premium markets, including extending the list of states that grant exemptions under state Blue Sky laws governing secondary trading. The list currently includes 37 states for OTCQX and 33 for OTCQB giving population coverage of nearly 58% and over 53%, respectively. Blue Sky recognition is not directly linked to revenue generation but progress towards 100% coverage should be increasingly positive reputationally, helping to attract a broader range of corporate clients to OTCM’s premium markets. OTCM is also seeking recognition for OTC securities on its OTCQX and OTCQB markets for the purposes of federal regulations dealing with margin eligibility and employee stock ownership plans (an ESOP Fairness Act has been introduced in the House and Senate this year).

A summary of third quarter profit and loss figures is given in Exhibit 5 including Q220 and Q319 for comparison. We pick out key points below (comparisons are year-on-year unless stated).

Exhibit 6 sets out an indicative subdivisional analysis of gross revenue based on management commentary in Q320 and Q319 reports. Within OTC Link this shows the scale of the increase in revenue for OTC Link ECN resulting both from the volatility in equity markets and a continued increase in the number of broker dealer participants. In Market Data Licensing the revenue increase for professional user licences was the main absolute contributor to growth. Non-professional users saw a dramatic 64% increase in number, but because these subscriptions are at a much lower price point the absolute contribution to growth was more modest. The Corporate Services numbers show modest reductions for both OTCQX and OTCQB revenues, reflecting the lower average number of company clients after a challenging period for new client signings (see Background and outlook section for further discussion). Virtual events (VIC) recorded very strong growth and other services also contributed to growth.

Our next table summarises the change in operating expenses with commentary on the year-o-year changes. As noted above, the main contributor to overall expense growth was staff costs. Other points to highlight are that IT costs were flat as prior year one-off costs dropped out balancing ongoing investment in security and other areas, while occupancy costs were inflated in this quarter by the retroactive billing of certain costs.

Exhibit 8 shows changes in operating data and related revenue data. Under OTC Link the dollar volume of trades was higher year-on-year in each market segment as equity market volatility continued. Sequentially, OTCQB, which had been relatively subdued in Q220, showed a marked pickup in activity, while OTCQX and Pink retreated somewhat from their peak levels probably reflecting sectoral rotation as investors sought to adjust to changing expectations. The number of OTC Link ATS participants saw a further decline but ECN subscribers continued to increase.

Corporate Services figures show sequential and year-on-year increases in OTCQX clients while OTCQB saw a further modest erosion, albeit the rate of new client additions increased significantly (see Exhibit 14 in next section).

For Market Data Licensing the salient feature is the 45% y-o-y jump in non-professional subscribers. OTCM has consistently noted that these subscriber numbers have been much more volatile than the professional subscribers, so it remains to be seen what level will be retained when equity market trading activity normalises. Positively, there has been a longer-term trend for higher retail involvement in the equity market with factors cited by OTCM including robo-investing platforms, fractional trading and zero trading commissions so some portion of the new subscribers may prove sticky. As noted earlier, the larger impact on segment revenues has been the more modest increase in professional users (and price increases).

Among the regulatory developments highlighted by OTCM in its quarterly report are the SEC’s final rule amending Exchange Act Rule 15c2-11 (26 September) and Consolidated Audit Trail obligations. Rule 15c2-11 deals with information requirements before quotes may be published on interdealer quotation systems such as OTC Link ATS. Positively, the amended rule recognises OTCM markets’ disclosure standards and OTC Link ATS will be permitted to act as a qualified IDQS (interdealer quotation system) reviewing disclosure to determine whether a security is eligible for public quoting. This will enable it to streamline onboarding of securities to OTCM’s markets, removing the risk and administrative burden of certifying the suitability of securities for quotation from broker dealers, which in turn will allow them to focus on their financial advisory role. For companies that do not meet the information requirements there is the potential for an expert market exemption allowing sophisticated or professional investors to continue to trade in the securities. OTCM has already established an Expert Market and is continuing to engage with the SEC with the aim of refining implementation of the amended rule to provide well-informed markets for its corporate clients, broker dealers and investors. The group expects to invest significantly (at a level yet to be determined) in technology and personnel to comply with the rule ahead of the 26 September 2021 deadline.

The initial phase of Consolidated Audit Trail (CAT) obligations for OTC trading began in June 2020 with subsequent obligations taking effect in 2021. The prospective costs for firms such as OTC Link LLC and other FINRA broker dealer members to fund the database of trading activity have yet to be established and there are also costs involved in building the capability to submit trade reports to meet CAT requirements.

Otherwise OTCM continues to work towards increasing regulatory recognition for its markets including the number of states granting Blue Sky recognitions for OTCQX and OTCQB (unchanged in Q320).

We start with a table of recent equity market index performance. Strikingly, after a period of accentuated volatility, most indices over most of the periods shown are in positive territory, with the bounce since the initial onset of the pandemic particularly evident in the six-month figures.

In Exhibit 10 we show the readings from State Street Investor Confidence Index from just before the global financial crisis in 2008/2009. This indicator tracks changes in institutional investor holdings of risky versus safer investments. On this measure, the level of confidence bounced following the financial crisis, later peaking in 2015 then declining to a lower level in 2018/19 coinciding with global trade tensions followed by the pandemic this year. Confidence did recover quite sharply following the initial onset of the pandemic but, as can be seen, the latest readings suggest greater caution and do not capture more encouraging recent news relating to vaccines that may curtail the impact of COVID-19.

Another indicator of the environment for corporate decision-making is the Economic Policy Uncertainty Index shown below. The index component selected here reflects daily newspaper coverage related to economic uncertainty and shows the substantial impact of the pandemic compared with the global financial crisis, for instance. Reflecting the nature of its compilation, the index does show a more severe spike with the arrival of the pandemic and more marked subsequent easing than the investor confidence index but remains at elevated levels.

Next, we show the trends in numbers of IPOs on the Nasdaq, TSX and TSX Venture exchanges. For Q320 the number of IPOs on Nasdaq bounced strongly (Exhibit 12), up 156% y-o-y compared with 27% and 30% y-o-y reductions for the first and second quarters respectively. TSX IPOs to end October were up 37% while in contrast the TSX Venture exchange saw a 48% drop in IPOs; in terms of IPO money raised both were strongly up yearonyear: +392% and +278% respectively. While the number of IPOs in the higher risk TSX Venture market was down, the positive trend in other data suggests an appetite among corporates and investors to take opportunities and look beyond the pandemic and other current market uncertainties.

We highlighted earlier the increase in the number of corporate client additions for both OTCQX and OTCQB in Q320. For OTCQX there were 44 additions in the third quarter compared with nine and 19 in Q120 and Q220. The net increase in Q320 was 26 to 441 (see earlier Exhibit 8). OTCQX renewals are annual on a calendar year basis.

Exhibit 14 sets out the figures behind the downtrend in OTCB client numbers in recent quarters. Looking at the current year, the number of new additions was particularly depressed in the first quarter, as would be expected, but has improved in the second and third quarters. OTCQB client renewal is annual or semi-annual, based on when companies originally signed contracts, and renewals are spread broadly evenly between quarters. The level of voluntary non-renewals was lower in Q320 (c 3%) and has averaged 5% for 9M20 compared with 6% in FY19. Other departures, including compliance downgrades (which help protect the quality of the market), were at a higher rate in Q320 (c 7%) but the 9M20 rate (5%) was only slightly above the FY19 level.

Beyond the third quarter, OTCM reports that the trends have been encouraging with OTCQB seeing net client additions in both September and October, while there are good pipelines for both OTCQX and OTCQB and high levels of issuer engagement, including international companies. It remains to be seen whether the market background allows this positive trend to continue into 2021 but Q420 appears to have started well.

A positive factor for Corporate Services revenue in 2021 will be annual/semi-annual fee increases for OTCQX and OTCQB of between 15% and 16.7% for companies renewing from January onwards. These are the first increases since 2016 for OTCQX and 2018 for OTCQB. The effect will be immediate for OTCQX but phased for OTCQB with the full benefit seen in 2022 given the incidence of renewals.

Turning to OTC Link, the group indicated that trading levels have continued at very high levels into October and November. Looking further ahead, it seems reasonable to expect a moderation of market volatility and trading activity. OTC Link ECN should nevertheless still benefit from its enlarged subscriber base.

Market Data and Licensing should continue to benefit in the fourth quarter from price increases introduced this year and beyond this from the increased subscriber numbers reported. The subscription-based nature of revenues provides resilience although, in the event of a longer-term economic downturn, subscription numbers could contract again for a period. Compliance data has been an area of growth within the division but OTCM believes it has captured a large part of the available market. Nevertheless, new introductions such as the Blue Sky Data Product, launched in September, should help broaden the market opportunity (the product provides compliance data on 16,000 OTC equity and 80,000 OTC fixed income securities).

Key figures from our revised estimates are shown in Exhibit 15 and further detail is given in the financial summary (Exhibit 18). For FY20 our revenue estimate is increased by 3% with similar increases for each division. For FY21, where our revenue estimate is increased by 5%, the main change has been an increase in Corporate Services to allow for the fee increases announced in September and also an assumption of a more favourable trend in corporate client additions. As before, we factor in some normalisation of equity market trading activity levels, assuming that OTC Link FY21 revenues are 10% lower than our FY20 estimate. With expense assumptions little changed, our diluted EPS estimates for FY20 and FY21 increase by 9% and 16% respectively.

We note that although there is currently more positive news on potential vaccines for COVID-19, the development of the pandemic and its economic ramifications remain uncertain. Our FY21 estimate would be likely to prove optimistic were a more sustained economic downturn to emerge in place of the recovery consensus expectations point to.

OTCM’s balance sheet remains strong with no debt and cash of $28.6m or $30.2m including restricted cash. Operating cash flow for the first nine months of 2020 (9M20) was $10.3m of which $0.9m was allocated to capital expenditure (IT infrastructure), $5.2m dividends and $3.5m purchases of treasury stock. In addition to the cash held OTCM has an undrawn line of credit of up to $1.5m available.

We have updated our comparative P/E table in Exhibit 16. This includes information providers MSCI and Markit together with the average multiples for global exchanges. OTCM shares are trading on prospective P/Es below the average for exchanges and noticeably below those for information providers. To some extent the discount can be attributed to the relative illiquidity of OTCM shares and to its exposure to smaller companies through its venture market. Positively, the group is financially strong and has a high proportion of subscription-based revenues.

The sensitivity of our discounted cash flow valuation to different discount rates and long-term growth assumptions is shown in the next table. The model factors in our increased explicit forecasts for FY20/21, together with an assumption of FY22–23 cash flow growth of 8%, long-term growth of 4% and a terminal cash flow multiple of 16x. At a discount rate of 10% these assumptions give a value of $35.00 per share ($30.40 previously but with 12% growth FY22–23 from a lower base).