OTC Markets Group — Hitting it out of the ballpark

Exhibit 1 provides a summary of profit and loss figures, comparing the Q321 results with Q221 and Q320. In the comments below, we are comparing Q321 with Q320 unless stated.

Gross revenues were up 42% on Q320. While there was a decrease in revenue from OTC Link trading quarter-on-quarter (a FINRA member broker-dealer that operates two Securities and Exchange Commission (SEC) registered Alternative Trading Systems), the Corporate Services division, which in our view is the highest quality and thus implicitly the most highly valued component of OTC’s businesses, was up 16% relative to Q221.

Market Data Licensing (distributes market data and financial information) revenue increased by 18%, with the main contributor being the growth in non-professional users as retail participation in equity markets remained elevated. Growth in professional users and price increases were among the other factors at play.

Corporate Services (operates the OTCQX and OTCQB markets and offers issuers disclosure and regulatory compliance products) revenue growth of 57% was generated by a combination of strong additions in new clients for OTCQX and OTCQB markets (see Exhibit 2), price increases and an increasing number of companies subscribing to the group’s DNS product in order to comply with regulation 15c2-11.

Redistribution fees, which relate to market data services, grew by 8% and transaction-based expenses (payments for liquidity provision on OTC Link ECN) were up 172% as a result of higher transaction activities.

Operating expenses (before depreciation and amortisation) were up 21%, with the main contributors being personnel costs, and clearing and regulatory costs resulting from the expansion of ECN trading (see further detail in Exhibit 4).

At the pre-tax profit level, the increase was 78% to $9.7m, while a higher tax charge of 22.5% versus 18.1% left diluted earnings up 68% at $0.62 from $0.37.

Exhibit 2 shows how the corporate client base for the OTCQX and OTCQB markets has evolved from Q319. After a low point in Q120/Q220, the rate of new client additions for both markets improved again in the third quarter year-on-year. In OTCQX they were down slightly quarter-on-quarter from previously elevated levels.

Q321 showed a continuation of the strong momentum with 55 additions for OTCQX (OTC Markets’ premium platform market providing efficient public trading without the complexity and cost of a national securities exchange listing) and 115 for OTCQB (a venture market providing public trading for entrepreneurial and development-stage companies and which applies standards that promote price transparency and facilitate public disclosure). OTCQB is also open to international companies, representing 10.4% and 11.3% of the opening client base for each market respectively. At the same time, the rate of cancellations and downgrades was similar to previous quarters at 4.5% (OTCQX) and 6.7% (OTCQB), leaving net additions in the quarter at 31 and 47 companies respectively.

Of the 55 new corporates joining OTCQX, 44 were international issuers and of the 115 joining OTCQB, 90 were international. Management noted increased sales in the UK and Canadian offices, which remain at healthy levels. This highlights the importance of the contribution by international companies to the group’s growth profile and of the value that OTCM can offer to international companies seeking access to the US capital markets at a lower cost than incumbent exchanges.

Exhibit 3 shows changes in operating expenses between Q320 and Q321. The main drivers of the 19.8% increase were higher compensation, and professional and consulting costs (rule 15c2-11), a continuation of the trend in Q221. Compensation and information technology costs remain a significant proportion of overall expenses, representing approximately 80% of total operating expenses (excluding one-offs). Higher incentive compensation combined with higher sales commissions (strong sales at OTCQX and OTCQB) were the key driver.

Exhibit 4 sets out operating and related revenue data, showing year-on-year and quarter-on-quarter changes. OTC Link data show a slowdown in in trading volumes compared with Q221 but still remaining at elevated levels, which reflects the wider US equity markets generally. For Corporate Services, analysis of the growth in OTCQX and OTCQB client numbers is discussed above (see Exhibit 2). In Market Data Licensing, the growth in non-professional users has slowed but is still reflecting high retail investor participation, a phenomenon that began during the COVID-19 lockdowns. We note that the number of non-professional users has been volatile historically and, should equity markets correct, we see risk of a pullback here.

OTCM launched its third alternative trading system (ATS) in Q321 called OTC Link NBQ in addition to OTC Link ATS and OTC Link ECN. The two existing platforms are complementary, with OTC Link ATS providing a network to publish quotes and facilitate trades between subscribers, while OTC Link ECN operates an anonymous matching engine and acts as an order router, functioning as the execution party on an agency basis.

OTC Link NBQ will provide alternative functionality to broker dealers, enabling electronic matching and execution, but with full disclosure rather than anonymity and allowing distribution of full depth of book data rather than top of book alone. Management has stated that it is unable to gauge the financial impact or how successful this new interdealer quotation system (IDQS) will be. However, we believe the launch of NBQ will be an attractive proposition to clients and thus should be a positive for OTC Link’s revenue in the medium term.

Given the impact of trading activity on recent results, we include in Exhibit 5 an index of the average daily volume of US equity share trading. This shows two spikes in early 2020 and from the end of 2020 to Q121. In line with OTCM’s commentary, this appears to have begun to return to more normal levels. These trends have been reflected in OTC’s trading revenues.

The trends in the number of IPOs on the Nasdaq, TSX and TSX Venture exchanges are shown in Exhibits 6 and 7. The number of IPOs on Nasdaq has tempered after very strong activity in Q121. TSX IPOs for the first 10 months of 2021 were up 5% by number compared with the same period in 2020 and the TSX Venture exchange saw a 147% increase.

Looking at the trend in the number of corporate client additions for OTCM shown in Exhibit 2, the Q321 figures reflect the favourable development in IPOs highlighted above.

Headline figures from our revised estimates are shown in Exhibit 8 with further detail, including the divisional breakdown of revenues, shown in the financial summary (Exhibit 10).

Following a strong Q321, we have increased our group revenue estimate for 2021 by 5.9%. This includes a 10% increase in the estimate for OTC Link (reflecting strong quarterly performance followed by an assumed normalisation in trading activity, as discussed above). We continue to assume a significant normalisation (-40%) in revenue for the division in 2022. The higher multiple value (in our view) divisions of Market Data Licensing and Corporate Services also beat our Q321 expectations by 6% and 32% respectively.

Our revenue growth assumptions for Market Data Licensing (19% and -7% for 2021e and 2022e) are influenced by our assumption of lower trading levels possibly affecting non-professional subscription levels, particularly in 2022. Uncertainty on this point, as well as on the outlook for trading activity levels in US equities, is incorporated in our estimates. Nevertheless, we increase our Market Data Licensing revenue estimates by 2.6% for both 2021 and 2022.

For Corporate Services, the strong new client additions and strong sales of the DNS product have translated into an increase in our estimates (by 6.0% for 2021e and 5.6% 2022e).

OTCM’s balance sheet remains strong, with no debt and cash of $50.0m or $51.5m including restricted cash at the end of Q321. In addition to cash held, OTCM has an undrawn line of credit of up to $1.5m available. This indicates that the capital return profile, mainly in the form of dividends, is reasonably secure in the near to mid-term. The group has paid a special dividend since 2014 and we expect this to continue in the near to medium term.

An updated version of our comparative P/E table is shown in Exhibit 9 below. 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 global exchanges for 2021 and 2022 (which also reflects the normalisation in elevated trading volumes). The shares trade on markedly lower P/Es than those for information providers. While the multiple applied to prospective earnings may be limited by the relative illiquidity of OTCM shares, the group is financially strong and has a high proportion of subscription-based revenues. The positive change in business mix in Q321 suggests a higher multiple rating could be justified going forward.