OTC Markets Group — Update 21 November 2016

OTC Markets’ third-quarter figures showed revenues and operating income down 2% and 4% y-o-y respectively, continuing the relatively resilient performance seen in the second quarter against a less favourable market background: a testament to the benefits of the company’s primarily subscription-based business model. The established trend for consolidation among broker dealers has continued while, cyclically, the dearth of IPOs and subdued corporate activity has contributed to a slower pace of company client recruitment, which in turn has meant a reduction in the number of corporate clients. An important positive signal for the longer term is the continued addition of new states to the list according OTCQX and/or OTCQB Blue Sky recognition.

Key data points from the third-quarter results included:

In our next table we have provided a further analysis of revenues for OTC Link ATS and the corporate services activities. These numbers are mainly inferred from percentage changes given in the management commentary so are subject to rounding errors and should be treated as indicative. There are Q3 reductions across the revenue lines within OTC Link ATS reflecting the reduction in active subscribers and lower quote and message volumes. The marked decline in quote position revenue in the nine months to end September is also influenced by fee changes last year that included the removal of quote fees for the two premium markets, OTCQX and OTCQB, with a partially offsetting increase in trade messaging fees also evident.

In corporate services there were declines for both OTCQX and OTCQB revenues in Q3, while the disclosure and news service, where activity can fluctuate with the level of announcements, saw an increase of over 20% y-o-y, partially reflecting a price increase implemented in February 2016. Looking at nine-month revenues, the increase of over 28% in OTCQB this year reflects the lower starting point for corporate clients in 2015. Since peaking in Q315, client numbers have contracted through higher non-compliance related and non-renewal reductions.

Since the end of the first half, a further seven states have given Blue Sky recognitions. These include Alaska, Colorado, Georgia and Kansas for OTCQX plus Mississippi, Nebraska and New Mexico for both OTCQX and OTCQB. This takes the total to 12 recognising OTCQX and 10 recognising OTCQB out of 44 states and jurisdictions that maintain manual exemptions. These generally permit secondary trading in securities in a state and if OTCM can continue to extend this recognition the attraction of OTCM’s premium markets should progressively broaden.

In a further initiative to increase transparency within its OTC Link ATS network, OTCM has launched Q Score, a system that tracks liquidity metrics so that users can identify those participants that are better providers of liquidity beyond displayed quotation sizes.

The launch of Research Marketplace in collaboration with ACF Equity Research, Sidoti & Co and Edison provides companies with a choice of sources for sponsored research in order to have professionally prepared analytical reports available for investors and potential investors. This builds on the data driven research provided by Morningstar and crowd-sourced commentary from Seeking Alpha, providing a range of options for companies to increase transparency for investors.

Transparency again lies behind the launch of the Transfer Agent Verified Shares Program, which uses technology to draw together information from transfer agents in order to verify the outstanding share capital for corporates. Undisclosed dilution is a source of risk for investors so as the system gains penetration this should increase confidence and willingness to invest in those covered.

Finally, OTCM has announced that OTCQX rules will be adjusted incrementally from January 2017 to remove unnecessary burdens on corporates by eliminating the ongoing OTCQX adviser requirement.

In this section we review some indicators of the equity capital markets background for OTCM and consider factors that might influence the company’s trading outlook. We start by reviewing the number of IPOs on NASDAQ, TMX, TMX Venture and AIM. At NASDAQ the number of IPOs has been on a downtrend since a peak in 2014 and, the nine-month rate for 2016 on an annualised basis would be nearly 40% below the prior year. The number of IPOs on the Canadian TMX markets (Exhibit 4) is significantly below the levels seen in 2011/12, but, pro rata, TMX is running only slightly behind and TMX Venture is ahead of 2015.

In London the AIM market (Exhibit 5), like NASDAQ, is running well below its recent 2014 peak, but in terms of IPOs was actually ahead of 2015 on an annualised basis for the first nine months of the year despite a difficult macro background and a tapering off in the level of activity since May.

Trends across these markets have therefore been subdued but not uniformly so year to date. The economic outlook has remained uncertain but US GDP has shown a positive trend (Q3 +2.9%) and the IMF’s October forecasts looked for growth of 1.6% in 2016 and 1.8% in 2017. Despite uncertainty the level of these markets has been perhaps surprisingly positive, with their indices all in positive territory (US and UK indices are up between 3% and 9% year-to-date) and the commodity-heavy Canadian indices ahead nearly 14% (S&P TSX) and 42% (S&P TSX Venture).

Looking ahead, the Trump victory in the US presidential election may well represent an important turning point in a range of policy areas including taxation, healthcare, trade and foreign relations. With Republicans also having control of the House and Senate there is potential for real change and, over coming months, markets will be trying to assess possible economic and stock specific implications. After a brief dip most equity markets appear to have taken the result in their stride and, as the transition from campaigning to administration takes place, stalled corporate activity could start to revive as expectations are adjusted and policy positions are worked through.

Our next chart updates the comparison we have shown before between the number of professional users of OTCM’s market data and users of UTP (Nasdaq). This shows an increase for both but with OTCM’s faster growth in Q3 its user base is equivalent to a slightly higher percentage of the UTP number at 8%. This still represents relatively low penetration of the potential market and, if OTCM can continue to build the reputation of its premium markets and win attractive companies as clients, there should be good potential to increase market data revenue.

Political and market uncertainty could delay a recovery in corporate activity and hence prolong the period of more difficult conditions for client acquisition for OTCM’s premium markets. However, the company has increased the focus in this area and, after an earlier phase of turnover in the sales team, it is now at full strength and the pipeline is described as promising.

On a medium-term view the company continues to work with the North American Securities Administrators Association and individual state regulators to increase the number of states recognising OTCQX and OTCQB. OTCM notes that Texas has proposed a change in its Civil Statutes (14 October) that would permit recognition of the two markets. While there can be no certainty over a level of recognition that would encourage a marked increase in corporate interest in joining these markets, OTCM notes that when Nasdaq listed Apple it did not have a full roster of ‘Blue Sky’ recognitions and that there might be a tipping point in the mid-30s that would also prompt further states to consider recognition.

Another potential medium-term positive driver for OTCM is the development of online or crowd funded capital raising facilitated by the Jumpstart Our Business Startups (JOBS) Act (including Regulation A+ and Regulation Crowdfunding). While there has currently been only one example of a company raising money through crowdfunding under Regulation A+ (and that company, Elio Motors, did choose to trade on OTCQX), as online funding matures OTCM sees good potential for such developing companies to be attracted to trading on its markets. OTCM aims for the costs for its corporate clients to be less than half the level of national securities exchanges while companies would also benefit from a lower administrative burden.

Potential challenges for OTCM should also be mentioned. These include competitive pressures, with successful companies tending to graduate to a national securities exchange; positively, such graduations also flag the successful role OTCM’s platforms play in corporate development. Exchanges and new platforms could seek to compete more directly with OTCM’s offering, in the process putting pressure on fees. Changes in regulation can impose costs (as with Regulation Systems Compliance and Integrity – SCI) or impinge on revenues (for example FINRA’s 2009 proposal for a Quotation Consolidation Facility – QCF– that if implemented could affect a part of market data revenues that account for c 18% of total gross revenues). OTCM has successfully invested to address Regulation SCI and FINRA’s QCF proposal has not seen any recent reported activity. Finally, in its Q3 report, OTCM mentions a proposal FINRA published for comment in August involving changes in its inter-dealer quotation system to include any OTC equity security, rather than only ‘reporting companies’. This ‘over-the-counter display facility’ (ODF) is proposed as a backup to OTCM’s OTC Link ATS and, subject to a volume hurdle, FINRA-member broker dealers would be required to connect to the system and participate in testing. OTCM plans to oppose the proposal indicating that it would be anti-competitive and that ODF is not likely to achieve the stated goals. Further details are set to be given in OTCM’s submission due before 29 November, but on the Q3 call the company noted that ODF would not offer an electronic trading capability and would entail significant costs. OTCM indicates that it is unable to estimate a potential impact on revenues based on the proposal as currently drafted.

Drawing these remarks together, the economic background, while still uncertain, has been more resilient than many forecasters feared and, as the political background in the US starts to become clearer, both corporate and equity market confidence could build, providing a better background for both IPOs and OTCM’s client signings. Regulatory and competitive risks remain features to monitor but, on a longer view, the two main opportunities for OTCM are first, the potential to continue to enhance the status and appeal of its premium markets through additional services and achieving wider Blue-Sky recognition and, second, to capitalise on development of still nascent online capital raising platforms.

Following the third quarter results our revenue and pre-tax profit estimates are effectively unchanged (see Exhibit 7), with small increases for market data income offsetting slightly lower OTC Link ATS revenues. As we highlighted in our previous note, revenues are set to benefit between 2016 and 2017 from price increases for c 40% of OTCQB companies that move from a promotional fee of $7,500 per annum to $10,000, while those OTCQX companies that were clients in 2015 will move from $15,000 to $20,000. The lower tax rate seen in the third quarter and assumed for future periods (we assume 36% for 2017) results in increases of 4% and 5% in our earnings estimates for this year and next.

At the end of the third quarter, cash on the balance sheet stood at $25.1m compared with $23.3m at the end of the second quarter. Assuming that the special dividend of $0.60 to be paid in Q4 this year will be repeated next year, we estimate that cash will stand at just over $20m and $21m at the end of 2016 and 2017, respectively.

We start with an updated version of our comparative P/E table (Exhibit 8), which includes major information providers MSCI and Markit (to reflect OTCM’s subscription based fees and market data exposure) together with global exchange averages and values for the S&P 500 index. OTCM trades below the information providers and is similar to the exchanges but above the broad market index. Further Blue-Sky recognitions and evidence of a pick-up in the environment for corporate activity could be catalysts for a higher rating.

A sensitivity table based on our discounted cash flow model is shown next with unchanged central assumptions including a discount rate of 9%, cash flow growth of 3% and a terminal value multiple of 10x giving a value of $18.90 ($18.70 previously). The small increase reflects the modest change in estimates outlined above.