OTC Markets Group — Update 19 November 2015

Financials

OTC Markets Group

Growth and a special dividend

Q315 results

Financial services

20 November 2015

Price	US$15.1
Market cap	US$169m

Net cash ($m) at 30 Sept 2015		24.4

Shares in issue (excluding treasury)	11.2m
Free float	60%
Code	OTCM

Primary exchange	OTCQX
Secondary exchange	N/A

Share price performance

%	1m	3m	12m
Abs	7.5	4.1	5.2
Rel (local)	5.0	4.1	3.6

52-week high/low

US$16.7

US$13.2

Business description

OTC Markets Group (OTCM) operates the OTCQX Best Market, OTCQB Venture Market and OTC Pink financial market for 10,000 US and global securities. Its trading system OTC Link ATS is operated by OTC Link LLC, a member of FINRA/SIPC and SEC regulated ATS. Its markets offer a cost-effective solution for targeting US investors.

Next event

FY15 results

March 2016 (estimated)

Analyst

Peter Thorne

+44 (0)20 3077 5765

financials@edisongroup.com

Edison profile page

OTC Markets Group is a research client of Edison Investment Research Limited

OTC Markets Group (OTCQX: OTCM) continues to benefit from its initiative to create a US venture market to rival AIM in the UK and TSX Venture in Canada. Revenues continued to rise in Q315 and operational gearing led to a higher operating margin. OTCM has net cash on its balance sheet and is generating considerable cash from its business. It has announced a special dividend for 2015, having also paid one in 2014. OTCM is trading on a yield of 7.4% for 2015 and 3.7% excluding the special dividend. It is also trading below our DCF valuation.

Year end	Gross revenue ($m)	PBT* ($m)	EPS* (c)	DPS** (c)	P/E (x)	Yield (%)
12/13	35.5	8.3	50.8	24.0	29.7	1.6
12/14	42.2	12.9	69.4	82.0	21.8	5.4
12/15e	50.2	16.8	88.8	112.0	17.0	7.4
12/16e	52.0	16.6	88.3	56.0	17.1	3.7

Note: *PBT and EPS are normalised and exclude exceptional items and amortisation of intangibles. **Includes special dividend of $0.5 for 2014 and $0.6 for 2015.

Q315 results show continued growth

Revenues grew 19% in Q315 y-o-y and 4% q-o-q, largely thanks to OTCM’s initiative in May 2014 to transform its OTCQB market into one for venture companies, which has boosted its corporate services income. OTCQB already has as many companies as the much longer established AIM market in the UK and given the size of the US economy there remains considerable scope for this market to expand further. Incremental costs from new companies joining OTCQB are small and less than the revenue so OTCM’s operating margin is rising; in Q315 it reached 37%, the highest level since 2007.

Another large special dividend

With the publication of its Q3 results, OTCM announced a $0.6 per share special dividend, payable in December 2015. This is in addition to its ordinary quarterly dividend of $0.14 per share. OTCM already has net cash of $24.4m and follows a progressive dividend policy in line with its profit growth. It announced an increase in its ordinary quarterly dividends to $0.14 from $0.1 in August 2015 with the publication of its Q215 results. In November 2014, when it published its Q314 results, OTCM announced a special dividend of $0.5 per share.

Valuation: High yield

OTCM shares are trading below our updated DCF valuation of $21.3 per share (previously $19.1) based on long-term growth of 3% and a cost of equity of 9%. Its 2015 P/E ratio is 3% lower than that of the S&P500 index and 34% lower than the average of the two data providers, MSCI and Markit. A large portion, c 80% in 2014 according to our estimates, of OTCM’s revenue is subscription based and not dependent on trading activity, so we believe that the two data providers are a useful benchmark with which to compare OTCM.

Q315 results

Q315 gross revenue rose 4% q-o-q and 19% y-o-y, with all of the growth coming from corporate service revenues. Operating expenses were flat q-o-q but up 14% y-o-y, similar to the increase in Q2 reflecting higher client volumes and increased regulatory and client expectations. Q3 operating margin rose to 37%, the highest level since 2007, as a result of positive operational gearing, as the increase in revenue from corporate services did not incur incremental costs. Q315 income before tax grew 33% y-o-y and 12% q-o-q. OTCM’s Q315 tax rate was particularly low, at 33% compared with 42% in Q215, as a result of one-off tax benefits arising from changes in estimates related to state and local apportionment rates. Net income increased by 59% to $3.1m.

Exhibit 1: OTCM quarterly results

$000s	Q314	Q215	Q315	% change
				y-o-y		q-o-q
OTC Link ATS	3,146	2,931	2,939	(7)	0
Market data licensing	5,123	5,169	5,087	(1)	(2)
Corporate services	2,530	4,330	4,874	93	13
Gross revenues	10,799	12,430	12,900	19	4
Re-distribution fees and rebates	(593)	(600)	(602)	2	0
Net revenue	10,206	11,830	12,298	20	4
Operating expenses (including depreciation and amortisation)	(6,759)	(7,741)	(7,707)	14	(0)
Income from operations	3,447	4,089	4,591	33	12
Other income/net interest	1	7	6	0	0
Income before provision for income taxes	3,448	4,096	4,597	33	12
Taxes	(1,511)	(1,704)	(1,512)	0	(11)
Net income	1,937	2,392	3,085	59	29
Operating margin (%)	34	35	37
Tax rate (%)	44	42	33

Source: OTCM, Edison Investment Research

OTC Link ATS revenues

OTC Link ATS enables broker-dealers to provide their clients with trade execution for companies quoted on OTCM’s various markets. It earns revenue by charging the broker-dealers various usage fees for stocks in which they make a market and messaging fees as well as subscription fees. OTC Link ATS revenues have been under pressure because of a decline in the number of broker-dealers, as the industry becomes more concentrated and firms with less competitive IT systems are forced to leave the industry. On 1 July 2015 OTCM introduced a new fee structure for OTC Link ATS. No charge is made for quoting securities traded on OTCQX and OTCQB and messaging fees were increased by 50% for priced securities and 20% for unpriced securities. OTCM anticipates that the pricing changes will encourage broker-dealers to quote on OTCQX and OTCQB and deepen the trading books of companies on these markets. In Q315, these changes reduced revenues for quotes by $216,000, but increased message revenue by $192,000. The operating systems of OTC Link ATS have also been enhanced to improve reliability and reduce latency, and OTCM believes it will benefit from these measures in the future, as they will encourage more activity.

Market data licensing

OTCM obtains revenue by providing subscribers with access to market data, company data and security information collected through OTC Link ATS and Corporate Services business lines. A repricing initiative in January 2014 resulted in a 38% y-o-y growth in revenue in 2014 and without the tailwind of this initiative it was expected that revenue growth in 2015 would slow down, which did occur.

Corporate Services

Within this division, services offered include the OTCQX Best and OTCQB venture markets, OTC Disclosure and News Services, Real-Time Level 2 Quote Display and Blue Sky Monitoring Service. Corporate services revenues have increased since Q314 after several periods of flat revenues following the introduction on 1 May 2014 of new standards for OTCQB and the designation of the market as one for venture companies. In Q315 revenues grew 93% y-o-y and 13% q-o-q. OTCQB subscribers at end Q315 increased to 959 from 955 at end Q215 and 118 at end Q314. Revenues from the OTCQB market were $2.3m in the quarter, up from $1.9m in Q2, while revenues from OTCQX were $1.6m compared with $1.5 in Q2. There has clearly been a slowdown in the pace of new companies joining OTCQB after the initial rush, but the company believes that its prospects are good given the entrepreneurial nature of the US economy. OTCQB is already as large as the much longer established AIM market in the UK.

Revenue trends

The following table shows the evolution of quarterly gross revenues at OTCM over the last 2 years. Revenue from OTC Link ATA has remained around $3m per quarter which is a solid performance given the declining number of market participants. Market data licensing achieved a step-up in revenues in Q114 as a result of a re-pricing initiative and has maintained a quarter run rate of around $5m ever since. Quarterly growth from corporate services started in Q214 following the implementation of new standards for OTCQB and its designation as a market for venture companies.

Exhibit 2: OTCM quarterly gross revenues

	Q213	Q313	Q413	Q114	Q214	Q314	Q414	Q115	Q215	Q315
Revenue $000s
OTC Link ATS	2,955	2,815	2,817	2,902	2,772	3,146	3,199	3,044	2,931	2,939
Market Data Licensing	3,647	3,778	3,749	4,959	5,148	5,123	5,104	5,233	5,169	5,087
Corporate Services	2,332	2,367	2,424	2,109	2,319	2,530	2,904	3,247	4,330	4,874
Gross revenues	8,934	8,960	8,990	9,970	10,239	10,799	11,207	11,524	12,430	12,900
% Change
OTC Link ATS		(5)	0	3	(4)	13	2	(5)	(4)	0
Market Data Licensing		4	(1)	32	4	(0)	(0)	3	(1)	(2)
Corporate Services		2	2	(13)	10	9	15	12	33	13
Gross revenues		0	0	11	3	5	4	3	8	4

Source: OTCM, Edison Investment Research

Expenses

In Q115, OTCM increased its compensation and benefits to staff, to remain competitive in the industry and reward them for the success of the company. It also incurred additional IT expenditure to meet new regulatory standards and customer expectations. The expense base since Q1 has remained around $7.7m per quarter.

Valuation

The following table compares OTCM’s P/E ratio with the US market represented by the S&P500 index as well as against two data providers, MSCI and Market. With over 40% of OTCM’s revenue from market data licensing and a large amount, c 80% according to our estimates, of OTC Link ATS and corporate services revenue linked to subscriptions rather than trading activity, we believe that these two data providers are a useful benchmark for OTCM. OTCM’s 2015 P/E ratio is 3% lower than that of the S&P500 and 34% lower than the average of MSCI and Markit.

We have also considered OTCM’s valuation using DCF. Net cash at 30 September 2015 was $24m and with c $12m of free cash flow in 2015 OTCM would be worth $21.3 per share on a DCF basis if we assume a long-term growth rate of 3% and a cost of capital of 9% (compared with $19.1 in August 2015). The uplift arose because of an increase in our estimate of free cash flow to $12m from $11m for 2015.

Exhibit 3: OTCM comparative multiples

	Estimated P/E ratios (x)
	2015	2016
MSCI	30.8	25.7
Markit	20.4	19.2
Average	25.6	22.5
S&P 500 index	17.5	16.1
OTCM	17.0	17.1

Source: Bloomberg, Edison Investment Research. Note: Prices at close of business on 19 November 2015.

Financials

We have made minor changes to our forecasts following the announcement of the Q315 results, as we show in Exhibit 4 below. We anticipate slightly higher revenue in Corporate Services, which has led to a 5% increase in our PBT estimate for 2015, given the operational leverage in this activity. The 10% increase in expected EPS for 2015 is the result of the PBT increase and a slightly lower tax rate than previously expected (39% vs 42%) as a result of the one-off tax effects in Q315.

With the announcement of its Q3 results, OTCM announced an ordinary dividend of $0.14 per share, in line with the previous quarter. It also announced a special dividend of $0.6 per share. Both are payable in December 2015. The special dividend reflects the $24.4m of cash on its balance sheet at end September 2015 and the company’s policy of paying dividends in line with profit growth. In Q414, OTCM paid a special dividend of $0.5 per share and an ordinary dividend of $0.1 per share, so the special dividend payable in Q415 has been increased by 20% and the ordinary dividend by 40%.

Exhibit 4: OTCM earnings revisions

	Net revenue ($m)			PBT ($m)			EPS (c)			Dividend (c)
	Old	New	Change (%)	Old	New	Change (%)	Old	New	Change (%)	Old	New	Change (%)
2015e	47.2	47.8	1	16.0	16.8	5	81.0	88.8	10	52.0	112.0	115
2016e	49.3	49.3	0	16.6	16.6	0	88.0	88.3	0	56.0	56.0	0

Source: Edison Investment Research, OTC Markets

Exhibit 5: Financial summary

$000s	2011	2012	2013	2014	2015e	2016e
Year-end 31 December
PROFIT & LOSS
OTC Link ATS	11,773	11,640	11,437	12,019	12,114	12,500
Market Data Licensing	13,680	14,081	14,741	20,334	20,639	21,000
Corporate services	7,498	9,305	9,331	9,862	17,451	18,500
Gross Revenue	32,951	35,026	35,509	42,215	50,204	52,000
Re-distribution fees and rebates	(2,188)	(1,842)	(1,869)	(2,388)	(2,402)	(2,700)
Revenue	30,763	33,184	33,640	39,827	47,802	49,300
Cost of Sales	(22,299)	(22,606)	(23,700)	(25,382)	(29,357)	(31,000)
Gross Profit	8,464	10,578	9,940	14,445	18,445	18,300
Operating Profit (before GW and except.)	8,464	10,578	9,940	14,445	18,445	18,300
Intangible Amortisation & depreciation	(1,358)	(1,622)	(1,642)	(1,543)	(1,680)	(1,750)
Operating Profit	7,106	8,956	8,298	12,902	16,765	16,550
Net Interest	(115)	30	0	9	29	0
Profit Before Tax (norm)	6,991	8,986	8,298	12,911	16,794	16,550
Tax	(2,139)	(3,509)	(2,667)	(5,021)	(6,602)	(6,455)
Profit After Tax (norm)	4,791	5,361	5,466	7,725	10,027	9,931
Profit After Tax (FRS 3)	4,852	5,477	5,631	7,890	10,192	10,096

Average Number of Shares Outstanding (m)	10.5	10.5	10.7	10.8	11.0	11.0
EPS - normalised (c)	45.5	50.5	50.8	69.4	88.8	88.3
EPS - FRS 3 (c)	45.7	50.9	51.2	71.3	91.2	90.3
Dividend per share (c)	16.0	20.0	24.0	82.0	112.0	56.0

Gross Margin (%)	28	32	30	36	39	37
EBITDA Margin (%)	28	32	30	36	39	37
Operating Margin (before GW and except.) (%)	28	32	30	36	39	37

BALANCE SHEET
Fixed Assets
Intangible Assets	291	291	291	291	291	291
Tangible Assets	5,143	5,066	4,184	4,357	3,853	3,753
Investments	209	209	210	210	210	210
Current Assets
Debtors	7,194	6,481	4,980	5,674	5,869	5,900
Cash & cash investments	10,170	13,611	18,936	20,272	20,390	24,624
Current Liabilities
Creditors	(3,695)	(3,589)	(3,909)	(4,450)	(4,794)	(4,485)
Long Term Liabilities
Deferred rent	(926)	(786)	(608)	(391)	(391)	(391)
Other long term liabilities	(1,598)	(1,176)	(974)	(954)	(1,086)	(1,082)
Net Assets	12,872	14,515	18,704	18,251	17,528	21,915
NAV per share ($)	1.21	1.34	1.68	1.60	1.52	1.88

CASH FLOW
Operating Cash Flow (pre-tax)	11,086	12,175	10,662	16,985	19,605	18,776
Net Interest	(115)	30	0	9	29	0
Tax	(1,871)	(3,498)	(2,334)	(4,492)	(5,881)	(6,431)
Capex	(2,426)	(1,346)	(471)	(1,582)	(1,261)	(1,650)
Financing / investments	(1,536)	1,301	79	(475)	(254)	0
Dividends	(1,671)	(5,221)	(2,611)	(9,109)	(12,119)	(6,463)
Net Cash Flow	3,467	3,441	5,325	1,336	119	4,233
Opening net (debt)/cash	6,703	10,170	13,611	18,936	20,272	20,391
Closing net (debt)/cash	10,170	13,611	18,936	20,272	20,391	24,624

Source: OTCM, Edison Investment Research

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