OTC Markets Group (OTCM)

Having spent a year or so digging around the securities on the OTC markets, it finally hit me to take a look at OTC Markets Group itself. This is a company that I will pass on for now, but I think is quite interesting and potentially a very good investment for someone that understands the business better than myself (and someone without a whole lot of money to deploy given the liquidity constraints). A synopsis of the situation follows.

Background

OTCM operates an interdealer quotation system (OTC Link) that allows broker-dealers to publish their quotation prices and directly interact with one another. OTCM is not an exchange in that it does not control execution or act as an intermediary - they are a subscription based technology company. They earn revenue in three ways:

1. Trading Services – monthly license, subscription and connectivity fees paid by broker-dealers for access to the OTC Link interdealer quotation, messaging, and trading platform. This business made up 36% and 41% of gross revenues for the years ended December 31, 2011 and 2010, respectively.
2. Market Data Licensing – provides subscribers with access to OTC market data and security information collected through the Trading and Issuer Services products. This business made up 40% and 42% of gross revenues for the years ended December 31, 2011 and 2010, respectively.
3. Issuer Services – various services provided to OTC issuers, such as their “premier” OTCQX marketplace, Blue Sky monitoring, news display, disclosure display. This business made up 24% and 17% of gross revenues for the years ended December 31, 2011 and 2010, respectively.

OTCQX

The fastest growing revenue source has been the Issuer Services business, specifically the OTCQX marketplace. OTCM organizes the equity securities quoted on its platform into three tiers depending mainly on information availability. OTCQX is OTCM’s highest tier, and is available to those meeting certain financial standards, disclosure requirements, and professional advisor sponsorship via OTCM’s “DAD/PAL” program. The DAD/PALs perform a review of the company’s disclosure to monitor compliance with OTCQX requirements. It is divided into OTCQX U.S. (requires a DAD – Designated Advisor for Disclosure – sponsor) and OTCQX International (requires a PAL – Principal American Liaison – sponsor). For inclusion in the OTCQX marketplace, issuers pay a one-time $5,000 application fee and a $15,000 annual subscription fee. In return they receive the means for creating a marketplace for their securities along with other services such as Blue Sky monitoring. This value proposition is more compelling for international companies wishing to reach U.S. investors, but who are already subject to home country/exchange reporting and accounting requirements.

Currently there are 389 companies on the OTCQX marketplace with a new company added every couple of days. The number of companies on the OTCQX marketplace is one of the key metrics to watch in order to track the progress of the business.

Key Financial Stats

Price: 7.09

Diluted Shares: 10.56mm

Mkt Cap: 76.33mm

Cash: 11.73mm

Debt: 0

Long Term Liabilities: 1.42mm

Equity: 13.78mm

EPS (TTM): 0.49

EPS (5y FY avg): 0.29

P/Diluted EPS (TTM): 14.47

Further to the above, over the last several years:

• Returns on equity have been very high (averaging north of 40%)
• Growth has been substantial, with revenues and diluted EPS growing respectively at 13% and 19% compounded annually over the last 5 years.

Competitors

OTCM is currently in a unique position in that it within its niche OTC security space, their competitive position is protected from the major exchanges by regulations that disallow them to quote prices in unlisted securities.  So currently OTCM’s direct competition is limited to FINRA’s OTC Bulletin Board (“OTCBB”).  OTCM has handily trounced OTCBB as illustrated by, among other metrics, the quote counts in OTCM’s financial reports. However in late 2009 FINRA filed a proposed rule change with the SEC (the Quotation Consolidation Facility or QCF) under which FINRA would provide a national best bid or offer for OTC securities traded on interdealer quotation systems for inclusion in the NASDAQ UTP Level One feed (at $4 per quote). This would essentially annex much of OTCM’s Market Data Licensing business.

Also, additional potential competitors are on the horizon.

1. Per OTCM’s financial reports, the SEC approved the creation of the “BX Venture Market,” a proposed listing market for OTC equity securities to be operated by NASDAQ OMX Group. Issuers listed on the BX Venture Market must be SEC registered and current in their reporting, and meet corporate governance standards similar to the listing requirements on The NASDAQ Stock Market.  OTCM Expects that the BX Venture Market will compete with its OTCQX U.S. marketplace (represents around 5% of the companies on OTCM’s platform, and at least – probably quite a bit more – 2% of revenue)
2. In early 2011, FINRA completed the sale of its OTC Bulletin Board assets to Rodman and Renshaw Capital Group, an investment bank. It is currently not clear what Rodman plans to do with these assets.

Comments

 Pros:

• On the basis of historical earnings, and historical earnings growth, OTCM looks quite exciting at its current P/E
•  On a forward looking basis, OTCM also appears to be benefitting from significant tailwinds.
• The universe of securities that OTCQX could appeal to (e.g., international companies that do not wish to be burdened by SEC registration requirements like SOX) is very large
• The JOBS act, signed into law in April 2012, promotes alternative means for raising capital for smaller companies by easing securities regulations. This is likely to broaden the universe of OTC traded securities.
• OTCQX annual renewal rates have been over 90%
• Clean balance sheet
• The founder runs the business and owns around 40% of the company
• For various reasons, risk of fraud strikes me as close to nil
• Pays modest dividend yielding 2.3%

Risks:

• Regulation: I have a hard time believing that the FINRA QCF proposal will be approved by the SEC. On the other hand, I am not familiar with the forces at work behind the scenes. More generally, this business is quite sensitive to the whims of regulators.
• Competition: The main thing preventing me from committing to OTCM is an insufficient understanding of the business and competitive environment. Why, for example, couldn’t someone else start a new quotation platform for lower fees and ruin OTCM’s business or at least erode its economics? I don’t quite grasp this yet, as it doesn’t seem particularly difficult to me.
• Technology change: OTCM is largely a technology company and its OTC Link platform is sensitive to changes in technology and/or obsolescence. I don't have any particular insight to evaluate this risk.
• Credit risk: OTCM will be accepting greater credit risk going forward through its factoring program, whereby it purchases access fee receivables from the broker-dealers participating on its platform. Currently I think this is a minor risk, but it something that should be monitored going forward using various receivables metrics.
• In the event regulation, competition, or other factors erode OTCM’s business, there are few hard assets to fall back on to support the stock price

These are things I continue to investigate and learn about as I follow this company and talk to those closer to the industry. Given that growth is a critical part of the long thesis, a better understanding of these forces is required on the investor’s part.

Conclusion

At current price levels around 76mm, OTCM seems like a potentially exciting opportunity given its current earnings, historical growth, growth outlook, and clean balance sheet. At the moment however, I am not comfortable enough with the long-term competitive environment to purchase the stock. This is definitely a company that I will continue to monitor on a regular basis may at some point invest in.

Disclosure: No position