OTCM - Navigating OTC Markets Group's Hold Recommendation: An Investment Thesis On The Company's Niche Market And Future Prospects

2023-10-12 07:08:59 ET

Summary

• OTC Markets Group has recorded extraordinary financial performance in every business segment, thanks to its strategy based on transparency and efficiency.
• The company operates as a monopoly within the OTC trading equity markets, with a unique pricing power that increases revenue in every segment.
• While there are some short-term headwinds, OTCM's long-term growth prospects appear to be strong, making it a promising investment opportunity.

Introduction

OTC Markets Group (OTCM) is a company that holds a unique pricing power within the OTC trading equity markets. The company has recorded extraordinary financial performance in every business segment, even in turbulent times, thanks to its strategy based on transparency and efficiency as a way to increase liquidity in OTC markets. Based on my analysis, I recommend a 'Hold' position on OTC Markets Group shares, as the company's long-term growth prospects appear to be strong, but the current valuation may not offer enough downside risk protection for some investors.

Business Overview

OTC Markets Group is an American financial market providing price and liquidity information for almost 10,000 over-the-counter (OTC) securities. The group has its headquarters in New York City. OTC-traded securities are organized into three markets to inform investors of opportunities and risks: OTCQX, OTCQB, and Pink (penny stocks).

The company has had an exceptional financial performance in the last decade with an average median ROIC of 62%. Likewise, the annual revenue growth rate in the previous decade was 11.6%, and the 10-year average median EBIT margin was 33.2%. EPS only fell in one year (2019) and in the first half of 2023 by 11%. It holds no financial debt besides operating leases with an implicit interest rate as of June 30, 2023.

The Group has three business segments: OTC Link, Market Data Licensing, and Corporate Services.

OTC Link

OTC Link generates revenue through subscription arrangements and transaction-based fees to broker-dealer subscribers. Broker-dealers pay monthly subscription and connectivity fees to use OTC Link ATS. OTC Link ECN generates transactional revenues based on share volume executed, where broker-dealer subscribers pay a fixed fee per share executed where their orders remove posted liquidity on OTC Link ECN while receiving a rebate on shares executed against their own posted liquidity. OTC Link NQB generates transactional revenues and incurs transaction-based expenses like OTC Link ECN.

Market Data Licensing

OTC Markets Group's Market Data Licensing business generates revenue by licensing its extensive market data, compliance data, Blue Sky data, issuer data, and security information, including SEC filings, on a subscription basis to a wide range of customers, including broker-dealers, investors, traders, institutions, companies, accountants, and regulators. To access this information, subscribers pay monthly, quarterly, or annual license fees.

Corporate Services

OTC Markets Group generates revenue from the OTCQX Best Market and the OTCQB Venture Market, as well as a suite of Corporate Services products. Companies that choose to have their securities designated as OTCQX or OTCQB securities pay a one-time application fee and annual or semi-annual fees.

Management

Furthermore, CEO Cromwell Coulson owned 3,260,800 shares or 27.5% of total ownership; hence, it's plausible to state the management is aligned with shareholders. Likewise, according to Comparably , the CEO is rated 84 out of 100, the overall culture is 4.2 out of 5, and the employee Net Promoter Score is 11; consequently, I believe employees are satisfied working at the company and like working for their CEO. Moreover, I think the CEO has done a flawless job, as its strategy of adding more transparency and efficiency to the market to bring liquidity has worked seamlessly, fortifying the dominant position of the Group and improving the reputation of OTC markets.

Competitive Landscape

I believe OTC Markets Group is a monopoly inside the OTC trading equity markets, so it has a unique pricing power used to increase revenue in every segment. Furthermore, no new entrant can compete with the Group, as the network effect and the scale work as high barriers to entry. Companies won't issue their securities in an OTC market with no brokers and investors, and investors won't use OTC markets with a few companies to invest and no liquidity. In addition, the scale of the Group allows it to carry out strategic acquisitions that improve the transparency of its OTC markets, such as Blue Sky Data Corp and Edgar Online ; moreover, the Group can spread its fixed costs over a greater number of transactions that no new entrant will be able to attain. Consequently, OTC Markets Group is the leader in the market, and I think it will be the leader in the future.

Nevertheless, stating it has no competition is false; indeed, some substitutes exist for OTC markets. First, for new issuers, the national stock exchanges, such as NASDAQ, NYSE, or the Members Exchange, represent capital markets where they can raise more funds than OTC markets and have more liquidity, incentivizing the creation of a secondary market. However, stock exchanges require a higher level of disclosure, compliance, and market cap value to allow an IPO. Hence, some companies find these requirements burdensome and prefer the OTC markets to raise funds and have a secondary market where shareholders can sell and buy stocks easily. Moreover, suppose a foreign company has all its capital needs satisfied in its foreign stock exchange. In that case, it will be less motivated to promote its stocks in the US to raise capital, as higher analyst coverage and greater prestige benefits are limited in the OTC markets compared to well-known stock exchanges.

Consequently, if foreign stock exchanges can access enough investors, the listed companies won't need US OTC markets. This is crucial as most listed companies in OTCQX Best Market and OTCQB Venture Market are international stocks. Nevertheless, the US stock markets remain the largest in the world by volume and market capitalization, indicating that global companies still benefit from listing in OTC (when compliance and regulations are burdensome) in the US.

Additionally, in FY2022, every security in OTCQX, on average, had a volume of $159 million , which is a decent volume, knowing that the best 50 companies in the exchange had an average market cap of $198.6 million . Regarding OTCQB, on average, every security had a volume of $7.35 million, which is decent when we know the companies are tiny. Therefore, I believe the Group offers a liquid secondary market to small companies, making it more attractive to venture capital, international stocks, and US stocks, trying to avoid costs from being a public company in a stock exchange. Moreover, most penny stocks are traded through OTC Markets Group's exchange, representing a liquid market for pink stocks and allowing the company more freedom when it comes to charging fees to broker-dealers.

From an investor's perspective, the Group offers a stock market where market inefficiencies can arise frequently and where investors can obtain a high return on investment if they are willing to accept a higher risk. Nevertheless, thanks to the Group, the counterparty risk no longer exists, the liquidity risk decreased considerably, and there is higher transparency (financial and compliance information); hence, investors can carry out their due diligence more easily. I think this makes investors more willing to invest in listed companies, motivating companies to list in the OTC markets. Nonetheless, OTC markets lack liquidity and companies with enough market capitalization to attract many big investors. Furthermore, in the OTC markets, there are many stock losers; hence, only active investing works, so I don't think OTC markets will benefit from the passive investing trend, as their returns are inferior .

Private equity ((PE)) is the second substitute for OTC markets (especially for OTCBX and OTCBQ). PE has some advantages over OTC markets from an issuer: first, the disclosure is limited to several qualified investors, so the issuer and investors can negotiate about how much information will be disclosed; second, PE markets have been increasing in the last decades and now offer significant quantities of capitals; third, companies do not have to pay annual fees to keep listed in an OTC market.

Moreover, PE has outperformed public stock markets in the last decade, achieving a median IRR of 20.1%. Thus, PE can easily attract new investors, as its returns are higher and its standard deviation lower, as PE does not tend to have violent changes in value as public markets do .

Nevertheless, PE has two drawbacks compared to public markets: first, there is no secondary market for its securities, increasing the liquidity risk; second, there is significant activism compared to OTC markets, so managers need to adapt to the requirements of shareholders and debtholders.

Lastly, I think the Group serves a niche inside the financial industry with advantages and weaknesses relative to other markets; however, it's a niche that other markets cannot wholly substitute. Hence, I believe the outstanding financial performance will continue in the future, as the firm raised impassable barriers to entry. Moreover, as the company focuses on bringing more transparency into the OTC markets, more liquidity is likely to come, increasing transparency as more investors are interested in investing in OTC markets, so more analyses are released about listed companies.

OTC Markets

The dollar volume traded has increased since 2017 in every market except for the OTCQB market. In 2021, the volume traded skyrocketed, but in 2022, the volume fell hastily, especially in the OTCQB, whose volume fell 73.63%. Furthermore, the volume in 2023 keeps falling further. OTCQX volume has decreased by -49.22 %, OTCQB by -50.54%, and Pink by -30.74% during the first half of 2023.

However, it doesn't mean a change in the tendency or the death of OTC markets. It has happened before, precisely during the Great Recession, when the trade volume almost halved compared to the trade volume in 2007.

We must remember that the securities in OTC markets are high-risk investments, so they are vulnerable to changes in interest rates and overall economic conditions. Hence, from my perspective, when interest rates soared in 2022, the risk appetite of many investors (especially retail investors) started to decline, so many companies began to seem overvalued compared to the yield of less risky assets. Therefore, investors changed their preference to safer assets, given the worsening economic conditions. Moreover, many listed companies are from Canada, specifically in the cannabis and mining industries. The Canadian cannabis industry has plummeted recently, and the mining sector is susceptible to business cycles.

However, short-term headwinds can't distract us from the success of the Group strategy in bringing more information, transparency, and efficiency to OTC markets. For example, the number of subscribers of the orders matching engine ECN has increased steadily since its introduction in 2018, smoothing the transactions in the OTC markets and, at the same time, eliminating counterparty risk as Apex Clearing Corporation clears all operations.

Furthermore, the efforts to bring transparency into OTC markets are paying off, as more companies are subscribing to its Corporate Services, as they can attract more investors by publishing news and reports on the Group's websites, facilitating compliance information, and engaging in meetings with potential investors.

Most listed companies in OTCQX and OTCQB are subscribers of the Corporate Services segment. But the most relevant thing is the increase in the number of pink stocks that subscribed in 2021 and that have remained subscribed in 1H23 even when volume is lower. I believe this indicates the substantial value added from Corporate Services to listed companies, which paid for their subscriptions even when the volume decreased significantly and the price increased-reflecting a significant pricing power.

Additionally, as more liquidity and transparency are added to the OTC markets, financial market participants have more interest in these markets. This interest is demonstrated in the number of professional and non-professional users interested in OTC market data.

Non-professional users have been more volatile and decreased in the last five years. However, professional users have steadily grown since 2017, even when volume plummeted. Notably, the Group is the sole provider of a significant portion of crucial OTC market information; thus, users are in a disadvantageous bargaining position, allowing the Group to keep increasing prices without losing users.

In a nutshell, I consider the Group's strategy has successfully brought more volume, transparency, and efficiency to the market; at the same time, it has fortified its competitive position. Furthermore, even when volume is plummeting and prices increasing, financial market participants keep buying its services, signaling a solid pricing power. Lastly, I think the firm is likely to continue with its exceptional financial performance.

Risk

Economic Conditions

As we saw above, the OTC markets as high-risk investments are sensitive to changes in the macroeconomic environment. Changes in the risk-free yield can increase or decrease investors' risk appetite, causing changes in trade volume in OTC markets and the valuation of listed companies. Nevertheless, the company has expanded its revenue even in challenging economic situations. For instance, revenue didn't decrease during the Great Recession, and even if the economic uncertainty is high, the Group's sales are increasing steadily, thanks mainly to price hikes. However, in 1H23, operating income decreased by 15%, leaving the operating margin at 28.4%, the lowest since FY2013. Thus, even if revenue hasn't been affected by economic conditions owing to price increases, these increases haven't been enough to offset all the adverse outcomes of the challenging environment.

Substitute Threat

Even if the company dominates the OTC markets and has mighty pricing power, Private Equity, US security exchanges, and international exchanges are dangerous substitutes that can partly impair the company's ability to raise prices, especially in the OTCQB and OTCQX markets.

System Failures

The company's business depends on the reliable operation of its IT and communications systems. If these systems fail, the company could experience disruptions in service, slower response times, and delays in introducing new or updated products and services. These disruptions and delays could reduce revenues and profits, lead to regulatory action, and damage the company's business and reputation.

The company has experienced system failures in the past, and system failures may occur in the future. Failures could be caused by various factors, including failures at third-party vendors, hardware or software malfunctions, weighty use of the company's systems, insufficient capacity or network bandwidth, power or telecommunications failures, natural disasters, human error, targeted attacks, and computer viruses. Any interruption in the third-party services on which the company relies could also be disruptive.

Regulatory Risk

In September 2021, the SEC's Exchange Act Rule 15c2-11 amendments were enacted. Rule 15c2-11, as amended, requires companies with securities traded on OTC Markets Group's markets to make ongoing disclosure publicly available, among other requirements. The enhanced requirements for trading on OTC Markets Group's markets may result in a reduction in the number of securities on its markets, particularly its Pink market, and a reduced demand for its Corporate Services products, which may negatively impact its revenue and could cause some broker-dealers to cease quoting on its markets altogether.

Moreover, any regulatory change favorable to national securities exchanges that would encourage or require more companies to list on an exchange may reduce the demand for OTC Markets Group's OTCQX and OTCQB markets

Valuation

I assumed a revenue growth rate of 8% in 2024 due to the recovery of trade volume in OTC markets and a growth rate of 6% for the rest of the period. I think this growth rate is conservative as, in the past, the company grew at 11.6% annually. Furthermore, as the company has a clear wide moat, I think an appropriate terminal value is a P/FCF of 25. The discount rate is 14.50%, as the company faces various risks, but I believe that thanks to its competitive advantage, it can reduce the effects of these risks.

Finally, given the results from my DCF analysis, OTC Markets Group shares are slightly undervalued; however, the margin of safety is less than 30%, so it doesn't offer enough downside risk protection. Thus, my recommendation is a 'Hold.' I will wait if the market allows me to buy cheaper (~$44 per share). Nonetheless, I think the company can increase its revenue faster, so the value could be even higher, but I prefer to be conservative in this aspect.

Conclusions

OTC Markets Group is a promising investment opportunity. The company operates in a niche market characterized by high barriers to entry and its unique pricing power. While there are some short-term headwinds to consider, the company's long-term growth prospects appear to be strong. Based on my DCF analysis, OTC Markets Group shares are slightly undervalued, but the margin of safety is less than 30%. Therefore, it may be prudent to wait for a better entry point before initiating a position in the company.

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