OTC MARKETS GROUP INC OTCM
March 11, 2013 - 11:27pm EST by
simplevalues
2013 2014
Price: 8.10 EPS $0.00 $0.00
Shares Out. (in M): 11 P/E 17.0x 0.0x
Market Cap (in $M): 86 P/FCF 10.0x 0.0x
Net Debt (in $M): -14 EBIT 8 0
TEV ($): 73 TEV/EBIT 9.0x 0.0x

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  • Stock exchange
  • High Barriers to Entry, Moat
  • owner operator
  • Pricing Power
  • Analyst Coverage
  • Insider Ownership

Description

OTC Markets: Long-Term Buy
(OTCQX: OTCM)

QUICK STATS
  • Last Price: $8.10
  • 52 week high: $9.00
  • ?52 week low: $6.25
  • Shares Outstanding: 10.6mm
  • Float: 5.6mm
  • Avg Daily Vol: 1,548 shares
  • Market Cap: $86.3mm
  • Net Debt: ($13.6mm)
  • Enterprise Value: $72.7mm

QUICK THESIS

OTC Markets is a marketplace for over-the-counter securities. Their market structure (described later) is fundamentally different from better-known stock exchanges and allows the Company to provide liquidity for an extensive number of securities while promoting those with quality businesses and current disclosure. Current valuation implies zero-growth and discounts OTCM’s deep moat. However, network effects, growth opportunities, and untapped pricing power will drive compounding returns for this well-managed franchise.


HOW OTCM MAKES MONEY

  • OTC Link ATS Trading Services (32-34% of revenue)
    • Broker-Dealers pay monthly license, subscription, and connectivity fees
    • Subscribers pay per security usage fees to publish quotes and communicate/negotiate with counterparties
  • Data Licensing (39% of revenue)
    • Provide subscribers with access to market data and security info collected through OTC Link ATS Trading Services, as well as Issuer Services
    • Segment generates majority of market data revenues through market data redistributors (Bloomberg, Interactive Data Corporation, etc.)
  • Issuer Services (26-29% of revenue)
    • Suite of information and communication services designed to improve quality and availability of information for investors
      • Specific services include OTC Disclosure and News Services, Access to Level 2+ quote display, OTC Market Report, and Blue Sky Marketing Service
    • OTCQX participants (discussed below), pay a one-time application fee and annual fees
    • Company’s not listed on OTCQX can purchase premium services separately

INDUSTRY TRENDS
  • NASDAQ, once the home of small companies, has attempted to compete directly with NYSE
    • In competing for large companies, listing requirements and processes have started to mimic NYSE
  • As companies grow larger, management teams and directors tend to own smaller percentages
    • Increasingly complicated operational and governance controls to counter principal-agent conflicts
    • Corporate governance processes and requirements for listing on an exchange, rather than SEC reporting, are now creating a larger share of the burden for exchange-traded companies
  • SEC registration costs and compliance have continued to grow in the wake of Dodd Frank and SOX regulations
  • Dramatic growth in # of trading venues: about one-third of trading volume in US-listed securities takes place away from exchanges on various internal broker-dealer systems, crossing networks, and Alternative Trading Systems (up 50% vs 3yrs ago)
 
OTCM’S UNIQUE MARKET STRUCTURE
  • A market, not an exchange
    • Inter-dealer quotation and trading system; there’s no intermediary or central exchange
    • System allows broker-dealers to post quotes then communicate and transact with each other using electronic messaging and trade negotiation infrastructure
    • Brokers can transact using their own liquidity and execution technology
    • Favorable regulatory implications
      • Less stringent and expensive regulatory requirements than comparable exchanges
      • Value proposition allows companies (particularly smaller/domestic and quality/foreign-listed) to avoid high listing fees, SEC registration expenses, Dodd-Frank compliance costs, and level II/III ADR issuance costs (for foreign companies)
  • Tiered market structure organizes 10,000 OTC-traded securities into one of three categories based on reporting method (SEC or alternative) and disclosure category (current, limited, or no information)
    • OTCQX: The Intelligent Marketplace ($23bn of dollar volume in 2012, $57mm per security)
      • Top tier reserved for best OTC companies
      • Exhibit strong operating profiles, rigorous disclosure, and commitment to engaging investors
      • Reputable, cost effective, and information-rich marketplace
    • OTCQB: The Venture Marketplace ($31bn of dollar volume in 2012, $9mm per security)
      • Current in reporting to SEC or other US regulator
      • No financial/qualitative standards for this tier
    • OTC Pink: The Open Marketplace ($71bn of dollar volume in 2012, $13mm per security)
      • Open to virtually any company
      • Sorted by status and amount of information provided (current, limited, or no info)
  • Across the three market places, ~150 financial services firms quote ~10,000 OTC securities

 

OUTPERFORMANCE IN DIFFICULT INDUSTRY CONDITIONS

  • 2012 was another abysmal year for market operators
    • Need to track back over 16 months to find a single month that posted an increase in YoY avg daily volume
    • Secular decline in trading volume > layoffs, lower commissions, and broker-dealer closures.
  • Company has bucked the trend
  • Revenues from new services and increased subscriber quote volume offset decrease in license subscriptions
  • While # of dealers has decreased 9% to 710 over the past nine months, segment revenues have remained flat.
  • Meanwhile, Market Data and Issuer Services have propelled Revenue (up 13% yoy) and EBIT (up 35% yoy)

 

WIDE AND DEFENSIBLE MOAT

  • FINRA’s OTCBB, OTCM’s major competitor, has collapsed in recent years
    • Sale of OTCBB trademark to Rodman and Renshaw failed, and R&R subsequently folded
  • As more broker-dealers move to OTCM, ‘network effect’ drives even further to the platform
    • Much more efficient to trade every OTC security on OTC’s platform
  • OTCM has established itself as the primary provider of OTC equity market data
    • Key relationships with Bloomberg, Interactive Data, Factset, and other major data redistributors
    • Partnership with Edgar Online to distribute financial data through professional databases and financial portals such as Yahoo! Finance; also a recently forged relationship with PR Newswire
  • Current pricing arrangements for Issuer Services Segment has discouraged NYSE/NASDAQ
  • BX Venture Market, a potential competitor for domestic listings, has been in vaporware stage since receiving SEC approval in May 2011

WHAT MAKES OTCM A LONG-TERM BUY
  • Deep moat in US OTC equity markets
    • Once broker-dealers are on the platform, they stay on the platform
    • The source for OTC data
    • With OTCBB out of the market, competition is weak
  • Quality owner-operator with clear strategy and strong history of capital allocation
    • CEO bought Company in 1997; since then, all growth has been organic
    • CEO owns 40% of the Company and his employment contract grants 2% of profits if annual NI >$4mm
  • Untapped pricing power in market data and trading services segments
  • Significant operating leverage and scalable business model
  • Tax advantaged under American Taxpayer Relief Act of 2012: no capital gains taxes for purchase of small business stock in 2013 if held >5yrs
  • Growth Opportunities
    • Expand broker-dealer network and trading platform from OTC to National Market System
      • Grow trading volume and revenue from ancillary offerings
    • Expansion into other securities markets (e.g. corporate bonds, preferred stock)
    • Attract more Foreign-Listed companies to OTCQX
      • Significant value proposition for Foreign-Listed equities
      • This market has driven much of OTCM's revenue growth over the past 3 years

KEY RISKS

  • Regulation
    • FINRA proposed a “Quotation Consolidation Facility” in 2009 that would threaten market data revenues
    • Opposition by industry participants & no public comments by the SEC in 2 years: QCF seems to be dying
    • Potential Exemption for smaller public companies of SOX could reduce incentive for companies to use services
  • Competition
    • BX Venture Market and other registered ATSs
    • Fees charged for issuers to join the OTCQX marketplace cannot support the same level of sales, marketing and advertising efforts as NYSE, NASDAQ, including the BX Venture Market, London Stock Exchange or others
  • Technology
    • Rapid changes in technology
    • Computer failures
  • Decline in Issuer Services Revenues
    • While there were 400 companies listed on OTCQX as of 12/31/2012, subscriptions have retreated to 370 as of 3/11/2013 due to difficult industry conditions
    • OTCQX listings has driven the growth in Issuer Services revenue; this is a key driver of value
    • OTCQX provides a fantastic value proposition when compared to major exchanges; biggest competition for OTCQX participants comes from other OTCM Markets (OTCQB & OTC Pink)
    • As an aside, I think there is significant risk (/opportunity) that OTCM reports disappointing earnings tomorrow due to slower rate of OTCQX enrollment and lower trading volumes across all three marketplaces; cash flow may also be low due to renewed capital investment now that ATS registration has been completed.
      • I do not believe that this harms long-term thesis and could present an interest buying opportunity
  • Liquidity: $80mm market cap & two largest shareholders own >50% of equity

VALUATION
  • On an LTM basis, Company trades at 10x FCF, 7x EBITDA and 17x Earnings
  • While there is no exact peer group due to the company’s unique business model, the company is cheap when compared to exchanges, marketplaces and networks (figuring out how to upload these figures)
    • Marketplace/Network group trades at 15x EBITDA
    • Exchanges trade at 9-10x EBITDA
    • Many comparable companies listed in the appendix are much larger and have achieved much higher margins due to scale
  • At the current FCF yield, all growth opportunities are free and the market dominance is discounted

POSSIBLE REASONS FOR UNDERVALUATION
  • Small Cap / No Analyst Coverage / Illiquidity / >50% Insider Ownership
  • Stigma associated with Pink Sheets and OTC securities

SUMMARY COMPS (source: CapIQ)
(on an LTM basis; I have some more complete valuation analyses but they're a pain to upload)

Exchanges
Deutsche Boerse AG: 9.6x EBITDA / 10.7x EBIT / 14.4x PE
London Stock Exchange: 9.3x EBITDA / 11.8x EBIT / 7.3x PE
Nasdaq OMX Group: 7.6x EBITDA / 12.8x EBIT / 15.7x PE
CME Group: 11.2x EBITDA / 12.8x EBIT / 23.1x PE
NZX Limited: 13.4x EBITDA / 18.4x EBIT / 35.8x PE
Group Average: 10.2x EBITDA / 12.5x EBIT / 19.3x PE

Misc. Markets and Netowrks
eBay: 15.5x EBITDA / 21.9x EBIT / 26.7x PE
Visa: 15.3x EBITDA / 16.1x EBIT / 44.7x PE
Mastercard: 14.3x EBITDA / 15.2x EBIT / 24.1x PE
Group Average: 15.0x EBITDA / 17.7x EBIT / 31.8x PE

OTC Markets: 7.3x EBITDA / 8.8x EBIT / 16.6x PE
 

FREE CASH FLOW BREAKOUT
Free Cash Flow           1,613         4,511            4,970            6,813         7,066
Free Cash Flow Walkdown   2008A 2009A 2010A 2011A LTM
EBITDA           3,662         6,570            6,148            8,464         9,941
Stock Based Comp              410            433                625                555            834
Cash Operating Taxes        (1,208)      (2,179)          (1,950)          (2,700)      (3,145)
Change in A/R                    -          (215)             (367)                275          (477)
Change in Expenses and Oth. Current Assets            (180)            (95)                271                (36)            132
Change in A/P              460            210             (404)                242            (98)
Change in Deferred Revenue                 37         2,024            1,568            2,329            617
Change in Deferred Rent              518               84                  59                110          (199)
CapEx        (2,086)      (2,320)             (980)          (2,426)          (540)

 
I do not hold a position of employment, directorship, or consultancy with the issuer.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Not catalyst-heavy; still, there are several events that may prompt a revaluation:
  • Now that the Company has registered as an Alternative Trading System (“ATS”) and submitted itself to SEC & FINRA regulation, it can resume CapEx and technological upgrades
  • Because registration is over, OTCM can push pricing
  • Resolution of QCF overhang and final ruling from the SEC
  • BX Venture Market disappears or materializes; either way, hard to compete with vaporware
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