OTC Markets Group (OTCM): Network Effects, Scalability, And Optionality At Play Here

Investment Thesis

OTC Markets Group (OTCQX:OTCM) represents a chance for buyers to purchase shares in a high-quality enterprise that’s uniquely positioned within the monetary ecosystem. It primarily operates as a quasi-monopoly that advantages from community results, scalability, and embedded optionality. It operates under-the-radar and has persistently grown income, earnings, and free money movement over time. Insiders are additionally seemingly aligned with shareholders as they personal 42% of the corporate. This is an efficient time for buyers to select up shares in a beautiful enterprise at a good worth.

Company Description

OTCM is an American monetary market firm offering worth and liquidity data for 12,000 US and worldwide securities. Drawing from its 2021 Annual Report, the corporate operates 3 enterprise strains:

• Trading Services: by OTC Link ATS (SEC regulated Alternative Trading System), OTCM connects US broker-dealers to supply liquidity and execution providers; generates revenues by subscription association and transaction-based charges to broker-dealer subscribers (~29% of whole revenues)
• Market Data: distributes market information and monetary data to a number of channels (e.g. Bloomberg, REDI Technologies, Thomson Reuters); generates revenues by licensing, on a subscription foundation, their market information, compliance information, Blue Sky information, firm information, and safety data (~33% of revenues)
• Corporate Services: operates the OTCQX and OTCQB markets and gives issuers disclosure and regulatory compliance merchandise; generates revenues by charging a one-time software price and annual/semi-annual fastened charges, in addition to from a number of Corporate Services merchandise (e.g. DNS, Real-Time Level 2 Quote Display, and so forth.) (~38% of revenues)

OTCM estimates that in 2021, 73% of the revenues have been recurring in nature (derived from subscription-based association) and 27% have been transaction-based revenues.

Under its Corporate Services section, OTCM organizes securities into 3 markets based mostly on the standard and amount of the data corporations disclose:

• OTCQX Best Market: supplies environment friendly public buying and selling for corporations that meet minimal monetary, disclosure and qualitative requirements set out within the OTCQX Rules; as of 12/31/21, 570 corporations traded (170 US, 400 worldwide)
• OTCQB Venture Market: supplies public buying and selling for entrepreneurial and development-stage corporations that meet the OTCQB Rules; as of 12/31/21, 1,150 corporations traded (400 US, 750 worldwide)
• Pink Open Market: corporations that don’t meet the OTCQX or OTCQB requirements have their securities traded on the Pink market by default

As for latest enterprise improvement:

• The firm introduced the acquisition of Blue Sky Data Corp, a supplier of compliance information relating to state Blue Sky securities guidelines and laws for ~40,000 equity and debt securities for ~$12M in money. The acquisition closed on May 2, 2022 and the enterprise shall be included within the Market Data Licensing enterprise section.
• The firm launched OTC Link NQB in Q3 2021, their third ATS (or Automated Trading System). However, the launch was not materials to monetary outcomes and its impression on future monetary outcomes remains to be unclear.

Valuation Analysis

With ~12M diluted shares excellent and a present worth of $54.70, the whole market cap is $652M.

The monetary metrics for OTCM are incredible:

• FCF Margins: ~30%
• ROE: ~75%
• ROIC: ~60%
• Revenue CAGR (10y): 12.5%
• FCF CAGR (10y): 21%
• EPS CAGR (10y): 18.8%
• Debt: none

From a valuation standpoint, buyers aren’t paying a excessive worth for OTCM both:

• P/E: 20.8x
• EV/EBITDA: 15.1x
• EV/FCF: 14.4x
• Dividend: ~1.3% ($0.72/sh)

Although OTCM is just not a proper monetary alternate, I’d take into account it an in depth relative as it’s a market and the last word purpose is to match consumers and sellers. And as such, the underlying economics are similar to a monetary alternate like Intercontinental Exchange (which I wrote up right here: Benefitting From Network Effects, Scalability, Inflation, And Optionality).

• Virtual Monopolies: it is laborious sufficient to start out a monetary alternate, as there are solely a handful of exchanges now and it is fairly tough to start out a profitable alternate from scratch; to high that, it is most likely even tougher to start out a market for OTC securities and compete with OTCM; OTCM’s quasi-monopolistic standing is mirrored by its 33% pre-tax revenue margins and 30% FCF margins
• Network Effects: as soon as broker-dealers are on the platform (OTC Link ATS), they have a tendency to remain on the platform as that’s the place the opposite broker-dealers are
• Scalability: revenues can enhance and not using a commensurate enhance in capital expenditures; as soon as the infrastructure is in place, the price to including extra merchandise and the power to course of extra transactions is marginal, which suggests further income primarily will get transformed straight into free money movement; within the case of OTCM, from 2012 to 2021, you possibly can see that working margin truly elevated from 27% to 38% whereas income was up 300%
• Optionality: constructing off the scalability level, OTCM is ready to add new securities (e.g. company bonds, most popular stock) at primarily zero-cost; in different phrases, OTCM has close to limitless name choices on all future merchandise/information/international locations which have but to be listed but; OTCM additionally has a name choice on will increase in buying and selling quantity as nicely

I’ve additionally chosen a couple of monetary exchanges (ICE, CME, SPXCF, JPXGY) and monetary expertise / information / analytics corporations (MSCI, INFO) under for comparability. It’s fairly clear that the present valuation for OTCM is on the low finish of the valuation spectrum (supply: QuickFS).

Insider Ownership & Transactions

Insiders personal ~5M shares or ~42% of the corporate and the CEO successfully owns 4.2M shares or ~35%. Normally I search for an insider possession share of ~5-10%, so OTCM’s 42% is reassuring; briefly, the insiders appear aligned with the shareholders.

Catalysts

• Continued Execution: natural/inorganic development and disciplined capital allocation will proceed to assist the enterprise develop and broaden, which is able to enhance each the dividend and share repurchases

• Rule 15c2-11: starting September 28, 2021, this rule prohibited broker-dealers to show or submit quotes (e.g. bids or gives) of securities that haven’t met sure public reporting necessities; because of this, there was a rise in variety of corporations that subscribed to its Corporate Services merchandise in 2021 and this can be a pattern that continues

• Untapped Pricing Power: OTCM has been elevating costs just lately; for instance, they elevated annual charges for OTCQX market from $20k to $23k and achieved a 96% retention price; OTCM’s dominant place permits it to extend costs accordingly whereas retaining prospects

Downside Risks

• Illiquidity: the shares of OTCM are illiquid and thus not appropriate for institutional money; 42% of the shares are held by insiders and day by day buying and selling quantity is ~2,620 shares (~$144,000) per day; in accordance with QuickFS, the share turnover price is 5% (for comparability, OXY’s share turnover is 712%)

• Competition From National Exchanges: various corporations that trade on OTC Link ATS may additionally high quality for a nationwide securities alternate itemizing; if the businesses go away OTC to listing elsewhere, that might hurt OTCM’s enterprise

Investment Summary

The greatest enterprise is a royalty on the expansion of others, requiring little capital itself. – Warren Buffett (1997 Email Exchange on Microsoft)

OTCM is uniquely positioned to profit from the expansion in each buying and selling quantity and newly listed securities on the OTC markets, which embrace each new merchandise (e.g. bonds, preferreds) and securities from international locations that OTCM hasn’t reached but. In different phrases, the corporate advantages as a royalty on the expansion of others (with out taking up a lot danger) and satisfies Buffett’s standards for a “best business”; on this case, the continued development of capital/monetary markets, continuous itemizing of recent merchandise and firms, and elevated demand for information providers.

Similar to my write-ups on high-quality corporations like CRL, CBRE and ICE, OTCM operates quietly within the background with no need for promoting and performs an essential half within the monetary system. These are the high-quality companies that one ought to yearn to personal at a good (or ideally, low-cost) worth.

Based on the analysis above, I like to recommend a protracted place in OTCM with a holding interval of some years (possibly even endlessly). I don’t know what the stock worth will do within the brief time period, however I’d look so as to add extra if it continues to say no, as I see the corporate being able to compound for a few years to come back.