OTC Markets Group: Framing an investment in Aug. 2020
Diligence Report | 30 min read | How I framed this opportunity as a buy-and-hold investor
Originally published on midstoryventures.com in August 2020.
Before you read this segment in the Diligence Report series — please read the “Introduction: Diligence Report Series” post here.
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A Regulated Flywheel
A Market Operator
OTC Markets Group (OTC Markets) is a market operator for over-the-counter (OTC) securities.
They do this by providing listings services, trading technologies, and investor relations services. OTC Markets then packages and sells the related market and compliance data to market participants. OTC Markets is similar to NASDAQ’s role as a market operator for exchange-traded securities.
A Flywheel Strategy
OTC Market Group’s strategy is a great example of the Flywheel Effect that Jim Collins made so famous in his book Good to Great. The competitive advantages of its three business segments work together to create positive feedback loops which build momentum, increasing the payoff of any incremental push.
The company’s flywheel strategy is simple: transparency drives liquidity which drives data and ultimately more liquidity.
The Flywheel strategy is illustrated in the following graphic.
A Respected Brand
Every flywheel begins with a push (investment). The first push began with the OTC Markets Group brand.
In 1997, Cromwell Coulson transformed the OTC space from an “inefficient market with high transaction costs and little liquidity” to an “open, transparent, and connected marketplace,” as stated in their Testimony to Congress in June 2013.
The acquisition in 1997 planted the seed for what was to come of the OTC Markets Group brand. Throughout the years, OTC Markets launched small but significant initiatives like their electronic trade messaging platform (formerly known as the Pink Quote system) in 2003 and their marketplaces designations (OTCQX) as early as 2006.
This eventually cultivated a strong reputation among investors, issuers, broker-dealers, and regulatory officials. Their reputation was a series “continuous small inputs which added up into an impressive output,” just as other Flywheels did once before.
The company’s reputation was so strong that it stole 99% of FINRA’s OTCBB listings in less than 2 years. Ultimately, FINRA disbanded their OTCBB operation in 2014.
In the Risk Factors section, the company essentially said that its brand is the crux of the business.
The OTC Markets brand can be summed up in the following sentence.
OTC Markets Group is known for fostering innovation, transparency, and connectivity which create an inclusive, informed, and efficient marketplace for small companies and international companies alike.
The company’s commitment to its mission of creating “better informed and more efficient financial marketplaces” is at the core of the flywheel and is present in each segment of the business.
Business Segments
The Start Pointing Point
Listings is the starting point of the flywheel. It is the secret sauce of the brand and the most visible part of the brand.
Listings is technically called “Corporate Services” by the company, but for the sake of simplicity, we’ll refer to the segment as Listings.
Listings operates the OTCQX “Best Market,” the OTCQB “Venture Market,” and the Pink “Open Market.” The OTCQX and OTCQB are premium market designations, which are meant to “encourage companies to make more current information publicly available.” Management’s motto for Listings is that “liquidity follows transparency,” which is evident in the numbers.
The average OTCQX company receives 4.5x more liquidity than the average Pink company, measured by dollar volume per security (DVPS).
The requirements vary between each premium designation. For the highest designation, an OTCQX listing, a company must meet certain disclosure, financial, corporate governance, and compliance requirements. For an OTCQB listing, a company is only required to meet the requirements.
Pink companies have no disclosure requirements since the company is technically not engaged with the market (only the broker-dealer is). However, Pink companies are categorized by Current Information, Limited Information, and No Information in order to help investors better navigate the 10,000+ names in the OTC market.
As of 2019, there were 489 OTCQX companies, 959 OTCQB companies, and 9,307 Pink companies.
In addition to meeting listing requirements, companies seeking a premium designation must pay an application fee and annual fee. OTCQX companies pay a $5,000 application fee and $20,000 annual fee. OTCQB companies pay a $2,500 application fee and $12,000 annual fee.
Through their payment, they get instant access to extremely valuable disclosure, compliance, and investor engagement tools.
The Connecting Piece
Trading is the “connecting piece” in the flywheel that creates all positive feedback loops. It captures the value from Listings business, and it is the foundation from which the Data business is built.
OTC Markets Group offers its technology to broker-dealers so they can serve as market makers to execute transactions on the company’s various marketplaces.
Their first product was an interdealer quotation system (IDQS). Inter-dealer brokers serve as market makers when there is no formal exchange or market maker system.
In a typical transaction at an exchange, only two broker-dealers are involved. In an inter-dealer broker system, a dealer looking to execute a transaction for its customer uses another dealer(s) in order to execute a transaction. This typically happens in illiquid markets where there may not be a market participant willing/able to execute the entire transaction. The IDQS is the best way to provide sufficient liquidity for the OTC securities market, which is inherently illiquid.
The company’s IDQS product, known as the Pink Quote system, allowed broker-dealers to post and display their real-time bid and ask quotes. They also offered their Pink Link system, which allowed broker-dealers to electronically communicate OTC trade information with each other.
Prior to these product introductions by OTC Markets, most transactions were being executed using a pen, paper, and phone. This is primarily because FINRA’s OTCBB was a telephonic market and expressed no desire to upgrade its technology.
In 2009, the SEC requested OTC Markets Group to register their IDQS as an alternative trading system (ATS). This put the company’s IDQS under SEC and FINRA oversight, which was an industry-wide trend after the Great Recession. The OTC Link ATS is the aftermath of the SEC’s request, which is just the Pink Quote / Pink Link system in a combined entity.
In 2017, OTC Markets introduced its second trading product, the OTC Link ECN. An ECN is an electronic communication network that automatically and anonymously executes trades.
The most important differences between the trading products are described as follows.
OTC Link ATS is not an intermediary. OTC Link ECN is an intermediary.
OTC Link ATS is not like the technology used at national exchanges. OTC Link ECN is similar to the technology used at national exchanges.
OTC Link ATS allows broker-dealers to make profit on the spreads. OTC Link ECN allows broker-dealers to make a profit on fixed commission.
OTC Link ATS allows broker-dealers to “use portions of their existing trading systems’ infrastructure already employed in trading NASDAQ and NYSE listed securities,” thus generating important cost-savings. OTC Link ECN is a new system that can’t be used with prior technology, so it is more expensive.
The combination of both technologies makes the investor trading experience almost identical to that of the NYSE and Nasdaq securities.
As of 2019, there were 87 broker-dealer ATS subscribers and 53 broker-dealer ECN subscribers.
Broker-dealer ATS subscribers pay monthly subscriptions and connectivity fees to use the ATS. They also pay every time they publish a quote for a company’s security and every time they send a trade message for a company’s security, but these represent a smaller percentage of revenue from ATS subscribers.
On the other hand, OTC Markets generates transaction revenue from its broker-dealer ECN subscribers. Broker-dealers pay a fixed fee for every transaction executed.
The Sticky Product
Market Data is the last part of the flywheel. It is built upon the value of the Trading business and is the stickiest part of the brand.
This business packages and sells market and compliance data pulled from OTC Link ATS and OTC Link ECN. The company earns monthly cash flow from their licenses to investors, traders, institutional funds, investment banks, accountants, regulators, and market data redistributors.
In 2019, there were 59 redistributors. Market data redistributors are the company’s most significant customers. They buy the company’s data and combine it with other market data from NYSE, NASDAQ, and other market operators.They then sell that data to professional and non-professional users in a bundled subscription. Some market data redistributors include Activ Financial, Bloomberg, Interactive Data Corp, Morningstar, NASDAQ Ultrafeed, NYSE Superfeed, SIX Financial Information, and Thomson Reuters.
Economics of the Flywheel
Jim Collins says that “each turn of the flywheel builds upon work done earlier, compounding your investment of effort.” The flywheel is evident in the economics of the business model.
Float
Firstly, the business model is naturally gifted with a cash float, since customers from across all segments pay cash up-front before the services are provided. For the past decade, the company has generated, on average, a debt-free, cash-free net working capital (DFCFNWC) balance of -17% every year.
The float is a powerful economic driver of the business because it pairs well with growth. The faster revenue grows, the larger the float becomes. The company’s revenue compounded at a rate of 10% per year for the past 10 years. Most of this revenue growth comes from Listings, which is fueling this net working capital deficit.
As Listings grows, the DFCFNWC balance grows more negative each year. This means that customers are financing more and more of the company’s operations. DFCFNWC started at 0% in 2010 and has grown to -31% in 2019.
Free Growth
Secondly, OTC Markets made the majority of its investments in technology before 2010. The business has seen these investments in technology scaled at an unbelievable level. As Cromwell Coulson says in his 2019 Shareholder Letter, “we benefited from our prior investments to strengthen relationships around the globe, which helped gain traction for our premium OTCQX market.”
The asset-light nature of the business leads to infinite returns on incremental invested capital (ROIIC). The average ROIC over the past 10 years is 166%. In 2019, it was 189%. To grow ROIC from 166% to 189% means that the business had to have generated returns much, much greater than 189%.
ROIIC is important to calculate the cost of growth. The average company with a ROIC of 8% has to pay $12.5 to grow free cash flow by $1. For OTC Markets, they would only have to pay $0.53 cents to grow free cash flow by $1.
Synergistic Growth
Thirdly, growth in one segment leads to growth in the other. As seen in the Flywheel illustration, transparency drives liquidity which drives data and ultimately more liquidity.
Through the natural synergies between these segments, OTC Markets generated a 14% 15-year revenue CAGR and a 15% 15-year EBIT CAGR.
Future Flywheel Performance
For the past two decades, the company’s flywheel has generated strong returns. The 9-year market cap CAGR was 23%.
To evaluate the future economic performance of the company, we have to dig deeper into the inner workings of each business segment, since each business builds on one another.
Trade-off in Listings
OTC Markets is a home for many different companies, but the most important companies are international companies and small companies.
About half of the companies listed in the OTCQB market are internationally based. In 2019, it represented 45% of total listings. The results are even more skewed in the OTCQX market, where 65% of listings.
International companies are such a big part of OTC Markets because it is one of the only ways an international company can access U.S. investors in a cost effective manner, and “US capital markets are one of the world’s leading and most consistent markets to provide issuers with access to capital and liquidity for shareholders,” according to McMillian.
Based on size, small start-ups represent the majority of total listings. OTCQB is a “Venture Market” and represents 66% of Premium marketplace listings. There are small companies on the OTCQX marketplace as well. They are labeled as Non-Premier OTCQX. These small OTCQX companies represents 66% of OTCQX listings. Combined, small companies represent 89% of total Premium listings, or 1,280 listings of 1,448 listings.
In 2019, the Listings business represented 40% of total revenue. It is the fastest growing segment, growing at 25% for the past 10 years. In the last 5 years, it maintained that growth by growing at 25% per year.
The Premise of Listings
OTC Markets Group is a cost-effective channel of U.S. liquidity for international companies because of favorable regulation and The Broker Arbitrage.
The first reason why OTC Markets is a cost-effective channel for U.S. liquidity is because it is extremely costly to “double-list” in their homeland exchange and a U.S. national securities exchange like NASDAQ and NYSE for most international companies.
An international company would have to generate SEC reporting and comply with the Sarbanes-Oxley Act (SOX) to list with NASDAQ or NYSE. Through SEC’s Rule 12g3-2(b), OTC marketplaces are given the ability to exclusively list and trade securities of international-based companies under a few conditions. The company must be compliant with their primary market’s disclosure standards and they must provide an electronic English version of the corresponding disclosure documents.
The NASDAQ and NYSE will never be able to uplift their SEC and SOX requirements because they would have to compromise the integrity of their brand.
The first reason why OTC Markets is a cost-effective channel for U.S. liquidity is because of the “The Broker Arbitrage.”
There should be theoretically two ways for a U.S. investor to invest in an international company: (1) through a broker of the country in which the company is based (2) through a U.S. broker that allows for foreign investing.
The Broker Arbitrage explains why these two things don’t occur in reality.
Under Regulation S of the Securities Act 1933, the SEC prohibits foreign financial institutions that are not registered and regulated in the US abroad from soliciting US residents as clients. In other words, they can’t advertise in the US or cold-call US residents to persuade them to open an account.
Regulation S limits an American investor’s ability from even finding out if there is a foreign brokerage. The problem with accessing foreign broker is further exacerbated with Foreign Account Tax Compliance Act (FATCA).
FATCA was signed in 2016 to ensure that all US citizens were reporting their financial holdings (banks and accounts) for tax reasons. However, all it did was incentive foreign brokers to turn away all Americans. FATCA put the onus of providing the necessary information on the foreign banks and brokers, even though they weren’t based in the United States. The reporting and compliance costs related to FATCA are extremely costly. As a result, most foreign financial institutions viewed U.S. investors as extremely risky customers and have adopted a “no US residents” policy.
Andrew Henderson, Managing Partner at Nomad Capital points out that “the odds of FATCA being repealed in its entirety are slim.” He explains that there have been past attempts by presidential candidates to repeal the act, since “it places undue hardship on honest people who simply want to live or operate a business abroad…. [but] it’s simply far too politically expedient to target the ‘evil rich’ who supposedly hide all of their money offshore.”
This problem is perpetuated by the fact that “the US is surprisingly low on stockbrokers that will buy foreign shares for retail investors,” according to Cris Heaton, an investment writer at The International Investor.
The biggest reason for this is because the foreign trading market is extremely competitive. As described by some writers on Value Investors Club, most U.S. brokers have had immense trouble breaking into the international trading market because the fees they would have to charge their customers would be too high to be profitable. Because International Brokers achieved the economies of scale in foreign brokering a long time ago, U.S. Brokers have chosen not to offer these services.
The combination of regulation and economic incentives will continue to make OTC marketplaces like OTCQX and OTCQB the most efficient channels to access U.S. capital and U.S. investors for the foreseeable future.
Listing Opportunities
While the Pink marketplace does not generate money for OTC Markets, it is a low-cost channel for new Premium listings.
Most listing acquisitions come from upgrades. For the past 3 years, 83% of new OTCQB listings came from Pink marketplace upgrades. In 2018, 89% of new OTCQX listings came from upgrades. Two-thirds of these upgrades came from the Pink market and one-third were from the OTCQB market.
There are 9,000+ companies listed in the Pink market. OTC Markets does not have to put any money into this market since it issuers do not engage with the company, so it serves as a cost-effective channel for Premium listings.
Besides the Pink marketplace funnel, the Listings business has significant long-term growth opportunities.
In 2008, management disclosed that “less than 20% of all issuers of OTC securities are currently able to meet the minimum financial and qualitative standards for listing on OTCQX.” There were 9,134 OTC listings in the industry at the time, so the total addressable market for OTCQX was estimated to be 2,000 securities.
The circumstances under which management made the estimate have changed. There were many factors that weren’t considered in 2008.
The most obvious is the new OTCQB marketplace designation introduced in 2010. This adds an additional number of companies available for listing. OTCQB has a total addressable market well beyond 2,000, since there were 1,850+ companies listed on the Toronto Stock Exchange (TSX) and 850+ on London Stock Exchange’s Alternative Investment Market (LSE AIM) as of 2019, both which are considered comparable venture marketplaces. There were 959 OTCQB listings in 2019.
The second significant change was the modification to Regulation A (Reg A) offerings. The JOBS act signed in 2015 eliminated the longstanding ban on general solicitation of Reg A offerings, giving thousands of previously ineligible companies the opportunity to publicly list their securities.
The first few years of Reg A+ have been slower than anticipated, due to poor SEC execution, but the future remains bright.
The market for crowdfunding IPOs is considerable. Fundera notes that in 2019, $17.2B was raised through crowdfunding in North America and 6.5M worldwide crowdfunding campaigns were launched. By 2023, 12M campaigns are projected to be launched. By 2030, the crowdfunding market is projected to be $300 billion, growing at a 10-year CAGR of 30% .
OTC Markets is well-positioned to capture this growth. Between 350 and 400 companies have gone public since the JOBS Act. In the early years, many of these companies went to the national exchanges for the appeal of being on the NYSE or NASDAQ, but they have quickly realized that they may not want to participate in the Reg A+ businesss. Due to a number of potentially fraudulent Reg A+ cases on national exchanges, NASDAQ and NYSE are reportedly shying away from IPOs conducted by companies using Reg A+.
In 2019, Reg A+ IPOs generated 9% of new OTCQX listings and 5% of new OTCQB listings. As crowdfunding grows and OTC Markets continues to prove its value proposition for Reg A+ issuers, OTC Markets is poised to be a home for a significant number of these companies.
The third significant change was the partnerships with other global exchanges. In 2017, OTC Markets struck a ground-breaking deal with Canadian Securities Exchange (CSE), a Canadian listing exchange recognized as a Qualified Foreign Exchange in the U.S. The strategic alliance offers international companies the ability to raise capital via an IPO in Canada and automatically list their securities in both CSE and OTCQX/OTCQB.
Management believes there are many global exchanges that are really interested in partnering with OTC Markets. With 1,500 companies going public every year around the world, the opportunity set is massive.
It’s important to note that these additional growth opportunities are attractive, but they do not have hockey-stick type growth curves. It will be a long process of educating the market, enhancing the offering, and working with advisors.
Transparency as a Moat
Transparency creates liquidity, and liquidity is the proof of the company’s competitive advantage.
OTC Market Group’s moat was apparent since the beginning. In 2009, OTCQX had 3x more liquidity than London Stock Exchange’s 13-year-old Alternative Investment Market (LSE:AIM) and 20x more liquidity than Toronto Stock Exchange’s 148-year-old Toronto Venture Exchange (TSX), measured in DVPS.
Transparency creates liquidity, but it also creates churn. Historically, every time management increased the marketplace standards, the total addressable market shrunk.
For example, in 2019, OTC Markets “raised market standards on the OTCQB market, which had the effect of reducing the available pool of domestic companies.”
OTC Market Group’s source of competitive advantage is their superior ability to balance the trade-offs between liquidity and churn.
Historically, mismanagement of this trade-off caused many venture-focused marketplaces to struggle. As the SEC Commissioner said in his Public Statement, “the lack of a fair, liquid, and transparent secondary market for securities [of small businesses] is a longstanding problem… Venture exchanges are hardly a new idea… and prior efforts to establish them in this country have fared poorly.”
The three marketplaces mentioned in his statement were LSE:AIM, TSX, and NASDAQ’s BX Venture Market.
LSE’s AIM dropped from 1,627 companies in 2009 to 850 in 2019. LSE:AIM struggled because it could not cultivate a brand of trust, integrity, and inclusiveness. As a result, LSE:AIM’s reputation was a marketplace of poor-quality companies.
TSX dropped from 2,337 companies in 2009 to 1,500 in 2019. TSX struggled because the marketplace had an overwhelmingly large dependence on companies in the mining and energy sectors during the Great Recession. Since then, the number of companies at TSX has dwindled from 1,850 to 850. You can find numerous articles on TSX like “Can the once-mighty TSX Venture Exchange be saved?”
NASDAQ received approval for its BX Venture Market in 2011. It would serve as a new listing market for early stage and smaller companies that do not qualify for a NASDAQ Capital Market listing. However, NASDAQ never ended up launching the marketplace, most likely due to the difficulty of venture marketplaces.
OTC Markets has carefully pruned for higher quality in the past.
Management initiated a significant increase in listing requirements for the OTCQB marketplace in 2014 and finished the transition by 2015. Prior to 2014, there were 3,000+ companies listed on the OTCQB. By the end of 2016, there were only 933 companies listed on the OTCQB. In other words, OTC Markets pruned 70% of its listings (2,100 companies) from its OTCQB marketplace.
Stronger listing requirements should create higher-quality companies and increase retention rates, but OTC Markets still has relatively high churn.
The long-term average annual churn is 19% for OTCQX companies and 27% for OTCQB companies. This is very high compared to national exchanges.
To give you an idea, we can compare the lifetime companies in each marketplace since Lifetime = 1 / Churn. OTCQX companies have an average lifespan of 5.2 years and OTCQB companies have an average lifespan of 3.6 years. These pale in comparison to the average life span of 18 years for companies listed on national exchanges.
In 2017, non-compliance downgrades represented 43% of OTCQX churn and 57% of OTCQB churn.
In order to maintain its superior liquidity and reduce churn, especially non-compliance churn, management will continue to fine tune listing requirements every year, even if it is at the cost of growth opportunities.
Disruption in Trading
As illustrated in the flywheel, trading activity typically increases as listing requirements strengthen; however, trading activity does not always correlate with Trading revenue.
As stated in its Annual Report, the company is “highly dependent upon the levels of trading activity in the OTC marketplace AND the number of broker-dealers in the market.”
In 2019, the Trading business represented 20% of total revenue. Despite its link connecting to Listings, it has been the slowest growing business. There are a few reasons for this.
Consolidation of Broker-Dealers
The trading landscape has changed dramatically.
In 2008, there were 170 active market participants in the OTCQX, OTCQB, or Pink marketplace. This number has dwindled down to a measly 87 in 2019.
This decline in broker-dealers is an industry-wide problem. The head of the SEC’s Office of Compliance Inspections and Examinations noted that the number of broker-dealers has dropped from 4,600 in 2012 to 4,000 in 2017.
The consolidation is attributable to their poor profit-making ability.
Broker-dealers are only allowed make money in one of two ways. They can earn commission if they act as a broker, matching buyers and sellers. They can earn a markup (spread) if they act as a dealer, buying and selling on behalf of its own account. However, they can’t simultaneously act as both. In addition, broker-dealers can’t charge commissions, markups, or markdowns of more than 5% in transactions, according to the “Five Percent Rule” created by FINRA in 1943
Since the Great Recession in 2008, their profit-making ability has only worsened. OTC Markets Group has seen a “continuing trend towards both consolidation and contraction in the broker dealer industry caused by declining volumes in the equities markets generally, a general trend towards margin compression caused by automation and the commoditization of execution and other services in the equities markets, and the increasing costs in recent years of regulatory compliance.”
ECNs are the main trading technologies that created the “automation and commoditization of execution” mentioned in the Annual Report. ECNs offer investors tighter bid-ask spreads, which have competed a lot of the profitability available for broker-dealers.
Today, the trading industry is made up of high-frequency traders (HFT) that execute nearly all the liquidity. On any given day, Citadel and Virtu alone represent 60% of dollar trading volume, 70% of share volume, and 70% of trades. Furthermore, the top 5 broker-dealers represent nearly 90% of dollar trading volume.
Dependence on ECN
Because OTC Link ATS generates revenue from broker-dealers on a fixed subscription basis, the only way it has been able to grow Trading revenue is through prices increases.
Historically, price increases have not been enough to offset the decline in broker-dealer subscribers. In 2009, the OTC Link ATS generated approximately $69,000 per broker-dealer subscriber. Over the next 9 years, it grew at a compounded rate of 6.8%. In 2019, OTC Link ATS generated $115,000 per broker-dealer subscriber. Despite the price increase, the 9-year CAGR for the Trading business was 0%.
With the top 5 broker-dealers currently generating nearly 90% of dollar trading volume, and with this percentage expected to increase as the broker-dealer industry consolidates, it is easy to imagine a scenario where the company reaches a ceiling of price increases due to the lack of bargaining power.
Therefore, future growth in the Trading business ultimately comes down to OTC Link ECN.
Since OTC Link ECN generates revenue from every transaction, the Trading revenue should grow as trading activity grows.
In fact, since its full-year introduction, OTC Link ECN has generated positive revenue growth for Trading. In 2018, the Trading business grew by 11%, and in 2019, it grew by 4%. In less than three years, it has become the third most active broker-dealer, right behind Citadel and Virtu.
OTC Markets introduced OTC Link ECN at a time. From 2016 to 2020, the number of OTC transactions grew by 26% every year.
Growth for OTC Link ECN should continue to generate positive Trading revenue, but the market opportunity is limited.
In an earnings call, Management said, “the vast majority of their trading is going to stay on stay in the OTC Link ATS” since the IDQS is the vehicle which best way to fill liquidity in a naturally illiquid market. They estimate that ECNs could serve less than half of the OTC trades since it is only meant to be used as a complementary trading strategy.
For example, a broker-dealer who doesn’t typically operate as a market maker could use the ECN to trade anonymously.
The OTC Markets Advantage
Since the market opportunity is limited, the long-term growth potential for OTC Link ECN is determined by the company’s ability to compete with its primary competitor.
NYSE runs a longstanding, OTC ATS called GlobalOTC. While it is not an apples-to-apples competitor based on functionality, it more or less competes for the same customers. OTC Markets outlines the differences between the trading platforms on their website.
In 2019, Global OTC generated about 5.6M trades for $42B in dollar trading volume, representing about 13% market share.
To put Global OTC’s market share into context, OTC Link ECN would have to generate 16,000 trades per day to catch up to Global OTC. In 2019, OTC Link ECN executed an average of 4,300 trades per day, or roughly 1.5M trades during the year. This comes out to about 3.4% market share in 2019.
Interestingly enough, Global OTC’s market share actually increased since the OTC Link ECN introduction in 2017. The growth in Global OTC and growth OTC Link ECN indicates that the companies are currently competing in different segments of the market; otherwise, the growth of one would have resulted in a corresponding decline of the other.
If the total industry growth in OTC transactions continues to grow at a fast rate, each company will continue to grow without competing aggressively with one another.
Over the long-term, management said they will have to compete more aggressively on pricing to gain more market share.
Beyond price, OTC Markets has the advantage of having broker-dealer relationships through its longstanding product, OTC Link ATS.
In 2019, there were 53 OTC Link ECN subscribers. More than half of OTC Link ECN subscribers are also OTC Link ATS subscribers. The cross-selling opportunities is extremely effective.
More importantly, the OTC Link ECN is already profitable, in terms of direct costs incurred to support and run the technology. In 2019, the revenue per OTC Link ECN subscriber was $28,000. This is 4x less than OTC Link ATS subscribers.
Assuming the max number of OTC Link ECN subscribers cannot exceed the OTC Link ATS subscribers, you can calculate the incremental revenue and/or profitability with the current revenue per OTC Link ECN subscriber.
Since OTC Markets will eventually have to compete on price, and the total addressable market is limited, it is unlikely that OTC Link ECN will be able to generate the same revenue per subscriber as OTC Link ATS. Regardless, you could calculate the incremental revenue and/or profitability to calculate the upside if OTC Link stole all of Global OTC’s market share.
Durability of Data
OTC Markets serves many different customers, but the bulk of the Data revenue comes from the Big 3 market data redistributors.
Approximately 40% of the Data revenue is generated by the Big 3 market data redistributors: Bloomberg, Interactive Data Corp, and Thomson Reuters. Between the three, Bloomberg is the largest account, generating nearly 25% of Data revenue. The average Data revenue generated per Big 3 Redistributor is $3,150,000. This is 10x more than the 56 non-Big 3 Redistributors, which generate about $300,000 each.
In 2019, Data revenue represented 40% of total revenue. It is the most consistent segment, compounding at 9% in the last 10 years and 4% in the last 5 years.
Growth: Pricing + Users
Like other market operators, OTC Markets has consistently grown revenue by increasing its prices on its market data.
To be clear, the company does not raise its prices every year. This differs from exchanges, who do increase their prices every year. Rather, they set a goal to grow at a certain rate and increase the price to hit that rate. So, while the Data revenue can look like it has slow growth in most years, a 5-year or 10-year CAGR shows Data revenue growing much faster than that.
In the last 15 years, OTC Markets has only increased prices twice. It is easy to tell which years the company increased prices.
In 2014, the price increase was justified to bring their “pricing in line with the industry.” As a result of the 2014 price increase, revenue from the Big 3 has compounded at 10-year CAGR of 4%.
In the years that OTC Markets did not increase its prices, Data revenue grew as a result of professional and non-professional user growth. In 2019, there were 22,000 professional users and 13,000 non-professional users.
Non-professional users are an increasingly important part of the business. The non-professional user 7-year CAGR is 6.7% whereas professional user 7-year CAGR was 2.9%
The growth in non-professional users “is in line with a more general trend of increased retail participation in the U.S. equities markets. It also reflects continued progress made in expanding our market data redistributor network.” These users typically access the company’s data through more accessible market data distributors, whether it’s financial portals like Morningstar or online brokerages like TD Ameritrade.
Bargaining Power
The ability to increase its prices comes down to OTC Market Group’s bargaining power.
The first source of the company’s bargaining power is the exclusivity of its trading data. OTC Markets has the exclusive ability to sell Real-time Data and Pricing & Reference Data products to various customers because of its ownership of OTC Link ATS and OTC Link ECN.
The second source of the company’s bargaining power is the relationship with its market data redistributors.
OTC Markets has bargaining power over the Big 3 because of the relative cost-to-benefit.
Bloomberg, the largest of the Big 3, generated $10B of revenue in 2019. In the same year, the total cost to Bloomberg for the OTC market data was $6M. This represents less than 1% of total revenue. Even though OTC equities is such a small part of the equities market, it is a necessary part of the Bloomberg product, since it claims that it is the ultimate gatekeepers of financial information.
OTC Markets has bargaining power over the other market data redistributors because of the supplier-to-customer ratio.
Because OTC Markets is the only provider of OTC transaction data, these customers have no other option. Market data redistributor who are unwilling to pay for the higher price for OTC market data have no leverage against OTC Markets. OTC Markets can always cut the customer off and sell it to their competitor.
Exclusivity of Data
Market data for Best Execution is currently the most debated topic in the national exchange market systems.
Broker-dealers who serve as market makers in the OTC equities market need the best data for Best Execution. Broker-dealers can either use SIP data or Proprietary Data.
SIP data, which stands for Securities Information Processor, is often found on Google Finance or Yahoo. It computes a single price to simplify the complex process where multiple market makers aggregate price data into one single quote. The price that the average investor sees on Google Finance is the SIP’s NBBO, or National Best Bid and Offer benchmark price.
The NNBO price is the “market price” that an investor on Google Finance can see when they execute a trade. In other words, the price they see (the SIP) is what they get, if they choose to make an order. This is why SIP’s are known to provide what is called “top-of-the-book” price data.
Proprietary Data is the data sold by marketplace operators like NYSE, NASDAQ, and OTC Markets Group. The information is taken into account the consolidated SIP, but at a more granular and faster level. This is why Proprietary Data provided by the marketplace operators is often called “depth-of-book” price data.
Market participants, through market forces and regulatory requirements, are pressured to buy the expensive “depth-of-book” data in order to uphold their Best Execution obligation, which essentially is the regulation that forces market participants to provide the best possible price for their customers.
The Regulation National Market System (Reg NMS) grants exchanges the exclusive responsibility to disseminate market data consolidated from their platforms. This regulation has given the exchanges extreme pricing power, which has caused a commotion in the broker-dealer community.
“Brokerage firms and large banks, operating under the Securities Industry and Financial Markets Association (SIFMA), claim that exchanges compensate for declining listing revenues by creeping up proprietary data fees,” according to Georges Ugeux from Columbia Blog.
The exchanges are obligated to seek approval from the SEC before they raise prices. For the past few decades, the SEC has sided with the exchanges. The SEC had approved 95/95 price increases until 2018. For the first time, they said no, and have started investigating if the exchanges, along with other marketplace operators, have not met their statutory obligation to prove their fees are fair and non-discriminatory.
The broker-dealer community has been so concerned about the abusive pricing power in market data that the top executives at JPMorgan and Goldman have taken multi-million dollar pay cuts Sachs to become top executives at the SEC to exert regulatory influence.
In addition, a new exchange has recently launched called Members Exchange (MEMX). It is backed by the largest broker-dealers and financial firms in the world, such as Morgan Stanley, UBS, Bank of America, Citadel Securities, Virtu Financial, Charles Schwab, E*Trade, Fidelity, and TD Ameritrade. The goal of MEMX is to charge lower fees for its Proprietary data feeds.
In 2009, FINRA attempted to replicate the same Reg NMS exclusivity in the OTC securities market.
Under their Quotation Consolidation Facility (QCF) Proposal, “FINRA would provide a national best bid or offer (“NBBO”) for OTC securities traded on interdealer quotation systems for inclusion in the NASDAQ UTP Level One feed.” This would “effectively require to provide FINRA with OTC Market Group’s OTC-BBO and all broker-dealer quotations on their OTC Link ATS, so that FINRA could provide an NBBO for OTC securities for inclusion in the NASDAQ UTP Level One feed.”
If the QCF Proposal passed, it would have taken out more than 40% of the company’s 2009 Market Data revenue, or $4M. After sending the SEC Comment Letters regarding the proposal and after threatening to sue the SEC and/or FINRA, FINRA submitted a new proposal which withdrew the QCF Proposal.
While the exclusivity over market data is a remnant of the past for OTC Markets Group, the current debate in the exchanges could very well extend into smaller marketplaces such as OTC Markets.
A Framework for Returns
Equity Bond
The easiest way to estimate your returns is by viewing OTC Markets Group as an equity bond.
Like a debt bond, an equity bond generates an equity coupon, but in this case, in the form of free cash flow. The benefit of owning an equity bond as opposed to a debt bond is that the equity coupon can grow while you hold it.
The formula to estimate your returns on an equity bond is free cash flow plus growth.
The business model of OTC Markets makes it particularly easy to estimate its returns because its return on incremental invested capital is nearly infinite. As a result, we do not need to consider any retained earnings for the cost of growth.
If you are looking for a 10% annualized return, you can calculate the free cash flow yield, then subtract the number from 10% to estimate the growth you would need to earn a sufficient return based on your hurdle rate.
For example, in 2019, OTC Market Group’s market cap was $410M. The company generated $17M in free cash flow. This comes out to a 4% free cash flow yield. With a 10% hurdle rate, you would need a 6% growth rate to earn a sufficient return.
Areas of Focus
This benefit of thinking in terms of OTC Markets as an equity bond is that it gives you a framework to identify the assumptions in your valuation.
For this equity bond to work, there are a few assumptions.
The first assumption is that OTC Markets has a perpetual life and it will never go out of business.
The second assumption is that OTC Markets will never have free cash flow below $17M or a free cash flow margin below 28% (since revenue in 2019 was $60M).
The third assumption is that OTC Markets will grow at 6% every year in perpetuity.
The fourth assumption is that OTC Markets will always have an infinite ROIC.
Key Questions
Many of the underlying details relating to each assumption was picked apart throughout the report. So, I will leave you with three questions to help spark more ideas as you craft your own valuation and ultimately make your own investment decision:
Under what circumstances would OTC Markets fail to retain its customers?
Under what circumstances would OTC Markets fail to raise its prices?
Under what circumstances would OTC Markets fail to generate free growth?
Thank you for reading. I hope to sharpen my skills every month and develop meaningful relationships along the way. What points do you agree with? What points would you like to share your own perspective?