- Preliminary post on OTC Markets Group
The Pink Sheets stocks book goes back to 1904 when a man named Arthur Elliot began distributing prices on these over the counter (from here-on “OTC”) stocks. In 1913 he joined a fellow competitor, and they created the National Quotation Bureau, seeing very obvious profits in disseminating prices of these forgotten stocks. Said company provided investors with a physical book that was delivered every day to brokerage houses. The business continued doing this until the appearance of the NASDAQ market in the 1960s took away most of that franchise. Somewhere along its history the company got sold to Commerce Clearing House because of NASDAQ they didn't see the point of investing in technology to keep the product up to date.
Then enters current owner and CEO, Cromwell Coulson who bought the company in 1997 and has since standardized and modernized the over the counter market in the US to resemble an official stock exchange. The modernization of OTC Markets has been modelled after London’s AIM market. Simply put, OTC Markets provides companies with a more cost-conscious and less risky way of accessing US investors’ capital and hence access the biggest stock market in the world. From a regulatory standpoint, OTC Markets benefits from the fact that it is allowed to list/quote foreign non-SEC registered companies like Danone, Heineken, Allianz, etc.
Cromwell Coulson was a trader at Carr Securities Corp where he worked for 10 years. He was particularly frustrated with the transactional side of buying and selling OTC securities – wide prices discrepancies, calling around to figure out prices, etc. As a trader he was an avid Bloomberg user and that led him, in 1996, to call Michael Bloomberg. He thought M. Bloomberg, having Bloomberg the company, was the ideal man to buy Pink Sheets and turn it electronic by incorporating it on Bloomberg. To which M. Bloomberg replied, “That’s the dumbest idea I’ve ever heard hung up on me”. And so, Cromwell Coulson, at 30 years old, ended up buying it. The company had about $2.5 million in revenue at the time. Today it’s $60 million. And trading volume of $50 billion in 2003 to over $300 billion today.
Besides other things, there was one major problem with the pink sheets and that was the transactional side, in other words, the utter lack of price transparency. If one goes back 30, 40 or 50 years what happened was brokers had all the information. The wasn’t really a price for a stock. There would be huge price swings between trades. Brokers had to call back and forth to figure out the price of a stock and they ultimately had all the information, which then allowed for customers to be to be ripped-off.
Technically speaking, OTC Markets operates an electronic quotation and trading system in the over the counter (hereon “OTC”) securities market. The difference between OTC Markets and an exchange is that securities traded over the counter are traded between brokers as opposed to on a centralized exchange. However, in terms of the economics of the business there is not much difference, because OTC Markets is still a central marketplace – that benefits from network effects inherent of a stock exchange – that charges companies that want to be part of its more premium markets, and that publishes and sells a diverse set of data/information. So naturally, the company benefits from the sticky and high retention rate revenues typical in stock exchanges.
Cromwell Coulson knew the Pink Sheets needed a lot of work. In 2000 he said, “This is not the Nasdaq which has a brand name like Disneyworld of exchanges. We have a brand name that`s Las Vegas.” He took the company from “a staid, file cabinet-lined midtown Manhattan office, to an open space (of a failed Internet company) in Soho where the walls are painted pink. He walks to work from his loft in trendy TriBeCa.” The first part on the road to fixing Pink Sheets would be to make it electronic. That would allow for price transparency and that in itself would already give a lot of credibility to the market and hence attract more investors. That first step has been completed successfully. The second step was to make information more easily accessible to less sophisticated investors. This was hard to tackle. The Pink Sheets had SEC reporting companies, non-SEC reporting companies, foreign ADRs that reported according to rules in their country, SEC-reporting and non-SEC reporting Community banks, etc. So, they started by creating the Alternative Reporting Standard (from here on “ARS”) and dividing the market into three tiers: (1) OTCQX, (2) OTCQB and (3) Pink sheets. Different ARS apply to the QX and QB market, and companies in those markets must follow those standards. Pink sheet companies are not required to follow any standards. The have accomplished this to a large extent, but there are still many companies that refuse to publish up to date information in the standardized format the company incentivizes.
OTC Markets has three different revenue lines, as shown in the following chart:
Trading Services (20% of revenue) is revenue from broker-dealers that pay monthly license subscriptions to trade OTC stocks. Fees are based on a subscription price per broker and not on the number of transactions. Secondly there’s Market Data Licensing (40% of revenue), this is revenue derived from all sorts of data on OTC securities sold to (1) roughly 60 market distributors like Bloomberg, Reuters, Fidessa, etc. and (2) users of financial data. – here too revenue is on a subscription basis. Lastly, we have Issuer Services (40% of revenue), essentially created in 2006, accounts for both the one-time and recurring fee companies have to pay to be part of the OTCQX and OTCQB markets. This last segment also includes revenue from OTC Disclosure & News Service which allows companies to share news and information with a wide audience of U.S. investors, media outlets (PR Newswire, Business Wire, etc.), etc. – this service is free for QX and QB companies but costs $5,500 to Pink companies.
Issuer services includes one-time fees for the OTCQX and OTCQB markets of $2,500-5,000 and recurring fees of $15,000-20,000, and OTC Disclosure and News which allows companies to publish news to numerous media outlets and other third-parties, along with other functions, providing a much more effective investor relations effort. Over 80% of revenue in this segment is from recurring fees, with another ~$4.5M in revenue from the one-time fee and OTC Disclosure and News.
In terms of how this segment fits into the whole business, I think it is the most important of all of them. Issuer services, and hence the growing or contracting number of companies quoted on the OTC Markets, will drive the growth or contraction of both trading services (the amount of broker dealer subscribed and hence interested in trading OTC stocks) and also the market data licensing, the interest there is for all kinds of data relating to the OTC stocks.
There are actually three markets for companies on OTC Markets: (1) OTCQX, (2) OTCQB and (3) Pink Sheet. Pink Sheet has by far most companies (Nestle is one) and these are companies that don’t pay anything to be on the website and are exempt from any financial standards or disclosure requirements – yet OTC Markets classifies them into Current, Limited or No Information based on the information they provide to investors.
The OTCQX is designated as a “quality-controlled marketplace for investor friendly companies that can meet the highest financial standards, however they do not need to register with the SEC, they can choose to do so based on their investor base and capital raising needs” and the OTCQB as “designed for smaller companies that are current in their reporting obligations to the SEC / US banking regulator, but not qualified to OTCQX“
It is hard to compare how much cheaper OTCQX and QB actually are to competitors like NASDAQ and NYSE. This is because companies on the QX and QB markets need a DAD/PAL, who provides advice and counsel to the company and attest to the disclosures made by the company. In terms of fees paid directly to OTC Markets, it is much cheaper than NYSE or NASDAQ. For comparison, listing fees for NASDAQ Capital Market (lowest tier) are a minimum of $50,000 for application and $43,000-77,000 in annual fees (depending on shares outstanding). The NYSE’s listing fee is $50,000 with annual fees of $40,000-60,000. The DAD/PAL fee can range from $10,000-100,000, depending on how complicated the business is.
In 2015 OTC Markets CEO, Cromwell Coulson, mentioned that the recurring fee for the OTCQX market is going to be set, roughly, relative to NASDAQ’s Capital Markets. The goal, set in 2015, for the next five years was to charge half to two-thirds of NASDAQ’s price ($21,500 to +$28,000 based on FY2020 NASDAQ’s price). As of FY2020, NASDAQ’s Capital Markets fee is $43,000 vs. OTC Market’s $20,000 annual fee for the QX tier, so OTC Markets has achieved the bottom-end of their goal. All this was achieved with retention rates ranging from 89% to 94%.OTC Market’s sales efforts, such as opening offices in London, have allowed them to increase the number of OTCQX stocks over time and increase fees. The number of OTCQB companies has fallen over time due to a major requirement change in May of 2014 that immediately eliminated over 1,000 companies. However, by December of 2014, there were 312 companies that met the criteria of OTCQB, and that number has grown over time. Retention rate since then, for both OTCQX and OTCQB, has been in the order of 90%.
To decide whether OTC Markets will continue having pricing power depends on two things: (1) they will be able to increase prices if NASDAQ also increases prices over time – this I believe is true for US-based companies. However, if international companies wanted to join say the NASDAQ, they would need to incur the burden of becoming SEC reporting companies and reconcile their financials to US accounting. Even if OTC Market’s prices come much closer to NASDAQ’s, there is still a significant value proposition in what OTC Market’s offers – because you don’t spend money reconciling financials. But, since prices for the QX/QB market are the same for national and international companies, I think what will determine the company’s pricing power is the extent to which NASDAQ increases its price.
Even though NASDAQ and the NYSE have much, much more well-known brand names companies like Adidas, easyJet, Heineken, Tesco, Repsol, Danone, Hugo Boss, etc. still see the cost and complexity benefit of not listing on an actual exchange.
OTCQX and QB currently include a total of about 678 international companies, however there are still +28,000 stocks traded on other foreign exchanges. So, we know that there are over 28,000 companies outside the US that are publicly traded on other national exchanges, so the question becomes what percentage of those companies do we think will be interested in (1) accessing US capital and, (2) doing it through OTC Markets. Right now, OTC Markets has a market share of ~2.4%.
From 2008-2012 there was +8-fold increase in the number of international companies on the QX tier, however since then performance in this segment has been lackluster. Until recently, and for a long time, OTC Market’s only had offices in New York and Washington D.C. However this changed in the end of 2018 when the company opened an office in London to improve the sales efforts for getting international companies to join. I think it will be important to see if the company’s international sales efforts can drive growth in the number of stocks on the QX and QB tier.
Market Data Licensing (“MDL”) sells data to professional (Bloomberg, Reuters, PR News Wire) and non-professional users. There are over 22,000 professional users and almost 13,000 non-professional users, where the three largest data customers (data distributors Bloomberg, Reuters, and Interactive Data) account for around 40% of this segment’s revenue.
Most revenues from MDL come from market redistributors, of which there are a total of about 60. Bloomberg, Reuters, Interactive Data and Fidessa account for ~50% of MDL revenues (20% of the company’s revenues). We know that in 2010, Bloomberg, Reuters and Interactive data accounted for over $7M in revenue. Bloomberg accounted for $4.3M in 2010 and today it accounts for $6.2M. The company gives no data as to how much Reuters, Fidessa or Interactive Data account for.
Even though there is substantial customer concentration, these are big companies, much bigger than OTC Markets. Bloomberg turns over +$10bn, Interactive Data probably north of $1bn (it was bought out in 2015 by Intercontinental Exchange for $5.6bn, Intercontinental itself does over $5bn in revenue) and Fidessa over $460M. And these companies are purchasing it on behalf of their many, many customers.
As long as OTC Markets remains a relevant player in the stock exchange industry, which it currently is given that it ranks number three amongst the stock exchanges in terms of annual dollar volume, there will be a recurring interest by customers like Bloomberg to have the most up-to-date information on companies so that it can be distributed to its customers. The exact same applies to Trading Services, brokers will want a piece of the action of this $300+ billion ‘stock exchange’.
It is very likely that in ten years there will be companies that trade over the counter. The question is whether OTC Markets will continue being the data aggregator that it is, and also the data disseminator that it is. Unless there is a regulatory change, and OTC Markets continues to provide a standardized, efficient, and straightforward website where companies, investors and brokers can come to, then they will continue to be at the center of where a lot of capital is traded ($200-300bn annually). This will allow them to reap benefits in terms of selling market data and selling broker-dealers several services. Furthermore, if OTC Markets continues to execute on the OTCQX and OTCQB and creates a more widespread brand for those markets, and is able to communicate the value proposition, then this will drive more revenue in each of their segments.
Over the last five years the company’s return on net tangible assets has averaged +100%, ROE have averaged 80% and ROIC indicates returns of +2000%. In fact, the return on net tangible assets and return on equity drastically understates the true returns of the business because it includes the company’s $28M in net cash. The reason why the ROIC is so high, is because there is (1) actually little/no capital employed in the business – there’s no inventory, no accounts receivable, little PP&E – and (2) there’s a lot of deferred revenue, meaning the company receives the subscription money before it provides the service, generating somewhat of a float. The existence of float is what allows the company to convert to much of its operating income into free cash flow. OTC Markets is a business that needs very little invested capital, needs little maintenance capital, and converts 80-90% of EBIT into free cash flow.
Since 2008, the company has produced just shy of $150M in operating cash flow and $130M in free cash flow of which, over $80M was delivered to shareholders mainly (90%) through dividends. Because OTC Markets has float, it can pay out basically all of its earnings and still grow. So, for this company, growth is tremendously valuable and returns on any kind of growth are infinite because the company is not having to put capital to grow. In recent years it has paid out roughly 85% of free cash flow.
When a business that has this high of a return for +10 years, there must a very significant barrier to entry that allows this. By definition, to a be a good business generating high ROICs you need at least one of these things working in your favor: (1) high switching costs, (2) network effects, (3) scale advantages or (4) brand.
The fundamental function of a stock market is to pool capital to fund business ventures, so that one of the most basic economic aspects of this business is that capital is going to be funneled, or concentrated, on a few stock exchanges. Some industries that lack network effects or scale advantages will be populated with many small companies, whereas industries with network effects and scale advantages will have fewer and much larger companies. In the case of a social network like Facebook, if you only have one user then that social network is insignificant, but if you add another ten users then that social network becomes more relevant. And if you add 100 users then it is even more relevant. This is true until the social network reaches a certain point (i.e. critical scale) where the incremental value of a new users starts diminishing. To a certain extent, the same applies to OTC Markets. If the company only quoted one stock and only showcased/distributed information on one stock it would be pretty irrelevant, but as more and more stocks are added the value of the company intermediating that, increases.
Going back to the Facebook example, it would be really hard for a new company to compete with Facebook. Everyone is one Facebook, and no one is in the new company. And Facebook users are only willing to move to the new company if the new company has their friends, relatives, etc. there (i.e. a significant number of users), so it becomes a chicken-and-egg problem. Plus, creating a business out of your new social network would be really hard because which advertisers would want to allocate part of their budget to your company when you have no users? The same applies to OTC Markets, companies want to be where the investors are, and OTC Markets is that central place.
Companies want to be where most capital is and investors want a standardized “one-stop-shop” where the companies are quoted and where there are standardized rules and standards that the aforementioned companies have to comply with. Branding is important in stock exchanges, and whilst OTC Markets does not have the best brand – everyone knows about the NYSE, but few people know about OTC Markets – it does allow companies a certain degree of flexibility that other stock exchanges don’t.
I think switching costs are also relevant here, particularly for the QX tier (most Pink Sheet and QB stocks do not fit the criteria to apply to an official exchange in the US). For international companies that are non-SEC reporting, they can only switch to another ‘exchange’ by becoming SEC reporting companies and reconciling financials to US dollars and then applying to join the NYSE or NASDAQ. This is because there is no equivalent to OTC Markets, only official stock exchanges. For US companies who are on the QX tier, most are not SEC reporting companies, so the transition to an official stock exchange would be complex and costly.
Companies that trade on OTC Market’s markets do not need to file with the SEC. Many publicly traded small companies do not see the cost-benefit in filing with the SEC. Some companies will even provide annual and quarterly reports along with conference calls and earnings transcripts, all without filing with the SEC. US companies do not need to register with the SEC, but foreign firms that are exempt from SEC registration, must be listed on a qualified non-US stock exchange. For example, Nestle SA, a $365bn market cap company, which is quoted on the Swiss Exchange and on OTC Markets, produces European financials (in terms of accounting, etc.) does not want the burden of having to reproduce US accounting based financial statements (and the costs involved), to be able to register with the SEC so that it can join one of the US’s stock exchanges like NYSE. OTC Markets allows for a much easier, cheaper and flexible way for Nestle to access US capital – in fact they are probably not missing out on much given that the annual dollar volume on OTC Markets is over $300bn, which ranks it as about the third largest in the US.
I think that fundamentally, the base rate for the durability of exchanges is unusually high as compared to oth1er kinds of industries. Furthermore, and as alluded to in the beginning of this write-up, OTC Markets business only exists because they benefit, and have benefited for a long time, from regulation which allows them to quote/list non-SEC registered companies –something NYSE and NASDAQ cannot do.
I will keep it pretty simple here and simply do a reverse DCF. With a $340 million market cap and $25 million in net cash, implying an EV of $315 million, the company would have to grow FCF at 7% p.a. over the next 10 years to justify its current valuation (using a 9% discount rate).