OTCM is both a ridiculously illiquid micro-cap and a unique business, as the dominant company behind the OTC market in the US.  Its recurring revenues are growing and it has significant potential operating leverage, as well as a strong balance sheet, free cash flow, dividends, and a reasonable valuation. Despite the general slowdown in listed stock trading (other than from the high speed algorithms) OTCM’s revenues have risen steadily, reflecting the growing number of US and foreign companies who want access to US investors without the expensive requirements of listing on the major exchanges.  The biggest risk in owning OTCM is that it operates in a highly regulated business, where unpredictable changes in SEC and FINRA rules could imperil parts of its business.

Description: Technically speaking, OTCM doesn’t operate an exchange, but operates an interdealer quotation system and electronic messaging service for broker-dealers to trade OTC equities.  There are about 150 firms making markets in over 10,000 securities using OTCM’s OTC LInk system.  These securities are segmented by OTCM into three tiers, based mainly upon the quality of their reporting.  The highest tier is the OTCQX, which currently has 329 listings, the mid level is OTCQB with 3626 issues listed, followed by OTC Pink with 6226 listings.

In the most recently reported quarter, ending Sep. 2011, OTCM got 38% of its net revenue from “Trading Services”, in which it charges brokers for using its system for making markets and conducting trades. It got another 34% of net revenues from “Market Data Licensing” in which it sells data on quotes and transactions to interested parties; much of that business goes through middlemen like Bloomberg, Interactive Data, and Thomson, which receive rebates, creating a difference between gross revenues and net revenues (gross minus rebates.)  The smallest of OTCM’s three revenue categories at 28% is also the fastest growing (up 68% y/y in Q3), “Issuer Services,” which generates most of its revenues from the highest tier marketplace, OTCQX.

Why OTCQX is Key:  With over 10,000 securities being traded on OTCM’s platform, one wouldn’t think that the OTCQX segment, with only 329 securities currently listed, would be that important, but it is, for a variety of reasons.  This is the elite part of the OTC market, consisting mostly of companies that could be on one of the major exchanges, but aren’t.  It might be because they are US companies that don’t want to take on the extra expense of complying with rules such as Sarbanes and Dodd-Frank, or foreign companies that don’t want to convert their books to US accounting.

OTCQX includes many name brand international companies, such as Adidas AG, Air France-KLM, Akzo Nobel, Allianz SE, AXA, BASF, BNP Parabas, and British Sky Broadcasting, just looking at the first two letters in the alphabet.  There are plenty of US companies on OTCQX as well, but most big US ones that do qualify for the established exchanges list on them because they are already subject to Sarbanes and already use US accounting standards, so OTCQX doesn’t add much value.

To foreign companies, especially the larger ones where there could well be an active US market for their shares, the OTCQX is a very cost effective way to reach US investors.   Many foreign exchanges are as strict or more so than US compliance, so OTCM assumes that being in good standing on certain foreign exchanges is an acceptable seal of approval.  Still, a prospective OTCQX candidate must hire a “Principal American Liaison” (“PAL”, as opposed to US candidates for OTCQX listing which must hire a “Designated Advisor for Disclosure” or “DAD” - cute, no?) which are either an approved investment banking firm or securities oriented law firm.

The DAD or PAL is required to provide a professional third-party review of an issuer’s initial application and disclosure statement and periodically review ongoing disclosure.  In particular, a DAD/PAL undertakes a limited review to confirm that the issuer meets its obligations under the OTCQX rules, including, in the case of foreign companies, posting in the US anything required to be disclosed in their home countries.

At its two lower levels, OTCM makes money from brokerage firms, market makers, and investors paying for access to its system that facilitates trades and information about those quotes and trades.  With OTCQX, OTCM makes money that way too, but can also charge the issuers themselves a listing fee, $5000 for the initial application, and thereafter $15,000/year to stay on the OTCQX.

As of Friday Feb. 10 there were 329 companies listed on the OTCX (up from 314 at the end of 2011 and 159 at the end of 2010.)  If growth in listed issues completely halted, that represents revenues of $4.9 MM per year.   At its current growth pace, one can plausibly expect there to be about 450 listing by this year’s end, which would represent $6.75 MM per year going forward.  Whatever additional costs there may be for OTCM to add my assumed additional 136 listings of next Dec. 31st versus last, it is unlikely marginal costs would go up anything close to the $2MM in additional annual revenue they would provide.

How many companies are there in the world that qualify for OTCQX listing?  Among foreign companies the number is well over 5,000 since the main requirement is that they already be trading on one of several dozen major foreign exchanges, meeting the compliance requirements of those exchanges.  For US companies they have to be real, operating companies (no SPACs, blind pools, or development stage companies) with at least a few million in revenues or $5 MM in market cap, and pass certain requirements for audited statements, current filings, minimum stock price, etc. I would guess that there are more than 1000 small public companies that meet those standards. The qualification rules for both foreign and US issuers can be downloaded here:  http://www.otcqx.com/qx/int/rules

Out of all those potential OTCQX listing candidates, how many would want to pay $15,000 per year to OTCM and an additional amount per year to a DAD or PAL for sponsorship, in order ease access to US investors?  Reasonable people may differ, but I would guess that the number could be many times the current 329 total.  One reason is that the current pace of 2 to 3 new listings a week seems much too fast for a series that is approaching saturation; one would expect a slowdown as it nears its limit, and that hasn’t happened yet.

Also, OTCM has a free, hard working, and growing sales force in the form of the investment banks and law firms that are encouraging qualified companies to hire them to be the DAD/PAL required to list on the OTCQX and stay listed.  The DAD/PAL could charge anything from about $15,000 a year for fairly bare-bones service that covers the basic paperwork to well over $100,000 per year for very full service that includes regular updates on market activity, road show trips to meet potential US investors, lining up research coverage, consulting on acquisition possibilities in the US market, and any number of other services.  Investment bankers and lawyers, like anyone else, want clients who provide recurring revenues and an opportunity to earn larger fees on specific projects.

OTCQX listed companies are not required to stick with the same DAD/PAL forever, but providing good service at a fair price should keep the business fairly sticky.  The number of qualified DAD/PAL firms has been growing from 27 at the end of 2009, 36 the next year, and currently 48.  In addition, it appears that the general profit squeeze on Wall St. is causing some of the DAD/PALs to devote more attention to OTCQX recruiting.

All this amounts to a powerful and growing sales force for OTCM for which it pays nothing.  Not only does each new OTCQX listing bring in $15,000 per year to OTCM, but also additional fees from those who make markets and trade the stock.  To the extent that more foreign stocks trade on the OTCQX, that may also increase the number of subscribers overseas who want to pay for real time trade data through their Bloomberg or other terminals.  While OTCM is glad to get any new listing, the large foreign companies that list will bring in much more in market maker and other fees because they tend to have much more activity than a US company known only to a few.  For example, Friday’s most active OTCQX stocks were nearly all foreign companies: Roche, Canadian Oil Sands, Wal-Mart de Mexico, Deutsche Telecom, Danone and similar names.

This probably won’t happen, but if Europe is stupid enough to institute a “Tobin Tax” on securities transactions as Sarkozy has been demanding, there would be tremendous pressure on major companies there to list on the OTCQX as the most cost effective way to let their shareholders avoid the tax.

Operating Leverage:  While it is clear that the marginal cost of adding one more OTCQX listing is trivial compared to the extra $15,000+ annual revenues that they generate, and in theory the operating leverage should be huge, in fact OTCM does have to invest increasing amounts in computer systems and personnel to keep the exchange competitive, the security robust, the computer systems able to handle surges in volume and hacker attacks, or anything else that might reduce the value of its brand.  Still, if it continues its recent growth, we should see, if not every quarter, an increase in operating profit margin.  For example, in the most recent report for the nine months ending Sep. 2011, net revenues rose 18% and operating profit 23% (adjusted for a $1.4MM one time write-down in 2010.)

Thus there has been some expansion of operating margins, but nothing explosive, at least not yet.  It will take some combination of accelerating revenue growth from the OTCQX companies and a flattening of operating expense growth for margins to take off, and I have no idea if or when that will happen.  But I know it is possible, because OTCM is inherently like many internet businesses, where once the system is set up, marginal revenues have almost no marginal cost.

Risks:  The biggest risk in OTCM is that it is in a highly regulated business, and subject to unexpected and arbitrary changes in SEC and FINRA policies.  For example, in November 2009 FINRA filed with the SEC a proposed rule change to create a “Quotation Consolidation Facility” that would in effect require OTCM’s quotation and transaction data be turned over to FINRA for the latter to sell to interested parties in competition with OTCM, if I understand the legalese correctly.  If approved, this would be very damaging to OTCM’s business.

Naturally the company has protested vociferously, and if enacted in anything close to its proposed form, I am sure OTCM would attempt to tie this up in court for years, but that just guarantees massive legal bills with no assurance of success.  The company is cautiously optimistic that the fact that more than two years have passed since the proposal was made with no approval from the SEC is a sign that it will either be dropped or heavily revised, but with bodies like FINRA and the SEC one never knows for sure what will happen.

Another possible negative change in the legal background comes from the fact that in recent years quite a few companies have deregistered from the SEC to avoid the expense and effort of compliance with Sarbanes-Oxley.  Most of them have chosen to have their stocks instead traded OTC, which benefits OTCM.  There have been various proposals in Congress to raise various thresholds so that smaller companies can stay registered with the SEC and listed on the bigger markets.  If passed these changes would reduce US companies’ incentive to list with OTCM.

Although OTCM has dominance of non-listed trading in the US, there are alternative systems in existence or proposed, and if any of them are perceived to offer a better platform at a lower cost OTCM’s listing growth could go in reverse.  Also, we have to keep in mind that in the last several years there has been a slump in stock trading, despite rising prices, other than from the high frequency trading algorithms.  OTCM has shown steady growth in revenues despite that, in contrast to NYX or NDAQ.  A severe bear market could cause a further drop in trading and a further consolidation on Wall St., reducing the number of market making firms and the demand for OTCM’s services.

Summary:  I think OTCM has a solid business with the potential for big operating leverage if OTCQX can continue to grow rapidly and the company can keep its systems and other expenses under control.  As it is, it is reasonably priced.  With 10.5 MM shares, $9 MM in cash and no debt, at $54 MM the EV is less than 2 times the estimated $30 MM in net revenues in 2011, and about 11 times last year’s earnings.  Capital spending needs are modest because servers aren’t that expensive, but the company has to keep spending on staff and programming, so free cash flow as such could be misleading.  The $0.04 quarterly dividend provides a 4% yield.  The upside could be significant if/when the operating leverage kicks in, but a negative development in the regulatory environment, and/or a collapse in stock trading and market making in a bear market could pull the rug out from under this story

I’ll finish where I started, by mentioning the ridiculously illiquid trading in the stock, which sometimes goes days without a single trade.  I have found that on micro-cap stocks with significant insider ownership, very low volume tends to be bullish, because it shows that insiders refuse to sell at the current level.  The volume increases only when the stock has moved up enough that the insiders do provide supply to meet demand.  That is when you can buy it in bigger size, but you may not want to.  Now is when you should, but it is near impossible to do so except in tiny quantities.  Who said investing was easy?