Description

- High quality compounder protected by multifaceted moat.

- Capital light business model: ~100% un-levered ROE; minimal capex; negative working capital.

- Long growth runway: five-year forecast of mid-high single digit revenue growth with low-40% EBITDA margins.

- Recurring revenue, variable cost model.

- Owner-operator with aligned interests (27%-owned by CEO).

Overview

OTC Markets Group, Inc (“OTCM”) is the marketplace for “over-the-counter” securities. Importantly, the markets OTCM manages are just that – marketplaces – as opposed to exchanges.  This has favorable regulatory implications, limits capital requirements, and allows for a lower-cost service to be provided.

“Our mission is to create better informed and more efficient data-driven markets. As a first guiding principle in pursuing that mission, our trading and data businesses must allow our broker-dealer subscribers to trade any security that has investor demand in an efficient and compliant manner.

“Our second guiding principle is the pursuit of increased issuer engagement, which drives market quality, price efficiency and trading volume by improving information availability, data integrity and compliance. This benefits investors, brokers and our markets.” (2Q 2024 Conference Call)

Over 80% of OTCM’s revenue is from recurring, subscription-based arrangements.

The company is organized into three segments, as per its annual report:

- OTC Link

o Broker-dealers pay monthly license, subscription and connectivity fees.

o Broker-dealers pay variable usage fees to publish quotes and communicate and negotiate with counterparties.

o Over 12,000 securities are quoted by broker dealers on OTC Link, and OTCM supports almost $400bn of annual dollar volume traded (2023 figure).

- Market Data Licensing

o Subscribers (investors, traders, institutions, accountants, regulators) pay monthly data license fees to access market data, company data, and security information.

o Services are priced per enterprise or per user, through direct connectivity and third-party market data redistributors/OMSs.

o EDGAR Online and EDGAR Pro platform

- Corporate Services

o Suite of disclosure and information services that companies may choose to adopt, which places companies in one of OTCM’s three tiers of service (OTCQX Best, OTCQB Venture, or Pink Open Market).

o Companies pay one-time application fees and ongoing subscription fees to be listed in the OTCQX and OTCQB marketplaces (and must comply with appropriate financial, disclosure, and qualitative standards).

o Additional services offered include OTC Disclosure & News Service, Real Time Level 2 Quote Display, and Blue Sky Monitoring Service.

Capital Light Compounder

OTCM is incredibly capital light – it requires essentially no reinvestment of capital into the business to maintain its moat nor to grow revenues.  The company has book equity of just $40 million, not much higher than the amount of cash and short-term securities carried on the balance sheet ($34mm).  In fact, cash on the balance sheet is approximately equal to total liabilities.  Working capital is negative, and the business requires essentially no fixed assets (net PP&E is just $8mm). Annual capex averages around $1mm.

Thus, the financial return characteristics of the business are incredible.  Despite maintaining a significant net-cash balance sheet (with no debt), the ROE and pre-tax return on tangible capital have been over 100%.

The downside of this capital light business model is that the ability to reinvest in the business is limited.  As such, the company currently pays out a healthy dividend, which has averaged over 75% of operating cash flows in each of the last few years. The dividend yield on the current price is approximately 4.7%.  On top of the dividend, the company repurchases a modest amount of stock most years. The total capital-return yield is ~5.4%.

Bottom line, the business gushes cash, and returns most of it to shareholders each year.

OTCM has made several small acquisitions over the years, most recently Blue Sky and Edgar Online. It has the characteristics of a business that could sustain some leverage (for the right deal), but management is very conservative and risk-averse.

Growth

Despite the lack of reinvestment into the business, organic revenue growth has been impressive.

OTCM grew net revenue at approximately 11% annually over the last fifteen years, and it is worth highlighting that the revenue growth CAGR was the same in the first half of this period as is in the second half: Net revenue grew at an 11% CAGR from 2009 to 2016, and an 11% CAGR from 2016 to 2023.

The company experienced significant growth in 2021 on the back of the SPAC bubble. It is impressive that the company has been able to grow revenue slightly in each of 2022 and 2023 following that tough comp.

“Growth is never linear unless you're cooking the numbers. So -- and that comes from my history of being an investor. If I saw linear growth or numbers going forward, our numbers are going to have noise. And we're going to be grinding stupid mistake, grinding, learn, get better. Wow, that was good. What are we going to do next? And that's how we've done it historically. And hopefully, that is something we will move forward towards is because we have a great group of people in the organization. We have great clients and we have a strong capital structure and opportunities to grow all of our business lines, but they won't grow if we just keep the status quo. We need to be agents of positive change.” (2Q 2024 Conference Call)

Margins

Operating Margins peaked at 42% in 2021 but have since fallen to the low-30% range, below the 10-year average of 35%. The company has explicitly talked about investing for growth and taking a long-term view. I believe that operating margins should get back to the mid-30s in the next few years. A real bull case would have them reapproach the low-40% range.

“Our approach to expense management is intentional. We pursue opportunities for growth, and we are at a stage where focus on longer-term planning will both reduce costs and bring benefits from scale.” (1Q 2024 Conference Call)

Moat

OTCM, despite being smaller than competitors NYSE and NASDAQ, has a solid moat. It is the low-cost solution. It has significant self-reinforcing network effects. And finally, switching costs to leave the platform are high.

- The all-in cost to a company to list via OTC Markets (including regulatory, compliance, audit, etc) is significantly lower than that of the major competitors (NYSE, Nasdaq).  

- OTCM has established itself as the primary marketplace and related data provider for over-the-counter securities.  As more broker-dealers, companies, and investors adopt the platform, the stronger OTCM’s network effect becomes.

- A significant portion of OTCM’s revenues are recurring in nature.  Once a company has selected and OTCM marketplace, they become a fairly sticky customer with reasonably high barriers to exit.

Management

Cromwell Coulsen, CEO, bought into the business in 1997 when he was 30 years old.  He owns over a quarter of the shares and runs it like an owner.  He has proven to be an impressive leader of the business.  

A list of the company’s values in past annual reports gives a flavor of its culture: be open, be transparent, be connected, be an overachiever (“attract the best and brightest people by being the best and brightest company”), be a teammate, be creative, be an owner, be trusted, be a capitalist (“we strive to be a successful enterprise that provides superior investment returns for our shareholders”).

Valuation

The company doesn’t scream cheap on the current earnings run-rate, but as I mentioned, I believe margins are temporarily depressed. If we assume 35% operating margins on $125 million of net revenue in 2027, that would put EBITDA at $45 million and Free Cash Flow at ~$39 million. Valuation would be 11.6x EBITDA and a 7.3% FCF yield. If margins get back to 40%, EBITDA would be $50mm and valuation 10x EBITDA/8.5% FCF yield.

The dividend could grow to $3-3.50/sh, and if this traded on a 4-5% dividend yield (falling interest rates won't hurt), the stock would trade in the $60-87.50/sh range. Including the dividend yield, I think this can compound at a mid-teens rate over the coming years (starting MSD FCF/dividend yield + mid-high single digit topline growth + margin expansion back to normalized levels).

Catalyst

 - Margin expansion back to normalized levels or beyond

 - Increase in number of listings on the platform (new listings to OTC; de-listings from Nasdaq/NYSE down to OTC)