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Steven Chen
Steven Chen
Articles (25)  | Author's Website |

Urbem's 'Wonderful Business' Series: OTC Markets Group

A recurring sales generator with a network effect moat

December 01, 2019 | About:

New York-based OTC Markets Group Inc. (OTCM) is the American financial market providing price and liquidity information for over-the-counter securities across OTCQX, OTCQB and Pink. Based on a mission to create better informed and more efficient financial markets, the company’s strategy is to share information through open and transparent networks, connect broker-dealers, organize markets, inform investors and deliver elegant, reliable and cost-effective subscription-based technology solutions.

The current CEO, Cromwell Coulson, acquired OTC Markets’ predecessor business more than two decades ago. Since then, he has transformed the company from a privately held publisher of broker-dealer quotations into a publicly traded company operating public markets for 10,000 securities that trade nearly $200 billion in dollar volume annually. Coulson and other individual insiders own more than 40% of the company’s shares as of the latest filing, which indicates an aligned management interest.

OTC Markets Group principally serves as a central network serving all parties involved in the U.S. over-the-counter market. It provides trading services (19% of fiscal 2018 sales) for broker-dealers, who pay subscription, usage-based and transaction-based fees, market data (39% of 2018 sales) for investors, traders, accountants and regulators who pay license fees and corporate services (42% of 2018 sales) for listed firms who pay application and service fees. What we especially appreciate the business model at OTC Markets Group is the almost 90% recurring portion of total sales, which sheds light on the company’s long-term cash flow and, hence, lowers risk for investors.

OTC Markets Group benefits from a multi-sided network effect, being the only major player in the niche over-the-counter segment. More listings may attract more traders and investors, generating more market data and liquidity, which, in turn, attracts more companies to get listed. This virtuous cycle continuously widens the moat for the business, strengthening the barrier of entry and increasing the value of the company’s products and services.

We do not see any prominent competition facing OTC Markets Group in the over-the-counter space. The company claims to mainly compete with national exchanges, such as the Nasdaq (NASDAQ:NDAQ) and New York Stock Exchange (NYSE:ICE) in the States and the London Stock Exchange (LSE:LSE) and Toronto Stock Exchange (TSX:X) internationally, as a portion of companies joining the OTC market may also qualify for a national securities exchange listing.

As described below, OTC Markets Group outperformed consistently based on return on assets since its IPO. Currently, the business generates over 40 cents annually on one dollar of assets, compared to less than 3 cents at its peers.

Thanks to the subscription-driven model (with a retention rate of above 90%) and the low capital intensity, OTC Markets Group is a cash cow even during a period of double-digit growth. The business only needed to absorb 1% to 2% out of sales for capital expenditures before this year. It has been delivering more free cash flow than earnings every year over the past decade (see below).

Going forward, we see overseas markets as a significant source of secular growth at OTC Markets Group. The management has been devoting resources to its international sales force, including opening a new office in London. At the same time, continuous investments in products and technology should pay off in the medium to long term by widening the moat and fueling further market penetration. Management just increased its capital spending significantly in the current fiscal year (see below).

Disclosure: The mention of any stock in this article does not constitute an investment recommendation; investors should always conduct careful analysis themselves or consult with their investment advisors before acting in the stock market. We own shares of OTC Markets Group.

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About the author:

Steven Chen
Steven CHEN is a quality-focused investor (with bottom-up opportunistic approaches), an ex-hedge fund analyst on Wall Street, a serial entrepreneur, computer scientist, and free-market capitalist. He contributes to well-known financial media sites, such as GuruFocus, SeekingAlpha. Steven is the Managing Partner of Urbem Partnership, a value/quality-focused investment partnership fund (www.urbem.capital), and Urbem Capital, the research boutique that focuses on the highest-quality 0.1% of all public companies worldwide.

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