LabStyle Innovations (OTCQB:DRIO) has been covered on these boards before, but my view is that the articles have taken an overly descriptive view of the market and the device itself, as opposed to a proscriptive view of the investment story and the risk/reward level for the stock here. I will attempt to blend the two and arrive at a reasonable framework for determining the investment path here on DRIO.
Briefly, DRIO is a med tech company that has developed an innovative and proprietary device/software pairing for use in diabetes testing. Its flagship product, called the Dario, has a sleeker (curvier) design than the boxy/heavy diabetes testing kits used widely, and has a back end including a mobile app, securing cloud computing platform, and patient data interface system.
I will not belabor the details as those have been covered extensively before, but essentially the Dario device is an all in one device which comprises a lancet (to get the blood sample), device-specific test trip cartridge, and a smartphone driven glucose reader adaptor to hold the strip. The app, which requires 0.3 microliter of blood and takes a sample within 5 seconds, then transmits data to the cloud.
The market for self-monitoring of blood glucose (SMBG) is immense, as monitoring is an integral part of managing diabetes, and the accuracy of these measurements is critical, particularly for patients who have to calculate their insulin levels frequently. Self monitoring is used by approximately 350mm diabetics WW, including 80 mm insulin-dependent diabetics who self-monitor. The addressable market is likely >$10bb worldwide.
The company's targets, Europe (50mm) and the U.S. (25mm), represent 40% of the testing market due to their high self-monitoring compliance. Within the company's initial European launch, the U.K. (3m), Italy (4m) and Germany (6m) uptake will be critical- and the company has already inked distribution agreements for U.K./Germany partners (Farla and Harmonium, respectively).
The glucometer/test strip market is currently dominated by major players, each of whom holds about 10-15% market share: Johnson & Johnson (JNJ), Roche (OTCQX:RHHBY), Abbott (ABT), Medtronic (MDT), Bayer (OTCPK:BAYZF) and Sanofi-Aventis (SNY).
However, there may be some cracks forming at the top. Last year, Bayer attempted to sell its blood glucose meter business for around $1.5 billion, only to pull the plug on the sale early this year after failing to find sufficient buyer interest. Recently, Roche was also rumored to have been shopping its glucose unit, but no deals have been announced. There are other products that appear to be "sleek", such as iBGStar and GlucoDock, but have not taken off.
This suggests to me that (1) the major players are already and will continue to underinvest in the area so much so that they are seeking to divest and (2) up starts that seek to capture market share from those incumbents have not taken off yet.
The Key Question: Market Uptake
In evaluating the stock, it is critical to assess the factors by which the device should have a strong uptake, and thus translate to a powerful revenue growth story. DRIO will be launching in Europe shortly, and anticipates launching in the U.S. in 2014, via a 510(k) application as a Class-II medical device. In my view, the 2 keys for either the EU or U.S. launch are penetration and pricing.
Penetration: The company is targeting the Type 1 Diabetics, who are 10-15% of the total diabetic population, and who test themselves 8-10 times a day (and who account for the majority of test strips sold today). Type II diabetics, 20-30% of the total population, test themselves 4-6 times a day. The remaining type II's test only 1x per day.
The revenue model is similar to a Razor/Razorblade -- selling the strips at gross margins at 75%. One can construct a bottoms up revenue model as assuming that strip reimbursement is $1 per strip, and a risk-weighted strip load per diabetic is about 4 per day (8 per day for type I and 1 per day for type II, and 4 per day for type II insulin dependent). Using this average, we arrive at 4 strips per day, yielding $1500 per patient per year. The worldwide target subset of diabetics, the type I and type II insulin dependent users, represent 70mm patients worldwide. Within the U.S. and Europe, the addressable market is closer to 25mm patients, or $37.5b in market opportunity.
Given the preponderance of large players that are already heavily marketing here and substantially invested in the space, I ascribe a low penetration outlook, of 0.5% to 1%, which still yields a stabilized revenue outlook of $200m-$375mm assuming the stabilized pricing. This penetration
Pricing: The company will be using the same reimbursement codes as existing vendors, but will be pricing at the higher end of the discounted range. The direct to consumer marketing strategy, complemented by its utilization of existing distribution channels, should highlight the superior functionality which will be its chief advantage versus its larger rivals. The connectivity improvements and aesthetic appeal, combined with the DTC approach (which none of the larger players can do due to long-standing distribution relationships) should allow for this premium pricing, although I question in the long term whether a product sold DTC and chiefly on the internet can truly command a price moat when the product itself (strip) is commoditized. That said, for the near term, I do believe that the company can hold pricing. Certainly, insurance companies are happy to fulfill orders through mail order (and patients also have to pay lower co pays) and thus there would not be the risk on that front. Even so, the company is not competing on price.
Financials: Illiquid Stock, but All Eyes on Launch
As of 8/26, DRIO's market cap was $55m, with a stock price of $2.85 (OTC). The company trades ~40k shares a day (~$110k notional). In its August 12th press release, the company also indicated it may consider up-listing the public stock later this year to a "national U.S. securities exchange"). After its secondary offering in April, which raised $10m in cash (4mm at $2.50 per share), the company should have enough cash should push the company through the approvals in the EU and U.S. Specifically, as of Q2, end of cash balance was $7m and the current burn is $500k a month.
Upon launch, I expect that the company will achieve very high gross margins (much north of 50%), since its COGS on the strips are likely better than JNJ's ($0.15), and pricing will be higher … with OpEx margin below its major peers due to the DTC approach [company has 22 employees overall, 11 are in R&D]. Essentially, at launch the company should stop being a net consumer of cash (if all goes well), while conversely, a poor direct to consumer launch would not yield much margin of safety due to the low cash balance relative to shares ($0.50/share in cash, based on 20mm diluted share count)
Conclusion & Risk/Reward
The market in this stock will be 90% dependent on flawless execution upon European launch, and then U.S. launch in 2014. If the European growth curve does not take off shortly after launch, I do not expect the stock to get much of a market multiple, and certainly the U.S. tracker will be critical. With cash position relatively muted (absent capital raise), the downside is simply that the stock will just not take off and will languish in a range. Certainly looking back at a chart you see that while there have been some small "spikes", the shares have traded in a range of $2-3 here, with most activity in the $2.50-$3.00 range, since April (on low volume). I ascribe downside in the shares at $1.50, which reflects a cash position and a subdued revenue launch, combined with a round of fresh capital to attempt to accelerate uptake.
On the upside, as outlined above, even a $300mm annual run rate based on my penetration assumptions, coupled with good operating margins and tight variable cost control, on existing share basis, yields in the range of $12 a share, or ~4x from today's levels, which would place the market cap around $200mm, or 1x sales. As such, it could pay for investors to wait in the stock for an inflection in an attempt to capture a rapid uptake (+400%) if the launch goes well, with the knowledge that the downside is -50%.