The first blood glucose meter came to market in doctors' offices in 1965. Within a minute of placing a drop of blood on a paper strip, a color reading was produced. The doctor compared this color to a color chart and came up with the blood glucose reading. The first digital readout came in 1970 with in home meters being produced starting in 1975. From 1975 until 2005, there were not too many updates to the at home blood glucose monitor: the device grew to be more accurate and smaller over time. Additionally meters are now available that enable physicians to download the readings onto their computers instead of patients having to write it down in a log. Enter the continuous glucose monitor in 2005.
The continuous glucose monitor is a device that that tracks blood glucose readings in real time. Typically attached to the stomach is a needle to draw minute amounts of blood. This links up to an electronic device that stores the data. The simple argument as to why this technology will be a breakthrough is because patients, mostly Type 1 Diabetics, will be able to monitor the highs and lows of their glucose levels, theoretically enabling them to better manage their condition. There are several reasons that the potential market for this device might be less than industry insiders and investors have come to believe. First, the patient has to feel that it is important enough to them to monitor their condition full time that they are willing to have these items attached to their body. Additionally, the patient still has to calibrate the device twice a day with a reading from a traditional glucometer. Also, insurance companies are on the fence about whether or not to cover the device. While commercial insurance companies have largely come around, there has been no national decision by Medicare and it is unlikely that Medicaid will ever take it up. That being said, CGM claims many Type 1 diabetes patients as fans. Many people swear by it and perhaps that's what has driven up the valuation of the only pure play public company with a device currently on the market, Dexcom (DXCM). Though far from its $25 high in 2005 at $9 currently, the company's market capitalization is 20% higher at $600 million now then it was in 2005 as a result of a tripling in the company's shares outstanding. The company has an accumulated deficit of over $400 million. While I don't think Dexcom is a bad company, it has become clear over the years that to get an increase in sales, the company has to spend incrementally more money. Though sales have increased from $2 million in 2006 to about $69 million in 2011, net loss has stayed about the same at around $45 million. The company has to spend a large amount of money to market its product because its primary competitor is Medtronic (MDT), a company with a great amount of resources. Medtronic has the only fully integrated product in the United States that combines an insulin pump with continuous glucose monitoring, making DXCM's sale a difficult one. As a result, we think DXCM's 8.5x Price/Sales multiple is not warranted without further evidence that the market is larger than current sales levels reflect.
* Numbers in Millions
The next big pure play in the diabetes technology market is Insulet (PODD), the maker of the OmniPod, the lightest insulin pump on the market. The clear competitive advantage that it has is being the only wireless pump in the United States. Type 1 diabetics have caught on to this product as well over the past few years. Similarly to Dexcom, while sales increased from $4 million in 2006 to about $135 million in 2011, net loss increased from $32 million to $64 million in the same respective period. A big part of this spend has gone into increasing awareness of the product and attempting to effectively compete with Medtronic. We think that while Insulet will continue to gain market share until Medtronic develops a tubeless pod system, sales will likely not accelerate further until the company receives FDA approval for a product that integrates the insulin pump with CGM, like Medtronic has on the market. While the stock topped out at $27 in 2007, market capitalization is at its high with the share count nearly tripling over the past four years. One particularly questionable move that the company made earlier in 2011 was the acquisition of Neighborhood Diabetes, a diabetes products supplier. Our thoughts are that the company made this large and non-core acquisition to thwart off any potential acquisition attempts. While the company was a pure play insulin pump company, a large med tech might have been interested in purchasing it. PODD trades at 8x price/insulin pump sales, similar to DXCM, compared to 2x sales for the average med-tech company. Additionally, over the past 6 months, executives have sold over 120,000 shares.
In conclusion, while we favor the fact that these products make the lives of diabetics easier in some cases, we do not think the current valuations are supported by fundamentals or realistic expectations for future demand. Medtronic, one of the largest Med-Tech companies in the world, currently dominates the space and companies including Johnson & Johnson (JNJ) & Roche (RHHBY.PK) are increasing their presence within the space. We think that the barriers to entry are somewhat low given that the IP for both products is based on established technology. We recommend investors stay away from the space until valuations rationalize considerably.
Disclosure: I am short PODD.