January was certainly a good month for shareholders of Dexcom (NASDAQ: DXCM), as two important press releases moved the stock. On January 10, 2017, the company updated the outlook for the fiscal year 2016 as well as for 2017. Expected revenue for 2016 will be $570 million, and therefore, 42% higher than the year before. For 2017, the company expects a revenue of $710-740 million and 270,000 patients worldwide. Only three days later, it was announced that the Dexcom G5 Continuous Glucose Monitoring (CGM) System received the classification as Durable Medical Equipment (DME). As the Dexcom G5 is the first and only CGM system that received this classification, investors were enthusiastic and shares gained 25% that day.
In light of recent developments, the guiding question seems rather obvious: Is it too late to invest in Dexcom, or was this short rally just the beginning of a long, bright future for the stock? For us to find an answer, we first have to know the product and understand how it works. Additionally, we have to take a look at the fundamentals of the company. In a second part, we then use different data to calculate how much revenue Dexcom could possibly generate in the future and determine if the company is fairly valued. Before the final conclusion whether to invest or not, we take a look at potential risks and problems associated with the company.
CGM: How the product works
Although the CGM system has been updated many times, Dexcom has really just one product it sells (which makes the business model fairly easy to understand). The current version that can be bought is the Dexcom G5 Mobile, which consists of three separate parts:
- Most important is the sensor, which has to be replaced every 7 days and costs about $70. Although it is recommended to use the sensor for just one week, it could be used for several weeks (but the accuracy may suffer). Part of the sensor is a tiny needle that will be inserted under the skin and measure the glucose level.
- You also need to buy a transmitter that sits on top of the sensor, but can be switched from sensor to sensor and therefore used again. The G5 Mobile transmitter will last three months before it needs to be replaced, and costs about $300.
- Finally, you need a receiver that will show you the data. In case of the G4 Platinum (predecessor model), you had to buy the Dexcom receiver, but in case of the G5 Mobile, you can choose between the G5 Mobile app on your smartphone or the G5 Mobile receiver. (Note: In Germany, it is not possible to buy just the sensor and transmitter without the receiver, as the CGM system wasn't approved without the receiver.)
The sensor measures the blood sugar level every five minutes and automatically transmits the data to the receiver, where it is displayed on a chart. The system is also able to warn you acoustically if your blood sugar is too low or too high (the patient can choose at which blood levels he wants to be warned). It can also warn you if the blood sugar is rising or falling very fast, and therefore, if the risk of hypoglycemia or hyperglycemia is particularly high. The receiver can save the data up to 30 days, and the data can also be analyzed via software provided by Dexcom.
Healthy company with a few flaws
Before we get to our estimations and calculations, we take a look at the fundamental picture of Dexcom. We find some aspects a little concerning, but the overall picture is that of a healthy company. Most concerning is certainly the fact that even 17 years after it was founded, the company is still not able to generate profits. Although Dexcom has accumulated about $550 million in losses and is still not expecting to be profitable in the next years, the losses per share are at least declining, and it looks like the company could be profitable in a few years.
A second aspect that is concerning to me as potential investor is the rapidly growing number of outstanding shares. It is perfectly natural that a young company will sometimes raise new capital by issuing new shares, but Dexcom has increased the number from 27 million shares in 2006 to about 83 million shares right now.
Although the company is still not profitable, Dexcom was able to increase revenue from year to year and is still growing in the higher double digits. In 2013 the revenue grew 60%, and in 2014 it grew 62%, in 2015 it increased 55% and in 2016 still 42%. Although revenue growth is slowing down a little bit, it is still in the high double digits. But not just the revenue is increasing. Dexcom was able to raise its gross profit margin from 46% in 2011 to 66% in 2016 and the net income margin from (59%) to only about (10%) right now. The price-to-book value ratio is still horrible, but the book value has been growing nevertheless in the last few years. Despite the fact that the company didn't make any profit, there is almost no debt (D/E was between 0.02 and 0.09 in the last years), and the current ratio was between 2.90 and 7.08 in the last six years. Instead of taking on debt, Dexcom issued new shares (as already discussed above). The cash and cash equivalents are $115 million right now and increasing from year to year.
The main reason why the company is not profitable yet is the high sales, general & administrative expenses (about 50% of last year's revenue) and those for research & development (about 26% of revenue). Although Dexcom should manage to spend no more than the incoming revenue, the high expenses for SG&A as well as for R&D are a rather positive sign for the future.
The optimist's view: Massive growth potential
After taking a look at the company as well as the product, we now turn towards our calculation. Usually, we use the free cash flow of the last years to determine the intrinsic value, but as Dexcom hasn't been profitable yet (and therefore, had hardly any free cash flow), we have to take a different approach.
In the article "Continuous Glucose Monitoring Systems - A Growing Market," we tried to estimate how big a market we can expect in the next years. Under consideration that the CGM users will mostly be type 1 diabetics who also have an insulin pump and only a few countries worldwide can cover the expenses (North America and Europe), we concluded that we could expect about 1.3 million possible users and, therefore, a market of roughly $4 billion.
In this article, we present another calculation and estimate the number of potential customers from a different direction. Now we are taking the Top 10 countries with the highest diabetes-related expenditures according to the IDF Diabetes Atlas. Of the total $673 billion spent, $532 billion (79%) are spent in these 10 countries. As the other countries are rather very poor and can't spend much money on diabetes or have very few residents, we can focus on these ten countries to determine the major markets.
Usually, we assume that a patient has to buy 52 sensors a year, but we can anticipate that some people might use the sensor for a longer time than one week. Therefore, let's expect that a patient needs 35 sensors a year. Additionally, they would need four transmitter a year, as one of them lasts for 3 months. And finally, they need the receiver. But as we can expect that more and more people will use the app on their smartphone, we expect a rather small number (20%) of patients to actually buy the receiver.
Receiver (only 20%)
If we assume that a Dexcom CGM system will cost about $3,850 a year, we have to cancel China from our list, as the average spending per diabetic is much too low to afford CGM systems (only a few people could afford it right now). In the remaining nine countries, there are 83.15 million diabetics.
Dexcom expects a revenue of $570 million in 2016 and has about 200,000 users, and therefore, an average of $2,850 spent per costumer. Although the actual number is about $1,000 lower, we still will use $3,850 for our calculation. First of all, we can expect that the company will raise prices in the years to come, and the sum of $3,850 spent is an average over 10 (or 20) years in our calculation. Secondly, we expect rising prices due to insurance companies which cover the costs and actually will pay for 52 sensors a year (as it should be).
Again, we assume that just the type 1 diabetics who also use an insulin pump will use the CGM system. As there are about 5% people with type 1 diabetes, we get 4.16 million type 1 diabetics and about 1.25 million potential CGM system users. Assuming average costs of $3,850 per year would give us a $4.81 billion market. Allied Market Research assumes that in 2021, the market for Continuous Glucose Monitoring Systems will reach $2.9 billion. But not all of them will use Dexcom. Right now, Dexcom has a rather high market share, so we assume that the company can manage to hold a market share of 60% over the next ten years, which would give us a revenue of $2.89 billion.
We assume the Dexcom's revenue will grow from $532 million and reach $2.89 billion in ten years from now. To reach that goal, the revenue will have to grow about 18.5% a year, on average (which seems realistic).
Calculating the intrinsic value
In order to calculate the intrinsic value of Dexcom, we need a few additional assumptions:
- Over the years, the company managed to bring the costs of revenue down to almost 30% of revenue, and could therefore increase the gross profit margin to almost 70%. For 2017, it expects gross margin to be between 67% and 70%. Let's be optimistic and assume the gross margin will stay at 70% for the next ten years.
- Dexcom has very high sales, general & administrative (SG&A) expenses. In the last fiscal year half of revenue was spent on SG&A. We can expect the percentage to stay rather high in the years to come, as similar companies like Medtronic (NYSE: MDT) or Abbott Laboratories (NYSE: ABT) also spend about 30-35% of revenue on SG&A. For our calculation, we assume that the percentage will continually decline and reach 35% in ten years.
- Dexcom is continuously raising its research & development (R&D) expenses, but has managed, at the same time, to decrease these costs as a percentage of revenue. In the last year, the company spent about 27% of revenue on R&D - compared to Medtronic and Abbott Laboratories (each between 7% and 10% in the last 10 years) - a rather high number. Similar to the SG&A costs, we also assume that R&D costs as percentage of revenue will decline over the years to reach similar levels as those of Medtronic or Abbott Laboratories.
- As it has almost no debt, we don't have to consider any interest expenses.
- We don't know a tax rate from the past years, as Dexcom was never profitable. We look again at similar companies like Abbott Laboratories (average tax rate of 17.12% over last ten years) or Medtronic (19.31% on average). For simplicity, we will use a tax rate of 20% for the company.
(Note: All amounts in the following three calculations are in millions, except the intrinsic value.)
In a second calculation, we assume instead of a 3% growth after 2025, a growth of 5% a year to eternity. Higher growth after 2025 could very well be justified, as we just included type 1 diabetics using an insulin pump. Therefore, revenue could very well grow beyond the estimated $2.9 billion if type 1 diabetics who inject insulin several times a day per needle or type 2 diabetics also start using a CGM system. Another aspect we have to consider is the possibility of raising prices, which could also increase revenue. This factor has to be considered, especially when insurance companies are paying for the CGM system.
In a third calculation, we not just consider the type 1 diabetics who use an insulin pump, but also those who inject insulin several times a day per needle. In this scenario, about 80% of all type 1 diabetics would be potential customers (3.326 million). Everything else being equal as in the scenario above, Dexcom's potential revenue would be $7.68 billion (but again, with the higher average spending per customer).
The pessimist's view: Problems and risks
Although the number of diabetics is expected to grow in the next decades and there should be more and more diabetics to use the CGM systems, we can't overlook the risks associated with the business. Dexcom is the market leader right now, and there aren't any clues why the company should lose that position anytime soon, but we can't be too sure about that. If we describe a moat as a structural advantage that helps a company to defend potential competitors, Dexcom probably doesn't have a wide moat. The CGM system itself can be described as kind of sticky, as a diabetic who used the CGM system over a few weeks or a few months will seldom go back to "normal" ways of glucose measurement. It suddenly seems almost impossible to get by with just measuring the blood sugar level five or seven times a day, if you once had the luxury to know your blood sugar all the time.
But the stickiness of CGM systems is no guarantee that people with diabetes will use the Dexcom G5 Mobile instead of other CGM systems. Dexcom is competing with a few blue-chip companies that have very large cash resources for research & development and have a distribution network. In this context, we need to mention the diabetes care division of Abbott Laboratories and Medtronic (both have received FDA approval for CGM-like systems). The FGM system FreeStyle Libre by Abbott Laboratories is a lot cheaper, and therefore, may gain market shares in the years to come.
I presented three different calculations for the intrinsic value of Dexcom, because I find it difficult to present an accurate calculation. There are too many elements of uncertainty, like the fact that we only can rely on similar companies for numbers like R&D expenses or the tax rate. Another uncertainty factor is the unknown target market. Our last calculation would suggest that Dexcom is a definite buy, but I am very skeptical if the number of potential customers is realistic.
Dexcom might be the story of great growth in the next few years, but the uncertainties associated with the stock require a high margin of safety. And as I think the last scenario, which would lead to an intrinsic value of $132.31, is too optimistic, Dexcom is probably overvalued right now - at least after the 25% jump in January. We also have to consider that the calculation is based on a number of 83 million shares and on an average spending of $3,850 per customer. But a lower average number of dollars per customer spent and a higher number of shares outstanding (a highly likely scenario) would lower the intrinsic value in all three scenarios. Although I would like to invest in Dexcom, I can't justify such a move with current prices, as the potential for future growth is already reflected in the stock price.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.