The Future Of Dexcom

Summary

• Over the next few quarters, Dexcom could profit from the possibility to link Dexcom sensors with the Apple Watch.
• But over the long timeframe, Dexcom investors have to watch Apple very closely and take the possibility of Apple introducing their own non-invasive CGM system as a serious threat.
• Even without new competition from Apple, Dexcom still seems to be overvalued.

Usually, continuous glucose monitoring (CGM) is nothing that gets much attention, but in the last few weeks, there has been some information regarding the medical device company Dexcom (NASDAQ: NASDAQ:DXCM) that is focusing on such CGM systems and the tech giant Apple (NASDAQ: AAPL). A few weeks ago there were rumors that Tim Cook was wearing a modified version of the Apple Watch with the ability to continuously measure blood sugar levels in a non-invasive way. Very recently Apple also announced at its WWDC that the next Apple Watch will link wirelessly to Dexcom’s glucose sensor.

While the wireless connection of Dexcom’s sensors to Apple’s Watch can be interpreted as good news (the stock spiked more than 6% that day), the outlook of Apple developing its own non-invasive glucose monitoring system is certainly not good news. Reason enough to analyze Dexcom once again. The article will be split in three major parts. In the first section, we will look at the positive effects the wireless connection of Dexcom’s and Apple’s products can have; in the second part, we will take a closer look at the potential danger of Apple introducing its own CGM system. Finally, we end with an intrinsic value calculation to determine if an investment in Dexcom makes sense.

Synthesis with Apple?

For the next few quarters, it is not unlikely that Dexcom could profit from the wireless link between their sensor and the Apple Watch as this could be a boost for their own revenue. There are a few reasons, why it could have a positive effect:

• Usually, patients using the CGM system need three components – a sensor, which has to be replaced every week, a transmitter that has to be replaced about 2-4 times a year and the Dexcom receiver. Of the three components, the receiver is the most expensive (although it only has to be bought once) and if patients can use the Apple Watch instead, it might probably persuade a few people to start using a CGM, that couldn’t afford it before. But this argument is rather weak for two different reasons: On the one hand, it is already possible in many countries to use a smartphone instead of Dexcom’s reading device and hence the connection to an Apple Watch is not really an improvement. On the other hand, the price might not be the big issue at all as Dexcom is trying to get insurance companies to cover the costs in the future and costs might therefore not be the decisive argument.
• Aside from the financial aspects, diabetics often don’t want to out themselves to everybody as diabetics and if they can get all the relevant information about their blood sugar levels on the smart watch, it is much more discrete than if they have to pull a Dexcom reading device out of their pocket. The Apple Watch can also just vibrate to show the diabetic that the blood sugar is too high or too low or moving very quickly in one direction (risk of hypo- and hyperglycemia).
• Finally, the connection between Dexcom’s sensors and the Apple Watch could have some advertisement effect as Apple is certainly much more popular and widely known than Dexcom. If Apple mentions the possibility to link to Dexcom sensors it could lead to some new customers for Dexcom that didn’t know the company or the CGM systems before, which would have a positive effect on revenue.

All three could maybe have a positive effect on Dexcom’s revenue, but we should also not forget, that the company might lose some revenue because it might sell less receiver. Of course, Dexcom’s revenue stems mostly from selling the transmitter and the sensor and therefore this shouldn’t be too big a problem.

But considering all the aspects, I can’t get too excited: the possibility of linking the sensors to the Apple Watch is certainly good news, but I am afraid, that revenue will only be increased a few percentage points and it is not the big effect investors are hoping for and we should, therefore, be really careful not to exaggerate the positive effect.

Apple as a competitor?

Although Dexcom could profit from the above-mentioned fact, that sensors can be linked to the Apple Watch, this positive effect is rather short-term. But as long-term investors, we have to look further in the future than just the next few quarters. And if we look further in the future some other news might become more important: Right now, most of it is just rumors, but definitely rumors every Dexcom investor should take seriously. If Apple would introduce their own glucose monitoring system and especially if they introduce a non-invasive system this would be a game-changer and a massive threat for Dexcom.

Of course, we don’t know yet how good a product Apple can bring on the market (Apple could also completely fail), but the future version of the Apple Watch as it is currently described would have a few advantages over the latest Dexcom G5 mobile system:

• Apple’s system would be non-invasive while Dexcom’s system is still relying on a needle. Wearing a Dexcom sensor is not painful, but the process of adjusting the sensor to the skin is certainly unpleasant. The Apple Watch with an optical sensor would hence be a big surplus in comfort.
• As already mentioned above, the current CGM systems need a sensor that has to be replaced every week. Although it is possible to wear the sensor longer, the data gets inaccurate as time passes by. Without having precise information right now, I expect that the Apple Watch doesn’t have a sensor, that needs to be replaced every week (as the sensor would most likely be part of the bracelet) and the annual costs for an Apple Watch might therefore be much cheaper than any other CGM system on the market right now.
• The Apple Watch can be used for different functions and not just for measuring blood sugar levels. The Apple Watch can measure much more data, like steps or heart rate, can be connected to the iPhone and offers many different apps.

Despite the advantages an Apple Watch might offer, there is currently no reason for Dexcom investors to panic. It will probably take a few more years before Apple can actually introduce their non-invasive glucose monitoring system and Dexcom also has their own research and development team and they are not idly sitting by, but are working on new sensors. The G6 sensor will be reduced in size, can be used for 10 days and only has to be calibrated once a day (instead of at least twice right now). It is also a fact, that Dexcom has an existing and functioning CGM system, while Apple does not. And the Dexcom G5 mobile has another advantage over Apple – it is currently the only system that is approved for therapeutic decision-making. Shortly after the FDA decision, Medicare issued a positive ruling for Dexcom’s therapeutic CGM. All people with diabetes on intensive insulin therapy will be covered under this ruling – this includes people with type-1 and type-2 diabetes.

Intrinsic Value Calculation

In my last article about Dexcom I provided a few different intrinsic value calculations, but as a few factors have changed since then, I think it makes sense to calculate the intrinsic value once again.

It is certainly true that Dexcom is still a growth company. In the first quarter of 2017 revenue grew 22% to $142.3 million, while international revenue increased even 37%. For the last few years, Dexcom even had a revenue CAGR of 55% and although Dexcom might continue to grow in the high double digits it seems rather unlikely that 55% growth rates are possible in the future. And revenue growth is not enough – the net income or earnings per share are the numbers that really count. Although gross margin was higher, the costs for research and development as well as for sales, general and administrative were almost 50% higher than in the first quarter of 2016. In the end, the net loss was significantly higher this quarter as any time during the last year. And although Dexcom has a market cap of $6.6 billion and is more a mid-cap company than a small-cap company, it is still not profitable. For 2018, analysts expect earnings per share of $0.17 – that would result in a forward P/E of 430! I am certainly not exaggerating if I tell you, that growth expectations have to be immense to justify such a high forward P/E.

As the charts below show the current US CGM patients are just a small fraction of the US total diabetes population and hypothetical the potential for massive growth exists. But it would be rather naive to assume that all 30 million diabetics in the United States will use a CGM system in the future.

Source: Dexcom Investor Relation Presentation

The number of patients currently treated with a Dexcom CGM system is somewhere between 200,000 and 250,000. According to the slide from Dexcom’s investor presentation, about 800,000 patients would be covered by Medicare. Dexcom estimates that the US intensive insulin population (those type-1 and type-2 diabetics that have to administer insulin regularly) is about 3 million people. For the mid-term future, this is the most likely target market for CGM systems. Of course, there are about 30 million people alone in the United States that have either type-1 or type-2 diabetes and therefore the market seems to be gigantic, but – as mentioned above – not all of those 30 million people will use a CGM system.

The decisive question to determine if Dexcom is overvalued or not is to estimate how many diabetics will use a CGM system in the future. As this number can fluctuate between a few hundred thousand right now and many million, it is difficult to estimate how big a market we are talking about. For our first intrinsic value calculation, let’s assume one of the best scenarios imaginable: In North America and Europe there are about 95 million diagnosed diabetics and we can assume that about 10% of them are on intensive insulin therapy. The target market for CGM systems could, therefore, be as high as 9.5 million people in the next decades. A diabetic spends about $2,800 right now (according to Dexcom) and although we can assume that these numbers might be lower in the future (diabetics don’t have to buy a receiver anymore and the sensors should get cheaper and last longer) we use the number to calculate the potential market. Assuming these numbers, the market could be as high as $26.6 billion a year. For our first calculation, we assume that Dexcom can defend its high market share of about 60% and would have a revenue of $15.96 billion in 2036. This would mean Dexcom has to grow 17.65% for the next 20 years (ambitiously, but not impossible). The intrinsic value would be $111.04[1].

But it seems quite natural that such a big market draws in competitors who demand their fair share. Right now, Dexcom is the leader in the CGM system market, but the efforts to remain in that position are immense – especially if Apple would enter the market with their non-invasive CGM system. We, therefore, provide a second calculation assuming only a market share of 30% for Dexcom as they might lose market shares to competitors like Abbott Laboratories (NYSE: ABT), Medtronic (NYSE: MDT) or maybe Apple. This would lead to an annual growth rate of 13.45% and an intrinsic value of $61.09.

Conclusion

We have two intrinsic value calculations and while in the first, Dexcom is definitely undervalued, in the second one it is overvalued. But we have two calculations, that are really optimistic. The first one, I would never bet on, because it seems extremely unlikely that Dexcom could have an annual revenue of almost $16 billion in 2036 and even for the second calculation, there shouldn’t be any disturbances in the next 20 years for Dexcom to match these expectations. In the end, I still think that Dexcom is overvalued and future free cash flow will not match current expectations. Aside from the high valuation, there is a second reason why I don’t want to invest in Dexcom right now. I am mostly focused on long-term investing and don’t care about quick profits or gains that can be made within a few weeks or months. If I invest in a company I want to be certain, that the company will exist in 10 or 20 years from now and that it will be profitable. For Dexcom, I am a bit skeptical that they might lose huge market share to competitors and as Dexcom is not a diversified company, this could really hurt their revenue (and earnings).

To be honest, the most likely scenario will be that Dexcom and Apple won’t be competitors at all because I think that Apple might buy Dexcom. If Apple really wants to enter the diabetes sector, Dexcom would be the perfect complement for Apple. The tech giant could easily afford to buy even an overvalued Dexcom and the knowledge and expertise Dexcom already has is extremely valuable for Apple.

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[1] Estimates for R&D, SG&A, the tax rate or free cash flow are identical as in my last article Spearhead Of A New Disruptive Technology In Diabetes. If you like to know why I used these estimates, please read the previous article on Dexcom. For full disclosure I also have to mention that the intrinsic value calculations in the last article are not accurate as I made a mistake discounting the free cash flow and therefore the intrinsic value - especially in the third calculation - is way too high.

Analyst’s 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.

All charts are - if not stated otherwise - my own work. All numbers are taken from Dexcom' s SEC filings and from Morningstar.