Dexcom's Stock Has Taken A Huge Hit - It Could Be Time To Be Greedy

Summary

• Dexcom stock has been in freefall - the company's shares dropped by 20% on Monday and have lost nearly 50% of their value during the past month.
• Prior to the COVID-19 crisis Dexcom's share price had increased by 100% in 3 months as the company smashed growth targets and looked set to grow sales exponentially.
• Stocks associated with diabetes treatment have been badly hit and recovery has lagged the market - but it is now happening.
• Dexcom says that its operations will not be affected by the coronavirus. If the investment case has not changed then it could be time to "be greedy".

Investment Thesis

Dexcom's (NASDAQ:DXCM) share price has fallen from a high of $303 to a low of $191 in less than one month. Even by COVID-19 standards, that is enough to give investors a sinking feeling. Yet the company has issued a statement stating that its operations have not been affected by the pandemic, and fundamentally, this is the same company that investors have been backing to the hilt on its impressive financial performance and the strong promise of its products.

Dexcom COVID-19 statement. Source: company website.

For those prepared to be brave there is a potential buying opportunity here. Before taking the plunge, however, it is worth performing a risk assessment of the company and looking out for any obvious red flags. In this article I will try to do that, and present a final recommendation as to whether I believe Dexcom is a "buy now" or a busted flush.

Overview and background

Until the beginning of this month (March) Dexcom - company and stock - had enjoyed a phenomenal 12 months.

The highlights reel for this manufacturer and distributor of integrated continuous glucose monitoring devices ("iCGMs") for use by people with diabetes included year-on-year sales growth of 44% and 43% in 2018 and 2019 respectively, becoming profitable for the first time (in 2019) and outperforming on revenues and EPS estimates across all 4 quarters of last year.

As such Dexcom stock grew from a price of $121 in June last year to an all-time high of $303 at the end of February this year - a 150% jump. The PE ratio at this price was ~274x, but - as I have argued before - this was justified by Dexcom's innovative medical devices and the large and under-penetrated market they address.

The past month has not been kind to Dexcom's share price, however. Of the 100+ healthcare sector stocks that I monitor closely Dexcom is comfortably one of the worst performers - its shares have lost 32% so far in March to reach their lowest point since November last year, and if the trend continues for much longer Dexcom is set to wipe out all of the gains it has made since a stellar set of Q319 earnings saw the stock gain ~30% in a single day.

I find that scenario hard to envisage however. I have done some digging to see if I can find any reasons why the company's fundamental value proposition has changed. I will present these arguments shortly, but first let's remind ourselves of what prompted analysts to set 1-year consensus price targets for Dexcom of ~$300.

Dexcom product overview

According to data from the International Diabetes Foundation (quoted in Dexcom's 2019 10K submission) diabetes was responsible for 4.2m deaths globally in 2019. According to the American Diabetes Association one in every four healthcare dollars in the US is spent on treatment of diabetics - around $327bn per annum. Medical expenditure on people with diabetes is typically 2.3x more than for non-sufferers.

If a diabetics' blood sugar gets too low (known as hypoglycemia) it can cause loss of consciousness or seizures, and if too high (hyperglycemia), they are prone to loss of vision, dizziness, and in extreme cases, can lose a limb. Besides amputation diabetes can also cause kidney failure and blindness.

Currently, most diabetics use a painful and unloved fingerstick procedure that must be performed, based on medical advice, between 4-10 times per day. Diabetics must prick their fingers and then run a blood sample using a blood glucose measuring device.

Hence, there is a substantial unmet need for a better treatment regime and Dexcom's products are designed to meet this need. The G6 device - approved by the FDA in March 2018 - consists of a small sensor inserted under the skin, a transmitter that sits on top of the sensor, and a display device - which can be substituted for a smartphone or smartwatch app. This system is able to take and display a blood glucose reading every five minutes -eliminating the need for fingersticks - and is also compatible with automated pumps (Dexcom has partnerships in place with several pump manufacturers) that can administer insulin as and when necessary.

This all-in-one solution is often referred to as the "artificial pancreas" since it is able to assume the role, performed by the pancreas in healthy people, of monitoring and administering insulin. As such, the product is quite revolutionary, and with each new iteration (a G7 device is currently subject to approval by the FDA) the devices are becoming smaller, and more effective. Research conducted by Dexcom shows that its iCGM solution increases blood sugar "time in range" by as much as 20%.

What makes the company's growth story special

Dexcom's products have proved popular among people with diabetes - management says they are approaching 650,000 net users globally who are consistently re-ordering Dexcom products. Each sensor typically lasts for 10 days and a box of 4 costs around ~$349. Transmitters are sold in pairs and cost ~$475, whilst the touchscreen receiver costs $349.

The really interesting part from a growth perspective is that despite their popularity among users CGMs have only achieved 35-40% market penetration among Type 1, and only 15% among Type 2 diabetics to date within their core intensive insulin therapy market.

Dexcom estimated market penetration with core intensive business. Source: investor presentation.

Dexcom management hopes that its products will soon become the standard-of-care for Type-1 diabetics and has successfully secured Medicare coverage for its G6 device meaning insurers will meet most of the hefty costs involved in acquiring and using the product (although Dexcom has promised that the price of its products will decrease as it ramps up manufacturing and streamlines the technology). A partnership with Walgreens also enables people to fill their prescriptions for Dexcom devices at any of the company's walk-in health centers.

Another catalyst for growth is the non-insulin dependent diabetics market, which consists of >27m people.Dexcom internal pilot results - iCGMs as a behavior modification tool. Source: investor presentation.

Health monitoring is a growing trend and over the longer term Dexcom will begin to address this market, which in my view could have as transformative an effect as the introduction of the smartphone in the early-noughties. Health technology has proved to be a very difficult field to master but it is also one that is being eyed-up by the tech giants - including Google, with whom Dexcom, via Google's health subsidiary Verily, have a strategic partnership in place, perhaps raising the prospect of an eventual acquisition.

Potential Red Flag 1 - Dexcom trades at a significant premium to fair value

Focusing on the here and now, however, Dexcom has forecast sales of ~$1,750m in 2019 or 19% year-on-year growth, and an operating margin of ~13% - solid, if unspectacular. Management says that the costs of ramping up its manufacturing facilities in order to meet growing demand is affecting operating margins, and has also led to an increase in capital expenditures in 2019 to $180m, from ~$60m in 2018 and 2017.

On the Q419 earnings call management told analysts that capex would likely increase further in 2020. The company reported $446m in cash and >$2bn in short term assets at the end of 2019, so it is no danger of running out of funds and management is right to try to build economies of scale, but investors might be starting to wonder when the bottom line growth will arrive.

Assuming revenue growth holds steady at ~19% until 2025 and net profit margin - 7% in 2019 - increases by 10% by 2025 and capex declines by $20m in each year after 2020, it is still hard to establish a fair value price much above $180 for Dexcom stock based on discounted cash flow analysis, meaning investors are being asked to pay a sizable premium to own Dexcom stock - even at current price. It is therefore conceivable that - in a depressed market - there is an investor backlash against the "jam tomorrow" investment proposition.

Dexcom ballpark fair value price calculation. Source: my table using data from company 2019 10K and company forecasts.

The corollary to this negative assessment is the sheer size of the market opportunity. Remember the core intensive insulin market is only 35-40% penetrated by CGMs, so it is quite possible that Dexcom can double the number of people using its products in this market over a short time period, particularly if the thesis around CGMs becoming the new standard-of-care holds. Almost on its own, this increase in revenues justifies the above revenue growth forecasts (or higher), but Dexcom hopes to target a much wider market.

Dexcom estimated addressable market. Source: investor presentation.

The above slide taken from Dexcom's 2018 investor day presentation provides some insight into why investors' were - and perhaps still are - prepared to pay a significant premium to Dexcom's calculated fair value price. Outside of the core intensive business, you have gestational, hospital, type-2 non-invasive and pre-diabetes screening markets, not to mention the potential casual health monitoring market I mentioned above.

If Dexcom is able to grow its current user base at a CAGR of 31% to 2.5m repeat users by 2025, revenues would rise to >$6bn and the fair value price of the stock would be creeping towards $300. Much depends on your expected rate of market return which I have set at 8%, given that the fact we may well be facing a lengthy bear market. 2.5m users is only 3% of the 84m market Dexcom is targeting but a more realistic assessment may be that it represents 10% of the 24.7m people estimated to be diagnosed with diabetes in the US. If you have doubts around the company's ability to drive this kind of user uptake then investing in Dexcom may not be for you.

Dexcom's target market estimates above look only at the US market, but there is strong evidence that the overseas market is also sizable and lucrative. The evidence for this is provided by one of Dexcom's biggest rivals in the iCGM space, Abbott (ABT). Abbott launched its version of Dexcom's G6, called the Freestyle Libre, in Europe in 2014 and in the US in 2017. Sales within Abbott's diabetes monitoring division grew by 30% to $2.5bn in 2019, with overseas sales accounting for $1.85bn of this figure.

Potential Red Flag 2: Competitive threats

Another reason why investors may be doubting Dexcom's value proposition is due to the strength of the competition. Abbott's global sales of $2.5bn in 2019 were greater than Dexcom's (although Dexcom had the larger share of the US market) and the company is due to release Freestyle Libre 2 this year subject to FDA approval. Abbott estimates that Freestyle Libre has more than 2m users - the majority of which are based overseas - but with an estimated 437m diabetics around the world, there is certainly room for more than one player in this market. Medtronic (MDT), however, is another company with a CGM offering - the Guardian Connect. Medtronic's diabetes care division made sales of $2.4bn in 2019.

It's interesting to note how all three company's sales are currently hovering around the $2bn mark, that all 3 companies are iterating new products rapidly and that the global diabetes monitoring market is estimated by Grand View Research to be worth $47bn by 2027. To my mind, these 3 companies are like athletes limbering up at the start of a long race, with dominant market share the prize on offer. There are also other competitors in this space, such as Seneonics' (SENS) Eversense, but the barriers to entry in this market are high and despite decent product specs, Senseonics is unlikely to challenge the current "big three".

The concern here is that Dexcom, the smallest player with the most to lose (since it is not a diversified business like Aboott and Medtronic) may ultimately lack the resources to keep pace with its competitors who are already undercutting Dexcom on price, albeit their products are generally regarded as inferior to Dexcom's. For me, however, the conversation about who wins this battle is for five years down the line. All three can thrive for the foreseeable future thanks to the huge addressable market and its high barriers to entry. Hence, I do not feel that the overwhelming strength of the competition is behind Dexcom's recent share price collapse.

Potential Red Flag 3 - trouble on the inside.

Having dealt with the 2 biggest challenges that Dexcom faces - growth and competition - and hopefully provided some rationale for Dexcom remaining a buy, I am still searching for the reason why Dexcom stock has suffered such heavy losses during the past month - disproportionate to its rivals and certainly disproportionate to its recent performance.

Dexcom stock performance vs sector rivals and S&P 500, past year. Source: TradingView.

Looking at Dexcom's 1-year share price performance we can see that the company's share price has proven to be far more volatile than that of its rivals - most likely due to the fact the company is reliant on a single product line. Thanks to its stellar performance prior to this March and despite its heavy losses, Dexcom's 1-year price performance has in fact held up the best.

Dexcom share price performance vs rivals - past month. Source: TradingView

When we look at the past month, however, Dexcom's performance is only worsted by Tandem (TNDM), a stock I have included in this chart because it is a provider of the insulin pumps that the CGM makers use.

This suggests that it is not just Dexcom but the wider diabetes / insulin pump market that investors appear to be losing confidence in. Another pump manufacturer with whom Dexcom recently inked a partnership agreement, Insulet (PODD), has seen its share price hit similar lows, falling from $216 in late February to $130, whilst analysts maintain a consensus price target of $200.

Whilst monitoring for news about Dexcom on Twitter ($DXCM) I noticed that several Dexcom insiders had been selling stock so decided to investigate insider selling patterns to see if management were preparing for the worst.

Dexcom insider trades since 2018. Source: my chart using data from SEC Form 4

There is some slight evidence that insider sales have been heavier than normal, but it is only slight, and I would not infer from this that management is panic-selling. For one thing, we can see similar volumes of trades around March 2018, which suggests that management cash in on share options at this time.

I also looked to see if there was a spike in short selling on Dexcom stock but the current ratio of 6% does not ring any alarm bells here either.

Conclusion - Dexcom losses have plateaued and I believe a (delayed) recovery is on the cards.

In conclusion, whilst I am not sure I can offer investors who bought Dexcom stock comfort that the price will regain all of the losses suffered in the past month, I cannot find any persuasive arguments to suggest that the company's fundamental value proposition has changed.

My best guess is that Dexcom's share price has suffered from 2 things mainly. Firstly being perceived as all-in on one asset, as opposed to having diversified product lines. And secondly, a market backlash against a currently niche, progressive approach to healthcare that is no longer front-of-mind in this bearish climate of fear.

This thesis could equally explain Tandem / Insulet's losses. Whilst it may be concerning to some that diabetes treatment related stocks have been so badly hit by the downturn it is my belief they have simply lagged the market somewhat and that their recovery will gather momentum in the coming days. In short, the growth story / value proposition will need to be communicated to investors all over again. A good set of quarterly results will once again send Dexcom's price soaring, in my view.

Dexcom will present its Q1 sales preview at the end of April. The company has had the opportunity to issue a statement that its sales or operations have been compromised due to the coronavirus, but it has sent the opposite message with a statement on its website stating it is not experiencing any serious issues. As such, if - like I do - you feel that Dexcom's stock is worth paying a premium for based on future sales and the promise of the CGM sector then you will - like me - be anticipating a significant uplift in price in the coming days - provided the markets are not rocked any further by external events.

In the past couple of days the markets have stabilized somewhat and most stocks in the healthcare sector have posted gains. Dexcom hasn't yet, but I believe it's time could be coming very soon, and the bounce back could be significant.

Disclosure: I am/we are long DXCM. 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.