Medtronic is a pure-play medical device company. The company is a mid-single digit revenue grower driven by product segment innovation, international growth, and acquisitions. Profitability is further boosted by integration of their acquisitions and growth within their high-margin segments. They also generate strong free cash flow and aim to return 50% of that to investors.
As a quick overview, Medtronic is split up into four segments: the Cardiac and Vascular Group (CVG), the Minimally Invasive Group (MITG), the Restorative Therapies Group (RTG), and the Diabetes Group (DG). CVG is the largest segment at 35% of sales. The MITG and RTG business are slower segments that have historically grown in the low-single digits. DG is the smallest, but fastest growing, segment and is arguably the most promising one among all of them. This is the segment I'll zoom in on in this article.
A Quick Diabetes Primer
For those who are unfamiliar, let's first talk about diabetes and survey the available treatments. But first, a disclaimer: I am no medical expert on diabetes, but hopefully I can give enough context and color on the basics for the purposes of this article.
There's two types of diabetes: Type 1 and Type 2.
Type 1 diabetes is when the body destroys cells that produce insulin at an early age. Without insulin, the body is unable to absorb glucose in the blood. There's about 1.3 million people in the US that have Type 1 diabetes.
Type 2 diabetes typically occurs as your body gradually develops insulin resistance and eventually cannot use insulin effectively to regulate glucose levels. Type 2 diabetes can occur at any age and is much more prevalent, affecting almost 28 million Americans.
Treatment and management differs for each type. Given the body's complete lack of insulin, Type 1 often involves a more complex regimen and maintenance schedule. Patients with Type 1 diabetes must either use insulin injections (via syringe or pen, for example) or an insulin pump. Injections are relatively easy and convenient to administer, but due to their imprecise nature, result in more fluctuations in glucose levels. Patients must also watch their diet and carefully manage their lifestyle accordingly. Pumps offer more precise injections, fewer needle pokes, and a more flexible diet and lifestyle. Overall, patients receive a better level of treatment using a pump than using injections, as numerous studies show that the pump does a better job of managing glucose levels. However, insulin pump therapy requires much more training, is expensive, and involves carrying a machine around that is connected to your body (which sounds horrifying to me). As a result, of the roughly 1.3M Type 1 diabetes patients in the US, only about 350-400K patients use a pump.
Treatment for Type 2 diabetes is less onerous, but is still a fairly involved process. Management involves a mixture of managing one's diet, consistent exercise, medication or insulin therapy, and blood monitoring. For some, a careful diet and exercise is enough to keep glucose levels in a safe range. For others, they may also need medication (such as metformin) that increases the body's sensitivity to insulin. Increasingly, many doctors are also recommending insulin therapy due to its benefits for the body. Like Type 1 diabetes patients, insulin therapy could come from either an injection or a pump. However, pumps are still used by just a small minority with Type 2 diabetes - roughly 30,000 of the 28 million, according to one estimate - as the training and inputs required to operate a pump are often too onerous for a patient.
Why exactly is a pump so onerous to use? There's a bunch of different inputs that are necessary for the pump to function. Users must input a basal rate (the continuous rate of insulin delivered in between meals), the user's insulin sensitivity factor, insulin-to-carbohydrate ratios, and glucose targets. Before meals, users must also input current blood glucose levels, measured from a CGM (continuous glucose monitor) device, and the number of carbohydrates in the meal they're about to eat. The CGM is a separate device, in addition to the pump, that must be carried around. Users end up carrying several devices and tubes connected to their body. They're also constantly inputting information into their pump throughout the day in order for it to work effectively.
Medtronic's 670G Opportunity
Medtronic got into the diabetes space with its acquisition of Minimed in the early 2000s. The company was one of the first to make insulin pumps mainstream, and today enjoys a sizable leadership position in insulin pumps (estimated at roughly 70% share). Other competitors in the insulin pump therapy space include Animas, Insulet, and Tandem. While these competitors own a smaller share, they have made larger splashes in recent years with their products, and have likely gained share on Medtronic in specific areas. For example, Insulet's Omnipod insulin pump has gained attention due to its tube-free design. Additionally, Dexcom's CGM device has also gained much of the retail market due to its sensor accuracy.
However, Medtronic's new 670G is expected to turn around the company's fortunes in the Diabetes Group segment. The device is the first to combine an insulin pump and a CGM in one device, which brings about a number of significant advantages.
The biggest advantage is that the 670G now requires much fewer inputs and user management. Pumps from competitors are all open loop systems - they require user intervention to communicate between devices and manage the insulin dosage. The 670G is the first "hybrid closed loop system," which essentially means that the device is able to automate and manage more of the insulin dosage by itself. Users still need to input carb levels and blood glucose readings prior to a meal - hence the "hybrid closed loop system" terminology - but it importantly automates much of the basal insulin management (the time in-between meals). The pump will now take readings directly from the CGM and adjust insulin dosage appropriately.
The hybrid closed-loop system is significant because it alleviates some of the maintenance requirements for insulin pumps. This should open up more of the Type 1 diabetes market to become pump users rather than insulin injectors. Additionally, it could potentially open up the huge Type 2 diabetes market to pump users as well. Both markets represent sizable increases in the TAM for the company.
Furthermore, the hybrid closed-loop system represents a significant step towards the creation of a fully functional artificial pancreas. Our pancreas naturally reads glucose levels and adjusts insulin levels appropriately in real time. The 670G now mimics some of these functions in-between meals. The next step is to build off of this platform and automate insulin dosage during meals. With the first hybrid closed-loop system approved by the FDA, and with Medtronic's strong service infrastructure in place, the company is well-positioned longer-term to potentially become a one-stop shop for all diabetic needs.
The innovation in the 670G - a device that allows the CGM to communicate with the insulin pump - seems like an obvious move for insulin pump manufacturers. However, getting FDA approval is not easy. Management estimates that the closest competition is still 2-3 years away from having such a device. With a clear field, Medtronic should see strong market share growth within the Type 1 diabetes market.
Timing and Financial Impact will be Delayed
With the company sitting on such a transformational product, investors are eager for the company to launch the product and drive growth rates within the Diabetes segment higher. However, management plans to roll out the product carefully to ensure that the proper support (manufacturing, training, and education) is in place. The company has noted that they plan to limit the roll-out in fiscal 1H18 to priority access users - those who have purchased the 630G recently - to ensure that initial use is by those who are already familiar with Medtronic's 6-series pumps. The company will then have a broader commercial roll-out in the fiscal 2H18. As a result, analysts are modeling growth in the Diabetes Group segment accelerating sequentially throughout 2018, peaking in F4Q18 in the double-digits.
These plans have seen slight hiccups in recent months, however. First, the company experienced a system-wide crash in June that slowed manufacturing and fulfillment for the entire company. Medtronic had to lower its sales guidance to the low-end of its communicated range for F1Q18 as a result. Second, the company has also faced supply constraints for the 670G due to sensor supply issues. This has led to analysts revising their sales expectations downward for the year, and for the stock to decline several points this week. Analysts now suspect that the broader 670G rollout will not happen until late into 2H18.
Despite these near-term hiccups, investors are still excited about the product, and expect the Diabetes Group to be the fastest growing segment for the company in the near-future. Consensus estimates show that analysts expect revenue to grow in the high-single digits annually through 2021. Importantly, investors are also excited about the potential for the segment to exceed these numbers should the company iterate on the 670G as planned. Between 2017 and 2022, management expects to grow the segment at even faster rates, in the mid-teens, reaching $4B in the future. The company expects much of this growth to be driven by a stronger pipeline of products. The higher rates are possible as the company was overly conservative with the device in order to get FDA approval (which is more difficult to get approval as it is the first hybrid closed-loop system to market). With approval, the company can now begin to get more aggressive with the device. As an example, the company can now seek pediatric approval (the device is currently only approved for 14 year old patients and older). Management noted that they expect to have pediatric approval in some countries as early as this summer.
As a result, management is expecting the Diabetes Group to become a much larger segment in the future. If the company is able to achieve its $4 billion Diabetes Group revenue target, it would represent 12% of the company's overall 2017 sales. And as a bigger chunk of the pie, the segment will become an increasingly important driver of the company's future outlook.
A few random points that I wanted to make:
- I am astonished at the lack of quality discussion in most healthcare articles out there. Maybe 95% of healthcare investment articles out there fail to talk about even one drug or medical device that the healthcare company sells. Instead, they speak vaguely about the healthcare industry as a whole, or about valuation or dividends for the company. As with any other public company, the real meat of the analysis should fall on what these companies are selling for revenue. You wouldn't look at Apple without considering the iPhone, would you?
- This was a great example of just how complex healthcare companies are. From what I can tell, this was a deeper-dive than anything else that is publicly available, but it's still incredibly shallow compared to what's available to institutional investors. All I did was talk about one of the company's products, in the company's smallest segment! I didn't even touch on the other segments or their products, which represents 96% of their sales. Healthcare companies are incredibly complicated and one could spend hours and hours researching them. And yet, as I noted above, retail investors are completely unaware of it.
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