It's not just drugmakers that are disrupting the massive diabetes market. Medical device makers are also developing new approaches that can help diabetics better control their disease. From medtech Goliaths Medtronic (NYSE:MDT) and Abbott Labs (NYSE:ABT) to small pure plays Dexcom (NASDAQ:DXCM), Insulet Corp. (NASDAQ:PODD), and Tandem Diabetes Care (NASDAQ:TNDM), we've got you covered.

On this episode of The Motley Fool's Industry Focus: Healthcare, host Kristine Harjes and Motley Fool contributor Todd Campbell explain how artificial pancreases, continuous glucose monitors, and insulin pumps are reshaping diabetes treatment and what could be at stake for investors.

A full transcript follows the video.

This video was recorded on May 23, 2018. 

Kristine Harjes: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. We're talking Healthcare today, May 23rd. I'm your host, Kristine Harjes. Calling in to Fool HQ in Alexandria, Virginia is healthcare contributor Todd Campbell. Todd, what's the latest?

Todd Campbell: I'm excited! I'm excited to talk today about what I think could be one of the most important investing themes in healthcare over the course of the next ten to 20 years.

Harjes: Absolutely. Today, just to dive right in, we're talking about the diabetes space, specifically some medical device makers within the diabetes space. We got a listener email from Brian B, thanks for writing in, who noticed that we tend to cover a lot of pharma companies and drug makers. It's true, we do. They have a lot of growth potential, I think they're very exciting. They have clinical updates all the time. 

But, Brian suggested that we spend a little bit more time of our coverage talking about medical devices and their makers. So, today, we thought we would do just that, specifically regarding the diabetes market. The impact of this disease, as you already alluded to, Todd, is staggering, and the number of patients is growing very quickly. Can you kick us off with some more background?

Campbell: Sure. I think it might be helpful to begin with, what is diabetes? I think we've all heard of diabetes, but we may not fully understand what the disease is. In healthy people, when we consume food and we get glucose into our bloodstream, the pancreas releases insulin, and that insulin allows our body to store the glucose for energy later on. In fact, glucose is the primary source of energy for the brain. 

In type 1 diabetes, because of either genetic or environmental factors, patients don't produce insulin, so they can't store the glucose. As a result, they end up with too much glucose in their bloodstream. That's called high blood sugar. In type 2 patients, basically, what happens is, they develop a resistance to the insulin that they produce, so they're not able to store the glucose. 

In both of those situations, Kristine, we're talking about a potentially life-threatening situation. You have consequences associated with diabetes that include everything from nerve loss to an increased risk of cardiovascular death. There are 30 million Americans alone with diabetes. Kristine, any guess as to how many people with prediabetes in the United States?

Harjes: Probably at least double the number of diabetics.

Campbell: 84 million! 84 million with elevated blood sugar levels that put them at the risk of diabetes. It's no wonder that there are 1.5 million new diabetes diagnoses in the U.S. alone every year.

Harjes: Yeah. And treatment on diabetes is going to continue to eat up more and more of our overall healthcare costs. From $408 billion to $622 billion, the levels of spending will rise between the years of 2015 and 2030, according to one study. It's a disease where it really does need to be managed for life. It's a chronic condition, and it is, as you mentioned, a life-threatening one, particularly if it's inadequately controlled. 

Traditionally, diabetics have had to prick their fingers for blood to measure their glucose levels throughout the day, and take action when necessary. So, while there are companies that are focused on making insulin or other non-insulin drugs to help regulate levels of insulin and glucose in the blood, there are also companies who are focused on the monitoring and trying to get the most practical information about the action that diabetics should then take. So, that's where you have your medical device makers come in.

Campbell: We oftentimes talk about, Kristine, the different drugs that are being brought to market by biopharma to try and help our bodies deal with these elevated levels of blood sugar. We don't oftentimes talk about the medical device companies, the med tech companies, that are out there trying to improve upon our understanding of our disease -- so, if we are a diabetic, helping us be able to have greater insight into our blood sugar levels so that we can treat ourselves better than we have in the past. 

If you were a diabetic in the 70s or 80s or 90s, I don't want to say it was a guessing game on insulin, but you were really depending on these finger sticks that you would do four to ten times a day to try to figure out, should I be taking insulin or not; or, you were relying on, basically, how your body was feeling. Like, am I starting to get a little woozy, or whatever. And unfortunately, if you wait for those symptoms to arrive, you're already having a problem. The idea would be to control the disease better so that you don't run the risk of either hypoglycemia or hyperglycemia, which are two very dangerous conditions that can occur in diabetics.

Harjes: Yep, absolutely. There have been a couple of advances that are really exciting for diabetics to get more information more continuously and be better able to react in real-time when the levels are getting a little bit out of whack, as opposed to having to wait for the symptoms to show -- which, of course, at that point, that's later than necessary. At that point, ideally, you already would have adjusted. 

I think our best approach here is to go company by company that's working in the space, talking a little bit about what they've done. Let's start with the goliath of today's discussion, which is Medtronic. The ticker is MDT. They're a huge company, a $115 billion market cap. To be clear, they are not a pure-play in diabetes. They're also working in cardiovascular and pain and surgery and a bunch of other areas. But, they do have a diabetes segment.

Campbell: Right, and that diabetes segment doesn't represent a huge amount of the company's revenue, but there is some pretty exciting stuff going on at Medtronic in diabetes that's making that segment a bigger driver of the company's quarter-to-quarter performance. 

Medtronic has long participated in what's called the continuous glucose monitor market, the CGM market. You mentioned there were two ways, two medical devices, that were getting more increasingly used by patients to evaluate and control their disease. One of those two is the continuous glucose monitors. They've always been a participant within that marketplace. 

But, what happened in 2017 is that they won FDA approval for something called the MiniMed 670G. The 670G is the first "closed-loop" artificial pancreas system that the FDA has signed off on. Essentially, what we're talking about there is a system that will automatically evaluate your blood sugar levels by testing every five minutes, and then, as necessary, automatically administer insulin to help to keep that blood sugar in check.

Harjes: Which is really a pretty cool development. You think about going from the single point-in-time finger pricks, and then evolving the care to a CGM. Picture a sine curve, for my math nerds out there, where you can actually see that your levels are rising and falling, and watch that trend over time. That's even more complete information. Then, with this what they're calling artificial pancreas, that's a step even beyond the information of the CGM. Now, it's actually taking action on it, too, and adjusting insulin in response to that information. That is a huge step forward for convenience and timeliness of reacting to the data. 

Right now, there are about 20,000 patients that are using this device, which was approved back in September 2016. And it should probably begin to gather even more use.

Campbell: Yeah. I've polled some of my friends who are diabetics -- this is a type 1 diabetes solution, primarily, because those are the people who are going to need to be managing the disease most intensely -- and they tend to prefer some of the other options we're going to talk about right now over this. But I think, over time, as the technology evolves and these systems get easier on the patient to use, etc, I think you'll see more and more patients using this.

You have 1.5 million Americans alone with type 1 diabetes. So, 20,000 patients worldwide using it, you don't have a huge amount of penetration. Nevertheless, it was still responsible for Medtronic's diabetes revenue growing by double digits year over year in Q1. Now, they didn't break out the exact sales of the MiniMed 670G. But what they did say is that diabetes segment sales in Q1 were $584 million. Which is pretty good. But, remember, Medtronic's sales in Q1 were $7.4 billion. So, if you're looking for a pure-play in diabetes, this isn't going to be it.

Harjes: Right. Another stock that's also not going to be your pure-play but is interesting to talk about in this space is Abbott. Their ticker is ABT. It's another huge company. They're over $100 billion. Again, they have a diabetes segment that's just one part of the larger company. Abbott, I believe, doesn't even break out their diabetes revenue, it just falls into the Other bucket for them. That Other bucket, for context, was a total of $430 million in revenue out of a total of $7.4 billion in the last quarter. So, again, they're only dealing with this market a little bit relative to the entire business, but they're still doing some interesting things.

They have their FreeStyle Libre, which was the first CGM that was approved that didn't require additional finger pricks for calibration of the system. When this came out, it was pretty revolutionary. We're going a little bit out of order here, because the next stock that we want to talk about is the stock that created the first CGM. But, I will leave you in suspense for which company that was, if you don't already know. When Abbott came out with its system, the stock that made the original CGM took a beating.

Campbell: Yeah. One of the big knocks against CGMs, these continuous glucose monitors, has been that they still require the finger sticks for calibrating them regularly. That's why, when the FDA approved the FreeStyle Libre from Abbott last year, it was such a big and intense and wonderful development for patients. As a result, that's turned into quite a commercial opportunity for Abbott. 

Most of our listeners would probably be familiar with Abbott if they're income investors, because Abbott has a very long track record of -- as a matter of fact, it's a dividend aristocrat -- increasing its dividend every year. They don't necessarily think about Abbott for the diabetes business. But maybe that will change, because since they launched the FreeStyle Libre, in Q1 alone, their diabetes revenue grew 30% year over year. That's remarkable growth for a medical device segment of this size. Now, granted, again, like Medtronic, a very small proportion of the overall pie here at Abbott. But still an intriguing stock to keep an eye on.

Harjes: For sure. I already started to intro our next company as the first company to get a CGM approved. This one is Dexcom, their ticker is DXCM. They're a much smaller company, around a $7.5 billion market cap. About a decade ago, they were able to achieve this distinction of being the first FDA-approved maker of a continuous glucose monitor, which was pretty revolutionary. We mentioned Abbott's system, and how that was very disruptive. Where does that leave Dexcom? Are they old news now, or are they still able to compete?

Campbell: A lot of people were very concerned about what this would mean for Dexcom. Now, Dexcom is 100% exposed to the diabetes marketplace, so this would be a pure-play within the area. They were pioneers and remain, I think, pioneers in CGM technology. They have taken an agnostic approach to developing CGMs, meaning that they want their CGM to be able to be used with whatever insulin pump or insulin delivery device a patient chooses. That could be an advantage for Dexcom longer-term.

They closed the gap to the FreeStyle Libre earlier this year when the FDA approved their latest generation CGM, that's the G6. The G6 also doesn't require finger sticks for calibration. It does have one advantage in that the FDA approved it to be interoperable with other devices. That's the first time the FDA has given that kind of a nod in its language to one of these CGMs. That means that this CGM can be used, again, agnostically, with other insulin pumps made by other companies we're going to talk about in a second, or even with apps that are developed for smartphones, etc.

Harjes: Right. I'll add one other distinction that Dexcom has going for it. In a head-to-head study of the G5, which was its previous system, vs. the FreeStyle, which was Abbott's system, it showed that the G5 actually outperformed in terms of time required to detect hypoglycemia. That study just came out earlier this year and should be a little bit of a tailwind for them in trying to compete with Abbott. But, I also truly don't think that the winner that comes out on top is necessarily going to be the only winner. This is an enormous market, as we led off with at the very beginning of the episode, so I can see room for multiple winners.

Campbell: That's an awesome point. On the FreeStyle Libre, Abbott is saying that they're adding, I think, 50,000 patients a month. This is a huge market. And two-thirds of those patients, I think, are type 1, and one-third is type 2. We're barely scratching the surface in type 2 diabetes for CGMs. 

I think, as these machines get more savvy, smaller, more efficient, more easily used, and potentially cheaper, payers are going to begin to reimburse them more widely. Just to put it in context, too, with the FreeStyle Libre being on the market, Dexcom still delivered year over year growth in the first quarter of 30%. That was $184 million in revenue. This year, they're guiding for sales of $850-860 million. So, despite the threat from Abbott, it's not like this company is seeing a deceleration in its sales.

Harjes: Those are your CGM makers. Let's move on and talk a little bit about the insulin pump makers themselves. One of them that we want to highlight is called Insulet, ticker PODD. They're a $5 billion market cap company, and they make something that's called the Omnipod Insulin Management System.

Campbell: These are really cool devices. They look a little bit like the old AirPort that was made by Apple, they're kind of a saucer-like device. They're relatively small, though, and you can stick them on your skin to deliver insulin directly into your body. You can wear them for up to three days. It's a very freeing device. I happen to know someone, a neighbor who's a young 15-year-old, very active, and he wears one and absolutely loves it. It's paired up, typically, with a CGM. Oftentimes, it's being paired up with CGMs that are made by Dexcom. Its sales last year, in 2017, grew 26% to $460 million. And, thanks to some new Medicare reimbursement coverage, sales should grow to between $565-580 million this year. That's up 22-25%. 

So, again, a pure-play insulin pump maker that also, intriguingly, wants to challenge Medtronic. They're developing their own closed-loop system. We talked a little bit about Medtronic and their 670G, which is their artificial pancreas system. Well, Insulet is developing its own. That system will be pairing up its pods with Dexcom's CGM. And according to management, they plan on incorporating, over time, the latest Dexcom that just got approved, the G6.

Harjes: There are several different intriguing partnerships and overlaps between some of these businesses. It's actually difficult to pick apart who's going to head-to-head as a competitor and who's playing nice with interoperability and working together to develop things, because all of these companies are fairly closely tied together. 

You mentioned reimbursement. I do want to stress that that's actually a really important point to look into for each of these companies. When a new device is approved, that doesn't necessarily mean that it's going to be covered, particularly by Medicare and Medicaid, which cover an enormous amount of patients. So, you'll see in some of the earnings reports and press releases for these companies that they will highlight, "Our newest device just got approved for coverage by Medicare Part D prescription drug benefit program." That's always really good news to see. So, another key development to look out for with all of these companies.

Campbell: Right, because otherwise you're paying for this stuff out of pocket and it can get pretty costly. It's been one of the things that's held back the penetration of the CGMs, especially, is showing and convincing payers that better control of your blood sugar levels over time will reduce their costs, it's a long-term money-saving thing. We've talked on the show about this in the past, Kristine, how difficult it is, because most people change their insurance within a few years. So, the company may be paying for something now that has a long-term benefit may actually not benefit from that long-term benefit, and maybe it's Medicare or someone else who actually gets the benefit from it.

Harjes: And these are largely razor-and-blade model businesses, which, from the business perspective, is really great. You have the initial sale of the device and then you have disposable consumable elements of it that produce recurring revenue. But, if you look at that from the payer side, maybe that's not quite as good, because that means that you're going to be on the hook for paying for not just the device, but also all of the consumables that go along with it.

The last company that we want to talk about today is somewhat similar to Insulet in that they are an insulin pump maker. They're called Tandem Diabetes Care, ticker TNDM. Pretty small company here. Actually, I think they're the smallest we've talked about today. They're only a $660 million market cap company. They've been extremely volatile, they have been extremely dilutive of their shareholders. But, they have some partnerships with Dexcom, and they're doing some interesting things.

Campbell: They make the touchscreen t:slim X2 insulin pump. It's the only pump, they claim, that can allow for remote feature updates from a computer. That could be advantageous to people who want to be able to buy it once and be able to get some updates on it. It is, like Dexcom and Insulate, 100% exposed to the diabetes market, so theoretically its demand and sales are going to grow right alongside diabetes growth. 

It is also working, like Insulate is, on its own closed-loop artificial pancreas system that could theoretically someday challenge Medtronic. But, we're still probably at least a year away from starting to see that product come on the market, maybe two years, depending on how these trials play out. On that artificial pancreas system, it's also working with Dexcom. It's pairing up Dexcom's CGM with its pump. 

You mentioned that it's the smallest of the bunch that we're talking about today, absolutely. Its revenue in the first quarter was much smaller than these other companies. It was about $27 million in the first quarter. In 2017, they only did $108 million in sales. First quarter sales, though, were up 44%. That's good. We'll have to see whether or not they continue to win market share away from these other pump makers. 

I think one of the things, though, that we have to remember, Kristine, to tell all of our investors is that these pure-plays that we're talking about? They're all losing money.

Harjes: That's true. It makes them kind of hard to value on traditional metrics. And even when you use stuff like price-to-sales, they actually still look very expensive. I think that's a question worth exploring a little bit. Most of these companies do look like they're extremely expensive. Are there any bargains to be found in this space?

Campbell: Well, bargains are always relative. Right, Kristine? We talk about this when we talk about investing all the time. I think, yeah, it's great if you can buy a stock on sale. But what's more important over a ten or 20 or 30-year long-term time horizon is, how big is the market opportunity, and is there a competitive advantage that could allow one of these companies to win vs. another company. 

So, yes, the price-to-sales ratios are elevated on these stocks. You're running anywhere between 5-10X for the pure-plays. But you can justify that if you say to yourself, "Yeah, but, we're only scratching the surface on the tens of millions of patients, theoretically, that could begin to use CGMs and pumps over the course of the next ten to 20 years."

My advice to investors would be, yeah, recognize that if you're a value investor, you're not going to be buying these three pure-plays. You might want to look at Medtronic and Abbott instead. But, if you're a growth investor, stay focused on the big picture, which is that the patient population, the addressable market, is going to climb significantly over the course of the next decade.

Harjes: And if, by chance, you're looking at Tandem specifically because it's so small, and saying, "Why shouldn't they be just as large as Insulet? Let me buy them now," I do want to make sure that I mention, this is a company that, as you mentioned, Todd, is losing money. But, that alone is not a terribly bad thing. That's OK for the place that they are right now in their business cycle. 

But, they have a large amount of debt. They have $72 million in cash. Most of that came from an equity offering in February. They have been extremely dilutive. Shares outstanding have risen 900% over the last one year, 400% since just January. This is a company that is fairly early stage relative to a company like Insulet, so they need financing, and they need to take these sorts of actions in order to keep their business running. 

So, when you're comparing your stocks, I wouldn't necessarily say, "Hey, these two have the same addressable market, but Tandem is so much cheaper on a market cap basis, let me immediately go for that." I mean, I think it's an interesting company, but it's a lot riskier than the more developed, more mature Insulet, which is, by its own accord, also not going to be as mature and as developed as something like Medtronic.

Campbell: Yeah. Maybe, of the three pure-plays, Dexcom is the more mature. I don't want to say it's less risky, because it's a plenty risky stock, Kristine. [laughs] Just look at its stock price chart over the course of the last three years, right? But, the fact that it's agnostic and it has exposure to both Tandem and to Insulet, maybe that makes it a little bit less risky, because it doesn't matter which one of Insulet or Tandem gets to market first with a competitor to Medtronic's closed-loop system.

Harjes: Yep, I agree. Thank you so much, Todd! That'll do it for today's show. I hope everyone enjoyed the break from our normal drug maker coverage. As always, people on the program may have interests in the stocks that they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. This show is produced by Austin Morgan. For Todd Campbell, I'm Kristine Harjes. Thanks for listening and Fool on!

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.