As the adage goes, two things in life are inevitable: death and taxes. Experienced growth investors might want to add a third inescapable truth to that list: Companies with a high-margin, fast-growing market to themselves will eventually see their space invaded by competition.
This is the situation with DexCom (NASDAQ:DXCM). The company was the first mover into the market for continuous glucose monitors (CGMs). These wearable devices allow people with diabetes to watch glucose levels without sticking their fingers to get blood samples. With such obvious advantages over existing methods for controlling insulin dosage and a growing incidence of diabetes, it's no wonder DexCom has delivered rapid growth, increasing revenue by 43% in 2019.
Competition isn't new for DexCom. However , investors are concerned about the success Abbott Laboratories (NYSE:ABT) is having with its second-generation CGM, FreeStyle Libre 2, which was approved in Europe in October 2018 and launched in the U.S. last quarter. Abbott is also in the process of launching a FreeStyle Libre 3 in Europe now. The U.S. could see that product within the next year or two.
Is it time for investors to bail on DexCom?
Will DexCom maintain a technological advantage with its hardware?
DexCom introduced its first product in 2006. With that first-mover position has come a technological advantage that put Abbott and other competitors in catch-up mode. The latest model, the G6, came out in 2018. It was accurate enough to be the first CGM approved by the U.S. Food and Drug Administration (FDA) for use in an integrated system with other devices, such as insulin pumps. The disposable sensor is good for 10 days. The transmitter beams send readings every five minutes to mobile devices such as tablets, smartphones, or smartwatches, and can trigger predictive alerts to avoid low blood sugar events.
Those features make the G6 the premium model CGM, but Abbott's FreeStyle Libre 2 is a step toward closing the gap. The FreeStyle Libre 2 sends readings every minute to a reader device, has real-time alerts, and a sensor that lasts 14 days. While the device still isn't approved for use in automated insulin dosing systems and the smartphone app hasn't yet been approved by the FDA, the company claims the Libre 2's accuracy is superior to the competition.
DexCom has said all along that the technology gap will narrow over time. It has an answer in the works. The G7 is in clinical trials and the company expects it to launch in the second half of 2021. DexCom disappointed observers in the last conference call by saying that it will launch G7 with a 10-day sensor life instead of the 15 days analysts had expected. The company said it will work on increasing the sensor's life after the launch. Other details of the G7's features are still under wraps, so investors will be very interested to see how the product stacks up against the competition.
Will DexCom be able to maintain premium pricing?
DexCom's customers have been willing to pay up for the advantages of its products. One effect of increasing competition, however, has been pressure on the selling price. The company is pushing to increase sales through pharmacies -- a channel already utilized by Abbott and one that requires lower prices than the distributor channel. DexCom estimates that pricing will be a $175 million headwind to total revenue in 2020, which it's expecting will come to about $1.9 billion.
Again, DexCom has anticipated the pricing shift and has done an excellent job so far of bringing down the manufacturing costs of the G6 while maintaining its position as the premium product. Gross margin actually expanded in the latest quarter to 68%, compared with 62.3% in the period a year earlier. The company also raised its full-year guidance for gross margin by a full point to 66%. DexCom says that the coming G7 was designed with low cost in mind, and that the model will give it some flexibility to further lower price while keeping profits up.
Abbott only started selling FreeStyle Libre 2 in the U.S. midway through the last quarter. DexCom is still expecting a strong top line in Q4, but the full impact of the competitive pressure hasn't hit yet. Investors will be watching for the warning signs of volume deceleration or margin compression in the next few quarters.
How valuable are DexCom's integrations, software, and data?
DexCom maintains that it'll continue to have the best CGM hardware on the market as it innovates. It also says that the user experience delivered by its software platform will be the big differentiator in the future. The company has amassed a huge amount of data from connected devices in its cloud-based reporting system that it can use to create personalized diabetes treatment plans by analyzing trends. The company has the lead in collaborations and integrations with other devices for automated insulin delivery.
What are these non-hardware assets worth? No one really knows at this point, but they're partly why DexCom stock gets a premium valuation, and could partly account for why the company has maintained its growth in the face of competition. The threat is real, however.
Abbott will pursue the same opportunities. Investors shouldn't assume that the company's size gives it an advantage, though. Abbott is diversified across various businesses, including pharmaceuticals and nutrition, that are competing for investment dollars. Its diabetes business contributes only about 10% of sales. DexCom is focused entirely on the space, has a first-mover advantage in CGMs, and is willing to invest 17% of revenue on research and development, compared with only 7% for the healthcare giant.
Is the market big enough for two or more big players?
This question is the only one on this list with a clear answer: yes.
The incidence of diabetes is growing worldwide, and CGMs are still in their early days. Most monitors are sold to patients with Type 1 diabetes on intensive insulin therapy. Type 2 diabetes is much more prevalent and drives much of the growth in healthcare expenditures. Selling CGMs to new populations of potential users, including those in underserved markets outside the U.S., represents huge opportunity for all the players.
Abbott is already selling more CGMs than DexCom is, but that's hardly made a dent in G6 sales. FreeStyle Libre sales in 2019 were $1.8 billion, overshadowing DexCom's total 2019 revenue of $1.5 billion. DexCom's top line has grown 34% in the first nine months of 2020, despite the decline in selling price for the G6. The company said on the latest conference call that unit growth in the most recent quarter was nearly 40%.
Is DexCom stock a buy?
There are enough questions about the impact of growing competition for DexCom that investors were probably justified in driving the share price down 26% from their all-time high earlier this year. The stock isn't cheap at 14 times analyst estimates of 2021 sales. That valuation for this quality growth stock could easily continue, though, unless the answers to these questions start turning negative.
I own shares of both companies with no plans to sell. I think DexCom will continue to grow at a rapid pace, but I'll probably hold off on buying new shares until the competitive picture becomes clearer, which could happen in the next few quarters. Aggressive investors may see a buying opportunity in DexCom here, but more conservative ones might want to consider adding some shares of Abbott instead.