Insulet Shares Swoon on Insurer Decision, but Fair Value Is Unchanged

We think Insulet is largely insulated from UnitedHealth's decision to go with Medtronic. First, UnitedHealth has long refused to reimburse for disposable insulin pump systems such as the OmniPod. Thus, we doubt that many OmniPods are currently being sold to UnitedHealth insureds. Second, UnitedHealth's new policy does not apply to pediatric patients. Thanks to the OmniPod's tubeless design, this product has long been especially appealing to the pediatric diabetic market. Based on management comments, we estimate nearly half of OmniPod new patient starts have consistently been pediatric patients.

In the meantime, we've been impressed by how Insulet has accelerated sales growth on all fronts--U.S. OmniPod, OmniPod overseas, and in its drug delivery business. Just in the first quarter, domestic OmniPod sales grew to the tune of 30%, while the much smaller drug delivery segment doubled its revenue. We project the firm is on track to exceed $350 million in revenue this year, just slightly beyond management's outlook. Importantly, Insulet has been keeping a tight rein on expenses, which is critical for the firm to reach profitability.

Success With New Patients Until Insulet's OmniPod came on the market at the end of 2005, all insulin pumps consisted of a controller and insulin reservoir attached to the injection site by a long flexible tube. The OmniPod design eliminates the tubing, consolidating the insulin reservoir and a self-inserting cannula into a single pod, smaller than a deck of cards, which is controlled by a wireless remote. The system is inconspicuous and easy to use and has so far been very successful among patients new to insulin pumps. These patients represent lots of growth potential, as 75% of American Type 1 diabetics still take daily insulin injections. The OmniPod has been particularly successful among children and teens.

In an effort to enlarge its presence in the larger diabetes market, Insulet purchased Neighborhood Diabetes, a specialty distributor of diabetes supplies and equipment, in 2011. From a strategic standpoint, we think the combination makes sense, increasing Insulet's breadth of products and services for the diabetic patient, including delivery of consumables like testing strips and drug therapies. But diabetic supplies are lower margin, and new competitive bidding measures have resulted in price pressure.

Insulet only reached operating profitability in late 2013 and continues to work at gaining enough economies of scale to bring down manufacturing and operating costs. The latest migration to the next-generation OmniPod bolstered margins, as the new product costs about one third less to make. To reach the black by the end of 2016, the firm needs to continue increasing sales rapidly while keeping marketing and administrative costs under control.

Also, a larger rival like Johnson & Johnson JNJ or Abbott ABT might be interested in acquiring Insulet. Although insulin pumps are not necessarily a high-growth market, we do expect solid, steady growth, which could be attractive to a potential buyer looking to round out its diabetes portfolio.

No Moat for Now, but That Could Change Despite Insulet's innovative technology and focus on customer service, we do not think it has dug an economic moat yet. Insulet remains a small upstart in the insulin pump market and has far to go before it becomes a serious threat to Medtronic, the market leader. Medtronic had been working to develop its own tubeless patch pump, but development has run into a series of delays as other diabetes products have taken higher priority. Roche RHHBY also has a wireless patch pump thanks to its acquisition of Medingo. Even though Insulet's elegant and aesthetically appealing pump design has garnered admirers, Medtronic remains the leader in algorithms and software thanks to its extensive data collection from the many diabetic patients using its pumps and corresponding glucose monitors. Medtronic also has achieved integration with continuous glucose monitoring devices--something that Insulet has been pursuing for several years with Dexcom and Abbott. Moreover, a handful of other companies, including Animas, Cellnovo, and Valeritas, are working on wireless pump technology. It would be very easy for Medtronic, Abbott, Roche, or J&J to snap up a smaller rival to gain access to the technology, distribute it through their extensive salesforces, and gain the upper hand over Insulet. At this point, Medtronic and J&J both seem to be more intent on working toward a closed-loop system that would approximate an artificial pancreas. Even without a tubeless patch pump product, Medtronic or J&J could put a damper on Insulet's pump business if either one could successfully launch a closed-loop system that would address concerns about hypoglycemia.

We do think Insulet's competitive advantage should grow stronger the longer competitors stay out of the patch pump niche. This will give the firm more time to cultivate its user base. Insulet's tubeless pump offers advantages that can make it a compelling choice for diabetics, especially for children with Type 1 diabetes. We doubt children who are used to using the tubeless patch pumps would voluntarily switch to pumps with tubing as they get older. Parents may also be reluctant to take on the risk of switching their children to a different brand or type of insulin pump, especially if blood sugar levels are well controlled on the OmniPod. Additionally, patch pumps are complex to build because they require a number of different replaceable parts. This also makes it more complex for insurance companies to reimburse. If Insulet were to achieve integration with Dexcom's continuous glucose monitors and Medtronic and Roche continue to run into delays through 2016, then we would entertain upgrading Insulet's moat.

Insulet has also been pursuing other applications of its OmniPod technology as a drug delivery device. Its collaboration with Amgen on Neulasta is the first opportunity to establish a footprint in that market.

Deep-Pocketed Rivals Are Main Risk Insulet's main danger comes from well-financed competitors like Medtronic, Abbott, Roche, and Johnson & Johnson, which already possess large salesforces and relationships with medical professionals. Medtronic was developing its own tubeless insulin pump, which could make it difficult for Insulet to increase sales and margins. However, Medtronic has run into delay after delay with its patch pump. Medtronic had originally expected to introduce a competitive product in the 2011-12 time frame. Considering where the firm has been focusing its development efforts and its integration of Covidien, we think the patch pump is a low priority at Medtronic. This should play to Insulet's advantage as it cultivates more users in the meantime. If Insulet stumbles in its initial expansionary phase or faces higher material costs from suppliers, its path to profitability could become longer. Like other medical device and equipment companies, Insulet ultimately will need to keep innovating beyond its next-generation product. Considering the relatively discretionary nature of insulin pumps, Insulet remains vulnerable to economic downturns when consumers tighten their financial belts.