Scale + Churn = Revenue Growth

When it comes to the real estate market the most important factor is location. When it comes to the insulin pump market it’s all about scale. And scale is something Medtronic has in abundance. However, this huge scale is also somewhat misleading, and the results released by Medtronic this morning are a perfect example of just how misleading scale can be.

This morning the company reported “Diabetes Group worldwide second quarter revenue of $583 million increased 26.2 percent, or 27.5 percent on a constant currency basis.” At first glance this seems like very impressive growth yet upon closer examination this growth in REVENUE does not necessarily mean the company is selling more insulin pumps.

As everyone knows when it comes to insulin pumps sensor augmented systems are where it’s at. Yet these systems aren’t just beneficial for the patient they are also cash cows particularly for a company like Medtronic. Here’s why. In the old days before sensor augmented systems each new patient adds meant not just the revenue from the sale of the hardware but also the continual revenue stream from the sale of pump supplies, this is where the real money is. Supplies which are made for pennies and sold for dollars.

Today sensors are a new revenue stream and in Medtronic’s case driving revenue growth. Looking closely at the results the company noted; “Over 135,000 trained, active users benefiting from 670G’s SmartGuard™ technology”. Notice they did not state these were NEW patient adds. Basically, what Medtronic is doing is churning their huge installed user converting patients to sensor augmented systems which generate greater per patient revenue linked directly to the sale of sensors.

In the old days each patient generated approximately $3,000 in supply revenue. Today when sensors are added to the mix that revenue stream increases dramatically. Just by way of example in the old days before 670G the 135,000 patients now on the 670G generated $405 million in supply revenue. Add sensors into the mix and those same patients now generate an additional $351 million in sensor revenue. This assumes each sensor costing $50 and each patient using 52 sensors per year.

Now this is basically found money for Medtronic as they are NOT experiencing the cost of adding a NEW patient to the mix, they are merely selling EXISTING patients another item. So yes, revenues grow but this does not necessarily mean their installed base of patients is growing. The reality is Medtronic should experience continued revenue growth simply by converting existing patients on older non-sensor augmented to the newer sensor augmented systems. Or put another way the goal for Medtronic hasn’t changed much over the years it’s all about protecting the goose that lays those golden eggs and the goose is their huge installed user base.

The fact is when it comes to new patient adds, patients who are either new to pump therapy or converting patients from a non-Medtronic system to a Medtronic system, the company isn’t doing all that well. This does not mean Medtronic is not adding new patients rather it means it’s adding them at a much slower rate than their competitors. The demise of Animas which should have been a layup for the company isn’t adding the expected number of new patients while Tandem and Insulet are adding new patients faster than Medtronic. Or put another way the demise of Animas is helping to add new patients just not in the numbers the company had hoped for.

As we have stated many times when it comes to the insulin pump market it’s not large enough nor growing fast enough to support the all the companies who want to play in this sandbox. The key for any Medtronic competitor is twofold, add as many patients as possible and take share away from Medtronic. So far Tandem and Insulet have done a good with the former but are having a tough time achieving the later. We hate to be redundant, but Medtronic has a tremendous advantage due to their huge scale. Add in the fact that they own the most important piece of real estate; formulary position and you can see why the goose continues to lay those golden eggs.

When it comes to diabetes and Medtronic rule one is to protect the golden goose at all costs, rule two is reread rule number one. Given these rules it’s understandable why the company recently scaled back their efforts outside of pumps. The company is well aware of what’s happening in the marketplace, sees that things aren’t going as planned for their bread and butter core competency. Add in the fact that this unit isn’t generating any real revenue and likely wouldn’t have for years to come. And let’s be very clear here quarterly performance drives nearly every decision made by Medtronic.

Here’s the reality for Medtronic – they have achieved scale – they own formulary – therefore they do not need to have the best toy in the toy chest. Yes, the company will continue to innovate, come out with new pumps, new sensors but given their huge scale these do not have to be the best systems – they do not have to be the coolest toys in the toy chest. All these new toys have to do is keep patients from converting to a non-Medtronic system. As long as Medtronic can keep these patients in the fold the goose will continue to lay those very profitable golden eggs.

As well as Tandem and Insulet are doing they have yet to figure out a profitable path for taking real share away from Medtronic. Since Medtronic has locked up formulary it forces Tandem and Insulet into playing on their turf. Even if they matched or undercut Medtronic when it comes to price, Medtronic would come right back and undercut them. Again, we hate to be redundant, but payors don’t care who has the best toy in the toy chest they care about money.

This is why the FDA’s investigation has wide ranging implications for Medtronic as it’s one thing the company cannot control and depending on the outcome could have a serious impact on revenues. Now let’s be very clear here crystal clear we have no idea what if anything the FDA will do. However, should the FDA come down hard on the company either issuing a warning letter or worse telling the company to halt sales of the 670G the situation changes dramatically. Again, we have no idea what if anything the FDA will do but the fact is the FDA is Medtronic’s biggest concern not Tandem or Insulet.