Taking a closer look

Taking a closer look

It’s been a week since Insulet (NASDAQ:PODD) announced they would be acquiring Neighborhood Diabetes, Inc., for approximately $63 million in cash and stock. In the five trading days since the deal was announced Insulet shares have fallen by nearly 4% while the Dow has been flat over that time frame and the NASDAQ has dropped just 2%. Although Insulet shares are up slightly so far today, it’s fair to state that the street is still trying to figure out just how this acquisition fits into Insulet’s long term strategy. Or put another way the street is asking a simple question – Just what did Insulet get for their $63 million investment?

Investors just might get some clues by looking at Insulet’s recent SEC filings which cover the deal. According to an 8-k filed on June 7th, “Neighborhood Diabetes has received a significant percentage of its historical net sales from Medicare reimbursement. Medicare reimbursement rates are reset annually by CMS and are typically subject to downward pressure. Furthermore, the Medicare Program is able to reset reimbursement rates and terminate contracts at will.”

What makes this statement so interesting is how Insulet positioned the acquisition as they noted in their press release back when the deal was announced; “More than 15,000 of Neighborhood Diabetes clients are insulin dependent with the majority of these clients using multiple daily injection (MDI) therapy.” During the conference call that followed the deal announcement the company noted that the majority of OmniPod users were previously following MDI therapy, the implication being that they could easily convert a substantial portion of the 15,000 insulin dependent Neighborhood clients to the OmniPod system.

What the company failed to mention and what no one bothered to ask was the company planned on converting these patients from MDI to the OmniPod or how many of these patients following MDI therapy where also Medicare patients. This is significant for a variety of reasons. First, the current set of Medicare reimbursement codes used for the OmniPod with Medicare are not financially feasible for the company giving them little, if any, room for profit and second Medicare patients tend to be older and less likely to convert to an OmniPod. The simple fact is older patients tend to stick with, excuse the play on words here, their existing therapy options rather than convert to an insulin pump. All one needs to do is look at the existing base of insulin pump patients and you’ll find the vast majority of the patients are well below the age where Medicare kicks in. It should also be noted that Medicare eligible patients make up the lowest percentage of insulin pump users.

More interesting information can be found in the S-3ASR, filed that same day. (S-3ASR is Automatic shelf registration statement of securities of well-known seasoned issuers) According to this filing William Haylon, Chairman of Neighborhood, will receive 238,396 Insulet shares – Thomas Cronin, Neighborhood’s CEO will receive 238,396 shares, Louis Belmonte, Jr. 129,211 shares and Kathleen Belmonte, Neighborhoods COO 129,211 shares. (There is no disclosure as to what Louis Belmonte, Jr. does nor is there any disclosure if Louis and Kathleen are married. Diabetic Investor can only assume that given they share the same last name they are related in some way.)

Based on Insulet’s current share price of $18.70 Mr. Haylon and Mr. Cronin stake is worth nearly $4.5 million, while the Belmonte’s combined stake is worth nearly $5 million.

While there is nothing strange about the executives at Neighborhood receiving stock nor is there anything wrong with them being rewarded for building Neighborhood into a company that was worth $63 million. The really strange part is the shares they were given come with no strings attached, no lock-up provision that states they cannot sell their shares for a specified length of time, nor are there any provisions which state that any of these people must remain employed with Insulet. These fortunate Neighborhood executives can sell their shares anytime they wish without restriction.

Diabetic Investor went back to the 8-K just to see if Insulet had done anything to retain these Neighborhood executives, who are now millionaires.  Specifically we were looking to see if Insulet had any plans to employ, even if it was for a short period of time, the very people who helped build this business. As diligently as we looked we could not find a single section in the 8-k which discussed the continued employment of the Neighborhood management team, no employment contract, nothing.

Granted Diabetic Investor is no expert on such things but one just might think that Insulet would either put some restrictions on the stock they have given these folks or at minimum signed them to some sort of employment agreement. The way things stand today per the way we read all the SEC documents, these folks can simply walk way, sell their stock and take a very nice vacation. Simply put this means that as we read things it will be left up to the current Insulet management team to not just run an insulin pump company they must know stretch their talents to run a diametrically different DME business. This is not like a glucose monitoring company buying an insulin pump company where the two businesses are somewhat synergistic, combining an insulin pump company with a DME is like mixing oil and water, the two just don’t mix.

The bottom line here is the closer we look at this deal, the more questions we have. We cannot exactly figure out just what Insulet has bought here for $63 million. While it’s possible they may sell more OmniPod systems we doubt they will have an easy time converting these MDI/Medicare patients to the OmniPod. Looked at realistically the best the company can hope for is about a 5% conversion rate, and even that number may be optimistic. Assuming our projections are correct that translates into 650 new OmniPod patients at bargain basement cost of almost $100,000 per new patient add.

Now some will note that this deal was not just done to add new OmniPod patients and that Neighborhood has other revenue sources which justify this hefty price tag. However, when you consider that reimbursement rates for glucose testing supplies continue to decline and that this market is highly competitive to begin with more questions emerge. This is significant when you consider that based on knowledge of the DME business in general typically 80% of a DME’s revenue comes from the sale of equipment rather than the sale of pharmaceuticals such as insulin or metformin. (It should be noted that Neighborhood does not breakout their revenues numbers by product type so there is no way to know for sure just how much of their revenue comes from items like testing supplies versus the sale of prescription medications.)

We also question the rationale that this deal somehow makes Insulet a more attractive acquisition target as it broadens their appeal. Actually Diabetic Investor sees the exact opposite scenario as the companies most likely to acquire Insulet would have no interest in also owning a DME, as we have stated previously these are two completely different businesses.

Another argument for the deal is Insulet is adding experienced sales people, only problem is there not experienced in the most difficult sale of all, selling insulin pumps. Even if they were, Neighborhood is a regional not national player and the region their strong in is already well covered by the current crop of Insulet sales people.

Fundamentally the question we continue to ask is how this deal will ultimately make Insulet more valuable. Or put more simply was the $63 million well spent or will it turn out to be a waste of money.  While it’s way too early to pass judgment on a deal that was just announced a week ago, the early analysis is not promising.  However, given all the areas where that money could have been spent Diabetic Investor believes ultimately this will go down as one of the worst decisions the company has ever made.