The Danger Zone

Years ago before Animas was bought by JNJ the company seemed to be doing well but behind the scenes was a much different story. In a somewhat famous moment for Diabetic Investor while attending the J P Morgan conference we overheard the then CEO state she was looking to sell the company. A comment we reported, she denied and then the company was sold.

After JNJ paid over $500 million for the company, which happened right before Animas was supposed to report earnings, we learned that JNJ had no choice but to buy the company as it was on the verge of collapsing. This deal wasn’t done for strategic reasons it was done so JNJ would not have egg on their face as their venture capital unit was one of the original investors in Animas.

Now JNJ likely would have bought Animas eventually but they weren’t ready to buy them when they did. Even crazier had they waited just a few days and let Animas report results which weren’t going to be good they could have saved themselves a few million. At the time we asked an industry insider why JNJ didn’t wait and the response was classic as we were told JNJ doesn’t like to do small deals and it would be considered embarrassing if they valued Animas under $500 million.

We mention for a few reasons;

1. The greater fool theory is one constant in the diabetes universe.

2. Deals are not always done for strategic reasons.

3. Hubris and arrogance extend to what someone is willing to pay, or we should say overpay.

Going back to the JNJ Animas deal for just a moment Animas NEVER EVER turned a profit for JNJ. Animas was in such bad shape when acquired JNJ first job was to fix what was wrong. Not being ready for the acquisition combined with the problems inherited doomed this acquisition. It didn’t help any that once the problems were fixed JNJ made numerous blunders when there was a chance for a recovery.

How does this story end? Yep JNJ sees the light and decides it’s time to get out of the insulin pump business. Thanks to more mismanagement with a little arrogance thrown in for good measure they cannot sell the company and end up giving it away to Medtronic. Seriously we wish we were making this up but as Momma Kliff used to say this is why real life is more fun than and a lot stranger than fiction.

Now we are not telling this story for grins and giggles nor to take a trip down memory. Right now there are two companies in our wacky world where this story applies just for different reasons. Let’s take the low hanging fruit first, Medtronic.

While their diabetes franchise is not in as bad shape as Animas was before acquired by JNJ, the unit is a shadow of its former self. They no longer have the coolest toy in the toy chest, they are in the midst of a recall and have become the third choice behind Tandem and Insulet when it comes to patients new to insulin pump therapy. Compounding these issues are two additional facts, they have nothing in their pipeline which will change any of this plus signs are emerging that the Control IQ is eating away at their installed user base. That goose that lays all those golden eggs.

Right this very moment the company is facing a major decision do they remain in the insulin pump business or do they find a greater fool. The company has already taken the traditional steps of lowering expenses in an attempt to improve margins. There has been a high level of turnover in the management suite and additional cutbacks. Yet the company knows these are temporary solutions to what is a long-term problem.

They also know if they truly want to get back in the game and once again become a serious player major investments are needed. As we have noted the 780G the replacement for the 670G isn’t all the spectacular and their CGM sensor continues to be a source of concern. The current team also understands that even if they make additional investments there is no guarantee they will get a return on this investment.

The unit still has value which would seem to make the choice easy, sell it. Well selling isn’t easy either and not just because they have to find a buyer. Right now Tandem has a market cap of over $5 Billion Insulet over $13 Billion and Dexcom a whopping almost $34 Billion. The diabetes franchise generates approximately $2 Billion plus in revenue which means any buyer would have to pay an astronomical multiple to make the mothership happy.

The most likely buyer would come from private equity and even with cheap money this is not a cheap deal.

Yet the conundrum for Medtronic is the longer they wait to make a move the less the unit is worth. The fact is things aren’t going to get much better and there is very good chance they will get a lot worse. Simply put in order to maximize value the time to sell is now. Given this set of circumstances logic would say ok sell the company and don’t worry about getting top dollar. Take the money and run before the unit becomes unsaleable.

That might be logical, but it isn’t how Medtronic, a company who has consistently demonstrated more than their fair share of hubris combined with arrogance sees it. Heaven forbid they sell and not match or exceed what Tandem, Insulet or Dexcom is worth. In Minneapolis this would tantamount to heresy.

The deal might make sense, it may have the blessing of Medtronic’s investment bankers, but hubris will likely prevent it from happening even though it is the right move strategically.

The other company where the Animas story applies is Livongo who reported results last night which included a positive bump in full year guidance. As expected, the stock is on fire today and this after two days of burning out of control. As we have stated Livongo is playing a dangerous game of chicken hoping to sell the company before they have to deliver on the results. With a market cap approaching $5 Billion Livongo could well run into the same problem as Medtronic, as an acquisition might be too expensive to make sense.

However delivering on results might be an even tougher job. Yesterday the company in typical fashion was extraordinarily confident with their increased full year guidance. When asked about the guidance Lee Shapiro the company’s CFO stated;

“And with regard to our guidance, please note that at the midpoint, we’re growing year-over-year by 74% to 75% over last year. And we feel very good about our prospects as a business for the long term but also recognize some of the near-term headwinds that might come to our clients and some of our members with regard to the COVID-19 pandemic.

We ran a number of scenarios internally and factored in some of the challenges that might face us in future quarters and tried to build in some conservatism into that model in light of the things that are unknown. I think what you’ll see from Livongo is both visibility due to our recurring revenue model as well as transparency. And what we’re sharing with you is that we don’t have full line of sight to what some of those challenges might be in the future. And our guidance reflects that, and we believe is still very strong guidance for the balance of the year.”

Let’s concentrate for a moment on that recurring revenue model. Keep in mind that Livongo has a very interesting method for reporting revenue. We know we have stated this before, but it is worth repeating as the company basically estimates the value of a contract based multiple factors. They don’t actually make real money until people sign up for the program and they start billing the company which according to their 8-K

“we generally invoice our clients in monthly installments at the end of each month in the subscription period based on the number of members in such month who were active on or used our solution within a certain period of time, as specified in the applicable client’s agreement.”

This is when the REAL money comes in the door.

What Livongo is assuming and the Street is buying is that members will remain enrolled and new members will continue to sign up even throughout the COVID crisis. Let’s us some simple math to illustrate. A client has 100 employees enrolled and using the program. As stated in the 8-K Livongo would then invoice the client for 100 enrolled members. Let’s assume the next month due to COVID 20 employees drop from the program and these members are not offset by new members. Obviously, this adversely impacts REAL revenue earned.

Based on what the company has stated they are confident that the COVID crisis will not adversely impact existing members or prevent them from signing up new members. That with all the clients they have that any attrition in the installed base will be more than offset by having more clients. This all makes perfect sense assuming of course the COVID crisis plays out as they project it will.

However what happens should things not turn out this way. Keep in mind while it may seem like the crisis has been around forever it’s only been around for a few months. Even with unemployment hitting new highs employers in the short term for the most part have remained generous with the employees they have laid off allowing their health benefits to continue. This cannot and likely will not last forever even when the crisis is over, and the economy begins to reopen.

Already we have seen major employers like United Airlines, Macy’s and others announcing major cutbacks. Unfortunately many businesses both large and small will not survive the crisis and close their doors J Crew is an example. Even those that do survive will likely begin making cutbacks in order to conserve capital cutbacks that will likely end the benefits they have been providing in the short term. This short-term generosity while appreciated does not make long term financial sense especially since most experts believe a recession is coming if not already here.

This is the reason we believe Livongo should have been more conservative in their guidance. Not to be redundant but as we have stated consistently, we really won’t know how this crisis is impacting results until second and third quarter numbers come out. Even then no one knows for sure what a recovery will look like or how long it will take.

Let’s dumb this down and look at the problem from a very simple perspective. What happens if layoffs continue unemployment gets worse and companies are slow to rehire. This means for Livongo less enrolled members which are not being replaced by new members. Bottom line revenue projected vanishes.

Hence the reason management wants to sell BEFORE this plays out and quite frankly this could happen. Telemedicine and remote patient monitoring has replaced digital health as the hottest thing going. It would not surprise us if a company, say CVS, came along and bought Livongo. The company already has a relationship with CVS and the Livongo platform appears to fit within the CVS strategy.

Yet with a market cap approaching $5 Billion valuation becomes an issue but then again maybe not. This would not be the first nor will it be the last time a deal is done where the acquiring company overpays only later to find out all the glitter isn’t gold. Hence the JNJ/Animas reference when we started today.

A dangerous game is being played here and only time will tell who wins and who gets burned.