Will the dominos begin to fall?

Will the dominos begin to fall?

Word coming out of Germany is that the Panasonic/KKR deal to buy Bayer’s diabetes unit is just about done and an announcement could come any day now. The question now becomes will this deal push other well-funded private equity firms into the glucose monitoring market. A question which becomes even more interesting for anyone who read an op-ed piece in today’s Wall Street Journal by former hedge fund manager Andy Kessler entitled “The Glory Days of Private Equity Are Over”.

In this excellent piece Mr. Kessler outlines several reasons for his belief. Stating “When it comes to private equity is pretty simple. You put buy a company, putting up some cash and borrowing the rest, sometimes from banks but often via exotic instruments that Wall Street is happy to sell. Then you manage the company for cash flow, making sure you can make interest payments with enough left over for fees and investor dividends. With enough free cash flow, you either take the company public or sell it to someone else. And how do you generate cash flow? You can expand the company, but more than likely you slash costs, close divisions, cut staff, curtail marketing, eliminate research and development and more. In other words, cutting to the bone.”

It’s the last part of that paragraph which is most interesting as for the major BGM companies they have already cut costs to the bone. This makes Diabetic Investor believe that Panasonic/KKR isn’t buying Bayer’s unit to generate better cash flow but as a defensive measure protecting the investment KKR made when they acquired Panasonic and formed Panasonic Healthcare. As we have noted previously Bayer has already cut costs to the bone, the latest move reducing headcount by more than 50%.

Some have speculated that once this deal becomes official other large well-funded private equity groups will play follow the leader and begin acquiring other players in the BGM market. The basic premise is that in the hands of private equity these units will become more efficient generating stronger cash flows. That even with today’s lower margins there is money to be made.

The theory is that private equity will then buy other diabetes device companies, bolt them onto the BGM unit and prepare for the day when interconnected diabetes management (IDM) becomes the standard of care. Once established they can then cash out either by spinning these units off in the form of an IPO or selling them to someone else. As Kessler notes private equity isn’t that complex.

It’s a good bet that the folks at Johnson and Johnson (NYSE:JNJ), Abbott (NYSE:ABT) and Roche want this to be the case. As all three would like nothing better than to sell their units to private equity, to actually find someone, anyone who will pay them to get out of this business. While all three have publicly stated they intend to remain in the diabetes device business, all three have explored options on getting out of the market. As we noted last week these companies know it’s just a matter of time before they become irrelevant and better to sell now when they still have value.

It’s not crazy to state that the strong possibility exists that five years from today all of the major players in BGM will be owned by private equity. That the BGM market as we know it today will cease to exist.

Diabetic Investor can envision the day when patients with diabetes won’t need prescriptions for a meter, that co-payments for test strips will be a thing of the past. That today’s world where formulary placement translates into market share will be replaced. That in the future patients will pay a monthly fee, similar to how they currently pay for smartphone service. This fee will not just cover the cost of the hardware a patient uses but also the apps and software that connect to the hardware.

The future of diabetes management is not about hardware, the future of diabetes management is all about transforming data into actionable information which hopefully translates into better patient outcomes. The winners in this race will be the companies who can successfully navigate the transition from a fee for service reimbursement model to an outcomes driven reimbursement model. The simple fact is this transition is currently underway as everyone knows outcomes are what matters. However no market makes any transition smoothly which basically means before the future gets here we still need parts of the system IDM is replacing.

This is why members of the old guard still have value as things like market share and formulary access still matter. The fact is if private equity is to get involved they will need to make money while the market transitions. As impressed as Diabetic Investor is with many of the newcomers to this space the ones with way cool systems that come with way cool apps that connect the patient with their healthcare team through the cloud, the fact is these companies aren’t making any money. Their value lies in their ability to prove their systems improve outcomes.

The reality is once again the BGM market is transforming, a transformation that is not just needed but will actually have a positive impact for patients with diabetes. Perhaps the best way to think about this is how the mobile technology market has transformed over the years. While it seems like ages ago it wasn’t that long ago when car phones were the hot technology, car phones which were then replaced by large, cumbersome mobile phones, which in turn were replaced by smaller mobile phones which in turn were replaced by smartphones which in reality are mini-computers that also can make phone calls. The fact is the mobile technology market needed to hold onto pieces of the older technology it was replacing.

This same transition is now underway in the diabetes device market and will expand to include the diabetes drug market as well. Whether the Panasonic/KKR Bayer deal is the first domino to fall no one knows for sure. Yet one thing Diabetic Investor does know is that the dominos are being set up to fall and when that first domino is knocked over it will set off a chain reaction that will forever change the diabetes management landscape. Thank goodness!!!!