Tandem & Insulet - EMBA F19 PDF

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Financial Statement Analysis Project ACC 502 Financial Accounting Executive MBA Class of 2021 Mukund Vasudevan, Vishal Verma, Sarah Like, Cara Habegger

The real story behind how Tandem Diabetes Care is attempting one of the most dramatic turnarounds in medical device history, and how Insulet Corporation is steadily beating them at their own game.

TABLE OF CONTENTS

The diabetes pump industry ................................................................................................................................................... 3 Introduction to Tandem Diabetes Care ................................................................................................................................. 3 Market and Product ............................................................................................................................................................... 3 Strategy and Business Model ............................................................................................................................................... 4 Introduction to Insulet Corporation ...................................................................................................................................... 4 Market and Product ............................................................................................................................................................... 4 Strategy and Business Model ............................................................................................................................................... 4 Financial statement analysis ................................................................................................................................................. 5 Analysis of Return on Equity, Financial Leverage, and Spread ............................................................................................. 5 Analysis of Revenue and Gross Margin ................................................................................................................................ 6 Analysis of Return on Operating Assets (RNOA) .................................................................................................................. 6 Analysis of Disaggregation of RNOA (NOPM, NOAT) .......................................................................................................... 6 Analysis of Cash-to-Cash Cycle ............................................................................................................................................. 7 Analysis of Stock Split and Debt Repayment ......................................................................................................................... 7 Conclusion ............................................................................................................................................................................... 8 References ................................................................................................................................................................................ 8 Appendices .............................................................................................................................................................................. 9 Appendix 1: Reformulation of Tandem Financial Statements ................................................................................................ 9 Appendix 2: Reformulation of Insulet Financial Statements ................................................................................................ 11 Appendix 3: Common Size Financial Statements ................................................................................................................ 13 Appendix 4: Comparison Calculations ................................................................................................................................. 14

The first insulin pump was designed by Dr. Arnold Kadish in 1963 and was designed to be worn as a backpack. (Wikipedia, 2019)

Tandem & Insulet Financial Statement Analysis

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The diabetes pump industry The insulin pump market is in a period of growth and change. Diabetes is on the rise, the population is aging, and consumers are demanding more techsavvy, non-invasive glucose monitoring. “The global insulin pumps market is foreseen to reach around a worth of US $9.5 billion by the end of the forecast period, which was evaluated in 2016, to be of worth around US $4.18 billion. The market is anticipated to flourish at a CAGR of 9.80% within the forecast period from 2017 to 2025.” (Transparency Market Research, 2019). Observers expect both the Type 1 and Type 2 diabetes markets and pump users to grow (Orchard, Nathan, and Zinman, 2015). Medtronic Diabetes has been the leading player in the U.S. and European insulin pump markets, however, industry shifts have created a race to redistribute market share. This report examines two of the pump providers making bids to capture the market: Tandem Diabetes Care and Insulet Corporation. How might they do it? In 2017 Johnson & Johnson (Animas) exited the space, creating opportunities to convert 90,000 existing pump users (Taylor, 2019). The FDA has also streamlined clearance of new diabetes products, allowing smaller tech-focused companies to market differentiators. One key technological advancement is coupling insulin pump therapy with a continuous glucose monitoring (CGM) device. Medtronic is the only company who currently manufactures both components, and other competitors contract with CGM manufacturers like Dexcom. Profit margin for insulin pumps is around 50-60%, lower than other devices (Johnson, 2018), so companies like Tandem and Insulet need to find a way to increase margins or support themselves with strong infrastructure and scale. The distribution channels for insulin pumps are also shifting. In recent years there has been a large swing in defining the target customer for an insulin pump manufacturer – is it the patient? Is it the prescribing health care professional? Is it the insurance company? Is it the pharmacy? Or, is it the patient’s family? Depending on who you ask, you’ll likely receive a different answer. This answer is driving market swings within the community and is impacting the financial performance of all the major players.

What is diabetes and why use a pump? Diabetes is a chronic condition that affects people of all ages and can be extremely challenging to manage. A person with diabetes has higher than normal blood glucose levels that is caused by one of two things: inability of their cells to acknowledge the insulin produced by their body (Type 2) or their pancreas stopping the production of insulin due to autoimmune attack to their Beta cells (Type 1). According to the American Diabetes Association, “it is estimated that in 2015, between 750,000 and 1 million people worldwide used an insulin pump. Domestically, 550,000 people in the United States use an insulin pump (Umpierrez and Klonoff, 2018). How insulin is administered to a patient’s body has been relatively unchanged for decades. Patients can use multiple daily injections (MDI) or an insulin pump. While there are many clinical benefits to using a pump, some patients may prefer to continue with MDI because of increased financial cost to patient, lifestyle/social concerns wearing a device in daily activities, visual impairment, lack of education or family support, or perceived “visibility” of patient’s disease.

Introduction to Tandem Diabetes Care The “easy-to-use” pump Tandem Diabetes Care (Tandem) is an insulin pump manufacturer founded in 2006 and is based in San Diego, CA. They were founded on the concept that “incorporating ease of use and attractive design would encourage more patients to consider the clinical benefits of insulin pump therapy” and increase therapy adoption. The company received FDA approval of its first insulin pump approval in November 2011 and was the first touch screen pump to enter the market (Wikipedia, 2019). Tandem market and product: Most recently, they have launched t:slim x2 with Dexcom G5 Mobile CGM integration and are expected to launch t:slim X2 with Basal-IQ technology in August 2018, their firstgeneration Automated Insulin Delivery System. (Tandem 10-K, 2018). The FDA also created a subcategory of approval for new interoperability designation for integrated CGM that will streamline the FDA regulatory pathway to less approval time and increase the cadence in which new technology reaches patients with diabetes. (Tandem 10-K, 2018)

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Tandem strategy and business model: Tandem Diabetes Care was in a major financial crisis in 2017 and was potentially facing bankruptcy. Observers noted that Tandem’s “decline was driven by competitor devices taking big steps up in technical capabilities and a decision by UnitedHealthcare to make Medtronic the insurer’s exclusive in-network supplier of insulin pumps, shutting out other companies from a large portion of the market” (Truong, 2019). As the financial statements will reveal below, Tandem was losing huge amounts of money. But Tandem implemented several strategic maneuvers in order to defer default. First, the timely 2017 closing of the Johnson & Johnson Animas pump line yielded them an opportunity to increase market share both domestically and internationally, as well as disrupt the marketplace. Tandem sold 84,000 total insulin pumps since commercial launch in August 2012 with 4,000 of those being outside the U.S. (Tandem 10-K, 2018). Tandem defined a marketing strategy to compete with giant Medtronic and position themselves as the sleeker, smaller, tech-friendly, “easy-to-use” pump. They are also partnered with the highest prescribed CGM in the market: Dexcom. At this time, Tandem has the only FDA-approved insulin pump in the marketplace to be able to work with Dexcom, so their ability to capture satisfied Dexcom users has been a catalyst to gaining market share in the diabetes community. Most dramatically, though operating losses continued, Tandem was able to perform financing maneuvers to raise capital, keeping the company alive as it ramped up sales of its new t:slim X2 Insulin Pump. They did a stock split October of 2017 and were able to take their low stock price of $2.47/share and started the rise of the stock price which is now, as of 10/5/2019, trading at $57.22. They also paid off almost all of their long-term debt in 2018. These two financing moves appeared to strengthen their balance sheets and combat ongoing heavy operating losses, to some observers positioning them for a comeback (Truong, 2019). Tandem prides itself on being simple to use and simple to initiate for providers, which allows them to operate with very little human capital in comparison to its competitors. This is a strategic move to allow for higher gross margin. They have 653 fulltime employees as of December 31, 2018 which is significantly less than other insulin pump companies (Tandem 10-K, 2018). They are currently in a five-year contract started in 2016 with TypeZero’s inControl AID algorithm to power their future technology, Control IQ AID system, and will have to pay royalties for each pump sold. (Tandem 10-K, 2018).

Introduction to Insulet Corporation The only “Patch Pump” Insulet Corporation (Insulet) was founded in 2005 in the United States and does business outside the U.S. in multiple European countries, Canada, and Israel. (Insulet 10-K, 2018) Insulet manufactures an insulin pump that is considered a “Patch Pump” and is commercially referred to as the “Omnipod System.” The pump differs from others on the marketplace because it does not utilize the traditional reservoir and infusion set but rather the pod is filled via syringe, placed on user for three days, and then entirely disposed of at the end. It’s controlled via a wireless handheld device called a Personal Diabetes Manager (PDM) or most recently through a patient’s mobile device which is referenced as their DASH System. The DASH system was FDA-approved in June 2018 which is their next generation digital mobile platform. (Insulet 10-K, 2018) Insulet market and product: Omnipod remains the only “patch pump” on the market to this day and continues to attract patients conscientious of being tethered to a traditional insulin pump. Per the investor conference call in March 2019, “66% of users would not have moved to pump therapy if not for Omnipod.” They have signed a contract with Dexcom to develop a CGM integrated platform but they have not released an FDA-approved device at this time. They also have plans to launch Omnipod Horizon Automated Insulin Delivery System that will be a hybrid closed loop system that utilizes their current DASH mobile platform with Dexcom’s continuous glucose monitoring system. (Insulet 10-K, 2018) Insulet strategy and business model: Insulet has focused on improving payer access: most insulin pump manufacturers bill under major medical benefits and Part B (medical benefits) under Centers for Medicare & Medicaid Services (“CMS”). This poses at times significant cost burden on patients as any initial costs are subject to a patient’s co-insurance and deductible levels. “In January 2018, CMS issued Tandem & Insulet Financial Statement Analysis

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guidance clarifying that Part D Plan Sponsors may provide coverage for products … under the Medicare Part D (prescription drug) program.” (Insulet 10-K, 2018). This is a huge opportunity for increasing therapy adoption among Part D users, because there are no requirements for insurance approval and expands market to previously denied Medicare patients. Insulet also markets to patients the opportunity to “pay-as-you-go”. Currently, Omnipod DASH is the only insulin pump that does not lock patients into a four-year contract. Because the pods are disposable and operate off a mobile device, there isn’t a large up-front cost for new patients to start using the pump (March 2019 Insulet Investor call). The distribution through the pharmacy channel and the pay-as-you-go model are also expected to prove beneficial to payers since it reduces their risk as well as the cost of member attrition. Insulet has 1,169 employees based upon the latest SEC filings (Owler, 2019). They sell directly to patients and sell through distributors, which accounts for the largest portion of their business. (Insulet 10-K, 2018). Insulet is expecting a continued rise in operation costs related to their DASH system approval and also establishing a US-based manufacturing facility. Previously, they were producing omnipods at a semi-automated manufacturing facility in China and this is expected to be in use until December 2022 (Insulet 10-K, 2018). Relocating to the US will help them to lower manufacturing costs and increase supply availability – they have invested $193 million in PPE (Insulet 10-K, 2018). The US-based facility will provide up to 50% the capacity of total China operation with up to 90% less headcount (March 2019 Insulet Investor call). With the expected launch of their Horizon System, Insulet is promoting clinical trials showing positive outcomes for 2-6- yearold patients, which will be a large area of opportunity given that other insulin pump companies do not have such low age indications and they are extremely popular in the pediatric market (Insulet media, 2019). Insulet is also preparing for additional mobile technology platforms that will allow for insulin delivery via the user’s phone and a secondary display on the caregiver’s phone giving increased market differentiation in pediatric markets (March 2019 Insulet Investor call).

Financial statement analysis Both of these companies are trying to play catch-up and gain market share in an industry dominated by a big player. Their financial statements indicate that they both have been taking heavy losses as they are in growth mode, banking on future technology and advertising gains. Insulet is a bigger company and emerging from the red; Tandem has a long way to go to profitability. We will examine each company’s income statement and balance sheets to assess financial and operating structure and major changes that have occurred over the last three years. Negative Return on Equity, Financial Leverage, and Spread Founded in 2005 and 2006, respectively, Insulet and Tandem have more of a start-up feel and are waiting to truly maximize shareholder value (start making money, paying down debt, and increasing retained earnings). It is difficult to compare these numbers as we see shocking disparity from the typical medical device industry Return on Equity (ROE) of 6-10% (CSIMarket, 2019) – we even see negative equity (Tandem at -240.14%). However, Insulet is finally reaching positive ROE at 1.78% in 2018 and achieving profitability. The negative numbers are primarily driven by negative RNOA pushing calculations into extreme territory (we will analyze RNOA below). Both Tandem and Insulet have consistently negative spreads over the last three years: Tandem with extreme numbers (huge improvement with -66.13% in 2018), but Insulet has a steadily improving spread almost out of the red (-0.79%). Insulet has had a steadily decreasing financial leverage (FLEV) suggesting improvement (2.20% in 2018), and Tandem’s consistently negative FLEV (-0.57 in 2018) reveals they actually have more financial assets than liabilities (financing strategies like stock issuance and debt repayment will be explored later).

Tandem & Insulet Financial Statement Analysis

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Upward movement in Revenues and Gross Margin Before we dig further into RNOA and the operating side of the business, we can note that at least both Tandem and Insulet are increasing their respective Gross Margins and Revenues, though sales growth is not necessarily value creation. We see Tandem’s sales jump by 71% to $183,866 in 2018, and Gross Profit increasing an impressive 104% from 2017 to 2018. Insulet has smaller increments of improvement but is steady, increasing revenues about 20% each year and actually lowering cost of goods sold. Insulet’s advantage might come from using a disposable pod, decreasing production costs, and replacement pods are an ongoing source of income. This has positioned them for 2018 as the first full year of positive operating income and net income in their history (Yahoo Finance, 2019). Gross Profit Margin reveals the relation of Sales to Cost of Goods Sold, in essence, the mark-up on the company’s products. Tandem has been playing catchup to Insulet and the rest of the industry, landing at 49% at the end of 2018. Insulet has stayed slightly above the industry average at 66% (Johnson, 2018). According to an industry insider, both Tandem and Insulet use the same manufacturer, so it appears that they can differentiate by increasing revenues and marking up their similar products higher. Going forward Tandem is likely able to increase margin with remote software updates that make upgrades more costeffective (Johnson, 2018).

Return on Net Operating Assets (RNOA) As the real driver of shareholder value, operating returns can give great insight into the promise and real growth of a company. RNOA has been negative for both companies to varying degrees but both are improving. Tandem shows the most extreme numbers: for the last three years, for every dollar of nonoperating assets, they lost anywhere from $3.58 to now $2.77 in 2018 (yes, an improvement!). Insulet continued a steady upward trend to finally yield a breakthrough of positive 3.51% RNOA in 2018. Tandem used 98% of their revenues just for SGA in 2016, and are getting it down to 57% in 2018, compared to Insulet’s steady 45-46% for SGA.

Tandem’s RNOA improvement comes from a slight lift in Net Operating Profit after Tax (NOPAT). They are losing less than in previous years (loss of $61 million in 2018). Their revenues are increasing (see analysis above). RNOA remains negative as they have very low operating assets (barely 3% of assets in 2018). Comparatively, Insulet’s steady move to positive RNOA is a very ...