In Part-I of this series of articles, we discussed how the Insulin delivery system is an Oligopoly between Medtronic, Tandem, and Insulet. In Part II of this series, we discussed the TAM and growth opportunities for the Insulin delivery system segment. Insulin delivery system segment growth over the long term is quite attractive. The sector is also one of the lowest volatility segments within the healthcare value chain. However, here are a few near-term risks that may impact the segment:
- Product recalls & durability: Since it’s a high upfront cost product, insurance companies require insulin pump manufacturers to provide a warranty of four years on the pump; the pump has to withstand daily usage wear and tear for four years. The pump is attached to the patient’s body, moves with the patient 24x7, and cannot fail as the patient’s life depends on it (in the case of Type 1 diabetes). It’s a difficult situation if the pump has to be recalled after say two years since it fails in one particular scenario, it could make the entire business unprofitable, quickly. If a pump fails to deliver insulin, from a simple issue such as the pump being detached from the body due to a loose connection, for a type 1 diabetes patient (about 90% of all pump users) it is an emergency. The patient (of type 1 diabetes) can sustain without Insulin only for six hours after which the patient gets into a life-threatening condition called diabetic ketoacidosis (DKA). The life expectancy of type 1 diabetic patients is on average 12 years less than that of the general population. Johnson & Johnson exited the insulin pump business in 2018; they couldn’t make the pump business profitable due to warranty service requirements. In mid-October, 2022, Insulet began a recall of the remote-control devices used with one of its insulin pumps after discovering that the devices’ batteries may be at risk of swelling, leaking, or overheating. A patient settled for $3,300,000 with an insulin pump manufacturer after a pump malfunction resulted in the patient unknowingly going into diabetic ketoacidosis and later multi-system organ failure. Consequently, the best insulin pump company to invest in is the one that offers an insulin pump with minimal mechanically moving parts (or the most durable pump) to ensure the lowest probability of recalls/liability from malfunction.
- Valuations based on increasing pump penetration in Type 2 diabetes patients: Currently, 90% of insulin pump users are Type 1 diabetes patients and a meager 5% of Type 2 diabetes patients use insulin pumps. Hence the most important growth driver and consequently valuation for a pump manufacturer is its capability to attract Type 2 diabetes patients. The market may be wrongly concluding and building in valuation that the success of a pump with Type 1 diabetes patients can be replicated with Type 2 diabetes patients. It hasn’t happened in the last 10 years; the 5% pump penetration levels in Type 2 diabetes patients have remained constant. Different levels of Basal & Bolus insulins required for Type1 & Type 2 patients make designing a common pump challenging. Moreover, inputs required for insulin pumps are quite complex and tedious which a Type 1 patient may be willing to go through since they may have been on it since childhood but for Type 2 patients with an average age of 51 years, it may be too much to handle. For pumps to attract Type 2 patients, they need to be designed specifically for them whereas currently all the pumps in the market are designed for Type 1 patients and are later offered to Type 2 patients with a few minor tweaks; hence they are unlikely to make a dent in the Type 2 pump market.
- Relying on insurance: In July 2016, UnitedHealthcare decided to make Medtronic the insurer’s exclusive in-network supplier of insulin pumps, shutting out other companies from a large portion of the market. This decision almost bankrupted, Tandem, Medtronic’s primary competitor at the time. The average cost of a Pump in the US is around $4,000 and consumables cost about $1,100 per year. So, most users will only buy an insulin pump if it's covered by their insurance and hence the reliance on insurance for pump manufacturers. Pumps are almost always covered for Type 1 patients but may not be for many Type 2 patients. Manufacturers that have stopped relying solely on insurance and introduced more consumer-friendly razor-blade type pricing models have reduced such insurance risk and could be more successful in the Type 2 segment.??
Conclusion: The risks are very real and could manifest anytime. However, to reduce the chances of a loss investors should prefer a pump (manufacturer) with minimal mechanically moving parts (or the most durable) to ensure the lowest probability of recalls/liability from malfunction. Such fat tail risk is a more important criterion in this sector and hence investors should give more weight to this risk and less to traditional investment criteria such as valuation, market share, etc. for this particular segment. The capability of a pump to penetrate Type 2 patients is also a risk and consequently an important investment criterion. Finally, innovative pricing models to diversify the customer base away from pure insurance pay contracts is very useful in penetrating different type of diabetes patients and reducing (insurance) customer concentration risk.?
Fat Tail Risk: It is (a probability) distribution that predicts movements of 3 or more standard deviations more frequently than a normal (probability) distribution. Given the high volatility of financial assets, it is becoming clear that financial asset returns exhibit fatter tails than normal distributions. By definition, the magnitude of such events is difficult to predict, however, left-tail events can be devastating for investment returns. Just like the insulin pump segment which exhibits a fat tail risk, there are other segments with similar characteristics thereby making the entire financial asset returns prone to fat tail risk. In constructing, BayFort Capital Global Leaders Portfolio, we are very cognizant of such risks in each stock as well as the entire portfolio and try to mitigate it so that our investors are protected from extreme return volatility while also maintaining a fifteen stock-only concentrated portfolio of growth stocks representing global leaders in various sectors.
We will continue our discussion about the next frontier in this space, Artificial Intelligence in Insulin pumps, and how it’s changing the industry fundamentally (which happens once in a decade or so in this space) in Part IV of this series.??
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Links to all articles in this Oligopoly in Diabetes Care series:
