DexCom, Inc. Tickled pink Q3 EPS less red than our estimate and new G4 color choice

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1 DexCom, Inc. Company Description: DexCom is a real-time diagnostics medical device company focused on the continuous glucose monitoring (CGM) market for both diabetics and critical care patients. The company has several ongoing development agreements to provide its technology for use with insulin pumps and in the critical care market. Feltl and Company Research Department 2100 LaSalle Plaza 800 LaSalle Avenue Minneapolis, MN Ben C. Haynor, CFA bchaynor@feltl.com Healthcare- Real-time Diagnostics Tickled pink Q3 EPS less red than our estimate and new G4 color choice (DXCM - $13.07) HOLD Key Points DexCom reported Q results yesterday that were below the consensus, but better than our recently revised estimates. Revenue was $23.1 million versus our estimate of $21.0 million and consensus of $23.1 million; EPS was ($0.25) versus our estimate of ($0.39) and consensus of ($0.22). Management expects 2012 product revenue to wind up near the midpoint of their $85 million to $92 million guidance range, or approximately $88.5 million. Maintaining HOLD rating and $14.00 price target (7.0x 2013 EV/Sales), but raising estimates slightly. Financial Summary Rev(mil) 2011A 2012E 2013E Mar 14.2A $20.1A $26.3E June 21.4A $23.5A $30.7E Sept 18.3A $23.1A $33.9E Dec 22.4A $27.7E $40.6E FY $76.3A $94.8E $131.5E P/Sales 11.8x 9.5x 6.9x DexCom reported Q results yesterday that were below consensus but better than our recently revised estimates. Revenue was $23.1 million versus our estimate of $21.0 million and consensus of $23.1 million; EPS was ($0.25) versus our estimate of ($0.39) and consensus of ($0.22). Based upon management commentary during the G4 Platinum approval conference call, we anticipated far greater one-time expenses and revenue impacts as a result of the approval than actually occurred. As a result, our estimates for Q3 wound up at or near the Street-low. The magnitude of these impacts was approximately half of what we had anticipated, causing the bottom line number to be less in the red than we estimated. Management guided to the midpoint of their $85 million-$92 million guidance range on product revenue. This implies Q product revenue of approximately $27.3 million. We now estimate $26.2 million, but it seems clear Q4 has the potential to be a sloppy quarter with a number of factors impacting results that are somewhat difficult to quantify at present. Results this quarter contained a $1.2 million warranty return reserve that reduced revenue dollar-fordollar and incurred $500,000 in additional COGS for SevenPlus starter kits shipped that are expected to be returned; assuming DexCom s gross margin on starter kits is 50%, this corresponds to approximately 1,200 patients they expect to return SevenPlus kits in exchange for the G4 Platinum platform under the 30-day return policy. Further, the company is offering a $399 upgrade option to SevenPlus systems under warranty (one-year warranty). We estimate 20,000-25,000 SevenPlus users might be able to take advantage of this offer, but find it difficult to speculate on the proportion of these users who may accept the offer. In addition, the mix between 30-day returns, discounted upgrade offers, new G4 users (including those choosing the tickled pink color option), and remaining SevenPlus users makes estimating gross margin quite amorphous. EPS 2011A 2012E 2013E Mar ($0.19)A ($0.21)A ($0.17)E Jun ($0.11)A ($0.21)A ($0.14)E Sept ($0.20)A ($0.25)A ($0.13)E Dec ($0.18)A ($0.19)E ($0.05)E FY ($0.68)A ($0.88)E ($0.50)E P/E NM NM NM Price: $ Week Range: $ $6.75 Target: $14.00 Rating: HOLD Shares Outstanding: 69.1 mil Mkt. Capitalization: $902 mil Ave. Volume: 300,000 Instit. Ownership: 92% BV / Share: $1.16 Debt / Tot. Cap.: 0% Est. LT EPS Growth: 30% Maintaining HOLD rating and $14.00 price target (7.0x 2013 EV/Sales). Our updated estimates have increased, but we feel that there is a decent amount of uncertainty around the G4 transition that makes us cautious on DXCM shares in the near term. Please see important disclosures on pages 6 to 8.

2 rops Strong, Pricing Weak, Farm Profits Could Suffer INVESTMENT THESIS We are maintaining our HOLD rating and our 12-month price target of $14.00 (7.0x 2013 EV/sales). DexCom is a real-time diagnostics company focused on developing continuous glucose monitors (CGMs) for use by diabetics and in critical care settings. We believe DexCom will grow the top line at a rate of over 30-40% Y/Y for the foreseeable future and successfully reach profitability on a quarterly basis in We view DexCom as having tremendous potential in a rapidly growing market. That being said, profitability is not imminent and we feel the company s own success has hurt their ability to grow as they have been quite successful in gaining share. This will tend to limit growth to slightly above market rates, making it difficult for us to assign DexCom the multiples it has enjoyed in the past. We believe that once CGM adoption reaches a tipping point of 8-10% penetration, adoption will accelerate. However, we estimate that the penetration rate for CGMs is currently in the ~7% range, and it does not appear to be reaching the tipping point rapidly. Should the CGM industry reach a tipping point, product sales begin exceeding expectations, positive developments on the Type 2 reimbursement front happen, or the share price become more attractively valued, we would be inclined to become more positive on the story. The DexCom Zebra Puzzle Due to competitive and other reasons (such as Roche sales or whether an Animas pump would qualify as a starter kit), DexCom ceased providing certain metrics on their Q call. Specifically, management no longer provides the number of starter kits sold nor the sequential sensor revenue growth. In place of these metrics, the company offered percentage of revenue attributable to sensors and starter kits, stating that product revenue broke down into approximately 70%-75% sensors and the balance being starter kits (or hardware). Based upon data the company has given on earnings calls over the past few years, we have developed the chart below which depicts DexCom s sequential growth in total product revenue, sensor revenue by solving what is essentially a system of linear equations with subjective error bounds to account for management statements such as, our ASPs have held steady, if not improved just slightly, as well as dealing with missing data. The various impacts as a result of the G4 approval (detailed in the table below) during the quarter reduce our ability to back into a potentially useful starter kit placement range. Q amount Y/Y change Product revenue (reported) $21.1 million +27% Warranty return reserve $1.2 million Adjusted product revenue $22.2 million +34% Q amount Gross margin Gross profit (reported) $7.7 million 36% Warranty return impact $0.5 million Obsolete inventory impact $2.5 million Additional depreciation expense $0.6 million Adjusted gross profit $11.9 million 54% Feltl and Company Research Department DexCom, Inc. (DXCM) Page 2

3 rops Strong, Pricing Weak, Farm Profits Could Suffer Miscellaneous Bullets G4 Platinum shipments began last week and the company has commenced full-scale order fulfillment as of this week. DexCom is focused on processing G4 orders for new patients, but they anticipate beginning to upgrade SevenPlus users this month. The company is working on completing all the requested upgrades by the end of Management noted that the average number of daily calls into their customer service organization is up 50% versus prelaunch, but this differential could be enhanced by a slower volume of calls in anticipation of G4 approval. Several pharmaceutical companies have suggested recently that they view CGM as an important tool to demonstrate efficacy of future diabetes compounds and have expressed dissatisfaction with competing CGM solutions. ASPs for sensors remained constant while the ASP for starter kits was impacted by the rebate program. DexCom entered into a loan and security agreement with Silicon Valley Bank and Oxford Finance which provides a $15 million revolving line of credit (interest-only at prime + 0.5% with a November 2015 maturity) and a $20 million term loan (interest-only first year at the three-year Treasury rate %, amortized thereafter, maturing in November 2016). No warrants or conversion features are associated with these lending agreements. The company completed its pediatric clinical trial and expects to file for US approval during the current quarter. They expect to be able to offer CGM to patients as young as 2 years old, a first for CGM. G4 received Australian approval, and management expects Canada and India approvals in the next six months. They are also exploring opportunities in China, Japan, and other Asian countries. DexCom anticipates becoming the first company with a Class III device approval that communicates directly with a mobile phone platform. US development activities related to the Animas Vibe are taking longer than expected, but the company plans on filing early next year for the combination product, which they believe has an outside chance of being approved prior to the ADA conference. The Edwards critical care product is near complete and they expect to obtain a CE Mark prior to year-end 2012, but the US timeline continues to be uncertain as the companies wait for additional clarity from the FDA. There is a high likelihood that Tandem Diabetes will seek to produce a Gen 4 integrated version of their t:slim insulin pump. An extended wear indication will not be attempted until Gen 5. Model Adjustments We are adjusting our model to reflect our estimates slightly higher for Q and Our changes increase our Q4 revenue estimate to $28.2 million from $27.7 million and our EPS estimate to ($0.19) from ($0.22). Although, as previously noted, we think Q4 could turn out to be a sloppy report given the numerous moving parts inherent in the G4 launch. Our 2013 estimates move up as well, with our revenue estimate increasing to $131.5 million from $129.5 million and our EPS estimate increasing to ($0.50) from ($0.58). Feltl and Company Research Department DexCom, Inc. (DXCM) Page 3

4 rops Strong, Pricing Weak, Farm Profits Could Suffer DexCom Q Variance Analysis Product revenue % Y/Y growth 17.1% 26.6% Development grant and other revenue % Y/Y growth -6.1% 25.7% Total revenue % Product cost of sales % Gross margin (products) 1.0% 36.5% Development and other cost of sales % Gross margin (development) 33.3% 35.5% Total cost of sales % Gross profit % Gross margin 3.3% 36.4% Operating expenses R&D % % of sales 49.1% 45.8% SG&A % % of sales 84.3% 65.6% Total operating expenses % Operating Income (27.3) (17.3) -36.6% Operating margin % -75.0% EBITDA (26.2) (16.2) -38.1% Total other income % Earnings before taxes (27.3) (17.3) -36.6% Tax expense (benefit) - (0.0) Tax rate 0.0% 0.0% Net income (27.3) (17.3) -36.8% EPS $ (0.39) $ (0.25) -36.7% Shares outstanding % Feltl and Company Research Department DexCom, Inc. (DXCM) Page 4

5 DexCom, Inc. (DXCM) Ben Haynor, CFA Income Statement (millions, except EPS) 2010 Q1 Q2 Q3 Q Q1 Q2 Q3 Q4E 2012E Q1E Q2E Q3E Q4E 2013E Product revenue Y/Y growth 122.7% 94.2% 67.9% 54.6% 54.0% 64.1% 41.7% 41.8% 26.6% 25.0% 32.6% 30.5% 33.3% 51.4% 47.4% 41.3% Development grant and other revenue Y/Y growth -27.5% -62.8% 127.4% 80.0% -27.3% 22.5% 42.7% -69.1% 25.7% 34.7% -28.4% 35.4% 3.8% -0.4% 0.0% 7.9% Total revenue Product cost of sales Gross margin (products) 35.0% 36.4% 45.0% 44.6% 48.9% 44.4% 48.5% 49.4% 36.5% 46.9% 45.3% 48.7% 52.6% 53.9% 60.3% 54.6% Development and other cost of sales Gross margin (development) 51.7% 31.8% 80.8% 46.2% 30.4% 63.4% 24.1% 31.6% 35.5% 35.0% 32.1% 35.0% 35.0% 35.0% 35.0% 35.0% Total cost of sales n Gross profit Gross margin 37.9% 36.1% 55.4% 44.7% 47.7% 47.0% 46.7% 47.9% 36.4% 46.0% 44.3% 47.7% 51.4% 52.7% 59.1% 53.4% Operating expenses R&D % of sales 47.8% 44.2% 32.8% 45.1% 41.2% 40.3% 48.3% 44.8% 45.8% 37.2% 43.5% 35.1% 31.8% 30.1% 25.7% 30.1% SG&A % of sales 83.3% 75.6% 57.2% 72.5% 61.3% 65.5% 75.0% 65.6% 65.6% 54.8% 64.4% 59.1% 52.4% 49.9% 42.8% 50.1% Total operating expenses Operating Income (45.3) (11.9) (7.4) (13.3) (12.3) (44.8) (15.4) (14.6) (17.3) (12.9) (60.3) (12.2) (10.0) (9.2) (3.8) (35.3) Operating margin -93.1% -83.7% -34.5% -72.9% -54.8% -58.8% -76.6% -62.5% -75.0% -45.9% -63.6% -46.6% -32.7% -27.2% -9.4% -26.9% EBITDA (42.9) (11.1) (6.5) (12.3) (11.2) (41.0) (14.2) (13.5) (16.2) (11.8) (55.8) (11.1) (8.9) (8.1) (2.7) (30.9) Total other income (9.9) Earnings before taxes (55.2) (11.9) (7.4) (13.3) (12.3) (44.7) (15.4) (14.6) (17.3) (12.9) (60.2) (12.2) (10.0) (9.2) (3.8) (35.2) Tax expense (benefit) (1.3) 0.1 (0.0) Net income (55.2) (11.9) (7.4) (13.3) (12.3) (44.7) (14.1) (14.7) (17.3) (12.9) (60.2) (12.2) (10.0) (9.2) (3.8) (35.2) EPS $ (0.97) $ (0.19) $ (0.11) $ (0.20) $ (0.18) $ (0.68) $ (0.21) $ (0.21) $ (0.25) $ (0.19) $ (0.88) $ (0.17) $ (0.14) $ (0.13) $ (0.05) $ (0.50) Shares outstanding Feltl and Company Research Department DexCom, Inc. (DXCM) Page 5

6 Analyst Certification I, Ben Haynor, CFA, certify that the views expressed in this research report accurately reflect my personal views about the subject company and its securities. I also certify that I have not been, am not, and will not be receiving direct or indirect compensation related to the specific recommendations expressed in this report. Important Disclosures: The analyst or a member of his/her household does not hold a long or short position, options, warrants, rights or futures of this security in their personal account(s). As of the end of the month preceding the date of publication of this report, Feltl and Company did not beneficially own 1% or more of any class of common equity securities of the subject company. There is not any actual material conflict of interest that either the analyst or Feltl and Company is aware of. The analyst has not received any compensation for any investment banking business with this company in the past twelve months and does not expect to receive any in the next three months. Feltl and Company has not been engaged for investment banking services with the subject company during the past twelve months and does not anticipate receiving compensation for such services in the next three months. Feltl and Company has not served as a broker, either as agent or principal, buying back stock for the subject company s account as part of the company s authorized stock buy-back program in the last twelve months. No director, officer or employee of Feltl and Company serves as a director, officer or advisory board member to the subject company. Feltl and Company Rating System: Feltl and Company utilizes a four tier rating system for potential total returns over the next 12 months. Strong Buy: The stock is expected to have total return potential of at least 20%. Catalysts exist to generate higher valuations, and positions should be initiated at current levels. Buy: The stock is expected to have total return potential of at least 10%. Near term catalysts may not exist and the common stock needs further time to develop. Investors requiring time to build positions may consider current levels attractive. Hold: The stock is expected to have total return potential between positive 10% and negative 10%. Fundamental events are not present to make it either a Buy or a Sell. The stock is an acceptable longer-term holding. Sell: Expect a negative total return of at least 10%. Current positions may be used as a source of funds. 11/2/2012 Ratings Distribution for Feltl and Company Investment Banking Number of Percent Number of Percent of Rating Stocks of Total Stocks Rating category SB/Buy 38 58% 0 0% Hold 26 39% 0 0% Sell 2 3% 0 0% % 0 0% The above represents our ratings distribution on the stocks in the Feltl and Company research universe, together with the number in (and percentage of) each category for which Feltl and Company provided investment-banking services in the previous twelve months. Feltl and Company Research Department DexCom, Inc. (DXCM) Page 6

7 06/09/11 Hold Target: $ /04/11 Hold Target: $ /16/11 Buy Target: $ /28/11 Hold Target: $ /03/11 Hold Target: $ /11/12 Hold Target: $ /03/12 Hold Target: $ /08/12 Hold Target: $14.00 Date Nature of Report Rating Price Target 06/09/11 Hold $ /21/11 FDA releases draft guidelines for artificial pancreas Hold $16.25 system precursor 08/04/11 Frustrating CGM adoption rate continues; Q2 beat Hold $15.85 consensus on grant revenue 08/16/11 Still waiting on tipping point but risk-reward becoming Buy $15.35 favorable, upgrading to Buy 10/28/11 Q3 preview cautious on second half 2011, reducing to Hold $10.70 HOLD 10/31/11 Q3 preview correction and FreeStyle Navigator sensor Hold $10.70 update 11/03/11 Q3 earnings disappoint, guidance reduced, reiterate Hold $10.00 HOLD 01/11/12 DexCom unveils 2012 guidance; maintaining HOLD, Hold $9.00 lowering price target 02/24/12 DexCom reports Q4, acquires SweetSpot; reiterate HOLD, Hold $9.00 $9.00PT 05/03/12 DexCom reports Q1 2012; maintaining HOLD, raising PT Hold $10.75 to $ /08/12 FDA clears DexCom s G4 PLATINUM sensor; Edwards inhousing GlucoClear? Hold $14.00 Feltl and Company does make a market in the subject security at the date of publication of this report. As a market maker, Feltl and Company could act as principal or agent with respect to the purchase or sale of those securities. Feltl and Company Research Department DexCom, Inc. (DXCM) Page 7

8 Valuation and Price Target Methodology: We derive our valuation using an EV/sales methodology. We believe this is appropriate being that DexCom will not likely generate positive EBITDA or earnings until late 2013 or early 2014 by our estimates. We have chosen 7.0x EV/sales as the multiple on which to DexCom based upon current high growth medical technology company multiples. Our $14.00 price target represents a 7.0x EV/sales multiple on our 2013 sales estimate. Risks to Achievement of Estimates and Price Target: DexCom s new products do not obtain FDA approval in a timely fashion. The FDA has significantly slowed down its rate of medical device approvals. While we believe management s current submission schedule is reasonable and that the company has far better guidance as to what the FDA will see as approvable, the risk remains that the approvals will continue to slip, causing investors to lose confidence in the company. The CGM industry is likely to become much more competitive. Currently, only DexCom and Medtronic (MDT not rated) have CGM systems that are being sold in the US. Numerous companies are attempting to develop CGM systems, and some have larger budgets and more experience commercializing technology. Abbott patent litigation. DexCom is currently involved in a patent fight with Abbott (ABT not rated) which may result in DexCom being forced into a licensing agreement on unfavorable terms or see its products removed from the market. While we believe that the latter scenario is unlikely to occur, investors may adjust their valuations to account for this possibility as a final decision draws closer. Other Disclosures: The information contained in this report is based on sources considered to be reliable, but not guaranteed, to be accurate or complete. Any opinions or estimates expressed herein reflect a judgment made as of this date, and are subject to change without notice. This report has been prepared solely for informative purposes and is not a solicitation or an offer to buy or sell any security. The securities described may not be qualified for purchase in all jurisdictions. Because of individual requirements, advice regarding securities mentioned in this report should not be construed as suitable for all accounts. This report does not take into account the investment objectives, financial situation and needs of any particular client of Feltl and Company. Some securities mentioned herein relate to small speculative companies that may not be suitable for some accounts. Feltl and Company suggests that prior to acting on any of the recommendations herein, the recipient should consider whether such a recommendation is appropriate given their investment objectives and current financial circumstances. Past performance does not guarantee future results. Additional information is available upon request. Feltl and Company Research Department DexCom, Inc. (DXCM) Page 8

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