Description

Thesis

Embecta is a classic orphan spinoff of a small subsidiary of a large company (Becton Dickinson) that was run for cash over the past decade. Embecta’s core business of selling needles used for injecting insulin is extraordinarily stable and has consistently had very high cash flow margins. New management plans on reinvesting the company’s prodigious free cash flow into research and development and small bolt on acquisitions to build out a pipeline of new medical devices targeting diabetes care. The company's most advanced product is a patch pump for Type 2 diabetics which the company has been working on since 2016 and recieved breakthrough device designation from the FDA last year. Trading at ~6x 2022 FCF and (~9x fully rebased 2024 FCF), EMBC’s shares are very cheap and price in no potential success on any of the company’s r&d activities as well as a highly unlikely steep declines in revenues. Growing medical device companies targeting diabetes trade at dramatically higher EV/sales and EV/EBITDA multiples. EMBC shares are likely worth north of $70/share today and potentially significantly more than that if the company is successful in its r&d activities and/or accretively allocates its ample free cash flow. 

Overview

Embecta was the diabetes business of Becton Dickinson. The Spin occurred on 4/1. EMBC is the ticker. EMBC was not included in the S&P 500 so there has been significant technical selling in the first trading days post spin. 

Embecta is the market leader in single use needles used for injecting insulin into diabetics with roughly 67% global market share. 83% of EMBC’s revenues come from selling pen needles (including safety needles) with most of the remainder coming from selling syringes. 

Embecta has been around for over 100 years and has been selling needles for almost 100 years.

Embecta sells 7.6 billion needles a year to roughly 30mm customers (ie around 250 needles per customer at a wholesale price of around $0.13 per needle.)

Embecta is the number 1 global player in each of needles, safety needles, and syringes.

73% of Embecta’s revenues come from the pen needle subcategory which has been growing 

15% of revenues come from syringes.

10% of revenues come from safety needle pins. Safety needle pins have higher prices. 

All of Embecta’s products are FDA approved with significant clinical research supporting efficacy and safety.

Embecta’s products are sold in over 100 countries

U.S. is 52% of revenues, rest of world is 48% of revenues. Emerging markets are 16-17% of revenues. 

Emerging markets are expected to grow mid single digits while developed markets revenues are flat. 

The company has 3 manufacturing plants covering North America, Europe and Asia.

Embecta has significant patent protection

The Diabetes market

Diabetes is a chronic disease and is growing all around the world due to poor diets. 537mm people world wide are diabetics and that is expected to grow to 643mm by 2030. 

Diabetes growth is expected to accelerate in emerging markets over the next 5 years.

There are 2 types of diabetes type 1 and type 2. Type 2 is usually caused by poor diets and is a progressive disease with insulin needs usually starting around 10 years after diagnosis whereas Type 1 diabetics need insulin immediately in order to live. The Type 2 market is about 10x the size of the Type 1 market in terms of the numbers of patients. Diabetes is treated mostly through insulin injections. Once a patient starts insulin therapy they use it for the rest of their life. 

This is a good article on the history of insulin delivery devices.

https://www.ncbi.nlm.nih.gov/pmc/articles/PMC7261311/ 

Needles are the standard of care in most markets but are losing market share to pumps in developed markets especially for Type 1 diabetics. Needles are likely to grow and remain standard of care in emerging markets due to their dramatically lower costs than alternative insulin delivery devices. Needles are much cheaper and easier to use than pumps and don’t require the patient to “wear the disease.”

In addition, in the Type 2 diabetes market, GLP-1 inhibitors (a class of drugs) have delayed the progression of diabetes in many patients. The benefits from GLP-1s appears to be waning potentially suggesting an acceleration in Type 2 diabetics being put on insulin therapy in the coming years.

Diabetics need to be constantly vigilent on their insulin levels. Companies like Dexcom have been very successful selling continuous glucose monitoring devices. Embecta has launched an app with 400k downloads so far, which is meant to help patients have a customized experience with the benefit to embecta of increasing treatment compliance. The app is also envisioned to be the first step in an integrated diabetes management system. 

We believe that this app is a potential predecessor to a larger integrated diabetes management system, and see a potential opportunity to expand our digital offerings, including areas such as integration with continuous glucose monitoring systems, safe and secure data sharing, remote patient monitoring, dosing calculators and food analyzers, among others. As an independent entity, we may pursue investments in these and other digitally enabled diabetes management tools.

Pumps are mostly used in Type 1 diabetics given their complexity and total insulin dose requirements of Type 1 diabetics. Roughly 95% of the pump market today is for Type 1 diabetics and 5% is for Type 2 diabetics.

There are some oral insulin delivery drugs in various stages of clinical trials as well as weekly instead of daily injectible forms of basal insulin working through various stages of clinical trials.

Why is EMBC being spun?

Embecta was run for cash insider of BDX and has not invested nearly as much as other diabetes medical device companies over the past decade. 

Purpose of the spin appears to be to allow this business to significantly increase investment in the business – ie dramatically rebasing margins through increasing emerging market penetration at lower gross margins and increasing r&d investment – especially into pump products. Embecta had 49% EBITDA margins as a division of BDX and that is being rebased to 41% at the time of the spin with a plan to lower EBITDA margins to 30% over the next 3 years in order to reinvest in the business. 

The pure play pump manufacturers have been home run investments in recent years and now trade at huge multiples. Globally 95% of diabetics use needles and 5% use pumps. 

Insulet trades at 79x 2022 EBITDA and 14.4x 2022 Revenues

Tandem trades at 61x 2022 EBITDA and 8x 2022 revenues

Of the needles manufacturers:

Terumo trades at 16x 2022 ebitda and 4.2x revenues

Novo Norodisk trades at 22x ebitda and 10.4x revenues

Ypsomed is probably the best comp to EMBC (with roughly half of revenues coming from injection devices) trades at 21x ebitda and 4.6x revenues

As part of the spin, EMBC management laid out an organic growth strategy of partnering with other players to increase compliance, investing in omnichannel retailing, expanding ecommerce capabilities, and driving conversion to higher value safety needles

In addition, Embecta has breakthrough device designation with the FDA for a patch pump product they are developing that would target the Type 2 diabetes market. BDX starting doing r&d on a patch pump product in 2016 and throughout 2018 publicly stated that they thought the pump would get FDA approval in 2019. In August 2019, after discussion with the FDA, BDX paused development of the patch pump, hired FDA approval consultants, and stopped updating the market on the research progress of the pump. In 2021, BDX received breakthrough device designation for their patch pump product. Embecta management was very coy about the patch pump during the spin off roadshow and investor day. They did not include any revenue from this pump product in their revenue projections. In theory the pump should get FDA approval sometime in late 2022 or more likely in 2023.

BDX has been investing in this pump technology since 2016 but had regulatory delays from the FDA in 2018 which caused them to pull their FDA submission before refiling it in 2021. 

On the FQ3 2019 earnings call, management explained the decision to stop the FDA approval process by stating the following: 

I would like to discuss the type 2 insulin patch pump. As we discussed on our call last quarter, the feedback we received from the FDA was more comprehensive than we had anticipated. Based on this feedback and given the intricacies of this product category, we have decided to withdraw our FDA application and have engaged a third-party R&D partner with expertise in this space while we work through our strategic options. As a result, our previous time line has been extended, and we will provide you with additional information as we make progress.

Management describes the rationale for this pump as follows

 For example, we are working on developing a potential insulin patch pump focused on serving the needs of people living with Type 2 diabetes. We anticipate this insulin patch pump will have an increased reservoir size to hold more insulin and a simplified delivery system compared to existing insulin patch pumps, and overall provide for an improved user experience. 

At the Raymond James conference in March 2021, management noted that it’s been working on the pump discretely over the past couple of years.

Lawrence Soren Keusch, Raymond James & Associates, Inc., Research Division - Managing Director [10]

 Okay. Terrific. Just one more on innovation, then we'll move on. Several years ago, there was a big push certainly and externally to talk a lot about the diabetes franchise. And you obviously talked about it, addressing chronic diseases earlier. You were trying to move into sort of smart pen needles, obviously, the swatch patch pump. Just haven't heard a lot about that as of late, and just wanted to sort of take your temperature on what is the strategy within the Diabetes Care franchise.

Thomas E. Polen, Becton, Dickinson and Company - President, CEO & Director [11]

 Yes. And it's not by accident that we're much on the patch pump where we've been working on it behind the scenes very actively. And stay tuned on that topic. So obviously, we remain a leader. 2/3 of all insulin injections in the world happen with our devices, by far, the largest. We touch more diabetes patients than any other companies on the planet because of that scale and breadth. We're focusing on the type 2 patch pump. It's still advancing behind the scenes. Again, we want to get that further before we came back out and share its new feature set and time line. But stay tuned and work on it.

The pump market for Type 2 diabetes is expected to be around a $1.5 billion market by 2030. Obviously any market share in this market that could be captured by EMBC would radically alter the company’s revenue and EBITDA growth profile.

Infusion

We are investing in the potential development of a continuous subcutaneous insulin infusion delivery system to provide the benefits of insulin pump therapy to a broader population, in particular those with Type 2 diabetes. We believe there is a significant unmet need for alternative treatment options for people with Type 2 diabetes who currently administer insulin via injection yet remain unable to effectively control their diabetes. Some third-party research over the last 10 years has demonstrated improved outcomes of subcutaneous insulin infusion devices over conventional injection insulin therapy. For example, a 2017 article published in Diabetes Metabolism Research and Reviews highlighted insulin pump treatment as a more physiologic method to managing insulin therapy, attaining desired glucose levels and reducing the dose requirement of insulin for people with Type 2 diabetes.

Although insulin pump therapy has the potential to improve glycemic control and quality of life in individuals with Type 2 diabetes, it is not widely used in this population due to the complexity, extensive training requirements, total daily dose limitations and reimbursement issues associated with current insulin pump devices. As a result, we estimate that globally approximately 1% of people with Type 2 diabetes use infusion via a pump to administer insulin. According to the Barclays Medical Supplies and Devices market model, however, the total addressable U.S. market for insulin pump devices for people with Type 2 diabetes could be between approximately $1.5 and $1.7 billion by 2030. We are seeking to develop a potential insulin infusion pump that can be more easily used by people with Type 2 diabetes.

This is how management explained the difference in its pump versus competitors Type 1 diabetes focused pumps at the GS HC conference in June 2018

On Swatch, we're in our second clinical insulin trial for patients. So we've done more with saline, et cetera, but we're now in trials with insulin on type 2 diabetics. All the trials have gone very well. We just met with the FDA last week. Very positive meeting. We're on track to submit to the FDA in the fall of -- this coming fall, again, marching towards the launch in FY '19. Our manufacturing lines are up and running. I mean, we're producing hundreds of them per, I think, it's not 100 per minute, it's hundreds -- it was probably about 1,000 an hour, at least, actually. It's high-volume manufacturing. We're doing this in Ireland. Shipping them over, we're using that now full-scale manufacturing in our clinical trials. And it's something we're really excited about, obviously. It's going to be the first such device in the marketplace doing basal and bolus doses, 3-day wearable type 2 diabetes product. We're not looking at the type 1 space at all. Our product is not designed for type 1. We get that question quite often. There are our other products in the marketplace that are disposable pumps targeted to the type 1 space. They serve that market well. We've designed ours using the capabilities that BD has quite uniquely, of a product that's much lower cost than a type 1 disposable pump, which we think is important for the type 2 space. But we're targeting to price this at parity to current insulin pen-based therapy, right? Because what happens is, when you go to a Swatch, you're not using a long-acting and short-acting insulin anymore. And so you get rid of the long-acting cost, using just the short-acting insulin from a vial that you're pre-filling the pump with. That cost savings basically offsets the cost of the device, from our perspective. So we hear really positive feedback from a payer perspective. We also tend to use, I mean, we're seeing data, 20% to 30% less insulin usage overall as well, with a continuous administration of drug. And that data's been seen in other companies who have had that type of pumping technology, a lower insulin utilization as well. So something we're really excited about.

On the FQ3 2018 conference call management was even more explicit that the BDX pump product’s competitive advantage will be its lower cost

Okay. Okay, Robbie, this is Tom. So for Swatch, we continue to be very excited about the potential of that product, and we continue to make good progress. We are progressing our clinical trials, as we had shared in the past, including the -- we've just completed the analysis of an in-human insulin fusion trial, and that went exactly to plan for us with a very positive response from patients on its ease of use and overall performance. So right now, we're actually preparing to start up our next in-home safety trial, again, using insulin. And we're making good progress overall, gearing up our manufacturing. We've moved that to our Ireland location, where that's going to be the permanent manufacturing location, and we're building our commercial plans at this point in time. So it has been designed specifically for type 2 patients, both from a feature set and an extreme ease of use, right? What really differentiates this product from other types of patch pumps, we think, are the extreme simplicity of the user interface on the digital side and on the hardware side. And so that we've designed to not necessarily have all the bells and whistles that someone with type 1 would want, but that's also allowed us to have a cost position that is very specifically targeted for type 2 patients. So think about cost position that's much more at parity with pen therapy than a significant premium that's typically associated with pump therapy. And that's one of the core value propositions that we hear a lot of excitement from payers on as well, so.

Financials 

Embecta historically has been a very stable business with very high EBITDA margins

Part of the rebasing of EBITDA margins from 49% as part of BDX to 41% at the time of the spin is due to BDX charging EMBC market rates in a separation agreement contract that results in BDX will being a major supplier of cannula to EMBC. 

 For example, in connection with the separation and prior to the distribution, Embecta and BD will enter into a cannula supply agreement, whereby BD will sell to Embecta cannulas for incorporation into Embecta’s products for sale within the diabetes care sector. Cannulas are a component part of a wide variety of medical devices that use needles to deliver fluid into, or through which blood is drawn from, the body. After the separation, BD will retain ownership of all cannula production activities and all intellectual property rights of BD and its subsidiaries relating to cannula, the manufacture thereof and other critical cannula-related technology. The cannula supply agreement will be terminable by BD without cause by providing at least 36 months’ written notice; however, such termination can be effective no earlier than ten years from the distribution date. In the event of a change of control of Embecta, BD will also have the right to terminate the cannula supply agreement. The cannula supply agreement will also terminate automatically, subject to a 36-month wind-down period, if Embecta’s yearly forecast is below the required minimum purchase amount, and the parties will have other customary termination rights for material breach or bankruptcy of the other party. Embecta is also limited to a maximum number of cannulas that it can purchase under the cannula supply agreement. If BD fails to perform under this agreement or BD terminates this agreement in accordance with its terms and, in either case, Embecta cannot find a way to purchase cannula from another party or manufacture cannula, or if Embecta needs to purchase more cannula than it is permitted under cannula supply agreement, Embecta may have insufficient cannulas for its products, which could materially adversely affect Embecta’s business, financial condition or results of operations.

Incremental corporate costs and the cannula supply contract post spin reduce EBITDA margins down from near 50% to the low 40%s. They are guiding to EBITDA margins falling to around 30% in the first 3 years post spin as they ramp up investment in their pump product, invest in sales and r&d and the company invests in building out its own supply chain, regulatory, quality control, procurement, et cetera as well as short term issues around material and supply chain costs. The margin compression is expected to be roughly 500bps of GM compression and 500bps from higher opex. R&D as a percent of sales is expected to rise from 5.5% to 7%. This level of margin compression guidance is likely highly conservative.

Long term guidance assumes 1100bps of EBITDA margin compression resulting in an acceleration of revenue growth to the low to mid single digits – assuming no revenues from their pump product.

Capital Structure

Embecta will have net leverage of 2.8x EBITDA at spin but EBITDA is forecasted to fall the first couple of years post separation – gross debt/2024 ebitda is more like 4.5x (though FCF generation will likely result in debt paydown in the interim period.) 

At the current share price, the stock is trading at 2.7x 2022 revenues and 7.0x 2022 EBITDA. On fully rebased 2024 EBITDA and assuming all FCF is just retained on balance sheet, EMBC is trading at 6.6x 2024 EBITDA. 

A 4.5x revenue multiple similar to Ypsomed would imply a share price around $70/share.

Embecta plans on paying out a dividend equal to 20% of net income which would equate to a dividend of around $1/share annually. 

Capital requirements in the business are fairly minimal

Net cash used for investing activities was primarily comprised of capital expenditures of $37 million, $42 million, and $66 million in 2021, 2020 and 2019, respectively to support further expansion of our business and operations.

Business generates significant FCF

Even with rebased earnings, FCF over the next few years should look something like:

In addition to the dividend, they have said they will look to use their fcf to do bolt on m&a 

Other

The big U.S. health care products distributors collectively makeup 39% of revenues. The 5 largest pharmacy companies are 14% of revenues.

 For example, for the fiscal year ended September 30, 2021, sales to McKesson Corporation, Cardinal Health and AmerisourceBergen Drug Corporation, Embecta’s three largest distributors, together represented approximately 39% of Embecta’s worldwide sales.

EMBC’s CEO was brought in during bankruptcy to reposition his last company Cardiac Science Corporation before it was sold to ZOLL Medical. 

Devdatt (Dev) Kurdikar, 53, serves as the Worldwide President of Diabetes Care at BD. Previously, Dev was the President and CEO of Cardiac Science Corporation (CSC), a global leader in the manufacturing and marketing of automated external defibrillators (AEDs) for public access, education, police, and fire and rescue markets. CSC had been acquired by a private equity firm via bankruptcy proceedings, and under Dev’s leadership, CSC returned to profitable growth and was sold in a successful exit to ZOLL Medical.

Catalyst

Technical selling related to the spin off ends. Company is discovered by investors. Company formally announces its dividend plans. Bolt on acquisitions build the company's pipeline. Share buybacks. 

FDA approval of Embecta's patch pump for Type 2 diabetes