DexCom: 120 Times Free Cash Flow Is Still Unreasonable (NASDAQ:DXCM)

When looking for stocks about which I have been terribly wrong over the last few years, DexCom (NASDAQ:DXCM) is certainly a candidate – at least considering the stock performance. Since 2018, I published three articles about DexCom and in all three articles I was bearish about DXCM stock and rated it as “Sell”. However, the stock continued to move higher and not only outperformed the S&P 500 (SPY), but an investment in DexCom would have generated a return of 453% over the last five years and a return of 2,240% over the last ten years.

My problem in the last few years was not the fundamental business of DexCom – the business is solid – but rather the extremely high valuations DexCom is trading for. Of course, high growth rates also justify higher valuation multiples, but in my opinion DexCom is still not a good investment (although I have been wrong in the last few years). In the following article, we take a closer look at DexCom again.

Valuation

And we start by looking at the valuation multiples. I have been wrong about the stock in the last few years, but that does not mean the downside risk for the stock was never an issue or is contained. DexCom continues to trade for extremely high valuation multiples – and the risk of multiples contracting is still an issue and a huge red flag in my opinion.

We can start by looking at the price-free-cash-flow ratio and DexCom is trading for 121 times free cash flow. In my opinion, such a valuation multiple can’t be justified for any company – no matter the growth rates.

Additionally, we can also look at the price-sales ratio which is 16.7 right now and therefore even above the ten-year average of 15.24. And once again, I don’t know how to justify such a valuation multiple for any business.

In the last few years, DexCom’s fundamental performance was great and therefore it is justified for the stock to grow at a high pace. But DexCom did not grow “into its valuation” – the stock is still trading for extremely high valuation multiples and therefore the risk of a multiple contraction leading to much lower stock prices is still extremely high.

Quarterly Results

Of course, we can’t discuss valuation multiples in isolation. We also must look at the performance of the business and especially the growth rates the business can achieve.

We start by looking at the last quarterly results, which were still great (despite economic challenges and several companies beginning to struggle). Revenue increased from $628.8 million in Q1/22 to $741.5 million in Q1/23 – resulting in 17.9% year-over-year growth. On an organic basis, DexCom could report 19% growth. Operating income also increased 14.3% year-over-year from $41.3 million in Q1/22 to $47.2 million in Q1/23. Only diluted net income per share declined from $0.23 in Q1/22 to $0.12 in Q1/23 – a decline of 48%.

And not only did DexCom report solid results for the first quarter, the company also raised its guidance for fiscal 2023. Now, DexCom is expecting revenue to be between $3,400 million and $3,515 million (resulting in 17% to 21% year-over-year growth). Additionally, management is expecting non-GAAP operating margin to be approximately 16.5%.

Growth Slowing Down

But we should not just look at the last quarterly results or the guidance for the next fiscal year. Instead, we should look at the bigger picture and when looking at the last ten years, we see growth rates – in this case: top line growth – slowing down over time. Don’t get me wrong, this is not problematic and a pattern we see almost always when companies are getting bigger and more mature over time. When looking at the 3-year average revenue growth rate, DexCom reported almost a 60% revenue CAGR in 2015 and that number slowed down to about 25% in 2022. Of course, these are still impressive growth rates.

Revenue growth slowing down is certainly not a problem – but it is also important that the lower growth rates are also reflected by expectations for the coming years. And when looking at analysts’ estimates, growth rates slowing down is reflected by the numbers. While revenue growth expectations for fiscal 2023 are still about 20%, top line growth is expected to be only about 11% to 12% in ten years from now.

And although analysts are expecting growth rates to slow down, DexCom is still seeing several growth opportunities in the years to come. One strategy would be to grow DexCom’s international business by entering new geographies and markets. Additionally, DexCom will focus on reducing administrative barriers as well as on gaining reimbursements.

However, we should also keep in mind that CGM systems are rather expensive and cost several thousand dollars every year for every patient and not many countries are wealthy enough to pay for such immense monthly or annual costs.

Aside from growing its international business, DexCom will also try to focus on new customer groups in the United States – including people with pre-diabetes and gestational diabetes as well as type 2 non-insulin diabetics. Especially the type 2 non-insulin market would be huge, but in my opinion, it is extremely speculative if DexCom can enter these markets as I don’t see the necessity for CGM systems in this case and insurance companies might not pay.

I already wrote about these problems in a previous article:

Of course, it is absolutely unrealistic to assume every diabetic is a potential customer. We have to differentiate between type 1 diabetics and type 2 diabetics and while type 2 diabetics might use a CGM system, the main target group are type 1 diabetics which make up about 5% of the total number. Additionally, many diabetics live in countries that can’t afford to spend $3,000-4,000 “just” to measure the blood sugar level. For these people, insulin or maybe an insulin pump is far more important. And finally, to buy and use DexCom’s system you must care about your disease and really be motivated to control it – and although insurance companies might pay, not every diabetic might care enough to spend money on a CGM system.

Of course, there is the chance that I am wrong and maybe I continue to underestimate the growth potential of DexCom (and its peers) in the years to come. Different studies are also expecting the CGM market to grow with a high pace – but not at astronomically high rates. Most studies are seeing the market growing in the low-to-mid teens in the next few years (see here and here for example). However, when looking at analysts’ estimates for the years to come, DexCom is still expected to outgrow the market (despite growth rates slowing down) and to achieve that goal DexCom must gain market shares.

Problem: Competition

But considering intensifying competition, it remains to be seen how much additional market share DexCom can gain. Not only are Medtronic (MDT) and Abbott Laboratories (ABT) two serious competitors (I mentioned this already in past articles), Apple (AAPL) might also have entered the ring again. Speculations that Apple might introduce its own CGM system at some point are nothing new (I already wrote about it in 2017), but it remained questionable if Apple would actually achieve this goal.

And although it might still take several years before Apple could enter the market, it seems like the company from Cupertino managed to have a breakthrough towards its goal to have blood glucose tracking on its Apple Watch. Of course, we don’t know anything yet about prices, but as the Apple Watch is cheaper and has much more functionality, this would most likely be a serious competitor for DexCom. Especially as DexCom is also trying to target type 2 non-insulin diabetics, Apple might be a serious competitor – as well as for the health and wellness market. These people might rather use an Apple Watch (in my opinion) as it is offering much more functionality. DexCom can only measure blood glucose levels and nothing else.

Aside from the medical devices companies (and Apple) there is even more competition we should not ignore. When DexCom is trying to target the non-insulin type 2 diabetics, it might also enter into competition with Novo Nordisk (NVO) and Eli Lilly (LLY). Especially Novo Nordisk is extremely successful with Ozempic – its weight loss drug. And if type 2 diabetics manage to lose weight – no matter if this is achieved by exercise, different eating habits or drugs like Ozempic – the demand for CGM systems might decline and many non-insulin type 2 diabetics might not see a CGM system, as necessary.

Problem: Recession

Another problem could be the looming recession. DexCom as medical device company could be seen as rather recession-resilient, and sales will probably remain stable even during an economic downturn. But first, it remains questionable if DexCom can keep up high double-digit growth rates during a recession. And especially as DexCom is targeting other diabetics – like type 2 non-insulin diabetics – it remains questionable how necessary a CGM actually is (and if these people will keep purchasing a CGM system during a recession when thy have to pay for themselves). All in all, I would see DexCom as more or less recession resilient but I would not calculate with growth rates of 10% or even 20% during a recession.

Intrinsic Value Calculation

The biggest remaining problem about DexCom as an investment is the unreasonable stock price that is not matching fundamentals. I already mentioned above that DexCom is trading for triple digit valuation multiples (P/FCF ratio) which is never a good sign.

But to underline how overvalued DexCom is, we can also use a discount cash flow calculation. As basis for our calculation, we take 418.5 million outstanding shares and the free cash flow of the last four quarters, which was $416 million. And as always, I assume 6% growth till perpetuity starting in 10 years from now. I never use a higher growth rate and in case of DexCom we can argue once again if higher growth rates might be justified. But we don’t know what will be in 10 or 20 years from now and assuming 6% growth till perpetuity is already optimistic.

When calculating with these assumptions, DexCom must grow between 28% and 29% in the next ten years to be fairly valued right now (assuming a 10% discount rate). And even when assuming top line growth combined with improving margins, almost 30% growth for ten years straight are extremely optimistic assumptions. Other investors might be different in their investment approach, but I simply don’t want to invest in such a company. By the way, these might be the highest growth rates necessary for a stock to be fairly valued among all the stocks I am covering.

Additionally, I don’t see any reason why I should invest in DexCom in the hope for the investment paying off when there are countless other investment opportunities. Right now, there are hundreds of other stocks I can chose, that seem less like a gamble to me. And considering the increasing competition, the potential recession and analysts seeing growth rates slowing down further, I can’t bet on almost 30% growth for the next ten years.

Conclusion

I don’t want to short DexCom. Especially the last few years have demonstrated how dangerous shorting can be. But I would still rate DexCom as a “Sell” and the company is certainly not an investment in my opinion – the risk of losing money over the next few years is rather high. DexCom seems like a good and solid business, but buying a stock that is trading for more than 100 times free cash flow seems like a gamble to me.

Additionally, we have the risk that we don’t know what will happen in a recession. Despite being a medical device company – and those companies usually perform well during a recession – I would not bet on DexCom being able to keep up the high growth rates over the next few quarters.

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