By Ee Hsin Kok. Edited by Aniket Bose and Swastik Patel.
On April 1st of 2022, Becton, Dickinson and Company (one of the world’s largest medical technology companies) completed its spin-off of its diabetes care business, Embecta Corp. Listed on the NASDAQ as ticker symbol EMBC, Embecta presents a great opportunity to own a strong reliable cash flow generating machine.
What Embecta Does
Embecta produces and sells diabetes injection devices such as single-use needles for injecting insulin. This is the primary way in which most people with diabetes (PWD) are treated. The company has been selling needles for nearly a century. Currently, they produce approximately 7.6B units annually for over 30 million PWDs (Persons With Disabilities) across 100 countries. They are the global market leader in their industry, with over 50% of the global market share for pen needles, syringes, and safety needles.
Source: Embecta Investor Presentation
Pen needles make up the majority of the company’s revenues (approx. over 70%), followed by syringes and safety needles together making up approximately 25% of revenues.
Understanding the Diabetes Market
Diabetes is a chronic condition that affects over 500 million people in the world today, and is also (unfortunately) expected that this number will reach over 780 million people in the next 25 years. There are two types of diabetes: Type 1 and Type 2.
Type 1 diabetes is usually genetic, and shows up during an early life stage. It is an autoimmune condition where one’s body attacks the pancreas so it cannot produce any insulin in the body. Type 1 diabetes patients are required to immediately start insulin therapy as soon as they are diagnosed.
On the other hand, Type 2 is more of a progressive disease, caused when the body either doesn’t produce enough insulin, or is insulin resistant. There is no specific cause for Type 2 diabetes, but it is known that environmental factors such as diet and activity have an effect on the development of the disease. Type 2 diabetes patients typically start insulin therapy 10 years after their diagnosis. Of all the diabetes patients in the world, around 90% of them have Type 2 diabetes.
There are currently 2 main ways in which insulin is administered: injections and pump. Injections are far more affordable than pumps – a new pump costs thousands of dollars if not covered by insurance, while a yearly supply of pen needles can be bought for under a hundred dollars. Additionally, they have been the standard for a long time (PWDs are used to it), and they allow them to avoid “wearing the disease”. Pumps are more popular among Type 1 Diabetes patients, but the penetration rate among Type 2 Diabetes patients is still in the single digits. However, the penetration rate should increase over time. Embecta estimates that for developed markets, “Pump penetration over the next decade is expected to reach ~55-60% for T1 PWD and ~20-25% for T2 insulin-intensive PWD.” For emerging markets, Embecta believes that injections will still remain the standard of care due to the lower costs.
Embecta was previously run under BD and did not do a lot of reinvestment into itself. As a spin off, Embecta seeks to invest in itself for future growth. This means temporarily lower margins (management is expecting EBITDA margins in the low 30% range by 2024) due to increased R&D (Research and Development) spending. A big part of the increased R&D spending will be on Embecta’s new pump patch product, which hopes to get approval within the next few years. Embecta first started developing this pump in 2016, and it targets the larger Type 2 Diabetes market. As developed markets slowly move toward pumps, this acts as another source of revenue for Embecta as well as a hedge against their main injection business.
Aside from the pump project, Embecta will also steadily grow from the increasing prevalence of diabetes. As mentioned previously, Diabetes is expected to affect 780 million people by 2045, compared to 500 million today. Additionally, due to economic growth in emerging markets, diabetes diagnosis rates and insulin treatment rates will also increase.
Is Embecta a great business?
We have discussed the diabetes market and Embecta’s plans for the future, now let’s take a look at their numbers to see if Embecta has the hallmarks of a great business.
Starting with Return on Invested Capital (ROIC), Embecta is expected to do about 440 million in adjusted EBITDA for FY 2022 on 761 million of invested capital. This comes out to an ROIC of 59% (which is extremely high, far above the low double digit ROICs of the average S&P 500 company).
Next, the company has generated 439 million of operating cash flow in the trailing twelve months, and has only spent 30 million on capital expenditures. This low capital requirement means that Embecta has an extremely high EBITDA to Free Cash Flow conversion rate of over 90%.
Finally, let’s take a look at the debt. Embecta has 9 million in short term debt, about 1.6 Billion in long term debt, and 292 million in cash. This means that Embecta has a Net Debt-to-Ebitda ratio of about 2.9. This ratio is below 3 meaning it is relatively safe, and is not too concerning unless it increases to 4 or above. It would also be ideal to see Embecta pay off some of its long term debt, especially because the ratio is expected to increase as EBITDA margins shrink in the coming few years as more is invested into R&D.
From a qualitative standpoint, Embecta is a highly defensive business with extremely predictable cash flows. Diabetes is a chronic condition, and regardless of economic conditions – whether inflation is high or if interest rates rise, or if there’s a recession – PWDs will continue to use needles from embecta for their Insulin therapy. Additionally, Embecta has a strong moat due its status as the global market leader for insulin injecting needles, and over 2000 patents protecting its intellectual properties and injection technologies.
While Embecta is a defensive healthcare company, there are still risks. The first big risk would be disruption from oral insulin. Oral insulin was a pipe dream in the medical community for a long time, but it appears that dream may soon come true. Oramed Pharmaceuticals, for example, has recently started two phase 3 trials for their oral insulin drug. The results of that first trial will be out in January of 2023. Should oral insulin be approved, it would likely grab a large share of the diabetes market from injections, how fast that could happen is unknown, but it would likely spell bad news for Embecta.
Additionally, Embecta has another risk which stems from their old parent company, BD. As part of the spin-off deal, Embecta entered into a cannula supply agreement with BD. Cannulas are tubes that can be inserted into the body, and hence are an essential component for Embecta’s products. This deal includes clauses for a minimum and maximum amount of cannulas that Embecta can purchase from BD. If Embecta’s annual forecast falls below the minimum required amount, the contract will be terminated; and should Embecta require more cannula than the maximum allowed by BD, they’re not allowed to purchase from another manufacturer, setting a ceiling on their operations.
Embecta’s current share price of $32, with 58.2 Million diluted shares puts the company at a market cap of around 1.86 Billion USD. If we add the Net Debt of 1.3 Billion to the market cap, we get an enterprise value (EV) of around 3.16 Billion. If we divide by the expected 2022 adjusted EBITDA of 440 million, that gives us an EV/EBITDA ratio of 7.18, which is pretty great (An EV/EBITDA ratio below 10 is usually considered a good deal).
Using a discounted cash flow analysis, we model a compression to 30% EBITDA margins by 2024, and use a 90% EBITDA-to-Free Cash Flow rate. Following the low in 2024, we grow cash flows by 3% until 2031. This 3% growth rate represents 2% of historical growth rate from increasing prevalence of diabetes + an additional 1% growth from the type 2 diabetes pump patch product.
From there, we assume a perpetuity growth rate of 2%, as well as a multiple of 12. The terminal value we get is the average of the two assumptions. When we add the present values of future cash flows to the terminal value, and discount them by 10%, we get an intrinsic value of 4.2 Billion in market cap. After subtracting the net debt, it leaves us with an intrinsic value of about 2.88 Billion in market cap. By dividing the 58.2 million diluted shares, we get a fair value share price of $49. We can buy shares of Embecta today for around $32, which represents a 35% discount to intrinsic value.
Embecta is a pure play diabetes company that has been around for over a century. Its main business focus is on making insulin injection devices, but it has also been innovating a pump patch in the next few years. Due to the nature of diabetes being a chronic condition, Embecta is a highly defensive business with extremely predictable cash flows. It is recession-proof and will continue to generate sales regardless of economic conditions. At the current share price, Embecta offers a great opportunity for one to pick up a defensive cash cow at a great discount to fair value.