By Jason Napodano, CFA

Earlier today, Zacks initiated coverage of LabStyle Innovations Corp. (DRIO) with a Buy rating. LabStyle is a healthcare technology company that has developed an ultra-convenient, affordable, and easy-to-use glucometer for the self-monitoring of blood glucose in patients with type-1 or type-2 diabetes. The device, called Dario, is of elegant design, with outstanding usability and accessibility by integrating a pocket-sized glucometer with a smartphone and mobile application. Dario combines a lancing mechanism, disposable strip cartridge, and glucose monitor with attached plug for insertion into a smartphone audio jack.

Management anticipates the commercial launch of Dario in the European Union in the second half of 2013. A U.S. 510(k) application as a Class-II medical device is also expected in the second half of 2013, which if approved, could lead to the U.S. launch in 2014. We see the Dario glucometer and diabetes management system as revolutionary in design and function. Dario, along with sales of disposable test strips, mobile applications, and community and physician interaction software, represents a $1 billion peak worldwide opportunity for LabStyle Innovations. We have built a detailed financial model to capture this opportunity, and conclude that the shares are worth significantly more than today. Our target is $12 per share.

Quick Diabetes Backgrounder

Diabetes mellitus, or simply, diabetes, is a group of metabolic diseases characterized by high blood glucose levels that result from defects in the body's ability to produce and/or use insulin. The defect usually stems from a dysfunction of the pancreas to either produce insulin, or because cells do not respond to the insulin that is produced. The primary manifestation of the disease, high blood glucose levels, has far-reaching implications in classical symptoms, including polyuria (frequent urination), polydipsia (increased thirst) and polyphagia (increased hunger).

Diabetes is classified into three broad categories: type-1 diabetes, type-2 diabetes, and gestational diabetes. A fourth category, called pre-diabetes, is also considered important from a clinical perspective, and may be the largest patient population.

Type-1 Diabetes: Type-1 diabetes is usually diagnosed in children and young adults, and was previously known as juvenile diabetes. In type-1 diabetes, the body does not produce insulin, most commonly the result of the body’s own immune system destroying the insulin-producing cells of the pancreas called beta cells.

Normally, the hormone insulin is secreted by the pancreas. When you eat a meal, sugar (glucose) from food stimulates the pancreas to release insulin. The amount that is released is proportional to the amount that is required by the size of that particular meal. Insulin's main role is to help move certain nutrients, mainly sugar, into the cells of the body's tissues. Cells use sugars and other nutrients from meals as a source of energy to function. The amount of sugar in the blood decreases once insulin transports sugar into the cells. In non-diabetic individuals, that signals the beta cells in the pancreas to lower the amount of insulin secreted so that low blood sugar, called hypoglycemia, does not develop. But the destruction of the beta cells that occurs in patients with type-1 diabetes disrupts this process. In people with type-1 diabetes, insulin is not available to transport sugar into the cells. The result is that sugar builds up in the blood. A high blood sugar level is called hyperglycemia. Hyperglycemia causes the body's cells to starve for nutrients. Thus, other systems in the body must provide energy for important bodily functions.

Hyperglycemia can cause dehydration due to increased urination as the body attempts to clear the high sugar levels from the body. Hyperglycemia may also result in weight loss due to the frequent urination and the lack of the body’s ability to take up sugar (calories) and turn it into energy. Diabetic ketoacidosis (DKA) is another common side-effect of frequent hyperglycemia, and results when the body breaks down fat cells for energy in the absence of the ability to turn sugar into energy. Fat cells contain acidic molecules called ketones. When ketones build up in the blood, the liver releases sugar to counter the high acid level. Unfortunately, this only compounds the problem.

The combination of dehydration, frequent urination, and acid build-up in the body is known as ketoacidosis. Over time, hyperglycemia and ketoacidosis can create damage to the nerves and small blood vessels of the eyes, kidneys, and heart. According to the American Diabetes Association, eye problems occur in about 80% of adults with type-1 diabetes. Kidney damage is also common, occurring in about 20-30% of type-1 diabetes over time.

Diabetics are also predisposed to atherosclerosis of the arteries and hypertension (high blood pressure), two major causes of heart attack and stroke. Poor blood circulation due to hardening of the arteries and nerve damage due to high blood glucose levels causes problems in the feet. This can lead to increased risk of injury and decreased ability to heal open sores and wounds, which in turn significantly raises the risk of diabetic foot ulcers.

Type-2 Diabetes: Type-2 diabetes, once called non-insulin dependent or adult-onset diabetes, is the most common form of diabetes and affects approximately 90% of all diabetics in the world. Similar to type-1 diabetes, type-2 diabetes is a metabolic disorder that is characterized by high blood glucose in the context of insulin resistance and relative insulin deficiency. This is in contrast to type 1 diabetes, in which there is an absolute insulin deficiency due to destruction of islet cells in the pancreas. However, the symptoms of type-2 are similar, in polyuria (frequent urination), polydipsia (increased thirst) and polyphagia (increased hunger). Yet, unlike type-1, obesity is thought to be the primary cause of type-2 diabetes in people who are genetically predisposed to the disease.

Gestational Diabetes: Gestational diabetes is a condition characterized by high blood sugar (glucose) levels that is first recognized during pregnancy. The condition occurs in approximately 3-5% of all pregnancies, and may improve of disappear after delivery; or it may develop into type-2 diabetes, which occurs approximately 25% of the time.

Though it may be transient, untreated gestational diabetes can damage the health of the fetus or mother. Risks to the baby include macrosomia (high birth weight), congenital cardiac and central nervous system anomalies, and skeletal muscle malformations. Increased fetal insulin may inhibit fetal surfactant production and cause respiratory distress syndrome. Hyperbilirubinemia may result from red blood cell destruction.

…Treating Diabetes…

Diabetes is a chronic disease, for which there is no known cure. The primary goal in the treatment of diabetes is management of blood glucose control, either through diet and exercise or medications, such as supplemental insulin or other anti-diabetic agents. The American Diabetes Association (ADA) recommends that diabetics check their blood glucose level daily, or more depending on the severity of the disease. The ADA also recommends patients check their A1C (average blood glucose control) and ketone levels. Understanding blood sugar levels and monitoring risk factors is paramount to maintaining stable disease.

Supplemental insulin is standard of care for type-1 and some type-2 diabetics. There are 20+ different types of insulin sold in the U.S. They differ in how they are made, duration of action, mode of administration, and dosing strategy. For example, fast-acting insulin analogues (aspart, lispro, glulsine) begin to work in 5 to 15 minutes and remain active for 3 to 4 hours. This may be ideal immediately following a meal. Other, intermediate-acting insulins may take 1 to 3 hours before they begin to work, but last in the blood for 18 to 24 hours. This is useful for daily glycemic control in patients with severe diabetes. Long and ultra-long acting insulins (glargine, detemir, degludec) may last for longer than 24 hours and provide improved glycemic control and convenience of less frequent dosing. Sanofi’s Lantus (insulin glargine), the leading long-acting insulin, posted sales of €4.9 billion ($6.1 billion) in 2012.

Besides insulin, there are a host of anti-diabetic medications on the market designed to lower blood glucose levels; some of which are oral and others which are injectable. Metformin is a first-line, oral, anti-diabetic drug that works by suppressing glucose production by the liver. Besides solid glycemic control and outstanding safety and tolerability, metformin has been shown to reduce LDL cholesterol and triglycerides, and is not associated with weight gain. As such, it is the most widely used anti-diabetic medication in the world. Sulfonylureas (glimepiride, glyburide) are another widely used anti-diabetic medication. These drugs work by stimulating insulin release by the pancreatic beta cells. The drug has modest efficacy with a low adverse event profile, but causes weight gain and risk of hypoglycemia. Thiazolidinediones (pioglitazone, rosiglitazone), or TZD’s for short, are oral medications that work to reduce insulin resistance by activating PPAR-g in fat and muscle cells. These drugs gained sizable market share in the 2000’s based on low risk of hypoglycemia and convenient dosing. However, TZDs have been associated with increased weight gain, edema, anemia, and increased risk of heart failure (rosiglitazone) and bladder cancer (pioglitazone). One TZD, troglitazone, was withdrawn from the market in 2000 because of an increased risk of liver toxicity. The leading TZD, Takeda’s Actos (pioglitazone), posted sales of $4.5 billion in 2011.

Dipeptidyl peptidase-4 inhibitors (sitagliptin, vildagliptin, saxagliptin, and linagliptin), or DPP-4 inhibitors for short, are a new class of anti-diabetic agents gaining popularity due to powerful efficacy, convenience of oral dosing, and lower potential for weight gain. The mechanism of DPP-4 inhibitors is to increase incretin levels (GLP-1), which inhibit glucagon release, which in turn increases insulin secretion, decreases gastric emptying, and decreases blood glucose levels. Several DPP-4 agents have been co-formulated with metformin to improve glycemic control and enhance convenience of dosing. Merck’s DPP-4 inhibitor, Januvia (sitagliptin), posted sales of $4.1 billion in 2012. A combination Januvia + metformin product, Janumet, posted sales of another $1.7 billion. Injectable anti-diabetic agents that target a similar pathway, GLP-1 activation, include exenatide and liraglutide. Both agents have low risk of hypoglycemia and strong glycemic control. For both DPP-4 inhibitors and GLP-1 agonists, safety and tolerability remain in question.

We discuss insulin therapy and anti-diabetic agents because use of these medications is in conjunction with lifestyle management, which centers on diet and exercise, and the monitoring of blood glucose, which is often performed by the diabetic patient themselves. Self-monitoring of blood glucose (SMBG) is a key component of the current treatment regimen for diabetes. Physicians recommend SMBG to as a precursor to taking insulin or other anti-diabetic medications. Taking too much insulin, or overdosing on Actor, Januvia, or Byetta can cause hypoglycemia. Not enough, and a patient can develop hyperglycemia and ketoacidosis. The key to effectively using all the medications discussed above is having timely and accurate information about blood glucose levels.

Self-Monitoring of Blood Glucose

The American Diabetes Association (ADA) notes SMBG as an important component of modern therapy for diabetes mellitus. The goal of SMBG is to enable maintenance of a more constant glucose level by more precise, and in some cases, real-time information about blood glucose levels. SMBG can be used to aid in the adjustment of a therapeutic regimen in response to blood glucose values and to help individuals adjust their dietary intake, physical activity, and insulin doses to improve glycemic control on a day-to-day basis. According to Dr. Evan M. Benjamin, MD, FACP, Director of Healthcare Quality at Baystate Medical Center and assistant professor at Tufts University School of Medicine, “Judicious use of SMBG data can help to improve glycemic control, select an anti-diabetic regimen, and provide powerful feedback to patients wishing to improve metabolic control.” In 2008, the ADA concluded and published in its Standard of Medical Care, that blood glucose monitoring helps in the planning of meals, activities, and at what time of day to take medications. As a result, use of SMBG devices has soared in the past decade. Approximately 10-20% of all diabetics use SMBG devices, the majority of which are type-1 diabetics.

SMBG is achieved by use of a blood glucose meter, or glucometer. A glucometer is a medical device that analyzes a small drop of blood, obtained by pricking the skin with a lancet. The blood is put on a small disposable test strip and then inserted into the glucometer. A glucometer test kit includes the lancing device, the glucometer itself, and disposable test strips. The design of glucometers is simple and has not changed much in the past three decades.

Since first developed in the early 1980’s, there hasn’t been much innovation in glucometers. Most all look and function the same. Although there has been improvement in size, battery power, testing strips, lancing device, blood sample sizes, and testing times, the progression of glucometers over the past three decades has been more one of evolution than revolution. Devices are getting small, lighter, and faster, but the devices on the market today generally operate under the same principle and mechanism as the ones first introduced in the 1980’s, only with a few more bells and whistles.

But given the relative lack of differentiation on software and user-experience, handheld glucometers, like the ones pictured to the above, compete mainly on price. When consumer products begin to complete on price, margins begin to shrink. In turn, innovation ceases and products become ordinary. They all look and function the same. They are not aesthetically pleasing and most are made of cheap plastic materials with poor ergonomics and cumbersome software.

Contrast the relatively slow evolution in handheld glucometers of the past two to three decades with the revolution in the cellular phone industry. Cellular phones in the 1980’s and 1990’s were large, undifferentiated, cumbersome, poorly made electronic devices. The main players, Nokia, Sony, Motorola, Ericsson, and Telco have almost all now exited the business because they kept making the same old poorly designed cell phones year after year. New entrants, like Apple, Samsung, HTC, and Google revolutionized the industry by combining quality, ergonomically designed devices, with outstanding software that not only dramatically improved the capability of the devices, but also improved the user experience. Cell phones of today, now called Smartphones, are ubiquitous devices that compete on technology, aesthetics, and emotional attachment.

Enter Dario – Blood Glucose Monitoring For A Mobile Age

LabStyle Innovations Corp. has developed a leap forward for glucometers and diabetes management systems. The product, called Dario, wipes clean the un-original thinking that plagues the bulky, cumbersome, and uninspiring glucometers that are on the market today. Dario is a compact, simple, elegant device that combines all of the components of a glucometer test kit – the lancing device, test strip and cartridge, and glucometer – with play-and-play integration into leading smartphones on the market.

(1) Lancing Device: Dario uses an ultra-thin lancet for comfortable blood sampling of only 0.3 ul.

(2) Strip Cartridge: Each strip cartridge holds 25 strips. It’s easy to pull out one strip at a time (using the built in roller that dispenses one strip at a time), and to replace the cartridge with a new one.

(3) Meter: The meter pulls out of the Dario device and easily connects to a smartphone headphone socket. Once connected to the smartphone, the meter automatically syncs with the Dario application.

Dario aims to replace stand alone, self-powered glucose meters and kits, which often include three separate components. We see several key advantages of the Dario device over conventional glucometers on the market:

- Ergonomics: The Dario is made of high quality material with outstanding look and feel. The entire device is roughly the size of a pack of gum, and fits handling in the users pocket or purse.

- Integration: The Dario is made with the same state of the art electro-chemical, blood-based measurement techniques as standard glucose monitors and offers familiar usability. Dario is easily integrated with the patient’s own smartphone (play-and-play) and accompanies application.

- Convenience: Dario has an integrated lancing device and disposable strip cartridge. This eliminates the need for a separate glucose monitor, lancing device and strip bottle and, we believe, makes Dario the glucose device with among the smallest footprint in the market.

- Usability: The Dario device comes with a smartphone application (available on iOS and Android) that launches automatically when the meter is inserted into the headphone jack. The software application is key to the Dario user experience. The application incorporates tools to help diabetic patients manage their disease. We discuss the application in greater detail below.

- Applicability: According to Nielsen, 55% of new cell phone buyers purchase a smartphone. Almost half of all cell phone users own a smartphone, with the number growing each year. There are 350 million diabetics worldwide, 10-20% of which are insulin-dependent and test their blood with a glucometer daily.

…The Dario Application…

Besides the Dario device, LabStyle will make Dario available with an integrated application for smartphones (currently available on iOS and Android). As noted above, the Dario meter works seamlessly with the smartphone application. Dario device owners can simply download the application and it will sync automatically with the meter when the meter is connected via the headphone jack. The application software creates a new ecosystem, similar to the ecosystem that Apple (AAPL) has created around iTunes, that keeps the user fully connected to the platform. Similar to the advantages of the device, the application software offers unique advantages for the diabetic patient:

- Results: The Dario meter and application makes monitoring blood glucose fast and easy. LabStyle’s product motto for Dario is, “Glucose Monitoring for the Mobile Age.” Smartphone users carry around their phones everywhere they go. The small and lightweight Dario enables SMBG on-the-go.

- Data Sync: The application logs each activity, allowing the user to track their blood glucose levels over time. The log provides valuable information to the user on glycemic control throughout the day or week or month.

- Tools: Beside blood glucose monitoring, the application also allows the user to input carbohydrate and food consumption, and track medication use and physical activity. The Dario application aims to be an all-encompassing tool for the management of diabetes.

- Sharing: The application includes a cloud-based data center, allowing the user to access the log on their desktop, tablet, phone, or send to their physician, pharmacist, or insurance company via email.

Screen-shots of the Dario Application are seen below:

…The Dario Ecosystem…

Above we related the potential for LabStyle to create an ecosystem around Dario similar to what Apple has created around the iPhone and iTunes. Because the Dario device is so small and compact, we expect that user compliance will be high when compared to stand alone, self-powered glucometers that require a separate lancing mechanism and test strips. The seamless integration with a smartphone application that syncs via cloud-based computing to a data center allows the user to store, track, and analyze their blood glucose information. The data can be exported and sent (via email) to the patients physician, dietitian, pharmacist, insurance company, or other care-giver.

Similar to consumers that have either embraced the Apple or Google smartphone platform, we believe once a user enters the Dario ecosystem, LabStyle has the potential to hold onto the user for an extended period of time, far beyond the typical useful life of a self-powered glucometer. LabStyle can also capture additional revenues from the patient through the proprietary sale of Dario disposable test strips and patient data.

LabStyle believes its disposable test strips are among the best strips available on the market today. The strips allow for blood glucose readings in 5 seconds with only 0.3 ul of blood. There is no coding involved. The Dario device utilizes an oxidase biosensor with a wide range of analysis (10-600 mg/dl).

The Dario cartridge holds 25 test strips. LabStyle plans to be the only supplier of these proprietary strips, and sell them direct to consumers (online) and partner with distributors. We note the company has contracted with a Korean supplier to supply the test strips, connectors, and other related components of the Dario device. We think that management will look to contract for additional supply in time.

This kind of razor / razor blade strategy is a proven business model that offers high margin, high customer retention. Data shows that some type-1 diabetes test their blood up to 8-10 times a day. LabStyle will work to gain full insurance reimbursement for the test strips after approval, further solidifying the revenue stream once the patient enters the Dario ecosystem.

We also see the potential for LabStyle to monetize the patient data generated by Dario users. LabStyle expects to offer information to contract research organizations, pharmaceutical companies and perhaps other medical device companies to aid in trial recruitment and market analyses, and to provide information regarding food and exercise regimens and their effects on blood glucose levels.

Commercializing Dario

In October 2012, LabStyle completed clinical trial to test the usability of Dario. The goal of this trial was to facilitate regulatory applications in Europe and the U.S. The trial was designed to assist first time users of the Dario device to use it under minimal guidance materials (i.e. quick user guide and iPhone App) in an effort to demonstrate how the use of the Dario device and related software could potentially improve patient care and diabetic compliance. The trial also attempted to capture and understand the potential weaknesses of the device and introduce methods of overcoming them to the users, and to establish the proposition that any user can operate the device compared to other devices on the market.

The study was performed in Israel with the prototype of the Dario product, with its basic functionalities combined with a simulating program for the smartphone. A total of 61 patients under varied diabetic conditions participated in the study (ages 8 to 80). The subjects were recruited from the diabetes clinic at Wolfson Medical Center in Tel Aviv. Over 95% of the patients completed the study.

…Regulatory Submissions…

Data from the study noted above was included in the European CE Mark regulatory filing, which took place in the fourth quarter of 2012. For sale in Europe, the device must display a CE Mark before they may be imported or sold and must comply with the requirements of the European Medical Device Directive (MDD) or the Active Implantable Medical Device Directive / In Vitro Diagnostic Directive (IVDD). LabStyle believes that Dario will be regulated under both directives. Management will also have to obtain International Organization for Standardization, or ISO-13485 certification. ISO is an internationally recognized quality system and recognized by applicable authorities of an EU Member State. EU regulators conducted the first audit of the company in October 2012, and management is currently in the process of completing additional technical filings to be sent for examination. The company is hoping to receive EU CE Mark certification around the middle of 2013, with the initial launch planned for Germany and the U.K., followed by Belgium and Scandinavia.

In the U.S., LabStyle believes that Dario will qualify as a Class-II medical device and must comply with FDA regulations on product design and development, pre-clinical and clinical testing, manufacturing, labeling, storage, pre-market clearance or approval, advertising and promotion, and sales and distribution. We believe this makes sense given that all new glucometers are regulated in a similar fashion. Approval of a Class-II medical device can be accomplished through a 510(k) premarket notification application or through a Section 515 premarket approval application (PMA). LabStyle believes they will be able to file for Dario under the shorter, less expensive, 510(k) pathway. A 510(k) submission must provide information supporting its claim of substantial equivalence to a predicate device. The submission will also include data from the 61-patient study noted above.

We believe this makes sense, as the FDA permits low risk medical devices to be marketed without requiring the manufacturer to submit a PMA. We expect the review of the Dario device following the 510(k) submission to be quick and eventless. We expect this submission in the second half of 2013. However, if the FDA does require a PMA submission or regulates Dario as a Class-III medical device (highly unlikely), LabStyle will need to conduct additional U.S. human clinical trials to compile the necessary data. This would add significant cost and time to the U.S. approval of the product.

Outside the two major markets of the U.S. and EU, LabStyle may seek to obtain regulatory clearance in certain attractive markets, including Japan, India, South Africa, Russia, and Brazil. The primary focus is on large market opportunities outside like Japan, India and Brazil. With respect to Brazil, all medical devices imported into or distributed must first be registered with the Agência Nacional de Vigilância Sanitária, also known as ANVISA or the National Health Surveillance Agency. However, only companies based in Brazil can apply for ANVISA registration. Therefore, LabStyle will have to either create a Brazilian subsidiary or partner with a Brazilian-based third party to obtain ANVISA and distribute Dario in Brazil.

…Marketing & Sales…

LabStyle Innovations plans to make Dario primarily an Internet-driven product, with direct-to-consumer marketing and distribution that seeks to reduce the reliance on traditional retail channels. Besides being a cost-effective approach, it eliminates the battle for shelf-shape and pricing wars that persist when undifferentiated consumer products battle for market share at superstores selling, soup, nuts, and Class-II medical devices. We believe this strategy makes sense considering Dario was designed for the “mobile age” and is coupled with a downloadable smartphone application and a cloud-based data hosting and sharing platform.

We suspect that, much like early-adopters of smartphones, Dario users will be technology-oriented, device and social-media savvy, and amenable to a potential paradigm shifting ecosystem for managing their disease. Thus, we believe Dario lends itself well to this type of direct to consumer, online distribution plan. The goal for LabStyle will be to create effective brand awareness with a significantly reduced use of our capital resources versus the amounts required via the traditional, offline retail channels. That being said, we do expect the company to use some aspects of distributor networks and revenue-sharing affiliates. We suspect these types of relationships will pay-for-performance and include well known online commerce websites.

We expect the initial marketing will be focused on the younger population of diabetics, then gradually broaden the marketing efforts toward the older population, where diabetes is even more prevalent. Management plans to initially focus on insulin dependent (mainly type-1) diabetes patients. Market research shows that, while this population constitutes about 10% of the diabetic patient population, it is responsible for over 50% of the revenue from blood glucose monitoring devices.

Intellectual Property

In May 2011, company founders filed a Patent Cooperation Treaty (PCT) application for a “smartphone based glucose and other body fluids content monitor” (PCT/IL2011/000369) which incorporates two U.S. provisional patent applications submitted in 2010. These applications and all related intellectual property were transferred to LabStyle Innovations Corp. by company founders in October 2011.

The PCT covers the specific processes related to blood glucose level measurement as well as more general methods of rapid tests of body fluids. The PCT has been converted into several national phase patent applications. With respect to PCT/IL2011/000369 for two U.S. provisional patent applications, management claimed the patent priority dates of September 5, 2010 for patent application no. 61/332,778 and November 1, 2011 for patent application no. 61/431,449. Management has advanced patent applications of PCT/IL2011/000369 outside the U.S., including in Israel, Europe, India, South Africa, Australia, China, Japan and Brazil.

With regards to company technology, management is continuing its pursuit of patent protection and are preparing for regulatory filings in multiple jurisdictions of both the Dario device and related software. Management is also preparing numerous additional patent filings related to the core technology and anticipated future generations of the Dario product. LabStyle is in the process of defining the final design of the initial Dario product and continuing development of the software through both internal and outsourced resources. In addition, management is seeking to develop new intellectual property around future generations of Dario hardware and software with the goal of achieving enhanced functionality, user interface and data usability. However, investors should keep in mind that patents have not been granted by any of applicable regulatory authority.

Future Products

Dario and its related Intellectual Property represent a platform for mobile rapid diagnostics. Numerous indications are noted in its IP filings, each representing a significant opportunity. These include blood coagulation test (PT/INR), a global market of $700M, HIV tests and monitoring, a $1 billion opportunity, and other such as pregnancy and cholesterol tests, each a greater than $1 billion opportunity.

Risk – Competition

We see Dario as a significant leap forward in glucometers and diabetes management. It is an elegant design and offers the users an improved experience and monitoring capabilities thanks to the software application and ecosystem that management is attempting to build around the entire platform. That being said, LabStyle is entering a highly entrenched market, with major market competitors, including Roche, Bayer Healthcare, Abbott Labs, and Johnson & Johnson all which make cheap product alternatives backed up with significant marketing dollars, field-based sales representatives, insurance reimbursement, and companion therapeutic agents.

Besides these four major players, there are several small, new entrants into the glucose monitoring market that will provide competition for LabStyle Innovations Corp. on the device side. On the application side, we found over two-dozen diabetes applications in the iTunes application store (or iOS devices). LabStyle’s application is designed to work seamlessly with the Dario device. Diabetics are free to use other diabetes applications along with Dario and the Dario App. However, LabStyle Innovations Corp. is not the only company seeking to capture the smartphone revolution or utilize cloud-based computing and social media / sharing applications to attract patients and build an ecosystem for the patient.

…On The Device…

Dario is designed for self-monitoring of blood glucose (SMBG). As elegant as the Dario device is, it still requires a lancing mechanism and test strips. Several companies are working on continuous glucose monitoring (CGM) platforms that could make SMBG products less common, or at the very least patients with both systems may test their blood less frequently (less sales of test strips) than those without CGM systems. We highlight two of these products below – neither of which we believe are “killer apps” that will make Dario obsolete, but do both represent competition and yet another potential paradigm shift – revolution instead of evolution – for diabetics with complete insulin deficiency. That being said, both the devices below will still require periodic calibration in which the diabetic patient may use both SMBG and CGM systems.

Other companies have developed stand-alone glucometers that are small, sleek, and work with Smartphones on the iOS or Android operating system. However, none of these devices combined all three components of the SMBG test kit, and most require the diabetic to carry around an additional device besides their smartphone and glucometer. We see the Dario device as the leading product in this shift towards small, smarter SMBG devices. Furthermore, the combination of cloud-based computing with App driven devices is innovative in this segment.

Echo Therapeutics (ECTE) is developing the Prelude SkinPrep and Symphony iCGM device. Prelude SkinPrep is a platform technology for painless and significantly enhanced skin permeation. Prelude and Symphony do not utilize a lancing mechanism and test strips. Instead, the skin is prepared with the Prelude device to (painlessly) remove the top layer of skin, called the stratum corneum.

The Symphony device is worn on the abdomen over the area of skin prepared by Prelude. Symphony measures blood glucose through a transdermal electro-chemical glucose sensor. Symphony contains a wireless transmitter and pairs with a remote monitor, compatible with ICU software.

Echo’s Prelude SkinPrep and Symphony iCGM platform is primarily for critical care, hospital based diabetics with complete insulin deficiency at high risk of hypo- or hyperglycemia. Echo is preparing to initiate its CE Mark and U.S. PMA (pivotal program) for this platform. We do not see the Prelude / Symphony platform as an immediate threat to LabStyle and Dario. LabStyle is years ahead of Echo, and Echo is currently focused on the in-hospital critical care segment. However, this first-generation product offers a glimpse into where glucose monitoring may be headed in the next decade.

C8 MediSensors, Inc. is developing a wearable continuous glucose monitor that syncs with a user’s smartphone. Like the Symphony iCGM, the C8 MediSensors Optical Glucose Monitor (OGM) measures blood glucose levels without the need for a lancing mechanism or test strips. The device is worn against the skin and provides painless and continuous monitoring of glucose levels with wireless output a smartphone. The C8 MediSensors OGM has impressive software and integration with a downloadable application. A potential knock on the device is the accuracy of optically reading glucose levels through the skin, and thus C8 MediSensors is designing the device with the notion that it will compliment convention glucometers instead of replacing them.

The other clear knock on the C8 MediSensors OGM is the bulky, cumbersome design. The device is held in place with a belt / wrap and Velcro. It is worn around the mid-abdomen, just above the belly-button. The picture above depicts a relatively healthy individual. We question the wearability of the device in patients with higher BMI. We could see the device being hot or uncomfortable. The device is currently investigational only. We do not expect to see it on the market for a few years. This is a first-generation product, and thus uptake will probably be low and reserved for the most severe of type-1 diabetics. However, like Echo’s product, the C8 MediSensors OGM gives investors a glimpse into where the market for SMBG is headed.

Telcare Medical Supply, Inc. is has developed the Telcare BGM device. Telcare BGM offers many of the same features that Dario offers, including a sleek device with cloud-based data hosting (called Telserve Hub), syncing to a mobile smart phone, data analysis applications, and an ecosystem that aims to provide test strips and add-on services to the patient. It requires no coding, personalization features, a rechargeable battery, small blood sample, and fast results.

The problem with Telcare BGM is that it is a separate device from the user’s smartphone. It even looks like a smartphone. We question by a user would want to carry around two smartphone sized devices, and a lancing mechanism, once Dario is on the market. LabStyle’s Dario product takes the Telcare BGM concept to the next level. Telcare BGM is currently available in the U.S. The product kit retails for $149.95 and includes the device, 10 lancets, and 10 test strips.

Sanofi-aventis (SNY) has developed a very sleek little device called the iBGStar. The device has a dock connector compatible with iPhone or iPod Touch, a micro-USB port for power adapter or connection to a PC, strip port, and display area for test results. The iBGStar is designed to work with iBGStar mobile application available on the iOS platform. The mobile App offers only a subset features and functions of the Dario App, allowing for analyses of test results, automatic syncing, tracking data, storage of history data, dynamic graphing, and a share function for family or healthcare.

The problems we see with the iBGStar are two-fold. No. 1, the device does not contain a lancet. The iBGStar comes with a separate lancing device about the size of a tube of lip balm. That’s one additional device that the patient must carry around compared to the Dario. Each time you use the device, a new lancet must be inserted along with the lancing cap. The other knock on the iBGStar is that the dock is the old iPhone 30-pin dock for iPhone 4 or less. It does not have the new Apple Lighting connection. Users must purchase this adapter separately for around $30. Plus, the iBGStar is not compatible with Android devices, which is over half the Smartphone market. The iBGStar retails for around $75 at Walgreens, and the proprietary test strips go for around $1.30 each.

Medisana AG has developed GlucoDock, a very similar product to Sanofi’s iBGStar. We see very little differentiation between GlucoDock and iBGStar. It has the same features and same characteristics that will limit use, including the lack of advanced software and lifestyle integration that the Dario has, such as a food database and insulin dosing recommendations. GlucoDock is currently not available in the U.S. It is available in parts of Europe and retails for €100.

…On The Software / Application…

Many of the above products come with their own software application that syncs with the device. The applications are free if you buy the software, and have little utility if you don’t buy the device. Our search of the iTunes store found over two dozen separate diabetes applications that aim to compete with the Dario App. None will sync automatically with the device. However, diabetics that currently have stand-alone glucometers like the FreeStyle Mini or One Touch Ultra may have already downloaded a separate, stand-alone application.

A recent article published in Clinical Diabetes in the Fall of 2012 (Tran et al., Vol.30:173-178) reviews several of the leading diabetes applications available in the iTunes store. Most cost money. We’ve compared these applications with the Dario App. It is clear that LabStyle “gets it” with respect to what diabetics are looking for in an App.

Management hat LabStyle believes the Dario App contains a number of other unique additional features that further separates it from the existing competition. These include a burned calories tracker, insulin recommendation and dose calculation, the ability to generate reports and charts, along with other measurement sharing tools, a sugar profile plan and alert system, and the cloud-based access to the patient data.

Market Opportunity & Sales Forecasts

LabStyle is targeting a massive market opportunity. The World Health Organization estimates that there are approximately 350 million people with diabetes worldwide (~90% type-2 diabetics). In Europe, the diabetic population was approximately 52.6 million in 2011 according to Frost & Sullivan, and there were approximately 25.8 million diabetics in the U.S. in 2011 according to the American Diabetes Association. An additional 79 million U.S. adults have pre-diabetes, which puts them at high risk for developing Type 2 diabetes. About 138 million adult diabetics live in China and India and another 10 million in Russia.

The medical Journal Lancet has reported that number of worldwide diabetics has doubled over the past thirty years. While about 70% of the increase has been attributed to population growth and aging, the balance was linked to changing diets, rising obesity levels and less physical activity. Diabetes is a growing epidemic for which no cure exists, but for which treatments (including a regimen of frequent blood glucose testing) are available.

It is also estimated that the costs of diabetes complications account for between 5% and 10% of total healthcare spending in the world. Early diagnosis of warning signs and ongoing monitoring of diabetes are the keys to the prevention and treatment of the disease, with blood glucose monitoring being the primary method of diagnosis and disease management, coupled with matching blood glucose readings with food (i.e., carbohydrate) and insulin or other medication intake. Since blood glucose self-monitoring is a key part of managing diabetes, the market for SMBG products required to service these many patients is also large.

According to research firm Visiongain, the global SMBG market was $9.7 billion in 2011 and the global market for diabetes monitoring devices is expected to be $27.42 billion by 2022. The Enterprise Analysis Corporation has estimated that the global market for SMBG testing supplies was $1.7 billion in 1994. By 2000, the market had reached approximately $3.8 billion, and by 2008, worldwide sales of these products climbed to $8.8 billion. It has been estimated that the U.S. accounts for 40% of the SMBG market, or approximately $3.9 billion, and Frost & Sullivan estimates that Europe accounted for $3.97 billion in this market in 2011.

Based on the available data, the SMBG market is growing at 12% CAGR. Key factors driving market growth include increasing diabetic population, growing patient awareness, technological advancements and increasing number of patients adopting blood glucose self-monitoring. In addition, the affordable cost of blood glucose test strips, and increase in daily monitoring, are also expected to contribute to market growth. As such, we believe the SMBG market represents a large and attractive opportunity for a new medical device.

However, LabStyle will be limited upon launch by the number of diabetics that own smartphones. In the U.S., Nielsen reports that 55% of new cell phone buyers purchased a smartphone as their new handset. The total percent of smartphones vs. older cell phones is approaching 50%. According to International Data Corporation, iOS and Android control 91% of the smartphone market (as of February 2013). We also see an increasing number of patients and physicians embracing applications for mobile health, or mHealth. According to a 2010 study by research2guidance, smartphone applications will enable the mHealth industry to reach 500 million of a total 1.4 billion worldwide smartphone users in 2015. An article published in the October 2009 issue of Diabetes, Obesity and Metabolism (Vol.11:913-930) concludes that mHealth applications have a positive impact on the use of numerous health services and glycemic control (Polisena et al, 2009). We believe that it is reasonable to assume that the percentage of smartphone users with diabetes mirrors that of the general population, and that Dario is designed to play directly into the three trends noted above – an increasing number of diabetes, an increasing smartphone user base, and rapid adoption for mHealth applications.

We have built a detailed financial model to forecast sales of the Dario device and related accessories, including the test strips and application software add-ons. Below is a representation of our models for the EU and U.S. We do not model sales of the Dario device outside of the EU or U.S. as of now. We will add these forecasts to our model upon regulatory submissions in countries outside these regions ad hoc. For sales in Europe, we suspect that the company will sign distribution agreements with leading medical supplies company’s on a country-by-county basis. For example, on April 25, 2013, the company signed an exclusive distribution agreement with Farla Medical, Inc. for distribution of Dario in the U.K. and Belgium.

For the purpose of modeling price, we suspect that LabStyle will essentially “give way” the Dario device to new users, at least early in the launch, to gain market share. Similar to the “Razor / Blade” model, the bulk of the money is made on the consumable strips. Giving away a device that maybe retails for $75 (and costs $25) seems counter-intuitive until you realize that the test strips, which may sell for $0.50-$0.75 per and only cost $0.10-$0.15 per is a far more lucrative business when we consider the average Type-1 diabetic may use 7 strips a day.

We see meaningful uptake for LabStyle’s Dario device. Sales of glucometers and test strips are dominated by only a handful of major players like Roche, Johnson & Johnson, Bayer Healthcare, Abbott Labs, and Sanofi-Aventis. The big players above each hold 10-15% market share. We believe LabStyle Innovations, with Dario, can become a major player in this area given the differentiating characteristics of the device.

Plus, medical opinion is clearly behind improving SMBG. A paper published in Current Medical Research and Opinion in December 2009 (Vol. 25-No.12:2903-2913) entitled, “Self-monitoring of blood glucose in non-insulin treated patients with type 2 diabetes: a systematic review and meta-analysis,” concludes that SMBG compared with non-SMBG is associated with a significantly improved glycaemic control in non-insulin treated patients with type-2 diabetes. We think LabStyle is well-positioned to take advantage of several emerging trends, including SMBG, more Smartphone users, and cloud-based / app-based computing.

For the European Market, we are assuming a distribution model where the company loses a tiny amount or breaks even on the device, and then captures a margin of around 50-60% on each strip. For the U.S. Market, we assume more of a direct sales model where the company loses money on the device, and then captures a margin of around 70-80% on each strip. We assume the average Type-1 diabetic tests 7 times a day and the average insulin-dependent Type-2 tests 3 times a day.

We note the company is targeting developed countries with large diabetic populations like Japan, China, India, and Brazil. Countries in the Middle East and Russia also present significant opportunities. Predicting market share in these countries is far more difficult prior to the U.S. and EU launch, so we are holding off for now with modeling sales outside the U.S. or EU. We are also holding off on modeling sales of the application software or data generated by the Dario users until we have a better sense of the future plans here.

Financing Complete

On May 10, 2013, LabStyle announced it had completed a $10 million financing through the sale of common stock and warrants to a group of accredited investors. The company sold 4.0 million units at $2.50 per unit, with each unit consisting of 1 share and 0.5 warrants. The warrants are exercisable at $5.00 per share and expire in early April 2016. Net procedure from the offering totaled roughly $9 million. We believe the company is well-capitalized to fund operations, including the launch of Dario in the EU, for the foreseeable future.

Initiating Coverage With Buy Rating

Zacks Small-Cap Research is initiating coverage of LabStyle Innovations Corp. with a Buy rating. We think that Dario is of elegant design, with outstanding usability and accessibility by integrating a pocket-sized glucometer with a smartphone and mobile application. Dario combines a lancing mechanism, disposable strip cartridge, and glucose monitor with attached plug for insertion into a smartphone audio jack. It is the first and only product to date that we see that combined all three components, along with intuitive and valuable application software. We see the Dario glucometer and diabetes management system as revolutionary in design and function. Dario, along with sales of disposable test strips, mobile applications, and community and physician interaction software, represents a $500 million peak opportunity for LabStyle Innovations in each the U.S. and EU.

We have built an aggressive sales model for the Dario device based on our belief that the company can capture between 5 and 10% market share in the U.S. and EU. This seems achievable based on the significant differentiation of the product vs. readily available, and similarly price, glucometers today. Sales of glucometers and test strips are dominated by only a handful of major players like Roche, Johnson & Johnson (JNJ), Bayer Healthcare, Abbott Labs (ABT), and Sanofi-Aventis. The big players above each hold 10-15% market share. We believe LabStyle Innovations, with Dario, can become a major player in this area given the differentiating characteristics of the device noted above. Based on this model, we believe the shares are significantly under-valued, and worth $12 per share.

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