Form 10-Q

Commission file number 1-9913

KINETIC CONCEPTS, INC.

(Exact name of registrant as specified in its charter)

8023 Vantage Drive
San Antonio, Texas 78230
Telephone Number: (210) 524-9000
(Address, including zip code, and telephone number, including area code,
of registrant's principal executive offices)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.     Yes___    No _X_

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.

Common Stock:   70,928,040 shares as of November 4, 2002

INDEX

      In 1996, the Company acquired a 26% interest in the capital stock of Polymedics N.V., ("Polymedics"), a Belgium manufacturer of foam used in certain V.A.C. dressings which was accounted for on a cost basis. During the first quarter of 2002, the Company acquired the remaining 74% of Polymedics stock for approximately $3.6 million in cash at which time the financial position and results of operations were reflected on a consolidated basis. Polymedics' operating results did not have a material impact on the Company's results of operations for 2002 or 2001.

      In August 2002, the Company sold its headquarters facility under a sales/leaseback arrangement. The facility was sold for $17.9 million, net of selling costs, resulting in a deferred gain of approximately $10.1 million. The deferred gain will be amortized over the term of the lease, of which approximately $170,000 was recognized as income through September 30, 2002. The initial lease term is 10 years and requires annual minimum lease payments ranging from $3.2 million to $3.8 million. The Company has two options to renew the lease for a term of three or five years each. Rental expense of $589,000 was recognized as of September 2002. The following table indicates the estimated cash lease payments, inclusive of executory costs, for the years set forth below (dollars in thousands):

      Accounts receivable consist of the following (dollars in thousands):

      Inventories are stated at the lower of cost (first-in, first-out) or market (net realizable value). Inventories are comprised of the following (dollars in thousands):

      On April 4, 2002, the Company entered into a Second Amended and Restated Credit and Guarantee Agreement (the "Amended Credit Agreement"). The Amended Credit Agreement funded a $30 million Tranche E Term Loan as part of a refinancing of the Company's Senior Secured Credit Facilities. Proceeds from the Tranche E Term Loan were used to pay down existing indebtedness of $29.6 million under the Revolving Credit Facility with the remaining proceeds used to pay fees and expenses associated with the transaction.

      As of September 30, 2002, indebtedness under the Senior Credit Facilities, as amended and restated, including the Revolving Credit Facility (other than certain loans under the Revolving Credit Facility designated in foreign currency) and the Term Loans, bear interest at a rate based upon (i) the Base Rate (defined as the higher of (x) the rate of interest publicly announced by Bank of America as its "reference rate" or (y) the federal funds effective rate from time to time plus 0.50%), plus 1.75% in respect of the Tranche A Term Loans and the loans under the Revolving Credit Facility (the "Revolving Loans"), 2.00% in respect of the Tranche B Term Loans, 2.25% in respect of the Tranche C and Tranche E Term Loans and 2.125% in respect of the Tranche D Term Loans, or at the Company's option, (ii) the Eurodollar Rate (as defined in the Senior Credit Facility Agreement) for one, two, three or six months, in each case plus 2.00% in respect of Tranche A Term Lo ans and Revolving Loans, 2.75% in respect of Tranche B Term Loans, 3.00% in respect of the Tranche C and Tranche E Term Loans and 2.875% in respect to the Tranche D Term Loans. Revolving Loans designated in foreign currency bear interest at a rate based upon the cost of funds for such loans plus 2.00%. Performance-based reductions of the interest rates under the Term Loans and the Revolving Loans are available.

      In January 2001, the Company entered into an interest rate swap which fixed the base-borrowing rate on $150 million of the Company's variable rate debt at 5.36% and was effective from January 5, 2001 through December 31, 2001. On October 1, 2001, the Company terminated its $150 million, 5.36% interest rate swap to take advantage of lower interest rates and entered into two new interest rate swaps, which resulted in additional interest expense of $1.1 million in the fourth quarter of 2001. One interest rate swap fixes the base-borrowing rate on $150 million of the Company's variable rate debt at 3.57% per annum and is effective October 1, 2001 through December 31, 2002. The second interest rate swap fixes the rate on an additional $100 million of the Company's variable rate debt at 2.99% annually and is effective October 1, 2001 through December 31, 2002. As of September 30, 2002, these agreements effectively fix the base-borrowing rate on 77.5% of th e Company's variable rate debt. As a result of the interest rate protection agreements, the Company recorded additional interest expense of approximately $1.2 million and $743,000 in the first nine months of 2002 and 2001, respectively. Subsequent to the end of the third quarter, the Company entered into two new

interest rate swap agreements. For further discussion of derivatives and the related subsequent event (See Notes 11 and 12).

      The Term Loans, other than Tranches D and E, are subject to quarterly amortization payments which began on March 31, 1998. The Tranche D Term Loan amortizes at 1% per year beginning September 30, 2001 through December 31, 2005 with a final payment of $90.7 million due March 31, 2006. The Tranche E Term Loan amortizes at 1% per year beginning September 30, 2002 with a final payment of $29.0 million due December 31, 2005. The Company may borrow additional funds under the Revolving Credit Facility at any time up to the borrowing limits thereunder. At September 30, 2002, the Company had no revolving loans outstanding, however, the Company had four Letters of Credit in the amount of $8.7 million, resulting in aggregate availability under the Revolving Credit facility of $41.3 million.

      Indebtedness of the Company under the Senior Credit Facilities Agreement is guaranteed by certain of the subsidiaries of the Company and is secured by (i) a first priority security interest in all of the tangible and intangible assets of the Company and its domestic subsidiaries (subject to certain customary exceptions), including, without limitation, intellectual property and real estate owned by the Company and its subsidiaries, (ii) a first priority perfected pledge of all capital stock of the Company's domestic subsidiaries and (iii) a first priority perfected pledge of up to 65% of the capital stock of foreign subsidiaries owned directly by the Company or its domestic subsidiaries.

      The Senior Credit Agreement requires the Company to meet certain financial tests, including minimum levels of EBITDA (as defined therein), minimum interest coverage, maximum leverage ratio and capital expenditures. The Senior Credit Agreement also contains covenants which, among other things, limit the Company's ability to: incur additional indebtedness, make investments, announce or pay dividends, make loans and advances, make capital expenditures, enter into transactions with affiliates, dispose of its assets, enter into acquisitions, mergers or consolidation transactions, make prepayments on other indebtedness, create or permit to be created any liens on any of its properties, or undertake certain other matters customarily restricted in such agreements. At September 30, 2002, the Company was in compliance with all applicable covenants.

      The Senior Credit Agreement also contains customary events of default, including payment defaults, any breach of representations and warranties, covenant defaults, cross-defaults to certain other indebtedness, certain events of bankruptcy and insolvency, failures under ERISA plans, judgment defaults, any change of control of the Company and failure of any guaranty, security document, security interest or subordination provision under the Senior Credit Agreement. In addition, the Senior Credit Agreement provides for mandatory repayments, subject to certain exceptions, of the Term Loans and the Revolving Credit Facility based on certain net asset sales outside the ordinary course of business of the Company and its subsidiaries, the net proceeds of certain debt and equity issuances and excess cash flows.

      The 9 5/8% Senior Subordinated Notes (the "Notes") due 2007 are unsecured obligations of the Company, ranking subordinate in right of payment to all senior debt of the Company and will mature on November 1, 2007. Interest on the Notes accrues at the rate of 9 5/8% per annum and is payable semiannually in cash on each May 1 and November 1, to the persons who are registered Holders at the close of business on April 15 and October 15, respectively, immediately preceding the applicable interest payment date. Interest on the Notes accrues from and includes the most recent date to which interest has been paid or, if no interest has been paid, from and including the date of issuance.

      As of September 30, 2002, the entire $200.0 million of Senior Subordinated Notes was issued and outstanding. The Notes are not entitled to the benefit of any mandatory sinking fund. The Notes will be redeemable, at the Company's option, in whole at any time or in part from time to time, on and after November 1, 2002, upon not less than 30 nor more than 60 days' notice, at the following redemption prices (expressed as percentages of the principal amount thereof) if redeemed during the twelve-month period commencing on November 1 of the year set forth below, plus, in each case, accrued and unpaid interest thereon, if any, to the date of redemption.

      At any time, or from time to time, the Company may acquire a portion of the Notes through open-market purchases. In order to effect the foregoing redemption with the proceeds of any equity offering, the Company shall make such redemption not more than 120 days after the consummation of any such equity offering.

      Goodwill represents the excess purchase price over the fair value of net assets acquired. Effective January 1, 2002, the Company has applied the provisions of Statement of Financial Accounting Standards No. 142, ("SFAS 142"), Goodwill and Other Intangible Assets in its accounting for goodwill. Under SFAS 142, goodwill and intangible assets that have indefinite useful lives are no longer subject to amortization over an estimated useful life. Rather, goodwill and indefinite-lived intangible assets are subject to an assessment for impairment at least annually. SFAS 142 provides specific guidance for testing goodwill for impairment. Intangible assets with finite useful lives continue to be amortized over their useful lives. Goodwill and indefinite-lived intangibles were tested for impairment during the first quarter of 2002 and will be tested for impairment at least annually, beginning in the fourth quarter of 2002.

      Goodwill, net of accumulated amortization, was $46.3 million at September 30, 2002, compared to $43.0 million at December 31, 2001. This increase relates to the acquisition of Polymedics by the Company in the first quarter of 2002 (See Note 2). Goodwill represented 11.0% and 12.5% of total assets at September 30, 2002 and December 31, 2001, respectively. For further discussion of goodwill, see Item 2, Management's Discussion and Analysis of Financial Condition and Results of Operations, Critical Accounting Policies.

      The following table shows the effect of the adoption of SFAS 142 on the Company's net income as of September 30, 2001 as if the adoption had occurred on January 1, 2001 (dollars in thousands, except per share data):

      The Company has recorded amortizable intangible assets which are included in Other Assets on the Condensed Consolidated Balance Sheets. Other assets include the following (dollars in thousands):

      Amortization expense, related to finite-lived intangibles, was approximately $127,000 and $189,000 for the three months ended September 30, 2002 and 2001, respectively, and approximately $1.1 million and $516,000 for the nine months ended September 30, 2002 and 2001, respectively. The Company amortizes these intangible assets over 5 to 17 years, depending on the estimated economic life of the individual asset. The following table shows the estimated amortization expense, in total for all finite-lived intangible assets, to be incurred over the next five years (dollars in thousands):

      The following table sets forth the reconciliation from basic to diluted average common shares and the calculations of net earnings per common share. Net earnings for basic and diluted calculations do not differ (dollars in thousands, except per share data):

      The Company is a party to several lawsuits arising in the ordinary course of its business. Provisions have been made in the Company's financial statements for estimated exposures related to these lawsuits. In the opinion of management, the disposition of these matters will not have a material adverse effect on the Company's business, financial condition or results of operations (See Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations, Legal Proceedings).

      The manufacturing and marketing of medical products necessarily entails an inherent risk of product liability claims. The Company currently has certain product liability claims pending for which provision has been made in the Company's financial statements. Management believes that resolution of these claims will not have a material adverse effect on the Company's business, financial condition or results of operations. The Company has not experienced any significant losses due to product liability claims and management believes that the Company currently maintains adequate liability insurance coverage.

      Other than commitments for new product inventory, including disposable "for sale" products of $8.2 million, the Company has no material long-term capital commitments and can adjust its level of capital expenditures as circumstances dictate.

      The components of other comprehensive income are as follows (dollars in thousands):

      The earnings associated with certain of the Company's foreign affiliates are considered to be permanently invested and no provision for U.S. Federal and State income taxes on these earnings or translation adjustments has been made.

      As of September 30, 2002, derivative financial instruments valued at a liability of approximately $980,000 were recorded as a result of the Company's adoption of FASB Statement No. 133, "Accounting for Derivative Instruments and Hedging Activities." This liability is based upon the valuation of the Company's interest rate protection agreements associated with its Senior Credit Facilities (See Notes 5, 11 and 12).

      The Company is principally engaged in the rental and sale of innovative therapeutic systems throughout the United States and in 15 primary countries and Puerto Rico internationally.

      The Company defines its business segments based on geographic management responsibility. The Company has two reportable segments: USA, which includes operations in the United States, and International, which includes operations for all international units. The Company measures segment profit as operating earnings, which is defined as income before interest income or expense, foreign currency gains and losses, income taxes and minority interest. All intercompany transactions are eliminated in computing revenues, operating earnings and assets. Information on segments and a reconciliation of consolidated totals are as follows (dollars in thousands):

      The Company entered into a $150.0 million swap agreement on January 5, 2001. In accordance with the transition provisions of SFAS 133, no cumulative effect of an accounting change was necessary. The $150.0 million swap was designated as a cash flow hedge of interest payments through December 31, 2001 and qualified for the shortcut method of accounting for such derivatives. On October 1, 2001, the Company terminated its $150.0 million, 5.36% interest rate swap and entered into a new agreement to take advantage of lower interest rates, which resulted in additional interest expense of $1.1 million in the fourth quarter of 2001. The new $150.0 million swap fixed the variable rate debt at 3.57% per annum and was designated as a hedge of interest payments effective October 1, 2001 through December 31, 2002. The amount included in other comprehensive income as of September 30, 2001 continues to be recognized over the original date through which interest pa yments were hedged, because the hedged item (interest payments) continues to exist. In addition, accumulated other comprehensive loss was reduced by approximately $550,000 as a loss on termination of interest rate swap during 2001, and increased by approximately $400,000 during 2002.

      Although no cash was exchanged, the new $150.0 million swap does not qualify for the shortcut method because the fair value of the new swap was not zero at inception (it had a negative value). The Company has elected to use the "hypothetical derivative" method to measure effectiveness, which allows the Company to use the change in the fair value of a "hypothetical derivative" (one which had no fair value at inception with terms mirroring the actual derivative that would be assumed to be perfectly effective) as a proxy for the change in the expected fair value of the hedged transactions. As of September 30, 2002, the hedged cash flows offset the change in the fair value of expected cash flows by 103.0%. As a result, the hedge was deemed to be "highly effective". Hedge ineffectiveness, of approximately $15,000, in the third quarter of 2002 was immaterial and recognized as an increase of interest expense. The ineffectiveness was approximately $14,000 i n the first nine months of 2002. The Company will continue to mark the $150.0 million derivative to its fair value and record an offsetting amount (based upon the lesser of the cumulative change in the derivative or the cumulative change in the hypothetical derivative) in other comprehensive income, net of any related tax effects. At September 30, 2002, the fair value of the swap agreement was in an unfavorable position and was adjusted to a liability of $676,000. Accumulated other comprehensive loss was adjusted $439,000 for the net derivative liability and deferred income taxes payable was adjusted $237,000 for the tax benefit related to the derivative liability. The reclassification adjustment for the loss recognized on the termination of the interest rate swap increased accumulated other comprehensive income liability by $147,000 ($226,000 less taxes of $79,000) in the third quarter of 2002.

      On October 1, 2001, the Company also entered into a new $100.0 million swap which fixed the variable rate debt at 2.99% annually. This swap was designated as a cash flow hedge of interest payments through December 31, 2002 and qualified for the shortcut method of accounting for such derivatives. The critical terms of the interest rate swap agreements and the interest-bearing debt associated with the swap agreements are the same. As of September 30, 2002, the fair value of the swap agreement was in an unfavorable position and was adjusted to a liability of $303,000. Accumulated other comprehensive loss was adjusted $197,000 for the net derivative liability and deferred income taxes payable was adjusted $106,000 for the tax benefit related to the derivative liability. Because the swap agreement is deemed to be an effective cash flow hedge, there will be no income statement impact related to the hedge ineffectiveness (See Notes 9 and 12).

      On October 29, 2002, the Company entered into two new interest rate swaps. One interest rate swap fixes the base-borrowing rate on $100 million of the Company's variable rate debt at 1.7450% per annum and is effective December 31, 2002 through December 31, 2003. The second interest rate swap fixes the rate on an additional $100 million of the Company's variable rate debt at 2.3750% annually and is effective December 31, 2002 through December 31, 2004. At December 31, 2002 these agreements will effectively fix the base borrowing rate on 62% of the Company's variable rate debt. The fair value of these swaps at inception was zero. However, due to subsequent movements in interest rates, as of October 31, 2002 the fair value of the one-year, 1.7450% swap and two-year, 2.3750% swap were ($151,732) and ($429,156), respectively (See notes 5 and 11).

      Kinetic Concepts, Inc. issued $200 million in subordinated debt securities to finance a tender offer to purchase certain of its common shares outstanding. In connection with the issuance of these securities, certain of its wholly-owned subsidiaries (the "guarantor subsidiaries") act as guarantors. Certain other subsidiaries (the "non-guarantor subsidiaries") do not guarantee such debt. The guarantor subsidiaries are wholly owned by the Company and the guarantees are full, unconditional, and joint and several. The Company has not presented separate financial statements and other disclosures concerning the Subsidiary Guarantors because management has determined that such information is not material to investors.

      Indebtedness of the Company under the Senior Credit Facilities Agreement is guaranteed by certain of the subsidiaries of the Company and is secured by (i) a first priority security interest in all, subject to certain customary exceptions, of the tangible and intangible assets of the Company and its domestic subsidiaries, including, without limitation, intellectual property and real estate owned by the Company and its subsidiaries, (ii) a first priority perfected pledge of all capital stock of the Company's domestic subsidiaries and (iii) a first priority perfected pledge of up to 65% of the capital stock of foreign subsidiaries owned directly by the Company or its domestic subsidiaries. The Senior Credit Agreement contains covenants which, among other things, limit the incurrence of additional indebtedness, investments, dividends, loans and advances, capital expenditures, transactions with affiliates, asset sales, acquisitions, mergers and consolidation s, prepayments of other indebtedness, liens and encumbrances and other matters customarily restricted in such agreements. The net assets of the guarantor subsidiaries are detailed on pages 17 and 18.

      The following tables present the condensed consolidating balance sheets of Kinetic Concepts, Inc. as a parent company, its guarantor subsidiaries and its non-guarantor subsidiaries as of September 30, 2002 and December 31, 2001 and the related condensed consolidating statements of earnings for the three and nine-month periods ended September 30, 2002 and 2001, and the condensed consolidating statements of cash flows for the nine-month periods ended September 30, 2002 and 2001, respectively (See pages 17 to 24).