Form 10-Q

Commission file number 001-09913

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 by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).  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:   71,122,556 shares as of July 21, 2003

INDEX

      The financial statements presented herein include the accounts of Kinetic Concepts, Inc., together with our consolidated subsidiaries ("KCI"). The unaudited condensed consolidated financial statements appearing in this quarterly report on Form 10-Q should be read in conjunction with the financial statements and notes thereto included in KCI's latest annual report on Form 10-K. The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information necessary for a fair presentation of results of operations, financial position and cash flows in conformity with accounting principles generally accepted in the United States. Operating results from interim periods are not necessarily indicat ive of results that may be expected for the fiscal year as a whole. In our opinion, the consolidated financial statements reflect all adjustments considered necessary for a fair presentation of our results for the periods presented. Certain reclassifications of amounts related to the prior year have been made to conform with the 2003 presentation.

      We use the intrinsic value method in accounting for our stock option plan. In the first six months of 2003 and 2002, compensation costs of approximately $1.7 million and $340,000, respectively, net of estimated taxes, have been recognized in the financial statements related to this plan. If the compensation cost for our stock-based employee compensation plan had been determined based upon a fair value method consistent with Statement of Financial Accounting Standards No. 123 ("SFAS 123"), "Accounting for Stock-Based Compensation," our net earnings and earnings per share would have been decreased to the pro forma amounts indicated below. For purposes of pro forma disclosures, the estimated fair value of the options is recognized as an expense over the options' respective vesting periods. Our pro forma calculations are as follows (dollars in thousands, except for earnings per share information):

      We are not required to apply, and have not applied, the method of accounting prescribed by SFAS 123 to stock options granted prior to January 1, 1995. Moreover, the pro forma compensation cost reflected above may not be representative of future expense.

      In June 2001, the Financial Accounting Standards Board, or ("FASB") issued SFAS 143, "Accounting for Asset Retirement Obligations," effective for fiscal years beginning after June 15, 2002. This standard addresses financial accounting and reporting obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. The standard requires us to record the fair value of a liability for an asset retirement obligation in the period in which it is incurred and to adjust its present value in each subsequent period. In addition, we must capitalize an amount equal to the adjustment by increasing the carrying amount of the related long-lived asset, which is depreciated over the remaining useful life of the related asset. We adopted SFAS 143 during the first quarter of 2003 and it did not have a significant effect on our financial position or results of operations.

      In January 2003, the FASB issued Interpretation No. 46 ("FIN 46"), "Consolidation of Variable Interest Entities," effective for fiscal years or interim periods beginning after June 15, 2003. FIN 46 addresses accounting for, and disclosure of, variable interest entities. FIN 46 requires the disclosure of the nature, purpose and exposure of any loss related to our involvement with variable interest entities. We adopted the provisions of FIN 46 for post January 31, 2003 variable interest entities during the first quarter of 2003 and it did not have a significant effect on our financial position or results of operations. We continue to evaluate the potential effects of the consolidation provisions of FIN 46 that will be adopted during the quarter ended September 30, 2003.

      Specifically, we are evaluating the beneficial ownership of two Grantor Trusts which we acquired in December 1996 and December 1994. The assets held by each Trust consist of a McDonnell Douglas DC-10 aircraft and three engines. In connection with the acquisitions, KCI paid cash of $7.2 million and $7.6 million, respectively. The Trusts held debt of $48.4 million and $51.8 million, respectively, which is non-recourse to KCI. The DC-10 aircraft are leased to the Federal Express Corporation through June 2012 and January 2012, respectively. Federal Express pays monthly rent to a third party who, in turn, pays the entire amount to the holders of the non-recourse indebtedness, which is secured by the aircraft. The holder's recourse in event of a default is limited to the Trusts assets.

      In April 2003, the FASB issued Statement of Financial Accounting Standards No. 149 (SFAS 149), "Amendment of Statement 133 on Derivative Instruments and Hedging Activities." This statement amends SFAS 133 to provide clarification on the financial accounting and reporting of derivative instruments and hedging activities and requires contracts with similar characteristics to be accounted for on a comparable basis. We do not expect the adoption of SFAS 149, which will be effective for contracts entered into or modified after June 30, 2003, to have a material effect on our financial condition or results of operations.

      On May 15, 2003, the FASB issued SFAS 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity." The statement established standards for classifying and measuring as liabilities certain financial instruments that embody obligations of the issuer and have characteristics of both liabilities and equity. SFAS 150 must be applied immediately to instruments entered into or modified after May 31, 2003. We have adopted SFAS 150 and have determined it will not have a material impact on our financial position or results of operations.

      For further information, see Note 1 to the consolidated financial statements included in KCI's Annual Report on Form 10-K for the year ended December 31, 2002.

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

      In January 2003, we received $175 million pursuant to the settlement of our antitrust lawsuit with Hillenbrand Industries (see Note 9 for additional discussion). The cash received, net of approximately $66 million of income taxes and approximately $2 million of fees and expenses, was used to pay down $107 million of indebtedness on the senior credit facility.

      As of June 30, 2003, we had no revolving loans outstanding. However, we had outstanding five letters of credit in the aggregate amount of $10.9 million. The resulting availability under the revolving credit facility was $39.1 million at the end of the quarter.

      We follow SFAS 133, "Accounting for Derivative Instruments and Hedging Activities," and its amendments, SFAS 137 and 138, in accounting for our derivative instruments. SFAS 133 requires that all derivative instruments be recorded on the balance sheet at fair value. We have designated our interest rate swap agreements as cash flow hedge instruments. The swap agreements are used to manage exposure to interest rate movement by effectively changing the variable interest rate to a fixed rate. The critical terms of the interest rate swap agreements and the interest-bearing debt associated with the swap agreements must be the same to qualify for the shortcut method of accounting. Changes in the effective portion of the fair value of the interest rate swap agreement will be recognized in other comprehensive income, net of tax effects, until the hedged item is recognized into earnings.

      The following chart summarizes interest rate hedge transactions effective during the first six months of 2003 (dollars in thousands):

      As of December 31, 2002, two $100 million interest rate swap agreements were in effect to take advantage of low interest rates. On January 31, 2003, we sold $20 million of our $100 million, 1.7450% interest rate swap effective March 31, 2003 which resulted in an expense of approximately

$74,000 which was recorded in the first quarter of 2003. As of June 30, 2003, the current interest rate swap agreements effectively fix the base-borrowing rate on 86% of our variable rate debt. The fair value of these swaps at inception was zero. Due to subsequent movements in interest rates, as of June 30, 2003, the fair values of the $80 million and $100 million swap agreements were negative and were adjusted to reflect a liability of approximately $300,000 and $1.6 million, respectively. As a result of interest rate protection agreements in effect during the first six months of 2003 and 2002, we recorded interest expense of approximately $770,000 and $1.3 million, respectively. (See Note 8.)

      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): (See Note 1 (b).)

      In May 2003, our Board of Directors approved the 2003 Non-Employee Directors Stock Plan (the "Directors Stock Plan"). Grants under this plan shall be made to non-employee directors of the company. The maximum aggregate number of shares of Common Stock that may be issued in connection with grants under the Directors Stock Plan is 400,000 shares, subject to adjustment as provided for in the plan. The exercise price of options granted under this plan is determined as the fair market value, as determined by our Board of Directors, of the shares of the Company's common stock on the date that such option is granted. The options granted will vest and become exercisable incrementally over a period of three years. The right to exercise an option shall terminate seven years after the grant date, unless sooner as provided for in the plan. The Directors Stock Plan is administered by a committee of the Board of Directors.

      The earnings associated with certain of our 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 June 30, 2003, derivative financial instruments valued at a liability of $1.9 million were recorded as a result of our adoption of SFAS 133, "Accounting for Derivative Instruments and Hedging Activities." This liability is based upon the valuation of our interest rate protection agreements associated with our Senior Credit Facility. (See Note 5.)

      Other than commitments for new product inventory, including disposable "for sale" products of $16.9 million, we have no material long-term capital commitments.

      We are principally engaged in the rental and sale of innovative therapeutic devices and systems throughout the United States and in 15 primary countries internationally.

      We define our business segments based on geographic management responsibility. We have two reportable segments: USA, which includes operations in the United States, and International, which includes operations for all international units. We measure segment profit as operating earnings, which is defined as income before interest income or expense, foreign currency gains and losses and income taxes. All intercompany transactions are eliminated in computing revenue, operating earnings and assets. The prior years have been made to conform with the 2003 presentation. Information on segments and a reconciliation of consolidated totals are as follows (dollars in thousands):

1. Other includes general headquarter expenses which are not allocated to the individual
   segments and are included in selling, general and administrative expenses within our
   Condensed Consolidated Statements of Earnings.

      In November of 1997, Kinetic Concepts, Inc. issued $200 million in subordinated debt securities to finance a tender offer to purchase certain of our common shares outstanding. In connection with the issuance of these securities, certain of our wholly owned subsidiaries (the "guarantor subsidiaries") act as guarantors. Certain other subsidiaries (the "non-guarantor subsidiaries") do not guarantee the debt. The guarantor subsidiaries are wholly owned by KCI and the guarantees are full, unconditional, joint and several. We have not presented separate financial statements and other disclosures concerning the Subsidiary Guarantors because management has determined that such information is not material to investors.

      Our indebtedness under the existing senior credit facility is guaranteed by certain of our subsidiaries and is secured by a first priority security interest in (1) all of our tangible and intangible assets and those of our domestic subsidiaries (subject to certain customary exceptions), including, without limitation, intellectual property and real estate owned by us and our subsidiaries, and (2) substantially all shares of capital stock and intercompany debt of each of our present and future subsidiaries (limited in the case of certain foreign subsidiaries to 65% of the voting stock of such entity). The senior credit facility 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 consolidations, 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 the following tables.

      The following tables present the condensed consolidating balance sheets of Kinetic Concepts, Inc. as a parent company, our guarantor subsidiaries and our non-guarantor subsidiaries as of June 30, 2003 and December 31, 2002 and the related condensed consolidating statements of earnings for the three and six-month periods ended June 30, 2003 and 2002, and the condensed consolidating statements of cash flows for the six-month periods ended June 30, 2003 and 2002, respectively.