UNITED STATES

SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

Form 10-Q

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   X      No       


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:  68,424,459 shares as of November 9, 2004

TABLE OF CONTENTS

KINETIC CONCEPTS, INC.

INDEX

 

 

 

 

 

Table of Contents

 

FORWARD-LOOKING STATEMENTS

 

      This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, which are subject to the “safe harbor” created by those sections. The forward-looking statements are based on our current expectations and projections about future events. Discussions containing such forward-looking statements may be found in “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and elsewhere in this document.  In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “could,” “predicts,” “projects,” “potential,” “continue,” “expects,” “anticipates,” “future,” “intends,” “plans,” “believes,” “estimates,” or the negative of these terms and other comparable terminology, including, but not limited to, the following:

   -  any projections of revenues, earnings, cash balances or cash flow, synergies or other financial items;
   -  any statements of the plans, strategies and objectives of management for future operations;
   -  any statements regarding future economic conditions or performance;
   -  implementing our business strategy;
   -  attracting and retaining customers;
   -  obtaining and expanding market acceptance of the products and services we offer;
   -  competition in our market;
   -  statements regarding the outcome of pending litigation;
   -  trends in the mix of rental and sales product mix and from lower-therapy products to capital purchases;
   -  future demand for V.A.C. systems;
   -  changes in patient demographics; and
   -  any statements of assumptions underlying any of the foregoing.

      These forward-looking statements are only predictions, not historical facts. These forward-looking statements involve certain risks and uncertainties, as well as assumptions. Actual results, levels of activity, performance, achievements and events could differ materially from those stated, anticipated or implied by such forward-looking statements. The factors that could contribute to such differences include those discussed under the caption “Risk Factors” in the section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” contained herein, as well as those discussed in our Form 10-K and other filings with the Securities and Exchange Commission. These risks include the fluctuations in our operating results and the possible inability to meet our expectations or those of our analysts in future periods; intense and growing competition we face; our dependence on our intellectual property; our dependence on new technology; the clinical efficacy of the V.A.C. relative to alternate devices or therapies; and third party reimbursement policies and collections.  You should also consider the risk factors and uncertainties under the caption “Risk Factors” among other things, in evaluating KCI’s prospects and future financial performance. The occurrence of the events described in the risk factors could harm the business, results of operations and financial condition of KCI. These forward-looking statements are made as of the date of this Quarterly Report on Form 10-Q. KCI disclaims any obligation to update or alter these forward-looking statements, whether as a result of new information, future events or otherwise.

 

In this report, unless the context requires otherwise, the words "we," "our," "us," and "KCI" refer to Kinetic Concepts, Inc., together with its consolidated subsidiaries.

 

 

TRADEMARKS

      The following terms used in this report are our trademarks: AirMaxxis™, AtmosAir™, BariAir®, BariKare®, BariMaxx® II, BariMaxx®, DynaPulse®, FirstStep®, FirstStep® Advantage™, FirstStep® Plus, FirstStep Select®, FirstStep Select® Heavy Duty, FluidAir Elite®, FluidAir™ II, KCI®, KinAir™ III, KinAir™ IV, KinAir™ MedSurg™, Kinetic Concepts®, Kinetic Therapy™, Maxxis® 300, Maxxis® 400, MiniV.A.C.™, PediDyne™, PlexiPulse®, PlexiPulse® AC, Pulse IC™, Pulse SC™, RIK®, RotoProne®, Roto Rest®, Roto Rest® Delta, T.R.A.C.™, The Clinical Advantage®, TheraPulse®, TheraPulse® II, TheraRest®, TriaDyne® II, TriaDyne® Proventa™, TriCell®, V.A.C.®, V.A.C.^ATS®™, V.A.C.® Freedom™, V.A.C.® Therapy™, The V.A.C.® System™, Vacuum Assisted Closure® and V.A.C.® Instill™. All other trademarks appearing in this report are the property of their holders.

Table of Contents

 

PART I - FINANCIAL INFORMATION

 

ITEM 1.     FINANCIAL STATEMENTS

 

Table of Contents

 

 

Table of Contents

 

        1)  This amount includes $66.8 million of income taxes paid related to the Hillenbrand antitrust settlement.

See accompanying notes to condensed consolidated financial statements.

Table of Contents

 

KINETIC CONCEPTS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

(1)     SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

(a)     Basis of Presentation

 

      The unaudited condensed consolidated financial statements presented herein include the accounts of Kinetic Concepts, Inc., together with its 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 indicative of results that may be expected for the fiscal year as a whole.  The consolidated financial statements reflect all adjustments, consisting of normal recurring accruals, 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 2004 presentation.

 

(b)     Stock-Based Compensation

 

      We use the intrinsic value method to account for our stock compensation plans. If the compensation cost for our stock-based employee compensation plans 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 (loss) available to common shareholders and net earnings (loss) per share would have been adjusted 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 (in thousands, except for earnings (loss) 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 compensation expense.

 

      In March 2004, the Financial Accounting Standards Board (“FASB”) issued an exposure draft entitled “Share-Based Payment, an Amendment of FASB Statements No. 123 and 95.”  This proposed statement would eliminate the ability to account for stock-based compensation using APB 25 and require such transactions be recognized as compensation expense in the income statement based on their fair values on the date of the grant.  Based on recent decisions made by the FASB, the statement would be effective for KCI on July 1, 2005.  The proposal is highly controversial and subject to public comment.  Accordingly, the provisions of the final statement, which the FASB expects to issue in late 2004, could significantly differ from those proposed.

 

      During the three and nine-month periods ended September 30, 2004, we issued approximately 664,000 and 3.4 million shares of common stock, respectively, under our stock-based compensation plans primarily through option exercises.  During the three and nine-month periods ended September 30, 2004, we granted approximately 37,000 and 956,000 options, respectively, to purchase shares of common stock under our stock-based compensation plans.

 

(c)     Other Significant Accounting Policies

 

       For further information on our significant accounting policies, see Note 1 of the Notes to the Consolidated Financial Statements included in KCI's Annual Report on Form 10-K for the year ended December 31, 2003.

 

 

(2)      RECENT PUBLIC STOCK OFFERINGS

 

      On February 27, 2004, we completed an initial public offering (“IPO”) of our common stock, through which we sold 3.5 million newly‑issued shares and selling shareholders sold an aggregate of 17.2 million existing shares at a price of $30.00 per share.  Net proceeds from the IPO to KCI were $94.4 million. The net proceeds, along with cash on hand, were used to redeem $71.75 million principal amount of our 7³/₈% Senior Subordinated Notes due 2013, together with a bond call premium of $5.3 million in connection with the redemption, to prepay $50.0 million of debt under our senior credit facility, and to pay management bonuses, payroll taxes and other expenses related to the IPO of $19.8 million.  In March 2004, we wrote off $3.3 million in loan issuance costs associated with the retirement of our debt, which was included in interest expense.

 

      As part of the IPO, the holders of our then-outstanding Series A convertible preferred stock received cumulative preferred dividends paid-in-kind through December 31, 2005 of $65.6 million, and immediately thereafter, all of the then-outstanding shares of preferred stock were automatically converted into approximately 19.2 million shares of common stock.

 

      On June 16, 2004, we completed a secondary offering of our common stock through which selling shareholders sold an aggregate of 16.1 million existing shares at a price of $47.50 per share.  KCI did not sell any shares or receive any proceeds in the offering. We incurred $2.2 million of expenses related to the secondary offering.

 

 

(3)      SUPPLEMENTAL BALANCE SHEET DATA

 

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

 

 

 

(4)      LONG-TERM OBLIGATIONS AND DERIVATIVE FINANCIAL INSTRUMENTS

 

Senior Credit Facility

 

      On September 30, 2004, we made an optional prepayment of $30.0 million on our senior credit facility and our remaining outstanding balance as of September 30, 2004 was $367.6 million.

 

7³/₈% Senior Subordinated Notes due 2013

 

      During the third quarter of 2004, we purchased $1.1 million principal amount of our 7³/₈% Senior Subordinated Notes due 2013 at an aggregate market price of $1.2 million.  As of September 30, 2004, $97.8 million principal amount of the notes remained outstanding. Wemay purchase additional amounts of the notes in the open market and/or in privately negotiated transactions from time to time, subject to limitations in our senior credit facility.

 

 

(5)      EARNINGS (LOSS) PER SHARE

 

      The following table sets forth the reconciliation from basic to diluted weighted average common shares and the calculations of net earnings (loss) per common share for the periods presented.  Net earnings (loss) per share was calculated using the weighted average number of common shares outstanding.  (See Note 1 (b).)

 

(1) Due to their antidilutive effect, 6,458 dilutive potential common shares from stock options and 8,485 dilutive potential common shares from
      the preferred stock conversion have been excluded from the diluted weighted average shares calculation for the three months ended
      September 30, 2003.  In addition, due to their antidilutive effect, 5,606 and 5,763 dilutive potential common shares from stock options
      and 3,994 and 2,860 dilutive potential common shares from the preferred stock conversion have been excluded from the diluted weighted
      average shares calculation for the nine months ended September 30, 2004 and 2003, respectively.

(6)      OTHER COMPREHENSIVE INCOME

 

      The Company follows Statement of Financial Accounting Standards No. 130, "Reporting Comprehensive Income," in accounting for comprehensive income and its components. Comprehensive income for the three months ended September 30, 2004 and 2003 was $34.2 million and a loss of $34.1 million, respectively.  For the nine months ended September 30, 2004 and 2003, comprehensive income was $64.1 million and $6.5 million, respectively.  The most significant adjustment to net earnings to arrive at comprehensive income consisted of a foreign currency translation adjustment.

 

 

(7)      COMMITMENTS AND CONTINGENCIES

 

      We are party to a number of legal proceedings for which provisions have been made, where necessary, in our financial statements to cover estimated costs.  For a description of ongoing legal proceedings, please see our Annual Report on Form 10-K for the year ended December 31, 2003 under the caption “Part I.  Item 3. Legal Proceedings.”  For a description of recent developments in our legal proceedings for the third quarter of 2004, please see “Part II.  Item 1. Legal Proceedings,” within this report.  Other than commitments for new product inventory, including disposable "for sale" products of $12.7 million, we have no material long-term capital commitments.

 

 

(8)      SEGMENT AND GEOGRAPHIC INFORMATION

 

      We are principally engaged in the rental and sale of therapeutic systems and surfaces throughout the United States and in 16 primary countries internationally. Revenues are attributed to individual countries based on the location of the customer.

 

      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 have two primary product lines - V.A.C. and Therapeutic Surfaces/Other.  Revenues for each of our product lines are disclosed for our operating segments.  No discrete financial information is available for our product lines other than revenue.  Our product lines are marketed and serviced by the same infrastructure and, as a result, we do not manage our business by product line but rather by geographical segments.  We use operating earnings (loss) to measure segment profit.  We define operating earnings (loss) as net earnings (loss) before interest income or expense, foreign currency gain and income taxes (benefit).  All intercompany transactions are eliminated in computing revenue and operating earnings (loss).  Prior years have been made to conform with the current presentation.

 

 

      Information on segments and a reconciliation of consolidated totals are as follows (in thousands):

 

 

(9)      GUARANTOR CONDENSED CONSOLIDATING FINANCIAL STATEMENTS

 

       On August 11, 2003, we issued and sold an aggregate of $205.0 million principal amount of 7³/₈% Senior Subordinated Notes due 2013.  Of this amount, $97.8 million of the notes remained outstanding as of September 30, 2004.

 

      The notes are fully and unconditionally guaranteed, jointly and severally, by each of KCI's direct and indirect 100% owned subsidiaries, other than any entity that is a controlled foreign corporation within the definition of Section 957 of the Internal Revenue code or a holding company whose only assets are investments in a controlled foreign corporation.  Each of these subsidiaries is a restricted subsidiary, as defined in the indenture governing the notes.

 

      The following tables present the condensed consolidating balance sheets of KCI as a parent company, our guarantor subsidiaries and our non-guarantor subsidiaries as of September 30, 2004 and December 31, 2003 and the related condensed consolidating statements of operations for the three and nine-month periods ended September 30, 2004 and 2003, and the condensed consolidating statements of cash flows for the nine-month periods ended September 30, 2004 and 2003, respectively.

 

 

 

 

 

 

 

 

 

 

Table of Contents

 

ITEM 2.     MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
                    AND RESULTS OF OPERATIONS

 

     The following discussion should be read in conjunction with the condensed consolidated financial statements and accompanying notes included in this report.  The following discussion contains forward-looking statements that reflect our plans, estimates and beliefs.  Our actual results could differ materially from those discussed in the forward-looking statements.  Factors that could cause or contribute to these differences include, but are not limited to, those discussed under “Risk Factors.”

 

General

 

      Kinetic Concepts, Inc. is a global medical technology company with leadership positions in advanced wound care and therapeutic surfaces. We design, manufacture, market and service a wide range of proprietary products that can significantly improve clinical outcomes while reducing the overall cost of patient care by accelerating the healing process or preventing complications. Our advanced wound care systems incorporate our proprietary V.A.C. technology, which has been clinically demonstrated to promote wound healing and to reduce the cost of treating patients with difficult‑to‑treat wounds. Our therapeutic surfaces, including specialty hospital beds, mattress replacement systems and overlays, are designed to address complications associated with immobility and obesity, such as pressure sores and pneumonia.

 

      We have direct operations in the United States, Canada, Western Europe, Australia, Singapore and South Africa, and we conduct additional business through distributors in Latin America, the Middle East, Eastern Europe and Asia.  We manage our business in two geographical segments, USA and International. In the United States, which accounted for 75.5% of our revenue for the nine months ended September 30, 2004, we have a substantial presence in all care settings.

 

      We derive our revenue from both rental and sale of our products.  In the U.S. acute and extended care settings, which accounted for more than half of our U.S. revenue, we directly bill our customers, such as hospitals and extended care facilities. In the U.S. home care setting, where our revenue comes predominantly from V.A.C. systems, we provide products and services directly to patients and we directly bill third-party payers, such as Medicare and private insurance.  Internationally, substantially all of our revenue is generated from the acute care setting, and therefore, only a small portion of international V.A.C. revenue comes from home care. 

 

      Since the fourth quarter of 2000, our growth has been driven primarily by increased revenue from V.A.C. system rentals and sales, which accounted for approximately 69.6% of total revenue for the nine months ended September 30, 2004, up from 61.9% for the same period in 2003.

 

      For the nine months ended September 30, 2004, the home care market accounted for 43.5% of V.A.C. revenue and 30.3% of our total revenue.  V.A.C. systems used in the home are reimbursed by government insurance (Medicare and Medicaid), private insurance and managed care organizations.

 

      We believe that the key factors underlying V.A.C. growth over the past year have been:

 

             -  Improving V.A.C.’s acceptance among customers and physicians, both in terms of the number of users
                 and the extent of use by each customer or physician.

             -  Encouraging market expansion by adding new wound type indications for V.A.C. use and increasing the
                percentage of wounds that are considered good candidates for V.A.C. therapy.  Recent examples of
                advances include the use of V.A.C. in open abdominal wounds, sternotomies and highly-infected wounds.

 

             -  Strengtheningour contractual relationships with third-party payers.  We increased the number of
                reported lives covered with private and governmental organizations from fewer than 20 million
                in mid-2000 to over 200 million as of September 30, 2004.  Our primary focus today is to leverage
                our relationship with these payers by providing advanced wound care to their beneficiaries while
                improving the business processes required to document therapy and invoice and pay claims.

 

      Over the last three years, we have focused our marketing and selling efforts on increasing physician awareness of the benefits of V.A.C. therapy. These efforts are targeted at physician specialties that provide care to the majority of patients with wounds in our target categories. Within these specialties, we focus on those clinicians who serve the largest number of wound care patients. Over time, we have added new specialties as awareness in our initial priority groups begin to approach appropriate levels.

 

      Continuous enhancements in product portfolio and positioning are also important to our continued growth and market penetration. In 2003 and the first nine months of 2004, we benefited from the continuing rollout of the new V.A.C.^ATS and the V.A.C. Freedom, which began in late 2002.  We believe these advanced technology systems have significantly increased customer acceptance and value perception of V.A.C. therapy.  We have also benefited from the introduction of three new dressing systems designed to improve ease-of-use and effectiveness in treating pressure ulcers and serious abdominal wounds.

 

      At the same time, ongoing clinical experience and studies have increased the market acceptance of V.A.C. and expanded the range of wounds considered to be good candidates for V.A.C. therapy. We believe this growing base of data and clinical experience has driven the trend toward use of the V.A.C. on a routine basis for appropriate wounds.

 

      Our other major product line, therapeutic surfaces, has been a stable line of business for the last three years. Therapeutic surfaces revenue accounted for approximately $213.5 million in revenue in the first nine months of 2004, up from $202.9 million in the prior-year period.

 

Recent Developments

 

      On September 30, 2004, we made an optional prepayment of $30.0 million on our senior credit facility.  As of September 30, 2004, the outstanding balance on our senior credit facility was $367.6 million.  During the third quarter of 2004, we also purchased $1.1 million principal amount of our 7³/₈% Senior Subordinated Notes due 2013 at an aggregate market price of $1.2 million.  As of September 30, 2004, $97.8 million principal amount of the notes remained outstanding.  Wemay purchase additional amounts of the notes in the open market and/or in privately negotiated transactions from time to time, subject to limitations in our senior credit facility.

Table of Contents

 

Results of Operations

 

      The following table sets forth, for the periods indicated, the percentage relationship of each item to total revenue as compared to the same period of the prior year:

 

 

 

       The following table sets forth, for the periods indicated, the amount of revenue derived from each of our geographical segments, USA and International (in thousands):

 

 

 

Total Revenue.  Total revenue in the third quarter of 2004 was $257.2 million, an increase of $59.1 million, or 29.9%, from the prior-year period.  Total revenue in the first nine months of 2004 was $719.0 million, an increase of $171.1 million, or 31.2%, from the prior-year period.  The growth in total revenue over the prior period was primarily due to the increased rental and sales volumes for V.A.C. wound healing devices and related disposables.  The growth in V.A.C. revenue was enhanced by the worldwide availability of the V.A.C.^ATS and V.A.C. Freedom, increased physician awareness of the benefits of V.A.C. therapy and increased product adoption across wound types.  For the nine months ended September 30, 2004, worldwide V.A.C. revenue from the combined acute and extended care settings grew 48.0%, and V.A.C. revenue from the home care setting grew 46.8% as compared to the nine months ended September 30, 2003, respectively.  Foreign currency exchange movements favorably impacted revenue by 2.6% and 2.9% in the third quarter and in the first nine months of 2004, respectively, compared to the corresponding periods of the prior year. 

 

Domestic Revenue.  Total domestic revenue was $193.0 million for the third quarter of 2004 and $542.6 million for the first nine months of 2004, representing increases of 27.7% and 30.2%, respectively, as compared to the prior-year periods due to increased rental and sales volumes for V.A.C. wound healing devices and related disposables.  

 

      Total domestic V.A.C. revenue was $148.8 million for the third quarter of 2004 and $406.4 million for the first nine months of 2004, representing increases of 40.5% and 43.8%, respectively, as compared to the prior-year periods.  Domestic V.A.C. rental revenue of $111.3 million for the third quarter of 2004 increased $28.4 million, or 34.2%, due to a 37.8% increase in average units on rent as compared to the prior-year quarter.  For the first nine months of 2004, domestic V.A.C. rental revenue of $302.7 million increased $79.9 million, or 35.9%, due to a 42.7% increase in average units on rent as compared to the prior-year period.  These increases were due to increased awareness of the benefits of V.A.C. therapy and continued market acceptance of the V.A.C.^ATS and V.A.C Freedom systems introduced in late 2002, which have now been fully implemented in the United States.  These unit increases were partially offset by a decline in the average V.A.C. rental pricing during the third quarter of 2004 and first nine months of 2004, due in part to the continued shift away from all-inclusive pricing for managed care organizations, which resulted in revenue movement from the rental classification to the sales classification.  Domestic V.A.C. sales revenue of $37.4 million in the third quarter of 2004 and $103.7 million in the first nine months of 2004 increased $14.5 million, or 63.4%, and $43.9 million, or 73.3%, respectively, from the prior-year period. This was due to higher sales volumes for V.A.C. disposables associated with V.A.C. system rentals, improved price realization from increased sales of our higher therapy disposables associated with V.A.C.^ATS and V.A.C. Freedom and a shift in pricing methodology for managed care organizations away from all-inclusive pricing. 

 

      Domestic therapeutic surfaces/other revenue was $44.3 million in the third quarter of 2004, representing a decrease of 2.4% over the prior-year quarter due primarily to lower sales.  For the first nine months of 2004, domestic therapeutic surfaces/other revenue was $136.2 million, an increase of 1.5% over the prior-year period.  For the first nine months of 2004, domestic therapeutic surfaces rental revenue of $114.2 million increased 2.8%, as compared to the prior-year period, primarily due to a 4.1% price increase resulting from favorable product mix changes, partially offset by a 1.6% decrease in the average number of units on rent as compared to the prior-year period.

 

International Revenue.  Total international revenue was $64.1 million for the third quarter of 2004 and $176.3 million for the first nine months of 2004, representing increases of 37.0% and 34.6%, respectively, from the prior-year periods as a result of increased V.A.C. demand, higher therapeutic surface rental revenue and favorable foreign currency exchange movements.  Favorable foreign currency exchange movements contributed 10.8% to the variance in the third quarter of 2004 and 12.0% to the variance in the first nine months of 2004.

 

      Total international V.A.C. revenue was $36.8 million in the third quarter of 2004 and $93.9 million in the first nine months of 2004, representing increases of 68.8% and 65.8%, respectively, from the prior-year periods.  Foreign currency exchange movements favorably impacted international V.A.C. revenue by 14.2% and 15.0% over the prior-year periods, respectively.  International V.A.C. rental revenue of $18.6 million in the third quarter of 2004 increased $7.5 million, or 67.4%, due to a 48.6% increase in average units on rent per month, together with a 3.5% increase in average rental price due tofavorable product mix changes.  For the first nine months of 2004, international V.A.C rental revenue of $47.3 million increased $18.6 million, or 64.7%, due to a 43.0% increase in average units on rent per month together with a 4.8% increase in average rental price due to favorable product mix changes.  Foreign currency exchange movements impacted international V.A.C. rental revenue favorably by 14.1% and 14.7% in the third quarter and first nine months of 2004, respectively.  International V.A.C. sales revenue of $18.2 million in the third quarter of 2004 and $46.6 million in the first nine months of 2004, increased $7.5 million, or 70.2%, and $18.7 million, or 67.0%, respectively, from the prior-year period, due to increased sales volumes for V.A.C. disposables associated with increased V.A.C. system rentals along with increased price realization from the sale of higher therapy disposables associated with the V.A.C.^ATS and V.A.C. Freedom.  Foreign currency exchange movements impacted international V.A.C. sales revenue favorably by 14.2% and 15.3% in the third quarter and first nine months of 2004, respectively, compared to the corresponding periods of the prior year.

 

      International therapeutic surfaces/other revenue was $27.4 million for the third quarter of 2004 and $82.4 million for the first nine months of 2004, representing increases of 9.3% and 10.8%, respectively, from the prior-year periods. These increases were primarily due to a 15.7% and 15.6% increase in the average number of therapeutic surface rental units on rent for the third quarter and first nine months of 2004, respectively, compared to the prior-year periods.  This increase was partially offset by a 14.0% and 11.7% declines in average rental pricing during the third quarter and first nine months of 2004, respectively.  The decline in average rental price resulted from competitive pressures and changes in product mix.  In addition, foreign currency exchange movements favorably impacted international therapeutic surfaces/other revenue by 7.9% and 9.7% over the prior-year periods, respectively.

 

Rental Expenses.Rental, or “field”, expenses are comprised of both fixed and variable components.  Field expenses, as a percentage of total rental revenue, were 61.0% in the third quarter of 2004 as compared to 61.2% in the prior-year quarter and 62.3% in the first nine months of 2004 as compared to 61.6% in the prior-year period.  Efficiencies recognized in our service model were offset by our increasing investment in product marketing and the impact of foreign currency exchange movements on field costs associated with our international business.  Also contributing to this variance was the impact of the shift from all-inclusive pricing, which had the effect of moving revenue from the rental classification to the sales classification.

 

Cost of Goods Sold.  Cost of goods sold were $18.8 million in the third quarter of 2004 and $52.1 million in the first nine months of 2004, representing increases of 4.2% and 12.4%, respectively, over the prior-year periods.  Sales margins increased to 72.5% in the third quarter of 2004 compared to 61.5% in the prior-year quarter.  In the first nine months of 2004, sales margins increased to 72.4% as compared to 63.3% in the prior-year period. These increased margins are due to favorable product mix changes, continued cost reductions resulting from our global supply contract for V.A.C. disposables and the shift away from all-inclusive pricing arrangements with managed care organizations.

 

Gross Profit.  Gross profit was $123.3 million in the third quarter of 2004 and $336.8 million in the first nine months of 2004, representing increases of 40.9% and 39.3%, respectively, over the prior-year periods due primarily to revenue increases.  Gross profit margin in the third quarter of 2004 was 47.9%, up from 44.2% in the prior-year quarter. For the first nine months of 2004, gross profit margin was 46.8%, up from 44.1% in the prior-year period.  Sales productivity gains, continued cost reductions resulting from our global supply contract for V.A.C. disposables, improved service efficiency and favorable product mix changes contributed to the margin expansion.

 

Selling, General and Administrative Expenses.  Selling, general and administrative expenses represented 23.0% of total revenue in the third quarter of 2004 compared to 21.2% in the prior-year period.  In the first nine months of 2004, these expenses represented 22.3% of total revenue compared to 21.6% in the prior-year period.  The increase in selling, general and administrative expenses as a percentage of revenue related primarily to increased incentive compensation expense accruals related to company performance, the impact of foreign currency exchange rate variances on our international business and a one-time charitable contribution partially offset by increased administration efficiencies throughout the organization.

 

Research and Development Expenses.Research and development expenses in the third quarter of 2004, including clinical studies, increased 11.7% over the prior-year period to $7.5 million.  In the first nine months of 2004, these expenses increased 39.9% to $21.9 million and represented 3.0% of total revenue as compared to 2.9% in the prior-year period.  We anticipate our rate of spending on research and development will increase in future periods.

 

Public Equity Offering Expenses.  In the first nine months of 2004, we paid bonuses of $19.3 million, including related payroll taxes, and approximately $562,000 of professional fees and other miscellaneous expenses in connection with our initial public offering.  In addition, we incurred $2.2 million in professional fees and other miscellaneous expenses in connection with our secondary offering, which was completed in June 2004.

 

Recapitalization Expenses.  During the third quarter of 2003, we recognized approximately $70.0 million in fees and expenses, excluding $16.3 million charged to interest expense, resulting from the transactions associated with our 2003 debt recapitalization.

 

Operating Earnings (Loss).  Operating earnings for the third quarter 2004 increased $87.8 million from the same quarter of 2003, due primarily to the $70.0 million of recapitalization expenses incurred in 2003. Operating margins in the third quarter of 2004 increased to 22.0%.  For the first nine months of 2004, operating earnings, including expenses related to our stock offerings in 2004 and recapitalization in 2003, increased 251.5% and operating margins increased to 18.4% from 6.9% in the prior-year period.  Operating margins were unfavorably impacted by the expenses incurred in connection with our recapitalization in 2003 and our stock offerings in 2004.

 

Interest Expense.  Interest expense in the third quarter of 2004 was $7.6 million compared to $25.3 million, including $16.3 million related to our recapitalization, in the third quarter of 2003.  During the third quarter of 2004, our average total debt outstanding and effective interest rate were lower, resulting in a reduction in interest expense compared to the prior-year period.  In the first nine months of 2004, interest expense was $37.5 million compared to $41.6 million, including $16.3 million related to our recapitalization, in the prior-year period. Interest expense for the first nine months of 2004 included payments of bond call and purchase premiums of $7.7 million associated with the redemption of a portion of our outstanding 7³/₈% Senior Subordinated Notes due 2013, the write-off of $5.1 million of loan issuance costs on debt retired and the impact of an increase in our average outstanding debt due to the recapitalization completed by KCI in the third quarter of 2003.

 

Net Earnings (Loss).  Net earnings for the third quarter of 2004 were $32.8 million, as compared to a net loss of $34.3 million, including after tax expenses of $53.9 million related to our 2003 debt recapitalization.  Diluted net earnings per share were $0.46 for the third quarter of 2004 compared to a net loss per share of $0.74 in the prior-year period.  Net earnings for the first nine months of 2004, including after tax expenses of $21.6 million related to our stock offerings and debt prepayments, were $62.3 million, an increase of $60.6 million from the prior-year period.  Diluted net loss per share after preferred stock dividends was $0.05 in the first nine months of 2004 compared to a net loss per diluted share of $0.03 per share in the prior-year period. The effective tax rate for the third quarter of 2004 and the first nine months of 2004 was 36.0% compared to 37.5% for the same periods a year ago. The income tax rate reduction is primarily attributable to a higher proportion of taxable income in lower tax jurisdictions.

 

 

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Non-GAAP Financial Information

 

     On February 27, 2004, we completed an initial public offering ("IPO") of common stock and on June 16, 2004, we completed a follow-on secondary stock offering. These transactions, along with related debt prepayments, had the effect of reducing net earnings for the nine-month period ended September 30, 2004 by $21.6 million. During the third quarter of 2003, KCI completed a leveraged recapitalization, which resulted in recapitalization expenses totaling $86.3 million on a pretax basis and $53.9 million, or $0.77 per diluted share, net of income taxes.

 

      Supplementally, we have presented income statement items on a non-GAAP basis to exclude the impact of expenses and the acceleration of the in-kind preferred stock dividends incurred as result of the 2004 stock offerings and debt prepayments and the 2003 leveraged recapitalization.  These non-GAAP financial measures do not replace the presentation of our GAAP financial results. We have provided this supplemental non-GAAP information because it provides meaningful information regarding our results on a basis that better facilitates comparisons between the periods presented. Management uses this non-GAAP financial information, along with GAAP information, for reviewing the operating results of its business segments and for analyzing potential future business trends. In addition, we believe investors use this information in a similar fashion.  A reconciliation of our GAAP income statement for the periods presented to the non-GAAP financial information is provided below.

 

Three months ended September 30, 2004 (Excluding Stock Offerings and Recapitalization Costs)

 

      On a comparable basis, operating earnings for the quarter ended September 30, 2004 increased $17.9 million, or 46.1%, to $56.7 million over the prior-year period.  Operating margins for the third quarter of 2004 were 22.0%, up from 19.6% in the prior–year period.  Interest expense decreased $1.5 million from the prior-year period.  Our 2003 recapitalization had the effect of reducing net earnings for the third quarter of 2003 by $53.9 million, or $1.02 per diluted share.  Net earnings for the 2004 third quarter of $32.8 million, were up 66.9% from the same period a year ago.  Net earnings per diluted share were $0.46 for the third quarter of 2004 compared to $0.28 for the same period in 2003, an increase of 64.3% from the prior-year period.

 

Nine months ended September 30, 2004(Excluding Stock Offerings and Recapitalization Costs)

 

      On a comparable basis, operating earnings for the nine months ended September 30, 2004 increased $46.8 million, or 43.5%, to $154.4 million compared to $107.6 million for the prior-year period.  Operating margins for the first nine months of 2004 on a comparable basis were 21.5% compared to 19.6% in the prior year.  Interest expense was $25.8 million for the nine months ended September 30, 2004 compared to $25.3 million in the prior-year period.  Net earnings for the first nine months of 2004 increased $28.3 million, or 50.9%, to $83.9 million compared to $55.6 million in the prior–year period.  Net earnings per diluted share were $1.19 in the first nine months of 2004 compared to $0.74 for the same period in 2003, an increase of 60.8% from the prior-year period.

 

      The following tables set forth, for the periods indicated, a reconciliation of our stock offerings, debt prepayments and recapitalization-related adjustments to the GAAP condensed consolidated statements of operations:

 

(1)  These non-GAAP financial measures do not replace the presentation of our GAAP financial results.
(2)  The percentage change reflects the percentage variance between the 2004 GAAP results and the 2003 (non-GAAP) results, excluding recapitalization.
(3)  Due to their antidilutive effect, 6,458 dilutive potential common shares from stock options and 8,485 dilutive potential common shares from the preferred
       stock conversion have been excluded from the diluted weighted average shares calculation, for the GAAP results, for the three months ended
       September 30, 2003.  In addition 8,485 dilutive potential common shares from the preferred stock conversion have been excluded from the diluted
       weighted average shares calculation, for the Excluding Recapitalization (non-GAAP) results, for the three months ended September 30, 2003.

 

(1)  These non-GAAP financial measures do not replace the presentation of our GAAP financial results.
(2)  The percentage change reflects the percentage variance between the 2004 (non-GAAP) results, excluding costs and expenses related to offerings and debt
       prepayments, and the 2003 (non-GAAP) results, excluding recapitalization.
(3)  Due to their antidilutive effect, 5,606 and 5,763 dilutive potential common shares from stock options and 3,994 and 2,860 dilutive potential common shares
       from the preferred stock conversion have been excluded from the diluted weighted average shares calculation, for the GAAP results, for the nine months ended
       September 30, 2004 and 2003, respectively.  In addition, due to their antidilutive effect, 2,860 dilutive potential common shares from the preferred stock
       conversion have been excluded from the diluted weighted average shares calculation, for the Excluding Recapitalization (non-GAAP) results, for the nine
       months ended September 30, 2003.

 

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Liquidity and Capital Resources

 

General

 

      We require capital principally for capital expenditures, systems infrastructure, debt service, interest payments and working capital. Our capital expenditures consist primarily of manufactured rental assets, computer hardware and software and expenditures related to the need for additional office space for our expanding workforce. Working capital is required principally to finance accounts receivable and inventory. Our working capital requirements vary from period to period depending on manufacturing volumes, the timing of shipments and the payment cycles of our customers and payers.

 

Sources of Capital

 

      Based upon the current level of operations, we believe our existing cash resources as well as cash flows from operating activities and availability under our revolving credit facility will be adequate to meet our anticipated cash requirements for at least the next twelve months. During the first nine months of 2004, our primary sources of capital were cash from operations and proceeds from our IPO.  The following table summarizes the net cash provided and used by operating activities, investing activities and financing activities for the nine months ended September 30, 2004 and 2003 (in thousands):

 

      (1) This amount includes the impact of a non-recurring working capital item for $21.6 million of after-tax expenses
            associated with our stock offerings and debt prepayments.  In addition, working capital changes include a non-
            recurring tax payment of $19.1 million primarily related to an anti-trust litigation settlement we reached in 2002.
      (2) This amount includes the impact of a non-recurring receipt for $175.0 million related to the anti-trust lawsuit
            settlement offset by tax payments on that settlement of $61.6 million along with tax benefits of $21.0 million
            resulting from our 2003 recapitalization, partially offset by $8.9 million of other working capital changes related
            to our 2003 recapitalization.
      (3) This amount includes receipt of $94.4 million in proceeds from the IPO, net of expenses of $10.6 million, prepayment
            of $110.0 million on our senior credit facility and purchase of $107.2 million of our 7³/₈% Senior Subordinated Notes
            due 2013.
      (4) This amount includes payment of $107.0 million of indebtedness on the previously-existing senior credit facility utilizing
            funds received related to the anti-trust lawsuit settlement.

 

      At September 30, 2004, cash and cash equivalents of $71.5 million were available for general corporate purposes. In addition, availability under the revolving portion of our senior credit facility was $85.7 million, net of $14.3 million in letters of credit.

 

Working Capital

 

      At September 30, 2004, we had current assets of $379.4 million and current liabilities of $165.6 million resulting in a working capital surplus of $213.8 million, compared to a surplus of $227.6 million at December 31, 2003. The reduction in our working capital balance of $13.8 million was related primarily to the prepayment of $217.2 million in long-term debt using the net proceeds received in the IPO and cash from operations.

 

      Net cash provided by operating activities for the first nine months of 2004 was $94.1 million as compared to $153.0 million for the prior-year period. Net cash provided by operating activities for the first nine months of 2004 includes reductions related to our stock offerings, debt prepayments, tax payments on the Hillenbrand settlement and tax benefits realized from our 2003 recapitalization of $40.7 million as described above.  Net cash provided by operating activities for the first nine months of 2003 includes the receipt of $175.0 million as the first installment of a two-part antitrust settlement partially offset by associated tax payments of $61.6 million and other working capital changes related to our 2003 recapitalization of $12.1 million.

 

      If rental and sales volumes for V.A.C. systems and related disposables continue to increase, we believe that a significant portion of this increase could occur in the homecare market, which could have the effect of increasing accounts receivable due to the extended payment cycles we experience with most third‑party payers. We have adopted a number of policies and procedures to reduce these extended payment cycles.  As of September 30, 2004, we had $238.6 million of receivables outstanding, net of reserves of $44.7 million for doubtful accounts and $13.4 million for Medicare V.A.C. receivables prior to October 1, 2000.  Our receivables, excluding our reserves related to our Medicare receivables prior to October 1, 2000, were outstanding for an average of 85 days at September 30, 2004 and December 31, 2003.

 

Capital Expenditures

 

      During the first nine months of 2004 and 2003, we made capital expenditures of $63.8 million and $56.6 million, respectively. The period-to-period increase is due primarily to purchases of materials for V.A.C. systems and other high-demand rental products. As of September 30, 2004, we have commitments to purchase new product inventory of $12.7 million over the next twelve months.  Other than commitments for new product inventory, we have no material long-term purchase commitments as of the end of the period.

 

Debt Service

 

      As of September 30, 2004, scheduled principal payments under our senior credit facility for the years 2004, 2005 and 2006 were $931,000, $3.7 million and $3.7 million, respectively. To the extent that we have excess cash, we may use it to reduce our outstanding debt.

 

Senior Credit Facility

 

      Our senior credit facility consists of a seven-year term loan facility and a $100.0 million six-year revolving credit facility.  On September 30, 2004, we made a $30.0 million prepayment on the term loan facility.  The following table sets forth the amounts outstanding under the term loan and the revolving credit facility, the effective interest rates on such outstanding amounts, and amounts available for additional borrowing thereunder, as of September 30, 2004 (in thousands):

 

7³/₈% Senior Subordinated Notes due 2013

 

      On August 11, 2003, we issued an aggregate of $205.0 million principal amount of our 7³/₈% Senior Subordinated Notes due 2013.  During the third quarter of2004, we repurchased $1.1 million principal amount of the notes at an aggregate market price of $1.2 million.  As of September 30, 2004, $97.8 million principal amount of the notes remained outstanding.  We may purchase additional amounts of the notes in the open market and/or in privately negotiated transactions from time to time, subject to limitations in our senior credit facility.

 

Interest Rate Protection

 

      At December 31, 2003, the fair values of our interest rate swap agreements were negative and were adjusted to reflect a liability of approximately $2.4 million.  Due to subsequent movements in interest rates, as of September 30, 2004, the fair values of our swap agreements were positive in the aggregate and were recorded as an asset of approximately $300,000. During the first nine months of 2004 and 2003, we recorded interest expense of approximately $3.2 million and $1.6 million, respectively, as a result of interest rate protection agreements.

 

Critical Accounting Estimates

 

      For a description of our critical accounting estimates, please see our Annual Report on Form 10-K for the year ended December 31, 2003 under the heading "Part II. Item 7.  Management's Discussion and Analysis of Financial Condition and Results of Operations‑Critical Accounting Estimates."

 

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RISK FACTORS

 

Risks Related to Our Business

 

      We face significant competition in our V.A.C. business from companies offering alternative wound therapies and from Hill‑Rom Company in our therapeutic surfaces business, which competition may adversely affect sales if these other companies commercialize competing products more successfully than us.

 

      The competition for our V.A.C. systems in wound healing and tissue repair consists mainly of wound‑healing modalities which do not operate in a manner similar to V.A.C. systems, including traditional wound care dressings, other advanced wound care dressings, skin substitutes, products containing growth factors and other medical devices used for wound care.  If the market for our product expands, we believe additional competitors may introduce products designed to mimic the V.A.C.  In this respect, BlueSky Medical Corporation, “BlueSky”, has introduced a medical device which is being marketed to compete with V.A.C. systems.  We have filed suit against BlueSky and related parties seeking to prohibit their continued marketing and sales of the devices, which we believe infringe our patents.  We have also taken legal action in Europe to protect our intellectual property rights.  If we are unable to maintain our proprietary position and these or other competitors successfully enter the V.A.C. market, we would lose market share or experience downward pricing pressure.

 

      Our primary competitor in the therapeutic surface business is Hill-Rom Company, whose financial and other resources substantially exceed those available to us. In Europe, we also face surfaces competition from Huntleigh Healthcare and Pegasus Limited.

 

      In medical technology, two types of competitive actions pose particularly important risks for potential market share loss. Significant technological innovations can result in substantial swings in market share if we are not able to launch comparably innovative products within months of a competitor's innovation. Similarly, significant changes in market share may also occur if competitors obtain sole‑source contracts with a substantial proportion of GPOs, large health care providers or third-party payers, effectively limiting our market access. Although we are unaware of any current   material competitive developments, future competitive initiatives by our competitors could result in the loss of market share and adversely affect our operating results.

 

      If our future operating results do not meet our expectations or those of the analysts covering us, the trading price of our stock could fall dramatically.

 

      We have experienced and expect to continue to experience fluctuations in revenue and earnings for a number of reasons, including:

 

      -  The level of acceptance of our V.A.C. systems by customers and physicians;
      -  The type of indications that are appropriate for V.A.C. use and the percentages of wounds that are good
          candidates for V.A.C. therapy;
      -  Clinical studies that may be published with respect to the efficacy of V.A.C. therapy, including studies
          published by our competitors in an effort to challenge the efficacy of the V.A.C.;
      -  Third-party government or private reimbursement policies with respect to V.A.C. treatment;
      -  New or enhanced competition in our primary markets, or an adverse determination with respect to our
          intellectual property rights relating to the enabling new or enhanced competition for the V.A.C.

      We believe that the trading price of our common stock has been favorably affected by our historical growth in revenue and earnings per share.  We do not expect that these rates are sustainable for the foreseeable future.  If we are unable to realize growth rates consistent with our expectations or those of the analysts covering KCI as a result of the foregoing or other factors, we would expect to realize an immediate and substantial decline in the trading price of our stock.  We would expect a similar or more significant decline in the trading price of our stock if we are unable to meet our published guidance or the projections of the analysts covering KCI. 

      Because our staffing and operating expenses are based on anticipated revenue levels, and because a high percentage of our costs are fixed, even small decreases in revenue or delays in the recognition of revenue could cause significant variations in our operating results from quarter to quarter.  In the short term, we do not have the ability to timely adjust spending to compensate for any unexpected revenue shortfall, which also could cause a significant decline in the trading price of our stock.

 

      Our intellectual property is very important to our competitive position, especially for our V.A.C. products. If we are unsuccessful in protecting our intellectual property, particularly our rights to the Wake Forest patents that we rely on in our V.A.C. business, our competitive position would be harmed.

 

      We place considerable importance on obtaining and maintaining patent protection for our products, particularly, our rights to the Wake Forest patents that we rely on in our V.A.C. business. We have numerous patents on our existing products and processes, and we file applications as appropriate for patents covering new technologies as they are developed. However, the patents we own, or in which we have rights, may not be sufficiently broad to protect our technology position against competitors. Issued patents owned by us, or licensed to us, may be challenged, invalidated or circumvented, or the rights granted under issued patents may not provide us with competitive advantages.  We would incur substantial costs and diversion of management resources if we have to assert or defend our patent rights against others. Third parties may claim that we are infringing their intellectual property rights, and we may be found to infringe those intellectual property rights. Any unfavorable outcome in intellectual property disputes or litigation could cause us to lose our intellectual property rights in technology that is material to our products. In addition, we may not be able to detect infringement by third parties, and could lose our competitive position if we fail to do so.

 

      For example, the primary European V.A.C. patent, which we rely upon for patent protection in Europe, was recently subject to an opposition proceeding before the Opposition Division of the European Patent Office.  Pursuant to a recent ruling, the patent was upheld, but was corrected to expand the range of pressures covered by the patent from 0.10—0.99 atmospheres to 0.01—0.99 atmospheres and was modified to provide that the "screen means" covered by our patent is polymer foam and, under European patent law, its equivalents. The screen means in the patent, among other things, helps to remove fluid from within and around the wound, distributes negative pressure within the wound, enhances the growth of granulation tissue and prevents wound overgrowth. In our V.A.C. systems, the foam dressing placed in the wound serves as the screen means.  We use two different types of polymer foams as the screen means in our V.A.C. systems.  KCI and one of the two companies who initiated the opposition proceeding have appealed the ruling.  The other opposing party entered into a settlement with KCI.  We believe it will take two to three years to complete the appeal process and we may not be successful in the appeal. During the pendency of the appeal, the original patents will remain in place. The restriction on the type of screen means covered by the patent may lead competitors to believe that they can enter the market with products using screen means other than polymer foam. Although we do not believe that a product using another type of screen means would be as effective as the V.A.C., direct competition would result in significantly increased pricing pressure and could result in a loss of some of our existing customer base.  Revenue for the V.A.C. product lines in Europe was $74.3 million for the nine months ended September 30, 2004.

 

      We have agreements with third parties, including our exclusive license of the V.A.C. patents from Wake Forest, that provide for licensing of their patented or proprietary technologies. These agreements include royalty‑bearing licenses. If we were to lose the rights to license these technologies or our costs to license these technologies were to materially increase, our business would suffer.

 

      If we are unable to develop new generations of V.A.C. and therapeutic surface products and enhancements to existing products, we may lose market share as our existing patent rights begin to expire over time.

 

      Our success is dependent upon the successful development, introduction and commercialization of new generations of products and enhancements to existing products. Innovation in developing new product lines and in developing enhancements to our existing V.A.C. and surfaces products is required for us to grow and compete effectively. Over time, our existing foreign and domestic patent protection in both the V.A.C. and surfaces businesses will begin to expire, which could allow competitors to adopt our older unprotected technology into competing product lines. If we are unable to continue developing proprietary product enhancements to V.A.C. systems and surfaces products that effectively make older products obsolete, we may lose market share in our existing lines of business. In addition, if we fail to develop new lines of products, we will not be able to penetrate new markets. Innovation in enhancements and new products requires significant capital commitments and investments on our part, which we may be unable to recover.

 

      Failure of any of our randomized and controlled studies or a third‑party study or assessment to demonstrate V.A.C. therapy's clinical efficacy may reduce physician usage of V.A.C. and cause our V.A.C. revenue to suffer.

 

      If any of our V.A.C. systems fail to demonstrate statistically significant clinical efficacy in any of our ongoing clinical studies when compared to traditional therapies, our ability to further penetrate the advanced wound care market may be negatively impacted as physicians may choose not to use V.A.C. therapy as a wound treatment. Furthermore, adverse  clinical  results  from these trials would hinder the ability of  V.A.C. to  achieve  standard‑of‑care  designation, which could slow the adoption of V.A.C. across all targeted wound types. As a result, usage of V.A.C. may decline and cause our revenue to suffer.

 

      The Agency for Healthcare Research and Quality ("AHRQ") has assigned a technology assessment on negative pressure therapies for wound healing to the Blue Cross Blue Shield Association Technology Evaluation Center. AHRQ is currently evaluating the technology assessment and has not indicated if, or when, it intends to issue the assessment. Although the technology assessment will not have any legal or binding effect, any technology assessment which is negative, in whole or part, could cause usage of our V.A.C. systems to decline.

 

      Changes to third-party reimbursement policies could reduce the reimbursement we receive for our products.

 

      Our products are rented and sold to hospitals and skilled nursing facilities that receive reimbursement for the products and services they provide from various public and private third‑party payers, including Medicare, Medicaid and private insurance programs. We also act as a durable medical equipment, or DME, supplier and, as such, we furnish our products directly to customers and subsequently bill third‑party payers such as Medicare, Medicaid and private insurance. As a result, the demand for our products in any specific care setting is dependent, in part, on the reimbursement policies (including coverage and payment policies) of the various payers in that setting. Some state and private payers make adjustments to their reimbursement policies to reflect federal changes as well as to make their own changes. If coverage and payment policies for our products are revised or otherwise withdrawn under existing Medicare or Medicaid policies, demand for our products could decrease. In addition, in the event any public or private third‑party payers challenge our billing, documentation or other practices as inconsistent with their reimbursement policies, we could experience significant delays, reductions or denials in obtaining reimbursement. In light of increased controls on health care spending, especially on Medicare and Medicaid spending, the outcome of future coverage or payment decisions for any of our products by governmental or private payers remain uncertain.

 

      In 2003, the Centers for Medicare and Medicaid Services issued new regulations on inherent reasonableness of such charges and while these regulations do not impact us currently, future coverage or payment decisions could impact our V.A.C. systems or any of our other products. If providers, suppliers and other users of our products and services are unable to obtain sufficient reimbursement for the provision of our products, demand for our products will decrease. In addition, under the Medicare Prescription Drug, Improvement and Modernization Act of 2003, a number of changes were made to the Medicare payment methodology for items of DME, including certain payment freezes, a competitive bidding program and clinical and quality standards.

 

      Also, in December 2002, we submitted a written request to the medical directors of the four Durable Medical Equipment Regional Carriers, or DMERCs, in which we requested clarification of a number of issues with respect to the DMERCs' "Negative Pressure Wound Therapy Policy." That policy establishes Medicare Part B reimbursement criteria for our V.A.C. products. In June 2003, we received a response from the medical directors and, in some instances, their interpretation of the policy differed from our interpretation.  Since that time, we have had a variety of interactions with the DMERC Medical Directors.  Most recently, the Medical Directors sent us a draft of new NPWT Guidelines dated September 16, 2004.  In essence, the draft guidelines provide that:  i) a wound must have a surface area of at least 4 sq cm and depth of at least 0.5 cm,  ii) except in exceptional circumstances with appropriate documentation, coverage will be limited to six months, and iii) coverage will end when the wound is filled with granulation tissue.  Although we do not agree fully with the DMERCs on the positions taken in the draft guidelines, we believe they are moving closer to what we believe the current clinical practice standards are.  We have responded to the recent draft guidelines and have a continuing dialogue with the DMERC medical directors on these issues. The tone of the discussions has been constructive and positive.  In the event that the medical directors do not agree to revise their interpretations on these issues, the rate of V.A.C. revenue growth would be impacted. Although difficult to predict, we believe the reimbursement issues addressed by the medical directors relate to approximately 20% of our annual V.A.C. Medicare revenue or about 2.2% of our overall annual revenue.

 

      If we are not able to timely collect reimbursement payments, our financial condition may suffer.

 

      The Medicare Part B coverage policy covering V.A.C. systems is complex and requires extensive documentation. In addition, the reimbursement process for the non-governmental payer segment requires extensive contract development and administration with several hundred payers, with widely varying requirements for documentation and administrative procedures, which can result in extended payment cycles. This has made billing home care payers more complex and time consuming than billing other payers.  If the average number of days our receivables are outstanding increases, our cash flows could be negatively impacted.

 

      We may be subject to claims audits that would harm our business and financial results.

 

      As a health care supplier, we are subject to extensive government regulation, including laws regulating reimbursement under various government programs. The billing, documentation and other practices of health care suppliers are subject to government scrutiny, including claims audits. To ensure compliance with Medicare regulations, contractors, such as the DMERCs, which serve as the government's agents for the processing of claims for products sold for home use, periodically conduct audits and request medical records and other documents to support claims submitted by us for payment of services rendered to our customers. Because we are a DME supplier, those audits involving home use involve audits of patient claims records. Such audits can result in delays in obtaining reimbursement and denials of claims for payment submitted by us. In addition, the government could demand significant refunds or recoupments of amounts paid by the government for claims which are determined by the government to be inadequately supported by the required documentation.

 

      Because we depend upon a limited group of suppliers and, in some cases, sole-source suppliers, we may incur significant product development costs and experience material delivery delays if we lose any significant supplier.

 

      We obtain some of our finished products and components included in our products from a limited group of suppliers, and, in one case, a sole-source supplier. We have entered into a sole-source agreement with Avail Medical Products, Inc. for V.A.C. disposables.  This supply agreement has a three-year term, ending in October 2006, with an automatic extension for an additional twelve months if neither party gives notice of termination. V.A.C. disposables represented 20.3% of our revenue for the nine months ending September 30, 2004. V.A.C. therapy cannot be administered without the appropriate use of our V.A.C. rental unit in conjunction with the related V.A.C. disposables. Any shortage of V.A.C. disposables could lead to lost revenues from decreased V.A.C. rentals.  We maintain an inventory of disposables sufficient to support our business for six weeks in the United States and eight weeks in Europe.  Additionally, we have ensured that Avail has duplicate manufacturing facilities, tooling, and raw material resources for the production of our disposables.  If we lose any supplier (or if a sole-source supplier experiences any manufacturing problems), we could be required to qualify one or more replacement suppliers and may be required to conduct a significant level of process and components validation to incorporate new suppliers or components in to our products. The need to change suppliers to incorporate new components might cause material delays in delivery or significantly increase costs.

 

      If we are unable to successfully implement our new management information systems or are otherwise unable to manage rapid changes, our business may be harmed.

 

      In the last three years we have grown rapidly, and we believe we will continue to grow at a rapid pace. We are currently implementing new management information systems to assist us in managing our rapid growth. If the implementation of these new systems is significantly delayed, or if our expectations for the efficiencies to be obtained through the new systems are not met, our business could be harmed. For example, if we experience problems with our new systems for procurement and billing, we could experience product shortages or an increase in accounts receivable. Any failure by us to properly implement our new information systems, or to otherwise properly manage our growth, could impair our ability to attract and service customers and could cause us to incur higher operating costs and experience delays in the execution of our business plan.

 

      We are subject to numerous laws and regulations governing the healthcare industry, and non-compliance with such laws, as well as changes in such laws or future interpretations of such laws, could reduce demand for and limit our ability to distribute our products and could cause us to incur significant compliance costs.

 

      There are widespread legislative efforts to control health care costs in the United States and abroad, which we expect will continue in the future. For example, the recent enactment of the Medicare Prescription Drug, Improvement and Modernization Act of 2003 eliminated annual payment increases on the V.A.C. system for the foreseeable future and initiated a competitive bidding program. At this time, we are unable to determine whether and to what extent these changes would be applied to our products and our business but this or similar legislative efforts in the future could negatively impact demand for our products.

 

      Substantially all of our products are subject to regulation by the U.S. Food and Drug Administration, or FDA, and its foreign counterparts. Complying with FDA requirements and other applicable regulations imposes significant costs and expenses on our operations. If we fail to comply with applicable regulations, we could be subject to enforcement sanctions, our promotional practices may be restricted, and our marketed products could be subject to recall or otherwise impacted. In addition, new regulations, such as the U.S. Health Insurance Portability and Accountability Act of 1996, or HIPAA, that regulate the way we do business will result in increased compliance costs.

 

      We are also subject to various federal and state laws pertaining to health care fraud and abuse, including prohibitions on the submission of false claims and the payment or acceptance of kickbacks or other remuneration in return for the purchase or lease of our products. The United States Department of Justice and the Office of the Inspector General of the United States Department of Health and Human Services have launched an enforcement initiative which specifically targets the long-term care, home health and DME industries. Sanctions for violating these laws include criminal penalties and civil sanctions, including fines and penalties, and possible exclusion from the Medicare, Medicaid and other federal health care programs. Although we believe our business arrangements comply with federal and state fraud and abuse laws, our practices may be challenged under these laws in the future.

 

      Current or future litigation could expose us to significant costs associated with adverse judgments.

 

      The manufacturing and marketing of medical products necessarily entail an inherent risk of product liability claims and the company carries product liability insurance to mitigate such risks.  In addition, we are currently defendants in several other legal actions, including two patent infringement suits.  In the event of an adverse judgment in any of these cases, we could be responsible for a large litigation damage award.

 

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ITEM 3.     QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

      We are exposed to various market risks, including fluctuations in interest rates and variability in currency exchange rates. We have established policies, procedures and internal processes governing our management of market risk and the use of financial instruments to manage our exposure to such risk.

 

Interest Rate Risk

 

      We have variable interest rate debt and other financial instruments, which are subject to interest rate risk and could have a negative impact on our business if not managed properly. We have a risk management policy, which is designed to reduce the potential negative earnings effect arising from the impact of fluctuating interest rates. We manage our interest rate risk on our borrowings through interest rate swap agreements which effectively convert a portion of our variable-rate borrowings to a fixed rate basis through August 21, 2006, thus reducing the impact of changes in interest rates on future interest expenses. These contracts are initiated within the guidance of corporate risk management policies and are reviewed and approved by our senior financial management. We do not use financial instruments for speculative or trading purposes.

 

      Our senior credit facility requires that we fix the base-borrowing rate applicable to at least 50% of the outstanding amount of our term loan under our senior credit facility for a period of two years from the date of issuance. As of September 30, 2004, we have seven interest rate swap agreements pursuant to which we have fixed the rates on $350.0 million, or 95.2%, of our variable rate debt as follows:

 

   -  2.375% per annum on $100.0 million of our variable rate debt through December 31, 2004;
   -  2.150% per annum on $60.0 million of our variable rate debt through August 22, 2005;
   -  2.130% per annum on $20.0 million of our variable rate debt through August 22, 2005;
   -  2.135% per annum on $20.0 million of our variable rate debt through August 21, 2005;
   -  2.755% per annum on $50.0 million of our variable rate debt through August 21, 2006;
   -  2.778% per annum on $50.0 million of our variable rate debt through August 21, 2006; and
   -  2.788% per annum on $50.0 million of our variable rate debt through August 21, 2006.

      The tables below provide information about our long-term debt and interest rate swaps, both of which are sensitive to changes in interest rates as of September 30, 2004.  For long-term debt, the table presents principal cash flows and related weighted average interest rates by expected maturity dates. For interest rate swaps, the table presents notional amounts and weighted average interest rates by expected (contractual) maturity dates. Notional amounts are used to calculate the contractual payments to be exchanged under the contract. Weighted average variable rates are based on implied forward rates in the yield curve at the reporting date (in thousands):

 

 

      (1)  Interest rate swaps are included in the variable rate debt under long-term debt.

 

Foreign Currency and Market Risk

 

      We have direct foreign operations in Western Europe, Canada, Australia, Singapore and South Africa and distributor relationships in many other parts of the world. Our foreign operations are measured in their applicable local currencies. As a result, our financial results could be affected by factors such as changes in foreign currency exchange rates or weak economic conditions in the foreign markets in which we have operations. Exposure to these fluctuations is managed primarily through the use of natural hedges, whereby funding obligations and assets are both managed in the applicable local currency.

 

      We maintain no other derivative instruments to mitigate our exposure to currency translation and/or transaction risk. International operations reported operating profit of $23.0 million for the nine months ended September 30, 2004. We estimate that a 10% fluctuation in the value of the dollar relative to these foreign currencies at September 30, 2004 would change our net income for the nine months ended September 30, 2004 by approximately $1.3 million. Our analysis does not consider the implications that such fluctuations could have on the overall economic activity that could exist in such an environment in the U.S. or the foreign countries or on the results of operations of these foreign entities.

 

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ITEM 4.     CONTROLS AND PROCEDURES

 

Evaluation of Disclosure Controls and Procedures

 

      Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of the period covered by this report.  Based on such evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, our disclosure controls and procedures are effective.

 

Changes in Internal Control

 

      There have not been any changes in our internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the fiscal quarter to which this report relates that have materially affected, or are reasonable likely to materially affect, our internal control over financial reporting.

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PART II - OTHER INFORMATION

 

ITEM 1.     LEGAL PROCEEDINGS

 

      Set forth below is a description of recent developments in our legal proceedings.  For a description of ongoing legal proceedings, please see our Annual Report on Form 10-K under the caption “Part I.  Item 3.  Legal Proceedings.”

 

      On September 1, 2004, Magistrate Judge Primomo issued a Supplemental Memorandum and Recommendation in the Novamedix lawsuit, which interpreted the claims of the patents involved in the case.  Although KCI has appealed certain aspects of the Recommendation, we believe that the claim construction set forth in the Memorandum supports KCI’s contention that the PlexiPulse device does not infringe Novamedix’s patents.

 

      On September 2, 2004, Judge Ashman issued a Memorandum Opinion and Order which interpreted the claims of the patents involved in the Safe Bed Technologies case.  The Court agreed with KCI’s interpretation of almost all of the claims in question.  As a result, we do not believe that a reasonable trier of fact could find that our products infringe the Safe Bed patents.  We believe Safe Bed will appeal this ruling.

 

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ITEM 2.     UNREGISTERED SALES OF EQUITY SECURITIESAND USE OF PROCEEDS

 

 

Issuer Purchase of Equity Securities

 

                 *    Transactions represent the repurchase of common shares from employees to pay the option exercise price in
                       connection with the exercise of employee stock options.

               **    No share repurchases were made pursuant to a publicly announced plan.

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ITEM 6.     EXHIBITS

 

        A list of all exhibits filed or included as part of this quarterly report on form 10-Q is as follows:

 

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SIGNATURES

 

       Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

 

                                                                                      KINETIC CONCEPTS, INC.
                                                                                      (REGISTRANT)

Date:  November 12, 2004                                            By:      /s/  DENNERT O. WARE                     
                                                                                      Dennert O. Ware
                                                                                      President and Chief Executive Officer
                                                                                      (Duly Authorized Officer)

 

 

Date:  November 12, 2004                                            By:     /s/  MARTIN J. LANDON                      
                                                                                      Martin J. Landon
                                                                                      Vice President and Chief Financial Officer
                                                                                      (Principal Financial and Accounting Officer)