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Kinetic Concepts Inc (NYSE:KCI)

Q3 2008 Earnings Call Transcript

October 22, 2008 8:30 am ET

Executives

Cathy Burzik - President and CEO

Marty Landon - SVP and CFO

Rich Cockrell - VP, IR

Steve Seidel - SVP, General Counsel and Secretary

Steve Sobieski - VP Finance and Administration, and CFO, LifeCell

Lynne Sly - President, Global Therapeutic Surfaces

Analysts

Taylor Harris - JPMorgan

Zafar Imron - Deutsche Bank Securities

Jayson Bedford - Raymond James

Vincent Ricci - Wachovia Capital Markets

Matt Miksic - Piper Jaffray

Paul Choi - Merrill Lynch

Operator

At this time, I would like to welcome everyone to the Kinetic Concept's third quarter Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. (Operator instructions)

I would now like to turn the call over to Rich Cockrell, Vice President of Investor Relations.

Rich Cockrell

Welcome to KCI's third quarter 2008 earnings conference call. Today, we will review the results that were announced in our press release earlier this morning, and today’s conference will include prepared remarks by Cathy Burzik, our President and Chief Executive Officer and Marty Landon, our Chief Financial Officer. We are also joined by other members of management.

If you have not received a copy KCI’s earnings release, it is currently available on the company's website at KCI.com. Today's call is being webcast live over the internet and a replay of this call will be made available on KCI's corporate website shortly after the conclusion of this call.

I would also like to remind everyone that KCI will be hosting an Analyst Day event on Thursday, October 30th, at the Grand Hyatt here in San Antonio. The event will include presentations by KCI's leaders as well as presentations by key opinion leaders in the field of Advanced Wound Care. To learn more about the event, go to KCI's Investor Relations website and click on the Analyst Day link. We look forward to seeing you there.

Our conference call this morning will include forward-looking statements about our business, including guidance on future plans, revenues and earnings. These statements are based on our current expectations and are subject to a number of risk and uncertainties, which could cause actual results to differ from our expectations.

More important information about potential risks factors may be found in our filings with the SEC. Also, reported results discussed on the call may exclude certain non-cash acquisition related expenses associated with the LifeCell acquisition. Please refer to the non-GAAP reconciliation of these metrics contained in our earnings release issued this morning.

I would now like to turn the call over to Cathy Burzik, our President and Chief Executive Officer.

Cathy Burzik

Thank you, Rich and good morning everyone. Thanks for joining us for KCI's third quarter 2008 conference call. I will begin with an overview of our business and our quarterly performance and then I will provide updates on a range of topics, including our V.A.C. Therapy business, progress on the LifeCell integration and our TSS business. Then Marty Landon, our CFO will go into more detail about our financial performance. At the end of the presentation we will open up the call to your questions.

Let me start by saying that our performance was solid this quarter, given an evolving competitive environment. Our business fundamentals remain strong. Our integration with LifeCell is now substantially complete and we are pleased to report very good results in this area. Our V.A.C. Therapy business is stable globally and we believe it is on a path of sustainable growth.

Our TSS business continues to meet our expectations. We also set a new quarterly high revenue exceeding $500 million. Consolidated revenues for the third quarter increased 22% to $503 million. Global V.A.C. Therapy revenues increased 10% to $360 million during the quarter. As expected, our Therapeutic Support Systems business was flat at $82 million, compared to the same period last year.

Consolidated revenues for the period include those from LifeCell's operations. LifeCell performed well in the third quarter of 2008 and achieved revenues of $61 million, an increase of 29% over the same period last year.

Overall, we reported GAAP net earnings of $57 million or $0.78 per diluted share, which compares to GAAP net earnings of $59 million or $0.82 per diluted share during the prior year period. Excluding certain non-cash acquisition related expenses associated with the acquisition of LifeCell, net earnings increased to $69 million or $0.96 per diluted share, an increase of 17% over the same period in 2007.

Revenues for our Global V.A.C. Therapy business increased 10% during the quarter, 8% growth excluding foreign currency movements to $360 million. V.A.C. revenues in North America increased 6% for the period to $270 million. EMEA/APAC revenues increased 24% to $90 million or 16% growth, excluding foreign currency movements.

As discussed last quarter, we believe the NPWT competitive environment has essentially stabilized in the US. While we continue to see new NPWT entrant, we see a fairly consistent number of competitive trials being conducted in the United States. However, we do see an increase in competitive trial internationally.

Clinicians often report a lack of satisfactory patient outcomes and less than satisfactory service levels from competitors with gauze-based wound drainage devices versus the proven outcomes of that therapy and quality service they consistently receive from KCI. As a result of competitive activity, we believe that we will lose two to three share points in 2008. Also we have been able to maintain a stable pricing environment.

Despite the increased competitive environment, KCI remains and is committed to remaining the market leader in Negative Pressure Wound Therapy. Over the next several years, we plan to grow our wound healing business on three dimensions, to continued penetration of our core markets, to geographic expansions and as a result of new product introductions.

We believe this growth will be partially offset by modest share erosions and modest price reductions mostly due to the 9.5% reduction in CMS reimbursement scheduled to begin in 2009. Given the above, we now expect our global wound healing growth for 2009 to be in the mid to high-single digit range.

KCI remains confident in its ability to sustain this level of growth in our V.A.C. business for the foreseeable future. We will be speaking about our wound healing growth strategy for 2009 and beyond in more detail at our Analyst Day meeting on October 30th.

Now, I would like to comment specifically on the US V.A.C. Therapy business. Growth in the US business has slowed for three reasons in 2008: Increased competitive trials, institutional budget constraints, and decreased length of V.A.C. Therapy in acute-care hospitals.

Regarding the first and second of these, we have taken and will continue to take a number of steps. We are selectively expanding our US field sales force. We have increased our investment in professional education. We have developed several flexible business models to provide our customers with ways to optimize their V.A.C. utilization beyond just daily rental.

We have developed tools to better educate our customers on the economic and clinical benefits of V.A.C. Therapy. We are implementing additional programs to enable easier transitions for patients to the homecare setting.

Let me now provide some color regarding the decrease in length of V.A.C. Therapy in acute-care hospitals. During 2008, we have maintained double-digit order growth in V.A.C. orders in the hospital setting. However, this year we have actually seen a 10% reduction in the number of days that V.A.C. is on a patient in the hospital. This reduction was driven by several factors.

First, we worked with care givers to help them understand that getting V.A.C. on patients earlier heals wounds faster. Secondly, more surgeons have found V.A.C. to be effective in speeding the wound healing process, and are placing more V.A.C's on patients in the operating room. These factors lead to better alignment with care givers and with their institutions.

Turning now to our international wound healing business. Our V.A.C. business performed as expected internationally for the quarter. International growth rates were affected by the normal seasonality of the summer months in Europe. We did make progress during the quarter in working towards German home care reimbursements. KCI plans to participate in an integrated contract process under German law, which involves obtaining clinical evidence of V.A.C. Therapy's efficacy by performing two RCTs and conducting a wound registry.

Additionally, we are progressing toward regulatory approval for V.A.C. in Japan. We have submitted for regulatory approval earlier this year and are now in the process of answering questions from the PMDA, the regulatory authority in Japan.

We would anticipate submitting for reimbursement in 2009 with the goal of achieving the reimbursement in early 2010. Our goal is to be able to place beta commercial systems in Japan upon receipt of regulatory approval, and we would anticipate doing so in late 2009. We are also in the early stages of planning our NPWT launches in other major Asia-Pacific countries.

The third part of our wound healing growth strategy, beyond penetrating current markets and expanding geographically, is growth through new product innovation. We expect to launch the first of these new products in Q4, our easy-to-use surface V.A.C dressing, which was co-developed with 3M.

This will be followed by the launch in Q1 of our novel V.A.C. dressing for diabetic foot ulcers, which will allow patients using offloading boots or casts to more easily and effectively receive the benefits of V.A.C. Therapy.

In the second half of 2009, we anticipate launching two new products for the surgical suite: Our proprietary open abdomen management systems and the first of our surgical wound management systems for surgical incision.

We are very enthusiastic about these new products, as they have been designed with significant clinician input and truly address unmet clinical needs. We will be speaking more about these products at our Analyst Day next week.

Turning now to our regenerative medicine business; I am pleased to report that the LifeCell business is now substantially integrated into our company and our family. When we brought LifeCell into KCI, one of the things we said, was that KCI and LifeCell are a good match on all levels. We share the same philosophy and outlook, uphold the same values and complement each other in both science and business. We are beginning to develop joint R&D plans that will enable us to combine and capitalize of the unique strength of KCI and LifeCell.

As I mentioned in our last conference call, we are convinced that bringing together KCI’s knowledge of tissue repair and LifeCell’s knowledge of tissue regeneration will yield significant and desirable long term results.

During the quarter, I had the opportunity to spend significant time with LifeCell management team and employees. I have been impressed with their focus of bringing to market innovative products that enable surgeons to change the practice of medicine. We are very proud to have LifeCell as part of the KCI team. We recently promoted Lisa Colleran to President, LifeCel as head of LifeCell's commercial operations and a member of its senior management team.

Lisa has been instrumental in the company's commercial success over the past five years and is well positioned to successfully be the next face of LifeCell's evolution at the KCI Company. Lisa knows our customers and our products and has been a key catalyst in driving LifeCell's growth. She joined LifeCell in 2002 as Vice President of marketing and business development, and was promoted to Senior Vice President of Commercial Operations in July 2004. Prior to joining LifeCell, Lisa spent 20 years at Baxter Healthcare Corporation in various roles of increasing responsibility in sales, marketing, business development and general management, including significant international experience.

We are excited about the progress we have made to date on LifeCell's protein derived tissue Matrix Strattice and its potential as a technology platform for the future. Strattice demand continues to exceed our expectations and accounted for approximately 15% of LifeCell's revenue in the third quarter. One of the goals we had to the LifeCell acquisition, was to be able to launch Strattice for the treatment of wounds obviously at the core KCI. To that end we are pleased that two weeks we received 510K approval for Strattice for wound in the US market. This is a very important achievement and will enable us to develop and launch Strattice for wound applications, the first of which will be for the treatment of chronic wounds.

We anticipate CE marking before the end of the calendar year and this will enable us to move forward with our initial launch plans in the German and UK markets. Our manufacturing scale of plan for Strattice are on target and we are confident that Strattice will in the long term open up many new application opportunities that are currently unavailable to us and we will expand our business overtime.

Yesterday, we reported the receipt of a warning letter from the FDA as a result of the recent audit of LifeCell. The company takes seriously its commitment to quality and we are working diligently to respond to the letter. We do not believe this will impact our business plans.

In the near-term LifeCell will continue to focus on increasing market penetration in its core markets, challenging ventral hernia repair and breast reconstructions as well as expanding into new applications. We are on target to launch several new hernia applications and enter the cosmetic surgery markets with an initial focus on breast augmentation revision and procedures. We are also pleased to announce that last week, we commence shipping Conexa a version of Strattice for orthopedic application to our partner Tornier.

Turning now to our therapeutic support systems business; this business continues to perform in line with our expectations and will be essentially flat through the end of the year. However, our relentless focus on enhancing profitability or increasing customer and patient satisfaction continues to yield positive result.

During the quarter, we found improvement in our customer service level and also increased our capital sale. Looking forward, we see opportunities in 2009 that may result in modest revenue growth, specifically, CMS's decision to no longer reimburse hospitals for pressure ulcers, acquired by the patient and the hospital is a positive for TSS in 2009, as we believe that KCI's products and services, in particular, our AtmosAir product line is ideally suited to healthcare givers, prevent and treat pressure ulcers.

The critical-care market, served by our life-saving RotoProne therapy, and the groin geriatric market will be additional focus areas for TSS in 2009. Also, we have a number of initiatives under way, particular in the area of service center restructuring that are aimed at continually improving the profitability of our TSS business.

Speaking now about our operating initiatives more broadly; we have several projects under way that come under the heading of operations improvements or profit excellence. These include our initiative to consolidate our service centers, while increasing our service levels and increasing customer satisfaction. Projects are streamlined in order to catch profits in our Advantage Center in San Antonio. Moving a portion of our V.A.C. disposable manufacturing to our new automated facility in Ireland and implementing our global IT platform strategy, consolidating over 20 IT systems into a single global system.

Several of these projects will yield results in 2009, others beyond that. We are committed to generating earnings growth in excess of revenue growth, and at the same time making the investments necessary for geographic expansion and new product development.

In summary, while we are in the midst of a challenging environment, KCI's business remains healthy. As I complete my second year with KCI, I continue to be amazed each and every day at our product and at our therapy, and how they change people's lives in a remarkable way. We are proud of what we do at KCI and we will continue to strive to bring to market the very best of innovative therapy in the fields of wound healing, regenerative medicine, and therapeutic support systems. We look forward to providing you more insights into how KCI see this business unfolding over the next several years in San Antonio next week.

Now I will turn the call over to, Marty to review the financial results for the quarter.

Marty Landon

Thank you, Cathy and good morning everyone. For the third quarter of 2008 we reported record consolidated revenue of $503.3 million. The 22% increase in revenue was driven by a combination of our LifeCell acquisition, which contributed $61.2 million in revenue for the period and higher global V.A.C. revenues which increased 10% to $360.3 million.

Revenue from Therapeutic Support Systems was flat compared to the third quarter of 2007 at $81.8 million. LifeCell's revenue of $61.2 million represented an increase of 29% over the prior year period and currently makes up approximately 12% of our consolidated revenue.

Foreign currency exchange movements favorably impacted total revenue by approximately 2% in the third quarter compared to the same period one year ago. In regards to the components of global V.A.C revenue North American revenue increased $14.1 million or 6% for the period to $270 million.

As Cathy mentioned we continue to experience competitive activities, represented mostly by a free evaluations of gauze-based systems. We are also seeing some earlier application of V.A.C. Therapy, which is resulting in faster healing times and declining treatment periods, particularly in the acute care setting.

Although this decline in average treatment period slows our revenue growth somewhat, is good for both patient outcomes and total healthcare expenditures and we believe it further differentiates our therapies from other offerings, resulting in higher demand for our products. As evidenced by continuing strong order activity.

V.A.C revenue from the EMEA/APAC region increased 24% to $90.3 million or 16% constant currency, driven by incremental demand, although we have seen increased competitive activities outside the US as well. Overall, V.A.C. sales revenue continued to grow at a faster rate than rentals, due to more flexible offerings, including long-term rentals and value pricing.

Revenue from our Therapeutic Support Systems was $81.8 million and was essentially flat versus $82 million in the third quarter of 2007. Despite the loss of a large CPO contract announced earlier this year, as we managed this business for improved profitability.

Foreign currency exchange movements favorably impacted worldwide TSS revenue by 3%. Our Regenerative Medicine business continues to perform well and Strattice continues to gain traction in the marketplace. Revenue for the Regenerative Medicine business increased 29% during the period, driven by increased demand for both AlloDerm and Strattice, which increased approximately 37% in our core challenging hernia repair and breast reconstruction applications, as compared to the year ago quarter.

Strattice continues to experience strong adoption in the market and represented approximately 15% of LifeCell's third quarter revenue. We expect continued growth in the Strattice product and we are building up capacity in our New Jersey facilities to support product demand.

Gross profit for the third quarter was $251.6 million, an increase of 23% over 2007. Gross profit margins increased 30 basis points to 50% of revenue compared to the same quarter a year ago, despite recording $7 million of additional cost of goods sold related to the LifeCell inventory step up as part of the purchase price allocation. The increased gross profit margins were driven primarily by higher margins in the LifeCell business relative to V.A.C. and TSS and increased service productivity within our core business.

SG&A for the third quarter increased to $106.7 million compared to $94.3 million in the 2007 period. The increase was primarily due to the acquisition of LifeCell. However, SG&A as a percentage of revenue decreased 177 basis points to 21% in the period.

Third quarter R&D expenses of $21.9 million increased $10.9 million from the prior year. The LifeCell acquisition accounted for $5.9 million of the increase. R&D as a percentage of revenue increased to 4.3% of revenue, 3.6% excluding the affects of the LifeCell acquisition, compared to 2.7% from the same period a year ago.

Operating earnings of $112.9 million for the third quarter increased 14% over the prior year period, including $10.2 million of acquired intangibles amortization and the $7 million in additional cost of good sold I mentioned previously.

On a non-GAAP basis excluding these items, our operating earnings increased approximately 32% from the same period of 2007, representing an operating profit margin of almost 26% demonstrating strong leverage in the model.

Effective income tax rate for the third quarter of 2008 was 33.3%, which compares to 34.2% during the year ago period. The lower tax rate is due to a greater proportion of our income being generated in lower tax foreign jurisdictions. Reported net earnings for the period were $56.6 million, compared to $59 million reported for the same period of 2007.

Earnings per diluted share were $0.78 compared to $0.82 in 2007. Earnings for the period include acquisition related costs of $0.18 per diluted share associated with our recent acquisition of LifeCell. On a non-GAAP basis, excluding those items, adjusted earnings per diluted share were $0.96, a 17% increase period-to-period.

Our balance sheet remains strong. At September 30th, we had an ending cash balance of $245 million and total long-term debt outstanding of $1.7 billion, comprised of $975 million under our five-year term loan A facility, $690 million of 3.25% convertible notes due 2015, and $75 million drawn under our revolving credit facility. In October, we paid down the $75 million outstanding under the revolver with cash on hand.

The interest rate on the term loan is based on a spread over three-month LIBOR rates. Today we have entered into fixed rate interest swap agreements on approximately $490 million of our outstanding balance, thereby locking the average effective LIBOR at approximately 3.3%.

These swap agreements expire in various periods, from December 2009 to September 2011. Applicable margin or spread is based on a leverage grid and based on our current borrowing level that spread is 325 basis points above LIBOR.

The convertible senior notes have a coupon of 3.25% and a conversion premium of 27.5% over the stocks closing price of KCI common on April 15. This translates into a base conversion of $51.34 per share. In order to minimize potential for earnings per share dilution, we entered into convertible note hedge and warrant transactions, which effectively increased that conversion price on the notes to $60.41 per share.

Our leverage ratio at the end of the period was approximately 2.9 times trailing EBITDA and we were in compliance on all debt covenants.

We also announced today that the Board of Directors has approved a share repurchase program of up to $100 million. Our primary use of free cash flow will continue to be the repayment of debt. However, at current valuation levels, we expect to be opportunistically reinvesting in this business.

Net accounts receivable at September 30, 2008 were $408.3 million representing approximately 73 days of revenue. Total net days outstanding for the period increased slightly from 72 days as of September 30, 2007, that is on a pro forma basis including LifeCell.

Collection improvements in EMEA were offset by increased homecare receivables in the US due in part to conversion issues associated with the requirement for national provider identification. We expect US homecare collections to improve overtime as various payer systems come in compliance with NPI standard.

Inventory of a $126.4 million at September 30th was $76.1 million higher than the year end 2007 due substantially to the LifeCell acquisition. Free cash flow for the nine months of 2008 was significantly affected by acquisition items. Excluding acquisition items, free cash flow approximated $194.7 million, compared to a $137 million in the prior year period.

As indicated in our press release this morning we have adjusted our fourth quarter revenue guidance to reflect continuing competitive activities, the estimated impact of recent fluctuations in currency exchange rates and the impact of shorter treatment periods for V.A.C in acute care. However, given the benefits we still see in our business model from customer service and process excellence initiatives, we have reaffirmed our previous earnings guidance.

At this time we will open the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions). Your first question comes from the line of Mike Weinstein.

Taylor Harris - JPMorgan

Thanks a lot. My first question is just on the V.A.C. landscape in the US. Would like to get your latest thoughts on the impact of competition. So what you’re seeing now most recently in the third quarter, still free trialing from the competitors versus what percentage of the modest share losses that you've had do you think is just there is a new lower end of the market that's been carved out for gauze-based therapy?

Cathy Burzik

I am happy to talk about that. You know, I had an opportunity during the course of this quarter to spend a lot of time in the field traveling with reps and really trying to get my own first-hand understanding of what's going on in the US market. I would say that the trialing is definitely still more of a free trialing nature and I would say that however there are certain types of wounds that are more on the drainage side, wound drainage kind of wounds that you do see these competitive product being adopted for. I would say that primarily what we are still seeing is free trialing and we are still seeing conversion of customers, back-to-back therapy post the trial.

Taylor Harris - JPMorgan

Okay. So as you are looking ahead to 2009 and you gave updated guidance for V.A.C. of mid to upper single-digit. Are you assuming there that, you just have persistent free trialing in the market or what are the other factors that would influence that outlook?

Cathy Burzik

I really wanted to be prudent here in how we look at V.A.C. going forward. As I said, I personally studied this a lot during the course of the last several months and tried to understand what's going on internally, as well as externally in the US. As I said in my call, we are seeing a stability of trials within the US. We've seen more players coming in, in the gauze-based systems, but not really anymore, what I would call, competitive pressure.

Internationally, we are seeing increased trialing in certain countries within Europe and that's a fairly recent event and so part of what I want to reflect here is we want to make sure we do our best to take that into account, while we predict the overall the global back number for next year because I want more and more. I like to encourage everyone to look at our business globally, because it is the global business and it will become even more global as we move into 2010 with back therapy.

So, I mean those of the factors and in addition to that we have the price cut from CMS that begins with the beginning of this coming year, that's 9.5% price cut, we take that into account in the overall guidance as well.

Taylor Harris - JPMorgan

Okay, and two other V.A.C questions. One, you talked about new business models for US hospitals, I was hoping maybe you could go into that in a little more detail. And then two, just on the length of stay on therapy, is that really primarily an acute care issue or are you seeing that to any extent in extended care or home care?

Cathy Burzik

Okay, I'll answer the last question first. The length of stay is primarily an acute care situation. For many years KCI as long as we had V.A.C. has tried to work with customers, to try to understand what's the optimal time for V.A.C. Therapy and I think we made a big breakthrough this year in helping people understand, get your V.A.C. on earlier because you get the patients' heal faster when you do that. So, that was a conscious effort.

I think, we improved our relationship with our customers as a result of doing that and you saw strong order volume, a 10% growth as we go or greater. I mean as we go into next year and some of the products that I talked about, we’ll be bring market products like our chronic wound, product for diabetic foot ulcers, and you will see us in 2009, kind of returning to a focus of, a more a balance between acute wound and chronic wound in the acute care setting.

Regarding your first question on the flexible business model, we've also studied a lot of this in a great detail this year, and really have learnt some lessons from Europe. Because Europe has had competition for a lot longer than the US has in terms of both the scope of it and the breadth of it. They’ve adopted a number of long-term rental programs. The idea here of these long-term rental programs is clearly to have the V.A.C. in the hospital. So that, they are for example, in the operating room and on the ward, so that when the surgeon or the nurse needs them, that they're there. And so we want V.A.C. to be top of the mind versus having to call up and have us deliver them a V.A.C. to rent for, a sort of a period of time the patient needs it.

So that’s one example, as well as just some general ways that we look at combinations of units and dressings, and try to do that in a way that optimal on a customer-by-customer basis. I hope that gets you some sense of what we're looking at.

Taylor Harris - JPMorgan

Yes. That’s perfect. And then if I could just squeeze one more in. the swims program, is that now -- would you say it's second half of next year event or did I miss that?

Cathy Burzik

Second half of 2009 and the first swims, we'll talk about that, Taylor if you're here next week. Paul will actually be able to take you to the R&D side and you'll get to see it. The first of the swims are -- we envision many of the programs, many of these products over time, but first will be specifically for incisional wounds.

Taylor Harris - JPMorgan

Okay. I had thought that that product was going to be first introduced later this year. Is there a delay there, or was I just wrong in that?

Cathy Burzik

There was -- we had some thinking here about a different version of swims, that version of Swims was going to be for cosmetic applications. For really some technical reasons we decided to reorder it and have the cosmetic application come out later and have the incisional application come out first.

Taylor Harris - JPMorgan

Okay. Got it. Thanks a lot.

Cathy Burzik

You're welcome.

Operator

Your next question comes from the line of Tao Levy with Deutsche Bank.

Zafar Imron - Deutsche Bank Securities

Hi.

Cathy Burzik

Hi, Zaf.

Zafar Imron - Deutsche Bank Securities

So firstly I wanted to touch on the warning letter. I mean, I think you gave for the good color on the call about it, but are there -- is there any issue with launching potential like new products out of the New Jersey facility. And do you foresee significant mitigation cost to get this warning letter resolved?

Cathy Burzik

Steve may want to comment on this in a minute or two. But, it’s never pleasant to receive a warning letter, but that said, we take it seriously. The warning letter talks about not going forward with PMA type approvals with the FDA, but the LifeCell products are really 510(k) type products. So we don’t foresee any impact on our ability to launch the new products, the new Strattice based products. So I think that’s good news for us.

Secondly, on the overall cost we are in the middle of assessing those costs as we speak, but we don't at this point in time believe that there is going to be cost here that we cant absorb within the company. Steve, you want to comment.

Steve Seidel

Yes, Steve Seidel. The regulatory and manufacturing teams and rest of management at LifeCell are pretty comfortable that they can address most of the issues raised by the FDA, and there are some corrective actions they'll take and some quality steps they are going to put in place there. But they believe they are all addressable. They don’t see it impacting their ability to bring new products to market over the next several years.

Zafar Imron - Deutsche Bank Securities

Great, and then -- that’s helpful. On the share buyback program, I think that was a pleasant surprise to see that. Are there -- do your debt covenants preclude you from using that at any particular time. I know domestic cash flow has to be used to service debt or 50% of it. So is this going to be probably used over a longer period of time?

Martin J. Landon - Senior Vice President and Chief Financial Officer

So the debt covenants provide for some buyback activity and the timing will just be determined by what the available cash is and what the appropriate uses are. So we know right now that we've gotten a valuation level that allows us to be opportunistic and we anticipate doing that.

Zafar Imron - Deutsche Bank Securities

Okay, thanks Marty. Then one last question I wanted to touch on was just on the 2% to 3% potential share loss that you are expecting to see in the Global V.A.C. market. Is that coming from any one particular channel? I don’t know if you had answered that, I may have missed it, but is it more in the extended care or acute or…

Cathy Burzik

I didn't go into detail on that, but I would say that, the place where we have continued to see the most competitive activity while I would say the competition sticks is in the area of extended care. And so that's where you would see the biggest impact. But you do see impact across the board, as a result of these trials really across all the care settings.

Zafar Imron - Deutsche Bank Securities

All right, that's great. I am looking forward to next week. Thanks a lot.

Cathy Burzik

Thank you, Zaf.

Marty Landon

Thanks a lot.

Operator

Your next question comes from the line of Jayson Bedford with Raymond James.

Jayson Bedford - Raymond James

Just a couple of quick questions, first on the fourth quarter revenue guidance. If I back out LifeCell it looks like it's kind of flat to up 5% year-on-year and I am just wondering is there anything in particular that will impact the fourth quarter or is that somewhat conservative assumptions on your part?

Cathy Burzik

This is Jason, right.

Jayson Bedford - Raymond James

It is.

Cathy Burzik

Okay, Jason for Jayson. We talked a lot about the fourth quarter guidance. We want to be appropriately prudent and conservative with our fourth quarter guidance. We clearly would be disappointed if we came in at the low end of that guidance. But that said, you got a currency shift here in the fourth quarter that we needed to take into account, and then in general just looking in particular this competitive activity that's now started in Europe. I wanted to dial-in potential impact of that, so we tried to take into all of those factors when we gave the guidance.

Jayson Bedford - Raymond James

Okay, and there is no revenue impact in the fourth quarter from the warning letter, I am assuming?

Cathy Burzik

There is no, no impact from the warning letter.

Jayson Bedford - Raymond James

Okay, that's a fair. And then is there anyway you can breakout just looking at the US V.A.C. business between acute and chronic? Just on a percentage basis.

Marty Landon

Sure, on the North American business just general term Jayson, so -- dominated of course by the US side of the things and on the US side of things you have got a little more than half the business is in the home, which tends to be the more chronic wounds and a little less than half the business is in the institutional side acute and extended. And on that institutional side acute tends to be about two-thirds of that total.

Jayson Bedford - Raymond James

Okay, that's helpful and then just last couple questions. Just on Strattice in Europe, it sounds like you'll make it available in the UK and Germany. Has reimbursement been set for that?

Cathy Burzik

It's a good question Jayson. So just a little color on how that works. We are going to start with UK and Germany, but fully expect to launch Strattice more broadly on that overtime. We just thought we'd pick the two biggest countries first. The way that it will work is the CE Marking and we believe now that we're on track to receive the CE Marking, well before the end of this year. So we'll be on the market in those two countries.

The way this is handled -- it's almost more like a DRG environment. The doctors can just order it. There's not a reimbursement issue. The place where it will eventually become an issue and why we're doing the clinical trials is usually when it gets to be a certain level of the expense, the hospitals will start asking questions about what is this product and show us the clinical data to show that it works.

So we think for all of the early adoption and the way that the physicians will start using it and the surgeons, there is not going to be any issue. The main issue is just getting the CE Marking and getting our commercial structure in place.

Jayson Bedford - Raymond James

Okay. So based on what you know now in the UK and Germany, there won't be any real resistance due to price?

Cathy Burzik

From what we know now, that's correct…

Jayson Bedford - Raymond James

And then, sorry

Cathy Burzik

That’s okay.

Jayson Bedford - Raymond James

And then just lastly, in terms of manufacturing of Strattice, if I recall it was manufactured in a pilot facility and LifeCell was transitioning to something more permanent, something a little more leverageable. Where are we with that?

Cathy Burzik

I'd ask Steve Sobieski, I'll have Steve address that.

Steve Sobieski

Yes. That is correct. We are currently producing at a pilot facility. The construction of our commercial facility, which is located in the same building in Branchburg, New Jersey, is nearing completion. We'll move into a validation phase over the next couple of months here and expect to be online by the beginning of the year.

Jayson Bedford - Raymond James

Okay, great. I'll jump back in queue. Thank you.

Cathy Burzik

Thank you, Jayson.

Operator

Your next question comes from the line of Michael Matson with Wachovia.

Vincent Ricci - Wachovia Capital Markets

Hi guys this is actually Vincent.

Cathy Burzik

Vincent for Michael.

Vincent Ricci - Wachovia Capital Markets

Yes. Sorry about that. Can you guys just breakout for us the gross margin on the core business and then on LifeCell?

Marty Landon

So, LifeCell gross margins continue to be as they have been in that 70% range. And the core business margins continue to improve. When you consider that you had $7 million of inventory step-up that you wrote-off, there is 140 basis points of burden that was in the gross margin that we had for the quarter. So, margins continue to be good across the businesses.

Vincent Ricci - Wachovia Capital Markets

Okay. And then on the V.A.C sell side, could you explain to us a little bit better what do you mean by the value pricing?

Marty Landon

So, this is Marty again and as Cathy was referring to, we're trying to be flexible with our customers and particularly as we have different applications or the units and different dressing prices for those various applications. We try and work with them, and so there are differences in those dressing prices for those various applications. We try and give some consideration to that in our rental pricing. So, you basically have just a combination of how much is rental versus sales in any particular application, maybe a little bit different in terms of percentages.

Vincent Ricci - Wachovia Capital Markets

Okay, great. And then just a question on Conexa , what is the opportunity as it compares to the GraftJacket opportunity? How much is accretive, how much is cannibalistic?

Cathy Burzik

So, the Conexa -- it's a good question. So just to give you a little color here, the Conexa product is primarily going to be launched at Tornier for rotator cuff repair. So, Tornier has a very leading position in that. My understanding it is especially good from a sports medicine perspective. So, you'll see that application will be a strong application.

The GraftJacket application tends to be more of the foot and ankle type of application. Then, also with the wound -- with the reaching of 510K, we will be able -- KCI itself, to take the Strattice product into the foot and ankle application ourselves. That was carved out of the Tornier agreement because we were in the middle of our LifeCell acquisition at the time. Does that help a little bit?

Vincent Ricci - Wachovia Capital Markets

That definitely helps. But just my last question, with Cosmesis, is that an opportunity you would partner with someone on or is that something you guys want to take yourself?

Cathy Burzik

Are you talking about Cosmesis from a Strattice perspective or a V.A.C. perspective.

Vincent Ricci - Wachovia Capital Markets

Both -- more of the Strattice perspective, but seeing as you have a product with the back based business also, seems like there is a strategy there?

Cathy Burzik

We're in the process. We are working with Lisa here to build capability at LifeCell. That will be cosmetic in nature. So we see an opportunity here to build a cosmetic franchise. Certainly the breast augmentation revision procedures will be the first procedure of Strattice that would be in that sales force. We also see an opportunity to take our version of swims, our area management swims, for example, liposuction will be sold to the same type of cosmetic surgeon. So we're developing that strategy overtime but its one place where we see the leverage between LifeCell and KCI.

Vincent Ricci - Wachovia Capital Markets

Okay, great. Thanks for taking my questions.

Cathy Burzik

You're welcome.

Operator

Your next question comes from the line of Matt Miksic with Piper Jaffray.

Matt Miksic - Piper Jaffray

Hi, thanks for taking the question.

.

Matt Miksic - Piper Jaffray

Just a couple of questions on, one on the VAC business. You talked about the mid-to-high single-digit expectations versus your prior expectations. Looking forward, can you talk -- since the reimbursement decreases was expected and which were the other factors do you think is the most significant here. You mentioned our US trialing increased your incomplete sentence. I guess ongoing US trialing and then there is length of therapy effect. Can you talk about maybe which one of those was most significant in adjusting your outlook?

Cathy Burzik

I think things are kind of equally balanced here, but I really do not want to give guidance here that we believe as prudent and achievable and most reflective of what we see in the marketplace as we go forward here. So in looking at the competition and understanding that there was going continue to be new entries they are coming to the marketplace. I want to take that into account. I wanted to take into account the situation both domestically within the US as well as internationally.

We also, while we have not seen direct impact yet from the economy, I wanted to take that into account because while most of our wounds are acute care type wounds in the hospital setting, there are chronic wounds that are as, Marty talked about, they are in the homecare setting. As I said we had yet to see any impact of the economy on that, so we wanted to take that into account.

Our hospitals continue to be budget constrained. We’re aware of that. We have a big push on with our budget impact model and evidenced-based selling tools for our sales force and we are in the process of this. We trained our sales force on that and in the process of getting more comfortable with using it, but we don't expect hospitals budgets to be any easier next year other than they were this year.

The length of therapy as probably the least, although it does take into account here but probably the least impactful of the ones that we talked about. But clearly, as I learned more about the length of therapy and I had not wanted to talk about that up until really digging in and personally understanding that this length of therapy situation was real. So we expect the 10% reduction that we saw this year. We don't expect that same level of reduction next year because there is more mix that we see between acute and chronic. So it would be a modest type of reduction also next year. So, I mean all of those factors were taken into account as we thought, we would put forward this guidance up from the mid-to-high single-digit growth.

Matt Miksic - Piper Jaffray

That’s helpful.

Cathy Burzik

And I think -- and lastly, at one point we had thought that we would have revenue from Japan in 2009. The way the reimbursement has shaken out the revenue will not come in Japan till 2010, but we will be placing data sites in 2009, but we don’t expect revenue from those data sites.

Matt Miksic - Piper Jaffray

Okay. That’s very helpful. And then as we look at our estimates here and think about the V.A.C. business, how should we think about the effect of these on sales versus rental? Is there anything you can add, any color you can provide as to how these different things might affect those different revenue lines?

Marty Landon

Matt, this is Marty. I just think that you're going to continue to see sales revenue growth. You know that I'd modeled sales revenue growth to grow at a faster rate than rentals, and the reason for that, rate is, you think about some of these longer-term rental programs and the like, you're going to have units in there everyday and some days they’re not going to be used, some days they are, you're going to get a lower daily rental rate for those kinds of things. The usage of dressings and canisters is going to continue to be there. So the sales line is just going to grow at a faster rate. And that is, it will also be affected by us introducing some of these new dressing applications that we're coming out with that, will have basically a higher level of therapy and a little higher price point.

Matt Miksic - Piper Jaffray

Okay. Thanks, Marty. The question on one here on the litigation with BlueSky, the appeals process and I know you don’t probably want to go into any great detail there but it would be helpful if you could let us know if there is any timing of next steps or how we should think about that playing out over the next six or twelve months?

Steve Seidel

Sure. Hi, this is Steve Seidel. First of all I think as everyone knows, the Federal Circuit heard the appeal on October 8, that was the oral argument, and it’s hard to predict the exact timing, but decisions would often be in the two to five month time period and obviously we are not in a position to predict how the court rules on that.

I do think it’s important to keep in mind a couple of points. First, this was the case in 2006, as BlueSky and Medela had involved us asserting only selected claims from both the 081 and 643 patents against the gauze-based system. And again it’s only those claims that we selected and that we pled in the case that are the issue in the appeals. So not all claims from those patents are up on appeal.

Specifically, the firm based claims in those patents were not asserted in the litigation against BlueSky or Medela, because they didn’t have a firm based system. So the validity of those claims, again I want to reiterate that the validity of those claims are not challenged in the appeal. So in the event the Federal Circuit would rule that the asserted claims are invalid, just taking account of a worst scenario for the appeal, it would not render our specific firm based claims and the 643 or the 081 patents invalid.

The firm based claims are subject to reexamination request that are in the patent office and that process will go on for sometime. As you know, it’s not uncommon in today's environment to have multiple re-exam requests filed with the US patent office. Again, there is no way to predict when and how the patent office is going to rule that, but I think it’s probably again helpful if there any questions we've gotten a few minutes just to give some examples.

There were two re-exam requests filed against the 643 patents. Earlier in the summer is actually in late July, the patent office issued a final office action in one of those re-exams. At which point they stated they reviewed again all of the submitted prior art. They did disallow one claim, but it wasn't kind of a critical claim for us. So again, we feel good about the initial rulings there. We requested the issuance of a [specific] of re-exam. We don't know if that's going to be issued at this point or if it's going to be merged with the other re-exam requests.

So again that process is ongoing, it's become a common tactic used by a lot of companies in the space and it's out there. So we don't have to predict how they are going to come out, I just thought it was important to keep in mind, what was the issue in the appeal, and it's really not anything relates to the firm based claims. Obviously, the claims we asserted against [Gauze] are fully at issue in that case and that's really what that law suit was about and what the appeal was about.

Matt Miksic - Piper Jaffray

Okay. You mentioned uncertainty around the re-exam on the firm based claims. But so timing could be six months, could be 12 months just for those folks, not that familiar with the process?

Steve Seidel

Yeah. On one of the re-exam request, the initial ruling from the examiner was that she looked at all the player odds and she decided that the claims were valid all but one. So again, that one, that's just kind of one initial indication, you cannot predict how the remainder of those are going to come out or if that somehow changes down the road. So the uncertainty is more just what you always have and the patent re-exam process is, it's not final or so they are expected to go on for some time period.

Matt Miksic - Piper Jaffray

Okay. And then one last question here on rentals, a jump out of line here but, curious -- if Kathy could talk about how this change in hospital reimbursement for pressure ulcers is affecting the dynamics in that business and services, and in your therapeutic support systems?

Kathy

I'll leave it here. I have Lynne to answer that question directly.

Lynne Sly

So what we are seeing today is an opportunity to really drive some volume and our mattress replacement and our overlay business. And because of the positive outcomes we get in particular with our AtmosAir lines, we are seeing some nice opportunity certainly in that area, that are helping our business today and also should help it next year as well.

Matt Miksic - Piper Jaffray

Okay. Anything there and on the bed business in terms of municipal budgets or capital budgets, I'm sure you get this question a lot but directionally are hospital still building, have you seen any evidence of slowing, any color there?

Lynne Sly

So it's a good question with regard to capital markets and capital budgets and while we are certainly mindful of that as we are looking at our current business today and as we think about 2009. The good news is that our typical order or typical purchase tends to be relatively small for hospitals compared to say in a multimillion dollar deal. So the ability to access capital on a smaller basis to get where we tend to play hasn't posed a big issue today. And where possible, we work with hospitals on payment plans or ways to help them, manage their budgets accordingly. So, so far we don't really see a big impact from that area.

Matt Miksic - Piper Jaffray

Okay. So its small price tag for beds relative to some of the other equipment, other things that hospitals need to purchase but any sense on your visibility into that market that hospitals are, that there is any sort of slowing or sideways movement or delays in construction or new purchases from your perspective?

Lynne Sly

It was interesting, I was just meeting yesterday with the Chief Operating Officer in a major institution and they’re re thinking, I think many of their forward-looking capital purchases. So it wouldn’t surprise me if you see that beginning to be much more cautious and slow down at least when I talk to customers.

Matt Miksic - Piper Jaffray

Okay. That’s helpful thanks.

Rich Cockrell

Rachel we have time for one more question.

Operator

Okay your final question comes from the line of [Paul Choi] with Merrill Lynch.

Paul Choi - Merrill Lynch

Cathy if we could step back a minute to the events you described in the acute care setting with the reduced treatment times. Is it your expectation that this moving upwards of, up-streaming the process of you starting back therapy will be more of a permanent change in terms of the treatment paradigm?

Cathy Burzik

So, it’s a good question Paul and we’re talking about that with Mike [Del Vecchio] and his team and I think it’s a little bit early to tell, but I would say if you go back and you trace the history of back, I mean there was a time where I think I’ve seen numbers as high like 12 days on average and its been coming, down, down, down, and as I said this year we saw a entire one day type of decline. I think that was pretty much of a one-time event and I think it was driven very much by the way we also interacted with our customers during this year and the focus that we had on the more critical wounds in getting the V.A.C.s on in the operating room.

As I said, a lot of this comes, where you pay your attention to. So as we go forward we’re going to have I think a balance here between those kind of wounds where we certainly do believe getting back on earlier is absolutely the right thing to do and in the operating room its absolutely the right thing to do. That’s why we’re coming out with swims incisional. But we think there is a large opportunity also in the chronic wound space and the data that I have seen says that we are still have a lot of way to go as far as an opportunity for penetration in the chronic wound space. This being as it relates to pressure ulcers and as it relates to diabetic foot ulcers. That will be a focus going forward. So I would expect the kind of treatment therapy types to kind of return to more what I’ll call normal levels of reduction on an annual basis.

Paul Choi - Merrill Lynch

Okay. That’s very helpful and in terms of the impacts of volume growth in the acute care setting. Can you just break that out for us? Would you guess its sort of continue to be in the mid to upper single digits? Is that reasonable?

Steve Seidel

Unit growth

Cathy Burzik

Are you talking about unit growth or order growth?

Paul Choi - Merrill Lynch

Yes, in the acute care setting.

Cathy Burzik

So what I said before was mid single, right?

Paul Choi - Merrill Lynch

Okay great. Thank you and then if we could, just a quick follow up on the warning letter itself. What is your sort of expectations in terms of what time it will take perhaps to address these issues that the FDA noted in terms of its 483 observations? If you had to qualitatively assess them how easily addressable are they?

Cathy Burzik

I have obviously been through the warning letter and Steve sent you warning letter too and we’ve had outside folks take a look at it as well as the rest of folks. Our assessment into the items in the warning letter are primarily process related things that are validation related things that are fixable and that we will move forward and fix them.

That said, from personal experience we know that it takes a while to get through these kind of warning letters with the FDA. So there will be several visits with them and they won’t need to comeback and verify. So the process tends to be a fairly lengthy process. I don't want to put a timeframe on it, but it's not a process that's measured in just a couple of months.

Paul Choi - Merrill Lynch

Okay, thank you for that. That's very helpful. And then the last question is on the sales guidance. Marty, if you could help us out with what you think that the fourth quarter currency impact will be? And also for the full year as well, please.

Marty Landon

Sure. Full year of 2009 or 2008?

Paul Choi - Merrill Lynch

Both, please.

Marty Landon

Why did I know that -- we've seen, I mean, everybody experienced it, right. You've seen dramatic changes in the currency rates and certainly, I'm not the right one to be predicting what or forecast currency rates will be but we're trying to take a conservative view here only because of the volatility Paul, and how much it's moved in very short periods of time. So from our standpoint, we don't expect a strong movement in currencies and foreign currencies, we don't expect the dollar to weaken a bunch in the fourth quarter. That's kind of how we've gone into it.

As you know the dollar has been weak right up through, probably the middle of August and then made a dramatic change. I do not know how those things are going to move going forward and we've tried to be conservative in our estimates as we look forward as well.

Paul Choi - Merrill Lynch

Okay, thanks a lot.

Rich Cockrell

All right, we appreciate you joining us on today's call. We look forward to seeing you at the Analyst Day. Thank you and have a good morning.

Operator

This concludes today's conference call.

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