Kinetic Concepts, Inc., Q4 2008 Earnings Call Transcript

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 |  About: Kinetic Concepts, Inc. (KCI)
by: SA Transcripts

Kinetic Concepts, Inc., (NYSE:KCI)

Q4 2008 Earnings Call

January 27, 2009 8:30 am ET

Executives

Catherine M. Burzik - Presient and Chief Executive Officer

Martin J. Landon - Chief Financial Officer

Stephen D. Seidel - Sr. Vice President

Michael Schneider - Senior Vice President, Manufacturing and Operations

Lynne D. Sly - President, Therapeutic Surfaces

Rich Cockrell - Investor Relations

Analysts

Michael Matson - Wachovia Capital Markets

Matt Miksic - Piper Jaffray

Taylor Harris - J.P. Morgan

Jayson Bedford - Raymond James

Seth Damergy - Deutsche Bank Securities

Operator

At this time, I would like to welcome everyone to the KCI fourth quarter and year ending conference call. (Operator Instructions). Mr. Cockrell, you may begin your conference.

Rich Cockrell

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

If you have not received a copy KCI’s earnings release, it is currently being available on our website at ww.kci1.com or you can call Sonia Brown at 210-255-6221. Today’s call is being webcast live over the internet and a replay of the call will be made available on KCI’s corporate website shortly after conclusion of the call.

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 risks and uncertainties, which could cause actual results to differ from our expectations. More information about potential risks factors may be found in our SEC filings.

Also, quarterly and full year results discussed on this call may reflect adjustments for expenses related to LifeCell and other significant costs incurred in the quarter. Please refer to our 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, our President and Chief Executive Officer.

Catherine M. Burzik

Thank you for joining us for KCI’s fourth quarter and full year 2008 earnings call. I will begin with recapping our business highlights for 2008, and then will comment on the fourth quarter including updates on our wound healing, regenerative medicines, and TSS businesses. Finally, I will comment on our outlook for 2009. Marty Landon, our CFO, will then go into more detail about our financial performance, and at the end of our prepared remarks, we will open up the call to your questions.

In addition to growing our business organically in 2008, we made significant progress in the three key areas of strategic importance to our future, namely R&D innovation, global expansion, and diversification.

Let me start by giving you a few significant highlights from the year. We launched the first product emerging from our new product pipeline, namely our V.A.C. Simplace dressing, and we are on track with a number of new product launches that are planned for 2009 and beyond. Additionally, we made progress toward regulatory approval of V.A.C. therapy in the very large Japanese market, and importantly, we made progress toward reimbursement of V.A.C. therapy for home use in Germany, our largest European market, where we already have a significant hospital presence.

Finally, we took a very important step toward diversification of our business with the acquisition of the leading regenerative medicine company, LifeCell. LifeCell’s xeno-based dermal matrix Strattice had a very strong initial year in the US market. We achieved CE marking and are now on the market in Germany and the UK, and we expect Strattice to be a truly outstanding growth platform for the future of KCI.

In 2008, we faced both increasing competition and a challenging economic environment. However, our determined fiscal discipline combined with our agile business model enabled us to once again deliver double-digit earnings growth for the year on an adjusted basis. In fact, this is the ninth consecutive year of double-digit earnings growth for KCI. We also finished 2008 with approximately $250 million cash on the balance sheet and liquidity, positioning us well for 2009.

I will now speak to the fourth quarter in more detail and discuss some of the factors that impacted our business. Our wound healing business demonstrated resilience in the midst of increasing competitive activity internationally and economic volatility in the US. The performance of our regenerative medicine business was exceptionally strong with evidence of continued and increasing demand for our Strattice product. TSS’ revenue for the quarter was affected by capital constraints and hospital spending cuts, and despite this, TSS once again delivered strong profit performance, which exceeded our expectations.

Concerning our financial performance, consolidated revenues for the fourth quarter increased 14% to $492 million. Wound healing revenues increased to $347 million during the quarter, a 5% increase on a constant currency basis. Our Therapeutic Support Systems business decreased to $77 million, which represented a 9% decrease on a constant currency basis. Our regenerative medicine business generated revenues of $68 million, an increase of 29% over the same period last year.

Overall, we reported GAAP net earnings of $52 million or $0.74 per diluted share compared to GAAP net earnings of $66 million or $0.92 per diluted share during the prior year period. The decrease in reported net earnings and net earnings per diluted share is due to after-tax acquisition related costs and expenses of $11.4 million or $0.16 per diluted share associated with our acquisition of LifeCell in the second quarter of 2008. In addition, restructuring charges in the quarter were approximately $5.7 million net of income taxes or $0.08 per diluted share.

Turning now to our wound healing business in more detail. During the fourth quarter our V.A.C therapy continued to be used to tens of thousands of complex wounds daily around the globe. Fourth quarter growth in the US was impacted modestly by a reduction in elective surgeries and changes in payer mix resulting from increased levels of Medicare and Medicaid patients. Overall our unit growth in the US remained stable and was consistent with Q3 mid single digit year-over-year unit growth. We did see growth in post-acute units somewhat higher than acute unit growth. Domestic growth during the quarter was not materially impacted by competitive factors as the level of competitive trailing had remained stable. Contracted pricing has also remained stable.

I am pleased that in the fourth quarter we launched the new V.A.C. Simplace dressing, which marks the very first product resulting from our strategic collaboration with 3M. These dressings are available in the US and will be introduced in additional countries in the second quarter. We are proud of our continued global leadership position in introducing best in class technologies benefiting both patients and caregivers who rely on V.A.C. therapy to treat traumatic, surgical, and chronic wounds.

Our wound healing business in the EMEA/APAC region delivered double digit growth in Q4 on a constant currency basis even as we experienced increased competition internationally as more wound drainage devices entered the marketplace.

Our regenerative medicines business continues to exceed our internal based case expectations. In 2008, we successfully achieved over $7 million of cost energy, and impressively, Strattice achieved over $30 million in revenue during 2008, its first year, and represents a very important technical and commercial growth platform for KCI’s future. Strattice’s attributes such as its sterility and biological equivalence to our industry leading AlloDerm matrix, while at the same time offering the convenience of being stocked and ready to use in the operative room, are being well received by leading surgeons performing challenging hernia repair and breast reconstruction procedures.

During the fourth quarter our partner, Tornier, began to sell, Conexa, a specially formatted version of Strattice for orthopedic surgery such as rotator cuff repair.

As announced during the fourth quarter, we received regulatory approval to sell Strattice products in all 27 European Union member countries. We are focusing on the UK and German markets initially and taking advantage of KCI’s strong presence in those countries. Strattice is now being successfully used in challenging hernia repair and breast reconstructions in both of these markets.

Turning now to our Therapeutic Support Systems business. Overall for the year, our TSS business performed as expected with revenue growth down 1% year over year. Our topline growth in the fourth quarter was negatively impacted by slowing of capital sales due to capital constraints and hospitals spending cuts. We continued to be focused on enhancing TSS profitability to improve service structure efficiencies, effective sales force deployment, contract pricing discipline, and an appropriate level of R&D in capital investments.

I will now comment on our plans for 2009. Despite an increase in competitive environment, KCI remains, and is committed to remaining, the market leader in negative pressure wound therapy. At our 2008 Investor Day, we discussed strategies to grow our wound healing business over the next several years through continued penetration of the current market, through geographic expansion, and through new product introduction. Taking into account a number of factors affecting our wound healing business including increased competition, payer mix changes in the US, and Medicare rate changes that were implemented on January 1, 2009, we now expect our global wound healing revenue growth for 2009 to be in the low single digits.

From a global expansion perspective, we continue to work towards achieving both homecare reimbursement in Germany and hospital reimbursement for V.A.C. therapy in Japan. Working with the insurance companies and government in Germany, we plan to commence two random control trials and a V.A.C. therapy registry in mid 2009. Additionally, we continue to make progress toward regulatory approval for V.A.C. in Japan. As you know, we submitted our application for regulatory approval in 2008 and look forward to achieving regulatory approval in the middle of this year. We anticipate submitting for reimbursement following regulatory approval with the goal of achieving reimbursement in early 2010. Our goal is to be able to place beta commercial systems in Japan upon receipt of regulatory approval later this year.

In addition to penetrating current markets and expanding geographically, a key element of our wound healing growth strategy is growth through new product innovation. We launched the first of these new products in Q4 of 2008, our easy-to-use Simplace V.A.C. dressing, which was co-developed with 3M. This will be followed by the launch in Q1 of 2009 of our novel GranuFoam bridge V.A.C. dressing for hard-to-reach chronic wounds such as diabetic foot ulcers.

In the second half of 2009, we anticipate launching two new products for the surgical suite; our proprietary Open Abdomen Management System and the first of our surgical wound management system for surgical incisions. We also anticipate launching Strattice for chronic wounds in the acute care setting late in 2009, and there is much more to come after that.

We expect our regenerative medicine business to grow in the 20% range in 2009. During 2009, we expect to introduce additional applications of Strattice including introducing cosmetic breast procedures and hernia prevention in stomas.

Several very exciting follow-on applications are currently in trial, and we anticipate the continued and steady launch of these new Strattice applications over the next 24 months. We are on track with our new automated Strattice manufacturing facility and plan to release our first batches of Strattice manufactured in this new facility during the current quarter.

Turning now to our Therapeutic Support Systems Business. As a result of current economic conditions facing US hospitals, we expect business growth during 2009 to be relatively flat to slightly lower. CMS’ decision to no longer reimburse hospitals for pressure ulcers acquired while the patient is in 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 help caregivers prevent and treat pressure ulcers. The critical care market served by our lifesaving RotoProne therapy and the growing bariatric market will be additional areas of focus for TSS in 2009. Also, we have a number of initiatives under way particularly in the area of service center restructuring that are aimed at continually improving the profitability of the TSS business.

We are also committed to continual expansion of operating margins. During 2009, we will work to expand margins to restructuring of our service centers, to increasing the penetration of Strattice, to execution of our global platform strategy, and to automating the manufacturing of V.A.C. consumables in Ireland.

In summary, while we are in the midst of a challenging environment, our business remains healthy. The markets in which we participate are large and under-penetrated, and KCI is very proud to be the market leader in the market it serves. As a result of our innovation and global commercialization ability, we have developed attractive markets and other tabs and will continue to try to come into these markets. Let it be known that KCI will continue to distinguish itself as the leading company in wound healing and regenerative medicine through relentless focus on innovation to meet unmet customer needs. Our products and our services cannot be commoditized. We provide patented, clinically-proven medical therapy that are essential to saving the lives and limbs of patients around the world, and our technologies are supported with a strong body of clinical evidence and are well regarded by medical doctors and nurses globally.

Those of you who attended our Investor Day saw our service infrastructure. This is the backbone of KCI that provides high services and support levels, which are unmatched in the industry. Paraphrasing a comment by a leading surgeon who was keynote speaker at our Investor Day, “In my business, I experience a great deal of nurse turnover and as a result, many of these nurses are not experienced with V.A.C. therapy; however, I’m comforted in knowing that KCI has the clinical support to ensure that my nurses are adequately trained and supported.” It is this level of service and support combined with unprecedented outcome, product innovation, and strong clinical relationships, and importantly, over a decade of NPWT and regenerative medicine know-how, that gives us confidence in the sustainability of KCI’s business. Importantly, our infrastructure is indeed leveragable and utilizes proprietary technology that affords us the unique ability to bill and collect from over 30,000 institutions globally who order KCI products and therapies.

In conclusion, 2008 was a year of progress for KCI strategically. We made progress in filling our R&D pipeline, we made progress toward bringing our V.A.C. therapy on the market in Japan, and we made progress in diversifying KCI as a result of our successful acquisition of LifeCell enabling KCI to assume the leading position in regenerative medicine. I am proud that our products and therapies are changing people’s lives in truly remarkable ways. All of KCI’s employees globally are passionately committed to bringing to market the very best of innovative therapies in the field of wound healing, regenerative medicine, and therapeutic support systems. KCI remains, and is highly committed to remaining, the market leader in the markets we serve.

I will now turn the over to Marty to review the financial results for the quarter.

Martin J. Landon

For the fourth quarter of 2008, we recorded a 14% increase in consolidated revenue to $492.5 million. The increase in revenue was primarily driven by our LifeCell acquisition, which contributed $68 million in revenue for the period. Foreign currency exchange rate movements were unfavorable in the fourth quarter reducing our consolidated revenue growth by 4% as compared to the year ago quarter, reducing worldwide V.A.C. revenue growth by 4% compared to last year and reducing worldwide Therapeutic Support Surfaces revenue by between 4% and 5% period to period. As a result of these currency movements and other factors, reported V.A.C. revenue increasing 1% to $347.5 million while revenue from Therapeutic Support Systems decreased 13% to $77 million. On a constant currency basis, worldwide V.A.C. revenue increased 5% from a year ago while Therapeutic Support Surfaces revenue declined 9%. LifeCell revenue for the fourth quarter was not affected by foreign currency fluctuations.

Reported net earnings for the fourth quarter were $52.2 million or $0.74 per diluted share compared to $66.5 million $0.92 per diluted share a year ago. As Cathy mentioned, the decrease in reported net earnings and net earnings per diluted share is primarily due to after-tax acquisition-related cost and expenses of $11.4 million or $0.16 per diluted share associated with our acquisition of LifeCell Corporation in the second quarter of 2008. In addition, we recorded restructuring charges in the quarter of approximately $5.7 million net of income taxes or $0.08 per diluted share. Excluding those items, our adjusted net earnings per diluted share for the fourth quarter increased approximately 6.5% to $0.98 per share.

Worldwide V.A.C. revenue for the fourth quarter increased approximately 1% to $347.5 million or as I mentioned 5% on a constant currency basis. North American V.A.C. revenue increased 1.6% to $267.3 million for the period while on a constant currency basis Q4 North American revenue increased 2.5%. North American V.A.C. rental unit volumes increased approximately 5% during the quarter reflecting continued solid demand for V.A.C. therapy. The lower revenue growth percentage for the period resulted from lower realized pricing per unit which was due to a combination of payer mix and lower disposables purchases per unit on rent. Our contracted pricing remained stable although our Medicare pricing declined 9.5% effective January 1, 2009. Medicare currently represents approximately 9% of overall consolidated revenue.

EMEA/APAC V.A.C. revenue for the fourth quarter of 2008 decreased 2.1% to $80.1 million. On a constant currency basis however despite increasing competitive activities, EMEA/APAC V.A.C. revenue increased approximately 11%. We did begin to see greater budgetary constraints developing outside the US as the quarter progressed. We believe the continued strong demand for V.A.C. therapy is due to two primary factors in addition to our other competitive advantages. One, we treat the most serious and complex wounds which are principally nondiscretionary, and two, we are best in class therapies and clinical support.

Fourth quarter revenue from our Therapeutic Support Systems business was $77 million, a 13% decrease compared to the prior year period. Reduced capital spending combined with contract losses accounted for the majority of this decline. Foreign currency exchange movements also unfavorably impacted revenue by 4.7%.

LifeCell, our regenerative medicine business, continues to perform exceptionally well and ahead of our expectations. Revenue for the fourth quarter of 2008 increased 29% to $68 million, driven primarily by increased Strattice demands. Strattice, which was launched in the first quarter of 2008, represented 22.1% of total LifeCell revenue in the quarter, compared to 15.4% during the third quarter of 2008. LifeCell now accounts for approximately 14% of total consolidated revenue.

Gross profit for the fourth quarter was solid at $246.9 million, an increase of 15.9% over 2007. Gross profit margins increase 80 basis points to 50.1% compared to the same quarter a year ago. The increase gross profit margins were driven primarily by higher gross margins associated with LifeCell products and increased service productivity within our core business.

SG&A for the fourth quarter was $120.8 million compared to $95.4 million in the 2007 period. Fourth quarter 2008, includes $15.6 million of restructuring and other charges recorded in the period. The fourth quarter restructuring charges consisted of approximately $9.3 million of severance and other restructuring costs associated with our service productivity and G&A globalization efforts. In addition, we recorded $3.8 million related to the write-down of an investment in leverage leases and recorded additional bad debt reserves as the potential risk of nonpayment increased due to deteriorating business and employment issues.

Excluding the restructuring and other charges in the period, SG&A was 21% of revenue, which is consistent with the same period in 2007. R&D expenses were $22.6 million or 4.6% of revenue for the fourth quarter compared to 4.2% for the same period a year ago. We expect R&D spending to continue to increase going forward as we develop new and innovative products to bring to the market.

Interest expense was $27.3 million in the fourth quarter related to the LifeCell acquisition financing, which was completed during the second quarter of this year. The acquisition financing was comprised of a $1 billion senior secured term loan, which currently carries interest at a rate of LIBOR plus 325 and $690 million of 3.25% convertible senior notes. The financing also includes a $300 million revolving credit facility, which at this time is essentially undrawn besides a few outstanding letters of credit. We also have now entered into agreements, which affectively fix the variable interest rate component on approximately $570 million of the term loan at an average of 2.9% plus the applicable margin.

Regarding foreign currency transactions, we used natural hedges to the extent possible to minimize exposure to foreign currency fluctuations and hedged any significant net exposure through forward foreign exchange contracts. In the fourth quarter, we recognize a net gain of approximately $4 million related to foreign currency related transactions.

The effective income tax rate for the fourth quarter of 2008 was 27%, which compares to 34% during the year ago period. The lower tax rate is due primarily to the favorable resolution of certain tax contingencies during the period. Excluding the IP R&D write-off that we recorded earlier this year, which is not deductible for income tax purposes, our effective tax rate for the year was approximately 32.5% compared to 33.8% in 2007. Looking towards 2009, we expect our effective tax rate to be approximately 33%, which considers changes in business mix and other relevant factors.

Our free cash flow was $108.8 million for the fourth quarter and $285.6 million for the full year of 2008 excluding acquisition-related items. You recall that we make semi-annual licensing fee payments related to our base V.A.C. patents in the first and third quarters of each year. Going forward, we expect free cash flow growth to be in line with earnings growth as we have historically been successful at keeping working capital generally neutral. We will continue to make investments in global expansion and new product development using cash flows generated from operations, and beyond that, our next priority will be to repay our outstanding debt.

During the fourth quarter, we also did re-purchase $15 million of KCI common stock under a previously announced share repurchase program. Under this program, we were authorized to re-purchase up to $100 million in market value of KCI stock. The program is authorized through October 2009.

Our balance sheet remains strong. Cash at the end of the period was $248 million. Total long-term debt outstanding at the end of the period was $1.67 billion, which included $950 million under our 5-year term loan A facility and $690 million of convertible notes due in 2015 and $29 million drawn on our revolving credit facility. Subsequent to the end of the year, we made voluntary prepayments totaling $79 million on the senior debt facilities.

Our leverage ratio at the end of the period was approximately 2.7 times our 2008 consolidated EBITDA, and we were in compliance with all debt covenants.

Net accounts receivable at December 31st were $406 million representing 74 days of revenue outstanding. Total net days revenue outstanding for the period increased slightly from 70 days at December 31st 2007 due primarily to slower payments in the US homecare portion of our business.

Inventory of $109.1 million at the end of the period was higher compared to $50.3 million reported in 2007. This increase was of course due substantially to the acquisition of LifeCell and additional inventory purchases related to our execution of a tall manufacturing agreement with our V.A.C. disposable supplier.

As indicated in our press release this morning, we have provided 2009 guidance, which reflects continuing growth in both revenue and earnings. Our 2009 revenue guidance of $2.0 billion to $2.06 billion has taken into consideration the following. With respect to our V.A.C. business, we have taken into consideration increasing competitive activity, shifts in payer mix, and Medicare rate changes that have been implemented for 2009.

Regarding our Therapeutic Supports Surfaces business, we expect there to be ongoing capital constraints, which will impact sales leading to flat or modestly declining revenue, and finally we expect LifeCell’s topline growth to be in the range of 20% as we expand Strattice applications in geographies or further penetrating the challenging hernia repair and breast reconstruction markets.

Given the significant volatility that most multinationals have experienced in foreign currency rates during the second half of 2008, it is very difficult to predict currency movements especially when coupled with uncertainties surrounding the global economic environment. With that in mind, we have generally used fourth quarter 2008 currency exchange rates in our 2009 guidance.

Our adjusted earnings per share guidance of $3.95 to $4.10 per share for 2009 reflects continuing business model and operating process improvements, which will allow our earnings growth rate to continue to outpace our revenue growth. On a comparable pro forma basis, assuming our LifeCell acquisition took place on January 1, 2008, our adjusted earning per share are projected to grow at a double-digit rate over the prior year. We continue to expect that the LifeCell acquisition will be accretive to earnings on an adjusted or cash basis for 2009. Included in our press release this morning, we provided you a reconciliation to this adjusted per share earnings, to help you with your modeling and to provide a consistent basis of comparison.

At this time, we will open up the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions). Your first question comes from the line of Michael Matson from Wachovia Capital Markets.

Michael Matson - Wachovia Capital Markets

I was wondering if you could give us a little more detail on the commentary in the press release about the days of use of the V.A.C. declining; I just want to understand what’s going on there and why the hospitals feel that they can use the product for fewer days per patient?

Catherine M. Burzik

Consistent with what we talked about in Q3 a lot of this time that a V.A.C. is on a person has to do with the mix of wounds, and during Q3 we talked about the length of therapy, during that call. What we saw during Q4 was really more of a stabilization in the overall length of therapy as we believe that we saw a more balanced mix between acute wounds and chronic wounds in the acute care setting.

Michael Matson - Wachovia Capital Markets

With regards to the tech assessment that CMS is going to be doing for negative pressure wound therapy, can you walk us through your thought process there and sort of highlight the best and worst case outcomes?

Catherine M. Burzik

For those of you on the call that aren’t really familiar with this process, this is totally in keeping with the MIPPA Legislation, the Medicare Improved Patient Performance Act that we were all part of getting passed during this summertime, and as part of that we had worked to request specifically that there be a relook at the coding associated with negative pressure wound therapy. So, Medicare initiated that relook through a company that’s called ECRI that is involved with looking at the tech assessment. We have provided, or are in the process actually, of providing to ECRI all of our clinical and technical evidence associated with V.A.C. therapy and why V.A.C. therapy works. I actually am very pleased with the document that ECRI came out with which encouraged people to come forward with a lot of different clinical evidence associated with the effectiveness of V.A.C. So we will work proactively with them. We assume then that they will write a report and that report will go to Medicare. Certainly one outcome is, and we would be optimistic that we could get there is that, our negative pressure wound therapy would be put in a separate class or separate code from the E2402 code which is for wound drainage devices, that we will be separated in that regard, that would be a good outcome. Another outcome could be that we keep all of the products in the same code and as a result of that then competitive bidding would just continue as it had been.

Michael Matson - Wachovia Capital Markets

Is there any risk that CMS could look at the results and decide that they know longer want to cover negative pressure or that they want to maybe reduce the coverage or increase the requirements of what a patient needs to qualify for negative pressure therapy?

Catherine M. Burzik

While I say there can always be those kinds of risks, I mean, that’s not the purpose of this assessment, and I personally don’t see that as the logical outcome of this.

Michael Matson - Wachovia Capital Markets

With regards to the patent suit with Smith & Nephew, given the news that Smith & Nephew can be launching a firm dressing and given that it sounds like you’re incorporating this into your existing case that you’re pursuing against Smith & Nephew; is there still a chance that you could a preliminary injunction against Smith & Nephew in the US similar to the temporary injunction you got in the UK?

Catherine M. Burzik

We certainly have been thinking about that and I think I’ll turn that directly over to Steve to answer that question.

Stephen D. Seidel

It is pled for in the pleadings. Again, the timing is a little different in the US than it is in European countries, for those of you that follow up those types of laws, it’s quite a bit as you’ll be aware. So, it is pled for. I think it’s possible we will more for it at the right point in time when it’s there and obviously you got to get the court to consider it. The other primary thing we’re trying to do is to prevent delays in the case that’s currently set for next October. The other side has pled for or asked for a continuance for that, to move a little bit further down the line, and again, we’re opposing that and trying to keep as quick a timeframe as possible there. So, we should know more, probably in the next three to four months, to update the group from a timing standpoint and what the overall possibilities are on that temporary injunction.

Operator

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

Matt Miksic - Piper Jaffray

Just a clarification on the FX impact over the V.A.C. guidance that gave; it is low single digits, that’s a constant currency guidance for 2009?

Martin J. Landon

Yes, at the end of the day, it’s a little bit higher than that if you’re pure constant currency, but at the end of the day we’re looking for that growth to be in that low single digit range.

Matt Miksic - Piper Jaffray

Okay. So, that’s assuming something like whatever, based on currency rates in December as you mentioned, 1% or 2% or something in that range?

Martin J. Landon

Yes.

Matt Miksic - Piper Jaffray

Okay. So, going back to your analyst meeting, you talked about the underlying V.A.C. market growing at around 7% to 9% and your ability to do better than that over the 2008 and 2011 timeframe; is this low single digit number an indication that you are changing that long-term view, or is that still the plan, what does this mean to 2010 and 2011 in terms of those requirements to hit that long run goal?

Catherine M. Burzik

Just to remind you what we said at the Analyst Day, what we said at the Analyst Day was that the market would be growing in the high single digits. We did not say that KCI would be growing at the market growth rate. We said that we expect modest amounts of share loss, a few share points a year, at the J.P. Morgan Conference I said, maybe I will give the competition the benefit of the doubt here and say maybe they could get to a mid single digit number. So, if you do the math of the competition gaining 5% and the market is going 8%, you can see where we’re looking at our growth for the year.

Martin J. Landon

And in terms of the longer-term view I don’t think there’s been any change there. When you think about the expansion into Japan that happens in 2010, when you think about the new products that we’re rolling out, all of that goes into our consideration of what the business generates as we look the 5-year term.

Matt Miksic - Piper Jaffray

Okay. So, just to make sure I am crystal clear on this, I am looking at the slide from your Analyst Day that talks about revenue growth from 2008 to 2011, and it has this 7% to 9% plus 1.5% geographic expansion, sort of a booster, and new products driving that growth up to 9% to 12%; should we be thinking instead about the 7% to 9% growth, some share loss, and then these geographic initiatives and new products partially offsetting some of the pressure from share losses; is that a better way to think about your long-term growth?

Catherine M. Burzik

That’s a better way to think about the long-term growth. Certainly, as we move towards our new next Analyst Day, we’ll update the 5-year growth plans, but I think Matt, what’s important to understand here is that as we look to 2010 and beyond, the products coming out of our R&D pipeline combined with the geographical expansion, we think, provide significant lift to the company. We talked about new products being in the range of 20% of our revenue come 2012.

Matt Miksic - Piper Jaffray

Okay. That’s great. And understanding there’s a lot of variables here that’ll play out in the next year or two around new products and then around litigation; a quick followup to Mike’s question on that in the PI, maybe for Steve, just to be clear; has KCI filed for permanent injunction in the US yet, and you talked about different timeframes, if you could give us a sense; once you file, is that typically a 3- or 6-month decision for the court or is that faster?

Stephen D. Seidel

The PI is at the judge’s discretion as to when they hear it. It is pled for, we’ve pled for that in the pleadings that we filed in December and that’s been requested. It’s hard to predict the timing of that. Again, it plays into when the judge sees the final trial is going to be and the urgency of hearing that. So, I think that will play out probably in the 3- to 6-month timeframe. We’ll get a decision from the judge as to whether or not he is willing to grant us a hearing on the temporary injunction. So, that’s hard to predict at this point in time. It’s pled for, it’s part of the strategy, but again, I would not want to create any expectation that it’s going to happen over any set timeframe. Again, our main concern is moving the whole process through as quickly as we can get it done. Again, we’re quite willing to move forward on an expedited timeframe and have the trial heard. So, that’s our number one focus in the US, and we’ve also got actions pending in other countries as we have updated in our prior press releases and in our SEC filings.

Matt Miksic - Piper Jaffray

One last one just for Marty on the P&L; if we look at the progression of gross margin or SG&A, or maybe pro forma operating margin, whatever is the easiest way to talk about it; where should we see the leverage in 2009, just because given the earnings growth, given the revenue growth, we’ll need to see some improvement, but where should that come and what may be is driving that money?

Martin J. Landon

You’ll see it on both lines, on both the gross margin line as well as additionally in SG&A. The drivers of the gross margin line will be similar to the fourth quarter, Matt, where you’ll see higher margins associated with the LifeCell products as well as the work that we’re doing on service productivity. As I’ve mentioned on prior calls, that works is kind of really in its early stages; there’s been a lot of design work going on but we’re steering to implement that now, and a lot of process excellence that’s going forward as well. Then when you go down to the SG&A side of things, you got the work that we’re doing around globalization of processes, the work around automation of billing processes and the like, and those things will drive operating improvements in the SG&A area, some of that of course will be offset as I said by our continuing increase in R&D but net-net you’ll get a little bit at the gross profit line and you’ll get additional out at SG&A.

Matt Miksic - Piper Jaffray

And should we think about a lot of the SG&A improvements, are those going to come further into the year as you get these things up and running in transition, and is there more of a second half benefit?

Martin J. Landon

Certainly, the globalization stuff continues throughout 2009 into 2010, so I would say, yes, that’s a little bit more in the back half. Some of the service stuff we’re working on now, and of course the Strattice accelerated growth will be there in the first half. I would caution in the first quarter just recall that we have the seasonality in the first quarter, so I wouldn’t expect a lot of increase in the first quarter due to seasonality issues as we generally have lower revenue in the first quarter, but once you get to Q2 and beyond, then you start to see that.

Operator

Your next question comes from the line of Taylor Harris with J.P. Morgan.

Taylor Harris - J.P. Morgan

It is Taylor here for Mike, I have a few questions. First one, you guys talked about capital constraints in the Surfaces business and then budgetary constraints outside the US in the V.A.C. business, so, on the capital constraints with Surfaces which is primarily a rental business, can you just talk us through may be why that’s happening, and in OUS, how are those budgetary pressures playing out, is it hospitals just saying we don’t want to use this therapy at all or a fewer days or what?

Catherine M. Burzik

I think Taylor I’ll turn the question directly over to Lynne. Lynne is here and she knows the most about the TSS business. I think she can address both the US question as well as the international one.

Lynne D. Sly

With regard to what we’re seeing particularly in the US market is either a postponement or a delay in spending due to capital not being available for spending particularly on our mattresses and frame. I think the other companies in this base have also indicated seeing that same trend. We went through October on a very strong patent capital sales, and then November and December literally had a shutdown and orders were either postponed or delayed. So, we did see hospitals cutting back and reducing their overall spend currently. Now, I just want to clarify, was your question on international relating to PSS or was that in the back arena?

Taylor Harris - J.P. Morgan

Before we get there let me just make sure I understood because it looked to me like most of the slowdown in the US Surfaces business came on the rental portion, which I wouldn’t have thought would have been effected by capital budgets, is that not the case?

Lynne D. Sly

So, couple of things with regard to our mix; one, we also saw some census coming down in some patient admissions which does impact a bit of our rental, but we had some known contract losses in a period which we were expecting capital sales to offset for an overall mix for quarter, so that’s why we were a little softer than what we anticipated for quarter 4.

Martin J. Landon

Just in terms of how you think about that business, three pieces to the Therapeutic Support Surfaces business; the critical care piece as you mentioned is highly a rental business and is the most critically ill patients, you’re talking about ARDS and acute lung injury and those kinds of things. Similarly with bariatrics, you have a significant amount of rental, but on the Wound Care Surfaces side, we’re starting to see, as we’ve talked about on prior calls, more sales activity, particularly on the lower end of those things, and I think that’s where those capital constraints have come into play that those kinds of deals, those kinds of tenders have been, as Lynne said, deferred or postponed, is what we’re seeing in the fourth quarter.

Taylor Harris - J.P. Morgan

And my question on OUS was more related to the V.A.C. business. I thought you guys have mentioned budgetary pressures affecting V.A.C. more outside the US than in the US.

Catherine M. Burzik

So, Taylor just to give you a little commentary here; I would say that the economic budgetary pressures that we see for the V.A.C. business were higher in the US during Q4, and they manifested themselves, as Marty talked a bit about, in the hospital setting fewer elective procedures, certainly we saw that in the hospitals, but I think more importantly it was the mix shift that we saw, when we saw more Medicaid patients, we saw more people move from managed Medicare to straight Medicare, and so that was an impact, and that of course impacted the revenue realization which is why you saw the units as pretty stable and reasonably solid and strong in Q4, but you didn’t see the revenue realization. Outside the US, we were impacting Q4 more by competition than we were by the economy, but there has been some stepped-up competitive trialing particularly in Germany. The situation in Germany also manifested with additional budget cuts, because near the end of the year, hospitals stopped spending on some of the V.A.C. units in Germany and there have been selective countries throughout Europe where we’re starting to see budgetary issues. We’ve had issues, for example, in Ireland and in France throughout all of 2008. Does that help some?

Taylor Harris - J.P. Morgan

Yes, that’s very helpful, and may be just extending from that, the ’09 guidance calls for V.A.C. growth in the low single digits and you talked about expecting some of these competitive pressures to persist, is there something that you expect to offset that in 2009 or really are you just saying we were expecting the fourth quarter trends to stay the same in 2009?

Catherine M. Burzik

You always want to be prudent in your overall guidance, but as I looked to 2009, I think we would be disappointed if we didn’t see continued strong uptake of our Simplace dressing which is the dressing I just mentioned, I think I’ll have my comment on that in a moment; as well as our new products are diabetic foot ulcer products, we’ve talked about the two new products are open abdomen product that will launch in the third quarter and our first version of Swim, and then if we can get through the regulatory and reimbursement situations with Strattice for chronic wound, we hope to be on the market with Strattice for chronic wound by the end of this year. All of those things to me are strong, potential upsides for us in the V.A.C. business, but as we look to the guidance here, we want to be prudent in how we look at the overall year, because I think as you’re hearing from numerous companies, none of us understand exactly what’s going to happen with the economy. We did see some impact from the economy in the fourth quarter, and we believe we will continue to see that through 2009, but as I said, on the optimistic side, I’m optimistic about these new products, and Mike may be just you want to comment a little on that.

Michael Schneider

We did launch the Simplace dressing in mid fourth quarter and we have received orders and shift over 20,000 units including to over 500 facilities here in the US, and very well received in the marketplace where we’ve launched at a priced premium and we’re very much looking forward to our GranuFoam dressing launch later this quarter.

Catherine M. Burzik

Does that help you understand a little bit?

Taylor Harris - J.P. Morgan

Yes, it does. And then two final questions for Marty, if I can; Marty you mentioned free cash flow growth for ’09 in line with earnings growth, is that your adjusted earnings growth or your GAAP earnings growth?

Martin J. Landon

That would be our adjusted earnings growth.

Taylor Harris - J.P. Morgan

And then finally just the earnings guidance that you’d given at your Analyst Day in October of 15% to 19% over a longer period of time, should we think about ’09 as an anomaly year just given everything that’s going on in the macro conditions and the LifeCell comp or is that longer term target something that we need to revisit in our thinking?

Catherine M. Burzik

I’m not prepared on this call to totally update the guidance for the next 5 years of the discussion that we had at the Analyst Day. What I would just say to you is that we view 2009 as a more challenging year because of the economy. As I look to 2010 and beyond, we do believe the global expansion of the new products provide a lot of optimism for KCI for 2010 and beyond. The only thing that I did change at the J.P. Morgan conference is I did say that if competition is successful, we could see a couple more points share loss annually than what I was talking about in October, so that needs to be dialed into this long-term growth number.

Martin J. Landon

When you think about it, Taylor, the basic tenants of how we get there haven’t changed. You’ve got best in class therapy, you’ve got a robust product pipeline of new products, you’ve got global expansion that we feel very good about, and you’ve got the work that’s ongoing around service productivity around G&A globalization, none of that has changed. Probably the one thing that has changed in this environment is just the length and depth of the economic malaise and we see that as a 2009 phenomenon but I’m sure everybody’s guessing just how long that lasts, but in terms of the basic tenants of the business, none of that has really changed. We think we’ve gotten effective tax structure; we’re going to be driving down tax rate over time. So, all of that is pretty much intact as you look forward.

Operator

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

Jayson Bedford - Raymond James

Just a few questions, you kind of touched on the competitive activity in the V.A.C. business outside the US, but just looking at the US business, are you still seeing the same level of trialing and has that dissipated at all, and then from a competitive response, does the Simplace allow you to hold the price a little bit better?

Catherine M. Burzik

First, on the competitive activity in the United States, it’s definitely stabilized and I would not say that it’s gone down. Obviously, we’re assuming with the new companies coming into the market, CompTech, etc., we’re going to see a stable level of trialing. So, we’ve dialed that into our expectation. We are seeing, as I said, increased amount of trialing in very selective companies within Europe and we’re dealing with that as we speak. From a Simplace perspective, I am pleased that Mike and his team have been able to take price on the product that speaks to the value of the product and our GPO contract and our contracts with some of our home health agencies have enabled us to do that. So, where we can take price on these new dressings, we certainly intend to do so.

Jayson Bedford - Raymond James

And just pricing on the V.A.C. business outside of the US, has that migrated a little lower?

Martin J. Landon

For the most part, we haven’t seen a lot of change in peer price. As we talked about some of the budget issues that we saw in the fourth quarter, it was more about utilization than price.

Jayson Bedford - Raymond James

Okay, and then just looking at Germany and the reimbursement there, is it adequate levels, the reimbursement, and then just in terms of the size of the RCT?

Catherine M. Burzik

I don’t know that we know an exact number statement of the size of the RCT, but the way this works within the German government, you work with a university, this is the University of Witten, and then you work with their insurance companies and I think they have two insurance companies in Germany, and so between that academic center of the university and the insurance companies, we structure both the registry and RCT. Do we know the exact number of patients?

Martin J. Landon

No, there’s not a cap on those numbers. I mean it depends on enrollment, the number of physicians enrolling, and so it gives you the room for kind of an expanded RCT and reimbursement during that time period. Those numbers have not been finally set, but we see it working really pretty from an advantageous situation, we’ll see a large number of patients enrolled in the RCT once it gets going mid year.

Catherine M. Burzik

And as we said, I think your question about the pricing, the way this is set up, they will reimburse us at the rate of the reimbursement that we get in Germany today, which is a very good reimbursement rate in the European market. So, we would expect once that trial starts in the middle of the year, to see additional volume as a result of that in Germany.

Jayson Bedford - Raymond James

That’s fair, and just lastly, on the LifeCell business, it looks like the Strattice uptake has been pretty strong here. Do you think it’s coming from existing AlloDerm users or do you think your extending it to new surgeons?

Catherine M. Burzik

I think Jayson it’s a combination of both. I was at the Surgeon Forum for LifeCell in the November timeframe, and I just was at the LifeCell sales meeting over the course of last weekend, and I can tell you there is huge enthusiasm for Strattice and we had 7 surgeons at that meeting. And what I would say is most of the surgeons will tell you if they have been AlloDerm surgeons once they experience Strattice, they will almost totally switch to Strattice, which we totally expected at the time that we bought LifeCell because of all the benefits you get with Strattice and the cost advantages we get with Strattice and the overall supply chain associated with Strattice is so much cleaner. So, it’s those clinicians who are brand new to the story effectively, that would start out with the AlloDerm product that we would expect that they would continue to utilize the AlloDerm product for some time, and we were pretty happy with our overall results in Q4 with that 29% growth rate.

Jayson Bedford - Raymond James

And just lastly, UK and Germany where you have launched Strattice, is reimbursement adequate in those two countries?

Catherine M. Burzik

We have not gone through the reimbursement situation yet in the UK and Germany. Recall the way this process works, it is very similar to V.A.C. You’re talking here about the hospital environment, and as long as the surgeons want to use these products in the hospitals and that’s what we’re seeing for reconstructive surgery for both breast as well as challenging hernia, as long as they’re able to get permission from their hospital to utilize the product, they will utilize the product. It will get to a certain level where the hospital will start to say there’s a big enough item here now, we want to work with the local reimbursement authority to get additional dollars to fund this. So I would say we’re in the very early stages here and we do have a reimbursement strategy and we are gearing up and we know who we need to go to and what we need to file in order to achieve the reimbursement in both those countries, but we have not done it yet.

Operator

And your last question comes from the line of Seth Damergy from Deutsche Bank Securities.

Seth Damergy - Deutsche Bank Securities

I have a couple, first on Japan, it sounds like things are going pretty well as far as getting the product to market, and I know the Japanese regulatory body recently announced that they’re going to hire additional staff to speed up approvals of devices, have you seen any acceleration in the review of your application and potentially getting the product out there?

Catherine M. Burzik

Well, as you know, we did achieve the status called the high need status review, and the high need status review while it’s kind of a painful process has enabled us to be moved up higher into the queue which is why we talk about a goal of being approved in the middle of this year. I’m actually heading to Japan in two weeks to meet with all these regulatory authorities and reimbursement authorities along with all of our consultants over there to once again hammer home the importance of this. The reason why we’ve been able to get this level of acceleration is every surgeon society, the classic surgeons, the general surgeons, have all explained to the Japanese government how important this product is, and so in Japan, you need the support of those big societies in order to get this high need status. So, we have gotten that far, and I think that’s what has enabled us to feel confident that we’re hoping for an optimistic reading, a good reading that we get this approval by the middle of the year, and the way Japan works, you can’t file for reimbursement until you actually get the approval, but we are ready to go on a reimbursement once we get the approval.

Seth Damergy - Deutsche Bank Securities

In that same region, have you moved along with plans to launch the product elsewhere?

Catherine M. Burzik

I’ll call it we have modest plans. Patrick Loh, who we have hired to head that region, I’ve explained to Patrick that his number 1 task is to get on the market in Japan. However, we have taken some baby steps in China, we do have an office established in Shanghai, we’ve hired ahead of China to being to explore the opportunity there, and likewise, we have significant management experience in India, and so we’ve also looked a little bit at the Indian opportunity, but as I said, I don’t want to get ourselves defocused away from Japan, so it’s a much more modest look.

Seth Damergy - Deutsche Bank Securities

Okay two more, you recently mentioned that Strattice could go I guess past $100 million in sales this year, do you see most of that growth coming outside the US or within or a bit of both?

Catherine M. Burzik

I see a vast majority of that growth being within the United States. I think we have modest expectations for growth in Europe during this first year. As I have just explained previously to Jayson, we’ve got to move through the reimbursement process and everything in Europe. So, we’re going to take it in a very thoughtful way as we move forward in Europe. So, we would see the vast majority of that revenue for Strattice being in the US markets.

Seth Damergy - Deutsche Bank Securities

Okay, and just finally, on the convert, I know it’s trading it like about 40% to 50% discount, do you have any thoughts of potentially paying down a portion of the convert or is your primary focus on debt pay down just on the revolver?

Martin J. Landon

We look at it and there are some restrictions in the credit agreements that would keep us from doing a lot there, but it is something that we look at, we haven’t done anything to this point, but we do keep an eye on it, we evaluate it on a regular basis with members of management as well as certain members of the board.

Rich Cockrell

Thank you all for calling and if you have any further questions, don't be afraid to give me a call directly.

Operator

This concludes today’s conference call. You may now disconnect.

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