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Kinetic Concepts Inc., (NYSE:KCI)

Q1 2009 Earnings Call

April 21, 2009; 8:30 am ET

Executives

Catherine Burzik - President & Chief Executive Officer

Marty Landon - Chief Financial Officer

Adam Rodriguez - Investor Relations

Analysts

Tao Levy - Deutsche Bank

Matt Miksic - Piper Jaffray

Taylor Harris - J.P. Morgan

Jayson Bedford - Raymond James

Michael Matson - Wachovia Capital Markets

Operator

Good morning. My name is Nikisha and I will be your conference operator today. At this time, I would like to welcome everyone to the KCI first quarter earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers remarks there will be question-and-answer session. (Operator Instructions)

I will now turn the conference over to Mr. Adam Rodriguez, Vice President of Business Development and Investor Relation. Sir, you may begin.

Adam Rodriguez

Thank you Nikisha and welcome to the KCI’s first quarter 2009 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; and Marty Landon, our Chief Financial Officer. We are also joined by other selected members of our senior leadership team.

If you have not received a copy of KCI’s earnings release, it is currently available on the company website at www.kci1.com. Today’s call is being webcast live over the internet. A replay of the call will be made available on KCI’s corporate website shortly after the conclusion of today’s 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 filings with the SEC.

Also, quarterly results discussed on this call may reflect adjustments for expenses related to LifeCell acquisition and other significant costs incurred during the quarter. 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 Catherine Burzik, President and Chief Executive Officer of Kinetic Concepts.

Catherine Burzik

Thank you Adam and good morning everyone. For today’s call, I will begin with some general comments and key aspects of our first quarter of 2009, including remarks regarding the earnings release, which we posted earlier today. I will then provide updates on several initiatives related to our core businesses, before handing the call to Marty, who will review first quarter financial results in more detail. Thereafter we will open the call for question.

This morning we released our financial results for the first quarter of 2009. Overall, our business performance demonstrated continued fundamental strength, despite notable challenges to our businesses from competition, reimbursement and the economy in general. Consolidated revenues for the first quarter, assuming constant currency, increased to $470 million, up nearly 4% pro forma, taking into account the LifeCell transaction.

Wound healing revenues increased to $329 million, up approximately 4% on a constant currency basis. Our regenerative medicine business generated revenues of $66 million, up 22% over what LifeCell reported in the same period last year. Our Therapeutic Support Systems business decreased to approximately $75 million, which represented an 8% decrease on a constant currency basis. As a reminder, KCI’s first quarter is typically the lightest as a percent of annual revenues versus other quarters.

We reported GAAP net earnings of approximately $40 million or $0.57 per diluted share, compared to $68 million or $0.94 per diluted share during the prior year period. This quarter included $12 million of costs associated with our May 2008 acquisition of LifeCell, and $6 million are previously announced restructuring and other charges; both figures net of taxes and together reduce GAAP earnings by $0.26 per diluted share.

In particular, we were encouraged with the stability and resilience of our V.A.C. business in the United States, which grew units in use over 6% versus Q1 of late year and the phase of broader market competition and lower hospital census, due to economic conditions.

We have now seen sustained incremental V.A.C. units in use growth since mid 2008 in the important U.S. market. Internationally, our V.A.C. business got up to a slow start, particularly in Germany due to government budget cuts late in the fourth quarter of 2008. Although performance in this business improved during the quarter, the growth rate was not as high as we expected.

Also importantly, LifeCell Strattice product continues to perform well, exceeding our expectations. We also made progress across each of our key strategic objectives, including new product innovation, global expansion and continued success with the LifeCell acquisition.

Regarding factors important to the quarter, we continue to see affects of the global economy, most significantly in our U.S. TSS business due to curved spending among financially constrained hospitals, rising unemployment which impacts our payer mix and an unfavorable foreign currency effect, also insolence performance in the quarter. However we would remind you that the bulk of our revenue is derived from relatively non-discretionary situation.

Turning now specifically to the V.A.C. Therapy business. Despite significant headwinds, we again demonstrated growth and expansion in the market. KCI’s V.A.C. Therapy System remains the clear NPWT system of choice in a field growing crowed with inferior devises and unproven products that are being aggressively marketed by competition, where questionable marketing practices rather than sound clinical evidence is being used place systems and unfortunately this is often at the expense of patient outcome.

Our proprietary V.A.C Therapy system with its intuited uses interfaces, unique features, such as our pattern protected ability to measure pressure at the site of therapy and portfolio of innovative foam-based dressing, continues to drive optimal patient outcome and to differentiate KCI’s V.A.C Therapy among key decision makers and stakeholders in the management of complex wound.

The rollout and acceptance of innovative customer focused program in the U.S., coupled with the remarkable success of the new Simplace and GranuFoam bridge products, demonstrate our considerable competitive strength and relentless commitment, to partnering with clinicians, to provide beneficial solutions, to best meet their needs.

As caregivers build familiarity with our technology, protocols and programs, we see the effect of more efficient patient care and especially transitions to lower cost of care settings such as the home, which can have a positive impact of facility budgets important in this economic environment. As expected, we are experiencing improved unit volume and higher transition orders for accounts that have moved to these programs.

We are very excited with the introduction of our Simplace Dressings, which enhances therapeutic application ease and speed, and our GranuFoam Bridge Dressing, which with a its unique lifting layer, integrated bridge and sensor track pad, enables V.A.C. therapy to be applied to wounds in challenging locations or in conjunction with other therapies such as off-loading for chronic wounds, including diabetic foot ulcers.

We have been able to increase price with both of these products based on their features and ease of use and are seeing excellent conversion in the market to-date. As a result of these high value products performing ahead of expectations, we have opted to accelerate the introduction into our international markets. With regard to V.A.C. Therapy pricing, consistent with prior periods, we are remaining disciplined and saw relatively stable prices overall during the quarter, although payer mix resulted in lower overall revenue realization.

Despite the previously disclosed 9.5% price cut by CMS, which went into effect January 1, we continue to deliver growth in the overall business. We also signed contracts with several key GPOs and managed care organizations, where we held favorable pricing due to the demonstrated clinical efficacy of our V.A.C. Therapy system, as well as our availability of new products.

Regarding Medicare reimbursements of V.A.C. Therapy, we believe that CMS has inappropriately grouped together KCI’s clinically proven V.A.C. Therapy, with multiple lower technology NPWT products, that lack meaning clinical evidence and thereby has disregarded the importance of clinical efficacy, the primary driver of cost savings in the system. It is the efficacy of NPWT system in these clinical settings and not the price of the therapy that drives down healthcare cost.

Further, we believe that any follow-on CMS coding our reimbursement decision, that do not appropriately recognize the unique mechanism of actions, at proven clinical efficacy of V.A.C. Therapy, could unfortunately lead to a potential reduction in the access to and quality of wound care received by Medicare patients, which could ultimately drive higher healthcare costs. As always, we will work with all of our payers to explore ways in which we may be able to provide, a high quality solutions to their customers in an efficient and cost effective manner.

Turning now to the V.A.C. Therapy business outside the U.S., incremental unit growth and increasing market penetration, underscore our growth in the quarter. We continue to make progress towards the initiation of the homecare trial in Germany about specifications for the tendering process that have now been finalized by relevant agency.

Regarding Japan, we remain enthusiastic with the progress we are making, with regulatory and reimbursement processes and we believe we are on track for beta relief later this year with the full scale launch in Japan, in April 2010.

I’m pleased with our liability to sustain growth on a constant currency basis in the global V.A.C business in these difficult times, and I’m especially excited about the clinical advances being made in key focus areas, namely our pace of innovation and global expansion of a negative pressure technology platform. We believe we are well on track with both as demonstrated by the strong uptake of the new Simplace and Bridge products, as well our progress towards approval in Japan.

Looking beyond V.A.C., our LifeCell business continues to exceed expectations and we see strong sustained clinical acceptance of Strattice, for channeling hernia repair and breast reconstruction, on top of the performance provided by our highly successful AlloDerm business.

Strattice with its easy-to-use handling characteristic, larger product sizes and stability, has quickly become the standard of choice among surgeons; further validating the differentiation of our proprietary processing capabilities and confirming our leadership in the regenerative medicine market. With the recent launch of Strattice in the U.K. and Germany, we are exited to expand the knowledge and utilization of our biologic materials, to international markets seeking improved solutions for challenging hernia repair and breast reconstruction.

Our breast plastic surgery initiative in the U.S. launched during the quarter, to a newly created specialty sales force. The program includes new product configurations of Strattice, customized for special applications and corrective breast surgery filing argumentation in other related procedure.

Connect, a customized version of Strattice for orthopedic applications is performing a head of plan as our partner Tornier continues to focus on market development activity; and importantly, we are on track to break $100 million in global revenue this year from Strattice.

As we saw in Q4, performance in our TSS business during Q1 was effected by capital equipment spending constrains, which persists in the U.S. hospital. The roll off of certain contracts disclosed on our last call also affected results. While such factors influence wound care surfaces and to a lesser extent the bariatric’s division. Our clinical care unit shows stability, due in part to our RotoProne Therapeutic System…

On April 3, 2009, we announced the strategic alliance with Carroll Hospital Groups, to commercialize best-in-class solutions designed to safely manage, handle and transport patients with the intension to reduce hospital-acquired pressure ulcers and address fall prevention.

As part of this relationship, KCI will be the exclusive rental provider of Carroll’s innovative Spirit Select low bed, which will be marketed with KCI’s broad mattress replacement portfolio, including AtmosAir products. Our focus in TSS remains on profitable growth and operational efficiencies to drive yield.

As a proven innovator KCI takes immense pride in the development and prevention of important therapy for patients and their caregivers. We are committed to the commercialization of programs discussed at our analyst day last October, such as Simplace and GranuFoam Bridge Dressing as previously mentioned, an AtmosAir system for the treatment of open Abdomen and our very exciting trivena therapy systems for surgical wound management. Both systems are on track to launch this year.

In addition, we are eager to complete development and launch forthcoming Strattice based configurations in the area of engueno [ph] and parasthomal [ph] hernia repair, as well as wound healing.

On the medical front, our substantial body of clinical evidence, entirely unprecedented in the industry, continuous to expand with the addition of new papers published in the first quarter and now includes over 2000 articles, references and publication, supporting the clinical and economic benefit of KCI’s proprietary technology.

As further evidence of our improving operational logility, we made substantial progress of several cost related initiative during the quarter. First, we successfully completed validation and have brought our new Strattice manufacturing facility and branch work online. This modern facility provides a high level of automation and clinical capacity to meet the growing demand for Strattice today and in the future.

Second, we finalized plans to continue the expansion of our manufacturing operation in Ireland, which should drive additional cost efficiency. Thirdly, we are actively working on optimizing our infrastructure globally and Marty Landon will speak more about that in his remarks.

I’m encouraged by the activities and ongoing adjustments we are making to our cost structure and its associated impact on operating performance in the quarter and are confident it’s the same benefits these actions will provide.

The first quarter also saw notable activity with regard to KCI litigation and intellectual property. As we disclosed, the Federal Patent Court in Germany found one of our patents to be invalid. We disagree with the finding and are appealing the decision. The patent will remain valid and enforceable during this appeal, which could several years.

Regardless of the outcome of the various litigation efforts underway, we remain highly confident in our ability to successfully compete and maintain our leading market position in NPWT. KCI has well over a decade of unparalleled and not easily replicated know-how, and clinical experience with NPWT; the scientific command of wound healing processes and most importantly, substantial commercial competencies and infrastructure, dedicated to ensuring our customers have supported with the most proven NPWT technology in the industry, the KCI V.A.C. Therapy system.

During Q1, the United States patent and trademark office issued initial office actions regarding claims contained and (Inaudible) patent. It is important to remind you that certain of these claims have already been upheld as valid, not only by the U.S. Court of Appeal, but also by the office itself, as evidenced by certificates issued following prior reexamination processes.

Notably, these reexaminations included consideration of prior order, used as primary references in other proceeding here and abroad. As part of the process, we look forward to presenting our position to the U.S. PTO, regarding validity of claims currently under challenge. We will continue to vigorously defend our intellectual property rights.

Turning now to our guidance and Marty will go into more detail regarding all the factors we thoughtfully considered in lowering our top line 2009 guidance. Well, we are disappointed with the needs to low our revenue guidance, because it was prudent to do so, given economic foreign currency and international competitive challenges. However, as a result of decisive actions we have taken to control costs, we are reaffirming our earnings guidance for the full year.

In closing, I would like to emphasize that despite notable impact from the economy and heightened market related activities in the quarter; we are encouraged by the continued demand for our innovative technologies and are essentially pleased with this stability shown in our U.S. V.A.C. business.

Our TSS business in the U.S. is being the most seriously impacted by the economy, so we would expect the business prospects to improve as hospitals and the economy begin to recover; and we are on track with our expectation for LifeCell, which is expected to become accretive to our bottom line on a cash EPS basis for the year.

As we enter the second quarter, our financial position is strong. We are making notable progress on the strategic initiatives that are important to our future and we look forward with confidence to the rest of 2009. In addition, we are preparing aggressively for our new product launches and expansion into the important Japanese market in 2010, as we continue to build a strong, sustainable KCI for the future.

Thank you and I will now turn the call over to Marty Landon.

Marty Landon

Thanks Cathy. Good morning everyone. As you can see in today’s release, there is a lot of activity to sort through. So, I’ll try and give you a little color for purposes of better understanding our results.

Starting with revenue, for the first quarter of 2009, we reported a 12% increase in consolidated revenue to $417.1 million. The increase in revenue was substantially driven by our LifeCell acquisition, which contributed $66 million in revenue for the period.

As with many other global companies, foreign currency exchange rate movements were a significant headwind for us in the period, reducing both consolidated revenue and V.A.C. revenue growth by 5% as compared to the year ago quarter and reducing TSS revenue growth by 6% compared to the first quarter of last year.

On a constant currency basis, consolidated revenue growth was 17% period-to-period. Adjusting for LifeCell’s first quarter 2008 revenue results, our pro forma organic growth was 3.5% in the period on a constant currency basis.

In terms of V.A.C. revenue, average U.S. unit growth increased to 6% reflecting good demand for V.A.C. Therapy. The 6% average unit growth rate in fact was the highest domestic V.A.C. growth rate we have recorded in the last four quarters; and as Cathy mentioned, the second consecutive quarter of growth rate acceleration in the U.S.

The U.S. V.A.C. revenue growth of nearly 3%, was tempered by a number of factors, including the effects of the 9.5% Medicare price reduction that was effective January 1, a shortened quarter with one less day in the period versus the prior year and a higher mix the patients covered by Medicare.

All combined, North American V.A.C. revenue for the first quarter increased 2% to $254.6 million. On a constant currency basis, first quarter North American V.A.C. revenue was up almost 3% and slightly above the comparable growth we experienced in the fourth quarter of 2008, despite the 1% price decline resulting from the Medicare price reduction at the start of the year. I’d like to remind everyone the Medicare Part B revenue accounted for approximately $170 million of our domestic V.A.C. revenue for the full year of 2008.

Outside North America, weak global economic conditions and a stronger U.S. dollar resulted in a slowing of EMEA/APAC V.A.C. revenue growth. On a reported basis EMEA/APAC V.A.C. revenue was $74.7 million, down 10% from the first quarter of 2008. While on a constant currency basis V.A.C. revenue from that region increased over 6%.

The weak global economy contributed to a slower than expected start to the year as hospitals operated under budgetary constrains. Although, we did experience some demand increase in the later stages of the quarter, trialing of gauze-based wound drainage devices and the appearance of some phone-based product evaluations continue to have an impact on our rate of growth.

Third quarter regenerative medicine revenue was up 22% to $66.2 million. For the first quarter of 2008, LifeCell reported total revenue of $54.3 million. We continue to experience increased demand for Strattice, our porcine-based regenerative tissue matrix launched in the first quarter of last year. Our growth in regenerative medicine revenue was again driven primarily from challenging hernia repair and breast reconstruction procedures.

During March, we successfully transitioned into our new production facility, which relieved some inventory constrains we felt in January and February, given the increasing demand for our Strattice product. Strattice which was introduced within select European markets during the fourth quarter of last year accounted for 25% of our total LifeCell revenue for the first quarter of 2009, compared to 22% in the fourth quarter of 2008.

First quarter revenue from our therapeutic support system or TSS business was $74.6 million, a 14% decrease compared to the same quarter a year ago; however on a constant currency basis, TSS revenue declined approximately 8% period-to-period, demonstrating the notable impact of foreign currency rate fluctuations on performance. Reduced U.S. hospital census, credit availability, capital constrains and a rollout from prior period contract losses contributed to the first quarter revenue shortfall.

Gross profit for the first quarter was $244.1 million, an increase of 15.6% over last year’s first quarter. Gross profit margins increased 160 basis points to 51.9%, compared to the same period of 2008. Similar to the fourth quarter, the increased gross margin was driven by higher gross margins associated with our regenerative medicine products and increased service productivity within the core business.

SG&A expense for the first quarter was $120.2 million, compared to $97.5 million in the same period of 2008. First quarter SG&A included $9.4 million of severance and other charges, associated with our recently announced restructuring. Excluding these charges, SG&A expenses was $110.9 million, an increase of $13.4 million or 13.7% from the year ago period, due entirely to LifeCell which had SG&A expenses of $18 million in the period.

From an operating perspective, we recorded higher expenses in a few areas during the first quarter, including provisions for uncollectible accounts receivable and legal fees associated with a number of ongoing cases. We continue to make progress in reducing transaction related costs and optimizing processes throughout the organization. In fact, total operating expenses for the first quarter of 2009 were approximately $20 million lower than those reported for the last quarter of 2008.

As announced at the end of March, we formed the Global Shared Services Team for the purpose of optimizing our organizational structure, business process design and technology systems across KCI’s infrastructure. While KCI is always focused on providing exceptional service to our customers, we believe the critical work of the Global Shared Services Team; will produce even a better means through which to deliver our beneficial solutions and we are targeting cost savings of approximately $100 million by the end of 2011.

These savings will come primarily in the areas of service deliveries, global procurement, order fulfillment, and finance and administration. Importantly our plus to this initiative is global and nature, as we look to augment both the effectiveness and efficiency of our core business processes.

In the short term, we instituted a labor reduction effort late in the quarter, which affected approximately 4% of our global workforce and while difficult, we made the decision to reduce the size of our workforce, while ensuring KCI would have the appropriate competencies to achieve our strategic vision and continue to compete effectively as a market leader in our fields. We believe efforts such as these will provide us with the additional capital necessary to continue investing in innovation and global expansion, while producing higher earnings and cash flows.

As part of our sustained commitment to innovation and as previously disclosed, we continue to increase our research and development investments. For the first quarter total R&D expense was $22.1 million, an increase of $7.4 million or 50% over the prior year period, due primarily to the addition of LifeCell, as well as augmented spending to continue developing our robust R&D pipelines. As a percent of total revenue, R&D was 4.7%, up 120 basis points from the same period in 2008.

As we said earlier, foreign currency rate fluctuations were unfavorable in the period, both from a translational and the transactional perspective. In January we saw a significant increase in the value of the U.S. dollar versus other foreign currency, particularly the euro and the pound. This resulted in approximately $5 million of realized and unrealized foreign currency transaction losses in January.

We’ve taken additional steps to reduce our exposure in these wildly volatile currency markets, including earlier settlement of inter-company transactions, cash management and use of hedge agreements; however, we are not able to overcome the January losses.

Interest expense was $23.7 million in the first quarter related to the LifeCell acquisition financing completed during the second quarter of 2008. The first quarter interest expense includes another of the new items we had in 2009, $4.8 million of non-cash interest expense associated with the required adoption of FASB Staff Position APB 14-1 related to convertible notes.

Given, several moving parts to the business, as we’ve discussed this morning, we once again provided within the earnings press release, a reconciliation of our GAAP earnings per share to our adjusted EPS, excluding certain non-cash acquisition related expenses. For example, our acquired intangibles amortization and non-cash interest expense associated with our adoption of Staff Position 14-1 and of course the restructuring charges.

Our adjusted diluted EPS for the period was $0.83 down from $0.94 one year ago, with foreign currency exchange fluctuations, bad debt and legal expenses accounting for $0.11 or substantially all of the year-to-year change. Our operating cash flow was solid at $53.8 million; despite lower earnings in the period and our net capital expenditure were $14.6 million, down from $24.6 million a year ago, resulting in free cash flow that was consistent with prior year levels.

We made scheduled and voluntary prepayments on our senior debt facilities totaling a $104 million in the first quarter and we expect to continue using free cash flow, after first funding our initials and initiatives in global expansion and innovation to further reduce our leverages levels. Our current leverage level is approximately 2.5 times on a trailing 12 months EBITDA and our revolving credit facility is un-drawn.

As indicated in our press release this morning, we have provided revised revenue guidance for the full year of 2009, while reaffirming our earnings guidance for the year. Referring to our press release, we have provided details showing the reconciliation of diluted EPS guidance to adjusted diluted EPS guidance. This information now extracts the effects of APB 14-1 and restructuring charges incurred.

Our revenue outlook for 2009 reflects our expectation for continued capital constrains in the hospital setting, which combined with certain contract losses in 2008 will continue to weigh negatively on our TSS revenue levels, particularly in the US. In addition we’ve adjusted our international V.A.C. Therapy growth expectations to reflect additional competitive activities in a difficult economic environment for hospitals.

Finally we’ve modified our currency expectations to reflect a slightly stronger dollar, consistent with what we experienced in the first quarter; although we recognize it as difficult to predict currency movements, given the uncertainties remaining in the global economic environment.

From an earnings perspective our outlook remains unchanged. With the actions we put in place in motion during March, combined with further manufacturing improvements, operations and delivery efficiencies and the work underway on Global Shared Services, we expect to see expanded margins and resulting higher earnings over the remainder of the year, as compared to first quarter results.

We also continue to expect that the LifeCell acquisition will be accretive to earnings on an adjusted or cash basis for the year, consistent with our original announcement of the transaction. Included in our press release this morning, we have again provided you a reconciliation to this adjusted earnings per share, to assist you with your modeling and to provide a consistent basis of comparison.

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

Question-and-Answer Session

Operator

(Operator Instructions) Your first question is from the line of Tao Levy with Deutsche Bank.

Tao Levy - Deutsche Bank

Yes, good morning. Hi Marty and Cathy this is Tao.

Catherine Burzik

Hi Tao.

Martin Landon

How are you?

Tao Levy - Deutsche Bank

I am doing well, thanks. First I just wanted to touch on your V.A.C. volume growth specifically in the U.S. and Europe. I think the 6%, it seems pretty impressive and I just wanted to know if domestically or overseas if you’ve seen any slowdown thus far into the second quarter and are just based on and what’s going on with the economy?

Catherine Burzik

You said slowdown in the second quarter, Tao based on what?

Tao Levy - Deutsche Bank

Yes, just based on any competition or hospital spending pressures or just less uses.

Catherine Burzik

Okay, it’s a great question. So, I’ve really thought a lot about this. I’ve worked with obviously Mike DelVacchio in the U.S. team and TLV in the European team and I think the type of performance that you saw in the first quarter, is what we feel the year will look like in general.

I see a sustained kind of level of growth rate in the United States as we saw in Q1. I would say that as we have talked about a minimum effect of the economy on our V.A.C. business, you’ll see the effect more in the revenue because of the payer mix, but we have very few procedures that are actually elective procedures with that.

So, while there’s some amount of economic impact, I’d say as long as the economy stays relatively the way it is, I think our V.A.C business will continue to perform as you saw in the first quarter. Notably we don’t see any increased impact from competitions at all. Outside the U.S., I’ll be disappointed if you didn’t see further improvement from what you saw in the first quarter.

As Marty talked about, we got off to a very slow starts, because there were some budget issues in Germany at the end of the year, government issues and we thought that’ll spill over and take longer than we thought to come back in the first quarter, but we ended the first quarter stronger than we began it for sure. So as I said, I’d be disappointed if you didn’t see some additional growth in the international V.A.C. market as the year unfolds. Does that give you some more color?

Tao Levy - Deutsche Bank

Yes, completely. So then just to touch on the guidance reduction, I assume then most of that is related to the surface business, is that right?

Catherine Burzik

The bulk of the guidance reduction is related to the TSS business for sure and then we dialed in some amount of reduction, because of the slow start on the international V.A.C. business.

Tao Levy - Deutsche Bank

Okay, great. I saw in the quarter; I think it looks like you get a new 510-K approval for the abdominal dressing and I wanted to know if you expect any meaningful contribution from revenue from that product and for swims if you said in 2009 you are expecting to launch the product, but is there any accelerated timeline or are you just still to continue at year end and do you expect any revenues or significant revenues from that product as well?

Catherine Burzik

Well, both great questions. We are now calling the open Abdominal Dressing, it has the name Absara [ph], that will launch during the third quarter and then Proventa launch during the fourth quarter and believe me, we’re doing everything we can to accelerate those launches. I don’t think Todd’s going to commit to accelerating those launches.

Then also we’re working with Lisa and the LifeCell team around Strattice for chronic wounds, which will also be timed somewhere at the end of the year, beginning of next year, as well as our next generation technology. So there is a lot, the overall R&D pipeline.

I think that you can view that the contribution we’re getting from Simplace and Bridge because they’re launched early in the year would be larger; and then what you see from Absara and Proventa, they’re launched later in the overall year.

Tao Levy - Deutsche Bank

Okay, that’s great. Then just one last question; now that I guess we’re almost anniversarying the LifeCell transaction, have you seen any of the synergies on the revenue side that you’ve talked about with LifeCell or is it just too early to tell if those have started to work through the model yet?

Catherine Burzik

I think it’s another good question. I think it is a little bit early, but I will tell you that our sales forces in certain areas of the United States are beginning to work together. So, I think that there’s been a lot of getting to know your V.A.C. and LifeCell reps out in the field and in some places we’re having more success with that than other, but I know Lisa and her team and Michael DelVacchio and his team are working on that.

Also, obviously if we move forward with product like the Absara; there is a close linkage between that product and the LifeCell product to give us a chance. They kind of have an overall process for doctors to use with the two products together; and then combined with Strattice for chronic wounds near the end of the year. So I think they are going to see more of that kind of synergy coming forward in ’10 than we see in ’09.

Tao Levy - Deutsche Bank

Great. Thank you very much.

Catherine Burzik

You’re welcome.

Operator

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

Catherine Burzik

Hi, Matt.

Matt Miksic - Piper Jaffray

Hi, good morning. A question on growth in the U.S.; so as you mentioned, the rental volume growth was up 6%; reported growth, revenue growth up 2%. You talked before about the impact of this new Medicare price cut coming in January and I think that was overall business impact of around 1%. So, I’m wondering if you could share what either the sales unit growth was for the quarter or help us understand what the delta was; the other 3% or so between the 6% and 2% U.S. growth.

Catherine Burzik

Yes, so I think and I’ll start with this; Marty might want to pop in, but I think it’s really a function of payer mix. So what you see here is a shift, then we look at this everyday practically. A shift from what I’ll call pure managed care to now you seeing more Medicare patients.

You definitely see more Medicaid patients and we see hospitals moving patients more into skilled nursing and into the home than we do with the LTAC, the Long Term Acute Care; and all of that ends up with a payer mix that when we recognize that, affects the overall top line revenue. You’re also right about your comment about Medicare; I think Marty about 1%?

Martin Landon

That’s right; that was about a 1% impact on the business. Remember also Matt, you had one less rental day in the period, which is also about 1%. So you’ve got 1% or so in Medicare; another percent or so in just in real life pricing due to mix where you have more Medicare and Medicaid patients than you do in, say acute care, and then you also have the one less rental day. In terms of sales activity per unit out, it was relatively consistent period-to-period.

Matt Miksic - Piper Jaffray

Okay, so consistent with the 6% or roughly in-line with the fourth quarter?

Marty Landon

Consistent with the unit growth.

Matt Miksic - Piper Jaffray

Got it, okay. Go ahead I’m sorry, Cathy.

Catherine Burzik

The U.S. revenue growth is 3%. Our revenue growth for North America is 2%.

Matt Miksic - Piper Jaffray

Right, okay. So these things like payer mix, which sounds like it’s the biggest factor and maybe other things like V.A.C. cycle times you talked about before, may be on the V.A.C. cycle times do we start to annualize that? I know you’ve been talking about it for two or three quarters now. Does that annualize or flipside I guess with payer mix, does that continue going forward? Just maybe help us understand how to think about and how that will progress?

Catherine Burzik

No, we saw probably or will predict to see another half a day this year in average length of therapy. So we talked at one point last year that we saw a full-day loss in the hospital. This year I think that we’re talking about a half a day loss with the trend that we’re currently on.

Realize that that has a downstream positive effect on our business. So, you see more growth outside the hospital than inside the hospital, because we are being very effective now in transitioning patients from the hospital into the home, right; better for the hospital, better for the patient, and certainly a decreased cost and care setting in the home versus keep these patients in the hospital.

Matt Miksic - Piper Jaffray

Okay and then the payer mix, we don’t know how long it will continue, but something we should think about seeing again next quarter?

Catherine Burzik

Yes, I diffidently see. I think until you see the economy change, you’re not going to see the payer mix situation improve and obviously, the Medicare 9.5% price cut that we took, I mean that’s says with us now.

Martin Landon

We know that hospitals are seeing more free care or charity care cases. So, it’s going to roll over in the acute care environment anyway into our business at some point.

Matt Miksic - Piper Jaffray

Okay, thanks for that. One follow-up on the promotional programs you mentioned, you put in place with customers. I think you mentioned you’re having some success enrolling customers in these and that seemed to help in the quarter. Can you talk a little bit about, a little more color as to the benefits to the customers? What you will see at benefits to KCI of some of these programs?

Catherine Burzik

So, you’re right Matt. I’m really pleased of the uptake that we’ve had on these programs and Mike and his team have been working on these programs obviously for several months. These are all really aimed at improving the availability of V.A.C. in the hospital, so that when someone wants to release the patient to the home, the V.A.C is there.

They are very much aimed at flexibility; being very sensitive to the fact of these hospitals are under pressure, homecare agencies are under pressure. So, really trying to be very close, making the whole ordering process easier, improving our online system, just in general making KCI, I thinking significantly easier to do business with, than we have been in the past.

Matt Miksic - Piper Jaffray

And easier flexibility in terms of swapping between devices or between like what sort of; I’m trying to understand what kind of it’s been and I understand a higher level of services for sure, but...?

Catherine Burzik

Right, so I mean think about the situation when a hospital wants to discharge of patient to homecare studying. In the past they’ve had call off, get the active V.A.C. for the home delivered to the hospital. Now we actually have in many, many, many hospital; 100’s of hospitals, we actually have the active V.A.C. now ready in the hospitals for them to release with the patients.

So, as soon as we get the approval from the insurance company, we can say “Okay go.” So that’s what I mean about being more flexible; that just one example of what we’re trying to do with the hospitals.

Matt Miksic - Piper Jaffray

Good. Okay will thanks for the color and for taking the questions.

Catherine Burzik

You’re welcome

Operator

Your next question is from the line of Mike Weinstein with J.P. Morgan.

Taylor Harris - J.P. Morgan

Thanks a lot. It’s actually Taylor Harris here for Mike.

Catherine Burzik

Hi Taylor, how are you?

Taylor Harris - J.P. Morgan

Doing well, good morning. So, I though maybe we would start with the AHRQ report and Cathy I just love to get your high level thoughts on that. I think it was interesting because they did point out that there’s really no data on computing systems, but at the same time they didn’t seem totally satisfied with your data. So, I’d love to get your thoughts on that?

Catherine Burzik

Yes, sure. Realize that we’re still in the commentary on AHRQ and I know many, many physicians and surgeons are in the process of writing in relative to the AHRQ report, but that said, when we first heard about Afry doing this technology assessment and we saw the list of information that AHRQ wanted, they encouraged us to come forward and specifically asses, to bring forward all the data that we have; not just RCT data, but all of the studies that we’ve had and I think KCI worked extremely hard, our R&D and our medical team, to make sure that we provided all of that data and we did that as requested by the AHRQ.

I think the issue here is that obviously nobody else has any data. So, I don’t know where they thought they were going to get additional data beyond what we provided. So, they did not rule at all about the equivalence of NPWT system across the board from KCI or any other. All they did was say, “there was insufficient amount of data presented, so we can’t make any conclusion.” I mean that’s really where this AHRQ came out.

So, I mean you can debate forever whether or not they like the data that we provided. We are very proud of the data that we provided. I mean this is data that shows for example, 60% reduction in application from the boom study. So I mean those are very, very highly important study and we think right now the market’s voting everyday. I mean the current marketplace is like to head-to-head clinical trial, they are voting everyday and they are voting for V.A.C. Therapy.

Taylor Harris - J.P. Morgan

Do you think you need to do a head-to-head clinical trial in order to achieve some of your priorities in Washington?

Cathy Burzik

I think the answer to that is, no. I think our biggest priority right now is around continued commercial success. As I just said, we are winning in the marketplace everyday, so the marketplaces like an ongoing live clinical trial.

We are going to continue to work with Washington. I think where we need to get with Washington is a better way to reimburse for V.A.C. Therapy than where we are today. We want to continue to work with them, at somewhere outcome stage type of a reimbursement strategy. We’re hoping to have an opportunity to do that. I’m never going to give up in working with CMS as a result of this AHRQ or any other study that comes out.

Taylor Harris - J.P. Morgan

Okay great, and then just a couple of other business question. Internationally, I just want to make sure that I’m interpreting your comments right, it sounds like you view this as a market based slowdown in the first quarter, not an increase in competition, is that right?

Catherine Burzik

I mean the first quarter, it’s clearly a market based slowdown and it was really an economy driven slowdown, primarily in our largest country of Germany. Now that slowdown really as a result of what happened in the fourth quarter and as we said, it’s just took us longer in the first quarter to get our sale, our rental programs back in order.

So, we did that and by the time we exited the quarter we were doing better in Germany, but I really hesitate to think we’re going totally catch up. Then I just wanted to be prudent also because of the potential for increased competitive activity international. So we dialed in a small amount of that potential as we re-looked at our guidance.

Taylor Harris - J.P. Morgan

Okay, makes sense. Then in the U.S. you talked about maintaining current unit growth rates and that you really don’t see any additional impacts and competition. So (Inaudible) is launching their foam product; have you seen enough of that product to really feel comfortable on that front?

Catherine Burzik

We’ve certainly seen enough of that product and so I dialed in everything that we know and that we suspect right now as I make my comments. I’m very confident on our ability to compete in the marketplace; in the U.S. as well as globally.

Taylor Harris - J.P. Morgan

Okay, great and Marty let me just ask you two hopefully quick questions. One is this FX loss that you repeated or that you reported in the quarter. If I look from the beginning to the end of the quarter, the Euro didn’t really change that much. So, did you reset some of the hedges in the middle of the quarter that made you have to realize that loss? I guess that’s question one and question two is, should we model in zero impact for the next three quarters or would you guide us differently there?

Marty Landon

Sure, the real change Taylor was from December to January. If you look at that, in late fourth quarter you saw the dollar weaken against foreign currencies and then it strengthens quite a bit in the first part of the quarter, so within January where we saw that.

In response to that we’ve expanded some of our hedging activities; we’ve accelerated some of cash cooling activities; we’re trying to settle those inter-company transactions as quickly as we can to limit the exposures, so we’ve reduced our exposures there. Then finally even on the cash management side, we’re taking currencies and turning those currencies to dollars as quickly as we can.

So, you take the combination of those three things and you’re minimizing the impact as much as possible, but for me to say would be zero. I am not sure that would be prudent given what’s happened with those currencies. I mean they change as you know everyday. Within the quarter I think they changed somewhere in the range of 15% to 20% from the high to the low; so there can be a pretty volatile swing. So it’s hard for me to say that you will get nothing in terms of an impact, but hopefully there will be a lot less than $5 million in any quarter.

Taylor Harris - J.P. Morgan

Okay great. Thank you guys very much.

Catherine Burzik

Welcome

Operator

Your next question is from the line of Jayson Bedford - Raymond James

Jayson Bedford - Raymond James

Good morning and thanks for taking the question.

Catherine Burzik

Hi Jayson.

Martin Landon

Hello Jayson.

Jayson Bedford - Raymond James

Good morning. Just a couple of quickies; just on the 6% growth in U.S. rental volume, what drove that; meaning is it a function of less trailing from your competitors or is it just better reception to some of the new promotional programs that you guys are offering?

Catherine Burzik

I think Jayson it’s a great question. As all these things happen, I think it’s a numbers of factors. We certainly are not seeing anymore competitive pressures, but I would say on top of it, I think our sales force in our organization learned a lot during the course of 2008; on how to compete effectively and I think you saw that as we ramp through 2008 to now in to 2009.

So I think certainly a combination of these programs, as I talked about that make us and they are really well designed program that enable us to be easier to do business with our customers. I think we’re also really helped by our first two new products Simplace and the Diabetics and the GranuFoam Bridge Dressing have really, really been very, very well received by our customers.

So I think it’s a combination of and definitely also we’re doing much better at transitioning patients into the home, which is a big benefit to the hospital. So a bunch of those things all come together, so that is what gives us confidence around the 6% units in these growth in the U.S.

Jayson Bedford - Raymond James

Alright, I guess are you seeing less trailing note from your competitors?

Catherine Burzik

I would say that it’s about steady.

Jayson Bedford - Raymond James

Okay and have you seen any noticeable change in the acute versus chronic mix in your revenue?

Catherine Burzik

You mean acute versus home?

Jayson Bedford - Raymond James

Yes.

Catherine Burzik

I would say that we have more growth in the home as you can expect than we would have in the acute, as hospitals are obviously under pressure and part of that is driven by the hospitals working with us to transition patients into the home.

Jayson Bedford - Raymond James

Okay. I’m just trying to understand the peer mix, Medicaid as a percentage of U.S. V.A.C.?

Marty Landon

Yes, I’d put it in neighborhood of 5% maybe Jayson. It’s probably a third of what Medicare is.

Jayson Bedford - Raymond James

Okay and then just jumping over to the LifeCell business, the growth seemed to slow a little bit from what you reported in 2008 here and I’m just wondering, is it more a market issue, a competitive issue and I guess specifically the slowdown versus what you were seeing; is that in the core, hernia, breast or is it in the other uses of the technology, kind of your ortho, gynol applications.

Catherine Burzik

Lisa’s here and I’ll let Lisa speak about this directly in a moment, but clearly our major factor for us, this particular quarter, was getting the new Strattice facility online and everything. So, we worked through that as the overall quarter came surpass and really late in the quarter is when we are able to really start shipping all of the large pieces of Strattice that we need to buy. Lisa, may you want to comment directly to Jayson.

Lisa Colleran

I think the only thing I would add to that Cathy is that we do continue to see very strong demand in our challenging hernia and breast reconstruction. So, we see no slowdown in that and that a thing we’ve faced this year in the third quarter was around our ability to supply Strattice to the very high demand that we are seeing in the marketplace.

Jayson Bedford - Raymond James

Okay, so it sounds like you entered 2Q with a bit of a backlog on Strattice?

Lisa Colleran

A bit of a backlog demand as far as what we had available; now that we have a new facility up in running, we’re starting to see that come out of that new facility and through the second quarter we’ll actually match demand.

Jayson Bedford - Raymond James

It sounds good. That’s it for me. Thank you.

Cathy Burzik

Alright Jayson.

Operator

Your final question is from the line of Michael Matson with Wachovia Capital Markets.

Michael Matson - Wachovia Capital Markets

Hi, I guess my first question would be on the restructuring program. It sounds like you’ve already gone through most or all of the headcount reduction. I guess how we model the $100 million savings we expect through 2011; and is that through 2011 or is that a run annualized run rate in 2011?

Marty Landon

No, you are at an annualized run rate coming out of 2011 that’s in that $100 million range Mike and what you’re going to see is, you’re going to see a variety of activities. As I said we’ve set up this Global Shared Services team and we’re really going through with the restructuring.

What we did was, we kind of took a look at the organization and we did things that we thought we’re at low risk to the business, because we really haven’t implemented a lot of process change yet. So we’ve got the designs going, you’ll see the implementation of those process changes as we go forward.

I would say 2010 is when you’ll really see a fair amount of that implementation take place and then as you go into 2011, you’ll start to see some real savings out of those changes, but early on here what we’ve done is, we’ve taken kind of top level headcount, no process change.

Now we’re working through process changes and enabling technology that will make us far more scalable as we look forward, but also no doubt as we get more efficient with things, we’re liable to have a lower overall headcount as you get into the 2010 year, than you have today, as you get more efficient.

Michael Matson - Wachovia Capital Markets

Okay and is that savings going to be pretty much across the board in all of your operating expense categories, COGS, SG&A and R&D or is it going to be more heavily in one than the other. In other words is it going to be non-proportional to that spending as it stands now or roughly proportional?

Marty Landon

So it’s a good question and it’s really going to be focused on the service delivery, the customer administration and then the infrastructure. So, there will be a disproportionate share on the SG&A side versus the commercial side of thing. So in terms of selling and R&D, there will be less change though there will be more change on the back office if you will type of things.

Making sure that as I talked about transaction related cost, really get reduced to bare a minimum and not only does the cost of those transactions go down, but the effectiveness, the quality of those transactions will go up over that same period. So as you grow revenue, you don’t have to grow headcount like we have historically.

Michael Matson - Wachovia Capital Markets

Okay and then another MedTech pharma reported yesterday and they said that they had gotten a letter from the IRS looking at some proposed tax adjustments given their transfer pricing between their production outside the U.S. and sales in the U.S. and so forth. Have you all received anything like that?

Marty Landon

We have not and of course we just like probably every other company, we have tired to be prudent in our application of transfer pricing principals and we tend to be fairly conservative in that area because we know it can be a little bit dicey.

Michael Matson - Wachovia Capital Markets

Okay and then forgive me if you mentioned this earlier, but what sort of run rate are you expecting for your free cash flow this year?

Marty Landon

If we think about what we did last year, we were in that 200 and 250 range and I think as you look at our earnings growth, you can expect that our free cash flow will approximate that. The reason for that is we think, we’re going to do a reasonably good job at managing working capital and some of the things that we had in CapEx last year for example, the build out of the LifeCell production facility, we won’t have that type of reputation this year. So, it will grow in relation to earnings and hopefully, maybe be slightly better than that.

Michael Matson - Wachovia Capital Markets

Okay, that’s all I’ve got. Thanks.

Catherine Burzik

Thanks Matt.

Operator

There are no further questions. Do you have any closing remarks?

Catherine Burzik

No operator. Thank you all very much for joining the call.

Operator

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

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Source: Kinetic Concepts Inc. Q1 2009 Earnings Call Transcript
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