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Kinetic Concepts Inc. (NYSE:KCI)

Q3 2009 Earnings Call

October 21, 2009; 8:30 am ET

Executives

Cathy Burzik - President & Chief Executive Officer

Marty Landon - Chief Financial Officer

Adam Rodriguez - Vice President of Business Development & Investor Relations

Analysts

Seth Waugh - Deutsche Bank

Michael Matson - Wells Fargo Securities

Jayson Bedford - Raymond James

Matt Miksic - Piper Jaffray

Jim - FTN Equity Capital

Randy Heck - Goodnow Group

Spencer Nam - Summer Street Research

Operator

Good morning. My name is [Vishaira] and I’ll be your conference operator today. At this time I’d like to welcome everyone to the KCI third quarter earnings conference call. All lines have been placed on mute to prevent any background noise. After the speaker’s remarks there will be a question-and-answer session. (Operator Instructions)

Now I’ll turn the call over to Mr. Adam Rodriguez, Vice President of Business Development and Investor Relations. Sir, you may begin.

Adam Rodriguez

Thank you and welcome to the KCI third 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 Cathy 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 have you not received a copy of KCI’s earnings release, it is currently available on the company’s website at www.kci1.com. Today’s call is being webcast live over the internet and replay will be made available on our 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 risk factors maybe found in our filings with the SEC. Also, quarterly results discussed on this call may reflect adjustments to revenue for changes in foreign currency exchange rates or adjustments to expenses related to the 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. Finally I would like to remind you of our upcoming Analyst Day event being held the morning of November 9 at the Grand Hyatt in New York City. Management will be on hand to review strategic initiatives and performance objectives. More information is available in the Investor Relations section of our website and we look forward to seen you there.

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

Cathy Burzik

Thank you, Adam and good morning everyone. Today’s call will cover highlights from our third quarter and updates on each of our primary businesses and then review of our financial results today. As usual, we will then open the call for your questions.

As Adam mentioned we look forward to seeing you at our Analyst Day 2009, which is just around the corner. So, if we don’t cover your questions here, we will be pleased to answer them during our Analyst Day Q-and-A. As witnessed in the first half of the year, we continue to demonstrate resilience and leadership across our core divisions in Q3 in the face of well known challenges.

We made significant progress on our key strategic Pillars of global expansion, innovation and diversification. We are also strengthening our global organizational readiness for execution in 2010 and beyond. You will hear me touching on these important themes throughout this call.

Let me first provide a few highlights for the quarter, before I go into further detail. Importantly, we were notified by the PMDA in Japan that in October the MHLW will grant regulatory approval for our Novel V.A.C. Therapy System. We enhanced our global dressing franchise with Simplace and Granufoam Bridge, which are now also widely available outside the US.

We expanded our innovative negative pressure technology platform with a future rollout of the ABThera Open Abdomen Negative Pressure Therapy System, which received an excellent reception at the recent AAFP and ACS conferences. We advanced our LifeCell regenerative medicine business with the introduction of Strattice for stomal reinforcement and an all too common complication following colostomy surgery resulting in over 50,000 corrective procedures annually.

All said we’re executing to our plan of global expansion, innovation and diversification. All aimed at future growth while maintaining our focus on today’s business. At the heart of KCI’s continued success is our firm commitment to generating optimal outcomes. This coupled with our truly differentiated competencies and know how continue to drive trust, expectations for superior experiences and associated credibility amongst KCI customers and then why we continue and will continue to lead.

I’m generally pleased with our progress this quarter and remain confident in the outlook for the balance of the year and beyond. I will now go into more specifics about our operating results. Consolidated revenues for the third quarter were $504 million, comparable to the third quarter of 2008, and up nearly 2% on a constant currency basis.

Assuming constant currency, wound healing and regenerative medicine revenues were up 2% and 17% respectively, while the therapeutic support systems business decreased nearly 10% on a constant currency basis. GAAP net earnings were approximately $65 million, or $0.91 per diluted share, up 21% over the prior year period.

Turning to the U.S. wound healing, that unit growth of over 4% year-over-year signified sustained customer conviction in the integrity of our effective and differentiated outcomes. Units in use in the acute hospital environment grew slightly versus Q2. Units in use growth in post-acute continues to be affected by the economic situation. While we saw growth in all post-acute segments, quarter-over-quarter growth rates were stronger in Medicare Part B and Medicaid and weaker in MCO’s and especially [SNIF].

One of the segments impacted hardest by the economy. We believe usage mix in the post-acute environment has been influenced by the high rates of unemployment in the U.S., and we do not expect this dynamic to change in the short term. We are monitoring this closely, as well as rolling out new processes to bring us even closer to the post-acute customer.

Q3 pricing trends showed modest anticipated declines reflecting a disciplined effort despite the 2009 CMS price cuts. Our ability to develop win-win partnering programs which build in flexibility and collaboration on service activities, has led to lower net price realization, but longer term contracts and importantly, at least margin neutrality. As well charitable use and mixed shift to government programs also influenced realization.

Internationally, we continue to perform, executing our global expansion strategy, leveraging competencies and driving best degree technologies. In the U.K. and Nordic area, we are seeing an increased use of the tender process as a pricing tool. This presents a difficult situation, slowing down decision making, increasing competitive activity and moving the focus to price from more important values. However, in Germany, V.A.C. unit are at an all time high, in spite of increased competitive efforts.

We are monitoring the situation closely, and are working collaboratively with customers by utilizing our business impact model to demonstrate the clinical and economic outcomes of back therapy. As part of our global expansion, we are now entering the large and unpenetrated Japanese markets with our highly regarded back therapy systems and are progressing with initial commercialization activities in advance of a full launch during the first half of 2010.

Lynne Sly, formally President of our TSS business is now on special assignment in Japan, to lead commercial efforts there. Lynne previously drove the U.S. marketing success of V.A.C, during the critical 2000 to 2005 timeframe and we are fortunate to have Lynne in place in Japan to drive our launch activities in this important region.

Building on KCI’s strong tradition of innovation will be a central theme at our upcoming Analyst Day. Our ABThera open abdomen negative pressure therapy system is rolling out nationwide in the U.S. Bringing truly valuable innovation to surgeons dealing with clinically challenging abdominal trauma, and expanding our involvement in the operating room. Feedback to-date has been even stronger than anticipated and highlights the KCI has again developed and delivered an important solution to a significant issue affecting care givers and their patients.

As recently announced, we are initiating a multi-center observational study on the ABThera system and look to begin enrollment in December. We plan to launch ABThera internationally in the near term, continuing our penetration of this global market of over 250,000 annual procedures. We are also excited at the potential for utilization of ABThera with Strattice and AlloDerm in critical cases, requiring an advanced tissue matrix to aid in closure.

We now look forward to further expansion of the NPTP portfolio with the planned introduction of Provena for the reduction of post surgical complications such as seroma, dehiscence and infection in high risk patients. With a completely redesigned pump and novel dressing, engineered to optimize application of negative pressure, and post-op incisions, we believe Provena could address an unmet need in as many as 3 million procedures annually.

Turning to our regenerative medicine business, AlloDerm and Strattice were up 20% year-over-year in their core applications of challenging hernia repair and breast reconstruction. In total, LifeCell grew 17% year-over-year. Lower than we’d like and tied primarily to supply constraints of both Strattice and AlloDerm, which I’ll talk about shortly. Strattice continues to be impressive, especially in its predominant application in challenging hernia repair, due to availability of large sizes, ready to use formulation, ease of use in the surgical site, and bio mechanical properties.

Strattice now represents 33% of regenerative medicine revenue and breast reconstruction, advocates have emerged for both Strattice and AlloDerm, although many surgeons express a preference for AlloDerm due to its handling characteristics. This has resulted in continued strong demand for AlloDerm at a higher level than expected. AlloDerm launched in the breast reconstruction market in 2005, and in four years, has changed the way reconstruction is performed.

We believe that more patients if made aware would choose to be reconstructed postmastectomy. Currently, less than 40% of patients postmastectomy under go restruction. The benefit of patient education is clear. To this end, and in perfect timing with breast cancer awareness month, we recently launched a new patient education site, breastreconstructionmatters.com, for patients and their loved ones looking for information on breast reconstruction.

Commenting now on our supply constraints, we are encouraged with improving manufacturing efficiencies and yields for Strattice finish products and believe the gap is closing between strong demand and constrained supplies. We continue to ramp in our new plant and are seeing improved product supply levels that continued to build as we enter Q4. For AlloDerm, we remain tighter than I’d prefer on inventories; and we are working hard to reach a satisfactory resolution to this supply constraint in early 2010.

Regarding LifeCell global expansion, in EMEA, we are seeing increasing success with Strattice in the U.K., where the business remains ahead of plan due in part to the faster uptake in breast reconstructions. In Germany, we now have an experienced dedicated lead in place, packed with bringing activities and performance in line with expectation, as we move into 2010. Importantly, biologic materials, as viable surgical solutions, were acknowledged at the prestigious and well-attended international Hernia Society meeting held in September in Berlin.

Strattice was especially well received there given its performance to-date and adoption by various EU-based key opinion leaders. Our clinical strategy for Strattice is also tracking well, as we anticipate the launch of the EU trial for abdominal wall repair utilizing Strattice to occur before year end. Conexa, our Strattice based solution for rotator cuff and foot and ankle applications distributed by Tornier, is evolving positively as is our breast plastic surgery business.

We initiated enrollment in a Conexant rotator cuff study, which we expect will yield a very important set of clinical data and recently received CE approval for Conexa enabling launch in the EU. In addition, a pilot launch for the use of Strattice for stoma reinforcement was initiated during the quarter to address a significant postoperative complication by taking advantage of Strattice’s notable bio mechanical strength to potentially reduce further herniation in a difficult anatomic site. We anticipate the Strattice could be utilized in at least 50,000 procedures annually in this application.

Turning now to TSS, we are taking a fresh look at this business. With the keen goal of determining how TSS can best add value to KCI going forward. I’m very pleased that Steve Seidel took over as President of this business during the quarter. Steve is a very experienced business leader and has been an important contributor as an active member of our executive committee.

Steve will continue to serve as our General Counsel is through the February trial and is in the process of developing future strategies for our TSS business. Similar to other hospital supply businesses, global economic conditions have negatively affected this business in the last 12 months.

That said, there are many bright spots in TSS, that are strongly aligned with delivering evidence based outcomes, such as our live saving RotoProne Therapy Bed, which is seeing increased demand due to its profound impact on outcomes of ICU patients with limited options to addresses are including complications from H1N1, and other flu strains, Texas and other severe conditions.

Notably, we are at an all time high for RotoProne placement. Additionally we are focused on working with hospitals to prevent never events, both through our AtmosAir mattress which prevents pressure ulcers and sprit select beds, which prevents falls. These never events are no longer being reimbursed with CMS and KCI feel we can partner with hospitals to assure they truly never happen and thus improving the performance of hospitals and importantly dramatically improving patient outcome.

Regarding organizational readiness, we are making substantial strides towards our goal of improved operations with the execution of initiatives to help as we shift towards becoming a more Agile progressive global enterprise. In addition to our progress in branch for manufacturing, our automation project for disposals at our plant in Ireland remains on track and first production runs are commencing shortly.

We look forward to notable cost reductions as this effort hits full stride in 2010. We also made progress in realigning our service center infrastructure, another project which should be nearly complete before year end, yielding more cost benefits. Finally, enhancing customer experience, productivity and efficiencies in our advantage center, remains of paramount importance to us and associated initiatives are underway.

With approximately one/third of our targeted annual savings achieved to date, we look forward to further progress towards our goal of $100 million, in run rate savings, by the end of 2011, which will fund growth initiatives and drive margins. Before closing, I’d like to make a few comments on healthcare reform in the U.S. As a member of the Abdomen Board, I have been very involved with healthcare reform in the U.S. over the last several months.

Our medical device industry was an early supporter of broad-based healthcare reform. Great progress has been made on important issues for patients and medical technology, such as comparative effectiveness research, physician payment disclosure and value-based purchasing which seeks to tight payments to quality standards. However, we are far from the finish line. There continues to be discussion regarding the inclusion of a medical device tax.

As one of the vehicles to pay for healthcare reform, we believe an excise tax on devices and diagnostics is bad policy. As it will increase costs for patients, stifle innovation and reduce jobs in one of America’s world-leading industries. As a key member of the device industry, KCI will work tirelessly to assure an optimal outcome to this debate on how to pay for healthcare reform in the U.S., while maintaining our focus on providing innovative and cost effective therapies for patients and their caregivers.

In closing, I’m proud of the contributions of our dedicated people. We deliver solutions that matter, in a profoundly high impact way. Thus remain a well trusted partner amongst our customers. We were especially reminded of the humbling impact our innovations can have when KCI was honored with a recent visit conformably conjoined twins now eight who were joined at the skull at birth and separated in a critical and highly riskily to 34 hour procedure that utilized a custom made that, developed by KCI’s TSS division.

What a great example of how our products have a wonderful impact on patient’s lives. This is what KCI has always done and this is what you can count on KCI to do going forward. We are singularly focused on providing these kinds of outcomes, while providing great careers for our employees and superior financial returns to our shareholders. We look forward confidence to the remainder of 2009 and look forward to speaking to you on our Analyst Day on November 9.

Now, I will turn the call over to Marty Landon for our financial review.

Marty Landon

Thanks, Cathy and good morning everyone. Similar to what we saw in the first half of the year, the third quarter again demonstrated KCI’s firm result as the market leader to maintaining market share and managing through the dual effects of a tough economic climate and increasing competitive activity. We continue to leverage multiple points of differentiation, in response to competitive offering, while maintaining spending disciplines in addition to our expansion, growth and litigation initiatives.

Importantly, as we press ahead, executing on the strategic pillars, Cathy discussed, our continued market penetration and operating disciplines are enabling us to make the investments necessary to drive our future success, such as our work in Japan and preparations for new product introductions.

Now let me provide financial details of our third quarter. For the third quarter of 2009, we’ve reported total revenue of $504.4 million, which is comparable to the same period one year ago and up nearly 3% or $13 million sequentially over the second quarter of this year. Gains in our wound healing business, driven by continued global penetration with our negative pressure technology platform were partially offset by lower, but continued unfavorable foreign currency exchange rate variances.

Increases in regenerative medicine revenue from strong unit demand were a counter balance to declines in our therapeutic support systems revenue. Foreign currency exchange rate movements continue to mute organic performance in the period somewhat, reducing both consolidated revenue growth and V.A.C revenue growth by approximately 1%, as compared to the year ago quarter and reducing TSS revenue growth by over 2% compared to the third quarter of 2008.

On a constant currency basis, consolidated revenue growth was a little less than 2%, compared to the year ago period. Worldwide V.A.C revenue for the third quarter of 2009 was $360.6 million, which was relatively flat with V.A.C revenue from a year ago. On a constant currency basis, worldwide V.A.C revenue increased approximately $5.5 million, or 2%, year-on-year, due to continuing demand for our uniquely effective products.

Average U.S. V.A.C rental unit growth remains solid at over 4%, again highlighting our clear clinical and competitive differentiations. North American V.A.C revenue of $270.8 million was essentially equivalent to the year ago period, as volume increases were offset by lower price realization, resulting from the 9.5% Medicare cut that we took as of January 1 this year, coupled with the effects of our improved customer relationship program, and a continued mix shift toward Medicare and Medicaid patients. On a constant currency basis, third quarter North American V.A.C revenue growth was less than 1%.

Turning to operations, outside North America, EMEA/APAC V.A.C reported revenue of $89.7 million for the third quarter, down less than 1% for the year ago period. While revenue on a constant currency basis increased $4 million, or nearly 4.5%, similar to the rate of growth demonstrated in the second quarter.

Despite hospital budgetary constraints, and operating dynamics, shaped by the economic slowdown that gave rise to resource rationalization, we managed to grow average rental units by over 10%. V.A.C pricing in EMEA/APAC region as expected offset more than a half of the unit gains due to increase tendering and facilities, customer programs such as long term rental agreements and other loyalty programs.

Regenerative medicine revenue for the third quarter was $71.8 million, up 17% or $10.5 million versus the prior year period. Strattice demand remains strong up from 22% of regenerative medicine revenue, when we started the year to the 33% ratio, Cathy mentioned. Our growth in regenerative medicine revenue was again driven primarily from challenging hernia repairs, and breast reconstruction procedures.

Therapeutic support systems revenue in Q3 was $72.1 million, a 12% decrease compared to the same quarter a year ago. On a constant currency basis, TSS revenue was 10% lower versus the prior year period. The well known constraints facing acute care facilities globally, contributed to revenue performance in the quarter. With severe hardships in the U.S., outweighing relatively flat results in the EMEA/APAC region.

As in Q2, we again demonstrated a strong quarterly growth profit at $274.9 million, an increase of 8%, over the prior year period. Growth profit margin increased nearly 400 basis points to approximately 55%, compared to the same period of 2008. The increase in gross margin was due to a combination of higher gross margin from the regenerative medicine business, and increased service productivity within our other business unit, resulting from our ongoing efficiency initiatives, which are yielding good results.

As we saw in Q2 versus Q1, our third quarter gross profit increased approximately $11 million from the second quarter of this year, which is close to our sequential revenue increase. Our research and development investment in the quarter again increased as a percent of revenues versus the prior year period and was just under 5%, reflecting our express commitment to further innovation.

For the third quarter, total R&D expense was $24.7 million, an increase of 13% over the second quarter of 2008. SG&A expense, for the third quarter, was $125.8 million compared to $109.4 million for the same period of 2008. Planned new product launches, consolidation of domestic service centers, higher share-based compensation expense, and our global business transformation initiative, as well as higher legal fees from ongoing litigation matters, contributed to the overall SG&A increase.

Productivity improvements and cost control and other areas served to offset some of these expense increases. As previously announced, we are targeting $100 million in run rate savings exiting 2011, from additional costs and effectiveness improvements in global operations, as part of our three year global business transformation initiatives. Some of this work comes at a cost in the short term. Thus, while we may see some choppiness from period-to-period, our overall expectation is to continue funding investments and at least maintain if not improve operating margins.

In the quarter, after making such investments, we still improved the operating margin over 20 basis points from the third quarter of 2008. Interest expense was $25.7 million in the quarter, related to the LifeCell acquisition financing completed during the second quarter of 2008. Compared to the prior year period, interest expense decreased over $4 million, due to our accelerated debt repayment program. The third quarter interest expense also included non-cash costs, of approximately $4.3 million, associated with our required adoption of accounting standards related to convertible notes. As a reminder, the impact of this adoption was retroactively applied to the third quarter of 2008.

Transactional impacts from foreign currency fluctuations resulted in a gain of $3.2 million in the quarter, versus a $3.3 million loss in the same period of the prior year. Our hedging programs continued to show effectiveness. The third quarter tax rate reflected the resolution of certain tax contingencies, which helped decrease our effective income tax rate to 29.7%, down 330 basis points from the third quarter of 2008.

Our recorded or GAAP earnings per share for the period were $0.91, compared to $0.75 per diluted share for the third quarter of 2008, an increase of over 21%. On an adjusted basis, we generated diluted EPS of $1.08 for the third quarter of 2009, up over 12%, versus the comparable period of the prior year and up $0.10, or 10%, from adjusted EPS for the second quarter of this year. Our improved earnings this period were the results of overall revenue stability, and importantly, improvements in our cost structure enhanced by financial leverage from strong debt and tax management.

Operating cash flow less net capital expenditures was $208.4 million for the first nine months of 2009, an increase of 18%, from the year ago period. We made schedules in voluntary payments of $50 million in the third quarter, on our senior debt facilities, bringing our total for the year to approximately $179 million, net of revolving credit borrowings. Consistent with our stated objectives, we expect to continue using free cash flow, after first funding our initiatives in global expansion and innovation, to further reduce our leverage level, which now sits at 2.4 times our EBITDA over the last 12 months.

Our financial position remains liquid and stable, with total worldwide cash of over $270 million, and a substantially unencumbered $300 million revolving credit line. As indicated in our press release this morning, we have reaffirmed our revenue and earnings per share guidance for the full year of 2009. Included in our press release in morning, we have also provided you reconciliation to the adjusted earnings per share, hopefully to assist you with your modeling and to provide a consistent basis of comparison.

At this time, we’ll open the lines for questions, Vishaira.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Seth Waugh - Deutsche Bank.

Seth Waugh - Deutsche Bank

Just first, I wanted to touch on the international V.A.C. growth. It was solid, a little bit higher than we expected. So I just wanted to see if any of the $90 million, if you can attribute any of that to be injunctions that we saw overseas?

Cathy Burzik

You’re asking about the injunctions?

Seth Waugh - Deutsche Bank

I was saying, Cathy, you had the injunctions in Germany and Australia, and if any of the bump up in our U.S. V.A.C growth was just due to those injunctions or do you think it was more just solid unit growth?

Cathy Burzik

It’s not due to the injunctions at all. I think that it’s really due to the execution in the area, and as I talked a little bit in the script, particularly in Germany, where we have very open competition at this point. We’re very pleased with the performance that we see there.

Seth Waugh - Deutsche Bank

Actually, on the ABThera product, I saw that ACS, there was definitely a big buzz about it. How do you expect this product is going to impact your mix and margin over the near term and is it priced at a premium or is it in line with your current structure?

Cathy Burzik

It’s a great question and we’re really pleased with ABThera. I know that many members of the KCI team were there, both AAST and ACS and there looks to be really strong demand and really good positive early feedback on this. The product is priced at a premium and just to remind you that, there are some of those applications of open abdominal compartment syndrome, where V.A.C is used today, but we know because of the limitations for example, these wounds, they have an awful lot of exudate.

So V.A.C today really is not optimal and therefore we’ve designed this ABThera system. So we believe that really this ABThera system will cannibalize what’s called the barker system, which is really the standard of care for treating those patients today. So we see this primarily as a market expansion.

Seth Waugh - Deutsche Bank

Okay, market expansion and market and margin expansion?

Cathy Burzik

Yes.

Seth Waugh - Deutsche Bank

One or two more and then I’ll jump back in. For Strattice, you were saying that you think supply and demand are kind of catching up with each other. Are there any supply issues on Strattice and then on the AlloDerm side, since last quarter, have you increased your cadaver supply?

Cathy Burzik

Yes. So on both of those cases, I’m really proud of what Lee’s and our team managed to do third quarter. I mean, we ramp Strattice production really strongly during the third quarter. So we’re going into the fourth quarter, not exactly where we want to be, but much closer to where we want to be.

AlloDerm, however, because of the demand that we see for AlloDerm, particularly in the breast reconstruction, the supply of AlloDerm isn’t where we need it to be and this isn’t an issue of the sources of the human cadaver, because as you know LifeCell has great, great reputation, probably better than anybody in this whole area, harvesting tissue from cadavers.

So we’ve ramped up on all of those supplies, but the amount of time that it takes to process those, you understand that there’s an awful lot of serology testing, background checking, etc., that has to be done. It just takes time to get that AlloDerm ramped up and we honestly don’t think that we’re going to be out of the woods here until well into the first quarter.

Seth Waugh - Deutsche Bank

So that said, Cathy, if you had more supply, you would have been able to push it into the market?

Cathy Burzik

Yes, we think probably a couple million dollars or so, we would have been able to do with AlloDerm.

Seth Waugh - Deutsche Bank

One last one and I’ll just jump back into the queue. The Provena comments, I kind of missed them, it got cut off. I just wanted to know, when the launch timing and is it going to be sold by the V.A.C sales force or the LifeCell sales force?

Cathy Burzik

We are anxiously awaiting FDA approval for Provena. We do not have it yet. It has been filed and we’re excited about it, and hope to receive it soon. The thinking is that the Provena product will initially be sold through Mike DelVacchio’s sales force. However, we continue to work with Jim Gorman in the LifeCell sales force and would fully expect that sales force eventually to also be selling a version of Provena.

Operator

Your next question comes from Michael Matson - Wells Fargo Securities.

Michael Matson - Wells Fargo Securities

I guess I just want to start with Strattice. I know that LifeCell had been running some human trials for Strattice and it seems like we were supposed to have seen that data by now. I was just wondering what’s going on with the trial data. Is it going to be published any time soon?

Adam Rodriguez

We released a six month trial data, interim data at the International Hernia Congress in Berlin that transpired back in September. That’s just an interim look, so we looked next to get to the one year point with that trial data, which at point we’ll release.

Michael Matson - Wells Fargo Securities

On the breast side is, there going to be any data released?

Cathy Burzik

I don’t believe we have any study underway associated with the breast application.

Michael Matson - Wells Fargo Securities

Then your gross margins were up pretty significantly. Are you benefiting from any kind of product mix shift due to the slowdown in the Therapeutic Services business, for example, and if that business were to pick back up, or your international sales were to pick back up, is there any kind of negative mix shift that could happen, or can we expect the gross margins to kind of stay at the level, or near the level that they’re at?

Marty Landon

Yes, so on the Therapeutic Support Systems question, specifically, Mike, we are seeing, as Cathy mentioned in her remarks, good uptake in the critical care area, with our RotoProne product and that’s a good solid product for us that saves lives.

So with the issues around H1N1, and some of pulmonary complications you get there, that’s a product that we’ve seen some nice uptake in, but generally, I would say that the primary mix shift, if there is a mix shift is, really as LifeCell revenues continue to grow at a faster pace than the rest of the organization and those carry nice high growth margins.

So as you’ve seen, we’ve continued to expand as the years gone on, I think, we don’t want to get too crazy on where that goes, but I think we’re comfortable that gross profit margin is in a good area.

Michael Matson - Wells Fargo Securities

Is it safe to assume that the gross margins overall at the Therapeutic Services business are lower, and potentially dragging down your corporate gross margin?

Marty Landon

Those margins due tend to be a little lower, particularly on the wound care surfaces side where you have a lot more mature marketplace, a lot more competition and over the years, we’ve seen things slide to the lower end, less therapeutic, more sales, at the low end, than the higher end. So generally, that part of the business has a lower gross margin than say the negative pressure business or the Regenerative Medicine business.

Michael Matson - Wells Fargo Securities

Operating margins in that business, are those lower as well, or…?

Marty Landon

I mean generally, they are, but it’s not quite as clear a differential there, because naturally, you’ve got probably more of your investment areas, through this part of the 2009 year, anyway, in the other parts of the business, so maybe not quite as large as the operating margin supplies.

Michael Matson - Wells Fargo Securities

Then just on your Strattice launch in Europe, has there been any progress in terms of getting reimbursement? Has that been an issue at all in the various countries over there that you mentioned, where you’re selling the product now?

Cathy Burzik

I think that if you had stronger reimbursement, perhaps we would be doing better, but I will tell you it has not been a hindrance at all for us in the U.K., I mean I have just recently heard a big briefing about our U.K. business, and our business is doing very well there, because the doctors have found how well Strattice is working for breast reconstruction, and challenging hernia, and quite honestly they’ve not used to biologics there.

So the uptake has been very positive. You can expect that reimbursement is going to take time and that is why we’ve launched these challenging hernia studies that we have going on, within the EU, to gather more data to do that filing, but it has not been a hindrance for us so far.

Operator

Your next question comes from Jayson Bedford - Raymond James.

Jayson Bedford - Raymond James

Just a few questions, from the V.A.C. business, slight deceleration in U.S. V.A.C. volumes and I’m wondering, I think that reflects more of a competitive impact, or does that reflect the current state of the economy?

Cathy Burzik

I think it’s a blend of both, but I mean I’ve taken a pretty deep dive into this and I’ll just give you a little bit of color. It is really more the economy, than it is the competition we see a pretty stable competitive environment, particularly in the United States, as I gave a little bit of color in my commentary, regarding post-acute, you kind have to tease that apart.

In the hospital, we see a lot of stability, and as you can imagine, the usage of V.A.C. in the hospitals is on pretty sick patients, but what we see some interesting data, particularly as we move into Q3 and throughout Q3, the shift into the government payers, Medicare, Medicaid, away from the MCOs and the SNIF, caused our growth in post-acute to certainly slow in Q3. We do think that is tied to the economy. We do think that is tied to the jobless numbers people losing their insurance, pretty much tied to what we see others saying, too.

Jayson Bedford - Raymond James

Just switching over to the LifeCell business, the supply issues, did they increase in the third quarter or are these kind of similar issues that you saw in the first half of the year?

Cathy Burzik

So in some ways it is a little bit complex, the situation with Strattice actually improved in the third quarter. We really kind of got our sea legs under us for manufacturing and that happened as the quarter went on, so of course, you didn’t quite catch up to the demand. The situation with AlloDerm, obviously, as we went into the year, we didn’t anticipate that there was going to be as much demand for AlloDerm for breast free construction, as what we have seen and that’s what has caused us to be lower, much lower than we would have liked on the AlloDerm supply.

Jayson Bedford - Raymond James

Maybe for Marty, SG&A jumped a little more than we had thought and just given the cost cutting initiatives, is it fair to say that the savings to date have been really realized more on the cost of goods and is that where we will see it going forward?

Marty Landon

It is a combination, but I would say from a proportionate share, give credit to the operations guys here they have done a lot of good work on that side of things and you see that in the gross margin numbers, but there have been improvements in both. In this particular quarter, as we approach the February 2010 trial here in the U.S. and with the amount of activity that we had going on overseas around litigation we had the higher legal expenses in the period.

As you approach the new product launches, we’re doing some work there to be ready to have very effective product launches, we’re investing in Japan to get ready for the launch there so I think you’ve got some things that in this quarter, build that up a little bit and as we said, related to the global business transformation, you’re going to have some places where you have to make investments before you can get out some of these costs.

So you are going to have a little bit of choppiness. So for us it wasn’t anything that was a total surprise from where we’re going. We are going to try to manage as we said operating margins to be consistent or slightly expanding, but I would tell you that we’ve done a good job on the operations side through the first nine months of 2009.

Jayson Bedford - Raymond James

Just lastly, on the TSS business you mentioned I think a fresh look, what are your options there and then I guess and I realize this maybe sensitive, but would this be a business you would consider divesting? Thanks.

Cathy Burzik

We get that question, from time-to-time, we really encourage, myself and our board, to take a really fresh look here at this business, all the options are on the table, as I said, I am really quite pleased right now with the uptake in RotoProne and the uptake in our select bed, and the continued strength of AtmosAir. It has been a tough year obviously for TSS as it has been for, all of the therapeutic support system suppliers.

So, I think is important, we’re asking question around, what more can be done around top line growth. What more can be done to increase revenue both domestically and internationally? How much further costs can we take out? Other things like spears select we can get from another company to bring into our portfolio? So we are really looking at a number of things there in that business.

Operator

Your next question comes from Matt Miksic - Piper Jaffray.

Matt Miksic - Piper Jaffray

I think you made some comments on unemployment and the impact on the market. Is it possible to give us sort of just a top down composition of growth, given that you effectively represent the vast majority of the market, just in terms of sort of units, price and mix? You talked about payer mix having an impact. How bad is that? Is that a negative two or three point impact against a slightly higher unit growth? Anything you could do to help us understand the composition right now on the market?

Cathy Burzik

That maybe a little more detail, Matt that then I want to take time to go into hear on the call, and we haven’t provided that level. As a matter of fact, we provided more granularity, I think in my comments than we ever had here. So I want to give you some directional sense here that again in the acute area we see the business as stable. I think that’s very important, given the pressures that the hospitals have and also the fact that we continue to look at length of therapy issues there, and we see that holding.

So I mean, we’re doing well I think in the hospital environment and the post acute environment, it is amazing, when you look at the numbers, and you look at the shift throughout Q3, I’ll say a pretty significant decline in the MCO utilization, and a comparable increase in the Medicaid and Medicare. We’ve seen SNIF’s go up and down overtime due to economy due to competition, but we’re right now also in a year-over-year reduction in the overall SNIF’s, and then in addition to that, we see a pretty significant increase in our charity utilization.

There is always a slippery slope, because you want to do the right thing for people who can’t afford them, but we do see more requests for charity V.A.C. So that’s probably about as much color as we can provide. I will tell you, you asked a little bit about price. The pricing impact comes certainly from the mix. The pricing impact to some extent also does come from our customer loyalty programs.

As you know, we’re doing a lot with new programs to get V.A.C’s on-site to keep V.A.C’s on-site to keep them ready to be moved out with the patients, doing a lot to make sure we work with our customers on long term rentals, so all of those customer loyalty programs I’d say a modest, very modest impacts, but on the top line, but are margin neutral for us.

Matt Miksic - Piper Jaffray

So would it be fair to characterize it as sort of stable units, some pressure on units, because of the economy, maybe most of the pressure here, due to pair mix, with some incremental modest, as you described price, and modest, maybe year-over-year competition? It sounds like competition is relatively stable.

Cathy Burzik

Competition is definitely relatively stable. So I don’t think you should in the U.S. put that into the factor. I think you should think about this primarily a function of mix, primarily mix, and again, as we look at that mix margin neutrality. I just want to make sure that’s my statement about MCO’s was clear. I did not mean to say that the MCO’s has declined and since the growth rate has declined. It’s that the growth rate has decelerated.

Matt Miksic - Piper Jaffray

To follow-up here on Strattice, to clarify your earlier comments on capacity, I think you said something like the capacity, you’ll be continuing to work to meet demand into the first quarter. Maybe when do you see, is it the second quarter when you can finally say that you’re meeting demand, and then secondly, on Strattice, any change there in the competitive dynamics, either here in the U.S., or in terms of the price that you’re able to get, sort of relative to the U.S., as you enter some of these U.S. markets?

Cathy Burzik

So Strattice, just to repeat a little bit here, we’re doing well now in ramping Strattice and I think that we will exit the year with the right amount of supply of Strattice in hand. So we ramped well through Q3. We’re in better shape going into Q4. We should be in good shape by the end of the year.

AlloDerm, I suspect, will continue to ramp. It will ramp during Q4, but it will take us well into Q1 and it’s probably going to be beginning Q2 before we get into a position where we’re really confident that we have enough AlloDerm. Regarding your questions, regarding price, have we disclosed price differences? I’m looking at Adam.

Adam Rodriguez

We’ve talked briefly about them and their relative differences that are very much in line with what you see between the U.S. and U.S. pricing. U.S., somewhat below where we are in the U.S. as far as the product is concerned.

Cathy Burzik

Your question though regarding competition, it’s pretty amazing the analogy sometimes between our V.A.C business and our LifeCell businesses. Competition, kind of rides on the coattails of our LifeCell products as it does on our V.A.C products. So we see others in there trying to get share, but we don’t see anyone else coming up with a clinical study, the clinical data, the evidence based outcomes, that LifeCell has historically generated. So there’s almost an analogy and a parallel to what we see in the V.A.C area.

Matt Miksic - Piper Jaffray

One question for Marty on SG&A trend just again, clarification of an earlier comment on where the benefits have been so far. Given the Japan spend that you mentioned, new product launch spend and legal. Marty, should we look at this as sort of SG&A trending off of Q3 as sort of in a seasonal way into Q4 and into Q1, or should we look at some of these as kind of onetime in Q3? When do we start to get some easing on the SG&A line?

Marty Landon

It’s a good question. I think that certainly on the litigation and the new product launches, you’re probably going to see that continue into the fourth quarter, Matt. On some of the other areas, you can see those maybe as a little bit more choppy, so you may not see them in the fourth quarter, but they may comeback again sometime during 2010, as you make that next level of investment as you move into new technology and new process.

In answer to the question around where are you getting the savings from, it’s going to fall into currently into the areas like HR finance and IT is the other side where you’re seeing the productivity gains, but I think in the fourth quarter, in the short term you’re going to continue to see us have a fair amount of litigation activity, you’re going to continue to see us invest in Japan, you’re going to continue to see us get ready for the product launches. So that may continue into the fourth quarter and we’ll offset that with improvements in other areas.

Matt Miksic - Piper Jaffray

Last question here and I’ll jump off, just a broader question on healthcare reform. Some of the other companies we cover have sort of proactively launched these comparative effectiveness studies in advance of what appears to be an increased scrutiny down the road on clinical effectiveness.

I realize you’ve already got a pretty impressive array of clinical data that’s been published on V.A.C, but can you talk about any plans that you have, if you do have plans to pursue studies that are kind of aligned with this sort of new strategy for comparative effectiveness?

Cathy Burzik

Yes, I think Matt, it’s a great question and I’ll tell you in some ways, we’re still developing our strategy, but clearly on our new products and that’s why you heard me talk about the study that we’re putting forward, this observational study, associated with ABThera, compared to the standard of care, I’ll call the sparker system.

I mean that’s what we want to continue to do is show how hour product. Our products in total compared to what the standard is, and I mean and that’s what everyone is going to be trying to do and I just want to emphasize, one of the things we talk a lot about at med is that comparative effectiveness is not cost effectiveness.

It’s great if the cost effectiveness gets aligned with comparative effectiveness, but it really is all about aligned with outcomes and outcomes based medicine. So we want to make sure that we stay very focused on that, similarly as we do many of our LifeCell studies, similarly, when we do comparisons to standard techniques. I think that’s the focus of where KCI wants to spend their clinical dollars.

Operator

Your next question comes from Jim - FTN Equity Capital.

Jim - FTN Equity Capital

Most of my questions have actually already been discussed, but I just had a quick one on regenerative medicine. I was wondering if you can give us an update on the FDA warning letter at the LifeCell facility.

Cathy Burzik

Certainly, we have continued to send the information into the FDA, as we had committed to associated with the warning letter and we have ongoing discussions with them. We’ve had face-to-face meeting with them and continue to provide the information as they’ve asked us to. We would expect at some point, in the future that there will be a follow on audit, where they would come to the company.

Adam did contact, for whoever asked about, whether there’s a Strattice breast study going on, there’s a small Strattice breast study underway of about 30 patients. As we get the results from that, we’ll definitely be sharing that with everyone.

Operator

Your next question comes from Randy Heck - Goodnow Group.

Randy Heck - Goodnow Group

You commented that Germany has been strong and yet your patents have been invalidated there and I’m wondering if you expect that strength to continue despite the invalidation of the patents and if so, is that tell you anything about the U.S. market in terms of the importance of your patents?

Cathy Burzik

Let me just talk a little bit about this. I think this is a very good example of how KCI competes in the open market. It is a combination certainly of products, but also of talent. We have a very strong sales force in Germany, as we have a very strong sales force under Mike DelVacchio who is sitting here in the United States and so it is a lot about focus, it’s a lot about execution.

I have maintained since I’ve come to KCI that competition only makes you stronger and competition sharp into your focus. That’s clearly what we’re doing. So, we’re continuing just as we do it within in the U.S., we have a lot of partnering programs with our customers in Germany and so we’re working on that and we will continue to work on that. So, I don’t know if that gives you some perspective, but I think it is a good example of how KCI can compete and will compete in a fairly open market.

Randy Heck - Goodnow Group

So I guess specifically, has the marketplace changed in Germany since the whatever court that was, since it invalidated the relevant patents, has the competitive environment changed and/or do you expect it to change going forward?

Cathy Burzik

The competitive environment has changed. It has changed in Germany it has changed in the U.K. The company is really I think, resilient in the face of that change. We see open phone-based competition in those major countries, within Europe for sure, as a result of the legal situation that occurred there.

We see competition working hard not on innovation, not on innovative products at all matter of fact we see no innovation, but we do see people attempting to buy business, by taking price versus selling value and of course the strength of KCI are all around the value proposition associated with who we are and what we have and the clinical advantage.

So it just gives us another opportunity to go in. So, you can see a slowing of decision making happening as a result of that as people have more options, but KCI just comes back with all of the data that we have and by and large continues to win in the marketplace.

Operator

Your final question comes from Spencer Nam - Summer Street Research.

Spencer Nam - Summer Street Research

Going back to gross margin, it looked very strong this quarter. I was just wondering what could be sort of a long term target here; could we potentially see 60% range here or are we getting close to sort of the upland of the potential?

Marty Landon

So there are a lot of factors that go into that, Spencer. I don’t want to project too much optimism, we’re working hard at getting it to increase, certainly mix helps us, always talked about the favorable margins, on the regenerative medicine side, we continue to do work on the operations side of the business, so I think it does become a matter of execution always looking for productivity gains, but I don’t think that we’re ready to speculate on just how high that can go.

We’re going to continue to execute. We understand our responsibility to continue to fund investments out of the business. So, we’re going to try and drive that North, but there are always going to be factors that are positive and negative in that respect, we talked about some of the pricing changes that and we got to get costs out of service, we got to get costs out of product, as we go forward, given some of those dynamics. I wouldn’t go way North with that number, just yet, but we’re pleased with where it is going.

Spencer Nam - Summer Street Research

The Japanese opportunity, how are you seeing the opportunity and what sort of the dynamics that we should expect as you move into Japan, obviously the V.A.C. is going to be the only negative pressure there, any thoughts?

Cathy Burzik

So, we really look forward to this opportunity in Japan. So, you asked about dynamics. As we wait for our reimbursement to occur, we are not sitting back idly, so we are investing in building our sales capability, we are investing in building our key opinion leaders and in educating customers. We moved a team of people, not just Lynne Sly, but some of our best and most successful V.A.C. people to Japan to work with the local team to really make sure we build capability in Japan, as rapidly as we possibly can.

So you can imagine that we will start with V.A.C. as we know it today and overtime, as we build the capability, we would introduce more and more of the products, that we have in the company, not just the negative pressure products, but at some point even the regenerative medicine products, so our goal here is to build the business for the long term, in Japan.

So you can expect us to invest, thoughtfully, but as we see the market here, unfold and I think you have seen the numbers, we’re looking at North of 250,000 wound opportunities just in the key acute centers, in Japan. So those are the ones that we’re going to go after first.

Cathy Burzik

I think that will conclude the call and I thank everyone for participating.

Operator

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

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