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Kinetic Concepts Inc. (NYSE:KCI)

Q4 2009 Earnings Call

January 26, 2010; 8:30 am ET

Executives

Catherine Burzik - President & Chief Executive Officer

Marty Landon - Chief Financial Officer

Lisa Colleran - President - LifeCell Corporation

Mike Genau - Global President of Wound Therapy

Adam Rodriguez - Vice President of Business Development & Investor Relations

Analysts

Taylor Harris - JP Morgan

Imran Zafar - Deutsche Bank

Roshni Sacks - Piper Jaffray

Michael Matson - Wells-Fargo Securities

[Shan Babick - FIG]

Jason Bedford - Raymond James

Chris Cooley - FTN Equity Capital

Spencer Nam - Summer Street

Greg Brash - Sidoti & Co.

Operator

Good morning. My name is Jennica and I’ll be your conference operator today. At this time, I would like to welcome everyone to the KCI fourth quarter and year end 2009 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)

I would now like to turn the call over to Adam Rodriguez, Vice President of Business Development and Investor Relations. You may begin.

Adam Rodriguez

Thank you and welcome to the KCI fourth quarter and year end 2009 earnings conference call. Today we will review the results that were announced in our press release earlier this morning. Today’s webcast and 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 have you not received a copy of KCI’s earnings release, it is currently available on our corporate website at www.kci1.com. A replay of this webcast will be made available on our website shortly after the 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 factors maybe found in our filings with the SEC. Also, quarterly and full year 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 period discussed. Please refer to the non-GAAP reconciliation of these metrics contained in our earnings release issued this morning.

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

Catherine Burzik

Thank you, Adam and good morning everyone. We appreciate your joining us to discuss our fourth quarter and fiscal 2009 full year results. On today’s call, I will cover key developments in the quarter, review the performance of our three core businesses and provide a Strattice report on several of our new products. Marty Landon will then review the financial results in more detail and provide some color on our fiscal 2010 guidance. We will conclude our call with a question-and-answer session.

To began, I’m very proud of the resilience demonstrated once again this quarter and year particularly in the state of such challenging 2009. This performance is evidence of the progress we are making on our strategic sellers, our geographic expansion, innovation, diversification, and organization of readiness.

Before turning to review our results, let me highlight a few important developments. First, regarding Japan, we achieved regulatory approval of our Vacuum Assisted Closure, V.A.C. Therapy systems in October as planned and are now building out the commercial infrastructure and commencing with initial market development efforts. We are waiting a decision on reimbursement, expected by April 2010 and are highly enthusiastic as we work towards commercial launch in the second quarter.

Secondly, our new product commercialization and innovation, we are delayed with the success of our new products and application recently brought to market, such as Simplace, Granufoam Bridge and ABThera. This year, we have several new product launches plan, including efforts to successfully of all from our third generation NPWT system to our broadened, highly differentiated negative pressure technology platform complete with the expanse of next generation V.A.C. Therapy, negative pressure tissue regeneration and negative pressure surgical management opportunities, such as Prevena for improved management of surgical institution.

We look forward to continued expansion of our regenerative medicine business. As we commercialize new opportunities and abdominal wall repair, generally construction and our new cosmetic franchise, such as Strattice for stomal reinforcement and [Inaudible]. Lastly, regarding organizational readiness, our cost savings program is delivering as planned, allowing us to sell some of the investments we believe our necessary to help drive KCI’s next phase of growth, while also driving positive margin development.

Let me now review results overall and by segment. Total fourth quarter revenues of $527 million increased 7%, from Q4 ‘08, and fiscal year revenues up $1.99 billion, grew over 6% from 2008 on a reported basis. Earnings per diluted share increased nearly 33%, to $0.93 in the quarter, versus $0.70 in the prior year period. Full year reported EPS of $3.24, rose 40% compared to EPS up $2.32 in 2008. Marty will provide you with additional details such as adjusted non-GAAP EPS figures.

Turning now to the Active Healing Solutions or AHS business, resilience was the same in the quarter and throughout 2009, despite various challenges. In the face of increasing competition, particularly from pharm-based product, our performance highlights the KCI remains the trusted partner for Advanced Wound Healing solutions, due to the compelling economic value and quality we provide, in our technology, our customer program, our clinical expertise and service, and unparalleled outcome.

Total AHS revenues increased 2.3% in the quarter, versus the prior year period on a constant currency basis it’s driven mainly by modest unit volume growth, and capital sales. Pricing decline in the low single digits versus Q4 ‘08 level was generally in line with our long term expectations. Driven by the congressionally mandated 9.5% to any cost, implemented in 2009, patient mix, and customer centric program.

We have learned that for 2010, the amounts only fees under the MPWT at fixed cost unchanged. The United States AHS markets, we called the effects of both trailing from the competition, and budgetary constraints due to the economy, particularly in our posted queue segments. That said I’m pleased with the hard work and results of our U.S. AHS team.

In Japan, since receiving official regulatory approval of our V.A.C. Therapy System in the quarter, we have driven the pace of activity making prudent investments in the important sales function, finalizing the marketing strategy and testing auto services infrastructure. All in advance of full launch anticipated for Q2 2010, filing reimbursement approval.

At the same time, early development efforts of key opinion leaders are underway and we have regard to target initial facilities for innovated V.A.C. Therapy System will be rolled out. In Germany, despite rising competitive activity, we are driving penetration in unit growth based on the expected value delivery and superior patient outcome. We’re addressing the challenges and competitive impacts, created by free trailing and the aggressive activities of me participants in the market.

Finally in the U.K. and northern regions, we grew modestly in the quarter. Although the economy and tendering process seeds sowed our growth to some extend. Q4 2009 was Mike Genau’s first full quarter of global AHS President. I’m very pleased with how quickly he has established himself in this complex business, and I am looking forward to continued strong AHS execution under Mike’s leadership.

In our regenerative medicine business, which is the life style operation we acquired in May 2008. Fourth quarter revenues increased 7% sequentially from Q3 ‘09 and 13% on a constant currency basis, but it is a strong Q4 ‘08 period. This performance brought our Q4 our full-year 2009 pro forma revenue growth to 18%, first and full year 2008, which is inline with our long term growth targets.

Growth in the quarter was driven primarily by Strattice, up 80% over Q4 ‘08, and based on where we exited the year is now an annual run rate above $120 million. While core application penetration continues in regenerative medicine, growth in the quarter was below long term expectations.

As we have discussed for most of 2009, we had difficulties keeping up with demand. Including a record increase in large sheet Strattice orders as we opened our new Strattice production facility and have stronger than expected to think how AlloDerm, particularly in breast reconstruction. Further on capacity, the constraints we’ve experienced and I could report that we reached our targeted levels for Strattice inventory as we exited 2009.

As we have stated previously, we expect to be unconstrained an AlloDerm, exiting the second quarter of this year as we successfully increase our production capacity. I’m also happy to report during the quarter we resolved the warning letter we received from the FDA in October of 2008.

Operationally, we progressed on a number of fronts in the quarter, and the U.S. the entire regenerative medicine sales force will now be selling our breast plastic surgery products as well as the new stomal reinforcement product. At the same time, we have recurred a specialty has a neck reconstruction sales force to focus efforts on an attractive opportunity for AlloDerm, which performed particularly well in these procedures.

The European sales force is also expanding. With 26 sales reps currently on the Board and 35 planned as we end Q1. All in support of our commercial effort in the U.K. and Germany, as well as eight new countries that we plan to enter during 2010. On the clinical front, our Strattice hernia repair trial in the EU is now open with multiple screening for post patients. This trial will be critical to support in market penetration and obtaining favorable reimbursement.

Turning now to our Therapeutic Support Systems or TSS business, which showed encouraging growth in the quarter, despite the economic situation impacting the entire industry, in fact, it is gratifying to report that in the fourth quarter TSS grew sequentially 7%, and rose 3% year-over-year on a constant currency basis to nearly $83 million.

These results suggest to the hospital environment that stabilizing this year. Our life saving RotoProne solution for patients for the acute respiratory distress syndrome was the key driver in the quarter as demand grows is due to incident of the H1N1 virus and other serious respiratory diseases.

As we mentioned, that our Analyst Day in November, we have been taking a fresh look at our TSS business. After careful review, we have concluded that retaining this important business served the best interest of our stakeholders, but do not expect a Strattice here. Going forward, we believe there are opportunities to strengthen the TSS unit. Especially, the critical care and bariatric segment and you can expect to see notable changes in this operation in the coming quarters.

Our efforts will be focused on the most profitable market segment that KCI also have sustained competencies and innovation and clinical relevant in order to drive greater stakeholder value. We have work now for several years along Steve Seidel, so we announced that the global present of TSS at our Analysts Day.

I’m confident that his leadership, passion and dedication to creating a strong profitable business, will yield tremendous benefit. Steve will retain his role as a General Counsel to the February trial. We have begun a search process for this success there and expect to name a new General Counsel in the coming periods.

I would now like to update you all on the progress we have made on one of our key Pillars of growth that of invasion. Beginning with ABThera, our negative pressure product for the management of the open abdomen wound, we have continued to receive excellent surgeon feedback, since the fall launch in the United States.

The uptake while early has been strong, and we are now through the very technical committees and approved for use in well over 10% of U.S. facilities. Surgeons are delighted, but they now have ready access to an advanced solution designed specifically for operating room to address these very unique and challenging wounds. We expect ABThera to be available on a global basis in the near term.

Since GranuFoam Bridge both value added dressing products are now available globally, and we are seeing early signs of these products do in deed provide meaningful advancement to dressing, and further serve to position KCI as a leader in negative pressure wound therapy.

We are looking forward to the broad introduction of Prevena, which is designed for the postoperative management of surgical incisions. Studies show Prevena may help reduce the risk of postoperative complication such as infection. The market opportunity for Prevena is a substantial $1 billion, based on a target market of approximately 3 million procedures, performed each year, on hugger’s patients.

In the United States, we’re currently awaiting FDA clearance to promote the product and then the EU we have obtained CE marking and are on the markets. Since we marked both to you about our pipeline, we moved closer to launching V.A.C Ultra our next generation system, with proprietary fluid installation technology in 2010, our worldwide basis. That is our next generation MPWT innovation, which is single use, easier to procure star and use than current V.A.C. Therapy product.

It’s also moving closer to as expected launch mid-year. These solutions in addition to the orders I just reviewed, carrying important new intellectual property, move us into meaningful new wound care market that were previously out of reach and serve to substantially expand our NPWT product offering.

In regenerative medicine innovation, Strattice for stomal reinforcement progressed well and it’s high safe. In earlier this month, we broadly launched this new application at our national sales meeting. This application is very exciting and we believe we can make a meaningful improvement in herniation rates, and a very complicated patient population.

We continued to be very encouraged by the progress, each of our new products is making towards our near term and long term goals. I’d look forward to updating you on our next call on commercialization efforts. A few summary comments before I turn things over to Marty.

Given the considerable challenges, KCI faced this past year I am proud of what we accomplished in 2009, as evidence by our results particularly our earnings and cash flow. As we move into 2010 on the competitive front, we have proven that providing consistent superior outcomes requires a unique and powerful combination of core competencies that leveraged strong products, service and experience.

On reimbursement and reforms, we see no change in MPWT Hicks-Picks reimbursement rates, and we foresee no advanced competitive bidding. We are optimistic regarding reimbursement for V.A.C. Therapy in Japan. Regarding intellectual property, we are confident and prepared to vigorously defend our current enhancement state in the upcoming patent trials.

We are augmenting our existing IP with know-how and new patents covering pipeline products, thus extending X3s, well past 2020. We remained well focused on competing fairly and effectively regardless of the outcome of the trial and while there is much concern about the economy around the world, we have begun to sense stability.

I’m pleased with the business unit structure we implemented in 2009, and as a leadership team we put in place. I firmly believe this structure will serve our customers and shareholders well, going forward as it provides greater focus and accountability of KCI growth.

Our progress with the global business transportation initiative in cost saving program are tracking well. Reflecting the hard work, that is going on to deliver efficiency in our business processes, we’re helping to secure our additional margins. The employees at KCI work industriously in 2009, to show both stakeholders and competitors that we are a determined and to leader in the markets we have defined and nurtured and are now vigorously evolving.

KCI is moving forward aggressively with a comprehensive strategy to both deepen penetration in our existing markets, and expand beyond. These efforts to capitalize on our unique capabilities and competencies are already beginning to realize value. We now look to 2010, with the same result to execute on our strategic objective.

Our 2010 financial guidance that we communicated in this morning’s release is based on this firm determination and centered on innovation, geographic expansion, diversification, and organization of readiness. We look forward to 2010, and to delivering our longer term objective with confidence.

I’ll now turn the call over to Marty Landon to review the financial results in more detail.

Marty Landon

Thanks, Cathy. Good morning, everyone. As Cathy’s remarks suggest, we continue to capitalize on multiple points of competitive differentiation, while managing our spending inline with our strategic initiatives, and focused on the four pillars of geographic expansion, innovation, diversification, and organizational readiness, to help drive KCI’s next phase of growth.

Total revenue for the fourth quarter of 2009, was $526.8 million, an increase of 7% from the $492.5 million reported for the same quarter one year ago, and a 4% sequential increase from the third quarter of this year. Excluding the effect of foreign currency exchange rate movements, fourth quarter 2009 revenue increased 4% year-to-year.

We experienced growth in each of our business segments during the period, due to continued demand for our therapeutic products, and high quality support services. In our active healing solutions or AHS business segment fourth quarter, negative pressure wound therapy up $367.2 million increased approximately 6% from the same period one year ago, and on a fully reported basis and a little more than 2% increase on constant currency basis.

We experienced an increase in the level of unit sales volumes in the fourth quarter as certain high usage customers purchased a base level of inventory. On a sequential basis, AHS revenue was up $6.7 million or 2%, from the third quarter of 2009. For the full year of 2009, AHS revenue of $1.407 billion was up a little less than 3%, on a constant currency basis, fourth quarter regenerative medicine revenue of $76.9 million increase 13% from the same period of the prior year while at 7% sequentially from Q3 2009.

As Cathy noted earlier the LifeCell unit continue to build the effects of inventory constraints during the fourth quarter, but we made progress in our Strattice production as the quarter progressed and we now believe that exiting 2009 we have adequate inventory to meet our expected demand moving forward.

For the full year of 2009, on a comparable pro forma basis, regenerative medicine revenue increased 18% from the prior year consistent with our expectations. Therapeutic support services or TSS revenue for the fourth quarter of 2009 increased 7% from the year ago period to $82.7 million, due to high demand for critical care and Kinetic Therapy such as RotoProne and TriaDyne and favorable currency movements.

On a constant currency basis TSS revenue was up 3% from the prior year period. On a sequential basis, the business also showed nice improvement, growing 15% from Q3, due in part to normal seasonality in business, but also reflecting the impact of H1N1 outbreak. Continuing the trend begun in Q2, we again reported strong quarterly gross profit at $297.6 million, an increase of 19% versus the prior year.

Our fourth quarter gross profit margin increased 580 basis points to approximately 56.5% compared to the same period of 2008. The increase in gross margin was due to a combination of higher V.A.C unit sales, higher revenue and associated gross margin, from our regenerative medicine business, lower product growth expense, and realization of our on going service efficiency initiatives.

Our research and development investment in the quarter increased to $24 million or approximately 6% above the fourth quarter of 2008. We continue development on several new products to be rolled out over the next 12 months to 24 months and have begun the clinical work necessary to support these innovative product launches. SG&A expense for the fourth quarter of $140.2 million rose 13% compared to $123.5 million for the same period of 2008.

The SG&A increase was largely due to planned initiatives including preparation work for new product and geographic launches, our global business transformation initiatives, legal fees associated with on going litigation matters, as well as higher share based compensation expense. Our focus on driving productivity improvements and reducing costs in other areas offset some of the higher expenses.

We expect to spending in several of these areas will continue into early 2010, as we head towards our market entry in Japan our February US IT litigation, new product launches and implication of our business transformation plans. As previously announced we are targeting a $100 million run rate and cost savings existing 2011 as part of the three year global business transformation or what we call here GBT initiative.

While we still expect to at least maintain a gradually improve operating margins overtime, as we have said on prior calls, some choppiness is expected from period-to-period, as we make the necessary investments to implement this program. In the fourth quarter, however our operating margin of 23.4% rose roughly 440 basis points compared to the same period in 2008 due primarily to restructuring charges incurred during the prior year period.

Compare to the preceding quarter of 2009, fourth quarter operating margin improved 80 basis points, as a result of higher gross profit generated in the period. Interest expense was $24.5 million in the quarter, largely related to the LifeCell acquisition financing completed during the second quarter of 2008. Compared to the year ago quarter, interest expense decreased over $7 million, due to our accelerated debt repayment program.

The fourth quarter 2009 interest expense also included non-cash charges of approximately $5.1 million, associated with the required adoption of new standards related to the accounting for convertible notes. As a reminder, the impact of this adoption was retroactively applied to the last three quarters of 2008 and increased the fourth quarter 2008 interest expense by $4.7 million.

The fourth quarter effect tax rate up 32.9%, compared to 26.2% in the prior year period. The lower rate in Q4, 2008 resulted from the favorable resolution of certain tax contingencies in that period. From an income tax provision standpoint, we continue to see slight improvements annually.

On an adjusted basis, excluding the effects of non-cash acquisition related item, we reported fourth quarter diluted EPS of $1.10, up 12% versus the comparable period of 2008, and fully year diluted EPS of $3.99 versus $3.78 from full year 2008. The improved earnings were the combined results of our top line growth coupled with the operating leverage of expanded growth and operating margins plus the financial leverage resulting from our focus on debt management.

Turning now to our balance sheet, our financial position remains liquid and stable, with total worldwide cash of over $260 million, and a substantial unincumbent $300 million revolving credit line. Because of our strong cash flows, we again made both scheduled and voluntary payments totaling $50 million in the fourth quarter on our term a bank debt, which brings our total repayments for the year in at $200 million.

Our total debt on an economic or debt instrument basis was $1.44 billion at year end 2009 or approximately 2.3 times or trailing 12 month EBITDA, but it’s declined with a voluntary prepayment of $50 million made mid January of this year. Consistent with our stated objectives, we expect to continue using cash flow to drive down our leverage.

Regarding our cash flows, operating cash flow less net capital expenditures was $293 million in 2009, we saw an increase in networking capital during Q4, as we increased our LifeCell inventory levels and made required tax payments. Accounts receivable days outstanding however, improved slightly from the prior year as we continue to work towards improving our billing and customer service operations.

Turning to our guidance for fiscal 2010, as indicated in our press release this morning, we are guiding the full year revenues of $2.05 billion to $2.9 billion implying growth of 3% to 5% and diluted non-GAAP earnings per share of $4.32 to $4.46, implying growth of approximately 8% to 12%.

Recorded or GAAP diluted earnings per share are targeted at $3.56 to $3.66, implying growth of 10% to 13%. To assist you with your modeling and to provide a consistent basis of comparison, we’ve included reconciliation to the adjusted earnings per share in this morning’s press release.

We believe the guidance reflects appropriate consideration of economic and competitive factors and we have assumed stable currency rates compared to the full year 2009. Continued business mix improvements and operating efficiencies will allow us to fund our organic growth investments, while expanding full year margin slightly, which combined with our continuing deleveraging and improved tax efficiencies should result in the higher net earnings.

With that, we’ll open the lines for Q-and-A. As a guideline this morning, we would request that each of you please try to limit yourself to one primary question with maybe one follow-up question to allow as many people in the queue to pose their questions as possible in the time we have remaining, and as always, we thank you for your assistance with this. Operator.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Taylor Harris - JP Morgan.

Taylor Harris - JP Morgan

Wanted to start out with the revenue performance in the fourth quarter which was a very good end of the year, picked up on an organic growth basis compared to what you are done earlier in the year. It looked like a couple of reasons for that one were the sales volume in the US V.A.C. business and the other was the surfaces business which had a very nice rebound. Wonder if you can comment on the sustainability of what you saw on those two particular lines?

Catherine Burzik

Happy to comment on this yes, we were pleased certainly with the revenue performance in fourth quarter. On the two points that you bring up on the V.A.C. sales in the United States, those sales are primarily focused on, in a couple of areas in the areas of the military, and that also in large customer, such as lift, it is really hard to predict how much of that we are going to actually see going forward, but we were pleased we were able to conclude that in Q4 its really our estimates on that are factored into our guidance for 2010, and of course we are going to continue to drive our disposable sales and that impact that number also.

In the areas surfaces, we indicate in the guidance that we see 2010 is being a more stable years certainly. As a result of the economy, stabilizing we were pleased we had increased rental units are not just in the United States, which was driven primarily by H1N1. We also had in Q4 a very nice international rental pick up also which we think is a primarily a function of the overall global economy. I hope that gives you some sense of how we see it.

Taylor Harris - JP Morgan

Definitely and just as my one follow up and I will jump back into line. So, in the U.S. for V.A.C. it sounds though and I’d love your comment on this. You aren’t seeing some sort of a shift away from the rental revenue model and toward the sales model, but this was more so just in effect some large customers doing year end purchases. It sound more one off than a meaningful shift in the business. Is that right?

Catherine Burzik

Yes, Taylor there is no meaningful shift away from rental and just a little color on this. Our customers particular in the acute care segment and as the hole health agencies and post cute they logged the rental model right because KCI provides all the services and make as part of it making easier to do business with. So, where we have rental units as been very selective and as you said more of half type of things.

Operator

Your next question comes from Imran Zafar - Deutsche Bank

Imran Zafar - Deutsche Bank

This is actually Imran Zafar for Tao. Thanks for taking my question. My first question is on guidance, I wanted to know what you have assumed for in terms of timing and revenue contribution from Prevena and also what revenue rate assuming for Japan in this forecast. Thanks.

Catherine Burzik

I will start, and Marty might want to jump in. As we indicated in my comments, we are anxiously awaiting the FDA approval of Provena, and as, right now the FDA is working with a lot of companies on different approvals. We are certainly hopeful that we will have approval for Provena in the first half before the middle of year.

So, we factored some revenue from Provena into this year’s forecast or guidance and it is mostly from the second half of the year, and on your question regarding Japan, this is a startup year for Japan. So the revenue we have factored in is second half of the year revenue, and we have not disclosed exactly what the revenue number is planned for this year in Japan. Do you want to comment on any of this?

Marty Landon

I think you characterized it well. We are ready for Provena once we have receive FDA approval. I think that’s the important next step.

Imran Zafar - Deutsche Bank

As it relates to the Strattice and aerodrome supply constraints, can you roughly quantify what the negative impact of that was in other words, if there wasn’t these supply issues, what would revenue have been?

Catherine Burzik

If we said Imran through the course of last year, at least is actually here might want a comment on this, but what we have said probably a couple of million dollars of per quarter is how we characterize the impact.

Lisa Colleran

Yes. That’s, you are right. That’s the number that we have when we try to quantify, but we’re pretty excited about exit run rate at beyond of 2009, and at a run rate of $120 million for Strattice and we left the quarter, are targeted. So it feels like 2010 is a good year for that.

Operator

Your next question comes from Roshni Sacks - Piper Jaffray.

Roshni Sacks - Piper Jaffray

I just have one question, it’s about a year ago you had started several new your promotional programs to help offset some of the competitor trialing. Can you talk about the penetration of those programs in the U.S.? What effect we should see as you annualize those programs in 2010?

Catherine Burzik

Certainly, we are very pleased with these programs that we introduced in the United States and with that we introduced the program globally, we think that they have really contributed to the overall sustainability of our V.A.C business. Just to get you a sense of these programs. The programs generally are programs that are named at making KCI easier to do business with. Making V.A.C. so for example, we have a program called Ready Care, with V.A.C. that we’re actually in the hospital there already for overall release when the patients released from the hospital.

They take the V.A.C. home with them, we have other programs that are in general make the V.A.C.s available in the operating room for the patients. We have really enhanced our KCI express capability, which is the on line ordering capability for the company, and in general, I’d say, the seen more business model flexibility and in KCI has typically had. We have the, in the back business rolled at lot of these programs out globally. Did I miss any…?

Marty Landon

I think you hit the key. Our focus has really been around bringing the customers more flexibility and making it easier to do business with us and I think KCI express is a great example as we’ve achieved our target ramp ups in each of these programs across the board in the U.S., which is why we grow them up globally now. We’re starting to see the effect in each of our regions as cross the globe.

The impact of that, as you look forward is consistent with what we said at Analyst Day and what have seen this year is you have a little more consistent utility increases, but it does affect a little bit of your price. So you have improved units, and some price degradation overtime. Overall, you’ve got gross profit neutrality on those kinds of relationships.

Operator

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

Michael Matson - Wells-Fargo Securities

I was wondering if you could quantify the impact of the Medicare reimbursement cuts during 2009. I think your last annual filings said that Medicare was about 9% of your overall revenue, and if I multiply that by 9.5% I come up with a 1% drag on your overall revenue growth. Is that reasonable?

Marty Landon

Yes, that’s in range everyone like.

Michael Matson - Wells-Fargo Securities

Just on Provena, can you walk us through what initial indications or types of patients you’re going to be targeting and then walk us through, who’s going to be selling the product which sales force, if you’re going to set up a dedicated sales force, if we’re going to set up a dedicated sales forces of specialist or anything like that to solve about?

Catherine Burzik

Yes, certainly, Mike happy to do that. So this product, there’s Provena it is a platform technology. So overtime, there will be several versions of Provena, but the first Provena, it’s willing in for fashion, which has high risk, up issues associated with surgical complications such as obese patients, where you end up with wound dehiscence, you end up with seroma, and infection build-up underneath at surgical incision.

So Provena, which is a pealing stick is relative type of a system has a proprietary foam that goes over the incision and then Todd and his team have worked very hard to make sure that there is no skin breakdown, which I can tell you is no small feet associated with it. We see this as being applicable, because millions and millions of procedures, but originally, I think 3 million procedures that this is aimed at, which is a large market.

So, we are as Mike said, product is manufactured, sales force is trained. We are very anxious to get going on this overall product. Regarding the selling, we think the most appropriate initial sales force for this is the AHS or V.A.C. sales force, however, we work with LifeCell because we do think that there are follow on that Prevena that do make sense for the abdominal wall repair and general reconstruction areas that LifeCell focuses on.

Operator

Your next question comes from [Shan Babick – FIG.]

Shan Babick – FIG

I had a question about the treatment periods for V.A.C. I’ve noticed in a last couple press release for the quarters, you’ve mentioned that there’s been a reduced treatment time and I’m just wondering what is causing that and how that’s affecting V.A.C. sales.

Catherine Burzik

We call this average length of therapy and there’s good news and bad news here. We have determined and this is historical comment in the last several years, but as soon you’ll get V.A.C. on the patient here. So KCI tried to educated clinician about that fact and as a result of that, I think one point that we’d like 12 days. I think now it’s probably just under 10 days.

So you have patients out of the hospital faster, you save the overall hospital money. We have similar situations in post acute, where we’re working with Home Health Agencies to make sure the nurses are working with the patients that the V.A.C. is on for the appropriate amount of time. Remember that in the home, the average amount of days a V.A.C. is on is 44 days, so that is modestly going down overtime. So I think we definitely call average length of therapy

Shan Babick – FIG

It’s doesn’t have to do, it’s all better clinical outcomes than a cost issue…?

Catherine Burzik

That is correct. It is not the cost part of it. Although, we are saving the health care system money by doing this, but yes, it is really a function of getting the V.A.C. on for the right amount of time.

Shan Babick – FIG

Then one other question, Marty, when I look at the guidance, can you clarify your FX assumptions, the press release says that you assume FX in 2010 to be comparable to 2009, but given that the dollars are certainly weaker than a year ago, I just wanted a little more clarification there.

Marty Landon

So we’ve use the full year 2009 rate as a comparative and the dollar as you look at that is a stronger than where you had saw in the fourth quarter.

Operator

Your next question comes from Jason Bedford - Raymond James.

Jason Bedford - Raymond James

Just a couple of quick questions for you, in past and I apologize if I missed this. You’ve given U.S. procedure volume growth number, and I was wondering if you could give that for the fourth quarter here?

Marty Landon

Our unit volume.

Jason Bedford - Raymond James

I guess I kind of look at the same thing, just backing out the impact of pricing?

Marty Landon

So in the quarter we had about 1% overall unit in used growth on the U.S. rental side of the business.

Jason Bedford - Raymond James

Then in the U.S., you mentioned on the V.A.C. business, trialing in the post acute setting and I guess I had thought historically, you saw it a little more in the hospital setting. I’m wondering did you see more of it in the fourth quarter in terms of the post acute than you had in quarters past.

Marty Landon

The trialing has been relatively stable and we are seeing it both in the hospital and the post acute segments.

Jason Bedford - Raymond James

So, no change in the fourth quarter versus let’s say the first three quarters of ‘09?

Marty Landon

No, it has been fairly stable.

Jason Bedford - Raymond James

Then just if I can, jump on it lastly, on the OUS business, the V.A.C. business. Is it a function of increased competitive activity or are you looking at market saturation issue out there? Thank you.

Catherine Burzik

Jason, first it’s nowhere near a market saturation issue. I mean the same kind of issue we face in the United States. KCI is in a position now with the increased competition where our sales force has to play a lot of defense, and not just offense. So you clearly have strong competition and most of the country now, outside the U.S. Now, I will say we have a sales force that has gone really well, against competition and historically we’ve been able to fight competition in Europe.

We also had more complexity because in southern Europe for example in Spain, the government just really ran out of money and probably turned off the spec at the end of last year, and then we also have in the UK, and Nordic you have these tenders and you have an increase in tenders because the customer now that they more truly and I will say KCI wins a lot of those tenders, but a lot of it puts downward pressure on price and so the important thing is we are still generating strong demand outside the US. The units in use and Germany continue to with strong and increasing. So, it is a complex situation, and you almost have to take apart country-by-country.

Operator

Your next question comes from Chris Cooley - FTN Equity Capital.

Chris Cooley - FTN Equity Capital

If I may can we just maybe address LifeCell specifically looks at the biologic penetration how that may have changed within complex for any repair. There’s potentially some data coming up at the hernia meeting, could you just remind us how you expect penetration of biologic, whether would be Strattice the competitive offerings to transition as we go throughout the course of the year and one follow up on TSS after that? Thanks.

Lisa Colleran

Yes. I can make some comments on that and we continue to see the focus and hernia market on biologics to be very strong, as you attend any of the convention hernia meeting it just its pretty much correspond page news of the focus on away from Strattice in two biologics for challenging hernia continues to be strong. I don’t have exact numbers on the change in penetration for the fourth quarter for example, but we have seen an increase in penetration, with the biologic across the Board.

Chris Cooley - FTN Equity Capital

Just in regard to TSS, clearly that very encouraging is seeing that business go positive on a year-over-year comparison in this most recent quarter. When we think about in terms of profitability, when during 2010 do we start to see TSS operating kind of at the optimal level, you alluded during the analyst meeting you would be taking initiatives to not only enhance growth, but also enhance profitability. Could you just kind remind us where we are along that continued? Thank you.

Catherine Burzik

We step that on the profitability question for TSS in the last three years actually and a lot of the focus has been in the way we deliver service to the customers. So, there has been a lot of focus on our service centers, on our routing, on having the right units, right places in the United States, and I think Mike Schneider has done a great job in that regard and we are now focused during 2010 on tearing into Europe a lot of the learning that we had in the United States.

For example, each country in Europe still has its own service infrastructure and service philosophy. So really trying to see what type of consolidation can occur within Europe, so those initiative are planned throughout this year, kind of quarter-by-quarter, do with see that service impact certainly by the end of the year globally.

That said, I think, it is important to emphasize this is really a fresh look at the overall business, and we really are asking ourselves a lot of questions, still about the focus in our wound sector, there’s a wound part of it, this is BariAir and a critical care and we believe then in the BariAir for critical care we have some real unique opportunities not just in driving bottom line, but also driving top line.

Marty Landon

I think it is fair Cathy that as we move toward the targeted level of profitability you going to probably see changes in improvements in the portfolio, getting the right portfolio in place, I think you are you probably going to see changes as we look at that portfolio, in terms of the cost to produce our products. So, there are additional opportunities, but you don’t turn a big boat like that overnight. So it will be on going here for a little bit, yet.

Operator

Your next question comes from Spencer Nam - Summer Street.

Spencer Nam - Summer Street

First of all, your gross margin Q4 was exceptional level. I was wondering how you guys look at 2010 gross margin outlook, it could be close to 56 here or is it can more like 54, 55, where should I think about that?

Mike Genau

I think that there were something that helped us in the quarter, that the level of sales activity was higher and so that contributed to higher margins, I think as you look towards the things we can count on as certainly being sustainable the service improvements, the improvement in terms of the product mix, with LifeCell having higher margins and being a greater part of the business, you get pretty comfortable I think that you are going to see some marginal expansion still at that line, but I think that a number I think for the year, you were 542. If we get 50 basis points there, expansion in 2010 we are tracking along the levels that we would expect, so if you are in that 54, 55 range you probably in that too add place.

Spencer Nam - Summer Street

In second question is you guys guided between 3% to 5% growth in 2010, and in terms of the contribution by segments how does it change between 3% and 5% the scenario I mean what, where would you see the growth coming from in 2010 at the low end scenario versus high end?

Catherine Burzik

I will give you my thoughts and, always jump in your selling clients, just think about some of the dynamics we have as we enter the quarter right, our new product launch and it is always difficult to predict exactly where you are going to be on the new product launches, but if one these new products is home that clearly has upside, it could be in the LifeCell business with our new ENT sales force. It could be with Provena or our V.A.C. entries that we have at the end of the year.

So, I see that and then Japan, whether or not things take off faster in Japan. Similarly in LifeCell we are doing lot of geographic expansion in Europe. The question will be and very strong leader there, Willie burns had run the UK business, I have known Willie for years going back to J&J days and he is running LifeCell in Europe. So that kind of dynamic as we look to the year and then on TSS, obviously as we look to strengthen that business there is the potential of increased RotoProne usage depending on the H1N1 and depending on overall flu season turnout.

So there’s a wide variety of things that miss any could happen, and we try to take all of those into account. We don’t exactly know the reimbursement levels in Japan yet. Those could be higher or lower than what with we have planned and then if the economy picks up we have the potential for increased capital sales particularly in TSS. So, there’s just kind of a variety of things that could happen.

Spencer Nam - Summer Street

When do you find out the Japanese reimbursement rate?

Catherine Burzik

Sometime during this quarter, before April 1.

Spencer Nam - Summer Street

That’s when it will launch; right.

Catherine Burzik

We launch for plan on launching April 1.

Operator

Your next question comes from Greg Brash - Sidoti & Co.

Greg Brash - Sidoti & Co.

One of the more helpful aspects of your analyst day was the breakdown between core organic growth compared to and new markets and new applications for the next five years. You have many new launches here in 2010, seems a lot of them maybe in the second half, but how should we think about that, sort of the organic versus the contribution from new applications?

Catherine Burzik

I think you should think about the majority of our growth at our AHS business more coming from our core, and coming from some small amount from Japan, modest amount from Japan during the course of this year, and new products in the second part of the year. 2010 is a year of transition for us, with these new products and you should not think about modestly upside in the AHS business coming from new, from what is styled into our guidance. Mike?

Mike Genau

That’s fair, guys. What we are very encouraged by the pipeline, and the investments we are making are going to be important, weather it’s the product as well as 360 degrees healing and how will providing the services and clinical value across the globe so its actually more than product it all of those elements I think will help give us a lot of momentum in 2010.

Catherine Burzik

In similar in our LifeCell unit as we introduce new product in abdominal while repair and generally constructions and in cosmetics recently we made a comment and I think a lot of your growth is more also the core.

Lisa Colleran

Yes, we still respect of large challenging hernia repair and breast reconstruction, whether it’s still lots of room for increased penetration, people are using more plus procedure which causes growth and then our new products will start to pick up and new geographies for that matter at the end in second half of the year and most addressed in the call.

Greg Brash - Sidoti & Co.

Just one follow up, Cathy you mentioned that expect to see schedules unchanged for 2010 and you probably won’t see second round of competitive bidding to, you maybe at least 2010, is it your understanding that the fee schedule will likely remain unchanged in total competitive bidding or is there still that possibility they could reduce or raise it in 2011?

Catherine Burzik

So the crystal ball while we heard on these things, they do this senate of decision every year on the Hicks-Picks course. I think part of this is a function of what happens with healthcare reform. Whether or not it’s medical device tax that occurs or that will be an influence on what CMS does or does not do.

Competitive bidding is kind of in that same area, plus I think competitive bidding is somewhat a function of how well does round one really go, is CMS successful this time? So, I’d like to be else to more precise, but it’s really hard to predict 2011 and 2012 right now, at least until we get through the health care reform debate and know what’s really going to happen with regarding this medical device tax.

Operator

Your final question comes from Taylor Harris - JP Morgan.

Taylor Harris - JP Morgan

Just a few follow ups here. So first of all on the trial, we had down in our notes at least that it’s slated to kick off in early February with closing arguments towards the end of February. Is that still your understanding?

Catherine Burzik

Yes, I’ll have John Bavis here to confirm that, but I believe John that’s correct.

John Bavis

The jury selection begins on the February 4, and closing arguments are the last week of February.

Taylor Harris - JP Morgan

Then on the reimbursement in Japan, Cathy, is that going to be a daily rate like it is in the U.S., or some sort of all inclusive rate?

Catherine Burzik

The way the structure works in Japan there’s a material fee and a technical fee, in addition to that a fee to the doctors. So, there are several different components, and we just need to wait and hear all of them, but we are anticipating that there would be a kind of a length of therapy type of reimbursement and we’re still determining that what it has called in Japan, still deciding what that length of therapy should be. So we would expect to get a length of therapy type of amount and then also a disposable kind of a material fee that would be more like a daily kind of a thing.

Taylor Harris - JP Morgan

Do you have some sort of guidance on what a range that it’s going to come out and to be comfortable that it supports your ability to market the product?

Catherine Burzik

We have history here to guide us. As you know, I think the Japanese government requests reimbursement rate from all the key countries. So we are provided them all of the European type reimbursement rates as well as the U.S. reimbursement rates. They have what they call the foreign reference pricing.

So we have provided all of that to them. In addition to that, we have very strong key opinion leaders, who are the big named and wound here, in Japan really pushing to try to help make sure reimbursement is what KCI is expect going forward. So again there’s no big crystal ball here, but we have reason to believe that we are working with the right people in Japan and we remain optimistic that we would be at the levels we expect.

Marty Landon

Using their methodology, Taylor, all of that range of values would say that the reimbursement is sufficient to support our efforts.

Taylor Harris - JP Morgan

Cathy, a thought, maybe since you did make the decision to keep the surfaces business, could you just give us the one or two highlights on what the primary rational was for doing so?

Catherine Burzik

We did a lot of market research, external market research, spoke to a lot of customers during the end of last year and we were making a decision just trying to reconfirm to our self, where’s the KCI, where is the value added, how is this business that’s been in our heritage and founding business, how are we currently viewed.

I was very pleasantly surprised. I think the whole company was by how strong the brand recognition is for KCI, particularly in the bariatric space and at the critical care space, where KCI beginning with RotoRest, as what we done with RotoProne, it’s where we have a TriaDyne and when it comes to critical care therapy, the general feeling is nobody does it better than KCI.

As we looked at that, we said let’s focus on our strength and for that’s where Steve focuses right now on that. So that’s really what gave our cost to say, this is a really good business, and let’s get focus on this business and let’s figure out if we have ways to growing it.

Taylor Harris - JP Morgan

So how much of it came really simply from the fact that it does seem like a lot of the infrastructure is intertwined with the V.A.C. business? So there would be some slippage or leakage on any divestiture?

Catherine Burzik

That was not really a very big consideration. Certainly in the course of the last couple of years as we have started moving towards the business unit, there’s really a very limited amount of shared service right now, and certainly there’s still some for example we have unique sales forces in the United States.

One of the things Mike is working with Steve in Europe, is how best to decouple the V.A.C. and TSS organizations. I think I’m providing to focus within the business, and having the resources of a business tied to that business and with and so many product launches particularly in the AHS business. I think the TSS business is better served with unique resources. So that’s the direction we were on in any event. So that really didn’t come into play.

Taylor Harris - JP Morgan

Marty, cash flow was down year-over-year. Was that a function of having a very strong 2008, or were there some items of particular note in 2009?

Marty Landon

So there were a couple of things. One in 2008, we received a tax refund that was in the neighborhood of $25 million, $30 million and then as we built up the inventory in LifeCell and actually made tax payments in the fourth quarter of 2009. So your working capital changes were dramatically different year-over-year, Taylor, probably the biggest thing in terms of the overall free cash flow still progressing long life of where we’d expect it to be.

Operator

We have reached the allotted time for questions. Are there any additional closing remarks?

Catherine Burzik

No. I would just like to thank everybody for participating in the call. Have a good day.

Operator

This concludes today’s KCI fourth quarter and year end 2009 earnings conference call. You may now disconnect.

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Source: Kinetic Concepts Inc. Q4 2009 Earnings Call Transcript
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