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Kinetic Concepts, Inc. (NYSE:KCI)

Q2 2010 Earnings Call

July 27, 2010 8:30 am ET

Executives

Todd Wyatt - VP of IR

Cathy Burzik - President and CEO

Marty Landon - CFO

Mike Genau - Global President, Wound Therapy

John Bibb - Attorney-in-Fact

Analysts

Michael Matson - Wells Fargo Securities

Mike Weinstein - JPMorgan

Jayson Bedford - Raymond James

Paul Choi - Caris & Company

Matt Miksic - Piper Jaffray

Operator

At this time, I would like to welcome everyone to the KCI second quarter 2010 earnings conference call. (Operator Instructions) I would now turn the call over to Mr. Todd Wyatt, Vice President of Investor Relations.

Todd Wyatt

Thank you and welcome to the KCI second quarter 2010 earnings conference call. Today, we will review the results that we announced in our press release earlier this morning.

Today's webcast and 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 you have 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 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 may be included 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 and adjustments to expenses related to the LifeCell acquisition and restructuring and other charges incurred in the periods 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.

Cathy Burzik

Thank you, Todd, and good morning, everyone. We appreciate your joining us to discuss our second quarter 2010 results. On today's call, I will provide commentary on key developments in the quarter and then review the performance of our three businesses, including comments on new products and strategic initiatives. Marty Landon will review our financial results. We will conclude the call with the question-and-answer session.

As you know, 2010 is a year of transformation and investments for KCI. We are gaining momentum with the launch of our new AHS products globally as well as our very successful launch of V.A.C. Therapy in Japan. Additionally, we are pleased with the results of our launch of new surgical applications for our LifeCell tissue matrices as well as our expanded LifeCell launch in EMEA.

For the second quarter, total worldwide revenue of approximately $498 million increased 1% from Q2 '09 on a reported basis and increased by 2% on a constant currency basis. EPS on an adjusted non-GAAP basis was $1.01, an increase of 3% versus the prior-year quarter.

Key highlights for Q2 include FDA approval for two new key AHS products, our novel single-use V.A.C.Via and our Prevena Incision Management System for use in the operating room. Also during the second quarter, we launched V.A.C. Therapy in the Japanese market and we're very pleased with the progress we're making there.

Another positive for the quarter was the recent favorable ruling in the U.K. in our patent trial against Smith & Nephew, in which the Court found Smith & Nephew to infringe two of our NPWT patents. Additionally, we had very strong performance in our regenerative medicine business, including a return of AlloDerm to optimal inventory levels, strong growth in our European markets and positive market acceptance of our new stoma reinforcement product.

Also, we announced our single-source contract extension for Novation for our TSS business, and we announced the formation of an Advanced Research and Technology group for KCI.

We also faced some challenges in the quarter, including the sharp decline in the value of the euro and other currencies in relation to U.S. dollar and a later-than-planned FDA approval of Prevena resulting in a delayed launch of this promising product. This quarter also saw a decline in our TSS rental business and a challenging environment for our AHS business in EMEA and Canada.

Notably, as we enter the second half of 2010, we are pleased with the stability of our U.S. V.A.C. business. And we are confident in our new AHS products, the robustness of our LifeCell business and in our revenue growth in Japan.

Turning now to a review of our performance by business segments, all revenue growth rates will be stated in terms of constant currency figures. In our AHS business globally, revenue was equivalent to last year. North American AHS revenue declined slightly in the quarter compared to last year, primarily as a result of a decline in our business in Canada.

U.S. AHS revenue was essentially equivalent year-over-year in a very challenging environment. Sequentially, U.S. AHS revenues rose over 6%. We saw order growth in the hostile environment where the post-acute AHS market remains under pressure driven by a number of factors, including a decline in the number of chronic wounds treated outside the hospital that led to an unfavorable wound mix and an increase in utilization of other advanced wound care therapy.

During the second quarter, we spent considerable time analyzing the post-acute market in the U.S. and have made a number of changes that we believe will strengthen our post-acute business going forward. The most significant of these is our decision to expand our sales force aimed at increasing utilization of V.A.C. Therapy in post-acute facilities.

Mike Genau and his team plan on adding over 100 new sales in clinical professionals in the U.S. by the end of 2010. While some of these additions will be into the acute setting, aimed at increasing adoption of Prevena, ABThera and V.A.C.Via, the majority of these will go into post-acute.

Within the post-acute segment, which is still considerably underpenetrated, these new sales reps will focus on further penetrating wound care clinics and home health agencies, educating clinicians on the clinical and economic value of using V.A.C. Therapy, facilitating ordering and assisting our customers with insurance-driven documentation needs.

In the EMEA/APAC AHS markets, revenue grew approximately 1%. In EMEA, AHS revenue was essentially comparable year-over-year amid increasing competition and economic pressure. Our rental and sales volumes in EMEA increased, but were offset by lower realized price as a result of longer-term lower-priced rental arrangements.

Germany continues to perform well despite increased competitive activity, and we are pleased with our ability to continue to penetrate the German market. We believe the tendering process and focus on pricing throughout EMEA will continue through the remainder of 2010.

Regarding Japan, the first few months since launch have been particularly encouraging. And although we are still in the early stages of commercialization, I'm pleased with our performance. Our launch of V.A.C. Therapy is moving forward aggressively as we continue to broaden our investment and our Japanese sales force and to expand to cover more territory. We expect to generate between $5 million to $10 million in revenue in Japan during 2010.

And now for an update on our new AHS products. V.A.C.Via, our recently approved silent, single-use, handheld-powered NPWT product, has now been placed on our first patient.

I'm very excited about this game-changing technology that addresses many features our customers are looking for without sacrificing the unparalleled clinical outcomes of V.A.C. Therapy, including, but not limited to, affordability for patients to move around within the hospital and transition from the hospital faster, the elimination of noise to increase patient compliance and increased access to the product for earlier adoption. We have received very positive feedback from clinicians on this novel solution to wound healing and we plan the global launch of V.A.C.Via beginning in September.

As you know, we recently received FDA clearance for our novel negative pressure based Prevena incision management system and we are pleased to now be in the market in the U.S. We are very enthusiastic about the market potential in the US and we began shipping earlier this month. We are pleased to have had several patient placements of Prevena in the US in the month of July.

Our European and Canadian launches of Prevena are also going well, with hundreds of patients having received treatment thus far. We believe the global market opportunity for Prevena stands at a compelling $1 billion, assuming 3 million surgical procedures involving high-risk patients.

Moving on to ABThera, our unique negative pressure solution for active management of the open abdomen, the launch is still gaining traction, with promising results, and to-date approximately 52% of Level I and Level II trauma centers in the US have approved ABThera for use, up from 45% last quarter.

With the launch of these two negative pressure based products, Prevena and ABThera, we are organically growing a new surgical wound management business for KCI. Despite the delay in the launch of Prevena, we are pleased to be exiting Q2 on a $15 million annual run rate in revenue for this new segment.

Our new product portfolio for our negative pressure technology platform, or NPTP remains robust with a number of additional products expected to reach the market over the next 12 months such as V.A.C. Ulta, our next-generation system with proprietary fluid installation technology. Importantly, our new NPTP products are covered by IP with patent protections generally past 2020.

Turning now to LifeCell, our Regenerative Medicine business. Revenues in the period set another quarterly record of $84 million, a gain of approximately 18% versus Q2 '09. This strength is particularly notable given the very strong prior year quarter and an increasingly competitive environment.

LifeCell's products remain best-in-class and possess the strongest base of relevant clinical experience, thus bolstering our market-leading position. LifeCell's robust performance is in line with our long term growth targets as we penetrate core applications and enter new markets and new geographies.

Our AlloDerm inventory returned to normal supply levels in the quarter, consistent with our mid-year target that we communicated previously. This achievement, coupled with AlloDerm's continued reputation as the gold standard for regenerative tissue matrices, helped to drive the quarter's solid results.

Additionally, the continued uptake of Strattice helped to fuel the quarter's growth, rising 55% over Q2 '09, and now standing at 41% of revenues compared to 31% a year ago. Strattice is now on an annual run rate of $155 million, and is now a clear leader in biologic tissue matrices, given its superb clinical performance particularly in the challenging hernia repair applications.

Our yields on Strattice continue to improve, which will further enable us to grow the franchise and improve our margins. Regarding our LifeCell business in Europe, namely the UK and Germany, we are seeing uptake of Strattice for breast reconstruction and challenging hernia repair.

Sequentially, EMEA revenue grew approximately 59% to $1.6 million. I'm proud of the work Lisa Colleran and her team are doing there, and we feel very good about the underlying demand. We continue to dedicate resources to build the sales and marketing infrastructure to advance our launch in several other European countries.

Consistent with our plans for 2010, we have now launched in nine countries in Europe, and expect to have sales in 12 countries by year end. Importantly, we continue to see positive adoption trends for new applications of our regenerative medicine products, including Strattice for stoma reinforcement and mastopexy.

Our clinical program for Strattice is expected to be bolstered considerably later this fall, when 12-month data from the Rich Study will be presented at the American College of Surgeons' meeting. We have received confirmation that this data has been accepted for presentations. And while we cannot comment on the 12-month results, I can tell you, the study surgeon investigators are extremely excited about the results.

As we mentioned on the last call, we have six clinical studies underway, all waiting publication for Strattice, all of which will augment the clinical case to support our position as the leader in regenerative medicine.

Our sales force expansion, including the new head in our specialty sales force, will increasingly add to our growth in the second half of the year, as the new reps gain greater traction.

Finally, we are pleased with our partnering efforts in regenerative medicine, most notably one of our partners, Wright Medical recently announced favorable data on our human tissue based GraftJacket matrix in a first-of-its-kind clinical study for augmentation of rotator cuff repair.

Turning now to our TSS business. In the second quarter, TSS declined 6% year-over-year to $67 million. This shortfall can be attributed to continued challenges in our rental business globally, driven by a reduction in average length of therapy and decreases in orders as a result of tighter focus on controlling healthcare spending within hospitals and lower patient volumes, partially offset by slightly higher levels of capital sales in North America.

On the positive side, we're pleased to announce the recent extension of our sole-source contract with Novation, one of the nation's largest hospital GPOs. This contract provides access to future demands for a significant portion of the TSS business. And the fact that we're selected as the sole-source supplier confirms the strength of our technology as well as our compelling clinical outcomes.

To bring additional strength to our TSS business under Steve Seidel, we have formed a dedicated TSS R&D team led by Julie Burgett. Julie had 10 years of experience in TSS R&D prior to joining the V.A.C. Therapy R&D team in 2007. Julie has now returned to TSS and is focused on designing products that change the standard of care on how patients in wound care, bariatric and critical care spaces are treated and handled.

As part of our efforts to optimize our TSS product portfolio, we wrote off approximately $7 million of inventory in the quarter. We expect this to be a benefit to our TSS business over the longer term as we will be operating a more efficient portfolio of products in an effort to drive profitable growth.

Finally, as we announced this month, we have created an Advanced Research and Technology Center that will be led by David McQuillan and supported by our leading researchers and scientists. This center will be responsible for leading the company's efforts to develop revolutionary new technologies and treatments across wound healing, regenerative medicines and therapeutic support system.

By brining the best of these resources together under one time and goal, I believe we will continue to develop innovative technologies and products, so important for the future of KCI.

Before turning the call over to Marty, let me make some comments about our outlook. We're revising our revenue and earnings guidance for 2010 downward in light of the foreign currency headwind we will likely face over the rest of the year, coupled with continued weakness in our TSS rental business globally and a one or two quarter delay in the launch of our new AHS products.

We are confident that we will see revenue growth in the second half of 2010 and that growth will be governed by strong LifeCell performance, V.A.C. Therapy in Japan and our new AHS products.

I will now turn the call over to Marty Landon to review our financial performance in the quarter in more detail.

Marty Landon

Thanks, Cathy, and good morning, everyone. Total revenue for the second quarter of 2010 was $497.8 million, an increase of 1.3% from the $491.4 million reported for the same quarter one year ago. Excluding the effects of foreign currency exchange rate movements, second quarter revenue increased 1.7% year-to-year as foreign currency became a headwind for us and many other U.S. companies in the middle of May.

Second quarter 2010 net earnings per diluted share on a reported basis, including our special items, were $0.75 per share, down from the $0.82 we reported for the same quarter last year, but up slightly from the first quarter of this year.

During the second quarter, as Cathy mentioned, we recorded approximately $12.7 million or $0.11 per diluted share in special items related primarily to portfolio optimization within our TSS division and employee separation costs related to our Global Business Transformation project.

Excluding these special items and our normal non-cash acquisition related items, adjusted non-GAAP earnings per share were $1.01 per diluted share. We have provided a reconciliation of GAAP to adjusted non-GAAP earnings per share in today's release for your convenience.

Returning to revenue, in our AHS business segment, second quarter revenue of $347.7 million was substantially equivalent to the prior-year period on a reported basis and on a constant currency basis. On a sequential basis, worldwide AHS revenue improved over 4% in the first quarter of 2010, consistent with normal patterns of seasonality. AHS revenue in the U.S. was also comparable year-to-year, while up 6% sequentially. As Cathy remarked, the U.S. post-acute market impacted our domestic AHS results, although trends improve sequentially as seasonal factors lessened.

Outside the U.S., we continue to experience unit volume growth, but this unit growth was substantially offset by lower average pricing. We continue to see good demand for V.A.C. Therapy throughout Europe. Although given the overall economic conditions and various austerity measures in certain countries, combined with increased competition, we're also seeing more tender activity where pricing is often weighted more heavily than clinical results.

Due to unfavorable currency movements in the quarter, reported EMEA/APAC revenue was down 3% year-to-year, while constant currency growth was 1%.

Regenerative medicine second quarter revenue of $83.7 million increased approximately 18% in the same period of the prior year and increased 6% sequentially from Q1. As Cathy noted earlier, we believe that we have resolved our AlloDerm supply constraints during the second quarter and we also experienced production improvements in our Strattice line, both of which allowed for additional expansion of our consignment program, making our products immediately available to more physicians.

TSS revenue for the second quarter of 2010 decreased 6% from the year-ago period to $66.3 million. The revenue decline resulted from lower rental revenue in both North America and EMEA, partially offset by an increase in wound care services sales in the United States.

Gross profit in the quarter increased 3% versus the prior-year period, reaching $279.8 million, representing a gross margin of 56% versus 55% last year and an improvement of approximately 110 basis points year-to-year. The increase in gross margin was primarily due to favorable product mix resulting from the strong growth in our regenerative medicine business as well as the lower product royalty expense and further realization of our ongoing service efficiency initiatives.

SG&A expenses for the second quarter were $147.2 million, including the special items of $12.7 million. SG&A expenses, excluding special items, were $134.5 million for the second quarter compared to $125.8 million for the same period of 2009.

As Cathy stated, 2010 is a year of transition and investment for KCI, and this increase was in line with our expectations as we continue to invest in long-term growth initiatives, including our new product and geographic launches in Japan and Europe for both AHS and our regenerative medicine businesses and executing our Global Business Transformation initiatives.

These three initiatives together with the U.S. patent litigation cost accounted for approximately 80% of the year-to-year increase, excluding special items. We expect to continue spending in these areas with some offset due to our focus on driving productivity improvements in other areas of G&A.

For the second quarter, excluding special items, our adjusted non-GAAP operating margin was 23%, equivalent to the same period in 2009. For 2010, we expect to maintain or gradually improve operating margins, but I would note again that some variability in G&A spending is expected as we implement various phases of the Global Business Transformation project and launch new innovative products.

Interest expense in the second quarter of 2010 was $22.3 million, a decline of $4 million versus last year's second quarter due to our accelerated debt repayment program and lower interest rates. During the last 12 months, we've made scheduled and voluntary debt repayments totaling $225 million.

The second quarter effective income tax rate was 30% compared to 32% in the prior-year period, driven by a higher percentage of earnings coming in lower tax rate jurisdictions and some non-recurring benefits from the favorable resolution of certain tax contingencies.

On an adjusted basis, excluding the effects of non-cash acquisition-related items and the inventory and severance charges previously discussed, we reported second quarter diluted EPS of $1.01, up approximately 3% versus the comparable period of 2009. The improvement in earnings this quarter was largely attributable to the financial leverage resulting from our focus on debt management and improving the effective income tax rate.

Turning now to our balance sheet, our financial position remains liquid and stable with total worldwide cash of $247.1 million and a substantially unencumbered $300 million revolving credit facility. We again utilized our strong cash flows to make scheduled and voluntary debt payments totaling $50 million in the second quarter on our Term A bank debt. At quarter-end 2010, our total debt on an economic or debt instrument basis was $1.32 billion or approximately two times our trailing 12-month EBITDA.

Regarding our cash flows, operating cash flow less capital expenditures was $99 million in the second quarter, down from $125.6 million in the prior-year period, a reduction of $26.6 million primarily as a result of our anticipated increases in biologic inventory levels to meet growing demand for AlloDerm and Strattice tissue matrices, increased income tax payments, and higher capital expenditures, which were partially offset by improved cash collections and higher net earnings.

Accounts receivable days outstanding improved slightly from the prior quarter as we continue to work hard at improving our billing and customer service operations.

I think that the deleveraging we've done at this point contributed to earnings leverage while also positioning us to execute on our business development plan. As we look forward, our priorities for cash will be to support the growth initiatives within the existing businesses, to support business development activities underway in each of our business units, to further diversify sources of revenue and earnings growth, and to meet required debt amortization levels, and then to the extent we have excess free cash flow further reduce debt or perhaps buy back shares opportunistically and within the covenants of our existing credit agreement.

Turning to our guidance for fiscal 2010, as Cathy indicated, we are revising our full year guidance downward to reflect the impact of a few key changes on the business. For the full year, our revenue guidance is now $2.00 billion to $2.03 billion. This implies annual revenue growth rate of between 0% and 2% or a midpoint of 1% growth, down from the previous growth midpoint of 4%.

Our new revenue guidance reflects over 100 basis point decrease related to our expectation of continued volatility in foreign currency exchange rates and particularly a strong U.S. dollar versus European currencies. Another 100 basis points of the revenue guidance change relates to our current expectation of a mid-to-high single-digit contraction in our TSS business.

This reduction reflects continued challenges in our global rental business given the market dynamics that we experienced in the second quarter in which period we're being placed for the rest of 2010.

And finally, we see a slight decrease in projected second half 2010 AHS revenue growth rates related primarily to regulatory delays for our Via and Prevena product launches, although our early clinical results are encouraging.

Our outlook for double-digit growth in regenerative medicine remains unchanged from prior guidance. So said another way, while we don't provide specific quarterly guidance, we would expect that third and fourth quarter results should look similar to what we reported for Q2, stable AHS revenue, robust growth in our regenerative medicine business and a year-on-year contraction in the TSS business.

Reported GAAP diluted earnings per share are now anticipated at $3.40 to $3.50, implying growth of 5% to 8%. The reduction in 2010 projected GAAP EPS growth is due primarily to the expected contraction in our TSS business segment, the short-term impact of investing further in our AHS sales force, the impact on foreign currency exchange headwinds and the level of the TSS inventory write-down which is slightly higher than our earlier projected midpoint.

Our adjusted non-GAAP diluted earnings per share guidance is now $4.19 to $4.29 per share, reflecting adjustments similar to the GAAP EPS numbers.

We expect respect to leverage our second half revenue performance and the positive earnings growth primarily through gross margin expansion and financial leverage. To assist you with your modeling and to provide a consistent basis of comparison, we've included reconciliation to the adjusted earning per share outlook in this morning's press release.

And with that, I'll turn back call over to you, Cathy.

Cathy Burzik

Before turning the call over for questions, I'd like to summarize how we see the remainder of 2010. We expect that our Q3 and Q4 year-over-year growth will be similar to what we experienced in Q2 for all our businesses. Importantly, we see KCI base business as stable in the second half.

AHS revenue will benefit from both the ongoing ramp-up of V.A.C. Therapy in Japan and the ramp-up of revenue from the launch of Prevena and Via.

Additionally, we expect continued strong double-digit growth from LifeCell.

We believe that the investments we are making are important for our long-term growth. We are working hard to bring to market innovative products that assure superior clinical outcomes with compelling economics for patients and for their caregivers. And we may remain confident that collectively our actions will enable continued earnings growth and significant free cash flow.

I will now turn the call back to the operator for the Q&A.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question is from the line of Michael Matson with Wells Fargo Securities.

Michael Matson - Wells Fargo Securities

First of all, just wondering if you could talk a little bit more about the V.A.C.Via product. I think I asked this question last quarter and I didn't get kind of the answer that I was looking for. What will be the impact of this product be on your margins and revenue over the longer term? In other words, is the revenue per day of you similar to your current products and does it have a higher gross margin, because I kind of imagine it would given that it's disposable it doesn't require all the service and so forth?

Cathy Burzik

So I'll start this here and Marty or Mike might want to jump in. As you know, Mike, we're really excited about Via and we're excited that Via is now ready to be placed on patients or it has been placed on the patient. We have right now ramp-up costs that you have with any product. So you can imagine we are not in a settle-down state.

But if you look at the long term view of it, we would expect to get revenue from V.A.C.Via, roughly equivalent to a day of V.A.C. run till today. So the first version is targeted for seven days of therapy. So you should think of it at a price range of seven days of V.A.C. Therapy.

From an overall margin perspective, over time we expect it to be positive to our margins. In the initial stage, it will not yet be positive as we ramp up.

Mike Genau

I think as you look at our ability to treat new patients and as we transition more patients from the hospital to post-acute, our expectation is that V.A.C.Via will cover more patients both in and outside of the hospital.

Michael Matson - Wells Fargo Securities

Just on Japan, now that you've started selling V.A.C. there, I was just wondering is the market there that the clinicians sort of aware of V.A.C. products and ready to use these types of products, or is this the place where there is going to be market development required? In another words, you've to get out there and educate the clinicians about the product, how it works, what it does and so forth.

Cathy Burzik

Probably a little bit of both. It's a small world in many ways these days. So all of the clinicians that I've gone to see in Japan are clearly aware of V.A.C. Therapy. They wanted to get it on the market for a long time.

That said, I think that if you few move further down into the chain beyond the key opinion leaders that we have and the early adopters, there will be some market developments that we are investing in. So we have a pretty robust professional education program planned, just haven't right after what we have done in the U.S. and in the Europe.

Mike Genau

I would just add that early results, Mike, have been positive. The clinical application and the utility is running where we expected. The ease of use and most importantly the clinical benefit and the outcome to the patient is I think underscoring what we've believed going on, which is there is a new market that we're helping create and V.A.C. is playing an important part in the growth of the wound therapy treatment across Japan. I think probably one of our base issues is finding salespeople and growing that sales organization. The demand seems to be there.

Cathy Burzik

It's a limiting factor right now. Marty is right; it's the rate at which we can just hire great people.

Michael Matson - Wells Fargo Securities

And just wanted to ask a question or follow-up on Marty's comments about use of cash. It seems like now that the stocks have pulled back, I haven't run the numbers, but it seems like it might actually be more accretive to EPS to buy back shares versus pay down debt. And now that you have gotten your debt level down or leverage ratio down to about two times, does that mean that it's maybe a little more likely that you would go into the market and buy back some stock?

Marty Landon

Certainly we look at those things on a regular basis. We look at them opportunistically. There are still limitations within the credit agreement that would limit the amount of activity we could do there. I think it's fair to say, though, that we do review that with our Board on a regular basis. So I can't speak specifically that yes we would be in the market, but it is something that we give consideration to.

We first and foremost wanted to make sure that we got our leverage down and had flexibility to be able to capitalize on opportunities that we are working on in the business development area. We think we're in a pretty good place there. So should those kinds of things be there opportunistically, we might be inclined to look at them.

Michael Matson - Wells Fargo Securities

And then just one follow-up question on V.A.C.Via; I should have asked this earlier. Is V.A.C.Via going to require hospital purchasing committee approval to get it in the door or is that going to just be considered another V.A.C. product like your rental products? In other words, it won't, because it's not really a new technology, it won't have to go through the committees.

I'll let Mike answer that.

Mike Genau

Mike, we don't think so. I mean it's a little too soon to tell. But because it's V.A.C. Therapy, we believe that the new product committees will approve on a fairly fast basis and bring V.A.C.Via into their facilities.

Operator

Your next question comes from the line of Mike Weinstein with JPMorgan.

Mike Weinstein - JPMorgan

CMS has proposed to cut payments to home health agencies by 4.75% for FY '11. If that goes through, can you just think through the impact on your business?

Cathy Burzik

Well, it's part of the whole question, Mike, of health care reform and what the impact would be. The way we get paid at KCI is independent of the home health agency getting paid. So the home health agency has to measure the wounds and they send the data to us. Then we send the data to Medicare or a research company and then KCI gets paid directly.

So I don't think that there would be a direct impact of a cut to the home health agencies on KCI.

Marty Landon

That's right. And in fact, with the V.A.C. product, you end up with fewer return visits by the home health nurse. So in some respects, it cuts down the total cost that they incur. So it ends up being a benefit, but there is not a direct correlation there.

Mike Weinstein - JPMorgan

One of the comments you made, Cathy, was in terms of pressures on the business in the U.S. was an increasing utilization of other advanced wound care therapies. Can you just add more on that? What are you seeing competitively from the other technologies?

Cathy Burzik

We've got a lot of work in the post-acute segment in Q2. When you talk to wound care clinics in particular and physicians, there is this view of trying to "save money". So they will actually take wounds that they could put a V.A.C. on, but put a cheaper therapy on them, a hydrocolloid or an alginate to try to get the wound to heal.

Now, we know within KCI that we have an economic argument that that's not the long-term most cost-effective thing for the patient. So where we are is back now, playing together our economic data on how you get that in front of home health agencies, wound care clinics, doctors to help them understand that saving a penny now is going to cost them a lot of money for the future.

But what we definitely saw during Q2 was more of a tendency of docs to go back to technologies that they might have used in the past.

Mike Weinstein - JPMorgan

Cathy, can you give me an update on a couple of items? One would be pricing environment in the U.K. and Germany, which I know has been tough. And then second is your discussions with Wake Forest with regard to royalty.

Cathy Burzik

If you step back and you think about the quarter in general, slightly down in volume, but higher realized price. So in total in Mike Genau's business, we've been able to achieve a higher level of price across the business. I mean that's the good news, but it's a devil in the detail.

So if you look at different pockets of strength and weakness, our strength was in the post-acute in the U.S. where we did achieve higher price realization. The weaknesses are, from a pricing perspective, in Germany, in the U.K. and to some extent in the Nordic regions. In Germany, we've done a really good job in maintaining those CPO contracts that we talked about. And that's in the face of other competitive, even NPWT products coming in much cheaper.

So we've been able to maintain the volume. We've had to take some price in Germany. In the U.K., you're seeing an awful lot of continued free trailing by a number of competitors, and its coupled by the fact that the U.K. government and NHS is really trying to look at reducing cost.

So we see a lot of increased tendering and price pressure in the U.K. That said, we think products like our V.A.C. Via are going to be a really good product for the marketplace because it's going to allow us to move from being just a hospital based product in the U.K. into also being a home based product.

And your second question was on Lake Forest. The discussions we are having with Lake Forest are confidential. As you know, Mike, KCI has enjoyed for many, many years here a fabulous relationship with Lake Forest. And we are trying to make sure as we go forward and do this negotiation that it's done in the right way. And we are not going to disclose the details of that until it's finalized.

Operator

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

Jayson Bedford - Raymond James

Just to follow on the last question, on the AHS business, can you give us an idea of unit volume growth both in the U.S. and non-U.S.? Just trying to get a sense of pricing.

Cathy Burzik

As I said to Mike Weinstein, in the totality, volume in the business is slightly down, maybe 1% to 2% kind of range in the U.S. in particular. And if you then tease that apart, you have in the hospital environment, which I'm really happy about, we have an increase in orders, units in use up slightly, but price down in the hospital acute environment, primarily as a function of program mix.

So as we go in with our longer term rental agreements, there is some give and take on size with the hospital. So basically though, we have been able to see an increase in orders in the hospital, which I think is good.

In the area of post-acute, orders declined as we had anticipated and had previously communicated, primarily as a function of the economy as I just mentioned before. So you get some decline in orders in post-acute, but we've done a really good job in price realization.

So we've been able to hold price through a lot of the work that Mike and his team have done, particularly in the managed care area and in the Medicare area for higher price realization. That's why our overall U.S. business has gone up sequentially 6% and has been pretty equivalent to last year. In the area of Europe, we do have a volume increase in Europe. I don't know if we have communicated a volume increase.

Marty Landon

The number is clearly steady from that low double-digit range and the offset is substantially price. So you end up with growth that's in that 1% range on a constant currency basis.

Jayson Bedford - Raymond James

And sorry, Marty, you said the volumes in Europe were up low double-digits.

Marty Landon

Yes, we continue to see volume increases in Europe in particular, but most of those volume increases are offset by lower price.

Jayson Bedford - Raymond James

And just to clarify, the post-acute competitive activity, it sounded like it was other technology, not so much other NPWT products. Is that fair?

Cathy Burzik

It's a little bit of both I'd say, but stronger competitive environment is the non-NPWT things that are considered more cost effective, if you will. We obviously continue to see competitive pressure from other NPWT players. As we've kind of mentioned in the past, the biggest inroads tend to be in the SNP environment where there is a big cost constraint.

Jayson Bedford - Raymond James

Just switching gears to the LifeCell portion of the business, as I try to assume, most of Strattice sales are still in the hernia application?

Cathy Burzik

The way we've looked at this now is more of the abdominal wall. So applications of tissue replacement, tissue need even beyond the hernia, but definitely related to the abdominal wall. For example, it's often used in concert with our ABThera product for the open abdomen. So there are other uses of Strattice beyond just hernia.

And then obviously, we have launched last year the breast plastic surgery business from a cosmetic perspective. And so that's a growing business for us as well as is our partnered program with Tornier on rotator cuff repair.

So you get some other uses now. You're going to see increasing uses of Strattice. And then we launched the stoma repair this year, which has done extremely well. As you know, there are high rates of herniation for people who have stomas.

Marty Landon

And those are the dominant U.S. factors. Outside the U.S., it's pretty much 50-50 between breast reconstruction and challenging hernia repair.

Jayson Bedford - Raymond James

And just lastly for me on the breast reconstruction indication, how penetrated do you think that market is just in terms of use of biologic product?

Cathy Burzik

Well, we talk to Lisa a lot obviously in getting ready for the cost. She is not here today. But I think that we believe we're probably maybe in the 50% to 60% penetrated as far as conversion to biologic from synthetic.

Jayson Bedford - Raymond James

Cathy, is that the market or is that KCI?

Cathy Burzik

The market.

Operator

Your next question comes from the line of Paul Choi with Caris & Company.

Paul Choi - Caris & Company

Cathy, it sounds like based on what we saw here in the North American AHS business, we've seen a stabilization on the whole even without contributions from new products in terms of any sort of meaningful contribution. Is it fair to think about the growth ratio at least consistently being stable as you look forward for the next year or even perhaps slightly accelerating as an overall dynamic in the North American market?

Cathy Burzik

I'm going to let Mike comment on that. We're not going to give guidance yet, Paul, into 2011. But I am very pleased with how well Mike DelVacchio and his team have continued to manage through a difficult environment. And I think they doubled down our post-acute. They focused on it. They made a good case about adding more salespeople to continue to drive growth.

Mike Genau

Yes, we'll be disappointed if we didn't see good growth coming out of our new products going forward, Paul. I think to echo Cathy's point on how encouraged we are by how the team has managed through some challenging times. The investments that we're making in our sales organization both for the facility side of the acute side as well as post-acute is we think significant.

We'll hire over 100 sales and clinical people in the field, and the whole idea there is to have better territory management, smaller territory, so that the sales force can spend more time in account talking about the clinical value of all of our products. And as these new products start to hit the market, we'll be poised and ready to describe clinical value and hopefully continue to grow the business.

Paul Choi - Caris & Company

In terms of your outlook for the remainder for the year, you did call out V.A.C.Via and Prevena. But, Cathy, I think you also mentioned your new V.A.C. Ulta. And I think you previously had discussed a generation-four V.A.C potentially launching in this calendar year. Is that still your expectation in terms of the V.A.C. Ulta and the next-generation V.A.C being included in sort of your growth range for this year or is that being more of a next-year event?

Cathy Burzik

Much more of a next-year event now. Ulta is in front of the FDA for approval. But I think because the other one got a bit delayed, you don't want to get too much stuff in front of the sales force too fast. So I think it's better to think about Ulta being a 2011 opportunity and then the other products you have as a follow-on product to the V.A.C.Via that we launched that for a lot of reasons we haven't talked to as much openly about. But that product is also under development in our R&D lab or launch posted here.

Paul Choi - Caris & Company

Maybe turning to regenerative medicine, Strattice clearly has been doing very well for the past two quarters here. Can you maybe sort of give your expectation in terms of what you think surgeon adoption could be for our hernia repair given the resistance we saw at certain stage of this year to using biologic, and what do you think perhaps the outcome could be following the presentation at the American College of Surgeons?

Cathy Burzik

The LifeCell team has a work in published results from six months of data. And as you know, you have to be careful about what you say with 12 months of data. But this we believe is a very large patient population. And the study investigators who have been involved with this have told us they're very happy with the results. And we put it in front of the ACS and asked them if we could have a paper there and they got accepted. So that presentation will be in October.

And I know right now our marketing team at LifeCell is packaging up that information for use by the sales force. So yes, I definitely expect at least that we'd expect that the publication of the data will be very well received by the customers when they see it.

Operator

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

Matt Miksic - Piper Jaffray

I think you had a couple of questions on the pressures in the U.K. and some of the pressure in Europe, both competitively and in pricing. I think in the comments and the press release, there is something like offering your longer-term lower-priced rental agreements. How recent is that and maybe how different is that from either in terms of term or in terms of pricing? Is it from where you used to price these kinds of contracts? So I want to get a sense of what's changed and how recently it has changed for you in Europe?

Cathy Burzik

Mike, before he came on Board, for a long time, Europe has had long-term rental agreement, way before we get that in the United States, because they've done that often to make sure that they keep their customers over a longer period of time. So this is not like a new thing within Europe. I view this as just more an adoption of a program that we've always had.

Mike Genau

Yes, I think it just gets to customer loyalty. And as more customers want V.A.C. Therapy, we are working on longer-term contracts where we can and where it makes sense for them.

Matt Miksic - Piper Jaffray

Okay. So this gets back to Marty's comments on up double digits, volume down considerably and price. And that's just been the way it's been in Europe for some time.

Cathy Burzik

It's been that way in Europe for a long time. I think you're aware we've had probably 15-20 NPWT competitors in Europe for a long time. That's why the performance of KCI is still maintaining absolutely a very strong market share there. It's just a tribute. And also operating without the patents effectively in Germany and U.K. is just a huge tribute to the effectiveness of the product.

And so, Mike, is right. I mean everything we're trying to do now is around customer loyalty. And clearly, the Prevena launch has gone well in Europe. We expect the Via launch to go very well in Europe. We think it's going to be a really strong product over there. So we certainly are not giving up on Europe. And I think the situation with Europe with the economy, all companies are facing that, and we're just going to fight through that.

Mike Genau

I'd just add that in case of Germany, we successfully negotiated 10 of the 11 GPOs which make up the lion share of the market in Germany. And while we extended those contracts, we did have to offer some price to secure them, but we're very confident in our position there and we like the outlook.

Marty Landon

In my sense, it amounts to people coming back to us and saying I want the product, I've got these issues around my total cost, and are there ways to structure these deals. So we see more of the long-term rentals where we're able to offer them product, make sure they've access to product, give them a little bit of a price break. They do a little bit more of the service. And again from a gross profit standpoint, you're not much different than you've been historically. But it does impact your top-line a little bit.

Matt Miksic - Piper Jaffray

And then I had one to follow-up here on the U.S. and one that I know that you're not going to say much about what's going on at the court. But I do have a question I hope you can answer around what's going on in Texas.

Just to follow up in the U.S., Cathy, you mentioned that's stabilizing here in the front half and kind of flattish in the front half. In the back half, are we at a point where you think we'll start seeing, is it further stabilization of the back half in the North America, or are we going to start seeing some low single-digit growth again?

Cathy Burzik

I'm going to be kind of prudent here and conservative. And that probably talked about relative stability. I mean I think it's early with Prevena in the U.S. I mean they're literally just being launched back. Via is going to be really a fourth quarter kind of product. So I think they're going to see the benefit of those products more in 2011. I think they're going to see the benefit of our sales force expansion more in 2011.

That said, I'd be disappointed if we didn't see some kind of benefit from these things in Q4. But from a prudent perspective, I think we should we should just plan on stability in the business for the rest of the year.

Matt Miksic - Piper Jaffray

So you're planning for stability and hoping for maybe something better. But we should model for stability, it sounds like. And then finally on Texas, and maybe this kind of plays into that. The same question is, I think a lot of people are wondering if this goes as expected, if validity is held out to form patents, what kind of impact do you think that's had so far on your business while that's being sorted out, and is that catalyst for your business going forward? How does that affect your business on the expected ruling?

Cathy Burzik

I would say that it is fair to say that we have seen no impact as a result of the finding of validity and infringement. If anything, we've only seen some more aggressiveness on the part of the other party, which is surprising. But the other thing I would say, in the event that Fergeson does provide an injunction, the question is around the scope of the injunction.

So I don't really want to speculate. I want to turn over to John Bibb to make a couple of questions. But we've gone into this hearing confident, but we don't know exactly how he is going to finally rule. John, you want to comment?

John Bibb

No, I think what Cathy said is right. We've obviously done the hard work in winning the verdict on validity and infringement. The injunction hearing was held earlier this month. We're confident and optimistic about our chances over the final judgment and in injunction. But the scope of that, we really can't speculate on what the scope of an injunction might look like or the timing.

Cathy Burzik

So just here in closing, I'd like to thank everyone for attending the call. I would like to remind you that Q2 was record revenue for our second quarter for KCI ever. We're very proud of that. I'm proud of our plans as we look forward to continued growth in Q3 and Q4. So have a good day everyone. Thanks for dialing in.

Operator

Thank you all for joining today's conference call. You may now disconnect.

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Source: Kinetic Concepts, Inc. Q2 2010 Earnings Call Transcript
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