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Kinetic Concepts Inc, (NYSE:KCI)

Q3 2010 Earnings Conference Call

October 26, 08:31 am EST

Executives

Todd Wyatt - Vice President, Investor Relations

Cathy Burzik - President and Chief Executive Officer

Butch Hulse - Associate General Counsel

Michael Genau - Global President, Active Healing Solutions

Lisa Colleran - President, LifeCell Corporation

Analysts

Mike Weinstein - JPMorgan

Paul Choi - Caris & Company

Chris Cooley - Stevens

Jayson Bedford - Raymond James

Lennox Ketner - Bank of America

Operator

Good morning and welcome to the KCI Third Quarter 2010 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. (Operator instructions). Thank you Todd Wyatt, Vice President of Investor Relations. You may begin your conference

Todd Wyatt

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

Today's webcasted 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 found in our filings with the SEC.

Also, quarterly and full year results discussed on this call may reflect adjustments to revenues for changes in foreign currency exchange rates or adjustments to expenses related to the LifeCell acquisition and restructuring and other charges incurred during 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?

Cathy Burzik

Thank you, Todd, and good morning, everyone. We appreciate your joining us to discuss our third quarter 2010 results. On today's call, I will review some of the highlights of the third quarter and then review the performance of our three businesses, including an update on new products and strategic initiatives. Marty Landon will review our financial results. We will conclude with a question-and-answer session.

Before I begin, I’d like to comment on last week’s trial ruling in the US where the court held that the patent claims license by KCI from Wake Forest University were invalid. We disagree with the court’s decision and are evaluating our next step. Regardless of outcome, KCI has been preparing for an operating in an environment without these patterns for the past several years.

We are executing well to the strategy we laid out 3 years ago, the call for expansion of our business through new product innovations, diversification and geographic expansion. For over 15 years, KCI has offered the most proven and innovative NPWT solutions in the marketplace to our many generations [about] therapy products. Our clinical evidence, our clinical expertise, our field service and our commitment to clinicians and patients worldwide are unmatched in the industry, positioning us well to continue to win in the NPWT marketplace globally. Continuing now with the quarterly comments, the global healthcare landscape has faced many challenges in 2010n this past quarter with no exception.

During this time, we have remained focused on numerous investments to support our strategic initiatives and I’m pleased to report that our investments are beginning to bear fruit as evidenced by our 2% constant currency revenue growth from the prior year quarter. The launch of VAC therapy in Japan is off to a good start and several AHS products have launched or will be launching soon on a global basis.

Also, we continue to see significant growth in our LifeCell business, including the successful expansion of LifeCell into Europe and our new regenerative medicine applications are gaining tractions. For the third quarter, total worldwide revenue of approximately $507 million was comparable to Q3 ’09 on an as reported basis. EPS on an adjusted non-GAAP basis was $1.20, an increase of approximately 11% versus the prior year quarter.

Key business developments since our last call, beyond the headline of the trial verdict, includes the US launch of our Pervena incision management system for use in the operating room. The Pervena system is now available at a worldwide basis. The execution of an exclusive sales and marketing agreement for distribution of Novadaq Technology spy system, this is used by surgeons for real time operating room evaluation of tissue profusion, the release of exciting 12 month data from the Rich study that demonstrates Stratus being used as a safe and effective alternative to a 2 stage or a synthetic mesh repair. And additionally, our US acute and post acute VAC therapy has rebounded modestly, with unit growth across both care settings on a sequential basis and units up on a year-over-year basis in acute care and stable and post acute.

We posted a record quarter in the regenerative medicine business, led by strong growth in both [aladome] and Stratus and our core applications of challenging hernia repair and breast reconstructions, despite both competitive and price pressures, and good performance in Europe as our LifeCell presence expands.

And in TSS, we launched an exciting new therapy, Skin IQ microclimate manager for the preventive and management of pressure ulcers.

The challenges we faced in the quarter, we’re much likely to have them throughout this year, including a difficult economic environment, an increasingly competitive marketplace across all our businesses and volatility in the value of the Euro and other currencies in relation to the US dollar.

Additionally this quarter, we felt the impact of modest price degradation concentrated mainly in our AHS EMEA and [APAC] businesses. The increased austerity measures in EMEA, along with reduced hospital procedure volumes, particularly depressed our US and EMEA TSS rental business.

Turning now to our review of our performance by each segment, all revenue growth rates will be stated in terms of constant currency figures, unless otherwise noted.

In our Active healing solutions business, global revenue grew 1% compared to last year, and 3% sequentially. North American AHS revenue improved 1% compared to last year. Importantly, US AHS revenues increased 1% year-over-year and 3% sequentially. Volumes increased mid single digits both year-over-year and sequentially in our acute business as we saw good order growth rates over the summer months. This increase was realized despite a clear trend of [indiscernible] procedures versus the same quarter last year.

Additionally, our post acute revenue improved sequentially for the second straight quarter. I’m pleased with the work that Mike Genau and his team are doing, showing improved execution. As we mentioned last quarter, we are making investments in our US AHS sales force. These investments are ongoing and we are on track with our plans to hire 100 new sales and clinical professionals in the US by the end of 2010.

Although we have seen some early signs of success, we expect the results from these investments will become more evident in 2011 as we look to drive units and the NPWT business as well as new products recently introduced.

In the EMEA/APAC AHS markets, revenue was down approximately 2%, driven entirely by EMEA. Starting in APAC, I was recently in Japan and spent a considerable amount of time talking to key opinion leaders and customers, reviewing our operations and importantly, speaking to some of our patients. I met an elderly man who suffered from painful Venus leg ulcers on both his legs for over 6 years. Within one month of starting VAC therapy, he was effectively healed.

I’m very proud of the work that we’re now doing in Japan, the work that only KCI does so well; healing patients and improving the quality of their life. Given the adoption of VAC therapy over the past 2 quarters, we remain ahead of our plan and are committed to driving substantial growth for KCI in this important Japanese market.

Additionally during the quarter, we began operations in India and are now placing back some patients there and just last week, we received regulatory approval for VAC therapy in China. We have been quietly preparing for our China launch for some time, and are excited to finally be on the market in this important and growing country.

In EMEA, AHS revenues declined 5% year-over-year. The decline was largely related to continued pricing pressures resulting from increased healthcare austerity programs across Europe as well as some increased competitive activity. We have our EMEA sales forces focused on educating our customers on the value that KCI delivers to our 360 degrees of wound healing by providing best-in-class products and clinical evidence as well as delivering to a hospital administrator the economic benefit message that only VAC therapy can deliver.

Additionally, we are providing significant resources to EMEA aimed at driving the adoption of our new ABThera, Pervena and [indiscernible] products.

Now for an update on the AHS products. Beginning with ABThera, our unique negative pressure solution for active management of open abdominal wounds, we continue to see an increase in adoption in the US and Europe and to date, approximately 56% of level 1 and level 2 trauma centers in the US have approved ABThera for use.

The Pervena incision management system, a naval negative pressure based technology designed to reduce infection [adhesence] in surgical incisions was fully launched on a global basis in the third quarter and several thousand units have been sold to date.

With the launch of ABThera and now Pervena, our initial entries into negative pressure surgical management, we’re delivering on our objective to organically develop the surgical wound management opportunity for KCI. With the successful acceptance of ABThera and Pervena, our annualized Q3 revenue was $20 million for this new product group.

Turning now to [indiscernible] Via, our single use NPWT product, because the Via is the only NPWT product that is built with our proprietary [indiscernible] pump technology. During the third quarter, we conducted several clinical preference trials in order to optimally position Via with doctors and [indiscernible]. These trials were quite informative and the product was well received throughout the 50 placements in the US and EMEA.

We have made substantial investments in the development of this technology and have automated manufacturing of the product in our world class production facility in Ireland. Needless to say, we are very excited about Via’s upcoming launch in the fourth quarter.

Turning now to LifeCell, our regenerative medicine business posted another great quarter, with record revenues of $85 million. This reflects a year-over-year increase of 18% versus Q3 ’09. In the US, the strong performance of both [aladome] and Stratus delivered almost 20% growth over last year, driven by our unrivaled product performance, the successful sales force expansion of early 2010 and our best-in-class clinical data. We continue to see significant demand in both core applications, challenging hernia repair and breast reconstruction as biologics gain acceptance and become a more standard part of surgical practice.

We’re also pleased that these strong results were achieved in spite of an increasingly competitive market and accelerated price pressure. Regarding our LifeCell business in Europe, revenue rose sequentially to $1.8 million in the face of the normal summer slowdown in Europe, and contributed 2% to LifeCell’s overall revenue growth. The increase was driven by an uptake in Stratus or breast reconstruction and challenging hernia repair in the UK and Germany, our first 2 European countries for the launch of Stratus.

Additionally, we are pleased with the progress we are making in other European countries. Where we launched in early 2010 and expect acceleration in the fourth quarter. Another key component of the excellent Q3 results in our regenerative medicines business was the use of Stratus during [Stemma] placements to potentially reduce the risk of hernia formation. This new application, launched earlier this year is experiencing significant uptake.

Globally, Stratus grew a solid 52% in the quarter over Q3 ’09 and now comprises 43% of revenues compared to 33% a year ago. Stratus is now on an annual run rate exceeding $150 million in revenue. Stratus is a biologic of choice for challenging hernia repairs and the leading product in this application due to its superb clinical performance.

One of the most important developments in our LifeCell business occurred in October when 12 months data from the Rich study was presented at The American College of Surgeon’s Meeting. Rich, which stands for the Repair of Infected or Contaminated abdominal incision of Hernia, is truly a landmark study. Rich produced the only prospective multi-center evidence published to date supporting the use of a product in a single stage repair of difficult hernias, and demonstrates that Stratus has been used as a safe and effective alternative to a 2 stage or synthetic mesh repair. In the study, search inducing Stratus where able to achieve safe, definitive, single stage closure in more than 80% of patients with challenging infected or contaminated central hernias. Importantly, none of the patients died required explants of Stratus, which would have necessitated a second surgical procedure. Because LifeCell products remain best in class, and we possess the deepest base of relevant clinical experience and data, we are able to defend and even improve our market leading position.

Finally, we announced this quarter our signing of an exclusive sales and marketing agreement for distribution of Novadaq Technologies by imaging system in the North American surgical market. This by-system provides real time intra operative visual data to assist surgeons in the assessment of poor or inadequate patient profusion and change the surgical approach with the goal to prevent downstream complications. Adequate tissue profusion is critical to the success of tissue [revasporization] and survival. We believe this technology fits well with our LifeCell sales force and will be a new platform to drive the growth of this business.

Now turning to our TSS business. In the third quarter, TSS encountered several challenges and posted a revenue decline of 10% year-over-year to $63 million. As anticipated, the comparison to last year is difficult due to a severe flu season and the prior year period. In addition, the experience reduced volumes in half overall and a reduction in the length of stay, coupled with modest competitive share loss. During weaker periods such as this, our rental business tends to experience share loss, [indiscernible 00:00] relying more on existing capital on hand and there is less peak utility due to low patient volumes.

During the third quarter, we had an important win in the US. We were recently awarded access to a multi-source contract with MedAssets for our TSS business that will cover wound, bariatric and critical care. This contract will give us increased access to this TPOs number.

And finally, TSS launched an exciting new therapy in October, the Skin IQ microclimate manager. Skin IQ is a brand new therapeutic [indiscernible] approached for the prevention and management of [indiscernible]. It is an innovative and proprietary microclimate coverlet that controls moisture and temperature exceptionally well while also providing low sheer and friction properties.

Using Skin IQ, in combination with our atmosphere product family, provides an excellent alternative to the current standard of care, low air loss therapy and continues TSS’ mechanization, inner management of pressure ulcers. Before turning the call over to Marty, let me comment on our outlook.

The environment for our active healing solutions business remains challenging, particularly given head wins and EMEA. We think it is prudent to expect that EMEA has not yet stabilized and that it may be several quarters before the European economy improves. In the US, revenue growth and AHS has stabilized and the addition of new product introductions, coupled with the 100 or so new sales people in acute and post acute should help us counter the persistent challenges of an environment of fewer procedures and pricing pressures.

Our outlook for regenerative medicine remains robust and we are confident in our ability to achieve similar rates of growth over the rest of the year. As you know, we are working on improving our TSS business and I remain confident that the team is moving in the right direction.

As we move through the remainder of 2010, we expect to see the early benefits of several new product launches as noted above, the benefits of our geographic expansion of VAC in Japan and LifeCell in Europe and the benefits of our investments in the AHS and regenerative medicines sales forces.

As Marty will review, we are reaffirming our fiscal year 2010 revenue and are increasing our EPS guidance due to our strong EPS performance in Q3.

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

Marty Landon

Thanks Cathy, and good morning everyone.

Total revenue for the fourth quarter of 2010 was 506.7 million, a slight increase from the 504.4 million reported for the same quarter one year ago. Excluding the effects of foreign currency exchange rate movements, third quarter 2010 revenue increased to approximately 2% year to year as foreign currency remained a head win for us in the quarter.

Third quarter 2010 net earnings per diluted share on a fully reported or GAAP basis were $1.06 per share compared to the $0.91 per share we reported for the same quarter last year, and increase of 16%. Our EPS growth in the quarter reflected both operating and financial leverage within the businesses.

Our adjusted non-GAAP earnings per share were $1.20, up from $1.08 reported for the same period of 2009 and an increase of $0.19 or 19% sequentially. For your convenience, we’ve provided a reconciliation of GAAP to adjusted non-GAAP earnings per share in today’s release.

Turning to revenue, in our AHS business segment, third quarter revenue of 358.4 million were down 1% from the prior year period on a reported basis, well up 1% on a constant currency basis. Our worldwide AHS revenue improved over 3% from the second quarter of 2010, a nice improvement from the trends we saw in the first half. Third quarter AHS revenue in the US rose 1% over the prior year and improved 3% sequentially, also demonstrating improvement from the first half of this year.

As Cathy remarked, revenues improved sequentially in both our acute and post acute businesses in the US. In the EMEA/APAC region, AHS revenue was 82.9 million, a decrease of 8% on a reported basis and 2% on a constant currency basis. This third quarter decline in EMEA/APAC AHS revenue was largely attributable to continued pricing pressure from increased levels of competitive activity, which was linked to increased healthcare austerity measures across Europe. The EMEA decrease was partly offset by the strong demand in unit growth we are experiencing for VAC in Japan as we ramp up in this new and exciting market.

Regenerative medicine had another record quarter with revenue for the 3 months ended September 2010 of 84.9 million. This represents an 18% increase from the same period last year on both reported and constant currency basis, and a 1% improvement sequentially. LifeCell is now approaching 17% of overall KCI revenue, up from 12% at acquisition.

TSS revenue for the third quarter of 2010 decreased 12% from the year ago period to 63.4 million on a reported basis and 10% on a constant currency basis. The decline resulted chiefly from lower global rental volumes driven by lower influence of this quarter versus the prior year, continued economic weakness which has caused many acute care facilities to streamline spending and some modest competitive share loss. As Cathy mentioned, we recently introduced our skin microclimate manager coverlet, which represents the latest innovation in moisture and sheer prevention in our fleet, and which should be readily accessible and easily used by nurses and other caregivers.

Gross profit in the quarter of 289.4 million increased 3% versus the prior year period resulting in a gross margin of 57.1% versus 55.8% last year, an improvement of approximately 130 basis points. The increase in gross margin was primarily due to lower product royalty expenses, increased productivity of our service operations and higher gross margins associated with the LifeCell business.

SG&A expenses for the third quarter were 139.5 million compared to 132.4 million for the same period of 2009. Third quarter SG&A increases included continued investments associated with our entry into the Japanese market, an increased selling cost associated with the global LifeCall business. In addition, we recorded approximately 3 million during the quarter related to employee separation costs.

As part of our global business transformation initiative, we opened a share and service center in Budapest, Hungary during the quarter. This share and service center is an integral part of our plan to drive intermediate and long term transactional cost savings and efficiencies. The Budapest facility represents a consolidation of many functions and people that were formally spread across several distinct geographies. Over time, the Budapest office will grow in functionality and geographic coverage to support KCI’s growth in a very scalable structure, thereby enhancing our bottom line.

Research and development expense of 20.9 million for the quarter was down 15% from the prior year and comprised 4% of total revenue. The majority of this decrease was due to the timing of certain programs and activities and therefore are temporary in nature, but the 9 months ended September, our R&D spending has been approximately 4.5% of revenue and we would expect spending to return to normal levels in the fourth quarter.

Operating profits for the third quarter of 2010 was 122.2 million compared to 114.2 million in the prior year period, an increase of 5% over the same period last year. Our operating margin was 23.7% for the third quarter, up from 22.6% during the same period last year, which represented a 110 basis points increase driven by our strong gross profits, reduced acquired intangibles amortization and low R&D spending as previously mentioned.

In addition to our operating leverage, we saw a continued financial leverage in the period. Interest expense in the third quarter of 2010 was 21.5 million, down 4.2 million versus last year’s third 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 235 million. The third quarter effective tax rate was also down to 25% compared to 29.7% in the prior year period. The decrease in the effective income tax rate was a result of a higher percentage of taxable income being generated in low tax foreign jurisdictions and a favorable resolution of certain tax contingencies during the quarter.

We would expect the overall effective income tax rate for the fourth quarter to return to normal levels of approximately 30%.

Turning now to the balance sheet, our financial position remains liquid and stable with total worldwide cash of 263.3 million and a substantially [unincomprent] $300 million revolving credit line. We again utilized our strong cash flow to make both scheduled and voluntary debt payments totaling 60 million in the third quarter on our term A bank facility. At the end of the third quarter 2010, our total debt, on an economic or debt instrument basis was 1.26 billion, which is now below 2 times leverage, or approximately 1.9 times our trailing 12 month EBITDA, which is down from a leverage of around 3 times EBITDA at the turn of our LifeCell acquisition 2 years ago.

Regarding our cash flows, operating cash flow less capital expenditures was 179.6 million for the 9 months ended September 2010 versus 208.4 million in the prior year period, a reduction of 28.8 million, primarily as a result of our anticipated increases in biologic inventory level to meet growing demand for our [aledome] and Stratus tissue matrices in increased tax payments. These were partially offset by improved cash collections and higher net earnings.

Accounts receivables days outstanding improved from the prior year period as we continue to work hard in improving our billing and customer service operations. Looking forward, our priorities for cash remain chiefly to support the growth initiatives within our existing businesses, to support the business development activities underway in each business unit, to further diversify our sources of revenue and earnings growth, to meet required bank amortization levels and to the extent we have excess free cash, potentially buy back shares opportunistically and within the covenants of our existing credit agreement.

Our financial guidance for fiscal 2010 remains relatively unchanged, though we have reflected the impact of our strong Q3 earnings on our full year EPS guidance. Our revenue guidance of 2 billion to 2.03 billion naturally implies fourth quarter revenues of between 510 and 540 million. While we’re pleased with the results in the US AHS and regenerative medicine businesses in particular, and optimistic about our new product launches, given the economic difficulties in Europe and broadly increasing price pressure, we would expect our Q4 revenue performance to be reasonably comparable to last year’s fourth quarter. In Q4 2009 we reported revenue of approximately 527 million, representing growth of 7% due in part to a strong flu season combined with a 3% currency tail wind.

Our outlook for growth and operating margins remains unchanged. As this guidance implies, we continue to play an incremental investment in the fourth quarter, particularly for our sales force expansion, new product launches and geographic expansion. We are raising our guidance on reported or GAAP EPS which now reflects a diluted earnings per share range of $3.52 to $3.57, up from prior guidance of 3.40 to 3.50, implying year to year growth of 9 to 10%.

The lower end of our adjusted non-GAAP diluted earnings per share guidance is also narrowed to a revised range of $4.24 to $4.29, reflecting adjustments similar to the GAAP EPS numbers, partially offset by our tax rate and intangibles amortizations or non-GAAP add backs.

To assist you with your modeling and to provide a consistent basis of comparison, we have included reconciliation to the adjusted earnings per share outlook in this morning’s press release. And now I’ll turn the call back over to Todd Wyatt

Todd Wyatt

Thank you Cathy and Marty. Before we begin the Q and A session. I would like to ask everyone to please ask one leading question and one follow up question and then return to the queue. We will respond to as many questions as time permits, including those of you who may have re-queued to ask additional questions. Thank you very much. I will now turn the call over to the operator. Operator?

Question-and-Answer session

Operator

(Operator instructions). Your first question comes from Mike Weinstein from JPMorgan

Mike Weinstein - JPMorgan

Thank you. A couple of questions for you. Cathy, when you were talking about Stratus and Stratus has had a good quarter, you did sight increased competitive pressures and increasing price pressure in that market place. I was hoping you could just elaborate on that?

Cathy Burzik

Sure Mike. We’re really pleased, when you think about the short amount of time Stratus has been on the market to be at 150 million run rate, and clearly the preferred biologic. And my comments really just reflected the fact. As I think everybody knows there is competition in that market now, more folks coming on board with core scene and other based products and so I’ve wanted to acknowledge that. I don’t say that in a way to raise any level of concern. We just wanted to acknowledge that we see that. Clearly, I think the pricing pressures referred to the general pricing pressures. I think all of us feel right now with all the constraints from an economy perspective, and particularly is that impact cost.

Mike Weinstein - JPMorgan

So what is Stratus’ pricing during year over year basis at this point?

Marty Landon

Stratus pricing is relatively unchanged and what we see there is what we expect it right improved margins as we continue to lower the cost of production.

Mike Weinstein - JPMorgan

Okay, a couple of clarifications from your comments; one, the lower product royalty expenses, Marty, that you sighted that benefited gross margins. That’s not [indiscernible] other agreements you have that have either expired or you’ve renegotiated?

Marty Landon

That’s correct.

Mike Weinstein - JPMorgan

Okay, and 3 million of employees’ separation costs, was that embedded in that SG&A line this quarter?

Marty Landon

It was

Mike Weinstein - JPMorgan

Okay, and lastly, is there anything you can add on the call relative to the trial and expected appeals process?

Cathy Burzik

I’ll just take that one Mike. As I said in the press release last week, the overall document that was written by Judge Ferguson, the ruling, it’s pretty complicated. We’re spending a lot of time going through that. It’s clearly important for us to understand what actions we take and we light out in the others the potential for us to ask for reconsideration. There’s clearly to offer the alternative for the appeal. We just want to be really thoughtful in how we approach this.

Mike Weinstein - JPMorgan

Sorry, just one last on that, how does it impact the Common Tech litigation which I think was passed to trial a couple of weeks?

Cathy Burzik

I have Butch Hulse from our legal department, Mike, I’ll have Butch answer that.

Butch Hulse

Good morning Mike. The Common Tech case is not currently set for trial. The parties agreed that there needed to be some more discovery done so that case is not currently set for trial, and we’re still getting our head around how the ruling from Judge Ferguson is going to impact our ongoing pattern for litigation with ITI and Common Tech, but there could be an impact but we don’t know yet what that’s going to be.

Mike Weinstein - JPMorgan

Good. Thank you guys.

Operator

Your next question comes from Dave [Turquie] with CIG

Dave [Turquie] - CIG

Thanks. I may have missed this on the comments, but did you talk at all about unit growth for AHS either here in the US or in EMEA?

Cathy Burzik

We talked indirectly about it in that we talked about the fact that we have seen volume growth in the -- to give you the numbers, we see in the acute area of the US, we see volume growth of roughly around 4%. Post acute it’s pretty flat and in EMEA, we see volume growth pretty flat. We see price down in EMEA.

Dave [Turquie] - CIG

And just in terms of a percent or directionally, do you think this is the bottom in your P&L? Is there any commentary you could say like in terms of pricing that it could actually improve from here or do you expect that it’ll still kind of remain, I guess, down single digits or something to that effect looking ahead?

Cathy Burzik

I said, on my call, I’m going to turn this to Mike in a minute but I think the important thing to understand here is that I don’t think any of us can predict how long the situation in EMEA from this is going to last, and this has broad impact on the healthcare environment, not just on KCI so clearly -- you’ve seen the kinds of numbers that the UK, Germany, France, Spain, all these countries are taking a lot of money out of healthcare so all of us are trying to figure out the best way to be responsive to that. Mike, I don’t know if you want to specifically talk about forward-looking comments relative to EMEA

Michael Genau

Sure, thanks Cathy. Dave, I think as we’ve said, we continue to see with the austerity measures in Europe, the impact on tenders as they increased to slowdown how business has performed. The landscape has been consistent over these last few quarters. We’ve put programs in place and we’ve armed our sales force with the right information around the clinical outcomes and the evidence that we have and working closely with customers so the market will continue to perform as it has, we believe, over the next few quarters and we think we’re well positioned.

Dave [Turquie] - CIG

Last one. You mentioned buy backs, can you remind us if you have one in place and exactly what’s out there on that?

Marty Landon

We don’t right now Dave, and under our credit agreement, we’re currently limited to 50 million in total.

Dave [Turquie] - CIG

Thanks a lot.

Operator

Your next comes from Paula Chow with Caris & Company

Paul Choi - Caris & Company

Hi, good morning. Thanks for taking my question. First, on the margins, Marty or Cathy, if you could walk us through what’s going on with the rental margin. It looks like you had checked up a bit around 46% a little bit of improvement here over the past few quarters. Can you help us understand maybe what the impact or lack of drag rather was from the slower TSS and what maybe the contribution from some [indiscernible] tax question here?

Marty Landon

That was a mouthful, but generally I can tell you that on the rental side of things, I think in the US we had fairly stable prices and with the work we’ve been doing around service operations and the lower royalties we talked about, that helped those pieces of the margin. Certainly on the sales side of things, a lot of that is mix related as you have the higher margins associated with the LifeCell business. I would tell you that on the TSS business, in terms of covering that impact of decline, it’s just a smaller part of the business so the larger parts of the business are covering that. It would tell you that in that part of the business, we’ve had a little bit lower depreciation as we think about getting the right portfolio in place and Steve and his team are doing a lot of work there so we did see a little bit lower depreciation expense which would end up on the rental line as well so those are the kinds of things that go towards sustaining that and improving that over time.

On the new product, I guess I would limit my comments right now to say that anytime you launch a new product on the front end of that, the margins aren’t going to be as good as where you’d expect them to be ultimately. That said, I think we’re happy with the clinical outcomes from those products and in fact in one of those product lines, we’ve already -- because we’ve delivered a fair amount of value to the marketplace, we’ve already had the opportunity to increase the pricing slightly on one of those products just because of the value it’s delivering.

Paul Choi - Caris & Company

Okay, thank you. That’s useful. And then just quickly on tax, any sort of one special thing that we noted that came in a little lower than we were modeling this quartert?

Marty Landon

I think Paul we had some releases, you’re always trying to be conservative in your approach and as tax years close, there are certain things that you just cover for and those things then cross that tax [indiscernible] that have to be released, and so that’s what we saw in this period that took us down into that 25% range, I think, on a recurring basis you’re still looking at effective income tax rate that’s in that 29-30% range.

Paul Choi - Caris & Company

Okay, and then Cathy, maybe, a broader strategy question for you. Can you maybe comment a little bit on, given the environment, maybe some of your discussions with the board in terms of how you guys are thinking of potentially increasing shareholder value over book and year end intermediate term? Any sort of discussions you’ve been having on that -- any color on that would be useful.

Cathy Burzik

Sure Paul. I’ll come back to some of the things that you’ve heard me certainly talk about in the last 4 years, and we talk about this with my board all the time. You’re going to see KCI continue to invest in new products. We think that product innovation, KCI has now proven, we talked about this going back a few years ago. The commitment to new products, and you see these new products coming out and you know we’re very excited about Prevena, I’m particularly excited about Via, and then the new products and applications also for LifeCell and now you’re starting to see them on TSS with Skin IQ. Also, you’re going to see us continue to move towards market expansion globally. We were very happy with where Japan is coming out. That clearly was a top, it was a lot of investments, we believed in the investment, we stayed the course, we think it’s going to pay off and now you’re seeing also a market expansion into China and into India and Mike is working on expansion into Latin America and Lisa is very focused on EMEA so you see the global expansion opportunity and then you also have the opportunity of continued diversification because of the strong tax position that we have. Clearly, LifeCell was done now 2 years ago. We have a pretty robust price line. Clearly we’re not going to talk about that publicly but you can think of things -- like you saw me announce the Navadaq Technology. That’s clearly in the sweet spot, it’s a great product pretty used in the LifeCell type of applications today. We think it has wound applications also. You’re going to continue to see us make those kinds of investments to diversify our business. So those are the main things. It’s kind of like a mouthful but those are the what things we talk about with the board on how we see KCI continuing to grow for the future.

Paul Choi - Caris & Company

Okay, thank you very much. I’ll jump back in queue.

Operator

Your next question is from Chris Cooley with Stevens

Chris Cooley - Stevens

Hi Cathy, good morning. Thank you for taking my question. If I may just start with, could you maybe just address what’s fundamentally different now with AHS as you’d look at the post acute market and how you’ve expanded in terms of the number of feet on the street and you do have some new product [indiscernible] as well now -- really not in the fourth quarter but you’ve had 2 solid quarters now in a row. Help us kind of understand how -- what’s fundamentally different in how you’re approaching that market or what you’re seeing that’s different in that market that’s enabling you to really kind of be more aggressive and gain share in that space, and then I have a follow up? Thank you.

Cathy Burzik

Thank you for [indiscernible] I’m very proud of the work that KCI and Mike and his team has done in that post acute area. Mike could tell you specifically what he’s done. I can tell you exactly what he’s done, and in the face of continuing decline in the number of procedures there so the fact that we’re doing as well as we’re doing is a good tribute so like maybe you could just highlight a few of the actions you’ve taken

Mike Landon

Chris, along with the investment in our field sales team, which Cathy alluded to in her comments, both on the sales side as well as our clinical side, we’ve started to see some early wins and some good traction. What’s important to note there is how we continue to reach more patients through customer relationships and so as we look at as we follow patients who transition out of the hospital, as well as those who originate from the home, making sure that we reach more to provide Vac therapy, we’re seeing some great results as a result of those programs. Now, we do have programs that we’ve been using all year, whether it’d be our asset management program or ready care program which helps with our transitions out of the hospital, and our camp program, which is essentially taking the clinical resources that we have in the field, working with home health agencies and physician offices to help with speedy collection of information and the accurate submission of that data so that safety -- I think our services wrapping around the customer support piece have been a true differentiator, whether it’d be on the technical side or the clinical side, I think this 360 degrees of healing as you’ve heard us refer to it is really paying off, I think in an unparalleled way in the marketplace.

Chris Cooley - Stevens

Okay, super. And then if I may, just quickly, just kind of, I guess 2 final ones. When we think about the Japanese market opportunity, I notice you didn’t give specific revenue contribution there for the quarter but maybe can you just help us think about scaling in that opportunity -- how rapidly are you penetrating that market versus when you entered the US or Germany or other markets? You did state it was ahead of expectations. We’re just trying to get a little bit more color on that, and then the last question I had was in regards to the R&D expenses. As we think about the continued [indiscernible] in particular, I’m assuming you’re going to have to demonstrate efficacy and the number of specialties, guidance assumes those type of efficacy, cost effectiveness type studies, I’m assuming, or is that incorrect? Thank you.

Cathy Burzik

So let’s first talk about Japan a little bit here. We talked about last time, weighing to the thought of $10 million. We’re not changing that estimate of where we see for the end of the year. I will tell you that it’s impressive when you go over there. It’s impressive to see the number of hospitals that we’re penetrating, we’re clearly penetrating many more hospitals that had been in the plan with what I’ll call a pretty lean staff at this point because one of the things that I gave [indiscernible] with my guidance a lot of credit for is for being really thoughtful about the salespeople they add, we want to add very high quality salespeople. We’re making the investments to go find those people, as many of those people we can possibly find. We’re giving you kind of a long term expectation we have for Japan but as far as growth rate, I think the best proxy that you might think of would be Germany. As we launched our business in Germany, and we think that we will be able to penetrate the Japanese market at a great faster than we were able to do in Germany, and a lot of that is because we’ve moved classic KCI expertise and back over to Japan. We’ve got a really high quality team of people there guiding and teaching the Japanese salespeople how to approach the market, how to do surgeon forms over there, how to do all the professional occupation that we’ve learnt, so important for Mark in the US and in Germany and in Europe so that’s the way we’re going to build the Japanese market. So as we said before, we are not limiting the investment in Japan, the investment is paying off and we continue to plan to stay the course with that.

The R&D question

Marty Landon

I think it’s simple, Chris. I think one of the things that we expect at the business unit readers have put in place and thus for us is to make sure that we have clinical support for the new products that we roll out in the marketplace so clearly there’s going to be initiatives and efforts to do that. I think that’s one of the strengths of LifeCell at this point; is making sure that when they bring out a new application, it comes with good clinical data so I would us doing the same.

Chris Cooley - Stevens

Thank you.

Cathy Burzik

Welcome.

Operator

Your next question comes from Jayson Bedford with Raymond James

Cathy Burzik

Hi Jayson?

Jayson Bedford - Raymond James

Hi Cathy and good morning. Thanks for taking the questions. I’ll start with a clarification, on the EMEA business, on the VAC side, I think you said flat -- did you see flat volume year-over-year because I guess I was under the impression that that business has been growing kind of double digits on a volume basis historically?

Michael Genau

Hi Jayson, this is Mike. The volumes overall EMEA were flat. We’re seeing good volume improvement in Germany and as we look at other parts of Europe, we’re seeing some volume improvement. We haven’t seen as much of that in the UK so the mix in total would bring us to a flat.

Jayson Bedford - Raymond James

But that’s down from quarters past, is that right?

Michael Genau

Yes.

Jayson Bedford - Raymond James

Okay. And then in terms of adding 100 reps from the post acute side, how far along are you there?

Michael Genau

What we said was we would have 100 or so by the end of the year and we are on that plan.

Cathy Burzik

And Jayson, that’s not all proposed to acute [indiscernible] those are also going to acute to support the launch of the new products.

Jayson Bedford - Raymond James

Okay. And is it fair to assume kind of 50-50 in terms of the [indiscernible] third quarter, fourth quarter?

Marty Landon

No, actually I think we’re ahead of that. We had a very good Q3 in terms of bringing in new reps, getting them trained and so we’ll be at our plan by the end of the year, but I would say that it was a little bit better in the third quarter than fourth quarter.

Jayson Bedford - Raymond James

And then last couple here. VAC Alta, maybe I missed this but can you just give us an update of either timing or maybe your interaction with the FDA?

Cathy Burzik

Alta has been approved by the FDA, I think it was a couple of months ago now, sometimes in Q3 and the Alta product is an important product to complement our overall platform, and I think Mike we’re looking at like mid 11 foot launch of the Alta product. Right now we’ve got our sales force in the US and around the world quite honestly extremely focused on all these 3 new products we have, [indiscernible] Prevena, getting ready for Via and then Alta will be the fourth. We think from a timing perspective, obviously they spend time at our sales meetings in the year and then plan for our launch in mid ’11.

Jayson Bedford - Raymond James

So the timing of the launch is at your discretion, you’re not waiting for an enhanced label or anything like that?

Marty Landon

That’s right. It’s totally up to us. As Cathy pointed out, as we’ve been launching these new products, you want to make sure that the commercial organizations across the globe are able to take the new ones on, get the training done, digest it, get it in the marketplace and so it’s a planned kind of style or approach.

Jayson Bedford - Raymond James

Okay, great. And then lastly from me on the LifeCell business in Europe, can you talk about what you view as the key catalyst to break that market open? I guess I’m kind of leaning at are there any expected reimbursement decisions upcoming that could help you there? Thanks

Cathy Burzik

I have Lisa Colleran on the call. Lisa, why don’t you give your thoughts to Jayson regarding how you see Europe right now or what you think is going to take to drive some of your plans

Lisa Colleran

Great Cathy. Thanks Jayson for the question. Just to give a little bit of reminders of where we’ve been in Europe. We entered the European market about 18 months ago with a heavy focus on the UK and Germany. Probably about 12 months into that, the UK has taken off very substantially and actually it’s exceeding our expectations, and I think that we can point to a couple of things that drove that success, aside from the strong performance of the product in both [indiscernible] construction, we have great leadership on our UK team as well as we have had great success in hiring very skilled sales force. On top of that, we’ve leveraged what we’ve learnt in the US about market development activities so we have invested heavily in medical education and programs around that in the UK and then followed on by Germany.

In the last few months, sort of again, the 18 months pointing to Germany, we are seeing significant growth there. I think we’ve kind of hit our mark or our stride in those 2 major markets that we entered early on. The rest of Europe, we really just started to focus on those markets or those countries at the beginning of this year so I’ll call that Southern Europe and we’re just doing the building and the market development activity.

Now specifically to your question, we have a couple of things that really need to continue to hit their strides. We need to continue to develop and hire and train the right sales organization and again, I think we have a successful formula in the UK that we can leverage to the rest of Europe. Second is we are working on and do need to deliver European clinical data, and remember, Stratus is new in the US so we didn’t even have up until the Rich data, a lot of clinical data on Stratus, which is the product that we’re selling in Europe so the Rich data has been very positively received in Europe and will have an impact. It’ll be not only broadly the first multicenter prospective study in the challenging hernia a patient population but will be the first data on Stratus to be used in Europe, so second thing would be the clinical data.

Third, we’ll continue to make the investments in the market development, mainly focused on working with key opinion leaders and educating the surgeons on the benefits of using biologics and those 2 key applications.

And then last but not least, your point is reimbursement. There really isn’t a short term upcoming event on reimbursement but we are continuing to build our dossier and submitting those tender by tender or country by country to develop the reimbursement schemes and those activities, together with 2 European studies that we’ve initiated over the next coming years will give us the reimbursement that’s necessary

Jayson Bedford - Raymond James

Thank you.

Operator

Your last question comes from Lennox Ketner with Bank of America

Lennox Ketner - Bank of America

Thanks so much for taking the questions. One, just on Jayson’s question earlier about the unit growth in EMEA, I believe you said that was flat, I was under the impression as well that that market previously was seeing double digits offset by double digit pricing pressure so is it fair to assume that the pricing pressures improved there this quarter?

Cathy Burzik

I think we talked about double digit pricing pressures.

Marty Landon

We’ve said that a lot of that volume growth has been cut by the pricing and I would tell you that in this particular period we did see a slowdown in unit growth, that was fairly flat year to year and the decline than year on year was mostly related to price in the marketplace.

Lennox Ketner - Bank of America

Okay, but there must have been fairly moderate pricing pressures, because that business [indiscernible] 2%, correct?

Marty Landon

In that 5% range.

Lennox Ketner - Bank of America

Okay, and then I was wondering on the new product launches of ABThera and Pervena, if you could update us on the clinical trial front. I know you had a study that you were enrolling for ABThera, I’m just wondering if it’s possible to get an update on that and when we might see the data and then for Pervena, it seems like you’re not planning to do any clinical trials, you don’t think one is necessary right now? I’d get your thoughts on that.

Cathy Burzik

We are working with [indiscernible] as a registry effectively across a multi-centered type of a registry. Mike, I think 17 sites?

Michael Genau

And, as far as we are, it’s called the ABTech trial. It’s approaching kind of inflection point where the committee is meeting next month actually, the data monitoring committee to review the data, to determine if the study has been powered enough and so the sense there would be that we’re seeing very favorable results so we’ll know more in another month or so on the ABThera piece. On the Pervena piece, we’re working on several kind of targeted surgical indications when incisions are an increased risk of surgical site infections and other would complications and so we’ll be working with our key opinion leaders and researchers as we are now over the several months to have something towards the second half of 2011.

Lennox Ketner - Bank of America

To have a study towards the second half of 2011?

Michael Genau

We’ll have some initial data in the second half of 2011

Lennox Ketner - Bank of America

Okay, great. Thanks so much and congratulations on the quarter.

Cathy Burzik

Thank you Lennox, thank you. Bye bye.

Operator

Thank you. I’d like to turn the call back over to Cathy Burzik, President and CEO.

Cathy Burzik

So I’d like to thank you all for participating in the call, thanks for the great questions and have a good day.

Operator

This concludes today’s conference call, thank you for your participation. You may now disconnect.

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