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Kinetic Concepts (NYSE:KCI)

Q1 2011 Earnings Call

April 26, 2011 8:30 am ET

Executives

Catherine Burzik - Chief Executive Officer, President, Executive Director and Chairman of Technology Committee

Lisa Colleran - Global President of LifeCell

Michael Genau - Global President of Active Healing Solutions

Martin Landon - Chief Financial Officer, Principal Accounting Officer and Executive Vice President

Todd Wyatt - Vice President of Investor Relations

Analysts

Matthew Miksic - Piper Jaffray Companies

Michael Matson - Mizuho Securities USA Inc.

Michael Weinstein - JP Morgan Chase & Co

Christopher Cooley - Stephens Inc.

Paul Choi - Caris & Company

Tao Levy - Collins Stewart LLC

Spencer Nam - Madison Williams and Company LLC

Unknown Analyst -

Lennox Ketner - BofA Merrill Lynch

Operator

Good morning. My name is Ashley, and I will be your conference operator today. At this time, I would like to welcome everyone to the KCI First Quarter 2011 Earnings Conference Call. [Operator Instructions] Thank you. I would now like to turn today's conference over to Todd Wyatt, Vice President, Investor Relations. Sir, you may begin your conference.

Todd Wyatt

Thank you, and welcome to the KCI First Quarter 2011 Earnings Conference Call. Today, we will review the results that were 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're 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 the conclusion of this call.

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 results discussed on this call may reflect various GAAP and non-GAAP financial measures. A reconciliation between the two is contained in our earnings release issued this morning.

After our prepared remarks, we will open the lines for Q&A. [Operator Instructions]. I would now like to turn the call over to Cathy Burzik, President and Chief Executive Officer of Kinetic Concepts. Cathy?

Catherine Burzik

Thank you, Todd, and good morning, everyone. We appreciate your joining us to discuss our first quarter 2011 results. On today's call, I will review highlights of the first quarter and the performance of our 3 businesses, including an update on our strategic initiatives. Marty Landon will then review financial results and provide details behind our increase in fiscal 2011 guidance. We will conclude with a question-and-answer session.

So let's start with revenue. We had our first ever $500 million first quarter of the year. I'm proud of the 7,000 members of the KCI family around the world whose hard work and perseverance made this achievement possible. Our quarter demonstrated solid performance in the Americas AHS [Active Healing Solutions] business and robust growth in our LifeCell business.

Also, our Therapeutic Support Surfaces business, while down year-over-year, grew sequentially and is progressing as planned. The execution of our strategic initiatives, including new product introductions and geographic expansion, contributed nicely to this quarter's strong performance and remain our key drivers of long-term growth.

For the first quarter, our diluted earnings per share performance was also strong, up 27% on a reported basis and up 22% on an adjusted non-GAAP basis. These results were driven by strong operating and financial leverage during the quarter, as well as relief from the Wake Forest [Wake Forest University] royalties beginning in March.

I will now review some of the key events and operating highlights since our last call. First, I'd like to focus on Japan. Our hearts go out to those who are gravely affected by the tragedies of last month, and we continue to support our people and the Red Cross [Japanese Red Cross Society] relief efforts there. Fortunately, all of our associates and their families are safe.

I'm extremely proud of the dedication of our KCI team in Japan and our business remains on track due to their extraordinary efforts. We met our Q1 goals and now believe we will deliver more than $25 million in revenue in 2011.

We showed 3% growth in the Americas AHS business given by solid volume growth in the U.S. across both the acute and post-acute care setting. This performance demonstrates the strength of our product portfolio based on differentiated outcome from the use of KCI's Negative Pressure Therapy Platform, including our revolutionary V.A.C.Via, Prevena and ABThera products.

The LifeCell business once again delivered strong growth. In Q1, our business grew 18% over the prior year quarter, driven by strong performance of Strattice and AlloDerm and our core application, challenging hernia repair and breast reconstruction.

In February, we launched back V.A.C.Via and we're off to a good start. The miniaturized Vortis Pump Technology which underpins V.A.C.Via increasingly promises to a be a game changer in the field of Negative Pressure Wound Therapy.

And in TSS [Therapeutic Support Systems], we are beginning to move in the right direction as it grew sequentially in Q1 driven by the Critical Care [Critical Care Therapies] segment.

Let me turn now to a review of our first quarter performance by business segment, and I'll state all revenue growth rate in terms of constant currency figures, unless I indicate otherwise.

In our AHS business, global revenue grew 2% year-over-year. AHS revenues in the Americas, which includes the U.S., Canada and Latin America grew a solid 3% compared to last year's quarter, with all markets showing growth.

In the U.S., our overall revenue grew 3%, driven by volume growth in both acute and post-acute care setting, supported by stable pricing. The productivity of our new reps added during the second half of 2010 is still ramping up, but early signs are quite encouraging, as evidenced by this quarter's results.

Before I move on to other regions, let me briefly comment on the recent meeting that CMS [Centers for Medicare and Medicaid Services] held on April 5 to discuss the competitive bidding program. At that meeting, CMS did not announce what categories will be included on Round 2, but noted they would make this announcement this summer.

Additionally, implementation of Round 2 was delayed until July of 2013 at the earliest. In the meanwhile, KCI is very focused on educating CMS about the complexities of Negative Pressure Wound Therapy and the likely consequences to patients, including access and safety, if NPWT is included in the competitive bidding program.

Moving now on to the other AHS regions, and please note that we are now breaking out EMEA and APAC regions separately.

In the EMEA [Europe, Middle East and Africa] AHS market, we experienced a difficult quarter, as revenue was down approximately 9% versus the prior year quarter. We see economically driven austerity measures impacting our pricing in disposable usage, coupled with modest share loss due to competitive activity. We expect these headwinds to remain with us through 2011.

That said, I'm encouraged by early signs of strong acceptance of our V.A.C.Via in many countries throughout Europe, as clinicians see the economic value of being able to send patients home with Via. We are also selectively adding commercial resources and sales headcount in key countries in the European region to better meet our customers' needs and to increase our coverage of new products.

Turning to our APAC [Asia Pacific] region. AHS revenues improved nearly 70% during the quarter versus the prior year period. This was driven primarily by our Japan business. We saw strong demand in the quarter. We expect to deliver more than $25 million in revenue during 2011 from our Japanese business.

Regarding new AHS products, and starting with V.A.C.Via, we began the launch of V.A.C.Via in early February and are seeing encouraging signs across both the U.S. and Europe. V.A.C.Via will enable broader V.A.C. [Vacuum Assisted Closure] accessibility throughout many locations in the hospital: operating rooms, emergency rooms and supply rooms throughout hospitals.

I believe that we have something special with V.A.C.Via and as a Vortis Pump Technology, it's a true game changer to the future of Negative Pressure Wound Therapy.

Our Negative Pressure Surgical Management product group, which includes the new products, ABThera and Prevena, continues to see growth in revenue. Over the next few months, we will be hiring surgical management specialists in select markets to further penetrate these opportunities.

Additionally, we have continued to strengthen our investments in clinical data in order to drive further penetration in these new and large opportunities.

Importantly, we just completed a major multicenter perspective trial studying our ABThera products versus the conventional Barker Technique [Barker Vacuum Packing Technique] for critically ill open-abdomen patients. Completing such a study is a major milestone for us, and we look forward to presenting the results this summer.

We are also excited about the launch of our next AHS product, GRAFTJACKET in Q2. This product is an acellular human dermal-based tissue matrix for wound applications such as diabetic foot ulcers and venous stasis ulcers which is made by LifeCell and marketed under the GRAFTJACKET name. This product expands our offering along the wound healing continuum.

By combining our market-leading Negative Pressure Wound Therapy with this regenerative tissue matrix for wounds, the AHS sales force will have a stronger product offering for caregivers focused on hard-to-heal wounds.

And lastly, I want to give you an update on Wake Forest. On February 28, KCI filed a lawsuit in the Federal District Court in the Western District of Texas seeking a declaratory judgment that KCI no longer owes royalties to Wake Forest, since the relative patent have enrolled invalid. As expected, Wake Forest has terminated the licensing agreement and filed a lawsuit against KCI in North Carolina State District Court. We have removed this suit to federal court and are seeking to have the case dismissed or transferred to Texas and consolidated with the suit we filed in February.

Turning now to our LifeCell business, where once again we saw strong performance in the first quarter. Our LifeCell business posted 18% growth on a reported basis and now represents almost 19% of KCI revenue.

The increase in the quarter was especially fueled by Strattice, which rose 42% from Q1 2010 and now comprises almost 45% of LifeCell revenue. Strattice is still growing and growing well, and is now on an annual run rate of $165 million in revenue and remains the clear biologic of choice for challenging hernia repair due to its outstanding clinical performance.

In the Americas, LifeCell grew 16% over the prior year quarter. Growth remains driven by increasing acceptance of the use of biologics in both breast reconstruction and challenging hernia repair applications.

In addition, our new applications of Strattice for stoma reinforcement and for breast plastic surgery are gaining traction and were strong contributors in the quarter.

In Europe, LifeCell continues to ramp up, with the Q1 revenue growth of about 150% year-over-year. During this quarter, we saw significant growth in many of our European countries, with the U.K., Germany and southern countries all demonstrating strong performance. Overall, Europe contributed approximately 200 basis points of the 18% LifeCell revenue growth in Q1.

We are making headway in many European countries and look for steady growth over the rest of 2011 as the productivity of our European sales force increases and our products penetrate these newer markets.

In terms of new LifeCell products launching in 2011, our new formulation of AlloDerm, ready to use, is being rolled out in targeted accounts with a full launch plan for 2012.

As anticipated, it is being very well-received by our plastic surgeon customers. Additionally, we are planning to launch a Strattice for stoma reinforcement in Europe mid-Q2 and the pilot launch of Strattice for inguinal hernia is set for the second half of 2011 in the U.S.

And finally, I'm very enthusiastic about the potential for the SPY Elite tissue perfusion assessment system. As you recall, we signed an agreement with Novadaq Technologies to market this product for surgical application.

Thus far, early in our launch, it's very encouraging that so many surgeons are beginning to trial the system. We're pleased with our efforts to develop the market for this technology, which enables surgeons to see blood perfusion in tissue during surgical procedures and allows them to adjust their surgical approach real time before the patient leaves the OR [operating room] to achieve improved outcome.

And now wrapping up with our TSS business. In Q1, we saw a 9% decrease over the prior year quarter, but believe we are making progress towards stabilizing the business in the second half of 2011 as the sales force realignment and new products gain momentum.

In the first quarter, our Rental business strengthened sequentially led by our Critical Care segment. In terms of our new TSS products, we launched our highly innovative Skin IQ Microclimate Manager in Q4 and now completed a full quarter in the market. Skin IQ, which is a proprietary therapeutic surface approach for the prevention and management of pressure ulcers, is receiving very favorable clinical feedback from early patient placement. We recently received a U.S. patent on Skin IQ, which reinforces the proprietary strength of this unique product.

Additionally, we announced the acquisition of TechniMotion Medical this quarter, and are on track to launch this innovative and ergonomic patient handling system in the second half of 2011. Marty will go into more detail on the 2011 guidance, but before turning the call over to him, let me leave you with some comments on our outlook.

We're pleased with the 3% revenue growth we delivered in Q1, and believe the year is developing as planned. In this morning's press release, we reaffirmed our 2% to 4% revenue growth range for fiscal year 2011. Also in this morning's earnings release, we increased our earnings guidance for both GAAP and non-GAAP diluted EPS. This increase is primarily a function of the elimination of our royalty payment, as I mentioned earlier.

With that, I'll now turn the call over to Marty to review our financial performance for the quarter and to detail our 2011 guidance revision. Marty?

Martin Landon

Thanks, Cathy, and good morning, everyone. As Cathy mentioned, total revenue for the first quarter of 2011 was $501.2 million, up 3% on both the recorded and constant currency basis. Foreign currency exchange rate movements had a nominal impact on the first quarter results.

First quarter 2011 net earnings per diluted share on a fully reported basis were $0.94, compared to the $0.74 per share we reported for the same quarter last year, an increase of 27%. This first quarter earnings growth reflects higher revenue combined with strong operating and financial leverage compared to the prior year's quarter.

Our operating profit grew in part due to our relief from Wake Forest royalty expense beginning in March, which approximated $0.07 of diluted earnings per share. On an adjusted non-GAAP basis, earnings per share of $1.11 for Q1 2011 rose 22% from $0.91 per share reported in the same period 2010.

For your convenience, we have provided a reconciliation of GAAP to adjusted non-GAAP earnings per diluted share in today's release.

In the first quarter, our AHS business segment reported revenue of $340.5 million, a 2% increase from the prior year period on both the reported and constant currency basis. As Cathy mentioned, this year-over-year improvement was largely fueled by increases in our Americas region, as first quarter revenue rose 3% over the prior year on higher volumes and stable pricing.

On a sequential basis, worldwide AHS revenue declined 7%, consistent with historical patterns of first quarter seasonality.

In the EMEA region, AHS revenue was $68.9 million, a decrease of 9% on a reported and constant currency basis. This decline was, again, due to the challenges in Europe related to economic growth and austere healthcare budgets, which is resulting in pressure on pricing on disposable volumes. These challenges vary on a country-by-country basis, as Germany saw stronger performance than the U.K.

AHS revenues from the Asia Pacific region of $13.7 million were up $5.2 million or 69% on a constant currency basis, driven mainly by continued momentum in Japan despite numerous hardships resulting from the recent earthquake, tsunami and continuing aftershocks.

LifeCell revenues of $93 million grew approximately 18% over last year's first quarter on a reported basis and 17% on a constant currency basis. LifeCell continues to perform well and in line with our expectations from mid- to high-teens growth in 2011.

Revenue in our TSS business was down year-over-year by 8% on a reported basis and 9% on a constant currency basis, which compared favorably to the 19% contraction we experienced in the fourth quarter of last year. While still contracting year-to-year, our first quarter 2011 TSS revenue increased slightly on a sequential basis from Q4 2010. This improvement is aligned to our expectations that the TSS business will move towards and achieve a stability in the second half of 2011, driven by new products such as Skin IQ and productivity improvements from our sales force.

Gross profit in the quarter was $289 million, resulting in a gross margin of 57.7%, which compares favorably to 55.9% gross margin in the prior year period. The elimination of the royalty expense related to Wake Forest patents in March accounted for much of the improvement from last year's gross margin level.

In addition, gross margins benefited from favorable mix trends due to the higher and expanding margin associated with our LifeCell business, partially offset by our additional investment in the AHS sales force during the second half of 2010, which dilutes productivity in the short term.

SG&A expenses for the first quarter of $144.4 million rose 7% from last year. The increase was primarily related to investment in the LifeCell sales organization in the U.S. and EMEA plus higher marketing costs associated with new product launches and geographic expansion and increased amortization from recent technology acquisitions, partially offset by lower litigation costs.

Research and development expense of $21.2 million declined 15% from the prior year, still driven mainly by the timing of the programs, as we had increased spending in 2010 ahead of several new major product launches in the second half of 2010. R&D expense was 4.2% of revenue for the quarter. We expect R&D to increase over the rest of 2011 and track toward our planned 5% of revenue for the year.

Operating profit for the first quarter of 2011 was $114.6 million versus $101.3 million in the same period last year, an increase of 13%. First quarter operating margin increased 200 basis points to 22.9% compared to 20.9% last year, driven from a combination of lower royalty expense, favorable product mix and a temporary reduction in R&D spending.

Below the operating line, we again delivered financial leverage with interest expense of $20.8 million, compared to $23.6 million in Q1 2010 due to debt payments made over the last 12 months of approximately $155 million and lower interest rates.

Additionally, we completed the refinancing of our senior credit facility during the first quarter. And related to that refinancing, we wrote off $3.2 million in capitalized debt issuance costs, which is included within the interest expense line.

First quarter effective income tax rate was 27.3% versus 30% in the prior year period. The lower effective tax rate relative to last year was a function of a higher percentage of taxable income being generated in lower-tax foreign jurisdiction.

Our balance sheet continues to strengthen. At the end of the first quarter, our cash balance was $442.2 million. Operating cash flow less net capital expenditures was $123.2 million for the 3 months ended March versus $64.4 million in last year's first quarter. This increase of $58.8 million is due primarily to higher net earnings, lower cash outlays for royalties and good working capital management, partly offset by an increase in capital expenditures.

We made scheduled debt payments on our term A bank facility of $6.9 million in the first quarter as called for under the new facility. At the end of the first quarter, our total debt on an economic or debt-instrument basis was $1.2 billion or approximately 1.9x our trailing 12-month EBITDA.

Accounts receivable improved during the period as we continue to work on improved processes and customer relationships. Inventory levels also improved in Q1 due primarily to better management of our regenerative tissue matrix inventory and improved yields.

Turning to our financial guidance, noted in today's release. For the full year, we are reaffirming our revenue guidance of $2.05 billion to $2.09 billion, applying growth of 2% to 4%. Our revenue guidance maintains the expectations that growth in AHS is expected to be in the low single digit range, growth in LifeCell in the mid- to upper teens and the TSS business is expected to contract in the low to mid-single digits although strengthening throughout the year.

Foreign currency exchange rates are assumed to be comparable to 2010. With respect to earnings per share, we are raising our guidance for GAAP diluted earnings per share to $4.35 to $4.45, up from our prior guidance of $3.82 to $3.96. This new guidance reflects the relief from royalties due to Wake Forest, partially offset by selective commercial investments and higher litigation costs. Applying growth in earnings of approximately 22% to 25%.

Non-GAAP earnings per share guidance has also been increased to $4.96 to $5.08, up from $4.45 to $4.61 previously for 2010. Both the GAAP and non-GAAP numbers include an assumption that our diluted weighted average shares outstanding will grow 3% to 4% during 2011. To assist you with your modeling and to provide a consistent basis of comparison, we have included a reconciliation to the adjusted earnings per share in this morning's press release.

And now, I'll turn the call back to Cathy for concluding comments. Cathy?

Catherine Burzik

Thanks, Marty, and before I open the lines for questions, let me leave you with just a few comments.

First, we're off to a good start in 2011. During the remainder of the year, we will focus our efforts on driving new products across all 3 of our business units, on increasing our geographic penetration in our newer markets and on stabilization of our AHS business in Europe. We'll also focus on inorganic diversification aimed at strengthening our overall business.

And with that, I'll now open the call up to questions. Ashley?

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from the line of Lennox Ketner with Bank of America.

Lennox Ketner - BofA Merrill Lynch

First, I just was hoping if you'll maybe expand a little bit on the increased guidance. I know you said that the royalty upside is going to be offset slightly by some select commercial investments. I was hoping maybe you could expand a little bit more there, whether you're referring to some of the sales force adds that you refer to during your prepared remarks or increased R&D spend? And if so, kind of what some of that R&D spend would be targeted towards?

Catherine Burzik

Sure. It's a good question. Yes, it's a very selected and targeted number of commercial investments. We've also saved some back for potential legal expenses. But the commercial is primarily, as we talked about leasing off our surgical manage -- wound management system for our ABThera and Prevena launches, also selectively in a few countries in EMEA, particularly in the southern part of EMEA where we think that there is some opportunity here for revenue growth. Very modest amount in the area of R&D, it's primarily in the area of commercial -- the commercial area.

Lennox Ketner - BofA Merrill Lynch

Okay, thanks. And then just 1 follow-up on the V.A.C.Via launch, I was wondering if you could maybe just give a sense as to how that's going? I know that you had talked earlier about that potentially expanding the market into less acute patients, I'm wondering if that's something that you've seen so far? Or if its too early, just kind of a little more detail on what types of patients that's been used on.

Catherine Burzik

It is early in the launch, but I'm very encouraged by the launch, both in the U.S. as well as in Europe. Mike, do you want to comment a little bit?

Michael Genau

Yes, sure. Lennox, this is Mike Genau. We are seeing some activity in new areas, like split thickness skin graft, and it's helping with our transitions. And we're hearing from surgeons that it's given them more opportunity to move patients out of facilities sooner, which is an economic benefit, obviously, for them. But it's still pretty early on, but we like the progress that we're making.

Lennox Ketner - BofA Merrill Lynch

Okay. Thanks very much.

Catherine Burzik

Thanks Lennox.

Operator

And our next question comes from the line of Mike Weinstein with JP Morgan.

Michael Weinstein - JP Morgan Chase & Co

Thanks. Marty, as a first point, maybe you could just break out and make sure we're on the same page of the math of the incremental contribution from Wake Forest before we net it out against some of the other items.

Martin Landon

Yes, sure. It was roughly $0.07, Mike, in terms of its EPS impact, and roughly $8 million in terms of its impact on operating profit.

Michael Weinstein - JP Morgan Chase & Co

And for the year, that's $0.07 for the full year is what number?

Martin Landon

So for the full year, that's $0.07. What we put in our guidance is $0.50, and so you can think of that as being around $0.70 less $0.20 in additional investments and legal expenses.

Michael Weinstein - JP Morgan Chase & Co

Got you. And any of the incremental dilution from the convert, is that right?

Martin Landon

Correct.

Michael Weinstein - JP Morgan Chase & Co

Okay. This has been on a couple of different businesses, but I thought the obviously specific number was very strong this quarter. And I think I get a sense of maybe 2 items. 1, was there any benefit from the events in Japan where you actually saw some significant increase in your business as a result? And 2, just based on the trajectory, is that $25 million plus a good number at this point, or is that conservative? Just trying to get a sense for what's the real underlying run rate of that business. Thanks.

Catherine Burzik

Thanks, Mike. The growth in Japan is real, it's organic growth. It's not a function of the tsunami effort. It's kind of unfortunate. I've been talking with Lynne [Lynne Sly] live about this, and the situation in Japan, I'd say is more like what happened with the World Trade Center than it is Haiti. So we didn't see a lot of soft tissue injuries, people just kind of survived or didn't. And so we were ready to have V.A.C. staged. We did stage them in a number of the hospitals, but really they weren't used in that area, so -- I mean, the growth in Japan is very real. I'm extremely proud of the team and how well that team is executing. And I'd say, we're definitely on this trajectory to get to that $25 million.

Michael Weinstein - JP Morgan Chase & Co

Okay. And then, 1 other item and I'll let others jump in here, but could you just touch on Prevena and how you feel like that's going at this point? It seems like that launch has maybe been a little bit slower than I would have thought, and I'd like to get to your view of that, Cathy.

Catherine Burzik

Well, I'm going to turn it over to Mike in a minute. I think Prevena -- Prevena is definitely a new application for negative pressure that we've ever had before. As you know, it's going over closed incisions, and I think the 1 lesson that we've learn here is it that the size of the dressing limits the number of places where it can be applied, so maybe Mike, you can talk about our work here.

Michael Genau

Sure, sure. So Mike, what we're seeing is consistent with what we'd expect, it being as a platform, the first product out has addressed some very specific incisions around the sternum, the hip and the lower abdomen. And where it's being applied, we're seeing very favorable results. We have all along known that as a platform, we would need to extend it into new areas, so we have different sizes, and we're tracking to our plan, and we'll have additional extensions to the product coming out, which we think will address more incisions.

Michael Weinstein - JP Morgan Chase & Co

Thanks, Mike.

Catherine Burzik

Thanks, Mike

Operator

And our next question comes from the line of Tao Levy with Collins Stewart.

Tao Levy - Collins Stewart LLC

So first, on the U.S. V.A.C. business, which did well in the quarter, I was wondering if maybe you could dissect out the contribution from some of the newer products, sort of like Via [V.A.C.Via] in the quarter. Just try to get a sense of how the base V.A.C. business is doing?

Catherine Burzik

It's a good question, Tao. Let me give you my sense that we're proud of how well that the business in the U.S. is doing. You got to look at it from an acute and a post-acute perspective, and we saw growth in both of those areas. In the acute, the growth is primarily coming from the new products combination Via, Prevena, ABThera. And in the post-acute, you're seeing the benefit now, I think of our adds to the sales force and the refocusing that Mike Genau have actually done there. So it's a growth there in post-acute, of course, is coming from the fundamental Rental business. So I think that's the way you should think about it.

Tao Levy - Collins Stewart LLC

Okay, great. Thanks. And in Europe on the flip side there, some of the weakness that you're seeing on that business, you mentioned some loss of market share. Is that within specific countries? And if so, are those tender-related? Or anything that you could provide there.

Catherine Burzik

No. I spent a little bit of time in Europe this quarter, and Mike did also. And Mike will make some comments. I'd say the weakness in Europe is primarily focused in the U.K. I continue to really like what I see in the V.A.C. [ph] region and I'm encouraged by what we can continue to do in the south. I think the situation in the U.K. is certainly -- that the health environment in the U.K., we all read about that and we know that the Ministry of Health there is really tightening up on the dollars. It's also true that we have the strongest competition in NPWT there, including some -- a lot of tendering and some prices that are very difficult in that area. But I also think, you've got to look at the company, too, and say, "How do we execute better?" So I think Mike's made a number of changes there, that -- I want to be optimistic here that we could get work going in the U.K. similar to the way we did post-acute in the U.S.

Michael Genau

Yes, Tao. I think, a couple of things. 1 is with the new products coming into the marketplace, we're very optimistic about our opportunities to treat more wounds. We're organizing a bit differently in certain areas in the U.K, in particular, we're bringing more specialty and clinical focus into those markets in the south. It's really a little bit more about "more feet on the street" covering more of the landscape, again, because the new products. As we look across German Austria, Switzerland area, our German markets, we see a lot of good progress being made and the clinical support that we provide being a true differentiator. So as we look across each of the regions within EMEA, we've got specific growth plans that we're implementing right now and starting to execute on it, we're very confident in.

Tao Levy - Collins Stewart LLC

Great. Thanks. And then last question, on the LifeCell business, are you starting to see any early pull through with the florescence with the Novadaq product on either tissue products?

Catherine Burzik

Sure. Lisa, why don't you make a comment on that. We're really excited, Tao, about this first quarter here with SPY. So Lisa, would you like to make some comments?

Lisa Colleran

Sure, absolutely. To repeat what Cathy said, we continue to be incredibly excited about this new technology and the difference that it can make in the way surgeons treat various tissue flaps and pressure construction and all kinds of various different procedures. And so things are doing really, really well. It's a great question about pull through and can't certainly point to any specific revenue dollars. But having the opportunity to see more surgeons and spend more time in the OR, is absolutely powerful tool to help us to reinforce our AlloDerm and Strattice messages with those surgeons. So it absolutely is getting us some more face time.

Tao Levy - Collins Stewart LLC

Okay. Thank you.

Catherine Burzik

Thanks, Tao.

Operator

Your next question comes from the line of Chris Cooley with Stephens Inc.

Christopher Cooley - Stephens Inc.

Thank you. Congratulations on a great quarter. 2 questions if I may. First, could you maybe just talk directionally about the contributions of operating line for AHS? You showed some improvement in that to the back half of last year with the rep adds and the change in mix. Now when we think about Via, how should we think about AHS' contribution to operating profit as we transition through 2011 and then going to 2012? And then secondly, could you maybe just give us a little bit more color on the great growth that LifeCell continues to deliver? Is that more in 1 indication or another? Could you just maybe go into that just a little bit more as well? Thank you.

Martin Landon

Chris, this is Marty, so I'll answer the first part of that. So I think that naturally, as you grow the revenue levels, which we're seeing in AHS, that's going to be a little stronger contributor. You do have, in a period of transition a little bit, as you bring on some of the single-patient use products. So your manufacturing efficiency probably isn't where ultimately it will be. So if you look forward, I think you're going to see increasing contributions from that business, but we've been able to hold contributed profit levels and are increasing as we go forward. So I think that will get stronger as we go.

Christopher Cooley - Stephens Inc.

Okay.

Catherine Burzik

On your question on LifeCell, Chris. It's a good question, and we -- Lisa and her team are growing LifeCell at all aspects. The challenging hernia and breast reconstruction continues to have good double-digit growth. And so the base business continue to expand with more biologic procedures. We're obviously happy with the uptake on stoma and breast plastic surgery. And then, obviously, in Europe. So I think that you've got LifeCell pretty strongly here, executing in all regards.

Christopher Cooley - Stephens Inc.

Thank you so much.

Catherine Burzik

You're welcome.

Operator

And our next question comes from the line of Michael Matson with Mizuho Securities.

Michael Matson - Mizuho Securities USA Inc.

Given that you just started disclosing or breaking out the EMEA growth from Asia Pacific, I was just wondering if you could give us the numbers or the growth rate in EMEA for 2010 overall and for the fourth quarter just as a comparison? I know it's been pretty competitive there, and you've been seeing some declines, but I guess I'm just trying to figure out what is the current number in the context, is it getting better or is it getting worse? What's the trend?

Martin Landon

The trend, Mike, is we continue to feel that pressure. So it's been increasing slightly in terms of the pricing pressure that we've seen over time. I think we're getting a much better feel for, as Cathy mentioned, the pockets where we need to do some strengthening of the sales organization, bring in some of the new products. You've got certainly a very strong V.A.C. region, Southern Europe is quite strong. So it really varies by area. I would tell you that those changes aren't material just because Japan has been a small part of the business up until now. It's really getting to the point where -- contributing $5 million plus a quarter. So I think overall, if we are continuing to see the pressure, but in pockets we are holding up quite well and in the other areas, we know what we want to do.

Michael Matson - Mizuho Securities USA Inc.

Okay. And my second question, which is on the GRAFTJACKET. With the launch of that product, just wondering how you're going about sort of training your sales people since I guess this is going to be sold through the V.A.C. sales force. And sort of a different type of product. And then just related to that, pricing of GRAFTJACKET, is it going to be priced at a level where it will be a used in these wounds? Or is it going to -- is the pricing going to potentially be an issue?

Michael Genau

Yes. Michael, this is Mike Genau. On the training side, we've had our organizations together throughout the month of April, and we had some detailed clinical and technical training sessions. Don't forget that with our LifeCell partners, we've got a lot of that domain expertise, and so sharing those best practices and some of the go-to-market strategy plans has been very beneficial. The opportunity for GRAFTJACKET in the bag of the AHS rep is very real. When you think about chronic wounds and how surgeons are looking for broader solutions coming from a single source. In this case, we're able to bring more to bear there, especially in the chronic wound space with V.A.C. and our new product line. So GRAFTJACKET fits very well and strategically in the V.A.C. It is reimbursed so that pricing is in place in the post-acute space. And so what we'll do as we look at the acute opportunity is obviously, try to be as competitive as we can be, but really building our presence based upon our V.A.C. team right now and are coordinating with our LifeCell partners to make sure that we bring the best solution to the surgeon.

Michael Matson - Mizuho Securities USA Inc.

Okay, and then just V.A.C. Ulta, I didn't hear -- really hear any commentary on that, is that still going to be launched during 2011?

Catherine Burzik

V.A.C. Ulta will be launched, it's going to be launched in Europe first, about the middle to end of this summer. We're in what we call customer preference trials as we speak. So it's going on patients and by the end of the year, we anticipate a launching in the U.S. We're really excited about that product, the more you talk to clinicians about utilization of instillation therapy in concert with V.A.C., it's I think is going to be very helpful for seriously infected wounds.

Michael Matson - Mizuho Securities USA Inc.

All right, that's all I have. Thank you.

Catherine Burzik

You're welcome.

Operator

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

Paul Choi - Caris & Company

Thank you. Cathy, could you maybe perhaps comment on U.S. competitive trends since the court decision? And maybe on intra-quarter trends, specifically. Did you see, as the quarter progressed, maybe your competitors becoming more aggressive on price? I know you mentioned price overall was pretty flat. But maybe, if you could describe competitive behavior a little bit, that would be helpful for us.

Catherine Burzik

Sure. I would say, in short, we don't see any change in competitive behavior. We've got competition for sure across the world now, and particularly in the U.S. market. I mean, I get asked this question all the time. I think that competition is out there. KCI continues to be extremely successful in fighting back that competition again because of the clinical outcomes and because of the economic value added, and I think people understand that. So we've been able to hold our pricing pretty stable in the U.S.

Paul Choi - Caris & Company

Okay, thank you for that. And then a question on gross margin for Marty. Marty, if we strip out the Wake Forest royalty impact, and we think about sort of the price mix benefit, could you maybe comment on how we should think about the gross margin trends on an operational business progressing this year? And what the impact of the recent move in commodity prices will do to your gross margins?

Martin Landon

Yes. So there's a number of things that float through there, Paul. I would tell you that some of the things we've talked about on prior calls in terms of service productivity, getting improvements in our cost of goods sold. As I mentioned, the LifeCell becoming a bigger part of the business helps and not only that, but LifeCell continues to expand its margin as it gets better in the yield part of its production process. So between service and cost of goods, we mentioned the investments we made in the sales force has been a little bit of a headwind. We'd see that's kind of getting back to normalcy as we've talked about over a 6 to 9 months period. So I think you've got some drivers in there that as we go-forward, we still think that we have the ability to expand gross margins at outside of what's happening on the Wake Forest side.

Paul Choi - Caris & Company

And maybe, if you could quantify for us, what you think maybe the commodity pricing pressure might be for this year?

Martin Landon

In terms of what it's done to us, it's increased seems a little bit. I would not necessarily put a percentage on it, but I would say that we're doing some things to counteract that. I think we're getting better in the way we acquired goods. And so we're able to offset, I mean, it's a little bit of an opportunity for us in terms of how we procure goods to help to offset some of the increases we're seeing at the base prices.

Unknown Analyst -

Okay. Thank you for that. Congrats on a great quarter guys.

Catherine Burzik

Thanks, Paul.

Operator

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

Matthew Miksic - Piper Jaffray Companies

Thanks. 1 follow-up on the North American AHS business. Just noticing the growth in the U.S. last couple of quarters, or North America, I should say, has kind of been driven more so by sales than rental. Rental about 1%, sales 3% and then 7%. Any of the -- if you could expand a little bit on maybe what we can expect over the next couple of quarters? Or what might be driving those trends? Then I have a couple of quick follow-ups.

Catherine Burzik

No, I think Marty is going to expand more. But as we've talked, Matt, as our business, as we bring Prevena in, and ABThera in, Via in, I mean, you're going to start to see the sales in the AHS business definitely increase. And so you're starting to see in the last few quarters that transition.

Michael Genau

Yes, that trend will continue, Matt. As these new products, when you start talking about the surgical demands for products and you talk about Via, as those things continue to come on...

Catherine Burzik

GRAFTJACKET.

Michael Genau

...GRAFTJACKET more and more. You're going to see a greater proportion of the revenue increase on the sales lines than rentals, so not unexpected.

Matthew Miksic - Piper Jaffray Companies

So is it something like a Prevena is -- is that a sale of the patient interfaces to the hospital, sort of an advance of utilization? I mean, is this a building up of Prevena and some of these other products in the pipeline? Or how should we read that?

Martin Landon

The products are being used in new wounds or new patients are being treated, so it's expanding our opportunity.

Michael Genau

Yes, and the way it's rolling out, is you're getting through a new products committee or value assessment committee, and it's not like then the hospital turns around and orders a large supply. It's still physician-by-physician converting care, one physician at a time. So you're picking up these things patient-by-patient. There isn't any forward stocking that's going on here.

Matthew Miksic - Piper Jaffray Companies

And then the rent and the rental for those will -- is that sort of, that catches up to the sales? Is that what happened?

Catherine Burzik

There's not a rental. These are disposable products...

Martin Landon

Single-patient use.

Catherine Burzik

...Matt, single-patient use.

Michael Genau

And for example, in the case of Prevena, it's being applied on the closed surgical wounds, so in the past, V.A.C. would very rarely, if ever, be used on something like that. So these are a completely new application. So it doesn't affect the rental line to speak of.

Matthew Miksic - Piper Jaffray Companies

Okay. So with the exception of that it's -- these are all sort of disposable sales that are going to continue to drive that line?

Catherine Burzik

No. As we've talked about, I talked particularly about Via. We anticipate Via eventually getting on 30% of the wounds in the hospital environment that are there today, plus expanding to wounds that don't even get in NPWT today. So all of that Matt, all of that Via revenue will be in the sales line.

Matthew Miksic - Piper Jaffray Companies

Okay, that's helpful. And then one for Marty on the investment. Our link to auto [ph] estimates, it looked like something like $2 million in incremental investment relative to our estimates in SG&A in the quarter. If I take your math earlier on the call, on this sort of $0.20 of incremental investment and sort of a reserve for litigation. How should we think about the spend per quarter? Is it -- Do we ramp up to something like maybe $5 million or $6 million in greater expense on the SG&A line?

Martin Landon

I think that once again as a percent of revenue, you're going to see that stabilize and come down a little bit over time because we're building some efficiencies into the system. So the 1 thing I would point out though higher, and I think that people should be aware of is, remember that when we had the royalty expense, there were offsets to that royalty expense for cost and expenses in the business. And those, of course, remained resident in the business now, because you don't have a royalty stream, so you have no offsets for either of those pieces either. So I would say basically, your SG&A may go up slightly, but it's going to come down as a percent of revenue.

Matthew Miksic - Piper Jaffray Companies

Got it. And then just finally, you talked about these commercial -- select commercial investments, anything you can expand on in terms of geographic or product line focus that you're contemplating there?

Catherine Burzik

On 2 areas. 1 is some specialist associated with selling into the surgical suite for Prevena and ABThera, and that's a very modest number, but Mike [ph] is adding those, particularly in the U.S. And then we believe that there is some countries in the southern part of Europe that could benefit from a commercial sense with -- as Mike talked about a few more feet on the street. That's primarily where we're looking. We're also looking at a modest investment in LifeCell associated with some additional sales force there.

Matthew Miksic - Piper Jaffray Companies

Great. Thanks for taking our questions.

Catherine Burzik

Sure.

Operator

Our next question comes from the line of Spencer Nam with Madison Williams.

Spencer Nam - Madison Williams and Company LLC

Thanks for taking my questions. Just a couple of quick questions on Japan. What's the current reimbursement situation on V.A.C. is? And how would the change in reimbursement potentially impact the adoption? Sounds like its getting a lot of attention early on, but I was curious what the reimbursement could do for the full product.

Catherine Burzik

So our reimbursement is, as we've talked about, Spencer, is good in Japan. We're getting roughly around $100 a day. You could think about it that way. The doctors are also getting reimbursed for utilization of the product, the hospitals are getting reimbursed for using the product. So there's a lot of favorable trends in Japan, and I've been talking to Lynne and Mike add [ph] too about this, and I don't see any negative things happening in the area of reimbursement over the coming cycles here in Japan. I think one of the things they're starting to look at is how long are the units really staying on folks. And right now, I think it was approved for 21 days, is that right?

Michael Genau

Yes.

Catherine Burzik

And with an option of -- I think the surgeon can go for another month. So I think it can -- I mean...

Michael Genau

Another week.

Catherine Burzik

...another week. So it can be a total of 28 days. I think they're looking at the patients that have gotten -- there's hundreds and hundreds now of patients, actually thousands of patients that have been V.A.C.-ed, and looking at the amount of time it stayed on these patients and trying to decide whether or not they should lengthen that reimbursement. So I continue to be pretty optimistic about the reimbursement trends in Japan.

Spencer Nam - Madison Williams and Company LLC

Great, I appreciate that. And then, second question is on V.A.C.Via. You used a phrase, "game changing" and I just wanted to get -- and there's some questions have come up already, but I just wanted to get a description from you guys, what exactly is making V.A.C., the Via, the game-changing-product? And how is that being manifest in real world situation within the hospital settings or the less acute settings? How is this Via -- what is Via satisfying that maybe traditional V.A.C. or other products have not been able to satisfy?

Michael Genau

Hey, Spencer, it's a good question. There are 2 things. 1 is, its very important for patients to be ambulated and get them out of the hospital as soon as they can. It frees up an expensive hospital bed. We see Via as a real enabler to making that happen. Also, it helps keeping patients out of the hospital. It may come into the ER [emergency room], who otherwise would have been admitted, treated and taken up an expensive hospital bed. So those patients can have Via applied in the ER and can be sent home. So it takes cost out of the system. Also, the product itself, it's a quieter product. It's got a smaller footprint, so it's more discrete, allowing patients, for example, with diabetic foot ulcer to return back to work or to go back with what they're normally doing, get on with their life. So it brings that quality of life notion higher. And the feedback, early on, has been a very positive in each of these areas in providing that flexibility to the caregiver. Also, there are wounds that may not have been treated with V.A.C., and Via is opening up opportunities to treat even more wounds. Split thickness skin graft is a great example where it helps that graft bolster better. And so the feedback has been very, very positive in each of these areas.

Spencer Nam - Madison Williams and Company LLC

Thank you.

Catherine Burzik

You're welcome.

Operator

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

Unknown Analyst -

Cathy, this is Eddy [ph] sitting in for Jason. Did I hear Marty correctly that there was no stocking of Via in the quarter?

Martin Landon

Yes. I mean, it's pretty much at this point patient-by-patient, position-by-position. We're starting to see some repeat orders along the way, but I don't think you should attribute any of that growth to a forward stocking situation.

Unknown Analyst -

But just to make sure, the Via product is sold in packages with multiple disposables, correct?

Martin Landon

It's sold in packages of 5, but they're 3-day applications.

Unknown Analyst -

Got you. And then, can you walk us through the dilution impact from convertibles? And can you purchase any in the open market ahead of the conversion?

Martin Landon

So we certainly have the ability to repurchase shares in the market. The convertible is -- we're in a period where we basically have accounting dilution. The initial conversion price is $51.34 as our stock price has gotten above that. Using the treasury method, you're going to start to see some dilution there. There's nothing in the current quarter related to that, but as you look out over the year, you're going to start to see some of that as we go forward, just given where our price has been. We do, as I mentioned, have the ability to do that. There is some things that we generally talk about with our board in terms of the uses of cash. And there are a number of options that we're looking at, but first and foremost, of course, we want to invest in the business, that the growth that we see, in terms of our innovation and globalization, we want to make sure we support that well. We continue to think diversification is a good use of cash, although we're being disciplined in our approach. We must meet certain hurdles, we were looking at those things. And then of course, we think a share repurchase is viable and that there are a number of factors that go into that as well. So we also have the bond hedge that will protect us as we go between the initial conversion price of $51.34 and $60.40, which is where that premium gets raised to. But you do see some accounting dilution, and we've accounted for that in our guidance.

Operator

And there are no further questions in the queue at this time. I will now turn the call over to Cathy Burzik for any closing remarks.

Catherine Burzik

I just like to thank everyone for the questions and for the support of the company, and wish you all a good day. Thanks very much.

Operator

Thank you ladies and gentlemen. This does conclude today's conference call. You may now disconnect.

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