Kinetic Concepts, Inc. Q3 2007 Earnings Call Transcript

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 |  About: Kinetic Concepts, Inc. (KCI)
by: SA Transcripts

Operator

Good day ladies and gentlemen, and welcome to the Third Quarter 2007 Kinetic Concepts, Inc. Earnings Conference Call. My name is Lacy and I will be your coordinator for today's call. At this time, all participants are in a listen-only mode. We will conduct a question-and-answer session towards the end of the conference. [Operator Instructions]. As a reminder this conference is being recorded for replay purposes. I would now like to introduce Mr. David Holmes, Director of Investor Relations for Kinetic Concepts. Please proceed, Mr. Holmes.

David Holmes - Director of Investor Relations

Thank you, Lacy, and good morning to all of you joining us to review our financial results for the third quarter of 2007, which we released earlier this morning. Today's conference call will begin with prepared remarks by Catherine Burzik, our President and Chief Executive Officer; and Marty Landon, our Chief Financial Officer. We are also joined by other selected members of the senior leadership team. Following our remarks, we will open the floor for questions.

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

Catherine M. Burzik - President and Chief Executive Officer

Thank you, David, and good morning everyone. On behalf of the KCI leadership team, thank you for joining us. This morning we reported a record quarter for KCI in terms of both revenue and earnings as we continue to execute our business plans. We reported record quarterly revenues of $411 million for Q3, which is an increase of 17% over the same period last year. Our growth and V.A.C. revenue continues increasing 19% over the prior year period to $329 million for the quarter, up $52 million over the same period in 2006.

Our surfaces business posted strong growth for the quarter as well with revenue increasing 11% over the prior year quarter. Net earnings for the third quarter were $59 million, which was an increase of nearly 21% compared to the same period a year ago. Diluted earnings per share were also strong at $0.82 for the quarter, up 22% over the same period last year.

Our results from the quarter demonstrate our continued commitment to double digit growth and revenues while at the same time creating leverage in the business such that growth and earnings outpaces revenue growth. I'm fast approaching my first anniversary here at KCI and I am pleased with what we have accomplished so far. We have made continued progress towards our strategic priorities that we set down at the beginning of 2007 aimed at increasing shareholders value namely continued global market penetration of both our V.A.C. therapy and therapeutic surfaces investing in innovation both in terms of our internal R&D portfolio as well as external M&A, and licensing opportunities and driving operational efficiencies.

We will continue to make changes to our business and to strengthen our organizational capability aimed at ensuring long-term revenue and earnings growth. We have tightened our revenue guidance for the fourth quarter and increased our EPS guidance. We believe that it is prudent to be conservative on our Q4 revenue projection in light of the healthcare reimbursement environment globally and continue streamlining of our internal processes aimed at strengthening KCI for the future. I think that my team is well aligned at what we must do to achieve the goals we've set for ourselves and I am excited about KCI's future. Marty will provide a more detailed review of our financial results at the conclusion of my remark.

I will now update you on several developments and important topics relevant to the third quarter and to our full fiscal year. There were several important factors that contributed to our success in the quarter. First, the global launch of our next generation NPWT system Info-V.A.C. continues and during the third quarter, we initiated product launches in the United States, Germany and Austria. Initial caregiver feedback has been favorable. Production levels have increased and the global rollout will continue to accelerate through the fourth quarter.

We also made good progress in the third quarter on the introduction of our next generation Active V.A.C. therapy system for the ambulatory and home-based patients where new designed features allow for increased mobility and enhanced ease of use. Our plans call for a city by city rollout in U.S. and we anticipate having the next generation systems fully deployed in approximately 25% of our U.S. homecare placements by the end of this year.

The international launch is being undertaken on a phase basis and it's scheduled to continue through next year with full deployment of these new technologies extending into 2009. We continue to monitor the competitive landscape and remain confident in our ability to grow back revenue despite the existence of additional market entrance. Alternative devices that have been launched to-date are comprised primarily of gauze-based wound drainage systems but aren't moving clinical outcomes. KCI V.A.C. therapy is a unique proprietary technology that provides unparalleled advance wound care, thereby enabling us to differentiate ourselves in the marketplace by providing superior patient outcomes that serve to lower the overall cost for both patients impaired.

This differentiation was well articulated at our September analyst day by four world renounced physicians in the field of advance wound care who like the over 60,000 V.A.C. prescribers continue to be the primary decision makers in the treatment of complex hard-to-heal wounds.

Growth in our therapeutic surfaces business at 11% was strong in the quarter as our strategy continues to focus on obtaining new business to GPO contract to profitably increase market share while reducing cost in our service structure. With regard to CMS and Medicare reimbursements, an reimbursement change resulting from the first round of the competitive bidding process is scheduled to be effective in July 2008. CMS has also announced plans for rolling out the competitive bidding process in an additional 70 MSAs in the second phase.

As I have said on previous calls, our strategy with respect to the bidding process is competitive information as it would be for any other major contract and therefore we do not plan to provide additional detail on our bidding strategy. Regarding international reimbursement, we are also working on responding to help technology assessment request in Europe regarding the efficacy of NPWT versus moist wound therapy for treating serious wounds. KCI can equally position in the NPW space as we have a large body of clinical evidence regarding the efficacy of that therapy, which we have utilized successfully in the past to respond to similar assessments.

On September 19th we announced plans for the development of a new manufacturing distribution facility in Ascension Island and we have made continued progress implementing our plans since the announcements. This facility will manufacture a next generation V.A.C. therapy units and disposables and will also be a key component of our supply chain as we further expand our reach into Europe. KCI solid business fundamentals have resulted in strong financial performance year-to-date in 2007 and have provided flexibility as we continue to execute on the strategic initiatives, I outlined earlier.

Amongst these initiatives is investing in new platforms for growth to both internal R&D investment as well as external technology licensing and acquisition. Our focus on growth and expansion is along two dimensions of the advanced wound care space but we seek to leverage our knowledge of the science of wound healing. The first axis for growth is expanding into lower acuity wounds. Today, V.A.C. therapy targets the wound population that we estimate to be approximately 3.4 million wounds per year for the markets we currently serve, which is comprised of the most serious complex and hard-to-heal wounds.

Our plans include the development of new anti-WT therapeutic surface systems that will effective treatment alternatives for less severe wounds not currently targeted by KCI. These new systems should enable us to penetrate into the additional 10 million wounds that today are treated by standard moist wound therapies.

Our second axis of growth aims at expanding along the wound therapy continuum for today, V.A.C. therapy focuses primarily of the areas with exudate management, edema reduction and the formation of granulation tissues. Broader portfolio applications will allow for treatment of wounds within the cleaning, debridement and disinfection phases. A recent example is our exclusive worldwide license for Neutraface, topical solution technology, reuse of our V.A.C. installation therapy.

We also have plans in place to introduce our negative pressure technology platform into the surgical suite where negative pressure can be used prophylactically. Additionally, our R&D plans include developing products aimed at heart tissue regeneration in the areas of bone, cartilage and meniscus.

Turning now to our therapeutic surfaces business, as you know this business competes in a mature, highly price sensitive market where growth will be primarily driven by market share. We believe that recent changes in outside Medicare with respect to reimbursement for hospital acquired pressure ulcers will serve to benefit this segment of our business. In August, CMS announced that effective October 2008, it would no longer reimburse for hospital acquired pressure ulcers and that announcement was followed on September 5th by an article on the Wall Street Journal, which highlighted the significant cost associated with treating this largely preventable condition.

The article featured KCI's atmosphere pressure relief mattress system, which has proven to be effective in both pressure release and pressure reduction. For over 15 years, KCI have offered programs that partner with hospitals to measure and manage both prevalent and incident of hospital acquired pressure ulcers and this program will continue to be a valuable tool in helping hospitals improve outcomes and navigate the changing reimbursement landscapes. Going forward, our plans for this line of business will be to target disciplined growth. The focus is on the profitability of both the product portfolio as well as our contract relationships. Due to our focus on profitability, we think it is reasonable to expect a reduced rate of revenue growth for our surfaces business for the next few quarters.

Steps are also underway to ensure that our cost structure will allow us to be both efficient and competitive. We continue to make significant progress in our globalization efforts and we are now beginning to see the benefits of this work. These efforts have allowed us to improve communication, eliminate redundancies and operate the business more efficiently. I'm pleased to report that we are ahead of schedule in our clinical trials in Japan, which are now fully enrolled. This is an important first step as we seek to enter Japan and the border Asia-Pacific markets.

On the people side of the business, we continue to make progress in our efforts to create a best in class senior leadership team. I'm pleased to report that we have recruited Mike Schneider who joins us as Senior Vice President of Operations. Mike brings over 30 years of proven global leadership experience in the areas of service and manufacturing, and his experience includes work of Eastern Corner [ph] Company and Applied Biosystems. In his new role, Mike will oversee our global service manufacturing and supply chain operations.

I'm also pleased to announce the promotion of Rohit Kashyap to the position of Senior Vice President, Corporate Development. Rohit has been leading of strategy of business development efforts on an interim basis over the last year where he has directed our business acquisition and technology licensing initiatives. He has been a member of the KCI team since 1998 and holds a PhD at biomedical engineering from Cape Western Research Reserve University and a MBA from the Kellogg School of Management at Northwestern University. Both Rohit and Mike are members of the KCI community and report directly to me.

We are also making solid progress in recruiting new leadership for our European and Asia-Pacific markets. In summary, we are very confident in our demonstrated ability to compete successfully in the market. We are focused on executing to our strategic priorities and are building a strong leadership team and strong business prophecies aimed at assuring KCI's future. At this time, I will turn the call over to Marty Landon who will brief you on our quarterly financial results.

Martin J. Landon - Sr. Vice President, Chief Financial Officer

Thank you, Cathy, and good morning everyone. Our third quarter financial results reflect strong business fundamentals and a capital structure that is well positioned for growth. Revenue for the third quarter of 2007 was $410.9 million, which was up $60 million or 17% over the same period in 2006. Foreign currency exchange movements favorably impacted third quarter revenue by approximately $8.3 million.

On a sequential basis total revenue for the third quarter was up $14.2 million or 4% from the second quarter 2007 levels as demand for V.A.C. therapy continues worldwide. Net earnings for the third quarter were $59 million, up $10 million or 21% over the same period last year. Net earnings per diluted share increased to $0.82, up 22% over the third quarter of the prior year despite recording one-time refinancing charges of $4.5 million net of taxes or $0.06 per diluted share associated with the completion of our new $500 million revolving credit facility.

Net earnings growth in the third quarter outpaced our revenue growth consistent with our expectations, driven primarily by the improvement in gross profit for the period. Domestic revenue for the third quarter was $294 million, an increase of $39.8 million or 16% over Q3 2006. International revenue of $116.8 million for the third quarter was up $20.2 million or 21% over the year-ago period. Looking at our revenue by product line, global V.A.C. revenue growth continues to lead the way, increasing to $328.9 million for the quarter, up 19 % over the same period last year.

Our growth in the quarter was driven by continue demand for our V.A.C. therapy system, both in the U.S and abroad. U.S. V.A.C. revenue for the period was $244.9 million, an increase of $35.7 million or 17% over the same period last year. Third quarter revenue units increased across all care settings, although as expected homecare growth rates continue to exceed growth rates in the institutional settings.

International V.A.C. revenue for the third quarter grew to $84 million, an increase of $16.4 million or 24% over the year-ago period. Higher V.A.C. rental units and use accounted for the majority of the period over period increase and growth rates varied across geographies. Favorable foreign currency exchange rate movements accounted for $5.9 million of the international V.A.C. revenue increase.

We've now experienced four consecutive quarters of strong V.A.C. growth during the period of changing global healthcare reimbursement and increased competitive entrance and I think that speaks to the clinical and economic advantages associated with the use of KCI's V.A.C. therapy system as evidenced by continued strength in prescriber patterns.

Worldwide revenue for our therapeutic surfaces business as Cathy said had impressive growth for the third quarter at $82 million representing $7.9 million or 11% increase over the same period last year due to favorable trends both in units and use and average price. Domestic surfaces revenue for the third quarter of 2007 was $49.1 million, up 4.2 million or 9% over the same period last year due primarily to a large number of account conversions under GPO contracts.

International surfaces revenue increased to $32.9 million for the quarter, up $3.8 million or 13% over the same period in 2006. Favorable foreign currency exchange rate variances accounted for more than half of the increase in international services revenue. Gross profit for the third quarter was $204.2 million, an increase of $40.1 million or 24% over the third quarter of 2006. Gross margin was strong at 49.7% improving by approximately 290 basis points over the prior year period and 180 basis points sequentially. Strong demand for both V.A.C. and therapeutic surfaces combined with field service efficiency and lower depreciation and product marketing cost contributed to our strong margin performance.

Our financial guidance for the remainder of this year reflects our plans to reinvest some of this additional margin in areas such as international sales force expansion and global marketing programs associated with the current launches of the Info-V.A.C. and Acti-V.A.C. therapy systems. These investments along with others will play a significant role in helping us to achieve solid revenue growth over the next several years.

During the third quarter, we also recognized share-based compensation expense of $6.6 million before taxes under the provisions of FAS 123R, which is $2.6 million higher than the third quarter of the prior year. We also recorded other expenses in the third quarter related to reserves on selected non-core therapeutic surfaces inventory and rental assets, as we look to drive product rationalization and improve profitability in this part of our business. We increased our R&D spending for the quarter by $1.8 million year-on-year and for the quarter our total investment was $11 million, representing 20% increase over the third quarter of 2006.

We expect additional increases in R&D spending going forward as we continue to broaden and leverage our knowledge of the science of wound healing to drive further innovation in negative pressure technology platform applications. Below the operating line, our results for the quarter reflect the progress as it has been made over the last few years in increasing liquidity and reducing leverage.

During the third quarter, we completed our new $500 million revolving credit facility and used a portion of the proceeds to repay the remaining balance outstanding on our term long B and to regain the remaining $68 million outstanding under our seven and three-eight percent senior subordinated notes. As a result of this transaction, we recorded one-time charges of $4.5 million net of taxes or as I said $0.06 per diluted share. Our effective income tax rate was 34.2% for the third quarter and 33.6% on a year-to-date basis. The year-to-date tax rate is up slightly from the 2006 period due to favorable resolution of certain tax matters last year.

Free cash flow for the first nine months of the year was strong at $137million. Increases in free cash flow versus the same period last year resulted primarily from higher net earnings and good working capital management. Our balance sheet continues to reflect high liquidity and reduced leverage. Our cash balance was $164.2 million at quarter end, which was down slightly from the second quarter of 2007 due primarily to voluntary payments on our revolving credit facility. Out net accounts receivable balance at the end of the quarter was $357 million, up $29 million from year-end levels due primarily to our strong revenue growth.

Payor relationships remain good due to increased process efficiencies and proactive relationships management. Total days revenue outstanding for the period declined by just under two days from the same period in 2006. U.S. receivable days outstanding decreased 3% from 77.4 days at September 30, 2006 to 75.1 days for the third quarter of 2007. International days outstanding also improved falling from 88 days in the prior year period to 86.6 days for the current quarter.

We continued to work during the quarter on Medicare claim audit covering prior years. While I cannot predict the ultimate outcome of these examinations, we have experience in successfully handling these types of audits and we have met submission date deadlines with respect to all requests for information. Our long-term debt balance at quarter end was less than $100 million and our trailing 12 month EBITDA is now $443.4 million.

On July 31, we successfully closed our revolving credit facility and upon completion, we borrowed $150 million to repay the outstanding balance due on our then existing senior credit facility plus certain fees and expenses associated with the transaction. On August 31, we redeemed the remaining $68.1million under our senior subordinated notes and paid a make whole [ph] premium and accrued interest expense of approximately 5.1 utilizing additional borrowings under our rewarding credit facility.

We also repaid a total of $100 million under the new revolving credit facility during the quarter. The new financing is designed to provide enhanced strategic and operational flexibility and a capacity with fewer and less... restrictive covenants and a lower overall cost of capital. S&P rate of this debt investment grade and this indication was well over subscribed.

We made no open market share repurchases during the quarter under our previously announced share buyback plan. This morning's press release included changes in our 2007 financial guidance, which now reflects full year 2007 revenue projected at $1.58 to $1.60 billion and earnings per diluted share of $3.20 to $3.30 per share. The revised guidance reflects our latest thinking around the range of business factors including the current dynamics of healthcare reimbursement and our ongoing investments with respect to positioning KCI to achieve our strategic priorities.

We remain confident in the strength of our business fundamentals. And finally, we expect to file our quarter report on Form 10-Q with the SEC in early November. This will conclude our prepaid remarks and at this time, we will turn the call back over to the operator to begin our question-and-answer session. Operator?

Question And Answer

Operator

[Operator Instructions]. And our first question comes from the line of Tao Levy with Deutsche Bank. Please proceed.

Unidentified Analyst

Yes, good morning. This is Seth [ph] in for Tao. Congrats on a good quarter.

Catherine M. Burzik - President and Chief Executive Officer

Thank you.

Unidentified Analyst

So Cathy, just a couple of questions. First on the domestic V.A.C. competitive landscape, so have you felt any competitive pricing pressures for the V.A.C. or have you... and I guess have you won any big contracts that have helped drive the V.A.C. business domestically?

Catherine M. Burzik - President and Chief Executive Officer

Sure. Let me talk a little bit about that. We have not seen any increased competitive pressures on the domestic front associated with V.A.C. therapy, so that'll be the answer to that. I believe in the last call we talked a little bit about our position with Premier. We got a very good position with Premier, very recently associated with V.A.C. and we are certainly cashing in on that now.

Unidentified Analyst

Okay. Second, I guess coming on to the analysts meeting you talked about, a lot about low hanging fruit. I assume some of that pushed through to the margin line, the rental margin line this quarter. So one, is there any additional leverage on that rental profit margin line? And two, when new manufacturing facility comes on, is that going to negatively impact the margins, if I heard correctly appreciation just helped a little bit and noticing out to the opposite direction?

Catherine M. Burzik - President and Chief Executive Officer

Maybe I'll turn that question over to Marty.

Martin J. Landon - Sr. Vice President, Chief Financial Officer

Yes. We did have good margins. We have said historically that we believe there is leverage in the model and as I said in my comments, we are going to manage that to make sure that we make the kind of investments necessary to continue the top line growth. So while there is leverage in the model, we will moderate that a little bit of long lines of what we told people in the past, look for 50 to 100 basis points of margin expansion, some of them at the gross profit line, some of that at the operating profit line. I don't think that's changed. In terms of the Irish manufacturing facility, certainly we think that we have got other activities going on, as we look at those kinds of things we look to, to manage our margins. So I wouldn't expect a significant margin squeeze as a result of that coming online.

Unidentified Analyst

Okay. And Marty, should we model in any future tax, lowering of the tax line from this manufacturing facility and when?

Martin J. Landon - Sr. Vice President, Chief Financial Officer

Certainly Ireland has a lower tax structure than what we see in other parts of the world and so I would expect that over time as we produce product there, we would have an opportunity to lower our effective tax rate. I think that that will be measured but we do see that coming down over time.

Unidentified Analyst

And when does this come online?

Martin J. Landon - Sr. Vice President, Chief Financial Officer

We'll start full production in the first quarter of 2008.

Unidentified Analyst

Okay. Thank you very much. Congrats.

Catherine M. Burzik - President and Chief Executive Officer

You're welcome.

Operator

Our next question comes from the line of Michael Weinstein with J.P. Morgan. Please proceed.

Unidentified Analyst

Thanks. It's Taylor [ph] here for Mike. So, Cathy congrats on nearing anniversary number one and Marty on a few more than that.

Catherine M. Burzik - President and Chief Executive Officer

Thank you, Taylor.

Unidentified Analyst

First question is, let's talk about the U.S. V.A.C. business and the components of growth there. Can you split that out for us roughly between units, pricing and payor mix, etcetera?

Martin J. Landon - Sr. Vice President, Chief Financial Officer

Yes, I would... this is Marty, Taylor, and thanks for recognizing the longevity. Yes, so primarily unit driven, business continues to be driven by increased units and market penetration. We do see as we've mentioned in our commentary, improved revenue realization so we have seen at least stable pricing if not a slight increase in overall pricing related to our ability to build and collect particularly in the home. Mix does have an impact and has had a negative impact overall, because we see more growth particularly in Medicaid, which has a lower rate. So that kind of offsets a little bit of the revenue realization. But I think from a modeling standpoint, if you think of the revenue growth as primarily driven by units, you are in a good place.

Unidentified Analyst

Okay. So if we compare it to the second quarter, which... second quarter surprised us with the reacceleration of U.S. V.A.C. but it seemed like that was driven... you had a fairly stable unit growth rate in the 20% to 21% range, this was my impression with the fluctuations around that being pricing, mix. So this quarter if we... as we go from 22% in the second quarter to 17% in the third quarter, did unit growth stay in that 20% to 21% or was it fluctuations again in pricing and mix?

Martin J. Landon - Sr. Vice President, Chief Financial Officer

It was closer to the revenue line, so we actually saw unit growth that was down a little bit from what we saw in the second quarter on a percentage basis year-on-year.

Unidentified Analyst

Okay, so unit growth was closer to the 17%?

Martin J. Landon - Sr. Vice President, Chief Financial Officer

Correct.

Unidentified Analyst

Okay. And is there anything to attribute that to, any particular care setting?

Martin J. Landon - Sr. Vice President, Chief Financial Officer

If I had to pick a care setting, I would generally scribe that to the acute care environment where we have seen lower senses, we have seen some things where they are getting squeezed a little bit from a reimbursement standpoint, but nothing on market I would say in terms of that change. I think you just see a number of factors. There are... as you grow the business, there are natural points of resistance in the business both in the U.S. and Internationally, and as I said in my comments, we saw growth that varied by geography and as you think about that environment getting homecare reimbursement becomes important as you move forward because this becomes a fairly significant line item in certain institutions and you get to a point where you not only have to do the clinical sale, which we are very good at but you also have to do the economic sale to keep pushing through. And those are things that we've dealt with in the past and so the expectation here is that we will move through those as well.

Unidentified Analyst

Okay. And does that affect your... as we think about the fourth quarter guidance, which based on the full year guidance implies I think sales growth of 9% to 14%, which would certainly represent a deceleration from what you have done so far in the year. I know you talked about the surfaces business expecting lower revenue growth there but is there an expectation for deceleration in the V.A.C. business as well?

Catherine M. Burzik - President and Chief Executive Officer

Taylor, this is Catherine. Let me just comment a little bit about that. As Marty indicated in his comments, we've had four quarters now of very strong growth and that growth rate began at fourth quarter of 2006, so one of the things to take into account here is the comparison this quarter to last quarter. That's said this global healthcare reimbursement environment that Marty spoke a little bit about has created some cost pressures both domestically and internationally. In the domestic area, I will give you for example the fact that Medicare has reduced the reimbursement for the long-term acute care facility, so they are really struggling right now on how best to move forward. And so we obviously have to... have to work through that and deal through that. We've done that successfully in the past.

In international, we see some additional health technology assessments and these health technology assessments come from various countries within Europe that are actually trying to understand what is the effectiveness of negative pressure wound therapy versus moist wound therapy, and so we have to work through these on a case-by-case basis. The good news here is, KCI as you know has a large volume of evidence associated with the clinical and the economic effectiveness of V.A.C. We have shown time and again that we can put that evidence forward and work through these kind of situations both domestically and internationally, and we certainly intend to do that but I thought it was prudent to try to factor in what we think the impact that those are going to be in Q4.

Unidentified Analyst

Okay, great. And then just last question and then I'll drop. Gross margin was very strong, can you just go through the reasons for that again and how much of that is sales force productivity driven?

Catherine M. Burzik - President and Chief Executive Officer

There is certainly a piece of that gross margin is sale force productivity driven, which you see on the top line results were pieces [ph]. Our service organization productivity driven in there as well as you starting to see some of the benefits associated with our globalization efforts. That said I want to just repeat something that Marty indicated. You know as we look to that kind of growth margin, we definitely want to take some of that margin going forward and invest it particularly in our international sales organization where we look to build capability in Japan going forward as well as growth in certain European countries. We also want to invest this in a number of marketing programs as we go forward here for Info-V.A.C. and Acti-V.A.C. So we have places that we want to invest that money.

Unidentified Analyst

Okay. Thanks a lot.

Martin J. Landon - Sr. Vice President, Chief Financial Officer

Thanks Taylor.

Operator

Our next question comes from the line of Mark Richter with Jefferies & Company. Please proceed.

Mark Richter - Jefferies & Co.

Yes, good morning guys and great quarter.

Catherine M. Burzik - President and Chief Executive Officer

Thank you, Mark.

Martin J. Landon - Sr. Vice President, Chief Financial Officer

Thank you, Mark.

Mark Richter - Jefferies & Co.

Few questions first, so excluding the $0.06 one-time financing charges, you would have done $0.88, you know, first closed at $0.79 and analysts were sort of mixed in terms of some taking out the charge or some including it on their estimates for the quarter, so first call was a little bit nebulous. That said you posted a great EPS number, can you give us a bit of more color on what drove the dramatic upside?

Catherine M. Burzik - President and Chief Executive Officer

Well, I will comment a little bit and then Marty may also want to comment but thank you for the compliment. Yes, we are definitely proud of the quarter. I mean we are focusing a lot on the internal management of the business and I think you see some of the fruits of that coming in this quarter. I just talked a bit about the gross margin piece and what drove that gross margin, so you see a lot of it coming from, actually from the gross margin line leveraged on to the bottom line. And as we said that, it comes from both certainly sales force productivity but also improved efficiency facilitated with our service organization. And then also, we think that we could spend more in the marketing area than we have spent, so some of that comes from what I would call an under spend in the area of marketing.

Martin J. Landon - Sr. Vice President, Chief Financial Officer

Yes, I think the global alignment efforts have been effective to this point, Mark, and I think they have eliminated some redundancies in terms of people repeating processes and that's helped. Certainly, we have had good strong revenue growth and we have had stable pricing that helps pricing always results in better margins. I think that we have put in place programs that were just not rolling out in terms of new products and so those types of things have helped us generate higher margins. We look forward and we say, look you got to have those marketing programs for these new products that you go forward. You got to expand the work force as you look forward and so that is why we are saying that this is a very solid margin growth, but don't get carried away. We are going to manage this as we invest for the future.

Mark Richter - Jefferies & Co.

Perfect. And just on the gross margin topic, where do you see sort of peak gross margins coming on?

Catherine M. Burzik - President and Chief Executive Officer

Peak gross margins?

Mark Richter - Jefferies & Co.

Yes, peak gross margins, correct.

Martin J. Landon - Sr. Vice President, Chief Financial Officer

Oh, hard to say. I mean... as I said, we think that we have an ability to expand margins as we go forward. Our expectation in the short-term is that we will be higher than where we have been but again, we will measure that. Could we get above 50%, I think that as you think about a pattern of expanding margins, it's not inconceivable to think that you would get there at some point but that is dependent upon a number of factors including reimbursement, including product innovations, etcetera, etcetera. So I'd hate to predict that, but we do think there's leverage in the model.

Mark Richter - Jefferies & Co.

Okay, perfect. And then, can you give us a sense of timing for your swims product. You talked about using that for prophylactic use during your analyst day and earlier in the call, in the surgical suite, but can you give us a sense of timing of the launch and maybe any anecdotal feedback from Wake Forest where they are already using V.A.C. for this use?

Catherine M. Burzik - President and Chief Executive Officer

Sure. The product is under development as we talked about in our analyst day. I want to be careful here about predicting market availability because we have got to get the product finished, and then we also have to get it through regulatory approval. So you can assume that it is a product probably in the 2009, 2010 kind of timeframe most likely. So it's not an imminent product, but it's a product that we feel very good about and expanding into what I'll called over 2 million surgical wounds that today are treated, and quite often some of those wounds today are even treated with V.A.C. and that is exactly what Wake Forest your question is doing? Wake Forest is... from my understanding and talking to Dr. Ajanta uses V.A.C. prophylactically with just about every surgery that they do. So you do find some physicians that are already doing this even though we think V.A.C. today works in that vein, we do think that our improved product, which is really going to be earmarked specifically for surgery is going to be a better product for that application.

Mark Richter - Jefferies & Co.

Okay, perfect. And then the last question is, so I am just... your strategy for global expansion sounds like it's progressing very well. Can you give us a sense of what the next countries we can expect approval and/or your sort of focus on?

Catherine M. Burzik - President and Chief Executive Officer

Sure. And yes, we are definitely focused a lot on global expansion and that includes both strengthening the penetration within Europe to the point that Marty made around investing in our international sales organization will be a key thing that we move forward with in 2008. This includes for example, we are strong today in Germany and we are working towards a potential for homecare reimbursement in Germany, but we are also investing on sales force expansion in France and in Spain, if you look beyond and perhaps in the U.K. if we can get some additional reimbursement for home use in the U.K.

If you look into Asia, this is going to be a key area for us going forward in 2008 and 2009. Particularly in Japan, where as I commented in my comments; we are really pleased that we were able to accelerate the whole enrollment and the completion of our clinical trials in Japan. And the results to-date look good so far and we are putting together now our strategy here for getting regulatory and reimbursement approval in Japan. As we go forward and bring on... ahead of Asia Pacific then we are close to being able to announce that individual, we will give that person some priorities here associated with expanding from Japan and to really understanding what the market opportunity would be for China and India. So those will be key focuses for us as we move into Asia.

Mark Richter - Jefferies & Co.

Great, very helpful and again, great quarter. Thanks guys.

Catherine M. Burzik - President and Chief Executive Officer

Thank you. Thanks Mark.

Operator

Our next question comes from the line of Mark Mullikin with Piper Jaffray. Please proceed.

Mark Mullikin - Piper Jaffray

Good morning. I'd just like to get a little more color on the nature of the health technology research assessment. Which countries have you received those and does that have any immediate impact on your ability to place V.A.C. systems.

Catherine M. Burzik - President and Chief Executive Officer

Sure Mark. I'd be happy to provide some color on that. These... our health technology assessments are things that I know that KCI has dealt with for the last several years, but more recently in the last several months, we have gotten technology assessments request from the Netherlands and from Belgium, and from the U.K. I think those are the three major countries that we have them in. And they take several different flavors. Generally, there is not an immediate impact, although some times there is. Generally, there is not an immediate impact but you have some time to work with the government to provide the evidence about the overall clinical and economic outcomes associated with V.A.C. So we work through this on a case-by-case basis that I said. In some cases, I'll tell you in particular of the case that happened in the Netherlands, this was a little bit of a different one. In the Netherlands, we did see an immediate impact as a result of that because in the Netherlands, although really in the homecare environment, no longer allowing that to be placed until we can get through that assessment with them.

Mark Mullikin - Piper Jaffray

Okay. And then on the competitive front, two of your competitors have signed agreements with Universal Hospital Services, commonage rentals of their devices and I was just wondering, what differentiates your model from a model like that in terms of just how the customer interfaces with you?

Catherine M. Burzik - President and Chief Executive Officer

Yes. I understand and yes, I am aware of those two competitors that have signed, one in services and one in the area of V.A.C. I have a pretty strong perceptive about this. I am very proud of the capability that KCI has to directly distribute and service our product and interact with our customer, and I've traveled enough now to interact with many of our customers around the world and understand that it is the combination of our sales organization, our distributional organization, our service organization and ability that we have to do collection and billing directly that it is really... I mean, I call it part of this KCI clinical advantage. So I think it is a key advantage that we have and it's a model that KCI put together some time ago. We execute that model globally. I mean, we intend to continue to do that.

Mark Mullikin - Piper Jaffray

Okay. And then just one last one, have you seen any competitive phone-based systems out in the field?

Catherine M. Burzik - President and Chief Executive Officer

We have not seen any competitive phone-based systems out in the field.

Mark Mullikin - Piper Jaffray

Okay. Thank you very much.

Catherine M. Burzik - President and Chief Executive Officer

You're welcome.

Martin J. Landon - Sr. Vice President, Chief Financial Officer

Thanks Mark.

Operator

Our next question comes from the line of Michael Watson with Wachovia [ph]. Please proceed.

Unidentified Analyst

Hi, thanks for taking my question. I guess just with regards to Japan, can you remind us how much follow-up is going to be required there? And then secondly, what is the number of wounds in that market you think you can treat? And then finally, are there any other types of... maybe gauze-based NPWT systems on the market there?

Catherine M. Burzik - President and Chief Executive Officer

Sure, so... we started this clinical trial in Japan last December and the trial is now totally enrolled. The patients are not totally through it but they are close to being totally through it, and then we will put that data together and work with what's called the, pharmaceutical manufacturing distributional organization, PMDA in Japan and the Ministry of Health in Japan to obtain reimbursement. The reason why the Japanese market is attractive... an attractive market for us is it's known that the length of stay in Japan is quite long. That's the Japanese philosophy of healthcare. They like to keep the patients in the hospital for a longer period of time than they do for example in the U.S. or in Europe. We think that V.A.C. will be uniquely suited to treat wounds in the Japanese market. When we look at the acute-care space alone, we think that it's 200,000 type of annual wound opportunity in Japan. And so a major piece of work that Woody Staub and his team will work on during the course of this year is starting to develop the commercial capability for us to go-to-market in Japan. Did that answer the question?

Unidentified Analyst

For the most part but are there any competitive --

Catherine M. Burzik - President and Chief Executive Officer

Oh yes, you question about competitive. Yes, to my knowledge there are no competitive negative pressure wound therapy systems in Japan. My understanding is to do wound drainage. They do sometimes use valve suction, valve suction counts, which is common I know around the world to do that. But as far as the whole mechanism of action and the healing that one gets not just draining the wound but the healing of the wound as far as I am aware and I have been over there now a few times. I am not aware of any other NPWT company on the market there.

Unidentified Analyst

All right. And then you talked a little bit about expecting some reimbursement pressure and I think that from what we have seen... that is kind of common, just generally across medical device industry but specifically with regards to negative pressure, how do you think that will manifest itself. Do you think that that will lead to slower unit growth for your V.A.C. systems or maybe pricing pressure or more of these healthcare assessments types of things?

Catherine M. Burzik - President and Chief Executive Officer

It's all the way. Let me just give you my philosophy on that and maybe Marty will want to comment on this too. But as the dollars... V.A.C. is such a fabulous treatment alternative that cost little [ph]. I was recently at the American Association of Trauma Surgeons and they complimented us on creating the V.A.C. and they said that we revolutionized their ability to treat patients... to treat patients that they could never heal before. And so with that comes a lot of growth and with the growth, the numbers get larger, different levels of administration become more and more aware. I mean that's like what's happened at CMS where it becomes a large number and it becomes... the insurance companies become aware of this and the administration becomes aware of this.

I think it is incumbent on KCI to be able to provide the evidence about the overall cost effectiveness and clinical outcomes of V.A.C. and if you net out all of our clinical trials, the answer here is that you have 35% reduction of wound healing time. And you have a 25% reduction in the overall cost... I'm sorry, 25% of the overall cost of treating the wound. That's been now proven to many different clinical trials. We have to package all that information together in our leadership changes in these different hospitals, leadership changes in government and we have to continue to sell the story. I think the comment I will also make is that there is obviously no other participant in the NPWT space that could possibly have the body of evidence that KCI has. So we are truly advantage as we go forward. But the reality is that we are breaking into a new category. We're developing a whole new category in our healthcare. So as a result of that... as the size of the category grows, certain individuals become concerned about the overall dollar spend.

Martin J. Landon - Sr. Vice President, Chief Financial Officer

Yes. And Mike, the only thing I'd add to that is I think that... I'm not sure exactly how it ends up manifesting itself. But anything where you have a restricted reimbursement, those things that get better outcomes that reduce treatment times or cost of care are going to work favorably. So logically in my mind, I think it actually has the opportunity for us to drive demand because we have a product that gets good positive outcomes. You think back to 1983 in the surfaces business when DRGs came out, right, and there was a fixed payment reimbursement. Well, actually our unit volume went up and the reason it did is because we were getting patients... keeping them from getting pneumonia, keeping them from getting pressure sores, things that would increase the cost of care and I see this somewhat similarly as reimbursement continues to get constrained, those products that bring real effective outcomes actually are advantaged.

Unidentified Analyst

All right. And then are there any updates that you can provide on your business development activities and in your acquisition strategy?

Catherine M. Burzik - President and Chief Executive Officer

Mike, it's the same thing that we always say here. We are actively involved in a number of potential things here that we are looking at. I think it's important for us to go forward in the areas that we talked about at the analyst day that we continue to look at and to build by capability. So I think that's probably all that I really want to say about the business development at this point.

Unidentified Analyst

All right, that's all I have got. Thanks a lot.

Catherine M. Burzik - President and Chief Executive Officer

You're welcome.

Operator

[Operator Instructions]. Our next question comes from the line of Randy Heck with Grownow [ph] Investment Group. Please proceed.

Randall Heck - Goodnow Investment Group

That's Goodnow. Hi, good morning. My question is on Japan and it was pretty much answered, but maybe I will ask one other question about Japan. What is the timeframe now, your best estimate of timeframe?

Catherine M. Burzik - President and Chief Executive Officer

Okay, Randy. Thank you for asking the question. We are putting together the results of the clinical trial as we speak here, and would anticipate in the first part of next year interacting with the right government agencies in Japan to cement for regulatory approvals. And we will shortly after that begin the reimbursement approval process and we will start to build commercial capability next year. My organization in Japan continues to tell me that in 2010 is when they will be on the market and I continue to push V.A.C. and try to get them to start thinking about 2009. So we will see whether we are able to get some on the market in 2009, but I certainly would see that we would be with key opinion leaders, we would be with key universities. We should have some major placements with beta sites, etcetera, I would say by the end of '08 and certainly then into '09.

Unidentified Analyst

Okay, okay. That's all I had.

Catherine M. Burzik - President and Chief Executive Officer

Okay. Thank you, Andy.

Operator

And our last question comes from the line of Spencer Nam with Summer Street Research. Please proceed.

Spencer Nam - Summer Street Research

Good morning, Cathy and everyone. Thanks for taking my call. Just a couple of quick questions. On this lawsuit that was filed by the ITI, any comments you guys can provide on what... where that is and what you guys want to do with that?

Catherine M. Burzik - President and Chief Executive Officer

Hi Spencer. How are you? I am going to turn the question over to Steve. You know that we don't provide very much color on these kind of things but we are certainly aware of the ITI suit.

Stephen D. Seidel - Sr. Vice President, General Counsel and Secretary

Yes, Spencer, on the public filings there in Delaware, you can see that we have now filed a responsive motion which is a motion to dismiss. This is actually a device [ph] that we haven't seen... at least haven't seen to date in the marketplace. We don't even know the product specifications of it. So we filed a motion to dismiss kind of stating that we view that as a premature filing at this point. And the judge may rule. But again, this is a product that we haven't seen. It hasn't been introduced as far as we can tell out in the marketplace yet and we will see how it develops from there. We will probably know more a quarter from now as to how that's going to proceed.

Spencer Nam - Summer Street Research

Great. I appreciate that. And then second question is just on your current conversations or relationship with CMS whether you guys are in conversations with them on various issues with respect to the negative pressure space in the V.A.C. and how the CMS is responding or viewing the overall product... the different data that you have presented over the past years?

Catherine M. Burzik - President and Chief Executive Officer

So, I will give a few comments on that, Spencer. We continue to work with CMS. We also continue to work with the FDA and other areas of helping human services here to tell the overall V.A.C. story. My emphasis in going forward and I personally spent a lot of time now with CMS, my emphasis here in going forward will be through our Chief Medical Officer and kind of the health economics and reimbursement part of our organization. I think there is wonderful opportunity that KCI has at this point with the approval of Info-V.A.C. and Acti-V.A.C. for home use, which no other NPWT provider has to go back to CMS and try to explain to CMS the huge amount of data that we had to provide to the FDA in order to get that clearance, which I think really separates us from any other providers in the state. And so I think that is the really important part of the work of Dan Ciaburri and his team, and they have already started a plan relative to meeting with the individuals that we need to meet within CMS to begin to tell that story. So that clearly is part of it as well as the overall new data that we have from our diabetic foot ulcer trial that we just talked about in the last earnings call is also very compelling data about the overall effectiveness of V.A.C. versus moist wound therapy. So I think those are important things for us to go back to CMS and tell the story. Did that help somewhat?

Spencer Nam - Summer Street Research

That sounds good. It was very helpful. Thank you.

Catherine M. Burzik - President and Chief Executive Officer

Okay. You're welcome.

Operator

I would now like to turn the call back over to management for closing remarks.

David Holmes - Director of Investor Relations

Thank you, Lacy. This concludes our third quarter earnings call. We appreciate your questions and participation and on behalf of the KCI team, thank you and have a great week.

Operator

Thank you for your participation in today's conference. This concludes your presentation. You may now disconnect. Good day.

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