Kinetic Concepts Inc. Q1 2008 Earnings Call Transcript

Apr.23.08 | About: Kinetic Concepts, (KCI)

Kinetic Concepts Inc. (NYSE:KCI)

Q1 2008 Earnings Call

April 22, 2008  8:30 am ET

Executives

David Holmes - Director, Investor Relations

Catherine Burzik - President and CEO

Marty Landon - Chief Financial Officer

Linwood "Woody" Staub - Global V.A.C. Therapy President

Analysts

Vincent Ricci - Wachovia

Tao Levy - Deutsche Bank Securities

Jayson Bedford - Raymond James

Mark Mullikin - Piper Jaffray

Taylor Harris - J.P. Morgan

[Paul Houdelik - Silverback]

Operator

Good day, ladies and gentlemen, and welcome to the first quarter 2008 Kinetic Concepts Incorporated earnings conference call. My name is [Shaquanna], and I will be your coordinator for today. (Operator Instructions) I would now like to turn the presentation over to your host for today's call, Mr. David Holmes, Director of Investor Relations for Kinetic Concepts. Please proceed, Mr. Holmes.

David Holmes

Thank you, Shaquanna, and welcome to the KCI first quarter 2008 conference call. Today we will review the results that were announced in our press release earlier this morning. Our conference call will include prepared remarks by Catherine Burzik, our President and Chief Executive Officer, and Marty Landon, our Chief Financial Officer. We are also joined by other selected members of our senior leadership team. Following our prepared remarks we will open the call 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 Burzik

Thank you, David, and good morning everyone. Today's call will begin with general comments and key takeaways from the earnings release that we posted earlier this morning. I will then provide updates on a range of topics, including the status of our plans for the strategic acquisition of LifeCell Corporation which we announced on April 7.

This morning we released our results for the first quarter of 2008, which showed continued strength in the fundamentals of our business. Total revenue for the period was $420 million, up 14% from the same period last year. V.A.C. revenue continues to fuel our growth, increasing $44 million or over 15% from last year. Our Therapeutic Support Systems business also demonstrated strong performance, up 8% over the same period in 2007.

Net earnings for the period were $68 million, which is an increase of 27% over last year. Diluted earnings per share were also strong at $0.94, which is a 25% increase over the same period in 2007.

Marty will provide a more detailed review of our financial performance at the conclusion of my remarks.

I would now like to discuss our plans to acquire LifeCell, and I'm very pleased to report that yesterday we launched our tender offer. This opportunity represents an important step in advancing the strategic priorities that were set out when I joined the company in the fall of 2006.

In making this decision, senior management undertook a disciplined and thorough approach to identify an innovative growth company with leading technologies that are complimentary to KCI and a business that is penetrating markets with large potential. LifeCell clearly meets these criteria, but we believe it also provides additional opportunities due to the synergistic nature of the two company's products, the strength of their management teams, and the extraordinary cultural fit.

The combined entity will create a strong commercial enterprise that will continue to grow revenue while credibly establishing a third platform that diversifies our core businesses.

We are very excited about this opportunity and the combined capabilities it will create. Both KCI and LifeCell have reached leadership positions by bringing to market best in class gold standard therapies that leverage a scientific understanding of the mechanisms of action around healing, tissue regeneration and repair. Together we expect to create revenue synergies and innovative products that will enable our plan for consistent and sustained double-digit revenue growth.

We have now commenced our tender offer and have also completed our meetings with the lenders that will finance this combination of our company. And as we have stated before, we plan to close this transaction in the second quarter.

I will now move on to review KCI's results for the quarter. In our last conference call, we announced plans to realign our U.S. sales force. This more is an important part of our plan to increase penetration of the underserved V.A.C. wound care market and provide profitable growth in our Therapeutic Support Systems product line. We believe that this new dedicated structure will also simplify and improve our interaction with the patients and caregivers that we serve since the [inaudible] are unique to each business.

I am pleased to report that the transition process is substantially complete. We are highly focused on realizing the benefits of this new structure to enhance sales execution and strengthen revenue momentum. In addition to these activities, we also expect to drive revenue synergies to the V.A.C. and LifeCell sales forces in the near future.

Last quarter we reported that we continued to see competitive activity in the United States and Europe. New market entrants are behaving as we expected. They are providing evaluation units free of charge or at substantial discount. While these actions are having a short-term disruptive impact, the very positive news is that consistent with past experience the overwhelming majority of customers continue to utilize KCI products post the evaluation. This is true in both the United States and internationally. We believe that this result is due to the superior outcomes achieved with KCI's V.A.C. therapy, and we anticipate that KCI's V.A.C. therapy will be the negative pressure wound therapy product of choice for the foreseeable future. KCI remains very confident in the sustainability of our V.A.C. therapy franchise.

Looking forward to 2009, we are providing preliminary guidance of sustained double-digit V.A.C. revenue growth for calendar year 2009. We continue to monitor developments with respect to reimbursement, and I want to update you on our progress in a few of these areas.

In late March, CMS notified bidders regarding round one of competitive bidding. The reduction in price for NPWT ranged from 7% to 23% across the 10 CBAs. It remains to be proven whether CMS can guarantee access to NPWT at these discounted levels for the nation's elderly and disabled.

It is important to remember that KCI's NPWT market leadership position is the result of a unique therapeutic offering that combines proprietary technology, skilled clinical support, and a full-service infrastructure that patients and caregivers have come to rely upon. The patient outcomes that we are able to achieve with V.A.C. therapy are well documented and are unmatched by any other product in the NPWT space. Outcomes from V.A.C. therapy are not easily duplicated.

From what we know today it is unlikely that KCI will be able to provide V.A.C. therapy, with its clinically proven superior outcomes, at the bid prices offered to us by CMS in round one. We remind you that if KCI chooses to not participate in this round, the total impact would be approximately one-half of 1% of KCI's total estimated revenue for 2008 or approximately $9 million.

Looking forward, KCI is committed to finding an economically feasible way to provide our life and limb saving V.A.C. therapy to the nation's elderly and disabled. Therefore, if we move into round two of competitive bidding, KCI is analyzing NPWT business alternatives that would allow us to participate. We are currently developing this strategy and for competitive reasons we will not disclose it. As previously communicated, the total potential 2009 revenue impact for competitive bidding would represent less than 5% of KCI's total revenue.

On the international reimbursement front we are seeing real progress. In February we announced that we have reached an important milestone with respect to home care reimbursement in Germany and efforts are under way to initiate the study that was approved by the Ministry of Health. The study provides full reimbursement for V.A.C. placement, and it's limited to KCI proprietary back system. The study will be conducted over a maximum period of three years and will target patients that are transitioning from receiving therapy in the acute care setting to receiving care in the post-acute setting as well as patients who initiate treatment in the home.

This is a very important development for KCI and is an initiative that has been under way for several years. V.A.C. therapy is widely accepted in the German acute care setting, and this development will enable KCI to significantly expand our presence in the home. Remember that Germany is our second-largest market outside the United States.

We also continue to monitor reimbursement developments in other geographies, including the Netherlands and the U.K. We have focused on demonstrating the role that V.A.C. therapy plays in reducing the overall cost of patient care, and we are optimistic that these persistent efforts will result in a continued favorable reimbursement pattern.

With regard to global geographic expansion of V.A.C. therapy, we continued to make progress in Japan, where we have completed our clinical trial. We submitted our regulatory dossier at the end of the first quarter. Every effort is being made to accelerate this process, and we hope to have V.A.C. therapy available in the acute care setting in Japan before the end of 2009. We estimate this market at approximately 200,000 V.A.C.-able wounds per year.

On the innovation front we invested over $15 million in research and development during the quarter as we continued to develop our new product pipeline and support the clinical adoption of our current products.

In our earnings call one year ago, I announced our renewed commitment to our robust R&D pipeline based on our belief that innovation and advancing our understanding of the science of wound healing will play very important roles in KCI's future. We continue to execute on this initiative, and today we see advances in our product portfolio that will create new opportunities to address unmet clinical needs utilizing our proprietary negative pressure technology platform.

The LifeCell acquisition represents an important strategic step in enabling the launch of two of the products in our R&D pipeline that are aimed at the surgical suite. Our Surgical Wound Management System will target an annual addressable market of over 2 million high-risk surgical procedures and is being designed to reduce the incidence of post-surgical infections and complications, accelerate the healing process, and improve cogenesis. In addition, the product may provide synergistic benefits to LifeCell's AlloDerm and Strattice products.

We are also making continued progress with our vacuum-assisted tissue regeneration technology aimed at hard tissue applications. Once again, we see the potential for both development and commercialization opportunities from the LifeCell acquisition. One of the key advantages of the LifeCell acquisition will be the ability to leverage their strong presence in the operating room to deliver these new product platforms to the market.

Our Therapeutic Support Systems business posted a solid quarter as we continue in our efforts to focus on profitable market share gains in this business. In February, we were pleased to announce the introduction of our AtmosAir V-Series Mattress Replacement System that is designed to assist hospitals in the treatment and prevention of pressure ulcers. This new system enhances the AtmosAir family of surfaces which already accommodates a wide range of hospital bed frames and stretchers and is now compatible with the Hill-Rom VersaCare frame.

In summary, this was a very important quarter in terms of positioning KCI for long-term growth and value creation. We continue to be very proud of the strength of our business fundamentals, and we look forward with confidence to the future.

At this time I will turn the call over to Marty to review our financial results for the period.

Marty Landon

Thank you, Cathy. Good morning, everyone. This morning I'll first focus on our financial results for the quarter, and then I'll briefly summarize the terms of our recently announced financing transaction in connection with our acquisition of LifeCell Corporation. Then after that we'll open the floor for questions.

Our quarterly results were essentially in line with our expectations, and we think that they reflect the strength of this business in terms of both revenue growth through V.A.C. and TSS and our operating leverage.

Q1 is historically a weak sequential comp for us, but we grew revenue, earnings and margins versus the same period last year. In this morning's press release we reported total revenue for the first quarter of 2008 of $420 million, up $51.2 million or 14% over the same period last year.

Foreign currency exchange rate movements favorably impacted first quarter revenue by 4% compared to the prior year period.

Like prior first quarters, on a sequential basis total revenue for the first quarter was down $13.6 million or 3% from the first quarter of 2007, driven primarily by normal seasonality in our V.A.C. business and the impact of our U.S. sales force realignment as well as the increased competitive activity that Cathy described in her earlier remarks.

Net earnings for the first quarter were $68 million, up $14.4 million or 27% over the same period last year.

Net earnings per diluted share increased to $0.94, up $0.19 or 25% over the first quarter of the prior year.

Net earnings growth in the first quarter outpaced our revenue growth, consistent with our expectations as we continue to create leverage in the business model while investing in key development areas such as R&D.

During 2007, we took steps to structure KCI as a true global company, which included the alignment of key leadership positions for specific geographic regions. Beginning this quarter and I'm sure you saw in the press release, we're reporting financial results consistent with this new structure as follows: North America will include our operations in the U.S., Canada and Puerto Rico, EMEA or EMEA will cover Europe, the Middle East and Africa, and APAC will cover our operations in the Asia Pacific region. Today's press release as well as releases going forward will track current and prior period amounts under this revised reporting structure to enable investors and other interested parties to adjust their financial models accordingly.

Looking now at first quarter revenue for North America, total revenue was $309.5 million, an increase of $25.8 million or 9% over Q1 2007. Total revenue for EMEA and APAC was $110.6 million for the first quarter, up $25.4 million or 30% over the year ago period.

Turning to revenue by product line, global V.A.C. revenue was $333 million for the quarter, up 15% over the same period last year, driven by continued demand for our V.A.C. therapy systems both in the U.S. and abroad.

V.A.C. revenue for North America was $250.2 million for the period, an increase of $23.3 million or 10% over the same period last year. First quarter V.A.C. revenue growth in North America was primarily unit driven, as rental volumes increased across all care settings. As expected growth rates in the home care setting slightly exceeded growth rates in the institutional settings, and pricing remained stable.

As noted, [inaudible] V.A.C. revenue growth slowed early in the first quarter of 2008 as we completed work on the redeployment of our domestic sales force. The final steps in completing this transition were accomplished during the first quarter, and all team members are trained and operational in their new roles. We have seen some reacceleration of rental unit volume as the sales team gains traction under this new structure.

Internationally V.A.C. revenue in the EMEA and APAC regions for the first quarter was $82.7 million, an increase of $21.1 million or 34% over the year ago period. Higher V.A.C. revenue from increased rental unit volume accounted for the majority of the period-over-period increase combined with favorable foreign currency exchange rate movements. Virtually offsetting the unit gains was lower overall pricing. As in North America, we continue to see increased competitive selling efforts internationally related to less-sophisticated gauze-based devices. This activity is generally in the form of free trials and evaluations.

Worldwide revenue from our Therapeutic Support Systems or TSS business was solid for the quarter, totaling $87.1 million, up $6.8 million or 8% over the same period last year. TSS revenue for North America was $59.2 million for the first quarter, up $2.5 million or 4% over the same period last year due to higher rental volumes and increases in average rental prices. EMEA and APAC Support Systems revenue increased to $27.8 million for the quarter, up $4.3 million or 18% over the same period in 2007. Favorable foreign currency exchange rate variances accounted for 13% of the year-over-year TSS increase.

Gross profit for the first quarter was $209 million, an increase of $37.8 million or 22% over the prior year period.

Gross margin for the period was strong at 49.8%, improving by 335 basis points over the first quarter of 2007. Favorable variances in field service expenses, product depreciation, cost of sales and marketing expenses accounted for the majority of the margin improvement.

Below the gross profit line we saw increases in our SG&A expenses due primarily to costs associated with our U.S. sales force realignment. There were also additional costs associated with the transition of V.A.C. unit production to our Ireland manufacturing facility as well as increases in share-based compensation expense. All that contributed to the increase.

We continued to increase our R&D investment in the quarter, which was up $4.9 million or 50% yearonyear. Our total R&D investment of $14.7 million represented 3.5% of total revenue for the quarter and it reflects our continued commitment to investing in a robust R&D pipeline that leverages our capabilities and knowledge around our proprietary negative pressure technology platform.

Operating earnings for the quarter were $98.9 million, up 19% over the previous year.

Below the operating line our results for the quarter reflect increased liquidity and reduced leverage. Interest income increased to $2 million in the first quarter, and interest expense again declined for the period due to the active deleveraging that took place in 2007.

Total long-term debt outstanding at the end of the period was $68 million.

Our effective income tax rate was 33.5% for the quarter, which is comparable to the tax rate from the same period a year ago.

Free cash flow year-to-date was year-to-date was strong at $38.9 million, up $5.1 million or 15% from the prior year. Increases in free cash flow versus the same period last year resulted primarily from higher net earnings and strong working capital management.

KCI's balance sheet remained strong and liquid, reflecting impressive cash generation capabilities and low leverage. Our cash balance of $305.2 million reflects favorable collection patterns during the quarter. Our cash balance is also net of the licensing fee payments made to Wake Forest University during the period. Those licensing fee payments take place in the first and third quarters of each year.

Our quarter end net accounts receivable balance of $355.4 million reflects the continued efforts of our order to cash process improvement.

Total days revenue outstanding for the period declined slightly by just under two days when compared to the same period in 2007 due to continued focus on the proactive management of [inaudible] relationships.

As I mentioned previously, our long-term debt balance at the quarter was just under $70 million and significantly less than our trailing 12-month EBITDA, which is now approximately $483 million.

In connection with our planned acquisition of LifeCell Corporation, we made an announcement on April 16 regarding the issuance of $600 million in senior convertible notes which are due 2015. The notes bear interest at 3.25%, and we also granted an option to the initial purchasers to purchase up to an additional $90 million in aggregate principal amount of notes to cover over allotments. The notes call for an initial conversion price of $51.34 per share of common stock, but we also entered into a convertible note hedge and warrant transaction which effectively increases the conversion price of the notes to over $60 per share, which is approximately a 50% premium over KCI's closing price on April 15. Our intent is to settle the principal amount of these notes in cash. This debt issuance was part of a synchronized financing strategy that we think gives us an opportunity to finance this transaction at reasonable rates while providing an opportunity for rapid deleveraging without significant prepayment penalties.

In this morning's press release we reaffirmed our guidance for 2008, which calls for revenue of $1.77 to $1.82 billion and earnings per diluted share of $3.85 to $3.95 per share to exclude any impact on the anticipated acquisition of LifeCell. This guidance of course reflects our continued confidence in the business fundamentals and our ability to further penetrate the global V.A.C. market despite the short-term distractions associated with additional competitive entrants and the Medicare competitive bidding program. As Cathy mentioned, our very early look at 2009 calls for sustained double-digit growth of our V.A.C. franchise.

Finally, we expect to file our quarterly report on Form 10Q with the SEC in early May 2008.

This concludes our prepared remarks, and at this time I'll turn the floor back over to Shaquanna to begin our question-and-answer session.

Shaquanna?

Questions-and-Answer Session

Operator

Thank you. (Operator Instructions) Your first question comes from the line of Vincent Ricci with Wachovia. Please proceed.

Vincent Ricci - Wachovia

Hi, guys. Thanks for taking my question.

The first question's on gross margins. Can you quantify the impact of currency on your gross margins, and a little bit further, what's the differential between V.A.C. and beds there?

Marty Landon

Yes, this is Marty and from a currency standpoint, there's not much impact on the P&L. It serves as an inflation as you do the measurement, remeasurement, over the period, so basically you get an inflation in a little bit of your revenue stream but you also get inflation of expenses. So at the gross profit line and at the operating profit line, there's not a huge contribution of any sort from foreign currency.

In terms of the differences in gross margins, certainly as you look at the V.A.C. business and as it has become more of a large proportion of our business you've seen gross margins increase. That is because we have good gross margins in the V.A.C. business.

On the Surfaces side of things, where you have sales of surfaces in particular, you don't quite have the same margins. You have a higher cost of production versus what you do on the V.A.C. side. So the margins on the V.A.C. business are a little bit better than those on the Surfaces business.

Vincent Ricci - Wachovia

Okay, great. And then just one quick follow-up question. When do we expect to get some guidance on how the LifeCell acquisition will be incorporated and impact the P&L specifically? Is that going to be a second quarter conference call thing or will there be a call when you guys close the deal?

Marty Landon

Yeah, so this is Marty again. I would expect that the first thing we need to do is close the transaction, and that's what we're working hard to get done. And then post closing I think that's an appropriate time for us then to discuss how we see the combined companies operating going forward.

Vincent Ricci - Wachovia

Okay, great. Thanks for taking my questions.

Catherine Burzik

Thank you.

Operator

Your next question comes from the line of Tao Levy with Deutsche Bank. Please proceed.

Tao Levy - Deutsche Bank Securities

Good morning.

Catherine Burzik

Good morning, Tao.

Tao Levy - Deutsche Bank Securities

Good morning. On the U.S. market trends, you mentioned some trial and some competitive activity. Are you seeing that more in sort of the home care, acute care setting, and any sense of how long on average it takes an account to try and then come back to V.A.C.?

Catherine Burzik

So, Tao, this is Cathy, and it's a good question. And as I indicated in my remarks, we did see, as you would expect, some additional competitive activity during the course of this past quarter where individual companies both gave away product as well as deeply discounted those products.

We've tracked most of those trials, and I would say that we see at most a few percentage point gains as a result of those companies against our overall market share. I'm talking here about just a couple percentage points.

So I would say that typically we see these trials, I don't know what, like maybe a couple of months' kind of an impact is what we've been seeing.

Tao Levy - Deutsche Bank Securities

Great. And also can you give us a sense, obviously the gross margins were strong this quarter; is that something that we should continue to see improve? Obviously you've made some realignments to the sales force and I don't know if, you know, the move of some of the manufacturing to Ireland, whether that will play a role going forward.

Marty Landon

Yes, this is Marty. I think they were good gross margins and we're proud of that. I would tell you that as far as how much it continues, it really kind of depends a little bit on mix of product. We talked about the difference in margins so if you have more sales of one product versus another - let's say you have more sales of a low-end surface - you may have some impact on margins.

We did reduce the cost of production related to V.A.C. disposables during the period. That's a good thing. We also had some favorable variances.

So we'll work hard to continue to drive those things, but how it plays out going forward is going to be dependent on a number of factors just like it was this quarter. But that said, as we've always said, we think there's leverage in the business model and we're going to try and drive some of that both at the gross margin line as well as the operating profit margin line.

Tao Levy - Deutsche Bank Securities

Great. And my final question, on your preliminary 2009 double-digit V.A.C. growth, what are you assuming there for competitive bidding and your participation within that? And then can you also flesh out your thinking of how this evolves for Medicare-type patients who maybe are on V.A.C. in a hospital and then have to switch to a different product and I guess the company's responsibility in trying to make sure the patient's outcomes aren't impacted?

Catherine Burzik

Sure. Let me talk first about the way we see 2009. And I just want to say here, Tao, due to the fact that we've received so many questions we felt that it was good to give what we're calling very preliminary guidance. And recognize there's always some unknowns here. I've talked about the fact that we hope that we are on the market in Japan. Certainly we have the continued what we believe is going to be progress in the home care market. And from a CMS perspective, if we move into round two, there's a lot of speculation about whether round two will be moved out or whether round two will occur as currently planned, which would take effect in July of 2009.

So as we gave our guidance here, we tried to take into account kind of a blend of what's likely to happen between this reimbursement area as well as what we would see as competitive activity at that point in time. And we thought it was important to signal that net-net, all of that, we continue to see dividend V.A.C. revenue growth for 2009.

So hopefully that answers the first part of your question and then the second part, the whole question about Medicare and access to quality care as a result of the competitive bidding program, I would say right now, Tao, that the one word that comes to my mind is disappointment. We are very disappointed in the way CMS is kind of rolling out this competitive bidding program, and I would just tell you that since different DMEs have been selected and these different CBAs, we are now receiving a number of calls from DMEs who were awarded contracts who have no access to negative pressure wound therapy. They don't even know what it is. So clearly as CMS looked at these bidders they did not require that the bidders even have negative pressure wound therapy at the time that they bid.

As I said, we're disappointed that that happened. That's a reality of the overall situation that we're facing here at round one, and that is why, as we look strategically at what we want to do for round two, KCI does want to find a way to provide our V.A.C. therapy to the nation's elderly and disabled. It's an important thing for us to be able to do. We just simply cannot do it at the same levels of high quality with clinical evidence that we do today.

So there are several ways that we can think about doing that - different distribution methods, a different clinical structure, an overall different business model for Medicare - and those are the kinds of things that we are currently considering.

Tao Levy - Deutsche Bank Securities

Great. Thank you very much.

Catherine Burzik

You're welcome.

Operator

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

Jayson Bedford - Raymond James

Thanks. Good morning.

Catherine Burzik

Hi, Jayson.

Jayson Bedford - Raymond James

Just a couple questions. I guess first, for Marty, maybe now that you've completed the convert can you comment on the blended interest rate on the $1.4 billion that you'll take on in debt? It seemed like that was the biggest swing factor in the accretion dilution analysis when we looked at '09?

Marty Landon

Yes, Jayson, I'm not done yet but feeling reasonably good about it. As Cathy mentioned in her comments, we just finished the lenders' meeting and as I mentioned, this is really part of a synchronized effort to bring the whole package together. So we feel good about the interest that we've received on the bank side of things. The demand has been quite good given the choppiness in the credit markets, as you know. So we're not in a position where that's closed out and we can announce anything yet, but I would tell you that we're very comfortable with our discussion around mid single digits for an overall interest rate.

Jayson Bedford - Raymond James

Okay. And then I guess just back to the base business, anyway you can quantify the impact of the sales force disruption and then maybe comment on what you've seen from this change, meaning have you seen increased productivity levels? Have you opened up new accounts? What's really the result of the change that you implemented?

Catherine Burzik

I have Woody here and he might want to make a comment on this also, but what I see as I travel around and talk to different sales people is they are definitely now - you see the focus on the V.A.C. business and the focus on the Therapeutic Support Systems business. So I think we have achieved what we wanted to in that area.

We also track productivity for each of our sales forces, and we have seen their productivity ramp during Q1. I would anticipate that it will continue to ramp during Q2.

So, I don't know, Woody, would you like to make a couple comments on that?

Linwood "Woody" Staub

Yeah. Hi, Jayson, this is Woody. I would add that the redeployment was really designed to allow our reps to focus on those procedures that exist in that additional 70% of the market that we haven't penetrated yet.

I would say the disruption and noise that we've had in the marketplace temporarily takes our reps away from growing that market. I don't have a number on what that is. I would say it's in the 1% to 2% range in terms of how it affects our ability to grow that additional market.

Jayson Bedford - Raymond James

Okay. And has there been any change in your competitive strategy I guess to deal with this trialing activity that's taking place.

Catherine Burzik

You have to sell the overall economic value proposition of V.A.C. This is something that we certainly are extremely focused on. And I just want to remind you, Jayson, that this isn't new. KCI has done this now for several years, domestically and internationally. You can see that from an international perspective where we've had very strong competition in both Germany and the U.K. You see the international results that we've had, so we have clearly worked through that.

Additionally, from an economic value - in the United States we're in the process of launching something we've talked about before which is our budget impact model which allows a sales rep to go into a specific hospital, use the data from that hospital, and help that hospital understand how V.A.C. is going to save them money. These other companies that have come into the market clearly don't have the database around data that we have that shows the overall economic value proposition associated with our therapy in particular. So we have been in the process of rolling that out during the course of this quarter and we'll continue that into next quarter.

Jayson Bedford - Raymond James

Okay. Thanks. And just lastly, you said a little less leverage in the SG&A line. Any costs associated with kind of the sales force reorg or even the acquisition that were included in the first quarter that maybe were nonrecurring in nature?

Catherine Burzik

Yeah. The costs associated with the sales force deployment were the major reasons why SG&A was a little higher than what you might have thought.

Jayson Bedford - Raymond James

Okay.

Catherine Burzik

Okay? You're welcome.

Operator

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

Mark Mullikin - Piper Jaffray

Good morning.

Catherine Burzik

Hi, Mark.

Mark Mullikin - Piper Jaffray

Hey. So it looks like domestically here the sales growth in V.A.C. accelerated quite strongly while the rental decelerated. Can you just discern if there were any particular factors driving that? Was it driven by competition, the reorg - what's driving that?

Marty Landon

Mark, this is Marty. It's really around minutes and pricing programs. And in some of our accounts we have programs where we have, again, meeting customer needs around longer-term type rentals and you have increases in prices of dressings and canisters and net-net that all kind of washes out. So there's some mix just in customers and in products. No real change in terms of the unit growth. It kind of went along historical lines.

And to earlier questions, that's one of the interesting things that Cathy mentioned in her comments. We were $44 million worth of growth in the quarter. When you think back along historical lines, from a dollar growth standpoint that's not a whole lot different than we've done historically but it is a bigger business.

But in terms of the rental versus sales line, it really is about pricing programs and about mix.

Mark Mullikin - Piper Jaffray

So should we expect that trend to continue through the remainder of the year or should we expect a sales growth number to be in the 20% to 30% range and the rental number to be maybe 10% to 15%?

Marty Landon

I think it's safe to say that you can expect the sales growth line to be a little bit higher than the rental growth line.

Mark Mullikin - Piper Jaffray

Okay. And how does that impact the margin profile of the company?

Marty Landon

It doesn't a whole lot. As we looked at the programs, we've tried to, again, be responsive to customers' needs but maintain the adequate returns for the company, so from an overall gross margin standpoint, we've geared these things to be effective for both parties.

Mark Mullikin - Piper Jaffray

Okay. And then just a final question. Is there anything new on the litigation with ITI?

Catherine Burzik

I would say fundamentally - Steve might want to comment - but there really is not anything new from what we have already indicated to the community.

Mark Mullikin - Piper Jaffray

So there aren't any dates on the court calendar?

Catherine Burzik

There are no dates on the court calendars.

Mark Mullikin - Piper Jaffray

Okay. Thank you.

Catherine Burzik

You're welcome.

Operator

Your next question comes from the line of Mike Weinstein with J.P. Morgan. Please proceed.

Taylor Harris - J.P. Morgan

Thanks a lot. Hi, it's Taylor here for Mike. So just wanted to follow up on the competitive dynamics, and Cathy, you said it, you've been dealing with this for awhile so I'm just curious how much more did you see competition in the U.S. this quarter than you did in, say, the back half of 2007.

Catherine Burzik

Well, Taylor, as you would expect we had a major wound care company come into the marketplace during the - we saw them a bit in Q4; we saw them more in Q1. So you did see that. However, the product is obviously the same gauze-based wound drainage device that we have competed against for a long time. You know, marketing muscle, people are able to get in there and try to get the product trials, but the results of the trials are really no different than what KCI has historically seen.

I think it's fair to characterize that there are low-hanging fruit - there are some simpler, easier to heal wounds  that gauze-based wound drainage devices will be able to heal, so they're able to kind of cherry pick and pick those kinds of wounds to heal. But as I said, it's a really small number of customers that are willing to even consider these products post evaluation.

Taylor Harris - J.P. Morgan

Okay. And how do these trials work? Does an institution just take a few units from the competition at a given point in time or are you seeing a wholesale change-out within an institution from foam-based to gauze-based for a certain period of time?

Catherine Burzik

No, they're not wholesale changes. We see this both in the United States and in Europe, and this is what we've always seen. It'll be a few units here or there in an institution.

Taylor Harris - J.P. Morgan

Okay. And so I'm curious about your expectations for the next three quarters in 2008. In the first quarter you had obviously some increased trialing activity and you had the sales force redeployment, which probably both dragged down the North American V.A.C. growth rate. Would you expect that to accelerate in North America for the next three quarters?

Catherine Burzik

Well, we reaffirmed our guidance which I think speaks to how confident we are in the business, Taylor. And so we're not going to give quarter-by-quarter guidance here but directionally I would think of the following. I mean, the sales force is now - the deployment is done. The sales force is focused. Marty indicated that we're starting to see some acceleration in that vein. The first efforts from some serious competition have been made, and we've moved through that now. And I'm sure there'll be more as we move into the rest of this year, but we saw a lot of that during Q1 and we fought that successfully. So as I look forward to the rest of the year, I look forward with confidence to our overall V.A.C. business as we move through the rest of 2008 and into 2009.

Taylor Harris - J.P. Morgan

Okay. I guess your previous guidance had been Surfaces flat, V.A.C. mid-teens growth. Is that still your expectation?

Catherine Burzik

Yeah. We are - and Lynn, obviously, and her team did a very nice job in Q1; we're pleased with the results that we have there - but I think from a prudent guidance perspective as we look forward for the rest of the year on a worldwide basis we would continue to reiterate that we would expect the Surfaces business to be relatively flat for the year.

Taylor Harris - J.P. Morgan

Okay, great. And then just a couple of other follow-up questions to questions that have already been asked. On competitive bidding, is there a mechanism for feedback from round one before moving on, proceeding with round two?

Catherine Burzik

There is no mechanism for feedback, Taylor, and that's part of the biggest frustration. If you follow - there's an organization that's writing actively, almost on a daily basis, called the American Association Home Care  AA Home Care. And the kinds of things I've talked about, where you have bidders - which clearly in our category did; well, we'll provide 10% of negative pressure wound therapy to Cincinnati at some price, and they don't even know what negative pressure wound therapy is - I mean, the fact that those kind of things were allowed to happen and CMS did not show that the bidders had access to the technology, it really runs in the face of the major criteria that Congress told CMS that they had to do, that they had to guarantee access at the same time that they reduced the overall Medicare bill.

So it looks to us that they have not guaranteed access, and that's what causes ourselves and companies or associations like American Association of Home Care that represents all these DMEs to really have no confidence in the process.

We continue to work Congress around our bill, but I've talked about the Medicare Wound Therapy Patient Protection Act. We have tremendous support from all of the physician organizations, all of the wound care organizations. And the concern for competitive bidding is broader than negative pressure wound therapy. There's just concern about the process in total because it just appears to be a pretty flawed process.

That said, it also appears that CMS is going to rush right into round two without looking at round one and that's why, if we kind of fight through this round one situation and try to educate them - we're trying to be proactive, we're trying to work with everyone  we realize that we really need to turn our attention to round two and see what we can do to find a way to participate.

Taylor Harris - J.P. Morgan

Okay, great.

Catherine Burzik

That help?

Taylor Harris - J.P. Morgan

Yeah. That definitely helps. Thank you. Last question. Marty, on the convert accounting can you walk through with us at what point in time shares could show up in the share base, et cetera? I just want to make sure I understand the convert accounting.

Marty Landon

Yeah. So in terms of GAAP EPS, Taylor, we'll start to see some small impact on the share account as we get above the base conversion rate of $51.34, but from an economic standpoint you really don't see any impact from that until you get above the $60.41. And all that will wash out eventually when those notes are either repurchased or settled. But in terms of GAAP EPS, you will start to see on a treasury stock method - it gets fairly complex if I go much further than this - but just think of it that, from a treasury stock method on a GAAP basis, you will start to see some minor dilution once you get above $51.34.

Taylor Harris - J.P. Morgan

Okay. But is the dilution only representative of the premium above the $600 million since you settled that in cash?

Marty Landon

Correct.

Taylor Harris - J.P. Morgan

Okay.

Marty Landon

Correct. And it's done on a treasury stock method, and that's why I say it's a minimum dilution impact until you get really above the $60, where you start to see a little bit more. And that again is on a GAAP basis. On a cash basis you don't see any impact.

Taylor Harris - J.P. Morgan

Okay. Thank you very much.

Operator

Ladies and gentlemen, due to time restraints we have time for one further question. That question comes from the line of Paul Houdelik with Silverback. Please proceed.

[Paul Houdelik - Silverback]

Hi. My question's already been answered. Thank you.

Operator

I would now like to turn the call back over to Mr. David Holmes for closing remarks.

David Holmes

Thank you, Shaquanna. This concludes our first 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 the presentation. You may now disconnect and have a good day.

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