UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K

 

 

KINETIC CONCEPTS, INC.

(Exact name of registrant as specified in its charter)

 

 

Registrant’s telephone number, including area code:  (210) 524-9000

Securities registered pursuant to Section 12(b) of the Act:

Securities registered pursuant to section 12(g) of the Act:  NONE

     Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
                                                                                                                      Yes      X             No                

     Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.
                                                                                                                      Yes                      No     X         

     Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
                                                                                                                      Yes      X             No                

     Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.                 

     Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.  See definition of "accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check one):
               Large accelerated filer          X                Accelerated filer                               Non-accelerated filer                                   

     Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
                                                                                                                      Yes                      No     X         

     The aggregate market value of the voting and non-voting common equity held by non-affiliates as of June 30, 2005 was $3,114,617,040 based upon the closing sales price for the registrant's common stock on the New York Stock Exchange.

     As of March 13, 2006, there were 71,225,532 shares of the registrant's common stock outstanding.

     Documents Incorporated by Reference:  Certain information called for by Part III of this Form 10-K is incorporated by reference to the definitive Proxy Statement for the 2006 Annual Meeting of Shareholders, which will be filed not later than 120 days after the close of the Company's fiscal year.

 

TABLE OF CONTENTS

KINETIC CONCEPTS, INC.

 

TRADEMARKS

 

     The following terms used in this report are our trademarks:  AirMaxxisÔ, AtmosAir®, BariAir®, BariatricSupportÔ, BariKare®, BariMaxx® II, BariMaxx®, DynaPulse®, FirstStep®, FirstStep® AdvantageÔ, FirstStep® Plus, FirstStep Select®, FirstStep Select® Heavy Duty, FluidAir Elite®, FluidAir® II, KCI®, GranuFoam® Silver, KinAir® III, KinAir® IV, KinAir MedSurg®, KCI Express® Kinetic Concepts®, Kinetic TherapyÔ, MaxxAir ETS®, Maxxis® 300, Maxxis® 400, PediDyne®, PlexiPulse®, PlexiPulse® AC, Pulse ICÔ, Pulse SCÔ, RIK®, RotoProne®, Roto Rest®, Roto Rest® Delta, T.R.A.C.®, The Clinical Advantage®, TheraKair®, TheraKair® VisioÔ, TheraPulse®, TheraPulse® II, TheraPulse® ATPÔTheraRest®, TriaDyne® II, TriaDyne Proventa®, TriCell®, V.A.C.®, V.A.C.® ATS® , V.A.C. ® Freedom®, V.A.C.® TherapyÔ, The V.A.C.® SystemÔ, Vacuum Assisted Closure® and V.A.C.® Instill®.  All other trademarks appearing in this report are the property of their holders.

 

SPECIAL NOTE REGARDING FORWARD LOOKING STATEMENTS

 

     This Annual Report on Form 10-K contains forward‑looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, which are covered by the "safe harbor" created by those sections. The forward‑looking statements are based on our current expectations and projections about future events. Discussions containing forward‑looking statements may be found in "Management's Discussion and Analysis of Financial Condition and Results of Operations," "Risk Factors," and elsewhere in this report. In some cases, you can identify forward‑looking statements by terminology such as "may," "will," "should," "could," "predicts," "projects," "potential," "continue," "expects," "anticipates," "future," "intends," "plans," "believes," "estimates," or the negative of these terms and other comparable terminology, including, but not limited to, statements regarding the following:

 

-      projections of revenues, expenditures, earnings, or other financial items;

-      future demand for V.A.C. systems or other products;

-      the expected timing and outcome of pending litigation;

-      expectations for third-party and governmental reimbursement;

-      the plans, strategies and objectives of management for future operations;

-      expectation of market size and market acceptance or penetration of the products and services we offer;

-      expectations for the outcomes of our clinical trials;

-      attracting and retaining customers;

-      competition in our markets;

-      productivity of our sales force;

-      future economic conditions or performance, including seasonality;

-      changes in patient demographics;

-      estimated charges for compensation or otherwise; and

-      any statements of assumptions underlying any of the foregoing.

     These forward‑looking statements are only predictions, not historical facts, and involve certain risks and uncertainties, as well as assumptions. Actual results, levels of activity, performance, achievements and events could differ materially from those stated, anticipated or implied by such forward‑looking statements. The factors that could contribute to such differences include those discussed under the caption "Risk Factors." These risks include the fluctuations in our operating results and the possible inability to meet our published financial guidance; growing competition that we face; our dependence on our intellectual property; adverse results from pending litigation; our dependence on new technology; the clinical efficacy of V.A.C. therapy relative to alternate devices or therapies and the results from related clinical trials; and third-party and governmental reimbursement policies and collections for our products and those of our competitors. You should consider each of the risk factors and uncertainties under the caption "Risk Factors" among other things, in evaluating KCI's prospects and future financial performance. The occurrence of the events described in the risk factors could harm the business, results of operations and financial condition of KCI. These forward‑looking statements are made as of the date of this report. KCI disclaims any obligation to update or alter these forward‑looking statements, whether as a result of new information, future events or otherwise.

Table of Contents

PART I - FINANCIAL INFORMATION

 

ITEM 1.     BUSINESS

General

     Kinetic Concepts, Inc. is a global medical technology company with leadership positions in advanced wound care and therapeutic surfaces. We design, manufacture, market and service a wide range of proprietary products that can improve clinical outcomes and can help reduce the overall cost of patient care. Our advanced wound care systems incorporate our proprietary V.A.C. technology, which has been demonstrated clinically to help promote wound healing and can help reduce the cost of treating patients with serious wounds. Our therapeutic surfaces, including specialty hospital beds, mattress replacement systems and overlays, are designed to address pulmonary complications associated with immobility, to prevent and treat skin breakdown and assist caregivers in the safe and dignified handling of obese patients. We have an infrastructure designed to meet the specific needs of medical professionals and patients across all health care settings, including acute care hospitals, extended care facilities and patients' homes both in the United States and abroad.

     We were founded in 1976 and are incorporated in Texas.  Our principal executive offices are located at 8023 Vantage Drive, San Antonio, Texas 78230.  Our telephone number is (210) 524-9000.  Our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(e) or 15(d) of the Securities Exchange Act, as amended, are available free of charge on our website at www.kci1.com, as soon as reasonably practicable after we file or furnish such information with the SEC.  Information contained on our website is not incorporated by reference to this report.

Clinical Applications

     Our advanced wound care systems and therapeutic surfaces address four principal clinical applications, advanced wound healing and tissue repair, therapies to treat pulmonary complications in the intensive care unit, bariatric care and wound treatment and prevention.

Advanced Wound Healing and Tissue Repair

     In the acute care setting, serious trauma wounds, failed surgical closures, amputations (especially those resulting from complications of diabetes) and serious pressure ulcers present special challenges to the physician. These are often complex and/or large wounds that are prone to serious infection and further complications due to the extent of tissue damage or the compromised state of the patient's health. These wounds are often difficult—or in the worst cases, impossible—to treat quickly and successfully with traditional treatments. Physicians and hospitals need a therapy that addresses the special needs of these wounds with high levels of clinical and cost effectiveness. Given the high cost and infection risk of treating these patients in health care facilities, the ability to create healthy wound beds and reduce bacterial levels in the wound is particularly important. Our V.A.C. Therapy systems are designed to meet these needs by promoting the reduction in local edema, managing exudate, reducing infection risk, and stimulating the growth of healthy, vascularized granulation tissue.

     In the extended care and home care settings, different types of wounds—with different treatment implications—present the most significant challenges. Although a large number of acute wounds require post-discharge treatment, a majority of the challenging wounds in the home care setting are non-healing chronic wounds. These wounds often involve physiologic and metabolic complications such as reduced blood supply, compromised lymphatic system or immune deficiencies that interfere with the body's normal wound healing processes. Diabetic ulcers, arterial and venous insufficiency wounds and pressure ulcers are often slow-to-heal wounds. These wounds often develop due to a patient's impaired vascular and tissue repair capabilities. These conditions can also inhibit a patient's healing process, and wounds such as these often fail to heal for many months, and sometimes for several years. Difficult-to-treat wounds do not always respond to traditional therapies, which include hydrocolloids, hydrogels and alginates.

     Physicians and nurses look for therapies that can accelerate the healing process and overcome the obstacles of patients' compromised conditions. They also prefer therapies that are easy to administer, especially in the home care setting, where full-time skilled care is generally not available. In addition, because many of these patients are not confined to bed, they want therapies that are minimally disruptive to the patient's or the provider's typical daily routines. Our V.A.C. Freedom system is designed to allow patients mobility to conduct normal lives while their wounds heal.

 

Therapies to Treat Pulmonary Complications in the Intensive Care Unit

     The most critically ill patient population is generally cared for in the intensive care unit, or ICU, of a hospital, where they can receive the most intense medical treatment and attention. Patients seen in the ICU usually suffer from serious acute or chronic diseases or severe traumatic injuries. These patients often have, or develop, pulmonary complications, such as Acute Respiratory Distress Syndrome (“ARDS”), resulting directly from their conditions or stemming from their impaired mobility.  Some ICU patients are in such acute distress that their organ systems are at risk of failure and many are on some type of life-support. In 2003, there were approximately 1.1 million ICU patients in the United States with pulmonary complications.

     Treating pulmonary complications requires special equipment and treatment methods. Because of the aggressive and specialized treatments required to address these life-threatening conditions, daily patient-care costs in the ICU are high. Our critical care therapies consist of Kinetic Therapy, Prone Therapy and Kinetic Prone Therapy to provide mobility to patients who cannot mobilize themselves. Kinetic Therapy involves the side‑to‑side rotation of a patient to an angle of at least 40 degrees per side and has been shown in independent clinical studies to reduce the incidence of certain pulmonary complications and length of stay in the ICU. Prone Therapy involves turning a patient from the supine to prone position and often is done manually by nurses in the ICU. Proning an ICU patient may improve oxygenation in ARDS patients and reduce ventilator time and ICU length of stay. Kinetic Prone Therapy involves delivering Kinetic Therapy in the Prone position.

Bariatric Care

     In the U.S., the prevalence of obesity has increased from 15% in the late 1970s to approximately 23% in 2003. In addition, obesity is now the second leading cause of preventable death in the U.S., and has been estimated at 5.3% of total medical spending. Obese patients are often unable to fit into standard‑sized beds and wheelchairs and pose an increased risk to caregivers. KCI's BariatricSupport, a comprehensive offering of therapy-driven, safety-focused products, education and training, provides obese patients with the surface therapies, accessories, and support they need. In addition, our bariatric products enable caregivers to care for obese patients in a safe and dignified manner in all care settings. While our bariatric products are generally used for patients weighing from 300 to 600 pounds, most are expandable and can accommodate patients weighing up to 850 to 1,000 pounds. Our most sophisticated bariatric products can serve as a chair, weight scale, and x‑ray table; and they provide therapies like those in our wound treatment and prevention systems. Moreover, treating obese patients is a significant staffing issue for many health care facilities, moving many facilities to adopt a “no lift” policy, because moving and handling obese patients increases the risk of injury to health care personnel. Our products and accessories enable health care personnel to treat these patients in a manner that is safer for health care personnel, safer and more dignified for the patient, and assists facilities in complying with their “no lift” policy.

Wound Treatment and Prevention

     Our pressure relieving therapeutic surfaces provide therapy for the treatment of pressure sores, burns, ulcers, skin grafts, and other skin conditions. They also help prevent the formation of pressure sores that can develop in immobile individuals. Our therapeutic surfaces reduce the amount of pressure on a patient's intact skin (prevention) or an existing wound site (treatment) by redistributing forces away from the skin or wound site through immersion of the patient into a medium such as air, foam, silicon beads, or viscous fluid. Our products also help to reduce shear, a major factor in the development of pressure ulcers, by reducing the amount of friction between the skin surface and the surface of the bed. Many of our products also provide moisture control, a major cause of maceration of the skin, by flowing air through the support surface to the skin, keeping the skin dry and moisture free. In addition to providing pressure relieving therapy, some of our products also provide for pulsing of air into the surface cushions, known as Pulsation Therapy, which helps improve blood and lymphatic flow to the skin. Some of our products further promote healing and reduce nursing time by providing an automated "wound care" turn of at least 20 degrees per side. Our wound care therapeutic surfaces are utilized by patients in hospitals, residents in nursing homes and individuals in the home.

Products

     We offer a wide range of products in each clinical application to meet the specific needs of different subsets of the market, providing innovative, cost effective, outcome-driven therapies across multiple care settings.

Advanced Wound Healing and Tissue Repair Products

     Our four wound healing and tissue repair systems incorporate our proprietary V.A.C. technology.  The V.A.C. System consists of a therapy unit and four types of disposables: a foam dressing, an occlusive drape, a tube system connecting the dressing to the therapy unit and a canister.  The therapy unit consists of a pump that generates controlled negative pressure and internal software that controls and monitors the application of the therapy.  The therapy can be programmed for individualized use.  Additionally, the V.A.C.^ATS and V.A.C. Freedom units include safety alarms that respond in real time to alert users of any lumen blockage, dressing leakage or machine tilting that may otherwise interfere with appropriate therapy delivery.  The systems have a number of on screen user-assist features such as treatment guidelines.

     Our negative pressure therapy is delivered to the wound bed through a proprietary foam dressing cut to fit the size and shape of the wound size. The dressing is connected to the therapy unit through a tube which both delivers the negative pressure and measures the pressure delivered to the wound surface. An occlusive drape covers the dressing and secures the foam, thereby allowing negative pressure to be maintained at the wound site. Negative pressure can also be applied intermittently to the wound site, which we believe further accelerates the growth of granulation tissue. The canister collects the fluids, or exudates, and helps reduce odors through the use of special filters. V.A.C. dressings are typically changed every 48 hours for non-infected wounds, versus traditional dressings which often require dressing changes one or more times per day. Our V.A.C. dressings are specially designed to address the unique physical characteristics of different wound types, such as large open wounds, surgical wounds, diabetic foot ulcers and open abdominal wounds, among others.

     Our wound healing and tissue repair systems are targeted to meet the needs of specific care settings and wound or patient requirements, and consist of the following:

     -  The V.A.C.^ATS System was introduced in 2002 to meet the acute care requirements for a flexible, easy-to-use, high-capacity system that is effective with the largest and most challenging trauma, orthopedic reconstruction and abdominal wounds. The V.A.C.^ATS incorporates advanced features and controls to provide flexibility to customize the treatment protocol to the requirements of different wound types and physician preferences. It also incorporates our proprietary T.R.A.C. technology, which enables the system to monitor pressure at the wound site and automatically adjust system operation to maintain the desired therapy protocol. The V.A.C.^ATS also simplifies dressing changes and incorporates smart alarms that help ensure patient safety.

     -  The V.A.C. Freedom System was introduced in 2002 to meet the requirements for a robust, lightweight, high-performance product suitable for patients who are able to walk and are not confined to bed. Similar to the V.A.C.^ATS system, it incorporates advanced features and T.R.A.C. technology, but in a 3.2-pound package adapted for convenient unobtrusive use by more active patients. It also includes special filters that help reduce wound odor, a common and embarrassing problem for many ambulatory wound patients. While the design of the V.A.C. Freedom system addresses the treatment needs of chronic wound patients, its 300 cc canister capacity also makes it appropriate for patients with highly exudating wounds.

     -  The V.A.C. Instill System was introduced in 2003 to add additional therapeutic capability to the V.A.C. system. The V.A.C. Instill combines the ability to instill fluids into the wound with V.A.C. therapy. Fluids prescribed by physicians for topical use—including antibiotics, antiseptics and anesthetics—can be instilled, making the system particularly well suited for infected and painful wounds. Future uses could include cytokines, growth factors, or other agents to stimulate wound healing. Because the V.A.C. Instill is based on the V.A.C.^ATS system, it also includes all the capabilities and features of the V.A.C.^ATS.

     The superior clinical efficacy of our V.A.C. wound healing and tissue repair systems is supported by an extensive collection of published clinical studies. V.A.C. systems have been reviewed in at least 242 peer reviewed journal articles, 342 abstracts, 48 case studies and 49 textbook citations. Of these, the research for 53 articles and 56 abstracts was funded by research grants from KCI.  Negative Pressure Wound Therapy, as delivered by the V.A.C. System, has been granted a seal of approval by the American Podiatric Medical Association, the German Wound Healing Society and the Austrian Wound Healing Society.  In addition, independent consensus conferences have issued guidelines for the use of Negative Pressure Wound Therapy for diabetic foot wounds, pressure ulcers, complex chest wounds, hospital treated wounds and open abdominal wounds.

     Additionally, we are sponsoring five ongoing prospective, randomized and controlled multicenter clinical studies specifically designed to provide statistically significant evidence of V.A.C. therapy's clinical efficacy for treating a wide range of targeted wound types. These clinical studies are managed by our 23-member Clinical Operations team within our Medical department.

Products Treating Pulmonary Complications in the ICU

     Our critical care therapies line includes both Kinetic Therapy products and Prone Therapy products. In 2004, we introduced the RotoProne Therapy System, an advanced patient-care system for the treatment and prevention of pulmonary complications associated with immobility. Providing Kinetic Therapy, Prone Therapy and Kinetic Prone Therapy, the RotoProne Therapy System enables caregivers to automatically rotate immobile patients with respiratory complications from the supine to the prone position and to also rotate them from side to side up to 62 degrees in both the supine and prone positions. The Rotoprone Therapy System can help improve patient outcomes by providing caregivers an easier way to deliver multiple intervals of Prone or Kinetic Prone Therapy over an extended period of time.  It also has the capability of delivering Kinetic Therapy in the supine position. The RotoProne Therapy System features include programmable rotation, up to 62 degrees in either the prone or supine position, with an acclimation mode as well as pause and hold functions to suspend the patient in a side‑lying position for ease in nursing care. Other features of the RotoProne Therapy System include a proprietary tube management system, electronically monitored buckles, an ergonomically‑designed head positioning system and 40‑second or less return to supine from the prone position for delivery of CPR.

     Our Kinetic Therapy products include the TriaDyne Proventa, TriaDyne II, Roto Rest Delta, PediDyne and Rotoprone Therapy systems. The TriaDyne Therapy System product line is used primarily in acute care settings and provides patients with four distinct therapies on an air suspension surface. The TriaDyne Therapy System applies Kinetic Therapy by rotating the patient up to 45 degrees on each side. There are three different modes of rotation: upper body only, full body rotation, and counter rotation, simultaneously rotating the patient's torso and lower body in opposite directions to keep the patient centered on the patient surface. The TriaDyne Therapy System also provides percussion therapy to loosen mucous buildup in the lungs and pulsation therapy to promote capillary and lymphatic flow. The Roto Rest Delta is a specialty bed that can rotate a patient up to 62 degrees on each side for the treatment of severe pulmonary complications and respiratory failure. The Roto Rest Delta is also designed, and has been shown, to improve the care of patients suffering from multiple trauma and spinal cord injury.  Kinetic Therapy has been clinically studied in at least 17 randomized clinical trials, 55 peer reviewed articles, 10 other published articles, 42 abstracts, 19 case studies and three textbook citations. Of these, the research for 16 articles, 32 abstracts and 19 case studies was funded by research grants from KCI.

Bariatric Care Products

     Our bariatric products provide a range of therapy options and the proper support needed by obese patients that enable nurses to properly care for these patients in a safe and dignified manner. The most advanced product in this line is the BariAir Therapy System, which can serve as a bed, cardiac chair or x-ray table. The BariAir, first introduced in 1996, provides low air loss pressure relief, continuous turn assist, percussion and step-down features designed for both patient comfort and nurse assistance. This product can be used for patients who weigh up to 850 pounds. We believe that the BariAir is the most advanced product of its type available today and is indicated for the treatment of the most complex bariatric patient, typically found in the ICU. In addition to therapy, the BariAir provides a risk management platform for patients weighing up to 850 pounds. It is a front exit bed with the ability to convert to a cardiac chair position. In 1996, we also introduced the FirstStep Select Heavy Duty overlay, which provides pressure-relieving low air loss therapy when placed on a BariKare bed, our front-exit risk management platform for patients up to 850 pounds. Our AirMaxxis product provides a therapeutic air surface for the home environment for patients weighing up to 650 pounds. The Maxxis 300 and Maxxis 400 provide a home care bariatric bed frame for patients weighing up to 600 pounds and 1,000 pounds, respectively.

     The BariMaxx II bed provides a basic risk management platform for patients weighing up to 1,000 pounds for those customers looking for a set of features including built-in scales and an expandable frame at a lower cost. The BariMaxx II side exit feature allows the caregiver to assist patients in a more traditional exit of the bed. This is an important factor in a patient's rehabilitation and prepares them for facility discharge. The MaxxAir ETS (Expandable Turning Surface) mattress replacement system is a low‑air pressure relieving surface option for the BariMaxx II that also includes rotational therapy of up to 30 degrees on each side.

     All of our bariatric beds can be combined with an EZ-Lift patient transfer system, an Air Pal air assisted lateral transfer system, a Carechair combination chair / stretcher, and other accessories such as wheelchairs, walkers and commodes to create a complete bariatric suite offering. This complete suite offering helps care givers in the day to day care of the bariatric patient and also assists with compliance to “no lift” policies being implemented in health care facilities.

Wound Treatment and Prevention Products

     We offer a wide variety of therapeutic surfaces for wound treatment and prevention, providing pressure reduction, pressure relief, pulsation, alternating pressure, and a continuous turn of a minimum of 20 degrees. Most of our therapy beds and surfaces incorporate the exclusive use of Gore Medical Fabric in the patient contact areas to provide an ideal microclimate for skin protection and moisture control. Our pressure relief products include a variety of framed beds and overlays such as the KinAir MedSurg and KinAir IV framed beds; the FluidAir Elite and FluidAir II bead beds; the FirstStep, FirstStep Plus, FirstStep Select, FirstStep Advantage, TheraKair, TheraKair Visio and TriCell overlays, the AtmosAir family of non-powered, dynamic mattress replacement and seating surfaces; and the RIK fluid mattress and overlay. Our pulsation products include the KinAir MedSurg Pulse and TheraPulse ATP framed beds and the DynaPulse overlay. Our alternating pressure or air cycling products include a powered model of the AtmosAir, and the Intercell. Our turn assist products include the KinAir IV, Therapulse ATP, and a powered AtmosAir model.  Internationally, the TheraKair Visio represents the next generation of our strong Therakair brand, providing low air loss pressure relief with Pulsation Therapy.

     The KinAir MedSurg and KinAir IV have been shown to provide effective skin care therapy in the treatment of pressure sores, burns and post-operative skin grafts and flaps and to help prevent the formation of pressure sores and certain other complications of immobility. The FluidAir Elite and FluidAir II support patients on a low-pressure surface of air-fluidized beads providing pressure relief and shear relief for skin grafts or flaps, burns and pressure sores. The TheraKair, TheraKair Visio, and FirstStep family of overlays and mattress replacement systems are designed to provide pressure relief and help prevent and treat pressure sores. The AtmosAir family is primarily for-sale mattress replacement products that have been shown to be effective for the prevention and treatment of pressure sores in a series of hospital‑based case studies. The proprietary AtmosAir with Self Adjusting Technology (SAT) utilizes atmospheric pressure and gravity to deliver non-powered dynamic pressure relief.

     The KinAir MedSurg Pulse and TheraPulse ATP framed beds and the DynaPulse overlay provide a more aggressive form of treatment through a continuous pulsating action which gently massages the skin to help improve capillary and lymphatic circulation in patients suffering from severe pressure sores, burns, skin grafts or flaps, swelling or circulatory problems.

     The KinAir IV, Therapulse ATP and a powered AtmosAir model all provide turn assist of a minimum of 20 degrees to each side. Turn assist helps the caregiver reposition and/or turn a patient in order to provide patient care and pressure relief.

Competitive Strengths

     We believe we have the following competitive strengths:

     Product innovation and commercialization.  We have a successful track record in pioneering new wound care and therapeutic surface technologies.  Our recent development and commercialization of new V.A.C. systems and disposable dressing variations have strengthened KCI's leadership position in advanced wound care.  We have also developed and commercialized a broad spectrum of therapeutic surfaces, a number of which have significantly enhanced patient care.  Our most recent innovation in therapeutic surfaces is RotoProne Therapy, an advanced patient-care system for the treatment and prevention of pulmonary complications associated with immobility.  Proning therapy may improve oxygenation in patients with Acute Respiratory Distress Syndrome.

     Superior clinical efficacy.  The superior clinical efficacy of our V.A.C. systems and our therapeutic surfaces is supported by an extensive collection of published clinical studies, peer-reviewed journal articles, and textbook citations, which aid adoption by clinicians.

     Broad reach and customer relationships.  Our worldwide sales team, consisting of approximately 1,630 individuals, including approximately 485 employees with clinical backgrounds, has strong relationships with our customers due to the clinical support and consultation we provide and our education and training programs. We also have broad reach across all health care settings. In the United States, for example, we have relationships with over 3,800 acute care hospitals, approximately 5,900 extended care facilities and over 10,800 home health care agencies and wound care clinics.

     Extensive service center network.  With a network of 139 U.S. and 70 international service centers, we are able to rapidly deliver our critically needed products to major hospitals in the United States, Canada, Australia and most major European countries. Our network gives us the ability to deliver our products to any major Level I domestic trauma center within hours. This extensive network is critical to securing national GPO contracts and allows us to efficiently serve the home market directly. Our network also provides a platform for the introduction of additional products.

     Reimbursement expertise.  A significant portion of our V.A.C. revenue is derived from home placements, which are reimbursed by third-party payers such as private insurance, managed care, Medicare and Medicaid.  We have dedicated significant time and resources to develop capabilities and expertise in third-party reimbursement, and we have developed systems to support and manage the deployment of our domestic and international sales and service efforts.

Customers

     We have a broad reach across all health care settings. In the United States, for example, we have relationships with over 3,800 acute care hospitals, approximately 5,900 extended care facilities and over 10,800 home health care agencies and wound care clinics. As of December 31, 2005, we served over 2,400 medium to large hospitals in the United States. Through our network of 139 U.S. and 70 international service centers, we are able to rapidly deliver our critically needed products to major hospitals in the United States, Canada, Australia and most major European countries. This extensive network is critical to securing national contracts with group purchasing organizations (“GPOs”), and allows us to efficiently serve the home market directly. Our network also provides a platform for the introduction of additional products.

     Our agreements with GPOs and reimbursement under Medicare Part B account for a significant portion of our revenues.  We have agreements with numerous GPOs, which represent large groups of acute care and extended care facilities in order to negotiate rental and purchase terms on behalf of their members.  Our largest GPO relationship is with Novation, LLC.  Under our agreements with Novation, we provide products and therapies to over 1,800 acute care and extended care facilities.  Rentals and sales to Novation participants in the years ended December 31, 2005 and 2004, accounted for $159.6 million, or 13.2% of total revenue, and $145.3 million, or 14.6% of total revenue, respectively.  Medicare, which reimburses KCI for placement of products and therapies with Medicare participants, accounted for $148.6 million, or 12.3% of total revenue, and $114.6 million, or 11.5% of total revenue for the years ended December 31, 2005 and 2004, respectively.  No other customers or payers accounted for 10% or more of total revenues for the years ended December 31, 2005 and 2004, respectively.

     Our customers generally prefer to rent our V.A.C. systems and therapeutic surfaces and purchase the related disposable products, such as V.A.C. dressings. We believe that some of our customers, who tend to be our larger customers, desire alternatives to rental for at least some of their business. We expect this trend may continue as V.A.C. penetration increases, and we are exploring alternative models so that we meet our customers' needs.

Billing and Reimbursement

     We have extensive contractual relationships and reimbursement coverage for our products in the United States. In acute and extended care, we have contracts with nearly all major hospital-organizations and most major extended-care organizations. Generally, these acute and extended care organizations pay us directly for our products and services. In the home care market, we provide our products and services directly to patients and bill third‑party payers, including Medicare and private insurance. We currently have V.A.C. contracts with private and governmental organizations covering over 200 million member lives in the United States as of December 31, 2005. This represents more than 10 times the number of member lives we had under contract as of mid-2000.

     The following table sets forth, for the periods indicated, the percentage of revenue derived from different types of payers:

 

Employees

     As of December 31, 2005, we had 5,735 employees.  Our corporate, manufacturing, finance and administrative functions are performed by approximately 1,115 employees who are located in San Antonio, Texas. Our USA division had 2,865 employees, including 980 employees located in San Antonio who perform functions associated with customer service and sales administration. As of December 31, 2005, we had approximately 1,755 employees in our international division. Approximately 80 employees in our France subsidiary are represented by a workers' council, pursuant to applicable industrial relations laws. Our employees are not otherwise represented by labor unions or workers' councils and we consider our employee relations to be good.

Corporate Organization

     Our business has two geographical operating segments: USA and International.

     With approximately 2,865 employees as of December 31, 2005, our USA division serves the domestic acute care, extended care and home care markets with the full range of our products and services. The domestic division distributes our medical devices and therapeutic surfaces to over 3,800 acute care hospitals and approximately 5,900 extended care facilities and also directly serves the home care market through our service center network. Our USA division accounted for approximately 73%, 75%, and 76% of our total revenue in the years ended December 31, 2005, 2004 and 2003, respectively.

     As of December 31, 2005, our International division had direct operations in 17 foreign countries including Germany, Austria, the United Kingdom, Canada, France, the Netherlands, Switzerland, Australia, Italy, Denmark, Sweden, Ireland, Belgium, Spain, Singapore, Japan and South Africa. The International division distributes our medical devices and therapeutic surfaces through a network of 70 service centers. Our international corporate office is located in Amsterdam, the Netherlands. We have international manufacturing and engineering operations based in the United Kingdom and Belgium.  In addition, our International division serves the demands of a growing global market through relationships with approximately 50 independent distributors in Latin America, the Middle East, Eastern Europe and Asia. The International division consists of approximately 1,755 employees who are responsible for all sales, service and administrative functions within the various countries we serve. Our International division accounted for approximately 27%, 25% and 24% of our total revenue in the years ended December 31, 2005, 2004 and 2003, respectively.

Sales and Marketing Organization

     Our worldwide sales organization consists of approximately 1,630 individuals. Our sales organization is organized by care setting. Since physicians and nurses are critical to the adoption and use of advanced medical systems, a major element of the sales force's responsibility is to educate and train these medical practitioners in the application of our products, including the specific knowledge necessary for optimal clinical outcomes and reducing the cost of patient care. We have approximately 485 clinical consultants, all of whom are health care professionals, whose principal responsibilities are to make product rounds, consult on complex cases and assist facilities and home health agencies to develop their patient-care protocols. Our clinicians educate the hospital, long-term care facility or home health agency staff on the use of our products. In addition, we employ approximately 140 field‑based specialists who consult with our customers regarding the often demanding and complex paperwork required by Medicare and private insurance companies. In fulfilling the paperwork requirements, these specialists enhance the overall productivity of our sales force.

     Our international sales organization includes more than 590 employees in 17 foreign countries. In each foreign market where we have a presence, we sell our products through our direct sales force or through local distributors with local expertise.

     Selling, marketing and advertising expenses in each of the periods below were as follows (dollars in thousands):

 

Service Organization

     Our USA division has a national 24-hour, seven day-a-week customer service communications system, which allows us to quickly and efficiently respond to our customers' needs. In 2005, we launched KCI Express, our online secure, encrypted website allowing customers in acute care, extended care and home care to transact business with KCI on the web.  The branded site, www.kciexpress.com provides KCI’s customers self-service applications designed to meet the specific needs in their care setting.  Our USA division distributes our medical devices and therapeutic surfaces through a network of 139 domestic service centers.  Our USA division's network gives us the ability to deliver our products to any major Level I domestic trauma center within hours.  Our International division distributes our medical devices and therapeutic surfaces through a network of 70 service centers.

     In addition to delivery, pick-up, and technical support services, our service organization cleans, disinfects, and reconditions products between rentals.  To assure availability when products are needed, the service organization manages our rental fleet of approximately 100,000 units, deploying units to meet individual service center demand patterns while maintaining high levels of rental asset utilization.  Services are provided by approximately 930 people in the United States and 540 people internationally.

Research and Development

     We have a successful track record of pioneering new wound care and therapeutic surface technologies through new product introductions and significant enhancements to existing products. Our development and commercialization of V.A.C. systems including proprietary disposable dressings have established KCI as a leader in advanced wound care. Our therapeutic surfaces technology originated with the introduction of the Roto Rest bed 29 years ago. Since that time, we continue to develop and commercialize a broad spectrum of therapeutic surfaces, a number of which have significantly enhanced patient care. More recently, we have developed a broad portfolio of bariatric surface products to improve the care of obese patients.

     Our primary focus for innovation is to increase the clinical and economic benefit of our products to our customers and their patients. In addition, we strive to make our products user-friendly and increase their operational efficiency, both of which are critical in the demanding and sometimes short‑staffed world of health care today. Significant investments in our 2005 research and development included:

        -  new, advanced wound healing systems and dressings tailored to the needs of different wound types and care
           settings;

        -  new technologies in wound healing and tissue repair;

        -  new applications of V.A.C. technology and enhanced therapeutic effectiveness through improved understanding
           of the V.A.C. systems' various mechanisms of action; and

        -  commercialization of RotoProne, an advanced therapeutic surface to address critical needs of patients with
           Acute Respiratory Distress Syndrome and other severe pulmonary complications, and development of a new
           therapeutic surface to provide neuroprotection for cardiac arrest and stroke patients.

     Expenditures for research and development, including clinical trials, in each of the periods below, were as follows (dollars in thousands):

 

Patents, Trademarks and Licenses

     To protect our proprietary rights in our products, new developments, improvements and inventions, we rely on a combination of patents, copyrights, trademarks, trade secret and other laws, and contractual restrictions on disclosure, copying and transfer of title, including confidentiality agreements with vendors, strategic partners, co-developers, employees, consultants and other third parties. We seek patent protection in the United States and abroad. We have approximately 160 issued U.S. patents relating to our existing and prospective lines of therapeutic medical devices. We also have approximately 60 pending U.S. patent applications. Many of our specialized beds, medical devices and services are offered under proprietary trademarks and service marks. We have approximately 55 trademarks and service marks registered with the United States Patent and Trademark Office. We also have agreements with third parties that provide for the licensing of patented and proprietary technology.

     We have patents relating to our current V.A.C. products, in the form of owned and licensed patents, including at least 19 issued U.S. patents (including 10 design patents) and at least 13 U.S. patent applications pending. Our worldwide patent portfolio (including owned and licensed patent assets) relating to current and prospective technologies in the field of V.A.C. Therapy includes more than 225 issued patents and more than 140 pending patent applications, including protection in Europe, Canada, Australia, Japan and the United States. Most of the V.A.C. patents in our patent portfolio have a term of 20 years from their date of priority. The V.A.C. utility patents, which relate to our basic V.A.C. Therapy, extend through the middle of 2014. We also have multiple longer-term patent filings directed to cover unique central systems, dressings and other improvements of the V.A.C. system.

     On October 6, 1993, we entered into a license agreement with Wake Forest University on which we rely in connection with our V.A.C. business. Under this agreement, Wake Forest University has licensed to us on a worldwide, exclusive basis, the right to use, lease, sell and sublicense its rights to certain patents that are integral to the technology that we incorporate in our V.A.C. products. The term of the agreement continues for as long as the underlying patents are in effect, subject to Wake Forest University's right to terminate earlier if we fail to make required royalty payments or are otherwise in material breach or default of the agreement.

     We are subject to legal proceedings involving our patents that are significant to our business.  These proceedings are discussed subsequently in “Item 3: Legal Proceedings.”

Manufacturing

     Our manufacturing processes for V.A.C. systems, therapeutic surfaces, mattress replacement systems and overlays involve producing final assemblies in accordance with a master production plan. Assembly of our products is accomplished using (1) metal parts that are fabricated, machined, and finished internally, (2) fabric that is cut and sewn internally and externally, and (3) plastics, electronics and other component parts that are purchased from outside suppliers. Component parts and materials are obtained from industrial distributors, original equipment manufacturers and contract manufacturers. The majority of parts and materials are readily available in the open market (steel, aluminum, plastics, fabric, etc.) for which price volatility is low. The manufacturing process is in compliance with the International Organization for Standardization (“ISO”) 9001 (1994), ISO 13485, and the United States Food and Drug Administration’s Quality System Regulation.

     We contract for the manufacture of V.A.C. disposable supplies through Avail Medical Products, Inc., a leading contract manufacturer of sterile medical products.  We entered into an exclusive agreement with Avail for our V.A.C. related disposable products, which became effective in October 2002 for our U.S. orders and in May 2003 for our international orders.  This evergreen supply agreement has a term through October 2008, which automatically extends for additional twelve-month periods in October of each year, unless either party gives notice to the contrary.  Approximately 23% of our total revenue for the year ended December 31, 2005 was generated from the sale of these disposable supplies.  The terms of the supply agreement provide that key indicators be provided to us that would alert us to Avail's inability to perform under the agreement.  We maintain an inventory of disposables sufficient to support our business for approximately six weeks in the United States and eight weeks in Europe.  However, in the event that we are unable to replace a shortfall in supply, our revenue could be negatively impacted in the short term.

Working Capital Management

     We maintain inventory parts and supplies to support customer needs in our service centers and in our manufacturing facilities. We also maintain inventory for conversion to our surface and V.A.C. rental fleet in our manufacturing facilities. Our V.A.C. rental equipment cannot be used without the disposables that support the V.A.C. systems. As such, we buy and ship disposable inventory directly from our single supplier to the customer.

     Our payment terms with hospitals and extended care facilities are consistent with industry standards and generally provide for payment within 30 days of invoice. Our payment terms with third-party payers, including Medicare and private insurance, are consistent with industry standards and are regulated by contract and state statute and generally vary from 30 to 45 days. A portion of our receivables relate to unbilled revenues arising in the normal course of business.  A portion of our revenues remain unbilled for a period of time due to monthly billing cycles requested by our hospital or extended care facility customers or due to our internal paperwork processing and compliance procedures regarding billing third-party payers.

Competition

     We believe that the principal competitive factors within our markets are clinical efficacy, cost of care, clinical outcomes and service. Furthermore, we believe that a national presence with full distribution capabilities is important to serve large, national and regional health care GPOs. We have contracts with most major hospital GPOs and most major extended care GPOs for V.A.C. systems. The medical device industry is highly competitive and is characterized by rapid product development and technological change. In order to remain competitive with other companies in our industry, we must continue to develop new cost-effective products and technologies.

     In wound healing and tissue repair, we compete with products designed to mimic V.A.C. functions and other treatment methods offered by a number of companies in the advanced wound care business.  For example, BlueSky Medical Corporation is actively marketing a medical device to compete directly with V.A.C. Therapy.  We believe that this device violates our intellectual property rights and we have taken legal action against BlueSky, its suppliers and several of its distributors to protect our rights.  In 2004, BlueSky received FDA clearance of its pump and one of its dressings and in 2005, BlueSky’s product was assigned to the Medicare billing codes for Negative Pressure Wound Therapy.  Since obtaining these approvals, BlueSky has been actively marketing its products within the KCI customer base.  In the event that KCI is unsuccessful in its case against BlueSky, or if other manufacturers are able to successfully develop technologies that do not infringe our patents or intellectual property rights, KCI will likely face increasing competition in the advanced wound-care market.  As the market for, and revenues generated by the V.A.C. System expand, we believe additional competitors may introduce products designed to mimic the V.A.C.  Over time, as KCI’s patents in the V.A.C. field begin to expire, KCI expects increased competition with products adopting the basic V.A.C. technologies.

     Other wound healing methods are substantially different than the V.A.C. and include traditional wound care dressings, advanced wound care dressings (hydrogels, hydrocolloids, alginates), skin substitutes, products containing growth factors and medical devices used for wound care. Many of these methods can be used to compete with the V.A.C. or as adjunctive therapies which may complement V.A.C. therapy.  For example, caregivers may use one of our V.A.C. systems in order to reduce the wound size and create a healthy wound bed, and then use a skin substitute to manage the wound to final closure.

     With respect to therapeutic surfaces for treatment of pulmonary complications in the ICU, wound treatment and prevention, our primary competitors are Hill-Rom Company, Huntleigh Healthcare and Pegasus Limited. In the bariatric market, our primary competitors are Hill-Rom, Sizewise Rentals and Huntleigh Healthcare. We also compete on a regional, local and market segment level with a number of smaller companies.

Reimbursement

     Our products are rented and sold principally to hospitals, extended care facilities and directly to patients in the home who receive payment coverage for the products and services they utilize from various public and private third‑party payers, including government-funded programs, such as the Medicare and Medicaid programs in the U.S.  In the home care market, we provide our products and services to patients and bill insurance companies, including Medicare Part B. As a result, the demand and payment for our products are dependent, in part, on the reimbursement policies of these payers. The manner in which reimbursement is sought and obtained for any of our products varies based upon the type of payer involved and the setting to which the product is furnished and in which it is utilized by patients.

     We believe that government efforts to contain or reduce health care costs are likely to continue. These trends may lead third‑party payers to deny or limit reimbursement for our products, which could negatively impact the pricing and profitability of, or demand for, our products.

     In its 2006 Work Plan, the Office of the Inspector General (“OIG”) of the Department of Health and Human Services (“HHS”) through its Office of Evaluations and Inspections, listed two durable medical equipment evaluations: “Medical Necessity of DME” and “Medicare Pricing of Equipment and Supplies.”  More recently, we have learned from the 2006 work plan that the OIG plans to conduct a study on Negative Pressure Wound Therapy during 2006. The OIG Office of Evaluations and Inspections evaluates effectiveness and efficiency of a wide range of HHS programs.  We have participated in similar studies in the past on other product lines.  As part of the current study, the OIG has requested copies of our billing records for Medicare V.A.C. placements.  KCI submitted all copies requested and plans to cooperate fully with any and all requests associated with these evaluations. We cannot predict how either or both of them may impact reimbursement of our products in the future.

Medicare

     Medicare is a federally funded program that provides health care coverage primarily to the elderly and disabled. Medicare is composed of four parts: Part A, Part B, Part C and Part D. Medicare Part A (hospital insurance) covers, among other things, inpatient hospital care, home health care and skilled nursing facility services. Medicare Part B (supplementary medical insurance) covers various services, including those services provided on an outpatient basis. Medicare Part B also covers medically necessary durable medical equipment and medical supplies. Medicare Part C, also known as "Medicare Advantage," offers beneficiaries a choice of various types of health care plans, including several managed care options. Medicare Part D is the new Voluntary Prescription Drug Benefit Program. The Medicare program has established guidelines for the coverage and reimbursement of certain equipment, supplies and support services. In general, in order to be reimbursed by Medicare, a health care item or service furnished to a Medicare beneficiary must be reasonable and necessary for the diagnosis or treatment of an illness or injury or to improve the functioning of a malformed body part and not otherwise excluded by statute. Effective October 1, 2000, we received Medicare Part B reimbursement codes, an associated coverage policy and allowable rates for our V.A.C. systems and related disposable supplies in the home care setting.

     The methodology for determining the amount of Medicare reimbursement of our products varies based upon, among other things, the setting in which a Medicare beneficiary receives health care items and services. Most of our products are furnished in a hospital, skilled nursing facility or the beneficiary's home.

Hospital Setting

     Acute care hospitals are generally reimbursed for certain patients by Medicare for inpatient operating costs based upon prospectively determined rates. Under the prospective payment system (“PPS”), acute care hospitals receive a predetermined payment rate based upon the Diagnosis‑Related Group (“DRG”), which is assigned to each Medicare beneficiary's primary diagnosis, regardless of the actual cost of the services provided. Certain additional or "outlier" payments may be made to a hospital for cases involving unusually high costs or lengths of stay. Accordingly, acute care hospitals generally do not receive direct Medicare reimbursement under PPS for the distinct costs incurred in purchasing or renting our products. Rather, reimbursement for these costs must come from within the DRG-based payments made to hospitals for the treatment of Medicare‑eligible inpatients who utilize the products. Long-term care and rehabilitation facilities are now also paid under a PPS rate that does not directly account for all actual services rendered. Because PPS payments are based on predetermined rates, and may be less than a facility’s actual costs in furnishing care, facilities have incentives to lower their inpatient operating costs by utilizing equipment and supplies, such as our products, that will reduce the length of inpatient stays, decrease labor or otherwise lower their costs.

     Certain specialty facilities such as long term acute care or in-patient rehabilitation facilities also use our products.  In 2003, these specialty facility types completed a phase-in to a PPS reimbursement system.  To date, we have not experienced a material impact on our business from this reimbursement change.  However, in 2005, additional changes in admitting practices were being phased-in to these specialty facilities.  These changes have the potential of adversely impacting overall reimbursement for these specialty facilities.  We cannot predict the impact of these changes in admitting practices of long term acute care and in-patient rehabilitation facilities on the health care industry or on our financial position or results of operations.

Skilled Nursing Facility Setting

     Reimbursement for skilled nursing facilities (“SNFs”) under Medicare Part A changed from a cost-based system to a prospective payment system effective in 1998, which is based on resource utilization groups ("RUGs"). Under the RUGs system, a Medicare patient in a SNF is assigned to a RUGs category upon admission to the facility. The RUGs category to which the patient is assigned depends upon the medical services and functional support the patient is expected to require. The SNF receives a prospectively determined daily payment based upon the RUGs category assigned to each Medicare patient. These payments are intended generally to cover all inpatient services for Medicare patients, including routine nursing care, capital‑related costs associated with the inpatient stay and ancillary services. Because the RUGs system provides SNFs with fixed daily cost reimbursement, SNFs have become less inclined to use products, such as our therapeutic surfaces, which are no longer reimbursed as variable ancillary costs.

Home Setting

     Our products are also provided to Medicare beneficiaries in home care settings. Medicare, under the Part B program, reimburses beneficiaries, or suppliers accepting an assignment of the beneficiary's Part B benefit, for the purchase or rental of DME for use in the beneficiary's home or a home for the aged (as opposed to use in a hospital or skilled nursing facility setting). As long as the Medicare Part B coverage criteria are met, certain of our products, including air fluidized beds, air-powered flotation beds, alternating pressure air mattresses and our V.A.C. systems and related disposables are reimbursed in the home setting under the DME category known as "Capped Rental Items." Pursuant to the fee schedule payment methodology for this category, Medicare pays a monthly rental fee equal to 80% of the established allowable charge for the item. The patient (or his or her insurer) is responsible for the remaining 20%. The Medicare Prescription Drug, Improvement and Modernization Act of 2003 (“MMA”) provides for revisions to the manner in which payment amounts are to be calculated over the next five years (and thereafter). We cannot predict the full impact of the new law on our financial position or results of operations, which may be impacted negatively.

Medicaid

     The Medicaid program is a cooperative federal/state program that provides medical assistance benefits to qualifying low income and medically needy persons. State participation in Medicaid is optional and each state is given discretion in developing and administering its own Medicaid program, subject, among other things, to certain federal requirements pertaining to eligibility criteria and minimum categories of services. The Medicaid program finances approximately 50% of all care provided in nursing facilities nationwide. We sell or rent our products to nursing facilities for use in furnishing care to Medicaid recipients. Typically, nursing facilities receive Medicaid reimbursement directly from states for the incurred costs. However, the method and level of reimbursement, which generally reflects regionalized average cost structures and other factors, varies from state to state and is subject to each state's budget constraints. Current economic conditions have resulted in reductions in state funding for many Medicaid programs. Consequently, states are revising their policies for coverage of durable medical equipment in long-term care facilities and the home. We cannot predict the impact of policy changes on our Medicaid revenue, but it is, and will continue to be, a difficult market to operate in profitably.

Private Payers

     Many non-governmental third‑party payers, including indemnity insurers, employer group health insurance programs and managed care plans, presently provide coverage for the purchase and rental of our products. The scope of coverage and payment policies varies among third‑party private payers. Furthermore, many such payers are investigating or implementing methods for reducing health care costs, such as the establishment of capitated or prospective payment systems.

     We believe that government and private efforts to contain or reduce health care costs are likely to continue. These trends may lead third‑party payers to deny or limit reimbursement for our products, which could negatively impact the pricing and profitability of, or demand for, our products.

Market Outlook

Reimbursement of Healthcare Costs and Healthcare Reform

     The importance of payer coverage policies has been demonstrated by our experience with our V.A.C. technology in the home care setting.  On October 1, 2000, a Medicare Part B policy was approved, which provided for reimbursement codes, an associated coverage policy and allowable rates for the V.A.C. systems and V.A.C. disposable products in the home care setting.  The policy facilitated claims processing, permitted electronic claims submissions and created a more uniform claims review process.  Because many payers look to Medicare for guidance in coverage, a specific Medicare policy is often relied upon by other payers.  In contrast with this U.S. experience, coverage in several European countries has been limited to case-by-case approvals until the appropriate approvals have been granted by the government-sponsored approval body.  Switzerland approved home care reimbursement in 2004, which has opened the market for broad use in the home.  Germany is currently considering approval.  In other countries, such as Austria and the Netherlands, coverage by insurance companies is widespread, even without formal government approval.

     A significant portion of our wound healing systems revenue is derived from home placements, which are reimbursed by both governmental and non-governmental third‑party payers. The reimbursement process for home care placements requires extensive documentation, which has slowed the cash receipts cycle relative to the rest of the business.

     In the United States, health care reform legislation will most likely remain focused on reducing the cost of health care.  We believe that efforts by private payers to contain costs through managed care and other efforts will continue in the future as efforts to reform the health care system continue.

     The MMA contains revisions to payment methodologies and other standards for items of durable medical equipment.  These revisions could have a direct impact on our business.  Under the MMA, the reimbursement amounts for durable medical equipment, including V.A.C. systems, will no longer be increased on an annual basis through 2008.  Also, starting in 2007, Medicare will begin to implement a nationwide competitive bidding program in ten high-population metropolitan statistical areas, and in 2009, this program is to be expanded to 80 areas (and additional areas thereafter).  As of March 6, 2006, no proposed rules have been adopted for the implementation of the competitive bidding process.  KCI’s products may be subject to the competitive bidding process, which could impact KCI’s pricing for products that are reimbursed by Medicare in the home care setting.

     In 2003, the Centers for Medicare and Medicaid Services ("CMS") adopted a final rule implementing "inherent reasonableness" authority, which allows CMS and its carriers to adjust reimbursement amounts for durable medical equipment by up to 15% per year for certain items and services covered by Medicare Part B when the existing payment amount is determined to be grossly excessive or grossly deficient.  The regulation lists factors that may be used by CMS and the carriers to determine whether an existing reimbursement rate is grossly excessive or grossly deficient and to determine what is a realistic and equitable payment amount.  CMS may make a larger adjustment each year if they undertake prescribed procedures for determining the appropriate payment amount for a particular service.  Using this authority, CMS and the carriers could reduce KCI’s reimbursement levels for its products covered by Medicare Part B.

Consolidation of Purchasing Entities

     The many health care reform initiatives in the United States have caused health care providers to examine their cost structures and reassess the manner in which they provide health care services.  This review, in turn, has led many health care providers to merge or consolidate with other members of their industry in an effort to reduce costs or achieve operating synergies.  A substantial number of our customers, including proprietary hospital groups, GPOs, hospitals, national nursing home companies and national home health care agencies, have been affected by this consolidation.  An extensive service and distribution network and a broad product line are key to servicing the needs of these larger provider networks.  In addition, the consolidation of health care providers often results in the re-negotiation of contracts and the granting of price concessions.  Finally, as GPOs and integrated health care systems increase in size, each contract represents a greater concentration of market share and the adverse consequences of losing a particular contract increases considerably.

Health Insurance Portability and Accountability Act Compliance

     The Health Insurance Portability and Accountability Act of 1996 (“HIPAA”) covers a variety of provisions which impact our business including the privacy of patient health care information, the security of that information and the standardization of electronic data transactions for billing.  Sanctions for violating HIPAA include criminal penalties and civil sanctions.  HIPAA’s privacy regulations restrict the use and disclosure of certain individually identifiable health information, or “PHI.”  The HIPAA security standards require us to implement certain measures to protect the security and integrity of electronic PHI.  HIPAA regulations regarding standardization of electronic data billing transactions will also impact our business.  We continue to work with all business associates with whom we share protected health information and who process standardized transactions covered by the regulations in order to make the transition to standardized billing codes as smooth as possible.  However, the health care industry’s continued transition to standardized billing codes may create billing difficulties or business interruptions for us.

Government Regulation

United States

     Our products are subject to regulation by numerous governmental authorities, principally the FDA, and corresponding state and foreign regulatory agencies. Pursuant to the Federal Food, Drug, and Cosmetic Act, and the regulations promulgated thereunder, the FDA regulates the design, clinical testing, manufacture, labeling, distribution, sale and promotion of medical devices. Noncompliance with applicable requirements can result in, among other things, fines, injunctions, civil penalties, recall or seizure of products, total or partial suspension of production, failure of the government to grant pre-market clearance or pre-market approval for devices, withdrawal of marketing clearances or approvals and criminal prosecution. The FDA also has the authority to demand the repair, replacement or refund of the cost of any device that we manufacture or distribute that violates statutory or regulatory requirements.

     In the United States, medical devices are classified into one of three classes (Class I, II or III) on the basis of the controls deemed necessary by the FDA to reasonably ensure their safety and effectiveness. Although many Class I devices are exempt from certain FDA requirements, Class I devices are subject to general controls (for example, labeling, pre-market notification and adherence to the Quality System Regulation). Class II devices are subject to general and special controls (for example, performance standards, post-market surveillance, patient registries and FDA guidelines). Generally, Class III devices are high-risk devices that receive significantly greater FDA scrutiny to ensure their safety and effectiveness (for example, life-sustaining, life-supporting and implantable devices, or new devices which have been found not to be substantially equivalent to legally marketed Class I or Class II devices). Before a new medical device can be introduced in the market, the manufacturer must generally obtain FDA clearance (510(k) clearance) or pre-market application (“PMA”) approval. All of our current products have been classified as Class I or Class II devices, which typically are marketed based upon 510(k) clearance or related exemptions. A 510(k) clearance will generally be granted if the submitted information establishes that the proposed device is "substantially equivalent" in intended use and technological characteristics to a legally marketed Class I or Class II medical device or to a Class III device on the market since May 28, 1976, for which PMA approval has not been required. A PMA approval requires proof to the FDA's satisfaction of the safety and effectiveness of a Class III device. A clinical study is generally required to support a PMA application and is sometimes required for a 510(k) pre-market notification. For "significant risk" devices, such clinical studies generally require submission of an application for an Investigational Device Exemption (“IDE”). The FDA's 510(k) clearance process usually takes from four to twelve months, but may take longer. The PMA approval process is much more costly, lengthy and uncertain. The process generally takes from one to three years; but it may take even longer.

     Devices that we manufacture or distribute are subject to pervasive and continuing regulation by the FDA and certain state agencies, including record‑keeping requirements and mandatory reporting of certain adverse experiences associated with use of the devices. Labeling and promotional activities are subject to regulation by the FDA and, in certain circumstances, by the Federal Trade Commission. Current FDA enforcement policy prohibits the marketing of approved medical devices for unapproved uses and the FDA scrutinizes the labeling and advertising of medical devices to ensure that unapproved uses of medical devices are not promoted.

     Manufacturers of medical devices for marketing in the United States are required to adhere to applicable regulations, including the Quality System Regulation (“QSR”, formerly the Good Manufacturing Practice regulation), which imposes design, testing, control and documentation requirements. Manufacturers must also comply with the Medical Device Reporting (“MDR”) regulation, which generally requires that manufacturers report to the FDA if their device may have caused or contributed to a death or serious injury or malfunctioned in a way that would likely cause or contribute to a death or serious injury if it were to recur. We are subject to routine inspection by the FDA and certain state agencies for compliance with QSR requirements, MDR requirements and other applicable regulations. In December 2005, KCI received accreditation of the Joint Commission on Accreditation of Health Care Organizations. It is our understanding that third-party accreditation of DME suppliers will be required for Medicare Part B reimbursement starting on January 1, 2007.  Under this accreditation process, KCI will be reevaluated every 3 years and is subject to routine unannounced inspections by the Joint Commission on Accreditation of Health Care Organizations to ensure continued compliance with standards.

Fraud and Abuse Laws

     We may also be subject to federal and state physician self-referral laws. Federal physician self-referral legislation (commonly known as the “Stark Law”) prohibits, subject to certain exceptions, physician referrals of Medicare and Medicaid patients to an entity providing certain "designated health services" if the physician or an immediate family member has any financial relationship with the entity. A person who engages in a scheme to circumvent the Stark Law's referral prohibition may be fined up to $100,000 for each such arrangement or scheme. The penalties for violating the Stark Law also include civil monetary penalties of up to $15,000 per referral and possible exclusion from federal health care programs such as Medicare and Medicaid. The Stark Law also prohibits the entity receiving the referral from billing any good or service furnished pursuant to an unlawful referral, and any person collecting any amounts in connection with an unlawful referral is obligated to refund such amounts. Various states have corollary laws to the Stark Law, including laws that require physicians to disclose any financial interest they may have with a health care provider to their patients when referring patients to that provider. Both the scope and exceptions for such laws vary from state to state.

     We may also be subject to federal and state anti-kickback laws. Section 1128B(b) of the Social Security Act, commonly referred to as the “Anti-Kickback Law”, prohibits persons from knowingly and willfully soliciting, receiving, offering or providing remuneration, directly or indirectly, to induce either the referral of an individual, or the furnishing, recommending, or arranging for a good or service, for which payment may be made under a federal health care program such as Medicare and Medicaid. The Anti-Kickback Law is broad, and it prohibits many arrangements and practices that are otherwise lawful in businesses outside of the health care industry. The U.S. Department of Health and Human Services (“DHHS”) has issued regulations, commonly known as safe harbors, that set forth certain provisions which, if fully met, will assure health care providers and other parties that they will not be prosecuted under the federal Anti-Kickback Law. Although full compliance with these provisions ensures against prosecution under the federal Anti-Kickback Law, the failure of a transaction or arrangement to fit within a specific safe harbor does not necessarily mean that the transaction or arrangement is illegal or that prosecution under the federal Anti-Kickback Law will be pursued. The penalties for violating the Anti-Kickback Law include imprisonment for up to five years, fines of up to $25,000 per violation and civil penalties and possible exclusion from federal health care programs. Penalties of up to $50,000, plus up to three times the amount of the remuneration without regard to whether any portion was attributable to legitimate services, may be imposed.  Many states have adopted laws similar to the federal Anti-Kickback Law, and some of these state prohibitions apply to referral of patients for health care services reimbursed by any source, not only federal health care programs such as Medicare and Medicaid.

     In addition, HIPAA defined two new federal crimes: (i) health care fraud and (ii) false statements relating to health care matters. The health care fraud statute prohibits knowingly and willfully executing or attempting to execute a scheme or artifice to defraud any health care benefit program, including private payers. The false statements statute prohibits knowingly and willfully falsifying, concealing or covering up a material fact or making any materially false, fictitious or fraudulent statement or representation in connection with the delivery of or payment for health care benefits, items or services. This statute applies to any health benefit plan, not just Medicare and Medicaid.  Violations of these statutes may result in fines, imprisonment, or exclusion from government health care programs.  Additionally, HIPAA granted expanded enforcement authority to the DHHS and the U.S. Department of Justice (“DOJ”) and provided enhanced resources to support the activities and responsibilities of the DHHS's Office of the Inspector General (“OIG”) and the DOJ by authorizing large increases in funding for investigating fraud and abuse violations relating to health care delivery and payment.

     Under separate statutes, submission of claims for payment or causing such claims to be submitted that are "not provided as claimed" may lead to civil monetary penalties, criminal fines and imprisonment, and/or exclusion from participation in Medicare, Medicaid and other federally funded state health programs. These false claims statutes include the federal False Claims Act, which prohibits the knowing filing of a false claim or the knowing use of false statements to obtain payment from the U.S. federal government. When an entity is determined to have violated the False Claims Act, it must pay three times the actual damages sustained by the government, plus mandatory civil penalties of between $5,500 and $11,000 for each separate false claim. Suits filed under the False Claims Act, known as "qui tam" actions, can be brought by any individual on behalf of the government and such individuals (known as "relators" or, more commonly, as "whistleblowers") may share in the amounts paid by the entity to the government in fines or settlement. In addition, certain states have enacted laws modeled after the federal False Claims Act. Qui tam actions have increased significantly in recent years causing greater numbers of health care companies to have to defend false claim actions, pay fines or be excluded from the Medicare, Medicaid or other federal or state health care programs as a result of an investigation arising out of such action. Because we directly submit claims for payment for certain of our products, we are subject to these false claims statutes, and, therefore, could become subject to "qui tam" actions.

     The OIG has taken certain actions, which suggest that arrangements between manufacturers or suppliers of durable medical equipment or medical supplies and skilled nursing facilities (“SNF”) or other providers may be under continued scrutiny. In June 1995, the OIG issued a Special Fraud Alert setting forth fraudulent and abusive practices that the OIG had observed in the home health industry. Later that same year, OIG issued another Special Fraud Alert describing certain relationships between SNFs and suppliers that the OIG viewed as abusive under the federal Anti-Kickback Law. In July 1999, the OIG published OIG compliance program guidance for the durable medical equipment, prosthetics, orthotics and supply (“DMEPOS”) industry developed by the OIG in cooperation with, and with input from, the Centers for Medicare and Medicaid Services (“CMS”), the DOJ and representatives of various trade associations and health care practice groups. The guidance identifies specific areas of DMEPOS industry operations that may be subject to fraud and abuse.

     Several states also have referral, fee splitting and other similar laws that may restrict the payment or receipt of remuneration in connection with the purchase or rental of medical equipment and supplies. State laws vary in scope and have been infrequently interpreted by courts and regulatory agencies, but may apply to all health care products or services, regardless of whether Medicaid or Medicare funds are involved.

Claims Audits

     The industry in which we operate is generally characterized by long collection cycles for accounts receivable due to complex and time-consuming documentation requirements for obtaining reimbursement from private and governmental third‑party payers. Such protracted collection cycles can lead to delays in obtaining reimbursement. Moreover, the four durable medical equipment regional carriers ("DMERCs"), private entities that contract to serve as the U.S. government's agents for the processing of claims for products and services provided under Part B of the Medicare program for home use, and Medicaid agencies periodically conduct pre-payment and post-payment reviews and other audits of claims submitted. Medicare and Medicaid agents are under increasing pressure to scrutinize health care claims more closely. Reviews and/or similar audits or investigations of our claims and related documentation could result in denials of claims for payment submitted by us. Further, the government could demand significant refunds or recoupments of amounts paid by the government for claims which, upon subsequent investigation, are determined by the government to be inadequately supported by the required documentation.

ISO Certification

     Due to the harmonization efforts of a variety of regulatory bodies worldwide, certification of compliance with International Quality System Standards (e.g., those issued by the International Organization for Standardization, "ISO") has become particularly advantageous and, in certain circumstances, necessary for many companies in recent years.  We originally received ISO 9001 and EN 46001 certification in 1997, followed by certification in 2002 to ISO 13485:1996, a medical device-specific version of ISO 9001.  In 2005, we obtained certification to ISO 13485:2003, the latest version of that standard.  We are registered in the UK with the Medicines and Healthcare Products Regulatory Agency (“MHRA”), which, through a European Notified Body, certifies conformance with the EU Medical Device Directive.  We are thereby allowed to apply the CE mark to our products enabling sales and distribution throughout the European Union.  Since 2002, we have been licensed by Health Canada to sell and distribute our products within that country.

Environmental Laws

     We are subject to various federal, state and local environmental laws and regulations that govern our operations, including the handling and disposal of non-hazardous and hazardous substances and wastes, and emissions and discharges into the environment. Failure to comply with such laws and regulations could result in costs for corrective action, penalties or the imposition of other liabilities. We also are subject to laws and regulations that impose liability and cleanup responsibility for releases of hazardous substances into the environment. Under certain of these laws and regulations, such liabilities can be imposed for cleanup of previously owned or operated properties, or properties to which substances or wastes were sent from current or former operations at our facilities. From time to time, we have incurred costs and obligations for correcting environmental noncompliance matters and for cleanup of certain of our properties and third-party sites. We believe we have complied with our environmental obligations to date in all material respects and that such liabilities will not have a material adverse effect on our business or financial performance. However, such liabilities in the future may have a material adverse effect on our business or financial performance.

Other Laws

     We are subject to numerous federal, state and local laws and regulations relating to such matters as safe working conditions, manufacturing practices and fire hazard control.

International

     Sales of medical devices outside of the United States are subject to regulatory requirements that vary widely from country to country. Pre-market clearance or approval of medical devices is required by certain countries. The time required to obtain clearance or approval for sale in a foreign country may be longer or shorter than that required for clearance or approval by the FDA and the requirements vary. Failure to comply with applicable regulatory requirements can result in loss of previously received approvals and other sanctions and could have a material adverse effect on our business, financial condition or results of operations.

     We operate in multiple tax jurisdictions both inside and outside the United States. In the normal course of our business, we will undergo reviews by taxing authorities regarding the tariff classifications of our products and the amount of tariffs we pay on the importation and exportation of these products. Foreign and domestic tariffs have not had a material impact on our results of to date, however, our profitability could be harmed if foreign governments impose additional unanticipated tariffs.

Table of Contents

 

ITEM 1A.     RISK FACTORS

Risks Related to Our Business

     We face significant and increasing competition which could adversely affect our operating results.

     Historically, our V.A.C. systems have competed primarily with traditional wound care dressings, other advanced wound care dressings, skin substitutes, products containing growth factors and other medical devices used for wound care.  As a result of the success of our V.A.C. systems, competitors have announced or introduced products similar to or designed to mimic our V.A.C. systems.  In this regard, BlueSky Medical Group, Inc. is marketing a pump and dressing kits to compete directly with V.A.C. systems.  In 2004, BlueSky received U.S. FDA clearance of its pump and one of its dressings, which have recently been assigned by the Centers for Medicare and Medicaid Services (“CMS”) to the reimbursement codes for Negative Pressure Wound Therapy, the same codes assigned to our V.A.C. systems and disposables.  Also, BlueSky previously announced that a large midwest managed care organization has implemented a coverage policy for its product.  We believe the BlueSky device violates our intellectual property rights and have taken legal action against BlueSky, its supplier and several of its distributors to protect our rights.  While we have successfully challenged the marketing of imitative V.A.C. systems by several European companies, we may not be successful in our challenge of BlueSky and may not prevail in the pending litigation.  If these competitors or others are able to legally develop and market their products or obtain Medicare or other third-party reimbursement for competing products, our position in the wound care market could substantially erode or our pricing of V.A.C. systems could decline significantly, either of which could materially and adversely affect our operating results.  We derived $706.0 million in revenue, or approximately 58% of our total revenue for the year ended December 31, 2005, from our domestic V.A.C. products relating to the patents at issue.  U.S. V.A.C. revenue was $562.6 million and $399.9 million for 2004 and 2003, respectively.

     In the U.S., our therapeutic surfaces business primarily competes with the Hill-Rom Company and Sizewise Rentals and in Europe with Huntleigh Healthcare and Pegasus Limited. We face the risk that innovation by our competitors in our markets may render our products less desirable or obsolete or that our competitors may effectively limit our market access through sole source contracts with GPOs, large health care providers or third-party payers, which also would adversely affect our operating results.

Our intellectual property is very important to our competitive position, especially for our V.A.C. products. If we are unsuccessful in protecting and maintaining our intellectual property, particularly our rights under the Wake Forest patents, our competitive position would be harmed.

     We invest substantial resources and place considerable importance on obtaining and maintaining patent protection for our products, particularly, our license rights under the Wake Forest patents on which we rely in our V.A.C. business. We have numerous patents on our existing products and processes, and we file applications as appropriate for patents covering new technologies as they are developed. However, the patents we own, or in which we have rights, may not be sufficiently broad to protect our technology position against competitors. Issued patents owned by us, or licensed to us, may be challenged, invalidated or circumvented, or the rights granted under issued patents may not provide us with competitive advantages. We incur substantial costs and diversion of management resources when we have to assert or defend our patent rights against others.  Moreover, third parties may claim that we are infringing their intellectual property rights, and we may be found to infringe those intellectual property rights. Any unfavorable outcome in intellectual property disputes or litigation could cause us to lose our intellectual property rights in technology that is material to our business. In addition, we may not be able to detect infringement by third parties, and could lose our competitive position if we fail to do so.

     In 2003, we filed a lawsuit against BlueSky Medical Group, Inc., Medela, Inc., Medela AG and Patient Care Systems, Inc. In the case, we allege infringement of multiple claims under three V.A.C. patents arising from the manufacturing and marketing of a medical device by BlueSky. We are seeking damages and injunctive relief in the case.  Although it is not possible to reliably predict the outcome of the BlueSky litigation, we believe our claims are meritorious.  However, we may be unable to obtain an injunction against BlueSky, and we may not prevail in this litigation.  If we do not obtain an injunction or otherwise prevail, our share of the advanced wound-care market for our V.A.C. system could be significantly reduced due to increased competition, and pricing of V.A.C. systems could decline significantly, either of which would materially and adversely affect our operating results.  We derived $706.0 million in revenue, or approximately 58% of our total revenue for the year ended December 31, 2005, from our domestic V.A.C. products relating to the patents at issue.  U.S. V.A.C. revenue was $562.6 million and $399.9 million for 2004 and 2003, respectively.

     In 1998, Mondomed N.V. and Paul Hartmann A.G. filed an opposition in the European Patent Office to a Wake Forest European V.A.C. patent licensed to KCI.  In 2004, the European Patent Office issued a decision upholding the patent.  The decision corrected the patent to expand the range of pressures covered by the patent claims from 76 – 752 mmHg of negative pressure to 7.6 – 752 mmHg of negative pressure and modified the patent claims to provide that the "screen means" term describing the dressing is an open-cell polymer foam.  Our V.A.C. systems typically operate between 50 and 200 mmHg of negative pressure, with a default setting of 125 mmHg.  Wake Forest and Paul Hartmann A.G. appealed the decision.  Mondomed N.V. entered into a settlement with us and withdrew from the opposition.  The oral hearing for the appeal is currently set for April 6, 2006.  In connection with the hearing, the Board of Appeals advised the parties on a preliminary and nonbinding basis that the range of pressures covered by the patent should be changed to 103.8 – 752 mmHg.  If this preliminary ruling becomes final or Wake Forest is not successful in its appeal respecting the negative pressure ranges or the “screen means,” the patent claims could be narrowed or the patent could be invalidated.  In either case, third-party competitors could gain market share in Europe, which could erode our market position or cause the pricing of V.A.C. systems to decline there, either of which would materially and adversely affect our operating results.  We derived $151.6 million in revenue from European V.A.C. products, relating to the patents at issue, or 12.5% of our total revenue for the year ended December 31, 2005.  During the pendency of an appeal, the original patents remain in place.  We do not believe that any decision in this case will affect U.S. patents.

     We expect similar litigation may arise in the future. We also are subject to product liability litigation and risk arising from the manufacture and marketing of our medical products. The costs of pursuing or defending this litigation and other litigation that may arise may be substantial. Any adverse determination also could materially and adversely affect our operating results.

     We also have agreements with third parties, including our exclusive license of the V.A.C. patents from Wake Forest, that provide for licensing of their patented or proprietary technologies. These agreements include royalty-bearing licenses. If we were to lose the rights to license these technologies, or our costs to license these technologies were to materially increase, our business would suffer.

Changes to third-party reimbursement policies could reduce the reimbursement we receive for and adversely affect the demand for our products.

     The demand for our products is highly dependent on the policies of third-party payers such as Medicare, Medicaid, private insurance and managed care organizations that reimburse us for the sale and rental of our products.  If coverage or payment policies of these third-party payers are revised in light of increased controls on health care spending or otherwise, the price we may charge or the demand for our products may decrease.

     In this regard, CMS from time to time publishes reimbursement policies and rates that may favorably or unfavorably affect the reimbursement price and market for our products.  In the past our V.A.C. systems and disposables have been the only devices assigned to the CMS reimbursement codes for Negative Pressure Wound Therapy.  CMS recently announced that a pump and dressing kits marketed by BlueSky have been assigned to the same Negative Pressure Wound Therapy codes under the Healthcare Common Procedure Coding System.  Also, the unique existing code for reimbursement of V.A.C. disposable canisters was eliminated effective December 31, 2005, and consequently, we are required to bill Medicare Part B for V.A.C. canisters under a more generic existing code at a lower reimbursement rate beginning January 1, 2006.  As a result of these recent CMS decisions, we may experience increased competition from BlueSky products in future periods, and the pricing we receive from other third-party payers may be negatively impacted, either of which could materially and adversely affect our business and operating results.

     The assignment of CMS reimbursement codes to BlueSky products also increases the likelihood that our V.A.C. products will be subject to the Medicare competitive bidding process in 2007 which could negatively impact KCI’s pricing for products that are reimbursed by Medicare in the home care setting.  Any price declines in the Medicare setting could materially and adversely affect our business.  As of March 6, 2006, no proposed rules have been adopted for the implementation of the competitive bidding process.

     The reimbursement of our products is also subject to review by the medical directors of the four Durable Medical Equipment Regional Carriers (“DMERCs”).  The medical directors have indicated that policy interpretation for coverage and payment of durable medical equipment in the home will be handled separately by each of the four regional DMERCs.  As a result, our products in the past at times have not been and in the future may not be reimbursed uniformly by each of the four regional DMERCs, which could adversely affect our business and operations in a particular DMERC region or, in the event of an adverse determination by all of the DMERCs, in all regions.  We currently have approximately $11.0 million in outstanding receivables from CMS related to Medicare V.A.C. placements that have extended beyond four months in the home that are being disputed and denied by CMS as billed, as a result of DMERC policy interpretation.  We are in the process of submitting these receivables through the administrative process necessary to obtain payment.  We may not be successful in collecting these amounts, and if we are not, our revenue may suffer as a result of our inability to collect these claims and due to our inability to continue to provide the services that are represented by these disputed types of claims.  Revenue arising from such disputed claims represents less than 1% of total revenue for 2005.

     Due to the increased scrutiny and publicity of increasing health care costs, we may be subject to future assessments or studies by CMS, the FDA, or other agencies, which could lead to other changes in their reimbursement policies that adversely affect our business.   In this regard, we were informed in November 2004 that CMS intends to evaluate the clinical efficacy, functionality and relative cost of the V.A.C. system and a variety of other medical devices to determine whether they should be included in a competitive bidding process.  A negative assessment with respect to the efficacy of the V.A.C., or one that is perceived to be negative, could adversely affect the reimbursement of, or demand for, the V.A.C.

     More recently, we have learned from the 2006 work plan of the Office of the Inspector General (“OIG”) that the OIG plans to conduct a study on Negative Pressure Wound Therapy during 2006.  The OIG Office of Evaluations and Inspections evaluates effectiveness and efficiency of a wide range of programs of the Department of Health and Human Services.  We have participated in similar studies in the past on other product lines.  As part of the current study, the OIG has requested copies of our billing records for Medicare V.A.C. placements.  KCI submitted all copies as requested and plans to cooperate fully with any and all future requests associated with these evaluations.  In the event we are unable to satisfactorily meet the requirements of the OIG in connection with this study, our prior billings could be subject to claims audits, which could result in demands by third-party payers for refunds or recoupments of amounts previously paid to us.  The results of this study could also factor into determinations of the inherent reasonableness of our V.A.C. pricing, and to what extent our V.A.C. therapy will be subject to the competitive bidding process.

If we are unable to develop new generations of V.A.C. and therapeutic surface products and enhancements to existing products, we may lose market share as our existing patent rights begin to expire over time.

     Our success is dependent upon the successful development, introduction and commercialization of new generations of products and enhancements to existing products. Innovation in developing new product lines and in developing enhancements to our existing V.A.C. and therapeutic surfaces products is required for us to grow and compete effectively. Over time, our existing foreign and domestic patent protection in both the V.A.C. and therapeutic surfaces businesses will begin to expire, which could allow competitors to adopt our older unprotected technology into competing product lines. If we are unable to continue developing proprietary product enhancements to V.A.C. systems and therapeutic surfaces products that effectively make older products obsolete, we may lose market share in our existing lines of business. In addition, if we fail to develop new lines of products, we will not be able to penetrate new markets. Innovation in enhancements and new products requires significant capital commitments and investments on our part, which we may be unable to recover.

If our future operating results do not meet our expectations or those of the equity research analysts covering us, the trading price of our common stock could fall dramatically.

     We have experienced and expect to continue to experience fluctuations in revenue and earnings for a number of reasons, including:

     -  the level of acceptance of our V.A.C. systems by customers and physicians;
     -  the type of indications that are appropriate for V.A.C. use and the percentages of wounds that are good
        candidates for V.A.C. Therapy;
     -  clinical studies that may be published regarding the efficacy of V.A.C. Therapy, including studies published
        by our competitors in an effort to challenge the efficacy of the V.A.C.;
     -  developments or any adverse determination in our pending litigation;
     -  third-party government or private reimbursement policies with respect to V.A.C. treatment and competing
        products; and
     -  new or enhanced competition in our primary markets.

     We believe that the trading price of our common stock is based, among other factors, on our expected rates of growth in revenue and earnings per share. If we are unable to realize growth rates consistent with our expectations or those of the analysts covering us, we would expect to realize a decline in the trading price of our stock. Historically, V.A.C. revenue growth has been somewhat seasonal with a slowdown in V.A.C. rentals beginning in the fourth quarter and continuing into the first quarter, which we believe is caused by year-end clinical treatment patterns. The adverse effects in our business arising from seasonality may become more pronounced in future periods as the market for the V.A.C. systems matures and V.A.C. growth rates decrease.

     Because our staffing and operating expenses are based on anticipated revenue levels, and because a high percentage of our costs are fixed, even small decreases in revenue or delays in the recognition of revenue could cause significant variations in our operating results from quarter to quarter. In the short term, we do not have the ability to adjust spending in a time-effective manner to compensate for any unexpected revenue shortfall, which also could cause a significant decline in the trading price of our stock.

Failure of any of our randomized and controlled studies or a third-party study or assessment to demonstrate V.A.C. therapy's clinical efficacy may reduce physician usage of V.A.C. and cause our V.A.C. revenue to decline.

     For the past several years, we have been conducting a number of clinical studies designed to test the efficacy of V.A.C. across targeted wound types.  A successful clinical trial program is necessary to maintain and increase sales of V.A.C. products, in addition to supporting and maintaining third-party reimbursement of the product in the United States and abroad, particularly in Europe, Canada and Japan.  If a clinical trial conducted by us or others fails to demonstrate statistically significant results supporting the efficacy or cost effectiveness of V.A.C. therapy, physicians may elect not to use V.A.C. therapy as a treatment in general, or for the type of wound in question.  Furthermore, in the event of an adverse clinical trial, V.A.C. therapy may not achieve “standard-of-care” designations for the wound types in question, which could deter the adoption of V.A.C. in those wound types or others.  If we are unable to develop a body of statistically significant evidence from our clinical trial program, whether due to adverse results or the inability to complete properly designed studies, domestic and international public and private payers could refuse to cover V.A.C. therapy, limit the manner in which they cover V.A.C. therapy, or reduce the price they are willing to pay or reimburse for V.A.C. therapy.

We may be subject to claims audits that could harm our business and financial results.

     As a health care supplier, we are subject to extensive government regulation, including laws regulating reimbursement under various government programs. The billing, documentation and other practices of health care suppliers are subject to scrutiny, including claims audits. To ensure compliance with Medicare regulations, contractors, such as the DMERCs, which serve as the government's agents for the processing of claims for products sold for home use, periodically conduct audits and request medical records and other documents to support claims submitted by us for payment of services rendered to our customers. Because we are a DME supplier, those audits involving home use include review of patient claims records. Such audits can result in delays in obtaining reimbursement and denials of claims for payment submitted by us. In addition, the government could demand significant refunds or recoupments of amounts paid by the government for claims which are determined by the government to be inadequately supported by the required documentation.

     More recently, we have learned from the 2006 work plan of the Office of the Inspector General (“OIG”) that the OIG plans to conduct a study on Negative Pressure Wound Therapy during 2006.  The OIG Office of Evaluations and Inspections evaluates effectiveness and efficiency of a wide range of programs of the Department of Health and Human Services.  We have participated in similar studies in the past on other product lines.  As part of the current study, the OIG has requested copies of our billing records for Medicare V.A.C. placements.  KCI submitted all copies as requested and plans to cooperate fully with any and all future requests associated with these evaluations.  In the event we are unable to satisfactorily meet the requirements of the OIG in connection with this study, our prior billings could be subject to claims audits, which could result in demands by third-party payers for refunds or recoupments of amounts previously paid to us.  The results of this study could also factor into determinations of the inherent reasonableness of our V.A.C. pricing, and to what extent our V.A.C. therapy will be subject to the competitive bidding process.

     In addition, private payers may also conduct audits, such as one conducted by Michigan Blue Cross.  We reviewed a preliminary report of their findings and filed a response in December 2004 and are currently negotiating on specific claims. Although no abusive or fraudulent practices were identified by the payer, it is unclear what refunds or recoupments will be expected based on claims reviews. KCI will have appeal rights with regard to any such determinations.

Because we depend upon a limited group of suppliers and, in some cases, exclusive suppliers for products essential to our business, we may incur significant product development costs and experience material delivery delays if we lose any significant supplier, which could materially impact our rental and sales of V.A.C. systems and disposables.

     We obtain some of our finished products and components from a limited group of suppliers.  In particular, we rely exclusively on Avail Medical Products, Inc. for the manufacture and packaging of our V.A.C. disposables.  V.A.C. therapy cannot be administered without the appropriate use of our V.A.C. units in conjunction with the related V.A.C. disposables.  Total V.A.C. rental and sales revenue represented approximately 75% of our total revenue for 2005, of which sales of V.A.C. disposables represented approximately 23%.  Accordingly, a shortage of V.A.C. disposables would inevitably cause our revenue to decline and, if material or continued, may also reduce our market position.

     We have a long-term evergreen supply agreement with Avail through October 2008, which automatically extends for additional twelve-month periods in October of each year, unless either party gives notice to the contrary. We require Avail to maintain duplicate manufacturing facilities, tooling and raw material resources for the production of our disposables in different locations to decrease the risk of supply interruptions from any single Avail manufacturing facility.  However, should Avail or Avail’s suppliers fail to perform in accordance with their agreement and our expectations, our supply of V.A.C. disposables could be jeopardized, which could negatively impact our V.A.C. revenue. The terms of the supply agreement provide that key indicators be provided to us that would alert us to Avail's inability to perform under the agreement. We maintain an inventory of disposables sufficient to support our business for approximately six weeks in the United States and eight weeks in Europe. However, in the event that we are unable to replace a shortfall in supply, our revenue could be negatively impacted in the short term.

     Avail relies exclusively on Foamex International, Inc. for the supply of foam used in the V.A.C. disposable dressings.  In 2005, Foamex filed for Chapter 11 bankruptcy reorganization.  While in bankruptcy, Foamex could breach or terminate its purchase orders with Avail, reject, delay or refuse to fulfill Avail orders, cease production of the foam necessary for our V.A.C. products, or sell production to a third party.  Any of these outcomes could jeopardize Avail’s supply of foam and hence our supply of V.A.C. disposables.  We are in the process of identifying other suppliers that could provide such inventory to meet our needs in the event that Foamex is unable to do so.  If we are required but unable to timely procure an alternate source for this foam at an appropriate cost, our ability to obtain the raw material resources required for our V.A.C. disposables could be compromised, which would have a materially adverse effect on our entire V.A.C. business.

We are subject to numerous laws and regulations governing the health care industry, and non-compliance with such laws, as well as changes in such laws or future interpretations of such laws, could reduce demand for and limit our ability to distribute our products and could cause us to incur significant compliance costs.

     There are widespread legislative efforts to control health care costs in the United States and abroad, which we expect will continue in the future. Recent publicity has highlighted the need to control health care spending at the federal (Medicare) and state (Medicaid) levels. We believe this pressure will intensify over time. For example, the enactment of the Medicare Modernization Act eliminated annual payment increases on the V.A.C. system for the foreseeable future and initiated a competitive bidding program. At this time, we are unable to determine whether and to what extent these changes would be applied to our products and our business but this or similar legislative efforts in the future could negatively impact demand for our products.

     Substantially all of our products are subject to regulation by the FDA and its foreign counterparts. Complying with FDA requirements and other applicable regulations imposes significant costs and expenses on our operations. If we fail to comply with applicable regulations, we could be subject to enforcement sanctions, our promotional practices may be restricted, and our marketed products could be subject to recall or otherwise impacted. In addition, new FDA guidance and new and amended regulations that regulate the way we do business may occasionally result in increased compliance costs. Recently, the FDA published notice of its intent to implement new dimensional requirements for hospital bed side rails that may require us to change the size of openings in new side rails for some of our surface products. Over time, related market demands might also require us to retrofit products in our existing rental fleet, and more extensive product modifications might be required if FDA decides to eliminate certain exemptions in their proposed guidelines. Regulatory authorities in Europe and Canada have also recently adopted the revised standard, IEC 60601, requiring labeling and electro-magnetic compatibility modifications to several product lines in order for them to remain state-of-the-art. Listing bodies in the U.S. are expected to adopt similar revised standards in 2010. Each of these revised standards will entail increased costs relating to compliance with the new mandatory requirements.

     We are also subject to various federal and state laws pertaining to health care fraud and abuse, including prohibitions on the submission of false claims and the payment or acceptance of kickbacks or other remuneration in return for the purchase or lease of our products. The United States Department of Justice and the Office of the Inspector General of the United States Department of Health and Human Services have launched an enforcement initiative which specifically targets the long-term care, home health and DME industries. Sanctions for violating these laws include criminal penalties and civil sanctions, including fines and penalties, and possible exclusion from the Medicare, Medicaid and other federal health care programs.

     In addition, we are subject to various environmental laws and regulations both within and outside the United States affecting the use of substances in our manufacturing and sterilization processes.  Compliance with such laws can entail substantial cost and any failure to comply could result in substantial fines, penalties and delays in marketing the affected products.

Risks Related to Our Capital Structure

Our substantial indebtedness could adversely affect our financial condition.

     We have a significant amount of debt. As of December 31, 2005, we had $295.9 million of outstanding indebtedness and shareholders' equity of $191.5 million. This level of indebtedness could have important consequences, including the following:

     -  it may be difficult for us to satisfy our obligations under our senior credit facility and our senior subordinated
        notes;
     -  if we default on our secured debt, these lenders may foreclose on our assets;
     -  we may have to use a significant amount of our cash flow for scheduled debt service rather than for operations;
     -  we may be less able to obtain other debt or equity financing in the future;
     -  we could be less able to take advantage of significant business opportunities, including acquisitions or
        divestitures; or
     -  our vulnerability to general adverse economic and industry conditions could be increased; and we could be at
        a competitive disadvantage compared to competitors with less debt.

Restrictive covenants in our senior credit facility and the indenture governing our senior subordinated notes may restrict our ability to pursue our business strategies.

     Our senior credit facility and the indenture governing our senior subordinated notes limit our ability, among other things, to:

     -  incur additional indebtedness or contingent obligations;
     -  pay dividends or make distributions to our shareholders;
     -  repurchase or redeem our stock;
     -  make investments;
     -  grant liens;
     -  make capital expenditures;
     -  enter into transactions with our shareholders and affiliates;
     -  sell assets; and
     -  acquire the assets of, or merge or consolidate with, other companies.

     Our senior credit facility contains financial covenants requiring us to meet certain leverage and interest coverage ratios. Specifically, we are obligated not to permit ratios to fall outside certain specified ranges and maintain minimum levels of EBITDA.

     We may not be able to maintain these ratios. Covenants in our senior credit facility may also impair our ability to finance future operations or capital needs, or to enter into acquisitions or joint ventures or engage in other favorable business activities.

     If we default under our senior credit facility, we could be prohibited from making any payments on our senior subordinated notes. In addition, the lenders under our senior credit facility could require immediate repayment of the entire principal then outstanding. If those lenders require immediate repayment, we may not be able to repay them and also repay our senior subordinated notes in full. If we are unable to generate sufficient cash flow or otherwise obtain funds necessary to make required payments under our senior credit facility, or if we are unable to maintain the financial ratios under our senior credit facility, we will be in default under our senior credit facility, which could, in turn, cause a default under our senior subordinated notes, the related indenture and any other debt obligations that we may incur from time to time.

Our obligations under our senior credit facility are secured by substantially all of our assets.

     Our obligations under our senior credit facility are secured by liens on substantially all of our assets, and the guarantees of certain of our subsidiaries under our senior credit facility are secured by liens on substantially all of such subsidiaries' assets. If we become insolvent or are liquidated, or if payment under our senior credit facility or of other secured obligations are accelerated, the lenders under our senior credit facility or the obligees with respect to the other secured obligations will be entitled to exercise the remedies available to a secured lender under applicable law and the applicable agreements and instruments, including the right to foreclose on all of our assets.

Our articles of incorporation, our by-laws and Texas law contain provisions that could discourage, delay or prevent a change in control or management.

     Our articles of incorporation and by-laws and Texas law contain provisions which could discourage, delay or prevent a third party from acquiring shares of our common stock or replacing members of our Board of Directors. These provisions include:

 

     -  authorization of the issuance of preferred stock, the terms of which may be determined at the sole discretion of the
        Board of Directors;
     -  establishment of a classified Board of Directors with staggered, three-year terms;
     -  provisions giving the Board of Directors sole power to set the number of directors;
     -  limitations on the ability of shareholders to remove directors;
     -  requirements for the approval of the holders of at least two thirds of our outstanding common stock to amend our
        articles of incorporation;
     -  authorization for our Board of Directors to adopt, amend or repeal our by-laws;
     -  limitations on the ability of shareholders to call special meetings of shareholders; and
     -  establishment of advance notice requirements for presentation of new business and nominations for election to the
        Board of Directors at shareholder meetings.

     In addition, under Texas law and our articles of incorporation and our by-laws, action may not be taken by less than unanimous written consent of our shareholders unless the Board of Directors has recommended that the shareholders approve such action.  The limitation on the ability of shareholders to call a special meeting, to act by written consent and to remove directors may make it difficult for shareholders to remove or replace the Board of Directors should they desire to do so.  These provisions could also delay or prevent a third party from acquiring us, which could cause the market price of our common stock to decline.

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ITEM 1B.     UNRESOLVED STAFF COMMENTS

None.

ITEM 2.     PROPERTIES

     We lease approximately 154,000 square feet at our corporate headquarters building in San Antonio, Texas, the majority of which is leased under a 10-year lease that expires in 2012. We also lease approximately 28,300 square feet in adjacent buildings that are used for general corporate purposes, and approximately 88,500 square feet of office space in San Antonio for our customer service center. In addition, in February 2004 and February 2005, we entered into 99‑month leases for approximately 80,400 and 80,200 square feet of office space in San Antonio to be used as our research and development facility and for general corporate purposes, respectively.

     We conduct domestic manufacturing, shipping, receiving, engineering and storage activities in a 171,100 square foot facility in San Antonio, Texas, which we purchased in January 1988, and an adjacent 32,600 square foot facility purchased in 1993. Our operations are conducted with approximately 75% cumulative utilization of plant and equipment. We also lease two storage facilities in San Antonio. We lease approximately 139 domestic distribution centers, including each of our seven regional headquarters.

     Internationally, we lease 70 service centers. Our international corporate office is located in Amsterdam, the Netherlands. International manufacturing and engineering operations are based in the United Kingdom and Belgium. The United Kingdom plant is approximately 24,800 square feet, and the Belgium plant is approximately 19,600 square feet. These plants operate with 100% cumulative utilization of plant and equipment.

     We believe that our current facilities will be adequate to meet our needs for 2006.

     The following is a summary of our major facilities:

 

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ITEM 3.     LEGAL PROCEEDINGS

     On August 28, 2003, KCI and its affiliates, together with Wake Forest University Health Sciences ("Wake Forest"), filed a patent infringement lawsuit against BlueSky Medical Group, Inc. ("BlueSky"), Medela, Inc., Medela AG (collectively, "Medela") and Patient Care Systems, Inc. ("PCS") in the United States District Court for the Western District of Texas, San Antonio Division.  We subsequently entered into a settlement with PCS, pursuant to which the court entered a final judgment and permanent injunction prohibiting PCS from further acts of infringement, unfair competition or false advertising through the sale or marketing of BlueSky products.  KCI and Wake Forest continue to allege infringement by BlueSky and Medela of three V.A.C. patents arising from the manufacturing and marketing of a pump and dressing kits by BlueSky.  We have also asserted causes of action for breach of contract, tortious interference, unfair competition and conspiracy.  We are seeking damages and injunctive relief in the case.  A trial date has been set for May 30, 2006.

     On June 28, 2005 the court construed certain terms of U.S. Patent No. 5,636,643 (the “643 patent”) and ruled that other terms were sufficiently definite without further construction.  On November 2, 2005, the court denied defendants’ motions for summary judgment to dismiss our claims of tortious interference, unfair competition and conspiracy, but dismissed our breach of contract claim against Medela.  On January 26, 2006, the court ruled on construction of claims in U.S. Patent number 5,645,081 (the “081 patent”) and additional claims in the 643 patent.  The ruling, among other things further defined components of certain claims related to our dressing.  In addition, on March 1, 2006, the court denied BlueSky’s motions for summary judgment to dismiss our claims of patent infringement and granted our motion to exclude BlueSky’s damages against us.  The court also dismissed all of BlueSky’s counterclaims against KCI and Wake Forest with prejudice.  While it is difficult to predict what effect these rulings may have on the outcome of the central claims of infringement and invalidity, we presently do not believe that the rulings fundamentally impacted the nature of the litigation or our probability of success at trial.  Moreover, the court may reconsider any of its rulings at any time before trial.

     Although it is not possible to reliably predict the outcome of the BlueSky litigation, we believe our claims are meritorious.  However, we may be unable to obtain an injunction against BlueSky, and we may not prevail in this litigation.  If we do not obtain an injunction or otherwise prevail, our share of the advanced wound-care market for our V.A.C. system could be significantly reduced due to increased competition, and pricing of V.A.C. systems could decline significantly, either of which would materially and adversely affect our operating results.  We derived $706.0 million in revenue, or approximately 58% of our total revenue for the year ended December 31, 2005, from our domestic V.A.C. products relating to the patents at issue.  U.S. V.A.C. revenue was $562.6 million and $399.9 million for 2004 and 2003, respectively.

     In 1998, Mondomed N.V. and Paul Hartmann A.G. filed an opposition in the European Patent Office to a Wake Forest European V.A.C. patent licensed to KCI.  In 2004, the European Patent Office issued a decision upholding the patent.  The decision corrected the patent to expand the range of pressures covered by the patent claims from 76 – 752 mmHg of negative pressure to 7.6 – 752 mmHg of negative pressure and modified the patent claims to provide that the "screen means" term describing the dressing is an open-cell polymer foam.  Our V.A.C. systems typically operate between 50 and 200 mmHg of negative pressure, with a default setting of 125 mmHg.  Wake Forest and Paul Hartmann A.G. appealed the decision.  Mondomed N.V. entered into a settlement with us and withdrew from the opposition.  The oral hearing for the appeal is currently set for April 6, 2006.  In connection with the hearing, the Board of Appeals advised the parties on a preliminary and nonbinding basis that the range of pressures covered by the patent should be changed to 103.8 – 752 mmHg.  If this preliminary ruling becomes final or Wake Forest is not successful in its appeal respecting the negative pressure ranges or the “screen means,” the patent claims could be narrowed or the patent could be invalidated.  In either case, third-party competitors could gain market share in Europe, which could erode our market position or cause the pricing of V.A.C. systems to decline there, either of which would materially and adversely affect our operating results.  We derived $151.6 million in revenue from European V.A.C. products, relating to the patents at issue, or 12.5% of our total revenue for the year ended December 31, 2005.  During the pendency of an appeal, the original patents remain in place.  We do not believe that any decision in this case will affect U.S. patents.

     We are a party to several additional lawsuits arising in the ordinary course of our business.  Additionally, the manufacturing and marketing of medical products necessarily entails an inherent risk of product liability claims.

 

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ITEM 4.     SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

     None.

 

PART II

ITEM 5.     MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED SHAREHOLDER
                    MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

     Our common stock has traded on the New York Stock Exchange under the symbol "KCI" since February 24, 2004, the date of our initial public offering. The following table sets forth, for the periods indicated, the high and low sales prices for our common stock as reported by the New York Stock Exchange:

 

2005		High		Low
First Quarter		$76.24		$56.95
Second Quarter		$64.98		$53.32
Third Quarter		$64.00		$52.48
Fourth Quarter		$58.99		$33.00
2004		High		Low
First Quarter (from February 24, 2004 through March 31, 2004)		$45.15		$37.75
Second Quarter		$52.90		$43.17
Third Quarter		$52.86		$41.40
Fourth Quarter		$78.37		$46.00

     On March 13, 2006, the last reported sale price of our common stock on the New York Stock Exchange was $37.35 per share.  As of March 13, 2006, there were approximately 143 shareholders of record of our common stock.

     We do not currently pay cash dividends on our common stock. Any future payment of cash dividends on our common stock will be at the discretion of our Board of Directors and will depend upon our results of operations, earnings, capital requirements, contractual restrictions and other factors deemed relevant by our board.  Our Board of Directors currently intends to retain any future earnings to support our operations and to finance the growth and development of our business and does not intend to declare or pay cash dividends on our common stock for the foreseeable future.  In addition, our senior credit agreement and the indenture governing our senior subordinated notes limit our ability to declare or pay dividends on, or repurchase or redeem, any of our outstanding equity securities.  For more information regarding the restrictions under our Senior Credit Agreement and Indenture, see “Management’s Discussion & Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources—Debt Service.”

Use of Proceeds from Sales of Registered Securities

     None.

Recent Sales of Unregistered Securities

     None.

Purchases of Equity Securities by the Issuer and Affiliated Purchasers

     We did not purchase any shares of KCI common stock during the fourth quarter of 2005.

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ITEM 6.     SELECTED FINANCIAL DATA

     The following tables summarize our consolidated financial data for the periods presented. You should read the following financial information together with the information under "Management's Discussion and Analysis of Financial Condition and Results of Operations" and our consolidated financial statements and the notes to those consolidated financial statements appearing elsewhere in this report. The selected consolidated balance sheet data for fiscal 2004 and 2005 and the selected consolidated statements of earnings data for fiscal 2003, 2004 and 2005 are derived from our audited consolidated financial statements included elsewhere in this report. The selected consolidated financial data for fiscal 2001 and 2002 and the selected consolidated balance sheet data for fiscal 2003 are derived from our audited consolidated financial statements not included in this report.  Reclassifications have been made to our results from prior years to conform to our current presentation (in thousands, except per share data).

 

 

 

(1)   Amounts for fiscal 2002 include accrual in connection with the first installment payment of $175.0 million ($173.3 million, net
        of expenses of $1.7 million) as part of an anti-trust settlement. Amounts for fiscal 2003 include the second and final payment of
        $75.0 million under this settlement. Amounts for 2005 include the litigation settlement with Novamedix Limited of $72.0
        million, net of recorded reserves of $3.0 million.  See Notes 12 and 18 to our consolidated financial statements.

(2)   Amounts for fiscal 2004 include bonuses paid of $19.3 million, including related payroll taxes, and approximately $562,000 of
        professional fees and other miscellaneous expenses in connection with our initial public offering.

(3)   Amounts for fiscal 2004 include $2.2 million of professional fees and other miscellaneous expenses in connection with our
        secondary offering, which was completed in June 2004.

(4)   Recapitalization expenses include non‑interest related expenses incurred in connection with our 2003 recapitalization. See
        Note 15 to our audited consolidated financial statements for additional information about our 2003 recapitalization.

(5)   Amounts for fiscal 2003 include an aggregate of $16.3 million in expense for the redemption premium and consent fee paid in
        connection with the redemption of our previously‑existing 9⁵/₈% senior subordinated notes combined with the write off of
        unamortized debt issuance costs associated with the previously‑existing senior credit facility. Amounts for fiscal 2004 include
        an aggregate of $11.7 million in expense incurred in connection with our offerings, including bond call premiums totaling
        $7.7 million incurred in connection with the redemption of $107.2 million of our outstanding senior subordinated notes and
        $4.0 million of debt issuance costs that we wrote off related to the retirement of debt.

(6)   Potentially dilutive stock options that were excluded from the computation of diluted earnings per share, because the options’
        exercise price exceeded the average market price of the common stock during the year, totaled 595, 72 and 117 for 2005,
        2004 and 2003, respectively.

(7)   Due to their antidilutive effect, 2,990 and 7,522 dilutive potential common shares from the preferred stock conversion have been
        excluded from the diluted weighted average shares calculation for the year ended December 31, 2004 and 2003, respectively.

(8)   Total debt equals current and long-term debt and capital lease obligations.

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ITEM 7.     MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
                    RESULTS OF OPERATIONS

General

     Kinetic Concepts, Inc. is a global medical technology company with leadership positions in advanced wound care and therapeutic surfaces.  We design, manufacture, market and service a wide range of proprietary products that can improve clinical outcomes and can help reduce the overall cost of patient care.  Our advanced wound care systems incorporate our proprietary V.A.C. technology, which has been demonstrated clinically to help promote wound healing and can help reduce the cost of treating patients with serious wounds.  Our therapeutic surfaces, including specialty hospital beds, mattress replacement systems and overlays, are designed to address pulmonary complications associated with immobility, to prevent skin breakdown and assist caregivers in the safe and dignified handling of obese patients.  We have an infrastructure designed to meet the specific needs of medical professionals and patients across all health care settings, including acute care hospitals, extended care facilities and patients’ homes both in the United States and abroad.

     We have direct operations in the United States, Canada, Western Europe, Australia, Singapore, Japan and South Africa, and we conduct additional business through distributors in Latin America, the Middle East, Eastern Europe and Asia.  We manage our business in two geographical segments: USA and International.  Operations in the United States accounted for approximately 73% of our total revenue for the year ended December 31, 2005.

     We derive our revenue from both the rental and sale of our products.  In the U.S. acute care and extended care settings, which accounted for more than half of our U.S. revenue in 2005, we directly bill our customers, such as hospitals and extended care facilities.  In the U.S. home care setting, where our revenue comes predominantly from V.A.C. systems, we provide products and services directly to patients and we directly bill third‑party payers, such as Medicare and private insurance.  Internationally, most of our revenue is generated from the acute care setting.

     For the last several years, our growth has been driven primarily by increased revenue from V.A.C. system revenue, which accounted for approximately 75% of total revenue for the year ended December 31, 2005, up from 70% in 2004.  Historically, we have experienced a seasonal slowing of V.A.C. revenue growth beginning in the fourth quarter and continuing into the first quarter, which we believe has been caused by year-end clinical treatment patterns, such as the postponement of elective surgeries, and increased discharges of individuals from the acute care setting around the holidays.

     We believe that the historical growth in our V.A.C. revenue has been due in part to the reimbursement code assigned to our V.A.C. systems and disposables by the Centers for Medicare and Medicaid Services (“CMS”).  While in the past V.A.C. systems and disposables have been the only devices assigned to the codes for Negative Pressure Wound Therapy, a pump and dressing kits marketed by BlueSky Medical Group, Inc. have recently been assigned to the same Negative Pressure Wound Therapy codes under the Healthcare Common Procedure Coding System.  Also, the existing code for reimbursement of V.A.C. disposable canisters was eliminated effective December 31, 2005, which now requires us to bill Medicare Part B for V.A.C. canisters under an alternate existing code at a lower reimbursement rate.  As a result, we may experience increased competition from BlueSky products in future periods and the pricing we receive from other third-party payers may be negatively impacted, either of which could materially and adversely affect our business and operating results.

        We believe we have the following competitive strengths:

     Product innovation and commercialization.  We have a successful track record in pioneering new wound care and therapeutic surface technologies.  Our recent development and commercialization of new V.A.C. systems and disposable dressing variations have strengthened KCI's leadership position in advanced wound care.  We have also developed and commercialized a broad spectrum of therapeutic surfaces, a number of which have significantly enhanced patient care.  Our most recent innovation in therapeutic surfaces is RotoProne Therapy, an advanced patient-care system for the treatment and prevention of pulmonary complications associated with immobility.  Proning therapy may improve oxygenation in patients with Acute Respiratory Distress Syndrome.

     Superior clinical efficacy.  The superior clinical efficacy of our V.A.C. systems and our therapeutic surfaces is supported by an extensive collection of published clinical studies, peer-reviewed journal articles, and textbook citations, which aid adoption by clinicians.

     Broad reach and customer relationships.  Our worldwide sales team, consisting of approximately 1,630 individuals, including approximately 485 employees with clinical backgrounds, has strong relationships with our customers due to the clinical support and consultation we provide and our education and training programs.  We also have broad reach across all health care settings.  In the United States, for example, we have relationships with over 3,800 acute care hospitals, approximately 5,900 extended care facilities and over 10,800 home health care agencies and wound care clinics.

     Extensive service center network.  With a network of 139 U.S. and 70 international service centers, we are able to rapidly deliver our critically needed products to major hospitals in the United States, Canada, Australia and most major European countries.  Our network gives us the ability to deliver our products to any major Level I domestic trauma center within hours.  This extensive network is critical to securing national GPO contracts and allows us to efficiently serve the home market directly.  Our network also provides a platform for the introduction of additional products.

     Reimbursement expertise.  A significant portion of our V.A.C. revenue is derived from home placements, which are reimbursed by third-party payers such as private insurance, managed care, Medicare and Medicaid.  We have dedicated significant time and resources to develop capabilities and expertise in third-party reimbursement, and we have developed systems to support and manage the deployment of our domestic and international sales and service efforts.

     We believe that the key factors underlying V.A.C. growth over the past year have been:

     -  Improving V.A.C. adoption among customers and physicians, both in terms of the number of users and the
        extent of use by each customer or physician.

     -  Market expansion by adding new wound type indications for V.A.C. use and increasing the percentage of wounds
        that are considered good candidates for V.A.C. therapy.  Recent advances include the launch of the V.A.C.
        (GranuFoam^® Silver) dressing for use in infected wounds.

     -  Strengthening our contractual relationships with third‑party payers.

     We continue to focus our marketing and selling efforts on increasing physician awareness and adoption of the benefits of V.A.C. therapy.  These efforts are targeted at physician specialties that provide care to the majority of patients with wounds in our target categories.  Within these specialties, we focus on those clinicians who serve the largest number of wound care patients.  In order to meet our goals of increasing physician awareness, we increased our total sales force by approximately 290 employees in 2004 and 190 employees in 2005.

     Our intellectual property is very important to maintaining our competitive position.  Specifically with respect to our V.A.C. business, we rely on our rights under the Wake Forest patents licensed to us and a number of KCI patents in the U.S. and internationally.  Continuous enhancements in product portfolio and positioning are also important to our continued growth and market penetration.  We believe our advanced V.A.C. systems have increased customer acceptance and the perceived value of V.A.C. therapy.  We have benefited from the introduction of specialized dressing systems designed to improve ease-of-use and effectiveness in treating pressure ulcers and serious abdominal wounds.  At the same time, ongoing clinical experience and studies, such as the randomized, controlled clinical trial of V.A.C. for the treatment of amputation wound of the diabetic foot, which we sponsored and that was published in November 2005 in the Lancet, have increased the market acceptance of V.A.C. and expanded the range of wounds considered to be good candidates for V.A.C. therapy.  We believe this growing base of data and clinical experience has driven the trend toward use of the V.A.C. on a routine basis for appropriate wounds.

     Our other major product line, therapeutic surfaces, has continued to grow modestly internationally, while remaining stable in the U.S.  Therapeutic surfaces revenue was $301.0 million in 2005, up from $293.6 million in 2004.

Results of Operations

Year ended December 31, 2005 Compared to Year ended December 31, 2004

     The following table sets forth, for the periods indicated, the percentage relationship of each item to total revenue in the period, as well as the percentage change in each line item comparing 2005 to 2004:

 

 

      The following table sets forth, for the periods indicated, total revenue for V.A.C. systems and therapeutic surfaces/other and the amount of revenue derived from each of our geographical segments: USA and International (dollars in thousands):

 

     For additional discussion on segment and geographical information, see Note 16 to our consolidated financial statements.

      Total Revenue.  Total revenue for 2005 was $1.2 billion, an increase of $215.9 million, or 21.8%, from the prior year.  The growth in total revenue over the prior period was due primarily to increased rental and sales volumes for V.A.C. wound healing devices and related disposables.  The growth in V.A.C. revenue was attributable to increased physician awareness of the benefits of V.A.C. therapy and increased product adoption across wound types.  Foreign currency exchange movements accounted for 0.7% of the increase in total revenue in 2005, compared to the prior year.

     Domestic Revenue.  Total domestic revenue was $886.2 million for 2005, representing an increase of 19.1% as compared to the prior year.  Total domestic V.A.C. revenue was $706.0 million for 2005, representing an increase of 25.5% compared to the prior year.  For 2005, domestic V.A.C. rental revenue of $519.6 million increased $102.6 million, or 24.6%, due to a 27.5% increase in average units on rent compared to the prior year.  The unit increase was partially offset by a 2.0% decline in the average V.A.C. rental pricing during 2005, generally attributable to moving non-contracted payers in the home care market to contracted pricing.  Entering into payer agreements with non-contracted payers has the effect of decreasing the price paid by such payers while improving the protocols and payment cycles of such payers.  Domestic V.A.C. sales revenue of approximately $186.4 million in 2005 increased 28.1% from the prior year.  This was due primarily to higher sales volumes for V.A.C. disposables associated with the 27.5% increase in V.A.C. system unit rentals and the shift away from all-inclusive pricing arrangements with managed care organizations.

      Historically, we have experienced a seasonal slowing of V.A.C. unit growth beginning in the fourth quarter and continuing into the first quarter, which we believe is caused primarily by year-end clinical treatment patterns, such as the postponement of elective surgeries, and increased discharges of individuals from the acute care setting around the holidays. Although we do not know if our historical experience will prove to be indicative of future periods, a similar slow-down may recur in subsequent periods.

      Domestic therapeutic surfaces/other revenue was approximately $180.2 million for 2005, a decrease of 0.8% as compared to the prior year.  For 2005, domestic therapeutic surfaces rental revenue of $152.0 million was essentially flat compared to the prior year.  The average units on rent and the average daily rental price were stable compared to the prior year.

     International Revenue.  Total international revenue was $322.4 million for 2005, representing an increase of 29.8% from the prior year as a result of increased V.A.C. demand, a $7.7 million government-funded sale of V.A.C. and surface products in Canada during the first quarter of 2005 and favorable foreign currency exchange movements.  Favorable foreign currency exchange movements contributed 2.9% to the variance in 2005.

      Total international V.A.C. revenue was $201.5 million in 2005 representing an increase of 47.7% from the prior year.  Foreign currency exchange movements favorably impacted international V.A.C. revenue and accounted for 3.3% of the increase from the prior year.  International V.A.C. rental revenue of $96.0 million for 2005 increased $27.5 million, or 40.2%, due to a 41.2% increase in average units on rent per month.  The average rental price for 2005 decreased 1.1% as compared to the prior year due to increased revenue in countries with lower reimbursement levels.  International V.A.C. sales revenue of $105.5 million in 2005 increased 55.4% from the prior year due primarily to overall increased sales of V.A.C. disposables associated with the increase in rental units.

      International therapeutic surfaces/other revenue was $120.9 million for 2005, representing an increase of 8.0% from the prior year.  During the first quarter of 2005, we completed a $5.1 million sale of therapeutic surfaces in Canada.  Foreign currency exchange movements favorably impacted international therapeutic surfaces/other revenue for 2005, representing 2.3% of the increase from the prior year.  The remaining variance from the prior year was primarily due to a 6.3% decrease in the average rental price, partially offset by a 6.1% increase in the average number of therapeutic surface rental units on rent.  The decline in average rental price resulted primarily from pricing pressure due to increased competition on our lower therapy products and changes in product mix.

     Rental Expenses.  Rental, or “field,” expenses are comprised of both fixed and variable costs.  Field expenses, as a percentage of total revenue, were comparable in 2005 at 43.7% as compared to 45.1% in the prior year.  This decrease was due primarily to efficiencies recognized in our service model including lower costs per work order, partially offset by an increase in our sales and service headcount from approximately 2,820 at December 31, 2004 to 3,100 at December 31, 2005.

     Cost of Goods Sold.  Cost of goods sold was $89.3 million in 2005, representing an increase of 26.2% over the prior year.  Sales margins in 2005increased to 74.5% compared to 73.4% in the prior year.  The increased margins were due to favorable changes in our product mix, continued cost reductions resulting from our global supply contract for V.A.C. disposables, and favorable profit margins on the Canadian sale in the first quarter of 2005.

     Gross Profit.  Gross profit was $591.2 million in 2005, representing an increase of 24.7% over the prior year.  Gross profit margin in 2005 was 48.9%, up from 47.8% in the prior year. Purchase discounts under an agreement with a primary supplier, efficiency improvements in our service model that included lower costs per work order and favorable changes in our product mix contributed to the margin expansion.

     Selling, General and Administrative Expenses.  Selling, general and administrative expenses represented 23.1% of total revenue in 2005 compared to 23.5% in the prior year.  Selling, general and administrative expenses include administrative labor, incentive and sales commission compensation costs, product licensing expense, insurance costs, professional fees, depreciation, bad debt expense and finance and information systems costs.  The Company adopted Statement of Financial Accounting Standards No. 123 Revised, “Share-Based Payment”, on January 1, 2006 and expects to incur compensation expense in future periods related to stock option grants and employee participation in the Employee Stock Purchase Plan.

     Research and Development Expenses.  Research and development expenses in 2005 were $30.6 million and represented 2.5% of total revenue as compared to 3.2% in the prior year.  Clinical spending was consistent as a percentage of revenue as compared to the prior year.  For 2005, the decline in research and development spending was due primarily to the termination of one research and development project and the timing of spending on other ongoing research and development projects.  Research and development expenses relate to our investments in new advanced wound healing systems and dressings, new technologies in wound healing and tissue repair, new applications of V.A.C. technology and upgrading and expanding our surface technology.

     Litigation Settlement Expense.  On September 30, 2005, we reached an agreement to settle our litigation with Novamedix Limited, a subsidiary of Orthofix International NV.  Under the terms of the settlement, we paid Novamedix $75.0 million.  The settlement payment resulted in a charge of $72.0 million, net of recorded reserves of $3.0 million, in 2005.  The Novamedix settlement will not have a continuing impact on future operations or cash flows.  See Note 12 to our consolidated financial statements.

     Operating Earnings.  Operating earnings for 2005 were $209.0 million compared to $187.7 million in the prior year primarily due to increased revenue, partially offset by the Novamedix litigation settlement recorded in 2005.  Current year operating margins were unfavorably impacted by the litigation settlement of $72.0 million recorded in the third quarter of 2005.  Prior-year operating margins were unfavorably impacted by the expenses incurred in connection with our 2004 stock offerings of $22.1 million.

     Interest Expense.  Interest expense in 2005 was $25.2 million compared to $44.6 million in the prior year.  Interest expense in 2005 includes write-offs of $2.9 million of debt issuance costs associated with the 2005 debt prepayments of $135.9 million on our senior credit facility and $13.4 million on our 7 ⅜% Senior Subordinated Notes due 2013. Interest expense for 2004 included payment of bond call and purchase premiums of $7.7 million associated with the redemption of a portion of our outstanding 7 3/8% Senior Subordinated Notes due 2013 and the write-off of $5.5 million of debt issuance costs on debt retired during the period.  The remaining variance of approximately $9.1 million in interest expense resulted from a decrease in our average outstanding debt balance from the prior year.

     Net Earnings.  Net earnings for 2005 were $122.2 million, compared to net earnings of $96.5 million in the prior year.  Net earnings in 2005 were unfavorably impacted by the Novamedix litigation settlement of $47.4 million, net of taxes, recorded in the third quarter of 2005.  Net earnings in 2004 were unfavorably impacted by costs and expenses incurred in connection with our stock offerings and debt prepayments of $21.8 million, net of taxes.  The effective income tax rate for 2005 was 34.0% compared to 35.5% for the prior year. The income tax rate reduction was primarily attributable to a higher portion of taxable income being generated in lower tax jurisdictions.

     Net Earnings per Share Available to Common Shareholders.   Diluted net earnings per share available to common shareholders was $1.67 in 2005, which was unfavorably impacted by the litigation settlement charge of $47.4 million, or $0.65 per diluted share, net of taxes, compared to the net earnings per share available to common shareholders of $0.45 in the prior year, which was unfavorably impacted by expenses of $21.8 million and preferred stock dividends of $65.6 million associated with our stock offerings and debt prepayments, or $1.22 per diluted share, net of taxes.

Year ended December 31, 2004 Compared to Year ended December 31, 2003

     The following table sets forth, for the periods indicated, the percentage relationship of each item to total revenue in the period, as well as the percentage change in each line item comparing 2004 to 2003:

 

 

 

     The following table sets forth, for the periods indicated, total revenue for V.A.C. systems and therapeutic surfaces/other and the amount of revenue derived from each of our geographical segments: USA and International (dollars in thousands):

 

     Total Revenue.  Total revenue for 2004 was $992.6 million, an increase of $228.8 million, or 30.0%, from the prior year.  The growth in total revenue was primarily due to the increased rental and sales volumes for V.A.C. wound healing devices and related disposables.  V.A.C. revenue in 2004 was $699.0 million, an increase of $217.2 million, or 45.1%, from the prior year.  The growth in V.A.C. revenue was attributable to the increased worldwide availability of the V.A.C.^ATS and V.A.C. Freedom, increased physician awareness of the benefits of V.A.C. therapy and increased product adoption across wound types.  In 2004, worldwide V.A.C. revenue from the combined acute and extended care settings grew 46.4%, and V.A.C. revenue from the home care setting grew 43.4% as compared to the prior year.  Foreign currency exchange movements accounted for 2.9% of the year-over-year increase in total revenue.

     Domestic Revenue.   Total domestic revenue was $744.3 million for 2004, representing an increase of 28.4% as compared to the prior year.  Total domestic V.A.C. revenue was $562.6 million for 2004, representing an increase of 40.7% as compared to the prior year.  Domestic V.A.C. rental revenue of $417.0 million for 2004 increased $105.3 million, or 33.8%, due to a 39.6% increase in average units on rent as compared to the prior year.  The unit increase was partially offset by a decline in the average V.A.C. rental pricing during 2004, due in part to the continued shift away from all-inclusive pricing for managed care organizations, which resulted in revenue movement from the rental classification to the sales classification.  Additionally, revenue reserves were established against current period revenue related to expected future billing adjustments and estimated write-offs of uncollectible patient receivables after their third-party payer has settled the primary portion of the claim.  Domestic V.A.C. sales revenue of $145.6 million in 2004 increased $57.4 million, or 65.1% from the prior year. This was due to higher sales volumes for V.A.C. disposables associated with V.A.C. system rentals and improved price realization from increased sales of our higher therapy disposables.

     Domestic therapeutic surfaces/other revenue was $181.7 million for 2004, an increase of 0.9% over the prior year.  For 2004, domestic therapeutic surfaces rental revenue of $151.9 million increased 2.0%, as compared to the prior year, primarily due to a 3.0% average daily rental price increase resulting from favorable product mix changes, partially offset by a 1.2% decrease in the average number of units on rent as compared to the prior year.

     International Revenue.  Total international revenue was $248.3 million for 2004, representing an increase of 35.0% from the prior year as a result of increased V.A.C. demand, higher therapeutic surface renta