| KINETIC CONCEPTS INC /TX/ ITEM 1A RISK FACTORS Risks Related to Our Business We face significant and increasing competition which could adversely affect our operating results |
| Historically, our VAC 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 VAC systems, competitors have announced or introduced products similar to or designed to mimic our VAC systems |
| In this regard, BlueSky Medical Group, Inc |
| is marketing a pump and dressing kits to compete directly with VAC systems |
| In 2004, BlueSky received US 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 VAC 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 VAC 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 VAC systems could decline significantly, either of which could materially and adversely affect our operating results |
| We derived dlra706dtta0 million in revenue, or approximately 58prca of our total revenue for the year ended December 31, 2005, from our domestic VAC products relating to the patents at issue |
| US VAC revenue was dlra562dtta6 million and dlra399dtta9 million for 2004 and 2003, respectively |
| In the US, 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 VAC 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 VAC 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 VAC 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 VAC system could be significantly reduced due to increased competition, and pricing of VAC systems could decline significantly, either of which would materially and adversely affect our operating results |
| In 1998, Mondomed NV and Paul Hartmann AG filed an opposition in the European Patent Office to a Wake Forest European VAC 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 7dtta6 – 752 mmHg of negative pressure and modified the patent claims to provide that the "e screen means "e term describing the dressing is an open-cell polymer foam |
| Our VAC systems typically operate between 50 and 200 mmHg of negative pressure, with a default setting of 125 mmHg |
| Mondomed NV 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 103dtta8 – 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 VAC systems to decline there, either of which would materially and adversely affect our operating results |
| We derived dlra151dtta6 million in revenue from European VAC products, relating to the patents at issue, or 12dtta5prca 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 US 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 VAC 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 VAC 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 VAC disposable canisters was eliminated effective December 31, 2005, and consequently, we are required to bill Medicare Part B for VAC 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 VAC 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 dlra11dtta0 million in outstanding receivables from CMS related to Medicare VAC 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 1prca 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 VAC 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 VAC, or one that is perceived to be negative, could adversely affect the reimbursement of, or demand for, the VAC 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 VAC 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 VAC pricing, and to what extent our VAC therapy will be subject to the competitive bidding process |
| If we are unable to develop new generations of VAC 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 VAC 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 VAC 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 VAC 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 VAC systems by customers and physicians; - the type of indications that are appropriate for VAC use and the percentages of wounds that are good candidates for VAC Therapy; - clinical studies that may be published regarding the efficacy of VAC Therapy, including studies published by our competitors in an effort to challenge the efficacy of the VAC; - developments or any adverse determination in our pending litigation; - third-party government or private reimbursement policies with respect to VAC 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, VAC revenue growth has been somewhat seasonal with a slowdown in VAC 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 VAC systems matures and VAC 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 VAC therapyapstas clinical efficacy may reduce physician usage of VAC and cause our VAC revenue to decline |
| For the past several years, we have been conducting a number of clinical studies designed to test the efficacy of VAC across targeted wound types |
| A successful clinical trial program is necessary to maintain and increase sales of VAC 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 VAC therapy, physicians may elect not to use VAC therapy as a treatment in general, or for the type of wound in question |
| Furthermore, in the event of an adverse clinical trial, VAC therapy may not achieve “standard-of-care” designations for the wound types in question, which could deter the adoption of VAC 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 VAC therapy, limit the manner in which they cover VAC therapy, or reduce the price they are willing to pay or reimburse for VAC 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 governmentapstas 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 |
| 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 VAC 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 VAC disposables |
| VAC therapy cannot be administered without the appropriate use of our VAC units in conjunction with the related VAC disposables |
| Total VAC rental and sales revenue represented approximately 75prca of our total revenue for 2005, of which sales of VAC disposables represented approximately 23prca |
| Accordingly, a shortage of VAC 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 VAC disposables could be jeopardized, which could negatively impact our VAC revenue |
| The terms of the supply agreement provide that key indicators be provided to us that would alert us to Availapstas 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 VAC disposable dressings |
| 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 VAC products, or sell production to a third party |
| Any of these outcomes could jeopardize Avail’s supply of foam and hence our supply of VAC 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 VAC disposables could be compromised, which would have a materially adverse effect on our entire VAC 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 VAC 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 US 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 dlra295dtta9 million of outstanding indebtedness and shareholders &apos equity of dlra191dtta5 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 &apos 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 |