KINETIC CONCEPTS INC /TX/ - 10-Q Quarterly Report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

Form 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2004

Commission file number 001-09913

KINETIC CONCEPTS, INC.

(Exact name of registrant as specified in its charter)

Texas	74-1891727
(State of Incorporation)	(I.R.S. Employer Identification No.)

8023 Vantage Drive
San Antonio, Texas 78230
Telephone Number: (210) 524-9000
(Address, including zip code, and telephone number, including area code,
of registrant's principal executive offices)

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 whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).
Yes ___ No X

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.

Common Stock: 66,682,958 shares as of August 9, 2004

TABLE OF CONTENTS

PART I - FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

Condensed Consolidated Balance Sheets

Condensed Consolidated Statements of Earnings

Condensed Consolidated Statements of Cash Flows

Notes to Condensed Consolidated Financial Statements

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

ITEM 4. CONTROLS AND PROCEDURES

PART II - OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

SIGNATURES

Table of Contents

KINETIC CONCEPTS, INC.

INDEX

		Page No.
PART I.	FINANCIAL INFORMATION		5
	Item 1.	Financial Statements	5
		Condensed Consolidated Balance Sheets	5
		Condensed Consolidated Statements of Earnings	6
		Condensed Consolidated Statements of Cash Flows	7
		Notes to Condensed Consolidated Financial Statements	8
	Item 2.	Management's Discussion and Analysis of Financial Condition and Results of Operations	22
	Item 3.	Quantitative and Qualitative Disclosures About Market Risk	45
	Item 4.	Controls and Procedures	46
PART II.	OTHER INFORMATION		47
	Item 1.	Legal Proceedings	47
	Item 2.	Changes in Securities and Use of Proceeds	47
	Item 6.	Exhibits and Reports on Form 8-K	47
	SIGNATURES		49

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FORWARD-LOOKING STATEMENTS

This Quarterly Report on Form 10-Q 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 subject to the "safe harbor" created by those sections. The forward-looking statements are based on our current expectations and projections about future events. Discussions containing such forward-looking statements may be found in "Management's Discussion and Analysis of Financial Condition and Results of Operations," and elsewhere in this document. 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,&qu ot; or the negative of these terms and other comparable terminology, including, but not limited to, the following:

   - any projections of revenues, earnings, cash balances or cash flow, synergies or other financial items;
   - any statements of the plans, strategies and objectives of management for future operations;
   - any statements regarding future economic conditions or performance;
   - implementing our business strategy;
   - attracting and retaining customers;
   - obtaining and expanding market acceptance of the products and services we offer;
   - competition in our market;
   - statements regarding the outcome of pending litigation;
   - trends in the mix of rental and sales product mix and from lower-therapy products to capital purchases;
   - future demand for V.A.C. systems;
   - expenditures with respect to our therapeutic surfaces business and demand for our bariatric products;
   - changes in patient demographics; and
   - any statements of assumptions underlying any of the foregoing.

These forward-looking statements are only predictions, not historical facts. These forward-looking statements 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" in the section entitled "Management's Discussion and Analysis of Financial Condition and Results of Operations" contained herein, as well as those discussed in our Form 10-K and other filings with the Securities and Exchange Commission. These risks include the fluctuations in our operating results and the possible inability to meet our expectations or those of our analysts in future periods; intense and growing competition we face; our dependence on our intellectual property; our de pendence on new technology; the clinical efficacy of the V.A.C. relative to alternate devices or therapies; and third party reimbursement policies and collections. You should also consider the risks 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 Quarterly Report on Form 10-Q. KCI disclaims any obligation to update or alter these forward-looking statements, whether as a result of new information, future events or otherwise.

In this report, unless the context requires otherwise, the words "we," "our," "us," and "KCI" refer to Kinetic Concepts, Inc.

TRADEMARKS

The following terms used in this report are our trademarks: AirMaxxis™, AtmosAir™, BariAir®, BariKare®, BariMaxx® II, BariMaxx®, DynaPulse®, FirstStep®, FirstStep® Advantage™, FirstStep® Plus, FirstStep Select®, FirstStep Select® Heavy Duty, FluidAir Elite®, FluidAir™ II, KCI®, KinAir™ III, KinAir™ IV, KinAir™ MedSurg™, Kinetic Concepts®, Kinetic Therapy™, Maxxis® 300, Maxxis® 400, MiniV.A.C.™, PediDyne™, PlexiPulse®, PlexiPulse® AC, Pulse IC™, Pulse SC™, RIK®, RotoProne®, Roto Rest®, Roto Rest® Delta, T.R.A.C.™, The Clinical Advantage®, TheraPulse®, TheraPulse® II, TheraRest®, TriaDyne® II, TriaDyne® Proventa™, TriCell®, V.A.C.®, V.A.C.^ATS®™, V.A.C.® Freedom™, V.A.C.& reg; Therapy™, The V.A.C.® System™, Vacuum Assisted Closure® and V.A.C.® Instill™. All other trademarks appearing in this report are the property of their holders.

Table of Contents

PART I - FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

KINETIC CONCEPTS, INC. AND SUBSIDIARIES
Condensed Consolidated Balance Sheets
(in thousands)

	June 30,	December 31,
	2004	2003
	(unaudited)
Assets:
Current assets:
Cash and cash equivalents	$ 75,493	$ 156,064
Accounts receivable, net	214,556	199,938
Inventories, net	30,823	32,253
Deferred income taxes	24,095	22,749
Derivative financial instruments	1,282	-
Prepaid expenses and other current assets	15,793	11,811
	_______	_______
Total current assets	362,042	422,815
	_______	_______

Net property, plant and equipment	162,913	145,208
Loan and preferred stock issuance costs, less accumulated amortization
of $3,248 in 2004 and $1,014 in 2003	13,273	19,779
Goodwill	48,791	48,797
Other assets, less accumulated amortization of $8,530 in 2004 and
$8,190 in 2003	29,214	28,497
	_______	_______
	$ 616,233	$ 665,096
	_______	_______
Liabilities and Shareholders' Deficit:
Current liabilities:
Accounts payable	$ 33,594	$ 34,386
Accrued expenses	122,275	112,652
Current installments of long-term debt	4,166	4,800
Current installments of capital lease obligations	1,504	1,576
Derivative financial instruments	-	2,402
Income taxes payable	-	39,403
	_______	_______
Total current liabilities	161,539	195,219
	_______	_______
Long-term debt, net of current installments	492,682	678,100
Capital lease obligations, net of current installments	1,298	1,351
Deferred income taxes, net	29,248	26,566
Deferred gain, sale of headquarters facility	8,647	9,183
Other non-current liabilities	213	212
	_______	_______
	693,627	910,631
Series A convertible preferred stock, 0 issued and outstanding
at June 30, 2004 and 264 at December 31, 2003	-	261,719

Shareholders' equity (deficit):
Common stock; authorized 225,000 at June 30, 2004 and
150,000 at December 31, 2003; issued and outstanding 66,664
at June 30, 2004 and 41,270 at December 31, 2003	67	41
Additional paid-in capital	468,479	1,157
Deferred compensation	(1,515)	185
Retained deficit	(555,066)	(518,955)
Accumulated other comprehensive income	10,641	10,318
	_______	_______
Shareholders' deficit	(77,394)	(507,254)
	_______	_______
	$ 616,233	$ 665,096
	_______	_______
See accompaning notes to condensed consolidated financial statements.

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KINETIC CONCEPTS, INC. AND SUBSIDIARIES
Condensed Consolidated Statements of Earnings
(in thousands, except per share data)
(unaudited)

	Three months ended		Six months ended
	June 30,		June 30,
	2004	2003	2004	2003
Revenue:
Rental	$ 175,579	$ 140,854	$ 341,487	$ 270,296
Sales	61,406	42,023	120,332	79,584
	_______	_______	_______	_______
Total revenue	236,985	182,877	461,819	349,880
	_______	_______	_______	_______

Rental expenses	109,572	87,911	214,978	167,290
Cost of goods sold	16,560	14,713	33,328	28,358
	_______	_______	_______	_______
Gross profit	110,853	80,253	213,513	154,232

Selling, general and administrative expenses	52,898	40,050	101,440	76,531
Research and development expenses	7,188	4,439	14,307	8,864
Initial public offering expenses	302	-	19,836	-
Secondary offering expenses	2,219	-	2,219	-
	_______	_______	_______	_______
Operating earnings	48,246	35,764	75,711	68,837

Interest income	158	347	529	747
Interest expense	(11,050)	(8,050)	(29,894)	(16,228)
Foreign currency gain (loss)	201	2,368	(263)	4,156
	_______	_______	_______	_______
Earnings before income taxes	37,555	30,429	46,083	57,512

Income taxes	13,520	11,411	16,590	21,567
	_______	_______	_______	_______
Net earnings	$ 24,035	$ 19,018	$ 29,493	$ 35,945

Series A convertible preferred stock dividends	-	-	(65,604)	-
	_______	_______	_______	_______
Net earnings (loss) available to common shareholders	$ 24,035	$ 19,018	$ (36,111)	$ 35,945
	_______	_______	_______	_______
Net earnings (loss) per share available to common shareholders:
Basic	$ 0.37	$ 0.27	$ (0.63)	$ 0.51
	_______	_______	_______	_______
Diluted	$ 0.34	$ 0.25	$ (0.63)	$ 0.47
	_______	_______	_______	_______
Weighted average shares outstanding:
Basic	65,087	71,070	57,709	71,032
	_______	_______	_______	_______
Diluted	71,303	77,236	57,709	76,904
	_______	_______	_______	_______

See accompanying notes to condensed consolidated financial statements.

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KINETIC CONCEPTS, INC. AND SUBSIDIARIES
Condensed Consolidated Statements of Cash Flows
(in thousands)
(unaudited)

	Six months ended June 30,
	2004	2003
Cash flows from operating activities:
Net earnings	$ 29,493	$ 35,945
Adjustments to reconcile net earnings to net cash provided by operating activities:
Depreciation and amortization	27,763	21,991
Provision for uncollectible accounts receivable	6,053	3,527
Amortization of deferred gain on sale of headquarters facility	(535)	(521)
Write-off of deferred loan issuance costs	4,534	-
Non-cash amortization of stock award to directors	114	-
Tax benefit related to exercise of stock options	30,177	-
Change in assets and liabilities:
Increase in accounts receivable, net	(20,741)	(10,342)
Decrease (increase) in other accounts receivable	(784)	175,000
Decrease in current deferred income taxes	(1,346)	(66,838)
Decrease in inventories	1,406	4,148
Increase in prepaid expenses and other current assets	(3,981)	(1,979)
Increase (decrease) in accounts payable	(800)	1,218
Increase in accrued expenses	15,945	18,100
Increase (decrease) in income taxes payable	(39,403)	20,282
Increase (decrease) in deferred income taxes, net	1,580	(1,826)
Net cash provided by operating activities	49,475	198,705
	_______	_______
Cash flows from investing activities:
Additions to property, plant and equipment	(42,376)	(34,381)
Increase in inventory to be converted into equipment for short-term rental	(4,800)	(1,300)
Dispositions of property, plant and equipment	1,293	634
Business acquisitions, net of cash acquired	-	(2,224)
Increase in other assets	(264)	(425)
Net cash used by investing activities	(46,147)	(37,696)
	_______	_______
Cash flows from financing activities:
Repayment of notes payable, long term, capital lease and other obligations	(186,177)	(114,856)
Initial public offering of common stock:
Proceeds from issuance of common stock	105,000	-
Stock issuance costs	(10,604)	-
Proceeds from exercise of stock options	8,214	846
	_______	_______
Net cash used by financing activities	(83,567)	(114,010)
	_______	_______
Effect of exchange rate changes on cash and cash equivalents	(332)	1,489
Net increase (decrease) in cash and cash equivalents	(80,571)	48,488
Cash and cash equivalents, beginning of period	156,064	54,485
Cash and cash equivalents, end of period	$ 75,493	$ 102,973
	_______	_______
Cash paid during the six months for:
Interest (1)	$ 25,431	$ 14,903
Income taxes	$ 28,283	$ 69,392
Non-cash activity:
Non-cash consideration for exercise of stock options	$ 6,354	$ -

1) 2004 amount includes purchase premiums of $7.7 million related to the prepayments on our 7 3/8% Senior Subordinated Notes due 2013.

See accompanying notes to condensed consolidated financial statements.

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KINETIC CONCEPTS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(a) Basis of Presentation

The unaudited condensed consolidated financial statements presented herein include the accounts of Kinetic Concepts, Inc., together with our consolidated subsidiaries ("KCI"). The unaudited condensed consolidated financial statements appearing in this quarterly report on Form 10-Q should be read in conjunction with the financial statements and notes thereto included in KCI's latest annual report on Form 10-K. The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information necessary for a fair presentation of results of operations, financial position and cash flows in conformity with accounting principles generally accepted in the United States. Operating results from interim period s are not necessarily indicative of results that may be expected for the fiscal year as a whole. The consolidated financial statements reflect all adjustments, consisting of normal recurring accruals, considered necessary for a fair presentation of our results for the periods presented. Certain reclassifications of amounts related to the prior year have been made to conform with the 2004 presentation.

(b) Stock-Based Compensation

We use the intrinsic value method to account for our stock compensation plans. If the compensation cost for our stock-based employee compensation plans had been determined based upon a fair value method consistent with Statement of Financial Accounting Standards No. 123 ("SFAS 123"), "Accounting for Stock-Based Compensation," our net earnings (loss) to common shareholders and earnings (loss) per share would have been adjusted to the pro forma amounts indicated below. For purposes of pro forma disclosures, the estimated fair value of the options is recognized as an expense over the options' respective vesting periods. Our pro forma calculations are as follows (dollars in thousands, except for earnings (loss) per share information):

	Three months ended		Six months ended
	June 30,		June 30,
	2004	2003	2004	2003

Net earnings (loss) available to common shareholders
as reported	$ 24,035	$ 19,018	$ (36,111)	$ 35,945
	______	______	______	______
Pro forma net earnings available to common shareholders:
Net earnings (loss) available to common
shareholders as reported	$ 24,035	$ 19,018	$ (36,111)	$ 35,945
Compensation expense under intrinsic method	46	988	73	1,646
Compensation expense under fair value method	(905)	(401)	(1,206)	(775)
	______	______	______	______
Pro forma net earnings (loss) available to common shareholders	$ 23,176	$ 19,605	$ (37,244)	$ 36,816
	______	______	______	______
Net earnings (loss) per share available to common shareholders as reported:
Basic net earnings (loss) per common share	$ 0.37	$ 0.27	$ (0.63)	$ 0.51
Diluted net earnings (loss) per common share	$ 0.34	$ 0.25	$ (0.63)	$ 0.47

Pro forma net earnings (loss) per share available to common shareholders:
Basic net earnings per common share	$ 0.36	$ 0.28	$ (0.65)	$ 0.52
Diluted net earnings per common share	$ 0.33	$ 0.25	$ (0.65)	$ 0.48

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We are not required to apply, and have not applied, the method of accounting prescribed by SFAS 123 to stock options granted prior to January 1, 1995. Moreover, the pro forma compensation cost reflected above may not be representative of future compensation expense.

During the three and six-month periods ended June 30, 2004, we issued approximately 1.9 million and 2.7 million shares of common stock, respectively, under our stock-based compensation plans primarily through option exercises.

During the three-month period ended June 30 2004, we granted approximatley 900,000 options to purchase shares of common stock under our stock compensation plans.

(c) Other Significant Accounting Policies

For further information on our significant accounting policies, see Note 1 of the Notes to the Consolidated Financial Statements included in KCI's Annual Report on Form 10-K for the year ended December 31, 2003.

(2) RECENT PUBLIC STOCK OFFERINGS

On February 27, 2004, we completed an initial public offering ("IPO") of our common stock, through which we sold 3.5 million newly-issued shares and selling shareholders sold an aggregate of 17.2 million existing shares at a price of $30.00 per share. Net proceeds from the IPO to KCI were $94.4 million. The net proceeds, along with cash on hand, were used to redeem $71.75 million principal amount of our 7³/₈% Senior Subordinated Notes due 2013, together with a bond call premium of $5.3 million in connection with the redemption, to prepay $50.0 million of debt under our senior credit facility, and to pay management bonuses, payroll taxes and other expenses related to the IPO of $19.8 million. In March 2004, we wrote off $3.3 million in loan issuance costs associated with the retirement of our debt, which was included in interest expense.

As part of the IPO, the holders of our then-outstanding Series A convertible preferred stock received cumulative preferred dividends paid-in-kind through December 31, 2005 of $65.6 million, and immediately thereafter, all of the then-outstanding shares of preferred stock were automatically converted into 19,199,520 shares of common stock.

On June 16, 2004, we completed a secondary offering of our common stock, through which selling shareholders sold an aggregate of 16.1 million existing shares at a price of $47.50 per share. KCI did not sell any shares or receive any proceeds in the offering. We incurred $2.2 million of expenses related to the secondary offering.

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(3) SUPPLEMENTAL BALANCE SHEET DATA

Accounts receivable consist of the following (dollars in thousands):

	June 30,	December 31,
	2004	2003
Trade accounts receivable:
Medical facilities	$ 129,367	$ 123,016

Third-party payers:
Medicare / Medicaid	39,549	36,392
Managed care, insurance and other	88,514	75,059
	_______	_______
	257,430	234,467
Medicare V.A.C. receivables prior to October 1, 2000	13,445	13,445
Employee and other receivables	1,492	1,724
	_______	_______
	272,367	249,636

Less: Allowance for doubtful accounts	(44,366)	(36,253)
Allowance for Medicare V.A.C. receivables
prior to October 1, 2000	(13,445)	(13,445)
	_______	_______
	$ 214,556	$ 199,938
	_______	_______

Inventories are stated at the lower of cost (first-in, first-out) or market (net realizable value). Inventories are comprised of the following (dollars in thousands):

	June 30,	December 31,
	2004	2003

Finished goods	$ 12,331	$ 12,137
Work in process	3,277	2,847
Raw materials, supplies and parts	31,895	28,689
	______	______
	47,503	43,673

Less: Amounts expected to be converted
into equipment for short-term rental	(13,800)	(9,000)
Reserve for excess and obsolete
inventory	(2,880)	(2,420)
	______	______
	$ 30,823	$ 32,253
	______	______

(4) LONG-TERM OBLIGATIONS AND DERIVATIVE FINANCIAL INSTRUMENTS

Senior Credit Facility

On June 1, 2004, we made an optional prepayment of $30.0 million on our senior credit facility and our remaining outstanding balance as of June 30, 2004 was $397.6 million.