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EX-31.2 - CERTIFICATION OF THE CHIEF FINANCIAL OFFICER - KINETIC CONCEPTS INCexhibit-31_2.htm
EX-31.1 - CERTIFICATION OF THE CHIEF EXECUTIVE OFFICER - KINETIC CONCEPTS INCexhibit-31_1.htm
EX-32.1 - CERTIFICATION OF CHIEF EXECUTIVE OFFICER AND CHIEF FINANCIAL OFFICER - KINETIC CONCEPTS INCexhibit-32_1.htm
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, 2011
 
Commission File Number: 001-09913
 
KCI LOGO

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                           
(Address of principal executive offices)
 
(Zip Code)

Registrant’s telephone number, including area code:  (210) 524-9000
 
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 has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
  Yes     X            No   ____    

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer
X
 
Accelerated filer
 
         
Non-accelerated filer
 
(Do not check if a smaller reporting company)
Smaller reporting company
 

Indicate by check mark whether the registrant is a shell company (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: 73,067,017 shares as of August 2, 2011
 
 
 

 

TABLE OF CONTENTS

KINETIC CONCEPTS, INC.



 
 
SPECIAL NOTE REGARDING 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 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 those terms and other variations of them or by comparable terminology.

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."  You should consider each of the risk factors and uncertainties under the caption “Risk Factors” in this Quarterly Report on Form 10-Q and in our Annual Report on Form 10-K for the fiscal year ended December 31, 2010, among other things, in evaluating our prospects and future financial performance.  The occurrence of the events described in the risk factors could harm our business, results of operations and financial condition.  These forward-looking statements are made as of the date of this report.  We disclaim any obligation to update or alter these forward-looking statements, whether as a result of new information, future events or otherwise.


TRADEMARKS

3M™ Tegaderm™ is a licensed trademark of 3M Company; Spirit Select™ is a licensed trademark of Carroll Hospital Group, Inc.; GRAFTJACKET® is a licensed trademark of Wright Medical Technology Inc.; and Novadaq® and SPY® are licensed trademarks of Novadaq Technologies, Inc.  Unless otherwise indicated, all other trademarks appearing in this report are proprietary to KCI Licensing, Inc. or LifeCell Corporation, their affiliates and/or licensors.  The absence of a trademark or service mark or logo from this report does not constitute a waiver of trademark or other intellectual property rights of KCI Licensing, Inc. or LifeCell Corporation, their affiliates and/or licensors.
 


ITEM 1.     FINANCIAL STATEMENTS

KINETIC CONCEPTS, INC. AND SUBSIDIARIES
 
 
(in thousands)
 
             
             
   
June 30,
   
December 31,
 
   
2011
   
2010
 
   
(unaudited)
       
Assets:
           
Current assets:
           
Cash and cash equivalents
  $ 498,424     $ 316,603  
Accounts receivable, net
    411,095       414,083  
Inventories, net
    168,647       172,552  
Deferred income taxes
    29,065       30,112  
Prepaid expenses and other
    47,738       34,199  
                 
Total current assets
    1,154,969       967,549  
                 
Net property, plant and equipment
    299,332       271,063  
Debt issuance costs, net
    30,691       22,622  
Deferred income taxes
    20,597       17,151  
Goodwill
    1,328,881       1,328,881  
Identifiable intangible assets, net
    443,922       453,802  
Other non-current assets
    15,537       14,931  
                 
    $ 3,293,929     $ 3,075,999  
                 
Liabilities and Shareholders' Equity:
               
Current liabilities:
               
Accounts payable
  $  51,227     $  60,137  
Accrued expenses and other
    241,628       225,524  
Current installments of long-term debt
    27,500       169,500  
                 
Total current liabilities
    320,355       455,161  
                 
Long-term debt, net of current installments and discount
    1,097,486       935,290  
Non-current tax liabilities
    37,395       35,588  
Deferred income taxes
    140,996       163,386  
Other non-current liabilities
    2,650       3,495  
                 
Total liabilities
    1,598,882       1,592,920  
                 
Shareholders' equity:
               
Common stock; authorized 225,000 at 2011 and 2010; issued and outstanding 72,928 at 2011 and 71,996 at 2010
    73       72  
Preferred stock; authorized 50,000 at 2011 and 2010; issued and outstanding 0 at 2011 and 2010
    -       -  
Additional paid-in capital
    904,845       852,152  
Retained earnings
    763,277       613,434  
Accumulated other comprehensive income, net
    26,852       17,421  
                 
Shareholders' equity
    1,695,047       1,483,079  
                 
    $ 3,293,929     $ 3,075,999  
                 
See accompanying notes to condensed consolidated financial statements.
 
 
 
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,
 
 
2011
   
2010
   
2011
   
2010
 
Revenue:
                     
Rental
$ 279,314     $ 283,084     $ 558,014     $ 563,075  
Sales
  240,516       214,688       463,000       420,502  
                               
Total revenue
  519,830       497,772       1,021,014       983,577  
                               
                               
Rental expenses
  146,353       155,622       296,845       308,841  
Cost of sales
  60,418       62,307       122,137       123,231  
                               
Gross profit
  313,059       279,843       602,032       551,505  
                               
Selling, general and administrative expenses
  152,155       147,212       296,522       282,591  
Research and development expenses
  23,411       21,718       44,594       46,502  
Acquired intangible asset amortization
  8,856       9,556       17,712       19,715  
                               
Operating earnings
  128,637       101,357       243,204       202,697  
                               
Interest income and other
  267       143       469       279  
Interest expense
  (17,157 )     (22,264 )     (37,997 )     (45,826 )
Foreign currency loss
  (206 )     (2,657 )     (25 )     (5,267 )
                               
Earnings before income taxes
  111,541       76,579       205,651       151,883  
                               
Income taxes
  30,116       22,974       55,808       45,565  
                               
Net earnings
$ 81,425     $ 53,605     $ 149,843     $ 106,318  
                               
Net earnings per share:
                             
                               
Basic
$ 1.13     $ 0.76     $ 2.09     $ 1.50  
                               
Diluted
$ 1.09     $ 0.75     $ 2.04     $ 1.48  
                               
Weighted average shares outstanding:
                             
                               
Basic
  72,128       70,836       71,748       70,678  
                               
Diluted
  74,882       71,805       73,420       71,657  
                               
See accompanying notes to condensed consolidated financial statements.
 
 
 
KINETIC CONCEPTS, INC. AND SUBSIDIARIES
 
Condensed Consolidated Statements of Cash Flows
 
(in thousands)
 
(unaudited)
 
       
       
   
Six months ended
 
   
June 30,
 
   
2011
   
2010
 
Cash flows from operating activities:
           
Net earnings
  $ 149,843     $ 106,318  
Adjustments to reconcile net earnings to net cash provided by operating activities:
               
Amortization of convertible debt discount
    11,279       10,443  
Depreciation and other amortization
    71,685       80,511  
Provision for bad debt
    5,364       4,139  
Write-off of deferred debt issuance costs
    3,218       1,928  
Share-based compensation expense
    15,879       15,434  
Deferred income tax benefit
    (21,061 )     (29,647 )
Excess tax benefit from share-based payment arrangements
    (2,082 )     (1,392 )
Change in assets and liabilities:
               
Decrease in accounts receivable, net
    3,586       30,932  
Decrease (increase) in inventories, net
    4,504       (36,102 )
Increase in prepaid expenses and other
    (13,540 )     (4,193 )
Decrease in accounts payable
    (8,585 )     (632 )
Increase (decrease) in accrued expenses and other
    17,824       (20,687 )
Increase (decrease) in tax liabilities, net
    2,088       (18,692 )
Decrease in deferred income taxes, net
    (3,541 )     (460 )
Net cash provided by operating activities
    236,461       137,900  
                 
Cash flows from investing activities:
               
Additions to property, plant and equipment
    (66,750 )     (46,192 )
Decrease (increase) in inventory to be converted into equipment for short-term rental
    (7,239 )     7,265  
Dispositions of property, plant and equipment
    913       1,067  
Increase in identifiable intangible assets and other non-current assets
    (17,364 )     (2,091 )
Net cash used by investing activities
    (90,440 )     (39,951 )
                 
Cash flows from financing activities:
               
Repayments of long-term debt, revolving credit facility and capital lease obligations
    (13,830 )     (125,054 )
Proceeds from exercise of stock options
    36,004       10,185  
Proceeds from the purchase of stock in ESPP and other
    4,107       3,451  
Excess tax benefit from share-based payment arrangements
    2,082       1,392  
Purchase of immature shares for minimum tax withholdings
    (3,681 )     (1,108 )
Refinancing of senior credit facility:
               
    Proceeds from borrowings on refinancing of senior credit facility
    146,012       -  
    Repayments on senior credit facility – due 2013
    (123,346 )     -  
    Payment of debt issuance costs
    (14,676 )     -  
Net cash provided (used) by financing activities
    32,672       (111,134 )
                 
Effect of exchange rate changes on cash and cash equivalents
    3,128       (2,904 )
                 
Net increase (decrease) in cash and cash equivalents
    181,821       (16,089 )
Cash and cash equivalents, beginning of period
    316,603       263,157  
                 
Cash and cash equivalents, end of period
  $ 498,424     $ 247,068  
                 
Cash paid for:
               
Interest, including cash paid under interest rate swap agreements
  $ 19,613     $ 28,215  
Income taxes, net of refunds
  $ 84,913     $ 94,306  
                 
See accompanying notes to condensed consolidated financial statements.
 
 
KINETIC CONCEPTS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)


NOTE 1.     Summary of Significant Accounting Policies

(a)     Basis of Presentation

The condensed consolidated financial statements presented herein include the accounts of Kinetic Concepts, Inc., together with its consolidated subsidiaries.  All intercompany balances and transactions have been eliminated in consolidation.  The consolidated entity is referred to herein as "KCI®."  The condensed consolidated financial statements appearing in this quarterly report on Form 10-Q should be read in conjunction with the consolidated financial statements and notes thereto included in KCI's Annual Report on Form 10-K for the fiscal year ended December 31, 2010 and our Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2011.

The accompanying condensed consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP” or “the Codification”) for interim financial information and in accordance 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 GAAP.  Operating results from interim periods are not necessarily indicative of results that may be expected for the fiscal year as a whole.  The condensed consolidated financial statements reflect all adjustments, consisting of normal recurring accruals, considered necessary for a fair presentation of our results for the interim periods presented.  Certain prior-period amounts have been reclassified to conform to the 2011 presentation.

We have three reportable operating segments which correspond to our global business units: Active Healing Solutions™ (“AHS”); LifeCell™; and Therapeutic Support Systems (“TSS”).  We have three primary geographic regions for which we provide supplemental information: Americas, which is comprised principally of the United States and includes Canada, Puerto Rico and Latin America; EMEA, which is comprised principally of Europe and includes the Middle East and Africa; and APAC, which is comprised of the Asia Pacific region.

(b)     Income Taxes

We compute our quarterly effective income tax rate based on our annual estimated effective income tax rate plus the impact of any discrete items that occur in the quarter.  The effective income tax rate for the second quarter and the first six months of 2011 was 27.0% and 27.1%, respectively, compared to 30.0% for the second quarter and the first six months of 2010.  The lower effective income tax rate in the second quarter and first six months of 2011 resulted primarily from a higher percentage of taxable income being generated in lower-tax foreign jurisdictions.

(c)     Derivative Financial Instruments and Fair Value Measurements

We use derivative financial instruments to manage the economic impact of fluctuations in interest rates.  We do not use financial instruments for speculative or trading purposes.  Periodically, we enter into interest rate protection agreements to modify the interest characteristics of our outstanding debt.  We designated our interest rate swap agreements as cash flow hedge instruments.  Each interest rate swap is designated as a hedge of interest payments associated with specific principal balances and terms of our debt obligations.  These agreements involve the exchange of amounts based on variable interest rates for amounts based on fixed interest rates, over the life of the agreement, without an exchange of the notional amount upon which the payments are based.  The differential to be paid or received, as interest rates change, is accrued and recognized as an adjustment to interest expense related to the debt.

We also use derivative financial instruments to manage the economic impact of fluctuations in currency exchange rates on our intercompany balances and corresponding cash flows and to manage our transactional currency exposures when our foreign subsidiaries enter into transactions denominated in currencies other than their local currency.  We enter into foreign currency exchange contracts to manage these economic risks.  These contracts are not designated as hedges; as such, we recognize the fair value of these instruments as an asset or liability with income or expense recognized in the current period.  Gains and losses resulting from the foreign currency fluctuations impact on transactional exposures are included in foreign currency loss in our condensed consolidated statements of earnings.
 
 
As required, all derivative instruments are recorded on the balance sheet at fair value.  The fair values of our interest rate swap agreements and foreign currency exchange contracts are determined based on inputs that are readily available in public markets or can be derived from information available in publicly-quoted markets, which represent level 2 inputs as defined by the Codification.  We estimate the effectiveness of our interest rate swap agreements utilizing the hypothetical derivative method.  Under this method, the fair value of the actual interest rate swap agreement is compared to the fair value of a hypothetical swap agreement that has the same critical terms as the portion of the loan being hedged.  Changes in the effective portion of the fair value of the remaining interest rate swap agreement are recognized in other comprehensive income, net of tax, until the hedged item is recognized into earnings.

(d)     Concentration of Credit Risk

KCI has a concentration of credit risk with financial institutions related to its derivative instruments and the note hedge described in Note 3.  As of June 30, 2011, Bank of America and JP Morgan Chase held equity hedges related to our convertible note hedge in notional amounts of approximately $176.5 million each.  Bank of America was also the counterparty on some of our interest rate protection agreements and our foreign currency exchange contracts in notional amounts totaling $50.0 million and $2.3 million, respectively.  Additionally, JP Morgan Chase was also the counterparty on some of our interest rate protection agreements and our foreign currency exchange contracts in notional amounts totaling $25.0 million and $6.5 million, respectively.  We use master netting agreements with our derivative counterparties to reduce our risk and use multiple counterparties to reduce our concentration of credit risk.

We maintain cash and cash equivalents with several financial institutions.  Deposits held with banks may exceed the amount of insurance provided on such deposits.  Generally, these deposits may be redeemed upon demand and are maintained at financial institutions of reputable credit and, therefore, bear minimal credit risk.

(e)     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 fiscal year ended December 31, 2010.


NOTE 2.     Supplemental Balance Sheet Data

(a)     Accounts Receivable, net

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

   
June 30,
   
December 31,
 
   
2011
   
2010
 
Gross trade accounts receivable:
           
    Americas:
           
        AHS and TSS
  $ 307,049     $ 341,874  
        LifeCell
    42,501       39,251  
                 
           Subtotal Americas
    349,550       381,125  
                 
    EMEA
    117,272       106,174  
    APAC
    12,825       11,583  
                 
           Total trade accounts receivable
    479,647       498,882  
                 
               Less:  Allowance for revenue adjustments
    (69,814 )     (87,035 )
                 
           Gross trade accounts receivable
    409,833       411,847  
                 
Less:  Allowance for bad debt
    (9,367 )     (9,970 )
                 
    Net trade accounts receivable
    400,466       401,877  
                 
Other receivables
    10,629       12,206  
                 
    $ 411,095     $ 414,083  
 

Americas trade accounts receivable consist of amounts due directly from acute and extended care organizations; third-party payers (“TPP”), both governmental and non-governmental; and patient pay accounts.  Included within the TPP accounts receivable balances are amounts that have been or will be billed to patients once the primary payer portion of the claim has been settled by the TPP.  EMEA and APAC trade accounts receivable consist of amounts due primarily from acute care organizations.

The domestic TPP reimbursement process requires extensive documentation which has had the effect of slowing both the billing and cash collection cycles relative to the rest of the business and, therefore, could increase total accounts receivable.  Because of the extensive documentation required and the requirement to settle a claim with the primary payer prior to billing the secondary and/or patient portion of the claim, the collection period for a claim in our homecare business may, in some cases, extend beyond one year prior to full settlement of the claim.

We utilize a combination of factors in evaluating the collectibility of our accounts receivable.  For unbilled receivables, we establish reserves to allow for expected denied or uncollectible items.  In addition, items that remain unbilled for more than a specified period of time, or beyond an established billing window, are reserved against revenue.  For billed receivables, we generally establish reserves using a combination of factors including historic adjustment rates for credit memos and cancelled transactions, historical collection experience, and the length of time receivables have been outstanding.  The reserve rates vary by payer group.  In addition, we record specific reserves for bad debt when we become aware of a customer's inability or refusal to satisfy its debt obligations, such as in the event of a bankruptcy filing.

(b)     Inventories, net

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

   
June 30,
   
December 31,
 
   
2011
   
2010
 
             
Finished goods and tissue available for distribution
  $ 92,612     $ 92,769  
Goods and tissue in-process
    16,187       9,507  
Raw materials, supplies, parts and unprocessed tissue
    90,463       96,197  
                 
      199,262       198,473  
                 
Less:  Amounts expected to be converted into equipment for short-term rental
    (17,247 )     (10,008 )
           Reserve for excess and obsolete inventory
    (13,368 )     (15,913 )
                 
    $ 168,647     $ 172,552  
 
 
NOTE 3.     Long-Term Debt

Long-term debt consists of the following (dollars in thousands):

   
June 30,
   
December 31,
 
   
2011
   
2010
 
             
Senior Credit Facility – due 2016
  $ 536,250     $ -  
Senior Credit Facility – due 2013
    -       527,333  
Senior Revolving Credit Facility – due 2016
    -       -  
Senior Revolving Credit Facility – due 2013
    -       -  
3.25% Convertible Senior Notes due 2015
    690,000       690,000  
Less:  Convertible Notes Discount, net of accretion
    (101,264 )     (112,543 )
                 
      1,124,986       1,104,790  
Less:  Current installments
    (27,500 )     (169,500 )
                 
    $ 1,097,486     $ 935,290  

The fair value of the senior credit facility and the convertible senior notes was $536.3 million and $884.2 million, respectively, at June 30, 2011.  At December 31, 2010, the fair value of the senior credit facility and the convertible senior notes was $527.3 million and $727.9 million, respectively.  The fair values of our senior credit facilities and the convertible senior notes were estimated based upon open-market trades and related market quotations at or near quarter or year-end.

Senior Credit Facility

In January 2011, we entered into a new credit agreement which was used to refinance existing debt under the prior senior credit facility and may be used for general corporate purposes.  The new credit agreement provides for (i) a $550.0 million term A facility that matures in January 2016, and (ii) a $650.0 million revolving credit facility that matures in January 2016 (the “2016 Senior Credit Facility”).  Up to $75.0 million of the revolving credit facility is available for letters of credit and up to $25.0 million of the revolving credit facility is available for swing-line loans.  Amounts available under the revolving credit facility are available for borrowing and reborrowing until maturity.  At June 30, 2011, no revolving credit loans were outstanding and we had outstanding letters of credit in the aggregate amount of $12.0 million.  The resulting availability under the revolving credit facility was $638.0 million.  The Company also has the right at any time to increase the total amount of its commitments under the 2016 Senior Credit Facility by an aggregate additional amount up to $500.0 million.  As of June 30, 2011, we were in compliance with all covenants under the senior credit agreement.

For further information on our senior credit facility, see Note 17 of the notes to the consolidated financial statements included in KCI's Annual Report on Form 10-K for the fiscal year ended December 31, 2010 and Note 3 of the notes to the condensed consolidated financial statement included in KCI’s Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2011.

3.25% Convertible Senior Notes and Related Note Hedge and Warrants

In 2008, we issued $690.0 million aggregate principal amount of 3.25% convertible senior notes due April 2015 (the “Convertible Notes”).  The notes are governed by the terms of an indenture dated as of April 21, 2008 (the “Indenture”).  Concurrently with the issuance of the Convertible Notes, we entered into a convertible note hedge (the “Note Hedge”) and warrant transactions (the “Warrants”) with affiliates of the initial purchasers of the notes.  These consist of purchased and written call options on KCI common stock.  The Note Hedge and Warrants are structured to reduce the potential future economic dilution associated with conversion of the notes and to effectively increase the initial conversion price to $60.41 per share, which was approximately 50% higher than the closing price of KCI’s common stock on April 15, 2008.  As of June 30, 2011, we were in compliance with all covenants under the Indenture for the Convertible Notes.
 

Conversion. Holders of the Convertible Notes may convert their notes at their option on any business day prior to October 15, 2014 only if one or more of the following conditions are satisfied:

(1)  
during any fiscal quarter commencing after June 30, 2008, if the last reported sale price of our common stock for at least 20 trading days in the period of 30 consecutive trading days ending on the last trading day of the preceding fiscal quarter is greater than or equal to 130% of the conversion price of the notes in effect on each applicable trading day;
(2)  
during the five business day period following any five consecutive trading day period in which the trading price for the notes (per $1,000 principal amount of the notes) for each such trading day was less than 98% of the last reported sale price of our common stock on such date multiplied by the applicable conversion rate; or
(3)  
if we make certain significant distributions to holders of our common stock or enter into specified corporate transactions. The notes are convertible, regardless of whether any of the foregoing conditions have been satisfied, on or after October 15, 2014 at any time prior to the close of business on the third scheduled trading day immediately preceding the stated maturity date.

Upon conversion, holders will receive cash up to the aggregate principal amount of the notes being converted and shares of our common stock in respect of the remainder, if any, of our conversion obligation in excess of the aggregate principal amount of the notes being converted.  The initial conversion rate for the notes is 19.4764 shares of our common stock per $1,000 principal amount of notes, which is equivalent to an initial conversion price of approximately $51.34 per share of common stock and represents a 27.5% conversion premium over the last reported sale price of our common stock on April 15, 2008, which was $40.27 per share.  The conversion rate and the conversion price are subject to adjustment upon the occurrence of certain events, such as distributions of dividends or stock splits.  As of June 30, 2011, our Convertible Notes were not convertible by the holders thereof.

For further information on our Convertible Notes and related Note Hedge and Warrants, see Note 5 of the notes to the consolidated financial statements included in KCI's Annual Report on Form 10-K for the fiscal year ended December 31, 2010.


NOTE 4.     Derivative Financial Instruments and Fair Value Measurements

We are exposed to credit loss in the event of nonperformance by counterparties to the extent of the fair values of the outstanding interest rate swap agreements and foreign currency exchange contracts, but we do not anticipate nonperformance by any of the counterparties.  For further information on our derivative financial instruments, see Note 6 of the notes to the consolidated financial statements included in KCI's Annual Report on Form 10-K for the fiscal year ended December 31, 2010.

Interest Rate Protection

At June 30, 2011 and December 31, 2010, we had 17 and 18 interest rate swap agreements in effect, respectively, pursuant to which we have fixed the rate on an aggregate of $475.0 million and $444.5 million, respectively, in notional amounts of our outstanding variable rate debt at weighted average interest rates of 0.750% and 1.226%, respectively, exclusive of the Eurocurrency Rate Loan Spread as disclosed in the senior credit agreement.

As of June 30, 2011, we had also entered into additional interest rate swap agreements to convert $225.0 million of our variable rate debt to a fixed rate basis at interest rates ranging from 0.810% to 0.940%, exclusive of the Eurocurrency Rate Loan Spread as disclosed in the senior credit agreement.  These agreements become effective on September 30, 2011 for $100.0 million and December 31, 2011 for $125.0 million and were designated as cash flow hedge instruments.

As a result of the interest rate swap agreements in effect as of June 30, 2011 and December 31, 2010, approximately 95.0% and 93.2%, respectively, of our long-term debt outstanding, including the Convertible Notes, was subject to a fixed interest rate.
 

The interest rate swap agreements have quarterly interest payments, based on three-month LIBOR, due on the last day of March, June, September and December.  The fair value of the swap agreements was zero at inception.  At June 30, 2011 and December 31, 2010, the aggregate fair value of our interest rate swap agreements was negative and was recorded as a liability of approximately $2.2 million and $1.7 million, respectively.  This amount was also recorded in other comprehensive income, net of tax.  No asset derivatives were held as of June 30, 2011 and December 31, 2010 related to our interest rate swap agreements.  The ineffective portion of these interest rate swaps was not significant for the second quarter or first six months of 2011 and 2010.  As of June 30, 2011 and December 31, 2010, the amount of hedge loss to be reclassified from Accumulated Other Comprehensive Income over the next 12 months was approximately $2.2 million and $1.7 million, respectively.  If our interest rate protection agreements were not in place, interest expense would have been approximately $0.7 million and $1.7 million lower for the second quarter and first six months of 2011, respectively, and $2.7 million and $5.7 million lower in the same periods of the prior year.

Foreign Currency Exchange Risk Mitigation

At June 30, 2011 and December 31, 2010, we had foreign currency exchange contracts to sell or purchase $56.5 million and $92.1 million, respectively, of various currencies.  The periods of the foreign currency exchange contracts generally do not exceed one year and correspond to the periods of the exposed transactions or related cash flows.

Fair Value Measurements

The following tables set forth the location and aggregate fair value amounts of all derivative instruments with credit-related contingent features (dollars in thousands):

   
Asset Derivatives
 
Liability Derivatives
 
   
Balance
 
Fair Value
 
Balance
 
Fair Value
 
   
Sheet
 
June 30,
 
December 31,
 
Sheet
 
June 30,
 
December 31,
 
   
Location
 
2011
 
2010
 
Location
 
2011
 
2010
 
                           
Derivatives
                         
designated as
                         
hedging
                         
instruments
                         
                           
   
Prepaid
         
Accrued
         
Interest rate
 
expenses
         
expenses
         
   swap agreements
 
and other
  $ -   $ -  
and other
  $ 2,210   $ 1,677  
                                   
                                   
Derivatives not
                                 
designated as
                                 
hedging
                                 
instruments
                                 
                                   
Foreign currency
 
Prepaid
             
Accrued
             
   exchange
 
expenses
             
expenses
             
   contracts
 
and other
    172     364  
and other
    1,018     3,425  
                                   
      Total derivatives
      $ 172   $ 364       $ 3,228   $ 5,102  
 
 
The location and net amounts reported in the Statements of Earnings or in Accumulated Other Comprehensive Income (“OCI”) for derivatives designated as cash flow hedging instruments under the Derivatives and Hedges topic of the Codification are as follows (dollars in thousands):

   
Three months ended June 30,
 
   
Effective portion
 
Derivatives
 
Amount of
 
Location of gain (loss)
 
Amount of gain (loss)
 
designated as
 
gain (loss)
 
reclassified from
 
reclassified from
 
cash flow hedging
 
recognized in
 
accumulated
 
accumulated
 
instruments
 
OCI on derivative
 
OCI into income
 
OCI into income
 
               
   
2011
   
2010
     
2011
   
2010
 
                           
Interest rate swap agreements
  $ (1,100 )   $ 85  
Interest expense
  $ (451 )   $ (1,736 )
                                   
                                   
               
   
Six months ended June 30,
 
   
Effective portion
 
Derivatives
 
Amount of
 
Location of gain (loss)
 
Amount of gain (loss)
 
designated as
 
gain (loss)
 
reclassified from
 
reclassified from
 
cash flow hedging
 
recognized in
 
accumulated
 
accumulated
 
instruments
 
OCI on derivative
 
OCI into income
 
OCI into income
 
                                   
     2011      2010        2011      2010  
                                   
Interest rate swap agreements
  $ (1,460 )   $ (793 )
Interest expense
  $ (1,113 )   $ (3,687 )

KCI’s foreign currency exchange contracts are not designated as hedging instruments under the Derivatives and Hedges topic of the Codification.  The gain or loss recognized on the foreign currency exchange contracts is included in the condensed consolidated statements of earnings under the caption “Foreign currency loss.”  The following table summarizes the composition of foreign currency gain (loss) (dollars in thousands):

   
Three months ended June 30,
   
Six months ended June 30,
 
   
2011
   
2010
   
2011
   
2010
 
                         
Foreign currency exchange contracts gain (loss)
  $ (1,683 )   $ 6,564     $ (3,016 )   $ 8,812  
Other foreign currency transaction gain (loss)
    1,477       (9,221 )     2,991       (14,079 )
                                 
    $ (206 )   $ (2,657 )   $ (25 )   $ (5,267 )

Certain of KCI’s derivative instruments contain provisions that require compliance with the restrictive covenants of our credit facilities.  For further information regarding the restrictive covenants of our credit facilities, see Note 17 of the notes to the consolidated financial statements included in KCI's Annual Report on Form 10-K for the fiscal year ended December 31, 2010 and Note 3 of the notes to the condensed consolidated financial statement included in KCI’s Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2011.

If we default under our credit facilities, the lenders could require immediate repayment of the entire principal.  If those lenders require immediate repayment, we may not be able to repay them which could result in the foreclosure of substantially all of our assets.  In these circumstances, the counterparties to the derivative instruments could request immediate payment or full collateralization on derivative instruments in net liability positions.  All of our derivative counterparties are also parties to our credit facilities.

No collateral has been posted by KCI in the normal course of business.  If the credit-related contingent features underlying these agreements were triggered on June 30, 2011, KCI could be required to settle or post the full amount as collateral to its counterparties.
 
 
NOTE 5.     Earnings Per Share

Net earnings per share was calculated using the weighted average number of shares outstanding during the respective periods.  The following table sets forth the reconciliation from basic to diluted weighted average shares outstanding and the calculations of net earnings per share (in thousands, except per share data):
 
   
Three months ended
   
Six months ended
   
June 30,
   
June 30,
   
2011
   
2010
   
2011
   
2010
                       
Net earnings
  $ 81,425     $ 53,605     $ 149,843     $ 106,318
                                 
Weighted average shares outstanding:
                               
Basic
    72,128       70,836       71,748       70,678
Dilutive potential common shares from stock options and restricted stock (1)
    1,441       969       1,371       979
Dilutive potential common shares from conversion of Convertible Notes (2)
    1,313       -       301       -
                                 
Diluted
    74,882       71,805       73,420       71,657
                                 
Basic net earnings per share
  $ 1.13     $ 0.76     $ 2.09     $ 1.50
                                 
Diluted net earnings per share
  $ 1.09     $ 0.75     $ 2.04     $ 1.48
                                 
                                   
                               
(1) Potentially dilutive stock options and restricted stock totaling 1,112 shares and 3,619 shares for the three months ended June 30, 2011 and 2010, respectively, and 1,330 shares and 3,723 shares for the six months ended June 30, 2011 and 2010, respectively, were excluded from the computation of diluted weighted average shares outstanding due to their antidilutive effect.
(2) The average price of our common stock was $56.90 and $52.52 for the three and six months ended June 30, 2011, respectively.
 
 
Holders of our Convertible Notes may convert the Convertible Notes into cash, and if applicable, shares of our common stock at the applicable conversion rate, at their option any business day prior to October 15, 2014 if specific conditions are satisfied.  For further information on the Convertible Notes, see Note 3 of the notes to the condensed consolidated financial statements.  The Convertible Notes have no impact on diluted earnings per share (“EPS”) unless the average price of our common stock for the period exceeds the conversion price (initially $51.34 per share) because the principal amount of the Convertible Notes will be settled in cash upon conversion.  Prior to conversion, we use the treasury stock method to include the effect of the additional shares that may be issued if our common stock price exceeds the conversion price.  The convertible note hedge purchased in connection with the issuance of our Convertible Notes is excluded from the calculation of diluted EPS as its impact is always anti-dilutive.  The warrant transactions associated with the issuance of our Convertible Notes have no impact on EPS unless our average share price for the period exceeds the $60.41 exercise price.


NOTE 6.     Incentive Compensation Plans

Share-based compensation expense was recognized in the condensed consolidated statements of earnings as follows (dollars in thousands):

   
Three months ended
   
Six months ended
 
   
June 30,
   
June 30,
 
   
2011
   
2010
   
2011
   
2010
 
                         
Rental expenses
  $ 1,074     $ 800     $ 2,304     $ 2,317  
Cost of sales
    280       133       516       444  
Selling, general and administrative expenses
    6,880       5,023       13,059       12,673  
                                 
Pre-tax share-based compensation expense
    8,234       5,956       15,879       15,434  
Less:  Income tax benefit
    (2,766 )     (2,167 )     (5,287 )     (5,369 )
                                 
Total share-based compensation expense, net of tax
  $ 5,468     $ 3,789     $ 10,592     $ 10,065  
 
 
A summary of our stock option activity, and related information, for the six months ended June 30, 2011 is set forth in the table below:

             
Weighted
     
             
Average
     
         
Weighted
 
Remaining
 
Aggregate
 
         
Average
 
Contractual
 
Intrinsic
 
   
Options
   
Exercise
 
Term
 
Value
 
   
(in thousands)
   
Price
 
(years)
 
(in thousands)
 
                     
Options outstanding – January 1, 2011
  5,470     $ 39.20          
Granted
  757     $ 46.98          
Exercised
  (919 )   $ 39.98          
Forfeited/Expired
  (270 )   $ 40.35          
                       
Options outstanding – June 30, 2011
  5,038     $ 40.17   7.06   $ 88,626  
                         
Exercisable as of June 30, 2011
  2,430     $ 42.16   5.97   $ 38,211  


The following table summarizes restricted stock activity for the six months ended June 30, 2011:

   
Number of
   
Weighted
 
   
Shares
   
Average Grant
 
   
(in thousands)
   
Date Fair Value
 
             
Unvested shares – January 1, 2011
  1,101     $ 37.41  
Granted
  651     $ 46.88  
Vested and distributed
  (264 )   $ 45.49  
Forfeited
  (128 )   $ 43.10  
               
Unvested shares – June 30, 2011
  1,360     $ 39.81  

KCI has a policy of issuing new shares to satisfy stock option exercises and restricted stock award issuances.  In addition, KCI may purchase shares in connection with the net share settlement exercise of employee stock options for minimum tax withholdings and exercise price and the withholding of shares to satisfy the minimum tax withholdings on the vesting of restricted stock.


NOTE 7.     Other Comprehensive Income

The components of total comprehensive income are as follows (dollars in thousands):
 
   
Three months ended
   
Six months ended
 
   
June 30,
   
June 30,
 
   
2011
   
2010
   
2011
   
2010
 
                         
Net earnings
  $ 81,425     $ 53,605     $ 149,843     $ 106,318  
Foreign currency translation adjustment, net of taxes
    1,914       (4,779 )     9,778       (6,534 )
Net derivative gain (loss), net of taxes
    (1,100 )     85       (1,460 )     (793 )
Amount of loss reclassified from accumulated OCI into income, net of taxes
    451       1,736       1,113       3,687  
                                 
Total comprehensive income
  $ 82,690     $ 50,647     $ 159,274     $ 102,678  
 
 
NOTE 8.     Commitments and Contingencies
 
Litigation Relating to the Proposed Merger

Following the announcement on July 13, 2011 that KCI had entered into a definitive merger agreement under which a consortium of funds advised by Apax Partners will acquire KCI (the “Merger”), two purported shareholders of KCI initiated legal actions challenging the Merger. On July 20, 2011, purported shareholder John Chevedden sent a letter to the KCI Board of Directors demanding that the Board take actions to remedy alleged breaches of fiduciary duties in connection with the Board’s approval of the Merger.  The purported shareholder stated that if the Board of Directors does not take actions as demanded in his letter, he will prosecute a shareholder derivative action against the Company and its directors.  The Board of Directors will review this purported shareholder’s demand and determine how to proceed in response to the allegations.

On July 22, 2011, purported shareholder Sharon M. Dunn filed a putative class action petition in the District Court of Bexar County, Texas, 288th Judicial District, in an action styled Dunn v. Apax Partners et al., Case No. 2011-CI-11943.  The action asserts claims against KCI’s directors and against KCI as a nominal defendant, and additionally names as defendants Apax Partners, Chiron Holdings, Inc., Chiron Merger Sub, Inc., and John Does 1-25 (unidentified associates and affiliates of Apax Partners forming the consortium to purchase the Company) (collectively, “Apax Partners”).  The petition in this putative class action alleges that KCI’s directors breached their fiduciary duties to shareholders and committed gross mismanagement and waste of corporate assets by their actions in approving the merger agreement.  The petition further alleges that Apax Partners aided and abetted these alleged breaches of fiduciary duties.  The petition requests that the Merger be enjoined.

On August 2, 2011, purported shareholder Michael Ross filed a putative class action petition in the District Court of Bexar County, Texas, 224th Judicial District, in an action styled Ross v. Kinetic Concepts, Inc. et al., Case No. 2011-CI-12497.  This action asserts claims against KCI and its directors and additionally names as defendants Apax Partners, the Canada Pension Plan Investment Board, the Public Sector Pension Investment Board, Chiron Merger Sub, Inc., and Chiron Holdings, Inc.  The petition in this putative class action alleges that KCI and its directors breached their fiduciary duties to shareholders by their actions in approving the merger agreement.  The petition further alleges that the remaining defendants aided and abetted these alleged breaches of fiduciary duties.  The petition requests that the Merger be enjoined.

Although it is not possible to predict the outcome of these litigation matters with certainty, KCI and its directors believe that the claims raised by these purported shareholders are without merit, and the defendants intend to defend their positions in these matters vigorously.  Currently we cannot determine whether the ultimate outcome of these legal actions will have a material impact on the Company’s financial position, results of operations, or cash flows.

Intellectual Property Litigation

As the owner and exclusive licensee of patents, from time to time, KCI is a party to proceedings challenging these patents, including challenges in U.S. federal courts, foreign courts and the U.S. Patent and Trademark Office (“USPTO”).  Additionally, from time to time, KCI is a party to litigation we initiate against others we contend infringe these patents, which often results in counterclaims regarding the validity of such patents.  It is not possible to reliably predict the outcome of the proceedings described below.  However, if we are unable to effectively enforce our intellectual property rights, third parties may become more aggressive in the marketing of competitive products around the world.

U.S. Intellectual Property Litigation

For the last several years, KCI and its affiliates have been involved in multiple patent infringement suits where claims under certain Wake Forest Patents were asserted against providers of competing negative pressure wound therapy (“NPWT”) products.  In October 2010, the Federal District Court for the Western District of Texas entered an order in the Smith & Nephew case described below, invalidating the Wake Forest patent claims asserted in the case.  In light of the ruling, KCI has determined that continued payment of the royalties scheduled under the Wake Forest license agreement was inappropriate.  On February 28, 2011, KCI filed suit in the Federal District Court for the Western District of Texas seeking a declaratory judgment that KCI no longer owes royalties to Wake Forest based on the patents in suit because the relevant patent claims are invalid or not infringed.  Historical royalties under the license agreement were accrued through February 27, 2011 and are reflected in our condensed consolidated financial statements.  For the year ended December 31, 2010, royalty payments to Wake Forest under the licensing agreement were approximately $86 million.  No royalty payments were made to Wake Forest during the first six months of 2011.
 

On March 18, 2011, Wake Forest provided written notice of termination under the license agreement with KCI and filed suit in Forsyth County Superior Court, North Carolina, alleging breach of contract by KCI.  In its termination notice, Wake Forest is demanding that KCI cease manufacturing and selling licensed products.  KCI subsequently removed the action from state court to the Federal District Court for the Middle District of North Carolina, after which Wake Forest amended its complaint to add allegations of patent infringement.  That action was stayed pending a ruling by the Federal District Court in Texas on a motion to dismiss or transfer filed by Wake Forest there.  On July 26, 2011, the Federal District Court in Texas denied Wake Forest’s motions and stayed the action pending a decision by the Court of Appeals for the Federal Circuit in the Smith & Nephew litigation described below.  KCI believes that it does not infringe any valid claims of the Wake Forest Patents and that our defenses to any claims are meritorious and we intend to vigorously defend against any such claims and KCI will continue to manufacture and sell V.A.C. ® Therapy products.  It is not possible to estimate damages that may result if we are unsuccessful in the litigation.  In addition, as a result of the Wake Forest royalty litigation, KCI will not join Wake Forest in the continued enforcement of the Wake Forest Patents against alleged infringers.  KCI intends to withdraw from each of the cases described below that involve the Wake Forest Patents, including any appeal of the Smith & Nephew litigation.

In May 2007, KCI, its affiliates and Wake Forest filed two related patent infringement suits: one case against Smith & Nephew and a second case against Medela, for the manufacture, use and sale of NPWT products which we alleged infringe claims of patents licensed exclusively to KCI by Wake Forest.  In October 2010, the Federal District Court for the Western District of Texas entered an order in the Smith & Nephew case invalidating the patent claims involved in the lawsuit.  As a result, KCI has initiated the Wake Forest royalty litigation described above, and KCI is not planning to participate in any appeal of the Smith & Nephew litigation.  Wake Forest is appealing the decision in the Smith & Nephew litigation.  The case against Medela’s gauze-based devices remains pending, but was recently stayed by the Federal District Court.

In January 2008, KCI, its affiliates and Wake Forest filed a patent infringement lawsuit against Innovative Therapies, Inc. (“ITI”) in the U.S. District Court for the Middle District of North Carolina.  The federal complaint alleges that a NPWT device introduced by ITI in 2007 infringes three Wake Forest patents which are exclusively licensed to KCI.  This case is currently stayed.

Also in January and June of 2008, KCI and its affiliates filed separate suits in state District Court in Bexar County, Texas, against ITI and several of its principals, all of whom are former employees of KCI.  These cases have now been consolidated into a single case.  The claims in this case include breach of confidentiality agreements, conversion of KCI technology, theft of trade secrets and conspiracy.  We are seeking damages and injunctive relief in the state court case.  At this time, the state court case against ITI and its principals is not set for trial.

In December 2008, KCI, its affiliates and Wake Forest filed a patent infringement lawsuit against Boehringer Wound Systems, LLC, Boehringer Technologies, LP, and Convatec, Inc. in the U.S. District Court for the Middle District of North Carolina.  The federal complaint alleges that a NPWT device manufactured by Boehringer and commercialized by Convatec infringes Wake Forest patents which are exclusively licensed to KCI.  In February 2009, the defendants filed their answer which includes affirmative defenses and counterclaims alleging non-infringement and invalidity of the Wake Forest patents.  This case was recently stayed by the Federal District Court.

International Intellectual Property Litigation

In June 2007, Medela filed a patent nullity suit in the German Federal Patent Court against Wake Forest’s German patent corresponding to European Patent No. EP0620720 (“the ‘720 Patent”).  In March 2008 and February 2009, Mölnlycke Health Care AB and Smith & Nephew, respectively, joined the nullity suit against the ‘720 Patent.  In March 2009, the German Federal Patent Court ruled the German patent corresponding to the ‘720 Patent invalid.  KCI is not appealing this decision.

In March 2009, KCI and its affiliates filed a patent infringement lawsuit asserting Australian counterparts to the Wake Forest Patents against Smith & Nephew in the Federal Court of Australia, requesting preliminary injunctive relief to prohibit the commercialization of a Smith & Nephew negative pressure wound therapy dressing kit.  The Federal Court issued a temporary injunction in the case which was subsequently overturned by the Full Court of the Federal Court of Australia.  A full trial on validity and infringement of the Wake Forest patent involved in the case was held in 2010.  A ruling in this case could be made at any time.
 

In March 2009, KCI's German subsidiary filed a request for a preliminary injunction with the German District Court of Düsseldorf to prevent commercialization of a Smith & Nephew negative pressure wound therapy system that KCI believes infringes the German counterpart of KCI’s European Patent No. EP0777504 (“KCI’s ‘504 Patent”).  Following a hearing in July 2009 on this matter, the Court denied KCI’s request for preliminary injunction.  Also, in April 2009, KCI's German subsidiary filed a patent infringement lawsuit against Smith & Nephew, GmbH Germany in the German District Court of Mannheim.  The lawsuit alleges that the negative pressure wound therapy systems commercialized by Smith & Nephew infringe KCI’s ‘504 Patent and another German patent owned by KCI corresponding to European Patent No. EP0853950 (“KCI’s ‘950 Patent”).  A trial was held in October 2009 on KCI’s ‘504 Patent claims, after which the Court dismissed KCI’s infringement allegations.  This decision was affirmed on appeal in July 2011.  A trial on KCI’s ‘950 Patent claims was held in June 2010, and in September 2010, the Court issued its ruling finding that components used with Smith & Nephew’s negative pressure wound therapy systems infringe KCI’s ‘950 Patent.  Smith & Nephew is appealing this decision.

In July 2009, KCI and its affiliates filed a patent infringement lawsuit against Smith & Nephew in France alleging infringement of KCI’s ‘504 Patent and KCI’s ‘950 Patent. KCI also filed a request for a preliminary injunction with the Paris District Court in France to prevent commercialization of Smith & Nephew’s NPWT system that KCI believes infringes the French counterpart of KCI’s ‘504 Patent.  A hearing on KCI’s request for preliminary injunction was held in October 2009 in France.  In November 2009, the Paris District Court denied KCI’s request for a preliminary injunction.  On April 29, 2011, the Paris District Court upheld the validity of key claims of KCI’s ‘504 patent but ruled KCI’s ‘504 patent was not infringed by Smith & Nephew’s NPWT systems.  The Paris District Court also ruled the asserted claims of KCI’s ‘950 patent invalid. KCI is considering its options, including whether to appeal this decision.

Also in July 2009, KCI and its affiliates filed patent infringement lawsuits against Smith & Nephew in the United Kingdom alleging infringement of KCI’s ‘504 Patent and KCI’s ‘950 Patent.  KCI withdrew its request for a preliminary injunction in the United Kingdom based on KCI’s ‘504 Patent and KCI’s ‘950 Patent and proceeded to trial in May 2010.  In June 2010, the Court in the United Kingdom ruled the claims at issue from KCI’s ‘504 Patent and ‘950 Patent to be valid and infringed by Smith & Nephew’s Renasys NPWT systems.  In July 2010, the Court ordered that Smith & Nephew be enjoined from further infringement of KCI’s ‘504 Patent and ‘950 Patent.  The Court stayed the injunction pending appeal, which was heard on October 18-19, 2010. On November 28, 2010, the Court of Appeal upheld the validity of key claims of both patents and the finding of infringement on KCI’s ‘950 Patent.  Smith & Nephew has since notified the Court that it will modify its products to avoid infringement and that its modified NPWT products will stay on the market in the United Kingdom.

LifeCell Litigation

In September 2005, LifeCell Corporation recalled certain human-tissue based products because the organization that recovered the tissue, Biomedical Tissue Services, Ltd. (“BTS”), may not have followed Food and Drug Administration (“FDA”) requirements for donor consent and/or screening to determine if risk factors for communicable diseases existed.  LifeCell Corporation promptly notified the FDA and all relevant hospitals and medical professionals.  LifeCell Corporation did not receive any donor tissue from BTS after September 2005.  LifeCell Corporation was named, along with BTS and many other defendants, in lawsuits relating to the BTS donor irregularities.  These lawsuits generally fell within three categories, (1) recipients of BTS tissue who claim actual injury; (2) suits filed by recipients of BTS tissue seeking medical monitoring and/or damages for emotional distress; and (3) suits filed by family members of tissue donors who did not authorize BTS to donate tissue.

LifeCell Corporation resolved all of those lawsuits which have now been dismissed.  The resolution of those lawsuits did not have a material impact on our financial position or results of operations.  Subsequently, LifeCell Corporation was served with approximately ten new suits filed by other family members of tissue donors who also allege no authorization was provided.  These cases are in the early stages of discovery and have not been set for trial.  Although it is not possible to reliably predict the outcome of the litigation, LifeCell Corporation believes that its defenses to these claims are meritorious and will defend them vigorously.  We do not expect these new cases to have a material impact on our results of operations or our financial position.

LifeCell Corporation is also a party to approximately 50 lawsuits filed by individuals alleging personal injury and seeking monetary damages for failed hernia repair procedures using LifeCell Corporation’s AlloDerm products.  These cases have been consolidated for centralized management in Middlesex County, New Jersey.  All of these cases are in the early stages of litigation and have not yet been set for trial. Although it is not possible to reliably predict the outcome of the litigation, we believe that the defenses to these claims are meritorious and will defend them vigorously.  We have insurance that we believe covers these claims and lawsuits and believe that after the application of our self-insured retention relating to products liability claims, such policies will cover litigation expenses, settlement costs and damage awards, if any, arising from these suits.  However, the insurance coverage may not be adequate if we are unsuccessful in our defenses. We do not expect these cases to have a material impact on our results of operations or our financial position.
 

Other Litigation

In February 2009, we received a subpoena from the U.S. Department of Health and Human Services Office of Inspector General ("OIG") seeking records regarding our billing practices under the local coverage policies of the four regional Durable Medical Equipment Medicare Administrative Contractors (“DMACs”).  The Company cooperated with the OIG’s inquiry and provided substantial documentation to the OIG and the U.S. Attorneys’ office in response to its request.  On May 9, 2011, the Company received notice that the U.S. Attorneys’ office had declined to intervene in qui tam actions filed against the Company by two former employees in Federal Court in California.  The complaints were recently unsealed, and KCI intends to defend itself in these matters vigorously, including seeking the dismissal of these allegations.

We are 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.  We maintain multiple layers of product liability insurance coverage and we believe these policies and the amounts of coverage are appropriate and adequate.

Other Commitments and Contingencies

As a healthcare supplier, we are subject to extensive government regulation, including laws and regulations directed at ascertaining the appropriateness of reimbursement, preventing fraud and abuse and otherwise regulating reimbursement under various government programs.  The marketing, billing, documenting and other practices are all subject to government oversight and review.  To ensure compliance with Medicare and other regulations, regional carriers often conduct audits and request patient records and other documents to support claims submitted by KCI for payment of services rendered to customers.

We also are subject to routine pre-payment and post-payment audits of medical claims submitted to Medicare.  These audits typically involve a review, by Medicare or its designated contractors and representatives, of documentation supporting the medical necessity of the therapy provided by KCI.  While Medicare requires us to obtain a comprehensive physician order prior to providing products and services, we are not required to, and do not as a matter of practice require, or subsequently obtain, the underlying medical records supporting the information included in such claim.  Following a Medicare request for supporting documentation, we are obligated to procure and submit the underlying medical records retained by various medical facilities and physicians.  Obtaining these medical records in connection with a claims audit may be difficult or impossible and, in any event, all of these records are subject to further examination and dispute by an auditing authority.  Under standard Medicare procedures, KCI is entitled to demonstrate the sufficiency of documentation and the establishment of medical necessity, and KCI has the right to appeal any adverse determinations.  If a determination is made that KCI’s records or the patients’ medical records are insufficient to meet medical necessity or Medicare reimbursement requirements for the claims subject to a pre-payment or post-payment audit, KCI could be subject to denial, recoupment or refund demands for claims submitted for Medicare reimbursement.  In the event that an audit results in discrepancies in the records provided, Medicare may be entitled to extrapolate the results of the audit to make recoupment demands based on a wider population of claims than those examined in the audit.  In addition, Medicare or its contractors could place KCI on an extended pre-payment review, which could slow our collections process for submitted claims.  If Medicare were to deny a significant number of claims in any pre-payment audit, or make any recoupment demands based on any post-payment audit, our business and operating results could be materially and adversely affected.  In addition, violations of federal and state regulations regarding Medicare reimbursement could result in severe criminal, civil and administrative penalties and sanctions, including disqualification from Medicare and other reimbursement programs.  Going forward, it is likely that we will be subject to periodic inspections, assessments and audits of our billing and collections practices.

On May 9, 2011, LifeCell Corporation received a warning letter dated May 5, 2011 from the FDA following an inspection by the FDA at LifeCell in November 2010.  The Warning Letter primarily related to the Company’s failure to submit required documentation to the FDA prior to conduct of certain clinical studies.  The FDA also identified certain observed non-compliance with FDA regulations covering the promotion of LifeCell’s Strattice/LTM product for use with breast implants.  The Company submitted a written response to the FDA on May 31, 2011.  LifeCell is cooperating with the FDA and believes that the corrective actions it is taking will resolve the FDA’s concerns without a material impact on the Company’s business.  However, the Company cannot give any assurances that the FDA will be satisfied with its response to the warning letter or as to the expected date of the resolution of the matters included in the warning letter.
 

NOTE 9.     Segment and Geographic Information

We are engaged in the rental and sale of advanced wound care systems, regenerative medicine products and therapeutic support systems.  KCI has operations in more than 20 countries.

We have three reportable operating segments which correspond to our business units: AHS; LifeCell; and TSS.  Our three global operating segments also represent our reporting units as defined by the Codification.  We have three primary geographic regions for which we provide supplemental information: Americas, which is comprised principally of the United States and includes Canada, Puerto Rico and Latin America; EMEA, which is comprised principally of Europe and includes the Middle East and Africa; and APAC, which is comprised of the Asia Pacific region.  Revenue for each of our geographic regions in which we operate is disclosed for each of our business units.  In most countries where we operate, our product lines are marketed and serviced by the same infrastructure and, as such, we have allocated these costs to the various business units based on allocation methods including rental and sales events, headcount, revenue and other methods as deemed appropriate.  We measure segment profit as operating earnings, which is defined as income before interest and other income, interest expense, foreign currency gains and losses, and income taxes.  All intercompany transactions are eliminated in computing revenue and operating earnings.

Information on segments and a reconciliation of consolidated totals are as follows (dollars in thousands):

   
Three months ended
   
Six months ended
 
   
June 30,
   
June 30,
 
   
2011
   
2010
   
2011
   
2010
 
Revenue:
                       
   AHS
                       
      Americas
  $ 266,859     $ 266,681     $ 524,719     $ 516,513  
      EMEA
    75,155       71,919       144,095       147,524  
      APAC
    15,957       9,126       29,696       16,642  
                                 
         Subtotal – AHS
    357,971       347,726       698,510       680,679  
                                 
   LifeCell
                               
      Americas
    93,268       82,188       183,505       160,162  
      EMEA
    3,062       1,555       5,839       2,596  
                                 
         Subtotal – LifeCell
    96,330       83,743       189,344       162,758  
                                 
   TSS
                               
      Americas
    40,966       44,563       85,519       92,963  
      EMEA
    24,191       21,564       47,061       46,453  
      APAC
    372       176       580       724  
                                 
         Subtotal – TSS
    65,529       66,303       133,160       140,140  
                                 
             Total revenue
  $ 519,830     $ 497,772     $ 1,021,014     $ 983,577  
 
 
   
Three months ended
   
Six months ended
   
   
June 30,
   
June 30,
   
   
2011
   
2010
   
2011
   
2010
   
Operating earnings:
                         
   AHS
  $ 128,815     $ 116,689     $ 243,189     $ 217,281    
   LifeCell
    24,775       19,819       52,913       41,871    
   TSS
    4,387       (5,204 ) (1)   8,619       2,968   (1)
                                   
   Non-allocated costs:
                                 
      General headquarter expense
    (12,251 )     (14,061 ) (2)   (27,927 )     (23,361 ) (2)
      Share-based compensation
    (8,234 )     (5,956 )     (15,879 )     (15,434 )  
      Acquisition-related expenses (3)
    (8,855 )     (9,930 )     (17,711 )     (20,628 )  
                                   
         Total non-allocated costs
    (29,340 )     (29,947 )     (61,517 )     (59,423 )  
                                   
             Total operating earnings
  $ 128,637     $ 101,357     $ 243,204     $ 202,697    
                                   
                                   
                                 
(1) Includes $7.4 million of expenses associated with the TSS product portfolio rationalization recorded in the second quarter of 2010.
(2) Includes expenses associated with our global business transformation efforts, including severance and other expenses of $5.3 million recorded during the second quarter of 2010.
(3) Includes amortization of acquired intangible assets and costs to retain key employees related to our purchase of LifeCell in May 2008.
   
 
 
NOTE 10.     Subsequent Events

On July 12, 2011, we entered into a definitive merger agreement under which a consortium of funds advised by Apax Partners, together with controlled affiliates of Canada Pension Plan Investment Board and Canada’s Public Sector Pension Investment Board, will acquire KCI for $68.50 per share in cash in a transaction valued at $6.3 billion, inclusive of KCI’s outstanding debt.

The Board of Directors of KCI has unanimously approved the merger agreement and recommended that KCI’s shareholders adopt the agreement with the consortium.  A special meeting of KCI’s shareholders will be held as soon as practicable after the filing of a definitive proxy statement with the U.S. Securities and Exchange Commission and subsequent mailing to shareholders.  The mailing of the proxy statement is expected to take place following the expiration of a 40-day ‘go-shop’ period, during which KCI is permitted to encourage and solicit alternative proposals from third parties.

The transaction is subject to certain closing conditions, including the approval of KCI’s shareholders, regulatory approvals and the satisfaction of other customary closing conditions, but is not subject to any condition with regard to the financing of the transaction.  The transaction is currently expected to close in the second half of 2011.
 
 

The following discussion should be read in conjunction with the condensed consolidated financial statements and accompanying notes included in this report.  The following discussion contains forward-looking statements that reflect our plans, estimates and beliefs.  Our actual results could differ materially from those discussed in the forward-looking statements.  Factors that could cause or contribute to these differences include, but are not limited to, those discussed in our “Risk Factors,” (Part II, Item 1A.), including those previously disseminated in KCI's Annual Report on Form 10-K for the fiscal year ended December 31, 2010.

GENERAL

Kinetic Concepts, Inc. (“KCI”) is a leading global medical technology company devoted to the discovery, development, manufacture and marketing of innovative, high-technology therapies and products that have been designed to leverage the body’s ability to heal, thus improving clinical outcomes while helping to reduce the overall cost of patient care.  We have an infrastructure designed to meet the specific needs of medical professionals and patients across all healthcare settings, including acute care hospitals, extended care organizations and patients’ homes, both in the United States and abroad.  Our primary business units serve the advanced wound care, regenerative medicine and therapeutic support systems markets.

·  
Our Active Healing Solutions ™ business unit (“AHS”), which represents a significant majority of our revenue, is focused on the development and commercialization of advanced wound care therapies based on our Negative Pressure Technology Platform (“NPTP”) which employs negative pressure in a variety of applications to promote wound healing through unique mechanisms of action and to speed recovery times while reducing the overall cost of treating patients with complex wounds.  NPTP comprises three primary product categories: Negative Pressure Wound Therapy (“NPWT”), Negative Pressure Surgical Management (“NPSM”) and Negative Pressure Regenerative Medicine (“NPRM”).  NPWT, through our proprietary V.A.C.® Therapy portfolio, currently represents the primary source of revenue for the AHS business.  In addition, we continue to develop and commercialize new products and therapies in NPSM and plan to launch NPRM products, which are currently being developed by our research and development group, to broaden and diversify our NPTP revenue streams in the future.  During 2011, our newest NPWT product, the V.A.C.ViaTM Therapy System, was launched in the U.S. and in select European markets.  In addition, during 2010, the Company launched our PrevenaTM Incision Management System (“Prevena”) globally.  In the acute care setting, we bill our customers directly for the rental and sale of our products.  In the homecare setting, we provide products and services to patients in the home and generally bill third-party payers directly.

·  
Our LifeCell™ business unit is focused on the development and commercialization of regenerative and reconstructive acellular tissue matrices for use in reconstructive, orthopedic, and urogynecologic surgical procedures to repair soft tissue defects, as well as for reconstructive and cosmetic procedures.  Existing products include our human-based AlloDerm® Regenerative Tissue Matrix (“AlloDerm”) and porcine-based StratticeTM Reconstructive Tissue Matrix (“Strattice”) in various configurations designed to meet the needs of patients and caregivers.  The majority of our LifeCell revenue is generated from the clinical applications of challenging hernia repair and post-mastectomy breast reconstruction, which is generated primarily in the United States in the acute care setting on a direct billing basis.  We continue efforts to penetrate markets with our other LifeCell products while developing and commercializing additional tissue matrix products and applications to expand into new markets and geographies.  During January 2011, the Company launched our newest acellular dermal matrix, AlloDerm® Regenerative Tissue Matrix Ready to Use.  AlloDerm® RTM Ready to Use provides all the regenerative features of AlloDerm in a sterile format that does not require rehydration like the freeze-dried version.

·  
Our Therapeutic Support Systems business unit (“TSS”) is focused on commercializing specialized therapeutic support systems, including hospital beds, mattress replacement systems, overlays and patient mobility devices.  Our TSS business unit rents and sells products in three primary surface categories: critical care, wound care and bariatric care.  Our critical care products, typically used in the ICU, are designed to address pulmonary complications associated with immobility; our wound care surfaces are used to reduce or treat skin breakdown; and our bariatric care surfaces assist caregivers in the safe and dignified handling of obese and morbidly obese patients, while addressing complications related to immobility.  We also have products designed to reduce the incidence and severity of patient falls in the hospital setting.
 

We are principally engaged in the rental and sale of our products in more than 20 countries.  We currently have approximately 7,000 employees worldwide and are headquartered in San Antonio, Texas.  We have research and development facilities in the United States and the United Kingdom, and we maintain manufacturing and engineering operations in Ireland, the United States, the United Kingdom and Belgium.

Historically, we have experienced a seasonal slowing of AHS unit demand 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 winter holidays.  LifeCell has also historically experienced a similar seasonal slowing of sales in the third quarter of each year.  Although we do not know if our historical experience will prove to be indicative of future periods, similar slow-downs may occur in subsequent periods.

RECENT DEVELOPMENTS

On July 12, 2011, we entered into a definitive merger agreement (the “Merger”) under which a consortium of funds advised by Apax Partners (“Apax”), together with controlled affiliates of Canada Pension Plan Investment Board (“CPP”) and Canada’s Public Sector Pension Investment Board (“PSP”), will acquire KCI for $68.50 per share in cash in a transaction valued at $6.3 billion, inclusive of KCI’s outstanding debt.

The Board of Directors of KCI has unanimously approved the merger agreement and recommended that KCI’s shareholders adopt the agreement with the consortium.  A special meeting of KCI’s shareholders will be held as soon as practicable after the filing of a definitive proxy statement with the U.S. Securities and Exchange Commission (“SEC”) and subsequent mailing to shareholders.  The mailing of the proxy statement is expected to take place following the expiration of a 40-day ‘go-shop’ period, during which KCI is permitted to encourage and solicit alternative proposals from third parties.

The transaction is subject to certain closing conditions, including the approval of KCI’s shareholders, regulatory approvals and the satisfaction of other customary closing conditions, but is not subject to any condition with regard to the financing of the transaction.  The transaction is currently expected to close in the second half of 2011.

Additional Information about the Merger and Where to Find It

This Form 10-Q may be deemed to be solicitation material in respect of the proposed acquisition of KCI by a consortium comprised of funds advised by Apax, together with controlled affiliates of CPP and Canada’s PSP. In connection with the proposed acquisition, KCI plans to file a preliminary proxy statement with the SEC.  INVESTORS AND SECURITY HOLDERS OF KCI ARE ADVISED TO READ THE PRELIMINARY PROXY STATEMENT, THE DEFINITIVE PROXY STATEMENT AND ANY OTHER RELEVANT DOCUMENTS FILED WITH THE SEC WHEN THEY BECOME AVAILABLE BECAUSE THOSE DOCUMENTS WILL CONTAIN IMPORTANT INFORMATION ABOUT THE PROPOSED ACQUISITION.  The definitive proxy statement will be mailed to shareholders of KCI.  Investors and security holders may obtain a free copy of the proxy statement when it becomes available, and other documents filed by KCI with the SEC, at the SEC’s web site at http://www.sec.gov.  Free copies of the proxy statement, when it becomes available, and KCI’s other filings with the SEC may also be obtained from KCI by directing a request to Kinetic Concepts, Inc., Attention: Investor Relations, 8023 Vantage Drive, San Antonio, TX 78230-4726, or by calling 210-255-6157.

KCI and its directors, executive officers and other members of its management and employees may be deemed to be soliciting proxies from KCI’s shareholders in favor of the proposed acquisition. Information regarding KCI’s directors and executive officers is available in its 2010 Annual Report on Form 10-K filed with the SEC on March 1, 2011, and definitive proxy statement relating to its 2011 Annual Meeting of Shareholders filed with the SEC on April 15, 2011.  Shareholders may obtain additional information regarding the interests of KCI and its directors and executive officers in the proposed acquisition, which may be different than those of KCI’s shareholders generally, by reading the preliminary proxy statement, definitive proxy statement and other relevant documents filed with the SEC when they become available.
 

RESULTS OF OPERATIONS

We have three reportable operating segments which correspond to our three global business units: AHS, LifeCell and TSS.  We have three primary geographic regions for which we provide supplemental information: Americas, which is comprised principally of the United States and includes Canada, Puerto Rico and Latin America; EMEA, which is comprised principally of Europe and includes the Middle East and Africa; and APAC, which is comprised of the Asia Pacific region.  Revenue for each of our geographic regions in which we operate is disclosed for each of our business units.  Certain prior period amounts have been reclassified to conform to the 2011 presentation.  In 2011, we began separately reporting the EMEA and APAC geographic revenue results.

Revenue by Operating Segment

The following table sets forth, for the periods indicated, business unit revenue by geographic region, as well as the percentage change in each line item, comparing the second quarter of 2011 to the second quarter of 2010 and the first six months of 2011 to the first six months of 2010 (dollars in thousands):

   
Three months ended June 30,
   
Six months ended June 30,
 
               
%
               
%
 
   
2011
   
2010
   
Change
   
2011
   
2010
   
Change
 
AHS revenue:
                                   
Americas
  $ 266,859     $ 266,681     0.1   $ 524,719     $ 516,513     1.6 %
EMEA
    75,155       71,919     4.5       144,095       147,524     (2.3 )   
APAC
    15,957       9,126     74.9       29,696       16,642     78.4  
                                             
Total – AHS
    357,971       347,726     2.9       698,510       680,679     2.6  
                                             
LifeCell revenue:
                                           
Americas
    93,268       82,188     13.5       183,505       160,162     14.6  
EMEA
    3,062       1,555     96.9       5,839       2,596     124.9  
                                             
Total – LifeCell
    96,330       83,743     15.0       189,344       162,758     16.3  
                                             
TSS revenue:
                                           
Americas
    40,966       44,563     (8.1 )        85,519       92,963     (8.0 )   
EMEA
    24,191       21,564     12.2       47,061       46,453     1.3  
APAC
    372       176     111.4       580       724     (19.9 )   
                                             
Total – TSS
    65,529       66,303     (1.2 )        133,160       140,140     (5.0 )   
                                             
Total revenue
  $ 519,830     $ 497,772     4.4   $ 1,021,014     $ 983,577     3.8

For additional discussion on segment and operation information, see Note 9 of the notes to the condensed consolidated financial statements.
 

Revenue by Geography

The following table sets forth, for the periods indicated, rental and sales revenue by geography, as well as the percentage change in each line item, comparing the second quarter of 2011 to the second quarter of 2010 and the first six months of 2011 to the first six months of 2010 (dollars in thousands):

   
Three months ended June 30,
   
Six months ended June 30,
 
               
%
               
%
 
   
2011
   
2010
   
Change
   
2011
   
2010
   
Change
 
Americas revenue:
                                   
Rental
  $ 218,338     $ 227,660     (4.1 )%   $ 438,958     $ 448,063     (2.0 )%
Sales
    182,755       165,772     10.2