10-Q 1 kci10q1qtr2008.htm KCI 10-Q 1ST QTR 2008 kci10q1qtr2008.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 March 31, 2008
 
Commission File Number: 001-09913


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

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

     Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.
                                                Common Stock: 72,376,382 shares as of April 30, 2008


TABLE OF CONTENTS

KINETIC CONCEPTS, INC.



 
 
TRADEMARKS

The following terms are our trademarks and may be used in this report:  ActiV.A.C.®, AirMaxxis®, AtmosAir®, AtmosAir® with SATÔ, BariAir®, BariatricSupportÔ, BariKare®, BariMaxx® II, BioDyne®, Dri-Flo®, DynaPulse®, EZ LiftÔ, FirstStep®, FirstStep® AdvantageÔ, First Step All in One®, FirstStep® PlusÔ, FirstStep Select®, FirstStep Select® Heavy DutyÔ, FluidAir®, FluidAir Elite®, GranuFoam®, InfoV.A.C.®, InterCell®, Innova Basic®, Innova Extra®, Innova Premium®, InstaFlate®, KCI®, KCI The Clinical Advantage®, KinAir® IV, KinAir MedSurg®, KinAir MedSurg® PulseÔ, KCI Express®, Kinetic Concepts®, Kinetic TherapyÔ, MaxxAir ETS®, Maxxis® 400, ParaDyne®, PediDyne®, PlexiPulse®, RIK®, RotoProne®, RotoRest®, RotoRest® Delta, Seal Check®, SensaT.R.A.C.Ô, T.R.A.C. ®, TheraKair®, TheraKair Visio®, TheraPulse® ATPÔ,  TheraRest®, TheraRest SMS®, TriaDyne® II, TriaDyne Proventa®, TriCell®, V.A.C.®, V.A.C. ATS®, V.A.C. Freedom®, V.A.C.® Therapy, The V.A.C.® System, V.A.C. GranuFoam Silver®, V.A.C. Instill®, V.A.C.® WhiteFoam, and V.A.C.® WRNÔ.  All other trademarks appearing in this report are the property of their holders.


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 these terms and other comparable terminology, including, but not limited to, statements regarding the following:

·  
our ability to complete the acquisition of LifeCell Corporation (“LifeCell”);
·  
the benefits that can be achieved with the LifeCell acquisition;
·  
the terms of the financing for the LifeCell acquisition;
·  
projections of revenues, expenditures, earnings, or other financial items;
·  
expectations for third-party and governmental audits, investigations, claims, product approvals and reimbursement;
·  
the plans, strategies and objectives of management for future operations;
·  
expectation of market size and market acceptance or penetration of the products and services we offer;
·  
the effects of any patent litigation on our business;
·  
dependence on new technology;
·  
expectations for the outcomes of our clinical trials;
·  
attracting and retaining customers;
·  
competition in our markets;
·  
inherent risks associated with our international business operations;
·  
material changes or shortages in the sources of our supplies;
·  
the timing and amount of future equity compensation expenses;
·  
productivity of our sales force;
·  
future economic conditions or performance, including seasonality;
·  
fluctuations in foreign currency exchange rates;
·  
changes in effective tax rates or tax audits;
·  
changes in patient demographics;
·  
estimated charges for compensation or otherwise; and
·  
any statements of assumptions underlying any of the foregoing.

These forward-looking statements are only predictions, not historical facts, and involve certain risks and uncertainties, as well as assumptions. Actual results, levels of activity, performance, achievements and events could differ materially from those stated, anticipated or implied by such forward-looking statements. The factors that could contribute to such differences include those discussed under the caption "Risk Factors." You should consider each of the risk factors and uncertainties under the caption "Risk Factors" 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.




 
Condensed Consolidated Balance Sheets
 
(in thousands)
 
   
March 31,
   
December 31,
 
   
2008
   
2007
 
   
(unaudited)
       
Assets:
           
Current assets:
           
Cash and cash equivalents
  $ 305,167     $ 265,993  
Accounts receivable, net
    355,429       356,965  
Inventories, net
    60,152       50,341  
Deferred income taxes
    41,780       41,504  
Prepaid expenses and other
    29,842       31,176  
                 
         Total current assets
    792,370       745,979  
                 
Net property, plant and equipment
    234,853       228,471  
Debt issuance costs, less accumulated amortization of $352 at 2008 and $218 at 2007
    2,322       2,456  
Deferred income taxes
    8,442       8,743  
Goodwill
    48,897       48,897  
Other non-current assets, less accumulated amortization of $10,788 at 2008 and $10,678 at 2007
    23,798       23,039  
                 
    $ 1,110,682     $ 1,057,585  
                 
Liabilities and Shareholders' Equity:
               
Current liabilities:
               
Accounts payable
  $  44,479     $  50,804  
Accrued expenses and other
    161,303       212,874  
Income taxes payable
    15,956       -  
                 
         Total current liabilities
    221,738       263,678  
                 
Long-term debt
    68,000       68,000  
Non-current tax liabilities
    33,189       31,313  
Deferred income taxes
    20,126       9,921  
Other non-current liabilities
    7,755       7,653  
                 
Total liabilities
    350,808       380,565  
                 
Shareholders' equity:
               
Common stock; authorized 225,000 at 2008 and 2007, issued and outstanding 72,315 at 2008 and 72,153 at 2007
    72       72  
Preferred stock; authorized 50,000 at 2008 and 2007; issued and outstanding 0 at 2008 and 2007
    -       -  
Additional paid-in capital
    653,640       644,347  
Retained earnings (deficit)
    60,774       (7,181 )
Accumulated other comprehensive income
    45,388       39,782  
                 
         Shareholders' equity
    759,874       677,020  
                 
    $ 1,110,682     $ 1,057,585  
                 
See accompanying notes to condensed consolidated financial statements.
 
 

 
Condensed Consolidated Statements of Earnings
 
(in thousands, except per share data)
 
(unaudited)
 
             
   
Three months ended
 
   
March 31,
 
   
2008
   
2007
 
Revenue:
           
Rental
  $ 297,839     $ 265,684  
Sales
    122,177       103,132  
                 
Total revenue
    420,016       368,816  
                 
                 
Rental expenses
    175,274       163,940  
Cost of sales
    35,756       33,691  
                 
Gross profit
    208,986       171,185  
                 
Selling, general and administrative expenses
    95,347       78,213  
Research and development expenses
    14,715       9,807  
                 
Operating earnings
    98,924       83,165  
                 
Interest income and other
    2,005       1,364  
Interest expense
    (1,128 )     (4,091 )
Foreign currency gain (loss)
    2,387       (265 )
                 
Earnings before income taxes
    102,188       80,173  
                 
Income taxes
    34,233       26,617  
                 
Net earnings
  $   67,955     $     53,556  
                 
Net earnings per share:
               
                 
Basic
  $ 0.95     $  0.76  
                 
Diluted
  $ 0.94     $    0.75  
                 
Weighted average shares outstanding:
               
                 
Basic
    71,665       70,347  
                 
Diluted
    72,162       71,079  
                 
See accompanying notes to condensed consolidated financial statements.
 
 

 
Condensed Consolidated Statements of Cash Flows
 
(in thousands)
 
(unaudited)
 
   
Three months ended
 
   
March 31,
 
   
2008
   
2007
 
Cash flows from operating activities:
           
Net earnings
  $ 67,955     $ 53,556  
Adjustments to reconcile net earnings to net cash provided by operating activities:
               
Depreciation, amortization and other
    21,258       20,954  
Provision for bad debt
    1,600       1,750  
Amortization of deferred gain on sale of headquarters facility
    (268 )     (268 )
Share-based compensation expense
    7,566       5,772  
Excess tax benefit from share-based payment arrangements
    (131 )     (7,076 )
Change in assets and liabilities:
               
Decrease in accounts receivable, net
    2,351       5,752  
Increase in inventories, net
    (9,376 )     (4,395 )
Decrease (increase) in prepaid expenses and other
    1,373       (4,973 )
Increase (decrease) in deferred income taxes, net
    10,230       (7,909 )
Decrease in accounts payable
    (6,048 )     (2,981 )
Decrease in accrued expenses and other
    (50,509 )     (39,773 )
Increase in tax liabilities, net
    18,014       31,361  
                 
Net cash provided by operating activities
    64,015       51,770  
                 
Cash flows from investing activities:
               
Additions to property, plant and equipment
    (15,600 )     (12,867 )
Increase in inventory to be converted into equipment for short-term rental
    (12,000 )     (5,200 )
Dispositions of property, plant and equipment
    3,031       410  
Increase in other non-current assets
    (559 )     (279 )
                 
Net cash used by investing activities
    (25,128 )     (17,936 )
                 
Cash flows from financing activities:
               
Repayments of long-term debt, capital lease and other obligations
    (28 )     (324 )
Excess tax benefit from share-based payment arrangements
    131       7,076  
Proceeds from exercise of stock options
    1,552       3,634  
Purchase of immature shares for minimum tax withholdings
    (5 )     (1,317 )
                 
Net cash provided by financing activities
    1,650       9,069  
                 
Effect of exchange rate changes on cash and cash equivalents
    (1,363 )     590  
                 
Net increase in cash and cash equivalents
    39,174       43,493  
                 
Cash and cash equivalents, beginning of period
    265,993       107,146  
                 
Cash and cash equivalents, end of period
  $ 305,167     $ 150,639  
                 
Cash paid during the three months for:
               
Interest, including cash paid for interest rate swap agreements
  $ 1,257     $ 2,487  
Income taxes, net of refunds
  $ 5,338     $ 3,582  
                 
See accompanying notes to condensed consolidated financial statements.
 
 
 
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 its 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 for the fiscal year ended December 31, 2007.  The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles 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 U.S. generally accepted accounting principles.  Operating results from interim periods are not necessarily indicative of results that may be expected for the fiscal year as a whole.  The unaudited 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 current period presentation.

During the first quarter of 2008, we completed the realignment of our geographic reporting structure to correspond with our current management structure.  Beginning this quarter, we are reporting financial results consistent with this new structure, including the reclassification of prior period amounts to conform to this current reporting structure.  We define our business segments based on geographic management responsibility.  We have two reportable segments: North America, which is comprised principally of the United States and includes Canada and Puerto Rico; and EMEA/APAC, which is comprised principally of Europe and includes the Middle East, Africa and the Asia Pacific region.

(b)     Recently Adopted Accounting Pronouncements

In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 157 (“SFAS 157”), “Fair Value Measurements, which defines fair value, establishes guidelines for measuring fair value and expands disclosures regarding fair value measurements.  SFAS 157 does not require any new fair value measurements but rather eliminates inconsistencies in guidance found in various prior accounting pronouncements.  SFAS 157 was effective for KCI beginning January 1, 2008, and the adoption of SFAS 157 did not have a material impact on our results of operations or our financial position.

In February 2007, the FASB issued SFAS No. 159 (“SFAS 159”), “The Fair Value of Financial Assets and Financial Liabilities, which permits entities to elect to measure many financial instruments and certain other items at fair value that are not currently required to be measured at fair value.  This election is irrevocable.  SFAS 159 was effective for KCI beginning January 1, 2008, and the adoption of SFAS 159 did not have a material impact on our results of operations or our financial position.

In June 2007, the FASB ratified Emerging Issues Task Force (“EITF”) Issue No. 07-3 (“EITF 07-3”), “Accounting for Nonrefundable Advance Payments for Goods or Services to Be Used in Future Research and Development Activities.”  The scope of EITF 07-3 is limited to nonrefundable advance payments for goods and services to be used or rendered in future research and development activities pursuant to an executory contractual arrangement.  This Issue provides that nonrefundable advance payments for goods or services that will be used or rendered for future research and development activities should be deferred and capitalized.  Such amounts should be recognized as an expense as the related goods are delivered or the related services are performed.  Companies should report the effects of applying this Issue prospectively for new contracts entered into on or after the effective date of this Issue.  EITF 07-3 was effective for KCI beginning January 1, 2008, and the adoption of EITF 07-3 did not have a material impact on our results of operations or our financial position.
 
 
(c)       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 first quarter of 2008 was 33.5%, compared to 33.2% for the corresponding period in 2007.

(d)     Recently Issued Accounting Pronouncements

In December 2007, the FASB issued SFAS No. 141 Revised (“SFAS 141R”), “Business Combinations, which establishes principles and requirements for how the acquirer of a business recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree.  SFAS 141R also provides guidance for recognizing and measuring the goodwill acquired in the business combination and determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination.  SFAS 141R applies prospectively to business combinations and is effective for fiscal years beginning after December 15, 2008. The impact that the adoption of SFAS 141R will have on our consolidated financial statements will depend on the nature, terms and size of business combinations that occur after the effective date.

In March 2008, the FASB issued SFAS No. 161 (“SFAS 161”), “Disclosures about Derivative Instruments and Hedging Activities – An Amendment of FASB Statement No. 133, which enhances the required disclosures regarding derivatives and hedging activities.  SFAS 161 is effective for fiscal years and interim periods beginning after November 15, 2008.  We are currently evaluating the impact SFAS 161 may have on our results of operations or our financial position.

(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, 2007.


(2)     SUPPLEMENTAL BALANCE SHEET DATA

(a)     Accounts Receivable

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

   
March 31,
   
December 31,
 
   
2008
   
2007
 
Gross trade accounts receivable:
           
    North America:
           
        Acute and extended care organizations
  $ 119,671     $ 123,643  
        Medicare / Medicaid
    64,297       66,922  
        Managed care, insurance and other
    156,225       153,612  
                 
           North America - trade accounts receivable
    340,193       344,177  
                 
    EMEA/APAC - trade accounts receivable
    109,545       102,682  
                 
               Total trade accounts receivable
    449,738       446,859  
                 
    Less:  Allowance for revenue adjustments
    (94,018 )     (90,095 )
                 
               Gross trade accounts receivable
    355,720       356,764  
                 
Less:  Allowance for bad debt
    (6,625 )     (6,695 )
                 
    Net trade accounts receivable
    349,095       350,069  
                 
Employee and other receivables
    6,334       6,896  
                 
    $ 355,429     $ 356,965  
 
 
Trade accounts receivable in North America consist of amounts due directly from acute and extended care organizations, third-party payers, or 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/APAC trade accounts receivable consist of amounts due primarily from acute care organizations.

The TPP reimbursement process in North America 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, increasing 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 against revenue 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 against revenue and bad debt 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.  If circumstances change, such as higher than expected claims denials, post-payment claim recoupments, a material change in the interpretation of reimbursement criteria by a major customer or payer, or payment defaults or an unexpected material adverse change in a major customer's or payer's ability to meet its obligations, our estimates of the realizability of trade receivables could be reduced by a material amount.

(b)     Inventories

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):

   
March 31,
   
December 31,
 
   
2008
   
2007
 
             
Finished goods
  $ 40,530     $ 34,647  
Work in process
    3,793       1,341  
Raw materials, supplies and parts (1)
    49,105       34,551  
                 
      93,428       70,539  
                 
Less: Amounts expected to be converted
               
            into equipment for short-term rental (1)
    (27,800 )     (15,800 )
         Reserve for excess and obsolete inventory inventory
    (5,476 )     (4,398 )
                 
    $ 60,152     $ 50,341  
                 
                                   
               
(1) The increase in raw materials and amounts expected to be converted into equipment for short-term rental is primarily related to the increase in V.A.C. unit materials necessary to support the launch of our next generation ActiV.A.C. and InfoV.A.C. products.  In addition, the increase in raw materials is attributable to the purchase of raw materials from Avail Medical Products, Inc. associated with the execution of our Toll Manufacturing Agreement.
 
 
 
(3)     EARNINGS PER SHARE

Net earnings per share were calculated using the weighted average number of shares outstanding during the respective quarterly 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
 
   
March 31,
 
   
2008
   
2007
 
             
Net earnings
  $ 67,955     $ 53,556  
                 
Weighted average shares outstanding:
               
   Basic
    71,665       70,347  
   Dilutive potential common shares from stock
               
      options and restricted stock (1)
    497       732  
                 
   Diluted
    72,162       71,079  
                 
Basic net earnings per share
  $ 0.95     $ 0.76  
                 
Diluted net earnings per share
  $ 0.94     $ 0.75  
                 
                                   
               
(1) Potentially dilutive stock options and restricted stock totaling 2,498 shares and 2,308 shares for the three months ended March 31, 2008 and 2007, respectively, were excluded from the computation of diluted weighted average shares outstanding due to their antidilutive effect.
 
 
 
(4)     EMPLOYEE BENEFIT PLANS

Deferred Compensation Plan:

In December 2006, management decided to discontinue the Kinetic Concepts, Inc. Executive Deferred Compensation Plan (the “Plan”) effective January 1, 2007.  All balances as of December 31, 2006 remained with the Plan throughout 2007 unless the participant had a previously-scheduled distribution.  All undistributed balances in the Plan, totaling $7.1 million as of December 31, 2007, were distributed during the first quarter of 2008.  In addition, KCI liquidated the Plan assets totaling $7.4 million, which were used by KCI in the first quarter of 2008 to fund participant distributions.

Stock Option Plans:

KCI recognizes share-based compensation expense under the provisions of SFAS No. 123 Revised (“SFAS 123R”), “Share-Based Payment,” which requires the measurement and recognition of compensation expense over the estimated service period for all share-based payment awards, including stock options, restricted stock awards and restricted stock units based on estimated fair values on the date of grant.
 
 
SFAS 123R requires the expensing of equity awards over the estimated service period and we have experienced an increase in share-based compensation expense, compared to the prior-year period, as additional equity grants are made.  Compared to the first quarter of 2007, we experienced an increase in share-based compensation expense as we made our annual equity grants during the first quarter of 2008.  Historically, annual equity grants were made during the second quarter.  Share-based compensation expense was recognized in the condensed consolidated statements of earnings as follows (dollars in thousands, except per share data):

   
Three months ended
 
   
March 31,
 
   
2008
   
2007
 
             
Rental expenses
  $ 1,469     $ 1,582  
Cost of sales
    148       206  
Selling, general and administrative expenses
    5,949       3,984  
                 
Pre-tax share-based compensation expense
    7,566       5,772  
Less:  Income tax benefit
    (2,324 )     (1,516 )
                 
Total share-based compensation expense, net of tax
  $ 5,242     $ 4,256  
                 
Diluted net earnings per share impact
  $ 0.07     $ 0.06  

During the first quarter of 2008 and 2007, KCI granted approximately 833,800 and 19,300 options, respectively, to purchase shares of common stock under the equity plans.  The weighted-average estimated fair value of stock options granted during the three-month periods ended March 31, 2008 and 2007 was $22.54 and $22.97 per share, respectively, using the Black-Scholes option pricing model with the following weighted average assumptions (annualized percentages):

   
Three months ended
 
   
March 31,
 
   
2008
   
2007
 
             
Expected stock volatility
    39.2 %       40.1 %  
Expected dividend yield
    -       -  
Risk-free interest rate
    3.1 %       4.8 %  
Expected life (years)
    6.3       6.3  

The expected stock volatility is based on historical volatilities of KCI and similar entities.  The expected dividend yield is 0% as we have historically not paid cash dividends on our common stock.  The risk-free interest rates for periods within the contractual life of the option are based on the U.S. Treasury yield curve in effect at the time of grant.  We have chosen to estimate expected life using the simplified method as defined in Staff Accounting Bulletin 107, “Share-Based Payment,” rather than using our own historical expected life as there has not been sufficient history since we completed our initial public offering to allow us to better estimate this variable.
 
 
A summary of our stock option activity, and related information, for the three months ended March 31, 2008 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, 2008
    3,212     $ 42.69              
Granted
    834     $ 51.61              
Exercised
    (50 )   $ 30.86              
Forfeited/Expired
    (69 )   $ 49.61              
                             
Options outstanding – March 31, 2008
    3,927     $ 44.62       7.93     $ 20,962  
                                 
Exercisable as of March 31, 2008
    973     $ 36.23       5.50     $ 12,271  

The intrinsic value for stock options is defined as the difference between the current market value and the grant price.  During the first quarter of 2008 and 2007, the total intrinsic value of stock options exercised was $1.0 million and $20.8 million, respectively.  Cash received from stock options exercised during the first quarter of 2008 and 2007 was $1.6 million and $3.6 million, respectively.

As of March 31, 2008, there was $57.0 million of total unrecognized compensation cost related to non-vested stock options granted under our various plans.  This unrecognized compensation cost is expected to be recognized over a weighted average period of 3.0 years.

During the first quarter of 2008 and 2007, we issued approximately 211,000 and 6,700 shares of restricted stock and restricted stock units under our equity plans, at a weighted average estimated fair value of $51.60 and $48.56, respectively.  The following table summarizes restricted stock activity for the three months ended March 31, 2008:

   
Number of
   
Weighted
 
   
Shares
   
Average Grant
 
   
(in thousands)
   
Date Fair Value
 
             
Unvested shares – January 1, 2008
    602     $ 45.88  
Granted
    211     $ 51.60  
Vested and distributed
    -       -  
Forfeited
    (12 )   $ 47.18  
                 
Unvested shares – March 31, 2008
    801     $ 47.34  

As of March 31, 2008, there was $30.4 million of total unrecognized compensation cost related to non-vested restricted stock granted under our plans.  This unrecognized compensation cost is expected to be recognized over a weighted average period of 2.7 years.

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.
 

(5)     SHARE REPURCHASE PROGRAM

In August 2006, KCI's Board of Directors authorized a share repurchase program for the repurchase of up to $200.0 million in market value of common stock.  In August 2007, the Board authorized a one-year extension of this share repurchase program through September 30, 2008.  As of March 31, 2008, the authorized amount for share repurchases under this program was $87.4 million.  Pursuant to the share repurchase program, we entered into a pre-arranged purchase plan under Rule 10b5-1 of the Exchange Act authorizing repurchases of up to $87.0 million of KCI common stock if our stock price is below certain levels.  Since the inception of the share repurchase program, 3.6 million shares of common stock have been repurchased and recorded as a reduction to shareholders’ equity totaling $112.6 million.  Effective April 7, 2008, KCI terminated the share repurchase program and the pre-arranged purchase plan under Rule 10b5-1 as a result of the merger agreement with LifeCell Corporation (“LifeCell”).  (See Note 9)

The stock repurchased in the first quarters of 2008 and 2007 resulted from the purchase and retirement of shares in connection with (i) the net share settlement exercise of employee stock options for the minimum tax withholdings and exercise price and (ii) the withholding of shares to satisfy the minimum tax withholdings on the vesting of restricted stock.  No open-market repurchases were made under the share repurchase program during the first quarter of 2008 or 2007.

 
(6)     OTHER COMPREHENSIVE INCOME

KCI follows SFAS No. 130, “Reporting Comprehensive Income,” in accounting for comprehensive income and its components.  Comprehensive income for the three months ended March 31, 2008 and 2007 was $73.6 million and $51.8 million, respectively.  The most significant adjustment to net earnings to arrive at comprehensive income consisted of a foreign currency translation adjustment gain of $5.6 million and a loss of $1.8 million for the three-month periods ended March 31, 2008 and 2007, respectively.


(7)     COMMITMENTS AND CONTINGENCIES

KCI and its affiliates, together with Wake Forest University Health Sciences, are involved in multiple patent infringement suits involving patents licensed exclusively to KCI by Wake Forest.  The 2003 case filed against BlueSky Medical Group, Inc., Medela, Inc. and Medela AG is currently on appeal before the Federal Circuit Court of Appeals in Washington, D.C.  In 2006, the District Court jury found that the Wake Forest patents involved in the litigation were valid and enforceable, but that the patent claims at issue were not infringed by the device marketed by BlueSky.  In 2007, BlueSky Medical was acquired by Smith & Nephew plc, which is now a party to the appeal.  Initial appellate briefs have been filed by all parties to the appeal.  As a result of the appeal, the District Court’s final judgment could be modified, set aside or reversed, or the case could be remanded to District Court for retrial.

In May 2007, KCI, its affiliates and Wake Forest filed two related patent infringement suits: one case against Smith & Nephew and BlueSky and a second case against Medela, for the manufacture, use and sale of negative pressure devices which we believe infringe a Wake Forest continuation patent issued in 2007 relating to our V.A.C. technology.  Also, in June 2007, Medela filed patent nullity suits in the German Federal Patent Court against two of Wake Forest’s German patents licensed to KCI.  These patents were originally issued by the German Patent Office in 1998 and 2000, upon granting of the corresponding European patents.  The European patents were upheld as amended and corrected during Opposition Proceedings before the European Patent Office in 2003.

In September 2007, KCI and two affiliates were named in a declaratory judgment action filed in the Federal District Court for the District of Delaware by Innovative Therapies, Inc. (“ITI”).  In that case, the plaintiff has alleged the invalidity or unenforceability of four patents licensed to KCI by Wake Forest University Health Sciences and one patent owned by KCI relating to V.A.C. Therapy, and has requested a finding that products made by the plaintiff do not infringe the patents at issue.
 
 
In January 2008, KCI, its affiliates and Wake Forest filed a patent infringement lawsuit against ITI in the U.S. District Court for the Middle District of North Carolina. The federal complaint alleges that a negative pressure wound therapy, or NPWT, device recently introduced by ITI infringes three Wake Forest patents which are exclusively licensed to KCI.  We are seeking damages and injunctive relief in the case. Also in January 2008, in a separate action, KCI and its affiliates filed suit in state District Court in Bexar County, Texas, against ITI and three of its principals, all of whom were former employees of KCI. The claims in the suit include breach of confidentiality agreements, conversion of KCI technology, theft of trade secrets and conspiracy. We are seeking damages and injunctive relief in the case.

In March 2008, Mölnlycke Health Care AB filed a patent nullity suit in Germany against one of Wake Forest’s German patents licensed to KCI.  Also in March 2008, Mölnlycke filed suit in the UK to have a related Wake Forest patent revoked.  These patents were originally issued in 1998 by the German Patent Office and the UK Patent Office upon granting of the corresponding European patents.  The corresponding European patents were upheld as amended and corrected during Opposition Proceedings before the European Patent Office in 2003.

Although it is not possible to reliably predict the outcome of the legal proceedings described above, we believe that each of the patents involved in litigation are valid and enforceable, and that our patent infringement claims are meritorious.  However, if any of our key patent claims were narrowed in scope or found to be invalid or unenforceable, or we otherwise do not prevail, our share of the advanced wound care market for our V.A.C. Therapy systems could be significantly reduced in the U.S. or Europe, due to increased competition, and pricing of V.A.C. Therapy systems could decline significantly, either of which would materially and adversely affect our financial condition and results of operations.  We derived approximately 57% of total revenue for the three months ended March 31, 2008 and 59% of total revenue for the year ended December 31, 2007 from our domestic V.A.C. Therapy products relating to the U.S. patents at issue.  In continental Europe, we derived approximately 14% of total revenue for the three months ended March 31, 2008 and 12% of total revenue for the year ended December 31, 2007 in V.A.C. revenue relating to the patents at issue in the ongoing German litigation.

Subsequent to the announcement of the merger agreement, on April 14, 2008, a purported stockholders’ class action complaint was filed by a stockholder of LifeCell in the Chancery Division of the Superior Court of New Jersey in Somerset County, naming LifeCell, its directors and KCI as defendants.  The complaint alleges causes of action against the defendants for breach of fiduciary duties in connection with the proposed acquisition of LifeCell by KCI and seeks relief including, among other things, (i) preliminary and permanent injunctions prohibiting consummation of the tender offer and the merger and (ii) payment of the plaintiff’s costs and expenses, including attorneys’ and experts’ fees.  KCI believes that the lawsuit is without merit and intends to defend vigorously against it.

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.

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 scrutiny.  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.

From time to time, we receive inquiries from various government agencies requesting customer records and other documents.  It has been our policy to cooperate with all such requests for information. The U.S. Department of Health and Human Services Office of Inspector General, or OIG, initiated a study on NPWT in 2005.  As part of the 2005 study, KCI provided OIG with requested copies of our billing records for Medicare V.A.C. placements.  In June 2007, the OIG issued a report on the NPWT study including a number of findings and recommendations to CMS.  The OIG determined that substantially all V.A.C. claims met supplier documentation requirements; however, they were unable to conclude that the underlying patient medical records fully supported the supplier documentation in 44% of the claims, which resulted in an OIG estimate that approximately $27 million in improper payments may have been made on NPWT claims in 2004.  The purpose of the OIG report is to make recommendations for potential Medicare program savings to CMS, but it does not constitute a formal recoupment action.  This report may result in increased audits and/or demands by Medicare, its regional contractors and other third-party payers for refunds or recoupments of amounts previously paid to us.
 
 
In June 2007, the Medicare Region D contractor notified KCI of a post-payment audit of claims paid during 2006.  The DMAC requested information on 250 NPWT claims for patients treated with KCI’s V.A.C. Therapy.  In addition to KCI’s records, the DMAC requested relevant medical records supporting the medical necessity of the V.A.C. and related supplies and quantities being billed.  We submitted all of the requested documentation in a timely manner.  The DMAC subsequently made a minor recoupment for the exceptions noted during its review.

KCI has responded to requests from a Medicare Region A Recovery Audit Contractor (‘‘RAC’’) covering 180 previously-paid claims submitted between 2004 and 2005. The RAC audits are part of a pilot program under the CMS Medicare Integrity Program, currently being conducted in California, Florida and New York.  The RAC audit initial findings were that approximately 29% of the claims subject to this audit were inappropriately paid.  We have disputed and appealed these results and believe that we will prevail on these disputes in the appeals process.

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 certificate.  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.  In the event that a post-payment 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.

We also routinely receive pre-payment reviews of claims we submit for Medicare reimbursement.  In December 2007, the Medicare Region B Durable Medical Equipment Administrative Contractors initiated a pre-payment review of all second and third cycle NPWT claims submitted by all providers, including KCI, which was suspended in the first quarter of 2008.  KCI has responded to these claim review requests, but has not yet received a final determination.  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 this pre-payment review, KCI could be subject to denial, recoupment or refund demands for claims submitted for Medicare reimbursement.  In addition, Medicare or its contractors could place KCI on extended pre-payment review, which could slow our collections process for these claims.  The results of this or any pre-payment audit could also result in subsequent post-payment audits for claims previously paid by Medicare.  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 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 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.

As of March 31, 2008, our commitments for the purchase of new product inventory were $35.3 million, including approximately $8.1 million of disposable products from our main disposable supplier and $12.4 million from our major electronic board and touch panel suppliers.  Other than commitments for new product inventory, we have no material long-term purchase commitments.

On April 7, 2008, we announced the execution of a definitive agreement to acquire LifeCell Corporation, a publicly held company (Nasdaq: LIFC), in a cash transaction valued at approximately $1.8 billion.  Under certain circumstances as defined in the merger agreement, should either party terminate such agreement, KCI may be required to pay or entitled to receive a termination fee of $50.0 million.  In the event we receive a termination fee, a portion may be payable to third parties.
 
 
(8)     SEGMENT AND GEOGRAPHIC INFORMATION

We are principally engaged in the rental and sale of advanced wound care systems and therapeutic support systems throughout the United States and in 18 primary countries internationally. Revenues are attributed to individual countries based on the location of the customer.

During the first quarter of 2008, we completed the realignment of our geographic reporting structure to correspond with our current management structure.  Beginning this quarter, we are reporting financial results consistent with this new structure, including the reclassification of prior period amounts to conform to this current reporting structure.  Our business segments are defined based on geographic management responsibility.  We have two reportable segments: North America, which is comprised principally of the United States and includes Canada and Puerto Rico; and EMEA/APAC, which is comprised principally of Europe and includes the Middle East, Africa and the Asia Pacific region.  We have two primary product lines: V.A.C. Therapy and Therapeutic Support Systems.  Revenues for each of our product lines are disclosed for our operating segments.  Other than revenue, no discrete financial information is available for our product lines.  In most countries where we operate, our product lines are marketed and serviced by the same infrastructure and, as such, we do not manage our business by product line, but rather by geographical segments.  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
 
   
March 31,
 
   
2008
   
2007
 
Revenue:
           
   North America
           
      V.A.C.
  $ 250,222     $ 226,937  
      Therapeutic Support Systems
    59,241       56,705  
                 
         Subtotal – North America
    309,463       283,642  
                 
   EMEA/APAC
               
      V.A.C.
    82,742       61,626  
      Therapeutic Support Systems
    27,811       23,548  
                 
         Subtotal – EMEA/APAC
    110,553       85,174  
                 
             Total revenue
  $ 420,016     $ 368,816  


   
Three months ended
 
   
March 31,
 
   
2008
   
2007
 
Operating earnings:
           
   North America
  $ 126,240     $ 112,420  
   EMEA/APAC
    19,502       6,423  
                 
   Other (1):
               
      Executive
    (16,176 )     (9,870 )
      Finance
    (12,660 )     (11,628 )
      Manufacturing/Engineering
    (6,748 )     (3,813 )
      Administration
    (11,234 )     (10,367 )
                 
         Total other
    (46,818 )     (35,678 )
                 
             Total operating earnings
  $ 98,924     $ 83,165  
                 
                                   
               
(1) Other includes general headquarter expenses which are not allocated to the individual segments and are included in selling, general and administrative expenses within our condensed consolidated statements of earnings.
 
 
 
The following information on segment assets, which was included in Note 16 to the Annual Report on Form 10-K for the year ended December 31, 2007, has been restated to reflect the change in our geographic reporting structure (dollars in thousands):

   
Year ended
 
   
 December 31, 2007
 
Total assets:
     
   North America
  $ 657,122  
   EMEA/APAC
    303,422  
   Other:
       
      Executive
    8,562  
      Finance
    25,150  
      Manufacturing/Engineering
    25,818  
      Administration
    37,511  
         
         Total other
    97,041  
         
            Total assets
  $ 1,057,585  

The following table sets forth, for the periods indicated, product line revenue by geographical segment which have been restated to reflect the change in our geographic reporting structure (dollars in thousands):

   
Year Ended December 31, 2007
 
   
First
   
Second
   
Third
   
Fourth
 
   
Quarter
   
Quarter
   
Quarter
   
Quarter
 
North America revenue:
                       
   V.A.C.
  $ 226,937     $ 247,275     $ 255,830     $ 262,998  
   Therapeutic Support Systems
    56,705       55,992       56,722       61,171  
                                 
      Total – North America
    283,642       303,267       312,552       324,169  
                                 
EMEA/APAC revenue:
                               
   V.A.C.
    61,626       70,032       73,065       81,860  
   Therapeutic Support Systems
    23,548       23,353       25,263       27,567  
                                 
      Total – EMEA/APAC
    85,174       93,385       98,328       109,427  
                                 
         Total revenue
  $ 368,816     $ 396,652     $ 410,880     $ 433,596  


(9)     SUBSEQUENT EVENT

On April 7, 2008, we announced the execution of a definitive agreement to acquire LifeCell Corporation, a publicly held company (Nasdaq: LIFC), in a cash transaction valued at approximately $1.8 billion.  Under certain circumstances as defined in the merger agreement, should either party terminate such agreement, KCI may be required to pay or entitled to receive a termination fee of $50.0 million.  In the event we receive a termination fee, a portion may be payable to third parties.  

The planned acquisition will be completed by means of a tender offer for all of the outstanding shares of LifeCell’s common stock, followed by a merger of LifeCell with our merger subsidiary that will result in LifeCell becoming a 100% owned subsidiary of KCI.  Pursuant to the terms of the merger agreement, we commenced the tender offer on April 21, 2008 to purchase all of the outstanding shares of LifeCell’s common stock at a price of $51.00 per share in cash.  KCI’s obligation to consummate the tender offer is conditioned upon the tender of at least a majority of the fully diluted LifeCell shares in the offer, completion and funding of KCI’s financing arrangements described below, and the satisfaction of regulatory and other customary closing conditions. The tender offer will expire at midnight on May 16, 2008, unless extended in accordance with the terms of the tender offer and the applicable rules and regulations of the SEC.  Following the completion of the tender offer, the merger will occur pursuant to which any remaining LifeCell shares would be acquired for $51.00 per share.  The closing of the merger is subject to additional conditions, including, if required under Delaware law, approval of the merger by LifeCell’s stockholders.
 
 
On April 7, 2008, in connection with the merger agreement, KCI and our merger subsidiary entered into a commitment letter, pursuant to which Bank of America, N.A., Banc of America Securities LLC, JPMorgan Chase Bank, N.A. and J.P. Morgan Securities, Inc. committed, subject to the conditions set forth therein, to provide a $1.0 billion term loan credit facility and a $300.0 million revolving credit facility.  The debt commitment letter originally provided for a $1.0 billion Term A credit facility and a $600.0 million Term B credit facility, but as a result of the convertible note offering described below, the term loan commitment is now $1.0 billion.  The commitment is subject to various conditions, including consummation of the acquisition in accordance with the merger agreement and other closing conditions similar to those applicable to the completion of the acquisition. In addition to providing financing for the acquisition, we expect to use the debt financing under the new credit facilities to (i) pay fees and expenses incurred in connection with the acquisition and related transactions, (ii) repay certain indebtedness of KCI and (iii) provide ongoing working capital and provide for other general corporate purposes of the combined company. We expect our obligations under the new credit facilities (i) to be guaranteed by each of the existing and future direct and indirect domestic subsidiaries of KCI, and (ii) to be secured, subject to certain exceptions, by all the capital stock of each of our present and future subsidiaries (limited, in the case of foreign subsidiaries, to 65.0% of the voting stock of such subsidiaries) and all of the present and future property and assets (real and personal) of KCI and the guarantors. The lenders have the right to change the pricing and scheduled amortization of the credit facilities within specified limits, as well as other terms, depending on market conditions.

Effective upon the execution of the merger agreement with LifeCell, KCI’s share repurchase program was terminated.  As of April 7, 2008, KCI had repurchased $112.6 million in common stock under the share repurchase program.

Subsequent to the announcement of the merger agreement, on April 14, 2008, a purported stockholders’ class action complaint was filed by a stockholder of LifeCell in the Chancery Division of the Superior Court of New Jersey in Somerset County, naming LifeCell, its directors and KCI as defendants.  The complaint alleges causes of action against the defendants for breach of fiduciary duties in connection with the proposed acquisition of LifeCell by KCI and seeks relief including, among other things, (i) preliminary and permanent injunctions prohibiting consummation of the tender offer and the merger and (ii) payment of the plaintiff’s costs and expenses, including attorneys’ and experts’ fees.  KCI believes that the lawsuit is without merit and intends to defend vigorously against it.

On April 21, 2008, KCI closed its offering of $600 million aggregate principal amount of 3.25% convertible senior notes due 2015.  KCI granted an option to the initial purchasers of the notes to purchase up to an additional $90 million aggregate principal amount of notes to cover over-allotments, which was exercised on May 1, 2008 for the entire $90.0 million aggregate principal amount.  The coupon on the notes will be 3.25% per year on the principal amount. Interest will accrue from April 21, 2008, and will be payable semi-annually in arrears on April 15 and October 15 of each year, beginning October 15, 2008.  The notes will mature on April 15, 2015, unless previously converted or repurchased in accordance with their terms.  The notes are not redeemable by KCI prior to the maturity date.  Upon conversion, holders will receive cash up to the aggregate principal amount of the notes being converted and shares of KCI common stock in respect of the remainder, if any, of KCI’s 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 KCI 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 KCI’s common stock on April 15, 2008 (the day of pricing of the notes), which was $40.27 per share.  In connection with the initial offering and over-allotment exercise, KCI entered into convertible note hedge and warrant transactions with financial institutions that are affiliates of two of the offering’s initial purchasers to increase the effective conversion price of the notes to approximately $60.41, which is approximately 50% higher than the closing price of KCI’s common stock on April 15, 2008.  We intend to settle the principal amount of these notes in cash.

KCI used a portion of the net proceeds from the offering to pay the $48.7 million cost of the convertible note hedge transactions, taking into account the proceeds to KCI from the warrant transactions, and we intend to use the balance of the net proceeds to fund a portion of the purchase price of the proposed acquisition of LifeCell Corporation, repay certain indebtedness of KCI, provide ongoing working capital and provide for other general corporate purposes of the combined company.  Although the initial net cash outlay for the convertible note hedge transactions totals $48.7 million, considering the tax deductibility of the bond hedge, the net present value cost of these hedge transactions totals approximately $7.4 million.
 
 

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 under Part II, Item 1A. “Risk Factors.”

General

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

For the last several years, our growth has been driven primarily by increased revenue from V.A.C. Therapy systems and related supplies, which accounted for approximately 79.3% of total revenue for the three months ended March 31, 2008, up from 78.2% for the same period in 2007.  We derive our revenue primarily from the rental of our therapy systems and the sale of related disposables.

We have direct operations in the United States, Canada, Western Europe, Australia, New Zealand, Singapore and South Africa, and we conduct additional business through distributors in Latin America, the Middle East, Eastern Europe and Asia.  We manage our business in two geographical segments: North America, which is comprised principally of the United States and includes Canada and Puerto Rico; and EMEA/APAC, which is comprised principally of Europe and includes the Middle East, Africa and the Asia Pacific region. Operations in North America accounted for approximately 73.7% and 76.9% of our total revenue for the three-month periods ended March 31, 2008 and 2007, respectively. Historically, we have experienced a seasonal slowing of domestic V.A.C. unit growth beginning in the fourth quarter and continuing into the first quarter, which we believe has been caused by year-end clinical treatment patterns, such as the postponement of elective surgeries and increased discharges of individuals from the acute care setting around the winter holidays.  Although we do not know if our historical experience will prove to be indicative of future periods, a similar slow-down may occur in subsequent periods.

In the U.S. acute care and extended care settings, which accounted for approximately half of our North American revenue for the three months ended March 31, 2008, we bill our customers directly for the rental and sale of our products.  In the U.S. homecare setting, where our revenue comes predominantly from V.A.C. Therapy systems, we provide products and services directly to patients and bill third-party payers directly, such as Medicare and private insurance.  We believe the growth in our U.S. V.A.C. Therapy revenue has substantially benefited from the availability of Medicare reimbursement for our products in the U.S. homecare setting.  In 2007, the Centers for Medicare and Medicaid Services, or CMS, adopted rules providing for competitively-bid reimbursement amounts for certain Medicare-covered durable medical equipment, including negative pressure wound therapy, or NPWT.  The competitive bidding program will be used initially to establish reimbursement amounts for NPWT in ten designated metropolitan areas beginning in July 2008.  By mid-2009, the competitive bidding program will be used to establish reimbursement amounts in a total of 80 designated metropolitan areas.  The competitive bidding program could have a negative impact on our Medicare reimbursement levels, and could result in increased price pressure from other third-party payers.  The competitive bidding program could also limit customer access to KCI’s homecare products in any designated metropolitan area where KCI is not a contracted provider for NPWT in the program.  We estimate the V.A.C. rentals and sales to Medicare beneficiaries in the ten designated metropolitan areas included in the first phase of the program represented approximately 1.0% of KCI’s total revenue for the three months ended March 31, 2008.  We estimate the V.A.C. rentals and sales to Medicare beneficiaries in the 80 designated metropolitan areas included in the second phase of the program represented approximately 5.0% of KCI’s total revenue for the three months ended March 31, 2008.
 
 
Outside of the U.S., most of our revenue is generated in the acute care setting on a direct billing basis.  We are continuing our efforts to obtain reimbursement for V.A.C. Therapy systems and related disposables in the homecare setting in foreign jurisdictions.  These efforts have resulted in varying levels of reimbursement from private and public payers in Germany, Austria, the Netherlands, Switzerland, Canada, South Africa and the UK.  In these jurisdictions and others outside the U.S., we continue to seek expanded homecare reimbursement.  We believe that obtaining expanded homecare reimbursement outside the U.S. is important in order to increase the demand for V.A.C. Therapy systems and related disposables in foreign markets.  Recently, the German Ministry of Health approved a clinical study providing for paid placements of V.A.C. Therapy systems and related disposables, which will allow selected patients to receive V.A.C. Therapy in the home in Germany.  The study will cover patients that transition out of the hospital to the home for post-acute treatment and patients who initiate treatment in the home.  During the study period, KCI will receive reimbursement from German health insurance funds for participating patients.

Competitive Strengths

We believe we have the following competitive strengths:

Innovation and commercialization.  KCI has a successful track record spanning over 30 years in commercializing novel technologies in advanced wound care and therapeutic support systems.  We leverage our competencies in innovation, product development and commercialization to bring solutions to the market that address the critical unmet needs of clinicians and their patients and can help reduce the overall cost of patient care.  We continue to support an active research and development program to advance our understanding of the science of wound healing and the physical and biologic processes that can be influenced to treat a variety of wounds.  Through such efforts, we seek to provide novel, clinically efficacious, therapeutic solutions and treatment alternatives that increase patient compliance, enhance clinician ease of use and ultimately improve healthcare outcomes.  Recent innovations include the launch of the next-generation InfoV.A.C. and ActiV.A.C. therapy systems.

Product differentiation and superior clinical efficacy.  We differentiate our portfolio of products by providing effective therapies, supported by a clinically-focused and highly-trained sales and service organization, which combine to produce clinically-proven superior outcomes.  The superior clinical efficacy of our V.A.C. Therapy systems and our therapeutic support systems is supported by an extensive collection of published clinical studies, peer-reviewed journal articles and textbook citations, which aid adoption by clinicians.  In February 2008, we announced the final efficacy results of a large, multi-center randomized controlled clinical trial utilizing V.A.C. Therapy compared to advanced moist wound therapy, or AMWT, in the treatment of diabetic foot ulcers, which resulted in the following statistically significant results:

·  
a greater proportion of foot ulcers achieved complete ulcer closure with V.A.C. Therapy versus AMWT;
·  
time to wound closure was less with V.A.C. Therapy than with AMWT; and
·  
patients on V.A.C. Therapy experienced significantly fewer amputations than with AMWT.

This study adds to KCI's significant body of clinical data that clearly shows that our V.A.C. Therapy system, including its unique foam dressing, provides clinical advantage for treatment of diabetic foot ulcers, including limb salvage.

KCI also continues to successfully distinguish its products from competitive offerings through unique FDA-approved marketing and labeling claims such as the V.A.C. Therapy system is intended to create an environment that promotes wound healing by preparing the wound bed for closure, reducing edema and promoting granulation tissue formation and perfusion.  Following a review of requested clinical data, new claims were approved by the Food and Drug Administration, or FDA, in 2007 which now specify the use of V.A.C. systems in all care settings, including in the home.  These newly-issued claims are unique to KCI’s V.A.C. systems in the field of NPWT.
 
 
Broad reach and customer relationships.  Our worldwide sales team, consisting of approximately 2,000 team members, has fostered strong relationships with our prescribers, payers and caregivers over the past three decades by providing a high degree of clinical support and consultation along with our extensive education and training programs. Because our products address the critical needs of patients who may seek treatment in various care settings, we have built a broad and diverse reach across all healthcare settings.  We have key relationships with an extensive list of acute care hospitals worldwide and long-term care facilities, skilled nursing facilities, home healthcare agencies and wound care clinics in the United States.

Reimbursement expertise.  A significant portion of our V.A.C. revenue is derived from home placements, which are reimbursed by third-party payers such as private insurance, managed care and governmental payers. We have dedicated significant time and resources to develop a core competency in third-party reimbursement, which enables us to efficiently manage our collections and accounts receivable with third-party payers.  We have over 375 contracts with some of the largest private insurance payers in the U.S.

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

·  
increasing V.A.C. Therapy awareness and adoption among customers and physicians by increasing the number of regular users and prescribers and the extent of use by each customer or physician;
·  
market expansion by educating physicians on new wound indications that may be treated more successfully and economically with the use of V.A.C. Therapy; and
·  
strengthening our contractual relationships with third-party payers.

Extensive service center network.  With a network of 141 U.S. and 67 international service centers, we are able to rapidly deliver our products to major hospitals in the United States, Canada, Australia, Singapore, South Africa, and most major European countries. Our network gives us the ability to deliver our products to any major Level I domestic trauma center within hours. This extensive network is critical to securing contracts with national group purchasing organizations, or GPOs, and the network allows us to efficiently serve the homecare market directly. Our network also provides a platform for the introduction of additional products in one or more care settings.

Recent Developments

On April 7, 2008, we announced the execution of a definitive agreement to acquire LifeCell Corporation, a publicly held company (Nasdaq: LIFC), in a cash transaction valued at approximately $1.8 billion.  Under certain circumstances as defined in the merger agreement, should either party terminate such agreement, KCI may be required to pay or entitled to receive a termination fee of $50.0 million.  In the event we receive a termination fee, a portion may be payable to third parties.  

The planned acquisition will be completed by means of a tender offer for all of the outstanding shares of LifeCell’s common stock, followed by a merger of LifeCell with our merger subsidiary that will result in LifeCell becoming a 100% owned subsidiary of KCI.  Pursuant to the terms of the merger agreement, we commenced the tender offer on April 21, 2008 to purchase all of the outstanding shares of LifeCell’s common stock at a price of $51.00 per share in cash.  KCI’s obligation to consummate the tender offer is conditioned upon the tender of at least a majority of the fully diluted LifeCell shares in the offer, completion and funding of KCI’s financing arrangements described below, and the satisfaction of regulatory and other customary closing conditions. The tender offer will expire at midnight on May 16, 2008, unless extended in accordance with the terms of the tender offer and the applicable rules and regulations of the SEC.  Following the completion of the tender offer, the merger will occur pursuant to which any remaining LifeCell shares would be acquired for $51.00 per share.  The closing of the merger is subject to additional conditions, including, if required under Delaware law, approval of the merger by LifeCell’s stockholders.
 
 
On April 7, 2008, in connection with the merger agreement, KCI and our merger subsidiary entered into a commitment letter, pursuant to which Bank of America, N.A., Banc of America Securities LLC, JPMorgan Chase Bank, N.A. and J.P. Morgan Securities, Inc. committed, subject to the conditions set forth therein, to provide a $1.0 billion term loan credit facility and a $300.0 million revolving credit facility.  The debt commitment letter originally provided for a $1.0 billion Term A credit facility and a $600.0 million Term B credit facility, but as a result of the convertible note offering described below, the term loan commitment is now $1.0 billion.  The commitment is subject to various conditions, including consummation of the acquisition in accordance with the merger agreement and other closing conditions similar to those applicable to the completion of the acquisition. In addition to providing financing for the acquisition, we expect to use the debt financing under the new credit facilities to (i) pay fees and expenses incurred in connection with the acquisition and related transactions, (ii) repay certain indebtedness of KCI and (iii) provide ongoing working capital and provide for other general corporate purposes of the combined company. We expect our obligations under the new credit facilities (i) to be guaranteed by each of the existing and future direct and indirect domestic subsidiaries of KCI, and (ii) to be secured, subject to certain exceptions, by all the capital stock of each of our present and future subsidiaries (limited, in the case of foreign subsidiaries, to 65.0% of the voting stock of such subsidiaries) and all of the present and future property and assets (real and personal) of KCI and the guarantors. The lenders have the right to change the pricing and scheduled amortization of the credit facilities within specified limits, as well as other terms, depending on market conditions.
 
Effective upon the execution of the merger agreement with LifeCell, KCI’s share repurchase program was terminated.  As of April 7, 2008, KCI had repurchased $112.6 million in common stock under the share repurchase program.

Subsequent to the announcement of the merger agreement, on April 14, 2008, a purported stockholders’ class action complaint was filed by a stockholder of LifeCell in the Chancery Division of the Superior Court of New Jersey in Somerset County, naming LifeCell, its directors and KCI as defendants.  The complaint alleges causes of action against the defendants for breach of fiduciary duties in connection with the proposed acquisition of LifeCell by KCI and seeks relief including, among other things, (i) preliminary and permanent injunctions prohibiting consummation of the tender offer and the merger and (ii) payment of the plaintiff’s costs and expenses, including attorneys’ and experts’ fees.  KCI believes that the lawsuit is without merit and intends to defend vigorously against it.

On April 21, 2008, KCI closed its offering of $600 million aggregate principal amount of 3.25% convertible senior notes due 2015.  KCI granted an option to the initial purchasers of the notes to purchase up to an additional $90 million aggregate principal amount of notes to cover over-allotments, which was exercised on May 1, 2008 for the entire $90.0 million aggregate principal amount.  The coupon on the notes will be 3.25% per year on the principal amount. Interest will accrue from April 21, 2008, and will be payable semi-annually in arrears on April 15 and October 15 of each year, beginning October 15, 2008.  The notes will mature on April 15, 2015, unless previously converted or repurchased in accordance with their terms.  The notes are not redeemable by KCI prior to the maturity date.  Upon conversion, holders will receive cash up to the aggregate principal amount of the notes being converted and shares of KCI common stock in respect of the remainder, if any, of KCI’s 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 KCI 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 KCI’s common stock on April 15, 2008 (the day of pricing of the notes), which was $40.27 per share.  In connection with the initial offering and over-allotment exercise, KCI entered into convertible note hedge and warrant transactions with financial institutions that are affiliates of two of the offering’s initial purchasers to increase the effective conversion price of the notes to approximately $60.41, which is approximately 50% higher than the closing price of KCI’s common stock on April 15, 2008.  We intend to settle the principal amount of these notes in cash.

KCI used a portion of the net proceeds from the offering to pay the $48.7 million cost of the convertible note hedge transactions, taking into account the proceeds to KCI from the warrant transactions, and we intend to use the balance of the net proceeds to fund a portion of the purchase price of the proposed acquisition of LifeCell Corporation, repay certain indebtedness of KCI, provide ongoing working capital and provide for other general corporate purposes of the combined company.  Although the initial net cash outlay for the convertible note hedge transactions totals $48.7 million, considering the tax deductibility of the bond hedge, the net present value cost of these hedge transactions totals approximately $7.4 million.
 
 
RESULTS OF OPERATIONS

Revenue by Geographical Segment

The following table sets forth, for the periods indicated, rental and sales revenue by geographical segment, as well as  the percentage change in each line item, comparing the first quarter of 2008 to the first quarter of 2007 (dollars in thousands):

   
Three months ended March 31,
 
               
%
 
   
2008
   
2007
   
Change
 
North America revenue:
                 
Rental
  $ 233,151     $ 216,584       7.6
Sales
    76,312       67,058       13.8  
                         
Total – North America
    309,463       283,642       9.1  
                         
EMEA/APAC revenue:
                       
Rental
    64,688       49,100       31.7  
Sales
    45,865       36,074       27.1  
                         
Total – EMEA/APAC
    110,553       85,174       29.8  
                         
Total rental revenue
    297,839       265,684       12.1  
Total sales revenue
    122,177       103,132       18.5  
                         
Total revenue
  $ 420,016     $ 368,816       13.9

Revenue by Product Line

The following table sets forth, for the periods indicated, rental and sales revenue by product line, as well as the percentage change in each line item, comparing the first quarter of 2008 to the first quarter of 2007 (dollars in thousands):

   
Three months ended March 31,
 
               
%
 
   
2008
   
2007
   
Change
 
V.A.C. revenue:
                 
Rental
  $ 222,097     $ 198,859       11.7
Sales
    110,867       89,704       23.6  
                         
Total V.A.C.
    332,964       288,563       15.4
                         
Therapeutic Support Systems revenue:
                       
Rental
    75,742       66,825       13.3
Sales
    11,310       13,428       (15.8 )   
                         
Total Therapeutic Support Systems
    87,052       80,253       8.5 % 
                         
Total revenue
  $ 420,016     $ 368,816       13.9

The growth in total revenue over the prior-year period was due primarily to increased rental and sales volumes for V.A.C. Therapy systems and related disposables and increased rental volumes of therapeutic support systems.  Foreign currency exchange rate movements favorably impacted total revenue by 3.9% compared to the prior year.

For additional discussion on segment and geographical information, see Note 8 to our condensed consolidated financial statements.
 
 
Revenue Relationship

The following table sets forth, for the periods indicated, the percentage relationship of each item to total revenue in the period, as well as the changes in each line item, comparing the first quarter of 2008 to the first quarter of 2007:

   
Three months ended March 31,
   
2008
   
2007
 
Change
Total revenue:              
North America revenue
    73.7     76.9
(320 bps)
EMEA/APAC revenue
    26.3       23.1  
320 bps 
                   
Total revenue
    100.0     100.0  
                   
V.A.C. revenue
    79.3     78.2
110 bps 
Therapeutic Support Systems revenue
    20.7       21.8  
(110 bps)
                   
Total revenue
    100.0     100.0  
                   
Rental revenue
    70.9     72.0
(110 bps)
Sales revenue
    29.1       28.0  
110 bps 
                   
Total revenue
    100.0     100.0  

North America Revenue

The following table sets forth, for the periods indicated, North America rental and sales revenue by product line, as well as the percentage change in each line item, comparing the first quarter of 2008 to the first quarter of 2007 (dollars in thousands):

   
Three months ended March 31,
 
               
%
 
   
2008
   
2007
   
Change
 
V.A.C. revenue:
                 
Rental
  $ 180,845     $ 168,088       7.6
Sales
    69,377       58,849       17.9  
                         
Total V.A.C.
    250,222       226,937       10.3  
                         
Therapeutic Support Systems revenue:
                       
Rental
    52,306       48,496       7.9  
Sales
    6,935       8,209       (15.5 )   
                         
Total Therapeutic Support Systems
    59,241       56,705       4.5  
                         
Total rental revenue
    233,151       216,584       7.6  
Total sales revenue
    76,312       67,058       13.8  
                         
Total North America revenue
  $ 309,463     $ 283,642       9.1

The growth in North America revenue over the prior-year period was due primarily to increased rental and sales volumes for V.A.C. Therapy systems and related disposables.

Total V.A.C. revenue in North America increased over the prior-year period primarily due to increased rental and sales unit volume due to continued market penetration.  The increase in North America V.A.C. rental revenue was primarily due to a 7.9% increase in rental unit volume compared to the prior-year period.  The increase in North America V.A.C. sales revenue over the prior-year period was due primarily to higher sales volumes for V.A.C. disposables associated with the increase in V.A.C. rental unit volume and the shift in pricing from V.A.C. rental units to V.A.C. disposables associated with our value-pricing offering.  However, the year-over-year growth rate was negatively impacted due to the realignment of our domestic sales force combined with increased competitive activities.  Growth in rental unit volume was reported across all care settings.

Therapeutic Support Systems revenue in North America increased over the prior-year quarter primarily due to higher rental volumes in the acute care setting partially offset by lower surfaces sales in the period due in part to the realignment of our domestic sales force.
 
 
EMEA/APAC Revenue

The following table sets forth, for the periods indicated, EMEA/APAC rental and sales revenue by product line, as well as  the percentage change in each line item, comparing the first quarter of 2008 to the first quarter of 2007 (dollars in thousands):

   
Three months ended March 31,
 
               
%
 
   
2008
   
2007
   
Change
 
V.A.C. revenue:
                 
Rental
  $ 41,252     $ 30,771       34.1
Sales
    41,490       30,855       34.5  
                         
Total V.A.C.
    82,742       61,626       34.3  
                         
Therapeutic Support Systems revenue:
                       
Rental
    23,436       18,329       27.9  
Sales
    4,375       5,219       (16.2 )   
                         
Total Therapeutic Support Systems
    27,811       23,548       18.1  
                         
Total rental revenue
    64,688       49,100       31.7  
Total sales revenue
    45,865       36,074       27.1  
                         
Total EMEA/APAC revenue
  $ 110,553     $ 85,174       29.8

Growth in total EMEA/APAC revenue is due primarily to increased rental and sales volumes for V.A.C. Therapy systems and related disposables and favorable foreign currency exchange rate variances.  Foreign currency exchange rate movements accounted for 13.9% of the increase in total EMEA/APAC revenue in the first quarter of 2008 compared to the prior-year period.

The increase in EMEA/APAC V.A.C. revenue over the prior year was primarily due to higher V.A.C. rental and sales unit volume and favorable foreign currency exchange variances.  Foreign currency exchange rate movements favorably impacted EMEA/APAC V.A.C revenue by 14.3% in the first quarter of 2008 compared to the prior-year period.  The growth in EMEA/APAC V.A.C. rental revenue over the prior-year period was due primarily to a 29.8% increase in rental unit volume.  Higher EMEA/APAC unit volume was partially offset by lower realized pricing due primarily to lower contracted pricing resulting from an increase in long-term rental contracts, GPO pricing pressures and increased competition.  The increase in EMEA/APAC V.A.C. sales revenue over the prior-year period was primarily due to overall increased sales of V.A.C. disposables associated with the increase in V.A.C. rental unit volume.

The increase in EMEA/APAC Therapeutic Support Systems revenue over the prior-year period was primarily due to a 7.7% increase in rental unit volume and foreign currency exchange rate movements which favorably impacted EMEA/APAC Therapeutic Support Systems revenue by 12.7% for the first quarter of 2008 compared to the prior-year period.
 
 
Restated Product Line Revenue by Geographical Segment - 2007

During the first quarter of 2008, we completed the realignment of our geographic reporting structure to correspond with our current management structure.  Beginning this quarter, we are reporting financial results consistent with this new structure, including the reclassification of prior period amounts to conform to this current reporting structure.  The following table sets forth, for the periods indicated, product line revenue by geographical segment, which have been restated to reflect the change in geographic reporting structure (dollars in thousands):

   
Year Ended December 31, 2007
 
   
First
   
Second
   
Third
   
Fourth
 
   
Quarter
   
Quarter
   
Quarter
   
Quarter
 
North America revenue:
                       
   V.A.C.
  $ 226,937     $ 247,275     $ 255,830     $ 262,998  
   Therapeutic Support Systems
    56,705       55,992       56,722       61,171  
                                 
      Total – North America
    283,642       303,267       312,552       324,169  
                                 
EMEA/APAC revenue:
                               
   V.A.C.
    61,626       70,032       73,065       81,860  
   Therapeutic Support Systems
    23,548       23,353       25,263       27,567  
                                 
      Total – EMEA/APAC
    85,174       93,385       98,328       109,427  
                                 
         Total revenue
  $ 368,816     $ 396,652     $ 410,880     $ 433,596  

Rental Expenses

The following table presents rental expenses and the percentage relationship to total revenue comparing the first quarter of 2008 to the first quarter of 2007 (dollars in thousands):

   
Three months ended March 31,
 
   
2008
   
2007
   
Change
 
                   
Rental expenses
  $ 175,274     $ 163,940       6.9
As a percent of total revenue
    41.7 %     44.5 %  
(280
 bps)

Rental, or field, expenses are comprised of both fixed and variable costs.  This decrease in rental expenses as a percent of total revenue was primarily due to a reduced rate of sales force growth, increased service team productivity and lower marketing expenditures and depreciation expense during the first quarter of 2008 compared to the prior-year period.  Our sales and service headcount increased to approximately 3,580 at March 31, 2008 from 3,560 at March 31, 2007, which resulted in a slower growth rate in expenses associated with our sales and service headcount than the rate of revenue growth.

Cost of Sales

The following table presents cost of sales and the sales margin comparing the first quarter of 2008 to the first quarter of 2007 (dollars in thousands):

   
Three months ended March 31,
 
   
2008
   
2007
   
Change
 
                   
Cost of sales
  $ 35,756     $ 33,691       6.1
Sales margin
    70.7 %     67.3 %  
340
 bps

Cost of sales includes manufacturing costs, product costs and royalties associated with our “for sale” products.  The increased sales margin was due to favorable changes in our product mix, the shift in pricing from V.A.C. rental units to V.A.C. disposables associated with our value-pricing offering and favorable manufacturing-related variances in the first quarter of 2008 as compared to the prior-year period.
 
 
Gross Profit Margin

The following table presents the gross profit margin comparing the first quarter of 2008 to the first quarter of 2007:

   
Three months ended March 31,
 
   
2008
   
2007
   
Change
 
                   
Gross profit margin
    49.8 %     46.4 %     340  bps

As a percent of total revenue, lower selling costs, field service expenses, product depreciation, cost of sales and marketing costs made up the majority of the increase in gross profit margin.

Selling, General and Administrative Expenses

The following table presents selling, general and administrative expenses and the percentage relationship to total revenue comparing the first quarter of 2008 to the first quarter of 2007 (dollars in thousands):

   
Three months ended March 31,
 
   
2008
   
2007
   
Change
 
                   
Selling, general and administrative expenses
  $ 95,347     $ 78,213       21.9
As a percent of total revenue
    22.7 %     21.2 %  
150
 bps

Selling, general and administrative expenses include administrative labor, incentive and sales commission compensation costs, insurance costs, professional fees, depreciation, bad debt expense and information systems costs.  The increase in selling, general and administrative expenses, as a percent of total revenue, is due primarily to certain costs associated with the U.S. sales force realignment, additional costs associated with the transition of V.A.C. unit production to our Ireland manufacturing facility and higher share-based compensation expenses.  The increase in share-based compensation expense is due primarily to the annual equity grants made during the first quarter of 2008 and during the second quarter in 2007.

Share-Based Compensation Expense

KCI recognizes share-based compensation expense under the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123 Revised (“SFAS 123R”), “Share-Based Payment,” which was adopted on January 1, 2006 and requires the measurement and recognition of compensation expense over the estimated service period for all share-based payment awards, including stock options, restricted stock awards and restricted stock units based on estimated fair values on the date of grant.

As SFAS 123R requires the expensing of equity awards over the estimated service period, we have experienced an increase in share-based compensation expense as additional equity grants are made, compared to the prior-year period.  In addition, during the first quarter of 2008, we experienced an increase in share-based compensation expense as we made our annual equity grants during the first quarter.  Historically, annual equity grants were made during the second quarter.  Share-based compensation expense was recognized in the condensed consolidated statements of earnings as follows (dollars in thousands, except per share data):

   
Three months ended
 
   
 March 31,
 
   
2008
   
2007
 
             
Rental expenses
  $ 1,469     $ 1,582  
Cost of sales
    148       206  
Selling, general and administrative expenses
    5,949       3,984  
                 
Pre-tax share-based compensation expense
    7,566       5,772  
Less:  Income tax benefit
    (2,324 )     (1,516 )
                 
Total share-based compensation expense, net of tax
  $ 5,242     $ 4,256  
                 
Diluted net earnings per share impact
  $ 0.07     $ 0.06  
 
 
Research and Development Expenses

The following table presents research and development expenses and the percentage relationship to total revenue comparing the first quarter of 2008 to the first quarter of 2007 (dollars in thousands):

   
Three months ended March 31,
 
   
2008
   
2007
   
Change
 
                   
Research and development expenses
  $ 14,715     $ 9,807       50.0
As a percent of total revenue
    3.5 %     2.7 %  
80
 bps

Research and development expenses relate to our investments in clinical studies and the development of new advanced wound healing systems and dressings.  This includes the development of new and synergistic technologies across the continuum of wound care, including tissue healing, preservation and repair, new applications of negative pressure technology, as well as upgrading and expanding our surface technologies in our Therapeutic Support Systems business.

Operating Margin

The following table presents the operating margin comparing the first quarter of 2008 to the first quarter of 2007:

   
Three months ended March 31,
 
   
2008
   
2007
   
Change