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|  | DECEMBER 14, 2004
 FOCUS STOCK By Robert Gold Kinetic Concepts Makes the Cut Earnings are good, patents secure, and market acceptance is expanding. What's not to like about the stock of this wound-care outfit? We at Standard & Poor's Equity Research believe Kinetic Concepts (KCI; recent price, $69) represents a compelling midcap name among the health-care companies we follow. We anticipate that market-share gains for the outfit's advanced wound-care system will drive substantial revenue and earnings growth in coming years. With a valuation below similar mid-cap growth names in our medical-device coverage universe, we believe there is significant upside potential for the shares. Based on our belief that Kinetic offers relatively high revenue and earnings visibility, and strong patent protection with few near-term direct competitive threats, we anticipate capital returns over the next 12 months will exceed both the S&P 500 stock index and our medical-device group. The stock carries Standard & Poor's highest investment recommendation of 5 STARS, or strong buy. FASTER HEALING. Kinetic makes, markets, and services a range of proprietary products designed to improve clinical outcomes, while reducing the overall cost of patient care by accelerating the body's healing process or preventing complications. The company generates revenues through the sale and rental of products in two primary categories: advanced wound-care and therapeutic surfaces. The advance wound-care systems incorporate vacuum-assisted closure (VAC), technology, which uses negative pressure, or vacuum, to stimulate the healing process in serious wounds subject to infection and other complications. The system consists of a therapy unit and four types of disposables: a foam dressing, an occlusive drape, a tube system connecting the dressing to the therapy unit, and a canister. Negative-pressure therapy is delivered to the wound site through a proprietary foam dressing cut to fit the wound size. When applied, the system increases blood flow to the wound, helping to promote the growth of granulation tissue, or small projections of tiny blood vessels and connective tissue that form on the surfaces of a wound during the healing process. The system can also help close superficial wounds where excessive granulation is undesirable. It also removes and collects fluid around the wound, decreasing excessive fluid collection in the skin and reducing the likelihood of infection. As a result, healing times are accelerated, infection rates lowered, and expensive hospital stays reduced. PATENT ENDORSEMENT. Within the acute-care setting, the company's VAC products are used to treat serious trauma wounds, failed surgical closures, amputations, burns, and serious pressure ulcers. In the extended-care and home-care settings, different types of wounds, with different treatment implications are treated with V.A.C. These include nonhealing chronic wounds, diabetic ulcers, arterial and venous insufficiency wounds, and pressure ulcers that do not always respond to traditional therapies such as hydrocolloids, hydrogels, and alginates. We believe the U.S. market opportunity for VAC. is about $2.5 billion to $2.7 billion. We estimate about 13% of the wounds considered candidates for V.A.C. therapy are currently treated with the system. Assuming the upcoming release of clinical studies being conducted by the company support the use of V.A.C. across a wide range of wound categories, we think Kinetic has the opportunity to capture about 15% of the addressable wound care market. Under an exclusive, worldwide agreement with Wake Forest University, Kinetic can use, lease, sell, or sublicense certain patent rights to the V.A.C. technology incorporated into the company's V.A.C. products, in return for a 7% royalty payment to Wake Forest on all V.A.C. sales. The patents do not begin to expire until 2013. The European Patent Office has validated the company's patent position in two recent rulings, and we believe the overall patent protection is strong. Within the other product categories, we look for more modest growth but significant levels of operating cash flow. We expect the therapeutic-surfaces segment (offering products for pressure relief and pressure reduction in the treatment of various skin conditions) and bariatric-products segment (products are designed to accommodate obese individuals within a health-care facility) to generate sales growth in the mid single digits through 2006. SOARING EARNINGS. However, we believe these segments have the capacity to provide Kinetic with an operating cash-flow yield of about 7% to 8% per annum. In our view, this cash will be an important component of the company's strategy of retiring debt and funding both SG&A and R&D expenditures. We also think the broad service-center infrastructure developed by the therapeutic-surfaces business is helping the company gain added penetration in trauma centers throughout the U.S. We project sales of $995.9 million in 2004, up from $763.8 million in 2003, on an expected 45% gain in revenues from the sale and rental of V.A.C. systems and a 12% increase in sales of therapeutic surfaces and bariatric products. For 2005, we look for an approximate 24% revenue gain, as a 32% advance in V.A.C. revenues is augmented by a 7% advance in other categories. The majority of VAC revenues should come from the U.S., but we anticipate increased contributions from Japan and Europe over the coming five years. We believe a continued sales-mix shift toward the VAC systems, and the associated increase in gross-profit margins, along with continued debt reductions, will allow the company to generate three-year average earnings per share gains of 29%, well above the 17% average for our device coverage. The company recorded net gains of $106.4 million in the fourth quarter of 2002 and $46.9 million in the fourth quarter of 2003 in connection with two separate payments from the settlement of an antitrust lawsuit with Hillenbrand Industries (HB ) and its wholly owned subsidiary, Hill-Rom Co. After removing those amounts, the discrepancy between Standard & Poor's Core EPS and the company's operating EPS was significant, but is not, in our view, an indicator of poor earnings quality. We project stock-option expenses would lower operating EPS by 8 cents in 2004 and 11 cents in 2005. In our opinion, Kinetic's exposure to stock-option expensing is modest relative to our medical-device coverage.
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