Description

KCI long
Summary:
KCI offers a compelling risk/reward opportunity with an upside target of $55+/share (50%+) with minimal downside risk. 

KCI is cheap on both an absolute and relative basis.  On 2010 #s, it trades at 5.6x EV/EBITDA, 6.6x EV/EBITDA-capex, 8.6x eps, 12% FCF yield on equity, 11% yield on enterprise.  While KCI does not have direct comparables given its high market share, competitors trade at 7.5-8.5x EBITDA and 12-15x eps.  Direct competitors for KCI include Smith & Nephew (wound healing), CR Bard (reconstructive tissue), and Stryker and Hill-Rom (specialty beds), while other potential comparables include medical device and supplies manufacturers including Teleflex, Covidien, Steris, Alere, and Baxter.  

Investor fears about market share, pricing, and patent strength (described below) have driven the low valuations at KCI.  Quantifying these concerns shows that they are overblown (see analysis below), as the company should be able to produce earnings growth under most scenarios, before accounting for new product introductions.  The company increased R&D spending from 2.6% of revenue in 2006-2007 to 4.6% in 2009, and a slate of new products are now being introduced.  These products have the potential to drive significant growth over the next few years.  As the company continues to produce strong earnings and begins to see growth accelerate from new products, the discount to competitors and low absolute valuation should correct.  Each 1x increase in EV/EBITDA multiple is worth approximately $9/share to KCI and each 1x increase in P/E is worth $4.20/share.  Even under a very bearish scenario where KCI fails to grow, it still generates substantial free cash flow and rapidly de-levers.

Background - the Parts:
KCI is a leading provider of products used to promote healing.  The company has three main divisions - Active Healing Systems (AHS), Regenerative Medicine (LifeCell), and Therapeutic Support Systems (TSS). 

AHS primarily sells products that use negative pressure wound therapy (NPWT) technology - which is a vacuum pump-based technology that promotes more rapid healing of severe or complex wounds.  The company rents Vacuum Assisted Closure (VAC) branded pumps and also sells corresponding disposable products.  Approximately 55% of AHS business is done in home care setting, 30% in hospitals, and 15% in assisted living facilities.  AHS produced approximately $1.4b of revenue, $500m of EBITDA, and $480m of EBITDA-capex in 2009.  Historic growth of 5-6% has recently slowed as market pressures (fewer procedures, pricing pressures) and competitive pressures (primarily Smith & Nephew) have offset traditional volume growth and geographic expansion.  VAC pumps maintain approximately 85% market share and are supported by patents that expire in 2012 (international) and 2014 (US).  AHS is currently launching new products that expand its addressable market including VAC Via and Ulta ($1b stated opportunity), Prevena ($1b stated opportunity), and ABThera ($400m stated opportunity), and it is expanding geographically in Japan ($500m sated opportunity).  Other new product introductions and geographic expansion are expected over the next few years.

Regenerative Medicine is largely comprised of LifeCell, a company purchased in 2008.  Alloderm and Strattice are the two primary products in regenerative medicine and are used as tissue matrices for reconstruction or tissue repair procedures.  Challenging hernia repair and breast reconstruction are the primary sources of revenue for LifeCell today, although the company plans to expand into other procedures.  Regenerative Medicine produced approximately $286m of revenue, $140m of EBITDA, and $130m of EBITDA-capex in 2009 and is growing at a high-teens rates.  The company expects to continue to grow at high teens rates through continued penetration of existing procedures, new procedures, and geographic growth.

TSS provides specialty hospital beds, mattresses, and overlays.  TSS specializes in intensive care beds, bariatric beds, and wound care surfaces.  TSS primarily rents its beds to hospitals and other medical facilities.  TSS produced $300m of revenue, $81m of EBITDA, and $66m of EBITDA-capex in 2009.  TSS has been shrinking in mid single digits the last couple years due to fewer procedures and spending pressures at hospitals.  TSS competes against Hill-Rom and Stryker.

SOTP:
Summing the parts shows AHS (70% of revenue) trades cheap.  If LifeCell is worth $1.7b (12x 2009 EBITDA and about the amount KCI paid in 2008 for LifeCell- $1.8b) and TSS is worth $500-600m (approximately 7x EBITDA), then AHS trades at approximately 3.3x EBITDA.

Why KCI Trades Cheap:
KCI stock has performed poorly due to a few primary concerns:

Competition in AHS segment.  Smith & Nephew (BlueSky) has been the primary competitor in the market but other competitors also sell product.  However, KCI has lost little share over the last few years (still has 85% share) because clinical data overwhelmingly supports the use of VAC therapies (vs other treatments), KCI has extensive infrastructure supporting its VAC products (1,300 sales and support reps), and clinicians prefer KCI products/service.  Through the recession, AHS has still grown.

Patent expiration for VAC.  VAC is supported by Wake Forest patents, however, competition has ignored these patents and introduced their own vacuum based foam technology.  KCI and Smith & Nephew have been fighting in the courts as KCI has tried to enforce its patents, with KCI winning a US jury trial in March 2010 that subsequently was reversed in October 2010 by the district court.  KCI is likely to appeal this district court decision, which probably adds another two years until the legal fight is concluded (or probably sometime in 2013).  The primary patents would expire in 2014 in the US regardless of the court outcome.  Outside the US, KCI has not been successful in the courts, but those patents begin to expire in 2012 anyway.  The introduction of Via and Ulta are designed to transition customers to new technologies that have superior performance while providing KCI with patent protection that extends another 10+ years.

Reimbursement pressure in AHS segment.  Medicare is in the process of reducing reimbursement rates for a variety of treatments through several rounds of competitive bidding.  KCI was not included in the first round of bidding but is expected to be included in the second round - which was expected to be announced this fall and was expected to take effect in 2013.  However, there have been significant problems with the bidding process, and it appears that delays in the second round (and potentially first round) are likely.  Nonetheless, KCI reduced its pricing to Medicare by 9.5% during the first round of bidding and expects to see reimbursement cuts from Medicare eventually - regardless of the competitive bidding process.

TSS business has shrunk.  TSS has been a drag on KCI earnings and the company has considered the sale of the business in the past.

Quantifying Downside Risks:
Competition in AHS segment - $40m to $170m of EBITDA at risk.  AHS has $1,400m of revenue.  In the base case, the market grows 3% per year for three years and KCI loses 5% share per year.  In the downside case, the market is flat and KCI loses 10% per year.  Incremental margins are assumed to be 45% on lost sales.  The 5% and 10% market share loss assumptions are far in excess of KCI's experience to date.

Patent expiration - this is essentially the same issue as competition so the loss is included in the numbers above.  It is important to note that KCI has essentially operated as if it had no patent in the last few years as competitors (notably Smith & Nephew) have sold products based on the foam/pump technology used in VAC.  KCI has not lost much market share despite this.

Reimbursement pressure - $30m to $60m of EBITDA at risk from Medicare.  Medicare accounts for 15% of AHS revenue or approximately $210m.  A 15% to 30% price reduction is assumed in base and downside case.

Private pay price pressure - an additional $45m to $180m of EBITDA at risk from non-Medicare payers.  For the ~$890m of non-Medicare business, a 10% to 20% price reduction is assumed.  KCI did not experience price reductions from private payers after the voluntary cuts to Medicare during the round 1 discussions.  However, to be conservative, a reduction is modeled.  It is worth noting though that it is not likely to occur until some time after 2013 given that the Medicare reduction will not be announced until then (at the earliest if the problems with Medicare reimbursement biddings continue).

TSS business shrinks - $10m to $20m of EBITDA at risk.  This assumes that KCI is not able to fix TSS cost structure, new products fail to generate material sales, and KCI loses some market share.

Offsetting EBITDA Factors:
Offsetting these risks are royalty recovery and growth in Japan and LifeCell.  KCI pays approximately 7-8% royalty for the Wake Forest patents for VAC.  Assuming 50% to 75% of these royalty payments stop, EBITDA improves by $50m to $85m.  Japan is expected to generate $100m of revenue in 3 years for VAC.  Assuming that Japan achieves $75m to $100m of revenue and delivers below average margins of 30-40%, yields an incremental EBITDA of $25m to $40m.  Regenerative medicine can continue to grow 15-20% per year.  Assuming that LifeCell margins do not improve with increased scale, LifeCell contributes another $100m to $170m of EBITDA.

Summing all this up, KCI EBITDA is up $50m in the base case and down $140m in the downside case - but this is before accounting for any of the new product launches.  Assuming that KCI continues to produce $300m of FCF per year over the next 3 years, KCI would then trade at 4.0x EBITDA and 4.6x EBITDA-capex in the base case and 5.0x EBITDA and 6.8x EBITDA-capex in the downside case.  And in either case, KCI would be essentially unlevered.

New product growth is tougher to estimate, but the opportunities can be very significant.  Using conservative assumptions for the key products introduced to date, yields another $40m to $185m of EBITDA.  Via and Ulta could together generate $50m to $250m revenue in the next three years and could contribute 30-50% incremental margin.  Prevena and ABThera could easily contribute another $50m to $100m and 50-60% margin.  This analysis does not account for other new geographies, new procedures for LifeCell, and other new products.  The point is that KCI should be able to generate substantial incremental EBITDA from new products.

Bridging everything yields +$240m of EBITDA to -$100m of EBITDA by 2013 or an EBITDA range of $530m to $870m.  The assumptions above are all relatively severe to give as much credit to the downside scenario as possible.  Most of the downside risks to EBITDA will not occur until 2013 or after, while much of the upside risk is more near term.  KCI will generate approximately $300m of FCF per year.   So KCI would trade at 3.1x to 5.0x EBITDA and 3.5x to 6.1x EBITDA-capex. 

Valuation:
At $55/share, KCI would trade at 7.5x EBITDA and 13x eps on 2010.  This would be 50% upside and KCI would still trade at the low end of competitive valuations.  Alternatively, at 7x 2013 EBITDA of $870m, KCI would be valued at $85/share, or $60/share discounting this back 2-3 years.

Downside case assumes KCI trades at 5.5x 2013 EBITDA of $530m.  The stock would be essentially flat in that case in 3 years.  Discounting this back 2-3 years would yield approximately $28/share in fair value terms.

So KCI has a risk/return of -$9/share to +$18/share.  The skew should be to the upside given the conservative bias in the estimates used in the analysis. 

Potential Catalysts:
Company demonstrates renewed growth.  This could be from new products, new geographies, or new procedures for existing products.

CMS round 1/round 2 bidding process developments.  Problems have occurred with round 1 and delays in either round 1 or round 2 are possible.

KCI re-levers.  In the last 15 years, KCI has essentially levered up 3 times:  an LBO in 1997 by Fremont Partners and Blum Capital, in 2003 through a recapitalization by the same private equity funds, and in 2008 with the acquisition of LifeCell.  KCI could choose to lever up again to buy shares or issue dividends.

Sale of TSS.  The company has considered this in the past.

Risks:
Highlighted above.

Catalyst