-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, OgdvTsNQ25hbEzmV7CPXY/5UALcKS8mpK678Fb0VjjLV6qNZTjh56/kzCFKrJesS HMBQccz46BB3DrHLz5ambA== 0000831967-99-000002.txt : 19990402 0000831967-99-000002.hdr.sgml : 19990402 ACCESSION NUMBER: 0000831967-99-000002 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 7 CONFORMED PERIOD OF REPORT: 19981231 FILED AS OF DATE: 19990331 FILER: COMPANY DATA: COMPANY CONFORMED NAME: KINETIC CONCEPTS INC /TX/ CENTRAL INDEX KEY: 0000831967 STANDARD INDUSTRIAL CLASSIFICATION: MISCELLANEOUS FURNITURE & FIXTURES [2590] IRS NUMBER: 741891727 STATE OF INCORPORATION: TX FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: SEC FILE NUMBER: 001-09913 FILM NUMBER: 99582049 BUSINESS ADDRESS: STREET 1: 8023 VANTAGE DR CITY: SAN ANTONIO STATE: TX ZIP: 78230 BUSINESS PHONE: 2103083993 MAIL ADDRESS: STREET 1: P. 0. B0X 659508 CITY: SAN ANTONIO STATE: TX ZIP: 78230 10-K 1 2 SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K (Mark One) [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 [FEE REQUIRED] For the fiscal year ended December 31, 1998 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 [NO FEE REQUIRED] For the transition period from ________________ to _________________ Commission file number 1-9913 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, TX 78230 (210) 524-9000 - ------------------------------- --------------------------------- (Address of principal executive (Registrant's telephone number) offices and zip code) Securities registered pursuant to Section 12(b) of the Act: NONE Securities registered pursuant to Section 12(g) of the Act: NONE 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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendments to this Form 10-K. [ ] As of March 1, 1999, there were 70,915,008 shares of the Registrant's Common Stock outstanding, of which 70,515,008 were held by affiliates. FORM 10-K TABLE OF CONTENTS PART I PAGE Item 1. Business..................................... 4 Item 2. Properties................................... 17 Item 3. Legal Proceedings............................ 17 Item 4. Submission of Matters to a Vote of Security Holders.......................... 19 PART II Item 5. Market for Registrant's Common Equity and Related Stockholder Matters.............. 19 Item 6. Selected Financial Data...................... 20 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations 22 Item 7a. Quantitative and Qualitative Disclosures about Market Risk............................ 36 Item 8. Financial Statements and Supplementary Data......................................... 38 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure....... 82 PART III Item 10. Directors and Executive Officers of the Registrant................................... 83 Item 11. Executive Compensation....................... 85 Item 12. Security Ownership of Certain Beneficial Owners and Management........................ 87 Item 13. Certain Relationships and Related Transactions................................. 88 PART IV Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K...................... 89 Signatures............................................... 92 TriaDyne(R), TriaDyne(R) II, BariKare(R), The V.A.C.(R), PlexiPulse(R), PlexiPulse, All-in-1 System TM, KinAir(R) III, KinAir(R) IV, FirstStep (R), FirstStep(R) Plus, FirstStep(R) Select, FirstStep(R) MRS, TheraPulse(R), TheraPulse(R) II, BioDyne(R), BioDyne(R)II, FluidAir(R) Plus, FluidAir(R) Elite, RotoRest(R), Q2 Plus(R), HomeKair(R) DMS, DynaPulse(R), FirstStep(R) TriCell, Impression (R) SR, RotoRest(R) Delta, PediDyne(R), BariAire(R), FirstStep(R) Select Heavy Duty, FirstStep (R) Advantage, TriCell(R), RIK(R) and AirWorks(R) Plus, are trademarks of the Company used in this Report. Kinetic Therapy SM, The Clinical Advantage SM, Genesis SM and Odyssey SM are service marks of the Company used in this Report. CAUTIONARY STATEMENT FOR PURPOSES OF THE "SAFE HARBOR" PROVISIONS OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995 The Private Securities Litigation Reform Act of 1995 provides a "safe harbor" for certain forward-looking statements. The forward-looking statements made in "Business", "Legal Proceedings" and "Management's Discussion and Analysis of Financial Condition and Results of Operations," which reflect management's best judgment based on market and other factors currently known, involve risks and uncertainties. When used in this Report, the words "estimate," "project," "anticipate," "expect," "intend," "believe" and similar expressions are intended to identify forward-looking statements. All of these forward-looking statements are based on estimates and assumptions made by management of the Company, which, although believed to be reasonable, are inherently uncertain. Therefore, undue reliance should not be placed upon such estimates and statements. No assurance can be given that any of such statements or estimates will be realized and actual results will differ from those contemplated by such forward-looking statements. PART I Item 1. Business - ----------------- General Kinetic Concepts, Inc. (the "Company" or "KCI") is a worldwide leader in innovative therapeutic systems which prevent and treat the complications of immobility that can result from disease, trauma, surgery or obesity. The Company's clinically effective therapeutic systems include specialty hospital beds, specialty mattress overlays and non-invasive medical devices combined with on-site patient care consultation by the Company's clinically-trained staff. The complications of immobility include pressure sores, pneumonia and circulatory problems which can increase patient treatment costs by as much as $75,000 and, if left untreated, can result in death. The Company's therapeutic systems can significantly improve clinical outcomes while reducing the cost of patient care by preventing these complications or accelerating the healing process and by providing labor savings. The Company has also been successful in applying its therapeutic expertise to bring to market innovative medical devices that treat chronic wounds and help prevent blood clots. The Company designs, manufactures, markets and services its products, many of which are proprietary. KCI's therapeutic systems are used to treat patients across all health care settings including acute care hospitals, extended care facilities and patients' homes. Health care providers generally prefer to rent rather than purchase the Company's products in order to avoid the ongoing service, storage and maintenance requirements and the high initial capital outlay associated with purchasing such products, as well as to receive the Company's high-quality clinical support. The Company can deliver its therapeutic systems to any major domestic trauma center within two hours of notice through its network of service centers. Founded by James R. Leininger, M.D., an emergency room physician, to provide better care for his patients, the Company was incorporated in Texas in 1976. The Company's principal offices are located at 8023 Vantage Drive, San Antonio, Texas 78230 and its telephone number is (210) 524-9000. On November 5, 1997, a substantial interest in the Company was acquired by certain affiliates of Fremont Partners L.P. ("Fremont") and Richard C. Blum & Associates, L.P. ("RCBA"). Fremont, RCBA, Dr. James Leininger and Dr. Peter Leininger own approximately 28.0 million, 18.4 million, 23.6 million and 0.4 million common shares, respectively, representing 39.7%, 26.2%, 33.5% and 0.6% of the total shares outstanding. Members of management have retained, and have been granted, additional options to purchase shares. Corporate Organization In 1998, the Company had three operating divisions: KCI Therapeutic Services, Inc. ("KCI Therapeutic Services" or "KCTS"), KCI International, Inc. ("KCI International") and KCI New Technologies, Inc. ("NuTech"). KCI Therapeutic Services KCI Therapeutic Services provides a broad line of therapeutic specialty support surfaces to patients in acute and sub-acute facilities as well as extended care settings. This division consists of approximately 1,100 personnel, many of whom have a medical or clinical background. Sales are generated by a sales force of approximately 320 individuals who are responsible for new accounts in addition to the management and expansion of existing accounts. A portion of this field organization is focused exclusively on either the acute and home care markets or the extended care market. KCI Therapeutic Services has a national 24-hour, seven days-a-week customer service communications system which allows it to quickly and efficiently respond to its customers' needs. The Company distributes its specialty patient support surfaces to acute and extended care facilities through a network of 141 domestic service centers. The KCTS service centers are organized as profit centers and the general managers who supervise the service centers are responsible for both sales and service operations. Each center has an inventory of specialty beds and overlays which are delivered to the individual hospitals or extended care facilities on an as-needed basis. The KCTS sales and support staff is comprised of approximately 250 employees with medical or clinical backgrounds. The principal responsibility of approximately 120 of these clinicians is making product rounds and participating in creating treatment protocols. These clinicians educate the hospital or long-term facility staff on issues related to patient treatment and assist in the establishment of protocols. The clinical staff makes approximately 200,000 product rounds annually. KCTS accounted for approximately 69%, 70% and 68%, respectively, of the Company's total revenue in the years ended December 31, 1998, 1997 and 1996. KCI has developed a continuum of products that address the unique demands of the home health care market. KCTS, through its Home Care group, distributes products primarily through home medical equipment ("HME") dealers. The Company believes that selling products through the home care provider network gives it access to a larger patient population and improves the overall contribution from this business segment despite a reduction in per patient revenue. KCI International KCI International offers the Company's therapies and services in 12 foreign countries including Germany, Austria, the United Kingdom, Canada, France, the Netherlands, Switzerland, Australia, Italy, Denmark, Sweden, and Ireland. In addition, relationships with 75 independent distributors in Latin America, the Middle East, Asia and Eastern Europe allow KCI International to service the demands of a growing global market. KCI International accounted for approximately 24%, 23% and 25%, respectively, of the Company's total revenue in the years ended December 31, 1998, 1997 and 1996. NuTech NuTech manufactures and markets a number of circulatory medical devices including the PlexiPulse and PlexiPulse All-in-l System. The NuTech products are sold through a direct sales force and a limited number of independent distributors and rented through an alliance with MEDIQ/PRN, a national medical device rental company with a strong portfolio of national accounts. NuTech accounted for approximately 7%, 6% and 6% of the Company's total revenue in 1998, 1997 and 1996, respectively. Therapies The Company's therapeutic systems deliver one or more of the following therapies: Pressure Relief/Pressure Reduction. The Company's pressure relief and pressure reduction surfaces provide effective skin care therapy in the treatment of pressure sores, burns, skin grafts and other skin conditions and help prevent the formation of pressure sores which develop in certain immobile individuals. The Company's beds and mattress overlays reduce the amount of pressure at any point on a patient's skin by using surfaces supported by air, silicon beads, or a viscous fluid. Some of the products further promote healing through pulsation. Pulmonary Care. The Company's pulmonary care systems provide Kinetic Therapy to help prevent and treat acute respiratory problems, such as pneumonia, by reducing the build-up of fluid in the lungs. The United States Center for Disease Control (the "CDC") defines Kinetic Therapy as the lateral rotation of a patient by at least 40 degrees to each side (a continuous 80 degree arc). Some of the Company's products combine Kinetic Therapy with additional therapies such as percussion and pulsation which help loosen mucous buildup and promote circulation. Bariatric Care. The Company offers a line of bariatric care products which are designed to accommodate obese individuals. These products are used generally for patients weighing from 300 to 600 pounds, but can accommodate patients weighing nearly 1,000 pounds. These individuals are often unable to fit into standard-sized beds and wheelchairs. The Company's most sophisticated bariatric care product can serve as a bed, chair, scale and x-ray table, helps patients enter and exit the bed, and contains other features which permit patients to be treated safely and with dignity. Moreover, treating obese patients is a significant staffing issue for many health care facilities because moving and handling these patients increases the risk of worker's compensation claims by such personnel. Management believes that these products enable health care personnel to treat these patients in a manner which is safer for hospital personnel than traditional methods, which can help reduce worker's compensation claims. Some of the bariatric products also address complications of immobility and obesity such as pressure sores. Closure of Chronic Wounds. The Company is the provider of a patented, non-invasive device which uses subatmospheric pressure to promote the healing of chronic wounds. This pressure is applied through a proprietary foam dressing which draws the tissue together, stimulates blood flow, reduces swelling and decreases bacterial growth. The device heals wounds more quickly than traditional methods and has been effective at closing chronic wounds which have, in some cases, been open for years. Circulatory Improvement. The Company offers a non-invasive device which improves blood circulation, decreases swelling in the lower extremities and reduces the incidence of blood clots. The therapy is accomplished by wrapping an inflatable cuff around a foot or leg and then automatically inflating and deflating the cuff at prescribed intervals. The products are often used by individuals who have had hip or knee surgeries, diabetes, or other conditions which reduce circulation. Products The Company's "Continuum of Care" is focused on treating wound care patients, pulmonary patients, large or obese patients and patients with circulatory problems by providing innovative, outcome driven therapies across multiple care settings. Pressure Relief/Pressure Reduction The Company's pressure relief products include a variety of framed beds and overlays such as the KinAir III and IV, TheraPulse I and II, FluidAir Elite, First Step TriCell, DynaPulse, First Step Plus, First Step Select, First Step Advantage, Impression SR and RIK Fluid mattress and overlay. The KinAir III has been shown to provide effective skin care therapy in the treatment of pressure sores, burns and post operative skin grafts and flaps, and to help prevent the formation of pressure sores and certain other complications of immobility. The TheraPulse provides a more aggressive form of treatment through a continuous pulsating action which gently massages the skin to help improve capillary and lymphatic circulation in patients suffering from severe pressure sores, burns, skin grafts or flaps, swelling or circulation problems. The FluidAir Elite supports the patient on a low-pressure surface of air-fluidized silicon beads providing pressure relief for skin grafts or flaps, burns and pressure sores. The DynaPulse is a pulsating mattress replacement system that helps prevent pressure ulcers in patients at high risk for skin breakdown and can also be used to treat existing pressure ulcers. The First Step family of overlays is designed to provide pressure relief and help prevent pressure sores. AirWorks Plus is a low-cost overlay which has air chambers which assist in redistributing pressure for better skin care. Impression is a self-contained for-sale product for the prevention of pressure sores which is intended to replace standard hospital mattresses. The RIK mattress and the RIK overlay are non-powered products that provide pressure relief using a patented viscous fluid and an anti-shear layer. Pulmonary Care The CDC defines Kinetic Therapy as lateral rotation of a patient by at least 40 degrees on each side (a continuous 80 degree arc). The Company believes Kinetic Therapy is essential to the prevention or effective treatment of pneumonia and other pulmonary complications in immobile patients. The Company's Kinetic Therapy products include the TriaDyne, TriaDyne II, RotoRest Delta, PediDyne, and Q2 Plus. The TriaDyne, introduced in mid-1995, provides patients mainly in acute care settings with three distinct therapies on an air suspension surface. The TriaDyne applies Kinetic Therapy by rotating the patient up to 40 degrees to each side and provides an industry-first feature of simultaneously turning the patient's torso and lower body in opposite directions while keeping the patient positioned in the middle of the bed. The TriaDyne can also provide percussion therapy to the patient's chest to loosen mucous buildup in the lungs and pulsating therapy to promote capillary circulation. The TriaDyne is built on Stryker Corporation's critical care frame, which is well suited to an ICU environment. The TriaDyne offers several other novel features not available on other products. The RotoRest Delta is a specialty bed which can rotate a patient up to a 62 degree angle on each side for the treatment of pulmonary complications and prevention of pneumonia. The RotoRest has been shown to improve the care of patients suffering from multiple trauma, spinal cord injury, severe pulmonary complications, respiratory failure and deep vein thrombosis. Bariatric Care The Company markets a line of therapeutic support surfaces and aids for patients suffering from obesity, a market that had previously been underserved. These products provide the proper support needed by obese patients, and enable nurses to care for obese patients in a dignified manner. The use of the Company's bariatric products also helps to prevent injuries to hospital staff and decreases the number of staff members needed to treat larger patients. The most advanced product in this line is the BariAir Therapy System, which can serve as a bed, cardiac chair, scale or x-ray table. The BariAir provides low air loss pressure relief, continuous turn assistance and step-down features designed for both patient comfort and nurse assistance. This product is used generally for patients weighing from 300 to 600 pounds but can be used for patients who weigh up to nearly 850 pounds. The Company believes that the BariAir is the most advanced product of its type available today. In 1996, the Company introduced the FirstStep Select Heavy Duty overlay which incorporates pressure-relieving therapy in a design that supports patients weighing up to 650 pounds. Closure of Chronic Wounds The Company manufactures and markets the Vacuum Assisted Closure device (the "V.A.C."), a non-invasive, active wound closure therapy that utilizes sub atmospheric pressure. The V.A.C. promotes healing in wounds, pressure ulcers and grafts that frequently do not respond to traditional methods of treatment. Treatment protocols with the V.A.C. call for a proprietary foam material to be fitted and placed in or on top of a wound and covered with an airtight, occlusive dressing. The foam is attached to a vacuum pump. When activated, the vacuum pump creates a subatmospheric pressure in the wound that draws the tissue together. This vacuum action also stimulates blood flow on the surface of the wound, reduces edema and decreases bacterial colonization, all of which stimulate healing. The dressing material is replaced every 48 hours and fitted to accommodate the decreasing size of the wound over time. This is a significant improvement over the traditional method for treating wounds which requires the nursing staff to clean and dress a serious wound every 8 to 12 hours. Circulatory Improvement The PlexiPulse and PlexiPulse All-in-1 System are non-invasive vascular assistance devices that aid venous return by pumping blood from the lower extremities to help prevent deep vein thrombosis ("DVT") and re-establish microcirculation. The pumping action is created by compressing specific parts of the foot or calf with specially designed inflatable cuffs that are connected to a separate pump unit. The cuffs are wrapped around the foot and/or calf and are inflated in timed increments by the pump. The intermittent inflation compresses a group of veins in the lower limbs and boosts the velocity of blood flowing back toward the heart. This increased velocity has been proven to significantly decrease formation of DVT in non-ambulatory post-surgical and post-trauma patients. The PlexiPulse is effective in preventing DVT, reducing edema and improving lower limb blood circulation. Competition The Company believes that the principal competitive factors within its markets are product efficacy, cost of care, clinical outcomes and service. Furthermore, the Company believes that a national presence with full distribution capabilities is important to serve large, sophisticated national and regional health care group purchasing organizations ("GPOs") and providers. The Company contracts with both proprietary hospital groups and voluntary GPOs. Proprietary groups own all of the hospitals which they represent and, as a result, can ensure compliance with a national agreement. Voluntary GPOs negotiate contracts on behalf of member hospital organizations but cannot ensure that their members will comply with the terms of a national agreement. Approximately 46% of the Company's total revenue during 1998 was generated under national agreements with proprietary groups and voluntary GPOs in the acute and extended care settings. The Company competes on a national level with Hill-Rom, Kendall and Invacare and on a regional and local level with numerous other companies. In the U.S. specialty surface market and certain international markets, the Company competes principally with Hill-Rom. The Company competes principally with Invacare in the home care segment. NuTech competes primarily with Kendall International in the foot and leg compression market. Market Outlook Health Care Reform There are widespread efforts to control health care costs in the United States and abroad. For example, the Balanced Budget Act of 1997 (the "BBA") significantly reduces the annual increases in federal spending for Medicare and Medicaid over the next five years by: a) reducing annual payment updates to acute care hospitals, b) changing payment systems for both skilled nursing facilities and home health care services from cost-based to prospective payment systems, c) eliminating annual payment updates for durable medical equipment ("DME") and d) allowing states greater flexibility in controlling Medicaid costs at the state level. The general effect of the BBA has been to place increased pricing pressure on the Company and its customers. In particular, the changes in the manner Medicare Part A reimburses skilled nursing facilities ("SNFs") has changed dramatically the manner in which the Company's SNF customers make renting and purchasing decisions. The Company also believes it is likely that efforts by governmental and private payors to contain costs through managed care and other efforts and to reform health systems will continue in the future. Consolidation of Purchasing Entities One of the most tangible results of the health care reform debate in the United States has been to cause health care providers to examine their cost structures and reassess the manner in which they provide health care services. This review, in turn, has led many health care providers to merge or consolidate with other members of their industry in an effort to reduce costs or achieve operating synergyies. A substantial number of the Company's customers, including proprietary hospital groups, group purchasing organizations, hospitals, national nursing home companies and national home health care agencies, have been affected by this consolidation. An extensive service distribution network and broad product line is key to servicing the needs of these larger provider networks. In addition, the consolidation of health care providers often results in the renegotiation of contracts and in the granting of price concessions. Finally, as group purchasing organizations and integrated health care systems increase in size, each contract represents a greater concentration of market share and the adverse consequences of losing a particular contract increases considerably. Reimbursement of Health Care Costs The Company's products are rented and sold principally to hospitals, skilled nursing facilities and DME suppliers who receive reimbursement for the products and services they provide from various public and private third party payors, including Medicare, Medicaid and private insurance programs. The Company also acts as a Durable Medical Equipment Supplier under 42 U.S.C. 1395 et seq. and as such furnishes its products directly to customers and bills payors. As a result, the demand for the Company's products in any specific care setting is dependent in part on the reimbursement policies of the various payors in that setting. In order to be reimbursed, the products generally must be found to be reasonable and necessary for the treatment of medical conditions and must otherwise fall within the payor's list of covered services. For example, the Company is seeking to establish coverage and payment by Medicare Part B for the V.A.C., its chronic wound treatment product. Although clinical acceptance of this product has continued to increase, it has not been classified as a covered item by Medicare Part B pending receipt and review of additional clinical data. In light of increased controls on Medicare spending, there can be no assurance on the outcome of future coverage or payment decisions for any of the Company's products by governmental or private payors. If providers, suppliers and other users of the Company's products and services are unable to obtain sufficient reimbursement for the provision of KCI products, a material adverse impact on the Company's business, financial condition or operations could result. Fraud and Abuse Laws The Company is subject to various federal and state laws pertaining to health care fraud and abuse including prohibitions on the submission of false claims and the payment or acceptance of kickbacks or other remuneration in return for the purchase or lease of Company products. The United States Department of Justice and the Office of the Inspector General of the United States Department of Health and Human Services has launched an enforcement initiative which specifically targets the long term care, home health and DME industries. Sanctions for violating these laws include criminal penalties and civil sanctions, including fines and penalties, and possible exclusion from the Medicare, Medicaid and other federal health care programs. Although the Company believes its business arrangements comply with federal and state fraud and abuse laws, there can be no assurance that the Company's practices will not be challenged under these laws in the future or that such a challenge would not have a material adverse effect on the Company's business, financial condition or results of operations. Patient demographics U.S. Census Bureau statistics indicate that the 65-and over age group is the fastest growing population segment and is expected to exceed 75 million by the year 2010. Management of wounds and circulatory problems is crucial for elderly patients. These patients frequently suffer from deteriorating physical conditions and their wound problems are often exacerbated by incontinence and poor nutrition. Obesity is increasingly being recognized as a serious medical complication. In 1996 approximately 730,000 patients in U.S. hospitals had a principal or secondary diagnosis of obesity. Obese patients tend to have limited mobility and thus are at risk for circulatory problems and skin breakdown. Treating obese patients is also a significant staffing issue for many health care facilities and a cause of worker's compensation claims among nurses. Research and Development The focus of the Company's research and development program has been to develop new products and make technological improvements to existing products. In 1998, the Company has introduced a number of new products including: the KinAir IV, TheraPulse II, First Step Advantage, Impression SR, FluidAir HC, Maxxis 300 & 400 (KCI-built variations of the Equitron beds) and the Mini V.A.C. Expenditures for research and development represented approximately 2% of the Company's total operating expenditures in 1998. The Company intends to continue its research and development efforts. Manufacturing The Company's manufacturing processes for its specialty beds, mattress overlays, and medical devices include the manufacture of certain components, the purchase of certain other components from suppliers and the assembly of these components into a completed product. Mechanical components such as blower units, electrical displays and air flow controls consist of a variety of customized subassemblies which are purchased from suppliers and assembled by the Company. The Company believes it has an adequate source of supply for each of the components used to manufacture its products. Patents and Trademarks The Company seeks patent protection in the United States and abroad. As of December 31, 1998, the Company had 74 issued U.S. patents relating to its various lines of therapeutic medical devices. The Company also has 50 pending U.S. Patent applications. Many of the Company's specialized beds, products and services are offered under trademarks and service marks. The Company has 43 registered trademarks and service marks in the United States Patent and Trademark Office. Employees As of December 31, 1998, the Company had approximately 2,100 employees. The Company's employees are not represented by labor unions and the Company considers its employee relations to be good. Government Regulation United States. The Company's products are subject to regulation by numerous governmental authorities, principally the United States Food and Drug Administration ("FDA") and corresponding state and foreign regulatory agencies. Pursuant to the Federal Food, Drug, and Cosmetic Act, and the regulations promulgated thereunder, the FDA regulates the clinical testing, manufacture, labeling, distribution and promotion of medical devices. Noncompliance with applicable requirements can result in, among other things, fines, injunctions, civil penalties, recall or seizure of products, total or partial suspension of production, failure of the government to grant premarket clearance or premarket approval for devices, withdrawal of marketing clearances or approvals, and criminal prosecution. The FDA also has the authority to request repair, replacement or refund of the cost of any device manufactured or distributed by the Company that violates statutory or regulatory requirements. In the United States, medical devices are classified into one of three classes (Class I, II or III) on the basis of the controls deemed necessary by the FDA to reasonably ensure their safety and effectiveness. Although many Class I devices are exempt from certain FDA requirements, Class I devices are subject to general controls (e.g., labeling, premarket notification, and adherence to Quality System Regulations). Class II devices are subject to general and special controls (e.g., performance standards, postmarket surveillance, patient registries, and FDA guidelines). Generally, Class III devices are high risk devices that receive greater FDA scrutiny to ensure their safety and effectiveness (e.g., life-sustaining, life-supporting and implantable devices, or new devices which have been found not to be substantially equivalent to legally marketed devices). Before a new medical device can be introduced in the market, the manufacturer must generally obtain FDA clearance ("510(k) Clearance") or Premarket Approval ("PMA"). All of the Company's current products have been classified as Class I or Class II devices, which typically are legally marketed based upon 510(k) Clearance or related exemptions. A 510(k) Clearance will generally be granted if the submitted information establishes that the proposed device is "substantially equivalent" to a legally marketed medical device. In recent years, the FDA has been requiring a more rigorous demonstration of substantial equivalence than in the past. Devices manufactured or distributed by the Company are subject to pervasive and continuing regulation by the FDA and certain state agencies, including record keeping requirements and mandatory reporting of certain adverse experiences resulting from use of the devices. Labeling and promotional activities are subject to regulation by the FDA and, in certain circumstances, by the Federal Trade Commission. Current FDA enforcement policy prohibits the marketing of approved medical devices for unapproved uses and the FDA scrutinizes the advertising of medical devices to ensure that unapproved uses of medical devices are not promoted. Manufacturers of medical devices for marketing in the United States are required to adhere to applicable regulations setting forth detailed Quality System Regulation ("QSR") (formerly Good Manufacturing Practices) requirements, which include design, testing, control and documentation requirements. Manufacturers must also comply with MDR requirements that a company report certain device-related incidents to the FDA. The Company is subject to routine inspection by the FDA and certain state agencies for compliance with QSR requirements, MDR requirements and other applicable regulations. The Company is also subject to numerous federal, state and local laws relating to such matters as safe working conditions, manufacturing practices, environmental protection, fire hazard control and disposal of hazardous or potentially hazardous substances. Changes in existing requirements or adoption of new requirements could have a material adverse effect on the Company's business, financial condition, and results of operations. There can be no assurance that the Company will not incur significant costs to comply with laws and regulations in the future or that laws and regulations will not have a material adverse effect upon the Company's business, financial condition or results of operations. Fraud and Abuse Laws. The Company is subject to federal and state laws pertaining to health care fraud and abuse. In particular, certain federal and state laws prohibit manufacturers, suppliers, and providers from offering or giving or receiving kickbacks or other remuneration in connection with the ordering or recommending purchase or rental, of health care items and services. The federal anti-kickback statute provides both civil and criminal penalties for, among other things, offering or paying any remuneration to induce someone to refer patients to, or to purchase, lease, or order (or arrange for or recommend the purchase, lease, or order of), any item or service for which payment may be made by Medicare or certain federally-funded state health care programs (e.g., Medicaid). This statute also prohibits soliciting or receiving any remuneration in exchange for engaging in any of these activities. The prohibition applies whether the remuneration is provided directly or indirectly, overtly or covertly, in cash or in kind. Violations of the law can result in numerous sanctions, including criminal fines, imprisonment, and exclusion from participation in the Medicare and Medicaid programs. These provisions have been broadly interpreted to apply to certain relationships between manufacturers and suppliers, such as the Company, and hospitals, skilled nursing facilities ("SNFs"), and other potential purchasers or sources of referral. Under current law, courts and the Office of Inspector General ("OIG") of the United States Department of Health and Human Services ("HHS") have stated, among other things, that the law is violated where even one purpose (as opposed to a primary or sole purpose) of a particular arrangement is to induce purchases or patient referrals. The OIG has taken certain actions which suggest that arrangements between manufacturers/suppliers of durable medical equipment or medical supplies and SNFs (or other providers) may be under continued scrutiny. An OIG enforcement initiative, Operation Restore Trust ("ORT"), has targeted an investigation of fraud and abuse in a number of states (i.e., California, Florida, Illinois, New York, and Texas), focusing specifically on the long-term care, home health, and DME industries. ORT's funding has officially ended and the Inspector General has announced plans to implement an "ORT-Plus" program in other states in conjunction with other federal law enforcement bodies. Furthermore, in August 1995, the OIG issued a Special Fraud Alert describing certain relationships between SNFs and suppliers that the OIG viewed as abusive under the statute. These initiatives create an environment in which there will continue to be significant scrutiny for compliance with federal and state fraud and abuse laws. Several states also have referral, fee splitting and other similar laws that may restrict the payment or receipt of remuneration in connection with the purchase or rental of medical equipment and supplies. State laws vary in scope and have been infrequently interpreted by courts and regulatory agencies, but may apply to all health care items or services, regardless of whether Medicaid or Medicaid funds are involved. The Company is also subject to federal and state laws prohibiting the presentation (or the causing to be presented) of claims for payment (by Medicare, Medicaid, or other third party payors) that are determined to be false, fraudulent, or for an item or service that was not provided as claimed. In one case, a major DME manufacturer paid more than $4 million to settle allegations that it had "caused to be presented" false Medicare claims through advice that its sales force allegedly gave to customers concerning the appropriate reimbursement coding for its products. ISO Certification. Due to the harmonization efforts of a variety of regulatory bodies worldwide, certification of compliance with the ISO 9000 series of International Standards ("ISO Certification") has become particularly advantageous and, in certain circumstances necessary for many companies in recent years. The Company received ISO Certification in the fourth quarter of 1997 and therefore is certified to sell and distribute the Company's products within the European community. Other Laws. The Company owns and leases property that is subject to environmental laws and regulations. The Company also is subject to numerous federal, state and local laws and regulations relating to such matters as safe working conditions, manufacturing practices, fire hazard control and the handling and disposal of hazardous or potentially hazardous substances. International. Sales of medical devices outside of the United States are subject to regulatory requirements that vary widely from country to country. Premarket clearance or approval of medical devices is required by certain countries. The time required to obtain clearance or approval for sale in a foreign country may be longer or shorter than that required for clearance or approval by the FDA and the requirements vary. Failure to comply with applicable regulatory requirements can result in loss of previously received approvals and other sanctions and could have a material adverse effect on the Company's business, financial condition or results of operations. Reimbursement The Company's products are rented and sold principally to hospitals, extended care facilities and Home Medical Equipment (HME) providers (also referred to as Durable Medical Equipment Providers) who receive reimbursement for the products and services they provide from various public and private third-party payors, including the Medicare and Medicaid programs and private insurance plans. The Company also directly bills third party payors, including Medicare and Medicaid, and receives reimbursement from these payors. In some cases, Medicare beneficiaries are billed twenty percent for coinsurance. As a result, demand and payment for the Company's products is dependent in part on the reimbursement policies of these payors. The manner in which reimbursement is sought and obtained for any of the Company's products varies based upon the type of payor involved and the setting in which the product is furnished and utilized by patients. Medicare. Medicare is a federally-funded program that reimburses the costs of health care furnished primarily to the elderly and disabled. Medicare is composed of two parts: Part A and Part B. The Medicare program has established guidelines for the coverage and reimbursement of certain equipment, supplies and support services. In general, in order to be reimbursed by Medicare, a health care item or service furnished to a Medicare beneficiary must be reasonable and necessary for the diagnosis or treatment of an illness or injury or to improve the functioning of a malformed body part. This has been interpreted to mean that the item or service must be safe and effective, not experimental or investigational (except under certain limited circumstances involving devices furnished pursuant to an FDA-approved clinical trial), and appropriate. To date, specific Medicare guidelines have not been established addressing under what circumstances, if any, Medicare coverage would be provided for the use of the PlexiPulse or the V.A C. The methodology for determining the amount of Medicare reimbursement of the Company's products varies based upon, among other things, the setting in which a Medicare beneficiary receives health care items and services. The recently enacted Balanced Budget Act (BBA) of 1997 will significantly impact the manner in which Medicare reimbursement is funded over the next five years. Most of the Company's products are furnished in a hospital, skilled nursing facility or the beneficiary's home. Hospital Setting. With the establishment of the prospective payment system in 1983, acute care hospitals are now generally reimbursed by Medicare for inpatient operating costs based upon prospectively determined rates. Under the prospective payment system ("PPS"), acute care hospitals receive a predetermined payment rate based upon the Diagnosis-Related Group ("DRG") into which each Medicare beneficiary is assigned, regardless of the actual cost of the services provided. Certain additional or "outlier" payments may be made to a hospital for cases involving unusually long lengths of stay or high costs. However, outlier payments based upon length of stay were phased out with fiscal year 1998. Furthermore, pursuant to regulations issued in 1991, and subject to a ten-year transition period, the capital costs of acute care hospitals (such as the cost of purchasing or renting the Company's specialty beds) are also reimbursed by Medicare pursuant to an add-on to the DRG-based payment amount. Accordingly, acute care hospitals generally do not receive direct Medicare reimbursement under PPS for the distinct costs incurred in purchasing or renting the Company's products. Rather, reimbursement for these costs is deemed to be included within the DRG-based payments made to hospitals for the treatment of Medicare-eligible inpatients who utilize the products. Since PPS rates are predetermined, and generally paid irrespective of a hospital's actual costs in furnishing care, acute care hospitals have incentives to lower their inpatient operating costs by utilizing equipment and supplies that will reduce the length of inpatient stays, decrease labor, or otherwise lower their costs. The principal manner in which the BBA impacts Medicare Part A in the acute care setting is that it has reduced the annual DRG payment updates to be paid over the next five years by more than $40.0 billion. In addition, the BBA authorizes the Health Care Financing Administration ("HCFA") to enact regulations which are designed to restrain certain hospital reimbursement activities which are perceived to be abusive or fraudulent. Certain specialty hospitals (e.g., long-term care, rehabilitation and children hospitals) also use the Company's products. Such specialty hospitals currently are exempt from the PPS and, subject to certain cost ceilings, are reimbursed by Medicare on a reasonable cost basis for inpatient operating and capital costs incurred in treating Medicare beneficiaries. Consequently, long-term care hospitals may receive separate Medicare reimbursement for reasonable costs incurred in purchasing or renting the Company's products; however, Medicare reimbursement for such hospitals is expected to be reduced by $3.5 billion over the next five years. There can be no assurance that a prospective payment system will not be instituted for such hospitals in future legislation. Skilled Nursing Facility Setting. Skilled nursing facilities ("SNFs") which purchase or rent the Company's products have traditionally been reimbursed directly under Medicare Part A for some portion of their incurred costs. On July 1, 1998, the manner in which SNFs were reimbursed under Medicare Part A changed dramatically. On that date, reimbursement for SNFs under Medicare Part A changed from a cost-based system to a prospective payment system. The new payment system is based on resource utilization groups ("RUGs"). Under the RUGs system, a SNF Medicare patient is assigned to a RUGs category upon admission to the facility. The RUGs category to which the patient is assigned depends upon the level of care and resources the patient requires. The SNF receives a prospectively determined daily payment based upon the RUGs category assigned to each Medicare patient. The daily payments made to the SNFs during a transition period are based upon a blend of their actual costs from 1995 and a national average cost from 1995 (which is subject to local wage-based adjustments). Initially, 75% of a SNF's per diem is based on its costs and 25% of the per diem is based on national average cost. At the end of the four-year phase-in period, all daily payments will be based on the national average cost. Because the RUG's system provides SNFs with fixed cost reimbursement, SNFs have become less inclined than in the past to use products which had previously been reimbursed as variable ancillary costs. The Company's revenue from SNF customers has dropped sharply since the implementation of the RUGs system. Home Setting. The Company's products are also provided to Medicare beneficiaries in home care settings. Medicare reimburses beneficiaries, or suppliers accepting assignment, for the purchase or rental of HME for use in the beneficiary's home or a home for the aged (as opposed to use in a hospital or skilled nursing facility setting). So long as the Medicare Part B coverage criteria are met, certain of the Company's products, including air fluidized beds, air-powered floatation beds and alternating air mattresses, are reimbursed in the home setting under the HME category known as "Capped Rental Items." Pursuant to the fee schedule payment methodology for this category, Medicare pays a monthly rental fee (for a period not to exceed fifteen months) equal to 80% of the established allowable charge for the item. Under the BBA, there will be a five-year freeze on consumer price index payment updates for Medicare Part B Services in the home care setting. Medicaid. The Medicaid program is a cooperative federal/state program that provides medical assistance benefits to qualifying low income and medically-needy persons. State participation in Medicaid is optional and each state is given discretion in developing and administering its own Medicaid program, subject to certain federal requirements pertaining to payment levels, eligibility criteria and minimum categories of services. The Medicaid program finances approximately 50% of all care provided in skilled nursing facilities nationwide. The Company sells or rents its products to SNFs for use in furnishing care to Medicaid recipients. SNFs, or the Company, may seek and receive Medicaid reimbursement directly from states for the incurred costs. However, the method and level of reimbursement, which generally reflects regionalized average cost structures and other factors, varies from state to state and is subject to each states budget restraints. Private Payors. Many private payors, including indemnity insurers, employer group health insurance programs and managed care plans, presently provide coverage for the purchase and rental of the Company's products. The scope of coverage and payment policies varies among private payors. Furthermore, many such payors are investigating or implementing methods for reducing health care costs, such as the establishment of capitated or prospective payment systems. The Company believes that government and private efforts to contain or reduce health care costs are likely to continue. These trends may lead third-party payors to deny or limit reimbursement for the Company's products, which could negatively impact the pricing and profitability of, or demand for, the Company's products. Item 2. Properties - ------------------- The Company's corporate headquarters are currently located in a 170,000 square foot building in San Antonio, Texas which was purchased by the Company in January 1992. The Company utilizes approximately 89,000 square feet of the building with the remaining space being leased to unrelated entities. In June 1997, the Company also acquired a 2.8 acre tract of land adjacent to its corporate headquarters. There are three buildings on the land which contain an aggregate of 40,000 square feet, which will be used for general corporate purposes. The Company conducts its manufacturing, shipping, receiving and storage activities in a 153,000 square foot facility in San Antonio, Texas, which was purchased by the Company in January 1988. In 1989, the Company completed the construction of a 17,000 square foot addition to the facility which is utilized as office space. The Company also owns a 37,000 square foot building in San Antonio, Texas which houses the Company's engineering. In 1992, the Company purchased a 35,000 square foot facility in San Antonio, Texas which is used for storage. The Company maintains additional storage at two leased facilities in San Antonio, Texas. In 1994, the Company purchased a facility in San Antonio, Texas which has been provided to a charitable organization to provide housing for families of cancer patients. The facility is built on 6.7 acres and consists of a 15,000 square foot building and a 2,500 square foot house. The Company leases approximately 141 domestic distribution centers, including each of its seven regional headquarters, which range in size from 1,500 to 18,000 square feet. The Company also leases two small manufacturing plants in the United Kingdom and Ireland which are approximately 18,000 square feet and 9,000 square feet, respectively. Item 3. Legal Proceedings - -------------------------- On February 21, 1992, Novamedix Limited ("Novamedix") filed a lawsuit against the Company in the United States District Court for the Western District of Texas. Novamedix manufactures the principal product which directly competes with the PlexiPulse. The suit alleges that the PlexiPulse infringes several patents held by Novamedix, that the Company breached a confidential relationship with Novamedix and a variety of ancillary claims. Novamedix seeks injunctive relief and monetary damages. Although it is not possible to reliably predict the outcome of this litigation or the damages which could be awarded, the Company believes that its defenses to these claims are meritorious and that the litigation will not have a material adverse effect on the Company's business, financial condition or results of operations. On August 16, 1995, the Company filed a civil antitrust lawsuit against Hillenbrand Industries, Inc. and one of its subsidiaries, Hill-Rom. The suit was filed in the United States District Court for the Western District of Texas. The suit alleges that Hill-Rom used its monopoly power in the standard hospital bed business to gain an unfair advantage in the specialty hospital bed business. Specifically, the allegations set forth in the suit include a claim that Hill-Rom required hospitals and purchasing groups to agree to exclusively rent specialty beds in order to receive substantial discounts on products over which they have monopoly power - hospital beds and head wall units. The suit further alleges that Hill-Rom engaged in activities which constitute predatory pricing and refusals to deal. Hill-Rom has filed an answer denying the allegations in the suit. Although discovery has not been completed and it is not possible to reliably predict the outcome of this litigation or the damages which might be awarded, the Company believes that its claims are meritorious. On October 31, 1996, the Company received a counterclaim which had been filed by Hillenbrand Industries, Inc. in the antitrust lawsuit which the Company filed in 1995. The counterclaim alleges that the Company's antitrust lawsuit and other actions were designed to enable KCI to monopolize the specialty therapeutic surface market. Although it is not possible to reliably predict the outcome of this litigation, the Company believes that the counterclaim is without merit. On December 24, 1996, Hill-Rom, a subsidiary of Hillenbrand Industries, Inc., filed a lawsuit against the Company alleging that the Company's TriaDyne bed infringes a patent issued to Hill-Rom. This suit was filed in the United States District Court for the District of South Carolina. This case was tried in January 1999 and, in February 1999, the trial judge ruled that the TriaDyne bed did not infringe the Hill-Rom patent. The Company is a party to several lawsuits arising in the ordinary course of its business, including three other lawsuits alleging patent infringement by the Company, and the Company is contesting adjustments proposed by the Internal Revenue Service to prior years' tax returns in Tax Court. Provisions have been made in the Company's financial statements for estimated exposures related to these lawsuits and adjustments. In the opinion of management, the disposition of these matters will not have a material adverse effect on the Company's business, financial condition or results of operations. The manufacturing and marketing of medical products necessarily entails an inherent risk of product liability claims. The Company currently has certain product liability claims pending for which provision has been made in the Company's financial statements. Management believes that resolution of these claims will not have a material adverse effect on the Company's business, financial condition or results of operations. The Company has not experienced any significant losses due to product liability claims and management believes that the Company currently maintains adequate liability insurance coverage. Item 4. Submission of Matters to a Vote of Security Holders - ------------------------------------------------------------ No matter was submitted to a vote of the Company's security holders during the fourth quarter of 1998. PART II Item 5. Market for Registrant's Common Equity and Related - ---------------------------------------------------------- Stockholder Matters - ---------------------------- The Company's common stock ("Common Stock") traded on The Nasdaq Stock Market under the symbol: KNCI until November 19, 1997, which was the date on which the Company delisted its common stock. The range of the high and low bid prices of the Common Stock for each of the quarters during the 1997 fiscal year is presented below, through the last date that the Company's common stock was traded on a national exchange. MARKET PRICES OF COMMON STOCK 1997 High Low ------------- ------- ------- First Quarter $ 3.938 $ 2.844 Second Quarter 4.594 3.375 Third Quarter 4.985 4.219 Fourth Quarter 4.875 4.531 The Company's Board of Directors declared quarterly cash dividends on the Common Stock in 1997 which totaled $0.0281 per share. No dividends were declared in 1998. The Company's credit agreements contain certain covenants which currently restrict the Company's ability to declare and pay cash dividends. As of March 1, 1999, there were 5 holders of record of the Company's Common Stock. There is currently no established public trading market for the Company's Common Stock. Item 6. Selected Financial Data - -------------------------------- Note: All share and per share amounts shown below have been adjusted to reflect a four-for-one stock split effective in the third quarter of 1998. KINETIC CONCEPTS, INC. AND SUBSIDIARIES SELECTED CONSOLIDATED FINANCIAL DATA (in thousands, except per share data) Year Ended December 31, -------------------------------------------- 1998 1997 1996 1995 1994
------- ------- ------- ------- ------- Consolidated Statements of Earnings Data: Revenue: Rental and service........$ 258,482 $ 247,890 $225,450 $206,653 $228,832 Sales and other........... 71,989 59,026 44,431 36,790 40,814 ------- ------- ------- ------- ------- Total revenue........... 330,471 306,916 269,881 243,443 269,646 ------- ------- ------- ------- ------- Rental expenses............. 165,461 156,179 146,205 137,420 159,235 Cost of goods sold.......... 27,881 23,673 16,315 13,729 19,388 ------- ------- ------- ------- ------- Gross profit............ 137,129 127,064 107,361 92,294 91,023 Selling, general and administrative expenses... 69,569 62,654 52,007 48,502 51,813 Unusual items (1)........... -- -- -- -- (84,868) Recapitalization expense (2) -- 34,361 -- -- -- ------- ------- ------- ------- ------- Operating earnings...... 67,560 30,049 55,354 43,792 124,078 Interest income............. 616 2,263 9,332 5,063 1,318 Interest expense............ (48,594) (10,173) (245) (509) (5,846) Foreign currency gain (loss) 20 (1,106) -- -- -- ------- ------- ------- ------- ------- Earnings before income taxes, minortiy interest and cumu- lative effect of change in accounting principle............. 19,602 21,033 64,441 48,346 119,550 Income taxes................ 7,851 8,403 25,454 19,905 55,949 ------- ------- ------- ------- ------- Earnings before minority interest and cumulative effect of change in accounting principle.. 11,751 12,630 38,987 28,441 63,601 Minority interest in subsidiary loss (gain).... 25 (25) -- -- 40 Cumulative effect of change in accounting for inventory (3)............. -- -- -- -- 742 ------- ------- ------- ------- ------- Net earnings............$ 11,776 $ 12,605 $ 38,987 $ 28,441 $ 64,383 ======= ======= ======= ======= ======= Earnings per common share (2).............$ 0.17 $ 0.08 $ 0.22 $ 0.16 $ 0.37 ======= ======= ======= ======= ======= Earnings per common share -- assuming dilution (2)..........$ 0.16 $ 0.08 $ 0.21 $ 0.16 $ 0.36 ======= ======= ======= ======= ======= Average common shares: Basic (weighted average common shares)(2)(4)...... 70,873 154,364 175,832 176,652 175,652 ======= ======= ======= ======= ======= Diluted (weighted average outstanding shares)(2) (4)..................... 73,233 159,640 181,956 181,828 176,572 ======= ======= ======= ======= ======= Cash flow provided by operations................$ 43,885 $ 10,704 $ 62,167 $ 56,782 $ 96,451 ======= ======= ======= ======= ======= Cash dividends paid to common shareholders.......$ -- $ 6,388 $ 6,607 $ 6,631 $ 6,588 ======= ======= ======= ======= ======= Cash dividends per share paid to common share- holders (4)...............$ -- $ .028 $ .038 $ .038 $ .038 ======= ======= ======= ======= ======= Consolidated Balance Sheet Data: Working capital...........$ 76,593 $ 96,365 $107,334 $109,413 $ 90,731 Total assets..............$ 308,073 $ 351,151 $253,393 $243,726 $232,731 Long-term obligations -- noncurrent..............$ 506,701 $ 530,213 $ -- $ -- $ 2,755 Other shareholders' equity..................$(261,588)$(275,698)$211,078 $210,324 $185,423
(1) Includes $81.6 million gain, net of legal expense, from the settlement of a patent infringement lawsuit. In addition, a $10.1 million pre-tax gain from the sale of the Company's Medical Services Division was recognized. The Company also recorded certain other unusual items related to planned dispositions of under-utilized rental assets and over-stocked inventories of $6.8 million. (2) See Note 2 of Notes to Consolidated Financial Statements for information on the Company's recapitalization . (3) On January 1, 1994, the Company changed its method of applying overhead to inventory. Historically, a single labor overhead rate and a single materials overhead rate were used in valuing ending inventory. Labor overhead was applied as labor was incurred while materials overhead was applied at the time of shipping. This change resulted in a cumulative earnings effect of $742,000. (4) See Note 8 of Notes to Consolidated Financial Statements for information regarding a four-for-one stock split declared in the third quarter of 1998. Item 7. Management's Discussion and Analysis of Financial - ---------------------------------------------------------- Condition and Results of Operations - -------------------------------------------- General The ongoing changes in health care reimbursement continue to create pressure on health care providers to control costs, provide cost effective therapies and improve patient outcomes. Industry trends resulting from these pressures include the accelerating migration of patients from acute care facilities into extended care (e.g., skilled nursing facilities and rehabilitation centers) and home care settings, and the consolidation of health care providers and national and regional group purchasing organizations. In August 1997, in an effort to reduce the federal deficit and lower overall federal healthcare expenditures, Congress passed the Balanced Budget Act, (the "BBA"). The BBA contains a number of provisions which will impact the federal reimbursement of health care costs and reduce projected payments under the Medicare system by $115 billion over the next five years. The majority of the savings are scheduled for the fourth and fifth years of this plan. The provisions include: (i) a reduction exceeding $30 billion in the level of payments made to acute care hospitals under Medicare Part A over the next five years (which will be funded primarily through a reduction in future consumer price index increases); (ii) a change, which commenced July 1, 1998, in the manner in which skilled nursing facilities ("SNFs") are reimbursed from a cost based system to a prospective payment system whereby SNFs receive an all inclusive, case-mix adjusted per diem payment for each of their Medicare patients (the "RUGS System"); and (iii) a five-year freeze on consumer price index updates for Medicare Part B services in the home and the implementation of competitive bidding trials for five categories of home care products. Less than 10% of the Company's revenues are received directly from the Medicare system. However, many of the health care providers who pay the Company for its products are reimbursed, either directly or indirectly, by the federal government under the Medicare system for the use of those products. The Company does not believe that the changes introduced by the BBA will have a substantial impact on its hospital customers or the dealers who distribute the Company's products in the home health care market. However, changes introduced by the BBA have impacted negatively the manner in which the extended care customers make purchasing and rental decisions with respect to the Company's products. Industry trends including pricing pressures, the consolidation of health care providers and national and regional group purchasing organizations and a shift in market demand toward lower-priced products such as mattress overlays have had the impact of reducing the Company's overall average daily rental rates on its individual products. These industry trends, together with the increasing migration of patients from acute care to extended and home care settings, have had the effect of reducing overall acute care market growth. Generally, the Company's customers prefer to rent rather than purchase the Company's products in order to avoid the ongoing service, storage and maintenance requirements and the high initial capital outlays associated with purchasing such products, as well as to receive the Company's high-quality clinical support. As a result, rental revenues are a high percentage of the Company's overall revenues. More recently, sales have increased as a portion of the Company's revenues. The Company believes this trend will continue because certain U.S. health care providers are purchasing products that are less expensive and easier to maintain such as medical devices, mattress overlays and mattress replacement systems. In addition, international health care providers tend to purchase therapeutic surfaces more often than U.S. health care providers. Results of Operations Year Ended December 31, 1998 Compared to Year Ended December 31, 1997 - --------------------------------------------------------------------- All share and per share amounts shown in Item 7 have been adjusted to reflect a four-for-one stock split which was effective in the third quarter of 1998. The following table sets forth, for the periods indicated, the percentage relationship of each item to total revenue as well as the change in each line item as compared to the prior year ($ in thousands): Year Ended December 31, ------------------------------- Revenue Increase Relationship (Decrease) --------------- -------------- 1998 1997 $ Pct ------- ------- ------- ---- Revenue: Rental and service........... 78% 81% $ 10,592 4% Sales and other.............. 22 19 12,963 22 --- --- ------ 100% 100% 23,555 8 Rental expenses................ 50 51 9,282 6 Cost of goods sold............. 9 8 4,208 18 --- --- ------ Gross profit............... 41 41 10,065 8 Selling, general and administrative expenses...... 21 20 6,915 11 Recapitalization costs......... -- 11 (34,361) (100) --- --- ------ Operating earnings......... 20 10 37,511 125 Interest income................ -- -- (1,647) (73) Interest expense............... (14) (3) (38,421) (378) Foreign currency gain (loss)... -- -- 1,126 102 --- --- ------ Earnings before income taxes and minority interest................. 6 7 (1,431) (7) Income taxes................... 2 3 552 7 Minority interest.............. -- -- 50 200 --- --- ------ Net earnings............... 4% 4% $ (829) (7)% === === ====== The Company's revenue is divided between three primary operating units. The following table sets forth, for the periods indicated, the amount of revenue derived from each of these segments ($ in millions): Year Ended December 31, ----------------------- 1998 1997 ---------- ---------- KCI,Therapeutic Services...... $229.6 $215.2 KCI,International............. 78.0 70.3 Nutech........................ 21.5 19.1 Other......................... 1.4 2.3 ----- ----- Total revenue $330.5 $306.9 ===== ===== Total Revenue: Total revenue in 1998 increased $23.6 million, or 7.7%, to $330.5 million from $306.9 million in 1997. Revenue from KCI,Therapeutic Services("KCTS") business unit was $229.6 million, up $14.4 million, or 6.7%, from $215.2 million in the prior year due substantially to V.A.C. rentals and sales growth. KCTS surfaces revenue increased slightly due to a combination of revenue from the RIK Medical acquisition, wound care product sales and higher patient therapy days which were virtually offset by lower blended rental rates. Sales for the period increased $13.0 million, or 22.0%, due substantially to sales of disposable products associated with the Company's medical devices. Revenue from the Company's international operating unit increased $7.7 million, or 11.0%, to $78.0 million from $70.3 million in 1997. The international revenue increase reflects higher therapy days in virtually all of the Company's middle-tier markets, e.g., the Netherlands, Canada and Switzerland, which were partly offset by unfavorable currency exchange rate fluctuations of approximately $2.1 million. Revenue from the Nutech segment, increased $2.4 million, or 12.6%, to $21.5 million from $19.1 million in 1997, due substantially to growth in PlexiPulse vascular assistance device rentals and sales combined with the acquisition of Jobst which contributed sales of approximately $800,000 in the year. Rental Expenses: Rental, or field, expenses increased $9.3 million, or 5.9%, to $165.5 million from $156.2 million in 1997. This increase is primarily attributable to costs associated with business acquisitions completed during 1997 and 1998 including increased equipment depreciation and field labor costs. As a percentage of rental revenue, rental expenses were 64.0% and 63.0% for the 1998 and 1997, respectively. Cost of Goods Sold: Cost of goods sold in 1998 increased $4.2 million, or 17.8%, to $27.9 million compared to $23.7 million in 1997. Cost of goods sold has increased primarily as a result of increased sales of disposables associated with the Company's medical devices. Gross Profit: Gross profit increased $10.0 million, or 7.9%, to $137.1 million in 1998 from $127.1 million in 1997 due primarily to increased revenue as discussed above. Gross profit margin for 1998, as a percentage of total revenue, was 41.5%, up from 41.4% for 1997. Selling, General and Administrative Expenses: Selling, general and administrative expenses increased $6.9 million, or 11.0%, to $69.6 million in 1998 from $62.7 million in 1997. This increase was due in part to increased sales commissions, goodwill amortization associated with acquisitions, increased inventory valuation reserves and increased legal and professional fees resulting from continuing litigation and systems/process improvement projects including conversion of the Company's manufacturing and payroll systems to Year 2000 compliant platforms. As a percentage of total revenue, selling, general and administrative expenses were 21.1% in 1998 as compared with 20.4% in 1997. Recapitalization: During 1997, the Company recognized $34.4 million in fees and expenses resulting from the transactions associated with a leveraged recapitalization of the Company (the "Recapitalization"). Recapitalization expenses consisted of compensation expense associated with employee stock option exercises and other incentives, commitment fees on unused credit facilities, legal and professional fees and other miscellaneous costs and expenses. Operating Earnings: Operating earnings for 1998 were $67.6 million, an increase of 124.8% from $30.0 million in 1997, due substantially to Recapitalization expenses of $34.4 million which were recognized in 1997. Excluding Recapitalization expenses, operating earnings for 1998 would have increased $3.2 million, or 4.9%, from 1997. As a percentage of total revenue, the Company's operating margin was 20.4%, down from 21.0%, excluding Recapitalization expenses, in 1997 primarily due to the increase in selling, general and administrative expenses discussed above. Interest Income: Interest income for 1998 was approximately $616,000 compared to approximately $2.3 million in the prior year. The decrease in interest income resulted from lower invested cash balances due primarily to acquisition activities in 1997 and the leveraged recapitalization transactions completed during the fourth quarter of the prior year. Interest Expense: Interest expense for 1998 was $48.6 million compared to $10.2 million for 1997. The interest expense increase was due to interest accrued on an average balance of approximately $525 million in long-term debt obligations associated with the Recapitalization. Income Taxes: The Company's effective income tax rate for 1998 and 1997 was 40.0%. Net Earnings: Net earnings for 1998 were $11.8 million, or $.17 per share, assuming no dilution, compared to 1997 net earnings of $12.6 million, or $0.08 per share. Excluding Recapitalization expenses, net earnings for 1997 would have been $39.2 million, or $0.25 per share. Year Ended December 31, 1997 Compared to Year Ended December 31, 1996 - --------------------------------------------------------------------- The following table sets forth, for the periods indicated, the percentage relationship of each item to total revenue as well as the change in each line item as compared to the prior year ($ in thousands): Year Ended December 31, ----------------------------------- Revenue Increase Relationship (Decrease) ------------------ --------------- 1997 1996 $ Pct --------- -------- -------- ------ Revenue: Rental and service......... 81% 84% $ 22,440 10% Sales and other............ 19 16 14,595 33 --- --- ------- 100% 100% 37,035 14 Rental expenses.............. 51 54 9,974 7 Cost of goods sold........... 8 6 7,358 45 --- --- ------- Gross profit............. 41 40 19,703 18 Selling, general and administrative expenses.... 20 19 10,647 20 Recapitalization costs....... 11 -- 34,361 N/A --- --- ------- Operating earnings....... 10 21 (25,305) (46) Interest income.............. -- 3 (7,069) (76) Interest expense............. (3) -- (9,928) N/A Foreign currency loss........ -- -- (1,106) N/A --- --- ------ Earnings before income taxes and minority interest............... 7 24 (43,408) (67) Income taxes................. 3 10 17,051 67 Minority interest............ -- -- (25) N/A --- --- ------ Net earnings 4% 14% $(26,382) (68)% === === ====== The Company's revenue is divided between three primary operating units. The following table sets forth, for the periods indicated, the amount of revenue derived from each of these markets ($ in millions): Year Ended December 31, --------------------------- 1997 1996 ----------- ----------- KCI,Therapeutic Services..... $215.2 $184.8 KCI, International........... 70.3 68.8 Nutech....................... 19.1 15.7 Other........................ 2.3 0.6 ----- ----- Total revenue $306.9 $269.9 ===== ===== Total Revenue: Total revenue in 1997 was $306.9 million, an increase of $37.0 million, or 13.7%, from $269.9 million in 1996. This increase was primarily attributable to growth in both the Company's domestic specialty surface and medical devices businesses. KCI,Therapeutic Services revenue includes revenue from acute and extended care facilities as well as revenue from the home care setting. Revenue from the KCTS business unit was $215.2 million, up $30.4 million, or 16.5%, from $184.8 million in the prior year due primarily to growth in V.A.C. rentals in the United States and therapy day growth in each of the wound care, pulmonary and bariatric markets combined with an overall increase in the average daily rental price of its products. Revenue from the Company's international business was $70.3 million compared to $68.8 million in the prior year, despite adverse foreign currency exchange fluctuations of approximately $6.4 million. Revenue from the Nutech segment of $19.1 million increased $3.4 million, or 21.7%, up from $15.7 million in the prior year, due substantially to increased market penetration associated with the Mediq/PRN alliance. Rental Expenses: Rental expenses consist largely of field personnel costs, depreciation of the Company's rental equipment and related facility costs. Rental expenses for 1997 totaled $156.2 million, an increase of $10.0 million, or 6.8%, from $146.2 million in the prior year. The addition of extended care sales representatives, new marketing programs and product costs associated with new and acquired therapies and technologies accounted for the majority of this increase. As a percentage of total revenue, 1997 rental expenses were 50.9%, down from 54.2% in the prior period. This decrease is primarily attributable to the increase in rental revenue, as the majority of the Company's rental or field expenses are relatively fixed. Gross Profit: Gross profit in 1997 was $127.1 million, an increase of $19.7 million, or 18.4%, from $107.4 million in the year-ago period due substantially to higher revenue, combined with relatively fixed field expenses and improved sales volumes. Gross profit margin for 1997, as a percentage of total revenue, was 41.4%, up from 39.8% for the prior year. Rental margins improved to 37.0%, up 1.9 percentage points from 1996, while sales margins declined to 59.9%, from 63.3%, as the product mix shifted toward lower-margin overlays, particularly in the international home care setting. Selling, General and Administrative Expenses: Selling, general and administrative (SG&A) expenses for 1997 were $62.7 million, an increase of $10.6 million, or 20.5%, from 1996. Key investments in marketing programs and information systems as well as higher legal and professional fees and provisions for uncollectible accounts receivable made up the majority of this increase. As a percentage of total revenue, SG&A expenses in 1997 were 20.4%, up slightly from 19.3% in the year-ago period. Recapitalization: During 1997, the Company recognized $34.4 million in fees and expenses resulting from the transactions associated with the Recapitalization. Recapitalization expenses consisted of compensation expense associated with employee stock option exercises and other incentives, commitment fees on unused credit facilities, legal and professional fees and other miscellaneous costs and expenses. Operating Earnings: Operating earnings for 1997 were $30.0 million, a decrease of $25.3 million, or 45.7%, from 1996, due substantially to Recapitalization expenses of $34.4 million in 1997. Excluding the Recapitalization expenses, operating earnings for 1997 were $64.4 million, an increase of $9.1 million, or 16.4%, from 1996. As a percentage of total revenue, the Company's operating margin, excluding the recapitalization expenses, improved to 21.0%, up from 20.5% in 1996. Interest Income: Interest income earned during 1997 was $2.3 million, a $7.1 million decrease from 1996. The prior year interest income included $5.2 million of non-recurring interest income from the early repayment of all remaining notes receivables from the 1994 disposition of the Medical Services Division. The remainder of the variance is due to lower invested cash balances in 1997 as the Company funded five acquisitions during the year from existing cash reserves. Interest Expense: Interest expense for the year was $10.2 million, an increase of $9.9 million from 1996. The majority of this increase was due to interest accrued on approximately $535.0 million of debt outstanding after completion of the Recapitalization. Income Taxes: The Company's effective income tax rate for 1997 was 40.0% compared to 39.5% in 1996. Net Earnings: Net earnings for 1997 were $12.6 million, or $0.08 per share, compared to 1996 net earnings of $39.0 million, or $0.22 per share. Excluding non-recurring items, net earnings for 1997 would have been $39.2 million, or $0.25 per share, compared to 1996 net earnings of $35.9 million, an increase of $3.3 million, or 9.2%. Higher revenue combined with controlled spending accounted for the earnings improvement. Financial Condition The change in revenue and expenses experienced by the Company during the year ended December 31, 1998 and other factors resulted in changes to the Company's balance sheet as follows: Cash and cash equivalents were $4.4 million at December 31, 1998, a decrease of $57.4 million from December 31, 1997. The cash decrease is primarily attributable to payments associated with the Recapitalization, including $32.3 million for first quarter 1998 repurchases of common stock, and $19.3 million for the repayment of long-term debt obligations. Accounts receivable at December 31, 1998 were $85.2 million, an increase of $4.0 million, or 4.9%, from the prior year end. V.A.C. rentals and sales which the Company has billed to the Medicare program increased receivables by $4.5 million as the Company has not been granted a Medicare Part B V.A.C. Reimbursement Code. The remainder of this increase was due primarily to (i) revenue growth in extended care and home care markets which tend to have customers and payors who historically have paid over a longer cycle than acute care customers and (ii) growth in international receivables. Inventories at December 31, 1998 increased $7.1 million, or 33.0%, to $28.7 million from the end of 1997, due primarily to purchases of wound dressing and disposable devices which make up a large percentage of total company sales revenue. Prepaid expenses and other current assets of $10.7 million decreased 42.0% as compared to $18.4 million at December 31, 1997. This change resulted primarily from the refund of all 1997 federal tax payments as the Recapitalization resulted in the Company recording a tax receivable for the year ended December 31, 1997. Goodwill increased $8.4 million, or 18.4%, from December 31, 1997 due primarily to the Jobst acquisition during 1998. The goodwill associated with this acquisition will be amortized over 25 years. Accounts payable and accrued liabilities at December 31, 1998 were $3.4 million and $37.3 million, respectively, compared to $40.4 million and $41.3 million, respectively, at the end of 1997. The decrease in accounts payable relates primarily to payments for shares of common stock not tendered as of December 31, 1997. Payments of interest on long-term debt obligations and payment of an earnout related to a prior year acquisition accounted for the majority of the decrease in accrued liabilities. Long-term debt obligations, including current maturities, decreased $19.3 million to $515.4 million as of December 31, 1998 due to the repayment of a portion of the Company's revolving credit facility in addition to scheduled principal payments. Income Taxes The provision for deferred income taxes is based on the asset and liability method and represents the change in the deferred income tax accounts during the year. Under the asset and liability method of FAS 109, deferred income taxes are recognized for the future tax consequences attributable to the difference between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. At the end of 1998, the net impact of these timing issues resulted in a net deferred tax liability comprised of deferred tax liabilities totaling $27.6 million offset by deferred tax assets totaling $17.5 million. Legal Proceedings A description of the Company's legal proceedings is set forth under the caption "Item 3. Legal Proceedings". Liquidity and Capital Resources At December 31, 1998, the Company had current assets of $128.9 million and current liabilities of $52.3 million resulting in a working capital surplus of $76.6 million, compared to a surplus of $96.4 million at December 31, 1997. During 1998, the Company made net capital expenditures of $28.4 million, including inventory to be converted into equipment for short term rentals of $700,000. Other than commitments for new product inventory, including disposable "for sale" products, of $4.0 million, the Company has no material long-term capital commitments and can adjust the level of its capital expenditures as circumstances warrant. The Company's principal sources of liquidity are expected to be cash flows from operating activities and borrowings under the Senior Credit Facilities. It is anticipated that the Company's principal uses of liquidity will be to fund capital expenditures related to the Company's rental products, provide needed working capital, meet debt service requirements and finance the Company's strategic plans. The Senior Credit Facilities originally totaled $400.0 million and consist of (i) a $50.0 million six-year Revolving Credit Facility, (ii) a $50.0 million six-year Acquisition Facility, (iii) a $120.0 million six-year amortizing Term Loan A, (iv) a $90.0 million seven-year amortizing Term Loan B and (v) a $90.0 million eight-year amortizing Term Loan C, (collectively, the "Term Loans"). The Term Loans were fully drawn to finance a portion of the Recapitalization, and scheduled principal payments totaling $4.8 million were made in a timely manner. The Acquisition Facility was partially drawn, in effect, to finance the RIK Medical acquisition. The Acquisition Facility provides the Company with financing to pursue strategic acquisition opportunities, and will remain available to the Company until December 31, 2000, at which time it will begin to amortize over the remaining three years of the facility. The Company originally utilized borrowings under the Revolving Facility to help effect the Recapitalization and pay related fees and expenses. While the Company reduced borrowings under this facility by $14.5 million in 1998, it has utilized and will utilize borrowings to fund capital expenditures and meet working capital needs. The Term Loans are payable in equal quarterly installments (1) subject to an amortization schedule as follows: Year Amount ---- ----------- 1999............................ $ 8,800,000 2000............................ $16,800,000 2001............................ $31,800,000 2002............................ $31,800,000 2003............................ $36,800,000 2004............................ $85,500,000 2005............................ $83,700,000 (1) The first three quarterly principal installments for 2004 shall be $450,000 with the final installment for that year equal to $84,150,000. For 2005, the first three installments shall be equal to $225,000 and the final installment shall be equal to $83,025,000. The Term Loans and the Notes are subject to customary terms, covenants and conditions which partially restrict the uses of future cash flow by the Company. The Company does not expect that these covenants and conditions will have a material adverse impact on its operations. At December 31, 1998, the Acquisition Facility and the Revolving Credit Facility had a balance of $10.0 million each. Accordingly, the aggregate availability under these two facilities was $80.0 million. Indebtedness under the Senior Credit Facilities, including the Revolving Credit Facility (other than certain loans under the Revolving Credit Facility designated in foreign currency), the Term Loans and the Acquisition Facility initially bear interest at a rate based upon (i) the Base Rate (defined as the higher of (x) the rate of interest publicly announced by Bank of America as its "reference rate" and (y) the federal funds effective rate from time to time plus 0.50%), plus 1.25% in respect of the Tranche A Term Loans, the loans under the Revolving Credit Facility (the "Revolving Loans") and the loans under the Acquisition Facility (the "Acquisition Loans"), 1.50% in respect of the Tranche B Term Loans and 1.75% in respect of the Tranche C Term Loans, or at the Company's option, (ii) the Eurodollar Rate (as defined in the Senior Credit Facility Agreement) for one, two, three or six months, in each case plus 2.25% in respect of Tranche A Term Loans, Revolving Loans and Acquisition Loans, 2.50% in respect of Tranche B Term Loans and 2.75% in respect of the Tranche C Term Loans. Certain Revolving Loans designated in foreign currency will initially bear interest at a rate based upon the cost of funds for such loans, plus 2.25% or 2.50%, depending on the type of foreign currency. Performance-based reductions of the interest rates under the Term Loans, the Revolving Loans and the Acquisition Loans are available. In December 1998, the Company entered into three interest rate protection agreements whereby the base interest rate on $280,000,000 of the term loans is fixed at an average rate of approximately 5.26% through 1999. Indebtedness of the Company under the Senior Credit Agreement is guaranteed by certain of the subsidiaries of the Company and is secured by (i) a first priority security interest in all, subject to certain customary exceptions, of the tangible and intangible assets of the Company and its domestic subsidiaries, including, without limitation, intellectual property and real estate owned by the Company and its subsidiaries, (ii) a first priority perfected pledge of all capital stock of the Company's domestic subsidiaries and (iii) a first priority perfected pledge of up to 65% of the capital stock of foreign subsidiaries owned directly by the Company or its domestic subsidiaries. The Senior Credit Agreement requires the Company to meet certain financial tests, including minimum levels of EBITDA (as defined therein), minimum interest coverage, maximum leverage ratio and capital expenditures. The Bank Credit Agreement also contains covenants which, among other things, limit the incurrence of additional indebtedness, investments, dividends, loans and advances, capital expenditures, transactions with affiliates, asset sales, acquisitions, mergers and consolidations, prepayments of other indebtedness (including the Notes), liens and encumbrances and other matters customarily restricted in such agreements. The Company is in compliance with the applicable covenants at December 31, 1998. The Senior Credit Agreement contains customary events of default, including payment defaults, breachs of representations and warranties, covenant defaults, cross-defaults to certain other indebtedness, certain events of bankruptcy and insolvency, failures under ERISA plans, judgment defaults, change of control of the Company and failure of any guaranty, security document, security interest or subordination provision supporting the Bank Credit Agreement to be in full force and effect. As part of the Recapitalization transactions, the Company issued $200.0 million of Senior Subordinated Notes (the "Notes") due 2007. The Notes are unsecured obligations of the Company, ranking subordinate in right of payment to all senior debt of the Company and will mature on November 1, 2007. The Notes are not entitled to the benefit of any mandatory sinking fund. The Notes will be redeemable, at the Company's option, in whole at any time or in part from time to time, on and after November 1, 2002, upon not less than 30 nor more than 60 days' notice, at the following redemption prices (expressed as percentages of the principal amount thereof) if redeemed during the twelve-month period commencing on November 1 of the year set forth below, plus, in each case, accrued and unpaid interest thereon, if any, to the date of redemption. Year Percentage ---- ---------- 2002.................................. 104.813% 2003.................................. 103.208% 2004.................................. 101.604% 2005 and therafter.................... 100.000% At any time, or from time to time, the Company may acquire a portion of the Notes through open-market purchases. Also, on or prior to November 1, 2000, the Company may, at its option, on one or more occasions use all or a portion of the net cash proceeds of one or more equity offerings to redeem the Notes issued under the Indenture at a redemption price equal to 109.625% of the principal amount thereof plus accrued and unpaid interest thereon, if any, to the date of redemption; provided that at least 65% of the principal amount of Notes originally issued remains outstanding immediately after any such redemption. In order to effect the foregoing redemption with the proceeds of any equity offering, the Company shall make such redemption not more than 120 days after the consummation of any such equity offering. As of December 31, 1998 the entire $200.0 million of Senior Subordinated Notes was issued and outstanding. During 1998, the Company generated $43.9 million in cash from operating activities compared to $10.7 in the prior year, an increase of $33.2 million. The increase in operating cash flows resulted primarily from improved collections of accounts receivable and a decrease in other current assets related to the refund of all federal tax payments made in 1997 as a result of the Company's leveraged recapitalization. Investment activities in 1998 used $42.5 million of cash, including net capital expenditures of $28.4 million and $11.3 million used to fund business acquisitions. Financing activities for 1998 used $59.1 million consisting primarily of $41.7 million used to complete the recapitalization transactions and $19.3 million of long-term debt repayments. At December 31, 1998, cash and cash equivalents of $4.4 million were available for general corporate purposes. Based upon the current level of operations, the Company believes that cash flow from operations and the availability under its line of credit will be adequate to meet its anticipated requirements for debt repayment, working capital and capital expenditures through 1999. Also at year-end, the Company was committed to purchase approximately $4.0 million of inventory associated with new products over the next year. In addition, the Company will complete its acquisition of the Jobst product line during 1999. The Company did not have any other material purchase commitments. Known Trends or Uncertainties Euro Currency - ------------- On January 1, 1999, the European Economic and Monetary Union ("EMU") entered a three-year transition phase during which a new common currency, the "Euro", was introduced in participating countries and fixed conversion rates were established through the European Central Bank ("ECB") between existing local currencies and the Euro. From that date, the Euro is traded on currency exchanges. Following introduction of the Euro, local currencies will remain legal tender until December 31, 2001. During this transition period, goods and services may be paid for with the Euro or local currency under the EMU's "no compulsion, no prohibition" principle. Based on its evaluation to date, management believes that the introduction of the Euro will not have a material adverse impact on the Company's financial position, results of operations or cash flows. However, uncertainty exists as to the effects the Euro will have on the marketplace, and there is no guarantee that all issues will be foreseen and corrected or that other third parties will address the conversion successfully. The Company has reviewed its information systems software and identified modifications necessary to ensure business transactions can be conducted consistent with the requirements of the conversion to the Euro. Certain of these modifications have been implemented, and others will be implemented during the course of the transition period. The Company expects that modifications not yet implemented will be made on a timely basis and expects the incremental cost of the Euro conversion to be immaterial. The Euro introduction is not expected to have a material impact on the Company's overall currency risk. The Company anticipates the Euro will simplify financial issues related to cross-border trade in the EMU and reduce the transaction costs and administrative time necessary to manage this trade and related risks. However, the Company believes that the associated savings will not be material to corporate results. Reimbursement - ------------- The implementation of a prospective payment system for extended care facilities has changed the way skilled nursing facilities buy or rent products. The effect of this change has been to sharply reduce the Company's rental revenues in the extended care market. The Company believes that in the long term, under a fixed payment system, decisions on selecting the products and services used in patient care will be based on clinical and cost effectiveness. The Company's innovative and extensive product continuum significantly improves clinical outcomes while reducing the cost of patient care should allow it to compete effectively in this environment. The Company currently rents and sells the V.A.C. in all care settings and market acceptance of this product has been better than expected. This is evidenced by the significant revenue growth experienced in the three years that the product has been available domestically. However, the Company has not received a Medicare reimbursement code, and an associated coverage policy, for the V.A.C. in the home care setting. HCFA has indicated that the grant of a reimbursement code is dependent upon its receipt and review of clinical data. The Company continues to vigorously pursue this reimbursement coverage. Impact of Year 2000 The Year 2000 issue arose as a result of computer software programs being written using two digits rather than four digits to define the date field. Certain of the Company's existing computer programs that have time-sensitive software may recognize a date using "00" as the year 1900 rather than the year 2000. This could result in system failure or miscalculations causing disruptions of operations, including, among other things, a temporary inability to process transactions or engage in other normal business activities. Based on a recent assessment, the Company has determined that it needs to modify or replace key portions of its software so that its information technology ("IT") systems will function properly with respect to dates beyond December 31, 1999. The Company presently believes that through its conversion to the Oracle applications platform and with modifications to other existing software, the Year 2000 issue may be mitigated. However, if such modifications and conversions are not made properly or are not completed timely, the Year 2000 issue could have a material impact on the operations of the Company. The Company's plan to resolve the Year 2000 issue involves the following four phases: assessment, remediation, testing and implementation. Assessment - ---------- To date, the Company has completed its assessment of all IT systems that could be significantly affected by the Year 2000. The completed assessment indicated that most of the Company's significant IT systems could be affected, particularly the general ledger, billing and manufacturing (inventory) systems. That assessment also indicated that software and hardware used in production, distribution and time and attendance systems also are at risk. However, based on a review of its product line, the Company has determined that the products it has sold and will continue to sell do not require remediation to be Year 2000 compliant. Accordingly, the Company does not believe that the Year 2000 presents a material exposure as it relates to the Company's products. In addition, the Company has gathered information about the Year 2000 compliance status of its significant suppliers and customers and continues to monitor their compliance. Remediation - ----------- The Company is 75% complete on the remediation phase for its IT systems and expects to complete software modifications and/or replacements no later that June 30, 1999. Once software modifications or replacements are completed, the systems are tested for compliance. These phases can run concurrently for different systems. To date, the Company has completed installations/modifications on all mission-critical domestic systems. Internationally, the Company is installing new integrated software applications which are expected to be completed by the end of July 1999. Testing - ------- Testing is in process or has been completed for all systems for which the remediation phase has been completed. To date, this testing has identified the need for certain additional program modifications. The additional modifications are expected to be made no later than June 30, 1999 at which time the upgraded systems will be retested. Testing of the remaining systems should be completed during the third quarter of 1999. An integration test will also be performed at that time. Implementation - -------------- Many applications and systems have been put into production. These include servers, personal computers and various software programs. Applications and systems are put into production once they have been tested. All affected applications and systems should be in production by the end of the third quarter of 1999. The Company believes that it has completed the assessment of all major non-information technology based systems. Remediation plans have been developed, where necessary, and implementation has been completed. Testing of the remediation steps will be completed during the second quarter. Third Parties and Related Systems - --------------------------------- The Company's third party payor ("claims") billing system interfaces directly with certain third party payor programs. The Company believes that its billing software is Year 2000 compliant and is in the process of testing the interfaces to ensure that the Company's claims billing interface systems are Year 2000 compliant by the end of September, 1999. In addition, the Company has surveyed its significant suppliers and large customers that do not share information systems with the Company. To date, the Company is not aware of any significant customer or supplier with a Year 2000 issue that would materially impact the Company's results of operations, liquidity or capital resources. However, the Company has no means of ensuring that all third parties will be ready for the Year 2000. There can be no guarantee that the inability of a significant customer or supplier to complete their Year 2000 readiness program in a timely manner would not materially impact the operations of the Company. Costs - ----- The total cost of the Year 2000 project is estimated at $7.4 million and is being funded through operating cash flows. $6.3 million of this total will be used to purchase new software that will be capitalized and the remaining $1.1 million will be expensed as incurred. Through December 31, 1998, the Company incurred approximately $6.9 million ($900,000 expensed and $6.0 million capitalized for new software), related to the assessment of the Year 2000 issue, development of a modification plan, preliminary software modifications, purchase of new software, where necessary, and testing of implemented systems. Risks and Contingency Plan - -------------------------- Management of the Company believes it has an effective program in place to resolve the Year 2000 issue in a timely manner. As noted above, however, the Company has not yet completed all necessary phases of the Year 2000 program. The Company is in the process of determining the risks it would face in the event certain aspects of its Year 2000 remediation program failed. It is also developing contingency plans for all mission-critical processes not yet completed. Under a "worst case" scenario, the Company's international operations would be unable to deliver, track and bill for products due to internal system failures and the Company, as a whole, would be unable to deliver key products due to the inability of external vendors to deliver such products. Alternative suppliers are being identified and inventory levels of certain key products and/or components may be temporarily increased. While virtually all internal systems can be replaced with manual systems on a temporary basis, the failure of any mission-critical system will have at least a short-term negative effect on operations. The failure of national and worldwide banking information systems or the loss of essential utility services due to the Year 2000 issue could result in the inability of many businesses, including the Company, to conduct business. Pending Accounting Pronouncements In June 1998, the Financial Accounting Standards Board issued Statement No. 133, Accounting for Derivative Instruments and Hedging Activities, which must be adopted in years beginning after June 15, 1999. The Company expects to adopt the new Statement effective January 1, 2000. The Statement will require the Company to recognize all derivatives on the balance sheet at fair value. Derivatives that are not hedges must be adjusted to fair value through income. If the derivative is a hedge, depending on the nature of the hedge, changes in the fair value of derivatives will either be offset against the change in fair value of the hedged assets, liabilities, or firm commitments through earnings or recognized in other comprehensive income until the hedged item is recognized in earnings. The ineffective portion of a derivative's change in fair value will be immediately recognized in earnings. The Company has not yet determined what the effect of Statement 133 will be on the earnings and financial position of the Company. In March 1998, the AICPA issued SOP 98-1, "Accounting For the Costs of Computer Software Developed For or Obtained For Internal-Use." The SOP is effective beginning January 1, 1999. The SOP will require the capitalization of certain costs incurred after the date of adoption in connection with developing or obtaining software for internal-use. The Company does not anticipate the adoption of this SOP will have a material impact on the Company's future earnings or financial position. Item 7A. Quantitative and Qualitative Disclosures about Market Risk - ------------------------------------------------------------------- The Company is exposed to various market risks, including fluctuations in interest rates and variability in currency exchange rates. The Company has established policies, procedures and internal processes governing its management of market risks and the use of financial instruments to manage its exposure to such risks. Interest Rate Risk - ------------------ At December 31, 1998, approximately 61% of the Company's long- term debt bore interest at variable rates. These variable-rate facilities bear interest at a stated rate based upon a Base Rate (defined as the higher of (i) the rate of interest publicly announced by Bank of America as its "reference rate" and (ii) the federal funds effective rate from time to time plus 0.50%) or the Eurodollar Rate (as defined) for one, two, three or six months plus associated credit risk factors from 1.50% to 2.75% depending on the base rate and maturity (see Note 5 to the Company's consolidated financial statements). In an effort to minimize the risk of adverse interest rate fluctuations, the Company has entered into three interest rate protection agreements which effectively fix the base borrowing rate on 88% of the Company's variable rate debt as follows (dollars in millions): Annual Swap Interest Maturity Amount Rate ---------- ------ --------- 01/08/2002 $150.0 5.5775% 12/29/2000 95.0 4.8950% 12/31/1999 35.0 4.8550% As a result of these interest rate protection agreements, the Company believes that movements in short term interest rates would not materially affect the financial position of the Company. Foreign Currency and Market Risk - -------------------------------- The Company has direct operations in Western Europe, Canada and Australia and distributor relationships in many other parts of the world. The Company's foreign operations are measured in their local currencies. As a result, the Company's financial results could be affected by factors such as changes in foreign currency exchange rates or weak economic conditions in the foreign markets in which the Company has operations. Exposure to this variability is managed primarily through the use of natural hedges, whereby funding obligations and assets are both managed in the local currency. The Company maintains no other derivative instruments to mitigate the exposure to translation and/or transaction risk. International operations reported operating profit of $15.3 million for the year ended December 31, 1998. It is estimated that the result of a 10% fluctuation in the value of the dollar relative to these foreign currencies at December 31,1998 would change the Company's 1998 net income by approximately $940,000. The Company's analysis does not consider the implications that such fluctuations could have on the overall economic activity that could exist in such an environment in the U.S. or the foreign countries or on the results of operations of these foreign entities. Item 8. Financial Statements and Supplementary Data - ---------------------------------------------------- KINETIC CONCEPTS, INC. AND SUBSIDIARIES Consolidated Balance Sheets (in thousands) December 31, ------------------ 1998 1997
------- ------- ASSETS Current assets: Cash and cash equivalents............. $ 4,366 $ 61,754 Accounts receivable, net.............. 85,212 81,238 Inventories........................... 28,662 21,553 Prepaid expenses and other............ 10,707 18,446 ------- ------- Total current assets.......... 128,947 182,991 ------- ------- Net property, plant and equipment....... 77,950 75,434 Goodwill, less accumulated amortization of $17,323 in 1998 and $13,989 in 1997 54,327 45,899 Loan issuance cost, less accumulated amortization of $2,687 in 1998 and $382 in 1997.......................... 15,380 17,346 Other assets, less accumulated amortization of $3,425 in 1998 and $3,100 in 1997........................ 31,469 29,481 ------- ------- $308,073 $351,151 ======= ======= LIABILITIES AND SHAREHOLDERS' DEFICIT Current liabilities: Accounts payable...................... $ 3,438 $ 40,353 Accrued expenses...................... 37,277 41,334 Current installments of long-term obligations......................... 8,800 4,800 Current installments of capital lease obligations......................... 150 139 Income tax payable.................... 2,689 -- ------- ------- Total current liabilities..... 52,354 86,626 ------- ------- Long-term obligations, excluding current installments.......................... 507,055 529,901 Capital lease obligations, excluding current installments.................. 129 312 Deferred income taxes, net.............. 10,123 10,010 ------- ------- 569,661 626,849 ------- ------- Commitments and contingencies (Note 13) Shareholders' deficit: Common stock; issued and outstanding 70,915 in 1998 and 17,713 in 1997..... 71 17 Retained deficit........................ (259,121) (273,231) Accumulated other comprehensive income.. (2,538) (2,484) ------- ------- (261,588) (275,698) ------- ------- $308,073 $351,151 ======= =======
See accompanying notes to consolidated financial statements. KINETIC CONCEPTS, INC. AND SUBSIDIARIES Consolidated Statements of Earnings (in thousands, except per share data) Year Ended December 31, ----------------------------------- 1998 1997 1996
---------- ---------- ---------- Revenue: Rental and service.............. $258,482 $247,890 $225,450 Sales and other................. 71,989 59,026 44,431 ------- ------- ------- Total revenue............ 330,471 306,916 269,881 ------- ------- ------- Rental expenses................... 165,461 156,179 146,205 Cost of goods sold................ 27,881 23,673 16,315 ------- ------- ------- 193,342 179,852 162,520 ------- ------- ------- Gross profit............. 137,129 127,064 107,361 Selling, general and administrative expenses........................ 69,569 62,654 52,007 Recapitalization expenses......... -- 34,361 -- ------- ------- ------- Operating earnings....... 67,560 30,049 55,354 Interest income................... 616 2,263 9,332 Interest expense.................. (48,594) (10,173) (245) Foreign currency gain (loss)...... 20 (1,106) -- ------- ------- ------ Earnings before income taxes and minority interest............... 19,602 21,033 64,441 Income taxes...................... 7,851 8,403 25,454 ------- ------- ------ Earnings before minority interest............... 11,751 12,630 38,987 Minority interest in subsidiary loss (gain)..................... 25 (25) -- ------- ------- ------- Net earnings $ 11,776 $ 12,605 $ 38,987 ======= ======= ======= Earnings per common share......... $ 0.17 $ 0.08 $ 0.22 ======= ======= ======= Earnings per common share - assuming dilution............... $ 0.16 $ 0.08 $ 0.21 ======= ======= ======= Average common shares: Basic (weighted average outstanding shares).. 70,873 154,364 175,832 ======= ======= ======= Diluted (weighted average outstanding shares).. 73,233 159,640 181,956 ======= ======= =======
See accompanying notes to consolidated financial statements. KINETIC CONCEPTS, INC. AND SUBSIDIARIES Consolidated Statements of Cash Flows (in thousands) Year Ended December 31, ---------------------------- 1998 1997 1996
--------- -------- -------- Cash flows from operating activities: Net earnings............................ $ 11,776 $ 12,605 $38,987 Adjustments to reconcile net earnings to net cash provided by operating activities: Depreciation.......................... 25,814 21,091 20,301 Amortization.......................... 5,964 2,989 1,493 Provision for uncollectible accounts receivable.......................... 3,707 5,888 2,457 Gain on early repayment of notes receivable.......................... -- -- (5,180) Change in assets and liabilities net of effects from purchase of subsidiaries and unusual items: Increase in accounts receivable, net (7,808) (24,920) (4,626) Decrease in notes receivable........ -- -- 3,187 Increase in inventories............. (7,186) (13) (1,034) Decrease (increase)in prepaid expenses and other................ 7,739 (11,199) (1,927) Increase in accounts payable........ 4,715 392 1,525 Increase (decrease) in accrued expenses.......................... (4,121) 1,896 3,349 Increase (decrease) in income taxes payable........................... 2,689 (2,970) (1,056) Increase in deferred income taxes, net............................... 113 4,945 4,691 Increase in non current deferred other............................. 483 -- -- ------ ------ ------ Net cash provided by operating activities.................. 43,885 10,704 62,167 ------ ------ ------ Cash flows from investing activities: Additions to property, plant and equipment........................... (29,913) (27,672) (27,783) Decrease (increase) in inventory to be converted into equipment for short-term rental................... (700) (2,850) 700 Dispositions of property, plant and equipment........................... 2,207 2,620 5,400 Excess principal repayment on discounted notes receivable......... -- -- 5,180 Business acquired in purchase transactions, net of cash acquired.. (11,266) (41,153) (1,146) Note paid by principal shareholder.... -- -- 10,000 Decrease (increase) in other assets... (2,806) 939 (9,960) ------ ------ ------ Net cash used by investing activities.................. (42,478) (68,116) (17,609) ------ ------ ------ Cash flows from financing activities: Borrowing (repayment) of notes payable and long-term obligations........... (19,329) 534,701 -- Borrowing (repayment) of capital lease obligations......................... (172) (333) 457 Loan issuance costs................... (339) (17,734) -- Proceeds from the exercise of stock options............................. 300 3,668 4,264 Purchase and retirement of treasury stock............................... -- (3,827) (35,241) Cash dividends paid to shareholders... -- (6,388) (6,607) Recapitalization costs-purchase of treasury stock...................... -- (631,606) -- Recapitalization costs-proceeds from common stock issuance............... -- 150,184 -- Recapitalization costs-fees and expenses............................ 2,088 (8,626) -- Recapitalization costs-amounts incurred in 1997, paid in 1998...... (41,652) 41,652 -- Other................................. (2) 253 (150) ------ ------ ------ Net cash provided (used) by financing activities........ (59,106) 61,944 (37,277) ------ ------ ------ Effect of exchange rate changes on cash and equivalents....................... 311 (1,823) (635) ------ ------ ------ Net increase (decrease) in cash and cash equivalents........................... (57,388) 2,709 6,646 Cash and cash equivalents, beginning of year.................................. 61,754 59,045 52,399 ------ ------ ------ Cash and cash equivalents, end of year.. $ 4,366 $ 61,754 $ 59,045 ====== ====== ======
See accompanying notes to consolidated financial statements. KINETIC CONCEPTS, INC. AND SUBSIDIARIES Consolidated Statements of Shareholders' (Deficit) Equity Three Years Ended December 31, 1998 (in thousands, except per share data) Notes Receivable from Accumu- Officers lated Total for Other Share- Additional Retained Exercise Compre- holders' Common Paid-In Earnings Treasury of Stock hensive Equity Stock Capital (Deficit) Stock Options Income (Deficit) ----- ---------- --------- -------- --------- -------- --------
Balances at December 31, 1995............ $ 44 $12,123 $ 197,290 $ -- $ (185) $ 1,052 $ 210,324 Net earnings.......... -- -- 38,987 -- -- -- 38,987 Foreign currency translation adjustment.......... -- -- -- -- -- (497) (497) ------- Total comprehensive income.............. 38,490 ------- Exercise of stock options............. -- 2,098 -- -- (150) -- 1,948 Tax benefit realized from stock option plan................ -- 2,166 -- -- -- -- 2,166 Treasury stock purchased........... -- -- -- (35,241) -- -- (35,241) Treasury stock retired (2) (16,387) (18,854) 35,241 -- -- (2) Cash dividends on common stock -- $0.038 per share.. -- -- (6,607) -- -- -- (6,607) ---------------------------------------------------------------------- Balances at December 31, 1996............ 42 -- 210,816 -- (335) 555 211,078 ---------------------------------------------------------------------- Net earnings.......... -- -- 12,605 -- -- -- 12,605 Foreign currency translation adjustment.......... -- -- -- -- -- (3,039) (3,039) ------- Total comprehensive income.............. 9,566 ------- Exercise of stock options............. -- 2,019 -- -- 335 -- 2,354 Tax benefit realized from stock option plan................ -- 1,567 -- -- -- -- 1,567 Treasury stock retired -- 15,330 (19,157) -- -- -- (3,827) Cash dividends on common stock-- $0.028 per share.. -- -- (6,388) -- -- -- (6,388) Purchase of treasury stock............... (32) (18,916) (612,658) -- -- -- (631,606) Proceeds from common stock issuance...... 7 -- 150,177 -- -- -- 150,184 Recapitalization fees and expenses... -- -- (8,626) -- -- -- (8,626) ----------------------------------------------------------------------- Balances at December 31, 1997............ $ 17 $ -- $(273,231) $ -- $ -- $(2,484) $(275,698) ----------------------------------------------------------------------- Net earnings.......... -- -- 11,776 -- -- -- 11,776 Foreign currency translation adjustment.......... -- -- -- -- -- (54) (54) ------- Total comprehensive income.............. 11,722 ------- Exercise of stock options............. -- 300 -- -- -- -- 300 Reimbursement of recapitalization costs -- 1 2,087 -- -- -- 2,088 Stock split........... 54 (54) -- -- -- -- -- Reclass to retained earnings............ -- (247) 247 -- -- -- -- ---------------------------------------------------------------------- Balances at December 31, 1998............ $ 71 $ -- $(259,121) $ -- $ -- $(2,538) $(261,588) -----------------------------------------------------------------------
See accompanying notes to consolidated financial statements. Notes to Consolidated Financial Statements NOTE 1. Summary of Significant Accounting Policies ------------------------------------------ (a) Principles of Consolidation --------------------------- The consolidated financial statements include the accounts of Kinetic Concepts, Inc. ("KCI") and all subsidiaries (collectively, the "Company"). All significant intercompany balances and transactions have been eliminated in consolidation. Certain reclassifications of amounts related to prior years have been made to conform with the 1998 presentation. (b) Nature of Operations and Customer Concentration ----------------------------------------------- The Company designs, manufactures, markets and distributes therapeutic products, primarily specialty hospital beds, mattress overlays and medical devices that treat and prevent the complications of immobility. The principal markets for the Company's products are domestic and international health care providers, predominantly hospitals and extended care facilities throughout the U.S. and Western Europe. Receivables from these customers are unsecured. The Company contracts with both proprietary hospital groups and voluntary group purchasing organizations ("GPOs"). Proprietary hospital groups own all of the hospitals which they represent and, as a result, can ensure complete compliance with an executed national agreement. Voluntary GPOs negotiate contracts on behalf of member hospital organizations but cannot ensure that their members will comply with the terms of an executed national agreement. Approximately 46% of the Company's revenue during 1998 was generated under national agreements with GPOs. The Company operates directly in 12 foreign countries including Germany, Austria, the United Kingdom, Canada, France, the Netherlands, Switzerland, Australia, Sweden, Italy, Denmark and Ireland (see Note 14). (c) Revenue Recognition ------------------- Service and rental revenue are recognized as services are rendered. Sales and other revenue are recognized when products are shipped. (d) Cash and Cash Equivalents ------------------------- The Company considers all highly liquid investments with an original maturity of ninety days or less to be cash equivalents. (e) Fair Value of Financial Instruments ----------------------------------- The carrying amount reported in the balance sheet for cash, accounts receivable, long-term securities, accounts payable, and long-term obligations approximates their fair value. The Company estimates the fair value of long-term obligations by discounting the future cash flows of the respective instrument, using the Company's incremental rate of borrowing for a similar instrument. (f) Inventories ----------- Inventories are stated at the lower of cost (first-in, first- out) or market (net realizable value). Costs include material, labor and manufacturing overhead costs. Inventory expected to be converted into equipment for short-term rental has been reclassified to property, plant and equipment. (g) Property, Plant and Equipment ----------------------------- Property, plant and equipment are stated at cost. Betterments which extend the useful life of the equipment are capitalized. (h) Depreciation ------------ Depreciation on property, plant and equipment is calculated on the straight-line method over the estimated useful lives (thirty to forty years for the buildings and between three and ten years for most of the Company's other property and equipment) of the assets. (i) Goodwill -------- Goodwill represents the excess purchase price over the fair value of net assets acquired and is amortized over three to twenty- five years from the date of acquisition using the straight-line method. The carrying value of goodwill is based on management's current assessment of recoverability. Management evaluates recoverability using both objective and subjective factors. Objective factors include management's best estimates of projected future earnings and cash flows and analysis of recent sales and earnings trends. Subjective factors include competitive analysis, technological advantage or disadvantage, and the Company's strategic focus. (j) Other Assets ------------ Other assets consist principally of patents, trademarks, long- term investments, cash and investments restricted for use by the Company's captive insurance company and the estimated residual value of assets subject to leveraged leases. Patents and trademarks are amortized over the estimated useful life of the respective asset using the straight-line method. (k) Income Taxes ------------ The Company recognizes certain transactions in different time periods for financial reporting and income tax purposes. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. The provision for deferred income taxes represents the change in deferred income tax accounts during the year. (l) Common Stock ------------ The Company is authorized to issue 400 million shares of Common Stock, $0.001 par value (the "Common Stock"). During the third quarter of 1998, the Company declared a four-for-one stock split on the outstanding shares of the common stock of the Company, par value $0.001 per share, payable to the holders of record of said stock on September 1, 1998. The split was achieved by means of a three-for-one stock dividend on all outstanding common shares of the Company. All share, per share, stock price and stock option amounts shown in the financial statements (except the Consolidated Statement of Changes in Shareholders' Equity) and related footnotes have been restated to reflect the stock split. (m) Earnings Per Share ------------------ In 1997, the Financial Accounting Standard Board issued Statement No. 128, Earnings per Share. Statement 128 replaced the calculation of primary and fully diluted earning per share with basic and diluted earnings per share. Unlike primary earnings per share, basic earnings per share excludes any dilutive effects of options, warrants and convertible securities. Diluted earnings per share is very similar to the previously reported fully diluted earnings per share. All earnings per share amounts for all periods have been presented, and where appropriate, restated to conform to the Statement 128 requirements. (n) Use of Estimates ---------------- The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. (o) Insurance Programs ------------------ The Company established the KCI Employee Benefits Trust (the "Trust") as a self-insurer for certain risks related to the Company's U.S. employee health plan and certain other benefits. The Company funds the Trust based on the value of expected future payments, including claims incurred but not reported. The Company has purchased insurance which limits the Trust's liability under the benefit plans. Through January 31, 1999, the Company's wholly-owned captive insurance company, KCI Insurance Company, Ltd. (the "Captive"), reinsured the primary layer of commercial general liability, workers' compensation and auto liability insurance for certain operating subsidiaries. On January 31, 1999, the captive insurance company was liquidated. Provisions for losses expected under these programs are recorded based upon estimates of the aggregate liability for claims incurred based on actuarial reviews. The Company has obtained insurance coverage for catastrophic exposures as well as those risks required to be insured by law or contract. (p) Foreign Currency Translation ---------------------------- The functional currency for the majority of the Company's foreign operations is the applicable local currency. The translation of the applicable foreign currencies into U.S. dollars is performed for balance sheet accounts using the exchange rates in effect at the balance sheet date and for revenue and expense accounts using a weighted average exchange rate during the period. (q) Stock Options ------------- During October 1995, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 123 "Accounting for Stock-Based Compensation." The Statement allows companies to continue accounting for stock-based compensation under the provisions of APB Opinion 25, "Accounting for Stock Issued to Employees"; however, companies are encouraged to adopt a new accounting method based on the estimated fair value of employee stock options. Companies that do not follow the new fair value based method are required to provide expanded disclosures in footnotes to the financial statements. The Company has elected to continue accounting for stock-based compensation under the provisions of APB Opinion 25 and has provided the required disclosures (See Note 9). (r) Research and Development ------------------------ The focus of the Company's research and development program has been to develop new products and make technological improvements to existing products. Expenditures for research and development are expensed as incurred and represented approximately 2% of the Company's total operating expenditures in each of the years ended December 31, 1998, 1997 and 1996. (s) Interest Rate Protection Agreements ----------------------------------- Periodically, the Company enters into interest rate protection agreements to modify the interest characteristics of its outstanding debt. Each interest rate swap is designated with all or a portion of the principal balance and term of a specific debt obligation. These agreements involve the exchange of amounts based on a variable interest rate for amounts based on fixed interest rates over the life of the agreement without an exchange of the notional amount upon which the payments are based. The differential to be paid or received as interest rate change is accrued and recognized as an adjustment to interest expense related to the debt. The fair value of the swap agreements and changes in the fair value as a result of changes in market interest rates are not recognized in these consolidated financial statements. NOTE 2. Recapitalization ---------------- On November 5, 1997, a substantial interest in the Company was acquired by Fremont Partners L.P. ("Fremont") and Richard C. Blum & Associates, L.P. ("RCBA") (collectively, the "Investors"). The Company and the Investors entered into a Transaction Agreement dated as of October 2, 1997, as amended by a letter agreement dated November 5, 1997 (as so amended, the "Transaction Agreement") pursuant to which the Investors purchased approximately $31.2 million shares of newly-issued shares of the Company's common stock, $0.001 par value per share, at a price equal to $4.81 per share. The proceeds of the stock purchase, together with approximately $534.0 million of aggregate proceeds from certain financings, (see Note 5), were used to purchase approximately 124.0 million shares of the Company's common stock from the selling shareholders at a price of $4.81 per share, net to seller and pay all related fees and expenses. Also pursuant to the Transaction Agreement, the Investors were subsequently merged with and into the Company on January 5,1998, with the Company as the surviving corporation of the Merger. Following the Merger, Fremont, RCBA, Dr. James Leininger and Dr. Peter Leininger own 28.1 million, 18.6 million, 23.8 million and 400,000 shares, respectively, representing 39.7%, 26.2%, 33.5% and 0.6% of the total shares outstanding. There is currently one other shareholder and certain members of management have retained, and/or have been granted, additional options to purchase shares. The transactions have been accounted for as a recapitalization and as such, a step-up of assets to fair market value was not required. The difference between the payment amount and the net book value of assets acquired and liabilities assumed was recorded as retained earnings as a cash distribution to the selling shareholders. During 1997, non-recurring costs in connection with the Recapitalization of approximately $34.4 million were incurred and expensed. Additionally, financing costs of approximately $17.7 million have been deferred and will be amortized over the lives of the new debt facilities. NOTE 3. Acquisitions and Dispositions ----------------------------- On February 1, 1997, the Company acquired the assets of H.F. Systems, Inc. of Los Angeles. H.F. Systems offered a line of therapeutic specialty support surfaces primarily to the California extended care marketplace. The Company acquired the assets of H.F. Systems in a single transaction for approximately $8.0 million in cash plus other consideration. H.F. Systems has been integrated into Kinetic Concepts' extensive distribution system and, as a result, the Company has benefited from the elimination of certain redundant expenses. H.F. Systems recorded revenue of approximately $7.0 million for 1996 and did not have a material impact on the Company's results of operations for 1998 or 1997. During 1997, the Company acquired 90% of the outstanding capital stock of Ethos Medical Group, Ltd. located in Athlone, Ireland, for approximately $2.8 million in cash plus other consideration. During 1998, the Company acquired the remaining 10% of Ethos for approximately $300,000. Ethos manufactures the Keene Roto Rest trauma bed and other medical devices and rents specialty support surfaces to caregivers throughout Ireland. Ethos Medical's operating results did not have a material impact on the Company's results of operations for 1998 or 1997. On July 31, 1997, the Company acquired the outstanding capital stock of Equi-Tron Mfg., Inc. located in Ontario, Canada, for approximately $3.2 million in cash plus other consideration. Equi- Tron Mfg., Inc. manufactures a line of products for bariatric patients used primarily in the home care market. The operating results of Equi-Tron Mfg., Inc. did not have a material impact on the Company's results of operations for 1998 or 1997. On October 1, 1997, the Company acquired substantially all of the assets of RIK Medical, L.L.C. ("RIK"), a Delaware limited liability company. The Company paid approximately $23.3 million in cash for the acquisition plus an earn-out of up to $2.0 million. RIK is a manufacturer of non-powered therapeutic support surfaces based in Boulder, Colorado. The RIK products incorporate several unique and patented components and features. The operating results of RIK Medical did not have a material impact on the Company's results of operations for 1998 or 1997. On November 6, 1998 the Company acquired certain assets related to its medical devices business from Beiersdorf-Jobst, Inc. The assets were acquired for a total purchase price of approximately $14.5 million, when completed, subject to certain terms and conditions. Approximately $8.7 million of the total purchase price was paid during 1998. The remaining portion is to be paid subsequent to December 31, 1998. The acquired assets consisted of DVT prophylaxis medical devices, related disposables, equipment, technology and other intangible assets. The acquisition was funded through the Company's revolving credit line. The operating results of the acquired business did not have a material impact on the Company's results of operations for 1998. The 1998 and 1997 acquisitions have been accounted for by the purchase method of accounting, and accordingly, the approximate purchase prices, shown above, have been allocated to the assets acquired and the liabilities assumed based on the estimated fair values at the dates of acquisition, with the excess of the purchase prices over assigned asset values recorded as goodwill which the Company is amortizing over periods of 15-25 years. The results of operations of the acquisitions have been included in the Company's consolidated financial statements since the acquisition dates. Because the 1998 and 1997 acquisitions are not material to the Company's financial position or results of operations, pro forma results of operations are not presented. NOTE 4. Supplemental Balance Sheet Data ------------------------------- Accounts receivable consist of the following (in thousands): December 31, ----------------- 1998 1997 -------- ------- Trade accounts receivable........... $92,684 $88,509 Employee and other receivables...... 2,201 3,933 ------ ------ 94,885 92,442 Less allowance for doubtful receivables......................... 9,673 11,204 ------ ------ $85,212 $81,238 ====== ====== Inventories consist of the following (in thousands): December 31, -------------------- 1998 1997 --------- --------- Finished goods................... $10,974 $ 8,487 Work in process.................. 4,203 2,743 Raw materials, supplies and parts 21,585 17,723 ------ ------ 36,762 28,953 Less amounts expected to be converted into equipment for short-term rental.............. 8,100 7,400 ------ ------ $28,662 $21,553 ====== ====== Net property, plant and equipment consist of the following (in thousands): December 31, ----------------- 1998 1997 ------- ------- Land............................... $ 649 $ 649 Buildings.......................... 17,173 16,693 Equipment for short-term rental.... 135,158 131,534 Machinery, equipment and furniture. 45,515 40,551 Leasehold improvements............. 1,696 1,560 Inventory to be converted into equipment........................ 8,100 7,400 ------- ------- 208,291 198,387 Less accumulated depreciation...... 130,341 122,953 ------- ------- $ 77,950 $ 75,434 ======= ======= Accrued expenses consist of the following (in thousands): December -------------------- 1998 1997 --------- --------- Payroll, commissions and related taxes............................ $12,217 $14,627 Interest expense................... 3,827 4,591 Insurance accruals................. 3,404 3,238 Other accrued expenses............. 17,829 18,878 ------ ------ $37,277 $41,334 ====== ====== NOTE 5. Long-Term Obligations --------------------- Long-term obligations consist of the following (in thousands): December 31, -------------------- 1998 1997 -------- --------- Senior Credit Facilities: Revolving bank credit facility........ $ 10,000 $ 24,500 Acquisition credit facility........... 10,000 10,000 Term loans: Tranche A due 2003................. 117,000 120,000 Tranche B due 2004................. 89,100 90,000 Tranche C due 2005................. 89,100 90,000 ------- ------- 315,200 334,500 9 5/8% Senior Subordinated Notes Due 2007 200,000 200,000 ------- ------- 515,200 534,500 Less: Current installments............... 8,800 4,800 ------- ------- 506,400 529,700 Other.................................... 655 201 ------- ------- $507,055 $529,901 ======= ======= Senior Credit Facilities Indebtedness under the Senior Credit Facilities, including the Revolving Credit Facility (other than certain loans under the Revolving Credit Facility designated in foreign currency), the Term Loans and the Acquisition Facility initially bear interest at a rate based upon (i) the Base Rate (defined as the higher of (x) the rate of interest publicly announced by Bank of America as its "reference rate" and (y) the federal funds effective rate from time to time plus 0.50%), plus 1.25% in respect of the Tranche A Term Loans, the loans under the Revolving Credit Facility (the "Revolving Loans") and the loans under the Acquisition Facility (the "Acquisition Loans"), 1.50% in respect of the Tranche B Term Loans and 1.75% in respect of the Tranche C Term Loans, or at the Company's option, (ii) the Eurodollar Rate (as defined in the Sr. Credit Facility Agreement) for one, two, three or six months, in each case plus 2.25% in respect of Tranche A Term Loans, Revolving Loans and Acquisition Loans, 2.50% in respect of Tranche B Term Loans and 2.75% in respect of the Tranche C Term Loans. Certain Revolving Loans designated in foreign currency will initially bear interest at a rate based upon the cost of funds for such loans, plus 2.25% or 2.50%, depending on the type of foreign currency. Performance-based reductions of the interest rates under the Term Loans, the Revolving Loans and the Acquisition Loans are available. In December 1998, the Company entered into three interest rate protection agreements which effectively fix the base borrowing rate on 88% of the Company's variable rate debt as follows (dollars in millions): Annual Swap Interest Maturity Amount Rate ---------- ------- --------- 01/08/2002 $150.0 5.5775% 12/29/2000 95.0 4.8950% 12/31/1999 35.0 4.8550% As a result of interest rate protection agreements in place throughout 1998, the Company recorded additional interest expense of approximately $74,000 in 1998. The fair value of these agreements at December 31, 1998 were not material. The Revolving Loans may be repaid and reborrowed. Under the Bank Credit Agreement, the Company is required to pay to the Banks a commitment fee initially equal to 0.50% per annum, payable in arrears on a quarterly basis, on the average daily unused portion of the Revolving Credit Facility and Acquisition Facility during such quarter. The Company is also required to pay to the Banks participating in the Revolving Credit Facility letter of credit fees equal to the applicable margin then in effect with respect to Eurodollar loans under the Revolving Credit Facility on the face amount of each letter of credit outstanding and to the Bank issuing a letter of credit a fronting fee of 0.25% on the average daily stated amount of each outstanding letter of credit issued by such Bank, in each case payable in arrears on a quarterly basis. Bank of America and Bankers Trust will receive and continue to receive such other fees as have been separately agreed upon. At December 31, 1998, the aggregate availability under the Revolving Credit and Acquisition Facilities was $80.0 million. The Term Loans are subject to quarterly amortization payments which commenced on March 31, 1998. Commitments under the Acquisition Facility will expire three years from the closing of the Bank Credit Agreement and the Acquisition Facility loans outstanding shall be repayable in equal quarterly amortization payments commencing March 31, 2001. In addition, the Bank Credit Agreement provides for mandatory repayments, subject to certain exceptions, of the Term Loans, the Acquisition Facility and/or the Revolving Credit Facility based on certain net asset sales outside the ordinary course of business of the Company and its subsidiaries, the net proceeds of certain debt and equity issuances and excess cash flows. Indebtedness of the Company under the Senior Credit Agreement is guaranteed by certain of the subsidiaries of the Company and is secured by (i) a first priority security interest in all, subject to certain customary exceptions, of the tangible and intangible assets of the Company and its domestic subsidiaries, including, without limitation, intellectual property and real estate owned by the Company and its subsidiaries, (ii) a first priority perfected pledge of all capital stock of the Company's domestic subsidiaries and (iii) a first priority perfected pledge of up to 65% of the capital stock of foreign subsidiaries owned directly by the Company or its domestic subsidiaries. The Senior Credit Agreement requires the Company to meet certain financial tests, including minimum levels of EBITDA (as defined therein), minimum interest coverage, maximum leverage ratio and capital expenditures. The Bank Credit Agreement also contains covenants which, among other things, limit the incurrence of additional indebtedness, investments, dividends, loans and advances, capital expenditures, transactions with affiliates, asset sales, acquisitions, mergers and consolidations, prepayments of other indebtedness (including the Notes), liens and encumbrances and other matters customarily restricted in such agreements. The Company is in compliance with the applicable covenants at December 31, 1998. The Senior Credit Agreement contains customary events of default, including payment defaults, breach of representations and warranties, covenant defaults, cross-defaults to certain other indebtedness, certain events of bankruptcy and insolvency, failures under ERISA plans, judgment defaults, failure of any guaranty, security document security interest or subordination provision supporting the Bank Credit Agreement to be in full force and effect and change of control of the Company. 9 5/8% Senior Subordinated Notes Due 2007 The 9 5/8% Senior Subordinated Notes Due 2007 (the "Notes") are unsecured obligations of the Company, ranking subordinate in right of payment to all senior debt of the Company and will mature on November 1, 2007. Interest on the Notes accrues at the rate of 9 5/8% per annum and is payable semiannually in cash on each May 1 and November 1, commencing on May 1, 1998, to the persons who are registered Holders at the close of business on April 15 and October 15, respectively, immediately preceding the applicable interest payment date. Interest on the Notes accrues from and including the most recent date to which interest has been paid or, if no interest has been paid, from and including the date of issuance. The Notes are not entitled to the benefit of any mandatory sinking fund. In addition, at any time, or from time to time, the Company may acquire a portion of the Notes through open-market purchases. Redemption Optional Redemption. The Notes will be redeemable, at the Company's option, in whole at any time or in part from time to time, on and after November 1, 2002, upon not less than 30 nor more than 60 days' notice, at the following redemption prices (expressed as percentages of the principal amount thereof) if redeemed during the twelve-month period commencing on November 1 of the year set forth below, plus, in each case, accrued and unpaid interest thereon, if any, to the date of redemption. Year Percentage ---- ---------- 2002.................................. 104.813% 2003.................................. 103.208% 2004.................................. 101.604% 2005 and thereafter................... 100.000% Optional Redemption upon Equity Offerings. At any time, or from time to time, on or prior to November 1, 2000, the Company may, at its option, on one or more occasions use all or a portion of the net cash proceeds of one or more equity offerings to redeem the Notes issued under the Indenture at a redemption price equal to 109.625% of the principal amount thereof plus accrued and unpaid interest thereon, if any, to the date of redemption; provided that at least 65% of the principal amount of Notes originally issued remains outstanding immediately after any such redemption. In order to effect the foregoing redemption with the proceeds of any equity offering, the Company shall make such redemption not more than 120 days after the consummation of any such equity offering. Interest paid during 1998, 1997 and 1996 was approximately $47.0 million, $5.1 million and $200,000, respectively. Future maturities of long-term debt at December 31, 1998 are as follows (in thousands): Year Amount ---- --------- 1999.................................. $ 8,800 2000.................................. $ 16,800 2001.................................. $ 35,133 2002.................................. $ 35,133 2003.................................. $ 50,133 Thereafter............................ $369,201 NOTE 6. Leasing Obligations ------------------- The Company is obligated for equipment under various capital leases which expire at various dates during the next four years. At December 31, 1998, the gross amount of equipment under capital leases totaled $619,000 and related accumulated depreciation totaled $423,000. The Company leases computer and telecommunications equipment, service vehicles, office space, various storage spaces and manufacturing facilities under noncancelable operating leases which expire at various dates over the next six years. Total rental expense for operating leases, net of sublease payments received, was $13.4 million, $13.2 million and $13.5 million for the years ended December 31, 1998, 1997 and 1996, respectively. Future minimum lease payments under capital and noncancelable operating leases (with initial or remaining lease terms in excess of one year) as of December 31, 1998 are as follows (in thousands): Capital Operating Leases Leases -------- --------- 1999....................................... $ 190 $11,119 2000....................................... 103 8,814 2001....................................... 1 5,796 2002....................................... -- 3,724 2003....................................... -- 2,312 Later years................................ -- 739 ----- ------ Total minimum lease payments............... $ 294 $32,504 ====== Less amount representing interest.......... 15 ----- Present value of net minimum capital lease payments................................. 279 Less current portion....................... 150 ----- Obligations under capital leases excluding current installments..................... $ 129 ===== NOTE 7. Income Taxes ------------ Earnings before income taxes and minority interest consists of the following (in thousands): Year Ended December 31, ------------------------------ 1998 1997 1996 --------- --------- -------- Domestic........................ $ 8,050 $12,493 $51,771 Foreign......................... 11,552 8,540 12,670 ------ ------ ------ $19,602 $21,033 $64,441 ====== ====== ====== Income tax expense attributable to income from continuing operations consists of the following (in thousands): Year Ended December 31, 1998 ------------------------------- Current Deferred Total ---------- -------- ------- Federal......................... $ 1,267 $ 1,441 $ 2,708 State........................... 397 (38) 359 International................... 4,901 (117) 4,784 ------ ------ ------ $ 6,565 $ 1,286 $ 7,851 ====== ====== ====== Year Ended December 31, 1997 ------------------------------- Current Deferred Total --------- -------- --------- Federal......................... $ 145 $ 3,380 $ 3,525 State........................... 19 1,105 1,124 International................... 3,549 205 3,754 ------ ------ ------ $ 3,713 $ 4,690 $ 8,403 ====== ====== ====== Year Ended December 31, 1996 -------------------------------- Current Deferred Total ---------- -------- -------- Federal......................... $14,363 $ 4,464 $18,827 State........................... 2,569 552 3,121 International................... 3,831 (325) 3,506 ------ ------ ------ $20,763 $ 4,691 $25,454 ====== ====== ====== Income tax expense attributable to income from continuing operations differed from the amounts computed by applying the statutory tax rate of 35 percent to pre-tax income from continuing operations as a result of the following (in thousands): Year Ended December 31, ------------------------- 1998 1997 1996 ------- ------ ------ Computed "expected" tax expense.... $6,869 $7,353 $22,554 Goodwill........................... 365 317 442 State income taxes, net of Federal benefit.......................... 233 731 2,028 Tax-exempt interest from municipal bonds............................ (88) (160) (445) Foreign income taxed at other than U.S. rates....................... 496 417 1,145 Utilization of foreign net operating loss carryforwards..... (38) (46) (123) Nonconsolidated foreign net operating loss................... 274 402 67 Foreign, other..................... (422) (268) (441) Other, net......................... 162 (343) 227 ----- ----- ------ $7,851 $8,403 $25,454 ===== ===== ====== The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 1998 and 1997 are presented below (in thousands): 1998 1997 ---------- --------- Deferred Tax Assets: Accounts receivable, principally due to allowance for doubtful accounts........ $ 3,118 $ 3,311 Intangible assets, deducted for book purposes but capitalized and amortized for tax purposes....................... 423 617 Foreign net operating loss carryforwards. 274 402 Net operating loss carryforwards......... -- 1,566 Inventories, principally due to additional costs capitalized for tax purposes pursuant to the Tax Reform Act of 1986............................ 814 895 Legal fees, capitalized and amortized for tax purposes........................... 533 533 Accrued liabilities...................... 1,456 1,381 Foreign tax credits, available for carryback.............................. 7,751 3,321 Deferred foreign tax asset............... 237 120 Other.................................... 3,204 1,804 ------ ------ Total gross deferred tax assets........ 17,810 13,950 Less valuation allowance............... (274) (402) ------ ------ Net deferred tax assets................ 17,536 13,548 Deferred Tax Liabilities: Plant and equipment, principally due to differences in depreciation and basis.. (25,949) (20,591) Deferred state tax liability............. (1,709) (2,077) Investments, principally due to differences in tax treatment of certain components..................... -- (804) Other.................................... (1) (86) ------ ------ Total gross deferred tax liabilities... (27,659) (23,558) ------ ------ Net deferred tax liability............. $(10,123) $(10,010) ====== ====== At December 31, 1998, the Company had $782,000 of operating loss carryforwards available to reduce future taxable income of certain international subsidiaries. These loss carryforwards must be utilized within the applicable carryforward periods. A valuation allowance has been provided for the deferred tax assets related to loss carryforwards. Carryforwards of $425,000 can be used indefinitely and the remainder expire from 2001 through 2003. Additionally, the Company had a foreign tax credit of approximately $3.7 million which will be carried forward to offset future tax liabilities. The Company anticipates that the reversal of existing taxable temporary differences and future income will provide sufficient taxable income to realize the tax benefit of the remaining deferred tax assets. Income taxes paid during 1998, 1997 and 1996 were $5.5 million, $12.1 million and $15.4 million, respectively. NOTE 8. Shareholders' Equity and Employee Benefit Plans ----------------------------------------------- Common Stock: The Company is authorized to issue 400 million shares of Common Stock, $0.001 par value (the "Common Stock"). During the third quarter of 1998, the Company declared a four-for-one stock split on the outstanding shares of the common stock of the Company, par value $0.001 per share, payable to the holders of record of said stock on September 1, 1998. The split was achieved by means of a three-for-one stock dividend on all outstanding common shares of the Company. All share, per share, stock price and stock option amounts shown in the financial statements (except the Consolidated Statement of Changes in Shareholders' Equity) and related footnotes have been restated to reflect the stock split. On November 5, 1997, a substantial interest in the Company was acquired by Fremont Partners L.P. ("Fremont") and Richard C. Blum & Associates, L.P. ("RCBA") (collectively, the "Investors"). The Company and the Investors entered into a Transaction Agreement dated as of October 2, 1997, as amended by a letter agreement dated November 5, 1997 (as so amended, the "Transaction Agreement") pursuant to which the Investors purchased approximately 31.2 million shares of newly-issued shares of the Company's common stock, $0.001 par value per share, at a price equal to $4.81 per share. The proceeds of the stock purchase, together with approximately $534.0 million of aggregate proceeds from certain financings, (see Note 5), were used to purchase approximately 124.0 million shares of the Company's common stock from the selling shareholders at a price of $4.81 per share, net to seller and pay all related fees and expenses. The number of shares of Common Stock issued and outstanding at the end of 1998 and 1997 was 70,915,000 and 17,713,000, respectively. Treasury Stock: In July, 1995, the Company's Board of Directors approved a program to repurchase up to 12.0 million shares of its Common Stock. The Company repurchased approximately 1.0 million shares during 1997 and 10.3 million shares during 1996. In 1994, the Company's Board of Directors adopted a policy to return all repurchased shares to the status of authorized but unissued shares. In accordance with this resolution, the Company retired 10.3 million treasury shares in 1996. In February 1997, the Company's Board of Directors approved a program which authorized the Company to purchase up to an additional 12.0 million shares. The Company repurchased no shares during 1997 under this program. Both programs were terminated in 1997 in connection with the November 1997 recapitalization transactions. Preferred Stock: The Company is authorized to issue up to 20.0 million shares of Preferred Stock, par value $0.001 per share, in one or more series. As of December 31, 1998 and December 31, 1997, none were issued. Employee Stock Ownership Plan: The Company established an Employee Stock Ownership Plan (the "ESOP") covering employees of the Company who meet minimum age and length of service requirements. The ESOP enabled eligible employees to acquire a proprietary interest in the Company. As of November 6, 1997, the ESOP was terminated and all shares of stock owned by the ESOP were tendered in connection with the November 1997 recapitalization transactions. No ESOP expense was recorded during 1998, 1997 and 1996. As of October 1998, all plan benefits had been paid out to participants. Investment Plan: The Company has an Investment Plan intended to qualify as a deferred compensation plan under Section 401(k) of the Internal Revenue Code of 1986. The Investment Plan is available to all domestic employees and the Company matches employee contributions up to a specified limit. In 1998, 1997 and 1996, the Company made matching contributions and charged to expense $847,000, $950,000 and $498,000, respectively. NOTE 9. Stock Option Plans ------------------ In October 1995, the Financial Accounting Standards Board (FASB) issued Statement No. 123, "Accounting and Disclosure of Stock-Based Compensation." While the accounting standard encourages the adoption of a new fair-value method for expense recognition, Statement 123 allows companies to continue accounting for stock options and other stock-based awards as provided in Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" (APB 25). The Company has elected to follow the provisions of APB 25 and related interpretations in accounting for its stock options plans because, as discussed below, the alternative fair-value method prescribed by FASB Statement No. 123 requires the use of option valuation models that were not developed for use in valuing employee stock options. Under APB 25, because the exercise price of the Company's employee stock options generally equals the market price of the underlying stock on the date of grant, no compensation expense is recognized. In December 1997, the Company's Board of Directors approved the 1997 Management Equity Plan. The maximum aggregate number of shares of Common Stock that may be issued in connection with grants under the Management Equity Plan, as adjusted, is approximately 4.8 million shares, subject to adjustment as provided for in the plan. The Management Equity Plan is administered, and grants determined, by a committee of the Board of Directors. The exercise price and term of options granted under the Management Equity Plan shall be determined by the committee, however, in no event shall the term of any option granted under the Management Equity Plan exceed seven (7) years. The Management Equity Plan supersedes all other stock option plans. As of December 31, 1997, all outstanding options granted under the superseded plans were 100% vested. The 1997 Kinetic Concepts, Inc. Stock Incentive Plan (the "Stock Incentive Plan") was approved by the Company's Board of Directors on May 13, 1997 and covered an aggregate of 10.0 million shares of the Company's Common Stock. Under the Stock Incentive Plan, options were granted to employees (including officers), non- employee directors and consultants of the Company. The exercise price of the options was determined by a committee of the Board of Directors of the Company. The Stock Incentive Plan permitted the Board of Directors to declare the terms for payment when such options are exercised. Options under the Stock Incentive Plan were granted with a term not exceeding ten years. The Stock Incentive Plan was superseded by the 1997 Management Equity Plan. The 1987 Kinetic Concepts, Inc. Key Contributor Stock Option Plan (the "Key Contributor Stock Option Plan") covered up to an aggregate of 23.0 million shares of the Company's Common Stock. Options were granted under the Key Contributor Stock Option Plan to employees (including officers), non-employee directors and consultants of the Company. The exercise price of the options was determined by a committee of the Board of Directors of the Company. The Key Contributor Stock Option Plan permitted the Board of Directors to declare the terms for payment when such options are exercised. Options under the Key Contributor Stock Option Plan were granted with a term not exceeding ten years. The Key Contributor Stock Option Plan expired on April 13, 1997 and was succeeded by the 1997 Stock Incentive Plan. The 1988 Kinetic Concepts, Inc. Directors Stock Option Plan (the "Directors Stock Option Plan") covered an aggregate of 1,200,000 shares of the Company's Common Stock which were to be granted to non-employee directors of the Company. The exercise price of the options granted under the Directors Stock Option Plan was determined to be the fair market value of the shares of the Company's Common Stock on the date that such option was granted. The Directors Stock Option Plan was succeeded by the 1997 Stock Incentive Plan. The 1995 Kinetic Concepts, Inc. Senior Executive Management Stock Option Plan (the "Senior Executive Stock Option Plan") covered a total of 5.6 million shares of the Company's Common Stock which were to be granted to certain senior executives of the Company at the recommendation of the Chief Executive Officer and at discretion of the Company's Board of Directors. The exercise price for each share of common stock covered by an option was established by the Board of Directors but was not in any case to be less than the fair market value of the shares of Common Stock on the date of grant. Vesting of options granted was subject to certain terms and conditions. The Senior Executive Stock Option Plan was superseded by the 1997 Management Equity Plan . Pro forma information regarding net income and earnings per share is required by Statement 123 and has been calculated based on the assumption that the Company had accounted for its employee stock options under the fair-value method of that statement. The fair value for options granted during the three fiscal years ended December 31, 1998, 1997 and 1996, respectively, was estimated using a Black-Scholes option pricing model with the following weighted average assumptions: risk-free interest rates of 5.0%, 5.6% and 6.1%, dividend yields of 1.1%, 1.1% and 0.9%, volatility factors of the expected market price of the Company's common stock of .26, .30 and .32 and a weighted-average expected option life of 5 years. The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company's employee stock options have characteristics significantly different from those of traded options, and because changes in the underlying assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options. For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options' vesting period. The Company's pro forma information follows (in thousands except for earnings per share information): 1998 1997 1996 ---------- --------- --------- Net Earnings as Reported.... $11,776 $12,605 $38,987 Pro Forma Net Earnings...... $ 9,650 $11,319 $37,996 Earnings Per Share as Reported: Earnings per common share. $ 0.17 $ 0.08 $ 0.22 Earnings per common share -- assuming dilution.... $ 0.16 $ 0.08 $ 0.21 Pro Forma Earnings Per Share Earnings per common share. $ 0.14 $ 0.07 $ 0.22 Earnings per common share -- assuming dilution.... $ 0.13 $ 0.07 $ 0.21 The Company is not required to apply the method of accounting prescribed by Statement 123 to stock options granted prior to January 1, 1995. As a result, the pro forma compensation cost reflected above may not be representative of future results. The following table summarizes information about stock options outstanding at December 31, 1998 (options in thousands): Weighted Average Options Remaining Weighted Options Weighted Range of Outstanding Contract Average Exercisable Average Exercise at Life Exercise at Exercise Prices 12/31/98 (yrs) Price 12/31/98 Price - -------------- -------- ------- --------- --------- -------- $0.88 to $1.16 1,283 5.4 $1.05 1,283 $1.05 $1.25 to $2.38 597 5.8 $1.73 597 $1.73 $2.78 to $4.81 7,617 6.7 $4.26 3,285 $3.53 ----- ---- ---- ----- ---- 9,497 6.4 $3.67 5,165 $2.70 A summary of the Company's stock option activity, and related information, for years ended December 31, 1998, 1997 and 1996 follows (options in thousands): 1998 1997 1996 ---------------- --------------- ----------------- Weighted Weighted Weighted Average Average Average Exercise Exercise Exercise Options Price Options Price Options Price ---------------- ---------------- ----------------- Options Outstanding - Beginning of Year... 9,344 $ 3.55 13,356 $ 2.17 11,332 $ 1.30 Granted............. 623 $ 4.81 6,832 $ 4.36 5,268 $ 3.62 Exercised........... (288) $ 2.13 (10,436) $ 2.35 (2,512) $ 1.26 Forfeited........... (182) $ 4.01 (408) $ 2.66 (732) $ 2.34 ----- ------ ------ Options Outstanding - End of Year......... 9,497 $ 2.71 9,344 $ 3.55 13,356 $ 2.17 ----- ------ ------ Exercisable at End of Year............. 5,165 $ 2.70 5,520 $ 2.67 5,284 $ 1.77 ----- ----- ------ ----- ------ ----- Weighted-Average Fair Value of Options Granted During the Year............ $ 1.58 $ 1.60 $ 1.45 Exercise prices for options outstanding as of December 31, 1998 ranged from $0.88 to $ 4.81. The weighted average remaining contractual life of those options is 6.4 years. The weighted average fair value of options granted during 1998 approximated the weighted average exercise price at the grant date. Note 10. Other Comprehensive Income The Company adopted Financial Accounting Standards Board ("FASB") Statement No. 130, "Reporting Comprehensive Income", in the first quarter of 1998. The adoption of this Statement has no impact on the net earnings or shareholders' equity of the Company. This standard requires disclosure of total nonowner changes in shareholders' equity, which is defined as net earnings plus direct adjustments to shareholders' equity such as equity and cash investment adjustments and foreign currency translation adjustments. For KCI, other comprehensive income consists of foreign currency translation adjustments. For 1998, 1997 and 1996, the Company's comprehensive income was $11.7 million, $9.6 million and $38.5 million, respectively. The earnings associated with the Company's investment in its foreign subsidiaries are considered to be permanently invested and no provision for U.S. federal and state income taxes on these earnings or translation adjustments has been provided. Note 11. Other Assets ------------ A summary of other long-term assets follows (in thousands): 1998 1997 -------- -------- Investment in assets subject to leveraged leases.......... $16,445 $16,069 Investment in long-term securities................... 5,281 5,443 Intangible assets.............. 4,352 4,096 Deposits and other............. 8,816 6,973 ------ ------ $34,894 $32,581 (Less) accumulated amortization (3,425) (3,100) ------ ------ $31,469 $29,481 ====== ====== The Company acquired beneficial ownership of two Grantor Trusts in December 1996 and December 1994. The assets held by each Trust consist of a McDonnell Douglas DC-10 aircraft and three engines. In connection with the acquisitions, KCI paid cash equity of $7.2 million and $7.6 million, respectively, and assumed non- recourse debt of $47.0 million and $51.8 million, respectively. The DC-10 aircraft are leased to the Federal Express Corporation through June 2012 and January 2012, respectively. Federal Express pays monthly rent to a third party who, in turn, pays this entire amount to the holders of the non-recourse certificated indebtedness, which is secured by the aircraft. The certificate holders recourse in the event of a default is limited to the Trust assets. Long-term securities consist primarily of government backed securities held by the Company's wholly-owned captive insurance company and are carried at market value, which is not significantly different than cost. The carrying value of the long-term securities approximates fair value. Subsequent to December 31, 1998, the Company liquidated, at no gain or loss, the securities held by the captive insurance company and acquired letters of credit to cover the remaining claims liability recorded by the Captive as of December 31, 1998. Note 12. Earnings Per Share ------------------ The following table sets forth the reconciliation from basic to diluted average common shares and the calculations of net earnings per common share. Net earnings for basic and diluted calculations do not differ (in thousands, except per share). 1998 1997 1996 ---------- ---------- --------- Net earnings................... $ 11,776 $ 12,605 $ 38,987 ====== ======= ======= Average common shares: Basic(weighted-average outstanding shares)........ 70,873 154,364 175,832 Dilutive potential common shares from stock options.. 2,360 5,276 6,124 ------ ------- ------- Diluted (weighted-average outstanding shares)........ 73,233 159,640 181,956 ====== ======= ======= Earnings per common share..... $ 0.17 $ 0.08 $ 0.22 ====== ======= ======= Earnings per common share - assuming dilution............ $ 0.16 $ 0.08 $ 0.21 ====== ======= ======= NOTE 13. Commitments and Contingencies ----------------------------- On February 21, 1992, Novamedix Limited ("Novamedix") filed a lawsuit against the Company in the United States District Court for the Western District of Texas. Novamedix manufactures the principal product which directly competes with the PlexiPulse. The suit alleges that the PlexiPulse infringes several patents held by Novamedix, that the Company breached a confidential relationship with Novamedix and a variety of ancillary claims. Novamedix seeks injunctive relief and monetary damages. Although it is not possible to reliably predict the outcome of this litigation or the damages which could be awarded, the Company believes that its defenses to these claims are meritorious and that the litigation will not have a material adverse effect on the Company's business, financial condition or results of operations. On August 16, 1995, the Company filed a civil antitrust lawsuit against Hillenbrand Industries, Inc. and one of its subsidiaries, Hill-Rom. The suit was filed in the United States District Court for the Western District of Texas. The suit alleges that Hill-Rom used its monopoly power in the standard hospital bed business to gain an unfair advantage in the specialty hospital bed business. Specifically, the allegations set forth in the suit include a claim that Hill-Rom required hospitals and purchasing groups to agree to exclusively rent specialty beds in order to receive substantial discounts on products over which they have monopoly power - hospital beds and head wall units. The suit further alleges that Hill-Rom engaged in activities which constitute predatory pricing and refusals to deal. Hill-Rom has filed an answer denying the allegations in the suit. Although discovery has not been completed and it is not possible to reliably predict the outcome of this litigation or the damages which might be awarded, the Company believes that its claims are meritorious. On October 31, 1996, the Company received a counterclaim which had been filed by Hillenbrand Industries, Inc. in the antitrust lawsuit which the Company filed in 1995. The counterclaim alleges that the Company's antitrust lawsuit and other actions were designed to enable KCI to monopolize the specialty therapeutic surface market. Although it is not possible to reliably predict the outcome of this litigation, the Company believes that the counterclaim is without merit. On December 24, 1996, Hill-Rom, a subsidiary of Hillenbrand Industries, Inc., filed a lawsuit against the Company alleging that the Company's TriaDyne bed infringes a patent issued to Hill-Rom. This suit was filed in the United States District Court for the District of South Carolina. On February 12, 1999, the South Carolina District Court concluded that the TriaDyne bed did not infringe the Hill-Rom patent. On March 12, 1999, Hill-Rom filed a Notice of Appeal regarding this decision. The Company is a party to several lawsuits arising in the ordinary course of its business, including three other lawsuits alleging patent infringement by the Company, and the Company is contesting adjustments proposed by the Internal Revenue Service to prior years' tax returns in Tax Court. Provisions have been made in the Company's financial statements for estimated exposures related to these lawsuits and adjustments. In the opinion of management, the disposition of these matters will not have a material adverse effect on the Company's business, financial condition or results of operations. The manufacturing and marketing of medical products necessarily entails an inherent risk of product liability claims. The Company currently has certain product liability claims pending for which provision has been made in the Company's financial statements. Management believes that resolution of these claims will not have a material adverse effect on the Company's business, financial condition or results of operations. The Company has not experienced any significant losses due to product liability claims and management believes that the Company currently maintains adequate liability insurance coverage. Other than commitments for new product inventory, including disposable "for sale" products, of $4.0 million and the completion of the Jobst purchase, the Company has no material long-term capital commitments and can adjust its level of capital expenditures as circumstances dictate. See discussion of the Company's self-insurance program at Note 1 and leases at Note 6. NOTE 14. Segment and Geographic Information ---------------------------------- The Company is principally engaged in the sale and rental of innovative therapeutic systems throughout the United States and in twelve primary countries internationally. In June 1997, the Financial Accounting Standards Board ("FASB") issued Statement No. 131 "Disclosures about Segments of an Enterprise and Related Information", which the Company has adopted in the current year. The Company identifies its business segments based on management responsibility within the United States and geographically for all international units. The KCI New Technologies ("Nutech") segment includes all operations related to the U.S. rental and sale of circulatory devices, namely the Plexipulse and Plexipulse All-in- One systems. The Company measures segment profit as operating profit, which is defined as income before interest income or expense, foreign currency gains and losses, income taxes and minority interest. All intercompany transactions are eliminated in computing revenues, operating income and assets. Information on segments and a reconciliation to income before interest, income taxes, foreign currency gains and losses and minority interest are as follows (in thousands): Year Ended December 31, ----------------------------- 1998 1997 1996 -------- -------- -------- Revenue: KCI Therapeutic Services.. $229,582 $215,156 $184,775 KCI International......... 78,039 70,274 68,765 Nutech.................... 21,525 19,124 15,726 Other (1)................. 1,325 2,362 615 ------- ------- ------- $330,471 $306,916 $269,881 ======= ======= ======= Operating Earnings: KCI Therapeutic Services.. $ 79,457 $ 73,143 $ 60,282 KCI International......... 15,308 11,284 14,327 Nutech.................... 7,352 6,404 3,872 Other (2)................. (34,557) (60,782) (23,127) ------ ------ ------ $ 67,560 $ 30,049 $ 55,354 ====== ====== ====== Depreciation and Amortization: KCI Therapeutic Services.. $ 16,969 $ 12,905 $ 12,398 KCI International......... 6,800 5,527 5,184 Nutech.................... 998 698 768 Other..................... 7,011 4,950 3,444 ------ ------ ------ $ 31,778 $ 24,080 $ 21,794 ====== ====== ====== Total Assets: KCI Therapeutic Services.. $169,748 $213,531 $137,650 KCI International......... 58,064 65,020 59,340 Nutech.................... 17,437 7,791 4,387 Other..................... 62,824 58,590 52,016 ------- ------- ------- $308,073 $344,932 $253,393 ======= ======= ======= Gross Capital Expenditures: KCI Therapeutic Services.. $ 16,244 $ 21,772 $ 15,522 KCI International......... 5,022 5,222 5,114 Nutech.................... 665 1,456 745 Other..................... 8,682 2,072 5,702 ------- ------- ------- $ 30,613 $ 30,522 $ 27,083 ======= ======= ======= (1) Other revenue sources consist primarily of contract metal fabrication income. (2) General headquarter expenses are not allocated to the individual segments and include executive, financial, legal and administrative expenses. Following is other selected geographic financial information of the Company (in thousands): Year Ended December 31, -------------------------------- 1998 1997 1996 ---------- ---------- ---------- Geographic location of long- lived assets: Domestic.......... $159,472 $149,349 $ 90,669 Foreign........... 19,654 18,811 18,537 ------- ------- ------- Total long-lived assets..... $179,126 $168,160 $109,206 ======= ======= ======= NOTE 15. Quarterly Financial Data (Unaudited) ------------------------------------ The unaudited consolidated results of operations by quarter, as adjusted for the stock split, are summarized below: Year Ended December 31, 1998 ----------------------------------- First Second Third Fourth Quarter Quarter Quarter Quarter ------- ------- ------- ------- Revenue................. $81,897 $81,358 $81,048 $86,168 Operating earnings...... $17,190 $15,560 $18,669 $16,141 Net earnings............ $ 2,986 $ 2,178 $ 3,792 $ 2,820 Per share: Earnings per common share............ $ 0.04 $ 0.03 $ 0.05 $ 0.04 Earnings per common share - assuming dilution......... $ 0.04 $ 0.03 $ 0.05 $ 0.04 Average common shares: Basic (Weighted average out- standing shares). 70,852 70,852 70,872 70,915 Diluted (Weighted average out- standing shares). 73,304 73,300 73,264 73,273 ====== ====== ====== ====== Year Ended December 31, 1997 ------------------------------------- First Second Third Fourth Quarter Quarter Quarter Quarter -------- ------- ------- ------- Revenue................. $73,181 $75,031 $76,299 $ 82,405 Operating earnings (loss) $16,217 $16,223 $16,165 $(18,556) Net earnings (loss)..... $10,003 $ 9,952 $ 9,948 $(17,298) Per share: Earnings (loss) per common share..... $ 0.06 $ 0.06 $ 0.06 $ (0.16) Earnings (loss) per common share - assuming dilution $ 0.06 $ 0.06 $ 0.06 $ (0.15) Average common shares: Basic (Weighted average out- standing shares).. 169,604 169,268 169,788 108,992 Diluted (Weighted average out- standing shares).. 175,052 175,224 176,364 112,852 ======= ======= ======= ======= Results for the fourth quarter of 1997 include recapitalization expenses of $34.4 million (See Note 2). Earnings per share for the full year may differ from the total of the quarterly earnings per share due to rounding differences. NOTE 16. Guarantor Condensed Consolidating Financial Statements ------------------------------------------------------ Kinetic Concepts, Inc. issued $200 million in subordinated debt securities to finance a tender offer to purchase certain of its common shares outstanding. In connection with the issuance of these securities, certain of its subsidiaries (the guarantor subsidiaries) act as guarantors. Certain other subsidiaries (the nonguarantor subsidiaries) do not guarantee such debt. The following tables present the condensed consolidating balance sheets of Kinetic Concepts, Inc. as a parent company, its guarantor subsidiaries and its nonguarantor subsidiaries as of December 31, 1998 and 1997 and the related condensed consolidating statements of earnings and cash flows for each year in the three- year period ended December 31, 1998. Condensed Consolidating Guarantor, Non-Guarantor And Parent Company Balance Sheet December 31, 1998 (in thousands) Kinetic Concepts, Reclassi- Kinetic Inc. Non- fications Concepts, Parent Guarantor Guarantor and Inc. Company Sub- Sub- Elimi- and Sub- Borrower sidiaries sidiaries nations sidiaries --------- --------- --------- --------- ---------
ASSETS Current assets: Cash and cash equivalents........ $ -- $ -- $ 9,543 $ (5,177) $ 4,366 Accounts receivable, net................ -- 72,173 17,474 (4,435) 85,212 Inventories.......... -- 18,971 9,691 -- 28,662 Prepaid expenses and other.............. -- 7,395 3,312 -- 10,707 ------- ------- ------ ------- ------ Total current assets......... -- 98,539 40,020 (9,612) 128,947 Net property, plant and equipment............ -- 79,110 9,717 (10,877) 77,950 Goodwill, net.......... -- 49,033 5,294 -- 54,327 Loan issuance cost, net -- 15,380 -- -- 15,380 Other assets, net...... -- 31,417 52 -- 31,469 Intercompany invest- ments and advances... (261,588) 460,361 1,104 (199,877) -- ------- ------- ------ ------- ------- Total assets..... $(261,588) $733,840 $ 56,187 $(220,366) $308,073 ======= ======= ====== ======= ======= LIABILITIES AND SHAREHOLDERS(DEFICIT) EQUITY Accounts payable........$ -- $ 6,512 $ 2,104 $ (5,178) $ 3,438 Accrued expenses........ -- 28,971 8,306 -- 37,277 Current installments on long-term obligations. -- 8,800 -- -- 8,800 Intercompany payables... -- 6,151 3,765 (9,916) -- Current installments of capital lease obli- gations............... -- 150 -- -- 150 Income tax payable...... -- 1,612 1,077 -- 2,689 ------- ------- ------ ------- ------- Total current liabilities..... -- 52,196 15,252 (15,094) 52,354 ------- ------- ------ ------- ------- Long-term obligations excluding current installments.......... -- 507,055 -- -- 507,055 Capital lease obligations, excluding current installments.......... -- 99 30 -- 129 Deferred income taxes, net................... -- 15,519 -- (5,396) 10,123 ------- ------- ------ ------- ------- Total liabilities. -- 574,869 15,282 (20,490) 569,661 Shareholders' (deficit) equity................ (261,588) 158,971 40,905 (199,876) (261,588) ------- ------- ------ ------- ------- Total liabilities and equity......$(261,588) $733,840 $ 56,187 $(220,366) $308,073 ======= ======= ====== ======= =======
Condensed Consolidating Guarantor, Non-Guarantor And Parent Company Balance Sheet December 31, 1997 (in thousands) Kinetic Concepts, Reclassi- Kinetic Inc. Non- fications Concepts, Parent Guarantor Guarantor and Inc. Company Sub- Sub- Elimi- and Sub- Borrower sidiaries sidiaries nations sidiaries --------- --------- --------- --------- ---------
ASSETS Current assets: Cash and cash equivalents........ $ -- $ 44,471 $ 17,316 $ (33) $ 61,754 Accounts receivable, net................ 681 75,252 15,002 (9,697) 81,238 Inventories.......... 16,716 3,056 9,547 (7,766) 21,553 Prepaid expenses and other.............. 5,663 11,847 1,584 (648) 18,446 ------ ------- ------ ------- ------- Total current assets......... 23,060 134,626 43,449 (18,144) 182,991 Net property, plant and equipment........ 14,310 75,471 9,065 (23,412) 75,434 Goodwill, net.......... 2,749 37,332 5,818 -- 45,899 Loan issuance cost, net -- 17,346 -- -- 17,346 Other assets, net...... 6,055 23,298 127 1 29,481 Intercompany investments and advances......... 264,135 228,016 1,017 (493,168) -- ------- ------- ------ ------- ------- Total assets...... $310,309 $516,089 $ 59,476 $(534,723) $351,151 ======= ======= ====== ======= ======= LIABILITIES AND SHAREHOLDERS(DEFICIT)EQUITY Accounts payable....... $ 37,594 $ 595 $ 2,196 $ (32) $ 40,353 Accrued expenses....... 12,714 23,429 5,691 (500) 41,334 Current installments on long-term obligations 4,800 -- -- -- 4,800 Intercompany payables.. -- 181,147 9,761 (190,908) -- Current installments of capital lease obli- gations.............. 139 -- -- -- 139 Income tax payable..... -- 1 648 (649) -- ------- ------- ------ ------- ------- Total current liabilities..... 55,247 205,172 18,296 (192,089) 86,626 ------- ------- ------ ------- ------- Long-term obligations excluding current installments......... 529,700 201 -- -- 529,901 Capital lease obligations, excluding current installments......... 256 -- 56 -- 312 Dererred income taxes, net.................. 804 17,636 -- (8,430) 10,010 ------- ------- ------ ------- ------- Total liabilities.. 586,007 223,009 18,352 (200,519) 626,849 Shareholders' (deficit) equity............... (275,698) 293,080 41,124 (334,204) (275,698) ------- ------- ------ ------- ------- Total liabilities and equity....... $310,309 $516,089 $ 59,476 $(534,723) $351,151 ======= ======= ====== ======= =======
Condensed Consolidating Guarantor, Non-Guarantor And Parent Company Statement of Earnings For the year ended December 31, 1998 (in thousands) Kinetic Historical Concepts, Reclassi- Kinetic Inc. Non- fications Concepts, Parent Guarantor Guarantor and Inc. Company Sub- Sub- Elimi- and Sub- Borrower sidiaries sidiaries nations sidiaries --------- --------- --------- --------- ----------
REVENUE: Rental and service..... $ -- $208,363 $ 50,119 $ -- $258,482 Sales and other........ -- 59,193 23,567 (10,771) 71,989 ------ ------- ------ ------ ------- Total revenue...... -- 267,556 73,686 (10,771) 330,471 Rental expenses........ -- 121,034 44,427 -- 165,461 Cost of goods sold..... -- 20,931 12,470 (5,520) 27,881 ------ ------- ------ ------ ------- -- 141,965 56,897 (5,520) 193,342 ------ ------- ------ ------ ------- Gross profit....... -- 125,591 16,789 (5,251) 137,129 Selling, general and administrative expenses............. -- 64,924 4,645 -- 69,569 ------ ------- ------ ------ ------- Operating earnings. -- 60,667 12,144 (5,251) 67,560 Interest income........ -- 334 282 -- 616 Interest expense....... -- (48,594) -- -- (48,594) Foreign currency gain(loss)........... -- 1,031 (1,011) -- 20 ------ ------- ------ ------ ------- Earnings before income taxes and minority interest -- 13,438 11,415 (5,251) 19,602 Income tax............. -- 5,167 4,784 (2,100) 7,851 Minority interest...... -- -- 25 -- 25 ------ ------- ------ ------ ------- Earnings before equity in earnings of subsidiaries..... -- 8,271 6,656 (3,151) 11,776 Equity in earnings of subsidiaries. 11,776 6,656 -- (18,432) -- ------ ------- ------ ------ ------- Net earnings....... $11,776 $ 14,927 $ 6,656 $(21,583) $ 11,776 ====== ======= ====== ====== =======
Condensed Consolidating Guarantor, Non-Guarantor And Parent Company Statement of Earnings For the year ended December 31, 1997 (in thousands) Kinetic Historical Concepts, Reclassi- Kinetic Inc. Non- fications Concepts, Parent Guarantor Guarantor and Inc. Company Sub- Sub- Elimi- and Sub- Borrower sidiaries sidiaries nations sidiaries --------- --------- --------- --------- ----------
REVENUE: Rental and service..... $ -- $202,938 $ 44,952 $ -- $247,890 Sales and other........ 42,290 36,777 21,190 (41,231) 59,026 ------ ------- ------ ------ ------- Total revenue...... 42,290 239,715 66,142 (41,231) 306,916 Rental expenses........ -- 123,346 40,946 (8,113) 156,179 Cost of goods sold..... 30,335 9,379 12,791 (28,832) 23,673 ------ ------- ------ ------ ------- 30,335 132,725 53,737 (36,945) 179,852 ------ ------- ------ ------ ------- Gross profit....... 11,955 106,990 12,405 (4,286) 127,064 Selling, general and administrative expenses............. 8,796 44,090 9,768 -- 62,654 Recapitalization expense.............. -- 34,361 -- -- 34,361 ------ ------- ------ ------ ------- Operating earnings. 3,159 28,539 2,637 (4,286) 30,049 Interest income........ 278 1,527 458 -- 2,263 Interest expense....... (9,736) (1,176) -- 739 (10,173) Foreign currency loss.. -- -- (1,106) -- (1,106) ------ ------ ------ ----- ------- Earnings before income taxes and minority interest (6,299) 28,890 1,989 (3,547) 21,033 Income tax............. (2,483) 11,169 1,381 (1,664) 8,403 Minority interest...... -- -- (25) -- (25) ------ ------- ------ ------ ------- Earnings before equity in earnings of subsidiaries..... (3,816) 17,721 583 (1,883) 12,605 Equity in earnings of subsidiaries.. 16,421 583 -- (17,004) -- ------ ------- ------ ------ ------- Net earnings....... $12,605 $ 18,304 $ 583 $(18,887) $ 12,605 ====== ======= ====== ====== =======
Condensed Consolidating Guarantor, Non-Guarantor And Parent Company Statement of Earnings For the year ended December 31, 1996 (in thousands) Kinetic Historical Concepts, Reclassi- Kinetic Inc. Non- fications Concepts, Parent Guarantor Guarantor and Inc. Company Sub- Sub- Elimi- and Sub- Borrower sidiaries sidiaries nations sidiaries --------- --------- --------- --------- ---------
REVENUE: Rental and service..... $ -- $176,135 $49,315 $ -- $225,450 Sales and other........ 54,716 10,989 18,768 (40,042) 44,431 ------ ------- ------ ------ ------- Total revenue...... 54,716 187,124 68,083 (40,042) 269,881 Rental expenses........ -- 110,198 45,851 (9,844) 146,205 Cost of goods sold..... 33,774 -- 9,027 (26,486) 16,315 ------ ------- ------ ------ ------- 33,774 110,198 54,878 (36,330) 162,520 ------ ------- ------ ------ ------- Gross profit....... 20,942 76,926 13,205 (3,712) 107,361 Selling, general and administrative expenses............. 22,615 38,218 3,101 (11,927) 52,007 ------ ------- ------ ------ ------- Operating earnings. (1,673) 38,708 10,104 8,215 55,354 Interest income........ 249 9,513 334 (764) 9,332 Interest expense....... (962) (810) -- 1,527 (245) ------ ------- ------ ------ ------- Earnings before income taxes and minority interest (2,386) 47,411 10,438 8,978 64,441 Income tax............. (788) 19,059 3,862 3,321 25,454 ------ ------- ------ ------ ------- Earnings before equity in earnings of subsidiaries..... (1,598) 28,352 6,576 5,657 38,987 Equity in earnings of subsidiaries.. 40,585 6,576 -- (47,161) -- ------ ------- ------ ------ ------- Net earnings....... $38,987 $ 34,928 $ 6,576 $(41,504) $ 38,987 ====== ======= ====== ====== =======
Condensed Consolidating Guarantor, Non-Guarantor And Parent Company Statement of Cash Flows For year ended December 31, 1998 (in thousands) Kinetic Concepts, Reclassi- Kinetic Inc. Non- fications Concepts, Parent Guarantor Guarantor and Inc. Company Sub- Sub- Elimi- and Sub- Borrower sidiaries sidiaries nations sidiaries --------- --------- --------- -------- ---------
Cash flows from operating activities: Net earnings.......... $ 11,776 $ 14,927 $ 6,656 $(21,583) $ 11,776 Adjustments to reconcile net earnings to net cash provided by operating activities.......... (9,767) 33,837 4,695 3,344 32,109 ------ ------ ------ ------ ------ Net cash provided by operating activities 2,009 48,764 11,351 (18,239) 43,885 Cash flows from investing activities: Additions to property, plant and equipment......... -- (31,166) (7,512) 8,765 (29,913) Decrease in inventory to be converted into equipment for short-term rental. -- (700) -- -- (700) Dispositions of property, plant and equipment..... -- 755 1,452 -- 2,207 Businesses acquired in purchase transactions, net of cash acquired.......... -- (10,939) (327) -- (11,266) Decrease (increase) in other assets... -- (3,054) 248 -- (2,806) ------ ------ ------ ------ ------ Net cash used by investing activities -- (45,104) (6,139) 8,765 (42,478) Cash flows from financing activities: Repayments of notes payable and long- term obligations.. -- (19,329) -- -- (19,329) Repayments of capital lease obligations. -- (145) (27) -- (172) Loan issuance costs. -- (339) -- -- (339) Proceeds from the excercise of stock options..... 300 -- -- -- 300 Proceeds (payments) on intercompany invesments and advances.......... (6,340) 15,003 (5,510) (3,153) -- Cash dividends paid to shareholders... -- -- (8,651) 8,651 -- Recapitalization costs - fees and expenses.......... 2,088 -- -- -- 2,088 Recapitalization costs - amount incurred in 1997, paid in 1998...... -- (41,652) -- -- (41,652) Other............... 1,943 (1,637) 1,204 (1,512) (2) ------ ------ ------ ------ ------ Net cash provided by financing activities (2,009) (48,099) (12,984) 3,986 (59,106) Effect of exchange rate changes on cash and cash equivalents.... -- -- -- 311 311 ------ ------ ------ ------ ------ Net decrease in cash and cash equivalents -- (44,439) (7,772) (5,177) (57,388) Cash and cash equivalents, beginning of year... -- 44,439 17,315 -- 61,754 ------ ------ ------ ------ ------ Cash and cash equivalents, end of year............. $ -- $ -- $ 9,543 $(5,177) $ 4,366 ====== ====== ====== ====== ======
Condensed Consolidating Guarantor, Non-Guarantor And Parent Company Statement of Cash Flows For year ended December 31, 1997 (in thousands) Kinetic Concepts, Reclassi- Kinetic Inc. Non- fications Concepts, Parent Guarantor Guarantor and Inc. Company Sub- Sub- Elimi- and Sub- Borrower sidiaries sidiaries nations sidiaries --------- --------- --------- --------- ---------
Cash flows from operating activities: Net earnings......... $ 12,605 $ 18,304 $ 583 $(18,887) $ 12,605 Adjustments to reconcile net earnings to net cash provided by operating activities......... (19,424) (5,196) 2,355 20,364 (1,901) -------- ------- ------- ------- ------- Net cash provided by operating activities (6,819) 13,108 2,938 1,477 10,704 Cash flows from investing activities: Additions to property, plant and equipment.......... (1,624) (22,565) (5,698) 2,215 (27,672) Decrease in inventory to be converted into equipment for short-term rental (2,850) -- -- -- (2,850) Dispositions of property, plant and equipment.... -- 521 2,099 -- 2,620 Businesses acquired in purchase transactions,net of cash acquired. -- (38,266) (2,886) (1) (41,153) Decrease (increase) in other assets.. 4,583 1,709 2,990 (8,343) 939 ------- ------ ------ ------- ------ Net cash provided (used) by investing activities......... 109 (58,601) (3,495) (6,129) (68,116) Cash flows from financing activities: Borrowings of notes payable and long- term obligations. 534,500 201 -- -- 534,701 Borrowings (repayments) of capital lease obligations...... (71) -- 8 (270) (333) Loan issuance costs (6) (17,728) -- -- (17,734) Proceeds from the excercise of stock options.... 3,668 -- -- -- 3,668 Proceeds (payments) on intercompany investments and advances......... (71,983) 59,803 7,521 4,659 -- Purchase and retirement of treasury stock... (3,827) -- -- -- (3,827) Cash dividends paid to shareholders.. (6,388) -- -- -- (6,388) Recapitalization costs - purchase of treasury stock............ (631,606) -- -- -- (631,606) Recapitalization costs - proceeds from C/S issuance 150,184 -- -- -- 150,184 Recapitalization costs - fees and expenses......... (8,626) -- -- -- (8,626) Recapitalization costs - amounts not yet paid..... 41,652 -- -- -- 41,652 Other.............. (787) (2,598) (4,141) 7,779 253 ------- ------- ------- ------ ------ Net cash provided by financing activities 6,710 39,678 3,388 12,168 61,944 Effect of exchange rate changes on cash and cash equivalents... -- -- -- (1,823) (1,823) ------- ------- ------- ------ ------ Net increase (decrease) in cash and cash equivalents........ -- (5,815) 2,831 5,693 2,709 Cash and cash equivalents, beginning of year.. -- 50,286 14,485 (5,726) 59,045 ------- ------ ------ ------- ------- Cash and cash equivalents, end of year............ $ -- $44,471 $17,316 $ (33) $ 61,754 ======= ====== ====== ====== =======
Condensed Consolidating Guarantor, Non-Guarantor And Parent Company Statement of Cash Flows For year ended December 31, 1996 (in thousands) Kinetic Concepts, Reclassi- Kinetic Inc. Non- fications Concepts, Parent Guarantor Guarantor and Inc. Company Sub- Sub- Elimi- and Sub- Borrower sidiaries sidiaries nations sidiaries --------- --------- --------- --------- ---------
Cash flows from operating activities: Net earnings........... $ 38,987 $ 34,928 $ 6,576 $(41,504) $ 38,987 Adjustments to reconcile net earnings to net cash provided by operating activities........... (32,912) 24,267 (5,031) 36,856 23,180 ------ ------ ------- ------ ------ Net cash provided by operating activities 6,075 59,195 1,545 (4,648) 62,167 Cash flows from investing activities: Additions to property, plant and equipment...... (8,474) (13,261) (10,017) 3,969 (27,783) Decrease in inventory to be converted into equipment for short-term rental.. 700 -- -- -- 700 Dispositions of property, plant and equipment...... -- 132 5,268 -- 5,400 Businesses acquired in purchase transactions, net of cash acquired... -- (1,146) -- -- (1,146) Excess principal repayment on discounted notes receivable... -- 5,180 -- -- 5,180 Note repaid from principal shareholder........ -- 10,000 -- -- 10,000 Decrease (increase) in other assets.... 23 (6,796) (1,227) (1,960) (9,960) ------ ------ ------- ------ ------ Net cash provided (used) by investing activities.......... (7,751) (5,891) (5,976) 2,009 (17,609) Cash flows from financing activities: Borrowings (repayments) of capital lease obligations........ 466 -- (6) (3) 457 Proceeds from the excercise of stock options............ 4,264 -- -- -- 4,264 Proceeds (payments) on intercompany investments and advances........... 39,442 (45,135) 5,565 128 -- Purchase and retirement of treasury stock..... (35,241) -- -- -- (35,241) Cash dividends paid to shareholders.... (6,607) -- -- -- (6,607) Other................ (648) 975 (480) 3 (150) ------ ------ ------ ------ ------ Net cash provided (used) by financing activities........... 1,676 (44,160) 5,079 128 (37,277) Effect of exchange rate changes on cash and cash equivalents .... -- -- -- (635) (635) ------ ------- ------ ------ ------ Net increase in cash and cash equivalents. -- 9,144 648 (3,146) 6,646 Cash and cash equivalents, beginning of year.... -- 41,142 13,837 (2,580) 52,399 ------ ------- ------ ------ ------ Cash and cash equivalents, end of year.............. $ -- $ 50,286 $ 14,485 $ (5,726) $ 59,045 ====== ====== ====== ====== ======
Independent Auditors' Report The Board of Directors and Shareholders Kinetic Concepts, Inc.: We have audited the accompanying consolidated balance sheets of Kinetic Concepts, Inc. and subsidiaries as of December 31, 1998 and 1997 and the related consolidated statements of earnings, cash flows and shareholders' (deficit) equity for each of the two years in the period ended December 31, 1998. Our audits also included the financial statement schedules, as it relates to information for the years ended December 31, 1998 and 1997, listed in the index at Item 14(a). These consolidated financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and schedules based on our audits. The consolidated financial statements for Kinetic Concepts, Inc. and subsidiaries for the year ended December 31, 1996 were audited by other auditors whose report dated February 5, 1997, expressed an unqualified opinion on those statements. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the 1998 and 1997 consolidated financial statements referred to above present fairly, in all material respects, the financial position of Kinetic Concepts, Inc. and subsidiaries as of December 31, 1998 and 1997 and the consolidated results of their operations and their cash flows for each of the two years in the period ended December 31, 1998 in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein. /s/ ERNST & YOUNG LLP ------------------------- Ernst & Young LLP San Antonio, Texas February 5, 1999 Independent Auditors' Report The Board of Directors and Shareholders Kinetic Concepts, Inc.: We have audited the accompanying consolidated balance sheet of Kinetic Concepts, Inc. and subsidiaries as of December 31, 1996 and the related consolidated statements of earnings, cash flows and shareholders' equity for each of the years in the two-year period ended December 31, 1996. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Kinetic Concepts, Inc. and subsidiaries as of December 31, 1996, and the results of their operations and their cash flows for each of the years in the two-year period ended December 31, 1996, in conformity with generally accepted accounting principles. /s/ KPMG PEAT MARWICK LLP ------------------------- KPMG Peat Marwick LLP San Antonio, Texas February 5, 1997 Independent Auditors' Report The Board of Directors and Shareholders Kinetic Concepts, Inc.: Under date of February 5, 1997, we reported on the consolidated balance sheet of Kinetic Concepts, Inc. and subsidiaries as of December 31, 1996, and the related consolidated statements of earnings, shareholders' equity and cash flows for each of the years in the two-year period ended December 31, 1996. In connection with our audits of the aforementioned consolidated financial statements, we also have audited the related financial statement schedule as listed in Item 14 (a) (2) of Form 10-K. This financial statement schedule is the responsibility of the Company's management. Our responsibility is to express an opinion on this financial statement schedule based on our audit. In our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects the information set forth therein. /s/ KPMG PEAT MARWICK LLP ------------------------- KPMG Peat Marwick LLP San Antonio, Texas February 5, 1997 Item 9. Changes in and Disagreements with Accountants on - --------------------------------------------------------- Accounting Matters and Financial Disclosure - ---------------------------------------------------- Ernst & Young LLP was the Company's certifying accountant for the two years ended December 31, 1998 and 1997. On February 18, 1997, the Board of Directors of the Company, upon the recommendation of the Audit Committee, voted to engage the accounting firm of Ernst & Young LLP as the Company's certifying accountant for the year ending December 31, 1997. The Company's previous certifying accountant, KPMG Peat Marwick LLP, was notified on February 21, 1997 and its engagement was terminated effective upon the completion and filing of the Company's 1996 Annual Report on Form 10-K. On February 24, 1997, the Company notified Ernst & Young LLP that it would be engaged as the Company's certifying accountant for the 1997 fiscal year. The report of KPMG Peat Marwick LLP on the Company's financial statements for the year ended December 31, 1996 did not contain an adverse opinion or disclaimer of opinion and was not qualified or modified as to uncertainty, audit scope or accounting principles. In connection with the audit of the Company's financial statements for the year ended December 31, 1996 and in the subsequent interim period through the date of dismissal, there were no disagreements with KPMG Peat Marwick LLP on any matters of accounting principles, financial statement disclosure or audit scope and procedures which, if not resolved to the satisfaction of KPMG Peat Marwick LLP, would have caused the firm to make reference to the matter in their report. The change in certifying accountant came in response to a Request for Proposal issued by the Company in 1996. Ernst & Young LLP, has been providing property and income tax planning services to the Company since 1995. PART III Item 10. Directors and Executive Officers of the Registrant - ----------------------------------------------------------- Set forth below are the names, ages and positions of the directors and executive officers of the Company, together with certain other key personnel. Name Age Position - ----------------- ---- --------------------- Robert Jaunich II....... 58 Chairman of the Board Raymond R. Hannigan..... 59 Director, President and Chief Executive Officer James R. Leininger M.D.. 54 Director, Chairman Emeritus James T. Farrell........ 34 Director N. Colin Lind........... 42 Director Charles N. Martin....... 52 Director Donald E. Steen......... 56 Director Jeffrey W. Ubben........ 37 Director Dennis E. Noll.......... 44 Senior Vice President, General Counsel and Secretary Christopher M. Fashek... 49 President, KCI Therapeutic Services Frank DiLazzaro......... 40 President, KCI International William M. Brown........ 56 Vice President and Chief Financial Officer Richard C. Vogel........ 44 Vice President and General Manager, NuTech Michael J. Burke........ 51 Vice President, Manufacturing Martin J. Landon........ 39 Vice President, Accounting and Corporate Controller Item 10. Directors and Executive Officers of the Registrant (Continued) - ------------------------------------------------------------------------- Robert Jaunich II became a director and Chairman of the Board after the consummation of the Tender Offer. Mr. Jaunich is a Managing Director of Fremont Partners where he shares management responsibility for the $605 million investment fund. He is also a Managing Director and a member of the Board of Directors and Executive Committee of The Fremont Group. Prior to joining the Fremont Group in 1991, he was Executive Vice President and a member of the Chief Executive Office of Jacobs Suchard AG, a Swiss-based chocolate, sugar confectionery and coffee company. He currently serves as a director of CNF Transportation, Inc. and as Chairman of the Managing General Partner of Crown Pacific Partners, L.P. Raymond R. Hannigan joined the Company as its President and Chief Executive Officer in November 1994 and has served as a director of the Company since 1994. From January 1991 to November 1994, Mr. Hannigan was the President of the International Division of Sterling Winthrop Consumer Health Group (a pharmaceutical company with operations in over 40 countries), a wholly-owned subsidiary of Eastman Kodak. From May 1989 to January 1991, Mr. Hannigan was the President of Sterling Drug International. James R. Leininger, M.D. is the founder of the Company and served as Chairman of the Board of Directors from 1976 until 1997. From January 1990 to November 1994, Dr. Leininger served as President and Chief Executive Officer of the Company. From 1975 until October 1986, Dr. James Leininger was also the Chairman of the Emergency Department of the Baptist Hospital System in San Antonio, Texas. James T. Farrell became a director after the consummation of the Tender Offer. Mr. Farrell is a Managing Director of Fremont Partners. Before joining The Fremont Group in 1991, he was an associate at ESL Partners, a private investment partnership. In 1985, he began his career at Copley Real Estate Advisors. Mr. Farrell is a former director of Coldwell Banker Corporation. He also serves as a director of the nonprofit Pacific Research Institute. N. Colin Lind became a director after the consummation of the Tender Offer. Mr. Lind is a Managing Director of Richard C. Blum & Associates, L.P. Before joining RCBA in 1986, he was a Vice President at R. H. Chappell Co., an investment concern focused on development stage companies, and was previously a Vice President of Research for two regional brokerage firms, Davis Skaggs, Inc. and Wheat First Securities. He has previously been a director of two public companies and seven venture capital backed companies. Charles N. Martin became a director in 1998. From January 1992 to January 1997, Mr. Martin served as Chairman, President and Chief Executive Officer of OrNda Health Corp. Starting in 1987 through January 1992, Mr. Martin served as President, Director and Chief Operating Officer for HealthTrust Inc. Mr. Martin serves as a director of Heritage Health Systems, Ambulatory Resource Centres, the Center for Professional Excellence and UniPhy. Donald E. Steen became a director in 1998. Mr. Steen is Chairman of the Board of United Surgical Partners International, Inc. ("USP"). Prior to USP Mr. Steen served as President of the International group of Columbia/HCA. He was formerly President of the Western Group of Columbia/HCA. Prior to joining Columbia/HCA, Mr. Steen served as President and Chief Executive Officer of Medical Care America, the holding company of Medical Care International, Inc. and Critical Care America, Inc. Mr. Steen currently serves on the Board of Directors of several health care companies. Jeffrey Ubben became a director after the consummation of the Tender Offer. Mr. Ubben is a Managing Director of Richard C. Blum & Associates, L.P. Before joining RCBA in 1995 he was manager of the $5 billion Fidelity Value Fund and had been employed by Fidelity for a period of nine years. Dennis E. Noll joined the Company in February 1992 as its Senior Corporate Counsel and was appointed Vice President, General Counsel and Secretary in January 1993. Mr. Noll was promoted to Senior Vice President in September 1995. Prior to joining the Company in February 1992, Mr. Noll was a shareholder of the law firm of Cox & Smith Incorporated. Christopher M. Fashek joined the Company in February 1995 as President, KCTS. Prior to joining the Company, he served as General Manager, Sterling Winthrop, New Zealand since February 1993, and served as Vice President Sales of Sterling Health USA from 1989 until February 1993. Frank DiLazzaro joined the Company in 1988 as General Manager, KCI Medical Canada. Mr. DiLazzaro served as Vice President, KCI International, Inc. from June 1989 to December 1992. Mr. DiLazzaro has served as President, KCI International, Inc. since January 1993 and was Vice President, Marketing from April 1993 to September 1995. William M. Brown joined the Company as its Vice President and Chief Financial Officer on July 1, 1998. Prior to joining the Company, he served as Executive Vice President and Chief Financial Officer for IMO Industries from 1992 until October 1997 and held various executive positions with ITT Corporation from 1967 through 1992. Richard C. Vogel joined the Company as its Vice President and General Manager, NuTech on July 1, 1996. From 1989 to 1996, Mr. Vogel served as Executive Vice President of Vestar, Inc., a California-based biotechnology company. Michael J. Burke joined the Company in September 1995 as Vice President, Manufacturing. Prior to joining the Company, Mr. Burke worked for Sterling Winthrop, Inc., a Division of Eastman Kodak Company, for 25 years, where he served as Vice President, Manufacturing and as General Manager, Sterling Health HK/China since 1992. Martin J. Landon joined the Company in May 1994 as Senior Director of Corporate Development and was promoted to Vice President, Accounting and Corporate Controller in October 1994. From 1987 to May 1994, Mr. Landon worked for Intelogic Trace, Inc., most recently serving as Vice President and Chief Financial Officer. Item 11. Executive Compensation - --------------------------------- SUMMARY COMPENSATION TABLE -------------------------- LONG- TERM COMPEN- SATION ANNUAL COMPENSATION AWARDS - ------------------------------------------------------------------------ Other Annual (2) Compen- Securities All Other Name and Principal sation Underlying Compen- Position Year Salary Bonus (1) Options sation - -------------------- ---- -------- -------- -------- ---------- --------
Raymond R. Hannigan 1998 $322,500 $ 64,500 -- $5,214 Chief Executive 1997 300,000 433,100 816,000 5,583 Officer,& President 1996 275,000 175,000 48,000 4,888 Frank DiLazzaro 1998 $188,667 $ 52,920 -- $1,695 President, 1997 181,000 390,323 352,000 1,409 KCI International, Inc. 1996 168,000 86,000 312,000 884 Christopher M. Fashek 1998 $219,000 $ 16,650 -- $2,338 President & Chief 1997 206,750 362,637 473,600 2,256 Executive Officer, KCI 1996 193,000 115,800 493,000 1,647 Therapeutic Services, Inc. Dennis E. Noll 1998 $187,750 $ 36,225 -- $1,612 Senior Vice-President, 1997 177,688 293,390 352,000 1,623 General Counsel & 1996 165,812 81,000 392,000 1,315 Secretary Richard Vogel 1998 $160,542 $ 54,000 -- $1,513 Vice President & G. 1997 150,833 287,539 188,800 1,463 Manager KCI New Technologies, Inc. 1996 72,500 29,000 $104,350 200,000 1,805
(1) The column entitled "Other Annual Compensation" includes monies paid to Mr. Vogel in 1996 for reimbursement of relocation expenses. Except with respect to personal benefits received by individuals in fiscal 1996, the personal benefits provided to each of the named executive officers under various Company programs did not exceed 10% of the individual's combined salary and bonus in any other year. (2) The "All Other Compensation" column includes the Company's contribution to the Company's Employee Stock Ownership Plan which was credited in 1996, a Company contribution of $1,000 in 1998 and $500 in 1997 to the Company's 401(k) plan for the named individuals and a premium for term life insurance in an amount which varied depending on the age of the executive officer. Item 11. Executive Compensation (continued) - ------------------------------------------ OPTION GRANTS AND EXERCISES IN LAST FISCAL YEAR No options were granted or exercised during 1998. FISCAL YEAR-END OPTION VALUE The following table sets forth certain information concerning the number and value of the options held by the named executive officers at the end of the fiscal year ended December 31, 1998. Number of Value of Underlying Unexercised Unexercised In-the-Money Options Options at at FY-End FY-End Exercisable/ Exercisable/ Name Unexercisable Unexercisable(1) - ------------------- ------------- ----------------
Raymond R. Hannigan 953,600 $2,651,500 614,400 -- Christopher M. Fashek 647,520 $1,104,375 353,280 -- Frank DiLazzaro 458,120 $ 800,568 256,000 -- Dennis E. Noll 264,000 $ 331,250 256,000 -- Richard C. Vogel 265,920 $ 214,400 122,880 --
(1) The Company's Common Stock is no longer publicly traded. For purposes of this calculation, the fair market value of the Common Stock was assumed to be $4.8125 per share. Item 12. Security Ownership of Certain Beneficial Owners - -------------------------------------------------------- and Management -------------- SECURITIES HOLDINGS OF PRINCIPAL SHAREHOLDERS, DIRECTORS AND OFFICERS Based upon information received upon request from the persons concerned, each person known to be the beneficial owner of more than five percent of the Company's outstanding common stock, each director, nominee for director, named executive officer (as defined on page 7 hereof) and all directors and executive officers of the Company as a group, owned beneficially as of March 1, 1999, the number and percentage of outstanding shares of Common Stock of the Company indicated in the following table: Shares of Common Stock Beneficially owned as of Percent March 1, 1999 (1) of Class ------------------ --------
James R. Leininger, M.D.............. 23,756,880 31.2% 8023 Vantage Drive San Antonio, TX 78230 Fremont Partners L.P................. 28,119,688 37.0% and certain related parties 50 Fremont Street, Suite 3700 San Francisco, CA 94105 Richard C. Blum & Associates......... 18,576,040 24.4% and certain related parties 909 Montgomery Street, Suite 400 San Francisco, CA 84133 Raymond R. Hannigan (2).............. 953,600 1.3% James T. Farrell (3)................. -- Robert Jaunich II (3)................ -- N. Colin Lind (4).................... -- Jeffrey W. Ubben (4)................. -- Charles N. Martin (5)................ -- Donald E. Steen (5).................. 64,200 * Christopher M. Fashek (2)............ 647,520 * Frank DiLazzaro (2).................. 458,120 * Dennis E. Noll (2)................... 264,000 * Richard C. Vogel (2)................. 265,920 * All directors and executive officers as a group (20 persons)(2)......... 3,666,840 4.8%
* Less than one (1%) percent (1) Except as otherwise indicated in the following notes, the persons named in the table directly own the number of shares indicated in the table and have the sole voting power and investment power with respect to all of such shares. Shares beneficially owned include options exercisable as of May 30, 1999. (2) The shares shown represent shares of Common Stock which such persons have the right to acquire under stock options granted by the Company as of May 30, 1999. (3) Messrs. Farrell and Jaunich are managing directors of Fremont Partners, L.P. and certain of its related parties ("Fremont"). The Shares shown do not include the Shares beneficially owned by Fremont. (4) Messrs. Lind and Ubben are managing directors of Richard C. Blum & associates, L.P. and certain of its related parties ("RCBA"). The Shares shown do not include the Shares beneficially owned by RCBA. (5) Messrs. Martin and Steen are outside directors and are not affiliated with Fremont Partners, LP or Richard C. Blum and Associates, L.P. Item 13. Certain Relationships and Related Transactions - ------------------------------------------------------- On December 18, 1996, a company controlled by Dr. James Leininger acquired a tract of land (the "Property") from the Company for $395,000. The Property is comprised of approximately 2.2 acres and is adjacent to the Company's corporate headquarters. The purchase price was based on the aggregate cost of the Property to the Company (including acquisition expenses). The Company believes that the acreage was transferred to Dr. James Leininger at a price equal to its fair market value. In connection with the purchase of the Property, the Company loaned Dr. James Leininger $3,000,000 in February 1997 to develop the Property. The loan bore interest at a rate equal to the prime rate of Texas Commerce Bank. The loan was non-recourse to Dr. James Leininger but was secured by the Property, the improvements on the Property and 1,200,000 shares owned by Dr. James Leininger. Dr. Leininger repaid the loan in full on December 31, 1997. Pursuant to the provisions of the Executive Committee Stock Ownership Policy, the Company loaned funds to Christopher M. Fashek, the President of KCI Therapeutic Services, Inc. (a division of the Company), Bianca A. Rhodes, the Company's Chief Financial Officer at the time and Dennis E. Noll, the Company's Senior Vice President and General Counsel. These loans were utilized by such executive officers to acquire Shares in order to meet the standards set forth in the Company's Executive Committee Stock Ownership Policy. The loans bore interest at the applicable federal rate established by the Internal Revenue Service and had a term of five years. The initial loans made to Mr. Fashek, Ms. Rhodes and Mr. Noll were $107,672, $170,672 and $86,310, respectively, and the outstanding balance of principal and accrued interest on such loans as of December 31, 1996 were $87,076, $166,003 and $81,888, respectively. Mr. Noll repaid his loan in February 1997. Ms. Rhodes repaid the principal amount of her loan in July 1997. Mr. Fashek repaid his loan on November 5, 1997. The Board has amended the Executive Committee Stock Ownership Policy to make the ownership thresholds in the policy voluntary and, as a result, the Company will not be making loans to executive officers under the policy in the future. At its December 1997 meeting, the Company's Board of Directors agreed to sell Dr. James R. Leininger certain of the Company's non-operating assets. The assets included the vehicle driven by Dr. Leininger and the Company's ownership interest in the San Antonio Spurs, Bionumerick, Inc. and a small aircraft. The vehicle was sold to Dr. Leininger at its depreciated book value and the ownership interests were to be sold at their cost to the Company. The assets were transferred in 1998. The Company believes that the transfers were made at prices equal to their fair market value. PART IV Item 14. Exhibits, Financial Statement Schedules, and Reports - ------------------------------------------------------------- on Form 8-K ----------- (a) The following documents are filed as part of this report: 1. Financial Statements -------------------- The following consolidated financial statements are filed as a part of this report: Consolidated Balance Sheets as of December 31, 1998 and 1997 Consolidated Statements of (Deficit) Earnings for the three years ended December 31, 1998, 1997 and 1996 Consolidated Statements of Cash Flows for the three years ended December 31, 1998, 1997 and 1996 Consolidated Statements of Shareholders' Equity for the three years ended December 31, 1998, 1997 and 1996 Notes to Consolidated Financial Statements Independent Auditors' Report 2. Financial Statement Schedules ----------------------------- The following consolidated financial statement schedules for each of the years in the three-year period ended December 31, 1998 are filed as part of this Report: Independent Auditors' Report Schedule VIII - Valuation and Qualifying Accounts - Years ended December 31, 1998, 1997 and 1996 All other schedules have been omitted as the required information is not present or is not present in amounts sufficient to require submission of the schedule, or because the information required is included in the financial statements and notes thereto. 3. Exhibits -------- The following exhibits are filed as a part of this Report: Exhibit Description ------- ----------- 3.1 Restatement of Articles of Incorporation (filed as Exhibit 3.2 to the Company's Registration Statement on Form S-1, as amended (Registration No. 33-21353), and incorporated herein by reference). 3.2 Restated By-Laws of the Company (filed as Exhibit 3.3 to the Company's Registration Statement on Form S-1, as amended (Registration No. 33-21353), and incorporated herein by reference). 4.1 Specimen Common Stock Certificate of the Company (filed as Exhibit 4.1 to the Annual Report on Form 10-K for the year ended December 31, 1988, and incorporated herein by reference). 10.1 KCI Employee Benefits Trust Agreement (filed as Exhibit 10.21 to the Company's Annual Report on Form 10-K/A dated December 31, 1994, and incorporated herein by reference). 10.2 Letter, dated September 19, 1994, from the Company to Raymond R. Hannigan outlining the terms of his employment (filed as Exhibit 10.22 to the Company's Annual Report on Form 10-K/A dated December 31, 1994, and incorporated herein by reference). 10.3 Letter, dated November 22, 1994, from the Company to Christopher M. Fashek outlining the terms of his employment (filed as Exhibit 10.23 to the Company's Annual Report on Form 10-K/A dated December 31, 1994, and incorporated herein by reference). 10.4 Deferred Compensation Plan (filed as Exhibit 99.2 to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1995 and incorporated herein by reference). 10.5 Kinetic Concepts, Inc. Senior Executive Stock Option Plan (filed as Exhibit 10.31 to the Company's Annual Report on Form 10-K for the year ended December 31, 1996, and incorporated herein by reference). 10.6 Form of Option Instrument with respect to Senior Executive Stock Option Plan (filed as Exhibit 10.32 to the Company's Annual Report on Form 10-K for the year ended December 31, 1996, and incorporated herein by reference). 10.7 Kinetic Concepts Management Equity Plan effective October 1, 1997 (filed as Exhibit 10.33 on Form 10-K for the year ended December 31, 1997, and incorporated herein by reference). * 10.8 Director Equity Agreement, dated May 12, 1998, between the Company and Charles N. Martin. * 10.9 Director Equity Agreement, dated May 12, 1998, between the Company and Donald E. Steen. * 10.10 Letter, dated June 4, 1998, from the Company to William M. Brown outlining the terms of his employment. *10.11 Supplier Agreement, dated December 1, 1998, between Novation, LLC and Kinetic Concepts, Inc. 16.1 Letter from KPMG Peat Marwick LLP to the Securities and Exchange Commission regarding agreement with statements made by Registrant under Item 9 of its Form 10-K dated March 28, 1997 (filed as Exhibit 16.1 to the Company's Annual Report on Form 10-K for the year ended December 31, 1996, and incorporated herein by reference). * 21.0 List of Subsidiaries. * 27.1 Financial Data Schedule. Note: (*) Exhibits filed herewith. (b) Reports on Form 8-K ------------------- No reports on Form 8-K have been filed during the last quarter of the period covered by this report. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of San Antonio, State of Texas on March 30, 1999. KINETIC CONCEPTS, INC. By: /s/ Robert Jaunich II ---------------------- Robert Jaunich II, Chairman of the Board of Directors Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, this Registration Statement has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Signature Date By: /s/ Robert Jaunich II March 30, 1999 ------------------------------- Robert Jaunich II Chairman of the Board of Directors By: /s/ Raymond R. Hannigan March 30, 1999 ------------------------------- Raymond R. Hannigan Chief Executive Officer and President By: /s/ William M. Brown March 30, 1999 ------------------------------- William M. Brown Vice President, and Chief Financial Officer (Principal Accounting Officer) SIGNATURES (CONTINUED) Signature Date By: /s/ James R. Leininger, M.D. March 30, 1999 ---------------------------- James R. Leininger M.D. Director By: /s/ James T. Farrell March 30, 1999 --------------------------- James T. Farrell Director By: /s/ N. Colin Lind March 30, 1999 -------------------------- N. Colin Lind Director By: /s/ Charles N. Martin March 30, 1999 -------------------------- Charles N. Martin Director By: /s/ Donald E. Steen March 30, 1999 -------------------------- Donald E. Steen Director By: /s/ Jeffrey W. Ubben March 30, 1999 -------------------------- Jeffrey W. Ubben Director Schedule VIII KINETIC CONCEPTS, INC. AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS (in thousands) Three years ended December 31, 1998 Additions Balance Charged Additions 12/31/96 at to Costs Charged Balance Beginning and to Other at End of Description of Period Expenses Accounts Deductions Period - -------------- --------- --------- --------- ---------- --------- Allowance for doubtful accounts $ 6,177 $2,457 $ - $1,102 $ 7,532 ====== ===== ===== ===== ====== Additions Balance Charged Additions 12/31/97 at to Costs Charged Balance Beginning and to Other at End of Description of Period Expenses Accounts Deductions Period - ----------- --------- --------- --------- ---------- --------- Allowance for doubtful accounts $ 7,532 $5,888 $ - $2,216 $11,204 ====== ===== ===== ===== ====== Additions Balance Charged Additions 12/31/98 at to Costs Charged Balance Beginning and to Other at End of Description of Period Expenses Accounts Deductions Period - ----------- --------- --------- --------- ---------- -------- Allowance for doubtful accounts $11,204 $3,707 $ - $5,238 $ 9,673 ====== ===== ===== ===== ====== EX-10 2 DIRECTOR EQUITY AGREEMENT (the "Agreement"), dated as of May 12, 1998 (the "Date of Grant"), between KINETIC CONCEPTS, INC., a Texas corporation (the "Company"), and the other party signatory hereto (the "Director"). WHEREAS, the Director was elected to the Board of Directors of the Company (the "Board of Directors") and the Company desires to provide him a direct proprietary interest in the Company's success in recognition of his contribution to the Company; and WHEREAS, the Company has agreed to award to the Director nonqualified stock options (the "Options") to purchase shares of the Common Stock, no par value, of the Company ("Common Stock"); NOW, THEREFORE, in consideration of the covenants and agreements herein contained, the parties hereto agree as follows: 1. Definitions. For purposes of this Agreement, the following terms have the following meanings: "Affiliate" means, with respect to any Person, any other Person directly or indirectly controlling, controlled by or under common control with, such Person. For purposes of this definition, "control" (including, with correlative meanings, the terms "controlling", "controlled by" or "under common control with"), as used with respect to any Person, shall mean the possession, directly or indirectly, of the power to direct or cause the direction of the management and policies of such Person, whether through the ownership of voting securities or by contract or otherwise. "Applicable Option Share Value" as of any date of determination means the Fair Market Value; provided, however, that if (A) such date falls prior to the third anniversary of the Date of Grant and (B) such value is being determined following a termination of service other than an Involuntary Termination, then the Applicable Option Share Value shall not exceed the Option Price plus 7% of the Option Price compounded annually on each anniversary of the relevant date of exercise. "Applicable Option Value" as of any date of determination means the Fair Market Value less the Option Price; provided, however, that if (A) such date falls prior to the third anniversary of the Date of Grant and (B) such value is being determined following a termination of service other than an Involuntary Termination, then the Applicable Option Value shall be zero. "B Purchaser" means RCBA PURCHASER I, L.P. "Beneficial owner" or "beneficially own" has the meaning given such term in Rule 13d-3 under the 1934 Act. "Beneficiary" or "Beneficiaries" means the person(s) designated by a Director or his Permitted Transferee in writing to the Company to receive payments pursuant to this Agreement upon the death of a Director or his Permitted Transferee. If no Beneficiary is so designated or if no Beneficiary is living at the time a payment is due pursuant to this Agreement, payments shall be made to the estate of the Director or Permitted Transferee. The Director or Permitted Transferee, as the case may be, shall have the right to change the designated Beneficiaries from time to time by written instrument filed with the Board of Directors in accordance with such rules as may be specified by the Board of Directors. "Call Right" means the right of the Company, exercisable in accordance with Section 5(a) following termination of a Director's service, (i) to purchase, and to cause a Director or his Permitted Transferee to sell, Option Shares beneficially owned by such Director or his Permitted Transferee and (ii) to cause a Director to surrender for cancellation, in consideration of the payment provided for in Section 5(a), unexercised Vested Options granted to such Director pursuant to this Agreement. "Cause" means, (i) the willful and continued failure or refusal of the Director substantially to perform the material duties required of him as a member of the Board of Directors; (ii) any willful material violation by the Director of any federal or state law or regulation applicable to the business of the Company or any of its Affiliates, or the Director's conviction of a felony, or any willful perpetration by the Director of a common law fraud; or (iii) any other willful misconduct by the Director which is materially injurious to the financial condition or business reputation of, or is otherwise materially injurious to, the Company or any of its Affiliates. "Commission" means the Securities and Exchange Commission. "Encumbrance" means any lien, security interest, pledge, claim, option, right of first refusal, marital right or other encumbrance with respect to any share of Common Stock or any Option. "F Purchaser" means FREMONT PURCHASER II, INC. "Fair Market Value" means the value of a share of Common Stock as determined in good faith by the Board of Directors or, under the circumstances described in Section 6, as determined in a written report to the Company by an independent appraisal or investment banking firm selected by the Board of Directors. For purposes of the definition of "Fair Market Value", the value to be determined by the Board of Directors or such appraisal or investment banking firm shall be the price per share at which a share of Common Stock would trade on a national securities exchange, NASDAQ or a similar market, assuming full liquidity and the absence of any "takeover" or "change in control" premium. "IPO" means a Public Offering that results in more than 20% of the outstanding Common Stock being traded on a national securities exchange, NASDAQ or a similar market. "Involuntary Termination" means a termination of the Director's service by reason of death, Permanent Disability, removal or failure to re-elect without Cause. "Involuntary Transfer" means a transfer of the Director's Option Shares by operation of law including, without limitation, as a result of (i) a sale or other disposition by a trustee or debtor in possession appointed or retained in a bankruptcy case, (ii) a sale at any creditors' or judicial sale or (iii) a transfer arising out of a divorce or separation proceeding. "Legended Certificate" means a certificate evidencing a number of shares of Common Stock issued under this Agreement and imprinted with a legend to indicate that (i) such shares are subject to the restrictions on transfer set forth in this Agreement and (ii) if the offer and sale of such shares have not been registered under the 1933 Act, such shares may be sold only pursuant to a registration statement under the 1933 Act or an exemption from registration under the 1933 Act that the Company has determined is available for such sale. "Management Equity Plan" means the Company's Management Equity Plan. "NASDAQ" means the National Association of Securities Dealers' Automated Quotation System. "1933 Act" means the Securities Act of 1933, as amended, and the rules and regulations of the Commission thereunder. "1934 Act" means the Securities Exchange Act of 1934, as amended, and the rules and regulations of the Commission thereunder. "Option Price" means, with respect to any Option, $19.25. "Option Shares" means the shares of Common Stock acquired by the Director upon exercise of an Option. "outstanding", with respect to any share of Common Stock, means, as of any date of determination, all shares that have been issued on or prior to such date, other than shares repurchased or otherwise reacquired by the Company or any Affiliate thereof, on or prior to such date. "Permanent Disability" means that the Director is unable to perform substantially all his duties as a member of the Board of Directors by reason of illness or incapacity for a period of more than six consecutive months, or six months in the aggregate during any 12-month period, established by medical evidence reasonably satisfactory to the Company. "Permitted Transferee" means with respect to outstanding shares of Common Stock or Options held by the Director, (i) the trustee or trustees of a trust revocable solely by such Director, (ii) the Director's guardian or conservator, (iii) any Person to whom such shares or Options are transferred by will or the laws of descent and distribution, or (iv) any Person with respect to which the Board of Directors shall have adopted a resolution stating that the Board of Directors has no objection if a transfer of shares or Options is made to such Person. "Person" means an individual, a partnership, a joint venture, a corporation, an association, a trust, an estate or other entity or organization, including a government or any department or agency thereof, or any group deemed to be a "person" under Section 14(d)(2) of the 1934 Act. "Prime Rate" means the rate which Bank of America announces from time to time at its principal office as its prime lending rate for domestic commercial loans, the Prime Rate to change when and as such prime lending rate changes. "Public Offering" means an underwritten public offering of equity securities of the Company pursuant to an effective registration statement under the 1933 Act. "Put Right" means the right of the Director, exercisable in accordance with Section 5(b) following termination of a Director's service, (i) to sell, and to cause a Director or his Permitted Transferee to sell, Option Shares beneficially owned by such Director or his Permitted Transferee and (ii) to surrender for cancellation, in consideration of the payment provided for in Section 5(b), unexercised Vested Options granted to such Director pursuant to this Agreement. "Sale by Fremont/RCBA" means a sale of Common Stock that is not a Public Offering by either F Purchaser or B Purchaser that results in F Purchaser and B Purchaser together holding less than sixty-nine percent of the shares of Common Stock initially held by F Purchaser and B Purchaser on the effective date of the transaction pursuant to which such Persons first acquired their equity interest in the Company, as such number may be adjusted to reflect stock splits, reverse stock splits, stock dividends, acquisitions and the exercise of Options. "Sale of Assets" means a sale (in one transaction or a series of transactions) by the Company of all or substantially all its business or assets (or both) to a third party that is not an Affiliate of the Company. "Sale of Stock" means a sale (in one transaction or in a series of transactions) by the Company's stockholders of at least two-thirds of the outstanding Common Stock to a Third Party, including any merger with a Public Company following the consummation of which two-thirds or more of the voting securities of the surviving entity (which is a Public Company) in such merger are held by Third Parties. "Third Party" means, with respect to the Director, any Person, other than any Affiliate of (a) the Director, (b) the Company and its subsidiaries or (c) F Purchaser or B Purchaser. "Vested Options" means, as of any date, Options which by their terms are exercisable on such date. 2. Grant of Options. Subject to the terms and conditions contained herein, the Company hereby grants to the Director 25,000 Options. Each such Option shall entitle the Director to purchase, upon payment of the Option Price, one share of Common Stock. The shares of Common Stock issuable upon exercise of the Options are from time to time referred to herein as the "Option Shares". The Options shall be exercisable as hereinafter provided. 3. Terms and Conditions of Options. The Options evidenced hereby are subject to the following terms and conditions: (a) Vesting. The Options shall vest and become exercisable in one-third installments on each of the first three anniversaries of the Date of Grant unless previously vested or forfeited in accordance with this Agreement. All Options shall vest upon the Director's termination of service as a result of death or Permanent Disability. All Options also shall vest upon a completion of a Sale of Stock or a Sale of Assets. Fifty percent of each unvested installment of Options, if any, shall vest upon completion of an IPO or a Sale by Fremont/RCBA. (b) Option Period. The Options shall not be exercisable following the seventh anniversary of the Date of Grant. The Options shall be subject to earlier termination as provided herein. Upon termination of the Director's service with the Company for any reason, the Options, to the extent then vested, may be exercised, subject to Section 3(g), at any time until the earlier of (A) 30 days (180 days upon a termination of service due to death or Permanent Disability) following the date of such termination of service (or, if a Vested Option may not be exercised on the date of such termination of service because the conditions to exercise set forth in Section 3(g) are not satisfied, 30 days (180 days upon a termination of service due to death or Permanent Disability) following the date on which the Company notifies the Director that such conditions have been satisfied and that the Option may be exercised), and (B) exercise by the Company of its Call Right under Section 5(a), but in no event after the expiration of the Option under the first sentence of this Section 3(b). The Options shall be exercisable during the Director's lifetime only by the Director. Upon termination of the Director's service with the Company for any reason, all Options which have not theretofore vested (and which do not vest by reason of Section 3(a) above) shall terminate and be canceled without any payment therefor. (c) Notice of Exercise. Subject to Sections 3(d) and 3(g) hereof, the Director may exercise any or all of the Options (to the extent vested and not forfeited) by giving written notice to the Board of Directors. The date of exercise of an Option shall be the later of (i) the date on which the Board of Directors receives such written notice or (ii) the date on which the conditions provided in Sections 3(d) and 3(g) hereof are satisfied. (d) Payment. Prior to the issuance of a Legended Certificate pursuant to Section 3(h) hereof evidencing Option Shares, the Director shall have paid to the Company the Option Price of all Option Shares purchased pursuant to exercise of such Options in cash or, with the consent of the Board of Directors (which consent shall be granted in the sole discretion of the Board of Directors), in shares of Common Stock already owned by the Director or in any combination of cash or shares of Common Stock. (e) Certain Restrictions. Options granted hereunder shall not be transferable by the Director otherwise than to a Permitted Transferee. (f) Stockholder Rights. The Director shall have no rights as a stockholder with respect to any shares of Common Stock issuable upon exercise of the Options until a certificate or certificates evidencing such shares shall have been issued to the Director, and no adjustment shall be made for dividends or distributions or other rights in respect of any share for which the record date is prior to the date upon which the Director shall become the holder of record thereof. (g) Limitation on Exercise. The Options shall not be exercisable unless the offer and sale of the shares of Common Stock subject thereto have been registered under the 1933 Act and qualified under applicable state "blue sky" laws, or the Company has determined that an exemption from registration under the 1933 Act and from qualification under such state "blue sky" laws is available. The Company may require, as a condition to exercise of an Option, that the Director make certain representations and warranties as to the Director's investment intent with respect to the Option Shares. (h) Delivery of Certificate. As soon as practicable following the exercise of any Options, a Legended Certificate evidencing the appropriate number of shares of Common Stock issued in connection with such exercise shall be issued in the name of the Director. (i) Dividends and Distributions. Any shares of Common Stock or other securities of the Company received by the Director as a result of a stock dividend or other distribution in respect of Option Shares shall be subject to the same restrictions as such Option Shares, and all references to Option Shares hereunder shall be deemed to include such shares of Common Stock or other securities. 4. Representations and Warranties. (a) The Director has been advised that the Options and Option Shares have not been registered under the 1933 Act and, therefore, cannot be resold unless they are registered or unless an exemption from registration is available. The Director is acquiring the Options, and Option Shares for his own account, for investment and not with a view to, or for resale in connection with, the distribution thereof, and the Director has no present intention of selling, assigning, transferring, distributing or otherwise disposing of, or causing the sale, assignment, transfer, distribution or other disposition of, any thereof. In making the foregoing representation, the Director is aware that he must bear the economic risk of an investment in the Options and Option Shares for an indefinite period of time since, in the view of the Commission, the statutory basis for exemption from registration under the 1933 Act would not be present if such representation meant merely that the Director's current intention is to hold these securities only for the long-term capital gains period of the Internal Revenue Code, or for a deferred sale, or for any fixed period in the future. (b) The Director has been given the opportunity to ask questions of, and receive answers from, the Company concerning the terms and conditions of the Options and Option Shares to be transferred hereunder and other related matters. The Director represents and warrants that he has been furnished with and has carefully read this Agreement, and that the Company has made available to the Director or his agents all documents and information requested by him or on his behalf in connection with his investment in the Options and Option Shares and that he understands and has evaluated the merits and risks of an investment in the Options and Option Shares. In evaluating the suitability of an investment in such Options and Option Shares, the Director has not relied upon any other representations or other information (whether oral or written) made by or on behalf of the Company other than as contemplated by the two preceding sentences. (c) The Director is aware of and familiar with the restrictions imposed on the transfer of any Options and Option Shares, including, without limitation, the restrictions contained in this Agreement. (d) The Director represents that this Agreement has been duly executed and delivered by the Director and constitutes a legal, valid and binding agreement of the Director, enforceable against the Director in accordance with its terms. 5. Termination of Employment or Status; Involuntary Transfers. (a) Company Call Right. (i) Exercise of Call Right. Unless the Board of Directors in its sole discretion determines otherwise and so sets forth in the applicable agreement, if prior to the completion of an IPO the service of a Director with the Company terminates for any reason, or an Involuntary Transfer occurs, the Company shall have a Call Right, exercisable for a period of 60 days after the date of such termination or Involuntary Transfer, with respect to all of the Vested Options and Option Shares beneficially owned by such Director and his Permitted Transferees. The Company may exercise such Call Right by giving written notice thereof to the Director or his Permitted Transferee, as the case may be, prior to the expiration of such 60-day period. The Company's Call Right shall become null and void subsequent to the completion of an IPO. (ii) Purchase Price. With respect to any exercise of a Call Right under this Section 5(a), (A) the purchase price per Option Share to be paid by the Company at the closing provided for in Section 5(c) shall be the Applicable Option Share Value, determined as of the date of termination of the Director's service or Involuntary Transfer and (B) the consideration to be paid by the Company in respect of Vested Options surrendered for cancellation at the closing provided for in Section 5(c) shall be the Applicable Option Value determined as of the date of termination of the Director's service or Involuntary Transfer. The Company will give notice of the purchase price to be paid per Option Share or Vested Option within a reasonable time from the date of determination of such price. (b) Director Put Right. (i) Exercise of Put Right. Subject to Section 5(b)(iii), if prior to the completion of an IPO the service of the Director with the Company terminates for any reason, the Director (or, in the case of the Director's death, his Beneficiary) shall have a Put Right, exercisable for a period of 60 days after the date of such termination, with respect to all of the Vested Options and Option Shares beneficially owned by the Director and his Permitted Transferees. The Director may exercise such Put Right by giving written notice thereof to the Company prior to the expiration of such 60-day period. The Director's Put Rights shall be null and void subsequent to the completion of an IPO. (ii) Purchase Price. The Put Right purchase price per Option Share to be paid by the Company at the closing provided for in Section 5(c) shall be the Applicable Option Share Value, determined as of the date of termination of the Director's service. The consideration to be paid by the Company in respect of Vested Options surrendered for cancellation at the closing provided for in Section 5(c) shall be Applicable Option Value, determined as of the date of termination of the Director's service. The Company will give notice of the consideration to be paid per Option Share or Vested Option within a reasonable time from the date of determination of such amount. (iii) Financial Capability. Anything in this Agreement to the contrary notwithstanding, if, at any time, the Board of Directors shall determine, subject to the written opinion of the Appraiser (as hereinafter defined) referred to below, that the Company is not financially capable of making some or all of the aggregate payments to be made thereafter pursuant to the exercise of Put Rights (the "Put Right Payments") under this Agreement, similar agreements with other directors and the Management Equity Plan, the Company shall have the right to defer such Put Right Payments but only on the terms hereinafter provided in this Section 5(b)(iii). In the event that the Board of Directors shall have made such determination with respect to the Company's financial capability, the Board of Directors shall, if so requested in writing by at least two directors or participants in the Management Equity Plan within 10 business days of the date that notice of such determination has been given (the "Request Period"), promptly retain an appraisal or investment banking firm, to be selected by the Chief Executive Officer and reasonably satisfactory to the Board of Directors (the "Appraiser"), to render a written opinion as to whether the Company has the financial capability to make any of, or any portion of, such Put Right Payments at such time as it would otherwise be required to make such Put Right Payments. If the Board of Directors' determination, or the Appraiser's written opinion, if so required, indicates that, at the time a Put Right Payment would otherwise be required to be made to the Director, the Company would not have the financial capability to make any of the Put Right Payments that would otherwise then be required to be made, or shall have the financial capability to make only a portion of such Put Right Payments, then payments with respect to such Put Right Payments shall be made on the following basis: As of the first day following a determination by the Appraiser of lack of financial capability in respect of which Put Right Payments are required to be made or, if no request for an Appraiser's appraisal is made, on the day following the last day of the Request Period (each such date being hereinafter called a "Payout Date"), all unpaid amounts payable with respect to Put Rights exercised prior to such a date, shall be aggregated (the "Aggregate Payable Amount"), and the amount payable to each director and participant in the Management Equity Plan shall be determined by multiplying the full amount owing to such director or participant as of such date by a fraction, the numerator of which shall be the amount that the Company, as indicated by the Board of Directors' determination or the Appraiser's written opinion, shall then be financially capable of paying (which may be zero if, as indicated by the Board of Directors' determination or the Appraiser's written opinion, the Company is not financially capable of making any of the Put Right Payments then otherwise required to be made) and the denominator of which shall be the Aggregate Payable Amount. Elections to exercise Put Rights (or portions thereof) not satisfied pursuant to such pro rata payment shall be deemed revoked, and the remaining awards (or portions thereof) with respect thereto shall thereafter be subject to the terms in effect as if a Put Right election had not been made, provided, however that Options will not be canceled pursuant to Section 3(b). In acting pursuant to this Section 5, the Appraiser shall be entitled to the rights and immunities of an arbitrator. (c) Election and Delivery Procedures. (i) The closing of any exercise of any Call Right or Put Right pursuant to Section 5(a) or 5(b) shall take place at the offices of the Company, or such other place as may be mutually agreed, not less than 15 nor more than 30 days after the date such Call Right or Put Right is exercised. The exact date and time of closing shall be specified by the party exercising such Call Right or Put Right. (ii) At such closing (the "Closing"), the Director (or, following the Director's death, the Director's Beneficiary or Beneficiaries) shall deliver certificates for the shares of Common Stock to be sold to the Company duly endorsed, or accompanied by written instruments of transfer in form reasonably satisfactory to the Company duly executed, by such transferor, free and clear of any Encumbrances, and shall consent to the cancellation of the Vested Options to be surrendered, which Vested Options shall also be free and clear of any Encumbrances. The Company shall pay the applicable purchase price for shares of Common Stock and consideration for surrendered Vested Options in cash; provided, however, that such payment may be deferred under the circumstances, and to the extent, provided for in Section 7. 6. Appraisal. If, in connection with the determination of the Fair Market Value used to calculate the purchase price for shares of Common Stock and Vested Options upon the exercise of any Call Right or Put Right under Section 5(a) or 5(b), the Director reasonably believes that the Board of Directors' determination of Fair Market Value (if applicable) is not reasonable, then such Director may challenge the Board of Directors' determination of such Fair Market Value by giving written notice to the Board of Directors no later than 15 business days after receipt of notice of the purchase price per share which the Company intends to pay with respect to such shares of Common Stock and Vested Options. In such event, the Company shall engage at its own expense an appraisal or investment banking firm that is independent of the Company and its Affiliates and is knowledgeable in the valuation of companies engaged in a business similar to the business in which the Company is engaged to determine the Fair Market Value of the Common Stock for purposes of determining the purchase price; provided, however, that if such a determination has been made by such an appraisal or investment banking firm less than six months prior to the date as of which the Fair Market Value of the Common Stock is to be determined, the Company shall not be required to engage any such firm and shall instead rely on such earlier valuation; provided further, however, that the Company shall not rely on such earlier valuation if it determines in good faith that such earlier valuation no longer reflects Fair Market Value. Any such appraisal or investment banking firm engaged by the Company shall be selected by the Board of Directors and shall be reasonably satisfactory to such Director. Such independent appraisal or investment banking firm's determination of Fair Market Value shall be conclusive and binding on the parties. Anything in this Section 6 to the contrary notwithstanding, if such an independent appraisal or investment banking firm is appointed, no payment shall be made in respect of the Director's shares of Common Stock or Vested Options pending the determination of Fair Market Value by such firm, and payment of the purchase price shall instead be made no later than the tenth business day following receipt by the Company of the report of such firm establishing Fair Market Value. If the Fair Market Value so determined by the independent banking firm exceeds the Fair Market Value as determined by the Board of Directors by more than 10%, the costs of such firm shall be for the account of the Company; in all other cases, the costs of such firm shall be borne by the Director, and the Company shall have the right to withhold such costs from any payment it makes in respect of its repurchase of shares of Common Stock or Vested Options from the Director. 7. Legal Limitations. Anything in this Agreement to the contrary notwithstanding, to the extent that the limitations or restrictions applicable to the Company or any subsidiary under the laws of their respective jurisdictions of incorporation, the restrictions or limitations contained in the Certificate of Incorporation or By-laws of the Company or any subsidiary or any other applicable law, rule or regulation or under the terms of any indebtedness for borrowed money of the Company or any subsidiary prohibit the Company from making any payment required under this Agreement with respect to a share of Common Stock or Vested Option, then the Company shall not be obligated to make such payment at such time, and shall have the right to defer such payment until the Board of Directors reasonably determines that such limitations and restrictions no longer restrict the Company from making such deferred payment. Any amounts the payment of which is so deferred shall bear interest, compounded annually and calculated at a rate equal to the Prime Rate, and shall be paid (with interest) promptly after, and to the extent that, the Board of Directors determines that the limitations and restrictions referred to in the first sentence of this Section 7 no longer restrict such payment. Notwithstanding a deferral of payment in accordance with this Section 7 for shares of Common Stock or Vested Options in respect of which a Call Right or Put Right shall have been exercised, the closing of any exercise of such Call Right or Put Right shall take place as provided in Section 5(c) and the right of the Director and his Permitted Transferees in respect of the shares of Common Stock and Vested Options subject to such Call Right or Put Right (other than the right to receive payment of amounts deferred in accordance with this Section 7) shall terminate as of such closing. 8. Miscellaneous. (a) No Rights to Additional Grants or Continued Service. The Director shall not have any claim or right to receive additional grants of stock options or to be offered the opportunity to purchase additional shares of Common Stock. Neither this Agreement nor any action taken or omitted to be taken hereunder shall be deemed to create or confer on the Director any right to serve on the Company's Board of Directors, to be retained in the service of the Company or to interfere with or limit in any way the right of the Company to terminate the service of the Director at any time. (b) No Restriction on Right of Company to Effect Corporate Changes. This Agreement shall not affect in any way the right or power of the Company or its stockholders to make or authorize any or all adjustments, recapitalizations, reorganizations or other changes in the Company's capital structure or its business, or any merger or consolidation of the Company, or any issue of stock or of options, warrants or rights to purchase stock or of bonds, debentures, preferred or prior preference stocks whose rights are superior to or affect the Common Stock or the rights thereof or which are convertible into or exchangeable for Common Stock, or the dissolution or liquidation of the Company, or any sale or transfer of all or any part of its assets or business, or any other corporate act or proceeding, whether of a similar character or otherwise. (c) 1934 Act. Notwithstanding anything contained in this Agreement to the contrary, if the consummation of any transaction under this Agreement would result in the possible imposition of liability to the Director pursuant to Section 16(b) of the 1934 Act, the Board of Directors shall have the right, in its sole discretion, but shall not be obligated, to defer such transaction to the extent necessary to avoid such liability, but in no event for a period in excess of 180 days. (d) Restrictions on Transfer. Options and Option Shares shall not be transferrable except as specifically provided in this Agreement. 9. Effect of Certain Corporate Changes and Changes in Control. (a) Dilution and Other Adjustments. In the event of a stock dividend or split, the Board of Directors shall make the following adjustments as are necessary or advisable (the form of which shall be determined by the Board of Directors in its sole discretion) to provide the Director with a benefit equivalent to that which he would have been entitled to had such event not occurred: (i) adjust the number of Options granted to the Director, (ii) adjust the Option Price, and (iii) make any other adjustments, or take such action, as the Board of Directors, in its discretion, deems appropriate. Such adjustments shall be conclusive and binding for all purposes. In the event of a change in the Common Stock which is limited to a change in the designation thereof to "Capital Stock" or other similar designation, or to a change in the par value thereof, or from par value to no par value, without increase or decrease in the number of issued shares of Common Stock, the shares resulting from any such change shall be deemed to be Common Stock within the meaning of this Agreement. (b) Effect of Reorganization. In the event that (i) the Company is merged or consolidated with another corporation, (ii) all or substantially all the assets of the Company are acquired by another corporation, person or entity, (iii) the Company is reorganized, dissolved or liquidated (each such event in (i), (ii) or (iii) being hereinafter referred to as a "Reorganization Event") or (iv) the Board of Directors shall propose that the Company enter into a Reorganization Event, then the Board of Directors shall make upon consummation of such Reorganization Event any or all of the adjustments described in Section 9(a) as are necessary or advisable in the sole discretion of the Board of Directors to provide the Director with a benefit equivalent to that which he would have been entitled to had such event not occurred. 10. Survival; Assignment, (a) All agreements, representations and warranties made herein and in the certificates delivered pursuant hereto shall survive the issuance to the Director of the Options and any Option Shares and, notwithstanding any investigation heretofore or hereafter made by the Director or the Company or on the Director's or the Company's behalf, shall continue in full force and effect. Without the prior written consent of the Company, the Director may not assign any of his rights hereunder except as permitted by this Agreement or by will or the laws of descent and distribution. Whenever in this Agreement any of the parties hereto is referred to, such reference shall be deemed to include the heirs and permitted successors and assigns of such party; and all agreements herein by or on behalf of the Company, or by or on behalf of the Director, shall bind and inure to the benefit of the heirs and permitted successors and assigns of such parties hereto. (b) The Company shall have the right to assign any of its rights and to delegate any of its duties under this Agreement to any of its Affiliates; provided, however, that such assignment shall not release the Company from any duty hereunder which remains unfulfilled by such an assignee. 11. Notices. All notices and other communications provided for herein shall be in writing and shall be delivered by hand or sent by certified or registered mail, return receipt requested, postage prepaid, addressed, if to the Director, to his attention at the mailing address set forth at the foot of this Agreement (or to such other address as the Director shall have specified to the Company in writing) and, if to the Company, to the General Counsel of the Company. All such notices shall be conclusively deemed to be received and shall be effective, if sent by hand delivery, upon receipt, or if sent by registered or certified mail, on the fifth day after the day on which such notice is mailed. 12. Waiver. The waiver by either party of compliance with any provision of this Agreement by the other party shall not operate or be construed as a waiver of any other provision of this Agreement, or of any subsequent breach by such party of a provision of this Agreement. 13. Entire Agreement; Governing Law. This Agreement and the other related agreements expressly referred to herein set forth the entire agreement and understanding between the parties hereto and supersede all prior agreements and understandings relating to the subject matter hereof. This Agreement may be executed in one or more counterparts, each of which shall be deemed to be an original, but all such counterparts shall together constitute one and the same agreement. The headings of sections and subsections herein are included solely for convenience of reference and shall not affect the meaning of any of the provisions of this Agreement. This Agreement shall be governed by, and construed in accordance with, the laws of the State of Delaware. IN WITNESS WHEREOF, the Company has caused this Agreement to be executed by its duly authorized officer and the Director has executed this Agreement, both as of the day and year first above written. KINETIC CONCEPTS, INC. By: /s/ Dennis E. Noll --------------------- Name: Dennis E. Noll Title: Senior Vice President DIRECTOR /s/ Charles N. Martin ------------------------ Name: Charles N. Martin Address: EX-10 3 DIRECTOR EQUITY AGREEMENT (the "Agreement"), dated as of May 12, 1998 (the "Date of Grant"), between KINETIC CONCEPTS, INC., a Texas corporation (the "Company"), and the other party signatory hereto (the "Director"). WHEREAS, the Director was elected to the Board of Directors of the Company (the "Board of Directors") and the Company desires to provide him a direct proprietary interest in the Company's success in recognition of his contribution to the Company; and WHEREAS, the Company has agreed to award to the Director nonqualified stock options (the "Options") to purchase shares of the Common Stock, no par value, of the Company ("Common Stock"), and to provide him the current opportunity to purchase shares of Common Stock ("Director Shares"); NOW, THEREFORE, in consideration of the covenants and agreements herein contained, the parties hereto agree as follows: 1. Definitions. For purposes of this Agreement, the following terms have the following meanings: "Affiliate" means, with respect to any Person, any other Person directly or indirectly controlling, controlled by or under common control with, such Person. For purposes of this definition, "control" (including, with correlative meanings, the terms "controlling", "controlled by" or "under common control with"), as used with respect to any Person, shall mean the possession, directly or indirectly, of the power to direct or cause the direction of the management and policies of such Person, whether through the ownership of voting securities or by contract or otherwise. "Applicable Director Share Value" as of any date of determination means the Fair Market Value; provided, however, that if (A) such date falls prior to the third anniversary of the Date of Grant and (B) such value is being determined following a termination of service other than an Involuntary Termination, then the Applicable Director Share Value shall not exceed $19.25 plus 7% compounded annually on each anniversary of August 31, 1998. "Applicable Option Share Value" as of any date of determination means the Fair Market Value; provided, however, that if (A) such date falls prior to the third anniversary of the Date of Grant and (B) such value is being determined following a termination of service other than an Involuntary Termination, then the Applicable Option Share Value shall not exceed the Option Price plus 7% of the Option Price compounded annually on each anniversary of the relevant date of exercise. "Applicable Option Value" as of any date of determination means the Fair Market Value less the Option Price; provided, however, that if (A) such date falls prior to the third anniversary of the Date of Grant and (B) such value is being determined following a termination of service other than an Involuntary Termination, then the Applicable Option Value shall be zero. "B Purchaser" means RCBA PURCHASER I, L.P. "Beneficial owner" or "beneficially own" has the meaning given such term in Rule 13d-3 under the 1934 Act. "Beneficiary" or "Beneficiaries" means the person(s) designated by a Director or his Permitted Transferee in writing to the Company to receive payments pursuant to this Agreement upon the death of a Director or his Permitted Transferee. If no Beneficiary is so designated or if no Beneficiary is living at the time a payment is due pursuant to this Agreement, payments shall be made to the estate of the Director or Permitted Transferee. The Director or Permitted Transferee, as the case may be, shall have the right to change the designated Beneficiaries from time to time by written instrument filed with the Board of Directors in accordance with such rules as may be specified by the Board of Directors. "Call Right" means the right of the Company, exercisable in accordance with Section 5(a) following termination of a Director's service, (i) to purchase, and to cause a Director or his Permitted Transferee to sell, Directors Shares and Option Shares beneficially owned by such Director or his Permitted Transferee and (ii) to cause a Director to surrender for cancellation, in consideration of the payment provided for in Section 5(a), unexercised Vested Options granted to such Director pursuant to this Agreement. "Cause" means, (i) the willful and continued failure or refusal of the Director substantially to perform the material duties required of him as a member of the Board of Directors; (ii) any willful material violation by the Director of any federal or state law or regulation applicable to the business of the Company or any of its Affiliates, or the Director's conviction of a felony, or any willful perpetration by the Director of a common law fraud; or (iii) any other willful misconduct by the Director which is materially injurious to the financial condition or business reputation of, or is otherwise materially injurious to, the Company or any of its Affiliates. "Commission" means the Securities and Exchange Commission. "Encumbrance" means any lien, security interest, pledge, claim, option, right of first refusal, marital right or other encumbrance with respect to any share of Common Stock or any Option. "F Purchaser" means FREMONT PURCHASER II, INC. "Fair Market Value" means the value of a share of Common Stock as determined in good faith by the Board of Directors or, under the circumstances described in Section 6, as determined in a written report to the Company by an independent appraisal or investment banking firm selected by the Board of Directors. For purposes of the definition of "Fair Market Value", the value to be determined by the Board of Directors or such appraisal or investment banking firm shall be the price per share at which a share of Common Stock would trade on a national securities exchange, NASDAQ or a similar market, assuming full liquidity and the absence of any "takeover" or "change in control" premium. "IPO" means a Public Offering that results in more than 20% of the outstanding Common Stock being traded on a national securities exchange, NASDAQ or a similar market. "Involuntary Termination" means a termination of the Director's service by reason of death, Permanent Disability, removal or failure to re-elect without Cause. "Involuntary Transfer" means a transfer of the Director's Director Shares or Option Shares by operation of law including, without limitation, as a result of (i) a sale or other disposition by a trustee or debtor in possession appointed or retained in a bankruptcy case, (ii) a sale at any creditors' or judicial sale or (iii) a transfer arising out of a divorce or separation proceeding. "Legended Certificate" means a certificate evidencing a number of shares of Common Stock issued under this Agreement and imprinted with a legend to indicate that (i) such shares are subject to the restrictions on transfer set forth in this Agreement and (ii) if the offer and sale of such shares have not been registered under the 1933 Act, such shares may be sold only pursuant to a registration statement under the 1933 Act or an exemption from registration under the 1933 Act that the Company has determined is available for such sale. "Management Equity Plan" means the Company's Management Equity Plan. "NASDAQ" means the National Association of Securities Dealers' Automated Quotation System. "1933 Act" means the Securities Act of 1933, as amended, and the rules and regulations of the Commission thereunder. "1934 Act" means the Securities Exchange Act of 1934, as amended, and the rules and regulations of the Commission thereunder. "Option Price" means, with respect to any Option, $19.25. "Option Shares" means the shares of Common Stock acquired by the Director upon exercise of an Option. "outstanding", with respect to any share of Common Stock, means, as of any date of determination, all shares that have been issued on or prior to such date, other than shares repurchased or otherwise reacquired by the Company or any Affiliate thereof, on or prior to such date. "Permanent Disability" means that the Director is unable to perform substantially all his duties as a member of the Board of Directors by reason of illness or incapacity for a period of more than six consecutive months, or six months in the aggregate during any 12-month period, established by medical evidence reasonably satisfactory to the Company. "Permitted Transferee" means with respect to outstanding shares of Common Stock or Options held by the Director, (i) the trustee or trustees of a trust revocable solely by such Director, (ii) the Director's guardian or conservator, (iii) any Person to whom such shares or Options are transferred by will or the laws of descent and distribution, or (iv) any Person with respect to which the Board of Directors shall have adopted a resolution stating that the Board of Directors has no objection if a transfer of shares or Options is made to such Person. "Person" means an individual, a partnership, a joint venture, a corporation, an association, a trust, an estate or other entity or organization, including a government or any department or agency thereof, or any group deemed to be a "person" under Section 14(d)(2) of the 1934 Act. "Prime Rate" means the rate which Bank of America announces from time to time at its principal office as its prime lending rate for domestic commercial loans, the Prime Rate to change when and as such prime lending rate changes. "Public Offering" means an underwritten public offering of equity securities of the Company pursuant to an effective registration statement under the 1933 Act. "Put Right" means the right of the Director, exercisable in accordance with Section 5(b) following termination of a Director's service, (i) to sell, and to cause a Director or his Permitted Transferee to sell, Directors Shares and Option Shares beneficially owned by such Director or his Permitted Transferee and (ii) to surrender for cancellation, in consideration of the payment provided for in Section 5(b), unexercised Vested Options granted to such Director pursuant to this Agreement. "Sale by Fremont/RCBA" means a sale of Common Stock that is not a Public Offering by either F Purchaser or B Purchaser that results in F Purchaser and B Purchaser together holding less than sixty-nine percent of the shares of Common Stock initially held by F Purchaser and B Purchaser on the effective date of the transaction pursuant to which such Persons first acquired their equity interest in the Company, as such number may be adjusted to reflect stock splits, reverse stock splits, stock dividends, acquisitions and the exercise of Options. "Sale of Assets" means a sale (in one transaction or a series of transactions) by the Company of all or substantially all its business or assets (or both) to a third party that is not an Affiliate of the Company. "Sale of Stock" means a sale (in one transaction or in a series of transactions) by the Company's stockholders of at least two-thirds of the outstanding Common Stock to a Third Party, including any merger with a Public Company following the consummation of which two-thirds or more of the voting securities of the surviving entity (which is a Public Company) in such merger are held by Third Parties. "Third Party" means, with respect to the Director, any Person, other than any Affiliate of (a) the Director, (b) the Company and its subsidiaries or (c) F Purchaser or B Purchaser. "Vested Options" means, as of any date, Options which by their terms are exercisable on such date. 2. Grant of Options. Subject to the terms and conditions contained herein, the Company hereby grants to the Director 25,000 Options. Each such Option shall entitle the Director to purchase, upon payment of the Option Price, one share of Common Stock. The shares of Common Stock issuable upon exercise of the Options are from time to time referred to herein as the "Option Shares". The Options shall be exercisable as hereinafter provided. 3. Terms and Conditions of Options. The Options evidenced hereby are subject to the following terms and conditions: (a) Vesting. The Options shall vest and become exercisable in one-third installments on each of the first three anniversaries of the Date of Grant unless previously vested or forfeited in accordance with this Agreement. All Options shall vest upon the Director's termination of service as a result of death or Permanent Disability. All Options also shall vest upon a completion of a Sale of Stock or a Sale of Assets. Fifty percent of each unvested installment of Options, if any, shall vest upon completion of an IPO or a Sale by Fremont/RCBA. (b) Option Period. The Options shall not be exercisable following the seventh anniversary of the Date of Grant. The Options shall be subject to earlier termination as provided herein. Upon termination of the Director's service with the Company for any reason, the Options, to the extent then vested, may be exercised, subject to Section 3(g), at any time until the earlier of (A) 30 days (180 days upon a termination of service due to death or Permanent Disability) following the date of such termination of service (or, if a Vested Option may not be exercised on the date of such termination of service because the conditions to exercise set forth in Section 3(g) are not satisfied, 30 days (180 days upon a termination of service due to death or Permanent Disability) following the date on which the Company notifies the Director that such conditions have been satisfied and that the Option may be exercised), and (B) exercise by the Company of its Call Right under Section 5(a), but in no event after the expiration of the Option under the first sentence of this Section 3(b). The Options shall be exercisable during the Director's lifetime only by the Director. Upon termination of the Director's service with the Company for any reason, all Options which have not theretofore vested (and which do not vest by reason of Section 3(a) above) shall terminate and be canceled without any payment therefor. (c) Notice of Exercise. Subject to Sections 3(d) and 3(g) hereof, the Director may exercise any or all of the Options (to the extent vested and not forfeited) by giving written notice to the Board of Directors. The date of exercise of an Option shall be the later of (i) the date on which the Board of Directors receives such written notice or (ii) the date on which the conditions provided in Sections 3(d) and 3(g) hereof are satisfied. (d) Payment. Prior to the issuance of a Legended Certificate pursuant to Section 3(h) hereof evidencing Option Shares, the Director shall have paid to the Company the Option Price of all Option Shares purchased pursuant to exercise of such Options in cash or, with the consent of the Board of Directors (which consent shall be granted in the sole discretion of the Board of Directors), in shares of Common Stock already owned by the Director or in any combination of cash or shares of Common Stock. (e) Certain Restrictions. Options granted hereunder shall not be transferable by the Director otherwise than to a Permitted Transferee. (f) Stockholder Rights. The Director shall have no rights as a stockholder with respect to any shares of Common Stock issuable upon exercise of the Options until a certificate or certificates evidencing such shares shall have been issued to the Director, and no adjustment shall be made for dividends or distributions or other rights in respect of any share for which the record date is prior to the date upon which the Director shall become the holder of record thereof. (g) Limitation on Exercise. The Options shall not be exercisable unless the offer and sale of the shares of Common Stock subject thereto have been registered under the 1933 Act and qualified under applicable state "blue sky" laws, or the Company has determined that an exemption from registration under the 1933 Act and from qualification under such state "blue sky" laws is available. The Company may require, as a condition to exercise of an Option, that the Director make certain representations and warranties as to the Director's investment intent with respect to the Option Shares. (h) Delivery of Certificate. As soon as practicable following the exercise of any Options, a Legended Certificate evidencing the appropriate number of shares of Common Stock issued in connection with such exercise shall be issued in the name of the Director. (i) Dividends and Distributions. Any shares of Common Stock or other securities of the Company received by the Director as a result of a stock dividend or other distribution in respect of Option Shares shall be subject to the same restrictions as such Option Shares, and all references to Option Shares hereunder shall be deemed to include such shares of Common Stock or other securities. 4. Purchase and Terms of Director Shares. (a) Subscription for Director Shares. Pursuant to the terms and subject to the conditions set forth in this Agreement, the Director hereby subscribes for and agrees to purchase 15,600 Director Shares at a purchase price of $19.25 per Director Share. (b) Closing. The closing of the sale of Director Shares hereunder (the "Closing") shall occur on August 31, 1998 in the offices of the Company. At the Closing, the Company shall deliver to the Director Legended Certificates in the name of the Director representing the Director Shares against delivery by the Director of a check in the amount of $300,300. (c) Stockholder Rights. The Director shall have all rights of a stockholder as to the Director Shares, including the right to receive dividends and the right to vote in accordance with the Company's Certificate of Incorporation. (d) Dividends and Distributions. Any shares of Common Stock or other securities of the Company received by the Director as a result of a stock distribution to holders of Common Stock or a stock dividend on Common Stock shall be subject to the same restrictions as the Director Shares and all references to Director Shares hereunder shall be deemed to include such shares of Common Stock or other securities. (e) Restrictions on Transfer. Prior to an IPO, the Director Shares shall be transferable only to a Permitted Transferee or the Company. 5. Termination of Employment or Status; Involuntary Transfers. (a) Company Call Right. (i) Exercise of Call Right. Unless the Board of Directors in its sole discretion determines otherwise and so sets forth in the applicable agreement, if prior to the completion of an IPO the service of a Director with the Company terminates for any reason, or an Involuntary Transfer occurs, the Company shall have a Call Right, exercisable for a period of 60 days after the date of such termination or Involuntary Transfer, with respect to all of the Director Shares, Vested Options and Option Shares beneficially owned by such Director and his Permitted Transferees. The Company may exercise such Call Right by giving written notice thereof to the Director or his Permitted Transferee, as the case may be, prior to the expiration of such 60-day period. The Company's Call Right shall become null and void subsequent to the completion of an IPO. (ii) Purchase Price. With respect to any exercise of a Call Right under this Section 5(a), (A) the purchase price per Director Share to be paid by the Company at the closing provided for in Section 5(c) shall be the Applicable Director Share Value, determined as of the date of termination of the Director's service or Involuntary Transfer, (B) the purchase price per Option Share to be paid by the Company at the closing provided for in Section 5(c) shall be the Applicable Option Share Value, determined as of the date of termination of the Director's service or Involuntary Transfer and (C) the consideration to be paid by the Company in respect of Vested Options surrendered for cancellation at the closing provided for in Section 5(c) shall be the Applicable Option Value determined as of the date of termination of the Director's service or Involuntary Transfer. The Company will give notice of the purchase price to be paid per Director Share, Option Share or Vested Option within a reasonable time from the date of determination of such price. (b) Director Put Right. (i) Exercise of Put Right. Subject to Section 5(b)(iii), if prior to the completion of an IPO the service of the Director with the Company terminates for any reason, the Director (or, in the case of the Director's death, his Beneficiary) shall have a Put Right, exercisable for a period of 60 days after the date of such termination, with respect to all of the Director Shares, Vested Options and Option Shares beneficially owned by the Director and his Permitted Transferees. The Director may exercise such Put Right by giving written notice thereof to the Company prior to the expiration of such 60-day period. The Director's Put Rights shall be null and void subsequent to the completion of an IPO. (ii) Purchase Price. The Put Right purchase price per Director Share to be paid by the Company at the closing provided for in Section 5(c) shall be the Applicable Director Share Value, determined as of the date of termination of the Director's service. The Put Right purchase price per Option Share to be paid by the Company at the closing provided for in Section 5(c) shall be the Applicable Option Share Value, determined as of the date of termination of the Director's service. The consideration to be paid by the Company in respect of Vested Options surrendered for cancellation at the closing provided for in Section 5(c) shall be Applicable Option Value, determined as of the date of termination of the Director's service. The Company will give notice of the consideration to be paid per Director Share, Option Share or Vested Option within a reasonable time from the date of determination of such amount. (iii) Financial Capability. Anything in this Agreement to the contrary notwithstanding, if, at any time, the Board of Directors shall determine, subject to the written opinion of the Appraiser (as hereinafter defined) referred to below, that the Company is not financially capable of making some or all of the aggregate payments to be made thereafter pursuant to the exercise of Put Rights (the "Put Right Payments") under this Agreement, similar agreements with other directors and the Management Equity Plan, the Company shall have the right to defer such Put Right Payments but only on the terms hereinafter provided in this Section 5(b)(iii). In the event that the Board of Directors shall have made such determination with respect to the Company's financial capability, the Board of Directors shall, if so requested in writing by at least two directors or participants in the Management Equity Plan within 10 business days of the date that notice of such determination has been given (the "Request Period"), promptly retain an appraisal or investment banking firm, to be selected by the Chief Executive Officer and reasonably satisfactory to the Board of Directors (the "Appraiser"), to render a written opinion as to whether the Company has the financial capability to make any of, or any portion of, such Put Right Payments at such time as it would otherwise be required to make such Put Right Payments. If the Board of Directors' determination, or the Appraiser's written opinion, if so required, indicates that, at the time a Put Right Payment would otherwise be required to be made to the Director, the Company would not have the financial capability to make any of the Put Right Payments that would otherwise then be required to be made, or shall have the financial capability to make only a portion of such Put Right Payments, then payments with respect to such Put Right Payments shall be made on the following basis: As of the first day following a determination by the Appraiser of lack of financial capability in respect of which Put Right Payments are required to be made or, if no request for an Appraiser's appraisal is made, on the day following the last day of the Request Period (each such date being hereinafter called a "Payout Date"), all unpaid amounts payable with respect to Put Rights exercised prior to such a date, shall be aggregated (the "Aggregate Payable Amount"), and the amount payable to each director and participant in the Management Equity Plan shall be determined by multiplying the full amount owing to such director or participant as of such date by a fraction, the numerator of which shall be the amount that the Company, as indicated by the Board of Directors' determination or the Appraiser's written opinion, shall then be financially capable of paying (which may be zero if, as indicated by the Board of Directors' determination or the Appraiser's written opinion, the Company is not financially capable of making any of the Put Right Payments then otherwise required to be made) and the denominator of which shall be the Aggregate Payable Amount. Elections to exercise Put Rights (or portions thereof) not satisfied pursuant to such pro rata payment shall be deemed revoked, and the remaining awards (or portions thereof) with respect thereto shall thereafter be subject to the terms in effect as if a Put Right election had not been made, provided, however that Options will not be canceled pursuant to Section 3(b). In acting pursuant to this Section 5, the Appraiser shall be entitled to the rights and immunities of an arbitrator. (c) Election and Delivery Procedures. (i) The closing of any exercise of any Call Right or Put Right pursuant to Section 5(a) or 5(b) shall take place at the offices of the Company, or such other place as may be mutually agreed, not less than 15 nor more than 30 days after the date such Call Right or Put Right is exercised. The exact date and time of closing shall be specified by the party exercising such Call Right or Put Right. (ii) At such closing (the "Closing"), the Director (or, following the Director's death, the Director's Beneficiary or Beneficiaries) shall deliver certificates for the shares of Common Stock to be sold to the Company duly endorsed, or accompanied by written instruments of transfer in form reasonably satisfactory to the Company duly executed, by such transferor, free and clear of any Encumbrances, and shall consent to the cancellation of the Vested Options to be surrendered, which Vested Options shall also be free and clear of any Encumbrances. The Company shall pay the applicable purchase price for shares of Common Stock and consideration for surrendered Vested Options in cash; provided, however, that such payment may be deferred under the circumstances, and to the extent, provided for in Section 7. 6. Appraisal. If, in connection with the determination of the Fair Market Value used to calculate the purchase price for shares of Common Stock and Vested Options upon the exercise of any Call Right or Put Right under Section 5(a) or 5(b), the Director reasonably believes that the Board of Directors' determination of Fair Market Value (if applicable) is not reasonable, then such Director may challenge the Board of Directors' determination of such Fair Market Value by giving written notice to the Board of Directors no later than 15 business days after receipt of notice of the purchase price per share which the Company intends to pay with respect to such shares of Common Stock and Vested Options. In such event, the Company shall engage at its own expense an appraisal or investment banking firm that is independent of the Company and its Affiliates and is knowledgeable in the valuation of companies engaged in a business similar to the business in which the Company is engaged to determine the Fair Market Value of the Common Stock for purposes of determining the purchase price; provided, however, that if such a determination has been made by such an appraisal or investment banking firm less than six months prior to the date as of which the Fair Market Value of the Common Stock is to be determined, the Company shall not be required to engage any such firm and shall instead rely on such earlier valuation; provided further, however, that the Company shall not rely on such earlier valuation if it determines in good faith that such earlier valuation no longer reflects Fair Market Value. Any such appraisal or investment banking firm engaged by the Company shall be selected by the Board of Directors and shall be reasonably satisfactory to such Director. Such independent appraisal or investment banking firm's determination of Fair Market Value shall be conclusive and binding on the parties. Anything in this Section 6 to the contrary notwithstanding, if such an independent appraisal or investment banking firm is appointed, no payment shall be made in respect of the Director's shares of Common Stock or Vested Options pending the determination of Fair Market Value by such firm, and payment of the purchase price shall instead be made no later than the tenth business day following receipt by the Company of the report of such firm establishing Fair Market Value. If the Fair Market Value so determined by the independent banking firm exceeds the Fair Market Value as determined by the Board of Directors by more than 10%, the costs of such firm shall be for the account of the Company; in all other cases, the costs of such firm shall be borne by the Director, and the Company shall have the right to withhold such costs from any payment it makes in respect of its repurchase of shares of Common Stock or Vested Options from the Director. 7. Legal Limitations. Anything in this Agreement to the contrary notwithstanding, to the extent that the limitations or restrictions applicable to the Company or any subsidiary under the laws of their respective jurisdictions of incorporation, the restrictions or limitations contained in the Certificate of Incorporation or By-laws of the Company or any subsidiary or any other applicable law, rule or regulation or under the terms of any indebtedness for borrowed money of the Company or any subsidiary prohibit the Company from making any payment required under this Agreement with respect to a share of Common Stock or Vested Option, then the Company shall not be obligated to make such payment at such time, and shall have the right to defer such payment until the Board of Directors reasonably determines that such limitations and restrictions no longer restrict the Company from making such deferred payment. Any amounts the payment of which is so deferred shall bear interest, compounded annually and calculated at a rate equal to the Prime Rate, and shall be paid (with interest) promptly after, and to the extent that, the Board of Directors determines that the limitations and restrictions referred to in the first sentence of this Section 7 no longer restrict such payment. Notwithstanding a deferral of payment in accordance with this Section 7 for shares of Common Stock or Vested Options in respect of which a Call Right or Put Right shall have been exercised, the closing of any exercise of such Call Right or Put Right shall take place as provided in Section 5(c) and the right of the Director and his Permitted Transferees in respect of the shares of Common Stock and Vested Options subject to such Call Right or Put Right (other than the right to receive payment of amounts deferred in accordance with this Section 7) shall terminate as of such closing. 8. Representations and Warranties. (a) The Director has been advised that the Director Shares, Options and Option Shares have not been registered under the 1933 Act and, therefore, cannot be resold unless they are registered or unless an exemption from registration is available. The Director is acquiring the Director Shares, Options, and Option Shares for his own account, for investment and not with a view to, or for resale in connection with, the distribution thereof, and the Director has no present intention of selling, assigning, transferring, distributing or otherwise disposing of, or causing the sale, assignment, transfer, distribution or other disposition of, any thereof. In making the foregoing representation, the Director is aware that he must bear the economic risk of an investment in the Director Shares, Options and Option Shares for an indefinite period of time since, in the view of the Commission, the statutory basis for exemption from registration under the 1933 Act would not be present if such representation meant merely that the Director's current intention is to hold these securities only for the long-term capital gains period of the Internal Revenue Code, or for a deferred sale, or for any fixed period in the future. (b) The Director has been given the opportunity to ask questions of, and receive answers from, the Company concerning the terms and conditions of the Director Shares, Options and Option Shares to be transferred hereunder and other related matters. The Director represents and warrants that he has been furnished with and has carefully read this Agreement, and that the Company has made available to the Director or his agents all documents and information requested by him or on his behalf in connection with his investment in the Director Shares, Options and Option Shares and that he understands and has evaluated the merits and risks of an investment in the Director Shares, Options and Option Shares. In evaluating the suitability of an investment in such Director Shares, Options and Option Shares, the Director has not relied upon any other representations or other information (whether oral or written) made by or on behalf of the Company other than as contemplated by the two preceding sentences. (c) The Director is aware of and familiar with the restrictions imposed on the transfer of any Director Shares, Options and Option Shares, including, without limitation, the restrictions contained in this Agreement. (d) The Director represents that this Agreement has been duly executed and delivered by the Director and constitutes a legal, valid and binding agreement of the Director, enforceable against the Director in accordance with its terms. 9. Miscellaneous. (a) No Rights to Additional Grants or Continued Service. The Director shall not have any claim or right to receive additional grants of stock options or to be offered the opportunity to purchase additional shares of Common Stock. Neither this Agreement nor any action taken or omitted to be taken hereunder shall be deemed to create or confer on the Director any right to serve on the Company's Board of Directors, to be retained in the service of the Company or to interfere with or limit in any way the right of the Company to terminate the service of the Director at any time. (b) No Restriction on Right of Company to Effect Corporate Changes. This Agreement shall not affect in any way the right or power of the Company or its stockholders to make or authorize any or all adjustments, recapitalizations, reorganizations or other changes in the Company's capital structure or its business, or any merger or consolidation of the Company, or any issue of stock or of options, warrants or rights to purchase stock or of bonds, debentures, preferred or prior preference stocks whose rights are superior to or affect the Common Stock or the rights thereof or which are convertible into or exchangeable for Common Stock, or the dissolution or liquidation of the Company, or any sale or transfer of all or any part of its assets or business, or any other corporate act or proceeding, whether of a similar character or otherwise. (c) 1934 Act. Notwithstanding anything contained in this Agreement to the contrary, if the consummation of any transaction under this Agreement would result in the possible imposition of liability to the Director pursuant to Section 16(b) of the 1934 Act, the Board of Directors shall have the right, in its sole discretion, but shall not be obligated, to defer such transaction to the extent necessary to avoid such liability, but in no event for a period in excess of 180 days. (d) Restrictions on Transfer. Director Shares, Options and Option Shares shall not be transferrable except as specifically provided in this Agreement. 10. Effect of Certain Corporate Changes and Changes in Control. (a) Dilution and Other Adjustments. In the event of a stock dividend or split, the Board of Directors shall make the following adjustments as are necessary or advisable (the form of which shall be determined by the Board of Directors in its sole discretion) to provide the Director with a benefit equivalent to that which he would have been entitled to had such event not occurred: (i) adjust the number of Options granted to the Director, (ii) adjust the Option Price, and (iii) make any other adjustments, or take such action, as the Board of Directors, in its discretion, deems appropriate. Such adjustments shall be conclusive and binding for all purposes. In the event of a change in the Common Stock which is limited to a change in the designation thereof to "Capital Stock" or other similar designation, or to a change in the par value thereof, or from par value to no par value, without increase or decrease in the number of issued shares of Common Stock, the shares resulting from any such change shall be deemed to be Common Stock within the meaning of this Agreement. (b) Effect of Reorganization. In the event that (i) the Company is merged or consolidated with another corporation, (ii) all or substantially all the assets of the Company are acquired by another corporation, person or entity, (iii) the Company is reorganized, dissolved or liquidated (each such event in (i), (ii) or (iii) being hereinafter referred to as a "Reorganization Event") or (iv) the Board of Directors shall propose that the Company enter into a Reorganization Event, then the Board of Directors shall make upon consummation of such Reorganization Event any or all of the adjustments described in Section 10(a) as are necessary or advisable in the sole discretion of the Board of Directors to provide the Director with a benefit equivalent to that which he would have been entitled to had such event not occurred. 11. Survival; Assignment, (a) All agreements, representations and warranties made herein and in the certificates delivered pursuant hereto shall survive the issuance to the Director of the Director Shares, Options and any Option Shares and, notwithstanding any investigation heretofore or hereafter made by the Director or the Company or on the Director's or the Company's behalf, shall continue in full force and effect. Without the prior written consent of the Company, the Director may not assign any of his rights hereunder except as permitted by this Agreement or by will or the laws of descent and distribution. Whenever in this Agreement any of the parties hereto is referred to, such reference shall be deemed to include the heirs and permitted successors and assigns of such party; and all agreements herein by or on behalf of the Company, or by or on behalf of the Director, shall bind and inure to the benefit of the heirs and permitted successors and assigns of such parties hereto. (b) The Company shall have the right to assign any of its rights and to delegate any of its duties under this Agreement to any of its Affiliates; provided, however, that such assignment shall not release the Company from any duty hereunder which remains unfulfilled by such an assignee. 12. Notices. All notices and other communications provided for herein shall be in writing and shall be delivered by hand or sent by certified or registered mail, return receipt requested, postage prepaid, addressed, if to the Director, to his attention at the mailing address set forth at the foot of this Agreement (or to such other address as the Director shall have specified to the Company in writing) and, if to the Company, to the General Counsel of the Company. All such notices shall be conclusively deemed to be received and shall be effective, if sent by hand delivery, upon receipt, or if sent by registered or certified mail, on the fifth day after the day on which such notice is mailed. 13. Waiver. The waiver by either party of compliance with any provision of this Agreement by the other party shall not operate or be construed as a waiver of any other provision of this Agreement, or of any subsequent breach by such party of a provision of this Agreement. 14. Entire Agreement; Governing Law. This Agreement and the other related agreements expressly referred to herein set forth the entire agreement and understanding between the parties hereto and supersede all prior agreements and understandings relating to the subject matter hereof. This Agreement may be executed in one or more counterparts, each of which shall be deemed to be an original, but all such counterparts shall together constitute one and the same agreement. The headings of sections and subsections herein are included solely for convenience of reference and shall not affect the meaning of any of the provisions of this Agreement. This Agreement shall be governed by, and construed in accordance with, the laws of the State of Delaware. IN WITNESS WHEREOF, the Company has caused this Agreement to be executed by its duly authorized officer and the Director has executed this Agreement, both as of the day and year first above written. KINETIC CONCEPTS, INC. By: /s/ Dennis E. Noll ------------------- Name: Dennis E. Noll Title: Senior Vice President DIRECTOR /s/ Donald E. Steen --------------------- Name: Donald E. Steen Address: EX-10 4 June 4, 1998 Mr. William M. Brown 16 Deerfield Drive Lawrenceville, NJ 08648 Dear Bill, On behalf of KCI, it is a pleasure to confirm the employment offer we discussed yesterday. The specific terms and conditions of your new position will be as follows: Position Title: Chief Financial Officer Employment Status: Regular Full-Time, Exempt Base Salary: $215,000.00 per year Auto Allowance: $500.00 per month Immediate Supervisor: Raymond R. Hannigan President and Chief Executive Officer Office Location: 8023 Vantage Drive San Antonio, TX 78230 Start Date: July 1, 1998 In addition to your base salary, you will be eligible to participate in a Management Incentive Plan (MIP) with a calendar year target bonus of 40% of your base annual salary, which equals $43,000.00 when prorated for the remainder of 1998. Per our agreement, your prorata bonus will be guaranteed for 1998. Future bonus payments will be determined on both individual and Corporate performance and will be contingent upon you remaining in a bonus eligible position through December 31, of each year. You will be recommended to the Key Contributor Stock Option Committee for a grant of 100,000 non-qualified stock options, with an exercise price of $19.25 per option. Options will vest at the rate of 20% of the outstanding grant on each anniversary of your employment date. A copy of KCI's Management Equity Plan is enclosed for your review. To assist you with your pending relocation from Lawrenceville, NJ to San Antonio, TX you will be eligible to participate in our senior management Relocation Assistance Program; a copy of which is enclosed. This letter serves to establish the entirety of your employment relationship with KCI and its subsidiaries, and supersedes any previous understanding which may have been implied or expressed, either verbally or in writing, by any representative of the Company or its agents. All employment offers are contingent upon satisfactory completion of our pre-employment screening, including INS requirements and substance abuse testing. Employment relationships with KCI and its subsidiaries are at- will and may be terminated by notification from either party at any time, with or without cause. You will be eligible for future participation in our standard employment related benefit programs such as vacations, education assistance, group health plan, insurance benefits, etc., contingent upon your satisfaction of the eligibility or enrollment requirements pertaining to those programs. Mr. William M. Brown June 4, 1998 Page 2 By your signature affixed below, you acknowledge that you have received a copy of the Company's arbitration procedures, have had the opportunity to review them and agree to abide by the procedures fully. In addition, you understand and agree that the Company is engaged in transactions involving interstate commerce and that this employment offer evidences a transaction involving commerce. If you find the above terms and conditions of employment acceptable, in order to activate your payroll status you must complete the appropriate signature blank below, and return the original to the Human Resources Department. A copy is included for your retention. It is my sincere hope you will find your experience with KCI to be personally and professionally rewarding. I look forward to a mutually prosperous working relationship. Sincerely, KCI UNDERSTOOD AND AGREED: /s/ Raymond R. Hannigan /s/ William M. Brown __________________________ _______________________________ Raymond R. Hannigan William M. Brown Date President and Chief Executive Officer Enclosures EX-10 5 For Purchases Direct From Supplier Not Subject to Competitive Bid Process NOVATION, LLC SUPPLIER AGREEMENT Replaces: UHC Agreements (CE-219, CE-269 and MS-94443) And VHA Agreement (CE146) TABLE OF CONTENTS PAGE 1. INTRODUCTION........................1 a. Purchasing Opportunities for Members 1 b. Supplier 1 c. Contract Prices; Non-Price Specifications; Special Conditions 1 2. BASIC TERMS 1 a. Purchase of Products 1 b. Optional Purchasing Arrangement 1 c. Market Competitive Terms 2 d. Changes in Contract Prices 2 e. Notification of Changes in Pricing Terms 2 3. TERM AND TERMINATION...................2 a. Term 2 b. Termination by Novation 3 c. Termination by Supplier 3 4. PRODUCT SUPPLY........................3 a. Delivery and Invoicing.....................3 b. Purchase Orders 3 c.Product Fill Rates; Confirmation and Delivery Times 3 d. Bundled Terms 3 e.Discontinuation of Products; Changes in Packaging 4 f. Replacement or New Products 4 g. Member Services 4 h. Product Deletion 4 i. Return of Products 5 j. Failure to Supply 5 5. PRODUCT QUALITY......................5 a. Free From Defects......................5 b. Product Compliance......................5 c. Patent Infringement 6 d. Product Condition 6 e. Recall of Products 6 f. Shelf Life 6 6. CENTURY COMPLIANCE.....................6 a. Definitions..........................6 b. Representations 7 c. Remedies 7 d. Noncompliance Notice 8 e. Survival 8 7. REPORTS AND ELECTRONIC DATA INTERCHANGE.........8 a. Report Content 8 b. Report Format and Delivery 8 c. Electronic Data Interchange 9 8. OBLIGATIONS OF NOVATION...................9 a. Information to Members.....................9 b. Marketing Services......................9 9. MARKETING FEES9 a. Calculation..........................9 b. Payment...........................9 10. ADMINISTRATIVE PENALTIES 10 11. NONPAYMENT OR INSOLVENCY OF A MEMBER 11 12. INSURANCE 11 a. Policy Requirements 11 b. Self-Insurance 11 c. Amendments, Notices and Endorsements 11 13. COMPLIANCE WITH LAW ..11 14 HOLD HARMLESS 12 15. BOOKS AND RECORDS; FACILITIES INSPECTIONS 12 16. USE OF NAMES, ETC 12 17. CONFIDENTIAL INFORMATION 13 a. Nondisclosure 13 b. Definition 13 18. MISCELLANEOUS......................... 13 a. Choice of Law ........................13 b. Not Responsible.........................13 c. Third Party Beneficiaries.................... 13 d. Notices............................. 14 e. No Assignment......................... 14 f. Severability............................ 14 g. Entire Agreement......................... 14 NOVATION, LLC SUPPLIER AGREEMENT 1. INTRODUCTION. a. Purchasing 0pportunities for Members. Novation, LLC ("Novation") is engaged in providing purchasing opportunities with respect to high quality products and services to participating health care providers ("Members"). Members are entitled to participate in Novation's programs through their membership or other participatory status in any of the following client organizations: VHA Inc., University HealthSystem Consortium, and HealthCare Purchasing Partners International, LLC (collectively, "Clients"). A current listing of Members is maintained by Novation in the electronic database included as part of the electronic data interchange described in Subsection 7.c below ("Novation Database"). A provider will become a "Member" for purposes of this Agreement at the time Novation adds the provider to the Novation Database and will cease to be a "Member" for such purposes at the time Novation deletes the provider from the Novation Database. b. Supplier. Supplier is the manufacturer of products listed on Exhibit A (the provider of installation, training and maintenance services for such products, and the provider of any other services listed on Exhibit A (such products and/or services are collectively referred to herein as "Products"). c. Contract Prices; Non-Price Specifications; Special Conditions. A description of the Products and pricing therefor ("Contract Prices") is attached hereto as Exhibit A, the other specifications are attached hereto as Exhibit B ("Non-Price Specifications"), and any Special Conditions are attached hereto as Exhibit C ("Special Conditions"). 2. BASIC TERMS. a. Purchase of Products. Novation and Supplier hereby agree that Supplier will make the Products available for purchase by the Members at the Contract Prices in accordance with the terms of this Agreement; provided, however, that this Agreement will not constitute a commitment by any person to purchase any of the Products. b. Optional Purchasing Arrangement. Novation and Supplier agree that each Member will have the option of purchasing the Products under the terms of this Agreement or under the terms of any other purchasing or pricing arrangement that may exist between such Member and Supplier at any time during the Term; provided, however, that all of Supplier's sales of the Products to Members, whether under the pricing and other terms of this Agreement or otherwise, will be reported by Supplier to Novation in accordance with Section 7 below and will be included in the aggregate dollar volume of purchases used in calculating the Marketing Fees payable to Novation in accordance with Section 9 below. If any Member uses any other purchasing or pricing arrangement with Supplier when ordering products covered by any contract between Supplier and Novation, Supplier will notify such Member of the pricing and other significant terms of the applicable Novation contract. c. Market Competitive Terms. Supplier agrees that the prices, quality, value and technology of all Products purchased under this Agreement will remain market competitive at all times during the Term Supplier agrees to provide prompt written notice to Novation of all offers for the sale of the Products made by Supplier during the Term on terms that are more favorable to the offeree than the terms of this Agreement. Supplier will lower the Contract Prices or increase any discount applicable to the purchase of the Products as necessary to assure market competitiveness. If at any time during the Term Novation receives information from any source suggesting that Supplier's prices, quality, value or technology are not market competitive, Novation may provide written notice of such information to Supplier, and Supplier will, within five (5) business days for Novation's private label Products and within ten (10) business days for all other Products, advise Novation in writing of and fully implement all adjustments necessary to assure market competitiveness. d. Changes in Contract Prices. Unless otherwise expressly agreed in any exhibit to this Agreement, the Contract Prices will not be increased and any discount will not be eliminated or reduced during the Term. In addition to any changes made to assure market competitiveness, Supplier may lower the Contract Prices or increase any discount applicable to the purchase of the Products at any time. e. Notification of Changes in Pricing Terms. Supplier will provide all Members with not less than forty-five (45) days' prior written notice and Novation with not less than sixty (60) days' prior written notice of any change in pricing terms permitted or required by this Agreement. For purposes of the foregoing notification requirements, a change in pricing terms will mean any change that affects the delivered price to the Member, including, without limitation, changes in list prices, discounts or pricing tiers or schedules. Such prior written notice will be provided in such format and in such detail as may be required by Novation from time to time, and will include, at a minimum, sufficient information to determine line item pricing of the Products for all affected Members. 3. TERM AND TERMINATION. a. Term. This Agreement will be effective as of the effective date set forth in Exhibit D attached hereto ("Effective Date"), and, unless sooner terminated, will continue in full force and effect for the initial term set forth in the Non-Price Specifications and for any renewal terms set forth in the Non-Price Specifications by Novation's delivery of written notice of renewal to Supplier not less than ten (10) days prior to the end of the initial term or any renewal term, as applicable. The initial term, together with the renewal terms, if any, are collectively referred to herein as the "Term." b. Termination by Novation. Novation may terminate this Agreement at any time for any reason whatsoever by delivering not less than ninety (90) days' prior written notice thereof to Supplier. In addition, Novation may terminate this Agreement immediately by delivering written notice thereof to Supplier upon the occurrence of either of the following events: (1) Supplier breaches this Agreement; or (2) Supplier becomes bankrupt or insolvent or makes an unauthorized assignment or goes into liquidation or proceedings are initiated for the purpose of having a receiving order or winding up order made against Supplier, or Supplier applies to the courts for protection from its creditors. c. Termination by Supplier. Supplier may terminate this Agreement at any time for any reason whatsoever by delivering not less than one hundred eighty (180) days' prior written notice thereof to Novation. 4. PRODUCT SUPPLY. a. Delivery and Invoicing. On and after the Effective Date, Supplier agrees to deliver Products ordered by the Members to the Members, FOB destination, and will direct it's invoices to the Members in accordance with this Agreement. Supplier agrees to prepay and absorb charges, if any, for transporting Products to the Members. Payment terms are 2%-10, Net 30 days. Supplier will make whatever arrangements are reasonably necessary with the Members to implement the terms of this Agreement; provided, however, Supplier will not impose any purchasing commitment on any Member as a condition to the Member's purchase of any Products pursuant to this Agreement. b. Purchase Orders. This Agreement will govern all orders for and sales of the Products by and to the Members, notwithstanding any pre-printed terms on Supplier's forms; provided, however, the terms of the usual purchase orders of the Members will supersede this Agreement in the event of conflict or inconsistency. c. Product Fill Rates; Confirmation and Delivery Times. Supplier agrees to provide product fill rates to Members of greater than ninety-five percent (95%), calculated as line item orders. Supplier will provide confirmation of orders from Members via the electronic data interchange described in Subsection 7.c below within two (2) business days after placement of the order and will deliver the Products to the Members within ten (10) business days after placement of the order. d. Bundled Terms. Supplier agrees to give Novation prior written notice of any offer Supplier makes to any Member to sell products that are not covered by this Agreement in conjunction with Products covered by this Agreement under circumstances where the Member has no real economic choice other than to accept such bundled terms. e. Discontinuation of Products; Changes in Packaging. Supplier will have no unilateral right to discontinue any of the Products or to make any changes in packaging which render any of the Products substantially different in use, function or distribution. Supplier may request Novation in writing to agree to a proposed discontinuation of any Products or a proposed change in packaging for any Products at least ninety (90) days prior to the proposed implementation of the discontinuation or change. Under no circumstances will any Product discontinuation or packaging changes be permitted under this Agreement without Novation's agreement to the discontinuation or change. In the event Supplier implements such proposed discontinuation or change without Novation's agreement thereto in writing, in addition to any other rights and remedies Novation or the Members may have by reason of such discontinuation or change, (i) Novation will have the right to terminate any or all of the Product(s) subject to such discontinuation or change or to terminate this Agreement in its entirety immediately upon becoming aware of the discontinuation or change or any time thereafter by delivering written notice thereof to Supplier; (ii) the Members may purchase products equivalent to the discontinued or changed Products from other sources and Supplier will be liable to the Members for all reasonable costs in excess of the Contract Prices plus any other damages which they may incur; and (iii) Supplier will be liable to Novation and the Clients for any loss of Marketing Fees resulting from such unacceptable discontinuation or change plus any other damages which they may incur. f. Replacement or New Products. Supplier will have no unilateral right to replace any of the Products listed in Exhibit A with other products or to add new products to this Agreement. Supplier may request Novation in writing to agree to a replacement of any of the Products or the addition of a new product that is closely related by function or use to an existing Product at least sixty (60) days prior to the proposed implementation of the replacement or to the new product introduction. Under no circumstances will any Product replacement or new product addition to this Agreement be permitted without Novation's agreement to the replacement or new product. g. Member Services. Supplier will consult with each Member to identify the Member's policies relating to access to facilities and personnel. Supplier will comply with such policies and will establish a specific timetable for sales calls by sales representatives to satisfy the needs of the Member. Supplier will promptly respond to Members' reasonable requests for verification of purchase history. If requested by Novation or any Members, Supplier will provide, at Supplier's cost, on-site inservice training to Members' personnel for pertinent Products. h. Product Deletion. Notwithstanding anything to the contrary contained in this Agreement, Novation may delete any one or more of the Products from this Agreement at any time, at will and without cause, upon not less than sixty (60) days' prior written notice to Supplier. i. Return of Products. Any Member, in addition to and not in limitation of any other rights and remedies, will have the right to return Products to Supplier under any of the following circumstances: (1) the Product is ordered or shipped in error; (2) the Product is no longer needed by the Member due to deletion from its standard supply list or changes in usage patterns, provided the Product is returned at least six (6) months prior to its expiration date and is in a re-saleable condition; (3) the Product is received outdated or is otherwise unusable; (4) the Product is received damaged, or is defective or nonconforming; (5) the Product is one which a product manufacturer or supplier specifically authorizes for return; or (6) the Product is recalled. Supplier agrees to accept the return of Products under these circumstances without charge and for full credit. j. Failure to Supply. In the event of Supplier's failure to perform in accordance with the terms of this Agreement, the Member may purchase products equivalent to the Products from other sources and Supplier will be liable to the Member for all reasonable costs in excess of the Contract Prices plus any other damages which they may incur. In such event, Supplier will also be liable to Novation and the Clients for any loss of Marketing Fees resulting from such failure plus any other damages which they may incur. The remedies set forth in this Subsection are in addition to any other rights and remedies Novation, the Clients or the Members may have resulting from such failure. 5. PRODUCT QUALITY. a. Free From Defects. Supplier warrants the Products against defects in material, workmanship and design for the warranty period set forth in the Non-Price Specifications ("Warranty Period"). Supplier will make all necessary arrangements to assign such warranty to the Members. Supplier further represents and warrants that the Products will conform to the specifications, drawings, and samples furnished by Supplier or contained in the Non-Price Specifications and will be safe for their intended use. If any Products are defective and a claim is made by a Member on account of such defect during the Warranty Period, Supplier will, at the option of the Member, either replace the defective Products or credit the Member. Supplier will bear all costs of returning and replacing the defective Products, as well as all risk of loss or damage to the defective Products from and after the time they leave the physical possession of the Member. The warranties contained in this Subsection will survive any inspection, delivery, acceptance or payment by a Member. In addition, if there is at any time wide-spread failure of the Products even after the Warranty Period has ended, the Member may return all said Products for credit or replacement, at its option. This Subsection and the obligations contained herein will survive the expiration or earlier termination of this Agreement. The remedies set forth in this Subsection are in addition to and not a limitation on any other rights or remedies that may be available against Supplier. b. Product Compliance. Supplier represents and warrants to Novation, the Clients and the Members that the Products are, if required, registered, and will not be distributed, sold or priced by Supplier in violation of any federal, state or local law. Supplier represents and warrants that as of the date of delivery to the Members all Products will not be adulterated or misbranded within the meaning of the Federal Food, Drug and Cosmetic Act and will not violate or cause a violation of any applicable law, ordinance, rule, regulation or order. Supplier agrees it will comply with all applicable Good Manufacturing Practices and Standards contained in 21 C.F.R. Parts 21O, 211, 225, 226, 600, 606, 610, 640, 660, 680, and 820. Supplier's representations, warranties and agreements in this Subsection will survive the expiration or earlier termination of this Agreement. c. Patent Infringement. Supplier represents and warrants that sale or use of the Products will not infringe any United States patent. Supplier will, at its own expense, defend every suit which will be brought against Novation or a Member for any alleged infringement of any patent by reason of the sale or use of the Products and will pay all costs, damages and profits recoverable in any such suit. This Subsection and the obligations contained herein will survive the expiration or earlier termination of this Agreement. The remedies set forth in this Subsection are in addition to and not a limitation on any other rights or remedies that may be available against Supplier. d. Product Condition. Unless otherwise stated in the Non-Price Specifications or unless agreed upon by a Member in connection with Products it may order, all Products will be new. Products which are demonstrators, used, obsolete, seconds, or which have been discontinued are unacceptable unless otherwise specified in the Non-Price Specifications or the Member accepts delivery after receiving notice of the condition of the Products. e. Recall of Products. Supplier will reimburse the Members for any cost associated with any Product corrective action, withdrawal or recall requested by Supplier or required by any governmental entity. In the event a product recall or a court action impacting supply occurs, Supplier will notify Novation in writing within twenty-four (24) hours of any such recall or action. Supplier's obligations in this Subsection will survive the expiration or earlier termination of this Agreement. f. Shelf Life. Sterile Products and other Products with a limited shelf life sold under this Agreement will have the longest possible shelf life and the latest possible expiration dates. Unless required by stability considerations, there will not be less than a eighteen (18) month interval between a Product's date of delivery by Supplier to the Member and its expiration date. 6. CENTURY COMPLIANCE. a. Definitions. For purposes of this Section, the following terms have the respective meanings given below: (1) "Systems" means any of the Products, systems of distribution for Products and Product manufacturing systems that consist of or include any computer software, computer firmware, computer hardware (whether general or special purpose), documentation, data, and other similar or related items of the automated, computerized, and/or software systems that are provided by or through Supplier or utilized to manufacture or distribute the Products provided by or through Supplier pursuant to this Agreement, or any component part thereof, and any services provided by or through Supplier in connection therewith. (2) "Calendar-Related" refers to date values based on the "Gregorian calendar" (as defined in the Encyclopedia Britannica, 15th edition, 1982, page 602) and to all uses in any manner of those date values, including without limitation manipulations, calculations, conversions, comparisons, and presentations. (3) "Century Noncompliance" means any aspects of the Systems that fail to satisfy the requirements set forth in Subsection 6.b below. b. Representations. Supplier warrants, represents and agrees that the Systems satisfy the following requirements: (1) In connection with the use and processing of Calendar-Related data, the Systems will not malfunction, will not cease to function, will not generate incorrect data, and will not produce incorrect results. (2) In connection with providing Calendar-Related data to and accepting Calendar-Related data from other automated, computerized, and/or software systems and users via user interfaces, electronic interfaces, and data storage, the Systems represent dates without ambiguity as to century. (3) The year component of Calendar-Related data that is provided by the Systems to or that is accepted by the Systems from other automated, computerized, and/or software systems and user interfaces, electronic interfaces, and data storage is represented in a four-digit CCYY format, where CC represents the two digits expressing the century and YY represents the two digits expressing the year within that century (e.g., 1996 or 2003). (4) Supplier has verified through testing that the Systems satisfy the requirements of this Subsection including, without limitation, testing of each of the following specific dates and the transition to and from each such date: December3l, 1998; January 1, 1999; September 9, 1999; September 10, 1999; December 31, 1999; January 1, 2000; February 28, 2000; February 29, 2000; March 1, 2000; December 3 1, 2000; January 1, 2001; December 31, 2004; and January 1, 2005. c. Remedies. In the event of any Century Noncompliance in the Systems in any respect, in addition to any other remedies that may be available to Novation or the Members, Supplier will, at no cost to the Members, promptly under the circumstances (but, in all cases, within thirty (30) days after receipt of a written request from any Member, unless otherwise agreed by the Member in writing) eliminate the Century Noncompliance from the Systems. d. Noncompliance Notice. In the event Supplier becomes aware of (i.) any possible or actual Century Noncompliance in the Systems or (ii) any international, governmental, industrial, or other standard (proposed or adopted) regarding Calendar- Related data and/or processing, or Supplier begins any significant effort to conform the Systems to any such standard, Supplier will promptly provide the Members with all relevant information in writing and will timely provide the Members with updates to such information. Supplier will respond promptly and fully to inquiries by the Members, and timely provide updates to any responses provided to the Members, with respect to (i.) any possible or actual Century Noncompliance in the Systems or (ii) any international, governmental, industrial, or other standards. In the foregoing, the use of "timely" means promptly after the relevant information becomes known to or is developed by or for Supplier. e. Survival. Supplier's representations, warranties and agreements in this Section will continue in effect throughout the Term and will survive the expiration or earlier termination of this Agreement. 7. REPORTS AND ELECTRONIC DATA INTERCHANGE. a. Report Content. Within twenty (20) days after the end of each full and partial month during the Term ("Reporting Month"), Supplier will submit to Novation a report in the form of a diskette containing the following information in form and content reasonably satisfactory to Novation: (1) the name of Supplier, the Reporting Month and year and the Agreement number (as provided to Supplier by Novation); (2) with respect to each Member (described by LIC number (as provided to Supplier by Novation), health industry number (if applicable), full name, street address, city, state, zip code and, if applicable, tier and committed status), the number of units sold and the amount of net sales for each Product on a line item basis, and the sum of net sales and the associated Marketing Fees for all Products purchased by such Member directly or indirectly from Supplier during the Reporting Month, whether under the pricing and other terms of this Agreement or under the terms of any other purchasing or pricing arrangements that may exist between the Member and Supplier. (3) the sum of the net sales and the associated Marketing Fees for all Products sold to all Members during the Reporting Month; and (4) such additional information as Novation may reasonably request from time to time. b. Report Format and Delivery. The reports required by this Section will be submitted electronically in Excel Version 7 or Access Version 7 and in accordance with other specifications established by Novation from time to time and will be delivered to: Novation Attn: SRIS Operations 220 East Las Colinas Boulevard Irving, TX 75039 c. Electronic Data Interchange. In addition to the reporting requirements set forth in Subsections 7.a and 7.b above, the parties agree to facilitate the administration of this Agreement by transmitting and receiving data electronically. The parties agree to all terms and conditions set forth in Exhibit E attached hereto. 8. OBLIGATIONS OF NOVATION. a. Information to Members. After the execution of this Agreement, Novation, in conjunction with the Clients, will deliver a summary of the purchasing arrangements covered by this Agreement to each Member and will, from time to time, at the request of Supplier, deliver to each Member reasonable and appropriate amounts and types of materials supplied by Supplier to Novation which relate to the purchase of the Products. b. Marketing Services. Novation, in conjunction with the Clients, will market the purchasing arrangements covered by this Agreement to the Members. Such promotional services may include, as appropriate, the use of direct mail, contact by Novation's field service delivery team, member support services, and regional and national meetings and conferences. As appropriate, Novation, in conjunction with the Clients, will involve Supplier in these promotional activities by inviting Supplier to participate in meetings and other reasonable networking activities with Members. 9. MARKETING FEES. a. Calculation. Supplier will pay to Novation, as the authorized collection agent for the Clients, marketing fees ("Marketing Fees") belonging to the Clients equal to the Agreed Percentage of the aggregate gross charges of all net sales of the Products to the Members directly or indirectly from Supplier, whether under the pricing and other terms of this Agreement or under the terms of any other purchasing or pricing arrangements that may exist between the Members and Supplier. Such gross charges will be determined without any deduction for uncollected accounts or for costs incurred in the manufacture, provision, sale or distribution of the Products, and will include, but not be limited to, charges for the sales of products, the provision of installation, training and maintenance services, and the provision of any other services listed on Exhibit A. The "Agreed Percentage" will be defined in the Non-Price Specifications. b. Payment. On or about the Effective Date, Novation will advise Supplier in writing of the amount determined by Novation to be Supplier's monthly estimated Marketing Fees. Thereafter, Supplier's monthly estimated Marketing Fees may be adjusted from time to time upon written notice from Novation based on actual purchase data. No later than the tenth (10th) day of each month, Supplier will remit the monthly estimated Marketing Fees for such month to Novation. Such payment will be adjusted to reflect the reconciliation between the actual Marketing Fees payable for the immediately preceding month with the estimated Marketing Fees actually paid during such preceding month. Supplier will pay all estimated and adjusted Marketing Fees by check made payable to "Novation, LLC." All checks should reference the Agreement number. Supplier will include with its check the reconciliation calculation used by Supplier to determine the payment adjustment, with separate amounts shown for each Client's component thereof Checks sent by first class mail will be mailed to the following address: Novation 75 Remittance Dr., Suite 1420 Chicago, IL 60675-1420 Checks sent by courier (Federal Express, United Parcel Service or messenger) will be addressed as follows: The Northern Trust Company 801 S. Canal St. 4th Floor Receipt & Dispatch Chicago, IL 60607 Attn: Novation, Suite 1420 10. ADMINISTRATIVE PENALTIES. In the event Supplier fails to pay the Marketing Fees in accordance with the requirements of Section 9 above, Novation may invoice Supplier for the Marketing Fees estimated by Novation to be due, payable within ten (10) days of the date of such invoice. Invoice by Novation or payment by Supplier will not relieve Supplier of its payment obligations under Section 9. In addition, upon the occasion of the first failure to receive Marketing Fees, to receive reports described in Section 7 above, or to receive notice of change in pricing terms described in Subsection 2.e above, in each case within the time and manner required by this Agreement, Supplier will receive a written warning. Upon the second and any subsequent failure to provide such Marketing Fees, reports or notices, Supplier will pay an administrative penalty in accordance with the following schedule: 2nd failure: $ 500.00 3rd failure: $ 1,000.00 4th failure: $ 2,500.00 5th failure: $ 5,000.00 6th & each subsequent failure: $10,000.00 Novation's assessment of administrative penalties in accordance with this Section will be in addition to any other rights and remedies Novation or the Clients may have by reason of Supplier's failure to pay the Marketing Fees or provide the reports or notices within the time and manner required by this Agreement. 11. NONPAYMENT OR INSOLVENCY OF A MEMBER. If a Member fails to pay Supplier for Products, or if a Member becomes bankrupt or insolvent or makes an assignment for the benefit of creditors or goes into liquidation, or if proceedings are initiated for the purpose of having a receiving order or winding up order made against a Member, or if a Member applies to the courts for protection from its creditors, then, in any such case, this Agreement will not terminate, but Supplier will have the right, upon prior written notice to Novation and the Member, to discontinue selling Products to that Member. 12. INSURANCE. a. Policy Requirements. Supplier will maintain and keep in force during the Term product liability, general public liability and property damage insurance against any insurable claim or claims which might or could arise regarding Products purchased by the Members from Supplier. Such insurance will contain a minimum combined single limit of liability for bodily injury and property damage in the amounts of not less than $2,000,000 per occurrence and $10,000,000 in the aggregate; will name Novation, the Clients and the Members, as their interests may appear, as additional insureds, and will contain an endorsement providing that the carrier will provide directly to all named insured copies of all notices and endorsements. Supplier will provide to Novation, within fifteen (15) days after Novation's request, an insurance certificate indicating the foregoing coverage, issued by an insurance company licensed to do business in the relevant states and signed by an authorized agent. b. Self-Insurance. Notwithstanding anything to the contrary in Subsection 12.a above, Supplier may maintain a selfinsurance program for all or any part of the foregoing liability risks, provided such self-insurance policy in all material respects complies with the requirements applicable to the product liability, general public liability and property damage insurance set forth in Subsection 12.a. Supplier will provide Novation, within fifteen (15) days after Novation's request: (1) the self- insurance policy; (2) the name of the company managing the self-insurance program and providing reinsurance, if any; (3) the most recent annual reports on claims and reserves for the program; and (4) the most recent annual actuarial report on such program. c. Amendments, Notices and Endorsements. Supplier will not amend, in any material respect that affects the interests of Novation, the Clients or the Members, or terminate said liability insurance or self-insurance program except after thirty (30) days' prior written notice to Novation and will provide to Novation copies of all notices and endorsements as soon as practicable after it receives or gives them. 13. COMPLIANCE WITH LAW. Supplier represents and warrants that to the best of its knowledge, after due inquiry, it is in compliance with all federal and state statutes, laws, ordinances and regulations applicable to it ("Legal Requirements") which are material to the operation of its business and the conduct of its affairs, including Legal Requirements pertaining to the safety of the Products, occupational health and safety, environmental protection, nondiscrimination, antitrust, and equal employment opportunity. During the Term, Supplier will: (1) promptly notify Novation of any lawsuits, claims, administrative actions or other proceedings asserted or commenced against it which assert in whole or in part that Supplier is in noncompliance with any Legal Requirement which is material to the operation of its business and the conduct of its affairs and (2) promptly provide Novation with true and correct copies of all written notices of adverse findings from the U.S. Food and Drug Administration ("FDA") and all written results of FDA inspections which pertain to the Products. 14. HOLD HARMLESS. Supplier will indemnify, hold harmless, and, if requested, defend Novation, the Clients and the Members, and their respective officers, directors, regents, agents, affiliates and employees, from and against any claims, liabilities, damages, actions, costs and expenses (including reasonable attorneys' fees and court costs) of any kind or nature, whether at law or in equity, arising from or caused by (1) the breach of any representation, warranty, covenant or agreement of Supplier contained in this Agreement, or (2) the condition of any Product at the time of its delivery to a Member pursuant to this Agreement, including a defect in material, workmanship or design, whether such breach or condition is caused by the negligence of any person seeking indemnification hereunder or otherwise; provided that such indemnification, hold harmless and right to defense will not be applicable where the claim, liability, damage, action, cost or expense arises solely as a result of an act or failure to act of the person seeking to be indemnified, held harmless or defended hereunder. This Section and the obligations contained herein will survive the expiration or earlier termination of this Agreement. The remedies set forth in this Section are in addition to and not a limitation on any other rights or remedies that may be available against Supplier. 15. BOOKS AND RECORDS; FACILITIES INSPECTIONS. Supplier agrees to keep, maintain and preserve complete, current and accurate books, records and accounts of the transactions contemplated by this Agreement and such additional books, records and accounts as are necessary to establish and verify Supplier's compliance with this Agreement. All such books, records and accounts will be available for inspection and audit by Novation representatives at any time during the Term and for two (2) years thereafter, but only during reasonable business hours and upon reasonable notice. Novation agrees that its routine audits will not be conducted more frequently than twice in any consecutive twelve (12) month period, subject to Novation's right to conduct special audits whenever it deems it to be necessary. In addition, Supplier will make its manufacturing and packaging facilities available for inspection from time to time during the Term by Novation representatives, but only during reasonable business hours and upon reasonable notice. The exercise by Novation of the right to inspect and audit is without prejudice to any other or additional rights or remedies of either party. 16. USE OF NAMES, ETC. Supplier agrees that it will not use in any way in its promotional, informational or marketing activities or materials (i.) the names, trademarks, logos, symbols or a description of the business or activities of Novation or any Client or Member without in each instance first obtaining the prior written consent of the person owning the rights thereto; or (ii) the existence or content of this Agreement without in each instance first obtaining the prior written consent of Novation. 17. CONFIDENTIAL INFORMATION. a. Nondisclosure. Supplier agrees that it will: (1) keep strictly confidential and hold in trust all confidential information of Novation, the Clients and the Members; (2) not use the confidential information for any purpose other than the performance of its obligations under this Agreement, without the prior written consent of Novation; (3) not disclose the confidential information to any third party (unless required by law) without the prior written consent of Novation; and (4) not later than thirty (30) days after the expiration or earlier termination of this Agreement, return to Novation, the Client or the Member, as the case may be, the confidential information. b. Definition. "Confidential information", as used in Subsection 17.a above, will consist of all information relating to the prices and usage of the Products (including at, information contained in the reports produced by Supplier pursuant to Section 7 above) and all documents and other materials of Novation, the Clients and the Members containing information relating to the programs of Novation, the Clients or the Members of a proprietary or sensitive nature not readily available through sources in the public domain. In no event will Supplier provide to any person any information relating to the prices it charges the Members for Products ordered pursuant to this Agreement without the prior written consent of Novation. 18. MISCELLANEOUS. a. Choice of Law. This Agreement will be governed by and construed in accordance with the internal substantive laws of the State of Texas and the Texas courts will have jurisdiction over all matters relating to this Agreement; provided, however, the terms of a Member's purchase order will be governed by and construed in accordance with the choice of law and venue provisions set forth in the purchase order. b. Not Responsible. Novation and the Clients will not be responsible or liable for any Member's breach of any purchasing commitment or for any other actions of any Member. In addition, none of the Clients will be responsible or liable for the obligations of any party to this Agreement. c. Third Party Beneficiaries. All Clients and Members are intended third party beneficiaries of this Agreement. All terms and conditions of this Agreement which are applicable to the Clients will inure to the benefit of and be enforceable by the Clients and their respective successors and assigns. All terms and conditions of this Agreement which are applicable to the Members will inure to the benefit of and be enforceable by the Members and their respective successors and assigns. d. Notices. Except as otherwise expressly provided herein, all notices or other communications required or permitted under this Agreement will be in writing and will be deemed sufficient when mailed by United States mail, or delivered in person against receipt to the party to which it is to be given, at the address of such party set forth below: If to Supplier: To the address set forth on the signature page of this Agreement If to Novation: Novation Attn: Vice President, Contract Services 220 East Las Colinas Blvd. Irving, TX 75039 or to such other address as the party will have furnished in writing in accordance with the provisions of this Subsection. e. No Assignment. No assignment of all or any part of this Agreement may be made without the prior written consent of the other party; except that Novation may assign its rights and obligations to any affiliate of Novation. Any assignment of all or any part of this Agreement by either party will not relieve that party of the responsibility of performing its obligations hereunder to the extent that such obligations are not satisfied in full by the assignee. This Agreement will be binding upon and inure to the benefit of the parties' respective successors and assigns. f. Severability. Whenever possible, each provision of this Agreement will be interpreted in such a manner as to be effective and valid under applicable law, but if any provision of this Agreement will be prohibited by or invalid under applicable law, such provision will be ineffective to the extent of such prohibition or invalidity without invalidating the remainder of such provision or the remaining provisions of this Agreement. Each party will, at its own expense, take such action as is reasonably necessary to defend the validity and enforceability of this Agreement and will cooperate with the other party as is reasonably necessary in such defense. g. Entire Agreement. This Agreement, together with the exhibits listed below and each Member's purchase order will constitute the entire agreement between each Member and Supplier and no other terms and conditions in any document, acceptance, or acknowledgment will be effective or binding upon a Member unless expressly agreed to in writing. The following exhibits are incorporated by reference in this Agreement: Exhibit A Product and Service Description and Pricing Exhibit B Non-Price Specifications Exhibit C Special Conditions Exhibit D Effective Date Exhibit E Electronic Data Interchange Agreement [Other Exhibits listed, if any] SUPPLIER: Kinetic Concepts, Inc. ADDRESS: 8023 Vantage Drive San Antonio, Texas 78230 SIGNATURE: /S/ SCOTT S. BROOKS -------------------- TITLE: Vice President, National Accounts DATE: November 11, 1998 NOVATION, LLC SIGNATURE: /S/ MARK MKENNA ---------------- TITLE: Senior Vice President, Operations DATE: November 11, 1998 EX-21 6 KCI Subsidiaries (Updated November 12, 1998) KINETIC CONCEPTS, INC., a Texas corporation (Tax ID #74-1891727) [Became a public company 6-7-88] Subsidiaries: 1. KCI Therapeutic Services, Inc., a Delaware corporation (Tax ID #74-2152396) 2. KCI New Technologies, Inc., a Delaware corporation (Tax ID #74-2615226) 3. KCI Properties Limited, a Texas limited liability company (Tax ID #74-2621178) 4. KCI Real Property Limited, a Texas limited liability company, d/b/a Premier Properties (Tax ID #74-2644430) 5. KCI Air, Inc., a Delaware corporation (Tax ID #74-2765302) 6. Medical Retro Design, Inc., a Delaware corporation (Tax ID #74-2652711) 7. KCI Clinical Systems, Inc., a Delaware corporation (Tax ID #74-2675416) [DISSOLVED 09/22/97] 8. KCI Holding Company, Inc., a Delaware corporation (Tax ID #74-2804102) 9. Plexus Enterprises, Inc., a Delaware corporation (Tax ID #74-2814710) 10. The Kinetic Concepts Foundation, a Texas non-profit corporation (Tax ID# 74-282-2321) 11. KCI-RIK Acquisition Corp., a Delaware corporation (Tax ID# ###-##-####) 12. KCI Bermuda Holding Ltd., a Bermuda corporation 13. KCI International Holding Company, a Delaware corporation (Tax ID# __________) 14. KCII Holdings, L.L.C., a Delaware Limited Liability Company (Tax ID# __________) 15. KCI International, Inc., a Delaware corporation (Tax ID #51-0307888) (a) KCI Medical Canada, Inc., a Canadian corporation (b) KCI Medical Ltd., a United Kingdom corporation (formerly Mediscus International Limited), name change effective October 31, 1995 NOTE: All assets of KCI Medical United Kingdom Limited and Mediscus Products Limited are being transferred to KCI Medical Limited effective January 1, 1996. (c) KCI United Kingdom Holdings Ltd.: A United Kingdom Corporation acting as holding company of KCII's operating companies in the United Kingdom, Denmark, Germany, Sweden, France, Switzerland, Spain and Italy. DORMANT UK COMPANIES: (i) KCI Medical United Kingdom Limited (ii) Mediscus Products Limited (iii) Home-Care Medical Products Limited (formerly KCII Medical Limited) NOTE: Home-Care Medical and KCII Medical swapped names in October, 1995. KCII Medical Limited was formerly Lingard Leasing. (d) NDM (UK) Limited (e) KCI Medical Holding GmbH (formerly KCI Handels GmbH) (i) KCI Medizinprodukte GmbH ( formerly - KCI Mediscus Produkte GmbH) (ii) KCI Therapie Gerate mbH (formerly Verwalt) (f) Equipement Medical KCI, S.A.R.L., a French corporation (g) KCI Medical B.V., a Netherlands corporation (h) KCI Mediscus AG, a Swiss corporation (i) KCI Mediscus Klinikausstattung Gesellschaft mbH with domicile in Vienna (j) KCI Europe Holding B.V., a Netherlands corporation (k) KCI International-Virgin Islands, Inc., a Virgin Islands corporation (l) KCI Medica Espana, S.A., a Spanish corporation (m) KCI Medical Australia PTY, Ltd., an Australian corporation (n) KCI Medical S.r.l., an Italian corporation (o) KCI Medical ApS, Denmark (p) KCI Medical AB, Sweden (q) Ethos Medical Group Ltd., an Irish Company, Athlone, Ireland (r) KCI Equi-Tron Inc., a Canadian corporation EX-27 7
5 YEAR DEC-31-1998 DEC-31-1998 4,365,620 0 93,556,262 8,318,851 28,662,469 129,947,451 208,290,223 130,340,521 308,073,369 52,354,434 506,701,013 0 0 70,915 (261,659,261) 308,073,369 71,989,289 330,470,795 27,881,471 235,029,702 0 3,707,211 48,593,931 19,602,017 7,850,625 11,775,938 0 0 0 11,775,938 $0.17 $0.16
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