UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2011

Commission File Number: 001-09913

KINETIC CONCEPTS, INC.

(Exact name of registrant as specified in its charter)

Texas		74-1891727
(State of Incorporation)		(I.R.S. Employer Identification No.)


8023 Vantage Drive San Antonio, Texas		78230
(Address of principal executive offices)		(Zip Code)

Registrant’s telephone number, including area code: (210) 524-9000

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes X No ____

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes X No ____

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

Large accelerated filer	X		Accelerated filer

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

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes ____ No X

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

Common Stock: 73,089,156 shares as of October 28, 2011

TABLE OF CONTENTS

KINETIC CONCEPTS, INC.

			Page No.
PART I.	FINANCIAL INFORMATION		4
	Item 1.	Financial Statements	4
		Condensed Consolidated Balance Sheets	4
		Condensed Consolidated Statements of Earnings	5
		Condensed Consolidated Statements of Cash Flows	6
		Notes to Condensed Consolidated Financial Statements	7
	Item 2.	Management's Discussion and Analysis of Financial Condition and Results of Operations	23
	Item 3.	Quantitative and Qualitative Disclosures About Market Risk	36
	Item 4.	Controls and Procedures	38
PART II.	OTHER INFORMATION		39
	Item 1.	Legal Proceedings	39
	Item 1A.	Risk Factors	42
	Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	46
	Item 6.	Exhibits	47
	SIGNATURES		48

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SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, which are covered by the "safe harbor" created by those sections. The forward-looking statements are based on our current expectations and projections about future events. Discussions containing forward-looking statements may be found in "Management's Discussion and Analysis of Financial Condition and Results of Operations," "Risk Factors," and elsewhere in this report. In some cases, you can identify forward-looking statements by terminology such as "may," "will," "should," "could," "predicts," "projects," "potential," "continue," "expects," "anticipates," "future," "intends," "plans," "believes," "estimates," or the negative of those terms and other variations of them or by comparable terminology.

These forward-looking statements are only predictions, not historical facts, and involve certain risks and uncertainties, as well as assumptions. Actual results, levels of activity, performance, achievements and events could differ materially from those stated, anticipated or implied by such forward-looking statements. The factors that could contribute to such differences include those discussed under the caption "Risk Factors." You should consider each of the risk factors and uncertainties under the caption “Risk Factors” in this Quarterly Report on Form 10-Q, our Annual Report on Form 10-K for the fiscal year ended December 31, 2010 and in our Quarterly Reports on Form 10-Q for the quarterly periods ended March 31, 2011 and June 30, 2011, among other things, in evaluating our prospects and future financial performance. The occurrence of the events described in the risk factors could harm our business, results of operations and financial condition. These forward-looking statements are made as of the date of this report. We disclaim any obligation to update or alter these forward-looking statements, whether as a result of new information, future events or otherwise.

TRADEMARKS

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

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PART I - FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

KINETIC CONCEPTS, INC. AND SUBSIDIARIES
Condensed Consolidated Balance Sheets
(in thousands)


	September 30,		December 31,
	2011		2010
	(unaudited)
Assets:
Current assets:
Cash and cash equivalents	$	656,793	$	316,603
Accounts receivable, net		404,004		414,083
Inventories, net		160,833		172,552
Deferred income taxes		28,140		30,112
Prepaid expenses and other		31,651		34,199

Total current assets		1,281,421		967,549

Net property, plant and equipment		299,037		271,063
Debt issuance costs, net		29,769		22,622
Deferred income taxes		20,643		17,151
Goodwill		1,328,881		1,328,881
Identifiable intangible assets, net		432,388		453,802
Other non-current assets		15,551		14,931

	$	3,407,690	$	3,075,999

Liabilities and Shareholders' Equity:
Current liabilities:
Accounts payable	$	38,171	$	60,137
Accrued expenses and other		259,025		225,524
Current installments of long-term debt		27,500		169,500
Income taxes payable		24,295		-

Total current liabilities		348,991		455,161

Long-term debt, net of current installments and discount		1,096,416		935,290
Non-current tax liabilities		38,007		35,588
Deferred income taxes		137,909		163,386
Other non-current liabilities		2,185		3,495

Total liabilities		1,623,508		1,592,920

Shareholders' equity:
Common stock; authorized 225,000 at 2011 and 2010; issued and outstanding 73,081 at 2011 and 71,996 at 2010		73		72
Preferred stock; authorized 50,000 at 2011 and 2010; issued and outstanding 0 at 2011 and 2010		-		-
Additional paid-in capital		919,190		852,152
Retained earnings		854,003		613,434
Accumulated other comprehensive income, net		10,916		17,421

Shareholders' equity		1,784,182		1,483,079

	$	3,407,690	$	3,075,999

See accompanying notes to condensed consolidated financial statements.

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KINETIC CONCEPTS, INC. AND SUBSIDIARIES
Condensed Consolidated Statements of Earnings
(in thousands, except per share data)
(unaudited)


	Three months ended						Nine months ended
	September 30,						September 30,
	2011			2010			2011			2010
Revenue:
Rental	$	279,135		$	288,970		$	837,149		$	852,045
Sales		252,236			217,738			715,236			638,240

Total revenue		531,371			506,708			1,552,385			1,490,285


Rental expenses		136,789			155,765			433,634			464,606
Cost of sales		62,925			61,551			185,062			184,782

Gross profit		331,657			289,392			933,689			840,897

Selling, general and administrative expenses		155,855			139,512			452,377			422,103
Research and development expenses		23,530			20,873			68,124			67,375
Acquired intangible asset amortization		8,855			8,855			26,567			28,570

Operating earnings		143,417			120,152			386,621			322,849

Interest income and other		297			265			766			544
Interest expense		(17,314	)		(21,534	)		(55,311	)		(67,360	)
Foreign currency gain (loss)		(2,117	)		2,148			(2,142	)		(3,119	)

Earnings before income taxes		124,283			101,031			329,934			252,914

Income taxes		33,557			25,258			89,365			70,823

Net earnings	$	90,726		$	75,773		$	240,569		$	182,091

Net earnings per share:

Basic	$	1.25		$	1.07		$	3.34		$	2.57

Diluted	$	1.16		$	1.06		$	3.21		$	2.54

Weighted average shares outstanding:

Basic		72,546			70,994			72,017			70,784

Diluted		78,411			71,695			74,889			71,647

See accompanying notes to condensed consolidated financial statements.

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KINETIC CONCEPTS, INC. AND SUBSIDIARIES
Condensed Consolidated Statements of Cash Flows
(in thousands)
(unaudited)


	Nine months ended
	September 30,
	2011			2010
Cash flows from operating activities:
Net earnings	$	240,569		$	182,091
Adjustments to reconcile net earnings to net cash provided by operating activities:
Amortization of convertible debt discount		17,084			15,818
Depreciation and other amortization		106,333			119,188
Provision for bad debt		8,350			7,024
Write-off of deferred debt issuance costs		3,218			2,301
Share-based compensation expense		23,738			24,173
Deferred income tax benefit		(24,957	)		(48,946	)
Excess tax benefit from share-based payment arrangements		(2,393	)		(1,426	)
Change in assets and liabilities:
Decrease in accounts receivable, net		1,101			14,829
Decrease (increase) in inventories, net		11,659			(53,353	)
Decrease in prepaid expenses and other		2,547			3,927
Increase (decrease) in accounts payable		(21,994	)		5,212
Increase (decrease) in accrued expenses and other		32,826			(18,117	)
Increase (decrease) in tax liabilities, net		27,118			(9,227	)
Decrease in deferred income taxes, net		(2,039	)		(10,379	)
Net cash provided by operating activities		423,160			233,115

Cash flows from investing activities:
Additions to property, plant and equipment		(89,029	)		(63,255	)
Decrease (increase) in inventory to be converted into equipment for short-term rental		(7,047	)		9,771
Dispositions of property, plant and equipment		1,186			1,557
Increase in identifiable intangible assets and other non-current assets		(19,093	)		(9,632	)
Net cash used by investing activities		(113,983	)		(61,559	)

Cash flows from financing activities:
Repayments of long-term debt and capital lease obligations		(20,734	)		(185,059	)
Proceeds from exercise of stock options		42,606			10,383
Proceeds from the purchase of stock in ESPP and other		4,107			3,452
Excess tax benefit from share-based payment arrangements		2,393			1,426
Purchase of immature shares for minimum tax withholdings		(3,797	)		(1,134	)
Payment of debt issuance costs related to KCI’s pending merger		(827	)		-
Refinancing of senior credit facility:
Proceeds from borrowings on refinancing of senior credit facility		146,012			-
Repayments on senior credit facility – due 2013		(123,346	)		-
Payment of debt issuance costs		(14,676	)		-
Net cash provided (used) by financing activities		31,738			(170,932	)

Effect of exchange rate changes on cash and cash equivalents		(725	)		(484	)

Net increase in cash and cash equivalents		340,190			140
Cash and cash equivalents, beginning of period		316,603			263,157

Cash and cash equivalents, end of period	$	656,793		$	263,297

Cash paid for:
Interest, including cash paid under interest rate swap agreements	$	23,752		$	35,894
Income taxes, net of refunds	$	86,265		$	139,728

See accompanying notes to condensed consolidated financial statements.

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KINETIC CONCEPTS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

NOTE 1. Summary of Significant Accounting Policies

(a) Basis of Presentation

The condensed consolidated financial statements presented herein include the accounts of Kinetic Concepts, Inc., together with its consolidated subsidiaries. All intercompany balances and transactions have been eliminated in consolidation. The consolidated entity is referred to herein as "KCI®." The condensed consolidated financial statements appearing in this quarterly report on Form 10-Q should be read in conjunction with the consolidated financial statements and notes thereto included in KCI's Annual Report on Form 10-K for the fiscal year ended December 31, 2010 and our Quarterly Reports on Form 10-Q for the quarterly periods ended March 31, 2011 and June 30, 2011.

The accompanying condensed consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP” or “the Codification”) for interim financial information and in accordance with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information necessary for a fair presentation of results of operations, financial position and cash flows in conformity with GAAP. Operating results from interim periods are not necessarily indicative of results that may be expected for the fiscal year as a whole. The condensed consolidated financial statements reflect all adjustments, consisting of normal recurring accruals, considered necessary for a fair presentation of our results for the interim periods presented. Certain prior-period amounts have been reclassified to conform to the 2011 presentation.

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

On July 12, 2011, we entered into a definitive merger agreement (“Merger Agreement”) under which a consortium of funds advised by Apax Partners (“Apax”), together with controlled affiliates of Canada Pension Plan Investment Board (“CPPIB”) and the Public Sector Pension Investment Board (“PSP Investments”), will acquire KCI (the “Merger”) for $68.50 per share in cash in a transaction currently valued at $6.1 billion, inclusive of KCI’s outstanding debt.

The transaction is subject to certain closing conditions but is not subject to any closing condition with regard to the financing of the transaction.

On October 28, 2011, we held a special meeting of shareholders to approve the Merger Agreement, which requires approval by the affirmative vote of holders of two-thirds of our outstanding shares entitled to vote. Approximately 85.7% of the outstanding shares of our common stock as of the record date were voted at the special meeting. Of the shares that were voted, approximately 99.9% voted in favor of the Merger and 0.05% voted against the Merger. We anticipate the Merger closing in early November 2011 with our subsequent delisting from the New York Stock Exchange.

(b) Income Taxes

We compute our quarterly effective income tax rate based on our annual estimated effective income tax rate plus the impact of any discrete items that occur in the quarter. The effective income tax rate for the third quarter and the first nine months ended September 30, 2011 was 27.0% and 27.1%, respectively, compared to 25.0% and 28.0%, respectively, for the third quarter and the first nine months of 2010.

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

We also use derivative financial instruments to manage the economic impact of fluctuations in currency exchange rates on our intercompany balances and corresponding cash flows and to manage our transactional currency exposures when our foreign subsidiaries enter into transactions denominated in currencies other than their local currency. We enter into foreign currency exchange contracts to manage these economic risks. These contracts are not designated as hedges; as such, we recognize the fair value of these instruments as an asset or liability with income or expense recognized in the current period. Gains and losses resulting from the foreign currency fluctuations impact on transactional exposures are included in foreign currency gain (loss) in our condensed consolidated statements of earnings.

As required, all derivative instruments are recorded on the balance sheet at fair value. The fair values of our interest rate swap agreements and foreign currency exchange contracts are determined based on inputs that are readily available in public markets or can be derived from information available in publicly-quoted markets, which represent level 2 inputs as defined by the Codification. We estimate the effectiveness of our interest rate swap agreements utilizing the hypothetical derivative method. Under this method, the fair value of the actual interest rate swap agreement is compared to the fair value of a hypothetical swap agreement that has the same critical terms as the portion of the loan being hedged. Changes in the effective portion of the fair value of the remaining interest rate swap agreement are recognized in other comprehensive income, net of tax, until the hedged item is recognized into earnings.

(d) Concentration of Credit Risk

KCI has a concentration of credit risk with financial institutions related to its derivative instruments and the note hedge described in Note 3. As of September 30, 2011, Bank of America and JP Morgan Chase held equity hedges related to our convertible note hedge in notional amounts of approximately $176.5 million each. Bank of America was also the counterparty on some of our interest rate protection agreements and our foreign currency exchange contracts in notional amounts totaling $50.0 million and $4.9 million, respectively. Additionally, JP Morgan Chase was also the counterparty on some of our interest rate protection agreements and our foreign currency exchange contracts in notional amounts totaling $25.0 million and $7.0 million, respectively. We use master netting agreements with our derivative counterparties to reduce our risk and use multiple counterparties to reduce our concentration of credit risk.

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

(e) Other Significant Accounting Policies

For further information on our significant accounting policies, see Note 1 of the notes to the consolidated financial statements included in KCI's Annual Report on Form 10-K for the fiscal year ended December 31, 2010.

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NOTE 2. Supplemental Balance Sheet Data

(a) Accounts Receivable, net

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

	September 30,			December 31,
	2011			2010
Gross trade accounts receivable:
Americas:
AHS and TSS	$	307,940		$	341,874
LifeCell		42,898			39,251

Subtotal Americas		350,838			381,125

EMEA		111,387			106,174
APAC		13,877			11,583

Total trade accounts receivable		476,102			498,882

Less: Allowance for revenue adjustments		(69,834	)		(87,035	)

Gross trade accounts receivable		406,268			411,847

Less: Allowance for bad debt		(9,854	)		(9,970	)

Net trade accounts receivable		396,414			401,877

Other receivables		7,590			12,206

	$	404,004		$	414,083

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

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

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

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(b) Inventories, net

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

	September 30,			December 31,
	2011			2010

Finished goods and tissue available for distribution	$	83,396		$	92,769
Goods and tissue in-process		24,925			9,507
Raw materials, supplies, parts and unprocessed tissue		83,071			96,197

		191,392			198,473

Less: Amounts expected to be converted into equipment for short-term rental		(17,054	)		(10,008	)
Reserve for excess and obsolete inventory		(13,505	)		(15,913	)

	$	160,833		$	172,552

NOTE 3. Long-Term Debt

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

	September 30,			December 31,
	2011			2010

Senior Credit Facility – due 2016	$	529,375		$	-
Senior Credit Facility – due 2013		-			527,333
Senior Revolving Credit Facility – due 2016		-			-
Senior Revolving Credit Facility – due 2013		-			-
3.25% Convertible Senior Notes due 2015		690,000			690,000
Less: Convertible Notes Discount, net of accretion		(95,459	)		(112,543	)

		1,123,916			1,104,790
Less: Current installments		(27,500	)		(169,500	)

	$	1,096,416		$	935,290

At September 30, 2011, the fair value of the senior credit facility and the convertible senior notes was $526.1 million and $970.0 million, respectively. At December 31, 2010, the fair value of the senior credit facility and the convertible senior notes was $527.3 million and $727.9 million, respectively. The fair values of our senior credit facilities and the convertible senior notes were estimated based upon open-market trades and related market quotations at or near quarter or year-end.

Senior Credit Facility

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

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For further information on our senior credit facility, see Note 17 of the notes to the consolidated financial statements included in KCI's Annual Report on Form 10-K for the fiscal year ended December 31, 2010 and Note 3 of the notes to the condensed consolidated financial statements included in KCI’s Quarterly Reports on Form 10-Q for the quarterly periods ended March 31, 2011 and June 30, 2011.

3.25% Convertible Senior Notes and Related Note Hedge and Warrants

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

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

(1)

during any fiscal quarter commencing after June 30, 2008, if the last reported sale price of our common stock for at least 20 trading days in the period of 30 consecutive trading days ending on the last trading day of the preceding fiscal quarter is greater than or equal to 130% of the conversion price of the notes in effect on each applicable trading day;

(2)

during the five business day period following any five consecutive trading day period in which the trading price for the notes (per $1,000 principal amount of the notes) for each such trading day was less than 98% of the last reported sale price of our common stock on such date multiplied by the applicable conversion rate; or

(3)

if we make certain significant distributions to holders of our common stock or enter into specified corporate transactions. The notes are convertible, regardless of whether any of the foregoing conditions have been satisfied, on or after October 15, 2014 at any time prior to the close of business on the third scheduled trading day immediately preceding the stated maturity date.

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

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

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NOTE 4. Derivative Financial Instruments and Fair Value Measurements

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

Interest Rate Protection

At September 30, 2011 and December 31, 2010, we had 19 and 18 interest rate swap agreements in effect, respectively, pursuant to which we have fixed the rate on an aggregate of $525.0 million and $444.5 million, respectively, in notional amounts of our outstanding variable rate debt at weighted average interest rates of 0.789% and 1.226%, respectively, exclusive of the Eurocurrency Rate Loan Spread as disclosed in the senior credit agreement.

As of September 30, 2011, we had also entered into additional interest rate swap agreements to convert $125.0 million of our variable rate debt to a fixed rate basis at interest rates ranging from 0.810% to 0.816%, exclusive of the Eurocurrency Rate Loan Spread as disclosed in the senior credit agreement. These agreements become effective on December 31, 2011 and were designated as cash flow hedge instruments.

As a result of the interest rate swap agreements in effect as of September 30, 2011 and December 31, 2010, approximately 99.6% and 93.2%, respectively, of our long-term debt outstanding, including the Convertible Notes, was subject to a fixed interest rate.

The interest rate swap agreements have quarterly interest payments, based on three-month LIBOR, due on the last day of March, June, September and December. The fair value of the swap agreements was zero at inception. At both September 30, 2011 and December 31, 2010, the aggregate fair value of our interest rate swap agreements was negative and was recorded as a liability of approximately $1.7 million. This amount was also recorded in other comprehensive income, net of tax. No asset derivatives were held as of September 30, 2011 and December 31, 2010 related to our interest rate swap agreements. The ineffective portion of these interest rate swaps was not significant for the third quarter or first nine months of 2011 and 2010. Effective October 2011, we elected to use one-month LIBOR for amounts outstanding under the 2016 Senior Credit Facility. As a result of this election, the ineffective portion of the interest rate swaps will likely increase. As of September 30, 2011 and December 31, 2010, the amount of hedge loss to be reclassified from Accumulated Other Comprehensive Income over the next 12 months was approximately $1.7 million for both periods. If our interest rate protection agreements were not in place, interest expense would have been approximately $0.6 million and $2.3 million lower for the third quarter and first nine months of 2011, respectively, and $2.0 million and $7.6 million lower during the same periods of the prior year.

Foreign Currency Exchange Risk Mitigation

At September 30, 2011 and December 31, 2010, we had foreign currency exchange contracts to sell or purchase $50.1 million and $92.1 million, respectively, of various currencies. The periods of the foreign currency exchange contracts generally do not exceed one year and correspond to the periods of the exposed transactions or related cash flows.

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Fair Value Measurements

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

Asset Derivatives

Liability Derivatives

Balance

Fair Value

Balance

Fair Value

Sheet

September 30,

December 31,

Sheet

September 30,

December 31,

Location

2011

2010

Location

2011

2010

Derivatives

designated as

hedging

instruments

Prepaid

Accrued

Interest rate

expenses

swap agreements

and other

1,681

1,677

Derivatives not

designated as

hedging

instruments

Foreign currency

Prepaid

Accrued

exchange

expenses

contracts

and other

1,172

364

and other

306

3,425

Total derivatives

1, 172

364

1,987

5,102

The location and net amounts reported in the condensed consolidated statements of earnings under the caption “interest expense” or included in our condensed consolidated balance sheets under the caption “accumulated other comprehensive income” (“OCI”) for derivatives designated as cash flow hedging instruments under the Derivatives and Hedges topic of the Codification are as follows (dollars in thousands):

	Three months ended September 30,
	Effective portion
Derivatives	Amount of						Location of gain (loss)	Amount of gain (loss)
designated as	gain (loss)						reclassified from	reclassified from
cash flow hedging	recognized in						accumulated	accumulated
instruments	OCI on derivative						OCI into income	OCI into income

	2011			2010				2011			2010

Interest rate swap agreements	$	(52	)	$	(926	)	Interest expense	$	(396	)	$	(1,281	)



	Nine months ended September 30,
	Effective portion
Derivatives	Amount of						Location of gain (loss)	Amount of gain (loss)
designated as	gain (loss)						reclassified from	reclassified from
cash flow hedging	recognized in						accumulated	accumulated
instruments	OCI on derivative						OCI into income	OCI into income

		2011			2010				2011			2010

Interest rate swap agreements	$	(1,512	)	$	(1,719	)	Interest expense	$	(1,509	)	$	(4,968	)

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

	Three months ended						Nine months ended
	September 30,						September 30,
	2011			2010			2011			2010

Foreign currency exchange contracts gain (loss)	$	1,082		$	(7,741	)	$	(1,933	)	$	1,071
Other foreign currency transaction gain (loss)		(3,199	)		9,889			(209	)		(4,190	)

	$	(2,117	)	$	2,148		$	(2,142	)	$	(3,119	)

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

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

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

NOTE 5. Earnings Per Share

Net earnings per share was calculated using the weighted average number of shares outstanding during the respective periods. The following table sets forth the reconciliation from basic to diluted weighted average shares outstanding and the calculations of net earnings per share (in thousands, except per share data):

	Three months ended				Nine months ended
	September 30,				September 30,
	2011		2010		2011		2010

Net earnings	$	90,726	$	75,773	$	240,569	$	182,091

Weighted average shares outstanding:
Basic		72,546		70,994		72,017		70,784
Dilutive potential common shares from stock options and restricted stock (1)		1,679		701		1,508		863
Dilutive potential common shares from conversion of Convertible Notes and Warrants (2)		4,186		-		1,364		-

Diluted		78,411		71,695		74,889		71,647

Basic net earnings per share	$	1.25	$	1.07	$	3.34	$	2.57

Diluted net earnings per share	$	1.16	$	1.06	$	3.21	$	2.54


(1) Potentially dilutive stock options and restricted stock totaling 43 shares and 3,931 shares for the three months ended September 30, 2011 and 2010, respectively, and 1,109 shares and 4,156 shares for the nine months ended September 30, 2011 and 2010, respectively, were excluded from the computation of diluted weighted average shares outstanding due to their antidilutive effect. (2) The average price of our common stock was $66.18 and $35.10 for the three months ended September 30, 2011 and 2010, respectively, and $57.15 and $40.33 for the nine months ended September 30, 2011 and 2010, respectively.

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Holders of our Convertible Notes may convert the Convertible Notes into cash, and if applicable, shares of our common stock at the applicable conversion rate, at their option any business day prior to October 15, 2014 if specific conditions are satisfied. For further information on the Convertible Notes, see Note 3 of the notes to the condensed consolidated financial statements. The Convertible Notes have no impact on diluted earnings per share (“EPS”) unless the average price of our common stock for the period exceeds the conversion price (initially $51.34 per share) because the principal amount of the Convertible Notes will be settled in cash upon conversion. Prior to conversion, we use the treasury stock method to include the effect of the additional shares that may be issued if our common stock price exceeds the conversion price. The convertible note hedge purchased in connection with the issuance of our Convertible Notes is excluded from the calculation of diluted EPS as its impact is always anti-dilutive. The warrant transactions associated with the issuance of our Convertible Notes have no impact on EPS unless our average share price for the period exceeds the $60.41 exercise price. The dilutive impact, if any, from the conversion of the Convertible Notes and Warrants has been included in the diluted weighted average shares for both the three and nine months ended September 30, 2011.

NOTE 6. Incentive Compensation Plans

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

	Three months ended						Nine months ended
	September 30,						September 30,
	2011			2010			2011			2010

Rental expenses	$	1,562		$	1,486		$	3,866		$	3,803
Cost of sales		224			292			740			736
Selling, general and administrative expenses		6,073			6,961			19,132			19,634

Pre-tax share-based compensation expense		7,859			8,739			23,738			24,173
Less: Income tax benefit		(2,750	)		(2,919	)		(8,037	)		(8,288	)

Total share-based compensation expense, net of tax	$	5,109		$	5,820		$	15,701		$	15,885

A summary of our stock option activity, and related information, for the nine months ended September 30, 2011 is set forth in the table below:

					Weighted
					Average
			Weighted		Remaining	Aggregate
			Average		Contractual	Intrinsic
	Options		Exercise		Term	Value
	(in thousands)		Price		(years)	(in thousands)

Options outstanding – January 1, 2011	5,470		$	39.20
Granted	757		$	46.98
Exercised	(1,059	)	$	40.93
Forfeited/Expired	(288	)	$	40.36

Options outstanding – September 30, 2011	4,880		$	39.96	6.84	$	126,526

Exercisable as of September 30, 2011	2,371		$	41.47	5.80	$	57,916

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The following table summarizes restricted stock activity for the nine months ended September 30, 2011:

	Number of		Weighted
	Shares		Average Grant
	(in thousands)		Date Fair Value

Unvested shares – January 1, 2011	1,101		$	37.41
Granted	713		$	48.73
Vested and distributed	(271	)	$	45.47
Forfeited	(137	)	$	42.70

Unvested shares – September 30, 2011	1,406		$	41.06

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

NOTE 7. Other Comprehensive Income

The components of total comprehensive income are as follows (dollars in thousands):

	Three months ended						Nine months ended
	September 30,						September 30,
	2011			2010			2011			2010

Net earnings	$	90,726		$	75,773		$	240,569		$	182,091
Foreign currency translation adjustment, net of taxes		(16,280	)		4,480			(6,502	)		(2,054	)
Net derivative loss, net of taxes		(52	)		(926	)		(1,512	)		(1,719	)
Amount of loss reclassified from accumulated OCI into income, net of taxes		396			1,281			1,509			4,968

Total comprehensive income	$	74,790		$	80,608		$	234,064		$	183,286

NOTE 8. Commitments and Contingencies

Litigation Relating to the Proposed Merger

Following the announcement on July 13, 2011 that KCI had entered into a definitive merger agreement under which a consortium of funds advised by Apax will acquire KCI, four purported shareholders of KCI initiated legal actions challenging the Merger. Between July 20 and August 23, 2011, these purported shareholders filed four separate putative derivative and/or class action petitions in the District Court of Bexar County, Texas. The petitions in these actions asserted claims against KCI’s directors and against KCI as a nominal defendant, and certain of these actions additionally named as defendants Apax, CPPIB, PSP Investments, Chiron Holdings, Inc., Chiron Merger Sub, Inc., and John Does 1-25 (unidentified associates and affiliates forming the consortium to purchase KCI) (collectively, “Apax Partners”). The petitions generally alleged that KCI’s directors breached their fiduciary duties by their actions in approving the Merger and that Apax Partners aided and abetted in these alleged breaches of fiduciary duties. The petitions additionally alleged that the Schedule 14A Preliminary Proxy Statement filed with the Securities and Exchange Commission in connection with the proposed transaction contained material omissions and misstatements. The petitions all requested that the Merger be enjoined. The District Court of Bexar County, Texas, consolidated these actions into a single action styled “In re Kinetic Concepts, Inc. Shareholder Litigation” (the “Consolidated Action”). KCI and its directors filed motions to dismiss the petitions pending in the Consolidated Action. On October 6, 2011, the District Court of Bexar County, Texas, held a hearing on the KCI defendants’ motions to dismiss. At the conclusion of the hearing, the court dismissed all of the claims asserted in the Consolidated Action, without prejudice.

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On October 18, 2011, certain of the plaintiffs who commenced the initial litigation relating to the Merger filed a new complaint relating to the Merger in the District Court of Bexar County, Texas, styled “Ross et al. v. Apax Partners, et al., No. 2011-CI-16858” (the “Second Shareholder Action”). The complaint in the Second Shareholder Action raised issues substantially similar to those raised in the Consolidated Action and also requested that the Merger be enjoined. On October 26, 2011, the District Court of Bexar County, Texas, held a hearing on the KCI defendants’ motions to dismiss the Second Shareholder Action. At the conclusion of the hearing, the court dismissed all of the claims asserted in the Second Shareholder Action, without prejudice.

Intellectual Property Litigation

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

U.S. Intellectual Property Litigation

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

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

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

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

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

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

International Intellectual Property Litigation

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

In March 2009, KCI and its affiliates filed a patent infringement lawsuit asserting Australian counterparts to the Wake Forest Patents against Smith & Nephew in the Federal Court of Australia, requesting preliminary injunctive relief to prohibit the commercialization of a Smith & Nephew negative pressure wound therapy dressing kit. The Federal Court issued a temporary injunction in the case which was subsequently overturned by the Full Court of the Federal Court of Australia. A full trial on validity and infringement of the Wake Forest patent involved in the case was held in 2010. In September 2011, the Federal Court ruled the asserted claims to be invalid and not infringed by Smith & Nephew’s product. KCI will not appeal the decision.

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

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

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

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LifeCell Litigation

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

LifeCell Corporation resolved all of those lawsuits which have now been dismissed. The resolution of those lawsuits did not have a material impact on our financial position or results of operations. Subsequently, LifeCell Corporation was served with approximately ten new suits filed by other family members of tissue donors who also allege no authorization was provided. All of these cases have been settled for amounts that will not have a material impact on our results of operations or our financial position.

LifeCell Corporation is also a party to approximately 60 lawsuits filed by individuals alleging personal injury and seeking monetary damages for failed hernia repair procedures using LifeCell Corporation’s AlloDerm products. All of these cases are in the early stages of litigation and have not yet been set for trial. Although it is not possible to reliably predict the outcome of the litigation, we believe that the defenses to these claims are meritorious and will defend them vigorously. We have insurance that we believe covers these claims and lawsuits and believe that after the application of our self-insured retention relating to products liability claims, such policies will cover litigation expenses, settlement costs and damage awards, if any, arising from these suits. However, the insurance coverage may not be adequate if we are unsuccessful in our defenses. We do not expect these cases to have a material impact on our results of operations or our financial position.

Other Litigation

In February 2009, we received a subpoena from the U.S. Department of Health and Human Services Office of Inspector General (“OIG”) seeking records regarding our billing practices under the local coverage policies of the four regional Durable Medical Equipment Medicare Administrative Contractors (“DME MACs”). KCI cooperated with the OIG’s inquiry and provided substantial documentation to the OIG and the U.S. Attorneys’ office in response to its request. On May 9, 2011, KCI received notice that the U.S. Attorneys’ office had declined to intervene in qui tam actions filed against KCI on March 20, 2008 and September 29, 2008 by two former employees in the U.S. District Court, Central District of California, Western Division. These cases are captioned United States of America, ex rel. Geraldine Godecke v. Kinetic Concepts, Inc., et al. and United States of America, ex rel. Steven J. Hartpence v. Kinetic Concepts, Inc. et al. The complaints contend that KCI violated the Federal False Claims Act by billing in a manner that was not consistent with the Local Coverage Determinations issued by the DME MACs and seek recovery of monetary damages. Under the Federal False Claims Act, a defendant determined to be liable by a court of law must pay three times the actual damages sustained by the government, plus civil penalties of between $5,500 and $11,000 for each separate false claim. Potential damages arising from these non-intervened cases are not currently probable and not reasonably estimable. These cases were originally filed under seal pending the government’s review of the allegations contained therein. Following the completion of the government’s review and their decision to decline to intervene in such suits, the live pleadings were ordered unsealed on May 3, 2011. KCI intends to vigorously defend itself in these matters, including seeking the dismissal of these suits.

We are party to several additional lawsuits arising in the ordinary course of our business. Additionally, the manufacturing and marketing of medical products necessarily entails an inherent risk of product liability claims. We maintain multiple layers of product liability insurance coverage and we believe these policies and the amounts of coverage are appropriate and adequate.

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Other Commitments and Contingencies

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

We also are subject to routine pre-payment and post-payment audits of medical claims submitted to Medicare. These audits typically involve a review, by Medicare or its designated contractors and representatives, of documentation supporting the medical necessity of the therapy provided by KCI. While Medicare requires us to obtain a comprehensive physician order prior to providing products and services, we are not required to, and do not as a matter of practice require, or subsequently obtain, the underlying medical records supporting the information included in such claim. Following a Medicare request for supporting documentation, we are obligated to procure and submit the underlying medical records retained by various medical facilities and physicians. Obtaining these medical records in connection with a claims audit may be difficult or impossible and, in any event, all of these records are subject to further examination and dispute by an auditing authority. Under standard Medicare procedures, KCI is entitled to demonstrate the sufficiency of documentation and the establishment of medical necessity, and KCI has the right to appeal any adverse determinations. If a determination is made that KCI’s records or the patients’ medical records are insufficient to meet medical necessity or Medicare reimbursement requirements for the claims subject to a pre-payment or post-payment audit, KCI could be subject to denial, recoupment or refund demands for claims submitted for Medicare reimbursement. In the event that an audit results in discrepancies in the records provided, Medicare may be entitled to extrapolate the results of the audit to make recoupment demands based on a wider population of claims than those examined in the audit. In November 2010, KCI USA, Inc.’s Raleigh, North Carolina office was the subject of a Medicare audit of 31 claims conducted by the Zone Program Integrity Contractor (“ZPIC”). In May 2011, based on an extrapolation of the ZPIC’s audit results, the ZPIC determined that KCI USA, Inc. had been overpaid by Medicare in the amount of $5.8 million. KCI appealed these claims to Redetermination and reduced the overpayment to $5.1 million. KCI has appealed these claims to the next level of review. Recoupment of the overpayment was stayed pending appeal and interest will accrue on the overpayment unless it is overturned on appeal. In addition to challenging the underlying clinical basis for the claims denials, KCI intends to challenge the validity of the sampling used to extrapolate the overpayment. If the extrapolation is found to have been invalid, the extrapolation may be rejected even if the actual claims denials on which the extrapolation was based are not overturned. We cannot predict the outcome of theses appeals. However, we do not expect that the final determination of the audit will have a material impact on our results of operations or our financial position. Other KCI offices could be subjected to similar audits in which overpayments are extrapolated. In addition, Medicare or its contractors could place KCI on an extended pre-payment review, which could slow our collections process for submitted claims. If Medicare were to deny a significant number of claims in any pre-payment audit, or make any recoupment demands based on any post-payment audit, our business and operating results could be materially and adversely affected. In addition, violations of federal and state regulations regarding Medicare reimbursement could result in severe criminal, civil and administrative penalties and sanctions, including disqualification from Medicare and other reimbursement programs. Going forward, it is likely that we will be subject to periodic inspections, assessments and audits of our billing and collections practices.

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

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NOTE 9. Segment and Geographic Information

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

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

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

	Three months ended				Nine months ended
	September 30,				September 30,
	2011		2010		2011		2010
Revenue:
AHS
Americas	$	281,227	$	275,494	$	805,946	$	792,007
EMEA		73,852		71,505		217,947		219,029
APAC		17,029		11,393		46,725		28,035

Subtotal – AHS		372,108		358,392		1,070,618		1,039,071

LifeCell
Americas		94,507		83,213		278,012		243,375
EMEA		2,934		1,722		8,773		4,318

Subtotal – LifeCell		97,441		84,935		286,785		247,693

TSS
Americas		37,687		41,788		123,206		134,751
EMEA		23,888		21,056		70,949		67,509
APAC		247		537		827		1,261

Subtotal – TSS		61,822		63,381		194,982		203,521

Total revenue	$	531,371	$	506,708	$	1,552,385	$	1,490,285

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	Three months ended						Nine months ended
	September 30,						September 30,
	2011			2010			2011			2010
Operating earnings:
AHS	$	154,442		$	122,827		$	397,631		$	340,108
LifeCell		27,511			24,561			80,424			66,432
TSS		(77	)		2,506			8,542			5,474		(1)

Non-allocated costs:
General headquarter expense (2)		(15,748	)		(12,194	)		(42,469	)		(35,555	)
Share-based compensation		(7,859	)		(8,739	)		(23,738	)		(24,173	)
Merger-related expenses (3)		(5,996	)		-			(7,202	)		-
LifeCell acquisition-related expenses (4)		(8,856	)		(8,809	)		(26,567	)		(29,437	)

Total non-allocated costs		(38,459	)		(29,742	)		(99,976	)		(89,165	)

Total operating earnings	$	143,417		$	120,152		$	386,621		$	322,849


(1) Includes $7.4 million of expenses associated with the TSS product portfolio rationalization recorded in the second quarter of 2010. (2) Includes restructuring charges of $2.1 million during the three and nine months ended September 30, 2011 and $5.3 million during the nine months ended September 30, 2010. (3) Represents expenses related to KCI’s pending merger. (4) Includes amortization of acquired intangible assets and costs to retain key employees related to our purchase of LifeCell in May 2008.

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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion should be read in conjunction with the condensed consolidated financial statements and accompanying notes included in this report. The following discussion contains forward-looking statements that reflect our plans, estimates and beliefs. Our actual results could differ materially from those discussed in the forward-looking statements. Factors that could cause or contribute to these differences include, but are not limited to, those discussed in our “Risk Factors,” (Part II, Item 1A.), including those previously disseminated in KCI's Annual Report on Form 10-K for the fiscal year ended December 31, 2010 and in our Quarterly Reports on Form 10-Q for the quarterly periods ended March 31, 2011 and June 30, 2011.

GENERAL

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

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

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

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

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We are principally engaged in the rental and sale of our products in more than 20 countries. We currently have approximately 7,100 employees worldwide and are headquartered in San Antonio, Texas. We have research and development facilities in the United States and the United Kingdom, and we maintain manufacturing and engineering operations in Ireland, the United States, the United Kingdom and Belgium.

Historically, we have experienced a seasonal slowing of AHS unit demand beginning in the fourth quarter and continuing into the first quarter which we believe has been caused by year-end clinical treatment patterns, such as the postponement of elective surgeries and increased discharges of individuals from the acute care setting around the winter holidays. LifeCell has also historically experienced a similar seasonal slowing of sales in the third quarter of each year. Although we do not know if our historical experience will prove to be indicative of future periods, similar slow-downs may occur in subsequent periods.

RECENT DEVELOPMENTS

The transaction is subject to certain closing conditions but is not subject to any closing condition with regard to the financing of the transaction.

RESULTS OF OPERATIONS

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

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Revenue by Operating Segment

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

	Three months ended September 30,						Nine months ended September 30,
					%						%
	2011		2010		Change		2011		2010		Change
AHS revenue:
Americas	$	281,227	$	275,494	2.1	%	$	805,946	$	792,007	1.8	%
EMEA		73,852		71,505	3.3			217,947		219,029	(0.5	)
APAC		17,029		11,393	49.5			46,725		28,035	66.7

Total – AHS		372,108		358,392	3.8			1,070,618		1,039,071	3.0

LifeCell revenue:
Americas		94,507		83,213	13.6			278,012		243,375	14.2
EMEA		2,934		1,722	70.4			8,773		4,318	103.2

Total – LifeCell		97,441		84,935	14.7			286,785		247,693	15.8

TSS revenue:
Americas		37,687		41,788	(9.8	)		123,206		134,751	(8.6	)
EMEA		23,888		21,056	13.4			70,949		67,509	5.1
APAC		247		537	(54.0	)		827		1,261	(34.4	)

Total – TSS		61,822		63,381	(2.5	)		194,982		203,521	(4.2	)

Total revenue	$	531,371	$	506,708	4.9	%	$	1,552,385	$	1,490,285	4.2	%

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

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Revenue by Geography

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

	Three months ended September 30,						Nine months ended September 30,
					%						%
	2011		2010		Change		2011		2010		Change
Americas revenue:
Rental	$	221,157	$	232,314	(4.8	)%	$	660,115	$	680,377	(3.0	)%
Sales		192,264		168,181	14.3			547,049		489,756	11.7

Total –Americas		413,421		400,495	3.2			1,207,164		1,170,133	3.2

EMEA revenue:
Rental		48,445		50,664	(4.4	)		150,659		157,348	(4.3	)
Sales		52,229		43,619	19.7			147,010		133,508	10.1

Total – EMEA		100,674		94,283	6.8			297,669		290,856	2.3

APAC revenue:
Rental		9,533		5,992	59.1			26,375		14,320	84.2
Sales		7,743		5,938	30.4			21,177		14,976	41.4

Total – APAC		17,276		11,930	44.8			47,552		29,296	62.3

Total rental revenue		279,135		288,970	(3.4	)		837,149		852,045	(1.7	)
Total sales revenue		252,236		217,738	15.8			715,236		638,240	12.1

Total revenue	$	531,371	$	506,708	4.9	%	$	1,552,385	$	1,490,285	4.2	%

The change in total revenue compared to the prior-year periods was due to increased LifeCell and AHS revenue, partially offset by decreased TSS revenue. Foreign currency exchange movements favorably impacted total revenue by 2% for both the third quarter and the first nine months of 2011 compared to the corresponding periods of the prior year.

Revenue Relationship

The following table sets forth, for the periods indicated, the percentage relationship of each item to total revenue in the period, as well as the changes in each line item, comparing the third quarter of 2011 to the third quarter of 2010 and the first nine months of 2011 to the first nine months of 2010:

	Three months ended September 30,					Nine months ended September 30,

	2011		2010		Change	2011		2010		Change

AHS revenue	70.0	%	70.7	%	(70 bps)	69.0	%	69.7	%	(70 bps)
LifeCell revenue	18.3		16.8		150 bps	18.5		16.6		190 bps
TSS revenue	11.7		12.5		(80 bps)	12.5		13.7		(120 bps)

Total revenue	100.0	%	100.0	%		100.0	%	100.0	%

Americas revenue	77.8	%	79.0	%	(120 bps)	77.8	%	78.5	%	(70 bps)
EMEA revenue	18.9		18.6		30 bps	19.2		19.5		(30 bps)
APAC revenue	3.3		2.4		90 bps	3.0		2.0		100 bps

Total revenue	100.0	%	100.0	%		100.0	%	100.0	%

Rental revenue	52.5	%	57.0	%	(450 bps)	53.9	%	57.2	%	(330 bps)
Sales revenue	47.5		43.0		450 bps	46.1		42.8		330 bps

Total revenue	100.0	%	100.0	%		100.0	%	100.0	%

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AHS Revenue

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

	Three months ended September 30,						Nine months ended September 30,
					%						%
	2011		2010		Change		2011		2010		Change
Americas revenue:
Rental	$	189,056	$	196,775	(3.9	)%	$	555,396	$	564,844	(1.7	)%
Sales		92,171		78,719	17.1			250,550		227,163	10.3

Total Americas revenue		281,227		275,494	2.1			805,946		792,007	1.8

EMEA revenue:
Rental		29,351		33,111	(11.4	)		91,575		101,967	(10.2	)
Sales		44,501		38,394	15.9			126,372		117,062	8.0

Total EMEA revenue		73,852		71,505	3.3			217,947		219,029	(0.5	)

APAC revenue:
Rental		9,528		5,961	59.8			26,349		14,242	85.0
Sales		7,501		5,432	38.1			20,376		13,793	47.7

Total APAC revenue		17,029		11,393	49.5			46,725		28,035	66.7

Total rental revenue		227,935		235,847	(3.4	)		673,320		681,053	(1.1	)
Total sales revenue		144,173		122,545	17.6			397,298		358,018	11.0

Total AHS revenue	$	372,108	$	358,392	3.8	%	$	1,070,618	$	1,039,071	3.0	%

The increase in AHS Americas revenue during both the third quarter and first nine months of 2011 compared to the prior-year periods was attributable to a combination of increased sales volumes of V.A.C.® Therapy units and increased sales revenue from the adoption of recently-launched, new negative pressure-based therapies in the U.S., partially offset by a decrease in rental volumes and realized pricing on V.A.C. Therapy rental units.

The increase in AHS EMEA revenue during the third quarter of 2011 compared to the prior-year period was due primarily to favorable foreign currency exchange rate movements, volume growth on sales of V.A.C.Via™, ABThera™ and V.A.C. Therapy units, partially offset by decreases in revenue due to continued pricing pressures on V.A.C. Therapy rental units and a decline in rental and sales volumes. Foreign currency exchange rate movements favorably impacted AHS EMEA revenue during the third quarter and first nine months of 2011 by 8.3% and 6.7%, respectively, compared to the prior-year periods.

The increase in AHS APAC revenue during the third quarter and first nine months of 2011 compared to the prior-year periods was due primarily to favorable foreign currency rate movements and higher rental and sales volumes in Japan. Foreign currency exchange rate movements favorably impacted AHS APAC revenue during both the third quarter and first nine months of 2011 by 17.4% compared to the prior-year periods.

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LifeCell Revenue

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

	Three months ended September 30,						Nine months ended September 30,
	2011		2010		Change		2011		2010		Change

Americas	$	94,507	$	83,213	13.6	%	$	278,012	$	243,375	14.2	%
EMEA		2,934		1,722	70.4			8,773		4,318	103.2

Total LifeCell revenue	$	97,441	$	84,935	14.7	%	$	286,785	$	247,693	15.8	%

The growth in LifeCell revenue over the prior-year periods was due primarily to increased demand for our acellular tissue matrix products as the result of continued market penetration and geographic expansion. EMEA LifeCell sales reported growth in all geographic locations where we have launched our LifeCell products. LifeCell revenue generated from the use of AlloDerm, Strattice, and other acellular tissue matrix products in reconstructive surgical procedures, including challenging hernia repair and breast reconstruction, accounted for 94.1% and 93.8%, respectively, of total LifeCell revenue for the third quarter and first nine months of 2011 compared to 94.3% and 93.5% during the corresponding prior-year periods. Direct sales of Strattice, our porcine-based reconstructive tissue matrix product, accounted for 46.1% and 45.4% of total LifeCell revenue for the third quarter and first nine months of 2011, respectively, compared to 42.2% and 39.6%, respectively, in the prior-year periods. Foreign currency exchange rate movements did not have a significant impact on worldwide LifeCell revenue as compared to the prior-year periods.

TSS Revenue

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

	Three months ended September 30,						Nine months ended September 30,
					%						%
	2011		2010		Change		2011		2010		Change
Americas revenue:
Rental	$	31,558	$	35,539	(11.2	)%	$	103,586	$	115,533	(10.3	)%
Sales		6,129		6,249	(1.9	)		19,620		19,218	2.1

Total Americas revenue		37,687		41,788	(9.8	)		123,206		134,751	(8.6	)

EMEA revenue:
Rental		19,094		17,553	8.8			59,084		55,381	6.7
Sales		4,794		3,503	36.9			11,865		12,128	(2.2	)

Total EMEA revenue		23,888		21,056	13.4			70,949		67,509	5.1

APAC revenue:
Rental		5		31	(83.9	)		26		78	(66.7	)
Sales		242		506	(52.2	)		801		1,183	(32.3	)

Total APAC revenue		247		537	(54.0	)		827		1,261	(34.4	)

Total rental revenue		50,657		53,123	(4.6	)		162,696		170,992	(4.9	)
Total sales revenue		11,165		10,258	8.8			32,286		32,529	(0.7	)

Total TSS revenue	$	61,822	$	63,381	(2.5	)%	$	194,982	$	203,521	(4.2	)%

The decrease in TSS Americas revenue was driven by our rental business, which has experienced increased competitive pressure and modest share loss. The increase in TSS EMEA revenue during the third quarter of 2011 compared to the prior-year period was due primarily to favorable foreign currency rate movements and strong capital sales. Foreign currency exchange rate movements favorably impacted Americas and EMEA TSS revenue by 1.0% and 9.8%, respectively, in the third quarter of 2011 and 0.9% and 6.9%, respectively, in the first nine months of 2011 compared to the prior-year periods.

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Rental Expenses

The following table presents rental expenses and the percentage relationship to AHS and TSS revenue comparing the third quarter of 2011 to the third quarter of 2010 and the first nine months of 2011 to the first nine months of 2010 (dollars in thousands):

	Three months ended September 30,								Nine months ended September 30,
	2011			2010			Change		2011			2010			Change
Rental expenses	$	136,789		$	155,765		(12.2	)%	$	433,634		$	464,606		(6.7	)%
As a percent of total AHS and TSS revenue		31.5	%		36.9	%	(540	bps)		34.3	%		37.4	%	(310	bps)

Rental, or field, expenses are comprised of both fixed and variable costs including facilities, field service, sales force compensation and royalties associated with our rental products. Rental expenses as a percent of total AHS and TSS revenue during the third quarter of 2011 decreased from the prior-year period due primarily to lower product royalty costs on AHS revenue associated with our previous license agreement with Wake Forest University and lower rental fleet depreciation, partially offset by the impact of unfavorable foreign currency movements. The year-to-date rental expenses decrease as a percent of total AHS and TSS revenue was lower than the current quarter resulting primarily from increased selling expenses related to additional investment in our AHS sales force during the second half of 2010 and first nine months of 2011.

Cost of Sales

The following table presents cost of sales and the sales margin (calculated as sales revenue less cost of sales divided by sales revenue for the period indicated) comparing the third quarter of 2011 to the third quarter of 2010 and the first nine months of 2011 to the first nine months of 2010 (dollars in thousands):

	Three months ended September 30,								Nine months ended September 30,
	2011			2010			Change		2011			2010			Change
Cost of sales	$	62,925		$	61,551		2.2	%	$	185,062		$	184,782		0.2	%
Sales margin		75.1	%		71.7	%	340	bps		74.1	%		71.0	%	310	bps

Cost of sales includes manufacturing costs, product costs and royalties associated with our “for sale” products. The increase in sales margins over the prior-year periods was due primarily to growth and improved yields in our LifeCell business unit and lower product royalty costs on AHS revenue associated with our previous license agreement with Wake Forest University.

Gross Profit Margin

The following table presents the gross profit margin (calculated as gross profit divided by total revenue for the periods indicated) comparing the third quarter of 2011 to the third quarter of 2010 and the first nine months of 2011 to the first nine months of 2010:

	Three months ended September 30,					Nine months ended September 30,
	2011		2010		Change	2011		2010		Change
Gross profit margin	62.4	%	57.1	%	530 bps	60.1	%	56.4	%	370 bps

The gross profit margin increase during the third quarter of 2011 compared to the prior-year period was due primarily to lower royalty expense associated with our previous license agreement with Wake Forest University, higher gross margins associated with our LifeCell business unit, lower rental fleet depreciation, and favorable product mix. The year-to-date gross profit margin increase was lower than the current quarter resulting primarily from increased selling expenses related to additional investment in our AHS sales force during the second half of 2010 and first nine months of 2011. During the third quarter and first nine months of 2011, we recorded $0 and $13.1 million, respectively, in royalty expense associated with our previously-existing licensing agreement with Wake Forest University compared to $23.9 million and $66.4 million, respectively, during the prior-year periods.

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Selling, General and Administrative Expenses

The following table presents selling, general and administrative expenses and the percentage relationship to total revenue comparing the third quarter of 2011 to the third quarter of 2010 and the first nine months of 2011 to the first nine months of 2010 (dollars in thousands):

	Three months ended September 30,								Nine months ended September 30,
	2011			2010			Change		2011			2010			Change
Selling, general and administrative expenses	$	155,855		$	139,512		11.7	%	$	452,377		$	422,103		7.2	%
As a percent of total revenue		29.3	%		27.5	%	180	bps		29.1	%		28.3	%	80	bps

Selling, general and administrative (“SG&A”) expenses include administrative labor, incentive and sales compensation costs, insurance costs, professional fees, depreciation, bad debt expense and information systems costs, but excludes rental sales force compensation costs. SG&A increases during the third quarter of 2011 compared to the prior-year period included the impact of foreign currency movements, transaction-related costs associated with our recently-announced acquisition, higher selling costs associated with our LifeCell division and higher costs associated with geographic expansion. The year-to-date percentage increase in SG&A expenses was lower than the current quarter resulting primarily from reduced litigation costs and prior-year charges associated with our TSS portfolio rationalization and our Global Business Transformation in the second quarter.

Research and Development Expenses

The following table presents research and development expenses and the percentage relationship to total revenue comparing the third quarter of 2011 to the third quarter of 2010 and the first nine months of 2011 to the first nine months of 2010 (dollars in thousands):

	Three months ended September 30,								Nine months ended September 30,
	2011			2010			Change		2011			2010			Change
Research and development expenses	$	23,530		$	20,873		12.7	%	$	68,124		$	67,375		1.1	%
As a percent of total revenue		4.4	%		4.1	%	30	bps		4.4	%		4.5	%	(10	bps)

Research and development expenses relate to our investments in clinical studies and the development of new and enhanced products and therapies. Our research and development efforts include the development of new and synergistic technologies across the continuum of wound care, including tissue regeneration, preservation and repair, new applications of negative pressure technology, as well as upgrading and expanding our surface technologies in our TSS business. Our research and development program is also leveraging our core understanding of biological tissues in order to develop biosurgery products in our LifeCell business. Research and development expenses were higher during the third quarter of 2011 compared to the prior-year period due to increased headcount following the 2010 formation of our Center for Advanced Research and Technology.

Acquired Intangible Asset Amortization

In connection with the LifeCell acquisition, we recorded $486.7 million of identifiable definite-lived intangible assets during the second quarter of 2008. Amortization expense associated with these acquired intangible assets was $8.9 million and $26.6 million in the third quarter and first nine months of 2011, respectively, compared to $8.9 million and $28.6 million in the corresponding prior-year periods.

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Operating Margin

The following table presents the operating margin, defined as operating earnings as a percentage of total revenue, comparing the third quarter of 2011 to the third quarter of 2010 and the first nine months of 2011 to the first nine months of 2010:

	Three months ended September 30,					Nine months ended September 30,
	2011		2010		Change	2011		2010		Change
Operating margin	27.0	%	23.7	%	330 bps	24.9	%	21.7	%	320 bps

The increase in operating margins resulted from a combination of lower royalty expense, favorable foreign currency movements and prior-year charges associated with our TSS portfolio rationalization and Global Business Transformation, partially offset by higher costs associated with our recently-announced acquisition. During the third quarter and first nine months of 2011, we recorded $6.0 million and $7.2 million, respectively, in expenses associated with our recently-announced acquisition.

Interest Expense

Interest expense decreased to $17.3 million and $55.3 million in the third quarter and first nine months of 2011, respectively, compared to $21.5 million and $67.4 million in the corresponding prior-year periods, due to debt payments made over the last twelve months, as well as lower interest rates due, in part, to our debt refinancing completed in the first quarter of 2011. Interest expense includes write-offs of $0 and $3.2 million, respectively, during the third quarter and first nine months of 2011 as compared to $374,000 and $2.3 million, respectively, during the corresponding prior-year periods for unamortized deferred debt issuance costs associated with the refinancing of our senior credit facility during 2011 and optional prepayments on our senior credit facility during 2010. In addition, we recorded $5.8 million and $17.1 million of additional non-cash interest expense related to amortization of the discount on our convertible senior notes in the third quarter and first nine months of 2011, respectively, as compared to $5.4 million and $15.8 million for the same periods of 2010.

Foreign Currency Gain (Loss)

We recognized foreign currency exchange rate losses of $2.1 million during both the third quarter and first nine months of 2011 compared to foreign currency exchange rate gains of $2.1 million during the third quarter of 2010 and foreign currency exchange rate losses of $3.1 million during the first nine months of 2010. The variance from the prior-year periods is due primarily to significant volatility in the foreign currency markets.

Net Earnings

For the third quarter of 2011, we reported net earnings of $90.7 million, an increase of 19.7% compared to $75.8 million in the prior-year period. For the first nine months of 2011, we reported net earnings of $240.6 million, an increase of 32.1% compared to $182.1 million in the prior-year period. The effective income tax rate for the third quarter and first nine months of 2011 was 27.0% and 27.1%, respectively, compared to 25.0% and 28.0%, respectively, for the corresponding periods in 2010. The increase in the effective income tax rate for the third quarter of 2011 as compared to the prior-year period was due primarily to the favorable resolution of certain tax contingencies during 2010.

Net Earnings per Diluted Share

Net earnings per diluted share for the third quarter and first nine months of 2011 were $1.16 and $3.21, respectively, as compared to net earnings per diluted share of $1.06 and $2.54, respectively, in the corresponding prior-year periods. The dilutive effect associated with our Convertible Notes and related warrants were $0.06 during both the third quarter and first nine months of 2011.

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LIQUIDITY AND CAPITAL RESOURCES

General

We require capital principally for capital expenditures, systems infrastructure, debt service, interest payments and working capital. Additionally, from time to time, we may use capital for acquisitions, share repurchases and other investing and financing activities. Our capital expenditures consist primarily of manufactured rental assets, manufacturing equipment, computer hardware and software, and expenditures related to leasehold improvements. Working capital is required principally to finance accounts receivable and inventory. Our working capital requirements vary from period-to-period depending on manufacturing volumes, the timing of shipments and the payment cycles of our customers and payers.

Sources of Capital

Based upon the current level of operations, we believe our existing cash resources, as well as cash flows from operating activities and availability under our revolving credit facility will be adequate to meet our anticipated cash requirements for at least the next twelve months. During the nine months ended September 30, 2011 and 2010, our primary source of capital was cash from operations. The following table summarizes the net cash provided and used by operating activities, investing activities and financing activities for the nine months ended September 30, 2011 and 2010 (dollars in thousands):

	Nine months ended
	September 30,
	2011			2010

Net cash provided by operating activities	$	423,160		$	233,115
Net cash used by investing activities		(113,983	)		(61,559	)
Net cash provided (used) by financing activities		31,738			(170,932	)
Effect of exchange rates changes on cash and cash equivalents		(725	)		(484	)

Net increase in cash and cash equivalents	$	340,190		$	140

As of September 30, 2011, our principal sources of liquidity consisted of $656.8 million of cash and cash equivalents and $638.0 million available under our revolving credit facility, net of $12.0 million in undrawn letters of credit. During the first nine months of 2011, we made scheduled repayments on the $550.0 million term A facility due in January 2016 totaling $20.6 million from cash-on-hand. The increase in net cash provided by operating activities was due primarily to higher net earnings and lower cash outlays for royalty payments, inventory purchases, interest and income taxes, partially offset by higher capital expenditures.

As of December 31, 2010, our principal sources of liquidity consisted of $316.6 million of cash and cash equivalents and $288.4 million available under our revolving credit facility, net of $11.6 million in undrawn letters of credit. During 2010, we made scheduled and voluntary net repayments on the senior credit facility totaling $222.7 million from cash-on-hand.

Working Capital

As of September 30, 2011, we had current assets of $1.28 billion, including $404.0 million in net accounts receivable and $160.8 million in net inventory, and current liabilities of $349.0 million resulting in a working capital surplus of $932.4 million. As of December 31, 2010, we had current assets of $967.5 million, including $414.1 million in net accounts receivable and $172.6 million in net inventory, and current liabilities of $455.2 million resulting in a working capital surplus of $512.3 million.

As of September 30, 2011 and December 31, 2010, we had $404.0 million and $414.1 million, respectively, of receivables outstanding, net of realization reserves of $79.7 million and $97.0 million, respectively. Americas receivables, net of realization reserves, were outstanding for an average of 60 days at September 30, 2011 compared to 63 days at December 31, 2010. EMEA and APAC net receivables were outstanding for an average of 96 days and 72 days, respectively, at September 30, 2011, compared to 93 days and 72 days, respectively, at December 31, 2010. The increase in EMEA days outstanding compared to December 31, 2010 was due primarily to the timing of collections.

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Capital Expenditures

During the first nine months of 2011 and 2010, we made capital expenditures of $89.0 million and $63.3 million, respectively. Capital expenditures during 2011 related primarily to expanding the rental fleet, the purchase of land and the construction of our global headquarters building, and information technology purchases. Capital expenditures during 2010 related primarily to expanding the rental fleet and information technology purchases.

Senior Credit Facility

In January 2011, we entered into a new senior credit facility consisting of a $550.0 million term A facility and a $650.0 million revolving credit facility due January 2016 (“2016 Senior Credit Facility”). The following table sets forth the amounts owed under the term loan and revolving credit facility, the effective interest rates on such outstanding amounts, and the amount available for additional borrowing thereunder, as of September 30, 2011 (dollars in thousands):

Effective

Amount Available

Maturity

Interest

Amount

for Additional

Senior Credit Facility

Date

Rate

Outstanding

Borrowing

Revolving credit facility

January 2016

637,952

(1)

Term loan facility

January 2016

KINETIC CONCEPTS INC 10-Q