KINETIC CONCEPTS, INC.

(Exact name of registrant as specified in its charter)

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

Securities registered pursuant to Section 12(b) of the Act:

Securities registered pursuant to section 12(g) of the Act:  NONE

     Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
                                                                                                                      Yes      X             No                

     Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.
                                                                                                                      Yes                      No     X         

     Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
                                                                                                                      Yes      X             No                

     Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.                 

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

     Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
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     The aggregate market value of the voting and non-voting common equity held by non-affiliates as of June 30, 2006 was $2,443,473,803 based upon the closing sales price for the registrant's common stock on the New York Stock Exchange.

     As of February 20, 2007, there were 70,904,177 shares of the registrant's common stock outstanding.

     Documents Incorporated by Reference:  Certain information called for by Part III of this Form 10-K is incorporated by reference to the definitive Proxy Statement for the 2007 Annual Meeting of Shareholders, which will be filed not later than 120 days after the close of the Company's fiscal year.

TABLE OF CONTENTS

KINETIC CONCEPTS, INC.

TRADEMARKS

      The following terms used in this report are our trademarks:  AirMaxxis^®, AtmosAir^®, AtmosAir^® with SATÔ, BariAir^®, BariatricSupportÔ, BariKare^®, BariMaxx^® II, DeltaThermÔ, DynaPulse^®, EZ LiftÔ, FirstStep^®, FirstStep^® AdvantageÔ, FirstStep^® All In OneÔ, FirstStep^® PlusÔ, FirstStep Select^®, FirstStep Select^® Heavy DutyÔ, FluidAir Elite^®, FluidAir^® II, InterCell^®, KCI^®, KinAir^® IV, KinAir MedSurg^®, KinAir MedSurg^® PulseÔ, KCI Express^®, Kinetic Concepts^®, Kinetic TherapyÔ, MaxxAir ETS^®, Maxxis^® 300, Maxxis^® 400, PediDyne^®, RIK^®, RotoProne^®, RotoRest^®, RotoRest^® Delta, T.R.A.C.^®, TheraKair^®, TheraKair Visio^®, TheraPulse^® ATPÔ, TriaDyne^® II, TriaDyne Proventa^®, TriCell^®, V.A.C.^®, V.A.C. ATS^®, V.A.C. Freedom^®, V.A.C.^® Therapy, The V.A.C.^® System, V.A.C. GranuFoam Silver^® and V.A.C. Instill^®.  All other trademarks appearing in this report are the property of their holders.

SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

     This Annual Report on Form 10-K contains forward‑looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, which are covered by the "safe harbor" created by those sections. The forward‑looking statements are based on our current expectations and projections about future events. Discussions containing forward‑looking statements may be found in "Management's Discussion and Analysis of Financial Condition and Results of Operations," "Risk Factors," and elsewhere in this report. In some cases, you can identify forward‑looking statements by terminology such as "may," "will," "should," "could," "predicts," "projects," "potential," "continue," "expects," "anticipates," "future," "intends," "plans," "believes," "estimates," or the negative of these terms and other comparable terminology, including, but not limited to, statements regarding the following:

-      projections of revenues, expenditures, earnings, or other financial items;

-      future demand for V.A.C. Therapy systems or other products;

-      expectations for third-party and governmental reimbursement;

-      the plans, strategies and objectives of management for future operations;

-      expectation of market size and market acceptance or penetration of the products and services we offer;

-      the effects on our business of the August 2006 jury verdict on our patent litigation and post-trial motion and appeals;

-      expectations for the outcomes of our clinical trials;

-      attracting and retaining customers;

-      competition in our markets;

-      the timing and amount of future equity compensation expenses;

-      productivity of our sales force;

-      future economic conditions or performance, including seasonality;

-      changes in patient demographics;

-      estimated charges for compensation or otherwise; and

-      any statements of assumptions underlying any of the foregoing.

     These forward‑looking statements are only predictions, not historical facts, and involve certain risks and uncertainties, as well as assumptions. Actual results, levels of activity, performance, achievements and events could differ materially from those stated, anticipated or implied by such forward‑looking statements. The factors that could contribute to such differences include those discussed under the caption "Risk Factors." These risks include growing competition that we face; our dependence on our intellectual property and our ability to protect our intellectual property rights; our dependence on new technology; changes in third-party or governmental reimbursement policies; the fluctuations in our operating results and the possible inability to meet our published financial guidance; the clinical efficacy of V.A.C. Therapy relative to alternative devices or therapies; adverse results from pending litigation; and the results from related clinical trials; shortages of products resulting from the use of a limited group of suppliers, adverse results of potential government investigations, laws and regulations, fluctuations in foreign currency exchange rates and changes in effective tax rates or tax audits.  In addition, there are risks related to our capital structure, including our indebtedness that could adversely affect our financial condition; our obligations under our senior credit are secured by substantially all of our assets and there are limitations to a change in control or management.  You should consider each of the risk factors and uncertainties under the caption "Risk Factors" among other things, in evaluating our prospects and future financial performance. The occurrence of the events described in the risk factors could harm our business, results of operations and financial condition. These forward‑looking statements are made as of the date of this report. We disclaim any obligation to update or alter these forward‑looking statements, whether as a result of new information, future events or otherwise.

Table of Contents

PART I - FINANCIAL INFORMATION

ITEM 1.     BUSINESS

General

     Kinetic Concepts, Inc., or KCI, is a global medical technology company with leadership positions in advanced wound care and therapeutic surfaces. We design, manufacture, market and service a wide range of proprietary products that can improve clinical outcomes and can help reduce the overall cost of patient care. Our advanced wound care systems incorporate our proprietary V.A.C. Therapy technology, which has been demonstrated clinically to help promote wound healing through unique mechanisms of action and can help reduce the cost of treating patients with serious wounds. Our therapeutic surfaces, including specialty hospital beds, mattress replacement systems and overlays, are designed to address pulmonary complications associated with immobility, to prevent skin breakdown and assist caregivers in the safe and dignified handling of obese patients. We have an infrastructure designed to meet the specific needs of medical professionals and patients across all health care settings, including acute care hospitals, extended care organizations and patients' homes, both in the United States and abroad.  Our strategy to maintain growth momentum includes the internal development of next generation technologies, development of new business opportunities through focused research and development activities and expansion of our product portfolio through acquisition and licensing opportunities.

     We were founded in 1976 and are incorporated in Texas.  Our principal executive offices are located at 8023 Vantage Drive, San Antonio, Texas 78230.  Our telephone number is (210) 524-9000.  Our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13 or 15(d) of the Securities Exchange Act, as amended, are available free of charge on our website at www.kci1.com, as soon as reasonably practicable after we file or furnish such information with the SEC.  Information contained on our website is not incorporated by reference to this report.

Clinical Applications

     Our advanced wound care systems and therapeutic surfaces address four principal clinical applications: advanced wound healing and tissue repair, pulmonary care and post cardiac arrest complications in the intensive care unit, bariatric care and wound treatment and prevention.

Advanced Wound Healing and Tissue Repair

     In the acute care setting, serious trauma wounds, failed surgical closures, amputations (especially those resulting from complications of diabetes) and serious pressure ulcers present special challenges to the physician and to the patient. These are often complex and/or large wounds that are prone to serious infection and further complications due to the extent of tissue damage or the compromised state of the patient's health. These wounds are often difficult—or in the worst cases, impossible—to treat quickly and successfully with traditional treatments. Physicians and hospitals need a therapy that addresses the special needs of these wounds with high levels of clinical and cost effectiveness. Given the high cost and infection risk associated with treating these patients in health care organizations, the ability to create healthy wound beds and reduce bacterial levels in the wound is particularly important. Our V.A.C. Therapy systems are designed to meet these needs by promoting the reduction in local edema, managing exudate, reducing infection risk, and stimulating the growth of healthy, vascularized granulation tissue.

     In the extended care and homecare settings, different types of wounds, with different treatment implications, present the most significant challenges. Although a large number of acute wounds require post-discharge treatment, a majority of the challenging wounds in the homecare setting are non-healing chronic wounds. These wounds often involve physiologic and metabolic complications such as reduced blood supply, compromised lymphatic system or immune deficiencies that interfere with the body's normal wound healing processes. In addition, diabetic ulcers, arterial and venous insufficiency wounds and pressure ulcers are often slow-to-heal wounds. These wounds often develop due to a patient's impaired vascular and tissue repair capabilities. These conditions can also inhibit a patient's healing process, and wounds such as these often fail to heal for many months, and sometimes for several years. Difficult-to-treat wounds do not always respond to traditional therapies, which include hydrocolloids, hydrogels and alginates.

     Physicians and nurses look for therapies that can accelerate the healing process and overcome the obstacles of patients' compromised conditions. They also prefer therapies that are easy to administer, especially in the homecare setting, where full-time skilled care is generally not available. In addition, because many of these patients are not confined to bed, they want therapies that are minimally disruptive to the patient's or the caregiver’s typical daily routines. Our V.A.C. Freedom system is designed to allow patients mobility to conduct normal lives while their wounds heal.

Pulmonary Care and Post Cardiac Arrest Complications in the Intensive Care Unit

     The most critically ill patient population is generally cared for in the intensive care unit, or ICU, of a hospital, where they can receive the most intense medical treatment and attention. Patients treated in the ICU usually suffer from serious acute or chronic diseases or severe traumatic injuries. These patients often have, or develop, pulmonary complications, such as Acute Respiratory Distress Syndrome, or ARDS, resulting directly from their conditions or stemming from their impaired mobility.  Some ICU patients are in such acute distress that their organ systems are at risk of failure and many are on some type of life-support. For the fiscal year 2006, there were an estimated 1.2 million ICU patients in the United States with, or at risk of, developing pulmonary complications.

     Treating pulmonary complications requires special equipment and treatment methods. Because of the aggressive and specialized treatments required to address these life-threatening conditions, daily patient-care costs in the ICU are high. Our critical care therapies consist of Kinetic Therapy, Prone Therapy and Kinetic Prone Therapy to provide mobility to patients who cannot mobilize themselves. Kinetic Therapy involves the side‑to‑side rotation of a patient to an angle of at least 40 degrees per side and has been shown in independent clinical studies to reduce the incidence of certain pulmonary complications and length of stay in the ICU. Prone Therapy involves turning a patient from the supine to prone position (180 degrees) and often is done manually by nurses in the ICU. Independent clinical studies have demonstrated that proning an ICU patient improves oxygenation in ARDS patients and reduces ventilator time and ICU length of stay, with more recent studies suggesting overall improved mortality rates.  Kinetic Prone Therapy involves delivering Kinetic Therapy in the prone position.

     Additionally, our most recent innovation in addressing patient needs in the ICU is an advanced, non-invasive therapeutic temperature management system, initially targeting patients who have suffered cardiac arrest. This temperature management system uses high airflow and adjustable air temperature to lower and raise a patient’s core body temperature to achieve clinical benefits.  Early clinical data indicates managing a patient’s temperature may help to improve neurological outcomes and reduce mortality in recovering cardiac arrest patients.

Bariatric Care

     In the U.S., the prevalence of obesity has increased from 15% in the late 1970s to approximately 23% in 2005. In addition, obesity is now the second leading cause of preventable death in the U.S., and has been estimated at 5.7% of total medical spending. Obese patients are often unable to fit into standard‑sized beds and wheelchairs and pose an increased risk to caregivers. KCI's BariatricSupport, a comprehensive offering of therapy-driven, safety-focused products, education and training, provides obese patients with the surface therapies, accessories and support they need. In addition, our bariatric products enable caregivers to care for obese patients in a safe and dignified manner in all care settings. While our bariatric products are generally used for patients weighing from 300 to 600 pounds, most are expandable and can accommodate patients weighing from 850 to 1,000 pounds. Our most sophisticated bariatric products can serve as a chair, weight scale, and x‑ray table; and they provide therapies like those in our wound treatment and prevention systems. Moreover, treating obese patients is a significant staffing issue for many health care organizations, causing several states and many organizations to adopt a "no lift" policy, because moving and handling obese patients increases the risk of injury to health care personnel. Our products and accessories assist organizations in complying with any applicable "no lift" policy, enable health care personnel to treat these patients in a manner that is safer for health care personnel and safer and more dignified for the patient.

Wound Treatment and Prevention

     Our pressure relieving therapeutic surfaces provide therapy for the treatment of pressure sores, burns, ulcers, skin grafts, and other skin conditions. They also help prevent the formation of pressure sores that can develop in immobile individuals. Our therapeutic surfaces reduce the amount of pressure on a patient's intact skin surface (prevention) or an existing wound site (treatment) by redistributing forces away from the skin or wound site through immersion of the patient into a medium such as air, foam, silicon beads, or viscous fluid. Our products also help to reduce shear, a major factor in the development of pressure ulcers, by reducing the amount of friction between the skin surface and the surface of the bed. Many of our products also provide moisture control, a major cause of maceration of the skin, by flowing air through the support surface to the skin, keeping the skin dry and moisture free. In addition to providing pressure-relieving therapy, some of our products also provide for pulsing of air into the surface cushions, known as Pulsation Therapy, which helps improve blood and lymphatic flow to the skin. Some of our products further promote healing and reduce nursing time by providing an automated "wound care" turn of at least 20 degrees per side. Our therapeutic wound care surfaces are utilized by patients in hospitals, residents in nursing homes and individuals in the home.

Products

     We offer a wide range of products in each clinical application to meet the specific needs of different subsets of the market, providing innovative, cost effective, outcome-driven therapies across multiple care settings.

Advanced Wound Healing and Tissue Repair Products

     Our wound healing and tissue repair systems incorporate our proprietary V.A.C. Therapy technology.  The V.A.C. Therapy system consists of a therapy unit and four types of disposables: a foam dressing, an occlusive drape, a tube system connecting the dressing to the therapy unit and a specialized canister.  The therapy unit consists of a pump that generates controlled negative pressure and sophisticated internal software that controls and monitors the application of the therapy.  The therapy can be programmed for individualized use.  Additionally, the V.A.C. ATS and V.A.C. Freedom therapy units include safety alarms that respond in real time to signal users of any lumen blockage, dressing leakage or machine tilting that may otherwise interfere with appropriate therapy delivery.  The systems have a number of on screen user-assist features such as treatment guidelines.

     Our negative pressure wound healing therapy is delivered to the wound bed through a proprietary foam dressing cut to fit the size and shape of the wound.  The dressing is connected to the therapy unit through a tube which both delivers the negative pressure and measures the pressure delivered to the wound surface. An occlusive drape covers the dressing and secures the foam, thereby allowing negative pressure to be maintained at the wound site. Negative pressure can also be applied intermittently to the wound site, which we believe further accelerates granulation tissue growth. The canister collects the fluids, or exudates, helps reduce odors through the use of special filters and provides for safe disposal of medical waste. V.A.C. dressings are typically changed every 48 hours for non-infected wounds, versus traditional dressings which often require dressing changes one or more times per day. Our V.A.C. dressings are specially designed to address the unique physical characteristics of different wound types, such as large open wounds, surgical wounds, diabetic foot ulcers and open abdominal wounds, among others.

     Our wound healing and tissue repair systems are targeted to meet the needs of specific care settings and wound or patient requirements, and consist of the following:

     -  The V.A.C. ATS System was introduced in 2002 to meet the acute care requirements for a flexible, easy-to-use, high-capacity system that is effective with the largest and most challenging trauma, orthopedic reconstruction and abdominal wounds. The V.A.C. ATS incorporates advanced features and controls to provide flexibility to customize the treatment protocol to the requirements of different wound types and physician preferences. It also incorporates our proprietary T.R.A.C. technology, which enables the system to monitor pressure at the wound site and automatically adjust system operation to maintain the desired therapy protocol. The V.A.C. ATS also simplifies dressing changes and incorporates smart alarms that help ensure patient safety.

     -  The V.A.C. Freedom System was introduced in 2002 to meet the requirements for a robust, lightweight, high-performance product suitable for patients who are able to walk and are not confined to bed. Similar to the V.A.C. ATS system, it incorporates advanced features and T.R.A.C. technology, but in a 3.2-pound package adapted for convenient unobtrusive use by more active patients. It also includes special filters that help reduce wound odor, a common and embarrassing problem for many ambulatory wound patients. While the design of the V.A.C. Freedom system addresses the treatment needs of chronic wound patients, its 300 cc canister capacity also makes it appropriate for patients with highly exudating wounds.

     -  The V.A.C. Instill System was introduced in 2003 to add additional therapeutic capability to the V.A.C. Therapy system. The V.A.C. Instill combines the ability to instill fluids into the wound with V.A.C. Therapy. Fluids prescribed by physicians for topical use—including antibiotics, antiseptics and anesthetics—can be instilled, making the system particularly well suited for infected and painful wounds. Future uses could include cytokines, growth factors, or other agents to stimulate wound healing. Because the V.A.C. Instill is based on the V.A.C. ATS system, it also includes all the capabilities and features of the V.A.C. ATS.

     The V.A.C. GranuFoam Silver Dressing was introduced into the wound care market in August 2005.  Designed specifically for the V.A.C. Therapy system, V.A.C. GranuFoam Silver Dressing combines the proven benefits of Negative Pressure Wound Therapy, or NPWT, with the antimicrobial attributes of silver.  The V.A.C. GranuFoam Silver Dressing is the only silver dressing that allows the GranuFoam dressing pores to come in direct contact with the wound, eliminating the need for additional silver dressing layers that may inhibit negative pressure and granulation.  Micro-bonded metallic silver is uniformly distributed throughout the dressing, providing continuous delivery of silver even after dressing sizing.  A single application of V.A.C. GranuFoam Silver Dressing eliminates the need for adjunct silver dressings.  The dressing offers a protective barrier to reduce certain infection-producing bacteria, yeast and fungi, and may help reduce infections in the wound.

     The superior clinical efficacy of our V.A.C. Therapy wound healing and tissue repair systems is supported by an extensive collection of published clinical studies. V.A.C. Therapy systems have been reviewed in at least 322 peer reviewed journal articles, 373 abstracts, 51 case studies and 53 textbook citations.  Of these, the research for 46 articles, 66 abstracts and all case studies were funded by research grants from KCI.  Negative Pressure Wound Therapy, as delivered by the V.A.C. Therapy system, has been granted a seal of approval by the American Podiatric Medical Association, the German Wound Healing Society and the Austrian Wound Healing Society.  In addition, independent consensus conferences have issued guidelines for the use of Negative Pressure Wound Therapy for diabetic foot wounds, pressure ulcers, complex chest wounds, hospital-treated wounds and open abdominal wounds.

     We are currently sponsoring ongoing U.S. prospective, randomized and controlled multi-center clinical studies specifically designed to provide evidence of V.A.C. Therapy's clinical efficacy for treating various targeted wound types.  We have also initiated pilot studies to evaluate V.A.C. Therapy at the cellular and molecular levels.

Products Treating Pulmonary and Post Cardiac Arrest Complications in the ICU

     Our pulmonary care therapies include both Kinetic Therapy products and Prone Therapy products. In late 2004, we introduced the RotoProne Therapy System, an advanced patient-care system for the treatment and prevention of pulmonary complications associated with immobility. Providing Kinetic Therapy, Prone Therapy and Kinetic Prone Therapy, the RotoProne Therapy System enables caregivers to automatically rotate immobile patients with respiratory complications from the supine to the prone position and to also rotate them from side to side up to 62 degrees in both the supine and prone positions. The Rotoprone Therapy System can help improve patient outcomes by providing caregivers an easier way to deliver multiple intervals of Prone or Kinetic Prone Therapy over an extended period of time.  It also has the capability of delivering Kinetic Therapy in the supine position. The RotoProne Therapy System features include programmable rotation, up to 62 degrees in either the prone or supine position, with an acclimation mode as well as pause and hold functions to suspend the patient in a side‑lying position for ease of nursing care. Other features of the RotoProne Therapy System include a proprietary tube management system, electronically monitored buckles, an ergonomically‑designed head positioning system and 40‑second or less return to supine from the prone position for delivery of CPR.

     Our other Kinetic Therapy products include the TriaDyne Proventa, TriaDyne II, RotoRest Delta, and PediDyne. The TriaDyne Therapy System is used primarily in acute care settings and provides patients with four distinct therapies on an air suspension surface. The TriaDyne Therapy System applies Kinetic Therapy by rotating the patient up to 45 degrees on each side. There are three different modes of rotation: upper body only, full body rotation, and counter rotation, simultaneously rotating the patient's torso and lower body in opposite directions to keep the patient centered on the patient surface. The TriaDyne Therapy System also provides percussion therapy to loosen mucous buildup in the lungs and pulsation therapy to promote capillary and lymphatic flow. The RotoRest Delta is a specialty bed that can rotate a patient up to 62 degrees on each side for the treatment of severe pulmonary complications and respiratory failure. The RotoRest Delta is also designed, and has been shown, to improve the care of patients suffering from multiple trauma and spinal cord injury.  Kinetic Therapy has been clinically studied in at least 17 randomized clinical trials, 56 peer reviewed articles, 10 other published articles, 42 abstracts, 19 case studies and three textbook citations. Of these, the research for 17 articles, 32 abstracts and 19 case studies was funded by research grants from KCI.

     Our most recent innovation in addressing patient needs in the ICU is the DeltaTherm, an advanced, non-invasive therapeutic temperature management system, initially targeting patients who have suffered cardiac arrest.  The DeltaTherm uses high airflow and adjustable air temperature to lower and raise a patient’s core body temperature to achieve clinical benefits.  Early clinical data indicates that DeltaTherm may help to improve neurological outcomes and reduce mortality in recovering cardiac arrest patients.

Bariatric Care Products

     Our bariatric products provide a range of therapy options and the proper support needed by obese patients that enable nurses to properly care for these patients in a safe and dignified manner. The most advanced product in this line is the BariAir Therapy System, which can serve as a bed, cardiac chair or x-ray table. The BariAir, first introduced in 1996, provides low air loss pressure relief, continuous turn assist, percussion and step-down features designed for both patient comfort and nurse assistance. This product can be used for patients who weigh up to 850 pounds. We believe that the BariAir is the most advanced product of its type available today and is indicated for the treatment of the most complex bariatric patient, typically found in the ICU. In addition to therapy, the BariAir provides a risk management platform for patients weighing up to 850 pounds. It is a front-exit bed with the ability to convert to a cardiac chair position. In 1996, we also introduced the FirstStep Select Heavy Duty overlay, which provides pressure-relieving low air loss therapy when placed on a BariKare bed, our front-exit risk management platform for patients up to 850 pounds. Our AirMaxxis product provides a therapeutic air surface for the home environment for patients weighing up to 650 pounds. The Maxxis 300 and Maxxis 400 provide a homecare bariatric bed frame for patients weighing up to 600 pounds and 1,000 pounds, respectively.

     The BariMaxx II bed provides a basic risk management platform for patients weighing up to 1,000 pounds for those customers looking for a set of features including built-in scales and an expandable frame at a lower cost. The BariMaxx II side-exit feature allows the caregiver to assist patients in a more traditional exit of the bed. This is an important factor in a patient's rehabilitation and prepares them for facility discharge. The MaxxAir ETS (Expandable Turning Surface) mattress replacement system is a low‑air-loss, pressure relieving surface option for the BariMaxx II that also includes rotational therapy of up to 30 degrees on each side.  In 2006, we launched a powered transport option that enables caregivers to safely and more easily transport patients on the BariMaxx II.

     All of our bariatric beds can be combined with our EZ Lift patient transfer system, an Air Pal air assisted lateral transfer system, a Carechair combination chair / stretcher, and other accessories such as wheelchairs, walkers and commodes to create a complete bariatric suite offering. This complete suite offering helps care givers in the day-to-day care of the bariatric patient and also assists with compliance to "no lift" policies being implemented in health care organizations.

Wound Treatment and Prevention Products

     We offer a wide variety of therapeutic surfaces for wound treatment and prevention, providing pressure reduction, pressure relief, pulsation, alternating pressure, and a continuous turn of a minimum of 20 degrees. Most of our therapy beds and surfaces incorporate the exclusive use of Gore Medical Fabric in the patient contact areas to provide an ideal microclimate for skin protection and moisture control. Our pressure relief products include framed beds and overlays such as the KinAir MedSurg and KinAir IV framed beds; the FluidAir Elite and FluidAir II bead beds; the FirstStep, FirstStep Plus, FirstStep Select, FirstStep Advantage, TheraKair, TheraKair Visio and TriCell overlays, the AtmosAir family of non-powered, dynamic mattress replacement and seating surfaces; and the RIK fluid mattress and overlay. Our pulsation products include the KinAir MedSurg Pulse and TheraPulse ATP framed beds and the DynaPulse mattress replacement system.  Our alternating pressure or air cycling products include a powered model of the AtmosAir and the InterCell. Our turn assist products include the KinAir IV, Therapulse ATP and a powered AtmosAir model.  Internationally, the TheraKair Visio represents the next generation of our strong TheraKair brand, providing low air loss pressure relief with Pulsation Therapy.

     The KinAir MedSurg and KinAir IV have been shown to provide effective skin care therapy in the treatment of pressure sores, burns and post-operative skin grafts and flaps and to help prevent the formation of pressure sores and certain other complications of immobility. The FluidAir Elite and FluidAir II support patients on a low-pressure surface of air-fluidized beads providing pressure relief and shear relief for skin grafts or flaps, burns and pressure sores. The TheraKair, TheraKair Visio, and FirstStep family of overlays and mattress replacement systems are designed to provide pressure relief and help prevent and treat pressure sores. The AtmosAir family consists primarily of for-sale mattress replacement products that have been shown to be effective for the prevention and treatment of pressure sores in a series of hospital‑based case studies. The proprietary AtmosAir with Self Adjusting Technology (SAT) utilizes atmospheric pressure and gravity to deliver non-powered dynamic pressure relief.

     The KinAir MedSurg Pulse and TheraPulse ATP framed beds and the DynaPulse overlay provide a more aggressive form of treatment through a continuous pulsating action which gently massages the skin to help improve capillary and lymphatic circulation in patients suffering from severe pressure sores, burns, skin grafts or flaps, swelling or circulatory problems.

     The KinAir IV, Therapulse ATP and a powered AtmosAir model all provide turn assist of a minimum of 20 degrees to each side. Turn assist helps the caregiver reposition and/or turn a patient in order to provide patient care and pressure relief.

     In 2006, we launched the next generation platform of mattress replacement systems, the FirstStep All In One.  The FirstStep All In One is the only mattress replacement system that combines multiple therapy levels (low air loss, pulsation, and rotation) at different price points with a higher weight capacity to allow maximum flexibility to help organizations in optimizing patient care and nursing efficiency.

Competitive Strengths

     We believe we have the following competitive strengths:

     Product innovation and commercialization.  We have a successful track record spanning over 30 years in pioneering novel technologies, such as those that are used in our advanced wound care and therapeutic surfaces businesses.  We leverage our competencies in innovation, product development and commercialization to bring solutions to the market that address the critical unmet needs of clinicians and their patients.  Our recent development and commercialization of new V.A.C. Therapy systems and disposable dressing variations have strengthened KCI's leadership position in advanced wound care.  We have also developed and commercialized a broad spectrum of therapeutic surfaces, a number of which have significantly enhanced patient care.  Our most recent innovation in addressing patient needs in the ICU is the DeltaTherm, an advanced, non-invasive therapeutic temperature management system, initially targeting patients who have suffered cardiac arrest.  Early clinical data indicates that DeltaTherm may help to improve neurological outcomes and reduce mortality in recovering cardiac arrest patients.

     Superior clinical efficacy.  Our broad continuum of clinically-effective products, supported by our clinically-focused and trained sales and service organization, combine to produce superior clinical outcomes.  The superior clinical efficacy of our V.A.C. Therapy systems and our therapeutic surfaces is supported by an extensive collection of published clinical studies, peer-reviewed journal articles, and textbook citations, which aid adoption by clinicians.

     Broad reach and customer relationships.  Our worldwide sales team, consisting of approximately 1,900 individuals, has strong relationships with our prescribers, payers and caregivers fostered over the past three decades due to the high degree of clinical support and consultation we provide along with our extensive education and training programs. Because our products address the critical needs of patients who may seek treatment in various care facilities, we have built a broad and diverse reach across all health care settings. In the United States, for example, we have relationships with over 3,900 acute care hospitals, approximately 6,900 extended care organizations and over 10,500 home health care agencies and wound care clinics, in addition to numerous clinicians in these facilities with whom we have long-established relationships.

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

     Reimbursement expertise.  A significant portion of our V.A.C. revenue is derived from home placements, which are reimbursed by third-party payers such as private insurance, managed care, Medicare and Medicaid.  We have dedicated significant time and resources to develop capabilities and expertise in third-party reimbursement, which enable us to efficiently manage our collections and accounts receivable with third-party payers.

Customers

     We have a broad reach across all health care settings. In the United States, for example, we have relationships with over 3,900 acute care hospitals, approximately 6,900 extended care organizations and over 10,500 home health care agencies and wound care clinics. As of December 31, 2006, we served over 2,600 medium-to-large hospitals in the United States. Through our network of 141 U.S. and 67 international service centers, we are able to rapidly deliver our critically needed products to major hospitals in the United States, Canada, Australia and most major European countries. This extensive network is critical to securing national contracts with GPOs, and allows us to efficiently serve the homecare market directly. Our network also provides a platform for the introduction of additional products.

     Our agreements with GPOs, reimbursement under Medicare Part B, and our contractual relationships with third-party private payers account for a significant portion of our revenues.  We have agreements with numerous GPOs, which represent large groups of acute care and extended care organizations, in order to negotiate rental and purchase terms on behalf of their members.  Our largest GPO relationship is with Novation, LLC.  Under our agreements with Novation, we provide products and therapies to over 1,800 acute care and extended care organizations.  Rentals and sales to Novation participants in the years ended December 31, 2006 and 2005, accounted for $179.2 million, or 13.1% of total revenue, and $159.6 million, or 13.2% of total revenue, respectively.  Medicare, which reimburses KCI for placement of our products and therapies with Medicare participants, accounted for $165.4 million, or 12.1% of total revenue, and $148.6 million, or 12.3% of total revenue for the years ended December 31, 2006 and 2005, respectively.  No other individual customer or payer accounted for 10% or more of total revenues for the years ended December 31, 2006 and 2005, respectively.

     Our customers typically prefer to rent our V.A.C. Therapy systems and therapeutic surfaces and purchase the related disposable products, such as V.A.C. dressings. We believe that some of our customers, who tend to be our larger customers, desire alternatives to rental for at least some of their business. We expect this trend may continue as V.A.C. penetration increases, and we are evaluating and developing alternative models that will meet our customers' needs now and into the future.

Billing and Reimbursement

     We have extensive contractual relationships and reimbursement coverage for our products in the United States. We have contracts with nearly all major acute care hospital organizations and most major extended care organizations. Generally, these acute and extended care organizations pay us directly for our products and services. In the homecare market, we provide our products and services directly to patients and bill third‑party payers, including Medicare and private insurance. We currently have V.A.C. contracts with private and governmental payer organizations covering over 200 million member lives in the United States as of December 31, 2006. This represents more than 10 times the number of member lives we had under contract as of mid-2000.

     The following table sets forth, for the periods indicated, the percentage of revenue derived from different types of payers:

Employees

     As of January 31, 2007, we had over 6,300 employees.  Our corporate, manufacturing, finance, research and administrative functions are performed by approximately 1,000 employees who are located in San Antonio, Texas. Our USA division had approximately 3,400 employees, including 1,100 employees located in San Antonio who perform functions associated with customer service and sales administration. As of December 31, 2006, we had approximately 2,000 employees in our international division. Approximately 80 employees in our France subsidiary are represented by a workers' council, pursuant to applicable industrial relations laws. Our employees are not otherwise represented by labor unions or workers' councils and we consider our employee relations to be good.

Corporate Organization

     Our business has two geographical operating segments: USA and International.

     With approximately 3,400 employees as of December 31, 2006, our USA division serves the domestic acute care, extended care and homecare markets with the full range of our products and services. The domestic division distributes our medical devices and therapeutic surfaces to over 3,900 acute care hospitals and approximately 6,900 extended care organizations and also directly serves the homecare market through our service center network. Our USA division accounted for approximately 72%, 73% and 75% of our total revenue in the years ended December 31, 2006, 2005 and 2004, respectively.

     As of December 31, 2006, our International division had direct operations in 17 foreign countries including Germany, Austria, the United Kingdom, Canada, France, the Netherlands, Switzerland, Australia, Italy, Denmark, Sweden, Norway, Ireland, Belgium, Spain, Singapore and South Africa. The International division distributes our medical devices and therapeutic surfaces through a network of 67 service centers. Our international corporate office is located in Amsterdam, the Netherlands. We have international manufacturing and engineering operations based in the United Kingdom and Belgium.  We also have research and development personnel in Japan who oversee our clinical studies and developments in that country.  In addition, our International division serves the demands of a growing global market through relationships with approximately 50 independent distributors in Latin America, the Middle East, Eastern Europe and Asia. The International division consists of approximately 2,000 employees who are responsible for all sales, service and administrative functions within the various countries we serve. Our International division accounted for approximately 28%, 27% and 25% of our total revenue in the years ended December 31, 2006, 2005 and 2004, respectively.

Sales and Marketing Organization

     Our worldwide sales organization consists of approximately 1,900 individuals. Our sales organization is organized by care setting. Since physicians and nurses are critical to the adoption and use of advanced medical systems, a major element of the sales force's responsibility is to educate and train these medical practitioners in the application of our products, including the specific knowledge necessary for optimal clinical outcomes and reducing the cost of patient care. We have approximately 600 clinical consultants, all of whom are health care professionals, whose principal responsibilities are to make product rounds, consult on complex cases and assist organizations and home health agencies in developing their patient-care protocols. Our clinicians educate the hospital, long-term care organization or home health agency staff on the use of our products. In addition, we employ approximately 200 field‑based specialists who consult with our customers regarding the often demanding and complex paperwork required by Medicare and private insurance companies. In fulfilling the paperwork requirements, these specialists enhance the overall productivity of our sales force.

     Our international sales organization includes approximately 700 employees in 17 foreign countries. In each foreign market where we have a presence, we sell our products through our direct sales force or through local distributors with local expertise.

     Selling, marketing and advertising expenses in each of the periods below were as follows (dollars in thousands):

Service Organization

     Our USA division has a national 24-hour, seven day-a-week customer service communications system, which allows us to quickly and efficiently respond to our customers' needs. In 2005, we launched KCI Express, our secure and encrypted website allowing customers in acute care, extended care and homecare to transact business with KCI directly on the web.  Our website, www.kciexpress.com, provides KCI’s customers self-service applications designed to meet the specific needs in their care setting.  Our USA division distributes our medical devices and therapeutic surfaces through a network of 141 service centers.   Our USA division's network gives us the ability to deliver our products to any major Level I domestic trauma center within hours.  Our International division distributes our medical devices and therapeutic surfaces through a network of 67 service centers.

     In addition to delivery, pick-up and technical support services, our service organization cleans, disinfects and reconditions products between rentals.  To ensure availability when products are needed, the service organization manages our rental fleet of approximately 115,000 units, deploying units to meet individual service center demand patterns while maintaining high levels of rental asset utilization.  Services are provided by approximately 1,000 people in the United States and 600 people internationally.

Research and Development

     We have a successful track record of pioneering advanced wound care and therapeutic surface technologies through new product introductions and significant enhancements to existing products. Our development and commercialization of V.A.C. Therapy systems, including proprietary disposable dressings, have established KCI as a leader in advanced wound care. Our therapeutic surfaces technology originated with the introduction of the RotoRest bed 30 years ago. Since that time, we have continued to develop and commercialize a broad spectrum of therapeutic surfaces which have significantly enhanced patient care. More recently, we have developed a broad portfolio of bariatric surface products to improve the care of obese patients and have introduced two new sophisticated critical care therapies.  Additionally, we continue to strengthen our medical capabilities and commitments to clinical research that continues to demonstrate the benefits of our technologies.  Our research and development activities are managed by approximately 200 employees worldwide.

     Our primary focus for innovation is to introduce new technologies that expand our current product portfolio into different clinical settings, explore novel opportunities across the entire spectrum of wound care, and evaluate opportunities that leverage our expertise in critical care and in a variety of other clinical disciplines to expand product offerings beyond wound care that address significant unmet needs of our customers and their patients.  In addition, we strive to improve the value proposition of our products by increasing their clinical and economic benefits and by improving their operational efficiency.  Significant investments in our 2006 research and development included:

        -  new, advanced wound healing systems and dressings tailored to the needs of different wound types and care
           settings;

        -  new technologies in wound healing and tissue repair;

        -  new applications of V.A.C. Therapy technology and enhanced therapeutic effectiveness through improved
           understanding of the V.A.C. Therapy systems' various mechanisms of action; and

        -  initiation, execution or support of a number of well-designed randomized-controlled clinical trials, registries,
           development studies, and investigator initiated trials.

     Expenditures for research and development, including clinical trials, in each of the periods below, were as follows (dollars in thousands):

Patents, Trademarks and Licenses

     To protect our proprietary rights in our products, new developments, improvements and inventions, we rely on a combination of patents, copyrights, trademarks, trade secrets and other laws, and contractual restrictions on disclosure, copying and transfer of title, including confidentiality agreements with vendors, strategic partners, co-developers, employees, consultants and other third parties. We seek patent protection in the United States and abroad. We have approximately 165 issued U.S. patents relating to our existing and prospective lines of therapeutic medical devices. We also have approximately 100 pending U.S. patent applications. Many of our specialized beds, medical devices and services are offered under proprietary trademarks and service marks. We have approximately 60 trademarks and service marks registered with the United States Patent and Trademark Office. We also have agreements with third parties that provide for the licensing of patented and proprietary technology.

     We have patents relating to our current V.A.C. Therapy products, in the form of owned and licensed patents, including approximately 40 issued U.S. patents (including 10 design patents) and approximately 60 U.S. patent applications pending. Our worldwide patent portfolio (including owned and licensed patent assets) relating to current and prospective technologies in the field of V.A.C. Therapy includes more than 300 issued patents and more than 210 pending patent applications, including protection in Europe, Canada, Australia, Japan and the United States. Most of the V.A.C. patents in our patent portfolio have a term of 20 years from their date of priority. The V.A.C. Therapy utility patents, which relate to our basic V.A.C. Therapy, extend through late 2012 in certain international markets and through the middle of 2014 in the U.S. We also have multiple longer-term patent filings directed to cover unique central systems, dressings and other improvements of the V.A.C. Therapy system.

     On October 6, 1993, we entered into a license agreement with Wake Forest University on which we rely in connection with our V.A.C. Therapy business. Under this agreement, Wake Forest University has licensed to us on a worldwide, exclusive basis, the right to use, lease, sell and sublicense its rights to certain patents that are integral to the technology that we incorporate in our V.A.C. Therapy products. The term of the agreement continues for as long as the underlying patents are in effect, subject to Wake Forest University's right to terminate earlier if we fail to make required royalty payments or are otherwise in material breach or default of the agreement.

     We are subject to legal proceedings involving our patents that are significant to our business.  These proceedings are discussed subsequently in "Item 3: Legal Proceedings."

Manufacturing

     Our manufacturing processes for V.A.C. Therapy systems, therapeutic surfaces, mattress replacement systems and overlays involve producing final assemblies in accordance with a master production plan. Assembly of our products is accomplished using (1) metal parts that are fabricated, machined, and finished internally, (2) fabric that is cut and sewn internally and externally, and (3) plastics, electronics and other component parts that are purchased from outside suppliers. Component parts and materials are obtained from industrial distributors, original equipment manufacturers and contract manufacturers. The majority of parts and materials are readily available in the open market (steel, aluminum, plastics, fabric, etc.) for which price volatility is low. The manufacturing process and quality system are in compliance with the International Organization for Standardization, specifically ISO 13485:2003, and the United States Food and Drug Administration’s Quality System Regulation, 21 CFR 820.

     We contract for the manufacture of V.A.C. disposable supplies through Avail Medical Products, Inc., a leading contract manufacturer of sterile medical products.  We entered into an exclusive agreement with Avail for our V.A.C. related disposable products, which became effective in October 2002 for our U.S. orders and in May 2003 for our international orders.  This evergreen supply agreement has a term through October 2009, which automatically extends for additional twelve-month periods in October of each year, unless either party gives notice to the contrary.  Approximately 23% of our total revenue for the year ended December 31, 2006 was generated from the sale of these disposable supplies.  The terms of the supply agreement provide that key indicators be provided to us that would alert us to Avail's inability to perform under the agreement.  We maintain an inventory of disposables sufficient to support our business for approximately seven weeks in the United States and nine weeks in Europe.  However, in the event that we are unable to replace a shortfall in supply, our revenue could be negatively impacted in the short term.

Working Capital Management

     We maintain inventory parts, supplies and V.A.C. disposables to support customer needs in our service centers, manufacturing facilities and supplier distribution warehouses. We also maintain inventory for conversion to our surface and V.A.C. rental fleet in our manufacturing facilities. Our V.A.C. rental equipment cannot be used without the disposables that support the V.A.C. Therapy systems. As such, we generally ship disposable inventory directly from our supplier to the customer.

     Our payment terms with hospitals and extended care organizations are consistent with industry standards and generally provide for payment within 30 days of invoice.  Our payment terms with third-party payers, including Medicare and private insurance, are consistent with industry standards and are regulated by contract and state statute and generally vary from 30 to 45 days.  A portion of our receivables relate to unbilled revenues arising in the normal course of business.  A portion of our revenues remain unbilled for a period of time due to monthly billing cycles requested by our hospital or extended care organization customers or due to our internal paperwork processing and compliance procedures regarding billing third-party payers.

Competition

     We believe that the principal competitive factors within our markets are clinical efficacy, clinical outcomes, cost of care and service. Furthermore, we believe that a national presence with full distribution capabilities is important to serve large, national and regional health care GPOs. We have contracts with most major hospital GPOs and most major extended care GPOs for V.A.C. Therapy systems. The medical device industry is highly competitive and is characterized by rapid product development and technological change. In order to remain competitive with other companies in our industry, we must continue to develop new cost-effective products and technologies.

     Historically, our V.A.C. Therapy systems have competed primarily with traditional wound-care dressings, other advanced wound-care dressings, skin substitutes, products containing growth factors and other medical devices used for wound care.  We believe our V.A.C. Therapy system is well-positioned to compete effectively in advanced wound care, based on the clinical efficacy and superior outcomes of V.A.C. Therapy, as established by the large body of evidence we have collected, our breadth and scope of customer relationships and our extensive sales and service infrastructure.  As a result of the success of our V.A.C. Therapy systems, a number of companies have announced or introduced products similar to or designed to mimic our V.A.C. Therapy systems and others may do so in the future.  If competitors are able to successfully develop technologies that do not infringe our intellectual property rights and obtain FDA clearance and reimbursement, we could face increasing competition in the advanced wound-care business.   Over time, as our patents in the V.A.C. field begin to expire, we expect increased competition with products adopting the basic V.A.C. technologies.

      In addition to direct competition from companies in the advanced wound-care market, health care organizations may from time to time attempt to assemble NPWT devices from standard hospital supplies.  While we believe that many possible NPWT device configurations by competitors or health care organizations would infringe our intellectual property rights, we may be unable to enforce our rights against the sale or use of such potentially competing products, which could harm our ability to compete and could adversely affect our business.

     Other wound healing methods are substantially different than V.A.C. Therapy and include traditional wound care dressings, advanced wound care dressings (hydrogels, hydrocolloids, alginates), skin substitutes, products containing growth factors and medical devices used for wound care. Many of these methods can be used to compete with V.A.C. Therapy or as adjunctive therapies which may complement V.A.C. Therapy.  For example, caregivers may use one of our V.A.C. Therapy systems in order to reduce the wound size and create a healthy wound bed, and then use a skin substitute to manage the wound to final closure.

     With respect to therapeutic surfaces for treatment of pulmonary complications in the ICU, wound treatment and prevention, our primary competitors are Hill-Rom Company, Huntleigh Healthcare and Pegasus Limited. In the bariatric market, our primary competitors are Hill-Rom, Sizewise Rentals and Huntleigh Healthcare. We also compete on a regional, local and market segment level with a number of other companies.

Reimbursement

     Our products are rented and sold principally to hospitals, extended care organizations and directly to patients in the home who receive payment coverage for the products and services they utilize from various public and private third‑party payers, including government-funded programs, such as the Medicare and Medicaid programs in the U.S. In the homecare market, we provide our products and services to patients and bill insurance companies, including Medicare Part B and Medicaid. As a result, the demand and payment for our products are dependent, in part, on the reimbursement policies of these payers. The manner in which reimbursement is sought and obtained for any of our products varies based upon the type of payer involved and the setting to which the product is furnished and in which it is utilized by patients.

     We believe that government and private insurance efforts to contain or reduce health care costs are likely to continue. These trends may lead third‑party payers to deny or limit reimbursement for our products, which could negatively impact the pricing and profitability of, or demand for, our products.

     The Office of the Inspector General, or OIG, of the Department of Health & Human Services, or HHS, initiated a study on NPWT for 2006. The OIG Office of Evaluations and Inspections evaluates effectiveness and efficiency of a wide range of programs of HHS. We have participated in similar studies in the past on other product lines. As part of the current study, the OIG requested copies of our billing records for Medicare V.A.C. placements. KCI submitted all copies as requested and plans to cooperate fully with any and all future requests associated with these evaluations. In the event we are unable to satisfy the OIG in connection with this study, our prior billings could be subject to claims audits, which could result in further audits and/or demands by third-party payers for refunds or recoupments of amounts previously paid to us. The results of this study could also factor into future federal reimbursement for our products, including determinations of the inherent reasonableness of our V.A.C. pricing and to what extent our V.A.C. Therapy will be subject to the competitive bidding process, as well as other Medicare and third-party payer determinations on coverage or reimbursement.

     In addition, the most recent publication of the OIG’s Work Plan for 2007 includes several projects that could affect our business. Specifically, the OIG has indicated that it plans to review durable medical equipment, or DME, suppliers’ use of certain claims modifiers to determine whether the underlying claims made appropriate use of such modifiers when billing to Medicare. Under the Medicare program, a DME supplier may use these modifiers to indicate that it has the appropriate documentation on file to support its claim for payment. Upon request, the supplier may be required to provide this documentation; however, recent reviews by Durable Medical Equipment Medicare Administrative Contractors, or DMACs, and Medicare Program Safeguard Contractors, or PSCs, have indicated that some suppliers have been unable to furnish this information. In addition, the 2007 Work Plan provides that the OIG intends to determine the appropriateness of Medicare payments for certain DME items, including wound care equipment, by assessing whether the suppliers’ documentation supports the claim, whether the item was medically necessary, and/or whether the beneficiary actually received the item. In the event that these initiatives result in any assessments respecting KCI claims, we could be subject to material refunds, recoupments or penalties.

Medicare

     Medicare is a federally funded program that provides health care coverage primarily to the elderly and disabled. Medicare is composed of four parts: Part A, Part B, Part C and Part D. Medicare Part A (inpatient/hospital insurance) covers, among other things, inpatient hospital care, home health care and skilled nursing facility services. Medicare Part B (supplementary medical insurance) covers various services, including physician services and other services provided on an outpatient basis. Medicare Part B also covers medically necessary DME and related medical supplies. Medicare Part C, also known as Medicare Advantage, offers Medicare beneficiaries a choice of various types of health care plans, including several managed care options. Medicare Part D is the new Voluntary Prescription Drug Benefit Program. The Medicare program has established guidelines for the coverage and reimbursement of certain medical equipment, supplies and support services. In general, in order to be reimbursed by Medicare, a health care item or service furnished to a Medicare beneficiary must be reasonable and necessary for the diagnosis or treatment of an illness or injury or to improve the functioning of a malformed body part and not otherwise excluded by statute. Effective October 1, 2000, we received Medicare Part B reimbursement codes, an associated coverage policy and allowable rates for our V.A.C. Therapy systems and related disposable supplies in the homecare setting.

     The methodology for determining the amount of Medicare reimbursement of our products varies based upon, among other things, the setting in which a Medicare beneficiary receives health care items and services. Most of our products are furnished in a hospital, skilled nursing facility or the beneficiary's home.

Hospital Setting

     Acute care hospitals are generally reimbursed for certain patients by Medicare for inpatient operating costs based upon prospectively determined rates. Under the prospective payment system, or PPS, acute care hospitals receive a predetermined payment rate based upon the Diagnosis‑Related Group, or DRG, which is assigned to each Medicare beneficiary's primary diagnosis, regardless of the actual cost of the services provided. Certain additional or "outlier" payments may be made to a hospital for cases involving unusually high costs or lengths of stay. Accordingly, acute care hospitals generally do not receive direct Medicare reimbursement under PPS for the distinct costs incurred in purchasing or renting our products. Rather, reimbursement for these costs must come from within the DRG-based payments made to hospitals for the treatment of Medicare‑eligible inpatients who utilize the products. Long-term care and rehabilitation organizations are now also paid under a PPS rate that does not directly account for all actual services rendered. Because PPS payments are based on predetermined rates, and may be less than a facility’s actual costs in furnishing care, organizations have incentives to lower their inpatient operating costs by utilizing equipment and supplies, such as our products, that will reduce the length of inpatient stays, decrease labor or otherwise lower their costs. Such facilities are also incentivized to pay as little as possible to procure such beneficial equipment and supplies.

     In April 2006, CMS issued a notice of proposed rulemaking, which includes the first significant changes to the Inpatient Prospective Payment System, or IPPS, since its implementation in 1983. The IPPS is the Medicare payment system for inpatient hospital services. Under this proposal,  CMS would assign payment values for most inpatient hospital services in a manner that is based on weighted averages of national hospital costs for providing the services, rather than the current method, which is based on a weighted average of hospital charges for such services. The resulting changes, if enacted as proposed, could place downward pressure on prices paid by acute care hospitals to KCI for our products used for inpatient services.

     Certain specialty organizations such as long term acute care or in-patient rehabilitation organizations also use our products. In 2003, these specialty organizations completed a phase-in to a PPS reimbursement system. In 2005, additional changes in admitting practices were being phased-in to these specialty organizations. These changes could adversely impact overall reimbursement for these specialty organizations, which in turn could affect demand for our products.

Skilled Nursing Facility Setting

     In 1998, reimbursement for skilled nursing facilities, or SNFs, under Medicare Part A changed from a cost-based system to a prospective payment system, which is based on resource utilization groups, or RUGs. Under the RUGs system, a Medicare patient in a SNF is assigned to a RUGs category upon admission to the facility. The RUGs category to which the patient is assigned depends upon the medical services and functional support the patient is expected to require. The SNF receives a prospectively determined daily payment based upon the RUGs category assigned to each Medicare patient. These payments are intended generally to cover all inpatient services for Medicare patients, including routine nursing care, capital‑related costs associated with the inpatient stay and ancillary services. Because the RUGs system provides SNFs with fixed daily cost reimbursement, SNFs have become less inclined to use products, such as our therapeutic surfaces, that are no longer reimbursed as variable ancillary costs.

Home Setting

     We also provide products to Medicare beneficiaries in the homecare setting. Medicare, under the Part B program, reimburses beneficiaries, or suppliers accepting an assignment of the beneficiary's Part B benefit, for the purchase or rental of DME for use in the beneficiary's home or a home for the aged (as opposed to use in a hospital or skilled nursing facility setting). As long as we continue to provide our products to Medicare beneficiaries in the homecare setting and the Medicare Part B coverage criteria are met, our homecare products are reimbursed under the Medicare DME benefit.  Pursuant to the fee schedule payment methodology for this category, Medicare pays a monthly rental fee equal to 80% of the established allowable charge for the item. The patient (or his or her supplemental insurer) is responsible for the remaining 20%.  As opposed to the hospital and SNF settings where we bill and collect from the inpatient facilities, KCI generally bills the Medicare program and other insurers directly, on an assignment basis, for the covered homecare items we furnish.  This direct billing, including billing to federal health care programs, raises additional potential liabilities. See “Government Regulation – Fraud and Abuse Laws.”

     In 2003, CMS adopted a final rule implementing an "inherent reasonableness" authority, which allows CMS and its administrative contractors to adjust reimbursement amounts for home use durable medical equipment by up to 15% per year for certain items and services covered by Medicare Part B when the existing payment amount is determined to be grossly excessive or grossly deficient.  The regulation lists factors that may be used by CMS and the administrative contractors to determine whether an existing reimbursement rate is grossly excessive or grossly deficient and to determine what is a realistic and equitable payment amount.  CMS may make a larger adjustment each year if they undertake prescribed procedures for determining the appropriate payment amount for a particular service.  Using this authority, CMS and the administrative contractors could reduce KCI’s reimbursement levels for its home care products covered by Medicare Part B.

     The Medicare Prescription Drug, Improvement and Modernization Act of 2003, or MMA, provides for revisions to the manner in which payment amounts are to be calculated over the next five years (and thereafter). The MMA contains revisions to payment methodologies and other standards for items of DME. These revisions could have a direct impact on our business. Under the MMA, the reimbursement amounts for DME, including V.A.C. Therapy systems, will no longer be increased on an annual basis through 2008. Also, starting in 2007, Medicare is required to begin to implement a nationwide competitive bidding program in ten high-population metropolitan statistical areas, and in 2009, this program is slated to be expanded to an additional 80 areas (and additional areas thereafter). As of December 31, 2006, no final rules have been adopted for the implementation of the competitive bidding process. If KCI’s products are included in the competitive bidding process and KCI elects to participate in the program, prices reimbursed by Medicare in the homecare setting could be negatively impacted.  The competitive bidding process could also limit customer access to KCI’s homecare products.  Based upon information in the proposed rule regarding the CMS selection methodology for choosing ten metropolitan statistical areas, we estimate that approximately 1-2% of our total revenue may be subject to the initial phase of competitive bidding if NPWT were to be included as a product category.

Medicaid

     The Medicaid program is a cooperative federal/state program that provides medical assistance benefits to qualifying low income and medically needy persons. Each state is given discretion in developing and administering its own Medicaid program, subject, among other things, to certain federal requirements pertaining to eligibility criteria and minimum categories of services. The Medicaid program finances approximately 50% of all care provided in nursing organizations nationwide. We sell or rent our products to nursing organizations for use in furnishing care to Medicaid recipients. Typically, nursing organizations receive Medicaid reimbursement directly from states for the incurred costs. However, the method and level of reimbursement, which generally reflects regionalized average cost structures and other factors, varies from state to state and is subject to each state's budget constraints. Current economic conditions have resulted in reductions in state funding for many Medicaid programs. Consequently, states are revising their policies for coverage of DME in long-term care organizations and the home.

Private Payers

     Many non-governmental third‑party payers, including indemnity insurers, employer group health insurance programs and managed care plans, presently provide coverage for the purchase and rental of our products. The scope of coverage and payment policies varies among third‑party private payers. Furthermore, many such payers are investigating or implementing methods for reducing health care costs, such as the establishment of capitated or prospective payment systems.

     We believe that government and private efforts to contain or reduce health care costs are likely to continue. These trends may lead third‑party payers to deny or limit reimbursement for our products, which could negatively impact the pricing and profitability of, or demand for, our products.

Market Outlook

Reimbursement of Healthcare Costs and Healthcare Reform

      The demand for our products is highly dependent on the policies of third-party payers such as Medicare, Medicaid, private insurance and managed care organizations that reimburse us for the sale and rental of our products. If coverage or payment policies of these third-party payers are revised in light of increased efforts to control health care spending or otherwise, the amount we may be reimbursed or the demand for our products may decrease.

    The importance of payer coverage policies has been demonstrated by our experience with our V.A.C. technology in the homecare setting. On October 1, 2000, a Medicare Part B policy was approved, which provided for reimbursement codes, an associated coverage policy and allowable rates for the V.A.C. Therapy systems and V.A.C. disposable products in the homecare setting. The policy facilitated claims processing, permitted electronic claims submissions and created a more uniform claims review process. Because many payers look to Medicare for guidance in coverage, a specific Medicare policy is often relied upon by other payers. In contrast with this United States-based experience, coverage in several European countries has been limited to case-by-case approvals until the appropriate approvals have been granted by the government-sponsored approval body. Switzerland approved homecare reimbursement in 2004, which has opened the market for broad use in the home.  Germany is currently considering approval.  In other countries, such as Austria and the Netherlands, coverage by insurance companies is widespread, even without formal government approval.

     A significant portion of our wound healing systems revenue is derived from home placements, which are reimbursed by both governmental and non-governmental third‑party payers. The reimbursement process for homecare placements requires extensive documentation, which has slowed the cash receipts cycle relative to the rest of the business.

     In the United States, health care reform legislation will most likely remain focused on reducing the cost of health care. We believe that efforts by private payers to contain costs through managed care and other efforts will continue in the future as efforts to reform the health care system continue. Current efforts include the MMA revisions that cease increases to DME fee schedule reimbursement through 2008 and the forthcoming Medicare DME competitive bidding program, each of which could impact reimbursement of our homecare products.

     From time to time, CMS publishes reimbursement policies and rates that may unfavorably affect the reimbursement and market for our products. In the past, our V.A.C. Therapy systems and disposables were the only devices assigned to the CMS reimbursement codes for NPWT. Beginning in 2005, CMS has assigned the same NPWT reimbursement codes to other devices being marketed to compete with V.A.C. Therapy systems. Also, CMS may reduce reimbursement rates on NPWT or its various components, which would reduce revenue. As a result of recent CMS decisions, we are experiencing increased development of products designed to compete with V.A.C. Therapy systems and inquiries from other third-party payers regarding reimbursement levels. Either increased competition or reduced reimbursement could materially and adversely affect our operating results.

     The assignment of CMS reimbursement codes to competing products also increases the likelihood of the NPWT category being subjected to the initial phases of Medicare competitive bidding, which could negatively impact KCI’s revenue from products that are reimbursed by Medicare in the homecare setting. In April 2006, CMS posted proposed rules on competitive bidding of DME in the homecare setting. In June 2006, we submitted comments to the proposed rules on competitive bidding. Although CMS has not yet decided on specific product categories that will be covered in the initial phases of competitive bidding, the category for NPWT is among those being considered for 2007 under the proposed rule and may be included in the final rules or in future rounds of the competitive bidding process. If KCI’s products are included in the competitive bidding process and KCI elects to participate in the program, prices reimbursed by Medicare in the homecare setting could be negatively impacted. The competitive bidding process could also limit customer access to KCI’s homecare products. The proposed rules also include proposals regarding how CMS will continue to set fee schedule prices for DME that are reimbursed outside of the competitive bidding process.

     The reimbursement of our products is also subject to review by government contractors that administer payments under federal health care programs, including DMACs and PSCs. These contractors are delegated certain authority to make local or regional determinations and policies for coverage and payment of DME in the home. Adverse interpretation or application of DMAC coverage policies, adverse administrative coverage determinations or changes in coverage policies can lead to denials of our claims for payment and/or requests to recoup alleged overpayments made to us for our products. Such adverse determinations and changes can often be challenged only through an administrative appeals process.

Consolidation of Purchasing Entities

     The many health care reform initiatives in the United States have caused health care providers to examine their cost structures and reassess the manner in which they provide health care services. This review, in turn, has led many health care providers to merge or consolidate with other members of their industry in an effort to reduce costs or achieve operating synergies. A substantial number of our customers, including proprietary hospital groups, GPOs, hospitals, national nursing home companies and national home health care agencies, have been affected by this consolidation. An extensive service and distribution network and a broad product line are key to servicing the needs of these larger provider networks. In addition, the consolidation of health care providers often results in the re-negotiation of contracts and the granting of price concessions. Finally, as GPOs and integrated health care systems increase in size, each contract represents a greater concentration of market share and the adverse consequences of losing a particular contract increases.

Government Regulation

United States

     Our products are subject to regulation by numerous governmental authorities, including the FDA, and corresponding state and foreign regulatory agencies.  Under the Federal Food, Drug, and Cosmetic Act, the FDA regulates the design, clinical testing, manufacture, labeling, distribution, sale and promotion of medical devices.  Noncompliance with applicable requirements can result in fines, injunctions, civil penalties, recall or seizure of products, total or partial suspension of production, failure of the government to grant pre-market clearance or pre-market approval for devices, withdrawal of marketing clearances or approvals and criminal prosecution.  The FDA also has the authority to demand the repair, replacement or refund of the cost of any device that we manufacture or distribute that violates regulatory requirements.

     In the United States, medical devices are classified into one of three classes (Class I, II or III) on the basis of the controls deemed necessary by the FDA to reasonably ensure their safety and effectiveness. Although many Class I devices are exempt from certain FDA requirements, Class I devices are subject to general controls (for example, labeling, pre-market notification and adherence to the Quality System Regulation). Class II devices are subject to general and special controls (for example, performance standards, post-market surveillance, patient registries and FDA guidelines). Generally, Class III devices are high-risk devices that receive significantly greater FDA scrutiny to ensure their safety and effectiveness (for example, life-sustaining, life-supporting and implantable devices, or new devices which have been found not to be substantially equivalent to legally marketed Class I or Class II devices). Before a new medical device can be introduced in the market, the manufacturer must generally obtain FDA clearance (510(k) clearance) or pre-market application, or PMA, approval. All of our current products have been classified as Class I or Class II devices, which typically are marketed based upon 510(k) clearance or related exemptions. A 510(k) clearance will generally be granted if the submitted information establishes that the proposed device is "substantially equivalent" in intended use and technological characteristics to a legally marketed Class I or Class II medical device or to a Class III device on the market since May 28, 1976, for which PMA approval has not been required. A PMA approval requires proof to the FDA's satisfaction of the safety and effectiveness of a Class III device. A clinical study is generally required to support a PMA application and is sometimes required for a 510(k) pre-market notification. For "significant risk" devices, such clinical studies generally require submission of an application for an Investigational Device Exemption. The FDA's 510(k) clearance process usually takes from four to twelve months, but may take longer. The PMA approval process is much more costly, lengthy and uncertain. The process generally takes from one to three years; but it may take even longer.

     Devices that we manufacture or distribute are subject to pervasive and continuing regulation by the FDA and certain state agencies, including record‑keeping requirements and mandatory reporting of certain adverse experiences associated with use of the devices. Labeling and promotional activities are subject to regulation by the FDA and, in certain circumstances, by the Federal Trade Commission. Current FDA enforcement policy prohibits the marketing of approved medical devices for unapproved uses and the FDA scrutinizes the labeling and advertising of medical devices to ensure that unapproved uses of medical devices are not promoted.

     Manufacturers of medical devices for marketing in the United States are required to adhere to applicable regulations, including the Quality System Regulation, or QSR, (formerly the Good Manufacturing Practice regulation), which imposes design, testing, control and documentation requirements. Manufacturers must also comply with the Medical Device Reporting, or MDR, regulation, which generally requires that manufacturers report to the FDA if their device may have caused or contributed to a death or serious injury or malfunctioned in a way that would likely cause or contribute to a death or serious injury if it were to recur. We are subject to routine inspection by the FDA and certain state agencies for compliance with QSR requirements, MDR requirements and other applicable regulations. In December 2005, KCI received accreditation of the Joint Commission on Accreditation of Health Care Organizations. We understand that CMS will announce the effective date after which third-party accreditation of DME suppliers will be required for Medicare Part B reimbursement in 2007.  Under this accreditation process, KCI will be reevaluated every three years and is subject to routine unannounced inspections by the Joint Commission on Accreditation of Health Care Organizations to ensure continued compliance with standards.

Fraud and Abuse Laws

      There are numerous rules and requirements governing the submission of claims for payment to federal health care programs.  If we fail to adhere to these requirements, the government could allege that claims we have submitted for payment violate the federal False Claims Act, or FCA. The FCA generally prohibits the known filing of a false or fraudulent claim for payment to the United States government or the known use of a false record or statement to obtain payment on a false or fraudulent claim paid by the conspiracy to defraud the United States government by getting a false or fraudulent claim allowed or paid. There are both civil and criminal provisions of the FCA. Violation of the criminal FCA can result in imprisonment of up to five years, a fine of up to $250,000 for an individual or $500,000 for an organization, up to three times the amount of the improper payment and/or exclusion from participating in federal and state health care programs.

     Under separate statutes, submission of claims for payment or causing such claims to be submitted that are "not provided as claimed" may lead to civil monetary penalties, criminal fines and imprisonment, and/or exclusion from participation in Medicare, Medicaid and other federally funded state health programs. These false claims statutes include, but are not limited to, the federal FCA. When an entity is determined to have violated the civil FCA, it must pay three times the actual damages sustained by the government, plus mandatory civil penalties of between $5,500 and $11,000 for each separate false claim. Suits filed under the FCA, known as "qui tam" actions, can be brought by any individual on behalf of the government and such individuals (known as "relators" or, more commonly, as "whistleblowers") may share in the amounts paid by the entity to the government in fines or settlement. In addition, certain states have enacted laws modeled after the federal FCA. Qui tam actions have increased significantly in recent years causing greater numbers of health care companies to have to defend false claim actions, pay fines or be excluded from the Medicare, Medicaid or other federal or state health care programs as a result of an investigation arising out of such action. Because we directly submit claims for payment for certain of our products to federal and state health care programs, we are subject to these false claims statutes, and, therefore, could become subject to "qui tam" or other false claims actions. Imposition of such penalties or exclusions would result in a significant loss of reimbursement and could have a material adverse effect on our financial condition.

     Recently, the federal government has significantly increased investigations of medical device manufacturers with regard to alleged kickbacks to physicians who use and prescribe their products.  The federal Anti-Kickback Statute is a criminal statute that prohibits the offering, payment, solicitation or receipt of remuneration (including any kickback, bribe or rebate), directly or indirectly, overtly or covertly, in cash or in kind, for (1) the referral of patients or arranging for the referral of patients to receive services for which payment may be made in whole or in part under a federal or state health care program; or (2) the purchase, lease, order, or arranging for the purchase, lease or order of any good, facility, service or item for which payment may be made under a federal or state health care program. Generally, courts have taken a broad interpretation of the scope of the Anti-Kickback Statute. The criminal sanctions for a conviction under the Anti-Kickback Law are imprisonment for not more than five years, a fine of not more than $25,000 or both, for each incident or offense, although the fine may be increased to $250,000 for individuals and $500,000 for organizations. If a party is convicted of a criminal offense related to participation in the Medicare program or any state health care program, or is convicted of a felony relating to health care fraud, the secretary of the United States Department of Health and Human Services is required to bar the party from participation in federal health care programs and to notify the appropriate state agencies to bar the individual from participation in state health care programs. Imposition of such penalties or exclusions would result in a significant loss of reimbursement and could have a material adverse effect on our financial condition and results of operations.

     Federal authorities have also increased enforcement with regard to the federal physician self-referral and payment prohibitions, commonly referred to as the Stark Law. The Stark Law generally forbids, absent qualifying for one of a few named exceptions, a physician from making referrals for the furnishing of any "designated health services," for which payment may be made under the Medicare or Medicaid programs, to any "entity" with which the physician (or an immediate family member) has a "financial relationship." DME items, including our homecare products, are designated health services. Our arrangements with physicians who prescribe our products, including arrangements whereby physicians serve as speakers and consultants for KCI, our training programs and our sales and marketing events (including meals, travel and accommodations associated therewith), could be deemed to create a "financial relationship" under the Stark Law, in which case, the physician may not order Medicare or Medicaid covered DME from us, and we may not present a claim for Medicare or Medicaid payment for such items. Penalties for Stark Law violations include denial of payment, civil monetary penalties of up to $15,000 for each illegal referral and up to $100,000 for any scheme designed to circumvent the Stark Law requirements. Prosecution under the Stark Law could have a material adverse impact on our financial condition and results of operations.

     In some cases, Anti-Kickback Statute or Stark Law violations may also be prosecuted under the FCA, which increases potential liability. In these cases, federal authorities and whistleblowers have alleged that items and services that were furnished in furtherance of an Anti-Kickback Statute or Stark Law violation are not billable to federal or state health care programs and that, to the extent that such claims for payment are submitted, they are false claims within the meaning of the FCA. Even the assertion of a violation under any of these provisions could have a material adverse effect on our financial condition and results of operations.

     Recent federal cuts to state administered health care programs, particularly Medicaid, have also increased enforcement activity at the state level under both federal and state laws.  In July 2006, CMS released its initial comprehensive Medicaid Integrity Plan, a national strategy to detect and prevent Medicaid fraud and abuse.  This new program will work to identify, recover and prevent inappropriate Medicaid payments through increased review of suppliers of Medicaid services.  KCI could be subjected to such reviews in any number of states.  Such reviews could result in demands for refunds or assessments of penalties against KCI, which could have a material adverse impact on our financial condition and results of operations.

     In addition, the Health Insurance Portability and Accountability Act of 1996, or HIPAA, defined two new federal crimes: (i) health care fraud and (ii) false statements relating to health care matters. The health care fraud statute prohibits knowingly and willfully executing or attempting to execute a scheme or artifice to defraud any health care benefit program, including private payers. The false statements statute prohibits knowingly and willfully falsifying, concealing or covering up a material fact or making any materially false, fictitious or fraudulent statement or representation in connection with the delivery of or payment for health care benefits, items or services. This statute applies to any health benefit plan, not just Medicare and Medicaid.  Violations of these statutes may result in fines, imprisonment, or exclusion from government health care programs.  Additionally, HIPAA granted expanded enforcement authority to the DHHS and the U.S. Department of Justice, or DOJ, and provided enhanced resources to support the activities and responsibilities of the DHHS's OIG and the DOJ by authorizing large increases in funding for investigating fraud and abuse violations relating to health care delivery and payment.

     The OIG has taken certain actions suggesting that arrangements between manufacturers or suppliers of DME or medical supplies and SNFs, or other providers may be under continued scrutiny. In June 1995, the OIG issued a Special Fraud Alert setting forth fraudulent and abusive practices that the OIG had observed in the home health industry. Later that same year, OIG issued another Special Fraud Alert describing certain relationships between SNFs and suppliers that the OIG viewed as abusive under the federal Anti-Kickback Law. In July 1999, the OIG published OIG compliance program guidance for the durable medical equipment, prosthetics, orthotics and supply, or DMEPOS, industry developed by the OIG in cooperation with, and with input from, CMS, the DOJ and representatives of various trade associations and health care practice groups. The guidance identifies specific areas of DMEPOS industry operations that may be subject to greater scrutiny, including those in which we operate.

     Several states also have referral, fee splitting and other similar laws that may restrict the payment or receipt of remuneration in connection with the purchase or rental of medical equipment and supplies. State laws vary in scope and have been infrequently interpreted by courts and regulatory agencies, but may apply to all health care products or services, regardless of whether Medicaid or Medicare funds are involved.

Claims Audits

     The industry in which we operate is generally characterized by long collection cycles for accounts receivable due to complex and time-consuming documentation requirements for obtaining reimbursement from private and governmental third‑party payers. Such protracted collection cycles can lead to delays in obtaining reimbursement. Moreover, the four DMACs periodically conduct pre-payment and post-payment reviews and other audits of paid claims. Medicare and Medicaid agents are under increasing pressure to scrutinize health care claims more closely. Reviews and/or similar audits or investigations of our claims and related documentation could result in denials of claims for payment submitted by us. Further, the government could demand significant refunds or recoupments of amounts paid by the government for claims which, upon subsequent investigation, are determined by the government to be inadequately supported by the required documentation.

Medical Record Confidentiality and Privacy Laws

     HIPAA covers a variety of provisions which impact our business, including the privacy of patient health care information, the security of that information and the standardization of electronic data transactions for billing. Sanctions for violating HIPAA include criminal penalties and civil sanctions. HIPAA’s privacy regulations restrict the use and disclosure of certain individually identifiable protected health information, or PHI.  The HIPAA security standards require us to implement certain measures to protect the security and integrity of electronic PHI. HIPAA regulations regarding standardization of electronic data billing transactions will also impact our business. We continue to work with all of our business associates with whom we share PHI and who process standardized transactions covered by the regulations in order to make the transition to standardized billing codes as smooth as possible. However, the health care industry’s continued transition to standardized billing codes may create billing difficulties or business interruptions for us.

ISO Certification

     Due to the harmonization efforts of a variety of regulatory bodies worldwide, certification of compliance with International Quality System Standards (e.g., those issued by the ISO) has become particularly advantageous and, in certain circumstances, necessary for many companies in recent years.  We originally received ISO 9001 and EN 46001 certification in 1997, followed by certification in 2002 to ISO 13485:1996, a medical device-specific version of ISO 9001.  In 2005, we obtained certification to ISO 13485:2003, the latest version of that standard.  We are registered in the UK with the Medicines and Healthcare Products Regulatory Agency which, through a European Notified Body, certifies conformance with Annex II of the EU Medical Device Directive 93/42/EEC.  We are thereby allowed to apply the CE mark to our products enabling sales and distribution throughout the European Union.  Since 2002, we have been licensed by Health Canada to sell and distribute our products within that country.

Environmental Laws

     We are subject to various federal, state and local environmental laws and regulations that govern our operations, including the handling and disposal of non-hazardous and hazardous substances and wastes, and emissions and discharges into the environment. Failure to comply with such laws and regulations could result in costs for corrective action, penalties or the imposition of other liabilities. We also are subject to laws and regulations that impose liability and cleanup responsibility for releases of hazardous substances into the environment. Under certain of these laws and regulations, such liabilities can be imposed for cleanup of previously owned or operated properties, or properties to which substances or wastes were sent from current or former operations at our facilities. From time to time, we have incurred costs and obligations for correcting environmental noncompliance matters and for cleanup of certain of our properties and third-party sites.

Other Laws

     We are subject to numerous federal, state and local laws and regulations relating to such matters as safe working conditions, manufacturing practices and fire hazard control.

International

     Sales of medical devices outside of the United States are subject to regulatory requirements that vary widely from country to country. Pre-market clearance or approval of medical devices is required by certain countries. The time required to obtain clearance or approval for sale in a foreign country may be longer or shorter than that required for clearance or approval by the FDA and the requirements vary. Failure to comply with applicable regulatory requirements can result in loss of previously received approvals and other sanctions and could have a material adverse effect on our business, financial condition or results of operations.

     We operate in multiple tax jurisdictions both inside and outside the United States. In the normal course of our business, we will undergo reviews by taxing authorities regarding the tariff classifications of our products and the amount of tariffs we pay on the importation and exportation of these products.

Table of Contents

ITEM 1A.     RISK FACTORS

Risks Related to Our Business

We face significant and increasing competition, which could adversely affect our operating results.

     Historically, our V.A.C. Therapy systems have competed primarily with traditional wound-care dressings, other advanced wound-care dressings, skin substitutes, products containing growth factors and other medical devices used for wound care.  As a result of the success of our V.A.C. Therapy systems, a number of companies have announced or introduced products similar to or designed to mimic our V.A.C. Therapy systems and others may do so in the future.  If competitors are able to successfully develop technologies that do not infringe our intellectual property rights and obtain FDA clearance and reimbursement, KCI could face increasing competition in the advanced wound-care business.  Over time, as our patents in the V.A.C. field begin to expire, we expect increased competition with products adopting the basic V.A.C. technologies.

     In addition to direct competition from companies in the advanced wound-care market, health care organizations may from time to time attempt to assemble Negative Pressure Wound Therapy, or NPWT, devices from standard hospital supplies.  While we believe that many possible NPWT device configurations by competitors or health care organizations would infringe our intellectual property rights, we may be unable to enforce our rights against the sale or use of such potentially competing products, which could harm our ability to compete and could adversely affect our business.

     We also face the risk that innovation by our competitors in our markets may render our products less desirable or obsolete.  Additionally, some of our V.A.C. Therapy and surfaces contracts with larger hospital group purchasing organizations, or GPOs, are sole-source or dual-source agreements.  GPOs have come under pressure to modify their membership requirements and contracting practices, including conversion of sole-source and dual-source agreements to agreements with multiple suppliers, in response to recent Congressional hearings and public criticism.  As our sole-source and dual-source agreements reach the end of their current terms, it is likely that renewals will result in dual or multi-source agreements with GPOs in the advanced wound care and therapeutic surfaces categories, which could result in increased competition in the acute and extended care settings for all of our product offerings.  Additionally, renewals of agreements could result in no award to KCI.  Our therapeutic surfaces business primarily competes with the Hill-Rom Company, Gaymar Industries, and Sizewise Rentals and in Europe with Huntleigh Healthcare and Pegasus Limited.

We may not be able to enforce or protect our intellectual property rights, which may harm our ability to compete and adversely affect our business.  If we are unsuccessful in protecting and maintaining our intellectual property, particularly our rights under the Wake Forest patents, our competitive position would be harmed.

     Our ability to enforce our patents and those licensed to us, together with our other intellectual property is subject to general litigation risks, as well as uncertainty as to the enforceability of our intellectual property rights in various countries.  We have numerous patents on our existing products and processes, and we file applications as appropriate for patents covering new technologies as they are developed.  However, the patents we own, or in which we have rights, may not be sufficiently broad to protect our technology position against competitors, or may not otherwise provide us with competitive advantages.  In addition, our patents may not prevent other companies from developing functionally equivalent products or from challenging the validity or enforceability of our patents.  Also, when we seek to enforce our rights, we may be subject to claims that the intellectual property right is invalid, is otherwise not enforceable or is licensed to the party against whom we are asserting a claim.   When we assert our intellectual property rights, it is likely that the other party will seek to assert alleged intellectual property rights of its own against us, which may adversely impact our business as discussed in the following risk factor.  If we are not ultimately successful in defending ourselves against these claims in litigation, we may not be able to sell or market a particular product or family of products, due to an injunction, or we may be required to pay material amounts in damages, which could in turn negatively affect our financial condition and results of operations.  Our inability to enforce our intellectual property rights under these circumstances may negatively impact our competitive position and our business.

     On August 3, 2006, a U.S. District Court jury found that the Wake Forest patents involved in our litigation against BlueSky Medical Group Inc. and Medela AG, and on which our V.A.C. Therapy systems rely, were valid and enforceable.  The jury also found that the patent claims at issue in the case were not infringed by the products marketed by BlueSky.  We derived $808.3 million in revenue, or 58.9% of total revenue, for the year ended December 31, 2006 and $706.0 million in revenue, or 58.4% of total revenue, for the year ended December 31, 2005 from our domestic V.A.C. Therapy products relating to the patents at issue.

     We also have agreements with third parties, including our exclusive license of the V.A.C. patents from Wake Forest, that provide for licensing of their patented or proprietary technologies. These agreements include royalty-bearing licenses. If we were to lose the rights to license these technologies, or our costs to license these technologies were to materially increase, our business would suffer.

We may be subject to claims of infringement of third-party intellectual property rights, which could adversely affect our business.

     From time to time, third parties may assert against us or our customers alleged patent or other intellectual property rights to technologies that are important to our business.  We may be subject to intellectual property infringement claims from certain individuals and companies who have acquired or developed patent portfolios in the fields of advanced wound care or therapeutic surfaces for the purpose of developing products that compete with ours, or for the sole purpose of asserting claims against us.  Any claims that our products or processes infringe the intellectual property rights of others, regardless of the merit or resolution of such claims, could cause us to incur significant costs in responding to, defending and resolving such claims, and may divert the efforts and attention of our management and technical personnel away from our business.  As a result of any such intellectual property infringement claims, we could be required to:

     -  pay material damages for third-party infringement claims;
     -  discontinue manufacturing, using or selling the infringing products, technology or processes;
     -  develop non-infringing technology or modify infringing technology so that it is non-infringing, which could be
        time-consuming and costly or may not be possible; or
     -  license technology from the third-party claiming infringement, which license may not be available on
        commercially reasonable terms or at all.

The occurrence of any of the foregoing could result in unexpected expenses or require us to recognize an impairment of our assets, which would reduce the value of our assets and increase expenses. In addition, if we alter or discontinue our production of affected items, our revenue could be negatively impacted.

If we are unable to develop new generations of V.A.C. Therapy and therapeutic surface products and enhancements to existing products, we may lose market share as our existing patent rights begin to expire over time.

     Our success is dependent upon the successful development, introduction and commercialization of new generations of products and enhancements to existing products. Innovation in developing new product lines and in developing enhancements to our existing V.A.C. Therapy and therapeutic surfaces products is required for us to grow and compete effectively.  Over time, our existing foreign and domestic patent protection in both the V.A.C. Therapy and therapeutic surfaces businesses will begin to expire, which could allow competitors to adopt our older unprotected technology into competing product lines. If we are unable to continue developing proprietary product enhancements to V.A.C. Therapy systems and therapeutic surfaces products that effectively make older products obsolete, we may lose market share in our existing lines of business. In addition, if we fail to develop new lines of products, we will not be able to penetrate new markets. Innovation through enhancements and new products requires significant capital commitments and investments on our part, which we may be unable to recover.

Changes in reimbursement regulations, policies and rules, or their interpretation, could reduce the reimbursement we receive for and adversely affect the demand for our products.

     The demand for our products is highly dependent on the regulations, policies and rules of third-party payers, including the Medicare and Medicaid programs, as well as private insurance and managed care organizations, that reimburse us for the sale and rental of our products.  If coverage or payment regulations, policies or rules of these third-party payers are revised in any material way in light of increased efforts to control health care spending or otherwise, the amount we may be reimbursed or the demand for our products may decrease.

     The reimbursement of our products by Medicare is subject to review by government contractors that administer payments under federal health care programs, including Durable Medical Equipment Medicare Administrative Contractors, or DMACs, and the Medicare Program Safeguard Contractors, or PSCs.  These contractors are delegated certain authority to make local or regional determinations and policies for coverage and payment of durable medical equipment, or DME, in the home. Adverse interpretation or application of DMAC coverage policies, adverse administrative coverage determinations or changes in coverage policies can lead to denials of our claims for payment and/or requests to recoup alleged overpayments made to us for our products. Such adverse determinations and changes can often be challenged only through an administrative appeals process.

     From time to time, we have been engaged in dialogue with the medical directors of these various contractors in order to clarify the local coverage policy for NPWT, which has been adopted in each of the DMAC regions. In some instances the medical directors have indicated that their interpretation of the NPWT coverage policy differs from ours. Although we have informed the contractors and medical directors of our positions and billing practices, our dialogue has yet to resolve all the open issues. In the event that our interpretation of the NPWT coverage policy in effect at any given time does not prevail, we could be subjected to recoupment or refund of all or a portion of any amounts in question as well as penalties, which could exceed our related revenue reserves, and could negatively impact our V.A.C. Medicare revenue. Although difficult to predict, we believe the reimbursement issues that continue to be discussed with the contractors and their medical directors relate to approximately 1% of our total revenue for 2006.

     In addition, the current NPWT coverage policy instructs the DMACs to initially deny payment for any Medicare V.A.C. placements that have extended beyond four months in the home; however, the policy allows for us to appeal such non-payment on a claim-by-claim basis. We currently have approximately $17.4 million in outstanding receivables from the Centers for Medicare and Medicaid Services, or CMS, relating to Medicare V.A.C. placements that have extended beyond four months in the home, including both unbilled items and claims where coverage or payment was initially denied. We are in the process of submitting all unbilled claims for payment and appealing the remaining claims through the appropriate administrative appeals processes necessary to obtain payment. We may not be successful in collecting these amounts. Further changes in policy or adverse determinations may result in increases in denied claims and outstanding receivables. In addition, if our appeals are unsuccessful and/or there are further policy changes, we may be unable to continue to provide the same types of services that are represented by these disputed types of claims in the future.

Medicare approval of, and assignment of billing codes to, products that compete with our V.A.C. products could reduce the reimbursement we receive for and adversely affect the demand for our products.

     From time to time, CMS publishes reimbursement policies and rates that may unfavorably affect the reimbursement and market for our products. In the past, our V.A.C. Therapy systems and disposables were the only devices assigned to the CMS reimbursement codes for NPWT. Beginning in 2005, CMS has assigned the same NPWT reimbursement codes to other devices being marketed to compete with V.A.C. Therapy systems. As a result of recent CMS decisions we are experiencing increased development of products designed to compete with V.A.C. Therapy. Also, in part due to this new competition, CMS may reduce reimbursement rates on NPWT or its various components and we are receiving increased inquiries from other third-party payers regarding reimbursement levels, all of which may reduce revenue. Either increased competition or reduced reimbursement could materially and adversely affect our business and operating results.

     The assignment of CMS reimbursement codes to competing products also increases the likelihood of our V.A.C. products being subjected to the initial phases of Medicare competitive bidding, which could negatively impact KCI’s revenue from products that are reimbursed by Medicare in the homecare setting. Any declines in Medicare reimbursement could materially and adversely affect our business.  If KCI’s products are included in the competitive bidding process and KCI elects to participate in the program, prices reimbursed by Medicare in the homecare setting could be negatively impacted.  The competitive bidding process could also limit customer access to KCI’s homecare products.

Reimbursement changes applicable to facilities, such as hospitals and skilled nursing facilities, that purchase our products could reduce the reimbursement we receive for and adversely affect the demand for our products.

     In April 2006, CMS issued a notice of proposed rulemaking, which includes the first significant changes to the Inpatient Prospective Payment System, or IPPS, since its implementation in 1983. The IPPS is the Medicare payment system for inpatient hospital services. Under this proposal, CMS would assign payment values for most inpatient hospital services in a manner that is based on weighted averages of national hospital costs for providing the services, rather than the current method, which is based on a weighted average of hospital charges for such services. The resulting changes, if enacted as proposed, could place downward pressure on prices paid by acute care hospitals to KCI for our products used for inpatient services.

The initiation by government agencies of periodic inspections, assessments or studies of the products, services and billing practices we provide with respect to Medicare and Medicaid patients could lead to reduced reimbursement for our products or result in material refunds, recoupments or penalties for past billings.

     Due to the increased scrutiny and publicity of increasing health care costs, we may be subject to future assessments or studies by CMS, FDA, or other agencies, which could lead to other changes in reimbursement policies that adversely affect our business. In this regard, we were informed in November 2004 that CMS intended to evaluate the clinical efficacy, functionality and relative cost of the V.A.C. Therapy system and a variety of other medical devices to determine whether they should be included in a competitive bidding process. The results of this assessment could potentially be used by CMS or other payers as a basis to reduce pricing or reimbursement for the V.A.C., which would have an adverse impact on our financial condition and results of operations.

     The Office of the Inspector General, or OIG, of the Department of Health & Human Services, or HHS, initiated a study on NPWT for 2006.  The OIG Office of Evaluations and Inspections evaluates effectiveness and efficiency of a wide range of programs of HHS.  We have participated in similar studies in the past on other product lines.  As part of the current study, the OIG requested copies of our billing records for Medicare V.A.C. placements.  KCI submitted all copies as requested and plans to cooperate fully with any and all future requests associated with these evaluations.  In the event we are unable to satisfy the OIG in connection with this study, our prior billings could be subject to claims audits, which could result in further audits and/or demands by third-party payers for refunds or recoupments of amounts previously paid to us.  The results of this study could also factor into future federal reimbursement for our products, including determinations of the inherent reasonableness of our V.A.C. pricing and to what extent our V.A.C. Therapy will be subject to the competitive bidding process, as well as other Medicare and third-party payer determinations on coverage or reimbursement.

The focus on DME in certain governmental work plans for 2007 and beyond could lead to reduced reimbursement for our products or result in material refunds, recoupments or penalties for past billings.

     The most recent publication of the OIG’s Work Plan for 2007 includes several projects that could affect our business. Specifically, the OIG has indicated that it plans to review DME suppliers’ use of certain claims modifiers to determine whether the underlying claims made appropriate use of such modifiers when billing to Medicare. Under the Medicare program, a DME supplier may use these modifiers to indicate that it has the appropriate documentation on file to support its claim for payment. Upon request, the supplier may be required to provide this documentation; however, recent reviews by DMACs and PSCs have indicated that some suppliers have been unable to furnish this information. In addition, the 2007 Work Plan provides that the OIG intends to determine the appropriateness of Medicare payments for certain DME items, including wound care equipment, by assessing whether the suppliers’ documentation supports the claim, whether the item was medically necessary, and/or whether the beneficiary actually received the item.  In the event that these initiatives result in any assessments respecting KCI claims, we could be subject to material refunds, recoupments or penalties.

We may be subject to claims audits that could harm our business and financial results.

     As a health care supplier, we are subject to claims audits by government regulators and private payers.  We are subject to extensive government regulation, including laws regulating reimbursement under various government programs. Our documentation, billing and other practices are subject to scrutiny by regulators, including claims audits. To ensure compliance with Medicare regulations, the DMACs and other government contractors periodically conduct audits of billing practices and request medical records and other documents to support claims submitted by us for payment of services rendered to our customers.  Also, our agreements with private payers commonly provide that payers may conduct claims audits to ensure that our billing practices comply with their policies. These audits can result in delays in obtaining reimbursement, denials of claims, or demands for significant refunds or recoupments of amounts previously paid to us.

We could be subject to governmental investigations regarding the submission of claims for payment for items and services furnished to federal and state health care program beneficiaries.

     There are numerous rules and requirements governing the submission of claims for payment to federal and state health care programs.  In many cases, these rules and regulations are not very clear and have not been interpreted on any official basis by government authorities.  If we fail to adhere to these requirements, the government could allege we are not entitled to payment for such claims, and may seek to recoup past payments made.  Governmental authorities could also take the position that claims we have submitted for payment violate the federal False Claims Act.  The recoupment of alleged overpayments and/or the imposition of penalties or exclusions under the federal False Claims Act or similar state provisions could result in a significant loss of reimbursement and may have a material adverse effect on our operating results.  Even if we were ultimately to prevail, an investigation by governmental authorities of the submission of widespread claims in non-compliance with applicable rules and requirements could have a material adverse impact on our business as the costs of addressing such investigations can be significant.

We could be subject to governmental investigations under the Anti-Kickback Statute, the Stark Law, the federal False Claims Act or similar state laws with respect to our business arrangements with prescribing physicians and other health care professionals.

     The federal government has significantly increased investigations of medical device manufacturers with regard to alleged kickbacks and other forms of remuneration to physicians who use and prescribe their products.  Such investigations often arise based on allegations of violations of the federal Anti-Kickback Statute, which prohibits the offer, payment solicitation or receipt of remuneration of any kind if even one purpose of such remuneration is to induce the recipient to use, order, refer, or recommend or arrange for the use order or referral of any items or services for which payment may be made in whole or in part under a federal or state health care program.  A number of states have passed similar laws, some of which apply even more broadly than the federal statute because they are not limited to federal or state reimbursed items or services and apply to items and services that may be reimbursed by any payer.

     Federal authorities have also increased enforcement with regard to the federal physician self-referral and payment prohibitions, commonly referred to as the Stark Law.  If any of our business arrangements with physicians who prescribe our DME homecare products for Medicare or Medicaid beneficiaries are found not to comply the Stark Law, the physician is prohibited from ordering Medicare or Medicaid covered DME from us, and we may not present a claim for Medicare or Medicaid payment for such items.  Reimbursement for past orders from such a physician could also be subject to recoupment.

     We have numerous business arrangements with physicians and other potential referral sources, including but not limited to arrangements whereby physicians provide clinical research services to KCI, serve as consultants to KCI, or serve as speakers for training, educational and marketing programs provided by KCI.  Many of these arrangements involve payment for services or coverage of, or reimbursement for, common business expenses (such as meals, travel and accommodations) associated with the arrangement.  Governmental authorities could attempt to take the position that one or more of these arrangements, or the payments or other remuneration provided thereunder, violates the Anti-Kickback Statute, the Stark Law or similar state laws.  In addition, if any of our arrangements were found to violate such laws, federal authorities or whistleblowers could take the position that our submission of claims for payment to a federal health care program for items or services realized as a result of such violations also violate the federal False Claims Act.  Imposition of penalties or exclusions for violations of the Anti-Kickback Statute, the Stark Law or similar state laws could result in a significant loss of reimbursement and may have a material adverse effect on our financial condition and results of operations.  Even the assertion of a violation under any of these provisions could have a material adverse effect on our financial condition and results of operations.

We could be subject to increased scrutiny in states where we furnish items and services to Medicaid beneficiaries that result in refunds or penalties.

     Recent federal cuts to state administered health care programs, particularly Medicaid, have also increased enforcement activity at the state level under both federal and state laws.  In July 2006, CMS released its initial comprehensive Medicaid Integrity Plan, a national strategy to detect and prevent Medicaid fraud and abuse.  This new program will work to identify, recover and prevent inappropriate Medicaid payments through increased review of suppliers of Medicaid services.  KCI could be subjected to such reviews in any number of states.  Such reviews could result in demands for refunds or assessments of penalties against KCI, which could have a material adverse impact on our financial condition and results of operations.

Failure of any of our randomized and controlled studies or a third-party study or assessment to demonstrate V.A.C. Therapy's clinical efficacy may reduce physician usage or put pricing pressures on V.A.C. and cause our V.A.C. Therapy revenue to decline.

     For the past several years, we have been conducting a number of clinical studies designed to test the efficacy of V.A.C. Therapy across targeted wound types.  A successful clinical trial program is necessary to maintain and increase sales of V.A.C. Therapy products, in addition to supporting and maintaining third-party reimbursement of the product in the United States and abroad, particularly in Europe and Canada.  If, as a result of poor design, implementation or otherwise, a clinical trial conducted by us or others fails to demonstrate statistically significant results supporting the efficacy or cost effectiveness of V.A.C. Therapy, physicians may elect not to use V.A.C. Therapy as a treatment in general, or for the type of wound in question.  Furthermore, in the event of an adverse clinical trial, V.A.C. Therapy may not achieve "standard-of-care" designations for the wound types in question, which could deter the adoption of V.A.C. Therapy in those wound types or others.  If we are unable to develop a body of statistically significant evidence from our clinical trial program, whether due to adverse results or the inability to complete properly designed studies, domestic and international public and private payers could refuse to cover V.A.C. Therapy, limit the manner in which they cover V.A.C. Therapy, or reduce the price they are willing to pay or reimburse for V.A.C. Therapy.

Because we depend upon a limited group of suppliers and, in some cases, exclusive suppliers for products essential to our business, we may incur significant product development costs and experience material delivery delays if we lose any significant supplier, which could materially impact our rental and sales of V.A.C. Therapy systems and disposables.

     We obtain some of our finished products and components from a limited group of suppliers.  In particular, we rely exclusively on Avail Medical Products, Inc. for the manufacture and packaging of our V.A.C. disposables.  V.A.C. Therapy cannot be administered without the appropriate use of our V.A.C. units in conjunction with the related V.A.C. disposables.  Total V.A.C. rental and sales revenue represented approximately 78% of our total revenue for the year ended December 31, 2006, of which sales of V.A.C. disposables represented approximately 23%.  Accordingly, a disruption in the supply of V.A.C. disposables resulting in a shortage of disposables would inevitably cause our revenue to decline and, if material or continued, a shortage may also reduce our market position.

     We have a long-term evergreen supply agreement with Avail through October 2009, which automatically extends for additional twelve-month periods in October of each year, unless either party gives notice to the contrary.  We require Avail to maintain duplicate manufacturing facilities, tooling and raw material resources for the production of our disposables in different locations to decrease the risk of supply interruptions from any single Avail manufacturing facility.  However, should Avail or Avail’s suppliers fail to perform in accordance with their agreement and our expectations, our supply of V.A.C. disposables could be jeopardized, which could negatively impact our V.A.C. revenue.  The terms of the supply agreement provide that key indicators be provided to us that would alert us to Avail's inability to perform under the agreement. We maintain an inventory of disposables sufficient to support our business for approximately seven weeks in the United States and nine weeks in Europe.  However, in the event that we are unable to replace a shortfall in supply, our revenue could be negatively impacted in the short term.

     Avail relies exclusively on Foamex International, Inc. for the supply of foam used in the V.A.C. disposable dressings.  We also contract exclusively with Noble Fiber Technologies, LLC for the supply of specialized silver-coated foam for use in our line of silver dressings.  In the event that Foamex or Noble experiences manufacturing interruptions, our supply of foam or silver V.A.C. dressings could be jeopardized.  We are in the process of identifying other suppliers that could provide inventory to meet our needs in the event that our existing suppliers are unable to fulfill our requirements for V.A.C. disposables.  If we are required but unable to timely procure alternate sources for these components at an appropriate cost, our ability to obtain the raw material resources required for our V.A.C. disposables could be compromised, which would have a material adverse effect on our entire V.A.C. Therapy business.

We are exposed to fluctuations in currency exchange rates that could negatively affect our operating results.

     Because a significant portion of our business is conducted outside the United States, we face exposure to adverse movements in foreign currency exchange rates related to the value of the U.S. dollar. While we enter into foreign exchange forward contracts designed to reduce the short-term impact of foreign currency fluctuations, we cannot fully eliminate the risk, which may adversely affect our expected results.

Changes in effective tax rates or tax audits could adversely affect our results.

     Our effective tax rates could be adversely affected by earnings being lower than anticipated in countries where we have lower statutory rates and higher than anticipated in countries where we have higher statutory rates, by changes in the valuation of our deferred tax assets and liabilities, or by changes in tax laws, regulations, accounting principles or interpretations thereof.  In addition, we are subject to the continuous examination of our income tax returns by the Internal Revenue Service and other tax authorities, which, if adversely determined could negatively impact our operating results.

If we fail to comply with the extensive array of laws and regulations that apply to our business, we could suffer civil or criminal penalties or be required to make significant changes to our operations that could reduce our revenue and profitability.

      We are required to comply with extensive and complex laws and regulations at the federal, state and local government levels relating to among other things:

     -  billing practices;
     -  product pricing and price reporting;
     -  quality of medical equipment and services and qualifications of personnel;
     -  confidentiality, maintenance and security of patient medical records;
     -  marketing and advertising, and related fees and expenses paid; and
     -  business arrangements with other providers and suppliers of health care services.

     In this regard, the Health Insurance Portability and Accountability Act of 1996, or HIPAA, defines two new federal crimes: (i) healthcare fraud and (ii) false statements relating to healthcare matters, the violation of which may result in fines, imprisonment, or exclusion from government health care programs.  Further, under separate statutes, submission of claims for payment or causing such claims to be submitted that are "not provided as claimed" may lead to civil monetary penalties, criminal fines and imprisonment, and/or exclusion from participation in Medicare, Medicaid and other federally funded state health programs.  We are subject to numerous other laws and regulations, the application of which could have a material adverse impact on our operating results.

We are subject to regulation by the FDA and its foreign counterparts that could materially reduce the demand for and limit our ability to distribute our products and could cause us to incur significant compliance costs.

     Substantially all of our products are subject to regulation by the FDA and its foreign counterparts. Complying with FDA requirements and other applicable regulations imposes significant costs and expenses on our operations. If we fail to comply with applicable regulations, we could be subject to enforcement sanctions, our promotional practices may be restricted, and our marketed products could be subject to recall or otherwise impacted. In addition, new FDA guidance and new and amended regulations that regulate the way we do business may occasionally result in increased compliance costs. Recently, the FDA published notice of its intent to implement new dimensional requirements for hospital bed side rails that may require us to change the size of openings in new side rails for some of our surface products. Over time, related market demands might also require us to retrofit products in our existing rental fleet, and more extensive product modifications might be required if FDA decides to eliminate certain exemptions in their proposed guidelines. Regulatory authorities in Europe and Canada have also recently adopted the revised standard, IEC 60601, requiring labeling and electro-magnetic compatibility modifications to several product lines in order for them to remain state-of-the-art. Listing bodies in the U.S. are expected to adopt similar revised standards in 2010. Each of these revised standards will entail increased costs relating to compliance with the new mandatory requirements that could adversely affect our operating results.

If our future operating results do not meet our expectations or those of the equity research analysts covering us, the trading price of our common stock could fall dramatically.

     We have experienced and expect to continue to experience fluctuations in revenue and earnings for a number of reasons, including:

     -  the level of acceptance of our V.A.C. Therapy systems by customers and physicians;
     -  the type of indications that are appropriate for V.A.C. Therapy and the percentages of wounds that are good
        candidates for V.A.C. Therapy;
     -  third-party government or private reimbursement policies with respect to V.A.C. Therapy and competing products;
     -  clinical studies that may be published regarding the efficacy of V.A.C. Therapy, including studies published
        by our competitors in an effort to challenge the efficacy of the V.A.C.;
     -  developments or any adverse determination in our pending litigation; and
     -  new or enhanced competition in our primary markets.

     We believe that the trading price of our common stock is based, among other factors, on our expected rates of growth in revenue and earnings per share. If we are unable to realize growth rates consistent with our expectations or those of the analysts covering us, we would expect to realize a decline in the trading price of our stock. Historically, domestic V.A.C. unit growth has been somewhat seasonal with a slowdown in V.A.C. rentals beginning in the fourth quarter and continuing into the first quarter, which we believe is caused by year-end clinical treatment patterns. The adverse effects in our business arising from seasonality may become more pronounced in future periods as the market for V.A.C. Therapy systems matures and V.A.C. Therapy growth rates decrease.

     Because our staffing and operating expenses are based on anticipated revenue levels, and because a high percentage of our costs are fixed, decreases in revenue or delays in the recognition of revenue could cause significant variations in our operating results from quarter to quarter. In the short term, we do not have the ability to adjust spending in a time-effective manner to compensate for any unexpected revenue shortfall, which also could cause a significant decline in the trading price of our stock.

Risks Related to Our Capital Structure

Our indebtedness could adversely affect our financial condition.

     As of December 31, 2006, we had $208.2 million of outstanding indebtedness and shareholders' equity of $356.2 million. This level of indebtedness could have important consequences, including the following:

     -  it may be difficult for us to satisfy our obligations under our senior credit facility and our senior subordinated
        notes;
     -  if we default on our secured debt, these lenders may foreclose on our assets;
     -  we may be less able to obtain other debt or equity financing in the future;
     -  we could be less able to take advantage of significant business opportunities, including acquisitions or
        divestitures;
     -  our vulnerability to general adverse economic and industry conditions could be increased; and we could be at
        a competitive disadvantage compared to competitors with less debt; and
     -  restrictive covenants in our senior credit facility and the indenture governing our senior subordinated notes may
        restrict our ability to pursue our business strategies.

     Our senior credit facility and the indenture governing our senior subordinated notes limit our ability, among other things, to:

     -  incur additional indebtedness or contingent obligations above certain levels;
     -  pay dividends or make distributions to our shareholders;
     -  repurchase or redeem our stock;
     -  make certain investments;
     -  grant liens;
     -  make capital expenditures above certain levels;
     -  enter into transactions with our shareholders and affiliates;
     -  sell assets; and
     -  acquire the assets of, or merge or consolidate with, other companies.

     Our senior credit facility contains financial covenants requiring us to meet certain leverage and interest coverage ratios. Specifically, we are obligated not to permit ratios to fall outside certain specified ranges and maintain minimum levels of EBITDA, as defined in our senior credit agreement.

     We may not be able to maintain these ratios. Covenants in our senior credit facility may also impair our ability to finance future operations or capital needs, or to enter into acquisitions or joint ventures or engage in other favorable business activities.

     If we default under our senior credit facility, we could be prohibited from making any payments on our senior subordinated notes. In addition, the lenders under our senior credit facility could require immediate repayment of the entire principal then outstanding. If those lenders require immediate repayment, we may not be able to repay them and also repay our senior subordinated notes in full. If we are unable to generate sufficient cash flow or otherwise obtain funds necessary to make required payments under our senior credit facility, or if we are unable to maintain the financial ratios under our senior credit facility, we will be in default under our senior credit facility, which could, in turn, cause a default under our senior subordinated notes, the related indenture and any other debt obligations that we may incur from time to time.

Our obligations under our senior credit facility are secured by substantially all of our assets.

     Our obligations under our senior credit facility are secured by liens on substantially all of our assets, and the guarantees of certain of our subsidiaries under our senior credit facility are secured by liens on substantially all of such subsidiaries' assets. If we become insolvent or are liquidated, or if payment under our senior credit facility or of other secured obligations are accelerated, the lenders under our senior credit facility or the obligees with respect to the other secured obligations will be entitled to exercise the remedies available to a secured lender under applicable law and the applicable agreements and instruments, including the right to foreclose on all of our assets.

Our articles of incorporation, our by-laws and Texas law contain provisions that could discourage, delay or prevent a change in control or management.

     Our articles of incorporation and by-laws and Texas law contain provisions which could discourage, delay or prevent a third-party from acquiring shares of our common stock or replacing members of our Board of Directors. These provisions include:

     -  authorization of the issuance of preferred stock, the terms of which may be determined at the sole discretion of the
        Board of Directors;
     -  establishment of a classified Board of Directors with staggered, three-year terms;
     -  provisions giving the Board of Directors sole power to set the number of directors;
     -  limitations on the ability of shareholders to remove directors;
     -  requirements for the approval of the holders of at least two-thirds of our outstanding common stock to amend our
        articles of incorporation;
     -  authorization for our Board of Directors to adopt, amend or repeal our by-laws;
     -  limitations on the ability of shareholders to call special meetings of shareholders; and
     -  establishment of advance notice requirements for presentation of new business and nominations for election to the
        Board of Directors at shareholder meetings.

     In addition, under Texas law and our articles of incorporation and our by-laws, action may not be taken by less than unanimous written consent of our shareholders unless the Board of Directors has recommended that the shareholders approve such action.  The limitation on the ability of shareholders to call a special meeting, to act by written consent and to remove directors may make it difficult for shareholders to remove or replace the Board of Directors should they desire to do so.  These provisions could also delay or prevent a third-party from acquiring us, which could cause the market price of our common stock to decline.

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ITEM 1B.     UNRESOLVED STAFF COMMENTS

      None.

ITEM 2.     PROPERTIES

     We lease approximately 156,400 square feet at our corporate headquarters building in San Antonio, Texas, the majority of which is leased under a 10-year lease that expires in 2012.  We also lease approximately 35,300 square feet in adjacent buildings that are used for general corporate purposes, and approximately 88,500 square feet of office space in San Antonio for our customer service center.  In addition, in February 2004 and February 2005, we entered into 99‑month leases for approximately 80,400 and 80,200 square feet of office space in San Antonio to be used as our research and development and medical facility and for general corporate purposes, respectively.

     We conduct domestic manufacturing, shipping, receiving, engineering and storage activities in a 171,100 square foot facility in San Antonio, Texas, which we purchased in January 1988, and an adjacent 32,600 square foot facility purchased in 1993.  Our operations are conducted with approximately 75% cumulative utilization of plant and equipment. We also lease two storage facilities in San Antonio.  We lease approximately 141 domestic service centers, including each of our five regional headquarters.

     Internationally, we lease 67 service centers. Our international corporate office is located in Amsterdam, the Netherlands.  International manufacturing and engineering operations are based in the United Kingdom and Belgium.  The United Kingdom plant is approximately 24,800 square feet, and the Belgium plant is approximately 19,600 square feet.  These plants operate with 100% cumulative utilization of plant and equipment.

     We believe that our current facilities will be adequate to meet our needs for 2007.

     The following is a summary of our primary facilities:

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ITEM 3.     LEGAL PROCEEDINGS

     In 2003, KCI and its affiliates, together with Wake Forest University Health Sciences, filed a patent infringement lawsuit against BlueSky Medical Group, Inc., Medela, Inc. and Medela AG in the United States District Court for the Western District of Texas, San Antonio Division alleging infringement of three V.A.C. patents and related claims arising from the manufacturing and marketing of a pump and dressing kits by BlueSky.  On August 3, 2006, the jury found that the Wake Forest patents involved in the litigation were valid and enforceable.  The jury also found that the patent claims involved in the case were not infringed by the Versatile 1 system marketed by BlueSky.  All parties in the case have filed motions for a new trial challenging various aspects of the case.  As a result of post-trial challenges and appeals, the verdict could be modified, set aside or reversed.  We derived $808.3 million in revenue, or 58.9% of total revenue, for the year ended December 31, 2006 and $706.0 million in revenue, or 58.4% of total revenue, for the year ended December 31, 2005 from our domestic V.A.C. Therapy products relating to the patents at issue.

     We are a 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.

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ITEM 4.     SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

     None.

PART II

ITEM 5.     MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED SHAREHOLDER MATTERS
                    AND ISSUER PURCHASES OF EQUITY SECURITIES

(a)     Our common stock has traded on the New York Stock Exchange under the symbol "KCI" since February 24, 2004, the date of our initial public offering. The following table sets forth, for the periods indicated, the high and low sales prices for our common stock as reported by the New York Stock Exchange:

    On February 20, 2007, the last reported sale price of our common stock on the New York Stock Exchange was $50.27 per share.  As of February 20, 2007, there were approximately 146 shareholders of record of our common stock.

     We do not currently pay cash dividends on our common stock. Any future payment of cash dividends on our common stock will be at the discretion of our Board of Directors and will depend upon our results of operations, earnings, capital requirements, contractual restrictions and other factors deemed relevant by our board.  Our Board of Directors currently intends to retain any future earnings to support our operations and to finance the growth and development of our business and does not intend to declare or pay cash dividends on our common stock for the foreseeable future.  In addition, our senior credit agreement and the indenture governing our senior subordinated notes limit our ability to declare or pay dividends on, or repurchase or redeem, any of our outstanding equity securities.  For more information regarding the restrictions under our Senior Credit Agreement and Indenture, see "Management’s Discussion & Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources—Debt Service."

(b)     None
(c)     Purchases of Equity Securities by KCI (in thousands, except per share amounts)

STOCK PERFORMANCE GRAPH

     The following graph shows the change in our cumulative total shareholder return since our common stock began trading on the New York Stock Exchange on February 24, 2004 based upon the market price of our common stock, compared with: (a) the cumulative total return on the Standard & Poor’s 500 Large Cap Index and (b) the Standard & Poor’s Healthcare Equipment Index. The graph assumes a total initial investment of $100 as of February 24, 2004, and shows a "Total Return" that assumes reinvestment of dividends, if any, and is based on market capitalization at the beginning of each period. The performance on the following graph is not necessarily indicative of future stock price performance.

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