Medical Device Link.

Originally Published MX March/April 2005

COVER STORY

Interview by Steve Halasey

When Dennert O. Ware joined Kinetic Concepts Inc. (KCI; San Antonio, TX) in 2000 as president and CEO, the once-public company was under private management, having been taken out of the public market through a 1997 leveraged buyout. A market leader in wound-care therapies and specialty beds designed to promote patient recovery, the company was doing well on entering 2004.

It departed that year doing even better, and enjoying the support and confidence of an investing public that again owns it. KCI issued an initial public offering in February 2004, one of the first of a surge of 18 companies in the medtech sector to do so during a remarkable comeback year for the IPO market.

Dennert O. Ware, president and CEO of Kinetic Concepts Inc., on public investment as an engine of market growth. Photo by J. MICHAEL SHORT

Leading medtech's IPO class of 2004 is KCI. It was by far the largest of the 18, in terms of employees and 2003 revenues. Its public investment venture has been outstanding in terms of its success out of the box, as well. KCI is one of two medtech firms whose share price has gained around 150% in value since issue. While only 7% of the companies that went public in 2004 were in the medtech sector, these two constituted 20% of the top 10 overall performers—in competition with 214 other issues.

Ware has plans for these incoming funds. R&D will be fed generously, and sales and marketing will get what it needs to pursue a larger share of an expanding market. Growing 30% over 2004, the company nearly reached the billion-dollar revenue milestone and expects to leave it considerably in the rearview mirror in 2005.

In this interview with MX editor-in-chief Steve Halasey, Ware discusses the origins of KCI and describes the path he has charted for its future. He touches on questions of KCI's intellectual property portfolio, market position, strategies for adoption and reimbursement, and ongoing product development.

MX: Since it was founded, in 1976, KCI has been in both private and public ownership. How did the company develop in its early years, and what were the drivers for changing the financial structure of the company?

Dennert O. Ware: The company was founded by James Leininger, MD, who headed the emergency room (ER) at Baptist Hospital in San Antonio. He got frustrated losing patients after he would stabilize them from serious trauma such as broken backs and then leave them immobilized. Because of their immobility, some patients would contract nosocomial pneumonia and die.

Dr. Leininger found a bed called the RotoRest that had been designed in Florida, where the rights resided. He bought the rights and started producing beds in his apartment in San Antonio. That was the genesis of the company. Leininger was a practicing physician in the ER, so he would be on 24 hours and off 24 hours. In his off-hours, he would work on building the beds. He found out it was tougher to get into medical devices than he thought. He was spending more money than he was taking in.

The company made some progress in the late 1970s and early 1980s, but it was touch-and-go for a long time. Things turned around in the early 1980s. Dr. Leininger got a couple of breaks and he continued to prosper. He acquired some surfaces for treating first the pulmonary conditions and later the pressure ulcers and wounds that were associated with immobility.

Then, in the mid-1980s, the business started to grow. It grew very rapidly particularly after it moved from a for-sale model to a rental model. Because of the large number of different specialty-bed products he had, and the relatively low frequency of each hospital's need for each type of bed, Leininger found that he had a more efficient distribution system if he would rent them. He set up service centers in individual cities and was able to manage the inventories more efficiently than the hospitals could.

As a result of that, the rental model grew, the company grew, and, in the late 1980s, Dr. Leininger took the company public. It stayed public until 1997 when, with the help of two mid-cap investment houses in San Francisco, Fremont Partners and Blum Capital, the managers took the company private in a leveraged buyout. The company then remained private until we went public last year.

Was it all smooth sailing during that period?

Not quite. In 1994, the company acquired the rights to the vacuum-assisted closure (VAC) technology through a license agreement. VAC is KCI's wound-healing system, which currently makes up approximately two-thirds of the company's revenue and the bulk of our growth. It received clearance for marketing in 1995. From 1995 until 2000, the company built the market primarily in acute care and some in home care. But it did not have specific Medicare codes or a specific negative-pressure wound-therapy coverage policy. Medicare, although it had given early indications that it would pay for the therapy under miscellaneous codes, ended up not paying a substantial portion of those.

The company wrote off about $15 million in losses associated with those Medicare billings in 1999. In October 2000, it did receive Medicare reimbursement, with a specific code for negative-pressure wound therapy and specific reimbursement rates. When that occurred, the business started taking off.

Medicare, of course, is not in the business of approving coverage for new technologies but rather of not approving them until it is satisfied that the therapeutic value of the new technologies warrants approval. When we did receive that approval, it gave a lot of people confidence that this wasn't just an experimental therapy but rather a real therapy that created real value for patients. When that occurred, then the business continued to grow in acute and extended care. But the real dynamic that was interesting was the growth in the home-care market.

The business grew very well in 2001 except that in the home-care market at that time private insurance was done on a case-by-case basis. It is difficult to get paid by insurance companies when you are not on their radar screen and you are not contracted with them. But by early in 2000 we had set up a separate sales force and really worked hard at getting contracted with insurance companies. That has been fairly successful over the past three years. We are very pleased with the position we have today with private insurance. Our business has continued to grow across all three care settings.

What was the rationale for taking the company private again in 1997?

Dr. Leininger wanted to get some liquidity out of the company. He had considered the possibility of selling the company, and the recapitalization provided an opportunity for him to retain a significant amount of ownership of it. At the same time, the investors infused new capital in the company to provide for growth.

You joined KCI in 2000 from Roche Diagnostics, where you were CEO. Did you find a major difference between the sales model of a clinical diagnostic company—which often involves leaseback arrangements and disposables sales—and the rental model used at KCI?

The real change wasn't between the for-sale model and the rental model. The real change was steering KCI from a relatively slow-growth company to a more-rapid-growth company. In 1998 Roche acquired Boehringer Mannheim, which had pioneered the blood glucose self-monitoring business, helping diabetics manage their disease through the guidance of physicians. That transition was really a transformation of the way diabetes is managed by physicians.

For KCI, VAC provided a similar transformation in the way physicians managed the most complicated, most complex, hard-to-heal wounds. The kinds of things we had to think about at KCI were similar to what we had had to think about for diabetes at Roche, with respect to changing the way medicine is practiced, presenting a new technology, and then providing the mechanisms to allow that business to develop.

How did the shift to a rapid-growth model influence your management style and strategies?

Essentially what we did was look at how KCI was run and look at the things that had to change to allow us to capture the opportunity that existed. It meant developing very extensive training programs for nurses and for physicians. It meant changing the distribution capabilities slightly, but really changing the way we managed billing and claims handling, changing the time frame. We had to expand the sales force rather dramatically and still maintain good controls.

So, we had to change many of the mechanisms by which we managed the sales force as we continued to expand it. It was really a change in the dynamic of how the business was run as opposed to worrying about the difference between a rental model and a for-sale model. Looking more at strategic issues than just tactical issues provided us with a longer time frame for our planning horizon.

Intellectual Property

You alluded to KCI's early purchase of the intellectual property (IP) for the RotoRest. Where did the company acquire the IP for its VAC device?

That patent estate actually consists of multiple pieces. But the most important patents came from Wake Forest University.

How has the company's IP held up in court challenges?

A patent challenge in Europe was decided in December 2003. The patents were upheld there. Two minor changes in the patents were made, but we are very pleased with the outcome generally.

Some of the VAC patents expire in 2010, while others don't expire until 2013. That gives KCI quite a head start to continue penetrating the market. How do you feel about the company's IP position going forward from those dates? Are you continuing to develop the intellectual property?

We have a very broad patent estate covering the existing products. We are continuing to develop new generations of the products, along with new technologies associated with the use of negative pressure and wound therapy. Of course, the IP part of what we are doing is important to us. We think we'll have a good IP position going forward from 2013.

For a company such as KCI, which has developed a strong niche and whose key product has minimal competition, how important is it to have a defensible IP portfolio?

I wouldn't say we have no competition. Considering the treatment of complex wounds, probably 8 million wounds in the market today are moderately complex. These get treated by a whole range of different treatment modalities. In advanced wound care, several major players are offering very sophisticated products.

Where vacuum-assisted closure plays an important role is in the most difficult of those 8 million wounds—about a million, or actually 1.4 million, of the wounds being treated in the United States. So, we do have competitors, but at the very high end of therapeutic difficulty.

Is maintaining KCI's IP position critical to maintaining its market edge?

I think it is something that certainly helps us. Another thing, of course, is that, because VAC has become recognized as the number-one brand in advanced wound care, we have developed a good market position with the product. It is respected as an outstanding therapy. For many physicians it is the therapy of choice for the most difficult wounds. The IP estate certainly is important to us in making sure that that therapy is delivered in the way we know is effective, and that both the product and the protocols we use for treating wounds with VAC are well established. When the protocols are adhered to, the product will give excellent results.

Market Size

You recently commissioned a study on the potential market for VAC and discovered that it was larger than you thought it might be.

Potentially 40% larger.

When we started in 2000, just before we got a Medicare code and established the Medicare policy, we did do a review. We hired a third-party consultant to help us size the market. At that time we believed there were probably just under a million wounds a year in the United States that should be treated by VAC. During the next four years, we saw some evidence that our penetration was doing a little better than we expected, in terms of both the number of patients with wounds and some of the indications for wounds.

In mid-2004, we brought that same consultant back for discussion, and we worked at reassessing the market potential. We looked at a couple of hundred peer-reviewed journal articles. We looked at a lot of databases for billing data on advanced wounds, including common procedural terminology (CPT) codes and diagnostic-related group (DRG) codes. We were looking at both physician billings and hospital billings in order to understand the population of wounds.

Then we interviewed more than 200 physicians and developed specific protocols for treatment patterns covering a broad set of wounds. What came out of that was recognition that there were probably about 1.4 million wounds a year in the United States that could or should be treated with VAC. The potential is probably bigger if you include wounds of slightly lesser severity, but we think that 1.4 million is certainly a very reasonable estimate.

That study reflected only the domestic market. But KCI is also very active internationally. How big is the international marketplace potentially?

We haven't done quite the detailed work because the data for the international markets are a little harder to come by. But, looking at the demographics in Canada and the major countries of Europe, looking at the populations and the portion of the economy that goes to healthcare, we see in Canada and Europe combined a very large market potential. Maybe not quite as big as the United States, but certainly significant. Considering other countries of the world where significant spending is done, probably the most interesting would be Japan. We are working on putting together a strategy to capture that market.

When KCI issued its initial public offering (IPO) in February 2004, it was estimated that the company had penetrated about 25% of the potential market. With your revised appraisal of the market's extent, what do you think your penetration is now?

We don't disclose exactly where we think we are in terms of penetration. But our U.S. revenues last year in VAC were at $563 million. If that market were on the order of $3 billion, or just over $3 billion, based on the 1.4 million wounds that potentially could be treated by VAC, then the number for share would be slightly south of 20%—somewhere in the mid-teens, probably.

That suggests significant growth potential. How well is the company positioned to capture more of the market?

We think we do have good growth potential. We continue to expand our sales force. We continue to invest in marketing, and we continue to invest in R&D and in clinical research. We are spending money in the areas that will help us sustain growth well into the future.

Reimbursement

Obtaining reimbursement coverage must be a major element in increasing the adoption rate for the VAC system. What did KCI do to support the effort to get reimbursement coverage approval?

We did a couple of things. First, back in 2000, in order to get Medicare Part B reimbursement, we submitted about a thousand cases to Medicare showing the efficacy of VAC on patients it covered. Also, a considerable number of physicians wrote to Medicare supporting VAC and explaining why it was an important tool for them in dealing with the most difficult wounds. We have continued to track data and report summaries of those data to Medicare. We have also established a prospective random-controlled trial program for various wound indications. Ten random-control studies are currently under way. We will continue to invest in this kind of clinical research.

How important was it that KCI was able to demonstrate not only the clinical efficacy of the VAC system but also its cost-effectiveness?

The most important thing is that we are able to care for patients and provide real patient solutions. There is a lot of concern about new medical technologies that use more money than they save, but quite a bit of evidence now shows that VAC is not only clinically effective, but reduces complications and, in some cases, reduces the length of treatment. When you look at all the different ways money is spent on dealing with complex wounds, VAC proves to be a cost-effective tool. I think that is a real plus.

Are you concerned about some of the suggestions for handling Medicare pricing, such as competitive bidding?

The U.S. economy, like other major economies in the world, is spending an increasing amount of money on healthcare, and society as a whole has to bear that burden. I think VAC plays a very interesting role—and an important role—in that it not only provides excellent clinical effectiveness but also does it at lower cost than other kinds of modalities, particularly with difficult wounds involving a lot of complications that require additional surgeries, hospital readmits, or other procedures to deal with them fully. Because VAC does a great job there, it is something that helps mitigate the general healthcare cost problem.

So, as long as you are able to demonstrate cost-effectiveness, then measures such as competitive bidding never really come into play?

Well, it is hard to say exactly what will happen in the regulatory world. The competitive bidding guidelines that have come out in the past year show that the Centers for Medicare and Medicaid Services (CMS) is working on a list of products in order to determine how to get the most bang for the buck in competitive bidding. At some point, I think we are going to see things like home-care hospital beds get on that list. Our job is to make sure we are doing the best with what we have today, and I think we are doing that.

How do you manage the reimbursement part of your business? Do you have a large group of reimbursement specialists? Do you outsource a lot of the work to clinical research organizations or reimbursement consulting firms?

We have a very competent group of people who, with the assistance of a clinical advisory panel, design our clinical research program. We certainly do work with many institutions in actually doing the research, but their work is conducted according to our specifications. We appreciate very much the support we are getting from the medical community, from people sitting on the panels and helping to guide us.

The most important thing is that we are able to care for patients and provide real patient solutions. Photo by J. MICHAEL SHORT

Working with Physicians

Because of the nature of the wound-care field, does KCI work with physicians from a lot of specialties?

Absolutely. When we started out and were trying to determine who saw the most wounds, who had the most experience there and stood to benefit the most, we worked initially with reconstruction-oriented plastic surgeons and trauma-oriented orthopedists in the acute-care environment. Also, we spent a lot of time working with podiatrists in the home-care environment, who see and treat the bulk of the diabetic foot ulcers. But in the past couple of years we have expanded that. We see a lot of thoracic surgeons and general surgeons. We see some primary-care physicians who deal with pressure ulcers and diabetic foot ulcers in the home-care market.

Then there are a lot of physicians who specialize primarily in wounds; we see them at wound-care clinics around the country. So, though the number of specialties has certainly increased, there tend to be physicians within each specialty who see more of the difficult wounds because they have learned how to handle them. These are the people we try to see, regardless of their specialty.

Do you have a clinical advisory board to which doctors who you are working with actively contribute?

We do. We have a very active clinical advisory panel made up primarily of physicians. Our in-house medical director is a physician. And a small number of physicians who work with us in the field are full-time employees who tend to be available to the sales force to help educate them, particularly with respect to some of the more difficult wounds.

Medical device salespeople work with physicians much more closely than their counterparts in pharmaceutical companies. How important is your sales force for gathering customer feedback and contributing to future product development? How do you structure those relationships, and how do you maintain control of them?

You have to think in terms of who are the people that influence the decision to use VAC. A physician writes the prescription, but it is also important for the nurses who are going to be using it to understand VAC technology. Many times, particularly early on as we were getting into this business, it was the enterostomal therapy nurses who managed wounds in acute care and saw the need for VAC in difficult cases who would say to the physicians, "Gee, here is a new technology you should be thinking about for a case like this." The physician would think about it and often would write a prescription.

As we developed the home-care market, we had to educate a lot of nurses associated with home health agencies. We established a very aggressive program for educating nurses there.

In the hospitals we do a lot of in-service. We are able to do that because of the structure of our sales force. A significant portion of our sales organization is made up of account executives, but another big block of them are clinical consultants. These clinical consultants are predominantly registered nurses who have wound-care or other clinical experience. They are out in the field educating nurses.

In addition, we have a speakers bureau of physicians so that we can hold meetings with physicians in groups and educate them on a peer-level basis. Educating a lot of physicians and a lot of nurses has helped make our enterprise very successful.

KCI has adopted an extensive set of personnel guidelines. How do KCI's practices compare with the AdvaMed code of ethics?

We are very strong supporters of AdvaMed. I have been on the board of AdvaMed for several years. The code of ethics that AdvaMed published, which went into effect about a year ago, is a terrific set of standards for people. It is not the only set of standards that we have, but we rely on that code of ethics for part of the principles by which we operate.

In addition to that, this company has a set of core values that are very much patient focused. We also have operating policies and guidelines that govern specific behaviors of not only our field sales force but our field service force as well.

Does it bother you that the well-publicized misbehavior in the pharmaceutical industry sometimes also reflects badly on the device industry?

I think it is important for each company in the healthcare field to recognize its responsibility to the patient. The core values of KCI, initially driven by a physician focused on patient care in Dr. Leininger, recognize that.

I think there will always be incidents in a large company where somebody makes a mistake. But the real question is, how do you deal with that? We have a very strong training program, a strong set of operating guidelines, and a strong ethics policy that is the AdvaMed policy. But a lot of different forces have to be brought into play in this area. It really boils down to people wanting to do a good job, and keeping an ethical umbrella over organizational pressures to execute on business plans.

IPO and After

Since issuing its IPO last February, KCI has outperformed all of the analysts' projections. And the company has projected that it will exceed $1 billion in revenues next year, with 21–26% growth. So how does all that revenue get spent? For instance, does the company have any debt remaining from the 1997 leveraged buyout?

Yes, we still have debt. We have done a very good job of paying it down, however. I think we paid well over $200 million against debt in 2004, about $100 million of that coming from the IPO. The rest came from balance sheet cash. Our leverage ratio—the ratio of total debt to EBITDA (earnings before interest, tax, depreciation, and amortization)—is now below 2x. Also, as far as the future is concerned, we have indicated that excess cash flow in the near term would be used to reduce debt.

We still have a long way to go. Nevertheless, we think we are certainly able to manage very well for years the debt level that we have now. We were once at much higher levels. I think that the investment community is comfortable with our financial strategy. It appears to be quite comfortable with our financial performance.

KCI's reported 2004 earnings per share (EPS) is down somewhat from the previous year, so the company's incoming funds presumably are not yet being given over to earnings. Is the company investing in its R&D pipeline the way it is in sales and marketing staff?

Looking at EPS on a recurring basis—that is, when the financial transaction costs and the benefit we got from a recent lawsuit where the award was fairly significant for us are canceled out—then EPS has been continuing to grow in a very steady way.

But we do invest fairly significantly in the areas of sales force expansion, marketing, R&D, and clinical support. We spend a reasonably high amount of money on capital equipment every year. Our rental pool is capitalized such that changes to the rental pool go into capital investment. We continue to invest in information technology in order to run the business as it grows. But those capital expenses are very much in line with how we ran the business in the past. I think that we have described that quite well for the investment community.

Is the company's investment in sales and marketing essential because of the rental market model?

This model has worked very well for us. It certainly is a service-driven business. As a result of that, our people have become a very important part of the business to focus on.

KCI's wound-care surfaces business has slower growth than the company's VAC business. Do you see growth potential in the surfaces market? If so, is KCI actively investing to capture that potential?

The surfaces business is really divided into three groups: wound-care surfaces, bariatrics, and pulmonary care at the intensive-care unit (ICU). We do see growth opportunities in bariatrics and in the ICU.

Last year we introduced a product called RotoProne, which can revolutionize treatment of prone patients, particularly those suffering from acute respiratory distress syndrome or acute lung injury. We think this product represents a growth opportunity because it provides a therapy that otherwise requires a lot of manual labor. It makes standardizing protocols much easier. Also, it makes it easier for the floor nurses to manage these patients. We invested in that product because we think we can do patients a lot of good and make work easier for the nursing staff at the same time.

In terms of R&D investment, do the surfaces businesses get about the same as or less than the VAC business? How do you sort out the priorities?

Because VAC is bigger and growing faster, it should and does get more attention with respect to R&D than surfaces. But there are important changes that have to be made as we update the existing pool of products we have on the surface side. We've seen certain opportunities because of our experience, and have been able to do a wonderful job in offering new therapies in surfaces. RotoProne is an example. We have a second therapy in neural protection that we will be introducing later this year, using some surfaces.

As standards change, we have to go back and redesign products to continually update and improve them. So, we won't be moving away from R&D in that area. But our more intense efforts are certainly in areas where we see the potential for higher growth.

Do you have an internal committee that sorts through and prioritizes proposals for R&D spending?

We have two ways of looking at that. First, strategically, in terms of where we see growth opportunities and in what arenas we want to play. That is part of a standard strategic planning process in which we engage on a regular basis. Then, the execution of that is managed through a separate, multifunctional committee that deals with managing priorities and scheduling projects that are approved for development.

Does this same committee later turn into the product development team, the group that conducts design reviews and so on?

Well, it is broader than that. It includes the marketing people, the market research people, the clinical people, and the regulatory people.

Overall, what percentage of revenues does KCI invest in R&D?

In 2000 we were at about 1.75%. We have been moving that percentage up steadily. We expect to take it into the 4–6% range eventually. Currently, we are at about 3.5%.

How does KCI's product development pipeline look? Is it starting to fill up because of that R&D spending?

We are doing some interesting work in a bunch of areas that we never thought about investigating in the past. We are pleased to be in a position to explore these issues. Certainly, the growth that we have experienced over the past several years came because we delivered good products to people, products that work.

The challenge for us now is to maintain high growth and to make sure we continue to innovate. This company was built on three cornerstones: innovation, improvement of patient outcomes, and contributing to lower total healthcare cost. It is a foundation that has worked very well for us for the past 28 years. We hope it will work well as a basis for going forward.

Regulatory Balance

Do KCI's products face any particular regulatory challenges?

Most of them are 510(k) products, so we have a set of standards to work to. We want to do a fair amount of clinical work to ensure that we claim the product does what it can do, no more and no less.

So, yes, there are certainly regulatory issues that we have to deal with. They tend to be rather straightforward in most cases, but as we move into new kinds of therapies, we have to do a little more work and make sure that we are on very firm ground.

What do you think about FDA's capability to review new products nowadays?

FDA has made great strides in the past few years. Funding for FDA is always a complicated problem for Congress. How the agency uses the resources it gets and how it prioritizes are important and difficult questions. But I think FDA has generally done a really good job. I think the current administration has put some very competent people in charge of FDA, and also CMS.

Regulators have to deal with complicated problems. I think they are always going to be too slow for business, but they have an important job in protecting the public. I believe they are working hard to get that balance in place.

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