[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES

For the fiscal year ended December 31, 1999

[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES

For the transition period from _____________ to ___________

Commission file number 1-9913

KINETIC CONCEPTS, INC.

(Exact name of registrant as specified in its charter)

of registrant's principal executive offices)

Securities registered pursuant to Section 12(b) of the Act: NONE

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

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

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

As of March 1, 2000, there were 70,915,008 shares of the Registrant's Common Stock outstanding, of which 70,515,008 were held by affiliates.

FORM 10-K TABLE OF CONTENTS

TriaDyne®, TriaDyne® II, BariKare®, The V.A.C.®, PlexiPulse®, PlexiPulse All-in-1 System TM, KinAir® III, KinAir® IV, First Step®, FirstStep® Plus, FirstStep® Select, FirstStep® MRS, TheraPulse®, TheraPulse® II, BioDyne®, BioDyne® II, FluidAir® Plus, FluidAir® Elite, FluidAir® II, RotoRest®, Q2 Plus®, HomeKair® DMS, DynaPulse®, FirstStep® TriCell, Impression® SR, RotoRest® Delta, PediDyne®, BariAire®, FirstStep® Select Heavy Duty, FirstStep® Advantage, TriCell®, RIK®, AirWorks® Plus, AirMaxxis™, AtmosAir™, Pulse SC™, Pulse IC™, Extremity Pump Systems®, and ParaDyne™ are trademarks of the Company used in this Report. Kinetic Therapy SM, The Clinical Advantage SM, Genesis SM and Odyssey SM are service marks of the Company used in this Report.

CAUTIONARY STATEMENT FOR PURPOSES OF THE "SAFE HARBOR" PROVISIONS OF THE

PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995

The Private Securities Litigation Reform Act of 1995 provides a "safe harbor" for certain forward-looking statements. The forward-looking statements made in "Business", "Legal Proceedings" and "Management's Discussion and Analysis of Financial Condition and Results of Operations", which reflect management's best judgment based on market and other factors currently known, involve risks and uncertainties. When used in this Report, the words "estimate", "project", "anticipate", "expect", "intend", "believe" and similar expressions are intended to identify forward-looking statements. All of these forward-looking statements are based on estimates and assumptions made by management of the Company, which, although believed to be reasonable, are inherently uncertain. Therefore, undue reliance should not be placed upon such estimates and statements. No assurance can be given that any of such statements or estimates will be realized and actual results will differ from those contemplated by such forward-looking statements.

Kinetic Concepts, Inc. (the "Company" or "KCI") is a worldwide leader in innovative therapeutic systems which prevent and treat the complications of immobility that can result from disease, trauma, surgery or obesity. The Company's clinically effective therapeutic systems include specialty hospital beds, specialty mattress replacement systems and overlays and non-invasive medical devices combined with on-site consultation by the Company's clinically trained staff. The complications of immobility include pressure sores, pneumonia and circulatory problems which can increase patient treatment costs by as much as $75,000 and, if left untreated, can result in death. The Company's therapeutic systems can significantly improve clinical outcomes while reducing the cost of patient care by preventing the onset of complications, accelerating the healing process of complications which have developed and by providing labor savings. The Company has also been successful in applying its therapeutic expertise to bring to market innovative medical devices that treat chronic wounds and help prevent blood clots.

The Company designs, manufactures, markets and services its products, many of which are proprietary. KCI's therapeutic systems are used to treat patients across all health care settings including acute care hospitals, extended care facilities and patients' homes. Health care providers generally prefer to rent rather than purchase the Company's products in order to avoid the ongoing service, storage and maintenance requirements and the high initial capital outlay associated with purchasing such products, as well as to receive the Company's high-quality clinical support. The Company can deliver its therapeutic systems to any major domestic trauma center within four hours of notice through its network of service centers.

Founded by James R. Leininger, M.D., an emergency room physician, to provide better care for his patients, the Company was incorporated in Texas in 1976. The Company's principal offices are located at 8023 Vantage Drive, San Antonio, Texas 78230 and its telephone number is (210) 524-9000.

On November 5, 1997, a substantial interest in the Company was acquired by certain affiliates of Fremont Partners L.P. ("Fremont") and Richard C. Blum & Associates, L.P. ("RCBA"). Fremont, RCBA, Dr. James Leininger and Dr. Peter Leininger own approximately 28.0 million, 18.4 million, 23.6 million and 0.4 million common shares, respectively, representing 39.7%, 26.2%, 33.5% and 0.6% of the total shares outstanding. Members of management have retained, and have been granted, additional options to purchase shares.

Through July 1999, the Company had three operating divisions: KCI USA, Inc. ("KCI USA" or "KCTS"), KCI International, Inc. ("KCI International") and KCI New Technologies, Inc. ("NuTech"). On August 1, 1999, NuTech merged into KCI Licensing, which transferred NuTech's assets to KCTS.

KCI USA is focused on improving outcomes in Wound, Pulmonary, Bariatric, and Vascular patient care. KCI USA manufactures and markets a broad line of therapeutic specialty support surfaces and medical devices designed to meet the needs of patients in acute, sub-acute and extended care facilities, as well as patients in their homes. This division consists of approximately 1,000 personnel. Rentals and

sales are generated by a sales force of approximately 360 individuals who are responsible for new accounts in addition to the management and expansion of existing accounts. In general, KCI USA's sales representative focuses exclusively on either the acute and home care markets, the extended care market or the V.A.C.

KCI USA has a national 24-hour, seven day-a-week customer service communications system which allows it to quickly and efficiently respond to its customers' needs. The Company distributes its specialty patient support surfaces and medical devices to acute and extended care facilities through a network of 136 domestic service centers. The General Managers, who supervise the service centers, are responsible for both sales and service operations. Each center has an inventory of specialty beds, overlays, and medical devices which are delivered to the individual hospitals or extended care facilities on an as-needed basis.

The KCI USA sales support staff is comprised of approximately 250 employees with medical or clinical backgrounds. The principal responsibility of approximately 110 of these clinicians is making product rounds and assisting facilities in developing their protocols. These clinicians educate the hospital or long-term care facility staff on issues related to the use of the Company's products. The clinical staff makes approximately 200,000 product rounds annually. KCI USA accounted for approximately 73%, 76% and 76%, respectively, of the Company's total revenue in the years ended December 31, 1999, 1998 and 1997.

KCI has also developed a continuum of products that address the unique demands of the home health care market. KCI USA, through its Home Care group, distributes products primarily through home medical equipment ("HME") dealers. The Company believes that selling products through the home care provider network gives it access to a larger patient population and improves the overall contribution from this business segment despite a reduction in per patient revenue.

KCI International has direct operations in 13 foreign countries including Germany, Austria, the United Kingdom, Canada, France, the Netherlands, Switzerland, Australia, Italy, Denmark, Sweden, Ireland and Belgium. In addition, relationships with approximately 50 active independent distributors in Latin America, the Middle East, Asia and Eastern Europe allow KCI International to service the demands of a growing global market. KCI International accounted for approximately 26%, 24% and 23%, respectively, of the Company's total revenue in the years ended December 31, 1999, 1998 and 1997.

The Company's therapeutic systems deliver one or more of the following therapies:

The Company's pressure relief and pressure reduction surfaces provide effective skin care therapy in the treatment of pressure sores, burns, ulcers, skin grafts and other skin conditions. The Company's surfaces also help prevent the formation of pressure sores which develop in certain immobile individuals. The Company's beds and surfaces reduce the amount of pressure at any point on a patient's skin by using surfaces supported by air, silicon beads or a viscous fluid. The Company's products also help to reduce shear, a major factor in the development of pressure ulcers by reducing the amount of friction (and therefore tearing of the skin) between the skin surface and the surface of the bed. Some of KCI's products provide advanced shear relief through the incorporation of a patented "anti-shear" sheet on top of the surface.

Some of the Company's products further promote healing and reduce nursing time by providing an automated "wound care" turn of approximately 25 degrees. This "nurse assist" replaces the need for nurses to manually turn and position patients.

In addition to providing Pressure relief, some of the Company's products also provide a pulsing of air through the surface cushions known as Pulsation Therapy which helps improve blood flow to the skin.

Kinetic Therapy is provided by the Company's pulmonary care systems (beds and overlays). The United States Center for Disease Control (the "CDC") defines Kinetic Therapy as the lateral rotation of a patient by at least 40 degrees to each side (a continuous 80-degree arc). Some of the Company's products combine Kinetic Therapy with additional therapies such as percussion which helps loosen mucous buildup. Kinetic Therapy has been clinically proven to help prevent and treat acute respiratory problems, such as pneumonia and Acute Respiratory Distress Syndrome (ARDS), by reducing the build-up of fluid in the lungs and improving the oxygenation of blood in the lungs.

KCI offers a line of products which are designed to accommodate obese individuals providing the support needed by obese patients and enabling hospital staff to care for these patients in a dignified manner. These bariatric care products are used generally for patients weighing from 300 to 600 pounds, but can accommodate patients weighing nearly 1,000 pounds. These individuals are often unable to fit into standard-sized beds and wheelchairs. The Company's most sophisticated bariatric care products can serve as a bed, chair, scale and x-ray table, help patients enter and exit the bed, and contain other features which permit patients to be treated safely and with dignity. Moreover, treating obese patients is a significant staffing issue for many health care facilities because moving and handling these patients increases the risk of worker's compensation claims by such personnel. Management believes that these products enable health care personnel to treat these patients in a manner which is safer for hospital personnel than traditional methods and can help reduce worker's compensation claims. Some of the bariatric products also address complications of immobility and obesity such as pressure sores and pulmonary complications.

The Company is the provider of a patented, non-invasive device which uses sub-atmospheric, or negative, pressure to promote the healing of wounds such as chronic pressure sores; arterial, venous and diabetic ulcers; dehisced surgical wounds; and trauma wounds. This pressure is applied through a proprietary foam dressing, covered with an airtight occlusive dressing, which creates a vacuum action that draws fluid out of the wound site, stimulates blood flow, decreases bacterial growth, and draws the edges of the wound together. Negative Pressure Therapy has been proven to heal wounds more quickly than traditional methods and has been effective at closing chronic wounds which have, in some cases, been open for years.

The Company offers a family of non-invasive devices which provide vascular assistance through either sequential or intermittent Compression Therapy. Compression Therapy has been clinically proven to improve blood circulation, decrease swelling in the lower extremities and reduce the incidence of blood

clots. The therapy is accomplished by wrapping an inflatable cuff around a foot, leg or arm and then automatically inflating and deflating the cuff at prescribed intervals. The products are often used by individuals who have had hip or knee surgeries, diabetes, or other conditions which reduce circulation.

The Company's "Continuum of Care" is focused on treating wound care patients, pulmonary patients, large or obese patients and patients with circulatory problems by providing innovative, cost effective, outcome driven therapies across multiple care settings.

The Company's pressure relief products include a variety of framed beds and overlays such as the KinAir III and IV (framed beds); the FluidAir Elite and FluidAir II; the FirstStep TriCell, Plus, Select and Advantage (overlays); the Impression SR (mattress replacement), the AtmosAir family of mattress replacement and seating surfaces; and the RIK Fluid mattress and overlay. The KinAir III and 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 the patient on a low-pressure surface of air-fluidized silicon beads providing pressure relief and shear relief for skin grafts or flaps, burns and pressure sores. The FirstStep family of overlays is designed to provide pressure relief and help prevent pressure sores. Both the Impression SR and the AtmosAir family are for-sale mattress replacement products for the prevention and early intervention of pressure sores. Impression SR utilizes electric power as its energy source and the proprietary AtmosAir utilizes atmospheric pressure to deliver dynamic pressure relief. The RIK mattress and the RIK overlay are static, non-powered products that provide pressure relief using a patented viscous fluid and a patented anti-shear sheet.

Both the TheraPulse (framed bed) 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 circulation problems.

The Company's Kinetic Therapy products include the TriaDyne II, RotoRest Delta, PediDyne and ParaDyne. The TriaDyne II is used primarily in acute care settings and provides patients with three distinct therapies on an air suspension surface. The TriaDyne II applies Kinetic Therapy by rotating the patient up to 40 degrees to each side and provides an industry-first feature of simultaneously turning the patient's torso and lower body in opposite directions while keeping the patient positioned in the middle of the bed. The TriaDyne II also provides percussion therapy to the patient's chest to loosen mucous buildup in the lungs and pulsating therapy to promote capillary circulation. The TriaDyne II is built on Stryker Corporation's critical care frame, which is well suited to an ICU environment. The ParaDyne provides therapies similar to the TriaDyne II for customers looking to manage their costs by utilizing their existing frames. The RotoRest Delta is a specialty bed which can rotate a patient up to 62 degrees on each side for the treatment of severe pulmonary complications and prevention of pneumonia. The RotoRest has been shown to improve the care of patients suffering from multiple trauma, spinal cord injury, severe pulmonary complications, respiratory failure and deep vein thrombosis.

These products provide the proper support needed by obese patients, and enable nurses to properly care for obese patients. The most advanced product in this line is the BariAire Therapy System, which serves as a bed, cardiac chair or x-ray table. The BariAire 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 nearly 850 pounds. The Company believes that the BariAire is the most advanced product of its type available today. The BariKare bed, the workhorse of KCI's bariatric products, provides a risk management platform for patients weighing up to 650 pounds, predominately in the Med-surg setting. In 1996, the Company introduced the FirstStep Select Heavy Duty overlay which, when placed on top of the BariKare, provides pressure-relieving therapy to the risk management platform. The Company's AirMaxxis product provides a therapeutic bed frame for the home environment for patients weighing up to 1000 lbs.

The Company manufactures and markets the proprietary Vacuum Assisted Closure device (the "V.A.C."), a non-invasive wound closure therapy that utilizes sub-atmospheric, or negative, pressure. The V.A.C. promotes healing in trauma and dehisced wounds, pressure, arterial, venous stasis and diabetic ulcers, flaps, skin grafts and burns that do not respond to traditional methods of treatment. Treatment protocols with the V.A.C. call for a proprietary foam material to be fitted and placed in or on top of a wound and covered with an airtight, occlusive dressing. The foam is attached to a vacuum pump. When activated, the vacuum pump creates a sub-atmospheric pressure in the wound that draws the tissue together. This vacuum action also stimulates blood flow on the surface of the wound, reduces edema and decreases bacterial colonization, all of which stimulate healing. The dressing material is replaced every 48 hours and fitted to accommodate the decreasing size of the wound over time. This is a significant improvement over the traditional method for treating wounds which requires the nursing staff to clean and dress a serious wound every 8 to 12 hours. V.A.C. Therapy is currently delivered by a battery backed, standard, V.A.C. unit or with the Mini-V.A.C., a portable, battery-powered unit designed to provide therapy in the home.

The PlexiPulse, PlexiPulse All-in-1, the Pulse IC, the Pulse SC, and the Extremity Pump Systems are non-invasive vascular assistance devices that aid venous return by pumping blood from the lower extremities to help prevent deep vein thrombosis ("DVT") and re-establish microcirculation. The pumping action is created by compressing specific parts of the foot or calf with specially designed inflatable cuffs that are connected to a separate pump unit. The cuffs are wrapped around the foot and/or calf and are inflated in timed increments by the pump. The intermittent or sequential inflation compresses a group of veins in the lower limbs and boosts the velocity of blood flowing back toward the heart. This increased velocity has been clinically proven to significantly decrease formation of DVT in non-ambulatory post-surgical and post-trauma patients. KCI's Compression Therapy products are effective in preventing DVT, reducing edema and improving lower limb blood circulation.

The Company believes that the principal competitive factors within its markets are product efficacy, cost of care, clinical outcomes and service. Furthermore, the Company believes that a national presence with full distribution capabilities is important to serve large, sophisticated national and regional health care group purchasing organizations ("GPOs") and their affiliates.

The Company contracts with both proprietary hospital groups and voluntary GPOs. Proprietary groups own all of the facilities which they represent and, as a result, can ensure compliance with a national agreement. Voluntary GPOs negotiate contracts on behalf of member hospital or skilled nursing facility organizations but cannot ensure that their members will comply with the terms of a national agreement. Approximately 48% of the Company's total revenue during 1999 was generated under national agreements with proprietary groups and voluntary GPOs in the domestic marketplace.

The Company competes on a national level with Hill-Rom, Mediq, Kendall, and Invacare and on a regional and local level with numerous other companies. In the US specialty surface market and certain international markets, the Company competes principally with Hill-Rom. The Company competes principally with Invacare in the home care segment.

The Balanced Budget Act of 1997 (the "BBA") significantly reduced the annual increases in federal spending for Medicare and Medicaid changing the payment system for both skilled nursing facilities and home health care services from cost-based to prospective payment systems and allowing states greater flexibility in controlling Medicaid costs at the state level. The general effect of the BBA has been to place increased pricing pressure on the Company and its customers. In particular, the changes in the manner Medicare Part A reimburses skilled nursing facilities ("SNFs") has changed dramatically the manner in which the Company's SNF customers make renting and purchasing decisions. As a result, the Company's revenue from the extended care market declined significantly in 1999. Certain portions of the BBA were amended by the Medicare, Medicaid and SCHIP Balanced Budget Refinement Act of 1999 (the "Refinement Act"). In essence the Refinement Act attempted to dampen the impact which the BBA had had on the health care industry. The Company does not believe that the Refinement Act will have a material impact on its business.

The Company also believes it is likely that efforts by governmental and private payors to contain costs through managed care and other efforts and to reform health systems will continue in the future. For example, the BBA, as amended by the Refinement Act and the Omnibus Consolidated and Emergency Supplemental Appropriations Act of 1999 ("OCESAA"), provides for the implementation of a Prospective Payment System ("Home Health PPS") for Medicare Home Health Services. Under Home Health PPS, patients treated by a home health agency under a plan of care will be categorized in 80 Home Health Resource Groups ("HHRGs") and home health agencies will receive a specified payment for each 60-day episode of care which will vary depending upon the patient's HHRG. The payments to be made under Home Health PPS are subject to a variety of adjustments. The final rule for Home Health PPS will be published in July 2000 and Home Health PPS is scheduled to be implemented on October 1, 2000.

The Health Care Financing Administration ("HCFA") has recently announced that it intends to review the policies under which reimbursement is provided for therapeutic surfaces in the home care environment. Although HCFA's focus appears to be products which represent a very small portion of the Company's business, there can be no assurance that changes, if any, which HCFA makes to the manner in which it covers and pays for therapeutic surfaces in the home care market will not have a negative effect on the Company's business in that market.

One of the most tangible results of the health care reform debate in the United States has been to cause health care providers to examine their cost structures and reassess the manner in which they

provide health care services. This review, in turn, has led many health care providers to merge or consolidate with other members of their industry in an effort to reduce costs or achieve operating synergies. A substantial number of the Company's customers, including proprietary hospital groups, group-purchasing organizations, hospitals, national nursing home companies and national home health care agencies, have been affected by this consolidation. An extensive service distribution network and broad product line is key to servicing the needs of these larger provider networks. In addition, the consolidation of health care providers often results in the renegotiation of contracts and in the granting of price concessions. Finally, as group purchasing organizations and integrated health care systems increase in size, each contract represents a greater concentration of market share and the adverse consequences of losing a particular contract increases considerably.

The Company's products are rented and sold principally to hospitals, SNF's and HME suppliers who receive reimbursement for the products and services they provide from various public and private third party payors, including Medicare, Medicaid and private insurance programs. The Company also acts as a Durable Medical Equipment ("DME") Supplier under 42 U.S.C. 1395 et seq. and as such furnishes its products directly to customers and bills payors. As a result, the demand for the Company's products in any specific care setting is dependent in part on the reimbursement policies of the various payors in that setting. In order to be reimbursed, the products generally must be found to be reasonable and necessary for the treatment of medical conditions and must otherwise fall within the payors' list of covered services. For example, the Company is seeking to establish coverage and payment by Medicare Part B for the V.A.C., its chronic wound treatment product. Although clinical acceptance of this product has continued to increase, it has not been classified as a covered item by Medicare Part B. In light of increased controls on Medicare spending, there can be no assurance on the outcome of future coverage or payment decisions for any of the Company's products by governmental or private payors. If providers, suppliers and other users of the Company's products and services are unable to obtain sufficient reimbursement for the provision of KCI products, a material adverse impact on the Company's business, financial condition or operations could result.

The Company is subject to various federal and state laws pertaining to health care fraud and abuse including prohibitions on the submission of false claims and the payment or acceptance of kickbacks or other remuneration in return for the purchase or lease of Company products. The United States Department of Justice and the Office of the Inspector General of the United States Department of Health and Human Services has launched an enforcement initiative which specifically targets the long term care, home health and DME industries. Sanctions for violating these laws include criminal penalties and civil sanctions, including fines and penalties, and possible exclusion from the Medicare, Medicaid and other federal health care programs. Although the Company believes its business arrangements comply with federal and state fraud and abuse laws there can be no assurance that the Company's practices will not be challenged under these laws in the future or that such a challenge would not have a material adverse effect on the Company's business, financial condition or results of operations.

U.S. Census Bureau statistics indicate that the 65-and over age group is the fastest growing population segment and is expected to exceed 75 million by the year 2010. Management of wounds and circulatory problems is crucial for elderly patients. These patients frequently suffer from deteriorating physical conditions and their wound problems are often exacerbated by incontinence and poor nutrition.

Obesity is increasingly being recognized as a serious medical complication. In 1998, approximately 880,000 patients in U.S. hospitals had a principal or secondary diagnosis of obesity. Obese patients tend to have limited mobility and thus are at risk for circulatory problems and skin breakdown. Treating obese patients is also a significant staffing issue for many health care facilities and a cause of worker's compensation claims among nurses.

The focus of the Company's research and development program has been to develop new products, particularly for use in the care of wounds, for prevention and treatment of pulmonary, circulatory and skin disorders, and for specialized care of bariatric patients, and to make technological improvements to existing product lines. In 1999, the Company introduced a number of new products including the AirMaxxis, AtmosAir, ParaDyne and TriaDyne II products and product lines. Expenditures for research and development represented approximately 2% of the Company's total operating expenditures in 1999. The Company intends to continue its research and development efforts in all of its core care settings while also looking for break-through development prospects in other settings as well.

The company's manufacturing processes for its specialty beds, mattress overlays, and medical devices include the manufacture of certain components, the purchase of certain other components from suppliers and the assembly of these components into a completed product. Mechanical components such as blower units, electrical displays and airflow controls consist of a variety of customized subassemblies which are purchased from suppliers and assembled by the Company. The Company believes it has an adequate source of supply for each of the components used to manufacture its products.

The Company seeks patent protection in the United States and abroad. As of December 31, 1999, the Company had 80 issued U.S. patents relating to its various existing and prospective lines of therapeutic medical devices. The Company also has 60 pending U.S. Patent applications. Many of the Company's specialized beds, products and services are offered under proprietary trademarks and service marks. The Company has 45 registered trademarks and service marks in the United States Patent and Trademark Office.

As of December 31, 1999, the Company had approximately 2,100 employees. The Company's employees are not represented by labor unions and the Company considers its employee relations to be good.

The Company's products are subject to regulation by numerous governmental authorities, principally the United States Food and Drug Administration ("FDA") and corresponding state and foreign regulatory agencies. Pursuant to the Federal Food, Drug, and Cosmetic Act, and the regulations promulgated thereunder, the FDA regulates the clinical testing, manufacture, labeling, distribution and promotion of medical devices. Noncompliance with applicable requirements can result in, among other things, fines, injunctions, civil penalties, recall or seizure of products, total or partial suspension of production, failure of the government to grant 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 request repair, replacement or refund of the cost of any device manufactured or distributed by the Company that violates statutory or regulatory requirements.

In the United States, medical devices are classified into one of three classes (Class I, II or III) on the basis of the controls deemed necessary by the FDA to reasonably ensure their safety and effectiveness. Although many Class I devices are exempt from certain FDA requirements, Class I devices are subject to general controls (e.g., labeling, pre-market notification, and adherence to Quality System Regulations). Class II devices are subject to general and special controls (e.g., performance standards, post-market surveillance, patient registries, and FDA guidelines). Generally, Class III devices are high-risk devices that receive greater FDA scrutiny to ensure their safety and effectiveness (e.g., life-sustaining, life-supporting and implantable devices, or new devices which have been found not to be substantially equivalent to legally marketed devices). Before a new medical device can be introduced in the market, the manufacturer must generally obtain FDA clearance ("510(k) Clearance") or Pre-market Approval ("PMA"). All of the Company's current products have been classified as Class I or Class II devices which typically are legally marketed based upon 510(k) Clearance or related exemptions. A 510(k) Clearance will generally be granted if the submitted information establishes that the proposed device is "substantially equivalent" to a legally marketed medical device. In recent years, the FDA has been requiring a more rigorous demonstration of substantial equivalence than in the past.

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

Manufacturers of medical devices for marketing in the United States are required to adhere to applicable regulations setting forth detailed Quality System Regulation ("QSR") (formerly Good Manufacturing Practices) requirements, which include design, testing, control and documentation requirements. Manufacturers must also comply with MDR requirements that a company report certain device-related incidents to the FDA. The Company is subject to routine inspection by the FDA and certain state agencies for compliance with QSR requirements, MDR requirements and other applicable regulations. The Company is also subject to numerous federal, state and local laws relating to such matters as safe working conditions, manufacturing practices, environmental protection, fire hazard control and disposal of hazardous or potentially hazardous substances. Changes in existing requirements or adoption of new requirements could have a material adverse effect on the Company's business, financial condition, and results of operations. There can be no assurance that the Company will not incur significant costs to

comply with laws and regulations in the future or that laws and regulations will not have a material adverse effect upon the Company's business, financial condition or results of operations.

The Company is subject to federal and state laws pertaining to health care fraud and abuse. In particular, certain federal and state laws prohibit manufacturers, suppliers, and providers from offering or giving or receiving kickbacks or other remuneration in connection with the ordering or recommending purchase or rental, of health care items and services. The federal anti-kickback statute provides both civil and criminal penalties for, among other things, offering or paying any remuneration to induce someone to refer patients to, or to purchase, lease, or order (or arrange for or recommend the purchase, lease, or order of), any item or service for which payment may be made by Medicare or certain federally-funded state health care programs (e.g., Medicaid). This statute also prohibits soliciting or receiving any remuneration in exchange for engaging in any of these activities. The prohibition applies whether the remuneration is provided directly or indirectly, overtly or covertly, in cash or in kind. Violations of the law can result in numerous sanctions, including criminal fines, imprisonment, and exclusion from participation in the Medicare and Medicaid programs. These provisions have been broadly interpreted to apply to certain relationships between manufacturers and suppliers, such as the Company, and hospitals, SNF's and other potential purchasers or sources of referral. Under current law, courts and the Office of Inspector General ("OIG") of the United States Department of Health and Human Services ("HHS") have stated, among other things, that the law is violated where even one purpose (as opposed to a primary or sole purpose) of a particular arrangement is to induce purchases or patient referrals.

The OIG has taken certain actions which suggest that arrangements between manufacturers/suppliers of durable medical equipment or medical supplies and SNFs (or other providers) may be under continued scrutiny. An OIG enforcement initiative, Operation Restore Trust ("ORT"), has targeted an investigation of fraud and abuse in a number of states (i.e., California, Florida, Illinois, New York, and Texas), focusing specifically on the long-term care, home health, and DME industries. ORT's funding has officially ended and the Inspector General has announced plans to implement an "ORT-Plus" program in other states in conjunction with other federal law enforcement bodies. Furthermore, in August 1995, the OIG issued a Special Fraud Alert describing certain relationships between SNFs and suppliers that the OIG viewed as abusive under the statute. These initiatives create an environment in which there will continue to be significant scrutiny for compliance with federal and state fraud and abuse laws.

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

The Company is also subject to federal and state laws prohibiting the presentation (or the causing to be presented) of claims for payment (by Medicare, Medicaid, or other third party payors) that are determined to be false, fraudulent, or for an item or service that was not provided as claimed. In one case, a major DME manufacturer paid more than $4 million to settle allegations that it had "caused to be presented" false Medicare claims through advice that its sales force allegedly gave to customers concerning the appropriate reimbursement coding for its products.

Due to the harmonization efforts of a variety of regulatory bodies worldwide, certification of compliance with the ISO 9000 series of International Standards ("ISO Certification") has become particularly advantageous and, in certain circumstances necessary for many companies in recent years.

The Company received ISO Certification in the fourth quarter of 1997 and therefore is certified to sell and distribute the Company's products within the European community.

The Company owns and leases property that is subject to environmental laws and regulations. The Company also is subject to numerous federal, state and local laws and regulations relating to such matters as safe working conditions, manufacturing practices, fire hazard control and the handling and disposal of hazardous or potentially hazardous substances.

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 the Company's business, financial condition or results of operations.

The Company's products are rented and sold principally to hospitals, extended care facilities and Home Medical Equipment ("HME") providers (also referred to as Durable Medical Equipment ("DME") providers) who receive reimbursement for the products and services they provide from various public and private third-party payors, including the Medicare and Medicaid programs and private insurance plans. In some cases, the Company also directly bills third party payors, including Medicare and Medicaid, and receives reimbursement from these payors. Medicare beneficiaries are generally responsible for deductible and coinsurance payments. As a result, demand and payment for the Company's products is dependent in part on the reimbursement policies of these payors. The manner in which reimbursement is sought and obtained for any of the Company's products varies based upon the type of payor involved and the setting in which the product is furnished and utilized by patients.

Medicare is a federally-funded program that provides health coverage primarily to the elderly and disabled. Medicare is composed of two parts: Part A and Part B. Medicare Part A, hospital insurance, covers services that require hospitalization on an inpatient basis and home health agency or hospice services. Medicare Part B, supplemental medical insurance, covers services provided on an outpatient basis. Part B also covers medically necessary durable medical equipment and medical supplies. The Medicare program has established guidelines for the coverage and reimbursement of certain equipment, supplies and support services. In general, in order to be reimbursed by Medicare, a health care item or service furnished to a Medicare beneficiary must be reasonable and necessary for the diagnosis or treatment of an illness or injury or to improve the functioning of a malformed body part. This has been interpreted to mean that the item or service must be safe and effective, not experimental or investigational (except under certain limited circumstances involving devices furnished pursuant to an FDA-approved clinical trial), and appropriate. To date, specific Medicare guidelines have not been established addressing under what circumstances, if any, Medicare coverage would be provided for the use of the PlexiPulse or the V.A C.

The methodology for determining the amount of Medicare reimbursement of the Company's products varies based upon, among other things, the setting in which a Medicare beneficiary receives health care items and services. The Balanced Budget Act (BBA) of 1997 has significantly impacted the manner in which Medicare reimbursement has and will be funded through 2002. Most of the Company's products are furnished in a hospital, skilled nursing facility or the beneficiary's home.

With the establishment of the prospective payment system in 1983, acute care hospitals are generally reimbursed by Medicare for inpatient operating costs based upon prospectively determined rates. Under the prospective payment system ("PPS"), acute care hospitals receive a predetermined payment rate based upon the Diagnosis-Related Group ("DRG") into which each Medicare beneficiary is assigned, regardless of the actual cost of the services provided. Certain additional or "outlier" payments may be made to a hospital for cases involving unusually high costs. In addition, pursuant to regulations issued in 1991, and subject to a ten-year transition period, the capital costs of acute care hospitals (such as the cost of purchasing or renting the Company's specialty beds) are also reimbursed by Medicare pursuant to an add-on to the DRG-based payment amount. Accordingly, acute care hospitals generally do not receive direct Medicare reimbursement under PPS for the distinct costs incurred in purchasing or renting the Company's products. Rather, reimbursement for these costs is deemed to be included within the DRG-based payments made to hospitals for the treatment of Medicare-eligible inpatients who utilize the products. Since PPS rates are predetermined, and generally paid irrespective of a hospital's actual costs in furnishing care, acute care hospitals have incentives to lower their inpatient operating costs by utilizing equipment and supplies that will reduce the length of inpatient stays, decrease labor, or otherwise lower their costs.

The principal manner in which the BBA impacts Medicare Part A in the acute care setting is that it has reduced the annual DRG payment updates to be paid over the next five years. In addition, the BBA authorizes the Health Care Financing Administration ("HCFA") to enact regulations which are designed to restrain certain hospital reimbursement activities which are perceived to be abusive or fraudulent.

Certain specialty hospitals (e.g., long-term care, rehabilitation and children hospitals) also use the Company's products. Such specialty hospitals currently are exempt from the PPS and, subject to certain cost ceilings, are reimbursed by Medicare on a reasonable cost basis for inpatient operating and capital costs incurred in treating Medicare beneficiaries. Consequently, such hospitals may receive additional Medicare reimbursement for reasonable costs incurred in purchasing or renting the Company's products; however, Medicare reimbursement for such hospitals is expected to be reduced over the next five years. There can be no assurance that a prospective payment system will not be instituted for such hospitals in future legislation.

Skilled nursing facilities ("SNFs") which purchase or rent the Company's products have traditionally been reimbursed directly under Medicare Part A for some portion of their incurred costs. On July 1, 1998, the manner in which SNFs were reimbursed under Medicare Part A changed dramatically. On that date, reimbursement for SNFs under Medicare Part A changed from a cost-based system to a prospective payment system. The new payment system is based on resource utilization groups ("RUGs"). Under the RUGs system, a 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 level of care and resources the patient requires. The SNF receives a prospectively determined daily payment based upon the RUGs category assigned to each Medicare patient. The daily payments made to the SNFs during a transition period are based upon a blend of their actual costs from 1995 and a national average cost from 1995 (which is subject to local wage-based adjustments). Initially, 75% of a SNF's per diem is based on

its costs and 25% of the per diem is based on national average cost. At the end of the four-year phase-in period, all daily payments will be based on the national average cost. The Refinement Act recently increased the payments for certain RUG's categories. Because the RUG's system provides SNFs with fixed daily cost reimbursement, SNFs have become less inclined than in the past to use products which had previously been reimbursed as variable ancillary costs. The Company's revenue from SNF customers has dropped sharply since the implementation of the RUGs system.

The Company's products are also provided to Medicare beneficiaries in home care settings. Medicare, under the Part B program, reimburses beneficiaries, or suppliers accepting assignment, for the purchase or rental of HME for use in the beneficiary's home or a home for the aged (as opposed to use in a hospital or skilled nursing facility setting). As long as the Medicare Part B coverage criteria are met, certain of the Company's products, including air fluidized beds, air-powered floatation beds and alternating pressure air mattresses, are reimbursed in the home setting under the HME category known as "Capped Rental Items." Pursuant to the fee schedule payment methodology for this category, Medicare pays a monthly rental fee (for a period not to exceed fifteen months) equal to 80% of the established allowable charge for the item. Under the BBA, there will be a five-year freeze on consumer price index payment updates for Medicare Part B Services in the home care setting. The BBA, as amended by the Refinement Act and OCESAA, provides for the implementation of Home Health PPS beginning October 1, 2000. Under Home Health PPS, most of the services which a Medicare patient receives under a plan of care will be covered by a single payment received by the home health agency for each 60-day episode of care. The amount of the payment will depend upon the HHRG category of the patient and is subject to a variety of adjustments. Durable medical equipment, such as the Company's therapeutic surfaces and medical devices, are excluded from Home Health PPS. However, certain supplies currently provided by the Company in a home care environment could be subject to Home health PPS. The Company does not believe that Home Health PPS will have a material impact on its business.

The Medicaid program is a cooperative federal/state program that provides medical assistance benefits to qualifying low income and medically needy persons. State participation in Medicaid is optional and each state is given discretion in developing and administering its own Medicaid program, subject to certain federal requirements pertaining to payment levels, eligibility criteria and minimum categories of services. The Medicaid program finances approximately 50% of all care provided in residential and skilled nursing facilities nationwide. The Company sells or rents its products to SNFs for use in furnishing care to Medicaid recipients. SNFs, or the Company, may seek and receive Medicaid reimbursement directly from states for the incurred costs. However, the method and level of reimbursement, which generally reflects regionalized average cost structures and other factors, varies from state to state and is subject to each states budget restraints.

Many private payors, including indemnity insurers, employer group health insurance programs and managed care plans, presently provide coverage for the purchase and rental of the Company's products. The scope of coverage and payment policies varies among private payors. Furthermore, many such payors

are investigating or implementing methods for reducing health care costs, such as the establishment of capitated or prospective payment systems.

The Company believes that government and private efforts to contain or reduce health care costs are likely to continue. These trends may lead third-party payors to deny or limit reimbursement for the Company's

Item 2. Properties

products, which could negatively impact the pricing and profitability of, or demand for, the Company's products.

The Company's corporate headquarters are currently located in a 170,000 square foot building in San Antonio, Texas which was purchased by the Company in January 1992. The Company utilizes approximately 89,000 square feet of the building with the remaining space being leased to unrelated entities. In June 1997, the Company also acquired a 2.8 acre tract of land adjacent to its corporate headquarters. There are three buildings on the land which contain an aggregate of 40,000 square feet that are used for general corporate purposes.

The Company conducts its manufacturing, shipping, receiving, engineering and storage activities in a 170,000 square foot facility in San Antonio, Texas, which was purchased by the Company in January 1988. The Company also leases two storage facilities in San Antonio, Texas. In 1994, the Company purchased a facility in San Antonio, Texas, which has been provided to a charitable organization to provide housing for families of cancer patients. The facility is built on 6.7 acres and consists of a 15,000 square foot building and a 2,500 square foot house.

The Company leases approximately 136 domestic distribution centers, including each of its seven regional headquarters, which range in size from 1,500 to 18,000 square feet. The Company also leases two small manufacturing plants in the United Kingdom and Ireland which are approximately 18,000 square feet and 9,000 square feet, respectively.

Item 3. Legal Proceedings

On February 21, 1992, Novamedix Limited ("Novamedix") filed a lawsuit against the Company in the United States District Court for the Western District of Texas. Novamedix manufactures the principal product which directly competes with the PlexiPulse. The suit alleges that the PlexiPulse infringes several patents held by Novamedix, that the Company breached a confidential relationship with Novamedix and a variety of ancillary claims. Novamedix seeks injunctive relief and monetary damages. A judicial stay which had been granted in this case has recently been lifted and discovery in this case is scheduled to close in late 2000. Although it is not possible to reliably predict the outcome of this litigation or the damages which could be awarded, the Company believes that its defenses to these claims are meritorious and that the litigation will not have a material adverse effect on the Company's business, financial condition or results of operations.

On August 16, 1995, the Company filed a civil antitrust lawsuit against Hillenbrand Industries, Inc. and one of its subsidiaries, Hill-Rom. The suit was filed in the United States District Court for the Western District of Texas. The suit alleges that Hill-Rom used its monopoly power in the standard hospital bed business to gain an unfair advantage in the specialty hospital bed business. Specifically, the allegations set forth in the suit include a claim that Hill-Rom required hospitals and purchasing groups to agree to exclusively rent specialty beds in order to receive substantial discounts on products over which they have monopoly power - hospital beds and head wall units. The suit further alleges that Hill-Rom engaged in activities which constitute predatory pricing and refusals to deal. Hill-Rom has filed an answer denying the allegations in the suit. Although discovery has not been completed and it is not possible to reliably predict the outcome of this litigation or the damages which might be awarded, the Company believes that its claims are meritorious.

On October 31, 1996, the Company received a counterclaim which had been filed by Hillenbrand Industries, Inc. in the antitrust lawsuit which the Company filed in 1995. The counterclaim alleges that the Company's antitrust lawsuit and other actions were designed to enable KCI to monopolize the specialty

therapeutic surface market. Although it is not possible to reliably predict the outcome of this litigation, the Company believes that the counterclaim is without merit.

The Company is a party to several lawsuits arising in the ordinary course of its business. Provisions have been made in the Company's financial statements for estimated exposures related to these lawsuits and adjustments. In the opinion of management, the disposition of these matters will not have a material adverse effect on the Company's business, financial condition or results of operations.

The manufacturing and marketing of medical products necessarily entails an inherent risk of product liability claims. The Company currently has certain product liability claims pending for which provision has been made in the Company's financial statements. Management believes that resolution of these claims will not have a material adverse effect on the Company's business, financial condition or results of operations. The Company has not experienced any significant losses due to product liability claims and management believes that the Company currently maintains adequate liability insurance coverage.

Item 4. Submission of Matters to a Vote of Security Holders

No matter was submitted to a vote of the Company's security holders during the fourth quarter of 1999.

Item 5. Market for Registrant's Common Equity and Related

Stockholder Matters

The Company's common stock ("Common Stock") traded on The NASDAQ Stock Market under the symbol: KNCI until November 19, 1997, which was the date on which the Company de-listed its common stock. No dividends were declared in 1999 or 1998. The Company's credit agreements contain certain covenants which currently restrict the Company's ability to declare and pay cash dividends.

As of March 1, 2000, there were 10 holders of record of the Company's Common Stock. There is currently no established public trading market for the Company's Common Stock.

Item 6. Selected Financial Data

and Results of Operations

The health care reimbursement environment continues to generate pressure on health care providers to control costs, provide cost effective therapies and improve patient outcomes. Industry trends resulting from these pressures include increased demand for lower-priced therapies and technologies in all care settings and the further consolidation of health care providers and national and regional group purchasing organizations.

In August 1997, in an effort to reduce the federal deficit and lower overall federal healthcare expenditures, Congress passed the Balanced Budget Act, (the "BBA"). The BBA contains a number of provisions which will impact the federal reimbursement of health care costs and reduce projected payments under the Medicare system by $115 billion over the five year period ending in 2002. The majority of the savings are scheduled for the fourth and fifth years of this plan. The BBA was amended by the Refinement Act which, in essence, attempted to dampen the impact which the BBA had on the health care industry. Among other things, the Refinement Act increased the fixed payments skilled nursing facilities receive for certain patients and excluded durable medical equipment (such as the Company's therapeutic surfaces and medical devices) from Home Health PPS.

Historically less than 10% of the Company's revenues are received directly from the Medicare system. However, many of the health care providers who pay the Company for its products are reimbursed, either directly or indirectly, by the federal government under the Medicare system for the use of those products. The Company does not believe that the changes introduced to date by the BBA have had a substantial impact on its hospital customers or the dealers who distribute the Company's products in the home health care market. However, changes introduced by the BBA have impacted negatively the manner in which extended care customers make purchasing and rental decisions with respect to the Company's products. The scheduled introduction of Home Health PPS in October 2000 could have a significant effect on the manner in which home health agencies conduct business. Although Home Health PPS does not directly impact the vast majority of the Company's home health products, a significant change in the manner in which home health agencies do business could affect the manner in which the Company markets certain of its products in this market. In addition, HCFA has recently announced that it is reviewing its coverage of therapeutic support surfaces in the home. Although HCFA's focus appears to be on Group 3 products (which do not represent a significant portion of the Company's home health business), there can be no assurance that HCFA will not modify policies which significantly change the manner in which therapeutic surfaces are reimbursed by Medicare in the home.

Industry trends including pricing pressures, the consolidation of health care providers and national and regional group purchasing organizations and a shift in market demand toward lower-priced products such as mattress overlays have had the impact of reducing the Company's overall average daily rental rates on its individual products. These industry trends have had the effect of reducing overall acute care market growth.

Generally, the Company's customers prefer to rent rather than purchase the Company's products in order to avoid the ongoing service, storage and maintenance requirements and the high initial capital outlays associated with purchasing such products, as well as to receive the Company's high-quality clinical support. As a result, rental revenues are a high percentage of the Company's overall revenues.

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More recently, sales have increased as a portion of the Company's revenues. The Company believes this trend will continue because certain U.S. health care providers are purchasing products that are less expensive and easier to maintain such as medical devices and associated disposable supplies, mattress overlays and mattress replacement systems. In addition, international health care providers tend to purchase therapeutic surfaces more often than U.S. health care providers.

All share and per share amounts shown in Item 7 have been adjusted to reflect a four-for-one stock split which was effective in the third quarter of 1998.

The following table sets forth, for the periods indicated, the percentage relationship of each item to total revenue as well as the change in each line item as compared to the prior year ($ in thousands):

The Company's revenue is divided between two primary operating segments. The following table sets forth, for the periods indicated, the amount of revenue derived from each of these segments ($ in millions):

Total Revenue: Total revenue in 1999 decreased 2.8% to $321.4 million from $330.5 million in the year ended of 1998. Revenue from KCI USA was $235.3 million, down $15.8 million, or 6.3%, from $251.1 million in the prior year. The decline in revenue was due to a sharp decrease in extended care surface revenue of $23.3 million, or 42.9%, which resulted from the extended care market's negative reaction to the Balanced Budget Act of 1997. This reaction was characterized by lower patient therapy days, lower product pricing and a product mix shift from framed products to overlays in the extended care market. In addition, Medicare Part B V.A.C. revenue declined by $6.6 million because the Company discontinued placing the V.A.C. on Medicare Part B patients in 1999. The Company does not intend to reinstate Medicare Part B placements until it has received a HCPCS code for the V.A.C. These revenue decreases were partially offset by a $13.0 million, or 54.1%, increase in V.A.C. revenue from payors other than Medicare Part B. Domestic patient days, overall, were comparable to the prior year as higher acute care patient days and increased market penetration of the V.A.C. were offset by the sharp decline in extended care patient days. Lower prices and a product mix shift to lower-cost overlays, particularly in the extended care marketplace resulted in lower domestic rental revenue for the year. Sales for the period increased $3.5 million, or 4.8%, due substantially to sales of disposable products associated with the Company's medical devices.

Revenue from the Company's international operating unit increased $7.0 million, or 9.0%, to $85.0 million from $78.0 million in the prior year. The international revenue increase reflects higher patient surface days in virtually all of the Company's markets, and partly offset by lower prices, combined with growth of $4.0 million, or 58.2%, in the V.A.C. product line. On a local currency basis, revenue increased $12.7 million compared to the same period a year ago.

Rental Expenses: Rental, or field, expenses of $166.9 million were 67.8% of total rental revenue in 1999 compared to 64.0% in 1998. This increase is primarily attributable to the decrease in rental revenue because the majority of the Company's rental or field expenses are relatively fixed. Overall, field expenses of $166.9 million increased approximately $1.4 million, or 0.9%, from the prior year due, in part, to increased equipment depreciation.

Cost of Goods Sold: Cost of goods sold increased 12.4% to $31.3 million in 1999 from $27.9 million in 1998. Cost of goods sold has increased primarily due to increased sales of disposables associated with the Company's medical devices and a non-recurring inventory writedown of $1.9 million related to a certain product line with fixed expiration dates. Excluding the inventory writedown, cost of goods sold increased approximately $1.6 million, or 5.8%. Sales margins decreased slightly during 1999 due primarily to lower sales prices and the fact that the Company continued to place the V.A.C. on Medicare Part B patients until August of 1999 despite the lack of a specific reimbursement code.

Gross Profit: Gross profit decreased $13.9 million, or 10.1%, to $123.2 million in 1999 from $137.1 million in 1998 due substantially to the decline in extended care rental revenue. The gross profit margin for 1999, as a percentage of total revenue, was 38.3%, down from 41.5% for 1998, due primarily to the decrease in rental revenue for the period.

Selling, General and Administrative Expenses: Selling, general and administrative expenses increased $5.8 million, or 8.4%, to $75.4 million in 1999 from $69.6 million in 1998. This increase was due primarily to certain non-recurring expense adjustments including an increase in the allowance for uncollectible receivables of approximately $5.9 million due substantially to the continued delay in obtaining a unique reimbursement code for the V.A.C. and a $1.1 million write-off of goodwill associated with a discontinued product line. Excluding the non-recurring items, selling, general and administrative expenses were $68.3 million, a $1.3 million, or 1.9%, reduction from the prior year due primarily to lower labor costs including incentive compensation. As a percentage of total revenue, selling, general and administrative expenses were 21.3% in 1999, excluding the non-recurring expense adjustments, as compared to 21.1% in 1998.

Operating Earnings: Operating earnings for 1999 decreased approximately $19.8 million, or 29.2%, to $47.8 million compared to $67.6 million in 1998. This decrease resulted primarily from the decrease in extended care and V.A.C. Medicare Part B revenue, net of related expenses, of $26.0 million combined with non-recurring asset write-offs and expense adjustments of $9.0 million. The operating earnings decrease were partially offset by (i) an increase in V.A.C. revenue from non-Medicare Part B payors, net of related expenses, of $9.1 million; (ii) a $1.3 million net increase in international operations; (iii) a one time sale of vascular devices of $1.6 million; (iv) operating earnings of $2.6 million related to the Company's Jobst acquisition made in November 1998; and (v) miscellaneous cost reductions of approximately $600,000.

Interest Income: Interest income for 1999 was approximately $348,000 compared to $616,000 in 1998. The decrease in interest income resulted from lower invested cash balances due primarily to the decline in operating earnings from 1998.

Interest Expense: Interest expense for 1999 was $46.5 million compared to $48.6 million for 1998. The interest expense decrease was due to repayments of long-term obligations made during 1999.

Income Taxes: The Company's effective income tax rate for 1999 exceeded 100% of pre-tax earnings due to the decline in operating earnings discussed previously and certain non-deductible items, for example, goodwill, which increased taxable earnings for the period. For 1998, the Company's effective tax rate was 40.0%.

Net Earnings (Loss): The net loss for 1999 was $314,000 as compared to net earnings of $11.8 million in 1998. The earnings decrease is due to the decrease in operating earnings as discussed above.

The following table sets forth, for the periods indicated, the percentage relationship of each item to total revenue as well as the change in each line item as compared to the prior year ($ in thousands):

The Company's revenue is divided between two primary operating segments. The following table sets forth, for the periods indicated, the amount of revenue derived from each of these segments ($ in millions):

Total Revenue: Total revenue in 1998 increased $23.6 million, or 7.7%, to $330.5 million from $306.9 million in 1997. Revenue from KCI USA was $251.1 million, up $16.8 million, or 7.2%, from $234.3 million in the prior year due substantially to V.A.C. rentals and sales growth. KCI USA surfaces revenue increased slightly due to a combination of revenue from the RIK Medical acquisition, wound care product sales and higher patient therapy days which were virtually offset by lower blended rental rates. Total sales for the period increased $13.0 million, or 22.0%, due substantially to sales of disposable products associated with the Company's medical devices.

Revenue from the Company's international operating unit increased $7.7 million, or 11.0%, to $78.0 million from $70.3 million in 1997. The international revenue increase reflects higher therapy days in virtually all of the Company's middle-tier markets, e.g., the Netherlands, Canada and Switzerland, which were partly offset by unfavorable currency exchange rate fluctuations of approximately $2.1 million.

Rental Expenses: Rental, or field, expenses increased $9.3 million, or 5.9%, to $165.5 million from $156.2 million in 1997. This increase is primarily attributable to costs associated with business acquisitions completed during 1997 and 1998 including increased equipment depreciation and field labor costs. As a percentage of rental revenue, rental expenses were 64.0% and 63.0% for 1998 and 1997, respectively.

Cost of Goods Sold: Cost of goods sold in 1998 increased $4.2 million, or 17.8%, to $27.9 million compared to $23.7 million in 1997. Cost of goods sold has increased primarily as a result of increased sales of disposables associated with the Company's medical devices.

Gross Profit: Gross profit increased $10.0 million, or 7.9%, to $137.1 million in 1998 from $127.1 million in 1997 due primarily to increased revenue as discussed above. Gross profit margin for 1998, as a percentage of total revenue, was 41.5%, up from 41.4% for 1997.

Selling, General and Administrative Expenses: Selling, general and administrative expenses increased $6.9 million, or 11.0%, to $69.6 million in 1998 from $62.7 million in 1997. This increase was due in part to increased sales commissions, goodwill amortization associated with acquisitions, increased inventory valuation reserves and increased legal and professional fees resulting from continuing litigation and systems/process improvement projects including conversion of the Company's manufacturing and payroll systems to Year 2000 compliant platforms. As a percentage of total revenue, selling, general and administrative expenses were 21.1% in 1998 as compared with 20.4% in 1997.

Recapitalization: During 1997, the Company recognized $34.4 million in fees and expenses resulting from the transactions associated with a leveraged recapitalization of the Company (the "Recapitalization"). Recapitalization expenses consisted of compensation expense associated with employee stock option exercises and other incentives, commitment fees on unused credit facilities, legal and professional fees and other miscellaneous costs and expenses.

Operating Earnings: Operating earnings for 1998 were $67.6 million, an increase of 124.8% from $30.0 million in 1997, due substantially to Recapitalization expenses of $34.4 million which were recognized in 1997. Excluding Recapitalization expenses, operating earnings for 1998 would have increased $3.2 million, or 4.9%, from 1997. As a percentage of total revenue, the Company's operating margin was 20.4%, down from 21.0%, excluding Recapitalization expenses, in 1997 primarily due to the increase in selling, general and administrative expenses discussed above.

Interest Income: Interest income for 1998 was approximately $616,000 compared to approximately $2.3 million in the prior year. The decrease in interest income resulted from lower invested cash balances due primarily to acquisition activities in 1997 and the leveraged recapitalization transactions completed during the fourth quarter of the prior year.

Interest Expense: Interest expense for 1998 was $48.6 million compared to $10.2 million for 1997. The interest expense increase was due to interest accrued on an average balance of approximately $525 million in long-term debt obligations associated with the Recapitalization.

Income Taxes: The Company's effective income tax rate for 1998 and 1997 was 40.0%.

Net Earnings: Net earnings for 1998 were $11.8 million, or $.17 per share, assuming no dilution, compared to 1997 net earnings of $12.6 million, or $0.08 per share. Excluding Recapitalization expenses, net earnings for 1997 would have been $39.2 million, or $0.25 per share.

The change in revenue and expenses experienced by the Company during the year ended December 31, 1999 and other factors resulted in changes to the Company's balance sheet as follows:

Inventories at December 31, 1999 decreased $6.7 million, or 23.4%, to $22.0 million from the end of 1998, due primarily to lower purchases of raw materials and for-sale items combined with an inventory valuation adjustment of $1.9 million related primarily to a certain product line subject to fixed expiration dates.

Prepaid expenses and other current assets of $10.1 million decreased 30.3% as compared to $14.6 million at December 31, 1998. This change resulted primarily from a decrease of $3.8 million in deferred charges related to V.A.C. Medicare receivables.

At December 31, 1999, goodwill, net of accumulated amortization, was $52.3 million, or 18.5% of total assets. Goodwill represents the excess purchase price over the fair value of net assets acquired and is amortized over three to twenty-five years from the date of acquisition using the straight-line method.

The carrying value of goodwill is based on management's current assessment of recoverability. Management evaluates recoverability using both objective and subjective factors. Objective factors include management's best estimates of projected future earnings and cash flows and analysis of recent sales and earnings trends. Subjective factors include competitive analysis, technological advantage or disadvantage, and the Company's strategic focus.

Other assets decreased $6.8 million, or 21.5%, to $24.7 million at December 31, 1999. This decrease is primarily attributable to the liquidation of the assets of KCI Insurance Co., Ltd. during the first quarter of 1999. Other assets consist principally of patents, trademarks, long-term investments, and the estimated residual value of assets subject to leveraged leases. Patents and trademarks are amortized over the estimated useful life of the respective asset using the straight-line method.

Long-term debt obligations, including current maturities, decreased $13.0 million to $502.9 million as of December 31, 1999 due to the repayment of a portion of the Company's revolving credit facility in addition to scheduled principal payments, of $8.8 million.

Net deferred income taxes at December 31, 1999 of $5.1 million decreased 49.4% as compared to $10.1 million at December 31, 1998. This decrease is due to the realization of temporary tax timing differences, primarily the net operating tax loss generated in 1999.

The provision for deferred income taxes is based on the asset and liability method and represents the change in the deferred income tax accounts during the year. Under the asset and liability method of FAS 109, deferred income taxes are recognized for the future tax consequences attributable to the difference between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. At the end of 1999, the net impact of these timing issues resulted in a net deferred tax liability comprised of deferred tax liabilities totaling $27.6 million offset by deferred tax assets totaling $22.5 million. The Company anticipates that the reversal of existing taxable temporary differences and future income will provide sufficient taxable income to realize the tax benefit of the remaining deferred tax assets.

A description of the Company's legal proceedings is set forth under the caption "Item 3. Legal Proceedings".

At December 31, 1999, the Company had current assets of $119.0 million and current liabilities of $56.5 million resulting in a working capital surplus of $62.5 million, compared to a surplus of $76.6 million at December 31, 1998.

During 1999, the Company made net capital expenditures of $22.0 million. Other than commitments for new product inventory, including disposable "for sale" products, of $5.3 million, the Company has no material long-term capital commitments and can adjust the level of its capital expenditures as circumstances warrant.

During 1999, the Company generated $36.8 million in cash from operating activities compared to $43.9 in the prior year, a decrease of $7.1 million. The decrease in operating cash flows resulted primarily from lower earnings due to the decline in revenue discussed previously. Investment activities in 1999 used $20.1 million of cash, including net capital expenditures of $22.0 million and $5.1 million used to fund business acquisitions. Financing activities for 1999 used $12.9 million consisting primarily of $13.0 million used for long-term debt repayments. Principal payments on the term loans will total $16.8 million in 2000.

The Company's principal sources of liquidity are expected to be cash flows from operating activities and borrowings under the Senior Credit Facilities. It is anticipated that the Company's principal uses of liquidity will be to fund capital expenditures related to the Company's rental products, provide needed working capital, meet debt service requirements and finance the Company's strategic plans.

The Senior Credit Facilities originally totaled $400.0 million and consisted of (i) a $50.0 million six-year Revolving Credit Facility, (ii) a $50.0 million six-year Acquisition Facility, (iii) a $120.0 million six-year amortizing Term Loan A, (iv) a $90.0 million seven-year amortizing Term Loan B and (v) a $90.0 million eight-year amortizing Term Loan C, (collectively, the "Term Loans"). The Term Loans were fully drawn to finance a portion of the Recapitalization, and scheduled principal payments for 1999, totaling $8.8 million, were made in a timely manner.

The Term Loans are payable in equal quarterly installments (1) subject to an amortization schedule as follows (in thousands):

The Term Loans and the Notes are subject to customary terms, covenants and conditions which partially restrict the uses of future cash flow by the Company. In November 1999, in anticipation of a potential default on its Interest Coverage, Minimum EBITDA and Leverage Ratio Covenants at December 31, 1999 due to the decline in extended care rental revenue discussed previously, the Company requested its Senior Lenders to waive these covenants for the period from December 31, 1999 to and including February 29, 2000. On November 30, 1999 the Lenders approved this waiver and amended certain other provisions of this Senior Credit Agreement. On February 17, 2000, the Company and the Lenders agreed to a third amendment to its $400.0 million Credit and Guarantee Agreement dated November 3, 1997 (the "Amendment"). The Amendment establishes revised financial covenant levels for Interest Coverage, Leverage Ratio and Minimum EBITDA. Loan Commitment levels and repayment schedules remain unchanged with the exception of the cancellation of the $40.0 million of remaining availability under the Acquisition Facility. The portion of the Acquisition Facility which has been drawn, $10.0 million, will amortize over three years beginning March 31, 2001. The Company does not expect that these covenants and conditions, as amended, will have a material adverse impact on its operations. At December 31, 1999, the Acquisition Facility and Revolving Facility had balances of $10.0 million and $6.0 million, respectively. Additionally, the Company had two Letters of Credit in the amount of $3.5 million. As a result of the Amendment completed on February 17, 2000, the aggregate availability under the Revolving Facility was $40.5 million.

Indebtedness under the Senior Credit Facilities, as amended, including the Revolving Credit Facility (other than certain loans under the Revolving Credit Facility designated in foreign currency), the Term Loans and the Acquisition Facility initially bear interest at a rate based upon (i) the Base Rate (defined as the higher of (x) the rate of interest publicly announced by Bank of America as its "reference rate" and (y) the federal funds effective rate from time to time plus 0.50%), plus 1.75% in respect of the Tranche A Term Loans, the loans under the Revolving Credit Facility (the "Revolving Loans") and the loans under the Acquisition Facility (the "Acquisition Loans"), 2.00% in respect of the Tranche B Term Loans and 2.25% in respect of the Tranche C Term Loans, or at the Company's option, (ii) the Eurodollar Rate (as defined in the Senior Credit Facility Agreement) for one, two, three or six months, in each case plus 2.75% in respect of Tranche A Term Loans, Revolving Loans and Acquisition Loans, 3.00% in respect of Tranche B Term Loans and 3.25% in respect of the Tranche C Term Loans. Certain Revolving Loans designated in foreign currency will initially bear interest at a rate based upon the cost of funds for such loans plus 2.75%. Performance-based reductions of the interest rates under the Term Loans, the Revolving Loans and the Acquisition Loans are available. In December 1998, the Company entered into three interest rate protection agreements whereby the base interest rate on $245.0 million of the term loans is fixed at an average rate of approximately 5.31% through December 2000.

Indebtedness of the Company under the Senior Credit Agreement is guaranteed by certain of the subsidiaries of the Company and is secured by (i) a first priority security interest in all, subject to certain customary exceptions, of the tangible and intangible assets of the Company and its domestic subsidiaries, including, without limitation, intellectual property and real estate owned by the Company and its subsidiaries, (ii) a first priority perfected pledge of all capital stock of the Company's domestic subsidiaries and (iii) a first priority perfected pledge of up to 65% of the capital stock of foreign subsidiaries owned directly by the Company or its domestic subsidiaries.

The Senior Credit Agreement requires the Company to meet certain financial tests, including minimum levels of EBITDA (as defined therein), minimum interest coverage, maximum leverage ratio and capital expenditures. The Bank Credit Agreement also contains covenants which, among other things, limit the incurrence of additional indebtedness, investments, dividends, loans and advances, capital expenditures, transactions with affiliates, asset sales, acquisitions, mergers and consolidations, prepayments of other indebtedness (including the Notes), liens and encumbrances and other matters customarily restricted in such agreements. As noted above, the Amendment established revised financial covenant levels for Interest Coverage, Leverage Ratio and Minimum EBITDA. Loan Commitment levels and repayment schedules remain unchanged with the exception of the cancellation of the $40.0 million remaining availability under the Acquisition Facility.

The Senior Credit Agreement contains customary events of default, including payment defaults, breaches of representations and warranties, covenant defaults, cross-defaults to certain other indebtedness, certain events of bankruptcy and insolvency, failures under ERISA plans, judgment defaults, change of control of the Company and failure of any guaranty, security document, security interest or subordination provision supporting the Bank Credit Agreement to be in full force and effect.

As part of the Recapitalization transactions, the Company issued $200.0 million of Senior Subordinated Notes (the "Notes") due 2007. The Notes are unsecured obligations of the Company, ranking subordinate in right of payment to all senior debt of the Company and will mature on November 1, 2007. As of December 31, 1999 the entire $200.0 million of Senior Subordinated Notes was issued and outstanding.

The Notes are not entitled to the benefit of any mandatory sinking fund. The Notes will be redeemable, at the Company's option, in whole at any time or in part from time to time, on and after November 1, 2002, upon not less than 30 nor more than 60 days' notice, at the following redemption prices (expressed as percentages of the principal amount thereof) if redeemed during the twelve-month

period commencing on November 1 of the year set forth below, plus, in each case, accrued and unpaid interest thereon, if any, to the date of redemption.

At any time, or from time to time, the Company may acquire a portion of the Notes through open-market purchases. Also, on or prior to November 1, 2000, the Company may, at its option, on one or more occasions use all or a portion of the net cash proceeds of one or more equity offerings to redeem the Notes issued under the Indenture at a redemption price equal to 109.625% of the principal amount thereof plus accrued and unpaid interest thereon, if any, to the date of redemption; provided that at least 65% of the principal amount of Notes originally issued remains outstanding immediately after any such redemption. In order to effect the foregoing redemption with the proceeds of any equity offering, the Company shall make such redemption not more than 120 days after the consummation of any such equity offering.

At December 31, 1999, cash and cash equivalents of $7.4 million were available for general corporate purposes. Based upon the current level of operations, the Company believes that cash flow from operations and the availability under its line of credit will be adequate to meet its anticipated requirements for debt repayment, working capital and capital expenditures through 2000. Also at year-end, the Company was committed to purchase approximately $5.3 million of inventory associated with new products over the next year. The Company did not have any other material purchase commitments.

On January 1, 1999, the European Economic and Monetary Union ("EMU") entered a three-year transition period during which a new common currency, the "Euro", was introduced in participating countries and fixed conversion rates were established through the European Central Bank ("ECB") between existing local currencies and the Euro. Since then the Euro has traded on currency exchanges.

Following the introduction of the Euro, local currencies will remain legal tender until December 31, 2001. During this transition period, goods and services may be paid for with the Euro or local currency under the EMU's "no compulsion, no prohibition" principle.

Based on its evaluation to date, management believes that the introduction of the Euro will not have a material adverse impact on the Company's financial position, results of operations or cash flows. However, uncertainty exists as to the effects the Euro will have in the marketplace, and there is no guarantee that all issues have been foreseen and corrected or that other third parties will address the conversion successfully.

The Company has reviewed its information systems software and identified modifications necessary to ensure that business transactions can be conducted in a manner consistent with the requirements of the conversion to the Euro. Certain of these modifications have been implemented, and others will be implemented during the course of the transition period. The Company expects that modifications not yet implemented will be made on a timely basis and expects the incremental cost of the Euro conversion to be immaterial.

The Euro introduction is not expected to have a material impact on the Company's overall currency risk. The Company anticipates the Euro will simplify financial issues related to cross-border trade in the EMU and reduce the transaction costs and administrative time necessary to manage this trade and related risks. However, the Company believes that the associated savings will not be material to corporate results.

The implementation of a prospective payment system for extended care facilities has changed the way skilled nursing facilities buy and rent products. The effect of this change has been to sharply reduce the Company's revenues in the extended care market. The Company believes that in the long term, under a fixed payment system, decisions on selecting the products and services used in patient care will be based on clinical and cost effectiveness. The Company's innovative and extensive product continuum significantly improves clinical outcomes while reducing the cost of patient care should allow it to compete effectively in this environment. Home Health PPS is scheduled to be implemented on October 1, 2000. Although it is difficult to predict the impact which Home Health PPS will have on the overall home health market, the Company does not believe that the implementation of Home Health PPS will have a material impact on the Company's business.

The Company currently rents and sells the V.A.C. in all care settings and market acceptance of this product has been better than expected. This is evidenced by the significant revenue growth experienced in the four years that the product has been available domestically. However, the Company has not received a Medicare reimbursement code, and an associated coverage policy, for the V.A.C. in the home care setting. The Company continues to vigorously pursue this reimbursement coverage.

In prior years, the Company discussed the nature and progress of its plans to become Year 2000 compliant. In late 1999, the Company completed its remediation and testing of systems. As a result of those planning and implementation efforts, the Company experienced no significant disruptions in mission critical information technology and non-information technology systems and believes those systems successfully responded to the Year 2000 date change. The Company spent approximately $1.7 million during 1999 in connection with remediating its systems. The Company is not aware of any material problems resulting from Year 2000 issues, either with our products, our internal systems, or the products and services of its vendors and suppliers. The Company will continue to monitor its mission critical computer applications and those of its suppliers and vendors throughout the year 2000 to ensure that any latent Year 2000 matters that may arise are addressed promptly.

In June 1998, the Financial Accounting Standards Board ("FASB") issued Statement No. 133, Accounting for Derivative Instruments and Hedging Activities. In June 1999, FASB Statement No. 133 was amended by FASB Statement No. 137, Accounting for Derivative Instruments and Hedging Activities - Deferral of the effective date of FASB Statement No. 133 and is effective for years beginning after June 15, 2000. The Company expects to adopt the new Statement effective January 1, 2001. The Statement will require the Company to recognize all derivatives on the balance sheet at fair value. Derivatives that are not hedges must be adjusted to fair value through income. If the derivative is a hedge, depending on the nature of the hedge, changes in the fair value of derivatives will either be offset against the change in fair value of the hedged assets, liabilities, or firm commitments through earnings or recognized in other comprehensive income until the hedged item is recognized in earnings. The ineffective portion of a derivative's change in fair value will be immediately recognized in earnings. The Company has not yet determined what the effect of Statement 133 will be on the earnings and financial position of the Company

Item 7a. Quantitative and Qualitative Disclosures about Market Risk

The Company is exposed to various market risks, including fluctuations in interest rates and variability in currency exchange rates. The Company has established policies, procedures and internal processes governing its management of market risks and the use of financial instruments to manage its exposure to such risks.

At December 31, 1999, approximately 11.4% of the Company's long-term debt bore interest at variable rates. These variable-rate facilities bear interest at a stated rate based upon a Base Rate (defined as the higher of (i) the rate of interest publicly announced by Bank of America as its "reference rate" and (ii) the federal funds effective rate from time to time plus 0.50%) or the Eurodollar Rate (as defined) for one, two, three or six months plus associated credit risk factors from 1.75% to 2.75% depending on the base rate and maturity (see Note 5 to the Company's consolidated financial statements).

In an effort to minimize the risk of adverse interest rate fluctuations, the Company has entered into two interest rate protection agreements which effectively fix the base borrowing rate on 81.0% of the Company's variable rate debt as follows (dollars in millions):

As a result of these interest rate protection agreements, the Company believes that movements in short term interest rates would not materially affect the financial position of the Company.

The Company has direct operations in Western Europe, Canada and Australia and distributor relationships in many other parts of the world. The Company's foreign operations are measured in their local currencies. As a result, the Company's financial results could be affected by factors such as changes in foreign currency exchange rates or weak economic conditions in the foreign markets in which the Company has operations. Exposure to this variability is managed primarily through the use of natural hedges, whereby funding obligations and assets are both managed in the local currency. The Company maintains no other derivative instruments to mitigate the exposure to translation and/or transaction risk. International operations reported operating profit of $15.7 million for the year ended December 31, 1999. It is estimated that the result of a 10% fluctuation in the value of the dollar relative to these foreign currencies at December 31, 1999 would change the Company's 1999 net income by approximately $875,000. The Company's analysis does not consider the implications that such fluctuations could have on the overall economic activity that could exist in such an environment in the U.S. or the foreign countries or on the results of operations of these foreign entities.

Item 8. Financial Statements and Supplementary Data

See accompanying notes to consolidated financial statements.