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CENTAUR GUERNSEY L.P. INC. - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion should be read in conjunction with the consolidated financial statements and accompanying notes included in this Annual Report on Form 10-K. The following discussion contains forward-looking statements that reflect our plans, estimates and beliefs. Our actual results could differ materially from those discussed in the forward-looking statements. Factors that could cause or contribute to these differences include, but are not limited to, those discussed in our "Risk Factors." (Part I, Item 1A.). OVERVIEW We are a leading global medical technology company devoted to the development and commercialization of innovative products and therapies designed to improve outcomes while helping to reduce the overall cost of patient care. Our primary businesses serve the advanced wound therapeutics and regenerative medicine markets and we are engaged in the rental and sale of our products throughout the United States and in over 75 countries worldwide through direct sales and indirect operations. We are owned by investment funds advised by Apax Partners and controlled affiliates of Canada Pension Plan Investment Board and the Public Sector Pension Investment Board and certain other co-investors. Our advanced wound therapeutics ("AWT") business is focused on the development and commercialization of AWT devices and dressings and accounted for approximately $1.291 billion or 73.4% of our global revenue in 2013. Our AWT business is primarily engaged in commercializing several technology platforms, including negative pressure wound therapy ("NPWT"), negative pressure surgical management ("NPSM") and epidermal harvesting. Our AWT dressings are used for the management of chronic and acute wounds. Our AWT business is primarily conducted by KCI and its operating subsidiaries, including Systagenix. Key brands in our AWT business include the V.A.C. NPWT line of products, Prevena, ABThera, CelluTome, Promogran, Tielle, and Adaptic. Our Regenerative Medicine business is primarily focused on the development and commercialization of regenerative and reconstructive acellular tissue matrices for use in general and reconstructive surgical procedures to repair soft tissue defects. Key brands within our product portfolio include our human tissue based AlloDerm and porcine tissue based Strattice in various configurations designed to meet the needs of patients and caregivers. In addition to our acellular tissue matrices, our Regenerative Medicine business markets autologous fat grafting solutions, such as Revolve, and distributes SPY Elite, a real-time operating room-based tissue perfusion imaging system, both of which are complementary to our tissue matrix business. Regenerative medicine accounted for approximately $468.2 million or 26.6% of our global revenue in 2013. Our customers include acute care hospitals, ambulatory surgical centers, and long-term care facilities, with whom we contract directly or through group purchasing organizations ("GPOs"). We bill these facilities directly for the rental and sale of our products. In the U.S. home care setting, we provide products and therapies to patients in the home and bill third-party payers, such as Medicare and private insurance, directly. Outside of the U.S., most of our revenue is generated in the acute care setting. Our sales and marketing organizations are focused on the training and education of care-givers on the proper application of our products and therapies, particularly with general, plastic and orthopedic surgeons, as well as wound ostomy care nurses. We also drive adoption of our products with the support of extensive clinical efficacy data, as well as the economic value proposition of our products to reduce the overall cost of care. Acquisitions and Divestitures In the fourth quarter of 2013, we closed the acquisition of Systagenix, an established provider of advanced wound therapeutics products. The adjusted purchase price paid, net of cash and cash equivalents, was $478.7 million. The purchase price was funded using $350.0 million of incremental borrowings under our existing senior secured credit facility along with cash on hand. The Systagenix portfolio of innovative wound care products comprises the majority of our advanced wound dressings business, discussed above. Systagenix, formerly part of Johnson & Johnson, generated annual revenue of approximately $205.5 million in 2013. Financial results of Systagenix are included within our consolidated financial statements for the period subsequent to the acquisition date. Combining Systagenix's advanced wound dressings with our KCI wound care business and innovation pipeline will enable us to create additional value for customers by providing more complete solutions for patients and clinicians. 36 -------------------------------------------------------------------------------- In the fourth quarter of 2012, we completed the divestiture of our legacy KCI TSS business to Getinge AB. The TSS business was comprised of specialized therapeutic support systems, including hospital beds, mattress replacement systems, overlays and patient mobility devices. At the closing of the divestiture, Getinge paid approximately $247 million for the assets of the TSS business. At the time of the divestiture, we entered into a transition services agreement with Getinge pursuant to which we will continue to provide certain financial and information technology services during 2014. The historical results of operations of the disposal group, excluding the allocation of general corporate overhead, are reported as discontinued operations in the consolidated statements of operations. Healthcare and Reimbursement Reform Significant reforms to the U.S. healthcare system were adopted in the form of the Patient Protection and Affordable Care Act of 2010 (the "PPACA"). The PPACA requires, among other things, medical device companies to pay a 2.3% excise tax on most U.S. medical device sales beginning in 2013. During 2013, the company paid excise taxes totaling $13.5 million. In the U.S. home care market, our NPWT products are subject to Medicare Part B reimbursement and many U.S. insurers have adopted coverage criteria similar to Medicare standards. For the year ended December 31, 2013, U.S. Medicare placements of our NPWT products represented approximately 8.1% of our total revenue. In 2013, a portion of our revenue from U.S. Medicare placements of NPWT products was subject to Medicare's durable medical equipment competitive bidding program. Beginning July 1, 2013, this program resulted in an average reimbursement decline of 41% for NPWT across 91 major metropolitan areas, covering approximately 40% of our U.S. Medicare Part B volumes. CMS's DME Competitive Bidding Round One Re-Compete program impacted an additional 9 areas, beginning January 1, 2014, with a similar reimbursement decline of 42%. Additionally, in March 2013, CMS announced that sequestration cuts of 2% applied to all Medicare Part A and B fee-for-service payments, including items under Medicare competitive bidding contracts, beginning April 1, 2013. CMS applies the 2% reduction to all claims after determining coinsurance and any applicable deductible and Medicare secondary payment adjustments. The sequestration cut is in place for 10 years (until 2021) unless Congress acts. RECENT DEVELOPMENTS On January 22, 2014, we entered into Amendment No. 5 to our Senior Secured Credit Facility ("Amendment No. 5"). As a result of the amendment, we created new classes of Dollar Term E-1 Loans, Euro Term E-1 Loans and Term E-2 Loans, having the same rights and obligations as the Dollar Term D-1 Loans, Euro Term D-1 Loans and Term D-2 Loans as set forth in the Credit Agreement and Loan Documents, except as revised by the amendment. Dollar Term E-1 Loans bear interest at a rate equal to, at KCI's election, a Eurocurrency rate plus 3.00% or an adjusted base rate plus 2.00%. Euro Term E-1 Loans bear interest at a rate equal to, at KCI's election, a Eurocurrency rate plus 3.25% or an adjusted base rate plus 2.25%. Term E-2 Loans bear interest at a rate equal to, at KCI's election, a Eurocurrency rate plus 2.50% or an adjusted base rate plus 1.50%. The Eurocurrency rate shall be subject to a floor of 1.00%, and the adjusted base rate shall be subject to a floor of 2.00%. We paid fees of $1.8 million as a result of this amendment. 37 -------------------------------------------------------------------------------- RESULTS OF OPERATIONS We have two reportable operating segments which correspond to our two businesses: Advanced Wound Therapeutics ("AWT") and Regenerative Medicine. Our AWT business is conducted by KCI and its subsidiaries, including Systagenix, while our Regenerative Medicine business is conducted by LifeCell and its subsidiaries. We have two primary geographic regions: the Americas, which is comprised principally of the United States and includes Canada, Puerto Rico and Latin America; and EMEA/APAC, which is comprised of Europe, the Middle East, Africa and the Asia Pacific region. Historically, we have experienced a seasonal slowing of unit demand for our NPWT devices and related dressings beginning in the fourth quarter and continuing into the first quarter, which we believe has been caused by year-end clinical treatment patterns, such as the postponement of elective surgeries and increased discharges of individuals from the acute care setting around the winter holidays. We typically experience a slowing of demand for our AWT dressings in the fourth quarter. Although we do not know if our historical experience will prove to be indicative of future periods, similar slow-downs may occur in subsequent periods. Revenue for each of our geographic regions in which we operate is disclosed for each of our businesses. Certain prior period amounts have been reclassified to conform to the 2013 presentation. The Year ended December 31, 2013 (Successor) compared to the Year ended December 31, 2012 (Successor) Revenue by Operating Segment The following table sets forth, for the periods indicated, business unit revenue (in thousands): Year ended December Year ended December 31, 2013 31, 2012 Advanced Wound Therapeutics revenue: Rental 743,818 $ 815,560 Sales 546,909 496,698 Total - Advanced Wound Therapeutics 1,290,727 1,312,258 Regenerative Medicine revenue: Rental 6,434 6,641 Sales 461,750 427,554 Total - Regenerative Medicine 468,184 434,195 Total consolidated revenue: Rental 750,252 822,201 Sales 1,008,659 924,252 Total consolidated revenue $ 1,758,911 $ 1,746,453 The increase in total revenue for 2013 as compared to the prior year was due to higher Regenerative Medicine sales revenue, partially offset by lower AWT rental revenue. Foreign currency exchange rate movements did not have a significant impact on worldwide revenue compared to the prior year. The decline in worldwide AWT revenue from the prior year was attributable primarily to lower rental revenue in established markets, partially offset by revenues from the Systagenix acquisition in the fourth quarter and increased revenue from expansion products and certain markets outside the U.S. The lower rental revenue in established markets resulted from a combination of lower volumes and lower average pricing. We anticipate our average global pricing will decline moderately in the future due to increased competition, healthcare reform and declining reimbursement. Foreign currency exchange rate movements did not have a significant impact on worldwide AWT revenue compared to the prior year periods. 38-------------------------------------------------------------------------------- The growth in worldwide Regenerative Medicine revenue over the prior year was due primarily to increased volumes of abdominal wall repair procedures due to demographic shifts and increased volumes of breast reconstruction procedures utilizing our products. Foreign currency exchange rate movements did not have a significant impact on worldwide Regenerative Medicine revenue. For additional discussion on segment and operation information, see Note 15 of the notes to the consolidated financial statements for the year ended December 31, 2013. Revenue by Geography The following table sets forth, for the periods indicated, rental and sales revenue by geography (in thousands): Year ended December Year ended December 31, 2013 31, 2012 Americas revenue: Rental 633,555 $ 682,868 Sales 783,369 733,489 Total - Americas 1,416,924 1,416,357 EMEA/APAC revenue: Rental 116,697 139,333 Sales 225,290 190,763 Total - EMEA/APAC 341,987 330,096 Total consolidated revenue: Rental 750,252 822,201 Sales 1,008,659 924,252 Total consolidated revenue $ 1,758,911 $ 1,746,453 Revenue Relationship The following table sets forth, for the periods indicated, the percentage relationship of each item to total revenue in the period, as well as the changes in each line item: Year ended December Year ended December 31, 2013 31, 2012 Advanced Wound Therapeutics revenue 73.4 % 75.1 % Regenerative Medicine revenue 26.6 24.9 Total consolidated revenue 100.0 % 100.0 % Americas revenue 80.6 % 81.1 % EMEA/APAC revenue 19.4 18.9 Total consolidated revenue 100.0 % 100.0 % Rental revenue 42.7 % 47.1 % Sales revenue 57.3 52.9 Total consolidated revenue 100.0 % 100.0 % 39--------------------------------------------------------------------------------Rental Expenses The following table presents rental expenses for the periods indicated (in thousands): Year ended December 31, 2013 Year ended December 31, 2012 Rental expenses $ 358,595 $ 443,446 Rental expenses are comprised of both fixed and variable costs including facilities, field service, sales force compensation and royalties associated with our rental products. Rental expenses during 2013 decreased from the prior year due primarily to a decrease in depreciation related to the fixed asset step up associated with purchase accounting related to the Merger and a reduction in operational expenses due to cost control measures. Cost of Sales The following table presents cost of sales (in thousands): Year ended December 31, 2013 Year ended December 31, 2012 Cost of sales $ 261,569 $ 249,338 Cost of sales includes manufacturing costs, product costs, royalties and the step up in value associated with purchase accounting adjustments associated with our "for sale" products. The increase in cost of sales in 2013 compared to the prior year was due primarily to increased sales volumes, partially offset by a $22.3 million net decrease in cost of sales related to the sale of inventory subject to a step up in value associated with purchase accounting adjustments. Gross Profit Margin The following table presents the gross profit margin (calculated as gross profit divided by total revenue for the periods indicated): Year ended December 31, 2013 Year ended December 31, 2012 Gross profit margin 64.7 % 60.3 % The gross profit margin increase during 2013 compared to the prior year was due primarily to a decrease in depreciation related to the fixed asset step up and lower cost of sales related to the inventory step up associated with purchase accounting and a reduction in operational expenses due to cost control measures. Selling, General and Administrative Expenses The following table presents selling, general and administrative expenses and the percentage relationship to total revenue (dollars in thousands): Year ended December 31, 2013 Year ended December 31, 2012 Selling, general and administrative expenses $ 696,175 $ 602,781 As a percent of total revenue 39.6 % 34.5 % Selling, general and administrative ("SG&A") expenses generally include administrative labor, incentive and sales compensation costs, insurance costs, professional fees, depreciation, bad debt expense and information systems costs, but exclude 40 -------------------------------------------------------------------------------- rental sales force compensation costs. The increase in SG&A expenses during 2013 compared to the prior year is due primarily to a fixed asset impairment charge of $30.6 million and an increase in restructuring-related expenses. Additionally, during 2013, write-offs of $16.9 million of other intangible assets were recorded due primarily to the discontinuation of certain projects. During 2012, SG&A expenses included impairment charges of $22.1 million associated with certain production equipment at our AWT manufacturing plant and inventory associated with our V.A.C.Via product. Research and Development Expenses The following table presents research and development expenses and the percentage relationship to total revenue (dollars in thousands): Year ended December 31, 2013 Year ended December 31, 2012 Research and development expenses $ 75,624 $ 71,859 As a percent of total revenue 4.3 % 4.1 % Research and development expenses relate to our investments in clinical studies and the development of new and enhanced products and therapies. Our research and development efforts include the development of new and synergistic technologies across the continuum of wound care, including tissue regeneration, preservation and repair, as well as new applications of negative pressure technology. Our research and development program is also leveraging our core understanding of biological tissues in order to develop biosurgery products in our Regenerative Medicine business. Acquired Intangible Asset Amortization In connection with the Merger, we recorded $2.89 billion of identifiable intangible assets during the fourth quarter of 2011. In 2013, we recorded an additional $253.6 million of identifiable intangibles in connection with our acquisition of Systagenix. We recognized $188.6 million and $221.0 million of amortization expense related to these acquired intangible assets during the years ended December 31, 2013 and 2012, respectively. Impairment of Goodwill and Intangible Assets During the third quarter of 2013 we recorded a $272.2 million impairment of goodwill and a $171.2 million impairment of indefinite-lived intangible assets related to our Regenerative Medicine reporting unit. Interest Expense Interest expense decreased to $419.9 million in 2013 compared to $466.6 million in the prior year due to lower average debt balances at lower interest rates. Foreign Currency Gain (Loss) Foreign currency transaction losses were $22.2 million during 2013 compared to $13.0 million in the prior year. The revaluation of the Term D-1 EURO loan to U.S. dollars represented $14.5 million and $6.3 million of the foreign currency transaction losses recorded during 2013 and 2012, respectively. Derivative Instruments Gain (Loss) During 2013, we recorded a derivative instruments gain of $1.6 million compared to a loss of $31.4 million in the prior year due primarily to fluctuations in the value of our interest rate derivative instruments. Gain (loss) from Discontinued Operations Earnings from discontinued operations, net of tax, were $3.3 million for 2013 compared to a gain of $92.2 million for 2012 related to the disposition of TSS assets. During 2012, we recognized a $93.9 million gain from the disposition of TSS assets, which is included in earnings from discontinued operations. See Note 3 of the notes to consolidated financial statements for the year ended December 31, 2013 for additional information on discontinued operations. 41 -------------------------------------------------------------------------------- The Year ended December 31, 2012 (Successor), the Period from November 4, 2011 through December 31, 2011 (Successor) and the Period from January 1, 2011 through November 3, 2011 (Predecessor) Revenue by Operating Segment The following table sets forth, for the periods indicated, business unit revenue (in thousands): Period from Period from November 4 January 1 Year ended through through December 31, 2012 December 31, 2011 November 3, 2011 Successor Successor Predecessor Advanced Wound Therapeutics revenue: Rental 815,560 142,506 745,457 Sales 496,698 88,643 436,504 Total - Advanced Wound Therapeutics 1,312,258 231,149 1,181,961 Regenerative Medicine revenue: Rental 6,641 456 1,359 Sales 427,554 73,159 320,092 Total - Regenerative Medicine 434,195 73,615 321,451 Total consolidated revenue: Rental 822,201 142,962 746,816 Sales 924,252 161,802 756,596 Total consolidated revenue $ 1,746,453 $ 304,764 $ 1,503,412 The decline in worldwide Advanced Wound Therapeutics revenue in 2012 was attributable primarily to lower rental revenue and disposable and therapy unit sales volumes in established markets, partially offset by increased revenue from new products including Prevena, GRAFTJACKET and V.A.C.Ulta as well as higher rental and sales volumes from our expansion markets. The lower rental and disposable sales revenue in established markets resulted primarily from a combination of lower hospital procedural volumes and lower average pricing. We anticipate our average global pricing to decline moderately in the future as our competitors market products designed to compete with our product portfolio. Foreign currency exchange movements unfavorably impacted total Advanced Wound Therapeutics revenues during 2012 compared to the prior year. The growth in Regenerative Medicine revenue over the prior-year periods was due primarily to increased demand for our acellular tissue matrix products as a result of continued market penetration and geographic expansion driven by revenue from the commercial launch of AlloDerm Ready to Use. Foreign currency exchange rate movements did not have a significant impact on worldwide Regenerative Medicine revenue. For additional discussion on segment and operation information, see Note 15 of the notes to the consolidated financial statements for the year ended December 31, 2013. 42--------------------------------------------------------------------------------Revenue by Geography The following table sets forth, for the periods indicated, rental and sales revenue by geography (in thousands): Period from Period from November 4 January 1 Year ended through through December 31, 2012 December 31, 2011 November 3, 2011 Successor Successor Predecessor Americas revenue: Rental 682,868 118,492 616,376 Sales 733,489 127,479 585,340 Total - Americas 1,416,357 245,971 1,201,716 EMEA/APAC revenue: Rental 139,333 24,470 130,440 Sales 190,763 34,323 171,256 Total - EMEA/APAC 330,096 58,793 301,696 Total consolidated revenue: Rental 822,201 142,962 746,816 Sales 924,252 161,802 756,596 Total consolidated revenue $ 1,746,453 $ 304,764 $ 1,503,412 The change in total revenue compared to the prior-year was due to lower Advanced Wound Therapeutics revenue, partially offset by higher Regenerative Medicine revenue. Foreign currency exchange movements had a slightly unfavorable impact on total revenue during 2012 compared to the prior year. Revenue Relationship The following table sets forth, for the periods indicated, the percentage relationship of each item to total revenue in the period, as well as the changes in each line item: Period from Period from November 4 January 1 Year ended December through through 31, 2012 December 31, 2011 November 3, 2011 Successor Successor Predecessor Advanced Wound Therapeutics revenue 75.1 % 75.8 % 78.6 % Regenerative Medicine revenue 24.9 24.2 21.4 Total consolidated revenue 100.0 % 100.0 % 100.0 % Americas revenue 81.1 % 80.7 % 79.9 % EMEA/APAC revenue 18.9 19.3 20.1 Total consolidated revenue 100.0 % 100.0 % 100.0 % Rental revenue 47.1 % 46.9 % 49.7 % Sales revenue 52.9 53.1 50.3 Total consolidated revenue 100.0 % 100.0 % 100.0 % 43--------------------------------------------------------------------------------Rental Expenses The following table presents rental expenses for the periods indicated (in thousands): Period from Period from November 4 January 1 Year ended December through through 31, 2012 December 31, 2011 November 3, 2011 Successor Successor Predecessor Rental expenses $ 443,446 $ 85,142 350,912 Rental, or field, expenses are comprised of both fixed and variable costs including facilities, field service, sales force compensation and royalties associated with our rental products. Rental expenses as a percent of total rental revenue during 2012 and the period from November 4 through December 31, 2011 increased from the prior period due primarily to depreciation expense associated with the purchase accounting adjustments related to the step up in value of rental medical equipment ("RME") related to the Merger, which totaled $102.9 million and $21.4 million for 2012 and the period from November 4, 2011 through December 31, 2011, respectively, or 12.5% and 14.9% of total rental revenue, respectively, partially offset by lower product royalty costs on NPWT revenue associated with our previous license agreement with Wake Forest University for which we ceased accruing royalties in the first quarter of 2011. Cost of Sales The following table presents cost of sales (in thousands): Period from Period from November 4 January 1 through through Year ended December 31, 2012 December 31, 2011 November 3, 2011 Successor Successor Predecessor Cost of sales $ 249,338 $ 43,761 190,927 Cost of sales includes manufacturing costs, product costs and royalties associated with our "for sale" products. Cost of sales for 2012 and the period from November 4 through December 31, 2011 includes cost of sales associated with the purchase accounting adjustments related to the step up in value of inventory related to the Merger, which totaled $25.5 million and $7.3 million for 2012 and the period from November 4, 2011 through December 31, 2011, respectively, or 2.8% and 4.8% of total sales revenue, respectively, and lower product royalty costs on NPWT revenue associated with our previous license agreement with Wake Forest University. The decrease in our cost of sales as a percent of sales revenue during the period from January 1, 2011 through November 3, 2011 was due primarily to lower product royalty costs on NPWT revenue associated with our previous license agreement with Wake Forest University and improved yields for Regenerative Medicine . Gross Profit Margin The following table presents the gross profit margin (calculated as gross profit divided by total revenue for the periods indicated): Period from Period from November 4 January 1 Year ended December through through 31, 2012 December 31, 2011 November 3, 2011 Successor Successor Predecessor Gross profit margin 60.3 % 57.7 % 64.0 % The gross profit margin decrease during 2012 and the period from November 4 through December 31, 2011 was due primarily to depreciation expense of $102.9 million and $21.4 million, respectively, and cost of sales of $25.5 million and $7.3 million, respectively, associated with the purchase accounting adjustments related to the step up in value of RME and inventory. This decrease was partially offset by lower royalty expense associated with our previous license agreement with Wake Forest University and higher gross margins associated with Regenerative Medicine. During 2012 and the period from November 4, 2011 through December 31, 2011, we did not record any royalty expense associated with our previously-existing licensing agreement with Wake Forest University. During the period from January 1, 2011 through November 3, 2011, we recorded $13.1 million in royalty expense associated with our previously-existing licensing agreement with Wake Forest University. 44 --------------------------------------------------------------------------------Selling, General and Administrative Expenses The following table presents selling, general and administrative expenses and the percentage relationship to total revenue (dollars in thousands): Period from Period from November 4 January 1 Year ended December 31, through through 2012 December 31, 2011 November 3, 2011 Successor Successor Predecessor Selling, general and administrative expenses $ 602,781 $ 217,717 $ 565,512 As a percent of total revenue 34.5 % 71.4 % 37.6 % SG&A expenses include administrative labor, incentive and sales compensation costs, insurance costs, professional fees, depreciation, bad debt expense and information systems costs, but excludes rental sales force compensation costs. SG&A increased during the period from November 4, 2011 through December 31, 2011 due primarily to charges, before taxes, related to the Merger, including $99.4 million of transaction costs and management fees and $35.2 million of restructuring and other costs. Additionally, the Company incurred higher selling and marketing costs associated with our Regenerative Medicine division and higher costs associated with geographic expansion. During the period from January 1 through November 3, 2011, the Company incurred significant charges, before taxes, related to the Merger, including $55.0 million of additional share-based compensation expense to settle in-the-money equity awards to employees and non-employee directors and $39.0 million of transaction costs. Research and Development Expenses The following table presents research and development expenses and the percentage relationship to total revenue (dollars in thousands): Period from Period from November 4 January 1 Year ended December 31, through through 2012 December 31, 2011 November 3, 2011 Successor Successor Predecessor Research and development expenses $ 71,859 $ 14,117 69,601 As a percent of total revenue 4.1 % 4.6 % 4.6 % Research and development expenses relate to our investments in clinical studies and the development of new and enhanced products and therapies. Our research and development efforts include the development of new and synergistic technologies across the continuum of wound care, including tissue regeneration, preservation and repair, as well as new applications of negative pressure technology. Our research and development program is also leveraging our core understanding of biological tissues in order to develop biosurgery products in our Regenerative Medicine business. Acquired Intangible Asset Amortization In connection with the Merger, we recorded $2.89 billion of identifiable intangible assets and recognized $188.6 million and $16.5 million of amortization expense during the year ended December 31, 2012 and the period from November 4, 2011 through December 31, 2011, respectively. Prior to the Merger, we recorded $486.7 million of identifiable definite-lived intangible assets during the second quarter of 2008 in connection with the LifeCell acquisition. Intangible asset amortization expense associated with the LifeCell acquisition was $29.5 million during the period from January 1, 2011 through November 3, 2011. Interest Expense Interest expense increased to $419.9 million during 2012 due to higher average debt balances at higher interest rates, and higher expense associated with interest rate swap and cap agreements. Interest expense increased to $105.1 million during the period from November 4, 2011 through December 31, 2011 due to one-time commitment fees of $32.3 million associated with Merger-related bridge financing, higher average debt balances at higher interest rates, and higher expense associated with interest rate swap and cap agreements. 45 --------------------------------------------------------------------------------Foreign Currency Gain (Loss) During the year ended December 31, 2012, foreign currency transaction losses were $13.0 million due primarily to significant volatility in the foreign currency markets. Foreign currency transaction gains were $21.8 million during the period from November 4, 2011 through December 31, 2011, of which $6.8 million related to the revaluation of the Term B-1 EURO loan to U.S. dollars, due primarily to significant volatility in the foreign currency markets. During the period from January 1, 2011 through November 3, 2011, foreign currency transaction losses were $0.1 million due primarily to significant volatility in the foreign currency markets. Earnings from Discontinued Operations Earnings from discontinued operations, net of tax, were $92.2 million, $3.8 million and $32.1 million for the year ended December 31, 2012, the period from November 4, 2011 through December 31, 2011 and the period from January 1, 2011 through November 3, 2011, respectively, related to the disposition of TSS assets. During 2012, we recognized a $93.9 million gain from this transaction, which is included in earnings from discontinued operations. See Note 3 of the notes to consolidated financial statements for the year ended December 31, 2012 for additional information on discontinued operations. LIQUIDITY AND CAPITAL RESOURCES We expect to fund our operations through a combination of internally generated cash from operations and from occasional borrowings under our Revolving Credit Facility. Our primary uses of cash are working capital requirements, capital expenditures and debt service requirements. We anticipate that cash generated from operations together with amounts available under our Revolving Credit Facility will be sufficient to meet our future working capital requirements, capital expenditures and debt service obligations as they become due. However, our ability to fund future operating expenses and capital expenditures and our ability to meet future debt service obligations or refinance our indebtedness will depend on our future operating performance which will be affected by general economic, financial and other factors beyond our control. See "Risk Factors-Risks Relating to our Capital Structure-To service our indebtedness, we will require a significant amount of cash." Our ability to generate cash depends on many factors beyond our control, and any failure to meet our debt service obligations could harm our business, financial condition and results of operations. For further information on the terms of our Revolving Credit Facility, see Note 6 of the notes to the consolidated financial statements for the year ended December 31, 2013. On November 8, 2012, KCI closed on the divestiture of its TSS business to Getinge AB. The final adjusted purchase price paid by Getinge to KCI was $241.5 million. The Company had one year of the close date to reinvest all of the net proceeds or otherwise use any remaining amount to repay its long-term debt obligations. The Company utilized the net proceeds from the sale to fund the acquisition of Systagenix and internal investments, which satisfied our reinvestment requirement. Historical - General We require capital principally for working capital requirements, capital expenditures and debt service requirements. Additionally, from time to time, we may use capital for acquisitions and other investing and financing activities. Working capital is required principally to finance accounts receivable and inventory. Our working capital requirements vary from period-to-period depending on manufacturing volumes, the timing of shipments and the payment cycles of our customers and payers. Our capital expenditures consist primarily of manufactured rental assets, manufacturing equipment, computer hardware and software, expenditures related to leasehold improvements and expenditures related to our global corporate headquarters building. We may from time to time seek to retire or purchase our outstanding debt through cash purchases, in open market purchases, privately negotiated transactions or otherwise. Such repurchases or exchanges, if any, will depend on prevailing market conditions, our liquidity requirements, contractual restrictions and other factors. The amounts involved may be material. 46 --------------------------------------------------------------------------------Sources of Capital Based upon the current level of operations, we believe our existing cash resources, as well as cash flows from operating activities and availability under our Revolving Credit Facility will be adequate to meet our anticipated cash requirements for at least the next twelve months. Cash flows related to discontinued operations were not material for the years ended December 31, 2013, and 2012, the period from January 1, 2011 through November 3, 2011 and the period from November 4, 2011 through December 31, 2011 and therefore have not been separately disclosed in the consolidated statements of cash flows. We do not anticipate the absence of cash flows from discontinued operations to significantly affect our liquidity and capital resources. During 2013, our primary source of capital was cash from operations and cash from financing activities related to our acquisition of Systagenix. During 2012, our primary source of capital was cash from operations and proceeds from the disposition of TSS assets held for sale. During the period from January 1, 2011 through November 3, 2011 and the period from November 4, 2011 through December 31, 2011, our primary source of capital was cash from operations. The following table summarizes the net cash provided and used by operating activities, investing activities and financing activities (in thousands): Period from November 4 Period from Year Ended through January 1 December 31, Year Ended December 31, through 2013 December 31, 2012 2011 November 3, 2011 Successor Successor Successor Predecessor Net cash provided (used) by operating $ 136,779 $ 162,693 $ (77,574 ) $ 487,968 activities Net cash provided (used) by investing (563,822 ) 144,535 (5,208,991 ) (122,657 ) activities Net cash provided (used) by financing 250,602 (140,200 ) 4,792,031 28,953 activities Effect of exchange rates changes on 240 696 (1,925 ) 1,018 cash and cash equivalents Net increase (decrease) in cash and $ (176,201 ) $ 167,724 $ (496,459 ) $ 395,282 cash equivalents As of December 31, 2013 and 2012, our principal sources of liquidity consisted of $206.9 million and $383.2 million, respectively, of cash and cash equivalents and availability under our Revolving Credit Facility. The availability under the Revolving Credit Facility was $178.8 million and $188.5 million at December 31, 2013 and 2012, respectively, and was reduced for $21.2 million and $11.5 million, respectively, of letters of credit issued by banks which are party to the Senior Secured Credit Facility. In addition, we had $12.6 million and $4.6 million of letters of credit issued by a bank not party to the Senior Secured Credit Facility as of December 31, 2013 and 2012, respectively. Capital Expenditures During the years ended December 31, 2013 and 2012 (Successor), the period of November 4, 2011 through December 31, 2011 (Successor), and the period of January 1, 2011 through November 3, 2011 (Predecessor), we made capital expenditures of $80.9 million, $91.6 million, $36.0 million and $98.6 million, respectively. Capital expenditures during the year ended December 31, 2013 (Successor) related primarily to expanding the rental fleet and information technology projects and purchases. Capital expenditures during the year ended December 31, 2012 (Successor), the period of November 4, 2011 through December 31, 2011 (Successor), and the period of January 1, 2011 through November 3, 2011 (Predecessor) related primarily to expanding the rental fleet, the construction of our global headquarters building, and information technology projects and purchases. Senior Secured Credit Facility On June 14, 2013, we entered into Amendment No. 2 to our Senior Secured Credit Facility ("Amendment No. 2"). As a result of the amendment we created new classes of Dollar Term D-1 Loans, Euro Term D-1 Loans and Term D-2 Loans, having the same rights and obligations as the Dollar Term C-1 Loans, Euro Term C-1 Loans and Term C-2 Loans as set forth in the Credit Agreement and Loan Documents, except as revised by the amendment. In connection with Amendment No. 2, Dollar Term C-1 Loans, Euro Term C-1 Loans and Term C-2 Loans were refinanced with Dollar Term D-1 Loans, Euro Term D-1 Loans and Term D-2 Loans, respectively. In connection with our acquisition of Systagenix, we borrowed $350.0 million of incremental term D-1 loans (the "Incremental Loans") incurred pursuant to Amendment No. 3 to our Senior Secured Credit Facility, dated as of October 28, 2013. The Incremental Loans were issued at a discount of $0.4 million. The interest rate and all other terms are identical to our previously-existing Dollar Term D-1 Loans. 47-------------------------------------------------------------------------------- The following table sets forth the amounts owed under the Senior Secured Credit Facility, the effective interest rates on such outstanding amounts, and the amount available for additional borrowing thereunder, as of December 31, 2013 (dollars in thousands): Effective Amount Available Maturity Interest Amount for Additional Senior Secured Credit Facility Date Rate Outstanding (1) Borrowing Senior Revolving Credit Facility November 2016 - % $ - $ 178,798 (2) Senior Dollar Term D-1 Credit Facility May 2018 4.92 % (3) 1,915,782 - Senior Euro Term D-1 Credit Facility May 2018 5.59 % (3) 327,127 -Senior Term D-2 Credit Facility November 2016 4.54 % (3) 314,051 - Total $ 2,556,960 $ 178,798 (1) Amount outstanding includes the original issue discount. (2) At December 31, 2013, the amount available under the revolving portion of our Senior Secured Credit Facility reflected a reduction of $21.2 million of letters of credit issued by banks which are party to the Senior Secured Credit Facility. In addition, we have $12.6 million of letters of credit issued by a bank not party to the Senior Secured Credit Facility. (3) The effective interest rate includes the effect of the original issue discount. Excluding the original issue discount, our nominal interest rate as of December 31, 2013 was 4.50% on the Senior Dollar Term D-1 Credit Facility, 4.75% on the Senior Euro Term D-1 Credit Facility and 4.00% on the Senior Term D-2 Credit Facility. On January 22, 2014, we entered into Amendment No. 5 to our Senior Secured Credit Facility ("Amendment No. 5"). As a result of the amendment we created new classes of Dollar Term E-1 Loans, Euro Term E-1 Loans and Term E-2 Loans, having the same rights and obligations as the Dollar Term D-1 Loans, Euro Term D-1 Loans and Term D-2 Loans as set forth in the Credit Agreement and Loan Documents, except as revised by the amendment. In connection with Amendment No. 5, Dollar Term D-1 Loans, Euro Term D-1 Loans and Term D-2 Loans were refinanced with Dollar Term E-1 Loans, Euro Term E-1 Loans and Term E-2 Loans, respectively. Dollar Term E-1 Loans bear interest at a rate equal to, at KCI's election, a Eurocurrency rate plus 3.00% or an adjusted base rate plus 2.00%. Euro Term E-1 Loans bear interest at a rate equal to, at KCI's election, a Eurocurrency rate plus 3.25% or an adjusted base rate plus 2.25%. Term E-2 Loans bear interest at a rate equal to, at KCI's election, a Eurocurrency rate plus 2.50% or an adjusted base rate plus 1.50%. The Eurocurrency rate shall be subject to a floor of 1.00%, and the adjusted base rate shall be subject to a floor of 2.00%. We paid fees of $1.8 million as a result of this amendment. 10.5% Second Lien Senior Secured Notes In November 2011, we issued $1.75 billion aggregate principal amount of second lien senior secured notes due 2018 (the "10.5% Second Lien Notes"). Interest on the 10.5% Second Lien Notes accrues at the rate of 10.50% per annum and is payable semi-annually in cash on each May 1 and November 1, beginning on May 1, 2012, to the persons who are registered holders at the close of business on April 15 and October 15 immediately preceding the applicable interest payment date. The 10.5% Second Lien Notes were issued at a discount resulting in an effective interest rate of 10.87%. Under the terms of the registration rights agreements entered into with respect to these notes, additional interest was accrued at a rate of 0.25% and 0.50% from November 4, 2012 to February 4, 2013 and February 5, 2013 to March 15, 2013, respectively. 12.5% Senior Unsecured Notes In November 2011, we issued $750.0 million aggregate principal amount of senior unsecured notes due 2019 (the "12.5% Unsecured Notes"); $612.0 million of which are still outstanding. Interest on the 12.5% Unsecured Notes accrues at the rate of 12.50% per annum and is payable semi-annually in cash on each May 1 and November 1, beginning on May 1, 2012, to the persons who are registered holders at the close of business on April 15 and October 15 immediately preceding the applicable interest payment date. The 12.5% Unsecured Notes were issued at a discount resulting in an effective interest rate of 12.62%. Under the terms of the registration rights agreements entered into with respect to these notes, additional interest was accrued at a rate of 0.25% and 0.50% from November 4, 2012 to February 4, 2013 and February 5, 2013 to March 15, 2013, respectively. 48 --------------------------------------------------------------------------------Convertible Senior Notes In 2008, we issued $690.0 million aggregate principal amount of 3.25% convertible senior notes due 2015 (the "Convertible Notes"). The Convertible Notes are governed by the terms of an indenture dated as of April 21, 2008 (the "Indenture"). In connection with the Merger, the holders of the Convertible Notes had the right to require us to repurchase some or all of their Convertible Notes. As of December 31, 2013, $101,000 aggregate principal amount of the notes remained outstanding. Covenants As of December 31, 2013 and 2012, the Senior Secured Credit Facility required we have a total leverage ratio of not to exceed 8.1:1 and 8.3:1, respectively, and an interest coverage ratio of at least 1.2:1 and 1.1:1, respectively. As of December 31, 2013 and 2012, our actual total leverage ratio was 6.0:1 and 5.6:1, respectively, and our interest coverage ratio was 1.9:1 and 1.6:1, respectively. As of December 31, 2013 and 2012, we were in compliance with all covenants under the Senior Secured Credit Facility. As of December 31, 2013, we were in compliance with all covenants under our Senior Secured Credit Facility, 10.5% Second Lien Notes, 12.5% Unsecured Notes, and the Convertible Notes. For further information on our long-term debt, see Note 6 of the notes to the consolidated financial statements for the year ended December 31, 2013. Interest Rate Protection At December 31, 2013 and 2012, we had three interest rate swap agreements to convert $1.5 billion of our outstanding variable rate debt to a fixed rate basis. These agreements became effective on December 31, 2013. The aggregate notional amount of the interest rate swaps decreases quarterly by amounts ranging from $1.7 million to $56.4 million until maturity. In November 2011, we entered into interest rate cap agreements with initial notional amounts of $1.6 billion that effectively limited the eurocurrency rate to 2% on a portion of the borrowings under our Senior Secured Credit Facility. These interest rate cap agreements expired December 31, 2013. Our interest rate protection agreements have not been designated as hedging instruments, and as such, we recognize the fair value of these instruments as an asset or liability with income or expense recognized in the current period. For further information on our interest rate protection agreements, see Note 7 of the notes to the consolidated financial statements for the year ended December 31, 2013. Contractual Obligations We are committed to making cash payments in the future on long-term debt, capital leases, operating leases, licensing agreements and purchase commitments. We have not guaranteed the debt of any other party. The following table summarizes our contractual cash obligations as of December 31, 2013 for each of the years indicated (in thousands): 2014 2015-2016 2017-2018 Thereafter Total(1) Long-term debt obligations(2) $ 26,311 $ 361,328 $ 3,965,527 $ 612,000 $ 4,965,166 Interest on long-term debt obligations(2) 377,738 749,782 626,158 64,600 1,818,278 Capital lease obligations 526 992 - - 1,518 Operating lease obligations 21,949 28,551 16,637 30,843 97,980 Licensing agreements 6,250 2,500 1,250 - 10,000 Purchase obligations 7,224 6,500 - - 13,724Related party management fees(3) 5,148 10,296 10,296 24,882 50,622 Total $ 445,146 $ 1,159,949 $ 4,619,868 $ 732,325 $ 6,957,288 (1) This excludes our liability of $53.7 million for unrecognized tax benefits. We cannot make a reasonably reliable estimate of the amount and period of related future payments for such liability. (2) Amounts and timing may be different from our estimated interest payments due to potential voluntary prepayments, borrowings and interest and foreign currency rate fluctuations. (3) Represents fees for strategic and consulting services paid to entities affiliated with the Sponsors. For further discussion of related party management fees, see Note 14 of the notes to the consolidated financial statements for the year ended December 31, 2013. 49 -------------------------------------------------------------------------------- Critical Accounting Estimates Critical accounting estimates as those that are, in management's opinion, very important to the portrayal of our financial condition and results of operations and require our management's most difficult, subjective or complex judgments. In preparing our financial statements in accordance with U.S. generally accepted accounting principles, we must often make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, expenses and related disclosures at the date of the financial statements and during the reporting period. Some of those judgments can be subjective and complex. Consequently, actual results could differ from our estimates. The accounting policies that are most subject to important estimates or assumptions are described below. Also, see Note 1 of the notes to the consolidated financial statements for the year ended December 31, 2013. Revenue Recognition and Accounts Receivable Realization We recognize revenue in accordance with the Revenue Recognition topic of the Codification when each of the following four criteria are met: 1) a contract or sales arrangement exists; 2) products have been shipped and title has transferred or services have been rendered; 3) the price of the products or services is fixed or determinable; and 4) collectibility is reasonably assured. We recognize rental revenue based on the number of days a product is used by the patient/organization, (i) at the contracted rental rate for contracted customers and (ii) generally, retail price for non-contracted customers. Sales revenue is recognized when products are shipped and title has transferred. In addition, we establish realization reserves against revenue to provide for adjustments including capitation agreements, estimated credit memos, volume discounts, pricing adjustments, utilization adjustments, product returns, cancellations, estimated uncollectible amounts and payer adjustments based on historical experience. In addition, revenue is recognized net of administrative fees paid to group purchasing organizations ("GPOs"). The Americas trade accounts receivable consist of amounts due directly from acute and extended care organizations, third-party payers ("TPP"), both governmental and non-governmental, and patient pay accounts. Included within the TPP accounts receivable balances are amounts that have been or will be billed to patients once the primary payer portion of the claim has been settled by the TPP. EMEA/APAC trade accounts receivable consist of amounts due primarily from acute care organizations. The TPP reimbursement process in the United States requires extensive documentation, which has had the effect of slowing both the billing and cash collection cycles relative to the rest of the business, and therefore, could increase total accounts receivable. Because of the extensive documentation required and the requirement to settle a claim with the primary payer prior to billing the secondary and/or patient portion of the claim, the collection period for a claim in our home care business may, in some cases, extend beyond one year prior to full settlement of the claim. We utilize a combination of factors in evaluating the collectibility of our accounts receivable. For unbilled receivables, we establish reserves to allow for expected denied or uncollectible items. In addition, items that remain unbilled for more than a specified period of time, or beyond an established billing window, are reserved against revenue. For billed receivables, we generally establish reserves using a combination of factors including historic adjustment rates for credit memos and canceled transactions, historical collection experience, and the length of time receivables have been outstanding. The reserve rates vary by payer group. In addition, we record specific reserves for bad debt when we become aware of a customer's inability or refusal to satisfy its debt obligations, such as in the event of a bankruptcy filing. If circumstances change, such as higher than expected claims denials, post-payment claim recoupments, a material change in the interpretation of reimbursement criteria by a major customer or payer, or payment defaults or an unexpected material adverse change in a major customer's or payer's ability to meet its obligations, our estimates of the realizability of trade receivables could be reduced by a material amount. A hypothetical 1% change in the collectibility of our billed receivables at December 31, 2013 would impact pre-tax earnings (loss) by an estimated $1.7 million. 50 --------------------------------------------------------------------------------Inventory Advanced Wound Therapeutics inventories Prior to the completion of the Merger on November 4, 2011, inventories were stated at the lower of cost or market (net realizable value), with cost being determined on a first-in, first-out basis. On November 4, 2011, inventories were recorded at fair value with the application of purchase accounting adjustments, with subsequent additions to inventory recorded at the lower of cost or market (net realizable value), with cost being determined on a first-in, first-out basis. On October 28, 2013, inventories purchased as part of our acquisition of Systagenix were recorded at fair value with the application of purchase accounting adjustments, with subsequent additions to inventory recorded at the lower of cost or market (net realizable value), with cost being determined on a first-in, first-out basis. Costs include material, labor and manufacturing overhead costs. Inventory expected to be converted into equipment for short-term rental is reclassified to property, plant and equipment. We review our inventory balances quarterly for excess sale products or obsolete inventory levels. Inventory quantities of sale-only products in excess of anticipated demand are considered excess and are reserved at 100%. For rental products, we review both product usage and product life cycle to classify inventory as active, discontinued or obsolete. Obsolescence reserve balances are established on an increasing basis from 0% for active, high-demand products to 100% for obsolete products. The reserve is reviewed and, if necessary, adjustments are made on a monthly basis. We rely on historical information and production planning forecasts to support our reserve and utilize management's business judgment for "high risk" items, such as products that have a fixed shelf life. Once the value of inventory is reduced, we do not adjust the reserve balance until the inventory is sold or otherwise disposed. Regenerative Medicine inventories Prior to the completion of the Merger on November 4, 2011, inventories were stated at the lower of cost or market (net realizable value), with cost being determined on a first-in, first-out basis. On November 4, 2011, inventories were recorded at fair value with the application of purchase accounting adjustments, with subsequent additions to inventory recorded at the lower of cost or market (net realizable value), with cost being determined on a first-in, first-out basis. Inventories on hand include the cost of materials, freight, direct labor and manufacturing overhead. We record a provision for excess and obsolete inventory based primarily on inventory quantities on hand, the historical product sales and estimated forecast of future product demand and production requirements. In addition, we record a provision for tissue that will not meet tissue standards based on historic rejection rates. Long-Lived Assets Prior to the completion of the Merger on November 4, 2011, property, plant and equipment was stated at cost. On November 4, 2011, property, plant and equipment was recorded at fair value with the application of purchase accounting adjustments, with subsequent additions to property, plant and equipment recorded at cost. On October 28, 2013, property, plant and equipment purchased as part of our acquisition of Systagenix was recorded at fair value with the application of purchase accounting adjustments, with subsequent additions to property, plant and equipment recorded at cost. Betterments, which extend the useful life of the equipment, are capitalized. Depreciation on property, plant and equipment is calculated on the straight-line method over the estimated useful lives (20 to 30 years for buildings and between three and seven years for most of our other property and equipment) of the assets. If an event were to occur that indicates the carrying value of long-lived assets might not be recoverable, we would review property, plant and equipment for impairment using an undiscounted cash flow analysis and if an impairment had occurred on an undiscounted basis, we would compute the fair market value of the applicable assets on a discounted cash flow basis and adjust the carrying value accordingly. Goodwill and Other Intangible Assets Business combinations are accounted for under the acquisition method. The total cost of an acquisition is allocated to the underlying identifiable net assets, based on their respective estimated fair values as of the acquisition date. Determining the fair value of assets acquired and liabilities assumed requires management's judgment and often involves the use of significant estimates and assumptions, including assumptions with respect to future cash inflows and outflows, discount rates, asset lives and market multiples, among other items. The excess of the purchase price over the estimated fair values of the net assets acquired is recorded as goodwill. 51 -------------------------------------------------------------------------------- Goodwill is tested for impairment by reporting unit annually as of October 31, or more frequently when events or changes in circumstances indicate that the asset might be impaired. Examples of such events or circumstances include, but are not limited to, a significant adverse change in legal or business climate, an adverse regulatory action or unanticipated competition. Impairment is tested by comparing the carrying value of the reporting unit to the reporting unit's fair value. The carrying value of each reporting unit is determined by taking the reported net assets of the consolidated entity, identifying reporting unit specific assets (including goodwill) and liabilities and allocating shared operational and administrative assets and liabilities to the appropriate reporting unit, which is the same as the segment to which they are assigned. The fair value of each reporting unit is determined using current industry market multiples as well as discounted cash flow models using certain assumptions about expected future operating performance and appropriate discount rates determined by our management. To ensure the reasonableness of the estimated fair value of our reporting units, we perform a reconciliation of the estimated fair value of our consolidated entity to the total estimated fair value of all our reporting units. The assumptions used in estimating fair values and performing the goodwill impairment test are inherently uncertain and require management judgment. When it is determined that the carrying value of goodwill may not be recoverable based upon the existence of one or more of the above indicators of impairment, the measurement of any impairment is determined and the carrying value is reduced as appropriate. Identifiable intangible assets include developed technology, in-process research and development, customer relationships, tradenames and patents. We amortize our identifiable definite lived intangible assets over 2 to 20 years, depending on the estimated economic or contractual life of the individual asset. For indefinite-lived identifiable intangible assets, impairment is tested by comparing the carrying value of the asset to the fair value. When it is determined that the carrying value of identifiable intangible assets may not be recoverable based upon the existence of one or more of the above indicators of impairment, the measurement of any impairment is determined and the carrying value is reduced as appropriate. The results of the third quarter 2013 interim impairment test indicated that the estimated fair value of the Regenerative Medicine reporting unit was less than its carrying value; consequently, during the third quarter of 2013 we recorded a $272.2 million impairment of goodwill and a $171.2 million impairment of indefinite-lived identifiable intangible assets related to our Regenerative Medicine reporting unit. There were no impairments of goodwill or identifiable intangible assets during 2012 or 2011. Our estimates of discounted cash flows may differ from actual cash flows due to, among other things, economic conditions, changes to our business model or changes in operating performance. Significant differences between these estimates and actual cash flows could materially affect our future financial results. These factors increase the risk of differences between projected and actual performance that could impact future estimates of fair value of all reporting units. In the event of an approximate 24% and 5% drop in the fair value of our KCI reporting unit and the fair value of our KCI indefinite-lived identifiable intangible assets, respectively, the fair value of the KCI reporting unit and indefinite-lived identifiable intangible assets would still exceed their book values as of October 31, 2013. Additionally, in the event of an approximate 7% and 2% drop in the fair value of our Regenerative Medicine reporting unit and the fair value of our Regenerative Medicine indefinite-lived identifiable intangible assets, respectively, the fair value of the Regenerative Medicine reporting unit and indefinite-lived identifiable intangible assets would still exceed their book values as of October 31, 2013. The carrying value of our Systagenix reporting unit and indefinite-lived identifiable intangible assets approximated their respective fair values as of October 31, 2013. Income Taxes Deferred income taxes are accounted for in accordance with the "Income Taxes" Topic of the FASB Accounting Standards Codification which requires the asset and liability method, whereby deferred tax assets and liabilities are recognized based on the tax effects of temporary differences between the financial statements and the tax bases of assets and liabilities, as measured by current enacted tax rates. When appropriate, we evaluate the need for a valuation allowance to reduce our deferred tax assets. We also account for uncertain tax positions in accordance with the "Income Taxes" Topic of the FASB Accounting Standards Codification. Accordingly, a liability is recorded for unrecognized tax benefits resulting from uncertain tax positions taken or expected to be taken in a tax return. We recognize interest and penalties, if any, related to unrecognized tax benefits in income tax expense. We have established a valuation allowance to reduce deferred tax assets associated with foreign net operating losses, certain state net operating losses and certain foreign deferred tax assets to an amount whose realization is more likely than not. We believe that the remaining deferred income tax assets will be realized based on reversals of existing taxable temporary differences and expected repatriation of foreign earnings. Accordingly, we believe that no additional valuation allowances are necessary. 52 --------------------------------------------------------------------------------Legal Proceedings and Other Loss Contingencies We are subject to various legal proceedings, many involving routine litigation incidental to our business. The outcome of any legal proceeding is not within our complete control, is often difficult to predict and is resolved over very long periods of time. Estimating probable losses associated with any legal proceedings or other loss contingencies is very complex and requires the analysis of many factors including assumptions about potential actions by third parties. Loss contingencies are disclosed when there is at least a reasonable possibility that a loss has been incurred and are recorded as liabilities in the consolidated financial statements when it is both (1) probable or known that a liability has been incurred and (2) the amount of the loss is reasonably estimable. If the reasonable estimate of the loss is a range and no amount within the range is a better estimate, the minimum amount of the range is recorded as a liability. If a loss contingency is not probable or cannot be reasonably estimated, a liability is not recorded in the consolidated financial statements. Recently Adopted Accounting Standards In January 2013, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No. 2013-01 "Clarifying the Scope of Disclosures about Offsetting Assets and Liabilities." The objective of this guidance is to clarify offsetting disclosures that apply to accounting for derivatives and hedging, including bifurcated embedded derivatives, repurchase agreements, reverse repurchase agreements and securities lending transactions. This guidance is effective for fiscal years and interim periods beginning on or after January 1, 2013. The adoption of this update did not have a material impact on our results of operations, financial position or disclosures. In January 2013, the FASB issued ASU No. 2013-02 "Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income." The objective of this guidance is to improve reporting of reclassifications out of accumulated other comprehensive income. The guidance does not change current requirements for reporting net income or other comprehensive income in financial statements. The guidance requires an entity to provide information about amounts reclassified out of accumulated other comprehensive income by component, and present either in the income statement or notes, significant amounts reclassified by the respective line items of net income. For public entities, this guidance is effective for reporting periods beginning after December 15, 2012. The adoption of this update did not have a material impact on our results of operations, financial position or disclosures. 53-------------------------------------------------------------------------------- |