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Kinetic Lures LBO on Cheapest Medical Products Value: Real M&A

Kinetic Concepts Inc. is enticing private equity firms with the U.S. medical products industry’s cheapest valuation for what would be the biggest leveraged buyout since the collapse of Lehman Brothers Holdings Inc.

Kinetic is discussing a sale with a group of at least two LBO firms that may value the company at more than $5 billion excluding debt, two people with knowledge of the talks said last week. A deal at that price plus net debt would value Kinetic at 9.2 times earnings before interest, taxes, depreciation and amortization in the last 12 months, compared with a median multiple of 12 times for all U.S. LBOs in the two years before Lehman’s bankruptcy, according to data compiled by Bloomberg.

While sales in Kinetic’s main wound-treatment business are little changed since 2008, the San Antonio-based company’s free cash flow yield of almost 9 percent and a new portable wound-care device may still help a buyout firm generate a return of as much as 40 percent in five years, Piper Jaffray Cos. estimates. Kinetic is currently valued at 7.8 times estimated 2011 Ebitda, the cheapest of any U.S. maker of medical products, instruments or hospital beds with a market capitalization between $1 billion and $10 billion, data compiled by Bloomberg show.

“The numbers work for an LBO,” said Matt Miksic, a New York-based analyst for Piper Jaffray. “It is a business that throws off a fair amount of cash. You need to lay out the potential upside of its new product and try to get a buyer to pay for that, while also recognizing that you have to account for some risks based on their core business.”

Kevin Belgrade, a spokesman for Kinetic, declined to comment.

Biggest LBO

A takeover of Kinetic at an equity value of $5 billion plus $684 million in net debt would surpass Del Monte Foods Co. as the biggest private equity LBO since New York-based Lehman filed for bankruptcy protection in September 2008, freezing credit markets and cutting off financing for leveraged transactions.

A group led by KKR & Co. of New York agreed in November to buy San Francisco-based Del Monte for about $3.8 billion, plus $1.3 billion in net debt, data compiled by Bloomberg show, after near zero percent interest rates had helped the U.S. stock market rebound from its worst slump since the Great Depression.

“Valuations are much more favorable in today’s market than they were pre-Lehman,” said Timothy Ghriskey, chief investment officer at Solaris Asset Management in Bedford Hills, New York, which manages $2 billion. “The favorable interest rate picture is also encouraging deals and making them financially attractive to the LBO.”

Lehman’s Collapse

In the two years leading up to New York-based Lehman’s collapse in September 2008, almost $514 billion worth of leveraged buyouts were announced at a median of 12 times Ebitda, according to data compiled by Bloomberg.

Kinetic is cheaper relative to its estimated Ebitda of $690.8 million this year than 19 other U.S. and U.K. makers of medical products, instruments or hospital beds with comparable market values between $1 billion and $10 billion, data compiled by Bloomberg show. It also has a price-to-earnings ratio of 16.6, almost half the industry average of 30.3, the data show.

The company could take on about $650 million of additional debt without lowering its BB+ credit rating, which is one level below investment grade, said Jesse Juliano, an analyst at Standard & Poor’s in Boston.

Credit Ratings

Increasing Kinetic’s long-term debt, including operating leases, by $650 million to $2.1 billion would reduce its ranking under Bloomberg’s Company Credit Ratings by one level to A2L, the fourth-highest investing grade level. Bloomberg’s ratings analyze borrowers based on their indebtedness, profitability and other financial ratios.

Kinetic, founded in 1976 by emergency-room physician Jim Leininger, makes negative-pressure devices that use vacuums to aid healing, tissue-regeneration products that use skin grafts in hernia and breast reconstruction and hospital bed and related equipment.

A judge invalidated two of Kinetic’s patents in October in a case against Smith & Nephew Plc, Europe’s biggest maker of shoulder and knee implants. Kinetic built its business around its patents and the reputation of its clinical representatives, said Suraj Kalia, an analyst with Rodman & Renshaw in New York..

With the patent setbacks, Kinetic faces rising competition and pricing pressure from competitors Smith & Nephew, Covidien Plc and C.R. Bard Inc., Miksic said. The company, which may be too dependent on hospitals that are now diversifying supplies, is using promotions and price cuts to hold onto its roughly 80 percent market share, he said.

Wound Treatment

Kinetic’s active healing solutions unit, which includes the company’s wound-treatment products, accounted for 70 percent of total revenue last year. The division’s sales have increased less than 1 percent in each of the last two years to $1.4 billion in 2010.

The transaction to go private has become more difficult to pull off in recent weeks because of tightening debt markets, said the people, who declined to be identified because the situation is private.

Investor concerns about a slowing U.S. economy and Europe’s debt crisis have also led to declines in U.S. leveraged loan issuance, making it more difficult for LBO firms to secure financing for buyouts. While offerings this year are the most since 2007, second-quarter loan sales fell to $116.4 billion from $141.2 billion in the three-month period ended March 31, according to Standard & Poor’s Leveraged Commentary and Data.

‘Recent Scare’

A U.S. Labor Department report last week that showed American employers added jobs at the slowest pace in nine months in June added urgency to efforts by President Barack Obama and congressional leaders to find a compromise on cutting deficits and raising the government’s $14.3 trillion debt ceiling to head off a default on U.S. debt obligations in early August.

“The recent scare around the U.S. debt ceiling and issues and European debt issues have maybe put some brakes on that momentum that we saw early on this year,” said Spencer Nam, a Boston-based analyst at Madison Williams & Co. “Maybe that’s the concern we’re hearing on this, and the banks are not willing to lend cash as readily as they used to.”

While Kinetic’s slow sales growth may deter strategic buyers, its free cash flow “automatically makes it a better choice for private equity,” said Jason Wittes, an analyst at Caris & Co. in New York. The company’s free cash flow yield of almost 9 percent will give it the flexibility to easily add leverage to its balance sheet, said Wittes.

‘Better Opportunity’

“These companies that have great cash flow yields, that really aren’t growing all that much, probably get a better value or at least have a better opportunity as private companies than they do as public companies,” said Malcolm Polley, who oversees $1 billion as chief investment officer at Stewart Capital in Indiana, Pennsylvania. “The public, for whatever reason, wants to see growth at any cost and, therefore, bigger multiples.”

According to Piper Jaffray’s Miksic, a private equity deal may also help Kinetic boost its business without the pressure of scrutiny from investors as a public company.

“What a financial sponsor can add is they can take the cost-cutting transformation investment steps to a faster pace and a higher level than the company might be able to do,” said Miksic. “The goal being to make these changes, getting the company repositioned to come public again at a multiple that in the future might make more sense.”

If a private equity firm were to pay between 7.5 times and 8.5 times Kinetic’s 2011 Ebitda, the buyer may get a 30 percent to 40 percent return in five years, Miksic estimated in a July 7 report. His analysis assumes an LBO would be made up of 55 percent debt.

‘Perfect Candidate’

The company also has a pipeline of new products in new markets. Kinetic introduced a disposable wound-care system called V.A.C.Via in February that “will help further penetrate the market opportunity in wound care,” said Tao Levy, an analyst with Collins Stewart LLC in New York. The company partnered with Novadaq Technologies Inc. in September on the SPY Imaging System in breast reconstruction and head, neck and colorectal surgeries.

Kinetic is also expanding in areas such as Japan and Brazil, Levy said.

“This is a pretty perfect candidate for a private equity LBO,” Solaris’s Ghriskey said. “The product line and the sales are fairly predictable. They’re not heavily influenced by economic factors. The company has had a very strong free cash flow, and the valuation is attractive. Those are all things LBO looks for.”

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