Kinetic Concepts (NYSE:KCI): Buzz Growing on Strattice Performance in the Breast; Lowering Estimates

JP Morgan has a very interesting note on Kinetic Concepts (NYSE:KCI), discussing the issues with Strattice dermal matrix:

KCI has what we believe to be a growing issue with the performance of its Strattice dermal matrix in breast reconstruction. Over the last few weeks, we’ve consulted with a number of leading surgeons in the field of post mastectomy breast reconstruction. Many of these surgeons are advisers to KCI, all are customers, and several were early adopters of Strattice and are considered thought leaders in their field. On the back of these discussions, it seems that while Strattice works well in areas such as hernia repair, where there is sufficient microvascularization, it is not integrating as well in the breast, and there is a higher rate of complications.

On several fronts this presents a challenge for KCI. For starters, Strattice has become in relatively short order the company’s leading growth driver. Since its introduction in 1Q08, sales have climbed to more than $85M annualized and are likely to surpass $100M in the back half of the year. Strattice has in part cannibalized Alloderm, but it’s also expanded the market, as Alloderm has been and remains capacity constrained. The introduction of Strattice has allowed KCI to promote its products for new applications and, for the first time, expand internationally. What’s important as well is that Strattice has much higher margins, by our estimates 15-20% higher than Alloderm. Thus, the shift from Alloderm to Strattice not only enables the company to overcome the capacity constraints of manufacturing and marketing a cadaver-based product, but it substantially improves the company’s profitability.

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Since its launch, KCI has aggressively promoted Strattice in both hernia repair and breast reconstruction. Hernia repair is today 70% of the company’s regenerative mix (Alloderm + Strattice), with reconstruction comprising the other 30%. Strattice’s uptake in breast has been significant. In fact, on the company’s 2Q call, management on multiple occasions highlighted the progress in breast reconstruction, indicating that demand was exceeding expectations. Part of what’s helping Strattice in both breast and hernia repair is not only wider availability, but (a) its availability in larger size grafts and (b) it’s less expensive than Alloderm for the hospital.

The problem is that in breast reconstruction adverse event rates with Strattice are in practice running higher than expectations. Surgeons we spoke with that have done large numbers of Strattice implants indicate that the porcine graft does not incorporate as well as Alloderm. Integration is taking longer, and the number of cases where Strattice fails to incorporate is leading to more revisions. Surgeons indicate a higher seroma1 rate with Strattice and a higher rate of post-implant infections.

Firm is lowering estimates on KCI as following:

Action: While the impact on total revenue & EPS estimates is rather small, it is never a good sign if the main growth engine runs into trouble. KCI shares have had a nice run after 2Q09 results, in part thanks to growth at Lifecell. Would expect the shares to see some weakness in the coming days as some of the most optimistic expectations need to be reset.