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We recently downgraded our recommendation on Kinetic Concepts Inc. to Neutral with a target price of $68.50. This rating was primarily supported by the company’s limited upside potential stemming from the pending acquisition by private equity firm Apax Partners and two Canadian pension funds for approximately $6.3 billion or $68.50 in cash per share including all outstanding debt.

Kinetic suffered several setbacks over the past few quarters mainly on the back of declining sales in the TSS segment. Although, there was a sequential TSS sales growth during the quarter, the company witnessed a significant 6.2% year-over-year plunge in revenue from this segment due to lower sales from the critical care business arising from less severe flu season coupled with lower rental volume and average rental pricing.

Moreover, following the announcement of the definitive merger agreement, under which a consortium of funds advised by Apax Partners will acquire Kinetic, some of the shareholders of Kinetic initiated legal actions challenging the merger.

Although Kinetic believes these claims are vague, and the defendants intend to defend their positions in these matters vigorously, this may take a dangerous turn if Kinetic fails to defend itself in the litigation. We also remain concerned about the uncertainty related the regulatory approvals associated with the merger as delay or termination of the contract may be a huge setback for Kinetic.

Other major concerns for the company are patent litigation with Smith & Nephew (SNN - Snapshot Report), challenging economic environment and competitive landscape. If any of the key patent claims go against Kinetic, the company s market share in the V.A.C. therapy would be reduced.

However, despite all the recent headwinds, Kinetic appears to be a lucrative acquisition target due to its steady financials. The company witnessed continuous expansion in its top line and is gradually expanding its Regenerative business in the EMEA region. Also, the AHS business is gradually streamlining its position globally based on the continuous product launches under the V.A.C. therapy system.

During the second quarter of fiscal 2011, the company witnessed gradual improvement in this segment attributable to higher unit volumes in the US, resulting from the increased usage of traditional V.A.C. Therapy products and new negative pressure-based therapies. Moreover, the company is gradually gaining a strong foothold in Japan and Europe, which should boost the top line further.

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