ARTHROCARE CORP - 10-Q Quarterly Report

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 29, 2002.

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

For the transition period from to

Commission File Number: 0-27422

ArthroCare Corporation

(Exact name of registrant as specified in its charter)

Delaware		94-3180312
(State of incorporation)		(I.R.S. Employer Identification No.)

680 Vaqueros Avenue

Sunnyvale, California 94085

(Address of principal executive offices)

(408) 736-0224

(Registrant’s telephone number, including area code)

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 ¨

The number of shares outstanding of the registrant’s common stock as of August 1, 2002 was 21,417,140.

ARTHROCARE CORPORATION

INDEX

		Page
PART I: FINANCIAL INFORMATION

Item 1.	Financial Statements (unaudited)

	Condensed Consolidated Balance Sheets as of June 30, 2002 and December 31, 2001	3

	Condensed Consolidated Statements of Income for the three-month and six-month periods ended June 30, 2002 and June 30, 2001	4

	Condensed Consolidated Statements of Cash Flows for the six-month periods ended June 30, 2002 and June 30, 2001	5

	Notes to Condensed Consolidated Financial Statements	6

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	11

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	32

PART II: OTHER INFORMATION

Item 1.	Legal Proceedings	33

Item 4.	Submission of Matters to a Vote of Security Holders	33

Item 6.	Exhibits and Reports on Form 8-K	34

SIGNATURES		38

Page 2 of 38

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

ARTHROCARE CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except per share data)

	June 30, 2002			December 31, 2001
	(Unaudited)
ASSETS
Current assets:
Cash and cash equivalents	$	47,316		$	41,507
Available-for-sale securities		13,836			26,662
Accounts receivable, net of allowances of $477 in 2002 and $776 in 2001		18,558			18,567
Inventories		16,038			14,207
Prepaid expenses and other current assets		6,566			6,250

Total current assets		102,314			107,193

Available-for-sale securities		16,349			8,526
Property and equipment, net		15,466			13,068
Related party receivables		1,205			1,205
Other assets		3,719			3,705

Total assets	$	139,053		$	133,697

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	3,185		$	3,142
Accrued liabilities		3,002			1,111
Accrued compensation		4,441			3,837
Income taxes payable		948			461

Total current liabilities		11,576			8,551

Deferred rent		80			53

Total liabilities		11,656			8,604

Contingencies (Note 6)

Stockholders’ equity:
Preferred stock, par value $ 0.001: Authorized: 5,000 shares; Issued and Outstanding: none
Common stock, par value $ 0.001: Authorized 75,000 shares; Issued and Outstanding: 21,824 shares in 2002, and 21,855 shares in 2001		22			22
Treasury stock: 1,052 shares in 2002, 951 shares in 2001		(20,301	)		(18,987	)
Additional paid-in capital		146,751			146,081
Accumulated other comprehensive loss		(319	)		(1,724	)
Retained earnings/(accumulated deficit)		1,244			(299	)

Total stockholders’ equity		127,397			125,093

Total liabilities and stockholders’ equity	$	139,053		$	133,697

The accompanying notes are an integral part of these condensed consolidated financial statements

Page 3 of 38

ARTHROCARE CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(In thousands, except per share data)

(Unaudited)

	Three Months Ended				Six Months Ended
	June 30, 2002		June 30, 2001		June 30, 2002		June 30, 2001
Revenues:
Product sales	$	20,709	$	18,505	$	39,997	$	35,530
Royalties, fees and other		1,386		3,799		2,175		4,788

Total revenues		22,095		22,304		42,172		40,318
Cost of product sales		7,201		7,213		14,777		13,868

Gross profit		14,894		15,091		27,395		26,450

Operating expenses:
Research and development		2,134		2,018		4,284		3,896
Sales and marketing		8,887		7,832		17,259		14,218
General and administrative		2,480		1,288		4,403		2,330

Total operating expenses		13,501		11,138		25,946		20,444

Income from operations		1,393		3,953		1,449		6,006
Interest and other income, net		329		1,082		854		2,142

Income before income tax provision		1,722		5,035		2,303		8,148
Income tax provision		551		1,813		760		2,944

Net income	$	1,171	$	3,222	$	1,543	$	5,204

Basic net income per share	$	0.05	$	0.14	$	0.07	$	0.23

Shares used in computing basic net income per share		21,851		22,268		21,842		22,312

Diluted net income per share	$	0.05	$	0.14	$	0.07	$	0.22

Shares used in computing diluted net income per share		22,769		23,470		22,764		23,480

The accompanying notes are an integral part of these condensed consolidated financial statements

Page 4 of 38

ARTHROCARE CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

	Six Months Ended
	June 30, 2002			June 30, 2001
Cash flows from operating activities:
Net income	$	1,543		$	5,204
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		3,576			2,705
Stock compensation expense		113			257
Provision for doubtful accounts receivable and product returns		(425	)		218
Provision for excess and obsolete inventory		77			(12	)
Deferred rent		27			(33	)
Changes in operating assets and liabilities:
Accounts receivable		190			(2,704	)
Inventories		(1,965	)		2,123
Prepaid expenses and other current assets		(333	)		(367	)
Accounts payable		39			2,385
Accrued liabilities		1,846			(820	)
Income taxes payable		487			—
Deferred revenue		—			(3,787	)
Other assets		(14	)		242

Net cash provided by operating activities		5,161			5,411

Cash flows from investing activities:
Purchases of property and equipment		(5,974	)		(3,603	)
Purchases of available-for-sale securities		(105,281	)		(8,980	)
Sales or maturities of available-for-sale securities		110,265			26,359

Net cash provided by/(used in) investing activities		(990	)		13,776

Cash flows from financing activities:
Purchase of treasury stock		(665	)		(2,736	)
Repayment of capital leases		—			(52	)
Proceeds from exercise of options to purchase common stock		557			2,273

Net cash used in financing activities		(108	)		(515	)

Effect of exchange rate changes on cash		1,746			(484	)

Net increase in cash and cash equivalents		5,809			18,188
Cash and cash equivalents, beginning of period		41,507			35,782

Cash and cash equivalents, end of period	$	47,316		$	53,970

The accompanying notes are an integral part of the condensed consolidated financial statements

Page 5 of 38

ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1. Basis of Presentation:

In the opinion of management, the accompanying unaudited condensed consolidated financial statements contain all adjustments (all of which are normal and recurring in nature) necessary to present fairly the financial position, results of operations and cash flows of ArthroCare Corporation and its subsidiaries (“ArthroCare,” “we,” “us” or “our”) for the periods indicated. Interim results of operations are not necessarily indicative of the results to be expected for the full year or any other interim periods. The notes to the consolidated financial statements contained in our Form 10-K for the year ended December 31, 2001 should be read in conjunction with these condensed consolidated financial statements. The balance sheet at December 31, 2001 was derived from our audited consolidated financial statements; however, the accompanying financial statements do not include all annual disclosures required by accounting principles generally accepted in the United States of America.

Our fiscal quarters end on the Saturday closest to the last day of the month. For presentation purposes both quarter end dates are shown as June 30.

2. Revenue Recognition:

We recognize product and royalty revenue upon shipment of our products to customers, upon fulfillment of acceptance terms, if any, and when no significant contractual obligations remain. Revenue is reported net of a provision for estimated product returns. We recognize license fee and milestone revenue from business partners over the term of the associated agreement unless the fee or milestone is in exchange for products delivered or services performed that represent the culmination of a separate earnings process.

We previously recognized commissions to stocking distributors as sales and marketing expenses at the time the related revenue was recognized. On January 1, 2002, we adopted EITF issue 01-09 “Accounting for Consideration Given by a Vendor (including a Customer of a Reseller of the Vendor’s products)” and changed our method of accounting for commissions to stocking distributors, to record such consideration as a reduction of revenue. All periods presented have been reclassified to conform to the current period. The impact of this change was a $1.3 million reduction of both revenue and sales and marketing expense for the quarter ended June 30, 2001. The corresponding decrease for the six month period ending June 30, 2001 was $2.3 million.

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3. Computation of Net Income Per Share:

Basic net income per share is computed using the weighted average number of shares of common stock outstanding during the period. Diluted net income per share is computed using the weighted average number of shares of common stock and common equivalent shares outstanding during the period. Common equivalent shares consist of stock options and are excluded from the computation if their effect is anti-dilutive.

The following is a reconciliation of the computation for basic and diluted net income per share (in thousands, except per share data):

	Three Months Ended				Six Months Ended
	June 30, 2002		June 30, 2001		June 30, 2002		June 30, 2001
Net income	$	1,171	$	3,222	$	1,543	$	5,204

Weighted average basic shares outstanding (used in computing basic net income per share)		21,851		22,268		21,842		22,312
Options and warrants		918		1,202		922		1,168

Shares used in computing diluted net income per share		22,769		23,470		22,764		23,480

Basic net income per share	$	0.05	$	0.14	$	0.07	$	0.23

Diluted net income per share	$	0.05	$	0.14	$	0.07	$	0.22

Options to purchase 3,210,676 and 3,176,593 shares of common stock at prices ranging from $13.75-$48.56 per share outstanding during the three-month and six-month periods ended June 30, 2002, respectively, were not included in the computation of diluted net income per share because their effects are anti-dilutive. Options to purchase 1,341,257 and 1,188,193 shares of common stock at prices ranging from $19.44-$48.56 per share outstanding during the three-and six-month periods ended June 30, 2001, respectively, were not included in the computation of diluted net income per share because the effects were anti-dilutive.

Page 7 of 38

4. Comprehensive Income:

Comprehensive income is comprised of net income and other comprehensive income such as foreign currency translation gains or losses and unrealized gains or losses on available-for-sale securities, which are recorded in stockholders equity. Our total comprehensive income is as follows (in thousands):

	Three Months Ended					Six Months Ended
	June 30, 2002		June 30, 2001			June 30, 2002			June 30, 2001
Net income	$	1,171	$	3,222		$	1,543		$	5,204
Other comprehensive income:
Change in unrealized gains and losses on available-for-sale marketable securities		69		2,688			(19	)		2,480
Foreign currency translation adjustment		947		(332	)		1,424			(1,518	)

Comprehensive net income	$	2,187	$	5,578		$	2,948		$	6,166

5. Inventories (in thousands):

	June 30, 2002		December 31, 2001
Inventories:
Raw materials	$	5,351	$	5,678
Work-in-process		3,955		2,692
Finished goods		6,732		5,837

Total	$	16,038	$	14,207

6. Litigation:

On July 25, 2001, ArthroCare filed a lawsuit against Smith & Nephew, Inc. (“the Defendant”) in the United States District Court of Delaware. The lawsuit alleges, among other things, that the Defendant has been, and is currently, infringing three patents issued to ArthroCare. Specifically, the Defendant uses, imports, markets and sells an electrosurgical system under the name Dyonics Control RF System that infringes these patents. ArthroCare seeks the following remedies: (1) a judgment that the Defendant has infringed these patents; (2) a permanent injunction precluding the Defendant from using, importing, marketing and selling the Dyonics Control RF System; and (3) an award of damages (including attorneys’ fees) to compensate us for lost profits and the Defendant’s use of our inventions with the damages to be trebled because of the Defendant’s willful infringement.

In conjunction with a medical malpractice suit against a physician, a product liability suit was brought against us in the Superior Court of Arizona, county of Yavapai on August 24, 2001. The lawsuit alleges that a patient, D. Earl, suffered internal and external injury to the patient’s knee as a result of a defective ArthroCare probe used in an arthroscopy procedure on the patient. ArthroCare believes these claims to be without merit and intends to defend itself vigorously.

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On August 29, 2001, Inamed Corporation filed a demand for arbitration in Santa Clara County, California. The demand alleges that ArthroCare wrongfully terminated its license and distribution agreement with Inamed and seeks damages for breach of contract including the repayment of licensing fees. On August 8, 2002, this dispute has been settled. The arbitration has been dismissed and both parties have executed mutual releases of their claims.

In November 2001, a product liability suit was brought against us in the United States District Court, Eastern District of Michigan. The lawsuit alleges that a patient, M. Pawlik, suffered burns to her left arm as a result of a defect in an ArthroCare device used in an arthroscopy procedure performed on the patient. ArthroCare believes these claims to be without merit and intends to defend itself vigorously.

In April 2002, a product liability suit was brought against us in the United States District Court, District of Maine. The lawsuit alleges that a patient, J. Herzog, suffered pain and weakening in his knee as a result of an ArthroCare device used in an arthroscopy procedure performed on the patient. ArthroCare believes these claims to be without merit and intends to defend itself vigorously.

7. Segment Information:

We have organized our marketing and sales efforts into business units based on product markets. These business units are comprised of the following: Arthroscopy, ENTec^®, ArthroCare Spine^™, Visage^®, AngioCare^™ and ArthroCare ENDO^™. Our reportable segments include Arthroscopy, ENTec, and ArthroCare Spine. Our Visage, AngioCare and ArthroCare ENDO business units have been aggregated and reported as Other. Product sales for the three- month and six-month periods ended June 30, 2002 and June 30, 2001 are summarized in the table below.

	Three Months Ended				Six Months Ended
	June 30, 2002		June 30, 2001		June 30, 2002		June 30, 2001
Product sales (in thousands):
Arthroscopy	$	16,155	$	15,241	$	31,132	$	29,262
ENTec		2,371		1,844		4,522		3,198
ArthroCare Spine		1,835		1,208		3,761		2,248
Other		348		212		582		822

Total	$	20,709	$	18,505	$	39,997	$	35,530

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Internationally, the Company markets and supports its products primarily through its subsidiaries and various distributors. Revenues attributed to geographic areas are based on the country in which subsidiaries are domiciled. The following tables represent a summary of total revenues and long-lived assets by geographical region.

	Three Months Ended				Six Months Ended
	June 30, 2002		June 30, 2001		June 30, 2002		June 30, 2001
Total revenue (in thousands):
United States	$	19,126	$	18,472	$	35,944	$	35,176
International		2,969		3,832		6,228		5,142

Total	$	22,095	$	$22,304	$	42,172	$	40,318

Balance as of:	June 30, 2002		December 31, 2001
Property and equipment:
United States	$	11,919	$	11,092
International		3,547		1,976

Total	$	15,466	$	13,068

8. Treasury Stock:

In April 2001, the Board of Directors authorized the repurchase of up to 1,000,000 shares of our common stock. In June 2002, the Board of Directors authorized the additional repurchase of up to 2,000,000 shares of our common stock, subject to certain limitations and conditions. For the six month period ended June 30, 2002, we repurchased 100,700 shares at a cost of $1.3 million, of which $0.6 million is accrued for at June 30, 2002. For the six month period ended June 30, 2001, we repurchased 154,000 shares at a cost of $2.7 million.

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PART I. FINANCIAL INFORMATION

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Overview

Statements in this Management’s Discussion and Analysis of Financial Condition and Results of Operations which express that ArthroCare Corporation (“ArthroCare” “we,” “us,” or “our”) “believes”, “anticipates”, “intends”, “estimates”, “expects” or “plans to”, as well as other statements which are not historical fact, are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Actual events or results may differ materially as a result of the risks and uncertainties described herein and elsewhere including, in particular, those factors described under “Business” set forth in Part I of our Annual Report on Form 10-K for the year ended December 31, 2001 and “ADDITIONAL FACTORS THAT MIGHT AFFECT FUTURE RESULTS” set forth below.

We are a medical device company that develops, manufactures and markets products based on our patented Coblation^® technology. Our products allow surgeons to operate with a high level of precision and accuracy, limiting damage to surrounding tissue. Our products operate at lower temperatures than traditional electrosurgical or laser surgery tools, and enable surgeons to ablate, sculpt, cut, aspirate and suction soft tissue, and to seal small bleeding vessels. Ablation is the disintegration or removal of tissue. Our soft-tissue surgery systems consist of a controller unit and an assortment of sterile, single-use disposable devices that are specialized for specific types of surgery. We believe our Coblation technology can replace the multiple surgical tools traditionally used in soft-tissue surgery procedures with one multi-purpose surgical system.

Coblation technology is applicable across many soft-tissue surgical markets. Our systems are used to perform many types of surgical procedures. Our strategy includes applying our patented Coblation technology to a broad range of soft-tissue surgical markets, including arthroscopy, spinal surgery, neurosurgery, cosmetic surgery, ear, nose and throat (ENT) surgery, gynecology, urology, general surgery and various cardiology applications. We have formed the following business units for commercialization of our technology in non-orthopedic markets: ArthroCare Spine, to commercialize our technology in the spinal and neurosurgery markets; Visage, to commercialize our cosmetic surgery products for use in various cosmetic surgery procedures; ENTec to commercialize our ENT surgery products for use in head and neck surgical procedures; ArthroCare ENDO to commercialize our Coblation based products in laparascopic and endoscopic open surgical procedures for general surgery, gynecology and urology applications; and AngioCare, to commercialize our technology in cardiology markets.

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We have received 510(k) clearance from the United States Food and Drug Administration, or FDA, to market our Arthroscopic Surgery System for use in arthroscopic and orthopedic surgery of the knee, shoulder, ankle, elbow, wrist and hip, and our Arthroscopic Surgery System is CE marked for use in arthroscopic surgery. The CE Mark is a requirement to sell our products in most of Europe. Our Cosmetic Surgery System has been cleared by the FDA and is CE marked for general dermatologic procedures and skin resurfacing in connection with wrinkle reduction procedures. Our ENT Surgery System is CE marked, and we have received 510(k) clearances from the FDA for use of our ENT Surgery System in general head, neck, oral and sinus surgery procedures, including treatments for snoring and turbinates, tonsillectomies and adenoidectomies and submucosal channeling procedures. Our Spinal Surgery System is CE marked, and we have received 510(k) clearances in the United States to market this system for spinal surgery and neurosurgery. We also have our general surgery, gynecology, urology, and plastic and reconstructive surgery products CE marked and have received 510(k) clearance from the FDA to market these products in the United States.

We commercially introduced our Arthroscopic Surgery System in December 1995 and have derived a significant portion of our sales from this system. As of June 30, 2002, we had shipped more than 14,800 controller units and more than 1,700,000 disposable devices for a variety of indications. We are marketing and selling our arthroscopic, ENT, cosmetic surgery and spinal surgery products in the United States through a network of direct sales representatives and independent distributors supported by regional managers. We have more than 70 distributors representing more than 400 field sales representatives in the United States. We have also established distribution capability in Europe, Australia, New Zealand, China, Korea, Japan, Taiwan, Canada, Mexico, the Caribbean, Russia, South Africa, the Middle East, Northern Africa and South and Central America.

In June 2000, we entered into a distribution agreement with Integra NeuroSciences, a division of Integra LifeSciences Holding Corporation, for Integra to be our exclusive sales and distribution partner in certain countries for our products in the neurosurgical market. On June 30, 2002, we notified Integra of our intent to terminate the distribution agreement due to material breach of the agreement by Integra. This agreement has been terminated as of August 1, 2002, and we have retained all worldwide rights to the neurosurgical market. We have entered into a strategic relationship with the GyneCare division of Ethicon to commercialize Coblation based products for laparoscopic and open surgical procedures for gynecological applications. We have also entered into a strategic relationship with ACMI, under which ACMI will market and sell our products for urologic indications, including transurethral resection of the prostate (TURP).

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Results of Operations

Three months ended June 30, 2002 and June 30, 2001

Revenues:

Product sales for the quarter ended June 30, 2002 were $20.7 million, an increase of $2.2 million, or 12%, over the second quarter of 2001. On January 1, 2002 we implemented EITF 01-09, which relates to the consideration from a vendor to a customer or reseller of the vendor’s product which stipulates that commissions we pay to stocking distributors be reflected as a reduction of revenues in the statement of income. Prior year amounts have been reclassified to conform to this new standard. This resulted in a $1.3 million decrease in 2001’s second quarter’s revenue, with a corresponding decrease in sales and marketing expenses. The company shipped almost 130,000 disposable devices during the quarter compared to almost 115,000 units for the same quarter of the prior year. All commercial business units posted sales increases in the second quarter of 2002 compared to the second quarter of 2001. Arthroscopy contributed $16.2 million in net product sales, an approximately 6% increase. The company’s ear, nose and throat (ENTec) business unit’s net product sales increased by 29%. The spinal surgery products’ sales (ArthroCare Spine) increased by 52%.

The increase in direct sales presence, which was begun in 2001, continued to have a positive effect on sales in the second quarter of 2002, as did the execution of our strategic plan to build market share through continued promotional programs of controller placements, commercialization of our technology in fields outside of arthroscopy and introduction of new products designed to address surgical procedures that have traditionally been difficult to perform.

International product sales for the three-month period were 14% of total product sales, compared to 21% for the same period of the prior year. Our growth in the domestic market was stronger than in the international market due mostly to the increased effectiveness of the direct sales force in the United States.

Based upon the estimated number of arthroscopic procedures performed each year, we believe that knee procedures represent the largest segment of the arthroscopic market, while shoulder procedures, in units, represent the fastest growing segment. To achieve increasing disposable device sales in arthroscopy over time, we believe we must continue to penetrate the market in knee procedures, expand physicians’ education with respect to Coblation technology and continue to work on new product development efforts specifically for knee applications. We believe that in our five years of product shipments we have penetrated approximately 50% of the hospitals that perform arthroscopic procedures in the United States. We believe that approximately 35-40% of our arthroscopy disposable device revenue is being generated by the sale of disposables for use in knee procedures.

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Royalties, fees and other were $1.4 for the three-month period ended June 30, 2002, as compared to $3.8 million for the three-month period ended June 30, 2001. Included in license fees, royalties and other revenue in the prior year period is approximately $3.2 million resulting from the cancellation of an agreement with our former cosmetic surgery distributor and the recognition of previously deferred revenue.

Cost of Product Sales

Cost of product sales for the three-month period ended June 30, 2002 was $7.2 million or 35% of product revenues as compared with $7.2 million or 39% of product revenues for the three-month period ended June 30, 2001. The decrease in cost as a percentage of product sales for the three-month period ended June 30, 2002 as compared to the prior year period is attributable to the increased efficiency of the manufacturing operations. As planned, Arthrocare’s new Costa Rica facility began shipping sub-assemblies to the Sunnyvale facility in the second quarter and is expected to contribute to gross margin improvements in the second half of 2002.

Operating Expenses

Research and development expenses were $2.1 million for the three-month period ended June 30, 2002, as compared to $2.0 million for the same prior year period. In general, overall spending in research and development for the three-month and six-month periods remained at 11% of product sales as we continued to develop new products in our currently commercialized markets, continued our development efforts for potential additional products and continued to maintain and develop our patent position.

We expect to increase the dollar amount of research and development spending through continued expenditures on new product development, regulatory affairs, clinical studies and patents.

Sales and marketing expenses were $8.9 million or 43% of product sales, during the three-month period ended June 30, 2002, as compared to $7.8 million or 42% of product sales, during the same prior year period. The increase in spending for the current three-month period was primarily due to $0.4 million associated with the accrual of higher commissions resulting from increased sales, $0.5 million due to the hiring of 22 new direct sales representatives, and higher expenses of $0.1 million related to increased marketing activities including travel and promotional materials.

We anticipate that sales and marketing spending may continue to increase slightly in absolute dollars due to the expansion of our distribution and sales force capabilities to address the ENT and spinal surgery markets, higher commissions from increased sales, the additional cost of penetrating international markets, higher promotional, demonstration and sample expenses and, additional investments in the sales, marketing and support staff necessary to market our current products and commercialize future products. We anticipate that sales and marketing spending will decrease as a percentage of product sales.

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General and administrative expenses were $2.5 million or 12% of product sales, during the three-month period ended June 30, 2002 compared to $1.3 million or 7% of product sales during the same prior year period. Of the $1.2 million increase, $0.8 million was attributable to higher costs of general and patents-related legal services, business development activities, insurance and international accounting and tax related expenditures necessary to expand our corporate infrastructure, $0.2 million related to costs for the new facilities, and another $0.2 million resulted from the headcount increase required to support the business structure. We expect general and administrative expenses to decrease slightly as a percentage of product sales and increase moderately in absolute dollar values as we continue business development activities and incur additional legal costs associated with patent infringement actions.

Interest and Other Income, net

Interest and other income, net, decreased to $0.3 million for the three-month period ended June 30, 2002 compared to $1.1 million during the same period of the previous year. The lower interest income is attributable to lower interest rates than in the same prior fiscal year period.

Six months ended June 30, 2002 and June 30, 2001

Revenues:

All three reportable segments experienced product sales increases for the first six months of 2002 compared to the first six months of 2001. Arthroscopy contributed $31.1 million in net product sales, a 6% increase. The company’s ear, nose and throat (ENTec) business unit’s net product sales increased by 41%. The spinal surgery products’ sales (ArthroCare Spine) increased by 67%. For the first six months of 2002, ENTec and ArthroCare Spine sales were 11% and 9% of total product sales.

International product sales for the six-month period ended June 30, 2002 were 15% of product sales compared and 14% of product sales for the same period of the prior year.

Royalties, fees and other were $2.2 million six-month period ended June 30, 2002, as compared to $4.8 million for the six-month period ended June 30, 2001. Included in license fees, royalties and other revenue in the prior year period is approximately $3.2 million resulting from the cancellation of an agreement with our former cosmetic surgery distributor and the recognition of previously deferred revenue.

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Cost of Product Sales

Cost of product sales for the six-month period ended June 30, 2002 was $14.8 million or 37% of product revenues as compared with $13.9 million or 39% of product revenues for the six month period ended June 30, 2001. The decrease in cost as a percentage of product sales for the six-month period ended June 30, 2002 as compared to the prior year periods is attributable to the increased efficiency of the manufacturing operations.

Operating Expenses

Research and development expenses were $4.3 million six-month period ended June 30, 2002, as compared to $3.9 million for the same prior year period. Overall spending in research and development for the six-month period remained at 11% of product sales as we continued to develop new products in our currently commercialized markets, continued our development efforts for potential additional products and continued to maintain and develop our patent position.

Sales and marketing expenses were $17.3 million or 43% of product sales, during the six-month period ended June 30, 2002, as compared to $14.2 million or 40% of product sales, during the same prior year period. The increase in spending for the current six-month period was primarily due to increased expenses of $1.1 million associated with the accrual of higher commissions resulting from increased sales, $1.1 million due to the hiring of 22 new direct sales representatives, and higher expenses of $0.7 million related to increased marketing activities including travel and promotional materials.

General and administrative expenses $4.4 million or 11% of product sales, during the six-month period ended June 30, 2002, as compared to $2.3 million or 7% of product sales during the same prior year period. Of the $2.1 million increase, $1.3 million was attributable to higher costs of general and patents-related legal services, business development activities, insurance and international accounting and tax related expenditures necessary to expand our corporate infrastructure, $0.2 million related to costs for the new facilities, and another $0.4 million resulted from the headcount increase required to support the business structure. We expect general and administrative expenses to decrease slightly as a percentage of product sales and increase moderately in absolute dollar values as we continue business development activities and incur additional legal costs associated with patent infringement actions.

Interest and Other Income, net

Interest and other income, net, decreased to $0.9 million for the six-month period ended June 30, 2002 compared to $2.1 million during the same period of the previous year. The lower interest income is attributable to lower interest rates than in the same prior fiscal year period as well as a reduction of our investment portfolio by approximately $8.0 million ($6 million in the second half of 2001 and $2 million in the first half of 2002).

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Liquidity and Capital Resources

On June 30, 2002, we had $90.9 million in working capital. The principal sources of liquidity consisted of $61.2 million in cash, cash equivalents and short term available-for-sale securities. The Company also has $16.3 million in non-current available for sale securities.

Net cash provided by operating activities for the six-month period ended June 30, 2002 was $5.2 million, as compared to $5.4 million provided by operating activities for the six-month period ended June 30, 2001. The decrease in cash provided by operating activities is primarily due to the increase in inventories more than offset by increases in liabilities.

Inventories increased to $16.0 million as of June 30, 2002 from $14.2 million as of December 31, 2001, to support the introduction levels required to support sales volume increases and provide safety stock of sub-assemblies during our shift of manufacturing to our new Costa Rica manufacturing facility.

Net cash flows used in investing activities for the six-month period ended June 30, 2002 were $1.0 million compared to $13.8 million of cash provided by investing activities for the six-month period ended June 30, 2001. The decrease of cash provided by investing activities is primarily due to the timing of purchases and sales or maturities of available for sale securities.

Net property and equipment increased to $15.5 million as of June 30, 2002 from $13.1 million as of December 31, 2001. The $6 million increase is primarily attributable to capital expenditures related to the new facility in Costa Rica as well as the capitalization of controllers placed under various promotional programs along with an increase of computer software and equipment.

Net cash flows used in financing activities for the six-month period ended June 30, 2002 were $0.1 million compared to $0.5 million for the six-month period ended June 30, 2001. The cash generated by the proceeds from exercise of options was mostly offset by the repurchase of treasury shares.

Our future liquidity and capital requirements will depend on numerous factors, including our success in commercializing our products, development and commercialization of products in fields other than arthroscopy, the ability of our suppliers to continue to meet our demands at current prices, obtaining and enforcing patents important to our business, the status of regulatory clearances/approvals and competition.

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ADDITIONAL FACTORS THAT MIGHT AFFECT FUTURE RESULTS

We became a public company in February 1996. Included here are risk factors as updated from our Annual Report on Form 10-K, filed March 29, 2002 for the year ended December 31, 2001. The following factors represent current challenges to us that create risk and uncertainty. Failure to adequately overcome any of the following challenges, either singularly or in combination, could have a material adverse effect on our results of operations, business, financial position and future growth prospects. Additional risks and uncertainties that we do not currently know about or that we currently deem immaterial could also impair our results of operations, financial position and future growth prospects.

We Are Dependent Upon Our Arthroscopic System

We commercially introduced our Arthroscopic System in December 1995. Since our Arthroscopic System accounted for 83% of our product sales in 2001 and 77% in the six-month period ending June 30, 2002, we are highly dependent on its sales. We have only recently begun to market our spinal surgery, neurosurgery, cosmetic surgery, ENT surgery and ENDO surgery products, and to date, we have sold only a small number of units. We cannot assure you that we will be able to continue to manufacture arthroscopy products in commercial quantities at acceptable costs or that we will be able to continue to market such products successfully.

To achieve increasing disposable device sales over time, we believe we must continue to penetrate the market in knee procedures, expand physicians’ education with respect to Coblation technology and continue working on new product development efforts specifically for knee applications. Furthermore, in order to maintain and increase current market penetration we must be aggressive in increasing our installed base of controllers to generate increased disposable device revenue. To date, we have priced our arthroscopic controllers at substantial discounts in order to stimulate demand for our disposable devices.

We believe that surgeons will not use our products unless they determine, based on experience, clinical data and other factors, that these systems are an attractive alternative to conventional means of tissue ablation. There are only a few independently published clinical reports and limited long-term clinical follow-up to support the marketing efforts for our Arthroscopic System. We believe that continued recommendations and endorsements by influential surgeons are essential for marketplace acceptance of our products. In addition, if long-term data does not support our current claims of efficacy, our business, financial condition, results of operations and future growth prospects could be materially adversely affected.

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Commercial Success of Our Non-Arthroscopic Products Is Uncertain

We have developed several applications for our Coblation technology in spinal surgery and neurosurgery, ENT surgery, cosmetic surgery, gynecology, urology and general surgery. Additionally we have established a program to explore the application of our Coblation technology in various areas within cardiology. Our products for these non-arthroscopic indications are in various stages of commercialization and development, and we may be required to undertake time-consuming and costly commercialization, development and additional regulatory approval activities. If we do not receive future clearances we may be unable to market these and other products for specific indications,and our business, financial condition, results of operations and future growth prospects could be materially adversely affected. We cannot assure you that product development will ever be successfully completed, that regulatory clearances or approvals, if applied for, will be granted by the FDA or foreign regulatory authorities on a timely basis, if at all, or that the products will ever achieve commercial acceptance.

We may have to make a significant investment in additional preclinical and clinical testing, regulatory, physician training and sales and marketing activities to further develop and commercialize our spinal surgery, neurosurgery, gynecology, urology, cosmetic surgery, ENT surgery, general surgery and cardiology product lines. Although we believe that these products offer certain advantages, we cannot assure you that these advantages will be realized, or if realized, that these products will result in any meaningful benefits to physicians or patients.

Development and commercialization of our current and future non-arthroscopic products are subject to the risks of failure inherent in the development for new medical devices. These risks include the following:

•

Such products may not be easy to use, will require extensive training or may not be cost-effective;

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New products may experience delays in testing or marketing;

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There may be unplanned expenditures or increases above those anticipated by us;

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Such products will not be proven safe or effective;

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Third parties may develop and market superior or equivalent products;

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•

Such products may not receive necessary regulatory clearances or approvals; and

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Proprietary rights of third parties may preclude us and our collaborative partners from marketing such products.

In addition, the success of our non-arthroscopic products will depend on their adoption as alternatives to conventional means of tissue ablation. Clinical experience and follow-up data for our non-arthroscopic indications are limited, and we have sold only a small number of units to date. We believe that recommendations and endorsement of influential physicians are essential for market acceptance of our products.

We Have Limited Marketing and Sales Experience

We currently have limited experience in marketing and selling our products. To the extent that we have established or will enter into distribution arrangements for the sale of our products, we are and will be dependent upon the efforts of third parties. We are marketing and selling our arthroscopic surgery, spinal surgery, neurosurgery, ENT surgery, cosmetic surgery and general surgery product lines in the United States through a network of independent distributors supported by regional sales managers and a direct sales force. These distributors sell arthroscopy, spinal surgery, neurosurgery, ENT surgery, cosmetic surgery and general surgery devices for a number of other manufacturers. We cannot assure you that these distributors will commit the necessary resources to effectively market and sell our arthroscopic surgery, spinal surgery, neurosurgery, ENT surgery, cosmetic surgery or general surgery product lines, or that they will be successful in selling our products.

We have recently established a marketing presence in various countries, and we cannot assure you that these newly established operations will be successful. In order to successfully market our products internationally, we will need to address many issues with which we have little or no experience, including the securing of necessary regulatory approvals in international markets and the potential reuse of our disposable devices by our customers. Even if we are able to successfully deal with these issues, we cannot assure you that we will be able to establish successful distribution capabilities internationally, we will need to address many issues with which we have little or no experience, including the securing of necessary regulatory approvals in international markets and the potential reuse of our disposable devices by our customers. Even if we are able to successfully deal with these issues, we cannot assure you that we will be able to establish successful distribution capabilities internationally or receive favorable pricing for our products. In addition, we may face currency exchange risks as part of our international expansion. To the extent our marketing and sales efforts are unsuccessful, our business, financial condition, results of operations and future growth prospects may be materially adversely affected.

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We Have Limited Manufacturing Experience

To be successful, we must manufacture our products in commercial quantities in compliance with regulatory requirements at acceptable costs. At the present time, we have limited manufacturing experience. Our manufacturing operations consist of an in-house assembly operation for the manufacture of disposable devices and controllers in the United States and Costa Rica. We currently produce more than 70 models of disposable devices utilizing different functionalities, including suction and fluid management. As we increase the number of product designs for our disposable devices, the complexity of our manufacturing processes will increase. We manufacture several different controller models. Although the manufacturing processes for the controllers designed to date are substantially the same, we cannot be certain that we will be able to continue to manufacture these controllers without additional expense and capabilities. We could also encounter difficulties in manufacturing our current or future products, which could reduce yields, result in supply disruptions and adversely affect our gross margins. If we have delays in manufacturing, we will not have adequate finished inventory to meet our needs. If our quality assurance programs do not continue to meet the demands of the complexity and capacity of the products we manufacture, we may experience product returns.

We Are Dependent on Key Suppliers

We depend on two sole source suppliers for many of our product components, including two components that we include in substantially all of our disposable devices. If the supply of materials from a sole source supplier were interrupted, replacement or alternative sources might not be readily obtainable due to the regulatory requirements applicable to our manufacturing operations. In addition, a new or supplemental filing with applicable regulatory authorities may require clearance prior to our marketing a product containing new material. This clearance process may take a substantial period of time and we cannot assure you that we would be able to obtain the necessary regulatory clearance for the new material to be used in our products on a timely basis, if at all. This could create supply disruptions that would materially adversely affect our business, financial condition, results of operations and future growth prospects.

In addition, we use a single subcontractor, using two facilities, to sterilize the disposable devices. We cannot assure you that we can identify and qualify an alternate sterilizer. Our inability to secure an alternative sterilizer, if required, would limit our ability to manufacture disposable devices and could have a material adverse effect on our business, financial condition, results of operations and future growth prospects.

We Face Intense Competition

The markets for our current and potential products are intensely competitive. These markets include arthroscopy, spinal surgery, neurosurgery, ENT surgery, cosmetic surgery, gynecology, urology, general surgery and cardiology. We cannot assure you that other companies will not succeed in developing technologies and products that are more effective than ours or that would render our technology or products obsolete or uncompetitive in these markets.

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In arthroscopy, we compete against companies, such as Johnson & Johnson, Smith & Nephew, Inc., Conmed Corporation and Stryker Corp., which market products to remove or shrink tissue. Specifically, Johnson & Johnson, Smith & Nephew and Stryker are currently marketing worldwide bipolar electrosurgical systems for tissue ablation and shrinkage based upon technology licensed by us. We are also aware of additional competitors that may commercialize products using technology similar to ours.

In spinal surgery, we compete against companies that market products to remove tissue and treat spinal disorders. In addition, Smith & Nephew is currently marketing a percutaneous thermal heating product for treating certain types of disc pain.

In ENT surgery, we compete against companies that offer manual instruments, such as Smith & Nephew, Stryker Corp., Conmed Corp., and Xomed Surgical Products Inc., Medical Technologies Inc., which was acquired by Medtronic, Inc. In addition, we compete with companies that develop and market lasers for various ENT surgery applications, including Lumenis. Smaller companies, including Somnus Medical Technologies Inc. (which was acquired by Gyrus, Inc.), Elmed Inc. and Ellman International, Inc., also sell medical devices for the treatment of various ENT disorders, including snoring and obstructive sleep apnea.

In cosmetic surgery, we compete against companies, such as Lumenis, that market lasers for use in this field. In addition, other large companies manufacture and sell medical devices that use radio frequency energy for certain applications in dermatology and cosmetic surgery.

In cardiology, we compete with companies that market lasers for use in this field. In addition, other large companies manufacture and sell medical devices that use radio frequency energy for certain applications in dermatology and cosmetic surgery. In cardiology, we compete with companies which use lasers to treat cardiovascular disease. Other approaches to alleviating cardiovascular disease, including drugs or other surgical approaches, are also competitive with our products.

Many of our competitors have significantly greater financial, manufacturing, marketing, distribution and technical resources than we do. Some of these companies offer broad product lines that they may offer as a single package and frequently offer significant discounts as a competitive tactic. For example, in order to compete successfully, we anticipate that we may have to continue to offer substantial discounts on our controllers in order to increase demand for our disposable devices, and that this competition could have a material adverse effect on our business, financial condition, results of operations and future growth prospects. Furthermore, some of our competitors use purchasing contracts that link discounts on the purchase of one product to purchases of other products in their broad product lines. Many of the hospitals in the United States have purchasing contracts with our competitors. Accordingly, customers may be dissuaded from purchasing our products rather than the products of these competitors to the extent the purchase would cause them to lose discounts on products.

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We Face Uncertainty Over Reimbursement

Failure by physicians, hospitals and other users of our products to obtain sufficient reimbursement from health care payors for procedures in which our products are used or adverse changes in environmental and private third-party payors’ policies toward reimbursement for such procedures would have a material adverse effect on our business, financial condition, results of operations and future growth prospects. Reimbursement for arthroscopic, spinal surgery, neurosurgery, ENT surgery, gynecology, urology and general surgery procedures performed using devices that have received FDA clearance has generally been available in the United States. Typically, cosmetic surgery procedures are not reimbursed.

We are unable to predict what changes will be made in the reimbursement methods used by third-party health care payors. In addition, some health care providers are moving toward a managed care system in which providers contract to provide comprehensive health care for a fixed cost per person. Managed care providers are attempting to control the cost of health care by authorizing fewer elective surgical procedures. We anticipate that in a prospective payment system, such as the diagnosis related group system utilized by Medicare, and in many managed care systems used by private health care payors, the cost of our products will be incorporated into the overall cost of the procedure and that there will be no separate, additional reimbursement for our products.

If we obtain the necessary international regulatory approvals, market acceptance of our products in international markets would be dependent, in part, upon the availability of reimbursement within prevailing health care payment systems. Reimbursement and health care payment systems in international markets vary significantly by country and include both government-sponsored health care and private insurance. We intend to seek international reimbursement approvals, but we cannot assure you that any such approvals will be obtained in a timely manner, if at all.

Our Business Depends on Attracting and Retaining Collaborators and Licensors

In order to successfully develop and commercialize certain products, we may enter into collaborative or licensing arrangements with medical device companies and other entities to fund and complete our research and development activities, pre-clinical and clinical testing, manufacturing, regulatory approval activities and to achieve successful commercialization of future products. In addition, we have entered into a distribution agreement with GyneCare and ACMI to market and sell our Coblation based products for gynecology and urology, respectively.

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Our participation in collaborative and licensing arrangements with third parties subjects us to a number of risks. Collaborative partners typically have significant discretion in electing whether to pursue any of the planned activities. We cannot control the amount and timing of resources our collaborative partners may devote to our products, and we cannot assure you that our partners will perform their obligations as expected. Business combinations or significant changes in a corporate partner’s business strategy may adversely affect that partner’s ability to meet its obligations in a timely manner, our business, financial condition, results of operations and prospects would be materially adversely affected. To the extent that we are not able to establish further collaborative arrangements or that any or all of our existing collaborative arrangements are terminated, we would be required to seek new collaborative arrangements or to undertake commercialization at our own expense, which could significantly increase our capital requirements, place additional strain on our human resource requirements and limit the number of products which we would be able to develop and commercialize. In addition, we cannot assure you that our existing and future collaborative partners will not pursue alternative technologies or develop alternative products either on their own or in collaboration with others, including our competitors.

We cannot assure you that disputes will not arise in the future with respect to the ownership of rights to any technology of products developed with any collaborative partner. Lengthy negotiations with potential new collaborative partners or disagreements between established collaborative partners and us could lead to delays in or termination of the research, development or commercialization of certain products or result in litigation or arbitration that would be time consuming and expensive. Failure by any collaborative partner to commercialize successfully any product to which it has obtained rights from us, or the decision by a collaborative partner to pursue alternative technologies or commercialize or develop alternative products, either on its own or in collaboration with others, could have a material adverse effect on our business, financial condition, results of operations and future growth prospects.

Our Operating Results Will Fluctuate

We achieved profitability in 1999 and, as of June 30, 2002, we had retained earnings of $1.4 million. Results of operations may fluctuate significantly from quarter to quarter due to many factors, including the following:

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The introduction of new product lines;

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Increased penetration in existing applications;

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Product returns;

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Achievement of research and development milestones;

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•

The amount and timing of receipt and recognition of license fees;

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Manufacturing or supply disruptions;

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Timing of expenditures;

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Absence of a backlog of orders;

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Receipt of necessary regulatory clearances/approvals;

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The level of market acceptance for our products;

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Timing of the receipt of orders and product shipments; and

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Promotional programs for our products.

We cannot assure you that future quarterly fluctuations will not adversely affect our business, financial condition, results of operations of future growth prospects. Our revenues and profitability will be critically dependent on whether or not we can successfully continue to market our Coblation based technology product lines. We cannot assure you that we will maintain or increase our revenues or level of profitability.

We May Be Unable to Effectively Protect Our Intellectual Property

Our ability to compete effectively depends in part on developing and maintaining the proprietary aspects of our Coblation technology. We believe that our issued patents are directed at the core technology used in our soft-tissue surgery systems, including both multi-electrode and single electrode configurations of our disposable devices, as well as the use of Coblation technology in specific surgical procedures.

We cannot assure you that the patents we have obtained, or any patents we may obtain as a result of our pending U.S. or international patent applications, will provide any competitive advantages for our products. We also cannot assure you that those patents will not be successfully challenged, invalidated or circumvented in the future. In addition, we cannot assure you that competitors, many of which have substantial resources and have made substantial investments in competing technologies, have not already applied for or obtained, or will not seek to apply for and obtain, patents that will prevent, limit or interfere with our ability to make, use and sell our products either in the United States or in international markets. Patent applications are maintained in secrecy for a period after filing. We may not be aware of all of the patents and patent applications potentially adverse to our interests.

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A number of medical device and other companies and universities and research institutions have filed patent applications or have issued patents relating to monopolar and/or bipolar electrosurgical methods and apparatus. We have received, and we may receive in the future, notifications of potential conflicts of existing patents, pending patent applications and challenges to the validity of existing patents. In addition, we have become aware of potential conflicts of existing patents, pending patent applications and challenges to the validity of existing patents. In addition, we have become aware of, and may become aware of in the future, patent applications and issued patents that relate to our products and/or the surgical applications and issued patents and, in some cases, have obtained internal and/or external opinions of counsel regarding the relevance of certain issued patents to our products. We do not believe that our products currently infringe any valid and enforceable claims of the issued patents that we have reviewed. However, if third-party patents or patent applications contain claims infringed by our technology and such claims are ultimately determined to be valid, we may not be able to obtain licenses to those patents at a reasonable cost, if at all, or be able to develop or obtain alternative technology. Our inability to do either would have a material adverse effect on our business, financial condition, results of operations and prospects. We cannot assure you that we will not have to defend ourselves in court against allegations of infringement of third-party patents, or that such defense would be successful.

In addition to patents, we rely on trade secrets and proprietary know-how, which we seek to protect, in part, through confidentiality and proprietary information agreements. We require our key employees and consultants to execute confidentiality agreements upon the commencement of an employment or consulting relationship with us. These agreements generally provide that all confidential information, developed or made known to the individual during the course of the individual’s relationship with us, is to be kept confidential and not disclosed to third parties. These agreements also generally provide that inventions conceived by the individual in the course of rendering services to us shall be our exclusive property. We cannot assure you that employees will not breach such agreements, that we would have adequate remedies for any breach or that our trade secrets will not otherwise become known to or be independently developed by competitors.

We May Become Subject to Patent Litigation

The medical device industry has been characterized by extensive litigation regarding patents and other intellectual property rights, and companies in the medical device industry have employed intellectual property litigation to gain a competitive advantage. We cannot assure you that we will not become subject to patent infringement claims or litigation or interference proceedings declared by the United States Patent and Trademark office, the USPTO, to determine the priority of inventions. In February 1998, we filed a lawsuit against Ethicon, Inc., Mitek Surgical Products, a division of Ethicon, Inc., and GyneCare, Inc. alleging, among other things, infringement of several of our patents. The parties subsequently settled this lawsuit. Under the terms of the settlement, Ethicon, Inc. has licensed a portion of our U.S. patents for current products in the arthroscopy and gynecology markets. The settlement agreement also established a procedure for resolution of certain potential intellectual property disputes in these two markets without litigation. Under this procedure, the licenses granted in the Ethicon settlement have been extended to Australia, Canada and Japan. In July 2001, we filed a lawsuit against Smith & Nephew alleging infringement of several of our patents. For further discussion of this lawsuit, see Note 6 in the Notes to Condensed Consolidated Financial Statements set forth above.

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Defending and prosecuting intellectual property suits, USPTO interference proceedings and related legal and administrative proceedings are costly and time-consuming. Further litigation may be necessary to enforce our patents, to protect our trade secrets or know-how or to determine the enforceability, scope and validity of the proprietary right of others. Any litigation or interference proceedings will be costly and will result in significant diversion of effort by technical and management personnel. An adverse determination in any of the litigation or interference proceedings to which we may become a party could subject us to significant liabilities to third parties, require us to license disputed rights from third parties or require us to cease using such technology, which would have a material adverse effect on our business, financial condition, results of operations and future growth prospects. Patent and intellectual property disputes in the medical device area have often been settled through licensing or similar arrangements, and could include ongoing royalties. We cannot assure you that we could obtain necessary licenses on satisfactory terms, if at all.

The Market Price of Our Stock May Be Highly Volatile

Within the last 12 months our common stock has traded between a range of $9.89 and $32.60 per share. The market price of our common stock could continue to fluctuate substantially due to a variety of factors, including:

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Quarterly fluctuations in results of our operations;

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Our ability to successfully commercialize our products;

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Announcements regarding results of regulatory clearances filing, clinical studies or other testing, technological innovations or new commercial products by us or our competitors;

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Developments concerning government regulations, proprietary rights or public concern as to the safety of technology;

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The execution of new collaborative agreements and material changes in our relationships with our business partners;

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Market reaction to acquisitions and trends in sales, marketing, and research and development;

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•

Changes in coverage or earnings estimates by analysts;

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Sales of common stock by existing stockholders; and

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Economic and political conditions.

The market price for our common stock may also be affected by our ability to meet analysts’ expectations. Any failure to meet such expectations, even slightly, could have an adverse effect on the market price and volume fluctuations. This volatility has had a significant effect on the market prices of securities issued by many companies for reasons unrelated to the operating performance of these companies. In the past, following periods of volatility in the market price of a company’s securities, securities class action litigation has often been instituted against the company. If similar litigation were instituted against us, it could result in substantial costs and a diversion of our management’s attention and resources, which could have an adverse effect on our business, results of operations and financial condition.

Delaware Law, Provisions in Our Charter and Our Stockholder Rights Plan Could Make the Acquisition of Our Company By Another Company More Difficult

Our stockholder rights plan and certain provisions of our certificate of incorporation and bylaws may have the effect of making it more difficult for a third party to acquire, or of discouraging a third party from attempting to acquire, control of our company. This could limit the price that certain investors might be willing to pay in the future for shares of our common stock. Some provisions of our certificate of incorporation and bylaws allow us to issue preferred stock without any vote or further action by the stockholders, to eliminate the right of stockholders to act by written content without a meeting, to specify procedures for director nominations by stockholders and submission of other proposals for consideration at stockholder meetings, and to eliminate cumulative voting in the election of directors. Some provisions of Delaware law applicable to us could also delay or make more difficult a merger, tender offer or proxy contest involving us, including Section 203, which prohibits a Delaware corporation from engaging in any business combination with any interested stockholder for a period of three years unless certain conditions are met. Our stockholder rights plan, the possible issuance of preferred stock, the procedures required for director nominations and stockholder proposals and Delaware law could have the effect of delaying, deferring or preventing a change in control of ArthroCare, including without limitation, discouraging a proxy contest or making more difficult the acquisition of a substantial block of our common stock.

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We Must Obtain Governmental Clearances or Approvals Before We Can Sell Our Products; We Must Continue To Comply With Applicable Laws and Regulations.

United States

Our products are considered medical devices and are subject to extensive regulation in the United States. We must obtain premarket clearance or approval by the FDA for each of our products and indications before they can be commercialized. FDA regulations are wide-ranging and govern, among other things:

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Product design and development;

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Product testing;

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Product labeling;

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Product storage;

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Premarket clearance or approval;

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Advertising and promotion; and

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Product sales and distribution.

Noncompliance with applicable regulatory requirements can result in enforcement action, which may include:

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Warning letters;

•

Fines, injunctions and civil penalties against us;

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Recall or seizure of our products;

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Operating restrictions, partial suspension or total shutdown of our production;

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Refusal of our requests for premarket clearance or approval of new products;

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Withdrawal of product approvals already granted; and

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Criminal prosecution.

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Generally, before we can introduce a new medical device into the US market, we must obtain FDA clearance of a 510(k) premarket notification or approval of a premarket approval application, or PMA application. If we can establish that our device is “substantially equivalent” to a “predicate device,” i.e., a legally marketed Class I or Class II device or a preamendment Class III device (i.e., one that was in commercial distribution before May 28, 1976) for which the FDA has not called for PMAs, we may seek clearance from the FDA to market the device by submitting a 510(k) premarket notification. The 510(k) premarket notification will need to be supported by appropriate data, including, in some cases, clinical data, establishing the claim of substantial equivalence to the satisfaction of the FDA.

We have received 510(k) clearance to market our Arthroscopic System for surgery of the knee, shoulder, elbow, wrist, hip and ankle joints. We have received 510(k) clearance in the United States to market our Spinal Surgery System. In addition, we have received 510(k) clearance to market our Cosmetic Surgery System in general dermatology procedures and for skin resurfacing for the purpose of wrinkle reduction. We have received 510(k) clearance to market our ENT Surgery System in general head, neck and sinus surgical procedures, as well as the treatment of snoring, hypertrophic turbinates, tonsilectomy and submucosal channeling. We have received 510(k) clearance to market our Endo for urology, general surgery and gynecology procedures. We cannot assure you that we will be able to obtain necessary clearances or approvals to market any other products, or existing products for new intended uses, on a timely basis, if at all. Delays in receipt or failure to receive clearances or approvals, the loss of previously received clearances or approvals, or failure to comply with existing or future regulatory requirements could have a material adverse effect on our business, financial condition, results of operations and future growth prospects.

After a device receives 510(k) clearance, any modification that could significantly affect its safety or effectiveness, or that would constitute a major change in the intended use of the device, requires a new 510(k) clearance. The FDA requires each manufacturer to make this determination in the first instance, but the FDA can review any such decision. If the FDA disagrees with a manufacturer’s decision no to seek a new 510(k) clearance, the agency may retroactively require the manufacturer to submit a premarket notification requesting 510(k) clearance. The FDA also can require the manufacturer to cease marketing and/or recall the modified device until 510(k) clearance is obtained. We have modified some of our marketed devices, but have determined that, in our view, new 510(k) clearances are not required for all products cleared under current 510(k)s. No assurance can be given that the FDA will not require us to seek 510(k) clearance for any modification; the FDA also may require us to cease marketing and/or recall the modified device until we obtain a new 510(k) clearance.

If we cannot establish that a proposed device is substantially equivalent to a legally marketed device, we must seek premarket approval through submission of a PMA application. A PMA application must be supported by extensive data, including, in many instances, preclinical and clinical trial data, as well as extensive literature to prove the safety and effectiveness of the device. If necessary, we will file a PMA application for approval to sell our potential products. The PMA process can be expensive, uncertain and lengthy. We cannot assure you that we will be able to obtain PMA approvals, and our failure to obtain such approvals could have a material adverse effect on our business, financial condition, results of operations and future growth prospects.

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We are also required to demonstrate and maintain compliance with the Quality System Regulation, or QSR. The QSR incorporates the requirements of Good Manufacturing practices (GMP), as well as the maintenance of records and documentation. The FDA enforces the QSR through inspections. We cannot assure you that we, or our key component suppliers, are or will continue to be in compliance, will not encounter any manufacturing difficulties, or that we or any of our subcontractors of key component suppliers will be able to maintain compliance with regulatory requirements. Failure to do so will have a material adverse effect on our business, financial condition, results of operations and future growth prospects.

We may not promote or advertise our products for uses not within the scope of our clearances or approvals or make unsupported safety and effectiveness claims. These determinations can be subjective. We cannot assure you that the FDA would agree that all of our promotional claims are permissible or that the FDA will not require us to revise our promotional claims or take enforcement action against us based upon our labeling and promotional materials. For example, in 2001 the company received and responded to a notification from the FDA that certain claims made in promotional materials were not clearly supported by 510(k) clearances. The company resolved this matter expeditiously to maintain compliance with FDA requirements.

International

International sales of our products are subject to strict regulatory requirements. The regulatory review process varies from country to country. We have obtained regulatory clearance to market our Arthroscopic System in Europe, Japan, Australia, Taiwan, Korea, Canada, China, Israel, Middle East, South America and Mexico; to market our cosmetic surgery products in Europe, Australia, Canada, Middle East, South America, Korea and Israel; to market our ENT surgery products in Europe, Australia, Canada, China, Israel, Japan, Middle East, Taiwan, Korea and South America; to market our spinal surgery products in Europe, Canada, Japan, Mexico, Middle East, Taiwan, Australia and Korea; to market our general surgery products in Europe, Canada, Middle East, Korea and Taiwan; and to market our neurosurgery and urology products in Europe, but we have not obtained any other international regulatory approvals in other international markets. We cannot assure you that we will obtain such clearances and approvals on a timely basis, or at all.

For European distribution, we have received ISO 9001/EN46001 certification and the EC Certificate pursuant to the European Union Medical Device Directive 93/42/EEC, allowing us to CE mark our products after assembling appropriate documentation.

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ISO 9001/EN46001 certification standards for quality operations have been developed to ensure that companies know the standards of quality on a worldwide basis. Failure to maintain the certification will preclude us from selling our products in Europe. We cannot assure you that we will be successful in maintaining certification requirements.

We Face Product Liability Risks and May Not Be Able to Obtain Adequate Insurance

The development, manufacture and sale of medical products involve significant risk of product liability claims. Our current product liability insurance coverage limits are $10.0 million per occurrence and $10.0 million in the aggregate. We cannot assure you that such coverage limits are adequate to protect us from any liabilities we might incur in connection with the development, manufacture and sale of our products. In addition, we may be required to increase our product liability coverage as potential products are successfully commercialized. Product liability insurance is expensive and may not be available to us in the future on acceptable terms, if at all. As described in Note 7 to the Financial Statements and Part II, Item 1 “Legal Proceedings”, a product liability suit has been filed against us, involving one of our arthroscopy products. A successful product liability claim or series of claims brought against us in excess of our insurance coverage could have a material adverse effect on our business, financial condition, results of operations and future growth prospects.

We May Be Unable to Attract and Retain Personnel

We are dependent upon a number of key management and technical personnel. The loss of the services of one or more key employees or consultants could have a material adverse effect on our business, financial condition, results of operations and future growth prospects. Our success will also depend on our ability to attract and retain additional highly qualified management and technical personnel. We face intense competition for qualified personnel, many of whom are often subject to competing employment offers, and we cannot assure you we will be able to attract and retain such personnel. Furthermore, our scientific advisory board members are all otherwise employed on a full-time basis. As a result, the scientific advisory board members are not available to devote their full time or attention to our business.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Our exposure to market risk for changes in interest rates relates primarily to our investment portfolio. We do not use derivative financial instruments in our investment portfolio and conduct all transactions in U.S. dollars. Our investment portfolio only includes highly liquid instruments.

We are subject to fluctuating interest rates that may impact, adversely or otherwise, our results of operations or cash flows for our cash and cash equivalents and our short-term investments.

Although payments under the operating leases for our facility are tied to market indices, we are not exposed to material interest rate risk associated with the operating lease.

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PART II. OTHER INFORMATION

Item 1. Legal Proceedings

Information with respect to this item is incorporated into this Part II, Item 1 by reference to Note 6 of the Condensed Consolidated Financial Statements contained in Part I above.

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

At the annual meeting the company’s stockholders on May 29, 2002, the following matters were submitted to a vote of the Company’s stockholders:

Proposal 1. Election of Directors.

Nominee	Votes For	Votes Withheld
Michael A. Baker	17,026,727	2,048,669
Annette J. Campbell-White	18,195,064	880,332
C. Raymond Larkin, Jr.	18,189,914	885,482
Tord B. Lendau	18,194,064	881,332
Robert R. Momsen	18,127,014	948,382
Peter L. Wilson	18,195,064	880,332

Proposal 2. Amendment to the Company’s 1993 Stock Plan to increase the number of shares of Common Stock reserved for issuance thereunder by 250,000 shares.

Votes For:

14,936,861

Votes Against:

3,472,873

Abstain:

665,662

Proposal 3. Amendment to the to the Company’s 1995 Director’s Option Plan to increase the number of shares of Common Stock reserved for issuance thereunder by 100,000 shares.

Votes For:

16,544,583

Votes Against:

1,864,590

Abstain:

666,223

Proposal 4. Ratification of the Appointment of PricewaterhouseCoopers LLP as the Company’s Independent Accountants.

Votes For:

17,728,218

Votes Against:

313,329

Abstain:

1,033,849

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Item 6. Exhibits and Reports on Form 8-K

a) Exhibits


3.1		Amended and Restated Certificate of Incorporation of ArthroCare Corporation.

3.2		Amended and Restated Bylaws of the Registrant. (Incorporated herein by reference to the same-numbered Exhibit filed previously with the Registrant’s Quarterly Report on Form 10-Q for the period ended October 3, 1998).

4.1		Specimen Common Stock Certificate. (Incorporated herein by reference to the same-numbered Exhibit filed previously with the Registrant’s Registration Statement on Form 8-A (Registration No. 000-27422)).

10.1		Form of Indemnification Agreement between the Registrant and each of its directors and officers. (Incorporated herein by reference to the same-numbered Exhibit filed previously with the Registrant’s Registration Statement on Form S-1 (Registration No. 33-80453)).

10.2		Incentive Stock Plan and form of Stock Option Agreement thereunder. (Incorporated herein by reference to the same-numbered Exhibit filed previously with the Registrant’s Registration Statement on Form S-1 (Registration No. 33-80453)).

10.3		Director Option Plan and form of Director Stock Option Agreement thereunder. (Incorporated herein by reference to the same-numbered Exhibit filed previously with the Registrant’s Registration Statement on Form S-1 (Registration No. 33-80453)).

10.4		Employee Stock Purchase Plan and forms of agreements thereunder. (Incorporated herein by reference to the same-numbered Exhibit filed previously with the Registrant’s Registration Statement on Form S-1 (Registration No. 33-80453)).

10.5		Form of Exclusive Sales Representative Agreement. (Incorporated herein by reference to the same-numbered Exhibit filed previously with the Registrant’s Registration Statement on Form S-1 (Registration No. 33-80453)).

10.6		Form of Exclusive Sales Representative Agreement. (Incorporated herein by reference to the same-numbered Exhibit filed previously with the Registrant’s Registration Statement on Form S-1 (Registration No. 33-80453)).

10.7		Consulting Agreement, dated May 20, 1993, between the Registrant and Eggers & Associates, Inc., and amendment thereto. (Incorporated herein by reference to the same-numbered Exhibit filed previously with the Registrant’s Registration Statement on Form S-1 (Registration No. 33-80453)).

10.10		Employment Letter Agreement, dated July 18, 1995, between the Registrant and Robert T. Hagan. (Incorporated herein by reference to Exhibit 10.16 filed previously with the Registrant’s Registration Statement on Form S-1 (Registration No. 33-80453)).

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10.11		Restricted Stock Purchase and Security Agreement, dated August 1, 1995, between the Registrant and Robert T. Hagan. (Incorporated herein by reference to Exhibit 10.17 filed previously with the Registrant’s Registration Statement on Form S-1 (Registration No. 33-80453)).

10.12+		Radiation Services Agreement, dated September 13, 1995, between the Registrant and SteriGenics International. (Incorporated herein by reference to Exhibit 10.19 filed previously with the Registrant’s Registration Statement on Form S-1 (Registration No. 33-80453)).

10.13		Amended and Restated Stockholder Rights Agreement, dated October 16, 1995, between the Registrant and certain holders of the Registrant’s securities. (Incorporated herein by reference to Exhibit 10.20 filed previously with the Registrant’s Registration Statement on Form S-1 (Registration No. 33-80453)).

10.14		Contribution Agreement, dated June 30, 1995, by and among Philip E. Eggers, Robert S. Garvie, Anthony J. Manlove, Hira V. Thapliyal and the Registrant. (Incorporated herein by reference to Exhibit 10.21 filed previously with the Registrant’s Registration Statement on Form S-1 (Registration No. 33-80453)).

10.15		Amended and Restated Stockholder Rights Agreement, dated October 2, 1998, between the Registrant and Norwest Bank Minnesota, N.A. (Incorporated herein by reference to Exhibit 10.20 filed previously with the Registrant’s Registration Statement on Form 8-A filed October 21, 1998 (Registration No. 000-27422)).

10.16		Exclusive Distributor Agreement, dated April 15, 1997, between the Registrant and Arthrex, GmbH and Amendment dated October 2, 1998. (Incorporated herein by reference to Exhibit 10.20 filed previously with the Registrant’s Quarterly Report on Form 10-Q for the period ended April 3, 1999).

10.18+		Exclusive Distributor Agreement, dated August 21, 1997, between the Registrant and Kobayashi Pharmaceutical Company, Ltd. (Incorporated herein by reference to Exhibit 10.25 filed previously with the Registrant’s Quarterly Report on Form 10-Q for the period ended September 27, 1997).

10.19+		License Agreement dated February 9, 1998, between the Registrant and Boston Scientific Corporation. (Incorporated herein by reference to Exhibit 10.26 filed previously with the Registrant’s Annual Report on Form 10-K for the period ended January 3, 1998).

10.20+		Development and Supply Agreement, dated February 9, 1998, between the Registrant and Boston Scientific Corporation. (Incorporated herein by reference to Exhibit 10.27 filed previously with the Registrant’s Annual Report on Form 10-K for the period ended January 3, 1998).

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10.21		Lease Agreement date March 25, 1998 between the Registrant and Aetna Life Insurance Company for the Registrant’s facility located at 840 Del Rey Avenue, Sunnyvale, California 94086. (Incorporated herein by reference to Exhibit 10.28 filed previously with the Registrant’s Annual Report on Form 10-K for the period ended January 3, 1998).

10.22+		Term sheet for License and Distribution Agreement between Xomed Surgical Products and the Registrant dated June 25, 1998. (Incorporated herein by reference to Exhibit 10.29 filed previously with the Registrant’s Quarterly Report on Form 10-Q for the period ended October 3, 1998).

10.23+		License Agreement dated February 9, 1999 between the Registrant and Collagen Aesthetics. (Incorporated herein by reference to Exhibit 10.27 filed previously with the Registrant’s Annual Report on Form 10-K for the period ended January 2, 1999).

10.25		The Form of “VP Continuity Agreement” between the Registrant and its Vice Presidents. (Incorporated herein by reference to Exhibit 10.29 filed previously with the Registrant’s Annual Report on Form 10-K for the period ended January 2, 1999).

10.26		Letter Agreement dated February 9, 1999 between the Registrant and Collagen Aesthetics. (Incorporated herein by reference to Exhibit 10.30 filed previously with the Registrant’s Annual Report on Form 10-K/A for the period ended January 2, 1999).

10.27		Employment Letter Agreement, between the Registrant and John R. Tighe dated January 26,1999. (Incorporated herein by reference to Exhibit 10.30 filed previously with the Registrant’s Quarterly Report on Form 10-Q for the period ended April 3, 1999).

10.28		Employment Letter Agreement, between the Registrant and Christine Hänni amended May 19, 1999. (Incorporated herein by reference to Exhibit 10.31 filed previously with the Registrant’s Quarterly Report on Form 10-Q for the period ended April 3, 1999).

10.29		Employment Letter Agreement, between the Registrant and Bruce Prothro amended May 19, 1999. (Incorporated herein by reference to Exhibit 10.32 filed previously with the Registrant’s Quarterly Report on Form 10-Q for the period ended April 3, 1999).

10.30+		Litigation Settlement Agreement, between the Registrant and ETHICON, Inc. dated June 24, 1999. (Incorporated herein by reference to Exhibit 10.33 previously filed with the Registrant’s Quarterly Report on Form 10-Q for the period ended July 3, 1999).

10.31		Relocation Loan Agreement, between the Registrant and John R. Tighe dated May 1, 1999. (Incorporated herein by reference to Exhibit 10.34 previously filed with the Registrant’s Quarterly Report on Form 10-Q for the period ended July 3, 1999).

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10.32		Line of Credit Agreement with Silicon Valley Bank dated June 11, 1999. (Incorporated herein by reference to Exhibit 10.35 previously filed with the Registrant’s Quarterly Report on Form 10-Q for the period ended July 3, 1999.)

10.33+		Amendment to License Agreement between ArthroCare Corporation and Inamed Corporation dated October 1, 1999. (Incorporated herein by reference to Exhibit 10.33 previously filed with the Registrant’s Registration Statement on Form S-3 (Registration No. 333-87187))

10.34		First Amendment to Rights Agreement between ArthroCare Corporation and Norwest Bank Minnesota, N.A. (the “Rights Agent”) dated March 10, 2000. (Incorporated herein by reference to Exhibit 99.1 previously filed with the Registrant’s Form 8-K filed March 10, 2000.)

10.35		Nonstatutory Stock Option Plan and form of Stock Option Agreement thereunder. (Incorporated herein by reference to the same-numbered exhibit filed previously with the Registrant’s Annual Report on Form 10-K for the period ended January 1, 2000.)

10.36+		License Agreement between ArthroCare Corporation and Stryker Corporation, dated June 28, 2000. (Incorporated herein by reference to the same-numbered exhibit filed previously with the Registrant’s Annual Report on Form 10-Q for the period ended July 1, 2000.)

10.37		Change of Control Agreement between the Registrant and Michael Baker, CEO, dated September 25, 2001. (Incorporated herein by reference to the same—numbered exhibit filed previously with the Registrant’s Quarterly on form 10-Q for the period ended September 29, 2001.)

10.38		Amendment to the 1993 Incentive Stock Plan (Incorporated herein by reference to Exhibit 4.2 to the Registrant’s Registration Statement on Form S-8 filed on August 8, 2000).

10.39		Amendment to the 1995 Director Option Plan (Incorporated herein by reference to Exhibit 4.3 to the Registrant’s Statement on Form S-8 filed on August 8, 2000).

Confidential treatment granted.

b) Reports on Form 8-K

None.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

		ARTHROCARE CORPORATION a Delaware corporation

Date: August 13, 2002		/s/ MICHAEL A. BAKER
		Michael A. Baker President, Chief Executive Officer and Director (Principal Executive Officer)

Date: August 13, 2002		/s/ FERNANDO SANCHEZ
		Fernando Sanchez Senior Vice President, Operations and Chief Financial Officer (Principal Financial and Accounting Officer)

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