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 September 28, 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 November 1, 2002 was 20,963,930.

ARTHROCARE CORPORATION

INDEX

		Page
PART 1: Financial Information
Item 1. Financial Statements (unaudited)
Condensed Consolidated Balance Sheets as of September 30, 2002 and December 31, 2001		3
Condensed Consolidated Statements of Income for the three-month and nine-month periods ended September 30, 2002 and September 30, 2001		4
Condensed Consolidated Statements of Cash Flows for the nine-month periods ended September 30, 2002 and September 30, 2001		5
Notes to Condensed Consolidated Financial Statements		6
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		12
Item 3. Quantitative and Qualitative Disclosures About Market Risk		34
Item 4. Controls and Procedures		34
PART II: Other Information
Item 1. Legal Proceedings		35
Item 6. Exhibits and Reports on Form 8-K		35
SIGNATURES		36
CERTIFICATIONS		37

Part I. FINANCIAL INFORMATION

Item 1. Financial statements

ARTHROCARE CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except per share data)

	September 30, 2002			December 31, 2001
	(Unaudited)
ASSETS
Current assets:
Cash and cash equivalents	$	33,542		$	41,507
Available-for-sale securities		7,285			26,662
Accounts receivable, net of allowances of $454 in 2002 and $776 in 2001		18,237			18,567
Inventories, net		18,486			14,207
Prepaid expenses and other current assets		5,767			6,250

Total current assets		83,317			107,193
Available-for-sale securities		26,469			8,526
Property and equipment, net		17,613			13,068
Related party receivables		1,205			1,205
Other assets		3,674			3,705

Total assets	$	132,278		$	133,697

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	4,069		$	3,142
Accrued liabilities		4,301			1,111
Accrued compensation		4,754			3,837
Income taxes payable		1,225			461

Total current liabilities		14,349			8,551
Deferred rent		100			53

Total liabilities		14,449			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: 20,959 shares in 2002, and 21,855 shares in 2001		23			22
Treasury stock: 1,977 shares in 2002, 951 shares in 2001		(31,106	)		(18,987	)
Additional paid-in capital		147,294			146,081
Accumulated other comprehensive loss		(272	)		(1,724	)
Retained earnings/(accumulated deficit)		1,890			(299	)

Total stockholders’ equity		117,829			125,093

Total liabilities and stockholders’ equity	$	132,278		$	133,697

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

ARTHROCARE CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(In thousands, except per share data)

(Unaudited)

	Three Months Ended				Nine Months Ended
	September 30, 2002		September 30, 2001		September 30, 2002		September 30, 2001
Revenues:
Product sales	$	21,332	$	17,975	$	61,329	$	53,505
Royalties, fees and other		879		2,287		3,054		7,075

Total revenues		22,211		20,262		64,383		60,580
Cost of product sales		7,981		7,522		22,758		21,390

Gross profit		14,230		12,740		41,625		39,190

Operating expenses:
Research and development		2,188		1,973		6,472		5,869
Sales and marketing		9,011		8,253		26,270		22,471
General and administrative		2,458		1,426		6,861		3,756

Total operating expenses		13,657		11,652		39,603		32,096

Income from operations		573		1,088		2,022		7,094
Interest and other income, net		377		2,961		1,231		5,103

Income before income tax provision		950		4,049		3,253		12,197
Income tax provision		304		1,458		1,064		4,402

Net income	$	646	$	2,591	$	2,189	$	7,795

Basic net income per share	$	0.03	$	0.12	$	0.10	$	0.35

Shares used in computing basic net income per share		21,085		22,477		21,595		22,428

Diluted net income per share	$	0.03	$	0.11	$	0.10	$	0.33

Shares used in computing diluted net income per share		22,060		23,860		22,514		23,503

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

ARTHROCARE CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

	Nine months Ended
	September 30, 2002			September 30, 2001
Cash flows from operating activities:
Net income	$	2,189		$	7,795
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		5,486			4,416
Stock compensation expense		144			419
Provision for doubtful accounts receivable and product returns		(322	)		(47	)
Provision for excess and obsolete inventory		93			(12	)
Deferred rent		47			(52	)
Changes in operating assets and liabilities:
Accounts receivable		501			(3,844	)
Inventories		(4,420	)		864
Prepaid expenses and other current assets		470			(101	)
Accounts payable		930			5,706
Accrued liabilities		2,420			1,061
Income taxes payable		764			—
Deferred revenue		—			(5,476	)
Other assets		31			—

Net cash provided by operating activities		8,333			10,729

Cash flows from investing activities:
Purchases of property and equipment		(8,344	)		(5,362	)
Purchases of available-for-sale securities		(133,547	)		(18,236	)
Sales or maturities of available-for-sale securities		135,668			33,271

Net cash provided by/(used in) investing activities		(6,223	)		9,673

Cash flows from financing activities:
Purchase of treasury stock		(12,119	)		(16,295	)
Repayment of capital leases		—			(67	)
Proceeds from exercise of options to purchase common stock		1,069			4,938

Net cash used in financing activities		(11,050	)		(11,424	)

Effect of exchange rate changes on cash		975			(711	)

Net increase/(decrease) in cash and cash equivalents		(7,965	)		8,267
Cash and cash equivalents, beginning of period		41,507			35,782

Cash and cash equivalents, end of period	$	33,542		$	44,049

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

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 September 30.

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 $1.7 million reduction of both revenue and sales and marketing expense for the quarter ended September 30, 2001. The corresponding decrease for the nine-month period ending September 30, 2001 was $4.0 million.

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				Nine Months Ended
	September 30, 2002		September 30, 2001		September 30, 2002		September 30, 2001
Net income	$	646	$	2,591	$	2,189	$	7,795

Weighted average basic shares outstanding (used in computing basic net income per share)		21,085		22,477		21,595		22,428
Options and warrants		975		1,383		919		1,075

Shares used in computing diluted net income per share		22,060		23,860		22,514		23,503

Basic net income per share	$	0.03	$	0.12	$	0.10	$	0.35

Diluted net income per share	$	0.03	$	0.11	$	0.10	$	0.33

Options to purchase 3,776,514 shares of common stock at prices ranging from $13.03-$48.56 per share outstanding during the three-month period ended September 30, 2002, and options to purchase 3,196,498 shares of common stock at prices ranging from $14.20-$48.56 per share outstanding during the nine-month period ended September 30, 2002 were not included in the computation of diluted net income per share because their effects are anti-dilutive. Options to purchase 1,750,874 shares of common stock at prices ranging from $29.64-$48.56 per share outstanding during the three-month period ended September 30, 2001, and options to purchase 1,825,021 shares of common stock at prices ranging from $23.00-$48.56 per share outstanding during the nine-month period ended September 30, 2001 were not included in the computation of diluted net income per share because their effects were anti-dilutive.

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					Nine Months Ended
	September 30, 2002			September 30, 2001		September 30, 2002		September 30, 2001
	September 30, 2002			September 30, 2001		September 30, 2002		September 30, 2001
Net income	$	646		$	2,591	$	2,189	$	7,795
Other comprehensive income:
Change in unrealized gains and losses on available-for-sale marketable securities		705			88		686		2,568
Foreign currency translation adjustment		(658	)		252		766		(1,266	)

Comprehensive net income	$	693		$	2,931	$	3,641	$	9,097

5. Inventories (in thousands):

	September 30, 2002		December 31, 2001
Inventories:
Raw materials	$	6,163	$	5,678
Work-in-process		3,615		2,692
Finished goods		8,708		5,837

Total	$	18,486	$	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 names Vulcan, Sapphire and Electroblade 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 above products; 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. ArthroCare believes these claims to be without merit and intends to defend itself vigorously.

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 was settled and the financial impact was recorded in the second quarter of 2002. 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. On November 6, 2002, the lawsuit was settled and both parties have executed mutual releases of their claims.

In April 2002, a product liability suit was brought against us in the United States District Court, District of Maine. The lawsuit includes a claim for punitive damages. Punitive damages, if awarded, are not covered by our insurance policies, and we would be required to pay any such punitive damages that were awarded. ArthroCare believes these claims to be without merit and intends to defend itself vigorously.

In September 2002, a product liability suit was brought against us in the 269^th Judicial District Court, Harris County, Texas. ArthroCare believes these claims to be without merit and intends to defend itself vigorously.

In October 2002, ArthroCare acquired all of the outstanding shares of Atlantech Medical Devices, Ltd. (“Atlantech”), a distributor of medical device products in the United Kingdom. Atlantech was involved in litigation with a former reseller regarding termination of a purported distribution agreement and seeks damages for alleged breach of contract. ArthroCare believes these claims to be without merit and intends to defend itself vigorously.

We believe that we have meritorious defenses against the above claims and intend to vigorously contest them. The outcomes of the outstanding litigation matters discussed above are not considered probable or cannot be reasonably estimated. Also, except as otherwise described above, ArthroCare has product liability insurance coverage in amounts its considers necessary to prevent material losses. We record a liability when a loss is known or considered probable and the amount can be reasonably estimated. If a loss is not probable or a probable loss cannot be reasonably estimated, a liability is not recorded. While it is not possible to predict the outcome of the actions discussed above, we believe that costs associated with them will not have a material adverse impact on our financial position or liquidity, but could be material to the consolidated results of operations of any one period.

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 nine-month periods ended September 30, 2002 and September 30, 2001 are summarized in the table below.

	Three Months Ended				Nine Months Ended
	September 30, 2002		September 30, 2001		September 30, 2002		September 30, 2001
	(in thousands)
Product sales:
Arthroscopy	$	15,553	$	15,021	$	46,685	$	44,283
ENTec		2,747		1,554		7,269		4,752
ArthroCare Spine		2,455		1,105		6,216		3,353
Other		577		295		1,159		1,117

Total	$	21,332	$	17,975	$	61,329	$	53,505

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				Nine Months Ended
	September 30, 2002		September 30, 2001		September 30, 2002		September 30, 2001
	(in thousands)
Total revenue:
United States	$	18,657	$	17,345	$	54,601	$	53,699
International		3,554		2,917		9,782		6,881

Total	$	22,211	$	20,262	$	64,383	$	60,580

Balance as of:

	September 30, 2002		December 31, 2001
	(in thousands)
Property and equipment:
United States	$	12,246	$	11,092
International		5,367		1,976

Total	$	17,613	$	13,068

8. Subsequent Events

On October 21, 2002, the Company acquired all of the outstanding shares of Atlantech Medical Devices, Ltd., a distributor of medical device products in the United Kingdom. In addition, the former shareholders of Atlantech Medical Devices, Ltd. Have the right to receive an earn-out, to be paid in varying amounts in 2003 through 2006, in the event Atlantech Medical Devices, Ltd. achieves certain business goals. The Company used cash to fund the acquisition. Also, the Company has reached an agreement to

acquire Atlantech GmbH, a German medical device distributor, and expects to complete this transaction by the end of November 2002.

PART 1. 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.

ArthroCare is 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-arthroscopic 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, endoscopic, and open surgical procedures for general surgery, gynecology and urology applications; and AngioCare, to commercialize our technology in cardiology markets.

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 for the treatment of wrinkles. 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 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, and urology 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 September 30, 2002, we had shipped more than 15,600 controller units and almost 1,900,000 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).

Results of Operations

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

Revenues:

Product sales were $21.3 million for the three-month period ended September 30, 2002, an increase of more than 18%, from the $18.0 million in the third 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 $1.7 million decrease in 2001’s third quarter’s revenue, with a corresponding decrease in sales and marketing expenses. The company shipped over 125,000 disposable devices during the third quarter of 2002 compared to approximately 120,000 units for the third quarter of 2001. All commercial business units posted sales increases in the third quarter of 2002 compared to the third quarter of 2001. Arthroscopy contributed $15.6 million in net product sales, an increase of 4%. The company’s ear, nose and throat (ENTec) business unit’s net product sales increased to $2.7 million, an increase of 77%. The spinal surgery products’ sales (ArthroCare Spine) increased to $2.5 million, an increase of 122%. Other product sales were $0.6 million in the third quarter of 2002, an increase of 96%.

The increase in direct sales presence, which was begun in 2001, continued to have a positive effect on sales in the third 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 were $3.6 million for the third quarter of 2002 or 17% of total product sales, compared to $2.9 million or 16% of total product sales for the third quarter of 2001.

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.

Royalties, fees and other were $0.9 million for the third quarter of 2002, as compared to $2.3 million for the third quarter of 2001. The decrease was primarily due to the recognition of $1.7 million in fees due to the cancellation of agreements with former distributor partners in the third quarter of 2001.

Cost of Product Sales

Cost of product sales was $8.0 million for the three-month period ended September 30, 2002 or 37% of product revenues, as compared with $7.5 million or 42% of product revenues in the third quarter of 2001. The decrease in cost as a percentage of product sales for the third quarter of 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 continued shipping sub-assemblies to the Sunnyvale facility in the third quarter and is expected to contribute to gross margin improvements in the fourth quarter of 2002 and fiscal 2003.

Operating Expenses

Research and development expenses were $2.2 million or 10% of product sales, for the three-month period ended September 30, 2002, as compared to $2.0 million or 11% of product sales for the same period in 2001. The increase in spending in the third quarter of 2002 is primarily due to continuing development of new products in our currently commercialized markets, continuing our development efforts for potential additional products and continuing 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 $9.0 million or 42% of product sales, for the three-month period ended September 30, 2002, as compared to $8.3 million or 46% of product sales during the same period in 2001. The increase in spending in the third quarter of 2002 was primarily due to $0.7 million associated with the accrual of higher commissions resulting from increased sales, $0.4 million due to the hiring of new direct sales representatives, partially offset by $0.3 million lower expenses related to marketing research and promotional activities.

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.

General and administrative expenses were $2.5 million or 12% of product sales, during the three-month period ended September 30, 2002, as compared to $1.4 million or 8% of product sales during the same period in 2001. The increase in spending was primarily due to $0.5 million in higher costs of general and patents-related legal services, business development activities, and insurance related to expanding our corporate infrastructure, $0.4 million related to costs for the new corporate facilities, and $0.2 million resulting from increased headcount 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 was $0.4 million for the three-month period ended September 30, 2002 compared to $3.0 million during the same period in 2001. The decrease was primarily attributable to a $2.1 million gain on the sale of an investment in third quarter of 2001, as well as a reduction in interest income due to the decrease of our investment portfolio by approximately $12.0 million at September 30, 2002 for the previous twelve months.

Nine-months ended September 30, 2002 and September 30, 2001

Revenues:

Product sales were $61.3 million for the nine months ended September 30, 2002, an increase of 15%, from the $53.5 million in the first nine months 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 $4.0 million decrease in 2001’s year-to-date revenue, with a corresponding decrease in sales and marketing expenses.

All three reportable segments experienced product sales increases for the first nine months of 2002 compared to the same period of 2001. Arthroscopy contributed $46.7 million in net product sales, a 5% increase. The company’s ear, nose and throat (ENTec) business unit’s net product sales increased to $7.3 million, a 53% increase. The spinal surgery products’ sales (ArthroCare Spine) increased to $6.2 million, an 85% increase. Other product sales were $1.2 million in the first nine months of 2002, an increase of 4%.

International product sales were $9.8 million for the nine-month period ended September 30, 2002 or 16% of product sales, compared to $6.9 million or 13% of product

sales for the same period in 2001. Our growth in the domestic market was stronger than in the international market due primarily to the increased effectiveness of the direct sales force in the United States.

Royalties, fees and other were $3.1 million for the nine-month period ended September 30, 2002, as compared to $7.1 million for the same period in 2001. Included in license fees, royalties and other revenue in 2001 is approximately $3.5 million resulting from the recognition of previously deferred revenue from the cancellation of an agreement with our former cosmetic surgery distributor, and $1.7 million in fees due to the cancellation of agreements with other former distributor partners, partially offset by higher royalties of $1.0 million, primarily in the arthroscopy area, and higher freight revenue of $0.2 million.

Cost of Product Sales

Cost of product sales was $22.8 million for the nine-month period ended September 30, 2002 or 37% of product revenues, as compared with $21.4 million or 40% of product revenues for the same period in 2001. The decrease in cost as a percentage of product sales for the nine-month period ended September 30, 2002 as compared to the prior year period is primarily due to the increased efficiency of the manufacturing operations, including the initiation of production at our Costa Rica facility.

Operating Expenses

Research and development expenses were $6.5 million or 11% of product sales, for the nine-month period ended September 30, 2002, as compared to $5.9 million or 11% of product sales for the same period in 2001. The increase in spending in the first nine months of 2002 is primarily due to continuing development of new products in our currently commercialized markets, continuing our development efforts for potential additional products and continuing to maintain and develop our patent position.

Sales and marketing expenses were $26.3 million or 43% of product sales, during the nine-month period ended September 30, 2002, as compared to $22.5 million or 42% of product sales during the same period in 2001. The increase in spending for the current year’s nine-month period was primarily due to increased expenses of $1.9 million associated with the accrual of higher commissions resulting from increased sales, $1.4 million due to the hiring of new direct sales representatives, and higher expenses of $0.3 million related to increased marketing activities including travel and promotional materials.

General and administrative expenses were $6.9 million or 11% of product sales during the nine-month period ended September 30, 2002, as compared to $3.8 million or 7% of product sales during the same period in 2001. The increase in spending was primarily due to $1.8 million in 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, $0.8 million related to costs for the new corporate facilities, and $0.5 million resulting from increased headcount 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 was $1.2 million for the nine-month period ended September 30, 2002 compared to $5.1 million during the same period in 2001. The decrease is primarily due to a $2.1 million gain on the sale of an investment in the third quarter of 2001, lower interest income attributable to lower interest rates in 2002 compared to 2001, as well as a reduction of our investment portfolio by approximately $5.0 million in the first nine months of 2002.

Liquidity and Capital Resources

On September 30, 2002, we had $69.0 million in working capital. The principal sources of liquidity consisted of $40.8 million in cash, cash equivalents and short-term available-for-sale securities. The Company also had $26.5 million of non-current available-for-sale securities as of September 30, 2002.

Net cash provided by operating activities for the nine-month period ended September 30, 2002 was $8.3 million, as compared to $10.7 million for the nine-month period in 2001. The decrease in net cash provided by operating activities is primarily due to the increase in inventories and depreciation, which was partially offset by decreases in accounts receivable and liabilities.

Inventories, net increased to $18.5 million as of September 30, 2002 from $14.2 million as of December 31, 2001 to support the levels of product required for sales volume increases and from the shift of manufacturing from outside contractors to our new Costa Rica manufacturing facility.

Net cash used in investing activities for the nine-month period ended September 30, 2002 was $6.2 million compared to net cash provided by investing activities of $9.7 million for the nine-month period in 2001. The decrease is primarily due to the timing of purchases and sales or maturities of available for sale securities and the purchase of fixed assets.

Net property and equipment increased to $17.6 million as of September 30, 2002 from $13.1 million as of December 31, 2001. Capital expenditures were $8.3 million in the first nine months of fiscal 2002 primarily due to the capitalization of controllers placed under various promotional programs, the purchase of equipment related to the new facility in Costa Rica, and an increase of computer software and equipment.

Net cash used in financing activities for the nine-month period ended September 30, 2002 was $11.1 million compared to $11.4 million for the nine-month period in 2001. The cash used was primarily for the repurchase of treasury shares, which exceeded the proceeds received from the exercise of options.

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 repurchase of up to 2,000,000 additional shares of our common stock, subject to certain limitations and conditions. For the nine-month period ended September 30, 2002, we repurchased 1,026,741 shares at a cost of $12.1 million. For the nine-month period ended September 30, 2001, we repurchased 801,000 shares at a cost of $16.3 million.

The Company believes that its cash flow from operations, current cash and cash investments will be adequate to meet its cash requirements for the next twelve months. 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.

SUBSEQUENT EVENTS

On October 21, 2002, the Company acquired all of the outstanding shares of Atlantech Medical Devices, Ltd., a distributor of medical device products in the United Kingdom. In addition, the former shareholders of Atlantech Medical Devices, Ltd. have the right to receive an earn-out, to be paid in varying amounts in 2003 through 2006, in the event Atlantech Medical Devices, Ltd. achieves certain business goals. The Company used cash to fund the acquisition. Also, the Company has reached an agreement to acquire Atlantech GmbH, a German medical device distributor, and expects to complete this transaction by the end of November 2002.

ADDITIONAL FACTORS THAT MIGHT AFFECT FUTURE RESULTS

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 on our results of operations, business, financial position and future growth prospects. Additional risks and uncertainties that we do not currently know effect 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 76% in the nine-month period ending September 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.

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:

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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.

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.

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. 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.

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.

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.

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 September 30, 2002, we had retained earnings of $1.9 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.

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.

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 $24.68 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.

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;

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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.

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 treatment of wrinkles. We have received 510(k) clearance to market our ENT Surgery System in head, neck and sinus surgical procedures, as well as the treatment of snoring, hypertrophic turbinates, tonsilectomy and submucosal channelling. 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 not 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.

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, and Korea; 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, South America 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. 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 in each policy year. 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 6 to the Financial Statements and Part II, Item 1 “Legal Proceedings”, several product liability suits have been filed against us, involving our arthroscopy products. A successful product liability claim or series of claims brought against us in excess of, or outside the scope 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. Our investment portfolio only includes highly liquid instruments. We do not use derivative financial instruments in our investment portfolio and conduct transactions primarily in U.S. dollars although other foreign currencies are used. As a result, the Company is subject to market risk from changes in foreign currency exchange rates

We are subject to fluctuating interest rates and foreign currency exchange 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.

Item 4. Controls and Procedures

The Company’s Chief Executive Officer and its Chief Financial Officer have evaluated the Company’s disclosure controls and procedures within 90 days of the filing of this report and have concluded that there are no significant deficiencies or material weaknesses. There have been no significant changes in the Company’s internal controls or in other factors that could significantly affect these controls.

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 6. Exhibits and Reports on Form 8-K

Exhibits

Reports on Form 8-K

On August 13, 2002, the Company filed a current report on Form 8-K under Item 9 (“Regulation FD Disclosure”) certifying that the Quarterly Report on Form 10-Q for the quarterly period ended June 29, 2002 fully complies with the requirements of Section 13(a) or Section 15(d), as applicable, of the Securities Exchange Act of 1934, as amended, and the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

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: November 8, 2002		/s/ Michael A. Baker
		Michael A. Baker
		President, Chief Executive Officer and Director (Principal Executive Officer)

Date: November 8, 2002		/s/ Fernando Sanchez
		Fernando Sanchez
		Senior Vice President,
		Operations and Chief
		Financial Officer
		(Principal Financial and Accounting Officer)

CERTIFICATION OF CHIEF EXECUTIVE OFFICER

PURSUANT TO

18 U.S.C. SECTION 1350

AS ADOPTED PURSUANT TO

SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002

I, Michael A. Baker, certify that:

I have reviewed this quarterly report on Form 10-Q of ArthroCare Corporation;

Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;

Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;

The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;

evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and

presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the registrant’s audit committee of the registrant’s board:

all significant deficiencies in the design or operation of internal controls which could adversely affect ArthroCare Corporation’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and

any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and

The registrant’s other certifying officer and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.


Date: November 8, 2002				/s/ MICHAEL A. BAKER
				Michael A. Baker President and Chief Executive Officer

CERTIFICATION OF CHIEF FINANCIAL OFFICER

PURSUANT TO

18 U.S.C. SECTION 1350

AS ADOPTED PURSUANT TO

SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002

I, Fernando Sanchez, certify that:

I have reviewed this quarterly report on Form 10-Q of ArthroCare Corporation;

evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and

presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and


Date: November 8, 2002				/s/ FERNANDO SANCHEZ
				Fernando Sanchez Chief Financial Officer

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