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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 March 31, 2003.

OR

¨  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)

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  ¨.

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2).  Yes  x  No  ¨

The number of shares outstanding of the registrant’s common stock as of April 30, 2003 was 21,010,580.

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ARTHROCARE CORPORATION

INDEX

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PART I.    FINANCIAL INFORMATION

Item 1.    Financial Statements

ARTHROCARE CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands)

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

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ARTHROCARE CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands except per share data)

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

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ARTHROCARE CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

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

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ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1.    FORMATION AND BUSINESS OF THE COMPANY:

ArthroCare Corporation (“ArthroCare”, “we” or the “company”) was incorporated on April 29, 1993 and our principal operations commenced in August 1995. We design, develop, manufacture and market medical devices for use in soft-tissue surgery. Our products are based on our patented soft-tissue surgical controlled ablation technology, which we call Coblation technology. Coblation technology involves an innovative use and the capability of performing at temperatures lower than traditional electrosurgical tools. Our strategy includes applying 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 are a global company with manufacturing facilities in the United States and Costa Rica and sales offices throughout the United States and Europe.

2.    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 and its subsidiaries 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, 2002 should be read in conjunction with these condensed consolidated financial statements. The balance sheet at December 31, 2002 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.

In the fourth quarter of 2002 we changed our fiscal periods, month and year, to conform to calendar periods. The first quarter of 2002 began on December 30, 2001 and ended on March 30, 2002.

3.    STOCK-BASED COMPENSATION:

We account for stock-based employee compensation using the intrinsic value method of accounting. Under the intrinsic value method of accounting, employee stock-based compensation expense is based on the difference, if any, on the date of the grant between the fair value of the Company’s stock and the exercise price of the award.

We account for stock options issued to non-employees using the fair value method of accounting. Stock-based compensation expense is recognized over the four-year vesting period. During the first quarter of 2003 and 2002 stock-based compensation expense, related to non-employee option grants, was $0.3 million and $0.1 million respectively and is included in Sales and Marketing and Research and Development expense.

Assumptions used in determining the fair value of non-employee stock option grants, in the first quarter of 2003, using the Black-Scholes pricing model, were:

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Had employee stock-based compensation been determined based on the fair value at the grant date the company’s net income per share and fully diluted net income per share for the first quarter ended March 31, 2003 and 2002 would have been as indicated below:

In determining the pro forma net loss, the fair value of each employee option grant was estimated on the date of grant using the Black-Scholes model with the following weighted average assumptions:

Stock Option Plans

Employee Stock Purchase Plan

The weighted average fair value of options granted to employees during the first quarter ended March 31, 2003 was $6.52 per share and during the first quarter ended March 31, 2002 was $8.62 per share.

4.    RECENT ACCOUNTING PRONOUNCEMENTS:

In November 2002, the Financial Accounting Standards Board issued FASB Interpretation No. 45 (“FIN 45”), “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.” FIN 45 requires that a liability be recorded in the guarantor’s balance sheet upon issuance of a guarantee. In addition, FIN 45 requires disclosures about the guarantees that an entity has issued, including a reconciliation of changes in the entity’s product warranty liabilities. The initial recognition and initial measurement provisions of FIN 45 are applicable on a prospective basis to guarantees issued or modified after December 31, 2002, irrespective of the guarantor’s fiscal year-end. The disclosure requirements of FIN 45 are effective for financial statements of interim or annual periods ending after December 15, 2002. The adoption of FIN 45 did not have a material impact on the Company’s operating results or financial position.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

In November 2002, the Emerging Issues Task Force (“EITF”) reached a consensus on Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables.” EITF Issue No. 00-21 provides guidance on how to account for arrangements that involve the delivery or performance of multiple products, services and/or rights to use assets. The provisions of EITF Issue No. 00-21 will apply to revenue arrangements entered into in fiscal periods beginning after June 15, 2003. The company is in the process of determining the financial effects, if any, on its consolidated financial statements.

In January 2003, the FASB issued FASB Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51.” FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 is effective immediately for all new variable interest entities created or acquired after January 31, 2003. For variable interest entities created or acquired prior to February 1, 2003, the provisions of FIN 46 must be applied for the first interim or annual period beginning after June 15, 2003. The company is in the process of determining the financial effects, if any, on its consolidated financial statements.

5.    COMPUTATION OF NET INCOME PER SHARE:

Basic net income per common share is computed using the weighted average number of shares of common stock outstanding. Diluted net income per common share is computed using the weighted average number of shares of common stock outstanding and potential shares of common stock when they are dilutive. The following is a reconciliation of the numerator (net income) and the denominator (number of shares) used in the calculation of basic and diluted net income per share (in thousands, except per share data):

Options to purchase 6,445,000 shares of common stock at prices ranging from $9.56-$46.62 per share outstanding at March 31, 2003, were not included in the computation of diluted net income per share because their effects are anti-dilutive. Options to purchase 3,137,000 shares of common stock at prices ranging from $13.75-$48.56 per share outstanding at March 31, 2002, were not included in the computation of diluted net income per share because their effects are anti-dilutive.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

6.    COMPREHENSIVE INCOME:

Comprehensive income is comprised of net income and other comprehensive income consisting of foreign currency translation gain/loss and unrealized gains or losses on available-for-sale marketable securities. Our total comprehensive income is as follows (in thousands):

7.    INVENTORIES (in thousands):

8.    COMMITMENTS AND CONTINGENCIES:

Operating Leases

We lease our facilities and certain equipment under operating leases. The company recognizes rent expense on a straight-line basis over the lease term. At March 31, 2003, total future minimum lease payments are as follows (in thousands):

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Warranties

The company generally provides customers with a limited 90-day warranty on products sold and a limited 1-year warranty on loaned controller units. We accrue for the estimated cost of product warranties at the time revenue is recognized. Our warranty obligation is affected by product failure rates, material usage and service delivery costs incurred in correcting a product failure. We periodically evaluate and adjust the warranty reserve to the extent actual warranty expense varies form the original estimates. The following table describes the activity in our warranty accrual for the quarter ended March 31, 2003 (in thousands):

Litigation

We are involved in litigation and other legal matters arising in the normal course of business.

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 Defendants use, import, market and sell electrosurgical devices under the names Saphyre, ElectroBlade and Dyonics Control RF System that infringe 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, the Electroblade and the Saphirre RF electrosurgical devices; and (3) an award of damages (including attorneys’ fees) to compensate us for lost profits and Defendant’s use of our inventions, with the damages to be trebled because of the Defendant’s willful infringement. On May 12, 2003, a jury found that Smith & Nephew’s products (Saphyre, ElectroBlade and Control RF) infringe the 16 asserted claims of US Patent Nos. 5,697,882, 5,697,536 and 6,224,592. The jury also upheld the validity of all asserted claims of these patents. ArthroCare is now seeking a permanent injunction and an award for damages.

On April 3, 2003, Smith & Nephew filed a complaint against ArthroCare in the United States District Court, Western District of Tennessee for patent infringement of two patents and for violation of Section 43(a) of the Lanham Act. The complaint does not contain any specifics regarding the alleged infringement. Upon initial review, we believe this complaint is without merit, and we will defend ourselves vigorously.

In conjunction with a medical malpractice suit against a physician, a product liability suit was brought against us in the Superior Court Arizona, County of Yavapai on August 24, 2001. The parties have reached an amicable resolution and the matter has been dismissed.

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 such punitive damages that were awarded. This lawsuit is pending and a jury trial is scheduled to commence on June 23, 2003. ArthroCare believes these claims to be without merit and is defending itself vigorously.

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

We believe that we have meritorious defenses against the above, unsettled claims and intend to vigorously contest them. The outcomes of the outstanding litigation matters discussed above 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.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

9.    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 (shoulder and knee arthroscopic products), ENT^®, (to include ear, nose, throat and the Visage^® cosmetic products), ArthroCare Spine^™ (to include spinal and neuro surgery products) and Coblation Technology (to include gynecology, urology, laparoscopic, general surgical and cardiology products). Our reportable segments include Arthroscopy, ENT, ArthroCare Spine and Coblation Technology.

Product sales are summarized in the table below (in thousands):

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 table represents a summary of product sales and long-lived assets by geographical region (in thousands):

10.    STOCKHOLDERS’ EQUITY:

Restricted Stock.    In the first quarter of 2003, we granted employees 127,300 shares of restricted common stock under the 1993 Incentive Stock Option Plan. The Company recorded $1.1 million of deferred compensation, which is being amortized to other compensation expense over 5 years. The total amortization recorded in the first quarter of 2003 was approximately $19,000.

Treasury Stock.    In April 2001, the Board of Directors authorized the repurchase of up to 1,000,000 shares of 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. In the first quarter of of 2003, we repurchased 169,000 shares at a cost of $2.0 million. In the first quarter of 2002 we repurchased 49,000 shares at a cost of $0.7 million.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

11.    SUBSEQUENT EVENTS:

On April 25, 2003, the company acquired all of the outstanding shares of Atlantech Austria, a distributor of medical device products in Austria, in a cash acquisition of $0.4 million, net of cash acquired. In addition, the former shareholders of Atlantech Austria have the right to receive an earn-out, to be paid in 2004, in the event Atlantech Austria achieves certain business goals.

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

The following discussion should be read in conjunction with the consolidated financial statements and notes thereto appearing elsewhere in this Form 10-Q. Statements in this Management’s Discussion and Analysis of Financial Condition and Results of Operations and elsewhere in this quarterly report on Form 10-Q which express that we “believe,” “anticipate,” “expect” or “plan 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, but not limited to, those factors described under “Business” set forth in Part I of our Annual Report on Form 10-K for the year-ended December 31, 2002 and “Additional Factors That May Affect Future Results” set forth below.

Overview

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 increased precision and accuracy, limiting damage to surrounding tissue thereby reducing pain and speeding recovery for the patient. Our products operate at lower temperatures than traditional electrosurgical or laser surgery tools and enable surgeons to ablate, shrink, sculpt, cut, or aspirate soft-tissue surgery procedures with one multi-purpose surgical system.

We have organized our marketing and sales efforts into business units based on product markets. These business units are comprised of the following: Arthroscopy (to include shoulder and knee arthroscopic products), ENT (to include ear, nose, throat and the Visage^® cosmetic products), ArthroCare Spine^™ (to include spinal and neuro surgery products) and Coblation Technology (to include gynecology, urology, laparoscopic, general surgical and cardiology products).

Coblation technology is applicable across many soft-tissue surgical markets. Our systems are used to perform many types of arthroscopic surgery. Our strategy includes applying our patented Coblation technology to a broad range of other soft-tissue markets, including spinal surgery, neurosurgery, cosmetic surgery, ENT surgery, general surgery, gynecology, urology and various cardiology applications.

We commercially introduced our Arthroscopic Surgery System in December 1995 and have derived a significant portion of our sales from this system. Our Spine and ENT businesses are growing and represent an increasingly larger portion of our total business. As of March 31, 2003 we have shipped more than 16,900 controllers and over 2,130,000 disposable devices for a variety of indications since we began commercialization in 1995. In the United States we are selling our Arthroscopy products through a network of 45 distributors and a direct sales organization consisting of 17 people. Our Spine products are sold through a network of 30 independent distributors and a direct sales force of 14 people. Our ENT business unit distributes its products through a direct sales force of 33 people supported by distributors in certain remote U.S. geographic markets. We have also established a distribution capability in Europe. For our Arthroscopy business unit we have a direct sales organization in the U.K. and Germany consisting of 15 people. Our ENT business also has a direct selling organization in the U.K. and Germany of 6 people. Our Spine business unit is sold through a network of independent distributors in Europe. For the balance of Europe and Australia, New Zealand, China, Korea, Japan, Taiwan, Canada, Mexico, the Caribbean, Russia, South Africa, the Middle East, Northern Africa, South and Central America, we have established a distribution capability through independent Distributors. During the first quarter of 2003 our ENT business unit introduced a new ENT controller that provides improved performance for tonsillectomy procedures. Also during the first quarter of 2003, our Spine business unit introduced a new procedure for performing a less-invasive microdiscectomy using our Coblation technology.

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Results of Operations

Revenues

Total revenues were $27.2 million for the first quarter ended March 31, 2003, an increase of 35% from the $20.1 million in the first quarter of 2002. In the first quarter of 2003, total revenues included $2.7 million of non-arthroscopy product due to Atlantech Medical Devices, Ltd. and Atlantech GmbH (collectively referred to as “Atlantech”), which we acquired in the fourth quarter of fiscal 2002. Product sales for first quarter of 2003 were $26.4 million, an increase of 37% from $19.3 million in the same period of the prior year. All commercial business units posted sales increases in the first quarter of 2003. The company’s Arthroscopy business unit contributed $20.4 million in net product sales in the first quarter of 2003, including $2.7 million of Atlantech sales of non-arthroscopy product, as compared to $15.3 million in the first quarter of 2002. The company’s ENT business unit contributed $3.0 million in net product sales in the first quarter of 2003 as compared to $2.2 million in the first quarter of 2002. The company’s spinal surgery (ArthroCare Spine) business unit contributed $2.6 million in net product sales in the first quarter of 2003 as compared to $1.9 million in the first quarter of 2002. The company’s Coblation Technology business unit contributed $0.4 million in net product sales in the first quarter of 2003 as compared to a loss of $0.1 million in the first quarter of 2002. International sales grew by $1.1 million, or 21%, during the first quarter of 2003 as compared to the fourth quarter of 2002 and grew by $3.2 million, or 95%, compared to the first quarter of 2002.

The increase in direct sales presence, which began in 2001, continued to have a positive effect on sales in the first quarter of 2003, 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, introduction of new products designed to address surgical procedures that have traditionally been difficult to perform and the acquisition of technologies or businesses that complement our business.

Overall, disposable devices are consistently sold at or near list price, except for sales to international distributors and marketing partners, which are sold at discounted prices. We expect these discounts to continue in the future. Disposable device sales were 97.8% of product sales, excluding Atlantech product sales, for the first quarter of 2003 and comprised approximately 97.9% of first quarter 2002 product sales. We anticipate that disposable device sales will remain the primary component of our product sales in the near future.

International product sales were $6.5 million, or 25% of total product sales, in the first quarter of 2003 as compared to $3.3 million, or 17% of total product sales, in the first quarter of 2002. The $3.2 million increase is primarily attributable to the acquisition of Atlantech, with Atlantech non-arthroscopy product sales in the first quarter of 2003 of $2.7 million.

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 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 seven years of product shipments, we have penetrated 30% to 35% of the hospitals that perform arthroscopic procedures in the United States. We believe that approximately 45% of our arthroscopy product sales are being generated by the sale of disposables for use in knee procedures.

Royalties, fees, and other revenues were $0.8 million for the first quarters of both 2003 and 2002.

Cost of Product Sales

The increase in gross product margin as a percentage of product sales to 68% in the first quarter of 2003 from 61% in the first quarter of 2002 is mainly attributable to increased average selling prices of disposable devices, increased manufacturing efficiency and increased production volume, which was partially offset by the increased controller placement costs and the lower gross margin on Atlantech sales. As planned, the company’s new Costa Rica facility continued shipping sub-assemblies to the Sunnyvale facility in the first quarter of 2003 and is expected to contribute to gross margin improvements in the future.

Operating Expenses

Research and development expense was $2.6 million in the first quarter of 2003, or 10% of product sales, compared to $2.2 million in the first quarter of 2002, or 11% of product sales. We believe that continued investment in our Coblation technology is essential for us to maintain our competitive position. We expect to increase the dollar amount of research and development expenses through continued expenditures on new product development, regulatory affairs, clinical studies and patents, but anticipate expenses to decrease slightly as a percentage of product sales.

Sales and marketing expense was $11.5 million, or 44% of product sales, for the three months ending March 31, 2003, as compared to $8.4 million, or 43% of product sales, for the same period of the prior fiscal year. In the first quarter of 2003, sales and marketing expense included $0.9 million due to Atlantech. Commission expenses were $1.1 million greater in the first quarter of 2003 compared to the first quarter of 2002 as a result of increased sales. Other compensation and related expense was $0.8 million

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higher in the first quarter of 2003 compared to the same fiscal period of the prior year due to increased investment in sales, marketing and support staff. Stock-based compensation increased in the first quarter of 2003 by $0.3 million. We anticipate that sales and marketing spending will continue to increase in absolute dollars as a result of expansion of our distribution capabilities to address the spinal surgery, ear, nose and throat and cosmetic surgical 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 products and to commercialize future products. We have entered into a strategic relationship with the GyneCare division of Ethicon, Inc. 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 prostrate (TURP).

General and administrative expense increased to $3.9 million, or 15% of product sales, in the first quarter of 2003, from $1.9 million, or 10% of product sales, in same period of the previous year. In the first quarter of 2003, general and administrative expense included $0.4 million due to Atlantech. The remaining $1.6 million increase in the first quarter of 2003 general and administrative expenses was primarily due to a $1.5 million increase in the cost of general and patent-related legal services. We expect that general and administrative expenses will decrease as a percentage of product sales but will increase in absolute dollar amounts as we incur additional legal expenses and continue business development activities.

Interest and Other Income, Net

Interest and other income, net, decreased to $0.3 million in the three months ended March 31, 2003 from $0.5 million in the same period of the previous year. The $0.2 million decrease in interest and other income in the first quarter of 2003 was primarily due to a $0.4 million decrease in interest income as a result of a decrease in the amount of cash and investment balance resulting from our investing and financing activities and declining interest rates since the first quarter of 2002.

At the end of the first quarter of 2003, we had $51.6 million in cash, cash equivalents, and available-for-sale securities as compared to $52.9 million at December 31, 2002.

Liquidity and Capital Resources

At the end of the first quarter of 2003, we had $48.1 million in working capital compared to $72.9 million at the end of fiscal 2002. Our principal sources of liquidity consisted of $51.6 million in cash, cash equivalents, and short-term and long-term available-for-sale securities at March 31, 2003 as compared to $77.1 million at March 31, 2002 and $52.9 million at December 31, 2002. The cash equivalents are highly liquid with original maturities of ninety days or less.

We generated positive cash flows from operations during the first three months of fiscal 2003. Cash generated by operating activities was $2.7 million for the first quarter of 2003, which was mainly attributable to net income before depreciation and amortization of $3.5 million.

Accounts receivable, net of allowances, decreased to $18.3 million at the end of the first quarter of 2003 from $18.4 million at the end of fiscal 2002. The decrease in accounts receivable in the first three months of 2003 was due to significant increase in sales that was offset by an improvement in the collection times.

Inventories increased to $24.9 million at the end of the first three months of 2003 compared to $22.7 million at the end of fiscal 2002. The increase in inventory was in order to support anticipated increasing product sales activity, safety stock for our move of the manufacturing operations into our facility in Costa Rica and the introduction levels required to grow and support sales volume increases. We expect future inventory levels to increase in absolute dollar value in order to support sales volume increases, to provide safety stock and support our expansion into additional markets.

Cash used in investing activities was $22.7 million for the first quarter of 2003, compared to $1.8 million provided in the same period of the prior year. Net cash used in investing activities in the quarter ended March 31, 2003 included net purchases of available-for-sale securities of $20.2 million and $2.5 million for purchases of property and equipment.

Cash used in financing activities was $1.6 million for the first quarter of 2003, compared to cash used of $0.5 million in the same period of 2002. The increased use of cash of $1.1 million was primarily due to the purchase of $2.0 million of treasury stock, which was partial offset by the proceeds from the exercise of common stock options.

We anticipate that existing sources of liquidity and cash flows from operations will be sufficient to satisfy our cash needs for the foreseeable future. However, risk factors mentioned below and included in our December 31, 2002 Form 10-K filed with the SEC could adversely effect our cash position.

On April 25, 2003, the Company acquired all of the outstanding shares of Atlantech Austria, a distributor of medical device products in Austria, in a cash acquisition of $0.4 million, net of cash acquired In addition, the former shareholders of Atlantech Austria have the right to receive an earn-out, to be paid in 2004, in the event Atlantech Austria achieves certain business goals.

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Recent Accounting Pronouncements

In November 2002, the Financial Accounting Standards Board issued FASB Interpretation No. 45 (“FIN 45”), “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.” FIN 45 requires that a liability be recorded in the guarantor’s balance sheet upon issuance of a guarantee. In addition, FIN 45 requires disclosures about the guarantees that an entity has issued, including a reconciliation of changes in the entity’s product warranty liabilities. The initial recognition and initial measurement provisions of FIN 45 are applicable on a prospective basis to guarantees issued or modified after December 31, 2002, irrespective of the guarantor’s fiscal year-end. The disclosure requirements of FIN 45 are effective for financial statements of interim or annual periods ending after December 15, 2002. The adoption of FIN 45 did not have a material impact on the Company’s operating results or financial position.

In November 2002, the Emerging Issues Task Force (“EITF”) reached a consensus on Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables.” EITF Issue No. 00-21 provides guidance on how to account for arrangements that involve the delivery or performance of multiple products, services and/or rights to use assets. The provisions of EITF Issue No. 00-21 will apply to revenue arrangements entered into in fiscal periods beginning after June 15, 2003. The company is in the process of determining the financial effects, if any, on its consolidated financial statements.

In December 2002, the FASB issued Statement of Financial Accounting Standards No. 148 (“SFAS No. 148”), “Accounting for Stock-Based Compensation, Transition and Disclosure.” SFAS No. 148 provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. SFAS No. 148 also requires that disclosures of the pro forma effect of using the fair value method of accounting for stock-based employee compensation be displayed more prominently and in a tabular format. Additionally, SFAS No. 148 requires disclosure of the pro forma effect in interim financial statements. The transition and annual disclosure requirements of SFAS No. 148 are effective for fiscal years ended after December 15, 2002. The interim disclosure requirements are effective for interim periods ending after December 15, 2002. The company has complied with the disclosure requirements of SFAS No. 148.

In January 2003, the FASB issued FASB Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51.” FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 is effective immediately for all new variable interest entities created or acquired after January 31, 2003. For variable interest entities created or acquired prior to February 1, 2003, the provisions of FIN 46 must be applied for the first interim or annual period beginning after June 15, 2003. The company is in the process of determining the financial effects, if any, on its consolidated financial statements.

ADDITIONAL FACTORS THAT MIGHT AFFECT FUTURE RESULTS

We Are Dependent Upon Our Arthroscopic Surgery System

We commercially introduced our Arthroscopic Surgery System in December 1995. Our Arthroscopic System accounted for 77% of our product sales in 2002, and we are highly dependent on its sales. During the past three years we began to market our spinal surgery, neurosurgery, ENT surgery, cosmetic surgery, and general surgery products. While sales of these products collectively are growing, to date, they represent a small percentage of the total units we sold in 2002. 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 or 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 and neurosurgery, ENT surgery, cosmetic surgery, gynecology, urology, and general surgery. Additionally we have established a program to explore the application of our

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Coblation technology in various areas within cardiac surgery through our Coblation Technology business unit. 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 o 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 cardiac surgery product offerings. 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:

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.

For information regarding the status of our regulatory approvals for our products, see the information under the heading “Government Regulation” of our Annual Report on Form 10-K for the year-ended December 31, 2002.

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, and ENT 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, and ENT surgery and Cosmetic surgery 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, coblation technology surgery, spinal surgery, neurosurgery, ENT and Cosmetic 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 securing 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. We currently produce more than 65 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

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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 of 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 approval 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 currently single source our product sterilization requirements. While there are alternate sources available, we would be required to qualify and validate a new supplier(s) which could lead to a disruption in the company’s operation and ability to supply products for a period of time.

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, Stryker Corp., and Arthrex, 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 which market products to remove tissue and treat spinal disorders. We compete against Stryker, which recently purchased Pain Concepts and their Dekompressor device which uses a mechanical auger to perform percutaneous discectomy. In addition, the Oratec division of Smith & Nephew and the Radionics division of Tyco, are currently marketing percutaneous thermal heating products for treating certain types of disc pain, and Stryker is marketing a new product for percutaneous removal of tissue in the disc to treat certain types of back and leg pain. Our Coblation-assisted microdiscectomy (CAM) procedure competes indirectly with large spine companies and their mechanical instruments, such as DePuy Acromed, Medtronic Sofamor Danek, Centerpulse Spine Tech, Stryker Spine and Synthes. In ENT surgery, we compete against companies that offer manual instruments, such as Smith & Nephew, Inc., Stryker Corp., Conmed Corporation, and Xomed Surgical Products 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. 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. (purchased by Gyrus Group, a company based in Cardiff, Wales) 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, which 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 Coblation Technology, we face competition from companies that sell general surgery and gynecology devices, including Ethicon ENDO, a division of Johnson and Johnson, Valleylab, a division of US Surgical, Gyrus, Olympus Medical Systems Group, and several smaller companies that sell mechanical, ultrasonic, monopolar and bipolar instruments. In urology, we face competition from companies that market monopolar, bipolar, mechanical, ultrasonic, and laser devices for a variety of urological procedures, including Karl Storz, Olympus Medical Systems Group, C.R. Bard, Gyrus, Medtronic, Urologix, and Laserscope. In cardiology, we face competition from several large companies, including Edwards Lifescience, Medtronic, Guidant, Johnson & Johnson and St. Jude Medical, as well as many smaller companies.

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, place controllers at customers sites at no cost or in return for a minimum purchase commitment of our surgical wands in order to increase demand for our disposable devices. 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 utilize 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,

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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, cardiology 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, although 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 distribution agreements with GyneCare and ACMI to market and sell our gynecology and urology products, respectively. See the information under the heading “Collaborative Arrangements” of our Annual Report on Form 10-K for the year-ended December 31, 2002 for a discussion of these arrangements.

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 product, 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 March 31, 2003, 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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We cannot assure you that future quarterly fluctuations will not adversely affect our business, financial condition, results of operations or 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.

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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 2000, we filed a lawsuit against Smith & Nephew alleging infringement of several of our patents. This lawsuit is pending and a jury trial is scheduled to commence on April 30 2003. On April 3, 2003, Smith & Nephew filed a complaint against ArthroCare in the United States District Court, Western District of Tennessee for patent infringement of two patents and for violation of Section 43(a) of the Lanham Act. The complaint does not contain any specifics regarding the alleged infringement. Upon initial review, we believe this complaint is without merit, and we will defend ourselves vigorously.

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 can obtain the necessary licenses on satisfactory terms, if at all.

The Market Price of Our Stock May Be Highly Volatile

During the 12 months ended March 31, 2003 our common stock has traded between a range of $8.82 and $18.01 per share. The market price of our common stock could continue to fluctuate substantially due to a variety of factors, including:

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. See “Item 5: Market for Registrant’s Common Equity and Related Stockholder Matters,” of our Annual Report on Form 10-K for the year-ended December 31, 2002 for more information regarding fluctuations in the price of our common stock.

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.

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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 consent 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. International sales of our products are also subject to strict regulatory requirements. For more information about the U.S. and foreign regulatory requirements, see information under the heading “Government Regulation” above.

Information pertaining to our products and indications before they can be commercialized can be found under the heading “Government Regulations” of our Annual Report on Form 10-K for the year-ended December 31, 2002.

Item 3.    Quantitative and qualitative disclosures about market risk

Interest Rate Sensitivity

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.

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 operating leases.

Foreign Currency Exchange Risk

Most of our revenue is realized in U.S. dollars and an increase in the value of the U.S. dollar relative to foreign currencies could make our products less competitive in foreign markets.

The functional currency of Atlantech Medical Devices, Ltd. and Atlantech GmbH (together “Atlantech”) is the UK Pound and the Euro respectively. Accordingly, all balance sheet accounts of this operation are translated into U.S. dollars using the current exchange rate in effect at the balance sheet date, and revenues and expenses are translated using the average exchange rate in effect during the period. The gains and losses from foreign currency translation of Atlantech’s financial statements are recorded directly into a separate component of stockholders’ equity under the caption “Accumulated Other Comprehensive Income.”

The functional currency of all other non-U.S. operations is the U.S. dollar. Accordingly, all monetary assets and liabilities of these foreign operations are translated into U.S. dollars at current period-end exchange rates and non-monetary assets and related elements of expense are translated using historical rates of exchange. Income and expense elements are translated to U.S. dollars using average exchange rates in effect during the period. Gain and losses from foreign currency transactions of these subsidiaries’ financial statements are recorded as other income or loss in the statement of operations.

Item 4.    Controls and procedures

We maintain disclosure controls and procedures (as defined in Securities Exchange Act 1934 Rules 13a-14(c) and 15d-14(c)) that are designed to ensure that information required to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

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Within 90 days of the filing date of this report, we carried out an evaluation, under the supervision and with the participation of the Company’s management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based on the foregoing, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective.

There have been no significant changes in our internal controls or in other factors that could significantly affect the internal controls subsequent to the date we completed our evaluation. There were no significant deficiencies or material weaknesses, and therefore no corrective actions were taken.

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 the section entitled “Commitments and Contingencies” in Note 8 of the Condensed Consolidated Financial Statements contained in Part I above.

Item 6.    Exhibits and Reports on Form 8-K

a)  Exhibits

b)  Reports on Form 8-K

On April 24, 2003, the Company filed a current report on Form 8-K under Item 12 with respect to a press release announcing our results of operations for the quarter ended March 31, 2003.

On April 28, 2003, the Company filed a current report on Form 8-K under item 12 with respect to a press release summarizing the Company’s stock repurchase program.

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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.

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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:

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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:

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