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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
ANNUAL REPORT
PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended Commission File Number
December 29, 2001 0-27422
ARTHROCARE CORPORATION
(Exact name of Registrant as specified in its charter)
Delaware 94-3180312
(State or other jurisdiction of (I.R.S. employer
incorporation or organization) identification number)
680 Vaqueros Avenue, Sunnyvale, California 94085
(Address of principal executive offices and zip code)
(408) 736-0224
(Registrant's telephone number, including area code)
Securities registered pursuant
to 12(b) of the Act: None
Securities registered pursuant Common Stock, $0.001 Par Value;
to Section 12(g) of the Act: Preferred Share Purchase Rights
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 if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [_]
As of March 15, 2002, the aggregate market value of the voting stock held by
non-affiliates of the Registrant was $175,781,675 (based upon the closing sales
price of such stock as reported by The Nasdaq Stock Market on such date). Shares
of Common Stock held by each officer, director, and holder of 5% or more of the
outstanding Common Stock on that date have been excluded in that such persons
may be deemed to be affiliates. This determination of affiliate status is not
necessarily a conclusive determination for other purposes.
As of March 15, 2002, the number of outstanding shares of the Registrant's
Common Stock was 21,836,267.
DOCUMENTS INCORPORATED BY REFERENCE
Certain information required by Items 10, 11, 12 and 13 of Part III of Form 10-K
is incorporated by reference from the Registrant's proxy statement for the 2002
Annual Stockholders Meeting (the Proxy Statement) which will be filed with the
Securities and Exchange Commission within 120 days after the close of the
Registrant's fiscal year ended December 29, 2001.
PART I
ITEM 1. BUSINESS
This Report on Form 10-K contains certain forward-looking statements
regarding future events with respect to ArthroCare Corporation ("ArthroCare,"
"we," "us," and "our" refer to ArthroCare Corporation, a Delaware corporation
unless the context otherwise requires). Actual events or results could differ
materially due to a number of factors, including those described herein and in
the documents incorporated herein by reference, and those factors described
under "Additional Factors that Might Affect Future Results".
OVERVIEW
We are a medical device company that develops, manufactures and markets
products based on our patented Coblation(R) technology. Our products allow
surgeons to operate with a high level of precision and accuracy, limiting damage
to surrounding tissue thereby potentially 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, aspirate and suction soft tissue, and to seal small bleeding
vessels. Ablation is the disintegration or removal of tissue. Our soft-tissue
surgery systems consist of a controller unit and an assortment of sterile,
single-use disposable devices that are specialized for specific types of
surgery. We believe our Coblation technology can replace the multiple surgical
tools traditionally used in soft-tissue surgery procedures with one
multi-purpose surgical system.
Coblation technology is applicable across many soft-tissue surgical
markets. Our systems are used to perform many types of surgical procedures. Our
strategy includes applying our patented Coblation technology to a broad range of
soft-tissue surgical markets, including arthroscopy, spinal surgery,
neurosurgery, cosmetic surgery, ear, nose and throat (ENT) surgery, gynecology,
urology, general surgery and various cardiology applications. We have formed the
following business units for commercialization of our technology in
non-orthopedic markets: ArthroCare Spine(TM), to commercialize our technology in
the spinal and neurosurgery markets; Visage(R), to commercialize our cosmetic
surgery products for use in various cosmetic surgery procedures; ENTec(R) to
commercialize our ENT surgery products for use in head and neck surgical
procedures; ArthroCare-ENDO(TM) to commercialize our Coblation-based products in
laparascopic and open surgical procedures for general surgery, gynecology and
urology applications; and AngioCare(TM), 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 surgery of the knee, shoulder, ankle, elbow, wrist and hip, and our
Arthroscopic System is CE marked for use in arthroscopic surgery. The CE Mark is
a requirement to sell our products in most of Western Europe. Our Cosmetic
Surgery System has been cleared by the FDA and is CE marked for general
dermatologic procedures and skin resurfacing in connection with wrinkle
reduction procedures. Our ENT Surgery System is CE marked, and we have applied
the CE mark and received 510(k) clearances from the FDA for use of our ENT
Surgery System in general head, neck, oral and sinus surgery procedures,
including treatments for snoring, and turbinates and submucosal channelling
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 have also applied the CE mark and received 510(k) clearance
from the FDA to market products based on Coblation technology for use in general
surgery, gynecology, urology, plastic and reconstructive surgery, and orthopedic
surgery.
We commercially introduced our Arthroscopic Surgery System in December
1995, and have derived a significant portion of our sales from this system. As
of December 29, 2001, we had shipped more than 13,700 controller units and more
than 1,500,000 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. We have 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. 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 prostate (TURP).
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The following is a list of our Coblation-based disposable devices as of December
29, 2001:
- -----------------------------------------------------------------------------------------------------------------------
Date of Current
Product Families Introduction # of models
---------------- ------------ -----------
Arthroscopy
Ablative Probes
90 degree August 1995 3
TurboDome(TM) July 1996 3
TurboBevel(TM) December 1996 3
Small Joint December 1997 2
Eliminator(TM) June 1998 1
Saber(TM) June 1998 1
LoPro(TM) April 1998 1
Microblator(TM) December 1999 1
Coblade(TM) May 2000 1
ACD50 April 2001 1
Suction Wands
CoVac(TM) June 1998 3
TurboVac(TM)/RazorVac/DiamondVac(TM) December 1998 3
MultiVac(TM) February 2000 3
Titan(TM) September 2000 1
Tristar(TM) September 2000 1
Shrinkage Wands
CAPSX(TM) April 1998 2
CAPSure(TM) June 1999 1
MicroCAP August 2000 1
Spinal and Neuro Surgery
ACCESS(TM)SpineWand(TM) September 1999 1
Aggressor(TM) June 2000 1
DisCoblator(TM) September 1999 2
Perc-D(TM) June 2000 1
Perc-DL(TM) June 2000 1
Perc-DLE(TM) March 2001
SpineVac(TM) June 2000 1
VersiTor(TM) May 2000 1
Cosmetic Surgery
Soft Touch(TM)Wand June 1998 2
MicroElectro Dissector December 1998 1
MicroTouch(TM)Wand December 1999 1
Plasma Scalpel September 1999 1
ENT Surgery
Hummingbird(TM) March 1999 1
Plasma Scalpel(TM) November 1998 3
Reflex(TM) June 1999 4
EVac(TM) February 2000 3
General Surgery
Plasma Scalpel GS September 1999 1
TurboVac GS November 1999 2
Versitor/Aggressor May 2000 2
Plasma Hook/Blade March 2001 3
Plasma Dissector December 2001 2
- -----------------------------------------------------------------------------------------------------------------------
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For information regarding the status of our regulatory approvals for our
products, see the information under the heading "Government Regulation."
ArthroCare Strategy
Our objective is to leverage our patented Coblation technology to design,
develop, manufacture and sell innovative, clinically superior surgical devices
for the surgical treatment of soft-tissue conditions throughout the body. The
key elements of our strategy include:
. EXPAND OUR PRODUCT OFFERING TO ADDRESS LARGE AND RAPIDLY GROWING MARKETS.
We are continuously expanding our portfolio of products and enhancing our
existing products to serve the needs of physicians. For example, we have
increased our penetration of arthroscopy procedures in the knee through the
addition of disposable devices with suction capability.
. REPLACE CURRENT TECHNOLOGY WITH COBLATION TECHNOLOGY. Coblation technology
offers a variety of options for physicians performing soft-tissue surgery.
Currently, our systems are being used to perform many types of
arthroscopic, cosmetic, ENT, spinal, neurosurgery and general surgery
procedures which were traditionally performed by mechanical, by
electrosurgical or laser surgery tools. In fact, soft tissue anywhere in
the body potentially can be treated with and benefit from our technology.
. FOCUS ON DISPOSABLE DEVICE SALES. We have utilized an aggressive
promotional product placement program in order for our controllers to
reside in hospitals throughout the world. Once a controller is placed
within an institution it may be utilized by a variety of physicians who
focus on different medical specialties. The same controller may be used to
perform arthroscopic, ENT, spinal, cosmetic, neurosurgery or general
surgery.
. LAYER GROWTH OPPORTUNITIES. We have established an extensive distributor
network, supported by our regional managers, in selected markets. We have
been executing a global distribution strategy in which we have been
expanding our direct sales presence in arthroscopy, spinal surgery and ENT
markets. We have signed agreements with several marketing partners to
assist with regulatory requirements and to market and distribute our
products internationally.
. ESTABLISH STRATEGIC PARTNERSHIPS TO COMMERCIALIZE OUR COBLATION TECHNOLOGY.
Our neurosurgery, gynecology and urology products are being commercialized
through strategic partnerships with Integra NeuroSciences, GyneCare and
ACMI, respectively.
COBLATION TECHNOLOGY
Our products are based on our patented soft-tissue surgical controlled
ablation technology, which we call Coblation technology. Coblation technology
involves an innovative use of radio frequency energy characterized by precision,
accuracy, ease of use and the capability of performing at temperatures lower
than traditional electrosurgical tools.
Traditional electrosurgical tools use heat to burn away targeted tissue,
which often results in thermal damage to tissue surrounding the surgical area.
Additionally, the lack of tactile feedback with these devices makes it difficult
for surgeons to control the depth of tissue penetration. Coblation technology
employs a lower temperature process that minimizes the risk of thermal burn to
surrounding tissue while increasing the surgeon's control and precision.
Coblation technology uses an electrically conductive fluid in the gap
between the electrode and tissue. When electrical current is applied to this
fluid, it creates a charged layer of particles. As the layer of charged
particles comes into contact with the targeted tissue, the molecular bonds
within the cells of the targeted tissue are broken. This process causes the
cells to disintegrate cell layer by cell layer, so that tissue is volumetrically
removed. Because this effect is confined to the surface layer of the targeted
tissue, minimal damage occurs to surrounding tissue, potentially resulting in
reduced pain and faster recovery for the patient. An additional advantage is
that Coblation can be performed in a continuous mode, resulting in efficient
tissue ablation thereby reducing the overall procedure time as compared to
conventional methods. In addition to achieving more precise tissue ablation or
shrinkage and less damage to surrounding tissue, surgical devices based on
Coblation technology can seal bleeding vessels near the surgical site.
We believe Coblation technology is applicable to soft-tissue surgery
throughout the body, and we have expanded its use into several non-arthroscopic
indications. In addition, we are exploring possibilities for the use of
Coblation technology in other markets.
We commercially introduced our soft-tissue surgery system in December 1995.
Since our arthroscopic soft-tissue surgery system accounts for a significant
portion of our product sales, we are highly dependent on its sales. Our spinal
surgery, neurosurgery, cosmetic surgery, and general surgery products, to date,
have sold only a relatively small number of units. We cannot assure you that we
will be able to continue to manufacture our 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
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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
placed our controller units 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 Surgical Systems. We believe
that continued recommendations and endorsements by influential surgeons are
essential for market acceptance of our Surgical Systems. If our Coblation
technology does not continue to receive endorsement by influential surgeons or
long-term data does not support the effectiveness of our Surgical Systems, our
business, financial condition, results of operations and future growth prospects
will be materially adversely affected.
THE ARTHROSCOPY MARKET
In 2001, approximately 3.5 million arthroscopic procedures were performed
worldwide. Due to patient demand for less invasive procedures, we believe the
number of arthroscopic procedures is growing. In addition, a greater emphasis on
physical fitness and an aging population is increasing the incidence of joint
and soft tissue injuries. Joints are susceptible to injuries from blows, falls
or twisting, as well as from natural deterioration and stiffening associated
with aging.
Historically, joint injuries have been treated using open surgery involving
large incisions, a hospital stay and a prolonged recovery period. In contrast,
arthroscopic surgery, which was introduced in the early 1980's, is performed
through several small incisions called portals and can be performed on an
outpatient basis. We believe that arthroscopic surgery has gained wide market
acceptance because it offers shorter hospital stays and reduced recovery time,
resulting in reduced costs and improved medical outcomes. Arthroscopic surgery
performed on elite athletes often results in rapid returns to action. Publicity
concerning these athletes increases the demand for less invasive surgical
options by the general public.
To perform arthroscopic surgery, a surgeon uses a tool to view the site and
other tools to perform the surgery. The tool used to view the site, called an
arthroscope, is a small fiber-optic viewing instrument made up of a small lens,
a light source and a video camera. During the arthroscopic procedure, an
irrigant such as saline is flushed through the joint to permit clear
visualization through the arthroscope and to create the space within the joint
for the surgical procedure. The surgeon inserts the arthroscope into the joint
through a portal measuring approximately six millimeters, or 1/4 of an inch, in
length. Other portals are used for the insertion of surgical instruments to
perform the surgery and to facilitate the flow of irrigants. With small incision
sites and direct access to most areas of the joint, a surgeon can diagnose and
correct an array of joint problems such as cartilage and meniscus tears,
ligament tears and removal of loose and degenerative tissue.
The advantages of arthroscopic surgery over open surgery are often
significant. Due to the smaller incisions and reduced surgical trauma, the
patient might experience several benefits including reduced pain, treatment on
an outpatient basis, reduced hospitalization times, smaller scars, immediate
joint mobility and less muscle atrophy, less surrounding tissue damage, lower
rate of complications, and generally quicker rehabilitation. In addition,
treatment on an outpatient basis and reduced operating time can significantly
lower hospital costs.
Knee
The knee is the most commonly injured joint. In 2001, knee injuries
accounted for approximately 2 million arthroscopic procedures in the United
States. Damage to a meniscus, a disc of fibrous tissue that helps cushion the
knee joint, is the most common form of knee injury. A meniscus can be torn by a
twist of the leg when the knee is flexed, displaced either inward toward the
center of the shin bone or outward beyond the surface of the thighbone, or worn
down by normal aging. The knee is also susceptible to partial or complete tears
of the ligaments and degeneration of the cartilage on the underside of the
kneecap. In addition, the cartilage covering the bony surfaces of the knee can
become rough or tear loose from the bone as a result of age or injury, causing
pain and interfering with smooth joint movement.
Shoulder
The shoulder joint, because of its range of motion, is susceptible to a
number of injuries. In 2001, approximately 1.1 million arthroscopic procedures
in the shoulder were performed in the world. We believe that shoulder
arthroscopy is the fastest-growing portion of the arthroscopy market. With
repetitive motion and lifting of the arm, such as that which occurs during a
tennis serve, a bone formation of the upper arm may pinch one of the shoulder
muscles and cause persistent pain, known as a rotator cuff injury. Strengthening
exercises and physiotherapy can treat this condition; however, many rotator cuff
injuries require surgical intervention. We believe that a significant percentage
of the population is born with a susceptibility to rotator cuff injuries.
Elbow, Ankle, Wrist and Hip
The elbow, ankle, wrist and hip joints are also susceptible to certain
stress-related injuries and deterioration due to aging. In 2001, approximately
400,000 arthroscopic procedures were performed in the elbow, ankle, wrist or hip
in the world. We believe that the current number of surgical procedures in the
elbow, ankle, wrist and hip is relatively small due to the limitations of
conventional arthroscopic surgical equipment.
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Non-Traumatic Soft Tissue Injuries
It is estimated that nearly 15 million Americans suffer from injuries
called tendonopathies, or tendonosis, which is a chronic pain associated with
degeneration of tendons commonly used in everyday activity. Runners' knee,
tennis and golfers' elbow, jumpers' knee, and heel spurs are but a few of the
conditions limiting the lifestyles of normally active adults. Often the pain
associated with these injuries results in constant discomfort, difficulty
sleeping and the inability to perform normal daily activities without pain.
Currently, the few options for these chronic conditions include rest,
rehabilitation, bracing, and steroid injections. Surgical options have until now
been equally limited to surgical release procedures, grafts, and surgical
debridement, each with a significant recovery period.
CONVENTIONAL ARTHROSCOPIC TREATMENT METHODOLOGIES: THE PROBLEM
Most arthroscopic procedures require the surgeon to probe, cut, sculpt and
shape tissue and seal bleeding vessels to achieve satisfactory results. Surgeons
frequently use a combination of instruments when performing an arthroscopic
procedure because each instrument is designed to perform a specific function.
Use of an assortment of tools requires the surgeon to insert and remove each of
the tools from the portals several times during the same procedure.
Surgical procedures can employ one or more of four groups of surgical
instruments: (1) power or motorized instruments, such as cartilage and bone
shavers; (2) mechanical instruments, such as basket punches, graspers and
scissors; (3) electrosurgical systems; or (4) laser systems.
Power instruments are generally used to smooth tissue and cartilage
defects on the surface of the bones of the joint. The damaged tissue is removed
from the joint using suction through a tube surrounding the shaft of the tool,
which can become obstructed by bits of tissue and bone. Power shavers have
rotating cutters inside a tube and are available in a number of tip angles or
sizes for the precise shaving of tissue. Mechanical instruments must be
resharpened at regular intervals and sterilized after each procedure.
Conventional electrosurgical systems are used to seal blood vessels,
which is necessary to minimize bleeding and maximize the arthroscopic surgeon's
visibility of the procedure through the arthroscope. Conventional
electrosurgical systems contain two electrodes: the electrode tip held by the
surgeon and a dispersive pad that rests under the patient's body. The metal
electrode tip of the instrument, which resembles a pencil point, is placed on or
near the bleeding vessel to be sealed. A generator connected to the electrode
delivers high-frequency voltage that arcs between the electrode and the target
tissue, sealing blood vessels in its vicinity. After arcing, the current travels
through the remaining tissue of the patient's body, through the skin to the
dispersive electrode pad, before being directed back to the generator.
Laser systems are used to remove tissue while sealing bleeding vessels.
Because laser systems are not tactile tools, the surgeon cannot feel how much
tissue is being ablated. The surgeon must be extensively trained to precisely
position the laser to control the depth of tissue penetration to minimize
unintended tissue damage. In addition, the temperature of the laser instrument
is high and, as a result, can cause damage to surrounding tissue and vascular
areas. We believe that laser tools have not received wide acceptance because of
high capital cost and significant ongoing maintenance and operating expenses,
lack of tactile feedback for the surgeon, required training and certification,
and the concern about damage that may be caused by the significant heat
generated by these devices.
THE ARTHROCARE ARTHROSCOPIC SYSTEM: A SOLUTION
Our Arthroscopic System is a radio frequency surgical device intended to
perform tissue ablation, sculpting or shrinkage as well as sealing bleeding
vessels. Our Arthroscopic System is comprised of an assortment of disposable
bipolar multi-electrode and single electrode devices, a connecting cable, foot
pedal or handswitch and a radio frequency controller. We sell our Arthroscopic
System for use in all six major joints: knee, shoulder, elbow, ankle, wrist and
hip. Many types of tissue, including cartilage and ligaments, can be ablated
using our Arthroscopic System.
Our controller delivers radio frequency energy to the disposable device.
Surgeons can use the disposable device to ablate, sculpt and shrink tissue and
to seal bleeding vessels. The surgeon can control the mode of operation and
power setting with the foot pedal or keys on the front panel of the controller.
The incorporation of ablation, suction and fluid management into a single
disposable device potentially reduces operating time and expense.
A surgeon using the Arthroscopic System does not need to remove and insert
a variety of instruments to perform different tasks as is required when using
conventional arthroscopic instruments. Our disposable devices are approved for
sale in tip sizes ranging from 1.5 mm to 4.5 mm, and in tip angles ranging from
zero to 90 degrees. We currently sell 32 models for arthroscopy in various tip
sizes, angles and shapes, enabling the surgeon to ablate different volumes of
tissue and to reach treatment sites not readily accessible by existing
mechanical instruments and motorized cutting tools. In addition, some of our
disposable devices provide suction capability.
We commercially introduced the Arthroscopic System in December 1995. The
list price of the controller, including the cable, is approximately $7,500. The
disposable devices have list prices ranging from approximately $151 to $270, and
typically one disposable device is used per procedure. We are marketing and
selling our Arthroscopic System worldwide through a network of direct sales
representatives
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and independent orthopedic distributors supported by regional managers. We have
continually increased our manufacturing capabilities while maintaining yields.
THE SPINAL SURGERY MARKET
We believe spinal surgery had an estimated 2001 market size of more than
$1.5 billion, or 1.4 million procedures worldwide and is the most rapidly
growing segment of the orthopedic surgery market, increasing in excess of 20%
annually. Chronic back pain afflicts approximately five million people in the
U.S. and is the number one cause of healthcare expenditures. Chronic back pain
is estimated to cost the nation more than $50 billion per year in direct and
indirect medical expenses. Approximately one-half of those afflicted suffer from
disabling pain. Chronic back pain is the most common reason for disability for
persons under age 50 and is the second leading cause of workers' absenteeism.
The major causes of persistent, often disabling, back pain are disruption of a
portion of the disc, chronic inflammation of the disc, also known as herniation,
or relative instability of the vertebral bodies surrounding a given disc, such
as the instability that often occurs due to a degenerative disease.
Intervertebral discs mainly function to cushion and tether the vertebrae,
providing flexibility and stability to the patient's spine. As discs degenerate,
they lose their water content and height, bringing the adjoining vertebrae
closer together. This results in a weakening of the shock absorption properties
of the disc and a narrowing of the nerve openings in the sides of the spine
which may pinch these nerves. This disc degeneration can eventually cause back
and leg pain.
Often, inflammation from disc herniation can be treated successfully by
non-surgical means, such as rest, therapeutic exercise, or through the use of
anti-inflammatory medications. In some cases, the disc tissue is irreparably
damaged, thereby necessitating a discectomy, the removal of a portion of the
disc or the entire disc to eliminate the source of inflammation and pressure. In
more severe cases, the adjacent vertebral bodies must be stabilized following
excision of the disc material to avoid recurrence of the disabling back pain.
One approach to stabilizing the vertebrae, termed spinal fusion, is to insert an
interbody graft or implant into the space vacated by the degenerative disc. In
this procedure, a small amount of bone may be grafted from other portions of the
body, such as the hip, and packed into the implants. This allows the bone to
grow through and around the implant, fusing the vertebral bodies and alleviating
the pain.
Another surgical treatment for degenerative disc disease, termed
laminectomy, involves cutting away the lamina, the bony plate that connects the
bony ridges of the spine, known as pedicles. This allows the nerve tissue to
shift position to release pressure.
Until recently, spinal discectomy, laminectomy and fusion procedures
resulted in major operations and traumatic dissection of muscle and bone removal
or bone fusion. The open surgical procedures are invasive and typically require
a team of surgeons due to the length and complexity of the procedure. Recovery
time is also lengthy. To overcome the disadvantages of traditional traumatic
spinal surgery, minimally-invasive spinal surgery was developed. In
minimally-invasive spinal procedures, the spinal canal is not penetrated and
therefore bleeding with ensuing scarring is minimized or completely avoided. In
addition, the risk of instability from ligament and bone removal is generally
lower in minimally-invasive procedures than with open discectomy. Further, less
trauma during surgery often results in rapid rehabilitation and fast recovery.
CONVENTIONAL TREATMENT METHODOLOGIES FOR TREATMENT OF SPINE DISEASES AND
DISORDERS: THE PROBLEM
Techniques for the treatment of spinal diseases and disorders include laser
and mechanical techniques. These procedures can be "open" or minimally invasive
depending on the complexity, and generally require the surgeon to form a passage
or operating corridor from the skin of the patient to the spinal disc(s) for
passage of surgical instruments and implants. Typically, the formation of this
operating corridor requires the removal of soft tissue, muscle or other types of
tissue. This tissue is usually removed with mechanical or powered instruments,
such as graspers, cutters and drills. Multiple mechanical and powered
instruments must be used and are time-intensive. In addition, these instruments
sever blood vessels within this tissue, often causing profuse bleeding that
obstructs the surgeon's view of the target site.
Once the operating corridor is established, the nerve root is retracted and
a portion or all of the disc is removed with mechanical or powered instruments.
These instruments are typically slow and tedious, and can require up to 40
minutes to remove a single disc. In addition, these instruments, particularly
powered instruments, are not extremely precise, and it is often difficult during
the procedure to differentiate between the target disc tissue and other
structures within the spine, such as bone, cartilage, ligaments, nerves and
surrounding tissue. Thus, the surgeon must be extremely careful to minimize
damage to the cartilage and bone within the spine, and to avoid damaging nerves.
Both lasers and monopolar radio frequency devices have been used in spinal
surgery. We believe both have significant drawbacks. Lasers are expensive and
tedious to use. Another disadvantage of lasers is the difficulty in judging the
depth of tissue ablation. Because healthy tissue, bones, ligaments and nerves
often lie within close proximity of the spinal disc, it is essential to maintain
a minimum depth of tissue penetration. Monopolar radio frequency devices
increase the risk of unwanted electrical stimulation to portions of the
patient's body by utilizing electric current that disperses into the patient's
body.
THE ARTHROCARE SPINAL SURGERY SYSTEM: A SOLUTION
In September 1999, we announced our expansion into the spinal surgery
market. Our Spinal Surgery System is CE marked. We have received 510(k)
clearance for use of the system in spinal and neurosurgery procedures in the
United States. Our spinal surgery products,
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based on our Coblation technology, include multi-functional disposable devices
optimized for spinal surgery. The disposable products are compatible with the
controller that is used for arthroscopic, ENT and general surgery procedures.
Our controller is used to deliver radio frequency energy to the disposable
devices. The disposable devices are intended for single use and utilize multiple
or single electrodes to ablate tissue and seal bleeding vessels. In some cases,
our disposable devices may also include one or more tubes for the delivery of
electrically conductive fluid to the target site and/or for suction capability.
The incorporation of ablation, suction and fluid management into a single
disposable device potentially reduces operating time and expense. Although we
have had limited clinical experience with these products in spinal surgery
procedures, we believe physician and patient benefits experienced in
arthroscopic surgery, such as more rapid recovery time, reduced thermal injury
to tissue and reduced post-operative pain when compared to existing techniques,
could also apply to spinal surgery procedures.
Our disposable devices consist of the ACCESS SpineWand, VersiTor,
Aggressor, SpineVac, Perc-D, Perc-DL and the DisCoblator. The ACCESS SpineWand
is a bipolar electrosurgical device designed for controlled ablation of soft
tissue. We believe that the ACCESS SpineWand is an effective tool for creating
precise incisions through connective tissue to provide access to the disc in
discectomy, laminectomy and fusion procedures. In addition, we believe that the
ACCESS SpineWand may be effectively used to remove soft tissue from bones in
preparation for fusion procedures.
The DisCoblator is a bipolar electrosurgical device designed for aggressive
removal of large tissue volumes. The DisCoblator includes fluid delivery and
suction capabilities and incorporates an active screen electrode design to
inhibit clogging. We have marketed the DisCoblator to volumetrically remove a
portion or all of the disc during discectomy and fusion procedures. Although
there has been limited clinical experience with this product, we believe that
the DisCoblator is capable of removing a disc in less time than mechanical
instruments, such as graspers or cutters.
During fiscal year 2001, we introduced the Perc-DLE Convenience Pack for
volumetric tissue removal in the nucleus of the disc. Nucleoplasty(R), a
minimally invasive partial discectomy procedure utilizing our Coblation
technology, for the treatment of lower back pain through the process of ablation
and coagulation of soft tissue, combines both approaches for partial removal of
the nucleus of a disc. Coblation ablates tissue via a low-temperature, molecular
dissociation process to create small channels within the disc. On withdrawal,
the channels are thermally treated producing a zone of thermal-coagulation.
Although there has been limited clinical experience with the Perc-D product
line, we believe that this treatment may relieve pressure in the disc, and
contract collagen in the thermal zone, further shrinking and stiffening the
disc.
THE ARTHROCARE NEUROSURGERY MARKET
Approximately 250,000 surgical procedures are performed in the brain
each year, and more than 110,000 metastatic brain tumors are diagnosed annually
in the United States. According to the American Cancer Society, brain tumors are
the second fastest growing cause of cancer death among people over age 65 and
are one of the most common types of cancer found in children. In addition, brain
trauma affects another 1.5 million people each year in the United States.
CONVENTIONAL TREATMENT METHODOLOGIES FOR TREATMENT OF NEUROLOGICAL DISEASES: THE
PROBLEM
Surgery, radiation, and chemotherapy are the three most common
treatments used individually or in combination, for brain tumors. While surgery
is the preferred method of treatment, it is not always practical given difficult
or impossible access to the tumor. Coblation therapy can allow minimally
invasive access to the tumor and allow the physician to quickly remove solid
tissue with minimal thermal injury.
THE ARTHROCARE NEUROSURGERY SYSTEM: A SOLUTION
In February 2000, we announced that we were expanding our marketing efforts
for our Spinal Surgery System to specifically address selected applications in
neurosurgery. Our Spinal Surgery System is CE marked in Europe, and we have
received 510(k) clearance for the use of this system in neurosurgery procedures
in the United. Our spinal surgery and neurosurgery products, based on our
Coblation technology, include multi-functional disposable devices optimized for
spinal and neurosurgery. The disposable products are compatible with the
controller that is used for arthroscopic, ENT and general surgery procedures.
Our controller is used to deliver radio frequency energy to the disposable
devices. The disposable devices are intended for single use and utilize multiple
or single electrodes to ablate tissue and seal bleeding vessels. In some cases,
our disposable devices may also include one or more tubes for the delivery of
electrically conductive fluid to the target site and/or for suction capability.
The incorporation of ablation, suction and fluid management into a single
disposable device potentially reduces operating time and expense. Although we
have had limited clinical experience with these products in neurosurgery
procedures, we believe physician and patient benefits experienced in
arthroscopic surgery, such as more rapid recovery time, reduced thermal injury
to tissue and reduced post-operative pain when compared to existing techniques,
could also apply to neurosurgery procedures.
We have entered into a distribution agreement with Integra Lifescienses to
license, market and distribute our Coblation-based products for neurosurgical
procedures in North America and certain additional international markets.
8
THE EAR, NOSE AND THROAT (ENT) MARKET
We believe that in 2001, approximately 4 million ENT procedures were
performed worldwide. For example, surgical approaches for the treatment of
obstructive sleep apnea include the removal of excess tissue from the upper
airway or moving the lower jaw forward to widen the patient's airway. These
procedures are performed by highly specialized surgeons are, expensive, and
extremely painful for the patient and involve lengthy recovery periods.
Non-invasive treatment approaches include continuous positive airway pressure,
or CPAP, which requires the patient during sleep to wear a nasal mask connected
to an airflow generator that forces air through the nasal passages. The most
common procedures are placement of ear tubes and the removal of adenoids and
tonsils. Other procedures include obstructive sleep apnea, snoring and other
obstructions of the sinus and nasal passages.
Conventional treatment methodologies for ENT surgical procedures have been
performed by lasers, electrosurgical devices, endoscopes and microsurgical
tools. We believe our Coblation technology can be used in numerous types of ENT
procedures.
THE ARTHROCARE ENT SURGERY SYSTEM
Our ENT Surgery System uses the same technology as the Athroscopic System,
which removes soft tissue through a more precise and significantly cooler
process than that of traditional electrosurgery devices. Our controller is used
to deliver radio frequency energy to the disposable devices. The disposable
devices are intended for single use and utilize multiple or single electrodes.
We have three categories of wands to address the ENT Market. Suction wands
simultaneously ablate and remove tissue in applications such as tonsillectomy,
providing enhanced visibility. Channeling wands combine controlled ablation and
effective coagulative lesion formation in applications such as the soft palate
for the treatment of snoring. Excision wands provide precise dissection for
minimal damage to surrounding tissue. Although we have limited clinical
experience in ENT, we believe our products provide the same physician and
patient benefits experienced in arthroscopic surgery, such as reduced
post-operative pain, more rapid recovery, and reduced thermal injury to tissue
when compared to existing techniques.
Our ENT Surgery System is CE marked, and we have received 510(k) clearances
in the United States for use of the system in general head, neck and oral
surgical procedures, including sinus surgery, the treatment of snoring,
reduction of turbinate, adenoidectomy and tonsillectomy. We have been marketing
the ENT products through a network of direct sales representatives and
independent distributors supported by sales managers since February 1999.
THE COSMETIC SURGERY MARKET
The cosmetic surgery market primarily consists of three segments: invasive
surgical procedures that remove or alter body structures such as rhytidectomy
(face lift), rhinoplasty (nose restructuring), blepharoplasty (eye lift) and
liposuction; resurfacing procedures that reduce wrinkles and even out skin tone
such as laser resurfacing and chemical peels and non- or less-invasive cosmetic
procedures such as botulinum toxin, collagen injections, and microdermabrasion.
Of the approximately 9 million total cosmetic procedures performed in 2001 in
the United States, approximately 2 million were invasive surgical procedures,
approximately 2 million were resurfacing procedures and 5 million were non- or
less-invasive cosmetic procedures.
CONVENTIONAL TREATMENT TECHNIQUES FOR RESURFACING: THE PROBLEM
Conventional treatments for skin resurfacing include chemical peels,
dermabrasion and laser resurfacing. In chemical peels, an acid-based solution is
used to improve the texture of the skin and reduce wrinkles by removing its
damaged outer layers. Light chemical peels can improve texture but do not
address wrinkles. Deeper chemical peels can reduce wrinkles but often produce
uneven results and hypopigmentation (loss of color). In dermabrasion a
mechanical device is used to remove the damaged outer layers of the skin. While
dermabrasion has fallen out of favor in the majority of practices, laser
resurfacing remains the most popular resurfacing procedure for the treatment of
wrinkles. In particular, the carbon dioxide, or CO\2\, laser is considered the
gold standard for efficacy in the treatment of wrinkles. However, the excessive
heat diffusion into surrounding healthy skin cells during the procedure results
in an unacceptably long recovery period and a significant level of side effects
such as hypopigmentation and scarring.
THE VISAGE COBLATION COSMETIC SURGERY SYSTEM: A SOLUTION
Our Cosmetic Surgery System utilizes the same technology as the
Arthroscopic System and removes skin cells through a more precise and
significantly cooler process than traditional electrosurgery systems or
dermatologic lasers. Our Cosmetic Surgery System is a bipolar radiofrequency,
electrosurgical device used in skin resurfacing and other dermatologic and
cosmetic procedures. Our Cosmetic Surgery System incorporates a bipolar
disposable device, a connecting resterilizable handpiece with cable and a radio
frequency controller which differs from the controllers used in arthroscopy, ENT
surgery and spinal surgery. The controller delivers radio frequency energy to
multi-electrode or single electrode disposable devices. Our Cosmetic Surgery
System has been cleared by the FDA for the treatment of wrinkle reduction as
well as for general dermatologic procedures. We believe our Cosmetic Surgery
System, when used for skin resurfacing, results in more rapid recovery than seen
with CO\2\ laser systems.
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THE GENERAL SURGERY, UROLOGY AND GYNECOLOGY MARKETS
We have established a new division, ArhroCare-ENDO, to develop and market
products for the general surgery, gynecology and urology markets. In general
surgery, we have developed, and are developing, a set of Coblation-based
products for laparoscopic and open approaches to general surgery procedures.
These products are being distributed in selected regions worldwide by a small
network of distributors. In gynecology, 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. In urology, we have 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).
BENEFITS OF OUR COBLATION TECHNOLOGY
Our patented Coblation technology, delivered in the form of multi-electrode
and single electrode, bipolar disposable devices, offers a number of benefits
that we believe may provide advantages over competing surgical methods and
devices. The principal benefits include:
. EASE OF USE. Our Coblation-based soft-tissue surgery systems perform
many of the functions of mechanical tools, power tools and
electrosurgery instruments, allowing the surgeon to use a single
instrument. The lightweight device is simple to use and complements the
surgeon's existing tactile skills without the need for extensive
training.
. PRECISION. In contrast to conventional tools, our Coblation-based
soft-tissue surgery systems permit surgeons to perform more precise
tissue ablation and sculpting. We believe this may result in more rapid
patient rehabilitation.
. BENEFITS TO PATIENTS. Coblation technology operates at cooler
temperatures than traditional electrosurgical tools. This can lead to
significant benefits for patients treated with Coblation-based
disposable devices due to the minimal amount of thermal injury to
surrounding tissue. As a result, we believe that patients are likely to
experience less trauma and pain following surgery and may recover more
quickly.
. ABLATION AND SEALING OF BLEEDING VESSELS. Our Coblation-based
soft-tissue surgery systems allow for the efficient sealing of small
bleeding vessels without changing tools.
. COST REDUCTION. Our Coblation soft-tissue surgery systems eliminate the
need to introduce multiple instruments to remove and sculpt tissue and
seal bleeding vessels. We believe this may reduce operating time and
thereby produce cost savings for health care providers.
For information regarding product sales in certain market segments, see the
notes to the financial statements under the heading, "Segment Information."
DEPENDENCE UPON COLLABORATIVE ARRANGEMENTS
Integra Lifesciences. In July 2000, we entered into a license and
distribution agreement with Integra NeuroSciences, a division of Integra
Lifesciences Holding Corporation ("Integra"). Under this agreement Integra has
become our exclusive sales and distribution partner for the Coblation-based
surgical system for neurosurgery in the United States and certain additional
international markets. In addition, we will cooperate on strategic marketing and
product development initiatives.
GyneCare. 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.
AMCI. We have also entered into a strategic relationship with AMCI, under
which AMCI will market and sell our products for urologic indications, including
transurethral resection of the prostate (TURP).
RESEARCH AND DEVELOPMENT
We have focused our research and development efforts in two areas. First,
in response to physician feedback, we are continually working on enhancements to
designs of our products to provide greater versatility in existing features and
functions. In addition, we continue to design new disposable devices that
incorporate added functionalities. Second, we are exploring new applications of
our Coblation technology in other soft-tissue surgical markets. We have
undertaken preliminary studies and development for the use of our technology in
several fields. Research and development expenses were $8.0 million in 2001,
$7.1 million in 2000 and $4.9 million in 1999.
MANUFACTURING
Our disposable devices and controllers are currently manufactured in a
portion of our 52,000 square foot facility in Sunnyvale, California. This
facility was acquired through a 5-year lease agreement in September 2001 and
became fully operational for our clean room manufacturing operations in January
2002. ArthroCare has also leased a 23,000 square foot facility in a tax-free
industrial park in Costa Rica for the purpose of manufacturing and packaging
additional disposable devices, which are currently made in Mexico and by two
contract manufacturers in Mexico. This facility has a five-year lease and is
expected to be in operation by June 2002. We believe that our Sunnyvale and
Costa Rican operations will provide adequate capacity for our manufacturing
needs through 2005.
Our products are manufactured from several components, most of which are
supplied to us from third parties. Most of the components that we use in the
manufacture of our products are available from more than one qualified supplier.
For some components, however, there
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are relatively few alternative sources of supply and the establishment of
additional or replacement suppliers may not be accomplished quickly. With
respect to a few components, we rely upon single source suppliers. For example,
two single source suppliers provide us with components used in substantially all
of our disposable devices. We also use a single subcontractor to sterilize our
disposable devices, but do not believe a major disruption is likely because the
supplier has multiple sterilization facilities throughout the United States as
well as internationally. See "ADDITIONAL FACTORS THAT MIGHT AFFECT FUTURE
RESULTS-We Have Limited Manufacturing Experience" for additional information
regarding the potential disruption in supply of our products and risks to our
operations resulting from our reliance upon single source suppliers.
We manufacture three different controller models for which the
manufacturing process is substantially the same.
We currently manufacture over 65 different versions of disposable devices.
Due to the various attributes of our disposable devices, which include, among
other functions, fluid management and suction, the manufacturing process is
varied. In order to improve yields and product cost, we operate under a
continuous improvement process.
We have established quality assurance systems in conformance with the FDA's
Quality System Regulation, or QSR. Our facility in Sunnyvale has received ISO
9001/EN46001 certification and is in conformance with the Medical Device
Directive, or MDD, for the sale of products in Europe.
The company has an agreement with a logistics company in Sweden that
provides for the warehousing, shipping and traceability of its products sold to
customers throughout Europe, Asia, the Middle East and South America.
MARKETING AND SALES
We have shipped more than 13,700 controller units and over 1,500,000
disposable devices, as of December 29, 2001 for a variety of indications. We use
a combination of distributors supported by regional sales managers, a direct
sales force and corporate partners to sell our products both domestically and
internationally.
We have more than 70 distributors representing more than 400 field sales
representatives in the United States. Integra NeuroSciences is our distributor
for neurosurgery in North and South America and certain additional international
markets. GyneCare, a division of Ethicon, Inc. is our worldwide distributor for
gynecology and ACMI is our worldwide distributor for urology.
We have established distribution capability in certain countries by means
of exclusive and non-exclusive distribution agreements with corporations,
including Kobayashi Pharmaceutical for the distribution of our arthroscopy,
spinal surgery and ENT surgery products in Japan. We have also established
distribution capability through relationships with distributors in arthroscopy
products in Europe, South Africa, South and Central America and Russia.
We believe the use of our products is generally intuitive to surgeons and
does not require extensive training. We frequently conduct training seminars and
demonstrations at regional training centers and trade shows. Our partners also
conduct training activities in their areas of responsibility.
At hospitals and surgical centers where several procedures can be performed
simultaneously, the procurement of multiple controllers is required. We have
offered our controllers at substantial discounts in the past and may be required
to continue to offer such discounts to generate demand for our disposable
devices. In addition, motorized and mechanical instruments, lasers and electro
surgery systems currently used by hospitals, surgical centers and private
physicians have become widely accepted. If physicians do not determine that our
soft-tissue surgery systems are an attractive alternative to conventional means,
our business would be materially adversely affected.
PATENTS AND PROPRIETARY RIGHTS
Our ability to compete effectively depends in part on developing and
maintaining the proprietary aspects of our Coblation technology. We own over 55
issued U.S. patents and over 20 issued international patents. In addition, we
have over 100 U.S. and international pending patent applications. 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. The issued patents are directed at,
among other things, the following:
. systems and methods for applying radio frequency energy to tissue in
the presence of electrically conductive fluid such as isotonic saline;
. disposable devices having an electrode array and a system designed to
supply current independently to individual electrodes; and
. systems and methods for employing radio frequency energy in urology,
gynecology, ENT, spine surgery, cosmetic surgery, skin resurfacing,
neurosurgery and cardiac procedures.
11
The pending patent applications include coverage for the fundamental tissue
ablation and cutting technology as well as methods and apparatus for specific
procedures.
We cannot assure you that the patents we have obtained, or any patents that
we may obtain as a result of our U.S. or international patent applications, will
provide any competitive advantages for our products or that they will not be
successfully challenged, invalidated or circumvented in the future. In addition,
we cannot assure you that competitors, many of whom have substantial resources
and have made substantial investments in competing technologies, 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.
A number of 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. 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
our 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 cannot assure you that we
would be able to obtain licenses to those patents at a reasonable cost, if at
all, or be able to develop or obtain alternative technology. The inability to do
either would have a material adverse effect on our business, financial
condition, results of operations and future growth prospects. We cannot assure
you that we will not have to defend ourselves in court against allegations of
infringement of third-party patents.
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 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 by us 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 the 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.
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, or 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 lawsuit
has been settled. In June 2000, we filed a lawsuit against Stryker, alleging
infringement of several of our patents. The lawsuit has been settled. In July
2000, we filed a lawsuit against Smith & Nephews alleging infringement of
several of our patents. This lawsuit is pending. The defense and prosecution of
this lawsuit and intellectual property suits generally, USPTO interference
proceedings and related legal and administrative proceedings are both costly and
time-consuming. We believe that these lawsuits were necessary, and if others
violate our proprietary rights, further litigation may be necessary to enforce
our patents, to protect trade secrets or know-how owned by us or to determine
the enforceability, scope and validity of the proprietary rights of others. Any
litigation or interference proceedings will be costly and cause significant
diversion of effort by our technical and management personnel. An adverse
determination, other litigation or interference proceedings to which we may
become a party could subject us to significant liabilities to third parties,
require disputed rights to be licensed from third parties or require us to cease
using such technology. Although patent and intellectual property disputes in the
medical device area have often been settled through licensing or similar
arrangements, costs associated with such arrangements may be substantial and
could include ongoing royalties. Furthermore, we cannot be sure that we could
obtain necessary licenses on satisfactory terms, if at all. Adverse
determinations in a judicial or administrative proceeding or failure to obtain
necessary licenses could prevent us from manufacturing and selling our products,
which would have a material adverse effect on our business, financial condition,
results of operations, and future growth prospects.
COMPETITION
We believe that the principal competitive factors in soft-tissue surgery markets
include:
. acceptance by leading physicians;
. improved patient outcomes;
. superior product quality;
. the publication of peer-reviewed clinical studies;
. product innovation;
12
. sales and marketing capability; and
. strong intellectual property.
Arthroscopy
In arthroscopic procedures, we compete directly with the providers of
tissue removal systems, including conventional electrosurgical systems, manual
instruments, power shavers and laser systems. Smith & Nephew Endoscopy (which
owns Acufex Microsurgical, Inc. and Dyonics, Inc. and have recently announced
its planned acquisition of Oratec Interventions, Inc.), Conmed Corporation
(including its Linvatec unit), Medtronic, Inc. (which owns Sofamor Danek), and
Stryker Corporation each have large shares of the market for manual instruments,
power shavers and arthroscopes.
Johnson & Johnson, including Mitek, a division of its Ethicon, Inc. unit,
markets a bipolar electrosurgical system developed by Gyrus Medical Ltd., a
company based in the United Kingdom which competes with us. Stryker Corporation
and Smith & Nephew have recently introduced a bipolar electrosurgical system.
The bipolar electrosurgical systems marketed by Mitek, Stryker and Smith &
Nephew competes directly with our tissue ablation and shrinkage technology in
arthroscopy. In addition, the Linvatec unit of Conmed Corporation is marketing a
monopolar electrosurgical tool for tissue ablation in arthroscopy. Oratec
Interventions manufactures and sells a monopolar tissue ablation, shrinkage
system that competes directly with our arthroscopic products. The tissue
shrinkage market represents a small portion of the overall market in arthroscopy
for our products.
We believe that our Arthroscopic System, comprising the controller unit
and disposable devices, presents a competitive pricing structure compared to
alternative tools being used in arthroscopic procedures. While our disposable
devices perform many functions in one tool, most competitive disposable devices
only perform a single function. In such cases, multiple disposable or reusable
devices would be required. Laser systems have a significantly higher capital
cost than our controller and require significant ongoing maintenance and
operating expenses. We are also aware of additional competitors that may
commercialize products using technology similar to ours.
Spinal and Neurosurgery
We believe that Coblation technology will compete effectively against
conventional tissue removal technology used in spinal and neurosurgery
procedures, such as mechanical instruments, monopolar electrosurgical
instruments, ultrasonic and powered instruments. Mechanical instruments for
tissue removal in the spine are manufactured and sold by a large number of
small, diverse, specialty companies, and the substantial bulk of monopolar
electrosurgical instruments are manufactured by Valleylab and Linvatec (unit of
Conmed). We may indirectly compete with large companies in the spine fusion
market, such as Medtronic Sofamor Danek, Sulzer Spine-Tech, Surgical Dynamics
and DePuy Acromed. In addition, we are aware of several small companies offering
alternative treatments for back pain that may indirectly compete with our
products. For example, Oratec Interventions manufactures and sells a catheter
that uses resistive heating to reduce chronic low back pain caused by
degenerative disc disease and Radionics, a division of Tyco, manufactures and
sells monopolar electrosurgical instruments for treating low back pain. In
neurosurgery, we directly compete with a variety of tissue removal systems
designed for removing brain and cranial-based tumors, such as the CUSA(TM), an
ultrasonic tissue aspiration system manufactured by Valleylab.
Ear, Nose and Throat Surgery
There are large companies, such as Smith & Nephew, Inc., Stryker Corp.,
Medtronic, Incorporated (which owns Xomed Surgical Products, Inc.) and Conmed
Corporation, which have shares of the market for manual and powered instruments
for minimally-invasive sinus surgery. In addition, we face competition from
laser companies, such as ESC Medical Systems Ltd., which develops and markets
lasers for various ENT surgery applications. We expect that competition from
these and other well-established competitors will increase as will competition
from smaller medical device companies, such as Somnus Medical Technologies, Inc.
(owned by Gyros Medical Ltd.), Elmed Inc. and Ellman International, Inc. Somnus
Medical Technologies, Inc. manufactures and sells medical devices that utilize
radio frequency energy for the treatment of upper airway disorders, such as
snoring and obstructive sleep apnea. Elmed Inc. and Ellman International, Inc.
both manufacture and sell a variety of medical devices that use conventional
radio frequency energy for tissue removal, cutting and/or coagulation for the
treatment of snoring and other ENT surgery procedures.
Cosmetic Surgery
The cosmetic surgery industry includes a number of large and well
established companies that provide devices for rejuvenating skin, hair removal,
scar removal, the treatment of vascular and pigmented lesions and other
applications, including companies that manufacture and sell dermabrasion
equipment or chemical peels, and companies that manufacture and sell lasers. In
skin resurfacing, we directly compete with much larger companies that
manufacture lasers for medical use, such as Lumenis, Inc., a company that
resulted from the acquisition of Coherent Medical Group by ESC Medical Group.
The combined company develops and markets lasers for a broad range of cosmetic
applications, including the non-invasive treatment of varicose veins and other
benign vascular lesions, hair removal, skin rejuvenation and
others. In addition, other large companies manufacture and sell medical
devices that use radio frequency energy for certain applications in dermatology
and cosmetic surgery.
13
We cannot assure you that we can effectively convince surgeons and
physicians to adopt our Coblation technology in the face of competition. In
addition, we cannot be sure that these or 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. Many of these
competitors have significantly greater financial, manufacturing, marketing,
distribution and technical resources than us. We have received 510(k) clearances
to market tissue ablation products to treat disorders in other surgical fields
that we may enter. These fields are intensely competitive and we cannot assure
you that these potential products would be successfully marketed.
Third-Party Reimbursement
In the United States, health care providers, such as hospitals and
physicians, that purchase medical devices, such as our products, generally rely
on third-party payors, principally federal Medicare, state Medicaid and private
health insurance plans, to reimburse all or part of the cost of the procedure in
which the medical device is being used. Reimbursement for arthroscopic, ENT
surgery, spinal and neuro surgery, gynecology, urology and general surgery
procedures performed using devices that have received FDA clearance has
generally been available in the United States. Generally, cosmetic procedures
are not reimbursed. 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.
Government Regulation
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:
. product design and development;
. product testing;
. product labeling;
. product storage;
. premarket clearance or approval;
. advertising and promotion; and
. product sales and distribution.
Noncompliance with applicable regulatory requirements can result in enforcement
action, which may include:
. warning letters;
. fines, injunctions and civil penalties against us;
. recall or seizure of our products;
. operating restrictions, partial suspension or total shutdown of our
production;
. refusing our requests for premarket clearance or approval of new
products;
. withdrawing product approvals already granted; and
. criminal prosecution.
Unless an exemption applies, generally, before we can introduce a new
medical device into the United States 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 must be
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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 clearance to market our Spinal Surgery System in the United States for
spinal and neuro surgery as well as the treatment of symptomatic patients with
contained herniated discs. In addition, we have received 510(k) clearance to
market our Cosmetic Surgery System in general dermatology and for skin
resurfacing for the purpose of wrinkle reduction. We have received 510(k)
clearance to market our ENT Surgery System in general head, neck and sinus
surgical procedures, as well as snoring, turbinate reduction, submucosal
channelling procedures and tonsillectomies. 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, technology, materials,
packaging, and certain manufacturing process may require 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. No assurance can be given that the
FDA would agree with any of our decisions not to seek 510(k) clearance. If the
FDA requires 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 on a timely basis, if at
all, and delays in receipt or failure to receive 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 Practice and relates to product design, testing, and manufacturing
quality assurance, 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 or 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.
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, Taiwan, Korea, Australia, South America and
Israel; to market our ENT surgery products in Europe, Australia, Canada, China,
Israel, Japan, Middle East, Korea, Taiwan, Australia, and South America; to
market our spinal surgery products in Europe, Canada, Japan, South America,
Australia, Korea, Mexico, Middle East, Taiwan; to market our general surgery
products in Europe, Canada, Middle East, Korea, South America, and Taiwan; and
to market 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 CE Mark will preclude us from selling
our products in Europe. We cannot assure you that we will be successful in
maintaining certification requirements. During the years ended December 31, 2001
and December 31, 2000, approximately 17% and 14%, respectively, of our sales
were derived internationally.
Product Liability Risk and Insurance Coverage
15
The development, manufacture and sale of medical products entail
significant risk of product liability claims. Our current product liability
insurance coverage limits are $10,000,000 per occurrence and $10,000,000 in the
aggregate. We cannot assure you that such coverage limits are adequate to
protect us from any liabilities we might incur in connection with the
development, manufacture and sale of our products. In addition, we may require
increased product liability coverage as products are successfully commercialized
in additional applications. Product liability insurance is expensive and in the
future may not be available to us on acceptable terms, if at all. A successful
product liability claim or series of claims brought against us in excess of our
insurance coverage could have a material adverse effect on our business,
financial condition, results of operations and prospects.
Employees
As of December 29, 2001, we had 286 employees of which 120 people were
engaged in manufacturing activities, 27 people were engaged in research and
development activities, 90 people were engaged in sales and marketing
activities, 25 people were engaged in regulatory affairs and quality assurance
and 24 people were engaged in administration and finance. No employees are
covered by collective bargaining agreements, and we believe we maintain good
relations with our employees.
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 us. Our success also depends on our ability to
attract and retain additional highly qualified management and technical
personnel. We face intense competition for qualified personnel, many of whom
often receive competing employment offers. We cannot assure you that we will
continue to 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 affairs.
Facilities
We lease an approximately 52,000 square foot facility in Sunnyvale,
California for administrative offices, research and development, general and
administrative purposes, manufacturing, warehousing, and distribution. Our lease
for the building will expire in September 2006.
We also leased approximately 32,000 square feet in two neighboring
buildings in Sunnyvale, California for the same purposes as above. Both these
leases expired in February 2002, and these buildings are no longer occupied by
our company.
We are leasing an approximately 23,000 square foot building in Costa Rica
for manufacturing and distribution. We believe that the two newly leased
facilities will be sufficient for operational purposes through 2005.
We also lease an approximately 3,300 square foot building in Stockholm,
Sweden for administrative and sales and marketing purposes.
ADDITIONAL FACTORS THAT MIGHT AFFECT FUTURE RESULTS
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 we are
highly dependent on its sales. We have only recently began to market our spinal
surgery, neurosurgery, cosmetic surgery, ENT surgery, and general 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
arthroscopic surgeons are essential for market acceptance of our Arthroscopic
System. If our Coblation technology does not continue to receive endorsement 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 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
16
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 of new medical devices. These risks include the following:
. such products may not be easy to use, will require extensive training
or may not be cost-effective;
. new products may experience delays in testing or marketing;
. there may be unplanned expenditures or in expenditures above those
anticipated by us;
. such products will not be proven safe or effective;
. third parties may develop and market superior or equivalent products;
. such products may not receive necessary regulatory clearances or
approvals;
. such products may be difficult or uneconomical to manufacture for
commercial sale; and
. 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.
For information regarding the status of our regulatory approvals for our
products, see the information under the heading "Government Regulation."
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 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 66 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
17
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 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 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, Stryker Corp. and Oratec
Interventions, Inc., which market products to remove or shrink tissue.
Specifically, Johnson & Johnson, Smith & Nephew and Stryker are currently
marketing worldwide bipolar electrosurgical systems for tissue ablation and
shrinkage based upon technology licensed by us. We are also aware of additional
competitors that may commercialize products using technology similar to ours. In
spinal surgery, we compete against companies which market products to remove
tissue and treat spinal disorders. In addition, Oratec 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, 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. Smaller companies, including Somnus Medical
Technologies 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, which markets lasers for use in this field. In addition, other large
companies manufacture and sell medical devices that use radio frequency energy
for certain applications in dermatology and cosmetic surgery. In cardiology, we
compete with companies which use lasers to treat cardiovascular disease. Other
approaches to alleviating cardiovascular disease, including drugs or other
surgical approaches, are also competitive with our products.
Many of our competitors have significantly greater financial,
manufacturing, marketing, distribution and technical resources than we do. Some
of these companies offer broad product lines that they may offer as a single
package and frequently offer significant discounts as a competitive tactic. For
example, in order to compete successfully, we anticipate that we may have to
continue to offer substantial discounts on our controllers in order to increase
demand for our disposable devices, and that this competition could have a
material adverse effect on our business, financial condition, results of
operations and future growth prospects. Furthermore, some of our competitors
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, 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 governmental 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
18
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 a distribution agreement with Integra Neurosciences to market
and sell our Coblation-based products for neurosurgery and with GyneCare and
ACMI to market and sell our gynecology and urology products, respectively. See
the information under the heading "Collaborative Arrangements" 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 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 under the arrangements. If
a collaborative partner were to terminate or breach its agreement with us, or
otherwise fail to complete 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 or 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 December 29, 2001, we had an
accumulated deficit of $0.3 million. Results of operations may fluctuate
significantly from quarter to quarter due to many factors, including the
following:
. the introduction of new product lines;
. increased penetration in existing applications;
. product returns;
. achievement of research and development milestones;
. the amount and timing of receipt and recognition of license fees;
. manufacturing or supply disruptions;
. timing of expenditures;
. absence of a backlog of orders;
. receipt of necessary regulatory approvals;
19
. the level of market acceptance for our products;
. timing of the receipt of orders and product shipments; and
. promotional programs for our products.
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, 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 June 2000, we filed a lawsuit against Stryker, alleging
infringement of several of our patents. The lawsuit has been settled. In July
2000, we filed a lawsuit against Smith & Nephews alleging infringement of
several of our patents.
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 rights 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
20
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 fiscal year ended December 29, 2001 our common stock has traded
between a range of $12.06 and $32.60 per share. The market price of our common
stock could continue to fluctuate substantially due to a variety of factors,
including:
. quarterly fluctuations in results of our operations;
. our ability to successfully commercialize our products;
. announcements regarding results of regulatory approval filings,
clinical studies or other testing, technological innovations or new
commercial products by us or our competitors;
. developments concerning government regulations, proprietary rights or
public concern as to the safety of technology;
. the execution of new collaborative agreements and material changes in
our relationships with our business partners;
. market reaction to acquisitions and trends in sales, marketing, and
research and development;
. changes in coverage or earnings estimates by analysts;
. sales of common stock by existing stockholders; and
. 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 of our common stock.
In addition, the stock market is subject to extreme 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."
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 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. FDA regulations are wide ranging and govern, among other things:
21
. product design and development;
. product testing;
. product labeling;
. product storage;
. premarket clearance or approval;
. advertising and promotion; and
. product sales and distribution.
Noncompliance with applicable regulatory requirements can result in enforcement
action, which may include:
. warning letters;
. fines, injunctions and civil penalties against us;
. recall or seizure of our products;
. operating restrictions, partial suspension or total shutdown of our
production;
. refusal of our requests for premarket clearance or approval of new
products;
. withdrawal of product approvals already granted; and
. criminal prosecution.
Generally, before we can introduce a new medical device into the United
States market, we must obtain FDA clearance of a 510(k) premarket notification
or approval of a premarket approval application, or PMA application. If we can
establish that our device is "substantially equivalent" to a "predicate device,"
i.e., a legally marketed Class I or Class II device or a preamendment Class III
device (i.e., one that was in commercial distribution before May 28, 1976) for
which the FDA has not called for PMAs, we may seek clearance from the FDA to
market the device by submitting a 510(k) premarket notification. The 510(k)
premarket notification will need to be supported by appropriate data, including,
in some cases, clinical data, establishing the claim of substantial equivalence
to the satisfaction of the FDA.
We have received 510(k) clearance to market our Arthroscopic System for
surgery of the knee, shoulder, elbow, wrist, hip and ankle joints. We have
received 510(k) clearance in the United States to market our Spinal Surgery
System. In addition, we have received 510(k) clearance to market our Cosmetic
Surgery System in general dermatology procedures and for skin resurfacing for
the purpose of wrinkle reduction. We have received 510(k) clearance to market
our ENT Surgery System in general head, neck and sinus surgical procedures, as
well as the treatment of snoring, hypertrophic turbinates and submucosal
channelling. 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. No assurance can be given that the
FDA would agree with any of our decisions not to seek 510(k) clearance. If the
FDA requires 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 on a timely basis, if at
all, and delays in receipt or failure to receive approvals, could have a
material adverse effect on our business, financial condition, results of
operations and future growth prospects.
22
We are also required to demonstrate and maintain compliance with the
Quality System Regulation, or QSR. The QSR incorporates the requirements of Good
Manufacturing Practice and relates to product design, testing, and manufacturing
quality assurance, 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 or 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, the company recently 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 intends to resolve this matter expeditiously
and 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 Israel; to market our ENT
surgery products in Europe, Australia, Canada, China, Israel, Japan, Middle
East, Twain and South America; to market our spinal surgery products in Europe,
Canada, Japan, Mexico, Middle East, Taiwan; general surgery products in Europe,
Canada, Middle East and Taiwan and 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 CE Mark will preclude us from selling
our products in Europe. We cannot assure you that we will be successful in
maintaining certification requirements.
ITEM 2. PROPERTIES
We lease an approximately 52,000 square foot facility in Sunnyvale,
California for administrative offices, research and development, general and
administrative purposes, manufacturing, warehousing, and distribution. Our lease
for the building will expire in September 2006.
We also leased approximately 32,000 square feet in two neighboring
buildings in Sunnyvale, California for the same purposes as above. Both these
leases expired in February 2002, and these buildings are no longer occupied.
Additionally, we are leasing an approximately 23,000 square foot building
in Costa Rica for manufacturing and distribution. We believe that the two
currently leased facilities will be sufficient for operational purposes through
2005.
We also lease an approximately 3,300 square foot building in Stockholm,
Sweden for administrative and sales and marketing purposes.
ITEM 3. LEGAL PROCEEDINGS
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 an electrosurgical system under the name Dyonics Control
RF System that infringes these patents. AthroCare seeks: (1) a judgment that the
Defendant has infringed these patents; (2) a permanent injunction precluding the
Defendant from using, importing, marketing and selling the Dyonics Control RF
System; and (3) an award of damages (including attorneys' fees) to compensate us
for lost profits and Defendant's use of our inventions, with the damages to be
trebled because of the Defendant's willful infringement.
In conjunction with a medial malpractice suit against a physician, a
product liability suit was brought against us in the Superior Court Arizona,
county of Yavapi on August 24, 2001. The lawsuit alleges that a patient, D.
Earl, suffered internal and external injury to the patient's knee as a result of
a defective ArthroCare probe used in an arthroscopy procedure on the patient.
ArthroCare believes these claims to be without merit.
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. ArthroCare
believes Inamed's claims are without merit and, on October 10, 2001, ArthroCare
filed and Answer and Counter claim seeking damages for Inamed's breach of
contract.
23
In November 2001, a product liability suit was brought against us in the
United States District Court, Eastern District of Michigan. The lawsuit alleges
that a patient, M. Pawlik, suffered burns to her left arm as a result of a
defect in an ArthroCare device used in an arthroscopy procedure performed on the
patient. ArthroCare believes these claims to be without merit.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not applicable
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Our common stock trades publicly on The Nasdaq Stock Market under the
symbol ARTC. The following table sets forth, for the periods indicated, the
quarterly high and low closing sales prices of the common stock on The Nasdaq
Stock Market.
Fiscal 2001
------------------------------------------------------------------------------------
Quarter 1 Quarter 2 Quarter 3 Quarter 4
------------- ----------------- -------------------- -------------------
High ....... $ 24.50 $ 28.51 $ 32.60 $ 24.68
Low ........ 12.06 13.75 19.56 16.15
Fiscal 2000
------------------------------------------------------------------------------------
Quarter 1 Quarter 2 Quarter 3 Quarter 4
------------- ----------------- -------------------- -------------------
High ....... $ 61.75 $ 52.56 $ 45.25 $ 23.81
Low ........ 29.13 23.00 18.44 15.44
As of March 15, 2002, there were no outstanding shares of Preferred Stock and
208 holders of record of 21,836,267 shares of outstanding Common Stock. The
company has not paid any dividends since its inception and does not intend to
pay any dividends on its Common Stock in the foreseeable future. In June 2000,
we approved a two-for-one stock split of our common stock which was paid on, and
began trading as of, July 5, 2000.
ITEM 6. SELECTED FINANCIAL DATA
The following selected financial data should be read in conjunction with
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" and the Consolidated Financial Statements and Notes thereto included
in this Annual Report on Form 10-K. The statements of operations data for the
years ended December 31, 2001, 2000 and 1999 and the balance sheet data as of
December 31, 2001 and 2000 have been derived from audited consolidated financial
statements included elsewhere in this report. The consolidated statement of
operations data for the years ended December 31, 1998 and 1997 and the balance
sheet data as of December 31, 1999, 1998 and 1997 have been derived from audited
consolidated financial statements that are not included in this report. The
historical results are not necessarily indicative of the results of operations
to be expected in the future.
24
Year Ended December 31,
(in thousands, except per share data)
---------------------------------------------------------------------------
2001 2000 1999 1998 1997
---- ---- ---- ---- ----
Statements of Operations Data:
Product sales $ 75,247 $ 64,012 $ 44,219 $ 24,624 $ 12,796
Royalties,fees and other 8,075 3,615 4,857 3,292 --
Total revenues 83,322 67,627 49,076 27,916 12,796
Gross profit 55,631 41,965 29,891 15,548 4,301
Operating expenses 47,941 34,467 25,242 18,625 13,401
Net income (loss) before cumulative 10,060 15,845 5,543 (2,141) (7,688)
effect of change in accounting
principle
Cumulative effect on prior years of -- (4,300) -- --
the application of SAB 101
Net income(loss) 10,060 11,545 5,543 (2,141) (7,688)
Basic net income (loss) per share $ .45 $ .53 $ .29 $ (0.12) $ (0.44)
Diluted net income (loss) per share $ .43 $ .50 .27 $ (0.12) $ (0.44)
December 31,
---------------------------------------------------------------------------
2001 2000 1999 1998 1997
---- ---- ---- ---- ----
Balance Sheet Data:
Cash, cash equivalents
and available-for-sale securities
(including long-term portion) $ 76,695 $ 86,814 $ 79,607 $ 8,058 $ 19,872
Working capital 98,642 97,013 85,118 16,973 20,342
Total assets 133,697 140,462 110,039 27,760 26,675
Total stockholders' equity(1) 125,093 126,345 102,883 22,305 23,546
(1) We have not declared any cash dividends on our common stock since our
inception and we do not anticipate paying cash dividends in the foreseeable
future.
ITEM 7. 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-K. Statements in this Management's Discussion and Analysis of Financial
Condition and Results of Operations and elsewhere in this annual report on Form
10-K 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 discussed in "ADDITIONAL FACTORS THAT MAY AFFECT FUTURE RESULTS"
set forth in Part I of this Report as well as other risks and uncertainties in
the documents incorporated herein by reference.
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 and to seal small bleeding vessels. Our soft-tissue surgery systems
consist of a controller unit and an assortment of 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 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.
In April 1998, we announced that we had entered the cosmetic surgery market
and formed a business unit called Visage to commercialize Coblation technology
in this field. In early 1999, we entered into a license and distribution
agreement with Collagen Aesthetics, Inc., which was subsequently purchased by
Inamed Corporation. Under this agreement, Inamed Corporation acquired exclusive,
worldwide, marketing rights for our cosmetic surgery line of products for the
dermatology and cosmetic surgery markets. In March 2001, we terminated this
contract, alleging breach by Inamed of certain terms of the contract. In April
2001, we terminated this agreement and have been marketing and selling our
cosmetic surgery product line through a network of distributors and direct sales
representatives.
In May 1998, we announced that we had entered the ear, nose and throat
market and had formed a business unit called ENTec to commercialize Coblation
technology in this field.
In early 1998, we formed a business unit, AngioCare(TM), for the purpose of
further developing and commercializing our technology in specific applications
in the field of cardiology. As part of those efforts, in February 1998, we
entered into a license agreement under which Boston Scientific Corporation would
help develop, obtain regulatory approval for and market products based on
Coblation technology for
25
myocardial revascularization procedures. In 2001 we terminated this agreement
and now retain all rights to Coblation technology in this field.
In September 1999, we announced that we had entered the spinal surgery
market. In February 2000, we announced that we were expanding our marketing
efforts for our spinal surgery system to specifically address selected
applications in neurosurgery. We are marketing and selling our spinal surgery
products through a network of independent distributors and direct sales
representatives supported by regional managers worldwide. In July 2000, we
entered into a license and distribution partnership with Integra Lifesciences to
market our products for neurosurgery in North America and certain other
international territories.
We have received 510(k) clearance to market our Arthroscopic System for use
in arthroscopic surgery of the knee, shoulder, ankle, elbow, wrist and hip, and
our Arthroscopy System is CE marked for use in arthroscopic surgery. Our Spinal
Surgery System is CE marked and we have received 510(k) clearance in the United
States to market this system for spinal surgery and neurosurgery. Our ENT
Surgery System in general head, neck, and sinus surgical procedures, including
snoring and the treatment of hypertrophic turbinates and submucosal channeling
in the United States. Our Cosmetic Surgery System is CE marked for general
dermatology and skin resurfacing for the purpose of wrinkle reduction procedures
and we have received 510(k) clearance for use of our Cosmetic Surgery System in
general dermatology procedures and for skin resurfacing for the purpose of
wrinkle reduction in the United States. We have received 510(k) clearance to
market Coblation technology for general surgery, gynecology and urology.
In December 1995, we introduced our Arthroscopy System commercially in the
United States and have derived a significant portion of our sales from this
system. Our strategy includes placing controller units, at substantial
discounts, to generate future disposable product revenue. Our strategy also
includes applying our patented Coblation technology to a range of other
soft-tissue surgical markets including the products we have introduced in the
fields of spinal surgery, neurosurgery, gynecology, urology, cosmetic surgery,
ear, nose and throat surgery and general surgery. We have received 510(k)
clearance for use of our technology in several fields. We cannot be sure that
any of our clinical studies in other fields will lead to 510(k) applications or
that the applications will be cleared by the FDA on a timely basis, if at all.
In addition, we cannot be sure that the products, if cleared for marketing, will
ever achieve commercial acceptance.
RESULTS OF OPERATIONS
The year ended December 31, 2001 was our sixth full year of product
shipments.
ArthroCare Corporation Statements of Operations:
Year Ended December 31,
------------------------------------------
2001 2000 1999
----------- ----------- -----------
Revenues:
Product sales $ 75,247 $ 64,012 $ 44,219
Royalties, fees and other 8,075 3,615 4,857
--------- ---------- -----------
Total revenues 83,322 67,627 49,076
Cost of product sales 27,691 25,662 19,185
--------- ---------- -----------
Gross profit 55,631 41,965 29,891
--------- --------- -----------
Operating expenses:
Research and development 8,036 7,145 4,929
Sales and marketing 34,599 22,472 15,493
General and administrative 5,306 4,850 4,820
--------- ---------- -----------
Total operating expenses 47,941 34,467 25,242
--------- ---------- -----------
Income from operations 7,690 7,498 4,649
Interest income and other, net 8,047 4,903 1,125
--------- ---------- -----------
Income before income tax 15,737 12,401 5,774
provision
Income tax provision/(benefit) 5,677 (3,444) 231
--------- ---------- -----------
Net income before cumulative
effect of a change in
accounting principle 10,060 15,845 5,543
Cumulative effect on prior years of
Application of SAB101 "Revenue
Recognition in Financial Statements" -- (4,300) --
--------- ---------- -----------
Net income $ 10,060 $ 11,545 $ 5,543
========= ========== ===========
Revenues
Product sales for fiscal 2001 were $75.2 million compared to $64.0
million for the prior year and $44.2 million for the year ended 1999. The
increases year-over-year are due to increasing unit sales of current products,
unit sales of newly introduced products and
26
increasing international sales. In fiscal 2001, the sale of current product
increased by 32,000 units over fiscal 2000, and by 15,000 units for new
products, and international sales grew by $4.1 million during this period. We
attribute increasing disposable device sales both domestically and
internationally, in part, to our strategic plan to build market share through
continued promotional programs of controller placements and the entry into new
surgical markets.
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.
For fiscal years 2001, 2000 and 1999, disposable device sales comprised
approximately 95% of our product sales. We anticipate that disposable device
sales will remain the primary component of our product sales in the near future.
During fiscal 2001 and 2000, approximately 17% and 14%, respectively, of our
sales were derived internationally. Approximately 85% of our product sales were
derived domestically during fiscal 1999. We believe that the increase in
international sales is attributable to our increasing marketing presence in
these markets overseas.
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 six 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 50% of our arthroscopy product sales is being
generated by the sale of disposables for use in knee procedures.
Royalties, fees, and other revenues increased to $8.1 million for fiscal
2001, from $3.6 million for fiscal 2000. During fiscal 1999 royalties, fees and
other revenues was $4.9 million. Royalties, fees and other increased in 2001
primarily due to the cancellation of agreements with distribution partners
resulting in recognition of $5.5 million in fees that previously had been
deferred. We previously recognized non-refundable license fee and milestone
revenue when the fee was received or on completion of certain milestones. During
fiscal year 2000, we adopted SEC Staff Accounting Bulletin No. 101 "Revenue
Recognition in Financial Statements" (SAB 101) and changed our method of
accounting for license fees and milestones from business partners to recognize
such revenues 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. Amounts received prior
to revenue recognition are recorded as deferred revenue. The cumulative effect
of the change of $4.3 million in fiscal 2000 was reported as a cumulative effect
of a change in accounting principle, retroactive to January 1, 2000. Prior
period amounts have not been restated in the accompanying statement of
operations. The cumulative effect of the change in accounting principle included
license fee revenues and deferred revenues that would be recognized over the
lives of the associated agreements.
During fiscal year 2001 and 2000, we recognized $0.6 million and $0.6
million, respectively, of royalties, fees and other revenues in accordance with
our agreement with Ethicon, Inc. In February 1998, we entered into a license
agreement under which Boston Scientific Corporation was granted an exclusive
right to develop and market products based on Coblation technology for
myocardial revascularization procedures. Boston Scientific Corporation pays
license fees to us upon achievement of designated milestones and royalties on
sales of resulting products, if any. During each of fiscal 2000 and 1999, we
recognized $0.4 million of such payments as license fees and royalties. We
received a license payment from Boston Scientific Corporation of $3.0 million in
February 1998 of which $2.6 million was recognized as revenue during fiscal
1998. In January 1999, we entered into a license and distribution agreement with
Inamed Corporation, which was expanded in February 1999, whereby Inamed
Corporation acquired exclusive, worldwide, marketing rights for our patented
Coblation technology in the cosmetic surgery market. Under the terms of the
agreement, Inamed Corporation paid us license fees based upon the achievement of
certain milestones and royalties on sales of product to end-users. During fiscal
years 2000 and 1999, we recognized $0.5 million and $2.3 million, respectively,
of these payments as royalties, fees and other revenues. As old underlying
agreements have been terminated, no unrecognized amounts remain at the end of
fiscal 2001.
Cost of Product Sales
Cost of product sales for fiscal 2001 was $27.7 million, or 37% of product
sales, compared with $25.7 million, or 40% of product sales, for fiscal 2000.
During fiscal 1999, cost of product sales was $19.2 million, or 43% of product
sales. The absolute dollar increase of $2 million in cost of product sales for
fiscal 2001 over fiscal 2000 resulted from the sale of 47,000 more disposables
units, partially offset by a lower number controllers sold as part of the
expansion of our controller placement program. The $8.5 million increase from
2000 over fiscal 1999 were due to increased unit sales of both disposable
devices and controllers. The increase in gross margin as a percentage of product
sales is attributable to increased average selling prices of disposable devices,
increased manufacturing efficiency and increased production volume. In addition,
we continued controller placements under a program whereby we maintain ownership
of the controller, which resulted in the cost being capitalized and amortized
cost of sales over future periods rather than expensing the entire cost at the
time of placement.
We cannot be sure that gross margins will remain at current levels or show
improvement in the future due to the distribution channels used, product mix,
fluctuation in manufacturing production levels and overhead costs, particularly
in relation to our recent facilities expansion, as new products are introduced.
We believe our gross margin will depend upon the mix of disposable device sales
versus
27
controller sales and/or placements and the various distribution channels
utilized to sell our products in all commercialized fields. There can be no
assurance that we will be successful in maintaining the mix of disposable
devices to controllers or in increasing demand for our disposable devices. In
addition, inefficiencies in manufacturing new products and the distribution
channels utilized to sell those products may adversely impact gross margin.
Operating Expenses
Research and development expense increased to $8.0 million in fiscal 2001,
or 11% of product sales, from $7.1 million in fiscal 2000, or 11% of product
sales, and from $4.9 million, or 11% of product sales in fiscal 1999. The $0.9
million and $2.2 million increases in spending between fiscal years 2001 and
2000 and between 2000 and 1999, respectively, are attributable primarily to
continued development of new products in our currently commercialized markets,
continued development of new markets and continued maintenance and development
of our patent position. In addition, we have continued to incur increased
compensation and related expenses, $0.6 million and $0.4 million increases
between fiscal years 2001 and 2000 and between 2000 and 1999, respectively, as
we have continued to increase headcount in order to support research and
development efforts. We also have higher costs for development prototype
materials $0.2 million and $0.7 million increases in fiscal years 2001 and 2000,
respectively, which were partly offset by a decrease in the research and
development efforts conducted on behalf of business partners and a reduction of
expenses incurred by the company for non-employee stock options. We believe that
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 increased to $34.6 million, or 46% of product
sales, in fiscal 2001, from $22.5 million, or 35% of product sales, in fiscal
2000, and from $15.5 million, or 35% of product sales, in fiscal 1999. Increased
expenses associated with hiring a direct sales force for certain of our
businesses and expenses associated with canceling distributors accounted for
$2.7 million and $0.6 million in fiscal 2001 and 2000, respectively. Increased
commissions resulting from increased sales accounted for $2.2 million and $4.6
million, respectively. Increased sales and marketing activity in our businesses
other than arthroscopy and our expanded international operations resulted in
increases of $3.9 million and $0.7 million, respectively.
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 dealer 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 to commercialize future products.
General and administrative expense increased to $5.3 million, or 7% of
product sales, in fiscal 2001, from $4.9 million, or 8% of products sales, in
fiscal 2000, and from $4.8 million, or 11% of product sales, in fiscal 1999.
Overall, the increase in general and administrative expenses was attributable to
increased staffing and salaries, $0.3 million and $0.2 million, respectively,
increases in the cost of general and patent-related legal services, business
development activities, insurance and international accounting and tax related
expenditures necessary to expand our corporate infrastructure. We expect that
general and administrative expenses will decrease as a percentage of product
sales, but will increase in dollar amounts as we incur additional legal expenses
and continue business development activities.
Interest and Other Income, net
Interest and other income, net, increased for fiscal 2001, to $8.0 million
from $4.9 million in fiscal 2000 and from $1.1 million, in fiscal 1999. The $3.1
million increase in interest and other income during fiscal 2001 included a $4.4
million gain on the sale of an investment. This gain was partially offset by a
reduction of $1.3 million in interest earned as a result of declining interest
rates throughout 2001 and a lower cash and investment balance resulting from our
repurchase of one million shares of our common stock during 2001. The $3.6
million interest income during fiscal 2001, $4.9 million in fiscal 2000, and
$1.1 million in 1999 were attributable to increased cash and investment balances
as a result of our secondary offering at the end of fiscal year 1999 and the
increase in the cash received from operating activities. At the end of fiscal
2001, we had $76.7 million in cash, cash equivalents and available-for-sale
securities as compared to, $86.8 million at the end of fiscal 2000 and to $79.6
million at the end of fiscal 1999.
Income Tax Provision /(Benefit)
The provision / (benefit) for income taxes was $5.7 million for fiscal 2001
as compared to ($3.4) million for fiscal 2000, and $0.2 in 1999. The 2001
effective rate was 36% as compared to 5% in 2000. The primarily difference
relates to the release of the valuation allowance in 2000. Included in the
income tax benefit during fiscal 2000, was a reduction of the company's tax
valuation allowance. Historically, we have established deferred tax assets
arising from federal net operating loss carryforwards, federal tax credit
carryforwards as well as from other timing differences. These deferred tax
assets have been offset in total by a valuation allowance due to the uncertainty
surrounding the realization of such assets. During fiscal 2000, we decreased the
valuation allowance and recognized a tax benefit relating to the recognition of
deferred tax assets of $4.9 million. The decrease in the valuation allowance and
the resulting recognition of a deferred tax benefit in the year was based on
management's belief that it is more likely than not that these deferred tax
assets will be realized.
28
We believe that in fiscal 2002 our tax rate will be approximately 36% as
compared to the 36% and 5% rate in 2001 and 2000. The effective tax rate is
lower than the statutory rate of approximately 40% which is primarily due to the
tax benefit recognized from federal and state research and development credits.
LIQUIDITY AND CAPITAL RESOURCES
At the end of fiscal 2001, we had $98.6 million in working capital
compared to $97.0 million at the end of fiscal 2000. Our principal sources of
liquidity consisted of $76.7 million in cash, cash equivalents and short and
long-term available-for-sale securities. The cash and cash equivalents are
highly liquid with original maturities of ninety days or less. In October and
November 1999, we sold a total of 2,737,000 shares of common stock at $28.00 per
share. The net proceeds from the offering of approximately $71 million has been
used by us for sales, marketing and development efforts associated with the
commercialization of our spinal surgery product line and the balance to fund the
development, commercialization and associated working capital requirements of
applying our Coblation technology to a broad range of other soft-tissue surgical
markets and for corporate and other general purposes. Cash generated by
operating activities was $12.9 million for fiscal 2001 which was mainly
attributable to net income of $10.1 million, depreciation of $5.8 million and
changes in deferred tax asset balances of $3.6 million. This was partially
offset by changes in deferred revenue of $5.5 million, accounts receivable of
$3.2 million and accounts payable of $1.0 million.
Accounts receivable net of allowances increased to $18.6 million as of the
end of fiscal 2001 from $16.2 million at the end of fiscal 2000 and $13.9
million at the end of fiscal 1999. The increase in accounts receivable were due
to significant increases in sales and the timing of sales and collections during
the year and the impact of longer payment terms relating primarily to increasing
sales to international customers.
Inventories increased to $14.2 million at the end of fiscal 2001 compared
to $13.7 million and $7.0 million at the end of fiscal 2000 and 1999,
respectively in order to support anticipated increasing product sales activity,
lower-than-expected sales at the end of fiscal 2001, safety stock for our move
of the manufacturing operations into our new facility in California in early
2002 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
commence our off-stock manufacturing operation and as a result of our expansion
into additional markets.
Purchases of property and equipment increased to $9.4 million for fiscal
2001 compared to $6.2 million in fiscal 2000. The increase at the end of fiscal
2001 was primarily due to leasehold improvements of $2.4 million in our new
headquarters and to the capitalization of controllers placed under various
promotional programs in the amount of $5.5 million along with an increase of
computer software $1.4 million.
Cash provided by investing activities was $6.8 million for fiscal 2001,
compared to $(25.5) million for 2000 and $(31.8) million for 1999. Cash used in
financing activities decreased to $13.6 million for fiscal 2001 as compared to
cash provided of $5.2 million and $74.5 million in fiscal 2000 and 1999,
respectively. The decrease in 2001 was primarily due to the repurchase of the
company's stock, totaling $19.0 million.
We plan to finance our future operating and capital needs principally with
cash from product sales, cash, cash equivalents, and available-for-sale
securities and related interest, and existing capital resources which we believe
will be sufficient to fund our operations at least through fiscal year 2004. At
the end of fiscal 2001, we had committed to capital expenditures of
approximately $2.0 million. 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 approvals and competition.
At the end of 2001, we had federal net operating loss carryforwards of
approximately $16.7 million and $6.2 million of state net operating loss
carryforwards. The Federal and State net operating loss carryforwards will begin
to expire in the year 2011 and 2002, respectively, if not utilized.
CRITICAL ACCOUNTING POLICIES
Management's Discussion and Analysis of Financial Condition and Results of
Operations discusses ArthroCare's consolidated financial statements, which have
been prepared in accordance with accounting principles generally accepted in the
United States of America. The preparation of these financial statements requires
management to make estimates and assumptions that affect the reported amounts of
assets and liabilities and the disclosure of contingent assets and liabilities
at the date of the financial statements and the reported amounts of revenues and
expenses during the reporting period. On an on-going basis, management evaluates
its estimates and judgements, including those related to product returns, bad
debts, inventories, investments, income taxes, warranty obligations, retirement
benefits, and contingencies and litigation. Management bases its estimates and
judgements on historical experience and on various other factors that are
believed to be reasonable under the circumstances, the results of which form the
basis for making judgements about the carrying values of assets and liabilities
that are not readily apparent from other sources. Actual results may differ from
these estimates under different assumptions or conditions.
We believe that our critical accounting policies are as follows:
Revenue Recognition
We recognize revenue upon shipment of our products to customers, upon fulfilment
of acceptance terms, if any, when no significant contractual obligations remain
and collection of the related receivable is reasonably assured. Revenue is
reported net of a provision for estimated product returns. Revenue related to
collaborative research and development contracts is recognized as the related
work is performed. 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.
Estimating Expenses
On an on going basis, we evaluate estimates for expenses including those
related to sales and marketing expenses, bonus and commissions, bad debts,
inventory reserves for obsolete and unusable inventory, income taxes, warranties
and other various expenses. We base these estimates on historical experience and
on various other assumptions that are believed to be reasonable under the
circumstances. Actual results may differ from those estimates under different
assumptions and conditions.
RECENT ACCOUNTING PRONOUNCEMENTS
In November 2001, the Financial Accounting Standards Board ("FASB")
Emerging Task Force (EITF) reached a consensus on EITF Issue 01-09, Accounting
for Consideration Given by a Vendor to a Customer or a Reseller of the Vendor's
products, which is codification of EITF 00-14, 00-22 and 00-25. This issue
presumes that consideration from a vendor to a customer or reseller of the
vendor's products should be characterized as a reduction of revenue
29
when recognized in the vendor's income statement. Revenue reduction is required
unless consideration relates to a separate identifiable benefit and the
benefit's fair value can be established. This issue is effective for our first
quarter ending March 31, 2002. Upon adoption we are required to reclassify all
prior period amounts to conform to the current period presentation. We are
currently evaluating the effects of these changes and while the net income
previously included in our consolidated financial statements will not change we
may be required to reclassify certain commissions from operating expenses to
revenue.
In July 2001, The FASB issued Statements of Financial Accounting
Standards No. 141 ("SFAS 141"), "Business Combinations," and No. 142 ("SFAS
142"), "Goodwill and Other Intangible Assets." SFAS 141 required that all
business combinations initiated after September 30, 2001 be accounted for under
a single method-the purchase method. Use of the pooling-of-interests method is
no longer permitted. SFAS 142 requires that goodwill no longer be amortized to
earnings, but instead be reviewed for impairment upon initial adoption of
goodwill will cease upon adoption of SFAS 142. The provisions of SFAS 142 will
be effective for fiscal years beginning after December 15, 2001. We believe
that the adoption of these standards will not have a material impact on our
financial statements.
In October 2001, the FASB issued Statement of Financial Accounting
Standards No. 144 ("SFAS 144"), "Accounting for the Impairment or Disposal of
Long-Lived Assets," which is effective for fiscal years beginning after December
15, 2001 and interim periods within those fiscal periods. SFAS 144 supersedes
FASB Statement No. 121 and APB Opinion No. 30, however, it retains the
requirement of Opinion No. 30 to report discontinued operations separately from
continuing operations and extends that reporting for the impairment of certain
long-lived assets and for long-lived assets to be disposed of. We believe that
SFAS 144 will not have a material impact on our financial position or results of
operations.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Our exposure to market risk for changes in interest rates relates primarily
to our investment portfolio. We do not use derivative financial instruments in
our investment portfolio and conduct all transactions in U.S. dollars.
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.
The table below presents principal amounts and related weighted average
interest rates as of December 29, 2001 for our cash and cash equivalents and
short-term investments.
Cash, cash equivalents and short-term investments........ $68,169,000
Average interest rate...................... 3.8%
Long-term available-for-sale securities.................. $ 8,526,000
Average interest rate...................... 5.0%
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.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Certain information required by this Item is included in Item 6 of Part II
of this Report and is incorporated herein by reference. All other information
required by this Item is included on pages 34 to 57 in Item 14 of Part IV of
this Report and is incorporated herein by reference.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
PART III
ITEM 10. EXECUTIVE OFFICERS AND DIRECTORS OF THE REGISTRANT
Information regarding the Directors of ArthroCare is incorporated by
reference the information set forth under the caption "Proposal No. 1: Election
of Directors" in the 2002 Proxy Statement. Information regarding the executive
officers of the company is incorporated by reference to the information set
forth under the caption "Executive Officers of the Company" at the end of Part I
of our Proxy Statement. Information with respect to Directors and Officers of
the Company required by Item 405 of Regulation S-K is set forth under the
caption "Disclosure with Regard to Delinquent Filings" which is incorporated by
reference to our Proxy Statement captioned "Section 16(a) Reports."
ITEM 11. EXECUTIVE COMPENSATION
30
The information required by this item is incorporated by reference from the
discussion in the 2002 Proxy Statement captioned "Executive Compensation."
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by this item is incorporated by reference from the
discussion in the 2002 Proxy Statement captioned "Share Ownership of Directors,
Officers and Certain Beneficial Owners."
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this item is incorporated by reference from the
discussion in the 2002 Proxy Statement captioned "Certain Transactions."
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENTS SCHEDULES AND REPORTS ON FORM 8-K
(a) The following documents are filed as part of this Report.
1. FINANCIAL STATEMENTS. The following financial statements of the company and
the Report of Independent Accountants, are included in Part IV of this Report
on the pages indicated.
PAGE
----
Report of Independent Accountants on financial statements and supplemental schedule................................... 34
Consolidated Balance Sheets as of December 31, 2001 and December 31, 2000............................................. 35
Consolidated Statements of Operations for the years ended December 31, 2001, 2000 and 1999............................ 36
Consolidated Statements of Stockholders' Equity for the years ended December 31, 2001, 2000 and 1999..................
37
Consolidated Statements of Cash Flows for the years ended December 31, 2001, December 31, 2000 and
December 31, 1999..................................................................................................... 38
Notes to the Consolidated Financial Statements........................................................................ 39
2. FINANCIAL STATEMENT SCHEDULE. The following financial statement schedule of
the company as of and for the years ended December 31, 2001, 2000 and 1999, is
included in Part IV of this Report on the pages indicated. This financial
statement schedule should be read in conjunction with the Financial Statements,
and notes thereto, of the company.
SCHEDULE TITLE PAGE
-------- ----- ----
II Valuation and Qualifying Accounts 49
Schedules not listed above have been omitted because they are not applicable,
not required, or the information required to be set forth therein is included in
the Financial Statements or notes thereto.
3. EXHIBITS (in accordance with Item 601 of Regulation S-K).
3.1 Restated Certificate of Incorporation of the Registrant.
3.2 Amended and Restated By laws of the Registrant. (Incorporated
herein by reference to the same-numbered exhibit filed
previously with the Registrant's Quarterly Report on Form 10-Q
for the period ended October 3, 1998).
4.1 Specimen Common Stock Certificate. (Incorporated herein by
reference to the same-numbered exhibit filed previously with
the Registrant's Registration Statement on Form 8-A
(Registration No. 000-27422)).
10.1 Form of Indemnification Agreement between the Registrant and
each of its directors and officers. (Incorporated herein by
reference to the same-numbered exhibit filed previously with
the Registrant's Registration Statement on Form S-1
(Registration No. 33-80453)).
10.2 Incentive Stock Plan and form of Stock Option Agreement
thereunder. (Incorporated herein by reference to the same-
numbered exhibit filed previously with the Registrant's
Registration Statement on Form S-1 (Registration No.33-80453)).
10.3 Director Option Plan and form of Director Stock Option
Agreement thereunder. (Incorporated herein by reference to the
same-numbered exhibit filed previously with the
31
Registrant's Registration Statement on Form S-1 (Registration No.
33-80453)).
10.4 Employee Stock Purchase Plan and forms of agreements thereunder.
(Incorporated herein by reference to the same-numbered exhibit
filed previously with the Registrant's Registration Statement on
Form S-1 (Registration No. 33-80453)).
10.5 Form of Exclusive Distribution Agreement. (Incorporated herein by
reference to the same-numbered exhibit filed previously with our
Registration Statement on Form S-1 (Registration No. 33-80453)
10.6 Form of Exclusive Sales Representative Agreement. (Incorporated
herein by reference to the same-numbered exhibit filed previously
with the Registrant's Registration Statement on Form S-1
(Registration No. 33-80453)).
10.7 Consulting Agreement, dated May 10, 1993, between the Registrant
and Philip E. Eggers, and amendment thereto. (Incorporated herein
by reference to the same-numbered exhibit filed previously with
the Registrant's Registration Statement on Form S-1 (Registration
No. 33-80453)).
10.8 Consulting Agreement, dated May 20, 1993, between the Registrant
and Eggers & Associates, Inc., and amendment thereto.
(Incorporated herein by reference to the same-numbered exhibit
filed previously with the Registrant's Registration Statement on
Form S-1 (Registration No. 33-80453)).
10.9 Lease Agreement, dated September 15, 1994, between Registrant and
The Arrillaga Foundation and the Perry Foundation for the
Registrant's facility located at 595 North Pastoria Avenue,
Sunnyvale, California 94086. (Incorporated herein by reference to
Exhibit 10.10 filed previously with the Registrant's Registration
Statement on Form S-1 (Registration No. 33-80453)).
10.10 Employment Letter Agreement, dated July 18, 1995, between the
Registrant and Robert T. Hagan. (Incorporated herein by reference
to Exhibit 10.16 filed previously with the Registrant's
Registration Statement on Form S-1 (Registration No. 33-80453)).
10.11 Restricted Stock Purchase and Security Agreement, dated August 1,
1995, between the Registrant and Robert T. Hagan. (Incorporated
herein by reference to Exhibit 10.17 filed previously with the
Registrant's Registration Statement on Form S-1 (Registration No.
33-80453)).
10.12+ Radiation Services Agreement, dated September 13, 1995, between
the Registrant and SteriGenics International. (Incorporated
herein by reference to Exhibit 10.19 filed previously with the
Registrant's Registration Statement on Form S-1 (Registration No.
33-80453)).
10.13 Amended and Restated Stockholder Rights Agreement, dated October
16, 1995, between the Registrant and certain holders of the
Registrant's securities. (Incorporated herein by reference to
Exhibit 10.20 filed previously with the Registrant's Registration
Statement on Form S-1 (Registration No. 33-80453)).
10.14 Contribution Agreement, dated March 31, 1995, by and among Philip
E. Eggers, Robert S. Garvie, Anthony J. Manlove, Hira V.
Thapliyal and the Registrant. (Incorporated herein by reference
to Exhibit 10.21 filed previously with the Registrant's
Registration Statement on Form S-1 (Registration No. 33-80453)).
10.15 Amended and Restated Stockholder Rights Agreement, dated October
2, 1998, between the Registrant and Norwest Bank Minnesota, N.A.
(Incorporated herein by reference to Exhibit 10.20 filed
previously with the Registrant's Registration Statement on Form
8-A filed October 21, 1998 (Registration No. 000-27422)).
10.16 Exclusive Distributor Agreement, dated April 15, 1997, between
the Registrant and Arthrex, GmbH. and Amendment dated October 2,
1998. (Incorporated herein by reference to Exhibit 10.20 filed
previously with the Registrant's Quarterly Report on Form 10-Q
for the period ended April 3, 1999).
10.17 Employment Letter Agreement, dated June 20, 1997, between the
Registrant and Michael A. Baker. (Incorporated herein by
reference to Exhibit 10.24 filed previously with the Registrant's
Quarterly Report on Form 10-Q for the period ended June 28,
1997).
10.18+ Exclusive Distributor Agreement, dated August 21, 1997, between
the Registrant and Kobayashi Pharmaceutical Company, Ltd.
(Incorporated herein by reference to Exhibit 10.25 filed
previously with the Registrant's Quarterly Report on Form 10-Q
for the period ended September 27, 1997).
10.19+ License Agreement dated February 9, 1998, between the Registrant
and Boston Scientific Corporation. (Incorporated herein by
reference to Exhibit 10.26 filed previously with the Registrant's
Annual Report on Form 10-K for the period ended January 3, 1998).
10.20+ Development and Supply Agreement dated February 9, 1998, between
the Registrant and
32
Boston Scientific Corporation. (Incorporated herein by
reference to Exhibit 10.27 filed previously with the
Registrant's Annual Report on Form 10-K for the period ended
January 3, 1998).
10.21 Lease Agreement date March 25, 1998 between the Registrant
and Aetna Life Insurance Company for the Registrant's
facility located at 840 Del Rey Avenue, Sunnyvale,
California 94086. (Incorporated herein by reference to
Exhibit 10.28 filed previously with the Registrant's Annual
Report on Form 10-K for the period ended January 3, 1998).
10.22+ Term sheet for License and Distribution Agreement between
Xomed Surgical Products and the Registrant dated June 25,
1998. (Incorporated herein by reference to Exhibit 10.29
filed previously with the Registrant's Quarterly Report on
Form 10-Q for the period ended October 3, 1998).
10.23+ License Agreement dated February 9, 1999 between the
Registrant and Collagen Aesthetics. (Incorporated herein by
reference to Exhibit 10.27 filed previously with the
Registrant's Annual Report on Form 10-K for the period ended
January 2, 1999).
10.24 Change of Control Agreement between the Registrant and the
CEO. (Incorporated herein by reference to Exhibit 10.28
filed previously with the Registrant's Annual Report on Form
10-K for the period ended January 2, 1999).
10.25 The Form of "VP Continuity Agreement" between the Registrant
and its Vice Presidents. (Incorporated herein by reference
to Exhibit 10.29 filed previously with the Registrant's
Annual Report on Form 10-K for the period ended January 2,
1999).
10.26 Letter Agreement dated February 9, 1999 between the
Registrant and Collagen Aesthetics. (Incorporated herein by
reference to Exhibit 10.30 filed previously with the
Registrant's Annual Report on Form 10-K/A for the period
ended January 2, 1999).
10.27 Employment Letter Agreement, between the Registrant and John
R. Tighe dated January 26,1999. (Incorporated herein by
reference to Exhibit 10.30 filed previously with the
Registrant's Quarterly Report on Form 10-Q for the period
ended April 3, 1999).
10.28 Employment Letter Agreement, between the Registrant and
Christine Hanni amended May 19, 1999. (Incorporated herein
by reference to Exhibit 10.31 filed previously with the
Registrant's Quarterly Report on Form 10-Q for the period
ended April 3, 1999).
10.29 Employment Letter Agreement, between the Registrant and
Bruce P. Prothro amended May 19, 1999. (Incorporated herein
by reference to Exhibit 10.32 filed previously with the
Registrant's Quarterly Report on Form 10-Q for the period
ended April 3, 1999).
10.30+ Litigation Settlement Agreement, between the Registrant and
ETHICON Inc. dated June 24, 1999 (Incorporated herein by
reference to Exhibit 10.33 previously filed with the
Registrant's Quarterly Report on Form 10-Q for the period
ended July 3, 1999).
10.31 Relocation Loan Agreement, between the Registrant and John
R. Tighe dated May 1, 1999. (Incorporated herein by
reference to Exhibit 10.34 previously filed with the
Registrant's Quarterly Report on Form 10-Q for the period
ended July 3, 1999).
10.32 Line of Credit Agreement with Silicon Valley Bank dated June
11, 1999 filed herewith. Incorporated herein by reference to
Exhibit 10.35 previously filed with the Registrant's
Quarterly Report on Form 10-Q for the period ended July 3,
1999.)
10.33+ Amendment to License Agreement between ArthroCare
Corporation and Inamed Corporation
dated October 1, 1999. (Incorporated herein by reference to
Exhibit 10.33 previously filed with the Registrant's
Registration Statement on Form S-3. (Registration No.
333-87187))
10.34 First Amendment to Rights Agreement between the ArthroCare
Corporation and Norwest Bank Minnesota, N.A. (the "Rights
Agent") dated March 10, 2000. (Incorporated herein by
reference to Exhibit 99.1 previously file with the
Registrant's Form 8-K filed March 10, 2000.)
10.35 Nonstatuatory Stock Option Plan and form of Stock Option
Agreement thereunder. (Incorporated herein by reference to
the same-numbered exhibit filed previously with this the
Registrant's Quarterly Report on Form 10-K for the period
ended December 31, 1999.)
10.36 License Agreement between ArthroCare Corporation and Stryker
Corporation, dated June 28, 2000. (Incorporated herein by
reference to the same-numbered exhibit filed previously with
the Registrant's Annual Report on Form 10-Q for the period
ended July 1, 2000.)
10.37 Change of control Agreement between the Registrant and
Michael Baker, CEO, dated September 25, 2001. (Incorporated
herein by reference to the same - numbered exhibit filed
previously with the Registrant's Quarterly on form 10-Q for
the period ended September 29, 2001.
33
21.1 Subsidiaries of the Registrant.
23.1 Consent of PricewaterhouseCoopers LLP, Independent Accountants
24.1 Power of Attorney (see Page xx).
(a) Confidential treatment granted.
(b) Reports on Form 8-K
(c) None
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Stockholders of ArthroCare Corporation:
In our opinion, the consolidated financial statements listed in the
accompanying index appearing under Item 14(a) 1 on page 31 present fairly, in
all material respects, the financial position of ArthroCare Corporation and its
subsidiaries (the "Company") at December 31, 2001 and 2000, and the results of
their operations and their cash flows for each of the three years in the period
ended December 31, 2001, in conformity with accounting principles generally
accepted in the United States of America. In addition, in our opinion, the
financial statement schedule in the accompanying index appearing under Item
14(a) 2 on page 34 presents fairly, in all material respects, the information
set forth therein when read in conjunction with the related consolidated
financial statements. These financial statements and financial statement
schedule are the responsibility of the Company's management; our responsibility
is to express an opinion on these financial statements and financial statement
schedule based on our audits. We conducted our audits of these statements in
accordance with auditing standards generally accepted in the United States of
America, which require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements, assessing the
accounting principles used and significant estimates made by management, and
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.
/s/ PricewaterhouseCoopers LLP
San Jose, California
January 25, 2002
34
ARTHROCARE CORPORATION
CONSOLIDATED BALANCE SHEETS
(in thousands, except per share data)
December 31
-------------------
2001 2000
------- -------
ASSETS
Current assets:
Cash and cash equivalents $ 41,507 $ 35,782
Available-for-sale securities 26,662 32,256
Accounts receivable, net of allowances
of $776 in 2001 and $560 in 2000 18,567 16,209
Inventories 14,207 13,702
Deferred tax asset 4,079 6,744
Prepaid expenses and other current assets 2,171 1,679
--------- ---------
Total current assets 107,193 106,372
Available-for-sale securities 8,526 18,776
Property and equipment, net 13,068 9,469
Related party receivables 1,205 1,205
Deferred tax asset 3,415 4,398
Other assets 290 242
--------- ---------
Total assets $ 133,697 $ 140,462
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 3,142 $ 3,985
Accrued liabilities 1,111 1,629
Accrued compensation 3,837 2,860
Income taxes payable 461 --
Deferred revenue -- 825
Capital lease obligation, current portion -- 60
--------- ---------
Total current liabilities 8,551 9,359
Capital lease obligation, less current portion 22
Deferred rent 53 85
Deferred revenue -- 4,651
--------- ---------
Total liabilities 8,604 14,117
Commitments and contingencies: (Note 5)
Preferred stock, par value $0.001:
Authorized: 5,000 shares;
Issued and outstanding: none -- --
Common stock, par value $0.001:
Authorized: 75,000 shares;
Issued and outstanding: 21,855 shares in 2001 and 22,216 shares in 2000 22 22
Treasury stock: 951 shares in 2001, none in 2000 (18,987) --
Additional paid-in capital 146,081 137,302
Accumulated other comprehensive loss (1,724) (620)
Accumulated deficit (299) (10,359)
--------- ---------
Total stockholders' equity 125,093 126,345
--------- ---------
Total liabilities and stockholders' equity $ 133,697 $ 140,462
========= =========
The accompanying notes are an integral part of these consolidated
financial statements.
35
ARTHROCARE CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
Year Ended December 31,
-------------------------------------
2001 2000 1999
----------- ----------- -----------
Revenues:
Product sales $ 75,247 $ 64,012 $ 44,219
Royalties, fees and other 8,075 3,615 4,857
--------- --------- ---------
Total revenues 83,322 67,627 49,076
Cost of product sales 27,691 25,662 19,185
--------- --------- ---------
Gross profit 55,631 41,965 29,891
--------- --------- ---------
Operating expenses:
Research and development 8,036 7,145 4,929
Sales and marketing 34,599 22,472 15,493
General and administrative 5,306 4,850 4,820
--------- --------- ---------
Total operating expenses 47,941 34,467 25,242
--------- --------- ---------
Income from operations 7,690 7,498 4,649
Interest income 3,434 4,845
Interest expense (53) -- 1,156
Other income (expense) 4,666 58 (22)
--------- --------- ---------
Income before income taxes 15,737 12,401 5,774
Income tax provision/(benefit) 5,677 (3,444) 231
--------- --------- ---------
Net income before cumulative effect of a
change in accounting principle 10,060 15,845 5,543
Cumulative effect on prior years of the
adoption of SAB101 "Revenue Recognition
In Financial Statements" -- (4,300) --
--------- --------- ---------
Net income $ 10,060 $ 11,545 $ 5,543
========= ========= =========
Net income per share--basic:
Net income per share before cumulative
effect of a change in accounting
principle $ 0.45 $ 0.72 $ 0.29
Cumulative effect on prior years of the
adoption of SAB 101 "Revenue
Recognition in Financial Statements" -- (0.19) --
--------- --------- ---------
Basic net income per share $ 0.45 $ 0.53 $ 0.29
========= ========= =========
Shares used in computing basic net income
per common share 22,222 21,923 18,920
Net income per share--diluted:
Net income per share before cumulative
effect of a change in accounting
principle $ 0.43 $ 0.68 $ 0.27
Cumulative effect on prior years of the
adoption of SAB 101 "Revenue
Recognition in Financial Statements" -- (0.18) --
--------- --------- ---------
Diluted net income per common share $ 0.43 $ 0.50 $ 0.27
========= ========= =========
Shares used in computing diluted income
per common share 23,182 23,167 20,474
The accompanying notes are an integral part of these
consolidated financial statements.
36
ARTHROCARE CORPORATION
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(in thousands, except per share data)
Notes
Common Common Treasury Additional Receivable
Stock Stock Stock Paid-In from Deferred
Shares Amount Amount Capital Stockholders Compensation
------ ------ ------ ------- ------------ -------------
BALANCES, DECEMBER 31, 1998 17,945,936 18 $ -- $ 49,892 $ (51) $ (68)
Issuance of common stock through:
Secondary offering at $28.00 per share
net of issuance costs of $5,165 2,737,000 3 -- 71,468 -- --
Exercise of options 671,220 -- -- 3,626 (273) --
Employee stock purchase plan 27,814 -- -- 204 -- --
Amortization of deferred compensation -- -- -- -- -- 68
Repayment of notes receivable from
stockholder -- -- -- -- 51 --
Change in unrealized gain on
available-for sale securities -- -- -- -- -- --
Currency translation adjustment -- -- -- -- -- --
Net income -- -- -- -- -- --
----------- -------- ---------- ------------ -------- ------------
BALANCES, DECEMBER 31, 1999 21,381,970 21 -- 125,190 (273) --
----------- -------- ---------- ------------ -------- ------------
Issuance of common stock through:
Exercise of options 790,857 1 -- 4,632 -- --
Employee stock purchase plan 17,750 -- -- 398 -- --
Employee bonus 6,048 -- -- 163 -- --
Restricted stock expense 19,000 -- -- 428 -- --
Stock compensation -- -- -- 246 -- --
Income tax benefit resulting
from exercise of stock options -- -- -- 6,245 -- --
Repayment of notes receivable from
stockholder -- -- -- -- 273 --
Change in unrealized gain on available-
for-sale securities -- -- -- -- -- --
Currency translation adjustment -- -- -- -- -- --
Net income -- -- -- -- -- --
----------- -------- ---------- ------------ -------- ------------
BALANCES, DECEMBER 31, 2000 22,215,625 22 -- 137,302 -- --
----------- -------- ---------- ------------ -------- ------------
Issuance of common stock through:
Exercise of options 558,883 -- -- 4,961 -- --
Employee stock purchase plan 30,053 -- -- 493 -- --
Employee bonus 1,063 -- -- 21 -- --
Restricted stock expense -- -- -- 232 -- --
Stock compensation -- -- -- 268 -- --
Income tax benefit resulting
from exercise of stock options -- -- -- 2,804 -- --
Change in unrealized gain on available
for-sale securities -- -- -- -- -- --
Currency translation adjustment -- -- -- -- -- --
Purchase of common stock (951,000) -- (18,987) -- -- --
Net income -- -- -- -- -- --
----------- -------- ---------- ------------ -------- ------------
BALANCES, DECEMBER 31, 2001 21,854,624 22 $ (18,987) $ 146,081 $ -- $ --
=========== ======== ========== ============ ======== ============
Accumulated
Other Total
Comprehensive Accumulated Stock holders' Comprehensive
Income/(loss) Deficit Equity Income/(loss)
------------ ------- ------ -------------
BALANCES, DECEMBER 31, 1998 $ (39) $ (27,447) $ 22,305 $ (2,190)
Issuance of common stock through:
Secondary offering at $56.00 per share
net of issuance costs of $5,165 -- -- 71,471 --
Exercise of options -- -- 3,353 --
Employee stock purchase plan -- -- 204 --
Amortization of deferred compensation -- -- 68 --
Repayment of notes receivable from
stockholder -- -- 51 --
Change in unrealized gain on
available-for sale securities (33) -- (33) (33)
Currency translation adjustment (79) -- (79) (79)
Net income -- 5,543 5,543 5,543
---------- ---------- ---------- ---------
BALANCES, DECEMBER 31, 1999 (151) (21,904) 102,883 5,431
---------- ---------- ---------- ---------
Issuance of common stock through:
Exercise of options -- -- 4,633 --
Employee stock purchase plan -- -- 398 --
Employee bonus -- -- 163 --
Restricted stock expense -- -- 428 --
Stock compensation -- -- 246 --
Income tax benefit resulting
from exercise of stock options -- -- 6,245 --
Repayment of notes receivable from
stockholder -- -- 273 --
Change in unrealized gain on available
for-sale securities (160) -- (160) (160)
Currency translation adjustment (309) -- (309) (309)
Net income -- 11,545 11,545 11,545
---------- ---------- ---------- ---------
BALANCES, DECEMBER 31, 2000 (620) (10,359) 126,345 11,076
---------- ---------- ---------- ---------
Issuance of common stock through:
Exercise of options -- -- 4,961 --
Employee stock purchase plan -- -- 493 --
Employee bonus -- -- 21 --
Restricted stock expense -- -- 232 --
Stock compensation -- -- 268 --
Income tax benefit resulting
from exercise of stock options -- -- 2,804 --
Change in unrealized gain on available
for-sale securities 308 -- 308 308
Currency translation adjustment (1,412) -- (1,412) (1,412)
Purchase of common stock -- -- (18,987) --
Net income -- 10,060 10,060 10,060
---------- ---------- ---------- ---------
BALANCES, DECEMBER 31, 2001 $ (1,724) $ (299) $ 125,093 $ 8,956
========== ========== ========== =========
The accompanying notes are an integral part of these consolidated financial
statements.
37
ARTHROCARE CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
Year Ended December 31,
--------------------------------------
2001 2000 1999
-------- -------- --------
Cash flows from operating activities:
Net income $ 10,060 $ 11,545 $ 5,543
Adjustments to reconcile net income to net cash provided by
operating activities:
Depreciation and amortization 5,752 4,136 2,415
Provision for doubtful accounts receivable and product returns 216 (123) 214
Provision for excess and obsolete inventory (323) (390) 740
Loss on disposal of property and equipment -- -- 74
Non cash stock compensation expense 500 674 68
Issuance of common stock for employee bonuses 21 163 --
Income tax benefit relating to employee stock options 2,804 6,245 --
Deferred rent (32) (49) (6)
Changes in operating assets and liabilities:
Accounts receivable (3,238) (2,169) (8,159)
Inventories (330) (6,352) (631)
Deferred tax asset 3,648 (11,142) --
Prepaid expenses and other current assets (597) (960) 319
Accounts payable (1,002) 1,055 1,133
Accrued liabilities 459 566 1,133
Income taxes payable 461 -- --
Deferred revenue (5,476) 5,454 (495)
Other assets (48) 23 75
-------- -------- --------
Net cash provided by operating activities 12,875 8,676 2,423
-------- -------- --------
Cash flows from investing activities:
Purchases of property and equipment (9,351) (6,239) (5,295)
Purchases of available-for-sale securities (62,931) (65,148) (29,084)
Sales or maturities of available-for-sale securities 79,083 45,688 2,551
-------- -------- --------
Net cash provided by (used in) investing activities 6,801 (25,699) (31,828)
-------- -------- --------
Cash flows from financing activities:
Issuance of notes receivable to related parties -- -- (848)
Purchase of treasury stock (18,987) -- --
Repayment of capital leases (82) (65) (64)
Repayment of notes receivable from related parties -- -- 93
Repayment of notes receivable from stockholder -- 273 51
Proceeds from issuance of common stock net of issuance costs 493 398 71,675
Proceeds from exercise of options to purchase common stock 4,961 4,633 3,626
-------- -------- --------
Net cash provided by (used in) financing activities (13,615) 5,239 74,533
-------- -------- --------
Effect of exchange rate on changes in cash (336) (309) (79)
-------- -------- --------
Net increase (decrease) in cash and cash equivalents 5,725 (12,093) 45,049
Cash and cash equivalents, beginning of year 35,782 47,875 2,826
-------- -------- --------
Cash and cash equivalents, end of year $ 41,507 $ 35,782 $ 47,875
======== ======== ========
Supplemental disclosure of cash flow information:
Cash paid for interest 13 10 23
Cash paid for income tax 95 300 93
The accompanying notes are an integral part of these consolidated financial
statements.
38
ARTHROCARE CORPORATION
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
1. FORMATION AND BUSINESS OF THE COMPANY:
ArthroCare Corporation ("we" or the "company") was incorporated on April 29,
1993. We design, develop, manufacture and market medical devices for use in
soft-tissue surgery. Our principal operations commenced in August 1995, at which
time we emerged from the development stage.
We sold 5,060,000 shares of common stock (including 660,000 shares from the
exercise of the underwriter's over-allotment option) at $7.00 per share through
an initial public offering in February 1996. Net proceeds (after underwriter's
commissions and fees along with other costs associated with the offering)
totaled $31,857,000. Upon completion of the offering, all outstanding shares of
preferred stock (a total of 17,356,000 shares) were converted into shares of
common stock on a two-for-one basis.
In October and November 1999, we sold 2,737,000 shares of common stock at
$28.00 per share through a secondary offering. The net proceeds from this
offering (after underwriter's commissions and fees along with other costs
associated with the offering) totaled $71,471,000.
We intend to finance operations primarily through cash, cash equivalents and
available-for-sale securities, together with future product sales. There can be
no assurance that the company will not require additional funding or that such
funding will be available on acceptable terms, if at all.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:
Basis of Presentation. We maintain a fifty-two/fifty-three week fiscal year
cycle ending on a Saturday. To conform our fiscal year ends, we must add a
fifty-third week to every fifth or sixth fiscal year. Fiscal 2001, 2000 and 1999
were fifty-two week years. For presentation purposes all year end dates in the
accompanying consolidated financial statements are shown as December 31.
Use of Estimates. The preparation of financial statements in conformity with
accounting principles generally accepted in the United States of America
requires management to make estimates and assumptions that affect the reported
amounts in the financial statements and accompanying notes. Actual results could
differ from those estimates.
Principles of Consolidation. The consolidated financial statements include
the accounts of ArthroCare and all of its wholly-owned subsidiaries. All
significant inter-company transactions and accounts have been eliminated.
Cash and Cash Equivalents and Available-for-Sale Securities. We consider all
highly liquid investments purchased with original maturities of ninety days or
less to be cash equivalents. Cash and cash equivalents include money market
funds and various deposit accounts.
We have classified our investments as "available-for-sale." Such
investments are recorded at fair value and unrealized gains and losses are
recorded as a separate component of equity until realized. Interest income is
recorded using an effective interest rate, with the associated premium or
discount amortized to "interest income". Realized gains and losses, if any, are
determined using the specific identification method.
Inventories. Our inventories are stated at the lower-of-cost-or-market, with
cost determined on a first-in, first-out basis.
Property and Equipment. Property and equipment, including equipment under
capital leases, is stated at cost and is depreciated on a straight-line basis
over the estimated useful lives of three to five years. We place the majority of
our controller units with customers in order to facilitate the sale of
disposable devices. Controller units placed with customers are capitalized at
cost and amortized over a three-year period to cost of goods sold. Leasehold
improvements are amortized over the shorter of the estimated useful lives or the
lease term. Maintenance and repair costs are charged to operations as incurred.
Revenue Recognition. We recognize revenue upon shipment of our products to
customers, upon fulfillment of acceptance terms, if any, when no significant
contractual obligations remain and collection of the related receivable is
reasonably assured. Revenue is reported net of a provision for estimated product
returns. Revenue related to collaborative research and development contracts is
recognized as the related work is performed. 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.
39
Amounts billed to customers relating to shipping and handling costs have
been classified as Royalties, fees and other revenues and related costs are
classified as cost of product sales on the accompanying statement of operations.
We previously recognized non-refundable license fee and milestone revenue
when the fee was received or on completion of certain milestones. During the
quarter ended September 30, 2000, effective January 1, 2000, we adopted SEC
Staff Accounting Bulletin No. 101 "Revenue Recognition in Financial Statements"
(SAB 101) and changed our method of accounting for license fees and milestones
to recognize such revenues 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. Amounts received
prior to revenue recognition are recorded as deferred revenue. The cumulative
effect of the change in accounting principle of $4.3 million (or $0.19 and $0.18
per share basic and diluted, respectively) was reported as a cumulative effect
of a change in accounting principle, retroactive to January 2, 2000. Prior
period amounts have not been restated in the accompanying statement of
operations. The cumulative effect of the change in accounting principle includes
license fee revenues and deferred revenues that were recognized over the lives
of the associated agreements.
Reclassification. Certain amounts in the prior financial statements have
been reclassified to conform to the current year presentation. These
reclassifications did not impact previously reported total assets, liabilities,
stockholders' equity or net income.
Research and Development. Research and development costs are charged to
operations as incurred.
Stock-based Compensation. We have adopted the proforma disclosure provisions
of Statement of Financial Accounting Standard (SFAS) No. 123, "Accounting for
Stock-Based Compensation". The proforma disclosures are presented in Note 7. As
permitted, we continue to account for stock-based compensation using the
intrinsic value method as prescribed by Accounting Principles Board Opinion
(APB) No. 25, "Accounting for Stock Issued to Employees." We account for stock
options issued to non-employees in accordance with the provisions of SFAS No.
123 and EITF 96-18, "Accounting for Equity Instruments That Are Issued to Other
Than Employees for Acquiring, or in Conjunction with Selling, Goods or
Services."
Foreign Currency Translation. The functional currency of each foreign
subsidiary is its local currency. Essentially all foreign assets and liabilities
are translated into U.S. dollars at year-end exchange rates, while elements of
the income statement are translated at average exchange rates in effect during
the year. Foreign currency transaction gains and losses are included in the
consolidated statement of operations. Adjustments arising from the translation
of net assets located outside the United States (gains and losses) are recorded
as a component of shareholders' equity.
Concentration of Risks and Uncertainties. Substantially all of our cash and
cash equivalents are maintained at financial institutions in the United States.
Deposits at these institutions may exceed the amount of insurance provided on
such deposits. We have not experienced any losses on our deposits of cash and
cash equivalents.
Our Sunnyvale facility currently accounts for all product manufacturing.
Disruption of operations at our production facility could cause delays in, or an
interruption of, production and shipment of products which could have a material
adverse impact on our business, operating results and financial condition.
We purchase certain key components of our products, from sole, single or
limited source suppliers. For some of these components there are few alternative
sources. A reduction or stoppage in supply of sole-source components would limit
our ability to manufacture certain products. There can be no assurance that an
alternate supplier could be established if necessary or that available
inventories would be adequate to meet our production needs during any prolonged
interruption of supply.
Our products require approval from the United States Food and Drug
Administration (FDA) and international regulatory agencies prior to the
commencement of commercial sales. There can be no assurance that our products
will receive any of these required approvals. If we were denied such approvals,
or if such approvals were delayed, it would have a material adverse impact on
our business.
Sales to both international and domestic customers are generally made on
open credit terms. Management performs ongoing credit evaluations of the
company's customers and maintains an allowance for potential credit losses when
needed but historically has not experienced any significant losses related to
individual customers or a group of customers in any particular geographic area.
See Note 11 for further discussion of export sales.
Fair Value of Financial Instruments. The carrying value of our financial
instruments approximate fair value.
Income Taxes. We account for income taxes under SFAS No. 109, "Accounting
for Income Taxes," which prescribes the use of the liability method whereby
deferred tax asset or liability account balances are calculated at the balance
sheet date using current tax laws and
40
rates in effect for the year in which the differences are expected to affect
taxable income. Valuation allowances are established when necessary to reduce
deferred tax assets to the amounts expected to be realized.
Computation of Net Income per Common 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
earnings per share (in thousands, except per share data):
Year Ended December 31,
-----------------------
2001 2000 1999
---- ---- ----
Basic:
Net income before cumulative effect of a change in accounting
principle $ 10,060 $ 15,845 $ 5,543
Cumulative effect on prior years of the change in accounting
principle -- (4,300) --
-------- -------- --------
Net income $ 10,060 $ 11,545 $ 5,543
======== ======== ========
Weighted average common shares outstanding 22,222 21,923 18,920
======== ======== ========
Net income per share before cumulative effect of a change
in accounting principle $ 0.45 $ 0.73 $ 0.29
======== ======== ========
Net income per share $ 0.45 $ 0.53 $ 0.29
======== ======== ========
Diluted:
Net income before cumulative effect of a change in accounting
principle $ 10,060 $ 15,845 $ 5,543
Cumulative effect on prior years of the change in accounting
principle -- (4,300) --
-------- -------- --------
Net income $ 10,060 $ 11,545 $ 5,543
======== ======== ========
Weighted average common shares outstanding 22,222 21,923 18,920
Options to purchase common stock 883 1,174 1,356
Warrants 77 70 198
-------- -------- --------
Total weighted common stock and common stock equivalents 23,182 23,167 20,474
======== ======== ========
Net income per share before cumulative effect of a change
in accounting principle $ 0.43 $ 0.68 $ 0.27
======== ======== ========
Net income per share $ 0.43 $ 0.50 $ 0.27
======== ======== ========
Antidilutive securities:
Options to purchase common stock 397 41 32
======== ======== ========
Recent Accounting Pronouncements.
In November 2001, the Financial Accounting Standards Board ("FASB")
Emerging Task Force (EITF) reached a consensus on EITF Issue 01-09, Accounting
for Consideration Given by a Vendor to a Customer or a Reseller of the Vendor's
Products, which is codification of EITF 00-14, 00-22 and 00-25. This issue
presumes that consideration from a vendor to a customer or reseller of the
vendor's products should be characterized as a reduction of revenue when
recognized in the vendor's income statement. Revenue reduction is required
unless consideration relates to a separate identifiable benefit and the
benefit's fair value can be established. This issue is effective for our first
quarter ended March 31, 2002. Upon adoption we are required to reclassify all
prior period amounts to conform to the current period presentation. We are
currently evaluating the effects of these changes and while the net income
previously included in our consolidated financial statements will not change we
may be required to reclassify certain commissions from operating expenses to
revenue.
In July 2001, the FASB issued Statements of Financial Accounting Standards
No. 141 ("SFAS 141"), "Business Combinations," and No. 142 ("SFAS 142"),
"Goodwill and Other Intangible Assets." SFAS 141 required that all business
combinations initiated after June 30, 2001 be accounted for under a single
method-the purchase method. Use of the pooling-of-interests method is no longer
permitted. SFAS 142 requires that goodwill no longer be amortized to earnings,
but instead be reviewed for impairment upon initial adoption of goodwill and
will cease upon adoption of SFAS 142. The provisions of SFAS 142 will be
effective for fiscal years beginning after December 15, 2001. We believe that
the adoption of these standards will not have a material impact on our financial
statements.
41
In October 2001, the FASB issued Statement of Financial Accounting
Standards No. 144 ("SFAS 144"), "Accounting for the Impairment or Disposal of
Long-Lived Assets", which is effective for fiscal years beginning after December
15, 2001 and interim periods within those fiscal periods. SFAS 144 supersedes
FASB Statement No. 121 and APB Opinion No. 30, however, it retains the
requirement of Opinion No. 30 to report discontinued operations separately from
continuing operations and extends that reporting for the impairment of certain
long-lived assets and for long-lived assets to be disposed of. We believe that
SFAS 144 will not have a material impact on our financial position or results of
operations of the Company.
3. AVAILABLE-FOR-SALE SECURITIES:
The following summarizes our available-for-sale securities at
December 31, (in thousands):
2001
----------------------------------------------------------------------------
Amortized Gross Gross Accrued Fair
Cost Unrealized Unrealized Interest Market
Gains Losses Value
----------------------------------------------------------------------------
Maturity date less than 1 year:
Government agencies $10,124 $ 49 $ -- $ -- $10,173
Corporate notes and bonds 16,483 12 (6) -- 16,489
Maturity date greater than 1 year:
Corporate securities 8,471 72 (17) -- 8,526
------- ------- ------- ------- -------
Total $35,078 $ 133 $ (23) $ -- $35,188
======= ======= ======= ======= =======
2000
----------------------------------------------------------------------------
Amortized Gross Gross Accrued Fair
Cost Unrealized Unrealized Interest Market
Gains Losses Value
---------------------------------------------------------------------------
Maturity date less than 1 year:
Commercial paper $26,737 $ 120 $ (7) $ -- $ 2685
Corporate notes and bonds 5,371 35 -- -- 5,406
Maturity date greater than 1 year:
Corporate securities 5,000 -- (458) -- 4,542
Corporate notes and bonds 14,090 112 -- 32 14,234
------- ------- ------- ------- -------
Total $51,198 $ 267 $ (465) $ 32 $51,032
======= ======= ======= ======= =======
Realized gains were $4.4 million and more in fiscal 2001 and 2000,
respectively.
4. BALANCE SHEET DETAIL:
December 31,
------------
(in thousands)
2001 2000
---- ----
Inventories:
Raw materials $ 5,678 $ 5,915
Work-in-process 2,692 3,278
Finished goods 5,837 4,509
------- -------
$14,207 $13,702
======= =======
42
Prepaid expenses and other current assets:
Prepaid supplies $ -- $ 525
Prepaid marketing fees -- 488
Prepaid insurance 285 74
Prepaid rent 428 15
Other 1,458 577
-------- --------
$ 2,171 $ 1,679
======== ========
Property and equipment:
Machinery and equipment $ 1,787 $ 1,759
Construction in Process 2,414 --
Tooling and molds 906 814
Computer equipment 4,189 2,829
Controller placements 17,315 11,781
Furniture and fixtures 386 381
Leasehold improvements 350 432
-------- --------
27,347 17,996
Less accumulated depreciation and
amortization (14,279) (8,527)
-------- --------
$ 13,068 $ 9,469
======== ========
Equipment acquired under capital leases
included in property and equipment above:
Machinery and equipment $ -- $ 109
Computer equipment 212 217
-------- --------
212 326
Less accumulated amortization (212) (241)
-------- --------
$ -- $ 85
======== ========
Accrued liabilities:
Accrued professional fees $ 103 $ 198
Accrued warranty 238 198
Other 770 1,233
-------- --------
$ 1,111 $ 1,629
======== ========
5. 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 December 31, 2001, total future minimum lease payments
are as follows (in thousands):
2002 $1,591
2003 1,553
2004 1,602
2005 1,653
2006 1,752
Thereafter 659
------
$8,810
======
Rent expense for the years ended December 31, 2001, 2000 and 1999 was
$1,155,000, $594,000, and $595,000, respectively.
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 Defendants use,
import, market and sell an electrosurgical system under the name Dyonics Control
RF System that infringes these patents. AthroCare seeks; (1) a judgment that the
Defendant has infringed these patents; (2) a permanent injunction precluding the
Defendant from using, importing, marketing and selling the Dyonics Control RF
System; and (3) an award of damages (including attorneys' fees) to compensate us
for lost profits and Defendant's use of our inventions, with the damages to be
trebled because of the Defendant's willful infringement.
In conjunction with a medial malpractice suit against a physician, a product
liability suit was brought against us in the Superior Court Arizona, county of
Yavapi on August 24, 2001. The lawsuit alleges that a patient, D. Earl suffered
internal and external injury to the patient's knee as a result of a defective
ArthroCare probe used in an arthrospopy procedure on the patient. ArthroCare
believes these claims to be without merit.
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. ArthroCare
believes Inamed's claims are without merit and, on October 10, 2001, ArthroCare
filed and Answer and Counter claim seeking damages for Inamed's breach of
contract.
7. STOCKHOLDERS' EQUITY:
Stock Split. In March 2000, our Board of Directors approved a two-for-one
stock split of our common stock, effective for stockholders of record as of June
19, 2000. Our common stock began trading on a post-split basis on July 5, 2000.
All references in the accompanying consolidated financial statements to the
number of common shares have been restated to give the effect to the stock
split.
Preferred Stock. Under our Certificate of Incorporation, we are authorized
to issue preferred stock. At December 31, 2001, 5,000,000 shares of preferred
stock were authorized and no preferred stock was issued and outstanding as the
previously outstanding preferred stock was converted into common stock in
connection with our initial public offering in 1996.
Treasury Stock. In April 2001, the Board of Directors authorized the
repurchase of up to 1,000,000 shares of our common stock, subject to certain
limitations and conditions. We repurchased 154,000 shares in the quarter ended
June 30, 2001 at a cost of $2.7 million, 647,000
43
shares in the quarter ended September 30, 2001 at a cost of $13.6 million, and
150,000 shares in the quarter ended December 31, 2001 at a cost of $2.7 million.
The shares will be used to offset the potentially dilutive effect of employee
incentive programs and may be used for other purposes that we deem appropriate.
Stock Option Plans. In May 1993, we approved the 1993 Stock Plan (1993
Plan) under which the Board of Directors is authorized and directed to enter
into stock option agreements with selected individuals. 272,000 shares were
authorized at the inception of the 1993 Plan with 500,000, and 2,300,050
additional shares authorized in 1994, and 1995, respectively. In May 1998, and
June 2000, our stockholders approved increases in the number of shares reserved
for issuance under the 1993 Plan by an aggregate of 1,500,000 and 800,000,
respectively, for a total of 5,372,050. Options granted under the 1993 Plan
generally become exercisable over a 48-month period. In August 1999, we granted
38,000 shares of restricted stock in accordance with the terms of the 1993 Plan,
which vested every six months over two years.
Activity under the 1993 Plan is as follows (in thousands):
Shares
Available Outstanding Options
----------------------------------
For Number Weighted-Average
Grant of Shares Exercise-Price
----------- -------------- ------------------
BALANCES, DECEMBER 31, 1998 1,120 2,863 $ 5.59
--------- ---------
Options granted (777) 777 $ 10.06
Options exercised -- (594) $ 4.24
Options canceled 172 (172) $ 7.02
--------- ---------
BALANCES, DECEMBER 31, 1999 515 2,874 $ 6.90
--------- ---------
Additional shares authorized 800 --
Options granted (352) 353 $ 21.47
Options exercised -- (730) $ 5.62
Options canceled 18 (18) $ 9.92
--------- ---------
BALANCES, DECEMBER 31, 2000 981 2,479 $ 9.45
--------- ---------
Options granted (400) 400 $ 27.75
Options exercised -- (402) $ 24.66
Options cancelled 46 (47) $ 8.76
--------- ---------
BALANCES, DECEMBER 31, 2001 627 2,430 $ 12.82
========= =========
At the end of 2001, 2000, and 1999, there were 1,496,000, 1,228,000, and
1,179,000 options, respectively, exercisable under the 1993 Plan.
In December 1995, we adopted the Director Option Plan ("Director Plan") and
reserved 200,000 shares of common stock for issuance to directors under this
plan. The plan allows for an initial grant and automatic annual grants of
options to outside directors of the company. In June 2000, our shareholders
approved an amendment to the Director Plan to increase the number of shares
available for issuance by 290,000 shares for a total of 490,000. For fiscal
years, 2001, 2000 and 1999 outstanding options under the Director Plan were
310,000, 153,000 and 96,000, respectively, with 276,000 options exercisable as
of December 31, 2001.
Nonstatutory Option Plan. In August 1999, we approved the Nonstatutory
Option Plan (1999 Plan). In June 2001 we authorized an amendment, effective
April 26, 2001, maximizing the aggregate numbers of shares authorized under the
plan to be 2,150,000. For fiscal years 2001, 2000 and 1999 there were 1,917,000,
1,283,000, and 499,000 options outstanding, respectively with 509,000 options
exercisable as of December 31,2001.
Employee Stock Purchase Plan. In December 1995, we approved the Employee
Stock Purchase Plan and reserved 300,000 shares of common stock for issuance
under this plan. For fiscal years 2001, 2000 and 1999, 30,000 shares, 18,000
shares and 28,000 shares of common stock were sold under the Employee Stock
Purchase Plan, respectively.
Warrants. In January 1998, we issued a warrant to purchase 160,000 shares
of common stock at a purchase price of $6.00 per share to certain international
employees. The warrant became exercisable over a four-year period. In March
1999, we issued warrants to purchase 80,000 shares of our common stock at a
purchase price of $7.00 per share to certain international employees. The
warrant became exercisable over a four-year period. There were 93,000, 153,000
and 160,000 warrants outstanding during each of fiscal years 2001, 2000, and
1999, respectively, of which 67,000, 47,000 and 10,000 were exercisable at the
end of 2001, 2000 and 1999, respectively.
Stockholders Rights Plan. In November 1996, our Board of Directors approved
a Stockholders Rights Plan declaring a dividend distribution of one Preferred
Share Purchase Right for each outstanding share of our common stock. This Plan
was amended in January 2000. Each right will entitle stockholders to buy
one-thousandth of one share of our Series A Participating Preferred Stock at an
exercise price of $185.00. This Plan was designed to assure that our
stockholders receive fair and equal treatment in the event of any proposed
takeover of the
44
company and to guard against partial tender offers and other abusive tactics to
gain control of the company without paying all stockholders the fair value of
their shares, including a "control premium."
Stock-Based Compensation. We have adopted the disclosure-only provisions of
SFAS No. 123 "Accounting for Stock-Based Compensation" and continue to account
for options granted to employees under APB Opinion No. 25, "Accounting for Stock
Issued to Employees." Had compensation cost for the 1993 Plan, the Director
Plan, the Non-Statutory Option Plan and the Employee Stock Purchase Plan been
determined based on the fair value at the grant date for awards in fiscal years
2001, 2000, and 1999 consistent with the provisions of SFAS No. 123, the
company's net income per common share and fully diluted net income per common
share for the years ended December 31, 2001, 2000, and 1999 would have been as
indicated below:
Year Ended December 31,
(in thousands, except per share data)
-----------------------------------------------
2001 2000 1999
-------------- ---------------- -------------
Net income -- as reported $ 10,060 $ 11,545 $ 5,543
Net income (loss) -- pro forma $ (2,675) $ 3,775 $ 2,768
Basic net income per common share as
reported $ 0.45 $ 0.53 $ 0.29
Basic net income (loss) per common
share pro forma $ (0.12) $ 0.17 $ 0.14
Net income per diluted share as
reported $ 0.43 $ 0.50 $ 0.27
Net income (loss) per diluted share
pro forma $ (0.12) $ 0.16 $ 0.13
The fair value of each option grant is estimated on the date of grant using the
Black-Sholes model with the following weighted average assumptions:
Stock Option Plans
Year Ended December 31,
-----------------------------------------
2001 2000 1999
------------ ------------ --------------
Risk-free interest rate 3.61-5.08% 4.98-7.13% 4.98-7.13%
Expected life 5 years 5 years 4 years
Expected dividends -- -- --
Expected volatility 70% 80% 52%
Employee Stock Purchase Plan
Year Ended December 31,
-----------------------------------------
2001 2000 1999
------------ ------------ --------------
Risk-free interest rate 1.80-4.06% 5.96-7.18% 4.87-5.44%
Expected life 0.5 year 0.5 year 0.5 year
Expected dividends -- -- --
Expected volatility 70% 96% 82%
The options outstanding and currently exercisable by exercise price for all
plans at December 31, 2001 were as follows (in thousands, except per share data
and contractual life):
Weighted Number
Average Weighted Exercisable Weighted
Remaining Average As of Average
Exercise Number Contractual Exercise December 31, Exercise
Price Outstanding Life Price 2001 Price
- --------------- --------------- --------------- --------------- --------------- ----------
$ 0.1000 - $ 0.1000 30,000 1.38 $ 0.1000 30,000 $ 0.10
0.1600 - 4.1250 476,763 5.34 3.8600 476,763 3.86
4.5000 - 7.0000 583,413 6.28 6.0981 468,192 5.89
7.4375 - 13.7550 590,204 7.78 10.2113 315,098 8.98
16.2800 - 17.3750 556,379 8.23 17.0969 205,904 17.26
17.6250 - 21.4065 569,396 8.71 20.0549 166,821 20.62
22.6000 - 22.6000 100,000 9.42 22.6000 75,000 22.60
23.0000 - 23.0000 596,389 8.48 23.0000 223,950 23.00
23.4100 - 26.7400 203,000 9.20 24.8069 78,250 23.98
27.5600 - 48.5625 953,784 9.13 31.5693 240,778 36.48
--------- ---- --------- --------- --------
4,659,328 7.86 $ 17.9170 2.299,769 $14.1240
45
Stock compensation expense recognized as a result of stock options granted
to employees and common stock issued subject to repurchase provisions was
$232,000, $428,000 and $68,000 for the years ended December 31, 2001, 2000, and
1999, respectively.
8. RELATED PARTIES:
In connection with the formation of ArthroCare, several of the founders and
a partnership of the founders entered into a licensing agreement to facilitate
patent transfers. As a result, we acquired an exclusive worldwide perpetual
royalty-free license, with right of sublicense, to make, use and sell products
and use patent methods covered by the patent rights limited to surgical
orthopedic and arthroscopic applications.
Also in connection with our incorporation, we entered into a consulting
agreement with a consulting and research firm, which is headed by one of our
founders. This consulting and research firm was contracted to perform research
related to the development of hand-held instruments used in arthroscopic
procedures. Research and development costs incurred on this contract in fiscal
2001, 2000, and 1999 were approximately $58,000, $68,000, and $85,000,
respectively.
In June 1997, we loaned an officer $500,000 pursuant to a provision in the
officer's employment agreement. The promissory note, which bears no interest, is
collateralized by a mortgage on the officer's residence and is due and payable
upon either the officer's termination of employment or the sale of the officer's
residence. If the officer is terminated by us, or if we are acquired, the loan
is due and payable within 12 months thereafter. As of December 31, 2001,
$500,000 of principal was outstanding on this note.
In November 1997, we issued a relocation loan of $130,000 to an employee.
This loan is collateralized by the employee's residence and is due and payable
upon either the sale or transfer of the property or the termination of the
officer's employment with us and bears no interest. As of December 31, 2001,
$130,000 of principal was outstanding on this loan.
In April 1999, we loaned an officer $225,000 pursuant to a provision in the
officer's employment agreement. The promissory note, which bears no interest, is
collateralized by a mortgage on the officer's residence and is due and payable
upon either the officer's termination of employment or the sale of the officer's
residence. If the officer is terminated by us or if we are acquired, the loan is
due and payable within 12 months thereafter. As of December 31, 2001, $225,000
of principal was outstanding on this note.
In May 1999, we loaned an officer $350,000 pursuant to a provision in the
officer's employment agreement. The promissory note, which bears no interest, is
collateralized by a mortgage on the officer's residence and is due and payable
upon either the officer's termination of employment or the sale of the officer's
residence. If the officer is terminated by us or if we are acquired, the loan is
due and payable within 12 months thereafter. As of December 31, 2001, $350,000
of principal was outstanding on this note.
In June 2001, we loaned an officer $100,000. The promissory note, which
bears interest, is due and payable at December 31, 2001. As of December 31,
2001, there is no balance outstanding on this note.
9. INCOME TAXES:
The income tax provision (benefit) consisted of the following;
December 31, December 31, December 31,
2001 2000 1999
Current
Federal $ 1,400 $ 691 $ 204
State 147 300 --
Foreign 482 84 27
---------- --------- --------
Total current 2,029 1,075 231
---------- --------- --------
Deferred
Federal 2,465 (2,091) --
State 1,000 (1,797) --
Foreign 183 (631) --
---------- --------- --------
Total deferred 3,648 (4,519) --
Total income tax provision/(benefit) $ 5,677 $ (3,444) $ 231
========== ========= ========
46
The income tax provision (benefit) differed from a provision (benefit) computed
at the U.S. statutory tax rate as follows:
2001 2000 1999
--------------------------------------------
Statutory tax rate provision $ 5,508 $ 4,340 $ 1,963
Foreign research and development cost share 482 3,029 --
Differences in foreign tax rates (85) 62 218
Foreign sales corporation benefit -- (157) (9)
State income taxes 624 712 327
Nondeductible expenses 104 278 134
Research and development credits (469) (809) (154)
Change in valuation allowance -- (11,238) (501)
Stock based compensation -- -- (1,897)
Other (487) 339 150
-------- --------- --------
Total income tax provision/(benefit) $ 5,677 $ (3,444) $ 231
======== ========= ========
In accordance with generally accepted accounting principles, a valuation
allowance must be established for a deferred tax asset if it is more likely than
not that a tax benefit may not be realized from the asset in the future. We
evaluate our net operating losses and other deferred tax assets and liabilities
in relation to our recent earnings history and our projected future earnings. As
a result of this review for fiscal 2000 we determined that a valuation allowance
was no longer required and it was reversed on September 30, 2000, which resulted
in a deferred tax benefit of $4,897,000.
At December 31, 2001, we had federal and state net operating loss
carryforwards of approximately $16,700,000 and $6,200,000, respectively. The
federal net operating loss carryover begins to expire in 2011. The state net
operating loss carryover begins to expire in 2002. In addition, we have
approximately $2,300,000 and $1,100,000 of federal and state research and
development credit carryforwards available to offset future income taxes. These
federal credits begin to expire in 2008.
Under the Internal Revenue Code, certain substantial changes in a company's
ownership could result in an annual limitation on the amount of net operating
loss carryfowards and income tax credits which can be utilized in future years
to offset future taxable income.
Our deferred tax assets and liabilities consist of the following (in
thousands):
December 31, December 31,
2001 2000
------------ ------------
Deferred tax assets:
Net operating loss carryforwards $ 6,670 $ 4,705
Capitalized research and development costs 275 760
Research and development credit 3,415 2,814
Allowances and reserves 824 4,753
Research and development cost share and other (3,690) (1,890)
-------- --------
Net deferred tax assets $ 7,494 $ 11,142
======== ========
10. EMPLOYEE BENEFIT PLAN:
We maintain a Retirement Savings and Investment Plan (401(k) Plan) which
covers substantially all employees. Eligible employees may defer salary (before
tax) up to a federally specified maximum. Management, at its discretion, may
make matching contributions on behalf of the participants in the 401(k) Plan. We
matched approximately $95,000 and $54,000 of employee contributions to the
401(k) Plan in fiscal 2001 and 2000, respectfully.
47
11. 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:
ArthroCare (for our arthroscopic surgery business), ArthroCare Spine (including
spinal and neuro surgery), ENTec (for ear, nose and throat surgery), Visage 9for
cosmetic surgery) and ArthroCare ENDO (for gynecology, urology and general
surgery). The accounting policies of our business units are the same as those
described in Note 1. For fiscal 2001 our reportable segments were ArthroCare,
ArthroCare Spine and ENTec for which product sales were $62.2 million, $4.5
million and $7.1 million, respectively, with all others amounting to $1.4
million. For fiscal 2000 our reportable segments were Arthroscopy. ENTec and
Visage for which product sales were $54.1 million, $3.1 million and $4.1
million, respectively, with all others amounting to $2.7 million. For fiscal
1999 we had only one reportable segment, ArthroCare, which had product sales of
$39.9 million with all other segments amounting to $4.3 million.
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 revenues and long-lived assets by
geographical region.
2001 2000 1999
--------------------------------
Revenues:
United States 62.0 54.9 37.4
International 13.2 9.1 6.8
--------------------------------
Total 75.2 64.0 7.2
--------------------------------
Long-lived assets:
United States 11.1 8.8 7.2
International 2.0 0.7 0.2
--------------------------------
Total 13.1 9.5 7.4
--------------------------------
12. BUSINESS COLLABORATIONS
Inamed Corporation. In early 1999, we entered into a license and
distribution agreement with Inamed Corporation (through its subsidiary, Collagen
Aesthetics, Incorporated). Under this agreement Inamed acquired exclusive,
worldwide marketing rights for our cosmetic surgery products. We perform product
development, manufacturing, and clinical and regulatory functions for our
Cosmetic Surgery System. In March 2001, we notified Inamed of termination of
this contract, alleging breach by Inamed of certain terms of the contract.
Boston Scientific Corporation. In February 1998, we entered into a license
and distribution agreement under which Boston Scientific Corporation will help
to develop, obtain regulatory approval for and market products based on our
Coblation technology for myocardial revascularization procedures. Under the
agreement, Boston Scientific Corporation acquired exclusive licensing rights to
our intellectual property in this field. Boston Scientific Corporation will pay
licensing fees to us upon achievement of designated clinical and regulatory
milestones, and royalties on sales of resulting products. Boston Scientific
Corporation will perform clinical and regulatory functions, product development
and sales and marketing. We will also focus on product development and will
manufacture devices for Boston Scientific Corporation.
GyneCare. We have entered into a strategic relationship with the GyneCare
division of Ethicon, Inc. to commercialise Coblation-based products for
laparoscopic and open surgical procedures for gynecological applications.
AMCI. We have also entered into a strategic relationship with AMCI, under
which AMCI will market and sell our products for urologic indications, including
transurethral resection of the prostate (TURP).
In July 2000, we entered into a license and distribution agreement with
Integra NeuroSciences, a subsidiary of Integra Lifesciences Holding Corporation.
Under this agreement Integra has become the exclusive sales and distribution
partner for our Coblation-based surgical system for neurosurgery in North
America and certain additional international markets. In addition, we will
cooperate on strategic marketing and product development initiatives.
13. QUARTERLY FINANCIAL INFORMATION (Unaudited):
The following tables present certain unaudited consolidated quarterly
financial information for each of the eight quarters ended December 31, 2001(in
thousands, except per share data). In our opinion, this quarterly information
has been prepared on the same basis as the consolidated financial statements and
includes all adjustments necessary to present fairly the information for the
periods presented.
Fiscal 2001
Quarter 1 Quarter 2 Quarter 3 Quarter 4
----------------------------------------------------
Total revenue $ 19,086 $ 23,576 $ 21,939 $ 18,721
Gross profit 12,431 16,363 14,417 12,420
Net income 1,982 3,222 2,591 2,265
Basic net income per share 0.09 0.14 0.12 0.10
Diluted net income per share 0.09 0.14 0.11 0.10
Fiscal 2000
Quarter 1(1) Quarter 2(1) Quarter 3(2) Quarter 4
-----------------------------------------------------
Total revenue $ 16,172 $ 18,717 $ 15,737 $ 17,001
Gross profit 9,602 $ 11,995 9,695 10,683
Net income (1,748) 4,500 7,023 1,770
Basic net/income (loss) per share (0.08) 0.20 0.32 0.08
Diluted net/income (loss) per share (0.07) 0.19 0.29 0.08
(1) Net income for the first quarter of fiscal 2000 includes the cumulative
effect of a change in accounting principle of $4.3 million or $0.19 per
share.
(2) Net income includes a tax benefit of $4.9 million or $0.20 per diluted
share, related to the release of the valuation allowance against net
deferred tax assets.
48
SCHEDULE II
ARTHROCARE CORPORATION
VALUATION AND QUALIFYING ACCOUNTS
(in thousands)
COLUMN COLUMN COLUMN COLUMN COLUMN
A B C D E
ADDITIONS
CHARGED
BALANCE AT TO COSTS BALANCE AT
BEGINNING OF AND END OF
PERIOD EXPENSES DEDUCTION PERIOD
-------------- ------------- ------------- ------------
YEAR ENDED DECEMBER 31, 2001 Deducted from asset accounts:
Allowance for doubtful accounts and product returns $ 560 $ 216 -- $ 776
Allowance for excess and obsolete inventory 763 -- 323 440
YEAR ENDED DECEMBER 31, 2000 Deducted from asset accounts:
Allowance for doubtful accounts and product returns $ 683 -- (123) $ 560
Allowance for excess and obsolete inventory 1,153 -- 390 763
YEAR ENDED DECEMBER 31, 1999 Deducted from asset accounts:
Allowance for doubtful accounts and product returns $ 469 $ 214 -- $ 683
Allowance for excess and obsolete inventory 413 740 -- 1,153
49
Pursuant to the requirements of Section 13 or 15(d) 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
By: /s/ Michael A. Baker
-------------------------------------
Michael A. Baker
President and Chief Executive Officer
Date: March 29, 2002
50
POWER OF ATTORNEY
KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature
appears below constitutes and appoints each of Michael A. Baker and Christine
Hanni as his or her attorney-in-fact for him or her, in any and all capacities,
to sign each amendment to this Report on Form 10-K, and to file the same, with
exhibits thereto and other documents in connection therewith, with the
Securities and Exchange Commission, hereby ratifying and confirming all that
said attorney-in-fact or his substitute or substitutes may lawfully do or cause
to be done by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this
Report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated:
SIGNATURE TITLE DATE
--------- ----- -----
/s/ MICHAEL BAKER President, Chief Executive Officer and Director March 29, 2002
- ----------------------------------------------------- (Principal Executive Officer)
Michael Baker
Vice President Finance, Chief Financial Officer and March 29, 2002
/s/ CHRISTINE HANNI Assistant Secretary
- ----------------------------------------------------- (Principal Financial and Accounting Officer)
Christine Hanni
/s/ ANNETTE J. CAMPBELL-WHITE
- ----------------------------------------------------- Director March 29, 2002
Annette J. Campbell-White
/s/ C. RAYMOND LARKIN, JR.
- ----------------------------------------------------- Director March 29, 2002
C. Raymond Larkin, Jr.
/s/ PETER L. WILSON
- ----------------------------------------------------- Director March 29, 2002
Peter L. Wilson
/s/ ROBERT R. MOMSEN
- ----------------------------------------------------- Director March 29, 2002
Robert R. Momsen
/s/ TORD B. LENDAU
- ----------------------------------------------------- Director March 29, 2002
Tord B. Lendau
51
ATHROCARE CORPORATION
Report on Form 10-K for
the year ended December 29, 2001
INDEX TO EXHIBITS*
EXHIBIT
NUMBER EXHIBIT NAME
------ ------------
21.1 Subsidiaries of the Registrant
23.1 Consent of PricewaterhouseCoopers LLP, Independent Accountants.
24.1 Power of Attorney (see page 51).
* Only exhibits actually filed are listed. Exhibits incorporated by reference
are set forth in the exhibit listing included in Item 14 of the Report on
Form 10-K.