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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

For the quarterly period ended March 31, 2004.

OR

For the transition period from              to             

Commission File Number: 0-27422

ArthroCare Corporation

(Exact name of registrant as specified in its charter)

680 Vaqueros Avenue

Sunnyvale, California 94085

(Address of principal executive offices)

(408) 736-0224

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨.

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

The number of shares outstanding of the registrant’s common stock as of April 26, 2004 was 21,262,161.

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ARTHROCARE CORPORATION

INDEX

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Part I. FINANCIAL INFORMATION

Item 1. Financial Statements

ARTHROCARE CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands)

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

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ARTHROCARE CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(in thousands, except per share data)

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

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ARTHROCARE CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

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

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ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1. Formation and Business of the Company:

ArthroCare Corporation (“ArthroCare”, “we” or the “company”) was incorporated on April 29, 1993 and our principal operations commenced in August 1995. We design, develop, manufacture and market medical devices for use in soft-tissue surgery. Our products are based on our patented soft-tissue surgical controlled ablation technology, which we call Coblation technology. Coblation technology involves an innovative use and the capability of performing at temperatures lower than traditional electrosurgical tools. Our strategy includes applying Coblation technology to a broad range of soft-tissue surgical markets, including sports medicine, spinal surgery, neurosurgery, cosmetic surgery, ear, nose and throat (ENT) surgery, gynecology, urology, general surgery and various cardiology applications. We are a global company with manufacturing facilities in the United States and Costa Rica and sales offices in the United States and Europe.

2. Basis of Presentation:

We have prepared the accompanying condensed consolidated financial statements in accordance with accounting principles generally accepted in the United States of America, and in accordance with the rules and regulations of Form 10-Q and Article 10 of Regulation S-X of the United States Securities and Exchange Commission. In the opinion of management, the accompanying unaudited condensed consolidated financial statements contain all adjustments (all of which are normal and recurring in nature) necessary to present fairly the financial position, results of operations and cash flows of ArthroCare and its subsidiaries for the periods indicated.

Interim results of operations are not necessarily indicative of the results to be expected for the full year or any other interim periods. These condensed consolidated financial statements should be read in conjunction with the notes to the consolidated financial statements contained in our Form 10-K for the year ended December 31, 2003. The balance sheet at December 31, 2003 was derived from our audited consolidated financial statements as of that date; however, the accompanying financial statements do not include all annual disclosures required by accounting principles generally accepted in the United States of America.

3. MDA Acquisition:

On January 28, 2004, we completed our acquisition of Medical Device Alliance Inc. (“MDA”) and its majority-owned subsidiary Parallax Medical, Inc. (“Parallax”) for a total of $27.3 million, including consideration and preliminary estimates of acquisition-related expenses, net of cash acquired. In addition, ArthroCare will make a payment in 2006 to former MDA shareholders relating to net revenue on the sale of certain on MDA’s products during the 2005 calendar year. Parallax owned a technology for the treatment of vertebral compression fractures and we intend to market the products based on this technology as a complement to our Coblation spine solutions. The MDA acquisition was accounted for using the purchase method of accounting. The net purchase price included the original purchase price and contingent consideration based on the net assets acquired. The original purchase price was paid in January 2004. The contingent consideration was paid in April 2004. Under the purchase method of accounting, the purchase price was allocated to the assets acquired, including intangible assets, and liabilities assumed based on the estimated fair values at the date of the acquisition. The value of assets and liabilities was estimated based on purchase price and future intended use. The value of intangible assets was estimated based on a third-party fair value assessment. These estimates are preliminary and may change as more facts become known. The excess of the purchase price over the fair value of assets acquired and liabilities assumed has been recorded as goodwill. Operating results from the acquired businesses are included in the consolidated statements of operations from the date of acquisition.

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The fair value of the assets acquired and liabilities assumed is as follows (in thousands):

Pro Forma Results (unaudited)

The following table reflects the unaudited pro forma results of operations of ArthroCare assuming that the acquisition had occurred on January 1, 2004 or 2003, respectively. These unaudited pro forma results of operations have been prepared for illustrative purposes only. This information does not purport to represent what the actual results of operations of ArthroCare would have been if the merger had actually occurred on the dates assumed and does not necessarily indicate what ArthroCare’s future operating results will be.

4. Stock-Based Compensation:

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

We account for stock options issued to non-employees using the fair value method of accounting. Non-employee stock-based compensation expense is recognized over the four-year vesting period of the options granted. Non-employee stock-based compensation expense for the three months ended March 31, 2004 and 2003 was $20,000 and $327,000, respectively. Stock-based compensation is included in Sales and marketing and Research and development expense.

Weighted-average assumptions used in determining the fair value of non-employee stock option grants using the Black-Scholes pricing model, were as follows:

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Had employee stock-based compensation been determined based on the fair value method as opposed to the intrinsic value method, the company’s net income (loss), net income (loss) per share and fully diluted net income (loss) per share for the three months ended March 31, 2004 and 2003 would have been as follows (in thousands, except per share data):

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

5. Computation of Net Income Per Share:

Basic net income per share is computed using the weighted-average number of shares of common stock outstanding less weighted-average restricted stock outstanding. Diluted net income per 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 weighted-average number of shares used in the calculation of basic and diluted net income per share (in thousands, except per share data):

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6. Comprehensive Income:

The components of comprehensive income were as follows (in thousands):

7. Inventories: (in thousands):

8. Intangible Assets:

Intangible assets resulting from acquisitions are estimates based on independent fair value assessments. Other intangible assets are valued at the amount paid for the assets. Intangible assets consist of the following (in thousands):

Intangible assets acquired in the first quarter of 2004 relate to the acquisition of Medical Device Alliance Inc. Newly acquired customer networks are being amortized on a straight-line basis over a five-year estimated useful life. Newly acquired contractual agreements are being amortized on a straight-line basis over a two-year estimated useful life. Newly acquired patents, trade names and trademarks, and intellectual property rights are being amortized over an eight year estimated useful life. Newly acquired non-competition agreements are being amortized on a straight-line basis over the three-year contract lives.

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Estimated future amortization expense for all intangible assets is as follows (in thousands):

9. Commitments and Contingencies:

Operating Leases

We lease most of our facilities and certain equipment under operating leases. We recognize rent expense on a straight-line basis over the lease term. At March 31, 2004, total future minimum lease payments are as follows (in thousands):

Warranties

We generally provide customers with a limited 90-day warranty on devices sold and a limited 1-year warranty on controller units sold. We accrue for the estimated cost of product warranties at the time revenue is recognized. Our warranty obligation is impacted by product failure rates, material usage and service delivery costs incurred in correcting a product failure. We periodically evaluate and adjust the warranty reserve to the extent actual warranty expense varies from the original estimates. The activity in our warranty accrual for the three months ended March 31, 2004 and 2003 was as follows (in thousands):

Litigation

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

On July 25, 2001, ArthroCare filed a lawsuit against Smith & Nephew, Inc. (“the Defendant”) in the United States District Court of Delaware. The lawsuit alleges, among other things, that the Defendant has been, and is currently, infringing three patents issued to ArthroCare. Specifically, the Defendant uses, imports, markets and sells electrosurgical products under the names of Dyonics Control RF System, ElectroBlade and Saphyre^™ that infringe these patents. ArthroCare seeks the following remedies: (1) a judgment that the Defendant has infringed these patents; (2) a permanent injunction precluding the Defendant from using, importing, marketing and selling the above-referenced products; and (3) an award of damages (including attorneys’ fees) to compensate us for lost profits and Defendant’s use of our inventions with the damages to be trebled because of the Defendant’s willful infringement. On May 12, 2003, the jury held that the use, manufacture and sale of the Dyonics Control RF System, the ElectroBlade and the Saphyre^™ RF electrosurgical devices infringed all 16 asserted claims of the three patents in suit. In addition, the jury upheld the validity of all 16 asserted claims. The court entered this verdict in June 2003 and held a hearing on September 15, 2003 to consider Defendant’s motions to overturn the jury’s verdict. Following this decision, the court will hear our motion to enjoin the

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Defendant from the use, manufacture and sale of the Dyonics Control RF System, the ElectroBlade and the Saphyre^™ RF electrosurgical devices in the United States. The court is to hold a second trial to award damages to us for the infringing activity of the Defendant. On March 10, 2004, the U.S. District Court in Delaware granted ArthroCare’s motion for permanently enjoining Smith & Nephew from manufacturing, using or selling in the United States surgical devices (the Saphyre^™, Dyonics Control RF and ElectroBlade) that infringe ArthroCare’s patents. In addition, the Court denied all of Smith & Nephew’s post-trial motions, including those requesting a new trial and for judgment as a matter of law. The Court also granted ArthroCare’s motions for judgment of no inequitable conduct and dismissal of the antitrust counterclaim. Smith & Nephew has appealed the court’s decisions to the United States Federal Circuit. On April 27, 2004, the Court rejected Smith & Nephew’s request for a stay of the permanent injunction pending appeal.

On April 3, 2003, Smith & Nephew filed a complaint against ArthroCare in the United States District Court, Western District of Tennessee for patent infringement of two patents and for violation of Section 43(a) of the Lanham Act. This case is still in the initial discovery stage. Upon initial review, we believe this complaint is without merit, and we intend to defend ourselves vigorously.

In July 2003, a product liability suit was brought against us in the New York State Supreme Court, County of Westchester. The lawsuit alleges that a patient suffered injury to her shoulder as a result of a defective ArthroCare probe used in an arthroscopic procedure on the patient. We believe these claims to be without merit and intend to defend ourselves vigorously.

In connection with a medical malpractice suit against a physician, a product liability suit was brought against us in the 269th Judicial District Court, Harris County, Texas in September 2002. The lawsuit alleges that a patient suffered internal and external injury to the patient’s ankle as a result of a defective ArthroCare probe used in an arthroscopic procedure on the patient. ArthroCare believes these claims to be without merit and intends to defend itself vigorously.

On October 27, 2003 a product liability suit was brought against us in the 9th Judicial Circuit, Orange County, Florida. The lawsuit alleges, among other things, that a patient died on July 27, 2001 as a result of a defective ArthroCare product used in a tonsillectomy procedure on the patient. Upon review, we believe these claims to be without merit and intend to defend ourselves vigorously.

On March 1, 2004, a product liability suit was brought against us in the Circuit Court of Tennessee for the 30th Judicial District at Memphis. The lawsuit alleges that a patient suffered injury to her shoulder as a result of a defective ArthroCare probe used in an arthroscopic procedure on the patient. We believe these claims to be without merit and intend to defend ourselves vigorously.

As part of the acquisition of MDA, we inherited two product liability suits filed against Lysonix, Inc., a manufacturer of ultrasonic liposuction equipment and a wholly-owned subsidiary of MDA. At the time of the acquisition of MDA by the Company, MDA had sold the assets of Lysonix and was no longer selling any Lysonix equipment. In one of the cases, a product liability suit was brought against Lysonix in the 120^th Judicial District Court, El Paso County, Texas. The lawsuit alleges, among other things, that a patient died after an ultrasonic-assisted liposuction procedure on October 16, 2000 at least partly as a result of Lysonix’s failure to timely warn the physician of the potential risks associated with the product. This case is still in the initial discovery stage. In the other case, a product liability suit was brought against Lysonix in the Circuit Court of Jefferson County, Alabama. The lawsuit alleges, among other things, that a patient died on January 20, 2001 after a liposuction procedure at least partly as a result of a design defect with a pressure garment sold by Lysonix. This case is still in the initial discovery stage. Upon initial review, we believe these claims to be without merit and we will defend ourselves vigorously.

We believe that we have meritorious defenses against the above claims and intend to vigorously contest them. The outcomes of the outstanding litigation matters discussed above are not considered probable or cannot be reasonably estimated. Also, except as otherwise described above, ArthroCare has product liability insurance coverage in amounts it considers necessary to prevent material losses. We record a liability when a loss is known or considered probable and the amount can be reasonably estimated. If a loss is not probable or a probable loss cannot be reasonably estimated, a liability is not recorded. We have not accrued loss contingencies against any of the above-described actions as losses are not probable or reasonably estimable.

10. Debt

In December 2003, we entered into a $15.0 million revolving credit facility and a $15.0 million term credit facility with Banc of America Securities and Wells Fargo Bank as co-loaners. Under the terms of the revolving credit facility, we may borrow up to $15.0 million at the Bank of America prime rate plus 0.0% to 0.5% or at LIBOR plus 1.75% to

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2.25% at our discretion for operating needs. The increase over the base rate is determined by our leverage ratio, as defined in the credit facility. Under the terms of the term credit facility, we may borrow $15.0 million for specified acquisitions at the same rates as noted above. The credit facility contains covenants which specify minimum financial ratios and limit our ability to take on additional debt, or make future acquisitions or dispositions. On January 28, 2004, in connection with the acquisition of Medical Device Alliance Inc., we borrowed $15.0 million under the term credit facility. The loan is due June 30, 2009 and bears interest at a variable interest rate which is updated every three months. At March 31, 2004, the interest rate was 2.88%.

11. Product Information:

We have organized our marketing and sales efforts based on four operating segments which are aggregated into one reportable segment – the development, manufacture and marketing of products based on our Coblation technology. Each of our operating segments has similar economic characteristics, technology, manufacturing processes, customers, distribution and marketing strategies, regulatory environments, and shared infrastructures. These operating segments, which we refer to as product markets, are Sports Medicine (shoulder and knee arthroscopic products), ENT, (ear, nose, throat and the Visage^® cosmetic products), ArthroCare Spine^™ (spinal and neuro surgery products) and Coblation Technology (gynecology, urology, laparoscopic, general surgical and cardiology products). Product sales by product market for the periods shown were as follows (in thousands):

Internationally, the Company markets and supports its products primarily through its subsidiaries and various distributors. Revenues attributed to geographic areas are based on the country in which subsidiaries are domiciled. Product sales by geography for the periods shown were as follows (in thousands):

Long-lived assets by geography at the balance sheet dates shown were as follows:

12. Subsequent Events:

On April 12, 2004, a product liability suit was brought against us in the 4^th Judicial District Court, Utah County, Utah. The lawsuit alleges, among other things, that a patient was injured as a result of a defective ArthroCare product used in an arthroscopic procedure on the patient in September 1999. Upon initial review, we believe these claims to be without merit and intend to defend ourselves vigorously.

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PART 1. FINANCIAL INFORMATION

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

The following discussion should be read in conjunction with the consolidated financial statements and notes thereto appearing elsewhere in this Form 10-Q. Statements in this Management’s Discussion and Analysis of Financial Condition and Results of Operations and elsewhere in this quarterly report on Form 10-Q which express that we “believe,” “anticipate,” “expect” or “plan to” as well as other statements which are not historical fact, are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Actual events or results may differ materially as a result of the risks and uncertainties described herein and elsewhere including, but not limited to, those factors described under “Business” and “Additional Factors That May Affect Future Results” set forth in Part I of our Annual Report on Form 10-K for the year-ended December 31, 2003.

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 and 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 (or disintigrate or remove), shrink, sculpt, cut, aspirate and suction soft-tissue with one multi-purpose surgical system.

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

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

We commercially introduced our Arthroscopic Surgery System in December 1995 and have derived a significant portion of our sales from this system. The ArthroCare Spine and ENT businesses are growing and represent an increasingly larger portion of our total business. In the United States we are selling our products through a network of more than 70 distributors and a direct sales organization consisting of 56 people. We have also established distribution capability in Europe, Australia, New Zealand, China, Korea, Japan, Taiwan, Russia, Canada, Mexico, the Caribbean, North Africa, the Middle East, and Central America. In January 2004, we acquired Medical Device Alliance Inc. and its majority-owned subsidiary, Parallax Medical, Inc., a business focused on the treatment of vertebral compression fractures.

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Results of Operations

Revenues

Product sales consist of sales of controller units and disposable devices. Product sales for the quarter ended March 31, 2004 were $34.3 million, compared to $26.4 million for the quarter ended March 31, 2003. Product sales by product market for the periods shown were as follows:

Product sales by geography for the periods shown were as follows:

Our continued increase in direct sales presence, in addition to our strategic plan to build market share through continued promotional programs of controller placements, commercialization of our technology in fields outside of arthroscopy, introduction of new products designed to address surgical procedures that have traditionally been difficult to perform and the acquisition of technologies or businesses that complement our business, such as Atlantech and Parallax, continued to have a positive effect on sales in the first quarter of 2004.

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Overall, disposable devices are consistently sold at or near list price, except for sales to international distributors and marketing partners, which are sold at discounted prices. We expect these discounts to continue in the future. Disposable device sales were 97% of product sales, excluding Atlantech and Parallax product sales, for the first quarter of 2004 and comprised approximately 98% of first quarter 2003 product sales. We anticipate that disposable device sales will remain the primary component of our product sales in the near future.

Royalties, fees and other revenues consist mainly of revenue from the licensing of our products and technology. Royalties, fees and other revenues were $1.3 million for the quarter ended March 31, 2004, compared to $0.8 million for the first quarter of 2003.

Cost of Product Sales

Cost of product sales consists of manufacturing costs, material costs, labor costs, manufacturing overhead, warranty and other direct product costs. Additionally, cost of product sales includes amortization of controller unit placements under a program whereby we maintain ownership of controller units shipped to customers, with the costs being capitalized and amortized into cost of product sales over the useful life of the controller unit. Cost of product sales was $13.1 million, or 38% of product sales, for the quarter ended March 31, 2004, as compared to $8.6 million, or 33% of product sales, for the first quarter of 2003. Cost of product sales for the quarter ended March 31, 2004 was adversely impacted by $1.2 million, or 4% of product sales, due to the higher cost of sales related to inventory acquired from Parallax. This included inventory acquired from Parallax at market value prior to the MDA acquisition of $0.9 million and the write-up to fair value of inventory acquired in the acquisition of $0.3 million. During the three months ended March 31, 2004, all such higher cost inventory was sold and future costs of sales related to the sale of Parallax inventory is expected to be in line with our manufacturing cost. The remaining change in cost of product sales as a percentage of product sales is due to increased controller placement costs and the lower gross margin on Atlantech sales. These decreases were partly offset by the continually increased efficiency of the manufacturing operations resulting mostly from the transition of manufacturing operations to our Costa Rica facility.

Operating Expenses

Research and development expenses were $3.1 million, or 9% of total revenues, for the quarter ended March 31, 2004, compared to $2.6 million, or 10% of total revenues, for the quarter ended March 31, 2003. The dollar increase is due to a continued investment in our Coblation technology, which we believe is essential for us to maintain our competitive position. The increase consists of $0.4 million in increased compensation and related expenses due to increased headcount, and $0.1 million in increased prototype development costs. 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 expenses were $14.3 million, or 40% of total revenues, for the quarter ended March 31, 2004, compared to $11.5 million, or 42% of total revenues, for the quarter ended March 31, 2003. The dollar increase consists of $1.7 million in compensation and related expenses associated with our increased direct sales force, especially in Europe, $0.3 million in increased sales commissions related to the increased product sales and $0.8 million in increased promotional, demonstration and sample expenses as we continue to promote our Coblation solutions in addition to our Atlantech and Parallax product lines. We anticipate that sales and marketing spending will continue to increase in absolute dollars as a result of the expansion of our distribution capabilities, higher promotional, demonstration and sample expenses, and additional investments in the sales, marketing and support staff necessary to market products and to commercialize future products.

General and administrative expenses were $3.3 million, or 9% of total revenues, for the quarter ended March 31, 2004, compared to $3.9 million, or 14% of total revenues, for the quarter ended March 31, 2003. The dollar decrease consists of $1.3 million in decreased legal expenses due to high legal expenses in the first quarter of 2003 as the company fought general and patent litigation. This decrease was partially offset by increases of $0.5 million in consulting fees, mainly for expenses relating to compliance with the Sarbanes-Oxley act, and $0.2 million of amortization of intangible assets purchased from MDA. We expect general and administrative expenses to increase in absolute terms as we continue business development activities and incur additional legal costs associated with patent infringement actions.

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Interest and Other Income, Net

Interest and other income, net, increased to $0.4 million for the quarter ended March 31, 2004, compared to $0.3 million for the quarter ended March 31, 2003. The increase in interest and other income is attributable to net foreign exchange gains, partially offset by lower interest income.

Income Tax Provision

The provision for income taxes was $0.6 million for an effective tax rate of 27 percent for the quarter ended March 31, 2004, compared to a provision of $0.3 million for an effective tax rate of 32 percent for the quarter ended March 31, 2003. The improvement in the effective tax rate is related to changes in the world-wide apportionment of income and the differing tax rates to which that income is subjected.

Liquidity and Capital Resources

As of March 31, 2004, we had $59.7 million in working capital, compared to $67.7 million at December 31, 2003. Our principal sources of liquidity consisted of $25.6 million in cash, cash equivalents and long-term available-for-sale securities. Cash equivalents consist of highly liquid investments with an original maturity of ninety days or less. $0.3 million of cash on hand was restricted for use to pay a stockholders’ agent related to the MDA acquisition.

Cash generated by operating activities for the quarter ended March 31, 2004 was $2.1 million, mainly attributable to net income adjusted for non-cash items and increases in accounts payable and accrued liabilities.

Cash used in investing activities for the quarter ended March 31, 2004 was $23.6 million, due mainly to our purchase of MDA during the quarter. In addition, we had capital purchases of $4.1 million and net investment maturities of $1.7 million.

Cash provided by financing activities for the quarter ended March 31, 2004 was $17.2 million, due mainly to the $15.0 million loan entered into in connection with the purchase of MDA. In addition, we received $2.3 million for stock option purchases in the quarter as a result of our stock price increasing, inducing employees to exercise options.

In December 2003, we entered into a $15.0 million revolving credit facility and a $15.0 million term credit facility with Banc of America Securities and Wells Fargo Bank as co-loaners. Under the terms of the revolving credit facility, we may borrow up to $15.0 million at the Bank of America prime rate plus 0.0% to 0.5% or at LIBOR plus 1.75% to 2.25% at our discretion for operating needs. The increase over the base rate is determined by our leverage ratio, as defined in the credit facility. Under the terms of the term credit facility, we may borrow $15.0 million for specified acquisitions at the same rates as noted above. The credit facility contains covenants which specify minimum financial ratios and limit our ability to take on additional debt, or make future acquisitions or dispositions. On January 28, 2004, in connection with the acquisition of Medical Device Alliance Inc., we borrowed $15.0 million under the term credit facility at an interest rate of 2.88% which will become due on June 30, 2009.

We believe that our credit and term facilities, in addition to cash generated from operations, will be sufficient to fund our operations through fiscal year 2004 and in the near future. 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.

Additional Factors That Might Affect Future Results

We Are Dependent Upon Our Arthroscopic Surgery System.

We commercially introduced our Arthroscopic System in December 1995. Since our Arthroscopic System accounted for 58% of our product sales in the first three months of 2004, we are highly dependent on its sales. 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 placed at no charge or have priced our arthroscopic controllers at substantial discounts in order to stimulate demand for our disposable devices.

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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 if continued recommendations and endorsements by influential surgeons or long-term data do not support our current claims of efficacy, our business, financial condition, results of operations and future growth prospects could be materially adversely affected.

Commercial Success Of Our Non-Arthroscopic Products Is Uncertain.

We have developed several applications for our Coblation technology in spinal surgery, 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 cardiac surgery through our Coblation Technologies business unit. At the present time, we consider sports medicine, spine surgery and ENT surgery to be our core businesses. Sales of our spinal surgery and ENT surgery products accounted for 16% and 17%, respectively, of our product sales in the first three months of 2004 such that product sales in our three core businesses accounted for approximately 100% of our product sales in the first three months of 2004. Our products for neurosurgery, cosmetic surgery, gynecology, urology, general surgery and cardiac surgery, our non-core business, are in various stages of commercialization and development, and we may be required to undertake time-consuming and costly commercialization, development and additional regulatory approval activities. If we do not receive future clearances we may be unable to market these and other products for specific indications and our business, financial condition, results of operations and future growth prospects could be materially adversely affected. We cannot assure you that product development will ever be successfully completed, that regulatory clearances or approvals, if applied for, will be granted by the FDA or foreign regulatory authorities on a timely basis, if at all, or that the products will ever achieve commercial acceptance.

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

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

In addition, the success of our non-core business products will depend on their adoption as alternatives to conventional means of tissue ablation. Clinical experience and follow-up data for our non-core business 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 such products.

For information regarding the status of our regulatory approvals for our products, see the information under the heading “Government Regulation” in our Form 10-K for the year ended December 31, 2003.

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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 and ENT surgery product lines in the United States through a combination of a direct sales force and a network of independent distributors supported by regional sales managers. These distributors sell arthroscopy, spinal surgery and ENT surgery products for a number of other manufacturers. We cannot assure you that these distributors will commit the necessary resources to effectively market and sell our sports medicine, spinal surgery and ENT surgery product lines, or that they will be successful in selling our products.

We Are Dependent On Key Suppliers.

Some of the key components of our products are purchased from single vendors. 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 a new material to be used in our products on a timely basis, if at all. This could create supply disruptions that would materially adversely affect our business, financial condition, results of operations and future growth prospects.

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

We Face Intense Competition.

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

In arthroscopy, we compete against companies, such as Johnson & Johnson, Smith & Nephew, Inc., Conmed Corporation, Stryker Corp., and Arthrex. Specifically, Johnson & Johnson, Smith & Nephew and Stryker are currently marketing bipolar electrosurgical systems for tissue ablation and shrinkage. We are also aware of additional competitors that may commercialize products using technology similar to ours. In spinal surgery, we compete against companies, which market products to remove tissue and treat spinal disorders. We compete against Stryker, which markets the Dekompressor device, which uses a mechanical auger to perform percutaneous discectomy. In addition, the Oratec division of Smith & Nephew, and the Radionics division of Tyco, are currently marketing percutaneous thermal heating products for treating certain types of disc pain. Our Coblation-assisted microdiscectomy (CAM) procedure competes indirectly with large spine companies and their mechanical instruments, such as DePuy Acromed, Medtronic Sofamor Danek, Centerpulse Spine Tech, Stryker Spine and Synthes. In ENT surgery, we compete against companies that offer manual instruments, such as Smith & Nephew, Inc., Stryker Corp., Conmed Corporation, and Xomed Surgical Products Inc., which was acquired by Medtronic, Inc. In addition, we compete with companies that develop and market lasers for various ENT surgery applications, including Lumenis. Smaller companies, including Somnus Medical Technologies Inc. (purchased by Gyrus Group, a company based in Cardiff, Wales), also sell medical devices for the treatment of various ENT disorders, including snoring and obstructive sleep apnea.

Many of our competitors have significantly greater financial, manufacturing, marketing, distribution and technical resources than we do. Some of these companies offer broad product lines that they may offer as a single package and frequently offer significant discounts as a competitive tactic. For example, in order to compete successfully, we anticipate that we may have to continue to offer substantial discounts on our controllers, place controllers at customers sites at no cost or in return for a minimum purchase commitment of our surgical wands in order to increase demand for our disposable devices, 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.

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We Face Uncertainty Over Reimbursement.

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

We are unable to predict what changes will be made in the reimbursement methods used by third-party health care payors. In addition, some health care providers are moving toward a managed care system in which providers contract to provide comprehensive health care for a fixed cost per person. Managed care providers are attempting to control the cost of health care by authorizing fewer elective surgical procedures. We anticipate that in a prospective payment system, such as the diagnosis related group system utilized by Medicare, and in many managed care systems used by private health care payers, 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.

Nucleplasty is ArthroCare’s version of percutaneous discectomy, where tissue is removed from the nucleus to decompress the disc. Several payors consider percutaneous discectomy in any form investigational, and other cover percutaneous discectomy, but consider Nucleoplasty investigational. There is no assurance that we will be able to obtain coverage with these payors for percutaneous discectomy in general, and Nucleoplasty in general.

Our Operating Results Will Fluctuate.

Results of operations may fluctuate significantly from quarter to quarter due to many factors, including the following:

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

We May Be Unable To Effectively Protect Our Intellectual Property.

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

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

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

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