ARTHROCARE CORP - 10-Q Quarterly Report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

x	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2004.

¨	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from to

Commission File Number: 0-27422

ArthroCare Corporation

(Exact name of registrant as specified in its charter)


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

680 Vaqueros Avenue

Sunnyvale, California 94085

(Address of principal executive offices)

(408) 736-0224

(Registrant’s telephone number, including area code)

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

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 July 30, 2004 was 21,598,943.

ARTHROCARE CORPORATION

INDEX


		Page
PART I:	Financial Information

Item 1.	Financial Statements (unaudited)

	Condensed Consolidated Balance Sheets as of June 30, 2004 and December 31, 2003	1

	Condensed Consolidated Statements of Operations for the three and six month periods ended June 30, 2004 and 2003	2

	Condensed Consolidated Statements of Cash Flows for the six month periods ended June 30, 2004 and 2003	3

	Notes to Condensed Consolidated Financial Statements	4

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	12

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	23

Item 4.	Controls and Procedures	23

PART II:	Other Information

Item 1.	Legal Proceedings	25

Item 4.	Submission of Matters to a Vote of Security Holders	25

Item 6.	Exhibits and Reports on Form 8-K	26

	Signatures	27

	Certifications

Part I. FINANCIAL INFORMATION

Item 1. Financial Statements

ARTHROCARE CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands)


	June 30, 2004			December 31, 2003
	(Unaudited)
ASSETS
Current assets:
Cash and cash equivalents	$	11,846		$	20,890
Accounts receivable, net of allowances of $458 in 2004 and $289 in 2003		26,215			24,122
Inventories		35,889			33,072
Prepaid expenses and other current assets		10,520			6,921

Total current assets		84,470			85,005

Available-for-sale securities		13,942			10,428
Property and equipment, net		26,666			23,493
Related party receivables		1,075			1,205
Intangible assets		13,821			5,864
Goodwill		28,423			10,383
Other assets		5,377			1,760

Total assets	$	173,774		$	138,138

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	6,094		$	6,808
Accrued liabilities		9,851			5,204
Accrued compensation		5,691			5,323

Total current liabilities		21,636			17,335

Loan payable		15,000			—
Other liabilities		3,826			155

Total liabilities		40,462			17,490

Commitments and contingencies: (Note 8)
Stockholders’ equity:
Preferred stock, par value $ 0.001:
Authorized: 5,000 shares
Issued and outstanding: none		—			—
Common stock, par value $ 0.001:
Authorized 75,000 shares:
Issued and outstanding: 21,578 shares in 2004 and 21,025 shares in 2003		22			21
Treasury stock: 2,704 shares in 2004 and 2003		(42,158	)		(42,158	)
Additional paid-in capital		165,389			156,283
Deferred stock-based compensation		(2,255	)		(951	)
Accumulated other comprehensive loss		(691	)		(836	)
Retained earnings		13,005			8,289

Total stockholders’ equity		133,312			120,648

Total liabilities and stockholders’ equity	$	173,774		$	138,138

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

ARTHROCARE CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)


	Three Months Ended June 30,				Six Months Ended June 30,
	2004		2003		2004		2003
Revenues:
Product sales	$	35,904	$	28,401	$	70,196	$	54,850
Royalties, fees and other		1,761		1,300		3,058		2,052

Total revenues		37,665		29,701		73,254		56,902
Cost of product sales		11,867		8,661		24,947		17,259

Gross profit		25,798		21,040		48,307		39,643

Operating expenses:
Research and development		3,531		2,607		6,651		5,253
Sales and marketing		14,088		11,519		28,416		23,038
General and administrative		4,302		4,781		7,620		8,693

Total operating expenses		21,921		18,907		42,687		36,984

Income from operations		3,877		2,133		5,620		2,659
Interest and other income, net		434		697		840		1,045

Income before income tax provision		4,311		2,830		6,460		3,704
Income tax provision		1,164		868		1,744		1,148

Net income	$	3,147	$	1,962	$	4,716	$	2,556

Basic net income per share	$	0.15	$	0.09	$	0.22	$	0.12

Shares used in calculating basic net income per share		21,159		20,911		21,085		21,039

Diluted net income per share	$	0.14	$	0.09	$	0.21	$	0.12

Shares used in calculating diluted net income per share		22,765		21,858		22,779		21,728

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

ARTHROCARE CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)


	Six Months Ended June 30,
	2004			2003
	(Unaudited)
Cash flows from operating activities:
Net income	$	4,716		$	2,556
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		6,129			4,987
Loss on disposition of equipment		39			4
Provision for doubtful accounts and product returns		208			—
Provision for excess and obsolete inventory		92			173
Realized gain on sale of long-term investment		(155	)		—
Stock compensation expense		305			267
Deferred rent		7			28
Changes in operating assets and liabilities, net of assets and liabilities acquired:
Accounts receivable		(2,188	)		(541	)
Inventories		(1,690	)		(5,879	)
Prepaid expenses and other current assets		(2,239	)		(664	)
Other assets		136			(41	)
Accounts payable		(432	)		1,761
Accrued liabilities		(86	)		(2,382	)
Income taxes payable		521			1,114

Net cash provided by operating activities		5,363			1,383

Cash flows from investing activities:
Purchases of property and equipment		(7,599	)		(5,902	)
Purchases of intangible assets		—			(2,150	)
Payment for purchase of MDA, net of cash acquired		(24,694	)		—
Payment for purchase of Atlantech Austria, net of cash acquired		—			(243	)
Purchases of available-for-sale securities		(24,694	)		(32,170	)
Sales or maturities of available-for-sale securities		21,461			44,337

Net cash provided by (used in) investing activities		(35,526	)		3,872

Cash flows from financing activities:
Purchase of treasury stock		—			(10,620	)
Repayment on loan from bank		—			(4	)
Proceeds from loan from bank, net of issuance costs		14,915			—
Proceeds from issuance of common stock, net of issuance costs		461			352
Proceeds from exercise of options to purchase common stock		5,763			750

Net cash provided by (used in) financing activities		21,139			(9,522	)

Effect of exchange rate on changes in cash		(20	)		13

Net decrease in cash and cash equivalents		(9,044	)		(4,254	)
Cash and cash equivalents, beginning of period		20,890			40,753

Cash and cash equivalents, end of period	$	11,846		$	36,499

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

The above condensed consolidated statements of cash flows and the end of period cash and cash equivalents balances do not include long-term available-for-sale securities of (in thousands) $13,942 and $10,428 at June 30, 2004 and December 31, 2003, respectively.

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 of a non-thermal process, and has 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 estimates of acquisition-related expenses, net of cash acquired, of which $2.6 million remained unpaid as of June 30, 2004. In addition, ArthroCare will make a payment in 2006 to former MDA shareholders relating to net revenue on the sale of certain of 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.

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


Tangible assets (primarily inventory, fixed assets and accounts receivable)	$	2,339
Intangible assets		9,160
Deferred tax assets		3,600
Goodwill		18,032
Liabilities assumed		(2,053	)
Deferred tax liabilities		(3,795	)

Total purchase price, net of cash acquired	$	27,283

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.


	Three Months Ended June 30,				Six Months Ended June 30,
	2004		2003		2004		2003
Pro forma total revenues	$	37,665	$	31,960	$	73,928	$	60,904

Pro forma net income	$	3,147		1,169	$	4,298		1,066

Pro forma basic net income per share	$	0.15	$	0.06	$	0.20	$	0.05

Pro forma diluted net income per share	$	0.14	$	0.05	$	0.19	$	0.05

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 was $28,000 and $102,000 for the three months ended June 30, 2004 and 2003, respectively, and $48,000 and $408,000 for the six months ended June 30, 2004 and 2003, respectively. This stock-based compensation expense 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 for all periods presented:


Risk-free interest rate	2.92	%
Expected life (in years)	5
Expected dividends	—
Expected volatility	70	%

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 and six months ended June 30, 2004 and 2003 would have been as follows (in thousands, except per share data):


	Three Months Ended June 30,						Six Months Ended June 30,
	2004			2003			2004			2003
Net income—as reported	$	3,147		$	1,962		$	4,716		$	2,556
Employee stock-based compensation expense determined under the fair value method, net of related tax effects		(3,094	)		(3,072	)		(6,125	)		(6,020	)

Pro forma net income (loss)	$	53		$	(1,110	)	$	(1,409	)	$	(3,466	)

Net income (loss) per share:
Basic—as reported	$	0.15		$	0.09		$	0.22		$	0.12
Basic—pro forma	$	0.00		$	(0.05	)	$	(0.07	)	$	(0.16	)
Diluted—as reported	$	0.14		$	0.09		$	0.21		$	0.12
Diluted—pro forma	$	0.00		$	(0.05	)	$	(0.06	)	$	(0.16	)

Restricted Stock

On April 1, 2004, we issued 70,650 shares of restricted stock to certain members of management. In connection with the issuance of these shares, we recorded $1.7 million of deferred compensation which will be amortized to compensation expense over the three-year vesting period of the restricted shares.

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):


	Three Months Ended June 30,				Six Months Ended June 30,
	2004		2003		2004		2003
Net income	$	3,147	$	1,962	$	4,716	$	2,556

Basic:
Weighted-average shares outstanding		21,159		20,911		21,085		21,039

Basic net income per share	$	0.15	$	0.09	$	0.22	$	0.12

Diluted:
Weighted-average shares outstanding used in basic calculation		21,159		20,911		21,085		21,039
Dilutive effect of outstanding options		1,540		857		1,627		618
Dilutive effect of unvested restricted stock		66		56		67		42
Dilutive effect of outstanding warrants		—		34		—		29

Weighted-average shares and equivalents		22,765		21,858		22,779		21,728

Diluted net income per share	$	0.14	$	0.09	$	0.21	$	0.12

Options excluded from calculation as their effect would be anti-dilutive		1,150		4,487		1,047		4,791

Price range of excluded options		$23.38 - $48.56		$15.12 - $48.56		$24.01 - $48.56		$12.75 - $48.56

6. Comprehensive Income:

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


	Three Months Ended June 30,						Six Months Ended June 30,
	2004			2003			2004			2003
Net income	$	3,147		$	1,962		$	4,716		$	2,556
Unrealized gains(losses) on available-for-sale securities arising during the period, net of tax		(37	)		92			238			556
Less: Reclassification adjustment for gains on available-for-sale securites, net of tax, included in earnings		—			(398	)		(113	)		(587	)
Foreign currency translation adjustment		(36	)		175			20			114

Comprehensive net income	$	3,074		$	1,831		$	4,861		$	2,639

7. Inventories: (in thousands):


	June 30, 2004		December 31, 2003
Raw materials	$	9,297	$	9,451
Work-in-process		7,432		6,062
Finished goods		19,160		17,559

Total	$	35,889	$	33,072

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):


	December 31, 2003			Additions			March 31, 2004			Additions			June 30, 2004
Distribution/customer network	$	2,900		$	800		$	3,700		$	—		$	3,700
OEM contractual agreements		1,100			60			1,160			—			1,160
Patents		200			1,800			2,000			—			2,000
Trade names/trademarks		700			600			1,300			—			1,300
Employment agreements		300			—			300			—			300
Non-competition agreements		100			200			300			—			300
Distributor agreements		450			—			450			—			450
Intellectual property rights		1,700			5,700			7,400			—			7,400

Gross intangible assets		7,450			9,160			16,610			—			16,610
Accumulated amortization		(1,586	)		(582	)		(2,168	)		(621	)		(2,789	)

Net intangible assets	$	5,864		$	8,578		$	14,442		$	(621	)	$	13,821

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.

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


2004 (6 months)	$	1,325
2005		2,634
2006		2,523
2007		2,297
2008		1,474
2009 and thereafter		3,568

Total	$	13,821

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 June 30, 2004, total future minimum lease payments are as follows (in thousands):


2004 (6 months)	$	1,110
2005		2,072
2006		2,012
2007		425

Total	$	5,619

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 and six months ended June 30, 2004 and 2003 was as follows (in thousands):


	Three Months Ended June 30,						Six Months Ended June 30,
	2004			2003			2004			2003
Balance at beginning of period	$	276		$	243		$	252		$	243
Accruals for warranties issued during the period		72			162			411			288
Warranty costs during the period		(116	)		(111	)		(431	)		(237	)

Balance at end of period	$	232		$	294		$	232		$	294

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. 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. On April 27, 2004, the Court rejected Smith & Nephew’s request for a stay of the permanent injunction pending appeal. On June 10, 2004, the Court issued the injunction order. Smith & Nephew has appealed all of the above rulings in the Federal Circuit Court of Appeals. The Court of Appeals has rejected Smith & Nephew’s motion to stay the 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. A jury trial is scheduled for October 31, 2005. 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.

On April 12, 2004, a product liability suit was brought against us in the 4th 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.

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, on November 15, 2002, 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 has been settled. The settlement had an insignificant impact on our financial position. In the other case, on January 13, 2003, 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 intend to 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 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 June 30, 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):


	Three Months Ended June 30,								Six Months Ended June 30,
	2004				2003				2004				2003
	$		%		$		%		$		%		$		%
Coblation Sports Medicine	$	20,408	57	%	$	18,032	63	%	$	40,447	58	%	$	35,793	65	%
Atlantech		2,707	8	%		2,241	8	%		5,858	8	%		4,906	9	%

Total Sports Medicine		23,115	65	%		20,273	71	%		46,305	66	%		40,699	74	%
ENT		7,158	20	%		4,124	15	%		12,818	18	%		7,133	13	%
ArthroCare Spine		5,498	15	%		3,537	12	%		10,967	16	%		6,174	11	%
Coblation Technology		133	0	%		467	2	%		106	0	%		844	2	%

Total Product Sales	$	35,904	100	%	$	28,401	100	%	$	70,196	100	%	$	54,850	100	%

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):


	Three Months Ended June 30,								Six Months Ended June 30,
	2004				2003				2004				2003
	$		%		$		%		$		%		$		%
United States	$	26,908	75	%	$	21,669	76	%	$	51,936	74	%	$	41,641	76	%
International		8,996	25	%		6,732	24	%		18,260	26	%		13,209	24	%

Total Product Sales	$	35,904	100	%	$	28,401	100	%	$	70,196	100	%	$	54,850	100	%

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


	June 30, 2004		December 31, 2003
United States	$	52,431	$	19,696
International		21,856		21,804

Total long-lived assets	$	74,287	$	41,500

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.

Results of Operations


	Three Months Ended June 30,								Six Months Ended June 30,
	2004				2003				2004				2003
	$		%		$		%		$		%		$		%
Revenues:
Product sales	$	35,904	95	%	$	28,401	96	%	$	70,196	96	%	$	54,850	96	%
Royalties, fees and other		1,761	5	%		1,300	4	%		3,058	4	%		2,052	4	%

Total revenues		37,665	100	%		29,701	100	%		73,254	100	%		56,902	100	%

Cost of product sales		11,867	32	%		8,661	29	%		24,947	34	%		17,259	30	%

Gross profit		25,798	68	%		21,040	71	%		48,307	66	%		39,643	70	%

Operating expenses
Research and development		3,531	9	%		2,607	9	%		6,651	9	%		5,253	9	%
Sales and marketing		14,088	38	%		11,519	39	%		28,416	39	%		23,038	41	%
General and administrative		4,302	11	%		4,781	16	%		7,620	10	%		8,693	15	%

Total operating expenses		21,921	58	%		18,907	64	%		42,687	58	%		36,984	65	%

Income from operations		3,877	10	%		2,133	7	%		5,620	8	%		2,659	5	%
Interest and other income, net		434	1	%		697	3	%		840	1	%		1,045	1	%

Income before income tax provision		4,311	11	%		2,830	10	%		6,460	9	%		3,704	6	%
Income tax provision		1,164	3	%		868	3	%		1,744	3	%		1,148	2	%

Net income	$	3,147	8	%	$	1,962	7	%	$	4,716	6	%	$	2,556	4	%

Comparison of Three and Six Months Ended June 30, 2004 and June 30, 2003

Revenues

Product sales consist of sales of controller units and disposable devices. Product sales by product market for the periods shown were as follows:


	Three Months Ended June 30,								Six Months Ended June 30,
	2004				2003				2004				2003
	$		%		$		%		$		%		$		%
Coblation Sports Medicine	$	20,408	57	%	$	18,032	63	%	$	40,447	58	%	$	35,793	65	%
Atlantech		2,707	8	%		2,241	8	%		5,858	8	%		4,906	9	%

Total Sports Medicine		23,115	65	%		20,273	71	%		46,305	66	%		40,699	74	%
ENT		7,158	20	%		4,124	15	%		12,818	18	%		7,133	13	%
ArthroCare Spine		5,498	15	%		3,537	12	%		10,967	16	%		6,174	11	%
Coblation Technology		133	0	%		467	2	%		106	0	%		844	2	%

Total Product Sales	$	35,904	100	%		28,401	100	%		70,196	100	%		54,850	100	%

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


	Three Months Ended June 30,								Six Months Ended June 30,
	2004				2003				2004				2003
	$		%		$		%		$		%		$		%
United States	$	26,908	75	%	$	21,669	76	%	$	51,936	74	%	$	41,641	76	%
International		8,996	25	%		6,732	24	%		18,260	26	%		13,209	24	%

Total Product Sales	$	35,904	100	%	$	28,401	100	%	$	70,196	100	%	$	54,850	100	%

The increase in sales for the three and six month periods ended June 30, 2004 over the corresponding periods in 2003 is mainly due to the following factors:

•

The increased acceptance of our products;

•

The continued increase in our direct sales presence;

•

The success of our promotional programs to build market share through placement of our controller units;

•

The introduction of new products designed to address surgical procedures that have traditionally been difficult to perform; and

•

The acquisition of technologies and businesses that complement our business, such as Atlantech and Parallax.

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 percent of product sales, excluding Atlantech and Parallax product sales, for the second quarter of both 2004 and 2003, and comprised approximately 97 percent and 98 percent for the six months ended June 30, 2004 and 2003, respectively. 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 $1.8 million for the quarter ended June 30, 2004, compared to $1.3 million for the second quarter of 2003. Royalties, fees and other revenues were $3.1 million for the six months ended June 30, 2004, compared to $2.1 million for the same period in 2003. The increase over the prior year periods is due to additional licensing of our products and higher sales of our licensed products.

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 $11.9 million, or 33% of product sales, for the three months ended June 30, 2004, as compared to $8.7 million, or 30% of product sales, for the second quarter of 2003. The increase in cost of product sales as a percentage of product sales is due principally to increased freight costs associated with the Parallax manufacturing process and increased costs associated with our move to a third-party logistics provider. These increases 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.

Cost of product sales was $24.9 million, or 36% of product sales, for the six months ended June 30, 2004, as compared to $17.3 million, or 31% of product sales, for the same period in 2003. Cost of product sales for the six months ended June 30, 2004 was adversely impacted by $1.2 million, or 2% 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. All such higher cost inventory was sold in the first quarter of 2004 and future costs of sales related to the sale of Parallax inventory is expected to be in line with our manufacturing cost. The remaining increase in cost of product sales as a percentage of product sales is due principally to increased freight costs associated with the Parallax manufacturing process and increased costs associated with our move to a third-party logistics provider. These increases 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 $3.5 million, or 9% of total revenues, for the quarter ended June 30, 2004, compared to $2.6 million, or 9% of total revenues, for second quarter of 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 dollar increase consists of $0.8 million in increased compensation and related expenses due to increased headcount, and $0.1 million in increased prototype development costs as we continue to invest in developing our technology.

Research and development expenses were $6.7 million, or 9% of total revenues, for the six months ended June 30, 2004, compared to $5.3 million, or 9% of total revenues, for the same period in 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 $1.1 million in increased compensation and related expenses due to increased headcount, and $0.3 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 $14.1 million, or 38% of total revenues, for the quarter ended June 30, 2004, compared to $11.5 million, or 39% of total revenues, for the second quarter of 2003. The dollar increase consists of $1.5 million in compensation and related expenses associated with our increased direct sales force, especially in Europe, $1.0 million in increased sales commissions related to the increased product sales and $0.1 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.

Sales and marketing expenses were $28.4 million, or 39% of total revenues, for the six months ended June 30, 2004, compared to $23.0 million, or 41% of total revenues, for the same period of 2003. The dollar increase consists of $3.2 million in compensation and related expenses associated with our increased direct sales force, especially in Europe, $1.3 million in increased sales commissions related to the increased product sales and $0.9 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 $4.3 million, or 11% of total revenues, for the quarter ended June 30, 2004, compared to $4.8 million, or 16% of total revenues, for the second quarter of 2003. The dollar decrease consists of $2.0 million in decreased legal expenses due to high legal expenses in 2003 as the company fought general and patent litigation. This decrease was partially offset by increases of $0.2 million in consulting fees, mainly for expenses relating to compliance with the Sarbanes-Oxley act, $0.3 million of amortization of intangible assets purchased from MDA, and $0.3 million in additional facilities expenses related to additional facilities acquired in the MDA acquisition.

General and administrative expenses were $7.6 million, or 10% of total revenues, for the six months ended June 30, 2004, compared to $8.7 million, or 15% of total revenues, for the same period of 2003. The dollar decrease consists of $3.2 million in decreased legal expenses due to high legal expenses in 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, $0.5 million of amortization of intangible assets purchased from MDA, and $0.7 million in addition facilities expenses related to additional facilities acquired in the MDA acquisition. 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.

Interest and Other Income, Net

Interest and other income, net, decreased to $0.4 million for the quarter ended June 30, 2004, compared to $0.7 million for the second quarter of 2003. Interest and other income net for the six months ended June 30, 2004 was $0.8 million, compared to $1.0 million for the same period of 2003. The decrease in interest and other income, net for compared to the prior year periods is attributable to higher interest expense as a result of our outstanding debt acquired in conjunction with the Parallax acquisition, partially offset by net foreign exchange gains.

Income Tax Provision

The provision for income taxes was $1.2 million for an effective tax rate of 27 percent for the quarter ended June 30, 2004, compared to a provision of $0.9 million for an effective tax rate of 31 percent for the second quarter of 2003. The provision for income taxes was $1.7 million for an effective tax rate of 27 percent for the six months ended June 30, 2004, compared to a provision of $1.1 million for an effective tax rate of 31 percent for the same period of 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

At June 30, 2004, we had $62.8 million in working capital, compared to $67.7 million at December 31, 2003. Our principal sources of liquidity consisted of $25.8 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 six months ended June 30, 2004 was $5.4 million, mainly attributable to net income adjusted for non-cash items and increases in accounts receivable, inventories and prepaid expenses. The increase in accounts receivable is due mainly to the increase in revenue over prior periods. The increase in inventories is due to the need to manufacture to meet the demands of the increased sales. The increase in prepaid expenses is due mainly to the payment of our annual insurance premiums during the second quarter of 2004.

Cash used in investing activities for the six months ended June 30, 2004 was $35.5 million, due mainly to our purchase of MDA during the quarter. In addition, we capitalized $6.0 million of controllers and had additional capital purchases of $1.6 million. Additionally, we had net investment purchases of $3.2 million as we were able to temporarily invest excess cash in available-for-sale securities.

Cash provided by financing activities for the six months ended June 30, 2004 was $21.1 million, due mainly to the $15.0 million loan entered into in connection with the purchase of MDA. In addition, we received $5.8 million for stock option purchases in the period 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.

Critical Accounting Policies

Please refer to our description of our critical accounting policies as set forth in Part II of our Annual Report on Form 10-K for the year ended December 31, 2003.

Recent Accounting Pronouncements

We have reviewed the accounting literature and have determined that there are no new pronouncements which would affect our accounting process. However, new pronouncements, including a pronouncement on the accounting for employee stock options, may be issued before the end of fiscal year 2004 which may have an impact on our accounting processes.

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 six 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.

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 18%, respectively, of our product sales in the first six months of 2004 such that product sales in our three core businesses accounted for approximately 100% of our product sales in the first six 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 for such products. 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:

•

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 may 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; and

•

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

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.

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.

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:

•

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;

•

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 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.

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 hysterocopic 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 and under the terms of the settlement, Stryker has licensed a portion of our worldwide patents for products in the arthroscopy market.

In July 2001, we filed a lawsuit against Smith & Nephew (the “Defendant”) alleging infringement of several of our patents. On May 12, 2003, the jury held that the use, manufacture and sale of the Dyonics Control RF System, the ElectroBlade and the Saphyre^{^™} 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. 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. On April 27, 2004, the court rejected Smith & Nephew’s request for a stay of the permanent injunction pending appeal. On June 10, 2004, the court issued the injunction order. Smith & Nephew has appealed all of the above rulings in the Federal Circuit Court of Appeals. The Court of Appeals has rejected Smith & Nephew’s motion to stay the injunction pending appeal.

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

The Market Price Of Our Stock May Be Highly Volatile.

During the three months ended June 30, 2004, our common stock traded between a range of $19.48 and $29.90 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 filing, clinical studies or other testing, technological innovations or new products commercialized by us or our competitors;

•

Developments concerning government regulations, proprietary rights or public concern as to the safety of our 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 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, Related Stockholder Matters and Issuer Purchases of Equity Securities” in our Form 10-K for the year ended December 31, 2003 for more information regarding fluctuations in the price of our common stock.

Delaware Law, Provisions In Our Charter And Our Stockholder Rights Plan Could Make The Acquisition Of Our Company By Another Company More Difficult.

Our stockholder rights plan and certain provisions of our certificate of incorporation and bylaws may have the effect of making it more difficult for a third party to acquire, or of discouraging a third party from attempting to acquire, control of our company. This could limit the price that certain investors might be willing to pay in the future for shares of our common stock. 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 And We Must Continue To Comply With Applicable Laws And Regulations.

Our products are considered medical devices and are subject to extensive regulation in the United States. We must obtain premarket clearance or approval by the FDA for each of our products and indications before they can be commercialized. International sales of our products are also subject to strict regulatory requirements. For more information about the U.S. and foreign regulatory requirements, see information under the heading “Government Regulation” in our Form 10-K for the year ended December 31, 2003. Information pertaining to our products and indications before they can be commercialized can be found under the heading “Government Regulations” in our Form 10-K for the year ended December 31, 2003.

Future Changes In The Accounting Treatment For Employee Stock Options May Cause Adverse Unexpected Fluctuations And Affect Our Reported Results Of Operations.

We currently account for stock options granted to employees using the intrinsic value method of accounting. Under this method, employee stock-based compensation expense is based on the difference, if any, between the fair value of our stock and the exercise price of the award on the date of the grant. On March 31, 2004, the Financial Accounting Standards Board, the principle United States accounting standards setting organization, issued a draft accounting pronouncement which, if implemented, will require us to record an expense for all outstanding unvested stock options and grants of new stock options effective January 1, 2005. The pronouncement as currently proposed would also require us to record an expense for our employee stock purchase plan. There is considerable uncertainty as to how the final pronouncement will deal with those issues. The final pronouncement will be issued in the third quarter of 2004 and certain portions of the proposed standard may change. If we are required to change our accounting policy in accordance with this draft accounting pronouncement, our reported earnings, beginning in the first quarter of 2005, would most likely be significantly negatively impacted.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Interest Rate Sensitivity

Our exposure to market risk for changes in interest rates relates primarily to our investment portfolio and our outstanding variable-rate debt. We do not use derivative financial instruments in our investment portfolio. We are subject to fluctuating interest rates that may impact, adversely or otherwise, our results of operations or cash flows for our cash and cash equivalents and available-for-sale securities in addition to our outstanding debt. Although payments under the operating leases for our facility are tied to market indices, we are not exposed to material interest rate risk associated with operating leases.

Foreign Currency Exchange Risk

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

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

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

Item 4. Controls and Procedures

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

As required by SEC Rule 13a-15(b), we carried out an evaluation, under the supervision and with the participation of the Company’s management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the quarter covered by this report. Based on the foregoing, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective at the reasonable assurance level.

There has been no change in our internal control over financial reporting during our most recent fiscal quarter that has materially affected, or is reasonable likely to materially affect, our internal controls over financial reporting.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

Information with respect to this item is incorporated into this Part II, Item I by reference to the section entitled “Litigation” in Note 8 to the Condensed Consolidated Financial Statements contained in Part I above.

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

(a) The Company held its annual meeting of stockholders on May 26, 2004.

(b) Votes regarding the election of our directors for terms expiring at our 2005 annual meeting of stockholders:


Term expiring in 2005	For	Withheld
Michael A. Baker	19,256,979	571,111
Barbara D. Boyan, Ph.D.	19,417,339	410,751
David F. Fitzgerald	18,692,088	1,136,002
James G. Foster	18,865,198	962,892
Tord B. Lendau	19,261,539	566,551
Jerry P. Widman	19,086,829	741,261
Peter L. Wilson	18,696,548	1,131,542

The above directors constitute our entire board of directors and are the only directors whose terms continued after our annual meeting of directors.

(c) In addition to the election of directors described above, the following matters were voted upon at our annual meeting of stockholders:

(i) Votes on the proposal to approve the amendment and restatement of the Company’s 1996 Employee Stock Purchase Plan to increase the number of shares of Common Stock reserved for issuance thereunder by 150,000 shares were as follows:

FOR

AGAINST

ABSTENTIONS AND

BROKER NON-VOTES

15,712,384

476,894

19,741

(ii) Votes on the proposal to approve the amendment and restatement of the Company’s 2003 Incentive Stock Plan to (a) increase the number of shares of Common Stock reserved for issuance thereunder by 750,000 shares and (b) provide for the ability to issue stock appreciation rights, restricted stock units, dividend equivalents, performance awards and stock payments, in addition to stock options and restricted stock awards were as follows:

FOR

AGAINST

ABSTENTIONS AND

BROKER NON-VOTES

8,717,704

7,360,056

131,606

(iii) Votes on the proposal to approve the amendment and restatement of the Company’s 1995 Director Option Plan to (a) provide for the ability to issue restricted stock awards in addition to non-statutory options, and (b) provide new formulas for the issuance of both restricted stock awards and non-statutory options to purchase the Company’s Common Stock were as follows:

FOR

AGAINST

ABSTENTIONS AND

BROKER NON-VOTES

10,513,142

5,651,017

45,207

(iv) Votes on the proposal to ratify the appointment of PricewaterhouseCoopers LLP as the Company’s independent accountants for the 2004 fiscal year were as follows:

FOR

AGAINST

ABSTENTIONS AND

BROKER NON-VOTES

19,530,954

281,312

15,823

Item 6. Exhibits and Reports on Form 8–K

Exhibits


10.41		Form of “Amendment to VP Continuity Agreement” between ArthroCare Corporation and its vice presidents.

10.42		Form of “Senior VP Continuity Agreement” between ArthroCare Corporation and its senior vice presidents.

10.43		Form of “Amendment to Senior VP Continuity Agreement” between ArthroCare Corporation and its senior vice presidents.

31.1		Certification of the Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2		Certification of the Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1		Certification of the Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2		Certification of the Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

b)	Reports on Form 8-K

On April 12, 2004, ArthroCare filed a Form 8-K/A including Item 7 information relating to our acquisition of Medical Device Alliance Inc.

On April 29, 2004, ArthroCare filed a Form 8-K including Item 7 information regarding a press release announcing our results of operations for the quarter ended March 31, 2004.

SIGNATURES

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


		ARTHROCARE CORPORATION
		a Delaware corporation

Date: August 6, 2004		/s/ Michael A. Baker
		Michael A. Baker
		President, Chief Executive Officer and Director (Principal Executive Officer)

Date: August 6, 2004		/s/ Fernando Sanchez
		Fernando Sanchez
		Senior Vice President,
		Operations and Chief Financial Officer
		(Principal Financial and Accounting Officer)

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