ARTHROCARE CORP - 10-K Annual Report

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 ¨ No x

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨

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

As of June 30, 2004, the aggregate market value of the voting stock held by non-affiliates of the Registrant was approximately $404,591,000 (based upon the closing sales price of such stock as reported by The NASDAQ Stock Market on such date). Shares of Common Stock held by each officer, director, and holder of 5% or more of the outstanding Common Stock on that date have been excluded in that such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes.

As of February 28, 2005, the number of outstanding shares of the Registrant’s Common Stock was 23,892,558.

Certain information required by item 5 of Part II of Form 10-K and items 10, 11, 12, 13 and 14 of Part III of Form 10-K is incorporated by reference from the Registrant’s proxy statement for the 2005 Annual Stockholders’ Meeting, which will be filed, with the Securities and Exchange Commission within 120 days after the close of the Registrant’s fiscal year ended December 31, 2004.

This Report on Form 10-K contains certain forward-looking statements regarding future events with respect to ArthroCare Corporation (“ArthroCare,” “we,” “us,” “our,” and “company” refer to ArthroCare Corporation, a Delaware corporation, unless the context otherwise requires). Actual events or results could differ materially due to a number of factors, including those described herein and in the documents incorporated herein by reference, and those factors described under “Additional Factors that Might Affect Future Results.”

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 a high level of precision and accuracy, limiting damage to surrounding tissue and thereby potentially reducing pain and speeding recovery for the patient. Our products operate at lower temperatures than traditional electrosurgical or laser surgery tools and enable surgeons to ablate (or disintegrate or remove), shrink, sculpt, cut, aspirate and suction soft tissue, and to seal small bleeding vessels. Our soft-tissue surgery systems consist of a controller unit and an assortment of sterile, single-use disposable devices that are specialized for specific types of surgery. We believe our Coblation technology can replace the multiple surgical tools traditionally used in soft-tissue surgery procedures with one multi-purpose surgical system.

Coblation technology is applicable across many soft-tissue surgical markets. Our systems are used to perform many types of surgical procedures. Our strategy includes applying our patented Coblation technology to a broad range of soft-tissue surgical markets, including arthroscopy, spinal surgery, neurosurgery, cosmetic surgery, ear, nose and throat (ENT) surgery, gynecology, urology, general surgery and various cardiac applications. In addition to our Sports Medicine business unit, formerly called the Arthroscopy business unit, created to introduce Coblation-based surgical instruments for use in shoulder and knee arthroscopic procedures, we have formed the following business units to commercialize our technology in non-orthopedic markets: ArthroCare Spine^{^™} to commercialize our technology in the spinal and neurosurgery markets; ENT to commercialize our ENT surgery products for use in head and neck surgical procedures and our Visage^® products for use in various cosmetic surgery procedures; and ArthroCare Coblation Technologies to commercialize our Coblation-based products through OEM partnerships in gynecology, urology, laparoscopic and open surgical procedures for use in general surgery, and AngioCare for developing cardiovascular applications.

We have received 510(k) clearance from the United States Food and Drug Administration, or FDA, to market our Arthroscopic Surgery System, or Arthroscopic System, for use in arthroscopic surgery of the knee, shoulder, ankle, elbow, wrist and hip. Our Arthroscopic System is comprised of an assortment of disposable bipolar multi-electrode and single electrode devices, a connecting cable, foot pedal or hand switch and a radio frequency controller. In addition, our Arthroscopic System is CE marked for use in arthroscopic surgery and the CE Mark is a requirement to sell our products in most of Western Europe. The FDA has cleared our Cosmetic Surgery System and it is CE marked for general dermatologic procedures and skin resurfacing in connection with wrinkle reduction procedures. Our ENT Surgery System is CE marked, and we have applied for the CE mark and received 510(k) clearances from the FDA for use of our ENT Surgery System in general head, neck, oral and sinus surgery procedures, including tonsillectomy and adenoidectomy, turbinate reduction to relieve nasal obstruction and soft palate stiffening to treat snoring. Our Spinal Surgery System is CE marked, and we have received 510(k) clearances in the United States to market this system for spinal surgery and neurosurgery. We have also applied for the CE mark and have received 510(k) clearance from the FDA to market products based on Coblation technology for use in general surgery, gynecology, urology, plastic and reconstructive surgery, and orthopedic surgery.

We commercially introduced our Arthroscopic System in December 1995, and have derived a significant portion of our sales from this system. Through December 31, 2004, we had shipped more than 25,000 controller units and more than 3,265,000 disposable devices for a variety of indications. We are marketing and selling our

arthroscopic, ENT, cosmetic surgery and spinal surgery products in the United States through a network of direct sales representatives and independent distributors supported by regional managers. We have also established distribution capability in Europe, Australia, New Zealand, China, Korea, Japan, Taiwan, Canada, Mexico, the Caribbean, North Africa, the Middle East and Central America. We have entered into a strategic relationship with ACMI, under which ACMI is marketing and selling our products for urologic indications, including transurethral resection of the prostate (TURP).

For information regarding the status of our regulatory approvals for our products, see the information under the heading “Government Regulation.”

ArthroCare was incorporated in California in 1993 and reincorporated in Delaware in 1995. We maintain an Internet website at http://www.arthrocare.com. On our website we make available, free of charge, the following filings as soon as reasonably practicable after they are electronically filed with or furnished to the Securities and Exchange Commission: our annual reports on Form 10-K, our quarterly reports on Form 10-Q, our current reports on Form 8-K and any amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act of 1934. You may also read and copy any materials that we file with the SEC at the SEC’s Public Reference Room at 450 Fifth Street, NW, Washington DC 20549. You may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. Our reports, proxy statements and other documents filed electronically with the SEC are available at the website maintained by the SEC at http://www.sec.gov.

Our objective is to leverage our patented Coblation technology to design, develop, manufacture and sell innovative, clinically-superior surgical devices for the surgical treatment of soft-tissue conditions throughout the body. The key elements of our strategy include:

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.

Traditional electrosurgical tools use heat to burn away targeted tissue, which often results in thermal damage to tissue surrounding the surgical area. Additionally, the lack of tactile feedback with traditional devices makes it difficult for surgeons to control the depth of tissue penetration. Coblation technology employs a highly targeted, non-thermal process that minimizes the risk of thermal burn to surrounding tissue while increasing the surgeon’s control and precision.

Coblation technology works by directing the flow of an electrically conductive fluid through the space between an active and return electrode(s) at the tip of the surgical tools. When an electrical current is passed from the electrode(s) into this fluid, it creates a charged layer of particles, or plasma, between the active and return electrode(s). As this plasma comes into contact with the targeted tissue, the charged particles in the plasma have sufficient energy to break down molecular bonds within the cells of the tissue, volumetrically dissolving the tissue cell layer by cell layer. Because this effect occurs only at the surface layer of the targeted tissue, minimal damage occurs to surrounding tissue, which can result in reduced pain and faster recovery for the patient. An additional advantage of Coblation is that it can be performed in a continuous fashion, resulting in efficient tissue removal, thereby reducing the overall procedure time as compared to conventional surgical methods. In addition to achieving more precise tissue removal and less damage to surrounding tissue, Coblation surgical tools can be designed to seal bleeding vessels near the surgical site.

We believe Coblation technology is applicable to soft-tissue surgery throughout the body, and we have expanded its use into several non-arthroscopic indications. In addition, we are exploring possibilities for the use of Coblation technology in other markets, such as laparoscopic general surgery, neurosurgery and cardiac surgery.

We commercially introduced our soft-tissue Arthroscopic System in December 1995 through what we call today our Sports Medicine business unit, formerly known as the Arthroscopy business unit. Since our Arthroscopic System accounts for a significant portion of our product sales, we are highly dependent on its sales. To date, our ArthroCare Spine, ArthroCare ENT and Coblation Technologies business units have sold a relatively smaller number of units compared to the unit sales in our Sports Medicine business unit. We cannot assure you that we will be able to continue to manufacture our products in commercial quantities at acceptable costs, or that we will be able to continue to market such products successfully.

To achieve increasing disposable device sales over time, we believe we must continue to penetrate the market in knee procedures, expand physicians’ education with respect to Coblation technology and continue working on new product development efforts specifically for 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. Currently, we place controller units with our customers at no cost or at substantial discounts in order to stimulate demand for our disposable devices.

We believe that surgeons will not use our products unless they determine, based on experience, clinical data and other factors, that these systems are an attractive alternative to conventional means of tissue ablation. There are only a few independently published clinical reports and limited long-term clinical follow-up to support the marketing efforts for our surgical systems. We believe that continued recommendations and endorsements by influential surgeons are essential for market acceptance of our surgical systems. If our Coblation technology does not continue to receive endorsement by influential surgeons or long-term data does not support the effectiveness of our surgical systems, our business, financial condition, results of operations and future growth prospects will be materially adversely affected.

In 2003, approximately 4.5 million arthroscopic procedures were performed worldwide. Due to patient demand for less invasive procedures, we believe the number of arthroscopic procedures is growing. In addition, a greater emphasis on physical fitness and an aging population are increasing the incidence of joint and soft tissue injuries. Joints are susceptible to injuries from blows, falls or twisting, as well as from natural degeneration and stiffening associated with aging.

Historically, joint injuries have been treated using open surgery involving large incisions, a hospital stay and a prolonged recovery period. In contrast, arthroscopic surgery, which was introduced in the early 1980’s, is performed through several small incisions called portals and can be performed on an outpatient basis. We believe that arthroscopic surgery has gained wide market acceptance because it offers shorter hospital stays and reduced recovery time, resulting in reduced costs and improved medical outcomes. For example, arthroscopic surgery performed on elite athletes often results in a rapid return to action and publicity concerning these athletes increases the demand for less invasive surgical options by the general public.

To perform arthroscopic surgery, a surgeon uses a tool to view the site and other tools to perform the surgery. The tool used to view the site, called an arthroscope, is a small fiber-optic viewing instrument made up of a small lens, a light source and a video camera. During the arthroscopic procedure, an irrigating solution, such as saline, is flushed through the joint to permit clear visualization through the arthroscope and to create the space within the joint for the surgical procedure. The surgeon inserts the arthroscope into the joint through a portal measuring approximately six millimeters, or 1/4 of an inch, in length. Other portals are used for the insertion of surgical instruments to perform the surgery and to facilitate the flow of irrigants. With small incision sites and direct access to most areas of the joint, a surgeon can diagnose and correct an array of joint problems, such as cartilage and meniscus tears, ligament tears and removal of loose and degenerative tissue.

The advantages of arthroscopic surgery over open surgery are often significant. Due to the smaller incisions and reduced surgical trauma, the patient might experience several benefits, including reduced pain, treatment on an outpatient basis, reduced hospitalization times, smaller scars, immediate joint mobility and less muscle atrophy, less surrounding tissue damage, a lower rate of complications and generally quicker rehabilitation. In addition, treatment on an outpatient basis and reduced operating time can significantly lower hospital costs.

The knee is the most commonly injured joint. We estimate that knee injuries accounted for nearly 60% of the 4.5 million arthroscopic procedures performed worldwide in 2003. Damage to a meniscus, a disc of fibrous tissue that helps cushion the knee joint, is the most common form of knee injury. A meniscus can be torn by a twist of the leg when the knee is flexed, displaced either inward toward the center of the shin bone or outward beyond the surface of the thighbone, or worn down by normal aging. The knee is also susceptible to partial or complete tears of the ligaments and degeneration of the cartilage on the underside of the kneecap. In addition, the cartilage covering the bony surfaces of the knee can become rough or tear loose from the bone as a result of age or injury, causing pain and interfering with smooth joint movement.

The shoulder joint, because of its range of motion, is susceptible to a number of injuries. We believe that a significant percentage of the population is born with a susceptibility to rotator cuff injuries. In 2003, approximately 1.1 million arthroscopic procedures were performed in the shoulder worldwide. We believe that shoulder arthroscopy is the fastest-growing portion of the arthroscopy market. With repetitive motion and lifting of the arm, such as that which occurs during a tennis serve, a bone formation of the upper arm may impinge one of the shoulder muscles and cause persistent pain, and may eventually tear the tissue causing a rotator cuff injury. Strengthening exercises and physiotherapy may sometimes help this condition; however, many rotator cuff injuries require surgical intervention.

The elbow, ankle, wrist and hip joints are also susceptible to certain stress-related injuries and deterioration due to aging. In 2003, approximately 600,000 arthroscopic procedures were performed in the elbow, ankle, wrist or hip worldwide. We believe that the current number of surgical procedures in the elbow, ankle, wrist and hip is relatively small due to the limitations of conventional arthroscopic surgical equipment.

It is estimated that nearly 15 million Americans suffer from injuries called tendonopathies, or tendonosis, which is a chronic pain associated with the degeneration of tendons commonly used in everyday activity. Runners’ knee, tennis and golfers’ elbow, jumpers’ knee and heel spurs are but a few of the conditions that cause pain in normal daily activities and otherwise limit normal lifestyles. Currently, the few options for these chronic conditions include rest, rehabilitation, bracing and steroid injections. Surgical options have until now been equally limited to surgical release procedures, grafts and surgical debridement, each with a significant recovery period.

Most arthroscopic procedures require the surgeon to probe, cut, sculpt and shape tissue and seal bleeding vessels to achieve satisfactory results. Surgeons frequently use a combination of instruments when performing an arthroscopic procedure because each instrument is designed to perform a specific function. Use of an assortment of tools requires the surgeon to insert and remove each of the tools from the portals several times during the same procedure.

Surgical procedures can employ one or more of four groups of surgical instruments: (1) powered or motorized instruments, such as cartilage and bone shavers; (2) mechanical instruments, such as basket punches, graspers and scissors; (3) electrosurgical systems; and (4) laser systems.

Powered instruments are generally used to smooth tissue and cartilage defects on the surface of the bones of the joint. The damaged tissue is removed from the joint using suction through a tube surrounding the shaft of the tool, which can become obstructed by bits of tissue and bone. Power shavers have rotating cutters inside a tube and are available in a number of tip angles and/or sizes for the precise shaving of tissue.

Mechanical instruments are typically hand held devices with sharpened tips that come in a variety of shapes, sizes and angles, referred to as basket punches, graspers, scissors and scalpels. These devices are used manually to remove or excise damaged tissue on the surface of the bones or joints or to remove damaged meniscal or cartilage tissue. Mechanical instruments must be resharpened at regular intervals and sterilized after each procedure.

Conventional electrosurgical systems are used to seal blood vessels, which is necessary to minimize bleeding and maximize the arthroscopic surgeon’s visibility of the procedure through the arthroscope. Conventional electrosurgical systems contain two electrodes: the electrode tip held by the surgeon and a

dispersive “return” pad that rests under the patient’s body. The metal electrode tip of the instrument, which resembles a pencil point, is placed on or near the bleeding vessel to be sealed. A generator connected to the electrode delivers high-frequency voltage that arcs between the electrode and the target tissue, sealing blood vessels in its vicinity. After arcing, the current travels through the remaining tissue of the patient’s body, through the skin to the dispersive electrode pad, before being directed back to the generator.

Laser systems are used to remove tissue while sealing bleeding vessels. Because laser systems are not tactile tools, a surgeon cannot feel how much tissue is being ablated. A surgeon must be extensively trained to precisely position a laser to control the depth of tissue penetration to minimize unintended tissue damage. In addition, the temperature of laser instruments is high and, as a result, can cause damage to surrounding tissue and vascular areas. We believe that laser tools have not received wide acceptance because of high capital cost and significant ongoing maintenance and operating expenses, as well as the concern about damage that may be caused by the significant heat generated by these devices.

Our Arthroscopic System is a radio frequency surgical device intended to perform tissue ablation, resection, as well as seal bleeding vessels. Our Arthroscopic System is comprised of an assortment of disposable bipolar multi-electrode and single electrode devices, a connecting cable, foot pedal or hand switch and a radio frequency controller. We sell our Arthroscopic System for use in all six major joints: knee, shoulder, elbow, ankle, wrist and hip. Many types of tissue, including cartilage and ligaments, can be ablated using our Arthroscopic System.

Our controller delivers radio frequency energy to the disposable surgical device without the need for a ground or “return” pad, which is required for conventional monopolar electrosurgical systems. A surgeon can use the disposable device for ablation, resection, coagulation of soft tissue and to seal bleeding vessels. A surgeon can control the mode of operation and power setting with the foot pedal or keys on the front panel of the controller. The incorporation of ablation, suction and fluid management into a single disposable device potentially reduces operating time and expense.

A surgeon using our Arthroscopic System does not need to remove and insert a variety of instruments to perform various tasks as can be required when using conventional arthroscopic instruments. Our disposable devices are approved for sale in tip sizes ranging from 1.5 mm to 0.5 mm, and in tip angles ranging from zero to 90 degrees. We currently sell 40 models for arthroscopy in various tip sizes, angles and shapes, enabling a surgeon to ablate different volumes of tissue and to reach treatment sites not readily accessible by existing mechanical instruments and motorized cutting tools. In addition, some of our disposable devices provide integrated suction capability, and have a pre-connected disposable cable that connects directly to the controller.

We commercially introduced the Arthroscopic System in December 1995. We are marketing and selling our Arthroscopic System worldwide through a network of direct sales representatives and independent orthopedic distributors supported by regional managers. We have continually increased our manufacturing capabilities while maintaining yields.

In October and November of 2002, we acquired two of our European distributors: Atlantech Medical Devices, Ltd., a distributor of ArthroCare products in the United Kingdom, and Atlantech GmbH, our German distributor. The acquisitions accelerate the implementation of our direct sales strategy in Europe, providing us with an immediate direct sales force in two key markets. We also obtained a complementary line of sports medicine products through the purchase of Atlantech Medical Devices. This product line consists of over 1500 individual arthroscopic surgery items. Each year there are over 2.7 million arthroscopic knee procedures and 1.1 million shoulder procedures that may use some portion of the Atlantech product set.

In November of 2004, we acquired Opus Medical. Opus Medical’s initial strategy was to develop, manufacture and market devices that facilitate the arthroscopic repair of the rotator cuff in the shoulder. In this target application, Opus Medical’s products will eliminate the need to use open surgery to reattach the rotator cuff to the humerus bone.

Today, more than 90% of all surgical repairs of the anterior cruciate ligament (ACL) in the knee are performed arthroscopically. In contrast, while approximately 273,000 surgical repairs of the rotator cuff were performed in the U.S. in 2003, less than 10% of all surgical repairs of the rotator cuff are performed arthroscopically due to inadequate instrumentation and the requirement for substantial technical skills, such as knot tying and intracorporeal, inside the body, suturing. Nonetheless, there is a high level of interest among surgeons in achieving total arthroscopic repair of the rotator cuff. Arthroscopic repair typically results in faster recovery, rehabilitation, lower costs and better cosmesis compared to open procedures.

The vast majority of surgeries are open or mini-open techniques. Five significant problems that currently exist with existing rotator cuff surgery that must be overcome in order to offer a total arthroscopic system are the elimination of the eyelet type bone anchor, improved suture management, the elimination of complex knot tying techniques, elimination of bulky knots in the capsule and faster suturing of the rotator cuff. The Opus AutoCuff System addresses each of the requirements for a total arthroscopic repair through its proprietary family of specialized instruments and devices. The Opus AutoCuff System is comprised of two platform enabling technologies, including an automated suturing instrument called the SmartStitch Suturing Device and a “knotless” bone anchoring system called the Magnum Knotless Implant. This may greatly reduce the recovery and patient morbidity usually associated with non-arthroscopic treatment procedures. These products may enhance efficacy, decrease complications, reduce costs, reduce procedure time and broader the treatable patient base.

We believe the spine surgery market in 2004 totaled approximately $3.5 billion worldwide and represents the most rapidly growing segment of the orthopedic surgery market, increasing, we estimate, at the rate of 15%-20% annually. U.S. government statistics indicate that back and/or leg pain is the most common reason for activity limitation in those under age 45, and is the leading cause of disability in the 45-65 age group. The National Center for Health Statistics reports that 14% of new patient visits to physician offices, approximately 13 million visits annually, are for complaints of low back pain. Approximately 80% of the general population experiences an episode of low back pain at sometime during their life, and an estimated 18% have debilitating back pain at any given time. The total societal annual cost of back pain in the United States is estimated to be between $20 billion and $50 billion. A high percentage of back pain can be traced to problems associated with intervertebral discs. Intervertebral discs mainly function to cushion and tether the vertebrae, providing flexibility and stability to the patient’s spine. Problems that can occur with intervertebral discs include degeneration and herniation. With degeneration, discs lose their water content and height, bringing the adjoining vertebrae closer together. This results in a weakening of the shock absorption properties of the disc and a narrowing of the nerve openings in the sides of the spine, which may pinch these nerves. With herniation, the outer layer of the disc, which is called the annulus, bulges and/or ruptures. Both disc degeneration and herniation can eventually cause back pain and/or pain that radiates to the extremities, including the buttocks, legs, shoulders and arms).

Often, pain and inflammation from disc degeneration or herniation can be treated successfully with non-surgical means, such as rest, therapeutic exercise or through the use of anti-inflammatory medications. In some cases, disc herniation results in intractable pain, thereby necessitating a microdiscectomy, the removal of a portion of the disc to eliminate the source of inflammation and pressure. Microdiscectomy is currently the most common spine surgery procedure performed worldwide with nearly one million performed in 2004. In more severe cases, the adjacent vertebral bodies must be stabilized following excision of the disc material to avoid recurrence of the

disabling back pain. One approach to stabilizing the vertebrae, termed spinal fusion, is to insert an interbody graft or implant into the space vacated by the degenerative disc. In this procedure, a small amount of bone may be grafted from other portions of the body, such as the hip, and packed into the implants. This allows the bone to grow through and around the implant, fusing the vertebral bodies, thereby alleviating the pain. More recently, the implantation of an artificial disc, termed disc arthroplasty, has become more popular primarily due to the potential for these artificial discs to preserve the natural motion of the spine and lead to faster recovery than fusion procedures.

Conventional Treatment Methodologies for Treatment of Spine Diseases and Disorders: The Problem

While the overall success rate for microdiscectomy with regard to significant reduction in pain is approximately 90%, published studies in peer reviewed journals indicate that the success rate is significantly lower for certain types of patients and that there are significant drawbacks to the procedure as currently performed. Specifically, according to these studies, patients with contained herniated discs, where the disc bulges but has not ruptured, achieve success rates in terms of pain relief that are below 50%. Currently, the vast majority of microdiscectomies are performed in an “open” fashion, where an incision is made that is large enough to expose the affected disc. In order to remove disc material, the surgeon creates a relatively large incision in the annulus, called an annulotomy. Several published studies have shown that microdiscectomy weakens the disc, increases the reherniation rate and may accelerate disc degeneration over time. The authors of these studies attribute these clinical side effects to the annulotomy.

Randomized controlled studies published in the literature have indicated that percutaneous disc decompression is an effective alternative to microdiscectomy for patients with contained herniated discs who have symptoms of back and/or radicular pain. Percutaneous disc decompression is a minimally invasive procedure where disc material is removed without making an incision. The disc is accessed through a narrow needle and the physician performs the procedure under fluoroscopic (live x-ray) guidance. During fiscal year 2001, we introduced the Perc-DLE Convenience Pack for percutaneous disc decompression, or volumetric tissue removal in the nucleus of the disc in the lumbar, or lower, spine. Nucleoplasty^®, a minimally invasive percutaneous discectomy procedure utilizing our Coblation technology to treat symptomatic patients with contained herniated discs, employs the process of ablation of soft tissue for partial removal of the nucleus of a disc. Coblation ablates tissue via a low-temperature, molecular dissociation process to create small channels within the disc. Late in 2002, we introduced the Perc-DC, a surgical wand very similar to the Perc-D, but designed so it can be used to perform a Nucleoplasty procedure in the cervical portion of the spine. The Micro Discoblator was introduced in the spring of 2003 to enable minimally invasive disc decompression during microdiscectomy procedures, thus avoiding an annulotomy.

In January 2004, we completed the acquisition of MDA and its wholly-owned subsidiary, Parallax, a leader in products for the treatment of vertebral compression fractures. Parallax’ product line includes vertebral access and bone biopsy needles, cement delivery systems, bone cement and opacifiers and ancillary devices.

Vertebral compression fractures occur primarily as a result of osteoporosis, although they can also be caused by tumors or trauma. We estimate that approximately 1.5 million vertebral compression fractures occur annually worldwide, that approximately one-third to one-half of these are symptomatic and that 125,000 vertebral compression fractures were treated in 2004.

We believe that in 2003, approximately six million ENT procedures were performed worldwide. The most common procedures are placement of ear tubes and the removal of tonsils and adenoids. We estimate that there

are approximately two million tonsillectomies performed worldwide each year. Other commonly performed ENT procedures include endoscopic sinus surgery, septoplasty, turbinate reduction and procedures to remove or stiffen tissue to treat obstructive sleep apnea and snoring. Highly specialized ear, nose and throat surgeons, typically in an outpatient or ambulatory surgery center, perform these procedures. For decades, monopolar electrosurgical instruments (e.g. bovie) have been the standard for removal of soft tissue and cauterization in ENT procedures. As in other surgical procedures, the high levels of heat associated with bovies often results in significant post-operative pain and extended recovery periods.

We have been marketing ENT products through a network of direct sales representatives and independent distributors supported by sales managers since February 1999 for use in general head, neck and oral surgical procedures, including sinus surgery, the treatment of snoring, reduction of nasal turbinates, adenoidectomy and tonsillectomy. Our ENT Surgery System uses the same technology as our Arthroscopic System, which removes soft tissue through a more precise and significantly cooler process than that of traditional electrosurgery devices. Our controllers, System 2000 and Coblator II, are used to deliver radio frequency energy to the disposable devices. The disposable devices are intended for single use and utilize multiple or single electrodes.

We have three categories of disposable devices, or wands, to address the ENT Market. Suction wands simultaneously ablate and remove tissue in applications such as tonsillectomy, providing enhanced visibility. Channeling wands combine controlled ablation and effective coagulative lesion formation in applications such as turbinate reduction to relieve nasal obstruction and stiffening of the soft palate for the treatment of snoring. Excision wands provide precise dissection of soft tissue with minimal damage to surrounding tissue. Coblation devices have been used in over 150,000 tonsillectomy and/or adenoidectomy procedures to date. Published clinical data and anecdotal surgeon feedback indicate that Coblation-assisted tonsillectomy provides a better overall post-operative experience for patients, including less pain, a faster return to normal diet and activity and less need for prescription medications. Coblation devices have also been used in over 250,000 turbinate reduction and snoring procedures with the primary benefits versus competitive methods being faster lesion formation and fewer and less severe post-operative morbidity.

The cosmetic surgery market primarily consists of three segments: invasive surgical procedures that remove or alter body structures, such as rhytidectomy (face lift), rhinoplasty (nose restructuring), blepheroplasty (eye lift) and liposuction; resurfacing procedures that reduce wrinkles and even out skin tone, such as laser resurfacing and chemical peels and non-invasive or less-invasive cosmetic procedures, such as botulinum toxin, collagen injections, and microdermabrasion.

Conventional treatments for skin resurfacing include chemical peels, dermabrasion and laser resurfacing. In chemical peels, an acid-based solution is used to improve the texture of the skin and reduce wrinkles by removing its damaged outer layers. Light chemical peels can improve texture but do not address wrinkles. Deeper chemical peels can reduce wrinkles but often produce uneven results and hypopigmentation, or loss of color. In dermabrasion, a mechanical device is used to remove the damaged outer layers of the skin. While dermabrasion has fallen out of favor in the majority of practices, laser resurfacing remains the most popular resurfacing procedure for the treatment of wrinkles. In particular, the carbon dioxide, or CO₂, laser is considered the gold standard for efficacy in the treatment of wrinkles. However, the excessive heat diffusion into surrounding healthy skin cells during the procedure can result in an unacceptably long recovery period and a significant level of side effects, such as hypopigmentation and scarring.

Our Cosmetic Surgery System utilizes the same technology as the Arthroscopic System and removes skin cells through a more precise and significantly cooler process than traditional electrosurgery systems or dermatologic lasers. Our Cosmetic Surgery System is a bipolar radio frequency, electrosurgical device used in skin resurfacing and other dermatologic and cosmetic procedures. Our Cosmetic Surgery System incorporates a bipolar disposable device, which is a connecting resterilizable headpiece with cable and a radio frequency controller. The controller delivers radio frequency energy to multi-electrode or single electrode disposable devices. Our Cosmetic Surgery System has been cleared by the FDA for skin resurfacing for treatment of wrinkles, as well as for general dermatologic procedures. We believe our Cosmetic Surgery System, when used for skin resurfacing, results in more rapid recovery than seen with CO₂ laser systems. We are not focusing our direct sales organization or marketing investments on the Cosmetic surgery system at this time; instead, distribution activities for the Coblation Cosmetic Surgery System are limited to serving this market through distributor agreements.

We established our Coblation Technologies division to develop and manufacture products as an OEM supplier of Coblation-based surgical instruments to companies in general surgery, cardiology, urology and gynecology markets. In urology, we have entered into a strategic relationship with ACMI, under which ACMI markets and sells our products for urologic indications, including transurethral resection of the prostate (TURP).

Our patented Coblation technology, delivered in the form of multi-electrode and single electrode, bipolar disposable devices, offers a number of benefits that we believe may provide advantages over competing surgical methods and devices. The principal benefits include:

We have focused our research and development efforts in three areas. First, in response to physician feedback, we introduced two new generator platforms in 2003 with several innovative features allowing increased ablation performance for Sports Medicine and ENT, and more control and power for coagulation in

ENT. Second, we have continued to design new disposable devices that incorporate added functionalities for faster and easier use. Third, we have developed products for new applications like urology and are exploring other new applications of our Coblation technology in other soft-tissue surgical markets. Research and development expenses were $13.3 million in 2004, $10.6 million in 2003 and $8.8 million in 2002.

We have also undertaken preliminary studies and development for the use of our technology in several new fields. To this end, we continue to explore and develop the plasma physics underlying Coblation technology. We are engaged with a number of doctors, scientists and research institutions to further understand the technology and its additional applications and other technical improvements. We have also initiated a collaborative research effort with two major Russian plasma physics laboratories and the Lawrence Livermore Laboratory to extend the application of Coblation technology to other types of tissues. In this effort, the Russian plasma physics laboratories and the Lawrence Livermore Laboratory are supported by a financial grant from the Department of Energy in conjunction with that Department’s efforts to identify non-military, commercial applications for former Soviet institute technologies. These unique partnerships provide new resources and markets for U.S. companies, while establishing important private sector linkages for former Soviet weapons scientists and engineers.

Our disposable devices are primarily manufactured at our 42,000 square foot facility located in a tax-advantaged industrial park in San Jose, Costa Rica. This facility commenced operations in 2002 and by year end 2004 was producing essentially all of our disposable device requirements at yields and quality levels similar to those generated in our Sunnyvale facility. In 2004, we transferred the manufacturing of our controllers from Sunnyvale to our Costa Rica facility. As of December 31, 2004, our Costa Rica facility was producing 100% of our requirements for controllers.

In 2003, we transformed our primary Sunnyvale facility from a general manufacturing facility to a facility with an increased focus on research, development and prototype manufacturing. This 52,000 square foot facility was acquired through a five-year lease agreement in September 2001 and became fully operational for our clean room manufacturing operations in January 2002. Approximately 50% of this facility is devoted to research and new product development. We believe that our Sunnyvale and Costa Rican operations will provide adequate capacity for our manufacturing needs through 2006.

Our products are manufactured from several components, most of which are supplied to us from third parties. Most of the components that we use in the manufacture of our products are available from more than one qualified supplier. For some components, however, there are relatively few alternative sources of supply and the establishment of additional or replacement suppliers may not be accomplished quickly. In isolated cases, we rely upon single source suppliers. We also use a single subcontractor to sterilize our disposable devices, but do not believe a major disruption is likely because the supplier has multiple sterilization facilities throughout the United States as well as internationally, and there are competing sterilization companies that offer similar services. Our Atlantech product line of handheld instruments are primarily single sourced. Disruption of this supply source would result in a material disruption of our ability to sell this line of products for an extended time period. See “Additional Factors that Might Affect Future Results—We Have Limited Manufacturing Experience” for additional information regarding the potential disruption in supply of our products and risks to our operations resulting from our reliance upon single source suppliers.

We have established quality assurance systems in conformance with the FDA’s Quality System Regulation, or QSR. Our facilities in Sunnyvale and Costa Rica have received ISO 9001/and ISO 13485 and CMDCAS certification and are in conformance with the Medical Device Directive, or MDD, for the sale of products in Europe.

In 2003, we entered into a comprehensive agreement with DHL Worldwide Express, Inc. This agreement identifies DHL as the primary provider of a full suite of logistic services to include warehousing of finished goods, shipment of finished products to customers and field returns, along with management of a portion our in- bound freight requirements. We have experienced favorable cost performance and have gained an ability to scale

our business at a faster pace due to this agreement. However, the complex nature of the underlying support technologies, such as “Electronic Data Interchange,” has, at times, caused disruptions in our ability to deliver products to customers on a timely basis. Failure of these supporting systems could impair our business for the duration of the failure. This agreement was executed in mid-2003 and expires in the fourth quarter of 2005, after which time we, at our sole discretion, may renew the agreement with DHL, terminate the agreement or move the business to a different logistics provider. Full implementation of this agreement in our international business is pending resolution of several operational and business issues.

As of December 31, 2004, we have shipped more than 25,000 controller units and over 3,265,000 disposable devices for a variety of indications. We use a combination of distributors supported by regional sales mangers, a direct sales force and corporate partners to sell our products both domestically and internationally. In the U.S., we principally use distributors and field sales representatives to sell our products. In Europe, we accelerated our strategy to move to a direct sales organization, by acquiring Atlantech Medical Devices, our distributor in the United Kingdom, in October 2002, Atlantech GmbH, our German distributor, in November 2002, and Atlantech Medizinische Produkte Vertreibs, our Austrian distributor, in April 2003. These transactions have provided us with an immediate direct sales force in two key European markets. As of December 31, 2004, we employed 71 employees in Europe, 40 of whom are involved in sales and marketing.

Outside of the U.S. and Europe, we have established distribution capability in certain countries by means of exclusive and non-exclusive distribution agreements with corporations, including Kobayashi Pharmaceutical for the distribution of our arthroscopy, spinal surgery and ENT surgery products in Japan. We have also established distribution capability through relationships with distributors of arthroscopy products in Europe, South Africa, South and Central America and Russia. For information regarding product sales in certain product markets and geographic areas, see Note 18, “Segment Information,” in the Notes to Consolidated Financial Statements in this Form 10-K. ACMI is our worldwide distributor for urology.

We believe the use of our products is generally intuitive to surgeons and does not require extensive training. We frequently conduct training seminars and demonstrations at regional training centers and trade shows. Our partners also conduct training activities in their areas of responsibility.

At hospitals and surgical centers where several procedures can be performed simultaneously, the procurement of multiple controllers is required. We have offered our controllers at substantial discounts in the past and may be required to continue to offer such discounts to generate demand for our disposable devices. In addition, motorized and mechanical instruments, lasers and electro surgery systems currently used by hospitals, surgical centers and private physicians have become widely accepted.

Our ability to compete effectively depends in part on developing and maintaining the proprietary aspects of our Coblation technology. We own over 125 issued U.S. patents and over 50 issued international patents. In addition, we have over 150 U.S. and international pending patent applications. We believe that our issued patents are directed at, among other things, 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 many different surgical procedures.

We cannot assure you that the patents we have obtained, or any patents that we may obtain as a result of our U.S. or international patent applications, will provide any competitive advantages for our products or that they will not be successfully challenged, invalidated or circumvented in the future. In addition, we cannot assure you that competitors, many of whom have substantial resources and have made substantial investments in competing technologies, will not seek to apply for and obtain patents that will prevent, limit or interfere with our ability to make, use and sell our products either in the United States or in international markets.

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

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

The medical device industry has been characterized by extensive litigation regarding patents and other intellectual property rights, and companies in the medical device industry have employed intellectual property litigation to gain a competitive advantage. We cannot assure you that we will not become subject to patent infringement claims or litigation or interference proceedings declared by the United States Patent and Trademark office, or USPTO, to determine the priority of inventions. In July 2001, we filed a lawsuit against Smith & Nephew 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 and held a hearing on September 15, 2003 to consider Smith & Nephew’s motions to overturn the jury’s verdict. On March 10, 2004, the U.S. District Court in Delaware granted our motion to permanently enjoin Smith & Nephew from manufacturing, using or selling in the United States surgical devices (the Saphyre^{^™}, Dyonics Control RF and ElectroBlade) that infringe our 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 our 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 an injunction order enjoining Smith & Nephew from the use, manufacture and sale of the infringing products in the United States. Smith & Nephew has appealed the above rulings in the Federal Circuit Court of Appeals. The U.S. District Court is to hold a second trial to award damages to us for the infringing activity of Smith & Nephew. On April 3, 2003, Smith & Nephew filed a lawsuit against us in the United States District Court, Western Tennessee alleging that we infringed two Smith & Nephew patents. In addition, Smith & Nephew has alleged that we are in violation of Section 43(A) of the Lanham Act for allegedly making false or misleading statements to deceive potential purchasers of Smith & Nephew’s medical devices. Smith & Nephew has requested that the Court issue a preliminary and permanent injunction preventing us from further infringement of the above mentioned patents and from making further false or misleading statements concerning Smith & Nephew’s medical devices. We believe these claims to be without merit and will defend ourselves vigorously. A jury trial is scheduled for October 2005.

The defense and prosecution of these lawsuits and intellectual property suits generally, USPTO interference proceedings and related legal and administrative proceedings are both costly and time-consuming. We believe

that this lawsuit was necessary, and if others violate our proprietary rights, further litigation may be necessary to enforce our patents, to protect trade secrets or know-how owned by us or to determine the enforceability, scope and validity of the proprietary rights of others. Any litigation or interference proceedings will be costly and cause significant diversion of effort by our technical and management personnel. An adverse determination in existing litigation, additional litigation or interference proceedings to which we may become a party could subject us to significant liabilities to third parties, require disputed rights to be licensed from third parties or require us to cease using certain technology. Furthermore, we cannot be sure that we could obtain necessary licenses on satisfactory terms, if at all. Adverse determinations in judicial or administrative proceedings or failure to obtain necessary licenses could prevent us from manufacturing and selling our products, which would have a material adverse effect on our business, financial condition, results of operations, and future growth prospects.

We believe that the principal competitive factors in soft-tissue surgery markets include:

We compete directly with the providers of tissue removal systems, including conventional electrosurgical systems, manual instruments, power shavers and laser systems. Smith & Nephew Endoscopy, which owns Acufex Microsurgical, Inc. and Dyonics, Inc. and has recently acquired Oratec Interventions, Inc., Conmed Corporation, including its Linvatec unit, Arthrex and Stryker Corporation each have large shares of the market for manual instruments, power shavers and arthroscopes.

Johnson & Johnson, including Mitek, a division of its Ethicon, Inc. unit, markets a bipolar electrosurgical system developed by Gyrus Medical Ltd., a company based in the United Kingdom, which competes with us. Stryker Corporation and Smith & Nephew have recently introduced a bipolar electrosurgical system. The bipolar electrosurgical systems marketed by Mitek, Stryker and Smith & Nephew competes directly with our tissue ablation and shrinkage technology in Sports Medicine. In addition, the Linvatec unit of Conmed Corporation is marketing a monopolar electrosurgical tool for tissue ablation in arthroscopy. The Endoscopy Division of Smith & Nephew, by virtue of its acquisition of Oratec Interventions, manufactures and sells a monopolar tissue ablation, shrinkage system that competes directly with our arthroscopic products, and has recently introduced a bipolar tissue ablation and coagulation system that also competes directly with our Coblation arthroscopy products.

We believe that our Arthroscopic System, comprising the controller unit and disposable devices, presents a very competitive alternative when compared to other tools being used in arthroscopic procedures. While our disposable devices perform many functions in one tool, most competitive disposable devices only perform a single function. With such devices, multiple disposable or reusable devices would be required. Laser systems have a significantly higher capital cost than our controller and require significant ongoing maintenance and operating expenses. We are also aware of additional competitors that may commercialize products using technology similar to ours.

These same competitors also compete against our Opus product set with rotator cuff repair systems that include suture passers and bone anchors to complete the repair. These same competitors also compete against our Atlantech product set by providing a wide range of instruments for arthroscopic knee and shoulder surgery.

We believe that Coblation technology will compete effectively against other options for percutaneous disc decompression, including the DeKompressor^™ from Stryker, which is a powered mechanical device, other mechanical devices and laser, or LASE, devices. We may indirectly compete with large companies in the spine fusion and discectomy markets such as DePuy Acromed, Medtronic Sofamor Danek, Stryker, Centerpulse and Synthes. In addition, we are aware of several small companies offering alternative treatments for back pain that may indirectly compete with our products. For example, Oratec Interventions, now part of the Smith & Nephew Endoscopy Division, manufactures and sells a catheter that uses resistive heating to reduce chronic low back pain caused by degenerative disc disease. Radionics, a division of Tyco, manufactures and sells a catheter that uses resistive heating to reduce chronic low back pain caused by degenerative disc disease.

In the vertebral compression fracture market, the primary direct competitors in the vertebroplasty market are Stryker, Cardinal Health/Allegiance and Cook Medical. Kyphon, with its balloon kyphoplasty procedure, is our leading competitor in the overall vertebral compression fracture market.

There are large companies, such as Gyrus Medical Ltd. and Medtronic, Incorporated, which owns Xomed Surgical Products, Inc., which have shares of the ENT market for manual and powered instruments for ENT, head and neck surgical procedures. We expect that competition from these and other well-established competitors will increase as will competition from smaller medical device companies, such as Somnus Medical Technologies, Inc., owned by Gyrus Medical Ltd. Somnus Medical Technologies, Inc. manufactures and sells medical devices that utilize radio frequency energy for the treatment of upper airway disorders, such as turbinate reduction, snoring and obstructive sleep apnea.

The cosmetic surgery industry includes a number of large and well established companies that provide devices for rejuvenating skin, hair removal, scar removal, the treatment of vascular and pigmented lesions and other applications, including companies that manufacture and sell dermabrasion equipment or chemical peels and companies that manufacture and sell lasers. In skin resurfacing, we directly compete with much larger companies that manufacture lasers for medical use, such as Lumenis, Inc., a company that resulted from the acquisition of Coherent Medical Group by ESC Medical Group. Lumenis develops and markets lasers for a broad range of cosmetic applications, including the non-invasive treatment of varicose veins and other benign vascular lesions, hair removal, skin rejuvenation and other applications. In addition, other large companies manufacture and sell medical devices that use radio frequency energy for certain applications in dermatology and cosmetic surgery.

We cannot assure you that we can effectively convince surgeons and physicians to adopt our Coblation technology in the face of competition. In addition, we cannot be sure that these or other companies will not succeed in developing technologies and products that are more effective than ours or that would render our technology or products obsolete or uncompetitive. Many of these competitors have significantly greater financial, manufacturing, marketing, distribution and technical resources than we do. In fact, due to market conditions, we are not presently focusing our direct sales organization or marketing investments on the Cosmetic surgery system at this time. Instead our distribution activities for the Coblation Cosmetic surgery system are limited to serving this market through distributor agreements within and outside the U.S. We have received 510(k) clearances to market tissue ablation products to treat disorders in other surgical fields that we may enter. These fields are intensely competitive and we cannot assure you that these potential products would be successfully marketed.

We believe that Coblation technologies will compete effectively against a variety of technologies used in gynecology, urology, laparoscopic and cardiology procedures. There are several large companies, such as Ethicon ENDO, a division of Johnson & Johnson; Valleylab, a division of U.S. Surgical; and Gyrus and Olympus Medical Systems Group, which have shares of the gynecology market for mechanical, ultrasonic, monopolar and bipolar instruments. In the field of urology, we face competition from companies that market monopolar, bipolar, mechanical, ultrasonic and laser devices for a variety of urological procedures, including transurethral prostatectomy (TURP) and transurethral incisions in the prostate (TUIP). These companies include Karl Storz, Olympus Medical Systems Group, C.R. Bard, Gyrus, Medtronic, Urologix and Laserscope. We expect that competition from these and other well-established competitors will increase as will competition from smaller medical device companies in both the field of gynecology and urology. Several large companies, including Edwards Lifescience, Medtronic, Guidant, Johnson & Johnson and St. Jude Medical, dominate cardiology. These companies, including several smaller companies, offer mechanical, powered, laser and electrosurgical systems.

We cannot assure you that we, or our corporate partners, can effectively convince surgeons and physicians to adopt Coblation technology in the face of competition. In addition, we cannot be sure that these or other companies will not succeed in developing technologies and products that are more effective than ours, or that would render our technology or products obsolete or uncompetitive. Many of these competitors have significantly greater financial, manufacturing, marketing, distribution and technical resources than we do, or they have corporate partners with greater financial, manufacturing, marketing, distribution and technical resources than we have. The gynecology, urology and cardiology fields are intensely competitive and we cannot assure you that Coblation-based potential products would be successfully marketed by our corporate partners or us.

In the United States, health care providers, such as hospitals and physicians, that purchase medical devices, such as our products, generally rely on third-party payors, principally federal Medicare, state Medicaid and private health insurance plans, to reimburse all or part of the cost of the procedure in which the medical device is being used. Reimbursement for arthroscopic, ENT surgery, spinal and neurosurgery, gynecology, urology and general surgery and cardiac surgery procedures performed using devices that have received FDA clearance has generally been available in the United States. Generally, cosmetic procedures are not reimbursed. In addition, some health care providers are moving toward a managed care system in which providers contract to provide comprehensive health care for a fixed cost per person. Managed care providers are attempting to control the cost of health care by authorizing fewer elective surgical procedures.

Nucleoplasty is our version of percutaneous discectomy. It involves the use of an ArthroCare Spine surgical device to remove a portion of the nucleus in order to decompress the disc. Several payors consider percutaneous discectomy in any form investigational, and others cover percutaneous discectomy, but consider Nucleoplasty investigational. Currently, major insurance carriers, such as United, Aetna, and the vast majority of Blue Cross and Blue Shield plans, do not cover Nucleoplasty. There is no assurance that we will be able to obtain coverage with these payors for percutaneous discectomy in general, and Nucleoplasty in particular.

Noncompliance with applicable regulatory requirements can result in enforcement action, which may include:

Unless an exemption applies, generally, before we can introduce a new medical device into the United States market, we must obtain FDA clearance of a 510(k) premarket notification or approval of a premarket approval application, or PMA application. If we can establish that our device is “substantially equivalent” to a “predicate device,” i.e., a legally marketed Class I or Class II device or a preamendment Class III device (i.e., a device that was in commercial distribution before May 28, 1976) for which the FDA has not called for PMAs, we may seek clearance from the FDA to market the device by submitting a 510(k) premarket notification. The 510(k) premarket notification must be supported by appropriate data, including, in some cases, clinical data establishing the claim of substantial equivalence to the satisfaction of the FDA.

We have received 510(k) clearance to market our Arthroscopic System for surgery of the knee, shoulder, elbow, wrist, hip and ankle joints. We have received clearance to market our Spinal Surgery System in the United States for spinal and neurosurgery as well as the treatment of symptomatic patients with contained herniated discs. In addition, we have received 510(k) clearance to market our Cosmetic Surgery System in general dermatology and for skin resurfacing for the treatment of wrinkles. We have received 510(k) clearance to market our ENT Surgery System in general head, neck and sinus surgical procedures, as well as treatment of snoring, turbinate reduction, submucosal palatal and tissue shrinkage procedures and tonsillectomies. We have received 510(k) clearance to market our Coblation-based products for a variety of laporscopic and open general surgery and gynecology procedures. We have received 510(k) clearance to market our Coblation-based urology products for endoscopic urological procedures, including transurethral prostatectomy (TURP) and transurethral incisions in the prostate (TUIP). Our products are CE marked and are available for sale in the European Union (EU). We cannot assure you that we will be able to obtain necessary clearances or approvals to market any other products, or existing products for new intended uses, on a timely basis, if at all. Delays in receipt or failure to receive clearances or approvals, the loss of previously received clearances or approvals, or failure to comply with existing or future regulatory requirements could have a material adverse effect on our business, financial condition, results of operations and future growth prospects.

After a device receives 510(k) clearance, any modification that could significantly affect its safety or effectiveness, or that would constitute a major change in the intended use of the device, technology, materials, packaging, and certain manufacturing process may require a new 510(k) clearance and the FDA may retroactively require the manufacturer to submit a premarket notification requesting 510(k) clearance. The FDA

also can require the manufacturer to cease marketing and/or recall the modified device until 510(k) clearance is obtained. FDA guidance documents define when to submit premarket notifications for new or modified devices. These guidance documents also define modifications for which a new 510(k) is not required. We have modified some of our marketed devices, and have determined that in certain instances new 510(k) clearances are not required. When a 510(k) clearance has been required, premarket notifications have been submitted to the FDA documenting the specific device modifications. No assurance can be given that the FDA would agree with any of our decisions not to seek 510(k) clearance. If the FDA requires us to cease marketing and/or recall the modified device until we obtain a new 510(k) clearance, our business, financial condition, results of operations and future growth prospects could be materially adversely affected.

If we cannot establish that a proposed device is substantially equivalent to a legally marketed device, we must seek premarket approval through submission of a PMA application. A PMA application must be supported by extensive data, including, in many instances, preclinical and clinical trial data, as well as extensive literature to prove the safety and effectiveness of the device. If necessary, we will file a PMA application for approval to sell our potential products. The PMA process can be expensive, uncertain and lengthy. We cannot assure you that we will be able to obtain PMA approvals on a timely basis, if at all, and delays in receipt or failure to receive approvals, could have a material adverse effect on our business, financial condition, results of operations and future growth prospects.

We are also required to demonstrate and maintain compliance with the Quality System Regulation, or QSR. The QSR incorporates the requirements of Good Manufacturing Practice and relates to product design, testing, and manufacturing quality assurance, as well as the maintenance of records and documentation. The FDA enforces the QSR through inspections. We cannot assure you that we or our key component suppliers are or will continue to be in compliance, will not encounter any manufacturing difficulties, or that we or any of our subcontractors or key component suppliers will be able to maintain compliance with regulatory requirements. Failure to do so will have a material adverse effect on our business, financial condition, results of operations and future growth prospects.

We may not promote or advertise our products for uses not within the scope of our clearances or approvals or make unsupported safety and effectiveness claims. These determinations can be subjective. We cannot assure you that the FDA would agree that all of our promotional claims are permissible or that the FDA will not require us to revise our promotional claims or take enforcement action against us based upon our labeling and promotional materials.

International sales of our products are subject to strict regulatory requirements. The regulatory review process varies from country to country. We have obtained regulatory clearance to market our Arthroscopic System in Europe, Japan, Australia, Taiwan, Korea, Canada, China, Israel, the Middle East, South America and Mexico; to market our cosmetic surgery products in Europe, Australia, Canada, the Middle East, Korea, South America and Israel; to market our ENT surgery products in Europe, Australia, Canada, China, Israel, Japan, Middle East, Korea Taiwan, Australia and South America; to market our spinal surgery products in Europe, Canada, Japan, South America, Australia, Korea, Mexico, the Middle East and Taiwan; to market our general surgery products in Europe, Canada, the Middle East, Korea, South America, and Taiwan; and to market neurosurgery products in Europe, Australia, South America and Japan, but we have not obtained any other international regulatory approvals in other international markets. We cannot assure you that we will obtain such clearances and approvals on a timely basis, or at all.

For European distribution, we have received ISO 9001 and ISO 13485 certification and the EC Certificate pursuant to the European Union Medical Device Directive 93/42/EEC, allowing us to CE mark our products after assembling appropriate documentation. ISO 9001 and ISO 13485 certification standards for quality operations have been developed to ensure that companies know the standards of quality on a worldwide basis. Failure to maintain the CE Mark will preclude us from selling our products in Europe. For Canadian distribution, we have

received CMDCAS certification allowing us to market our products in Canada. We cannot assure you that we will be successful in maintaining certification requirements. During the years ended December 31, 2004, 2003 and 2002, approximately 25%, 24% and 18%, respectively, of our sales were derived internationally.

The development, manufacture and sale of medical products entail significant risk of product liability claims. Our current product liability insurance coverage limits are $10,000,000 per occurrence and $10,000,000 in the aggregate. We cannot assure you that such coverage limits are adequate to protect us from any liabilities we might incur in connection with the development, manufacture and sale of our products. In addition, we may require increased product liability coverage as products are successfully commercialized in additional applications. Product liability insurance is expensive and in the future may not be available to us on acceptable terms, if at all. A successful product liability claim or series of claims brought against us in excess of our insurance coverage could have a material adverse effect on our business, financial condition, results of operations and prospects.

As of December 31, 2004, in North America, we had 643 employees, of which 322 were engaged in manufacturing activities, 71 in research and development activities, 179 in sales and marketing activities, 27 in regulatory affairs and quality assurance and 44 in administration and finance. In Europe, we have 81 employees in sales, marketing, product development, customer service and administration who are responsible for our international business. In Costa Rica, we have 306 employees engaged in manufacturing. We have no employees covered by collective bargaining agreements, and we believe we maintain good relations with our employees.

We are dependent upon a number of key management and technical personnel. The loss of the services of one or more key employees or consultants could have a material adverse effect on us. Our success also depends on our ability to attract and retain additional highly qualified management and technical personnel. We face intense competition for qualified personnel, any of whom often receive competing employment offers. We cannot assure you that we will continue to be able to attract and retain such personnel. Furthermore, our scientific advisory board members are all otherwise employed on a full-time basis. As a result, our scientific advisory board members are not available to devote their full time or attention to our affairs.

We commercially introduced our Arthroscopic System in December 1995. Since our Arthroscopic System accounted for 56% of our product sales in 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.

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.

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 15% and 19%, respectively, of our product sales in 2004 such that product sales in our three core businesses accounted for approximately 100% of our product sales in 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 any of these 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:

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.”

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.

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 or the availability of certain product drawings and/or specifications. 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 our operation and ability to supply products for a period of time.

We are also dependent on the performance of our 3PL logistics partner. Should this supplier experience a work stoppage for whatever reason, we would be unable to supply products to its customers on a timely basis. This work stoppage could take the form of labor action, significant weather events or extended systems downtime, which could materially adversely affect our business.

In 2003 and 2004, we acquired three companies representing three lines of business independent of our core Coblation platform: Atlantech and its mechanical handheld instruments; MDA and its line of Parallax bone cement and delivery systems; and Opus and its line of tissue suturing and anchoring products. Integration of these business has been a significant challenge to our the existing resources. At times, these integration issues have restricted sales of one or more product lines as a host of systems, distribution, logistics and product supply issues have materialized. While we are diligently focused on successful integration, the newness of these technologies along with the disbursed nature of the product development and supply chain represents a risk to our business and availability of internal resources. If we are unsuccessful in integrating these businesses, or experience disruptions related to our integration efforts, then our financial condition, results of operations and future growth prospects could be materially adversely affected.

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 that 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 International, Inc., 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.

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.

Nucleoplasty is our 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 others 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 specifically.

We achieved profitability in 1999 and, as of December 31, 2004, we had an accumulated deficit of $17.9 million. Results of operations may fluctuate significantly from quarter to quarter due to many factors, including the following:

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 and continue to integrate our recent acquisitions. We cannot assure you that we will maintain or increase our revenues or level of profitability.

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.

In July 2001, we filed a lawsuit against Smith & Nephew 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 and held a hearing on September 15, 2003 to consider Smith & Nephew’s motions to overturn the jury’s verdict. On March 10, 2004, the U.S. District Court in Delaware granted our motion to permanently enjoin Smith & Nephew from manufacturing, using or selling in the United States surgical devices (the Saphyre^{^™}, Dyonics Control RF and ElectroBlade) that infringe our 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 our 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 an injunction order enjoining Smith & Nephew from the use, manufacture and sale of the infringing products in the United States. Smith & Nephew’s has appealed the above rulings in the Federal Circuit Court of Appeals. In addition, the U.S. District Court is to hold a second trial to award damages to us for the infringing activity of Smith & Nephew.

On April 3, 2003, Smith & Nephew filed a lawsuit against us in the United States District Court, Western Tennessee alleging that we infringed two Smith & Nephew patents—nos. 5,980,504 and 6,261,311. Smith & Nephew has also alleged that we are in violation of Section 43(A) of the Lanham Act for allegedly making false or misleading statements to deceive potential purchasers of Smith & Nephew’s medical devices. Smith & Nephew has requested that the Court issue a preliminary and permanent injunction preventing us from further infringement of the above mentioned patents and from making further false or misleading statements concerning Smith & Nephew’s medical devices. In addition, Smith & Nephew has requested that the Court award compensatory damages and treble damages for willfulness, as well as legal fees. We believe these claims to be without merit and will defend ourselves vigorously. A jury trial is scheduled for October 2005.

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.

During the fiscal year ended December 31, 2004 our common stock has traded between a range of $19.76 and $33.11 per share. The market price of our common stock could continue to fluctuate substantially due to a variety of factors, including:

The market price for our common stock may also be affected by our ability to meet analysts’ expectations. Any failure to meet such expectations, even slightly, could have an adverse effect on the market price and volume fluctuations. This volatility has had a significant effect on the market prices of securities issued by many companies for reasons unrelated to the operating performance of these companies. In the past, following periods of volatility in the market price of a company’s securities, securities class action litigation has often been instituted against us. 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,” 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; 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” above.

Information pertaining to our products and indications before they can be commercialized can be found under the heading “Government Regulations” in Item 1, above.

We rely exclusively on our San Jose, Costa Rica facility to manufacture our high-volume Coblation products. If our Costa Rica facility is unable to produce our Coblation products in sufficient quantities or with adequate quality, or if our operations at our Costa Rican facility are disrupted, we will be forced to find alternative manufacturing options, which could cause sales to be delayed or increase our manufacturing costs, which could harm our reputation and profitability

Our high-volume disposable devices and controllers are primarily manufactured at our company-owned facility in a tax-advantaged industrial park in San Jose, Costa Rica. This facility commenced operations in 2002 and by year end 2004 was producing approximately 90% of our disposable device requirements, including as of December 31, 2004, 100% of our requirements for controllers. If our Costa Rica facility is not able to produce sufficient quantities of our controllers and other high-volume Coblation products with adequate quality, or if our Costa Rica operations are disrupted for any reason, then we may be forced to locate alternative manufacturing facilities, including facilities operated by third parties. Disruptions may include, but are not limited to changes in the legal and regulatory environment in Costa Rica; slowdowns or work stoppages within the Costa Rican customs authorities; acts of God and other issues associated with significant operations that are remote from our headquarters and operations centers. Locating alternative facilities would be time-consuming, would disrupt our production and cause shipment delays and could result in damage to our reputation and profitability. We cannot guarantee that alternative manufacturing facilities offering the cost and tax advantages associated with our Costa Rica facility would be available on favorable terms, or at all.

We lease an approximately 4,800 square foot facility in Austin, Texas for general and administrative purposes. Our lease for this building will expire in June 2006. We lease an approximately 52,000 square foot facility in

Sunnyvale, California for administrative offices, research and development, general and administrative purposes, advanced manufacturing, warehousing, and distribution. Our lease for this building will expire in February 2007.

We also lease a 7,000 square foot warehouse in a neighboring building in Sunnyvale, California to support product development requirements. This lease expires at the end of 2005. Also in the United States, we lease approximately 2,000 square feet in Sanford, Florida, which is used to house and distribute trade show booths and other promotional materials. This lease expires in 2006. In addition, as a result of our acquisition of MDA, we assumed a lease for a 12,800 square foot facility in Scotts Valley, California. We have negotiated an exit agreement with the landlord of this facility and our occupancy and leasing of this facility is scheduled to end on April 15, 2005, at which time we will pay a $255,000 early cancelation payment. As a result of our acquisition of Opus Medical we have a 10,000 square foot facility in San Juan Capistrano, California. This facility houses product development and limited manufacturing capability associated with the Opus Medical product line. This lease expires at the end of 2005.

Internationally, we lease 4,100 square feet in Stockholm, Sweden, which serves as our headquarters for International Operations, approximately 750 square feet in Vesoul, France, 3,100 square feet in Harrogate, England and 1,400 square feet in Radevormwald, Germany, all for administrative, sales and marketing purposes. The Harrogate, U.K. facility also contributes to the product development process for a portion of our Sports Medicine product line. We also own a 42,000 square foot building in Costa Rica located in a tax-advantaged business park. This building serves as our principal manufacturing location for disposable devices.

On July 25, 2001, we filed a lawsuit against Smith & Nephew, Inc. (Smith & Nephew) in the United States District Court of Delaware. The lawsuit alleges, among other things, that Smith & Nephew has been, and is currently, infringing three patents issued to ArthroCare. Specifically, Smith & Nephew uses, imports, markets and sells electrosurgical products under the names of Dyonics Control RF System, ElectroBlade and Saphyre^{^™} that infringe these patents. We seek the following remedies: (1) a judgment that Smith & Nephew has infringed these patents; (2) a permanent injunction precluding Smith & Nephew 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 Smith & Nephew’s use of our inventions with the damages to be trebled because of Smith & Nephew’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^{^™} 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. On March 10, 2004, the U.S. District Court in Delaware granted our motion to permanently enjoin Smith & Nephew from manufacturing, using or selling in the United States surgical devices (the Saphyre^{^™}, Dyonics Control RF and ElectroBlade) that infringe our 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 our 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 an injunction order enjoining Smith & Nephew from the use, manufacture and sale of the infringing products in the United States. Smith & Nephew’s has appealed the above rulings in the Federal Circuit Court of Appeals. In addition, the U.S. District Court is to hold a second trial to award damages to us for the infringing activity of Smith & Nephew.

Smith & Nephew’s medical devices. In addition, Smith & Nephew has requested that the Court award compensatory damages and treble damages for willfulness, as well as legal fees. We believe these claims to be without merit and will defend ourselves vigorously. A jury trial is scheduled for October 2005.

In April 2002, a product liability suit was brought against us in the United States District Court, District of Maine. The lawsuit alleged that a patient suffered damage to his knee as a result of the use of an ArthroCare probe in an arthroscopic procedure. The lawsuit included a claim for punitive damages; however, the court on summary judgment dismissed this claim, along with others. A jury trial on the remaining allegations commenced on June 30, 2003 and was completed on July 15, 2003. The jury returned with a defense verdict, denying all of the plaintiff’s liability claims and finding that the ArthroCare probe does not have a design defect and ArthroCare did not fail to warn physicians about any alleged dangers of using the ArthroCare probe on articular cartilage.

In July 2003, a product liability suit was brought against us in the New York State Supreme Court, County of Westchester. The lawsuit alleged 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 will defend ourselves vigorously.

In August 2001, a product liability suit was brought against us in the Superior Court Arizona, county of Yavapai. The lawsuit alleges that a patient suffered internal and external injury to the patient’s knee as a result of a defective ArthroCare probe used in an arthroscopic procedure on the patient. This case was settled in 2003 with no significant impact to ArthroCare’s financial condition.

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 alleged 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. The parties settled this suit in 2004.

In October 2002, ArthroCare acquired all the outstanding shares of Atlantech Medical Devices, Ltd. (“Atlantech”), a distributor of medical device products in the United Kingdom. Atlantech was involved in litigation with a former reseller regarding termination of a purported distribution agreement and seeks damages for alleged breach of contract. This lawsuit was settled in February 2003 with no significant impact to ArthroCare’s financial condition.

On October 27, 2003, a product liability suit was brought against us in the 9^th 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. We believe these claims to be without merit and will defend ourselves vigorously.

On March 1, 2004, a product liability suit was brought against us in the Circuit Court of Tennessee for the 30^th 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 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.

On October 28, 2004, we received a letter from an attorney representing a patient who underwent a rotator cuff surgery on October 16, 2003 in Texarkana, Texas. The letter alleges, among other things, that the patient suffered injury to her shoulder as a result of a defective ArthroCare probe used in an arthroscopic procedure on the patient. The patient has not filed a lawsuit for this claim as of yet. We believe these claims to be without merit and intend to defend ourselves vigorously.

On January 10, 2005, we received a letter from an attorney representing a patient who underwent surgery to repair a torn ACL on May 14, 2003 in Massachusetts. The letter alleges, among other things, that the patient suffered burns on her leg as a result of a defective ArthroCare probe used in an arthroscopic procedure on the patient. The patient has not filed a lawsuit for this claim as of yet. We believe these claims to be without merit and intend to defend ourselves vigorously.

On January 12, 2005, a product liability suit was brought against us in the 19^th Judicial District Court Parish of East Baton Rouge, Louisiana. The lawsuit alleges, among other things, that a patient suffered injury as a result of a spinal procedure (annuloplasty and Nucleoplasty) conducted on February 12, 2004. Upon initial review, we believe these claims to be without merit and intend to defend ourselves vigorously.

On January 21, 2005, a product liability suit was brought against us in the United States District Court of Vermont. The lawsuit alleges, among other things, that a patient suffered injury as a result of an arthroscopic procedure involving the use of an ArthroCare wand. Upon initial review, we believe these claims to be without merit and intend to defend ourselves vigorously.

As part of our 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 our acquisition of MDA, 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 ^thJudicial 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 was settled in 2004. 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 was settled in 2004.

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 for the purpose of recording a liability. Also, except as otherwise described above, we have product liability insurance coverage in amounts we consider 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.

Information required by this item is incorporated by reference from our Quarterly Report on Form 10-Q filed with the SEC on August 6, 2004.

ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Our common stock trades publicly on The Nasdaq Stock Market under the symbol ARTC. The following table sets forth, for the periods indicated, the quarterly high and low closing sales prices of our common stock.

As of February 28, 2005, there were no outstanding shares of Preferred Stock and 376 holders of record of 23,892,558 shares of outstanding Common Stock. We have not paid any cash dividends since our inception and do not anticipate paying cash dividends on our Common Stock in the foreseeable future.

Information required by this item regarding our equity compensation plans is incorporated by reference into our definitive Proxy Statement to be filed pursuant to Regulation 14A under the Exchange Act in connection with our annual meeting of stockholders.

The following selected financial data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the Consolidated Financial Statements and Notes thereto included in this Annual Report on Form 10-K. The statements of operations data for the years ended December 31, 2004, 2003 and 2002 and the balance sheet data as of December 31, 2004 and 2003 have been derived from audited consolidated financial statements included elsewhere in this report. The consolidated statement of operations data for the years ended December 31, 2001 and 2000 and the balance sheet data as of December 31, 2002, 2001 and 2000 have been derived from audited consolidated financial statements that are not included in this report. The historical results are not necessarily indicative of the results of operations to be expected in the future. Net loss for 2004 reflects significant charges related to acquisitions during the period, as described within Acquired in-process research and development costs in Item 7.

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

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

We are a medical device company that develops, manufactures and markets products based on our patented Coblation technology. Our products allow surgeons to operate with increased precision and accuracy, limiting damage to surrounding tissue thereby reducing pain and speeding recovery for the patient. Our products operate at lower temperatures than traditional electrosurgical or laser surgery tools and enable surgeons to ablate, shrink, sculpt, cut, or aspirate soft-tissue surgery procedures with one multi-purpose surgical system.

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

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

In April 1998, we announced that we had entered the cosmetic surgery market and formed a business unit called Visage to commercialize Coblation technology in this field. In early 1999, we entered into a license and distribution agreement with Collagen Aesthetics, Inc., which was subsequently purchased by Inamed Corporation. Under this agreement, Inamed Corporation acquired exclusive, worldwide, marketing right for our cosmetic surgery line of products for the dermatology and cosmetic surgery markets. In March 2001, we terminated this contract, alleging breach by Inamed of certain terms of the contract. We signed a settlement agreement with Inamed mutually releasing all claims against each other in 2002. In April 2001, we began marketing and selling our cosmetic surgery product line through a network of distributors and direct sales representatives. In 2003, we granted exclusive distribution rights to one U.S. distributor to sell the Visage product line exclusively for Microtouch. In 2004, we terminated this distribution agreement and granted an option to purchase the exclusive distribution rights to the Visage product line to a small, privately-held company, NovaDermis. On December 31, 2004, this option expired and we now retain all rights to Coblation technology in this field.

In May 1998, we announced that we had entered the ear, nose and throat market and had formed a business unit called ENTec to commercialize Coblation technology in this field.

In September 1999, we announced that we had entered the spinal surgery market. In February 2000, we announced that we were expanding our marketing efforts for our spinal surgery system to specifically address selected applications in neurosurgery. We are marketing and selling our spinal surgery products through a network of independent distributors and direct sales representatives supported by regional managers worldwide. In January 2004, we acquired MDA and its majority-owned subsidiary, Parallax, a business focused on the treatment of vertebral compression fractures. In November 2004, we acquired Opus Medical, a business focused on soft tissue to bone repair systems, including systems for the treatment of rotator cuff injuries.

We have received 510(k) clearance to market our Arthroscopic System for use in arthroscopic surgery of the knee, shoulder, ankle, elbow, wrist and hip, and our Arthroscopy System is CE marked for use in arthroscopic surgery. Our Spinal surgery System is CE marked and we have received 510(k) clearance in the United States to market this system for spinal surgery and neurosurgery. Our ENT Surgery System has received 510(k) clearance in the United States and is CE marked for general head, neck and oral surgical procedures, including tonsillectomy, adenoidectomy, snoring and the treatment of hypertrophic nasal turbinate and submucosal tissue channeling and shrinkage. Our Cosmetic Surgery System is CE marked for general dermatology and skin resurfacing for the purpose of wrinkle reduction procedures and we have received 510(k) clearance for use of our Cosmetic Surgery System in general dermatology procedures and for skin resurfacing for the purpose of wrinkle reduction in the United States. We have received 510(k) clearance to market Coblation technology for general surgery, gynecology and urology.

In December 1995, we introduced our Arthroscopy System commercially in the United States and have derived a significant portion of our sales from this system. Our strategy includes placing controller units at substantial discounts or placing controllers at customer sites at no cost in order to generate future disposable product revenue. Our strategy also includes applying our patented Coblation technology to a range of other soft-tissue surgical markets, including the products we have introduced in the fields of spinal surgery, neurosurgery, gynecology, urology, cosmetic surgery, ENT surgery, cardiology and general surgery. We have received 510(k) clearance for use of our technology in several fields. We cannot be sure that any of our clinical studies in other fields will lead to 510(k) applications or that the applications will be cleared by the FDA on a timely basis, if at all. In addition, we cannot be sure that the products, if cleared for marketing, will ever achieve commercial acceptance.

Product Sales consist of sales of disposable devices and controller units. Product sales for 2004 were $147.8 million, compared to $114.7 million and $85.0 million in fiscal 2003 and 2002, respectively. Product sales by product market for the periods shown were as follows (Dollar amounts in thousands):

Product sales by market for the years presented were favorably impacted by sales of our acquired product lines. Product sales included $23.3 million, $11.7 million and $2.8 million from the Company’s acquisitions of Atlantech, MDA & Opus Medical, for the years ended December 31, 2004, 2003 and 2002, respectively.

Product sales by geography for the periods shown were as follows (Dollar amounts in thousands):

Several years ago, we began aggressively transitioning our distribution channel away from stocking distributors to a more direct sales model. The execution of this strategy was substantially complete by the end of 2002. In connection with this strategy, we recorded $0.7 million in revenue reduction adjustments and charges in 2002 due to termination of stocking distributor agreements. The increase in direct sales presence has had a positive effect on product sales since inception, as did the execution of our strategic plan to build market share through continued promotional programs of controller placements, commercialization of our technology in fields outside of arthroscopy and introduction of new products designed to address surgical procedures that have traditionally been difficult to perform. Additionally, our improved presence in Europe and our acquisitions of the Atlantech, Parallax and Opus Medical product lines have added to our product sales growth.

We place controllers with our customers at no cost or sell them to customers at substantial discounts to generate demand for our disposable devices. We generally sell our disposable devices at or near list price, except for sales to international distributors and marketing partners, which are sold at discounted prices. We expect these discounts to continue in the future. For fiscal years 2004, 2003, and 2002, disposable device sales comprised approximately 98%, 98% and 98%, respectively, of our product sales. We anticipate that disposable device sales will remain the primary component of our product sales in the near future. We shipped approximately 700,000 disposable devices in 2004, compared to approximately 600,000 and 499,000 devices in 2003 and 2002, respectively.

Based upon the estimated number of arthroscopic procedures performed each year, we believe that knee procedures represent the largest segment of the arthroscopic market, while shoulder procedures represent the fastest growing segment. To achieve increasing disposable device sales in arthroscopy over time, we believe we must continue to penetrate the market in knee procedures, expand physicians’ education with respect to Coblation technology, and continue to work on new product development efforts specifically for knee applications. We believe that, in our eight years of product shipments, we have penetrated 30% to 35% of the hospitals that perform arthroscopic procedures in the United States. We believe that approximately 45% of our arthroscopy product sales are being generated by the sale of disposables for use in knee procedures. We expect our sales to continue to be strong in 2005, as we continue to increase our presence in Europe and add the recently acquired MDA and Opus Medical product lines to our sales mix.

Royalties, fees, and other revenues consist mainly of revenue from the licensing of our products and technology. Royalties, fees, and other revenues increased to $6.3 million in 2004 from $4.1 million and $3.8 million in 2003 and 2002, respectively, as a result of increased sales of our products.

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 for the quarters in 2003 and 2004 included amortization of capitalized controllers as follows (Dollar amounts in thousands):

Cost of product sales for 2004 was $51.1 million, or 35% of product sales, compared to $37.9 million, or 33% of product sales for 2003 and $33.4 million, or 39% of product sales, for fiscal 2002.

Gross product margin as a percentage of product sales decreased to 65% in 2004 from 67% in the prior year and increased in 2003 from 61% in 2002. The decrease in gross margin percentage compared to 2003 was a result of $1.4 million in charges relating to purchase price adjustments to inventory due to the MDA and Opus Medical acquisitions and start-up costs associated with our third-party logistics project. The increase in gross margin percentage compared to 2002 was mainly attributable to the increased efficiency of our manufacturing operations resulting mostly from the transition of manufacturing operations to our Costa Rica facility and increased production volume to cover our increased product sales, partially offset by the increased controller unit amortization and the lower gross margin on sales of Atlantech products. The 2002 gross product margin was additionally impacted by a $2.5 million charge to revalue inventory to bring it into line with our new, lower manufacturing cost structure and a $0.3 million charge relating to purchase price adjustments to inventory due to our acquisition of Atlantech.

We expect gross product margins to improve as we continue to experience savings from both our Costa Rica manufacturing facility and third party logistics infrastructure.

Research and development expense increased to $13.3 million, or 9% of total revenues, in 2004 from $10.6 million, or 9% of total revenues, in 2003 and from $8.8 million, or 10% of total revenues, in 2002. The increase in research and development costs in 2004 as compared to 2003 is primarily due to continued investments in Coblation based products and in the MDA product line. The increase in research and development expenses in 2003 as compared to 2002 is primarily due to our continued investment in Coblation technology, which we believe is essential for us to maintain and improve our competitive position. The increase consists of $1.2 million in increased compensation and related expenses due to increasing headcount, and $0.6 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, including for the newly acquired MDA and Opus Medical products, regulatory affairs, clinical studies and patents. We expect these expenses as a percentage of product sales to remain essentially flat.

Sales and marketing expense increased to $58.1 million, or 37.7% of total revenues, in 2004, from $46.1 million, or 38.8% of total revenues, in 2003, and from $36.5 million, or 41% of total revenues, in 2002. Increased expenses in 2004 as compared to 2003 related primarily to $3.7 million in increased sales commissions associated with the increased sales volume, $4.5 million in additional compensation and related expenses associated with our increased direct sales force and $2.5 million in sales and marketing expenses associated with the MDA and Opus Medical acquisitions. Increased expenses in 2003 as compared to 2002 related primarily to $3.6 million in increased sales commissions associated with the increased sales volume, $6.0 million in

additional compensation and related expenses associated with our increased direct sales force, especially in Europe. We anticipate that sales and marketing spending will continue to increase in absolute dollars as a result of the expansion of our distribution capabilities to address the spinal surgery and ear, nose and throat markets, higher dealer commissions from increased sales, the additional cost of penetrating international markets, higher promotional, demonstration and sample expenses, and additional investments in the sales, marketing and support staff necessary to market products and to commercialize future products. Further absolute dollar increases in sales and marketing expenses are expected to be driven by increased sales volumes from the MDA and Parallax product lines.

General and administrative expense increased to $16.3 million, or 11% of total revenues, in 2004, from $14.8 million, or 12% of total revenues, in 2003, and from $10.7 million, or 12% of total revenues, in 2002. The increase in general and administrative expenses in 2004 as compared to 2003 is due primarily to a $2.7 million increase in outside services, principally related to Sarbanes—Oxley compliance, and $1.9 million in increased facilities and depreciation expense relating to the MDA and Opus Medical acquisitions. These increases were partially offset by reduced patent-related legal spending. The increase in general and administrative expenses in 2003 as compared to 2002 is due primarily to a $2.4 million increase in compensation and related expenses due to increased staffing in the United States and international locations and a $1.3 million increase in legal costs due to the expenses involved in patent infringement litigation. We expect that general and administrative expenses will continue to decrease as a percentage of total revenues, but will increase in dollar amounts as we incur additional legal expenses and continue business development activities.

Amortization of intangible assets increased to $2.7 million or 2% of total revenues, in 2004, from $1.2 million, or 1% of total revenues, in 2003, and from $0.2 million, or 0.2% of total revenues, in 2002. The increase in amortization in 2004 as compared to 2003 relates to amortization of intangible assets acquired in the Opus Medical and MDA acquisitions. The increase in amortization in 2003 as compared to 2002 is attributed to the Atlantech acquisition, which was completed in October of 2002.

Acquired in-process research and development costs (IPR&D), in connection with our acquisition of Opus Medical during the fourth quarter of 2004, we expensed $36.4 million of the purchase price for IPR&D for projects related to automated suturing technology applicable to sports medicine surgical procedures. These projects related to technology which had not yet reached technological feasibility and had no future alternative use. Prior to the acquisition, we did not have a comparable product under development.

At the time of acquisition, we expect all acquired IPR&D will reach technological feasibility, but there can be no assurance that the commercial viability of these products will actually be achieved. The nature of the efforts to develop the acquired technologies into commercially viable products consists principally of planning, designing and conducting clinical trials necessary to obtain regulatory approvals. The risks associated with achieving commercialization include, but are not limited to, delay or failure to obtain regulatory approvals to conduct clinical trials, delay or failure to obtain required market clearances, and patent litigation. If commercial viability were not achieved, the Company would likely look to other alternatives to provide these therapies. We expect to incur $1.6 million in costs in 2005 to bring these products to commercialization in the United States. These costs are expected to be funded by internally generated cash flows.

The products in the IPR&D (attached table) involve novel implantable technology and devices for improving both the shoulder joint repair and biceps tendon repair procedures.

Included in the projected completion costs are expenses associated with final product testing, FDA clearances and the development of high quality, high yield manufacturing processes.

Interest and other income, net, decreased to $0.8 million in 2004 from $2.4 million in 2003 and from $2.5 million in 2002. The decrease in interest and other income in 2004 is due to lower cash balances and higher debt incurred due to our acquisitions of MDA and Opus Medical. The decrease in interest and other income, net, in 2003 is primarily due to lower interest income on lower average cash balances, partially offset by increased foreign exchange gains due to the strong European currencies in 2003. Due to the use of cash and borrowings in our purchase of MDA and Opus Medical in January and November of 2004, respectively, we anticipate interest and other income to decrease in the future.

The provision for income taxes was $3.3 million for 2004, compared to $3.0 million for 2003 and $0.6 million for 2002. The effective tax rate for 2004 was 14%; however, excluding the Opus Medical in-process research and development charge, the effective rate was 24%, compared to 29% in 2003 and 33% in 2002. The improvement in the effective tax rate is primarily due to the continued expansion of business activities in our Costa Rican operations and to tax credits for research and development activities.

As of December 31, 2004, we had $80.9 million in working capital, compared to $67.7 million at December 31, 2003. Our principal sources of liquidity consisted of $21.8 million in cash and cash equivalents. Cash equivalents are highly liquid with original maturities of ninety days or less.

Cash generated by operating activities was $17.2 million in 2004, mainly attributable to net income, excluding certain charges for non-cash items of $55.9 million, partially offset by an increased investment in inventory, necessary for our increased sales volume, and a buildup of accounts receivable and other assets, also precipitated by our increased sales volume and operating activity.

Inventories increased to $40.5 million at December 31, 2004 from $33.1 million at December 31, 2003. The increase in inventory was in order to support anticipated increasing product sales activity. Additionally, approximately $4.0 million of the increase related to the Opus product line. We expect future inventory levels to increase in absolute dollar value in order to support sales volume increases, to provide safety stock and support our expansion into additional markets.

Accounts receivable, net of allowances, increased to $34.0 million at December 31, 2004 from $24.1 million at December 31, 2003. The increase in accounts receivable in 2004 was due to the significant increase in sales, slightly offset by an improvement in average collection times. In addition, in connection with a review of outstanding U.S. accounts receivable, we wrote-off old credits of approximately $0.6 million in 2004. See Schedule II on page 79 for a summary of activity in this account.

Cash used in investing activities was $60.1 million in 2004, as compared to $15.0 million in 2003, due mainly to the purchases of MDA and Opus Medical of $56.1 million in addition to $15.0 million in investments in fixed assets, offset by net sales of available-for-sale securities of $11.0 million. Investments in property and equipment increased to $15.0 million for 2004, as compared to $13.8 million in 2003. The increase was primarily due to the capitalization of controllers placed with customers under various promotional programs, in addition to normal purchases of equipment.

Cash provided by financing activities was $43.8 million for 2004, compared to cash used in financing activities of $7.4 million in 2003, primarily due to loans taken out to finance our acquisitions. The increase in proceeds from the exercise of common stock options and warrants from 2003 is primarily driven by our higher stock prices in 2004, which led to increased exercises of options and warrants.

In the past, we have financed our operating and capital needs principally with cash from product sales, cash, cash equivalents, and available-for-sale securities and related interest income, and existing capital resources. However, in October 2003, we announced our intent to acquire MDA, an acquisition which was completed in January 2004, pursuant to which we were to make an initial cash payment of approximately $24.2 million in cash, net of certain holdbacks, which used a significant portion of our cash reserves. In anticipation of this acquisition, we entered into a $15.0 million revolving credit facility and a $15.0 million term credit facility with Bank of America, N.A. and Wells Fargo Bank, National Association, as co-lenders. Under the terms of the revolving credit facility, we were able to 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 could borrow $15.0 million for specified acquisitions at the same rates as noted above. The credit facility contained 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 MDA, we borrowed $15.0 million under the term credit facility. In September 2004, we repaid the entire $15.0 million borrowed under the term credit facility.

In October 2004, in anticipation of our acquisition of Opus Medical, we amended and restated our existing credit facility with Bank of America, N.A. and Wells Fargo Bank, National Association, as co-lenders. Under the terms of the amended and restated credit facility, we may borrow up to $20.0 million under a revolving line of credit and we may borrow up to $30.0 million under a term commitment loan. We may borrow under either of these loans at the Bank of America prime rate plus 0.0% to 1.0% or at a eurodollar rate. The increase over the base rate of either type of loan is determined by our leverage ratio, as defined in the amended and restated credit facility. The amended and restated credit facility contains covenants that specify minimum financial ratios and limit our ability to take on additional debt, or make significant future acquisitions or dispositions. Violation of certain of the covenants may result in acceleration of our repayment obligation. In connection with our acquisition of Opus Medical, we borrowed $30.0 million against the term commitment loan in November, 2004. At December 31, 2004, we had not drawn upon the $20.0 million revolving line of credit. At December 31, 2004, the weighted average interest rate applicable to borrowings under the amended and restated credit facility was 3.8%.

Due to our net loss in the fourth quarter of 2004, the Company was not in compliance with certain prior covenant provisions of the amended and restated credit facility. On March 30, 2005, we entered into an amendment to our existing amended and restated credit facility with Bank of America, N.A. and Wells Fargo Bank, National Association, as co-lenders, effective as of the execution of our amended and restated credit facility, October 15, 2004. The amendment revises two provisions of the facility to address certain information that was not fully known by all of the parties at execution of the original agreement. Under the March 2005 amendment, we were in compliance with all restrictive covenants at December 31, 2004. The revolving line of credit expires in 2007 and the term commitment loan expires in 2011. At December 31, 2004, available borrowing capacity under the credit facility was $20 million. We do not currently anticipate future borrowings under the term credit facility.

We believe that the above-described credit and term facilities, in addition to cash generated from operations, will be sufficient to fund our operations through fiscal year 2005 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.

The following table aggregates all material contractual obligations and commercial commitments that affect our financial condition and liquidity as of December 31, 2004:

In connection with the acquisition of MDA, which was consummated on January 28, 2004, we borrowed $15.0 million under our term credit facility. This amount was repaid on September 30, 2004. In connection with the acquisition of Opus Medical, which was consummated on November 12, 2004, we borrowed $ 30.0 million under our amended and restated term credit facility.

The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States requires management to make judgments, assumptions and estimates that affect the amounts reported in the Consolidated Financial Statements and accompanying notes. Note 2 to the Consolidated Financial Statements describes the significant accounting policies and methods used in the preparation of the Consolidated Financial Statements. Estimates are used for, but not limited to, the accounting for the allowance for doubtful accounts and sales returns; inventory allowances; warranty costs; impairment assessments for long-lived assets, including goodwill; contingencies and other special charges; and taxes. Actual results could differ materially from these estimates. The following critical accounting policies are impacted significantly by judgments, assumptions, and estimates used in the preparation of the Consolidated Financial Statements.

We recognize product and royalty revenue after shipment of our products to customers and fulfillment of any acceptance terms, and when no significant contractual obligations remain and collection of the related receivable is reasonably assured. Revenue is reported net of a provision for estimated product returns. Revenue related to collaborative research and development contracts is recognized as the related work is performed.

We recognize license fee and milestone revenue over the term of the associated agreement unless the fee or milestone is in exchange for products delivered or services performed that represent the culmination of a separate earnings process. Amounts billed to customers relating to shipping and handling costs are presented in the consolidated statements of operations within royalties, fees and other revenues and related costs are classified as a cost of product sales.

Inventory purchases and commitments are based upon future demand forecasts. We record an allowance against our inventory value to the extent we believe that demand for certain inventory items has decreased or if certain inventory items have become obsolete. If there were to be a sudden and significant decrease in demand for our products, or if there were a higher incidence of inventory obsolescence because of rapidly changing technology and customer requirements, we could be required to increase our inventory allowances and our gross margins could be adversely affected.

We accrue for warranty costs based on historical trends in product return rates and the expected material and labor costs to provide warranty services. If we were to experience an increase in warranty claims compared with our historical experience, or costs of servicing warranty claims were greater than the expectations on which the accrual had been based, our gross margins could be adversely affected.

When we acquire another entity, the purchase price is allocated, as applicable, between net tangible assets, IPR&D, other identifiable intangible assets, and goodwill. Our policy defines IPR&D as the value assigned to those projects for which the related products have not reached technological feasibility, have not received regulatory approval and have no alternative future use. Determining the portion of the purchase price allocated to IPR&D requires the Company to make significant estimates. The amount of the purchase price allocated to IPR&D is determined by estimating the future cash flows of each project or technology and discounting the net cash flows back to their present values. The discount rate used is determined at the time of acquisition, in accordance with accepted valuation methods, and includes consideration of the assessed risk of the project not being developed to a stage of commercial feasibility.

We currently have recorded goodwill related to our acquisitions of Atlantech, MDA and Opus Medical. We perform goodwill impairment tests on an annual basis and more frequently in certain circumstances. In response to changes in industry and market conditions, we may be required to strategically realign our resources and consider restructuring, disposing, or otherwise exiting businesses, which could result in an impairment of goodwill. Impairment is measured by the difference between the recorded value of goodwill and its implied fair value when the fair value of the reporting unit is less than its net book value.

Long-lived assets and certain identifiable intangible assets to be held and used are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. Determination of recoverability is based on an estimate of undiscounted future cash flows resulting from the use of the group of assets and their eventual disposition. Measurement of an impairment loss for long-lived assets and certain identifiable intangible assets that management expects to hold and use is based on the fair value of the asset. Long-lived assets and certain identifiable intangible assets to be disposed of are reported at the lower of carrying amount or fair value less costs to sell. Purchased intangible assets are carried at cost less

accumulated amortization. Amortization is computed over the estimated useful lives of the respective assets, generally one to eight years.

We are subject to the possibility of various loss contingencies arising in the ordinary course of business. We consider the likelihood of loss or impairment of an asset or the incurrence of a liability, as well as our ability to reasonably estimate the amount of loss in determining loss contingencies. An estimated loss contingency is accrued when it is probable that an asset has been impaired or a liability has been incurred and the amount of loss can be reasonably estimated. We regularly evaluate current information available to us to determine whether such accruals should be adjusted.

We account for stock-based employee compensation using the intrinsic value method of accounting. Under this method, employee stock-based compensation expense is based on the difference, if any, on the date of the grant between the fair value of our stock and the exercise price of the award. We account for stock options issued to non-employees using the fair value method of accounting, which requires us to assign a value to the stock options issued based on the Black-Scholes pricing model and to record that value as a compensation expense. If we were to account for stock options issued to employees using the fair value method of accounting rather than the intrinsic value method, our results of operations would be significantly affected.

In October 2004, the United States Congress passed the American Jobs Creation Act of 2004 (the “Jobs Act”). This legislation contains provisions which may affect the calculation of our taxable income for federal income tax in future periods. Significant features of the Jobs Act include (i) enactment of a deduction from taxable income for certain U.S. manufacturing activities, (ii) a one-time reduction of tax on qualifying repatriations of earnings from foreign subsidiaries. Also in October 2004, the Working Families Tax Relief Act of 2004 (the “Relief Act”) became law, and it provides for restoration of the research and experimentation tax credit, which had expired in June 2004. We are currently evaluating what effect, if any, the Jobs Act and Relief Act will have upon our future results of operations, financial position, or cash flows.

On November 24, 2004, the FASB issued SFAS No. 151, “Inventory Costs—an amendment of ARB No. 43.” SFAS No. 151 requires that idle facility costs, freight and handling costs, and costs of wasted material be excluded from the cost of inventory and the costs of inventories be based on the normal capacity of the production facilities. SFAS No. 151 will be effective on January 1, 2006. SFAS No. 151 is not expected to have a material impact on our consolidated results of operations, results of operations, financial position or cash flows.

On December 16, 2004, the Financial Accounting Standards Board (FASB) issued SFAS No. 123R, “Share-Based Payment.” SFAS No. 123R addresses the accounting for share-based payment transactions in which an enterprise receives employee services in exchange for (a) equity instruments of the enterprise or (b) liabilities that are based on the fair value of an enterprise’s equity instruments or that may be settled by the issuance of equity instruments. SFAS No. 123R eliminates the ability to account for share-based compensation transactions using the intrinsic value method of Accounting Principles Board Opinion No. 25. Instead, it generally requires that such transactions be accounted for using a fair-value-based method. We expect to adopt this standard on its effective date, which is July 1, 2005. We are in the process of assessing the impact of this standard on our consolidated results of operations, financial position and cash flows. This assessment includes evaluating valuation methods and assumptions which would be applied to accounting for employee stock options.

Our exposure to market risk for changes in interest rates relates primarily to our investment portfolio, including short-term investments and cash and cash equivalents. 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.

The table below presents principal amounts and related weighted average interest rates as of December 31, 2004 for our cash and cash equivalents.

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.

Borrowings under our amended and restated credit facility incur interest based on current market interest rates. To the extent that these rates fluctuate, our results of operations and cash flows, as well as our ability to borrow needed capital at a critical time, could be significantly affected. We estimate that a 1% change in applicable interest rates would impact our annual interest expense by approximately $262,000 assuming our borrowings were unchanged.

A significant portion of our European sales and operating expenses are denominated in currencies other than the U.S. Dollar. In 2004, most of these currencies grew stronger against the U.S. Dollar. To the extent that these currencies continue to become stronger or become weaker against the U.S. Dollar, we will experience variations in our results of operation and financial condition.

Certain information required by this Item is included in Item 6 of Part II of this Report and is incorporated herein by reference. All other information required by this Item is included in Item 15 of this Report and is incorporated herein by reference.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

We maintain disclosure controls and procedures (as defined in Securities Exchange Act of 1934 (“the Exchange Act”) Rules 13a-15(e) and 15(d)-15(e)) 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 disclosure 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 disclosure controls and procedures.

As of the end of the period covered by this report, our management carried out an evaluation, under the supervision and with the participation of the Chief Executive Officer and the Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Exchange Act Rules 13a-15(e) and 15(d)-15(e). Based upon, and as of the date of this evaluation, the Chief Executive Officer and the Chief Financial Officer concluded that our disclosure controls and procedures were not effective at the reasonable assurance level because of the material weakness discussed below. Due to the material weakness described below, the Company performed additional analyses and other post-closing procedures to ensure that the consolidated financial statements were prepared in accordance with generally accepted accounting principles. Accordingly, management believes that the financial statements included in this Annual Report on Form 10-K fairly present in all material respects our financial position, results of operations and cash flows for the periods presented.

Status of Management’s Report on Internal Control Over Financial Reporting

Pursuant to Securities and Exchange Commission Release No. 34-50754, which, subject to certain conditions, provides up to 45 additional days beyond the due date of this Form 10-K for the filing of management’s annual report on internal control over financial reporting required by Item 308(a) of Regulation S-K, and the related attestation report of our independent auditor, PricewaterhouseCoopers LLP, as required by Item 308(b) of Regulation S-K, management’s report on internal control over financial reporting and the associated report on the audit of management’s assessment of the effectiveness of the company’s internal control over financial reporting as of December 31, 2004, are not filed herein and are expected to be filed in April 2005.

Our management is responsible for establishing and maintaining adequate internal control over financial reporting as such term is defined in Rule 13a-15(f) of the Exchange Act, as amended. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with policies and procedures may deteriorate.

Management, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, is conducting an evaluation of the effectiveness of the design and operation of our internal control over financial reporting as of December 31, 2004. In making its assessment, management is using the criteria contained in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. In connection with this evaluation, management informed our Audit Committee of a material weakness in our internal control over financial reporting, which is described below.

A material weakness is a control deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected.

At December 31, 2004, we did not maintain effective controls over the accounting for foreign currency transactions. Specifically, we did not perform adequate analysis and review of the appropriateness of foreign currency transactions reported in the consolidated financial statements. Consequently, the Company’s controls failed to identify the improper classification of certain transactions related to our Swedish subsidiary. This control deficiency resulted in the restatement of the Company’s consolidated financial statements for the quarters ended March 31, 2004 and June 30, 2004. Additionally, this control deficiency could result in a misstatement to other income that would result in a material misstatement of annual or interim financial statements that would not be prevented or detected. Accordingly, management determined that this control deficiency constitutes a material weakness. The existence of one or more material weaknesses as of December 31, 2004 would preclude a conclusion that the Company’s internal control over financial reporting was effective as of that date. Upon

completion of our assessment, management expects to conclude that the Company did not maintain effective internal control over financial reporting as of December 31, 2004, based on criteria in Internal Control—Integrated Framework.

Management’s evaluation of its internal control over financial reporting as of December 31, 2004 is not complete. Further, upon completion of our ongoing evaluation of internal control over financial reporting we may identify additional control deficiencies, and those deficiencies, alone or in combination with others, may be considered additional material weaknesses.

We also expect that the report of our independent registered public accounting firm will contain an adverse opinion on the effectiveness of our internal control over financial reporting as of December 31, 2004.

To remediate the material weakness described above (1) management intends to increase staffing in our finance department in 2005 by approximately 50%, (2) management has implemented an internal control that requires our finance group to complete a top down review of the reasonableness of foreign currency transactions on a monthly basis and (3) our Swedish subsidiary will maintain its original accounting records in US Dollars, rather than in Swedish Krona, beginning in 2005. Management believes that these planned changes will be sufficient to correct the internal control design deficiency underlying the material weakness described above.

Except as otherwise discussed herein, there have been no changes in our internal control over financial reporting during our fourth fiscal quarter ended December 31, 2004 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

We have adopted a code of business conduct and ethics, or code of conduct, containing general guidelines for conducting our business consistent with the highest standards of business ethics. The code of conduct is designed to qualify as a “code of ethics” within the meaning of Section 406 of the Sarbanes-Oxley Act of 2002 and the rules promulgated thereunder as well as under applicable rules of the Nasdaq National Market to become effective in May 2004. Our code of conduct is available on the Investor Relations section of our website (www.arthrocare.com), which is on the Corporate Information section of our website. To the extent required by law or the rules of the Nasdaq National Market, any amendments to, or waivers from, any provision of the code will be promptly disclosed publicly. To the extent permitted by such requirements, we intend to make such public disclosure by posting the relevant material on the Investor Relations section of our website in accordance with SEC rules.

All additional information required by this item is incorporated by reference to our definitive Proxy Statement to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934, as amended, in connection with our annual meeting of stockholders.

The information required by this item is incorporated by reference into our definitive Proxy Statement to be filed pursuant to Regulation 14A under the Exchange Act in connection with our annual meeting of stockholders.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS

1. Financial Statements. The following financial statements of the company and the Report of Independent Auditors are included in this Report on the pages indicated.

2. Financial Statement Schedule. The following financial statement schedule of the company as of and for the years ended December 31, 2004, 2003 and 2002, is included in Part IV of this Report on the pages indicated. This financial statement schedule should be read in conjunction with the Financial Statements, and notes thereto, of the company.

Schedules not listed above have been omitted because they are not applicable, not required, or the information required to be set forth therein is included in the Financial Statements or notes thereto.

On October 12, 2004, ArthroCare filed a Form 8-K including Item 1.01 information filed, Item 8.01 information filed and Item 9.01 information filed relating to our acquisition of Opus Medical, Inc.

On October 20, 2004, ArthroCare filed a Form 8-K including Item 2.02 information filed and Item 9.01 information filed regarding financial results for the quarter ended September 30, 2004.

On October 21, 2004, ArthroCare filed a Form 8-K including Item 1.01 information filed and Item 2.03 information filed relating to our amended and restated credit facility with Bank of America, N.A. and Wells Fargo Bank, National Association.

On November 16, 2004, ArthroCare filed a Form 8-K including Item 2.02 information filed and Item 9.01 information filed relating to a reclassification of certain foreign exchange transactions in our Swedish subsidiary for our financial results for the quarter ended September 30, 2004.

On November 18, 2004, ArthroCare filed a Form 8-K including Item 2.01 information filed, Item 8.01 information filed and Item 9.01 information filed relating to our acquisition of Opus Medical, Inc.

On November 22, 2004, ArthroCare filed a Form 8-K including Item 3.01 information filed relating to a letter we received from Nasdaq indicating that, due to our delay in filing our Form 10-Q for the quarter ended September 30, 2004 with the Securities and Exchange Commission, we failed to comply with filing requirements for continued listing set forth in Marketplace Rule 4310(c)(14).

On November 26, 2004, ArthroCare filed a Form 8-K including Item 4.02 information filed and Item 8.01 information filed relating to the conclusion of our audit committee and management that the previously issued financial statements contained in our Quarterly Reports on Form 10-Q for the quarterly periods ended March 31, 2004 and June 30, 2004 contained two errors and should therefore no longer be relied upon.

On December 3, 2004, ArthroCare filed a Form 8-K including Item 8.01 information filed relating the trading plan of Michael A. Baker, our President and Chief Executive Officer.

On January 10, 2005, ArthroCare filed a Form 8-K including Item 1.01 information filed relating to approved changes to the equity and cash compensation for non-employee directors.

On February 22, 2005, ArthroCare filed a Form 8-K including Item 1.01 information filed and Item 9.01 information filed relating to approval of compensation to listed executive officers and the adoption of cash bonus plans.

On February 28, 2005, ArthroCare filed a Form 8-K including Item 1.01 information filed and Item 9.01 information filed to amend and restate the Form 8-K filed on February 22, 2005

On March 16, 2005, ArthroCare filed a Form 8-K including Item 2.02 information filed and Item 9.01 information filed regarding financial results for the quarter ended and fiscal year ended December 31, 2004.

In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of ArthroCare Corporation and its subsidiaries (the “Company”) at December 31, 2004 and 2003, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2004 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the accompanying indexpresents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

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

ArthroCare Corporation (“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.

Use of Estimates. The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities in the consolidated financial statements and the reported amount of revenue and expenses during the reporting period. Actual results could differ from those estimates.

Principles of Consolidation. The consolidated financial statements include the accounts of ArthroCare and all of its wholly owned subsidiaries. All significant inter-company transactions and accounts have been eliminated.

Cash and Cash Equivalents and Available-for-Sale Securities. We consider all highly liquid investments purchased with original maturities of ninety days or less to be cash equivalents. Cash and cash equivalents include money market funds and various deposit accounts.

We have classified our investments as “available-for-sale.” Such investments are recorded at fair value and unrealized gains and losses are recorded as a separate component of other comprehensive income until realized. Interest income is recorded using an effective interest rate, with the associated premium or discount also amortized to interest income. Realized gains and losses, if any, are determined using the specific identification method.

Inventories. Our inventories, which include material and labor costs, are stated at standard cost, which approximates actual cost determined on a first-in, first-out basis, not in excess of market value. We record reserves, when necessary, to reduce the carrying value of excess or obsolete inventories to their net realizable value.

Property and Equipment. Property and equipment, including equipment under capital leases, is stated at cost and is depreciated on a straight-line basis over the estimated useful lives of three to five years. We place the majority of our manufactured controller units with customers in order to facilitate the sale of disposable devices. Controller units placed with customers are capitalized at cost and amortized to cost of goods sold over a three- or four-year period. Leasehold improvements are amortized over the shorter of the estimated useful lives or the lease term. Maintenance and repair costs are charged to operations as incurred.

Revenue Recognition. We recognize product and royalty revenue after shipment of our products to customers and upon fulfillment of any acceptance terms, and when no significant contractual obligations remain and collection of the related receivable is reasonably assured. Revenue is reported net of a provision for estimated product returns. Revenue related to collaborative research and development contracts is recognized as the related work is performed.

We recognize license fee and milestone revenue over the term of the associated agreement unless the fee or milestone is in exchange for products delivered or services performed that represent the culmination of a separate earnings process. These items are classified as royalties, fees and other revenues on the accompanying statement of operations. Amounts billed to customers relating to shipping and handling costs have also been classified as royalties, fees and other revenues and related costs are classified as cost of product sales on the accompanying statement of operations.

Acquired In-Process Research and Development (IPR&D). When we acquire another entity, the purchase price is allocated, as applicable, between net tangible assets, IPR&D, other identifiable intangible assets, and goodwill. Our policy defines IPR&D as the value assigned to those projects for which the related products have not reached technological feasibility, have not received regulatory approval and have no alternative future use. Determining the portion of the purchase price allocated to IPR&D requires the Company to make significant estimates. The amount of the purchase price allocated to IPR&D is determined by estimating the future cash flows of each project or technology and discounting the net cash flows back to their present values. The discount rate used is determined at the time of acquisition, in accordance with accepted valuation methods, and includes consideration of the assessed risk of the project not being developed to a stage of commercial feasibility.

Goodwill. Goodwill is tested for impairment on an annual basis, and in the interim if events and circumstances indicate that goodwill may be impaired. Impairment is measured by the difference between the recorded value of goodwill and its implied fair value when the fair value of the reporting unit is less than its net book value. Aggregate goodwill acquired during the years ended December 31, 2004 and 2003 was approximately $47.5 million and $343,000, respectively. Through December 31, 2004, no goodwill impairment losses were required.

Impairment of Long-Lived Assets. Long-lived assets and certain identifiable intangible assets to be held and used are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. Determination of recoverability is based on an estimate of undiscounted future cash flows resulting from the use of the group of assets and their eventual disposition. Measurement of an impairment loss for long-lived assets and certain identifiable intangible assets that management expects to hold and use is based on the fair value of the asset. Long-lived assets and certain identifiable intangible assets to be disposed of are reported at the lower of carrying amount or fair value less costs to sell. Purchased intangible assets are carried at cost less accumulated amortization. Amortization is computed over the estimated useful lives of the respective assets, generally one to eight years.

Research and Development. Research and development costs consist mostly of payroll expenses and prototype development costs and are charged to operations as incurred.

Advertising Expense. Advertising expenses are charged to operations as sales and marketing expenses as incurred. Advertising expense was $4.0 million, $3.4 million and $3.1 million in 2004, 2003 and 2002, respectively.

Stock-Based Compensation. We account for stock-based employee compensation using the intrinsic value method of accounting. Under this method, 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. Assumptions used in determining the fair value of non-employee stock option grants in 2004, using the Black-Scholes pricing model, were: risk-free interest rate of 2.9%, expected life of 5 years, expected dividends of zero, and expected volatility of 70%.

Had employee stock-based compensation been determined based on the fair value at the grant date for awards in fiscal years 2004, 2003, and 2002, the company’s basic and diluted net income (loss) per share would have been as follows:

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:

The weighted average fair value of options granted to employees during the year ended December 31, 2004 was $15.26 per share. The weighted average fair value of shares under the employee stock purchase plan during the year ended December 31, 2004 was $6.59 per share.

We issued approximately 94,000 and 127,000 shares of restricted stock to certain employees in 2004 and 2003, respectively. The fair value of the stock was $2.4 million and $1.1 million in 2004 and 2003, respectively, and was charged to deferred compensation on the balance sheet and is being amortized to compensation expense over the vesting period of the restricted stock. Approximately $597,000 and $187,000 of compensation expense was recognized in connection with the restricted stock in 2004 and 2003, respectively.

Foreign Currency Translation. Certain of the company’s wholly owned subsidiaries have functional currencies other than the U.S. dollar. The functional currency of Atlantech Medical Devices, Ltd. (UK) is the British Pound. The functional currency of Atlantech GmbH (Germany), Atlantech Medizinische Produkte Vertreibs (Austria), ArthroCare Italy SPA and ArthroCare France SRL is the Euro. Accordingly, all balance sheet accounts of these operations 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 remeasured into U.S. dollars at current period-end exchange rates and non-monetary assets and related elements of expense are remeasured using historical rates of exchange. Income and expense elements are remeasured into U.S. dollars using average exchange rates in effect during the period. Gains and losses from currency transactions denominated in currencies other than the U.S. dollar are recorded as other income or loss in the statement of operations.

Concentration of Risks and Uncertainties. Substantially all of our cash and cash equivalents are maintained at financial institutions in the United States. Deposits at these institutions may exceed the amount of insurance provided on such deposits. We have not experienced any losses on our deposits of cash and cash equivalents.

We purchase certain key components of our products, from sole, single or limited source suppliers. For some of these components there are few alternative sources. A reduction or stoppage in supply of sole-source components would limit our ability to manufacture certain products. There can be no assurance that an alternate supplier could be established if necessary or that available inventories would be adequate to meet our production needs during any prolonged interruption of supply.

Our products require approval from the United States Food and Drug Administration (FDA) and international regulatory agencies prior to the commencement of commercial sales. There can be no assurance that our products will receive any of these required approvals. If we were denied such approvals, or if such approvals were delayed, it would have a material adverse impact on our business.

Sales to both international and domestic customers are generally made on open credit terms. Management performs ongoing credit evaluations of the company’s customers and maintains an allowance for potential credit losses when needed but historically has not experienced any significant losses related to individual customers or a group of customers in any particular geographic area.

Fair Value of Financial Instruments. The carrying values of our financial instruments approximate their fair values.

Income Taxes. We account for income taxes under the liability method, whereby deferred tax asset or liability account balances are determined based on the difference between the financial statement and the tax bases of assets and liabilities using current tax laws and rates in effect for the year in which the differences are expected to affect taxable income. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amounts expected to be realized.

Reclassifications. Amortization expense related to intangible assets have been reclassified from sales and marketing and general and administrative expense to amortization of intangible assets in the accompanying consolidated statement of operations.

Recent Accounting Pronouncements. In October 2004, the United States Congress passed the American Jobs Creation Act of 2004 (the “Jobs Act”). This legislation contains provisions which may affect the calculation of our taxable income for federal income tax in future periods. Significant features of the Jobs Act include (i) enactment of a deduction from taxable income for certain US manufacturing activities, (ii) a one-time reduction of tax on qualifying repatriations of earnings from foreign subsidiaries. Also in October 2004, the Working Families Tax Relief Act of 2004 (the “Relief Act”) became law, and it provides for restoration of the research and experimentation tax credit, which had expired in June 2004. The Company is currently evaluating what effect, if any, the Jobs Act and Relief Act will have upon our future results of operations, financial position, or cash flows.

On November 24, 2004, the FASB issued SFAS No. 151, “Inventory Costs – an amendment of ARB No. 43.” SFAS No. 151 requires that idle facility costs, freight and handling costs, and costs of wasted material be excluded from the cost of inventory and the costs of inventories be based on the normal capacity of the production facilities. SFAS No. 151 will be effective on January 1, 2006. SFAS No. 151 is not expected to have a material impact on our consolidated results of operations, results of operations, financial position or cash flows.

On December 16, 2004, the Financial Accounting Standards Board (FASB) issued SFAS No. 123R, “Share-Based Payment.” SFAS No. 123R addresses the accounting for share-based payment transactions in which an enterprise receives employee services in exchange for (a) equity instruments of the enterprise or (b) liabilities that are based on the fair value of an enterprise’s equity instruments or that may be settled by the issuance of equity instruments. SFAS No. 123R eliminates the ability to account for share-based compensation transactions using the intrinsic value method of Accounting Principles Board Opinion No. 25. Instead, it generally requires that such transactions be accounted for using a fair-value-based method. We expect to adopt this standard on its effective date, which is July 1, 2005. We are in the process of assessing the impact of this standard on the company’s consolidated results of operations, financial position and cash flows. This assessment includes evaluating valuation methods and assumptions which would be applied to accounting for employee stock options.

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

We held no available-for-sale securities at December 31, 2004. The following summarizes our available-for-sale securities at December 31, 2003 (in thousands):

Net realized gains were $0.3 million, $0.7 million and $0.9 million in 2004, 2003 and 2002, respectively, and are included in other income on the consolidated financial statements.

The following summarizes our property and equipment at December 31 (in thousands):

Depreciation expense related to our property and equipment was $10.6 million, $8.4 million and $7.4 million for the years ended December 31, 2004, 2003 and 2002, respectively.

Intangible assets are originally recorded at historical cost, in the case of separately purchased intangible assets, or at estimated fair value, in the case of assets acquired in the purchase of a business. Intangible assets consist of the following (in thousands):

Intangible assets are amortized on a straight-line basis over the periods benefited, which range between one and ten years. Estimated future amortization expense is as follows:

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

Rent expense was $2.4 million, $2.0 million and $1.8 million in 2004, 2003 and 2002, respectively.

The Company generally provides 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 affected by product failure rates, material usage and service delivery costs incurred in correcting a product failure. We periodically evaluate and adjust the warranty reserve to the extent actual warranty expense varies form the original estimates. The following table describes the activity in our warranty accrual for the years ended December 31 (in thousands):

On July 25, 2001, ArthroCare filed a lawsuit against Smith & Nephew, Inc. (“Smith & Nephew”) in the United States District Court of Delaware. The lawsuit alleges, among other things, that Smith & Nephew has been, and is currently, infringing three patents issued to ArthroCare. Specifically, Smith & Nephew 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 Smith & Nephew has infringed these patents; (2) a permanent injunction precluding Smith & Nephew 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 Smith & Nephew’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. 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 an injunction order enjoining Smith & Nephew from the use, manufacture and sale of the infringing products in the United States. Smith & Nephew’s has appealed the above rulings in the Federal Circuit Court of Appeals. In addition, the U.S. District Court is to hold a second trial to award damages to us for the infringing activity of Smith & Nephew.

On April 3, 2003, Smith & Nephew filed a lawsuit against us in the United States District Court, Western Tennessee alleging that we infringed two Smith & Nephew patents—nos. 5,980,504 and 6,261,311. In addition, Smith & Nephew has alleged that ArthroCare is in violation of Section 43(A) of the Lanham Act for allegedly making false or misleading statements to deceive potential purchasers of Smith & Nephew’s medical devices. Smith & Nephew has requested the Court to issue preliminary and permanent injunction preventing ArthroCare from further infringement of the above mentioned patents and from making further false or misleading statements concerning Smith & Nephew’s medical devices. In addition, Smith & Nephew has requested the Court to award compensatory damages and treble damages for willfulness, as well as legal fees. We believe these claims to be without merit and will defend ourselves vigorously. A jury trial is scheduled for October 2005.

As part of our 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 our acquisition of MDA, 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 was settled in 2004. 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 was settled in 2004.

In December 2003, we entered into a $15.0 million revolving credit facility and a $15.0 million term credit facility with Bank of America, N.A. and Wells Fargo Bank, National Association, as co-lenders. Under the original terms of the revolving credit facility, we were permitted to 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 was determined by our leverage ratio, as defined in the credit facility. On January 28, 2004, in connection with the acquisition of MDA, we borrowed $15.0 million under the term credit facility. In September 2004, we repaid the entire $15.0 million borrowed under the term credit facility.

We began making scheduled repayments of the term commitment loan in December 2004. Future contractual debt payments are as follows:

Preferred Stock. Under our Certificate of Incorporation, we are authorized to issue preferred stock. At December 31, 2003, 5,000,000 shares of preferred stock were authorized and no preferred stock was issued and outstanding.

Treasury Stock. In April 2001, the Board of Directors authorized the repurchase of up to 1,000,000 shares of our common stock, subject to certain limitations and conditions. In June of 2002, the Board of Directors authorized the repurchase of an additional 2,000,000 shares. In 2002, we repurchased 1,029,741 shares at a cost of $12.1 million. In 2003, we repurchased 726,543 shares at a cost of $11.0 million. The shares will be used to offset the potentially dilutive effect of employee incentive programs and may be used for other purposes that we deem appropriate.

In May 1993, we approved the 1993 Stock Plan (1993 Plan) under which the Board of Directors is authorized and directed to enter into stock option agreements with selected individuals. Under the 1993 Plan, we are authorized to issue options for up to 5,372,050 shares, which generally become exercisable over a 48 month period. In 2003, we granted 127,000 shares of restricted stock in accordance with the terms of the 1993 Plan, which vest in 2008. At the end of 2004, 2003 and 2002, there were 1,669,000, 1,889,000 and 1,765,000 options, respectively, exercisable under the 1993 Plan. The 1993 Plan expired in May 2003.

Activity under the 1993 Plan is as follows (in thousands, except per share data):

In December 1995, we adopted the Director Option Plan (“Director Plan”) and reserved 200,000 shares of common stock for issuance to directors under this plan. The plan allows for an initial grant and automatic annual grants of options to outside directors of the company. In May 2004, our shareholders approved an amendment to the Director Plan to increase the number of shares available for issuance by 100,000 shares, to a total of 690,000 shares. At December 31, 2004, 2003 and 2002 outstanding options under the Director Plan were 440,000, 340,000 and 398,000, respectively. There were 271,000 options exercisable as of December 31, 2004. No shares were exercised in 2004.

In August 1999, we approved the Nonstatutory Option Plan (“1999 Plan”). In June 2001 we authorized an amendment, effective April 26, 2001, setting the aggregate number of shares authorized under the 1999 Plan at 2,150,000. At December 31, 2004, 2003 and 2002 there were 2,455,000, 2,883,000 and 2,681,000 options outstanding, respectively. There were 1,447,000 options exercisable as of December 31,2004. Shares exercised in 2004 were 502,000.

In May 2003, we approved the 2003 Incentive Stock Plan (“2003 Plan”) under which the Board of Directors is authorized to grant incentive and nonstatutory stock option agreements to employees. In May 2004, our shareholders approved an amendment to the 2003 Plan to increase the number of shares available for issuance by 750,000 shares, to a total of 1,250,000. Options granted under the 2003 Plan generally become exercisable over a 48-month period. At December 31, 2004 and 2003, there were 459,000 and 21,000 options outstanding, respectively. There were 68,000 exercisable as of December 31, 2004. Shares exercised in 2004 were 500.

Options outstanding and currently exercisable by exercise price for all plans at December 31, 2004 were as follows (in thousands, except per share data and contractual life):

Employee Stock Purchase Plan. In December 1995, we approved the Employee Stock Purchase Plan and reserved 300,000 shares of common stock for issuance under this plan. In May 2004, our shareholders approved an amendment to the Employee Stock Purchase Plan to increase the number of shares available for issuance by 150,000 shares. For 2004, 2003 and 2002, 44,000, 67,000 and 51,000 shares of common stock were sold under the Employee Stock Purchase Plan, respectively. Under the plan, regular full-time employees (subject to certain exceptions) may contribute up to 10% of base compensation to the semi-annual purchase of shares of ArthroCare common stock. The purchase price is 85% of the fair market value at certain plan-defined dates.

Stockholders Rights Plan. In November 1996, our Board of Directors approved a Stockholders Rights Plan declaring a dividend distribution of one Preferred Share Purchase Right for each outstanding share of our common stock, which would issue on certain triggering events. This Plan was amended in January 2000. Each right will entitle stockholders to buy one-thousandth of one share of our Series A Participating Preferred Stock at an exercise price of $185.00. This Plan was designed to assure that our stockholders receive fair and equal treatment in the event of any proposed takeover of the company and to guard against partial tender offers and other abusive tactics to gain control of the company without paying all stockholders the fair value of their shares, including a “control premium.”

On January 28, 2004, we completed our acquisition of Medical Device Alliance Inc. (“MDA”) and its subsidiary, Parallax Medical, Inc. (“Parallax”) for a total of $27.3 million, including consideration and acquisition-related expenses, net of cash acquired, of which $2.1 million remained unpaid as of December 31, 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. The amount of the payment will be a multiple of revenues related to the MDA technology, less consideration already paid and certain other holdbacks. 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. 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 is estimated based on purchase price and future intended use. The value of intangible assets is estimated based on estimated future benefits of the various intangible assets acquired. The excess of the purchase price over the fair value of assets acquired and liabilities assumed is recorded as goodwill. The premium paid for the acquisition over the valuation of the identifiable assets was based on management’s belief that MDA’s technology for bone access, percutaneous injection of bone cement and bone augmentation in the spine were of significant strategic importance in our expanded interventional spine strategy and to create a multi-procedure interventional spine business. The resulting goodwill is not deductible for income taxes. 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):

On November 12, 2004, we completed our acquisition of Opus Medical, Inc., (“Opus”), for total initial consideration of $91.7 million, including consideration and estimates of acquisition-related expenses, net of cash acquired. Of the initial consideration, $0.8 million remained unpaid as of December 31, 2004. The consideration included $60.0 million in our common stock. In addition, ArthroCare will make a payment in 2005 of $40.0 million, less certain potential holdbacks and contingent deductions, consisting in either cash or our common stock at our election. ArthroCare will pay additional consideration, if the Opus products reach certain revenue goals during 2005. Opus owned a technology for reconnecting bone and tissue used commonly in rotator cuff surgery.

The Opus acquisition was accounted for using the purchase method of accounting. The premium paid for the acquisition over the valuation of the identifiable assets was based on management’s belief that Opus’ technology, especially when combined with our existing technology for arthroscopic surgery, gives us a significant advantage in providing a full solution for certain shoulder surgeries. The resulting goodwill is not deductible for income taxes.

In connection with our acquisition of Opus during the fourth quarter of 2004, we expensed $36.4 million of the purchase price for IPR&D projects. These costs were for significant projects related to automated suturing technology applicable to sports medicine surgical procedures. These projects related to technology which had not yet reached technological feasibility and had no future alternative use. Prior to the acquisition, we did not have comparable products under development. We expect to incur $1.6 million in costs in 2005 to bring these products to commercialization in the United States.

We are responsible for the valuation of IPR&D charges. The values assigned to IPR&D are based on valuations that have been prepared using methodologies and valuation techniques consistent with those used by independent appraisers. All values were determined by identifying research projects in areas for which technological feasibility had not been established. Additionally, the values were determined by estimating the revenue and expenses associated with a project’s sales cycle and the amount of after-tax cash flows attributable to these projects. The future cash flows were discounted to present value utilizing an appropriate risk-adjusted rate of return of 20% to 22%. The rate of return included a factor that takes into account the uncertainty surrounding the successful development of the IPR&D.

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

The following table reflects the unaudited pro forma results of operations of ArthroCare assuming that the acquisitions of MDA and Opus had occurred on January 1, 2004 or 2003, respectively. These unaudited pro forma results of operations have been prepared for illustrative purposes only. Pro forma net loss for 2004, shown below, includes a $36.4 million non-recurring charge for IPR&D projects. 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.

On October 21, 2002, the Company acquired all of the outstanding common stock of Atlantech Medical Devices, Ltd. (“Atlantech UK”), on November 11, 2002, the Company acquired all of the outstanding common stock of Atlantech GmbH (“Atlantech Germany”), and, on April 25, 2003, the Company acquired all of the outstanding common stock of Atlantech Medizinische Produkte Vertreibs (“Atlantech Austria”, together, “Atlantech”) in a cash acquisition totaling $13.1 million, net of cash acquired. Prior to this acquisition, Atlantech served as one of our distributors in the United Kingdom, Germany and Austria and also distributed a separate line of sports medicine products. The Company intends to expand its international base of operations through this acquisition and this purchase of our distributors in the United Kingdom, Germany and Austria is for the purpose of expanding our international base of operations. The addition of their complementary line of sports medicine products will allow us to compete across a broader base of the sports medicine market in selected geographies. The purchase price of $13.1 million, which includes the original purchase price and contingent consideration based upon the net assets of the acquired business and on revenue targets, was accounted for using the purchase method of accounting. 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 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 of Atlantech and a summary of the consideration exchanged for these assets is as follows (in thousands):

Additional payment to the former owners of Atlantech is contingent upon the continued employment of those former owners. This amount is being recognized as compensation expense over the period benefited through 2005.

In connection with the formation of ArthroCare, several of the founders and a partnership of the founders entered into a licensing agreement to facilitate patent transfers. As a result, we acquired an exclusive worldwide perpetual royalty-free license, with right of sublicense, to make, use and sell products and use patent methods covered by the patent rights limited to surgical orthopedic and arthroscopic applications.

In June 1997, we loaned an officer $500,000 pursuant to a provision in the officer’s employment agreement. The promissory note, which bears no interest, is collateralized by a mortgage on the officer’s residence and is due and payable upon either the officer’s termination of employment or the sale of the officer’s residence. If we terminate the officer or if we are acquired, the loan is due and payable within 12 months thereafter. As of December 31, 2004, $500,000 of principal was outstanding on this note.

In November 1997, we issued a relocation loan of $130,000 to an employee. This loan is collateralized by the employee’s residence and is due and payable upon either the sale or transfer of the property or the termination of the officer’s employment with us and bears no interest. This loan was repaid in full in 2004.

In April 1999, we loaned an officer $225,000 pursuant to a provision in the officer’s employment agreement. The promissory note, which bears no interest, is collateralized by a mortgage on the officer’s residence and is due and payable upon either the officer’s termination of employment or the sale of the officer’s residence. If we terminate the officer or if we are acquired, the loan is due and payable within 12 months thereafter. As of December 31, 2004, $225,000 of principal was outstanding on this note.

In May 1999, we loaned an officer $350,000 pursuant to a provision in the officer’s employment agreement. The promissory note, which bears no interest, is collateralized by a mortgage on the officer’s residence and is due and payable upon either the officer’s termination of employment or the sale of the officer’s residence. If we terminate the officer or if we are acquired, the loan is due and payable within 12 months thereafter. As of December 31, 2004, $350,000 of principal was outstanding on this note.

The income tax provision differed from a provision computed at the U.S. statutory tax rate as follows:

At December 31, 2004, the Company had acquired net operating loss carryforwards of approximately $25 million which will be subject to an annual utilization limitation of approximately $5.7 million under Section 382 of the Internal Revenue Code. These loss carryforwards will begin to expire in 2017. The Company has utilized all of its self-generated loss carryforwards.

At December 31, 2004 and 2003, the Company had federal and state research and development credit carryforwards of approximately $4.7 million and $2.5 million, respectively, available to offset future income taxes. These federal credits will begin to expire in 2008; the state credits are not subject to expiration.

Under the Internal Revenue Code, certain substantial changes in the Company’s ownership could result in an annual limitation on the amount of net operating loss carryforwards and income tax credits that could be utilized to offset future tax liabilities.

The Company’s deferred tax assets and liabilities consist of the following (in thousands):

Income tax benefits resulting from the exercise of options of $4.6 million, $1.6 million, and $0.7 million were credited to additional paid in capital for 2004, 2003 and 2002, respectively.

Deferred taxes are not provided for the earnings of the Company’s foreign subsidiaries, as those earnings are considered permanently reinvested in the operations of the foreign subsidiaries and the Company intends to continue to reinvest its undistributed international earnings to expand its international operations. It is not practical to estimate the amount of additional tax that might be payable on the foreign earnings should they become subject to tax in the United States.

We maintain a Retirement Savings and Investment Plan (401(k) Plan), which covers all United States-based employees. Eligible employees may defer salary (before tax) up to a federally specified maximum. Management, at its discretion, may make matching contributions on behalf of the participants in the 401(k) Plan. We matched approximately $104,000, $106,000 and $95,000 of employee contributions to the 401(k) Plan in 2004, 2003 and 2002, respectively.

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, (to include ear, nose, throat and the Visage^® cosmetic products), ArthroCare Spine^™ (to include spinal and neuro surgery products) and Coblation Technology (to include gynecology, urology, laparoscopic, general surgical and cardiology products). 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):

The following tables present certain unaudited consolidated quarterly financial information for each quarter in the years ended December 31, 2004 and December 31, 2003 (in thousands, except per share data). In our opinion, this unaudited quarterly information has been prepared on the same basis as the consolidated financial statements and includes all adjustments necessary to present fairly the information for the periods presented.

The above information for Quarter 4 of 2004 reflects a charge of approximately $36.4 million for acquired in-process research and development (see Note 12).

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized:


ARTHROCARE CORPORATION a Delaware Corporation

By:		/s/ MICHAEL A. BAKER Michael A. Baker President and Chief Executive Officer

Know All Persons By These Presents, that each person whose signature appears below constitutes and appoints each of Michael A. Baker and Fernando Sanchez as his or her attorney-in-fact for him, in any and all capacities, to sign each amendment to this Report on Form 10-K, and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that said attorney-in-fact or his substitute or substitutes may lawfully do or cause to be done by virtue hereof.

Pursuant to the requirements of the Securities Exchange Act of 1934, the following persons on behalf of the Registrant and in the capacities and on the dates indicated have signed this Report below:


Securities registered pursuant to 12 (b) of the Act:		None

Securities registered pursuant to section 12 (g) of the Act:		Common Stock, $0.001 Par Value; Preferred Share Purchase Rights


	2004
	Quarter 1		Quarter 2		Quarter 3		Quarter 4
High	$	27.30	$	29.35	$	29.94	$	33.11
Low		21.54		19.76		22.56		26.98

	2003
	Quarter 1		Quarter 2		Quarter 3		Quarter 4
High	$	12.75	$	18.20	$	21.37	$	25.88
Low		8.65		12.38		12.65		17.67


	Year Ended December 31,
	2004			2003		2002		2001		2000
	(in thousands, except per share data)
Statements of Operations Data:
Product sales	$	147,830		$	114,719	$	84,965	$	70,300	$	62,164
Royalties, fees and other		6,318			4,134		3,822		8,075		3,615
Total revenues		154,148			118,853		88,787		78,375		65,779
Gross profit		103,048			80,912		55,378		50,684		40,117
Operating expenses		126,801			72,767		56,225		42,994		32,619
Income/(Loss) before cumulative effect of change in accounting principle		(26,189	)		7,456		1,132		10,060		15,845
Cumulative effect of the application of SAB 101		—			—		—		—		(4,300	)
Net income/(loss)		(26,189	)		7,456		1,132		10,060		11,545
Basic net income (loss) per share	$	(1.21	)	$	0.36	$	0.05	$	0.45	$	0.53
Diluted net income (loss) per share	$	(1.21	)	$	0.34	$	0.05	$	0.43	$	0.50

	December 31,
	2004			2003		2002		2001		2000
	(in thousands)
Balance Sheet Data:
Cash, cash equivalents and available-for-sale securities (including long-term portion)	$	21,836		$	31,318	$	52,851	$	76,695	$	86,814
Working capital		80,912			67,670		72,939		98,642		97,013
Total assets		240,531			138,138		135,952		133,697		140,462
Long-term liabilities		34,290			155		161		53		4,758
Total stockholders’ equity(1)		175,252			120,648		118,163		125,093		126,345


	Year Ended December 31,
(Dollar amounts in thousands)	2004					2003				2002
Revenues:
Product sales	$	147,830		96	%	$	114,719	97	%	$	84,965		96	%
Royalties, fees and other		6,318		4	%		4,134	3	%		3,822		4	%

Total revenues		154,148		100	%		118,853	100	%		88,787		100	%
Cost of product sales		51,100		33	%		37,941	32	%		33,409		38	%

Gross profit		103,048		67	%		80,912	68	%		55,378		62	%

Operating expenses:
Research and development		13,346		9	%		10,642	9	%		8,826		10	%
Sales and marketing		58,087		38	%		46,100	39	%		36,519		41	%
General and administrative		16,310		10	%		14,845	12	%		10,679		12	%
Amortization of intangible assets		2,658		2	%		1,180	1	%		201		0	%
Acquired in-process research & development costs		36,400		23	%		—				—

Total operating expenses		126,801		82	%		72,767	61	%		56,225		63	%

Income (loss) from operations		(23,753	)	-15	%		8,145	7	%		(847	)	-1	%
Interest income and other, net		824		0	%		2,357	2	%		2,545		3	%

Income (loss) before income taxes		(22,929	)	-15	%		10,502	9	%		1,698		2	%
Income tax provision		3,260		2	%		3,046	3	%		566		1	%

Net income (loss)	$	(26,189	)	-17	%	$	7,456	6	%	$	1,132		1	%


	Year Ended December 31,
	2004				2003				2002
Sports Medicine	$	97,574	66	%	$	82,114	72	%	$	65,412	77	%
ENT		28,357	19	%		17,169	15	%		10,195	12	%
ArthroCare Spine		21,614	15	%		14,229	12	%		8,606	10	%
Coblation Technology		285	0	%		1,207	1	%		752	1	%

Total Product Sales	$	147,830	100	%	$	114,719	100	%	$	84,965	100	%


	(In thousands)
Acquired IPR&D Project Type	Projected Cost to Complete		Estimated Completion Date	Value
Shoulder joint repairs	$	784	December 31, 2005	$	11,000
Implantables		392	December 31, 2005		25,000
Tendon repairs		392	December 31, 2005		400

Total	$	1,568		$	36,400


	Payments Due by Period (In thousands)
	Total		Less than 1 Year		1-3 Years		4-5 Years		After 5 Years
Operating Lease Obligations	$	4,798	$	2,348	$	2,450	$	—	$	—
Contractual Obligations to Former Atlantech Owners	$	2,176	$	1,064	$	1,112	$	—	$	—
Debt Obligations	$	28,929	$	4,286	$	12,857	$	8,571	$	3,214
Payments to MDA Shareholders and other assumed liabilities	$	3,451	$	3,451	$	—	$	—	$	—
Payments to Opus Medical Shareholders	$	40,316	$	316	$	40,000	$	—	$	—

Total	$	79,670	$	11,465	$	56,419	$	8,571	$	3,214


		Page
Report of Independent Registered Public Accounting Firm on Consolidated Financial Statements and Financial Statement Schedule		53
Consolidated Balance Sheets as of December 31, 2004 and December 31, 2003		54
Consolidated Statements of Operations for the years ended December 31, 2004, 2003 and 2002		55
Consolidated Statements of Stockholders’ Equity for the years ended December 31, 2004, 2003, and 2002		56
Consolidated Statements of Cash Flows for the years ended December 31, 2004, 2003 and 2002		57
Notes to the Consolidated Financial Statements		58


Schedule	Title	Page
II	Valuation and Qualifying Accounts	79


2.1		Agreement and Plan of Merger, dated as of September 3, 2004, by and among ArthroCare Corporation, Opus Medical, Inc., OC Merger Sub Corporation, OC Acquisition Sub LLC, and James W. Hart and Steven L. Gex, as the Shareholders’ Agents (Incorporated herein by reference to Exhibit 2.1 to the Registrant’s Current Report on Form 8-K filed on November 18, 2004).

2.2		Amendment No. 1, dated as of October 6, 2004, to the Agreement and Plan of Merger, dated as of September 3, 2004, by and among ArthroCare Corporation, Opus Medical, Inc., OC Merger Sub Corporation, OC Acquisition Sub LLC, and James W. Hart and Steven L. Gex, as the Shareholders’ Agents (Incorporated herein by reference to Exhibit 2.2 to the Registrant’s Current Report on Form 8-K filed on November 18, 2004).

3.1		Restated Certificate of Incorporation of the Registrant. (Incorporated herein by reference to Exhibit 3.1 filed previously with the Registrant’s Annual Report on Form 10-K for the period ended December 30, 2000).


3.2		Amended and Restated By laws of the Registrant. (Incorporated herein by reference to Exhibit 3.2 filed previously with the Registrant’s Quarterly Report on Form 10-Q for the period ended October 3, 1998).

4.1		Specimen Common Stock Certificate. (Incorporated herein by reference to Exhibit 4.1 filed previously with the Registrant’s Registration Statement on Form 8-A (Registration No. 000-27422)).

10.1*		Form of Indemnification Agreement between the registrant and each of its directors and officers. (Incorporated herein by reference to Exhibit 10.1 filed previously with the Registrant’s Registration Statement on Form S-1 (Registration No. 33-80453)).

10.2*		Incentive Stock Plan and form of Stock Option Agreement thereunder. (Incorporated herein by reference to Exhibit 10.2 filed previously with the Registrant’s Registration Statement on Form S-1 (Registration No. 33-80453)).

10.3*		Director Option Plan and form of Director Stock Option Agreement thereunder. (Incorporated herein by reference to Exhibit 10.3 filed previously with the Registrant’s Registration Statement on Form S-1 (Registration No. 33-80453)).

10.4*		Employee Stock Purchase Plan and forms of agreements thereunder. (Incorporated herein by reference to Exhibit 10.4 filed previously with the Registrant’s Registration Statement on Form S-1 (Registration No. 33-80453)).

10.5		Form of Exclusive Distribution Agreement. (Incorporated herein by reference to Exhibit 10.5 filed previously with the Registrant’s Registration Statement on Form S-1 (Registration No. 33-80453)).

10.6		Form of Exclusive Sales Representative Agreement. (Incorporated herein by reference to Exhibit 10.6 filed previously with the Registrant’s Registration Statement on Form S-1 (Registration No. 33-80453)).

10.7		Consulting Agreement, dated May 10, 1993, between the Registrant and Philip E. Eggers, and amendment thereto. (Incorporated herein by reference to Exhibit 10.7 filed previously with the Registrant’s Registration Statement on Form S-1 (Registration No. 33-80453)).

10.8		Consulting Agreement, dated May 20, 1993, between the Registrant and Eggers & Associates, Inc., and amendment thereto. (Incorporated herein by reference to Exhibit 10.8 filed previously with the Registrant’s Registration Statement on Form S-1 (Registration No. 33-80453)).

10.9		Lease Agreement, dated May 20, 1993, between the Registrant and Eggers & Associates, Inc., and amendment thereto. (Incorporated herein by reference to Exhibit 10.9 filed previously with the Registrant’s Registration Statement on Form S-1 (registration No. 33-80453)).

10.10		Amended and Restated Stockholder Right Agreement, dated October 16, 1995, between the Registrant and certain holders of the Registrant’s securities. (Incorporated herein by reference to Exhibit 10.20 filed previously with the Registrant’s Registration Statement on form S-1 (Registration No. 33-80453)).

10.11		Contribution Agreement, dated March 31, 1995, by and among Philip E. Eggers, Robert S. Garvie, Anthony J. Manlove, Hira V. Thapliyal and the Registrant. (Incorporated herein by reference to Exhibit 10.21 filed previously with the Registrant’s Registration Statement on Form S-1 (Registration No. 33-80453)).

10.12		Amended and Restated Stockholder Rights Agreement, dated October 2, 1998, between the Registrant and Norwest Bank Minnesota, N.A. (Incorporated herein by reference to Exhibit 10.20 filed previously with the Registrant’s Registration Statement on Form 8-A filed October 21, 1998 (Registration No. 000-27422)).


10.13		Exclusive Distributor Agreement, dated August 21, 1997, between the Registrant and Kobyashi Pharmaceutical Company, Ltd. (Incorporated herein by reference to Exhibit 10.25 filed previously with the Registrant’s Quarterly Report on Form 10-Q for the period ended September 27, 1997).

10.14		License Agreement dated February 9, 1998, between the Registrant and Boston Scientific Corporation. (Incorporated herein by reference to Exhibit 10.26 filed previously with the Registrant’s Annual Report on form 10-K for the period ended January 3, 1998).

10.15		Development and Supply Agreement dated February 9, 1998, between the Registrant and Boston Scientific Corporation. (Incorporated herein by reference to Exhibit 10.27 filed previously with the Registrant’s Annual report on form 10-K for the period ended January 3, 1998).

10.16*		Change of Control Agreement between the Registrant and the CEO. (Incorporated herein by reference to Exhibit 10.28 filed previously with the Registrant’s Annual Report on Form 10-K for the period ended January 2, 1999).

10.17*		The form of “VP Continuity Agreement” between the Registrant and its Vice Presidents. (Incorporated herein by reference to Exhibit 10.29 filed previously with the Registrant’s Annual Report on Form 10-K for the period ended January 2, 1999).

10.18		Letter Agreement dated February 9, 1999 between the Registrant and Collagen Aesthetics. (Incorporated herein by reference to Exhibit 10.30 filed previously with the Registrant’s Annual Report on Form 10-K/A for the period ended January 2, 1999).

10.19*		Employment Letter Agreement, between the Registrant and John R. Tighe dated January 26, 1999. (Incorporated herein by reference to Exhibit 10.30 filed previously with the registrant’s Quarterly Report on Form 10-Q for the period ended April 3, 1999).

10.20*		Reserved.

10.21*		Employment Letter Agreement, between the Registrant and Bruce P. Prothro amended May 19, 1999. (Incorporated herein by reference to Exhibit 10.32 filed previously with the Registrant’s Quarterly Report on Form 10-Q for the period ended April 3, 1999).

10.22†		Litigation Settlement Agreement, between the Registrant and ETHICON Inc. dated June 24, 1999 (Incorporated herein by reference to Exhibit 10.33 previously filed with the Registrant’s Quarterly Report on Form 10-Q for the period ended July 3, 1999).

10.23		Relocation Loan Agreement, between the Registrant and John. R. Tighe dated May 1, 1999. (Incorporated herein by reference to Exhibit 10.34 previously filed with the Registrant’s Quarterly Report on Form 10-Q for the period ended July 3, 1999).

10.24		Line of Credit Agreement with Silicon Valley Bank dated June 11, 1999. (Incorporated herein by reference to Exhibit 10.35 previously filed with the Registrant’s Quarterly Report on Form 10-Q for the period ended July 3, 1999).

10.25†		Amendment to License Agreement between ArthroCare Corporation and Inamed Corporation dated October 1, 1999. (Incorporated herein by reference to Exhibit 10.33 previously filed with the Registrant’s Registration Statement on Form S-3 (Registration No. 333-87187)).

10.26		First Amendment to Rights Agreement between the ArthroCare Corporation and Norwest Bank Minnesota, N.A. (the “Rights Agent”) dated March 10, 2000. (Incorporated herein by reference to Exhibit 99.1 previously filed with the Registrant’s Form 8-K filed March 10, 2000.)

10.27*		Nonstatuatory Stock Option Plan and form of Stock Option Agreement thereunder. (Incorporated herein by reference to Exhibit 10.35 filed previously with this the Registrant’s Annual Report on Form 10-K for the period ended December 31, 1999).


10.28†		License Agreement between ArthroCare Corporation and Stryker Corporation, dated June 28, 2000. (Incorporated herein by reference to Exhibit 10.36 filed previously with this the Registrant’s Quarterly Report on Form 10-Q for the period ended July 1, 2000).

10.29*		Change of Control Agreement between the Registrant and Michael Baker, CEO, dated September 25, 2001. (Incorporated herein by reference to Exhibit 10.37 filed previously with the Registrant’s Quarterly Report on Form 10-Q for the period ended September 29, 2001).

10.30*		Amendment to the 1993 Incentive Plan (Incorporated herein by reference to Exhibit 4.2 to the Registrant’s Registration Statement on Form S-8 filed on August 8, 2000).

10.31*		Amendment to the 1995 Director Option Plan (Incorporated herein by reference to Exhibit 4.3 to the Registrant’s Statement on Form S-8 filed on August 8, 2000).

10.32††		Share Purchase Agreement relating to the entire issued share capital of Atlantech Medical Devices Limited and Atlantech Medical Devices (UK), Limited, dated October 21, 2002.

10.33*		Amended and Restated Nonstatutory Option Plan (Incorporated herein by reference to Exhibit 4.5 to the Registrant’s Registration Statement on Form S-8 filed on May 8, 2003).

10.34*		2003 Incentive Stock Plan (Incorporated herein by reference to Exhibit 4.4 to the Registrant’s Registration Statement on Form S-8 filed with the Securities and Exchange Commission on June 24, 2003).

10.35*		Second Amendment to the 1995 Director Option Plan (Incorporated herein by reference to Exhibit 4.3 to the Registrant’s Registration Statement on Form S-8 filed with the Securities and Exchange Commission on May 8, 2003).

10.36		Agreement and Plan of Merger, dated as of October 23, 2003, as amended by Amendment No. 1 to Agreement and Plan of Merger, dated as of January 5, 2004, by and among ArthroCare Corporation, Alpha Merger Sub Corporation and Medical Device Alliance Inc. (Incorporated herein by reference to Exhibit 2.1 to the Registrant’s Current Report on Form 8-K filed on February 11, 2004).

10.37		Contingent Value Rights Agreement, dated as of January 28, 2004, by and among ArthroCare Corporation, Alpha Merger Sub Corporation, Medical Device Alliance Inc., Wells Fargo Bank, N.A. and Frank Bumstead (Incorporated herein by reference to Exhibit 2.2 to the Registrant’s Current Report on Form 8-K filed on February 11, 2004).

10.38		Form of Stockholder Waiver Agreement, dated as of October 23, 2003, by each of Vegas Ventures, LLC, Jeffrey Barber and Howard Preissman (Incorporated herein by reference to Exhibit 99.3 to the Registrant’s Current Report on Form 8-K filed on October 31, 2003).

10.39		Stockholder Waiver Agreement, dated as of October 23, 2003, by the McGhan Entities (Incorporated herein by reference to Exhibit 99.4 to the Registrant’s Current Report on Form 8-K filed on October 31, 2003).

10.40††		Credit Agreement between the Registrant, Bank of America, N.A. and Wells Fargo Bank, National Association, dated December 19, 2003.

10.41		Form of “Amendment to VP Continuity Agreement” between ArthroCare Corporation and its vice presidents (Incorporated herein by reference to Exhibit 10.41 to the Registrant’s Quarterly Report on Form 10-Q filed on August 6, 2004).

10.42		Form of “Senior VP Continuity Agreement” between ArthroCare Corporation and its senior vice presidents (Incorporated herein by reference to Exhibit 10.42 to the Registrant’s Quarterly Report on Form 10-Q filed on August 6, 2004).

10.43		Form of “Amendment to Senior VP Continuity Agreement” between ArthroCare Corporation and its senior vice presidents (Incorporated herein by reference to Exhibit 10.43 to the Registrant’s Quarterly Report on Form 10-Q filed on August 6, 2004).


10.44		Employment Agreement between the Registrant and Michael Baker, dated January 1, 2003 (Incorporated herein by reference to Exhibit 10.44 to the Registrant’s Quarterly Report on Form 10-Q filed on November 26, 2004).

10.45††		Amended and Restated Credit Agreement between the Registrant, Bank of America, N.A. and Wells Fargo Bank, National Association, dated October 15, 2004 (Incorporated herein by reference to Exhibit 10.45 to the Registrant’s Quarterly Report on Form 10-Q filed on November 26, 2004).

10.46		2004/2005 Executive Officer Bonus Plan (Incorporated herein by reference to Exhibit 10.46 to the Registrant’s Current Report on Form 8-K/A filed on February 28, 2005).

10.47		2005 Executive Officer Bonus Plan (Incorporated herein by reference to Exhibit 10.47 to the Registrant’s Current Report on Form 8-K filed on February 22, 2005).

10.48		Form of Option Agreement under the Amended and Restated 2003 Incentive Plan (Incorporated herein by reference to Exhibit 10.48 to the Registrant’s Current Report on Form 8-K filed on February 22, 2005).

10.49		Form of Restricted Stock Bonus Agreement under the Amended and Restated Director Option Plan (Incorporated herein by reference to Exhibit 10.49 to the Registrant’s Current Report on Form 8-K filed on February 22, 2005).

10.50		Form of Restricted Stock Bonus Agreement under the Amended and Restated 2003 Incentive Stock Plan (Incorporated herein by reference to Exhibit 10.50 to the Registrant’s Current Report on Form 8-K filed on February 22, 2005).

10.51††		First Amendment to Amended and Restated Credit Agreement between the Registrant, Bank of America, N.A. and Wells Fargo Bank, National Association, dated March 30, 2005.

21.1		Subsidiaries of the Registrant.

23.1		Consent of PricewaterhouseCoopers LLP, Independent Registered Public Accounting Firm.

24.1		Power of Attorney (see Page 75).

31.1		Certification of the Chief Executive Officer pursuant to Rule 13a-14(a) of the Exchange Act, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2		Certification of the Chief Financial Officer pursuant to Rule 13a-14(a) of the Exchange Act, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1		Certification of the Chief Executive Officer pursuant to Rule 13a-14(b) of the Exchange Act and 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2		Certification of the Chief Financial Officer pursuant to Rule 13a-14(b) of the Exchange Act and 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.


	Common Stock Shares		Common Stock Amount			Treasury Stock Amount			Additional Paid-In Capital		Deferred Stock Compensation			Accumulated Other Comprehensive Income			Retained Earnings/ (Accumulated Deficit)			Total Stockholders’ Equity			Comprehensive Income (Loss)
Balances, December 31, 2001	21,855		$	22		$	(18,987	)	$	146,081	$	—		$	(1,724	)	$	(299	)	$	125,093
Issuance of common stock through:
Exercise of options	293			—			—			1,989		—			—			—			1,989
Employee stock purchase plan	51			—			—			542		—			—			—			542
Restricted stock expense	—			—			—			23		—			—			—			23
Stock compensation	—			—			—			83		—			—			—			83
Income tax benefit resulting from exercise of stock options	—			—			—			679		—			—			—			679
Change in unrealized gain on available-for-sale securities	—			—			—			—		—			(80	)		—			(80	)	$	(80	)
Currency translation adjustment	—			—			—			—		—			820			—			820			820
Purchase of common stock	(1,027	)		(1	)		(12,117	)		—		—			—			—			(12,118	)
Net income	—			—			—			—		—			—			1,132			1,132			1,132

Balances, December 31, 2002	21,172			21			(31,104	)		149,397		—			(984	)		833			118,163			1,872

Issuance of common stock through:
Exercise of warrants and options	387			1			—			3,007		—			—			—			3,008
Employee stock purchase plan	67			—			—			752		—			—			—			752
Issuance of restricted stock	126			—			—			1,138		(1,138	)		—			—			—
Stock compensation	—			—			—			392		187			—			—			579
Income tax benefit resulting from exercise of stock options	—			—			—			1,597		—			—			—			1,597
Change in unrealized gain on available-for-sale securities	—			—			—			—		—			(194	)		—			(194	)		(194	)
Currency translation adjustment	—			—			—			—		—			342			—			342			342
Purchase of common stock	(727	)		(1	)		(11,054	)		—		—			—			—			(11,055	)
Net income	—			—			—			—		—			—			7,456			7,456			7,456

Balances, December 31, 2003	21,025			21			(42,158	)		156,283		(951	)		(836	)		8,289			120,648			7,604

Issuance of common stock through:
Exercise of options	1,009			1			—			14,266		—			—			—			14,267
Employee stock purchase plan	44			—			—			879		—			—			—			879
Issuance of restricted stock	71			—			—			2,123		(2,123	)		—			—			—
Purchase of Opus Medical	1,937			2			—			59,998		—			—			—			60,000
Stock compensation	—			—			—			176		597			—			—			773
Income tax benefit resulting from exercise of stock options	—			—			—			4,630		—			—			—			4,630
Change in unrealized gain on available-for-sale securities	—			—			—			—		—			173			—			173			173
Currency translation adjustment	—			—			—			—		—			71			—			71			71
Net loss	—			—			—			—		—			—			(26,189	)		(26,189	)		(26,189	)

Balances, December 31, 2004	24,086		$	24		$	(42,158	)	$	238,355	$	(2,477	)	$	(592	)	$	(17,900	)	$	175,252		$	(25,945	)


	2003
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Market Value
Maturity date greater than 1 year but less than 5 years:
Corporate notes and bonds	$	10,590	$	—	$	(162	)	$	10,428

Total	$	10,590	$	—	$	(162	)	$	10,428


	December 31,						Estimated Useful Lives (Years)
	2004			2003			Estimated Useful Lives (Years)
Property and equipment:
Controller placements	$	40,971		$	31,452		3 to 4
Computer equipment and software		11,674			7,760		3 to 5
Machinery and equipment		6,585			4,618		5
Furniture, fixtures and leasehold improvements		3,447			2,988		5
Construction in process		1,286			2,985		—
Building and improvements		2,435			1,930		30
Tooling and molds		2,683			1,779		5
Land		406			760		—

		69,487			54,272
Less accumulated depreciation		(40,091	)		(30,779	)

Property and equipment, net	$	29,396		$	23,493


2005	$	6,122
2006		6,011
2007		5,784
2008		4,962
2009		4,815
Thereafter		12,265

	$	39,959


	Outstanding Options
	For Grant		Number of Shares		Weighted- Average Exercise Price
Balances, December 31, 2001	627		2,430		$	12.82
Additional shares authorized	250		—
Options granted	(691	)	691		$	12.17
Options exercised	—		(250	)	$	6.33
Options cancelled	18		(18	)	$	10.00

Balances, December 31, 2002	204		2,853		$	13.25
Options granted	(199	)	199		$	13.67
Restricted stock issued	(127	)	—
Options exercised	—		(260	)	$	7.45
Options cancelled	138		(138	)	$	19.74
Plan shares expired	(16	)	—

Balances, December 31, 2003	—		2,654		$	13.52
Options exercised	—		(507	)	$	11.39
Options cancelled	138		(138	)	$	18.13
Plan shares expired	(138	)	—

Balances, December, 31, 2004	—		2,009		$	13.74


Exercise Price	Number Outstanding	Weighted Average Remaining Contractual Life	Weighted Average Exercise Price		Number Exercisable As of December 31, 2004	Weighted Average Exercise Price
$ 0.20 - $ 7.62	610,480	2.68	$	4.81	610,480	$	4.81
8.62 - 10.71	661,782	7.09		10.03	357,173		9.84
11.45 - 13.59	787,025	7.73		12.63	306,636		12.87
13.60 - 15.55	576,857	7.57		14.17	330,724		14.07
15.97 - 19.44	564,470	6.24		17.09	489,944		17.20
19.56 - 23.00	863,072	6.35		22.36	665,077		22.50
23.41 - 27.56	878,042	7.96		26.08	470,435		26.79
27.75 - 31.00	333,842	8.07		30.00	137,819		29.88
39.06 - 46.62	87,249	5.35		43.14	87,249		43.14
48.56 - 48.56	500	5.21		48.56	500		48.56

	5,363,319	6.70	$	17.40	3,456,037	$	17.06


Tangible assets (primarily inventory, fixed assets and accounts receivable)	$	2,339
Intangible assets		9,160
Deferred tax assets		4,892
Goodwill		17,010
Liabilities assumed		(2,053	)
Deferred tax liabilities		(4,065	)

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


Tangible assets (primarily inventory, fixed assets and accounts receivable)	$	7,770
Intangible assets		64,300
Deferred tax assets		4,546
Goodwill		30,458
Liabilities assumed		(4,220	)
Deferred tax liabilities		(11,160	)

Total purchase price, net of cash acquired	$	91,694


	2003			2002
Tangible assets (primarily accounts receivable and inventory)	$	660		$	5,451
Intangible assets		—			5,300
Deferred tax liabilities		—			(2,160	)
Goodwill		422			10,040
Liabilities assumed		(452	)		(6,125	)

Total purchase price	$	630		$	12,506


	December 31, 2004			December 31, 2003			December 31, 2002
Current
Federal	$	2,321		$	1,764		$	576
State		330			649			58
Foreign		468			332			—

Total current		3,119			2,745			634

Deferred
Federal		1,733			1,338			71
State		80			191			(132	)
Foreign		(1,672	)		(1,228	)		(7	)

Total deferred		141			301			(68	)

Total income tax provision	$	3,260		$	3,046		$	566


	December 31, 2004			December 31, 2003
Deferred tax assets:
Net operating loss carryforwards	$	8,856		$	571
Capitalized research and development costs		—			960
R&D and MIC credits		6,102			4,797
Allowances and reserves		1,657			780
Deferred intercompany transactions		1,066			814
Alternative minimum tax credits		175			175
Non-goodwill intangibles		(14,987	)		(1,664	)
R&D cost share and other		(1,677	)		(1,420	)

Net deferred tax assets	$	1,192		$	5,013


	Balance at Beginning of Period		Additional Charged to Costs and Expenses		Deduction			Balance at End of Period
Year Ended December 31, 2004
Deducted from asset accounts:
Allowance for doubtful accounts and product returns	$	289	$	586	$	(475	)	$	400
Allowance for excess and obsolete inventory		754		246		—			1,000

Year Ended December 31, 2003
Deducted from asset accounts:
Allowance for doubtful accounts and product returns	$	1,073	$	—	$	(784	)	$	289
Allowance for excess and obsolete inventory		583		193		(22	)		754

Year Ended December 31, 2002
Deducted from asset accounts:
Allowance for doubtful accounts and product returns	$	776	$	683	$	(386	)	$	1,073
Allowance for excess and obsolete inventory		440		143		—			583


Signature	Title	Date

/s/ MICHAEL A. BAKER Michael A. Baker	President, Chief Executive Officer and Director (Principal Executive Officer)	March 31, 2005

/s/ FERNANDO SANCHEZ Fernando Sanchez	Senior Vice President Finance, Chief Financial Officer and Assistant Secretary (Principal Financial and Accounting Officer)	March 31, 2005

/s/ DAVID F. FITZGERALD David F. Fitzgerald	Director	March 31, 2005

/s/ JAMES FOSTER James Foster	Director	March 31, 2005

/s/ PETER L. WILSON Peter L. Wilson	Director	March 31, 2005

/s/ JERRY P. WIDMAN Jerry P. Widman	Director	March 31, 2005

/s/ TORD B. LENDAU Tord B. Lendau	Director	March 31, 2005


Exhibit Number		Exhibit Name

10.51††		First Amendment to Amended and Restated Credit Agreement between the Registrant, Bank of America, N.A. and Wells Fargo Bank, National Association, dated March 30, 2005.

21.1		Subsidiaries of the Registrant.

23.1		Consent of PricewaterhouseCoopers LLP, Independent Registered Public Accounting Firm.

24.1		Power of Attorney (see page 81).

31.1		Certification of the Chief Executive Officer pursuant to Rule 13a-14(a) of the Exchange Act, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2		Certification of the Chief Financial Officer pursuant to Rule 13a-14(a) of the Exchange Act, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1		Certification of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2		Certification of the Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.