Back to GetFilings.com

Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

For the quarter ended March 31, 2005.

OR

For the transition period from              to             

Commission File Number: 0-27422

ArthroCare Corporation

(Exact name of registrant as specified in its charter)

111 Congress Avenue, Suite 510, Austin, TX 78701

(Address of principal executive offices)

(512) 391-3900

(Registrant’s telephone number, including area code)

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

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

The number of shares outstanding of the registrant’s common stock as of April 29, 2005 was 24,242,315.

Table of Contents

ARTHROCARE CORPORATION

Form 10-Q Quarterly Report

For the quarter ended March 31, 2005

TABLE OF CONTENTS

Table of Contents

PART 1. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

ARTHROCARE CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited)

(in thousands, except per share data)

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

1

Table of Contents

ARTHROCARE CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(in thousands, except per share data)

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

2

Table of Contents

ARTHROCARE CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(in thousands)

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

3

Table of Contents

ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 1 – Description of Business and Basis of Presentation

ArthroCare Corporation (“ArthroCare”, “we” or the “Company”) was incorporated on April 29, 1993 and its principal operations commenced in August 1995. ArthroCare designs, develops, manufactures and markets medical devices for use in soft-tissue surgery. Its products are based on its patented soft-tissue surgical controlled ablation technology, which it calls Coblation technology. Coblation technology involves an innovative use and the capability of performing at temperatures lower than traditional electrosurgical tools. The Company’s 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. ArthroCare is a global company with manufacturing facilities in the United States and Costa Rica and sales offices in the United States and Europe.

The unaudited interim condensed consolidated financial statements include the accounts of ArthroCare Corporation and its wholly owned subsidiaries (collectively, the “Company” or “ArthroCare”). All intercompany accounts and transactions have been eliminated in consolidation.

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, the unaudited interim condensed consolidated financial statements reflect all adjustments (consisting of only normal recurring adjustments) necessary for a fair presentation of the Company’s financial position, results of operations and cash flows for the periods presented. These financial statements should be read in conjunction with the Company’s consolidated financial statements and notes thereto filed with the United States Securities and Exchange Commission in the Company’s annual report on Form 10-K for the year ended December 31, 2004. Operating results for the three-month period ended March 31, 2005 are not necessarily indicative of the results that may be expected for the year ended December 31, 2005.

The condensed consolidated balance sheet at December 31, 2004 was derived from the Company’s audited consolidated financial statements as of that date; however, the accompanying financial statements do not include all annual disclosures required by accounting principles generally accepted in the United States of America.

Use of Estimates

The condensed consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America, using management’s best estimates and judgments where appropriate. These estimates and judgments affect the reported amounts of assets and liabilities and disclosure of the contingent assets and liabilities at the date of the financial statements. The estimates and judgments will also affect the reported amounts for certain revenues and expenses during the reporting period. Actual results could differ materially from these estimates and judgments.

Reclassifications

Certain prior year amounts have been reclassified to conform to the current period presentation. These reclassifications had no effect on reported net income. Amortization expense related to intangible assets has been reclassified from sales and marketing and general and administrative expense to amortization of intangible assets in the accompanying condensed consolidated statements of operations.

4

Table of Contents

ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

NOTE 2 - Stock-Based Compensation

Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (“Statement 123”), prescribes accounting and reporting standards for all stock-based compensation plans, including employee stock options. As allowed by Statement 123, the Company accounts for stock-based employee compensation using the intrinsic value method of accounting in accordance with Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. When the Company issues options or its stock to its employees at an exercise price equal to the market value of the underlying common stock on the date of grant or issuance, no stock-based compensation costs are recorded. In the event that options are granted or restricted shares are issued at an exercise price that is less than the market value of the underlying common stock on the date of grant or issuance, the Company records deferred compensation expense in an amount equivalent to the difference between the market value and the exercise price of the respective option or restricted stock.

Stock options issued to non-employees are accounted for using the fair value method of accounting. Non-employee stock-based compensation expense is recognized over the four-year vesting period of the options granted. Non-employee stock-based compensation expense for the three months ended March 31, 2005 and 2004 was $11,000 and $20,000, respectively. Stock-based compensation is included in sales and marketing, general and administrative, and research and development expense in the condensed consolidated statements of operations.

Had employee stock-based compensation been determined based on the fair value method as opposed to the intrinsic value method, the company’s net income (loss), net income (loss) per share and fully diluted net income (loss) per share for the three months ended March 31, 2005 and 2004 would have been as follows (in thousands, except per share data):

5

Table of Contents

ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

In determining the pro forma net income (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:

Employee Stock Purchase Plan

Stock Option Plans

Equity instruments issued to non-employees are recorded at their fair value in accordance with Statement 123 and Emerging Issues Task Force Issue No. 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services.

During the quarter ended March 31, 2005, the Company issued 70,000 restricted common stock shares to certain employees, under its 2003 Incentive Stock Plan. These awards vest over a period of five years. In connection with the restricted stock grant, the Company recorded an increase of approximately $2.1 million to deferred stock-based compensation for the value of these awards. Deferred stock-based compensation will be amortized to operating expense over the vesting period of the awards.

6

Table of Contents

ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

NOTE 3 - Computation of Net Income Per Share

Basic net income per share is computed using the weighted-average number of shares of common stock outstanding less weighted-average restricted stock outstanding. Diluted net income per share is computed using the weighted-average number of shares of common stock outstanding and potential shares of common stock when they are dilutive.

The following is a reconciliation of the numerator (net income) and the denominator (number of shares) used in the calculation of basic and diluted net income per share (in thousands, except per share data):

7

Table of Contents

ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

NOTE 4 - Comprehensive Income

The Company’s comprehensive income is included as a component of stockholders’ equity and is composed of (i) net income, (ii) unrealized gains and losses on investments designated as available-for-sale, including reclassification adjustments, and (iii) foreign currency translation adjustments.

The following table presents the calculation of comprehensive income (in thousands):

NOTE 5 – Inventories

The Company’s inventories consist of the following (in thousands):

The Company’s 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. The Company records reserves, when necessary, to reduce the carrying value of excess or obsolete inventories to their net realizable value.

8

Table of Contents

ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

NOTE 6 - Intangible Assets

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 with definite lives are being amortized on a straight-line basis over the assets’ estimated useful lives, which range between one and ten years. The Company periodically reviews the estimated useful lives of its identifiable intangible assets, taking into consideration any events or circumstances that might result in either a diminished fair value or revised useful life. Total amortization expense for the three months ended March 31, 2005 and 2004 was approximately $1.5 million and $0.5 million, respectively, and is recorded as a separate line item on the Company’s condensed consolidated statements of operations. In accordance with Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets (“Statement 142”), the Company assesses its goodwill on December 31 each year or more frequently if events or changes in circumstances indicate that goodwill might be impaired.

Amortization expense related to intangible assets has been reclassified from sales and marketing and general and administrative expense to amortization of intangible assets in the condensed consolidated statements of operations, as indicated above.

Estimated amortization expense for the nine months ended December 31, 2005 and the next five years is as follows for all intangible assets (in thousands):

9

Table of Contents

ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

NOTE 7 - Commitments and Contingencies

Operating Leases

The Company leases most of its facilities and certain equipment under operating leases. It recognizes rent expense on a straight-line basis over the lease term. Rent expense was $0.6 million for each of the three months ended March 31, 2005 and March 31, 2004. At March 31, 2005, total future minimum lease payments are as follows (in thousands):

The Company does not have any significant contractual obligations other than those leases disclosed above.

Warranties

The Company generally provides customers with a limited 90-day warranty on devices sold and a limited 1-year warranty on controller units sold. It accrues for the estimated cost of product warranties at the time revenue is recognized. The Company’s warranty obligation is impacted by product failure rates, material usage and service delivery costs incurred in correcting a product failure. It periodically evaluates and adjusts the warranty reserve to the extent actual warranty expense varies from the original estimates. The activity in its warranty accrual for the three months ended March 31, 2005 and 2004 was as follows (in thousands):

Litigation

In July 2003, a product liability suit was brought against the Company 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. This lawsuit was settled in April of 2005 with no significant impact to ArthroCare’s financial condition.

On October 27, 2003, a product liability suit was brought against the Company 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. This lawsuit was settled in April of 2005 with no significant impact to ArthroCare’s financial condition.

On March 1, 2004, a product liability suit was brought against the Company 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. The Company believes these claims to be without merit and intends to defend itself vigorously.

10

Table of Contents

ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

On April 13, 2005, a product liability suit was brought against the Company in the United States District Court, Eastern District of Texas. The lawsuit alleges, among other things, that a patient suffered injury to his shoulder as a result of a defective ArthroCare probe used in an arthroscopic procedure on the patient. Upon initial review, the Company believes these claims to be without merit and intends to defend itself vigorously.

On January 12, 2005, a product liability suit was brought against ArthroCare 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, the Company believes these claims to be without merit and intends to defend itself vigorously.

On January 21, 2005, a product liability suit was brought against ArthroCare 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, the Company believes these claims to be without merit and intends to defend itself vigorously.

The Company believes that it has meritorious defenses against the above claims and intends 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, the Company has product liability insurance coverage in amounts it considers necessary to prevent material losses. The Company recognizes losses when they are known or considered probable and the amount can be reasonably estimated.

NOTE 8 - DEBT

In October 2004, in anticipation of our acquisition of Opus Medical, the Company amended and restated its 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, ArthroCare 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. The Company 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 its acquisition of Opus Medical, the Company borrowed $30.0 million against the term commitment loan in November 2004.

On March 30, 2005, the Company entered into an amendment to the 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 the time of the closing. The revolving line of credit expires in 2007 and the term commitment loan expires in 2011. At March 31, 2005, the Company had not drawn upon the $20.0 million revolving line of credit. At March 31, 2005, the weighted average interest rate applicable to borrowings under the amended and restated credit facility was approximately 4.6%.

11

Table of Contents

ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

NOTE 9 - Segment Information

The Company has organized its 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 the Company’s operating segments has similar economic characteristics, technology, manufacturing processes, customers, distribution and marketing strategies, regulatory environments, and shared infrastructures. These operating segments, which are referred to as product markets, are Sports Medicine (shoulder and knee arthroscopic products), ENT, (ear, nose, throat and the Visage^® cosmetic products), ArthroCare Spine^™ (spinal and neuro surgery products) and Coblation Technology (gynecology, urology, laparoscopic, general surgical and cardiology products).

Product sales by product market for the periods shown were as follows (in thousands):

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

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

12

Table of Contents

ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

NOTE 10 – Recently Issued Accounting Pronouncement

In April 2005, the Securities and Exchange Commission (“SEC”) delayed the effective date of Financial Accounting Standards Board issued Statement of Financial Accounting Standards 123R, Share-Based Payment (“Statement 123R”). Generally, the approach under Statement 123R will require companies to recognize as compensation expense in the statements of operations the fair value of share-based payments to employees, including grants of employee stock options and the right to purchase shares under an employee stock purchase plan. The Company is required to adopt Statement 123R in the first quarter of fiscal 2006. The pro forma disclosures previously permitted under Statement 123 will no longer be an alternative to financial statement recognition. See Note 2 in the notes to condensed consolidated financial statements for the pro forma net income (loss) and net income (loss) per share amounts, for the three months ended March 31, 2005 and 2004, as if we had used a fair-value-based method similar to the methods required under Statement 123R to measure compensation expense for employee stock incentive awards.

Statement 123R permits adoption using one of two methods: (1) a “modified prospective” method in which compensation cost is recognized beginning on the effective date based on the requirements of Statement 123R for all share-based payments granted after the effective date and based on Statement 123 for all awards granted to employees prior to the effective date that remain unvested on the effective date or (2) a “modified retrospective” method which includes the requirements of the modified prospective method, but also permits entities to restate all periods presented or prior interim periods of the year of adoption based on the amounts previously recognized under Statement 123 for purposes of pro forma disclosures. Although the Company has not yet determined whether the adoption of Statement 123R will result in amounts that are similar to the current pro forma disclosures under Statement 123, it is evaluating the requirements of Statement 123R, including the adoption methods.

PART 1. FINANCIAL INFORMATION

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion should be read in conjunction with the consolidated financial statements and notes thereto appearing elsewhere in this Form 10-Q. Statements in this Management’s Discussion and Analysis of Financial Condition and Results of Operations and elsewhere in this quarterly report on Form 10-Q which express that we “believe,” “anticipate,” “expect” or “plan to” as well as other statements which are not historical fact, are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.

Our forward-looking statements generally relate to our growth strategies, financial results, product development, regulatory approvals, competitive strengths, the scope of our intellectual property rights, and sales efforts. One must carefully consider forward-looking statements and understand that such statements involve a variety of risks and uncertainties, known and unknown, and may be affected by inaccurate assumptions, including, among others, those discussed in the sections entitled “Government Regulation”, “Patents and Proprietary Rights”, “Competition” and “Additional Factors That Might Affect Future Results” in Part 1 of our Annual Report on Form 10-K for the year ended December 31, 2004. Consequently, no forward-looking statement can be guaranteed and actual results may vary materially.

We undertake no obligation to update any forward-looking statement, but investors are advised to consult any further disclosures by us on this subject in our filings with the Securities and Exchange Commission, especially on Forms 10-K, 10-Q, and 8-K (if any), in which we discuss in more detail various important factors that could cause actual results to differ from expected or historical results. It is not possible to foresee or identify all such factors. As such, investors should not consider any list of such factors to be an exhaustive statement of all risks, uncertainties or potentially inaccurate assumptions.

13

Table of Contents

ARTHROCARE CORPORATION

Overview

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

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

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

In April 1998, we announced that we had entered the cosmetic surgery market and formed a business unit called Visage to commercialize Coblation technology in this field. In early 1999, we entered into a license and distribution agreement with Collagen Aesthetics, Inc., which was subsequently purchased by Inamed Corporation. Under this agreement, Inamed Corporation acquired exclusive, worldwide, marketing rights for our cosmetic surgery line of products for the dermatology and cosmetic surgery markets. In March 2001, we terminated this contract, alleging breach by Inamed of certain terms of the contract. 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 in the United States 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 in Europe. 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

14

Table of Contents

ARTHROCARE CORPORATION

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, which enable use of our disposable Coblation products, 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.

Overview of First Quarter Results

Relative to the fourth quarter of 2004, total revenue for the first quarter of 2005 increased 16% to $49.7 million. The increase was driven by the combined performance of all business units. Total revenue for the first quarter of 2005 increased 40% compared to the first quarter of 2004. This significant increase was driven by increased sales performance and to products associated with our acquisitions of Opus and MDA in 2004. International revenue represented approximately 22% of net product sales in the quarter. No single customer accounted for more than 10% of our net product sales.

Total operating expenses were approximately $29.2 million for the quarter, compared to $22.0 million, excluding the impact of the Opus acquisition in the fourth quarter of 2004. This $7.2 million increase was driven by the following factors: approximately $2.7 million represents increased sales and marketing expenses driven by our larger sales force; $2.2 million of this increase is a result of higher research and development spending; $1.4 million in increased commissions associated with our volume-driven distributor commissions; and intangible asset amortization of $0.9 million resulting from our Opus acquisition.

Our cash and cash equivalents balance at March 31, 2005 was $23.9 million, an increase of approximately $2.1 million from the fourth quarter.

Our headcount at March 31, 2005 was 708, an increase of 10% from 645 at December 31, 2004 and an increase of 24% from 574 at March 31 2004. Headcount increases are primarily attributable to increases in manufacturing personnel in Costa Rica associated with the Opus acquisition, and additions of personnel in administration and finance.

15

Table of Contents

ARTHROCARE CORPORATION

Results of Operations

Comparison of the three months ended March 31, 2005 to the three months ended March 31, 2004 (in thousands, unless otherwise noted).

Revenues

Product sales consist primarily of sales of disposable devices and controllers. Product sales for the quarter ended March 31, 2005 were $47.8 million, compared to $34.3 million for the quarter ended March 31, 2004. Product sales by product market for the periods shown were as follows:

16

Table of Contents

ARTHROCARE CORPORATION

The Company made two acquisitions in fiscal 2004: MDA and Opus Medical. Product sales by market for the periods presented were favorably impacted by sales of our acquired product lines. Product sales for the three months ended March 31, 2005 and 2004 included $9.8 million and $2.4 million from these acquisitions, respectively, primarily in the Company’s Sports Medicine and Spine product lines.

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

Our sustained increase in direct sales presence has continued to have a positive effect on product sales since inception, as did the execution of our strategic plan to build market share through promotional programs of controller placements, commercialization of our technology in fields outside of arthroscopy, and the 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 Atlantech, Parallax, and Opus Medical product lines have continued to have a positive effect on sales growth in the first quarter of 2005.

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 the three months ended March 31, 2005 and 2004, disposable device sales comprised approximately 81% and 80% of product sales, respectively. We anticipate that disposable device sales will remain the primary component of our product sales in the near future.

Royalties, fees and other revenues consist mainly of revenue from the licensing of our products and technology. Royalties, fees and other revenues were $1.8 million for the quarter ended March 31, 2005, compared to $1.3 million for the quarter ended March 31, 2004. The quarter over quarter increase is related to growth in the markets in which the Company receives royalties. The percentage of royalties, fees and other revenues as a percentage of income was 4% for both the quarter ended March 31, 2005 and March 31, 2004.

Cost of Product Sales

Cost of product sales consist 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.

17

Table of Contents

ARTHROCARE CORPORATION

Cost of product sales for the first quarter in 2005 and 2004 included amortization of capitalized controllers as follows:

Cost of product sales was $15.5 million, or 31% of revenue for the three months ended March 31, 2005, as compared to $12.8 million, or 36% of revenue, for the quarter ended March 31, 2004. Gross product margin as a percentage of product sales increased to 69% in the first quarter of 2005 from 64% during the same period in the prior year. The increase in gross margin percentage compared to 2004 and favorable increase in cost of product sales quarter over quarter is due to lower manufacturing costs at the Costa Rican manufacturing facility. Controller manufacturing was principally conducted in Costa Rica during the first quarter of fiscal year 2005 resulting in reduced facility requirements and comparatively lower labor rates in Costa Rica, as compared to the previous quarter.

Operating Expenses

Research and development expenses were $4.9 million, or 10% of total revenues, for the quarter ended March 31, 2005, compared to $3.1 million, or 9% of total revenues, for the quarter ended March 31, 2004. The dollar increase is due to a continued investment in our Coblation-based products and in the MDA product line. The increase is primarily attributable to $1.3 million in increased compensation and related expenses due to additional headcount, and $0.3 million in increased prototype development costs, and miscellaneous research costs totaling $0.2 million. We continue to expect to increase the dollar amount of research and development expenses through additional expenditures on new product development, including 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 expenses were $18.4 million, or 37% of total revenues, for the quarter ended March 31, 2005, compared to $14.0 million, or 39% of total revenues, for the quarter ended March 31, 2004. The increase in absolute dollars for the first quarter of 2005 compared to the first quarter of 2004 related primarily to $2.5 million in increased sales commissions associated with the increased sales volume, $1.5 million in additional compensation and related expenses associated with our increased direct sales force, and $0.4 million in freight, postage, outside training, and allocated charges. 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 expenses were $4.6 million, or 9% of total revenues, for the quarter ended March 31, 2005, compared to $3.1 million, or 9% of total revenues, for the quarter ended March 31, 2004.

18

Table of Contents

ARTHROCARE CORPORATION

The increase in general and administrative expenses for the three months ended March 31, 2005 compared to the three months ended March 31, 2004 is due primarily to approximately $0.8 million in additional compensation and related expenses due to increased staffing in the United States and international locations, a $0.5 million increase in outside services, principally related to Sarbanes Oxley compliance, and a $0.2 million increase resulting from business insurance rate increases. These increases were partially offset by reduced patent-related legal spending. We expect that general and administrative expenses will decrease as a percentage of total revenues, but will increase in dollar amounts as we incur legal expenses associated with patent infringement litigation and continue business development activities.

Amortization of intangible assets increased to $1.5 million or 3% of total revenues, during the first quarter of 2005, compared to $0.5 million, or 1% of total revenues, in the first quarter of 2004. The increase in amortization for the three months ended March 31, 2005 as compared to the same period in 2004 relates to amortization of intangible assets acquired in the Opus Medical and MDA acquisitions.

Interest and other income (expense), net declined to a net expense of $0.7 million for the quarter ended March 31, 2005, compared to interest and other income, net of $0.2 million for the quarter ended March 31, 2004. The increase in net interest expense of $0.2 million for the quarter ended March 31, 2005 compared to the quarter end March 31, 2004 is primarily a result of debt incurred due to our acquisitions of MDA and Opus Medical. The remaining net expense increase of $0.7 million is attributed to foreign exchange losses in the quarter ended March 31, 2005, whereas we had foreign exchange gains in the same period in 2004. We anticipate interest and other income to continue to decrease in the future due to the use of cash and borrowings in our purchase of MDA and Opus Medical in January and November of 2004, respectively.

Income Tax Provision

The provision for income taxes was $1.1 million for an effective tax rate of 25 percent for the quarter ended March 31, 2005, compared to $0.6 million for an effective tax rate of 27 percent for the quarter ended March 31, 2004. 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.

Liquidity and Capital Resources

As of March 31, 2005, we had $84.8 million in working capital, compared to $80.9 million at December 31, 2004. Our principal sources of liquidity consisted of $23.9 million in cash and cash equivalents. Cash equivalents consist of highly liquid demand securities.

Cash generated by operating activities for the quarter ended March 31, 2005 was $6.1 million, primarily attributable to net income adjusted for non-cash items and increases in accounts payable, partially offset by an increase in accounts receivable and a decrease in accrued liabilities. Cash generated by operating activities for the quarter ended March 31, 2004 was $2.1 million, mainly attributable to net income adjusted for non-cash items and increases in accounts payable and accrued liabilities.

Cash used in investing activities for the quarter ended March 31, 2005 was $3.5 million, due primarily to the capitalization of controllers. Cash used in investing activities for the quarter ended March 31, 2004 was $23.6 million, due mainly to our purchase of MDA during the quarter. In addition, we had capital purchases of $4.1 million and net investment maturities of $1.7 million during the three months ended March 31, 2004.

Cash used in financing activities for the quarter ended March 31, 2005 was $0.5 million, due primarily to debt repayments. Cash provided by financing activities for the quarter ended March 31, 2004 was $17.2 million, due mainly to the $15.0 million loan entered into in connection with the purchase of MDA. In addition, we received $2.3 million for stock option purchases in the first quarter of 2004 as a result of our stock price increasing, inducing employees to exercise options.

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

19

Table of Contents

ARTHROCARE CORPORATION

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.

On March 30, 2005, the Company 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 the time of the closing. The revolving line of credit expires in 2007 and the term commitment loan expires in 2011. At March 31, 2005, the Company had not drawn upon the $20.0 million revolving line of credit. At March 31, 2005, the weighted average interest rate applicable to borrowings under the amended and restated credit facility was 4.6%. 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.

There have been no significant changes in our contractual obligations and other commitments as previously disclosed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2004. We have no off-balance sheet financing arrangements other than certain operating leases as previously disclosed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2004.

Critical Accounting Policies and Estimates

Our consolidated financial statements are prepared in conformity with generally accepted accounting principles, which requires the use of estimates, judgments, and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the periods presented. Our accounting policies and critical accounting estimates are described in Note 2 to the 2004 Consolidated Financial Statements in our Form 10-K for the fiscal year ended December 31, 2004. Management believes that the accounting estimates employed are appropriate and resulting balances are reasonable; however, actual results could differ from the original estimates, requiring adjustments to these balances in future periods. Management has discussed the development, selection and disclosures of its critical accounting estimates with the Audit Committee of ArthroCare’s Board of Directors, and the Audit Committee has reviewed the Corporation’s disclosures relating to these estimates.

Additional Factors That Might Affect Future Results

There are numerous factors that affect ArthroCare’s business and the results of its operations. These factors include general economic and business conditions; our dependency upon our Arthroscopic Surgery System; uncertainty of the commercial success of products outside of our core businesses; our limited marketing and sales experience; our dependency on key suppliers; the level and intensity of competition in our core businesses; uncertainty over 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;

20

Table of Contents

ARTHROCARE CORPORATION

business integration risks; fluctuating operating results due to many factors, including, but not limited to, product and production-related as well as research and development activities; risks associated with our ability to protect our intellectual property; risks associated with potential patent litigation; the potential volatility of our stock; Delaware law provisions in our charter and our stockholder rights plan could make the acquisition of our company by another company more difficult; the requirement that we must obtain governmental clearances or approvals before we can sell our products and we must continue to comply with applicable laws and regulations; and, future changes in the accounting treatment for employee stock options may cause adverse unexpected fluctuations and affect our reported results of operations. For a discussion of these and other factors affecting ArthroCare’s business, see “Item 1 — Business — Additional Factors That Might Affect Future Results “ in our Form 10-K for the fiscal year ended December 31, 2004. In addition to the factors listed above and discussed in detail in our Form 10-K for the fiscal year ended December 31, 2004, the following factors could also affect our business and results of operations, as discussed below.

Our Business May Become Increasingly Susceptible to Risks Associated with International Operations

International operations are generally subject to a number of risks, including:

We derived 22% and 27% of our total revenue for the quarters ended March 31, 2005 and 2004, respectively, from customers located outside of the United States. We expect international revenue to remain a large percentage of total revenue and we believe that we must continue to expand our international sales activities to be successful. Historically, a majority of our international revenues and costs have been denominated in foreign currencies, and we expect future international revenues and costs will be denominated in foreign currencies. Our international sales growth will be limited if we are unable to establish appropriate foreign operations, expand international sales channel management and support organizations, hire additional personnel, develop relationships with international sales representatives, and establish relationships with additional distributors. In that case, our business, operating results and financial condition could be materially adversely affected. Even if we are able to successfully expand international operations, we cannot be certain that we will be able to maintain or increase international market demand for our products.

21

Table of Contents

ARTHROCARE CORPORATION

Circumstances Associated with the Company’s Acquisition Strategy and Internal Growth May Adversely Affect the Company’s Operating Results

An important element of our growth strategy has been the pursuit of acquisitions of other businesses which expand or complement our existing products. Integrating businesses, however, involves a number of special risks, including the possibility that management may be distracted from regular business concerns by the need to integrate operations, unforeseen difficulties in integrating operations and systems, problems assimilating and retaining our employees or the employees of the acquired company, accounting issues that could arise in connection with, or as a result of, the acquisition of the acquired company, regulatory or compliance issues that could exist at an acquired company, challenges in retaining our customers or the customers of the acquired company following the acquisition and potential adverse short term effects on operating results through increased costs or otherwise. In addition, we may incur debt to finance future acquisitions and/or may issue securities in connection with future acquisitions which may dilute the holdings of its current and future shareholders.

In addition to the risks associated with acquisition-related growth, our business has grown in size and complexity over the past few years as a result of internal growth. This growth and increase in complexity have placed significant demands on management, systems, internal controls and financial and physical resources. To meet such demands, we intend to continue to invest in new technology, make other capital expenditures and, where appropriate, hire and/or train employees with expertise to handle these particular demands. If the Company is unable to successfully complete and integrate strategic acquisitions in a timely manner or if the Company fails to efficiently manage operations in a way that accommodates continued internal growth, its business, financial condition or operating results could be adversely affected.

Recently Issued Accounting Pronouncement

In October 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standard 123R, Share-Based Payment (“Statement 123R”), which is a proposed amendment to Statement 123. Generally, the approach under Statement 123R will require companies to recognize as compensation expense in the statements of operations the fair value of share-based payments to employees, including grants of employee stock options and the right to purchase shares under an employee stock purchase plan. The Company is required to adopt Statement 123R in the first quarter of fiscal 2006. The pro forma disclosures previously permitted under Statement 123 will no longer be an alternative to financial statement recognition. See Note 2 in the notes to condensed consolidated financial statements for the pro forma net income (loss) and net income (loss) per share amounts, for the three months ended March 31, 2005 and 2004, as if we had used a fair-value-based method similar to the methods required under Statement 123R to measure compensation expense for employee stock incentive awards.

Statement 123R permits adoption using one of two methods: (1) a “modified prospective” method in which compensation cost is recognized beginning on the effective date based on the requirements of Statement 123R for all share-based payments granted after the effective date and based on Statement 123 for all awards granted to employees prior to the effective date that remain unvested on the effective date or (2) a “modified retrospective” method which includes the requirements of the modified prospective method, but also permits entities to restate all periods presented or prior interim periods of the year of adoption based on the amounts previously recognized under Statement 123 for purposes of pro forma disclosures. Although we have not yet determined whether the adoption of Statement 123R will result in amounts that are similar to the current pro forma disclosures under Statement 123, we are evaluating the requirements under Statement 123R, including the adoption methods.

22

Table of Contents

ARTHROCARE CORPORATION

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Interest Rate Sensitivity

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

Foreign Currency Exchange Risk

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

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

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

ITEM 4. CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

We maintain disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) that are designed to ensure that information required to be disclosed in our filings under the Exchange Act 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 management, including our Chief Executive Officer (CEO) and Chief Financial Officer (CFO), as appropriate, to allow timely decisions regarding required disclosure. It should be noted that, because of inherent limitations, our disclosure controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and that management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

As of December 31, 2004, we reported that management had identified a material weakness in its internal controls over financial reporting. At that time we concluded that we did not maintain effective controls over the recording of certain foreign exchange transactions. Specifically, we did not perform adequate analysis and review of the accuracy of the recording of the translation of our foreign subsidiaries’ financial information denominated in currencies other than U.S. dollars. This control deficiency resulted in the restatement of our consolidated financial statements for the quarters ended March 31, 2004 and June 30, 2004. Additionally, this control deficiency could result in a misstatement to the other income or related accounts that would result in a material misstatement of annual or interim financial statements that

23

Table of Contents

ARTHROCARE CORPORATION

would not be prevented or detected. As a result, we reported in our 2004 Annual Report on Form 10-K/A that management concluded that as a result of such material weakness, our disclosure controls were not effective as of December 31, 2004.

As required by SEC Rule 13a-15(b), we carried out an evaluation under the supervision and with the participation of our management, including the CEO and CFO, of the effectiveness of the design and operation of our disclosure controls and procedures as of March 31, 2005. As part of our evaluation, our management has evaluated whether the control deficiencies related to the reported material weakness in our internal controls over financial reporting continue to exist. Although we have devoted significant time and resources toward remediating our reported material weakness and made progress in that regard, our management has concluded that the control deficiencies relating to the reported material weakness had not been effectively remediated as of March 31, 2005.

Based upon this evaluation, our CEO and CFO have concluded that, because of the material weakness identified as part of our annual evaluation and discussed in Management’s Report on Internal Control over Financial Reporting in Item 9A of our most recently filed 10-K/A and described above, our disclosure controls and procedures were not effective as of March 31, 2005. In light of the material weakness, we performed additional analysis 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 report fairly present in all material respects our financial condition, results of operations and cash flows for the periods presented.

Changes in Internal Control Over Financial Reporting

There were no changes in our internal control over financial reporting that occurred during the quarter ended March 31, 2005 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

However, to remediate the material weakness described above, management is implementing 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 our Swedish subsidiary will maintain its original accounting records in US Dollars, rather than in Swedish Krona, beginning in 2005. This project is underway and significant progress has been made. Management believes that these planned changes will be sufficient to correct the internal control design deficiency underlying the material weakness described above.

Management continues to actively work to strengthen our accounting and finance teams to correct identified internal control deficiencies and ensure timely and accurate financial reporting. During 2005, we plan to increase our accounting staff level by approximately 50% over 2004 levels to address our growing business needs. To date, we have hired a new controller, SEC compliance manager, internal audit director and other accounting staff.

PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

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

24

Table of Contents

ARTHROCARE CORPORATION

ITEM 5. OTHER INFORMATION

(a) The Company has yet to file its form 8K/A, including financial statements associated with its acquisition of Opus Medical, Inc.

ITEM 6. EXHIBITS

Exhibits

SIGNATURES

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