10-Q 1 artc2013q210-q.htm 10-Q ARTC 2013 Q2 10-Q
 
 
 
 
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549 
Form 10-Q
 
x        QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the quarterly period ended June 30, 2013
OR
o        TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from                  to               
Commission File Number: 001-34607
ArthroCare Corporation
(Exact name of registrant as specified in its charter)
 
Delaware
 
94-3180312
(State or other jurisdiction of
incorporation)
 
(I.R.S. Employer Identification No.)
 
7000 W. William Cannon, Building One, Austin, Texas 78735
(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 x  No o
 
Indicate by check mark whether the registrant has submitted and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x  No o
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b.2 of the Exchange Act (check one): 
Large accelerated filer  x
 
Accelerated filer  o
 
 
 
Non-accelerated filer  o
 
Smaller reporting company  o
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b.2 of the Exchange Act). Yes  o  No  x
 
As of July 31, 2013, the number of outstanding shares of the Registrant’s Common Stock was 28,251,997.
 
 
 
 
 


ARTHROCARE CORPORATION
 
Form 10-Q Quarterly Report
For the quarter ended June 30, 2013
 
TABLE OF CONTENTS
 
EXHIBIT INDEX
Exhibit 31.1
 
Exhibit 31.2
 
Exhibit 32.1
 
Exhibit 32.2
 
Exhibit 101
 


PART I.  FINANCIAL INFORMATION
ITEM 1.  UNAUDITED FINANCIAL STATEMENTS 
ARTHROCARE CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(unaudited)
(in thousands, except par value)  
 
 
June 30,
2013
 
December 31,
 2012
 
 
 
 
 
ASSETS
 
 

 
 

Current assets:
 
 

 
 

Cash and cash equivalents
 
$
251,036

 
$
218,787

Accounts receivable, net of allowances of $1,396 and $1,565 at June 30, 2013 and December 31, 2012, respectively
 
42,241

 
48,881

Inventories, net
 
42,560

 
48,417

Deferred tax assets
 
16,502

 
20,090

Prepaid expenses and other current assets
 
7,103

 
6,022

Total current assets
 
359,442

 
342,197

 
 
 
 
 
Property and equipment, net
 
33,190

 
30,461

Intangible assets, net
 
11,728

 
1,859

Goodwill
 
119,330

 
119,893

Deferred tax assets
 
14,786

 
23,206

Other assets
 
422

 
2,171

Total assets
 
$
538,898

 
$
519,787

 
 
 
 
 
LIABILITIES, REDEEMABLE CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS’ EQUITY
 
 

 
 

Current liabilities:
 
 

 
 

Accounts payable
 
$
13,491

 
$
12,189

Accrued liabilities
 
59,224

 
41,674

Income tax payable
 
3,298

 
286

Other liabilities
 
354

 
318

Total current liabilities
 
76,367

 
54,467

 
 
 
 
 
Deferred tax liabilities
 
354

 
354

Other non-current liabilities
 
6,221

 
20,200

Total liabilities
 
82,942

 
75,021

 
 
 
 
 
Commitments and contingencies (Notes 6 and 7)
 


 


 
 
 
 
 
Series A 3% Redeemable Convertible Preferred Stock, par value $0.001; Authorized: 100 shares; Issued and outstanding: 75 shares at June 30, 2013 and December 31, 2012; Redemption value: $87,089
 
82,607

 
80,759

 
 
 
 
 
Stockholders’ equity:
 
 

 
 

Preferred stock, par value $0.001; Authorized: 4,900 shares; Issued and outstanding: none
 
—

 
—

Common stock, par value $0.001; Authorized: 75,000 shares; Issued: 32,175 and 31,949 shares Outstanding: 28,244 and 27,977 shares at June 30, 2013 and December 31, 2012, respectively
 
28

 
28

Treasury stock: 3,931 and 3,942 shares at June 30, 2013 and December 31, 2012, respectively
 
(106,126
)
 
(106,425
)
Additional paid-in capital
 
421,587

 
413,660

Accumulated other comprehensive income
 
3,857

 
5,300

Retained earnings
 
54,003

 
51,444

Total stockholders’ equity
 
373,349

 
364,007

Total liabilities, redeemable convertible preferred stock and stockholders’ equity
 
$
538,898

 
$
519,787

 

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


ARTHROCARE CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(unaudited)
(in thousands, except per-share data)
 
 
Three months ended
June 30,
 
Six months ended
 June 30,
 
 
2013
 
2012
 
2013
 
2012
 
 
 
 
 
 
 
 
 
Revenues:
 
 

 
 

 
 
 
 
Product sales
 
$
87,470

 
$
87,471

 
$
174,947

 
$
175,846

Royalties, fees and other
 
4,600

 
4,235

 
9,470

 
8,732

Total revenues
 
92,070

 
91,706

 
184,417

 
184,578

 
 
 
 
 
 
 
 
 
Cost of product sales
 
28,724

 
27,355

 
57,053

 
54,006

 
 
 
 
 
 
 
 
 
Gross profit
 
63,346

 
64,351

 
127,364

 
130,572

Operating expenses:
 
 

 
 

 
 

 
 

Research and development
 
8,659

 
7,899

 
17,103

 
15,493

Sales and marketing
 
30,218

 
28,842

 
60,550

 
59,042

General and administrative
 
8,683

 
8,154

 
16,141

 
16,642

Amortization of intangible assets
 
505

 
1,316

 
927

 
2,637

Exit costs
 
—

 
(938
)
 
—

 
(778
)
Investigation and restatement related costs
 
26,335

 
1,131

 
30,227

 
2,224

Total operating expenses
 
74,400

 
46,404

 
124,948

 
95,260

 
 
 
 
 
 
 
 
 
Income (loss) from operations
 
(11,054
)
 
17,947

 
2,416

 
35,312

 
 
 
 
 
 
 
 
 
Non-operating gains (losses)
 
(392
)
 
(1,147
)
 
129

 
(761
)
 
 
 
 
 
 
 
 
 
Income (loss) before income taxes
 
(11,446
)
 
16,800

 
2,545

 
34,551

 
 
 
 
 
 
 
 
 
Income tax provision (benefit)
 
(4,667
)
 
4,536

 
(1,860
)
 
9,329

 
 
 
 
 
 
 
 
 
Net income (loss)
 
(6,779
)
 
12,264

 
4,405

 
25,222

 
 
 
 
 
 
 
 
 
Accrued dividend and accretion charges on Series A 3% Redeemable Convertible Preferred Stock
 
(929
)
 
(887
)
 
(1,848
)
 
(1,766
)
 
 
 
 
 
 
 
 
 
Net income (loss) available to common stockholders
 
(7,708
)
 
11,377

 
2,557

 
23,456

 
 
 
 
 
 
 
 
 
Other comprehensive income (loss)
 
 

 
 

 
 

 
 

Foreign currency translation adjustments
 
(344
)
 
(778
)
 
(1,443
)
 
(386
)
 
 
 
 
 
 
 
 
 
Total comprehensive income (loss)
 
$
(7,123
)
 
$
11,486

 
$
2,962

 
$
24,836

Weighted average shares outstanding:
 
 

 
 

 
 

 
 

Basic
 
28,081

 
27,639

 
28,130

 
27,648

Diluted
 
28,081

 
27,934

 
28,836

 
28,003

 
 
 
 
 
 
 
 
 
Earnings (loss) per share applicable to common stockholders:
 
 

 
 

 
 

 
 

Basic
 
$
(0.27
)
 
$
0.34

 
$
0.08

 
$
0.70

Diluted
 
$
(0.27
)
 
$
0.34

 
$
0.07

 
$
0.69

 

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


ARTHROCARE CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
(in thousands)
 
 
 
Six months ended
June 30,
 
 
2013
 
2012
 
 
 
 
 
Cash flows from operating activities:
 
 

 
 

Net income
 
$
4,405

 
$
25,222

Adjustments to reconcile net income to net cash provided by (used in) operating activities:
 
 

 
 

Depreciation and amortization
 
7,935

 
10,646

Provision for doubtful accounts receivable, product returns, and inventory valuation
 
795

 
2,896

Stock compensation expense
 
3,945

 
4,054

Income tax benefits relating to employee stock options
 
(314
)
 
—

Deferred taxes
 
8,202

 
9,297

Other
 
322

 
486

Changes in operating assets and liabilities, net of assets acquired and liabilities assumed in business combinations:
 
 

 
 

Change in operating assets
 
13,008

 
(4,128
)
Change in operating liabilities
 
7,197

 
(81,412
)
Net cash provided by (used in) operating activities
 
45,495

 
(32,939
)
 
 
 
 
 
Cash flows from investing activities:
 
 

 
 

Purchases of property and equipment
 
(9,840
)
 
(5,289
)
Payments for business combinations
 
—

 
(1,297
)
Payments for intangible asset acquisition
 
(7,000
)
 
—

Net cash used in investing activities
 
(16,840
)
 
(6,586
)
 
 
 
 
 
Cash flows from financing activities:
 
 

 
 

Proceeds from exercise of stock options and issuance of common stock
 
3,688

 
1,606

Income tax benefits relating to employee stock options
 
314

 
—

Net cash provided by financing activities
 
4,002

 
1,606

 
 
 
 
 
Effect of exchange rate changes on cash and cash equivalents
 
(408
)
 
(440
)
 
 
 
 
 
Net increase (decrease) in cash and cash equivalents
 
32,249

 
(38,359
)
Cash and cash equivalents, beginning of period
 
218,787

 
219,605

Cash and cash equivalents, end of period
 
$
251,036

 
$
181,246

 


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


ARTHROCARE CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
 
NOTE 1 – BASIS OF PRESENTATION
 
Basis of Presentation
 
The accompanying unaudited condensed consolidated financial statements of ArthroCare Corporation (“ArthroCare”) and its subsidiaries (collectively with ArthroCare, the “Company”) have been prepared in accordance with the instructions to Form 10-Q and do not include all information and footnotes necessary for a fair presentation of financial position, results of operations and cash flows in conformity with United States generally accepted accounting principles (“GAAP”).  The condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto together with management’s discussion and analysis of financial condition and results of operations contained in the Company’s 2012 Annual Report on Form 10-K filed on February 14, 2013 (“2012 Form 10-K”).  In the opinion of management, the accompanying condensed consolidated financial statements reflect all adjustments of a normal recurring nature considered necessary to fairly state the financial position of the Company at June 30, 2013 and December 31, 2012, the results of its operations for the three and six month periods ended June 30, 2013 and 2012 and its cash flows for the six month periods ended June 30, 2013 and 2012.  The results of operations for the periods presented are not necessarily indicative of results that may be expected for the year ending December 31, 2013.
 
Use of Estimates
 
The unaudited condensed consolidated financial statements have been prepared in conformity with GAAP, 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.
 
Significant Accounting Policies
 
There have been no significant changes to the Company’s significant accounting policies disclosed in its 2012 Form 10-K.

New Accounting Pronouncements

Accounting Standards Update (ASU) 2013-11, “Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists” was issued in July 2013. The amendments in ASU 2013-11 require companies to present an unrecognized tax benefit, or a portion thereof, as a reduction to a deferred tax asset for a net operating loss (NOL) carryforward or a similar tax loss or tax credit carryforward, unless the uncertain tax position is not available to reduce, or would not be used to reduce, the NOL or carryforward under the tax law in the same jurisdiction; otherwise, the unrecognized tax benefit should be presented as a gross liability and should not net the unrecognized tax benefit with a deferred tax asset. ASU 2013-11 is effective for annual periods beginning after December 15, 2013 and should be applied to all unrecognized tax benefits that exist as of the effective date. Companies may choose to apply this guidance retrospectively to each prior reporting period presented. Management is in the process of evaluating the impact of this ASU.

 
NOTE 2 – COMPUTATION OF EARNINGS (LOSS) PER SHARE
 
The Company’s Series A 3% Redeemable Convertible Preferred Stock (the “Series A Preferred Stock”) has participation rights in dividends issued to common stockholders.  As a result, the Company calculates earnings per share using the two class method.  The following is a reconciliation of net income (loss) applicable to common stockholders and the number of shares used in the calculation of basic and diluted earnings per share applicable to common stockholders (in thousands, except per-share data):

ARTHROCARE CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)


 
 
Three months ended
June 30,
 
Six months ended
June 30,
 
 
2013
 
2012
 
2013
 
2012
 
 
 
 
 
 
 
 
 
Net income (loss) allocated to common stockholders, net of $0 and $1,975 attributable to Series A Preferred Stock for the three months ended June 30, 2013 and 2012, respectively and $436 and $4,071 for the six months ended June 30, 2013 and 2012, respectively.
 
$
(7,708
)
 
$
9,402

 
$
2,121

 
$
19,385

 
 
 
 
 
 
 
 
 
Basic:
 
 

 
 

 
 

 
 

Weighted-average common shares outstanding
 
28,081

 
27,639

 
28,130

 
27,648

Earnings (loss) per share allocated to common stockholders
 
$
(0.27
)
 
$
0.34

 
$
0.08

 
$
0.70

 
 
 
 
 
 
 
 
 
Diluted:
 
 

 
 

 
 

 
 

Weighted-average shares outstanding used in basic calculation
 
28,081

 
27,639

 
28,130

 
27,648

Dilutive effect of options
 
—

 
182

 
291

 
210

Dilutive effect of unvested restricted stock
 
—

 
113

 
415

 
145

Weighted-average common stock and common stock equivalents
 
28,081

 
27,934

 
28,836

 
28,003

Earnings (loss) per share allocated to common stockholders
 
$
(0.27
)
 
$
0.34

 
$
0.07

 
$
0.69

 
 
 
 
 
 
 
 
 
Stock issuable upon conversion of the Series A Preferred Stock
 
5,806

 
5,806

 
5,806

 
5,806

Stock awards excluded from calculation as their effect would be anti-dilutive
 
849

 
1,356

 
798

 
1,154

 
Awards approved under the Company’s Long Term Incentive Program are excluded from diluted shares as the market conditions and performance conditions of the awards have not been met.
 
NOTE 3 – INVENTORIES
 
The following summarizes the Company’s inventories (in thousands):
 
 
 
June 30,
 2013
 
December 31,
 2012
 
 
 
 
 
Raw materials
 
$
10,245

 
$
10,760

Work-in-process
 
14,130

 
11,984

Finished goods
 
22,767

 
30,338

 
 
47,142

 
53,082

Inventory valuation reserves
 
(4,582
)
 
(4,665
)
Inventories, net
 
$
42,560

 
$
48,417

 
NOTE 4 – INTANGIBLE ASSETS
 
On December 31, 2012, the Company entered into a stock purchase agreement to acquire Eleven Blade Solutions, Inc. (Eleven Blade) which was accounted for as an asset acquisition in the first quarter of 2013.  As a result of this transaction, the Company recorded $10.8 million of intangible assets in the form of intellectual property rights, non-compete agreements with the former employees, owners and consultants of Eleven Blade and the associated deferred tax liabilities.  The Company also agreed to pay the previous owners of Eleven Blade future cash consideration contingent on certain product sales over the next five years.  The amount of contingent future consideration payable to the previous owners of Eleven Blade is capped at $25 million and is not estimable at this time.
 
The useful lives of the intellectual property rights and non-compete agreements are 20 years and 3 years, respectively.  As a result of this transaction, estimated future amortization expense as disclosed in Note 7 of the 2012 Form 10-K has been revised as follows (in thousands):

ARTHROCARE CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)


 
2013
$
556

2014
935

2015
906

2016
713

2017
691

Thereafter
7,927

 
$
11,728

 
NOTE 5 – ACCRUED LIABILITIES
 
The following summarizes the Company’s accrued liabilities (in thousands):
 
 
 
June 30,
 2013
 
December 31,
2012
 
 
 
 
 
Insurance dispute reserve
 
$
30,000

 
$
9,729

Compensation
 
13,523

 
17,031

Indemnification expenses
 
4,540

 
2,799

Other
 
11,161

 
12,115

 
 
$
59,224

 
$
41,674

 
The Company has recently engaged in preliminary resolution discussions with the DOJ regarding the DOJ investigation (see further discussion in Note 7). As a result of these discussions, the balance of the insurance dispute reserve as of June 30, 2013 was increased to reflect management's current best estimate of the financial component that will likely be included in the final resolution. The actual amount could be greater or less, and the timing of the final resolution and payment cannot yet be determined.
NOTE 6 – COMMITMENTS
 
Operating Leases
 
The Company leases certain facilities and equipment under operating leases.  The Company recognizes rent expense on a straight-line basis over the lease term.  Rent expense was $1.7 million and $3.6 million for the three and six months ended June 30, 2013, respectively compared to $1.7 million and $3.7 million for the same periods in 2012.  There were no material changes from the Company’s lease obligations presented in its 2012 Form 10-K.
 
Indemnification Agreements
 
The Company advances legal fees as required pursuant to indemnification agreements that were entered with certain former executives and employees while they were employed with the Company.  During the six months ended June 30, 2013 the Company advanced $6.8 million and has expensed $5.4 million under these indemnity agreements.  The Company expects to continue to advance payments pursuant to these agreements in future periods; however, management is unable to estimate the amount or timing of future payments under such agreements.
 
NOTE 7 – LITIGATION AND CONTINGENCIES
 
In addition to the matters specifically described below, the Company is involved in other legal and regulatory proceedings that arise in the ordinary course of business that do not have a material impact on the Company’s business. Litigation claims and proceedings of all types are subject to many factors that generally cannot be predicted accurately.
 
The Company records reserves for claims and lawsuits when they are probable and reasonably estimable. Except as otherwise specifically noted, the Company currently cannot determine the ultimate resolution of the matters described below. For matters where the likelihood or extent of a loss is not probable or cannot be reasonably estimated, the Company has not recognized in its condensed consolidated financial statements the potential liability that may result from these matters. Further, for such matters where a loss is believed to be reasonably possible, but not probable, no accrual has been made and an estimate

ARTHROCARE CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)


of the reasonably possible loss cannot be made at this time. If one or more of these matters is determined against the Company, it could have a material adverse effect on the Company’s earnings, liquidity and financial condition.
 
The Company continues to gather additional facts and information related to insurance billing and healthcare compliance issues and marketing and promotional practices in connection with these legal and administrative proceedings with the assistance of legal counsel.
 
DOJ Investigation
 
The Department of Justice (the “DOJ”) is investigating certain of the Company's activities including past sales, accounting, and billing procedures primarily in relation to the operation of the Company's product sales. The DOJ is also reviewing the Company's relationship with its DiscoCare subsidiary. The Company is cooperating with this investigation. In connection with such cooperation, and pursuant to a request from the DOJ, the Company has entered into a statute of limitations tolling agreement with the DOJ effective until August 31, 2013.
The Company has recently engaged in preliminary resolution discussions with the DOJ. As a result of these discussions, management believes that a final resolution of this matter will include a financial component, and management's current best estimate of this financial component is $30 million. Accordingly, the balance of the insurance dispute reserve as of June 30, 2013 was increased to reflect this estimate and a charge of $20.2 million recorded in the second quarter of 2013 as investigation and restatement related expenses. The actual amount could be greater or less, and the timing of the final resolution and payment cannot yet be determined. Based on the current discussions with the DOJ, management believes that any final resolution will likely contain continuing obligations for the Company, such as (1) a deferred prosecution agreement between the Company and the government and (2) the continuation of the Company's already established compliance monitoring and reporting systems. At this point, management is unable to estimate the length of time or the other conditions on such continuing obligations that may be associated with a final resolution. No agreement has been reached with or approved by the DOJ and any resolution would require approval by the U.S. District Court.

Private Securities Class Action
 
In 2008, two putative securities class actions were filed in Federal court against the Company and certain of its former executive officers, alleging violations of Sections 10(b) and 20(a) of the Exchange Act and Rule 10b-5 promulgated thereunder. Plaintiffs allege that the defendants violated federal securities laws by issuing false and misleading financial statements and making material misrepresentations regarding the Company’s internal controls, business, and financial results. On October 28, 2008, and thereafter, the two putative securities class actions and the federal shareholder derivative actions were consolidated and designated: In Re ArthroCare Corporation Securities Litigation, Case No. 1:8-cv-574-SS (consolidated) in the U.S. District Court, Western District of Texas.
 
Settlement of Private Securities Actions
 
The Company reached an agreement to settle the private securities class action suits consolidated into the action titled In Re ArthroCare Corporation Securities Litigation, Case No. 1:8-cv-574-SS (consolidated) in the U.S. District Court, Western District of Texas.
 
The settlement resolves all claims arising from the purchase or sale of ArthroCare securities of a class of all purchasers of ArthroCare common stock and call options, and sellers of put options on ArthroCare common stock between December 11, 2007 and February 18, 2009, inclusive (the Class), except those members of the Class who opt out, for a payment of $74 million to a settlement fund to be created for the settlement. Counsel for the plaintiff applied for and received an award of attorneys’ fees and reimbursement of expenses from the settlement fund. On February 10, 2012, the Court entered an order of preliminary approval of the settlement and ordered that Notice be sent to all class members. Pursuant to the preliminary approval order, the Company paid the $74 million in settlement funds into the applicable settlement escrow account on February 23, 2012. The settlement was approved by the United States District Court for the Western District of Texas and entered as a final judgment on June 4, 2012.
 




ARTHROCARE CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)


False Claims Act Investigation
 
The Company received a Civil Investigative Demand from the DOJ, requesting information related to the marketing of its radio-frequency ablation devices, which could implicate the False Claims Act, 31 U.S.C. § 3729. The Company is cooperating fully with the investigation, although no assurances can be given regarding the duration of the investigation or whether proceedings will be instituted against the Company. Management intends to represent the Company’s interests vigorously in this matter. At this stage of the investigation, however, management cannot predict the ultimate outcome of the investigation or any potential liability the Company may incur.

NOTE 8 –EXIT COSTS
 
The Company completed the consolidation of its Sunnyvale, California activities to Austin, Texas in the fourth quarter of 2011.  In the second quarter of 2012, the Company entered into a sublease for its former Austin, Texas location which decreased the amount accrued for contract termination by $1.1 million.
 
The following table summarizes the accrued and paid exit costs during the six month period ended June 30, 2013 (in thousands):
 
 
 
Accrued Exit Cost Balance at January 1, 2013
 
Cost Incurred
 
Payments
 
Accrued Exit Cost Balance at
June 30, 2013
Contract termination and other
 
$
909

 
$
—

 
$
203

 
$
706

 
 
$
909

 
$
—

 
$
203

 
$
706

 
NOTE 9 – INCOME TAXES
 
The federal research and development tax credit was extended by the signing of the American Taxpayer Relief Act of 2012 (“Act”) on January 2, 2013. The Act retroactively extended this tax credit from January 1, 2012 through December 31, 2013. Since the Act was enacted during 2013, the income tax benefit related to the federal 2012 research and development tax credit resulted in a $0.8 million reduction of income tax expense for the six months ended June 30, 2013.

As disclosed in Note 14 of the 2012 Form 10-K, the Company was notified in 2010 by the Internal Revenue Service (“IRS”) of its intention to examine the 2006 federal income tax return related to certain transfer pricing tax positions. This examination was subsequently extended to include the 2007 — 2011 federal income tax returns. In April 2013, the Company reached a settlement to conclude the IRS examination that increased US taxable income and resulted in additional taxes payable of $3.1 million for the cumulative 2006 – 2011 tax years.  As a result of this settlement, the Company also reversed reserves for uncertain tax positions related to these years. The net effect of the settlement was a net income tax benefit of $10 million in the second quarter of 2013.
 
NOTE 10 – SEGMENT INFORMATION
 
Our business consists of one operating and reportable segment for the development, manufacturing and marketing of disposable devices and implants for select surgical procedures.  The development, manufacturing and other supporting functions, such as regulatory affairs and distribution, are common across our Company.  We organize and manage our sales and marketing functions according to geography and the surgical specialty that typically employs our products.  Most of the Company’s products are used in Sports Medicine or ENT procedures.
 











ARTHROCARE CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)


Product sales by product area for the periods shown were as follows (in thousands):
 
 
 
Three months ended
June 30, 2013
 
Three months ended
June 30, 2012
 
 
Americas
 
International
 
Total Product Sales
 
Americas
 
International
 
Total Product Sales
 
 
 
 
 
 
 
 
 
 
 
 
 
Sports Medicine
 
$
37,944

 
$
20,973

 
$
58,917

 
$
38,051

 
$
19,661

 
$
57,712

ENT
 
21,194

 
5,355

 
26,549

 
21,532

 
5,390

 
26,922

Other
 
311

 
1,693

 
2,004

 
411

 
2,426

 
2,837

Total product sales
 
$
59,449

 
$
28,021

 
$
87,470

 
$
59,994

 
$
27,477

 
$
87,471


 
 
Six months ended
June 30, 2013
 
Six months ended
June 30, 2012
 
 
Americas
 
International
 
Total Product Sales
 
Americas
 
International
 
Total Product Sales
 
 
 
 
 
 
 
 
 
 
 
 
 
Sports Medicine
 
$
76,806

 
$
41,727

 
$
118,533

 
$
77,081

 
$
39,943

 
$
117,024

ENT
 
40,942

 
11,223

 
52,165

 
43,308

 
10,783

 
54,091

Other
 
813

 
3,436

 
4,249

 
1,000

 
3,731

 
4,731

Total product sales
 
$
118,561

 
$
56,386

 
$
174,947

 
$
121,389

 
$
54,457

 
$
175,846


 
Internationally, the Company markets and supports its products primarily through its subsidiaries and various distributors.  Product sales attributed to geographic areas are based on the country or regional area where the Company’s customer is domiciled.  Product sales by geography for the periods shown were as follows (in thousands):

 
 
Three months ended
June 30,
 
Six months ended
June 30,
 
 
2013
 
2012
 
2013
 
2012
 
 
 
 
 
 
 
 
 
United States
 
$
57,670

 
$
57,194

 
$
114,578

 
$
116,001

Non-United States (1)
 
29,800

 
30,277

 
60,369

 
59,845

Total product sales
 
$
87,470

 
$
87,471

 
$
174,947

 
$
175,846

 ___________________________________________
(1) No additional locations are individually significant.
 
Long-lived assets, net by geography at the balance sheet dates shown were as follows (in thousands):
 
 
 
June 30,
2013
 
December 31,
2012
 
 
 
 
 
United States
 
$
122,136

 
$
109,950

Non-United States (1)
 
42,534

 
44,434

Total long-lived assets
 
$
164,670

 
$
154,384

 ___________________________________________
(1) No additional locations are individually significant.
 
NOTE 11 – SUBSEQUENT EVENTS
 
On July 1, 2013, the Company acquired ENTrigue Surgical, Inc. ("ENTrigue"), a privately-held Delaware corporation specializing in ENT sinus surgical products. The Company paid approximately $45.0 million in cash to the former stockholders of ENTrigue, less an amount placed in escrow to secure the indemnification obligations of the former

ARTHROCARE CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)


stockholders. The Agreement also provides that the former security holders will have the right to receive future contingent consideration shortly following each of the next five anniversaries of the acquisition date based on the annual growth in net sales of the acquired products. This transaction will be accounted for as a business combination and the preliminary purchase price allocation will be included in the Company's Form 10-Q for the period ending September 30, 2013.

On July 22, 2013, ArthroCare Costa Rica S.R.L. (“ACR”), an indirect wholly-owned subsidiary of ArthroCare, entered into agreements with Zona Franca Coyol, S.A. (“CFZ”) under which ACR will acquire property in Alajuela, Costa Rica for $4.9 million from CFZ and CFZ will design and construct a new manufacturing facility for the Company on the newly acquired property under a fixed-priced building contract valued at approximately $19.9 million.





ITEM 2.    MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
The following discussion should be read in conjunction with the condensed consolidated financial statements and notes thereto appearing elsewhere in this Form 10-Q. Readers should also review carefully  “Forward-Looking Statements,” in Part II of this quarterly report on Form 10-Q, which provides information about the forward-looking statements in this report and a discussion of the factors that might cause our actual results to differ, perhaps materially, from these forward-looking statements.  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 and are subject to the safe harbors created under the Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as amended.  Readers are cautioned that these forward-looking statements are only predictions and are subject to risks, uncertainties, and assumptions that are difficult to predict.  As such, 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 Part II — Item 1A — “Risk Factors” of this report on Form 10-Q and in Part I — Item 1A — “Risk Factors” of our annual report on Form 10-K for the year ended December 31, 2012.  In this quarterly report on Form 10-Q, the terms the “Company”, “we”, “us” and “our” refer to ArthroCare Corporation and its subsidiaries.
 
Overview
 
We are a medical device company that develops, manufactures and markets surgical products, many of which are based on our minimally invasive patented Coblation ® technology. Our products are used across several medical specialties, improving many existing soft-tissue surgical procedures and enabling new minimally invasive surgical procedures. Our business consists of one operating and reportable segment for the development, manufacturing and marketing of disposable devices and implants for select surgical procedures.  The product development, manufacturing and other supporting functions, such as regulatory affairs and distribution, are common across our Company.  We organize and manage our sales and marketing functions according to geography and the surgical specialty that typically uses our products.  Most of the Company’s products are used in Sports Medicine or ENT procedures.
 
Key Financial Items, Trends and Uncertainties Affecting Our Business
 
Our management reviews and analyzes several metrics and ratios in order to manage our business and assess the quality of and potential variability of our operating performance. The most important of these financial metrics and ratios include:
 
Product Sales
 
Our principal source of revenue is from sales of our products, which primarily include disposable surgical devices and implants. Product sales are made through our employed sales representatives, independent sales agents and distributors.  Product sales were essentially unchanged for the quarter ended June 30, 2013 and decreased 0.5 percent for the six-month period ended June 30, 2013 when compared to the same periods in 2012.  We anticipate that disposable surgical device sales and implant sales will remain key components of our product sales for the foreseeable future.  Currency rate fluctuations had minimal effect on the comparability of reported product sales in the quarter and six month period ended June 30, 2013.
 
We contract manufacture disposable surgical devices and implants based on our technologies for other medical device companies.  Product sales from contract manufacturing for the three and six month periods ended June 30, 2013 were $5.3 million and $10.9 million, respectively, compared to $6.5 million and $11.3 million during the same periods in 2012.
 
We also generate revenue from royalties, fees and other revenues from the licensing of our technology to other companies and earn other revenues from shipping and handling costs billed to customers.
 
Gross Product Margin
 
Gross product margin as a percentage of product sales for the three and six month periods ended June 30, 2013 was 67.1 percent and 67.4 percent, respectively, compared to 68.8 percent and 69.3 percent for the same periods in 2012.  Cost of product sales consists of all product manufacturing costs (including material costs, labor costs, manufacturing overhead, warranty and other direct product costs), adjustments to the carrying value of inventory for excess or obsolete items, certain

11

stock based compensation costs associated with manufacturing and operations personnel, costs to ship product to our customers, and, beginning in the first quarter of 2013, excise tax imposed on our US product sales resulting from the Patient Protection and Affordable Care Act which was signed into law in March 2010 (the Medical Device Tax).  Cost of product sales also includes the amortization of controller units and instruments that have been placed at customer locations to enable the use of our disposable surgical products. We maintain ownership of all placed controllers and instruments and the costs are amortized into cost of product sales over their estimated useful life.  Our products are mostly produced at our Costa Rica facility. Raw materials used to produce our products are generally not subject to substantial commodity price volatility.  Most of our product manufacturing costs are incurred in U.S. dollars.
 
The comparability of gross product margin between periods will be impacted by several items, including the Medical Device Tax that was newly implemented in 2013, the mix between proprietary and contract manufactured product sales; the stability of the average sales price we realize on proprietary products; changes in foreign exchange rates used to translate foreign currency denominated sales into U.S. dollars; changes in the estimated percentage of engineering activities related to manufacturing process design or improvement; and changes in our product emphasis which could result in excess and obsolescence charges being included in the cost of product sales in a particular period.
 
Operating Margin
 
Operating margin is our income from operations as a percentage of total revenues. Our key operating expenses include expenses incurred in connection with research and development, sales and marketing, and general and administrative activities, as well as the amortization of intangible assets.  Operating margin was negative 12.0 percent for the quarter ended June 30, 2013 and 1.3 percent for the six month period ended June 30, 2013 compared to 19.6 percent and 19.1 percent for the same periods in 2012.
 
Under the short-term incentive plan for 2013 approved by our Board of Directors, Adjusted Operating Margin is a key metric for purposes of evaluating management’s performance.  Adjusted Operating Margin is Operating Margin adjusted for investigation and restatement related costs.  Investigation and restatement related costs were 28.6 percent and 16.4 percent of total revenue for the three and six month periods ended June 30, 2013, respectively, compared to 1.2 percent of total revenue for the same periods in 2012.  Adjusted Operating Margin was 16.6 percent and 17.7 percent for the three and six month periods ended June 30, 2013, respectively, compared to 20.8 percent and 20.3 percent for the same periods in 2012. Adjusted Operating Margin is a non-GAAP measure of profitability and it should not be considered as a substitute for measures prepared in accordance with GAAP.
 
Net Earnings (loss)
 
For most periods, our net earnings (loss) will be affected by the same trends that impact our revenues, gross product margin and operating margin. In addition, net earnings (loss) will also be affected by non-operating other income and expenses, such as foreign currency gains and losses, and by income taxes.  We expect that we will report foreign currency gains or losses each period due primarily to changes in the value of the euro, British pound and Australian dollar versus the U.S. dollar.
 
In periods when we report income before taxes, our effective income tax rate is usually less than the U.S. statutory rate as a substantial portion of our operations are outside the U.S. in jurisdictions with lower tax rates, including Costa Rica, where we manufacture the majority of our products and have a tax holiday that extends through December 2015.  In years of loss, our effective tax rate has exceeded the U.S. statutory rate due to the apportionment of income or loss between jurisdictions in which we operate. In the second quarter of 2013, we settled the Internal Revenue Service (“IRS”) examination of our federal income tax returns for the 2006 - 2011 tax years and recorded a net income tax benefit of $10 million. We also reversed $3.7 million of deferred tax assets in the second quarter of 2013 related to amounts accrued previously as insurance dispute reserves. We currently estimate that amounts accrued as insurance dispute reserves will be paid to settle the DOJ investigation and as a result we will obtain no income tax deduction when this settlement is paid. We expect to be able to fully utilize our net deferred tax assets, which amounted to $30.9 million as of June 30, 2013.


12

Results of Operations
 
Results of operations for the three and six month periods ended June 30, 2013 and 2012 (in thousands, except percentages and per-share data) were as follows: 
 
 
Three months ended June 30,
 
Six months ended June 30,
 
 
2013
 
2012
 
2013
 
2012
 
 
Dollars
 
% Total
Revenue
 
Dollars
 
% Total
Revenue
 
Dollars
 
% Total
Revenue
 
Dollars
 
% Total
Revenue
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Revenues:
 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

Product sales
 
$
87,470

 
95.0
 %
 
$
87,471

 
95.4
 %
 
$
174,947

 
94.9
%
 
$
175,846

 
95.3
 %
Royalties, fees and other
 
4,600

 
5.0
 %
 
4,235

 
4.6
 %
 
9,470

 
5.1
%
 
8,732

 
4.7
 %
Total revenues
 
92,070

 
100.0
 %
 
91,706

 
100.0
 %
 
184,417

 
100.0
%
 
184,578

 
100.0
 %
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Cost of product sales
 
28,724

 
31.2
 %
 
27,355

 
29.8
 %
 
57,053

 
30.9
%
 
54,006

 
29.3
 %
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Gross profit
 
63,346

 
68.8
 %
 
64,351

 
70.2
 %
 
127,364

 
69.1
%
 
130,572

 
70.7
 %
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Operating expenses:
 
 

 
 

 
 

 
 

 
 
 
 
 
 
 
 
Research and development
 
8,659

 
9.4
 %
 
7,899

 
8.6
 %
 
17,103

 
9.3
%
 
15,493

 
8.4
 %
Sales and marketing
 
30,218

 
32.8
 %
 
28,842

 
31.5
 %
 
60,550

 
32.8
%
 
59,042

 
32.0
 %
General and administrative
 
8,683

 
9.4
 %
 
8,154

 
8.9
 %
 
16,141

 
8.8
%
 
16,642

 
9.0
 %
Amortization of intangible assets
 
505

 
0.5
 %
 
1,316

 
1.5
 %
 
927

 
0.5
%
 
2,637

 
1.4
 %
Exit costs
 
—

 
—
 %
 
(938
)
 
(1.0
)%
 
—

 
—
%
 
(778
)
 
(0.4
)%
Investigation and restatement related costs
 
26,335

 
28.6
 %
 
1,131

 
1.2
 %
 
30,227

 
16.4
%
 
2,224

 
1.2
 %
Total operating expenses
 
74,400

 
80.7
 %
 
46,404

 
50.7
 %
 
124,948

 
67.8
%
 
95,260

 
51.6
 %
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Income (loss) from operations
 
(11,054
)
 
(12.0
)%
 
17,947

 
19.6
 %
 
2,416

 
1.3
%
 
35,312

 
19.1
 %
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Non-operating gains (losses)
 
(392
)
 
 

 
(1,147
)
 
 

 
129

 
 
 
(761
)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Income (loss) before income taxes
 
(11,446
)
 
 

 
16,800

 
 

 
2,545

 
 
 
34,551

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Income tax provision
 
(4,667
)
 
 

 
4,536

 
 

 
(1,860
)
 
 
 
9,329

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net income (loss)
 
(6,779
)
 
 

 
12,264

 
 

 
4,405

 
 
 
25,222

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Accrued dividends and accretion charges on Series A 3% Redeemable Convertible Preferred Stock
 
(929
)
 
 

 
(887
)
 
 

 
(1,848
)
 
 
 
(1,766
)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net income (loss) available to common stockholders
 
(7,708
)
 
 

 
11,377

 
 

 
2,557

 
 
 
23,456

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Other comprehensive income (loss)
 
 

 
 

 
 

 
 

 
 
 
 
 
 
 
 
Foreign currency translation adjustments
 
(344
)
 
 

 
(778
)
 
 

 
(1,443
)
 
 
 
(386
)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total comprehensive income (loss)
 
$
(7,123
)
 
 

 
$
11,486

 
 

 
$
2,962

 
 
 
$
24,836

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Weighted-average shares outstanding:
 
 

 
 

 
 

 
 

 
 
 
 
 
 
 
 
Basic
 
28,081

 
 

 
27,639

 
 

 
28,130

 
 
 
27,648

 
 
Diluted
 
28,081

 
 

 
27,934

 
 

 
28,836

 
 
 
28,003

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Earnings (loss) per share applicable to common stockholders:
 
 

 
 

 
 

 
 

 
 
 
 
 
 
 
 
Basic
 
$
(0.27
)
 
 

 
$
0.34

 
 

 
$
0.08

 
 
 
$
0.70

 
 
Diluted
 
$
(0.27
)
 
 

 
$
0.34

 
 

 
$
0.07

 
 
 
$
0.69

 
 

13



Product Sales
 
Product sales by product group and geographic market for the periods shown were as follows (in thousands, except percentages):
 
 
 
Three months ended
June 30, 2013
 
Three months ended
June 30, 2012
 
 
Americas
 
International
 
Total Product Sales
 
% Net Product Sales
 
Americas
 
International
 
Total Product Sales
 
% Net Product Sales
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Sports Medicine
 
$
37,944

 
$
20,973

 
$
58,917

 
67.4
%
 
$
38,051

 
$
19,661

 
$
57,712

 
66.0
%
ENT
 
21,194

 
5,355

 
26,549

 
30.4
%
 
21,532

 
5,390

 
26,922

 
30.8
%
Other
 
311

 
1,693

 
2,004

 
2.2
%
 
411

 
2,426

 
2,837

 
3.2
%
Total product sales
 
$
59,449

 
$
28,021

 
$
87,470

 
100
%
 
$
59,994

 
$
27,477

 
$
87,471

 
100
%
% Net product sales
 
68.0
%
 
32.0
%
 
100
%
 


 
68.6
%
 
31.4
%
 
100
%
 
 


 
 
Six months ended
 June 30, 2013
 
Six months ended
June 30, 2012
 
 
Americas
 
International
 
Total Product Sales
 
% Net Product Sales
 
Americas
 
International
 
Total Product Sales
 
% Net Product Sales
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Sports Medicine
 
$
76,806

 
$
41,727

 
$
118,533

 
67.8
%
 
$
77,081

 
$
39,943

 
$
117,024

 
66.5
%
ENT
 
40,942

 
11,223

 
52,165

 
29.8
%
 
43,308

 
10,783

 
54,091

 
30.8
%
Other
 
813

 
3,436

 
4,249

 
2.4
%
 
1,000

 
3,731

 
4,731

 
2.7
%
Total product sales
 
$
118,561

 
$
56,386

 
$
174,947

 
100
%
 
$
121,389

 
$
54,457

 
$
175,846

 
100
%
% Net product sales
 
67.8
%
 
32.2
%
 
100
%
 


 
69.0
%
 
31.0
%
 
100
%
 
 

 
Worldwide Sports Medicine product sales increased $1.2 million or 2.1 percent and $1.5 million or 1.3 percent for the three and six month periods ended June 30, 2013, respectively, compared to the same periods in 2012 due to higher proprietary product sales.
 
Americas Sports Medicine product sales decreased $0.1 million or 0.3 percent and $0.3 million or 0.4 percent for the three and six month periods ended June 30, 2013, respectively when compared to the same periods in 2012.  For the three months ended June 30, 2013, contract manufacturing product sales decreased $1.2 million or 18.1 percent and proprietary Sports Medicine product sales increased $1.1 million or 3.4 percent for the three months ended June 30, 2013 when compared to the same period in 2012.  For the six month period ended June 30, 2013, contract manufacturing product sales decreased $0.5 million or 4.2 percent and proprietary Sports Medicine product sales increased $0.2 million or 0.3 percent when compared to the same period in 2012. The increase in Americas proprietary Sports Medicine sales in the quarter was a result of higher product sales of Coblation products designed for knee and hip arthroscopies, partially offset by lower average selling prices during the quarter. Fixation product sales were mostly unchanged in the quarter.
 
International Sports Medicine product sales increased $1.3 million or 6.7 percent and $1.8 million or 4.5 percent for the three and six month periods ended June 30, 2013, respectively, compared to the same periods in 2012.  Product sales in direct markets increased 8 percent and 5 percent for the three and six month periods ending June 30, 2013, respectively, when compared to the same periods in 2012 and product sales in direct markets comprised approximately 83 percent of total International Sports Medicine product sales in 2013.
 

14

Worldwide ENT product sales decreased $0.4 million or 1.4 percent and $1.9 million or 3.6 percent for the three and six month periods ended June 30, 2013, respectively, compared to the same periods in 2012 as a result of lower tonsillectomy product sales in the United States. Also, in the first quarter of last year we experienced higher Rapid Rhino product sales resulting from fulfilling approximately $1.0 million of Rapid Rhino back orders from the end of 2011.
 
Americas ENT sales decreased $0.3 million or 1.6 percent and $2.4 million or 5.5 percent for the three and six month periods ended June 30, 2013, respectively, compared to the same periods in 2012.  Tonsillectomy product sales were lower in 2013 than in the prior year.  In addition, Americas product sales in the first quarter of last year included approximately $0.7 million related to fulfilled Rapid Rhino back orders from the end of 2011.
 
International ENT product sales decreased less than $0.1 million for the three month period ended June 30, 2013 and increased $0.4 million or 4.1 percent for the six month period ended June 30, 2013 compared to the same periods in 2012.  International ENT product sales in the second quarter of 2013 were lower as a result of the timing of distributor shipments. Product sales in the first quarter of 2012 included approximately $0.3 million related to fulfilled Rapid Rhino back orders from the end of 2011. Product sales in direct markets comprised approximately 60 percent and 55 percent of all International ENT product sales in the three and six months ended June 30, 2013 compared to 49 percent and 54 percent for the same periods in 2012, respectively.
 
Worldwide Other product sales decreased $0.8 million and $0.5 million for the three and six month periods ended June 30, 2013, respectively, when compared to the same periods in 2012. Other product sales represent approximately 3.0 percent of total product sales in the three and six months ended June 30, 2013 and 2012.

Royalties, Fees and Other Revenues
 
Royalties, fees, and other revenues was 5.0 percent and 5.1 percent of total revenues for the three and six month periods ended June 30, 2013, respectively, compared to 4.6 percent and 4.7 percent for the same periods in 2012.
 
Cost of Product Sales
 
Costs of product sales for the periods shown were as follows (in thousands, except percentages):
 
 
 
Three months ended
 June 30,
 
 
2013
 
2012
 
 
Dollars
 
% Net
Product
Sales
 
Dollars
 
% Net
Product
Sales
Product cost
 
$
24,370

 
27.9
%
 
$
23,195

 
26.5
%
Controller amortization
 
1,692

 
1.9
%
 
2,199

 
2.5
%
Other
 
2,662

 
3.1
%
 
1,961

 
2.2
%
Total cost of product sales
 
$
28,724

 
32.9
%
 
$
27,355

 
31.2
%
 
 
Six months ended
June 30,
 
 
2013
 
2012
 
 
Dollars
 
% Net
Product
Sales
 
Dollars
 
% Net
Product
Sales
Product cost
 
$
48,231

 
27.6
%
 
$
45,511

 
25.9
%
Controller amortization
 
3,489

 
2.0
%
 
4,408

 
2.5
%
Other
 
5,333

 
3.0
%
 
4,087

 
2.3
%
Total cost of product sales
 
$
57,053

 
32.6
%
 
$
54,006

 
30.7
%
 
Gross product margin as a percentage of product sales was 67.1 percent and 67.4 percent for the three and six month periods ended June 30, 2013, respectively, compared to 68.8 percent and 69.3 percent for the same periods in 2012.  The decrease in gross product margin for the three months ended June 30, 2013 is due to the new Medical Device Tax which came into effect in the first quarter of 2013 and lower plant throughput than in the same periods of 2012.

15

 
Operating Expenses
 
Operating expenses for the periods shown were as follows (in thousands, except percentages):
 
 
 
Three months ended
 June 30,
 
Six months ended
June 30,
 
 
2013
 
2012
 
2013
 
2012
 
 
Dollars
 
% Total
Revenue
 
Dollars
 
% Total
Revenue
 
Dollars
 
% Total
Revenue
 
Dollars
 
% Total
Revenue
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Research and development
 
$
8,659

 
9.4
%
 
$
7,899

 
8.6
 %
 
17,103

 
9.3
%
 
15,493

 
8.4
 %
Sales and marketing
 
30,218

 
32.8
%
 
28,842

 
31.5
 %
 
60,550

 
32.8
%
 
59,042

 
32.0
 %
General and administrative
 
8,683

 
9.4
%
 
8,154

 
8.9
 %
 
16,141

 
8.8
%
 
16,642

 
9.0
 %
Amortization of intangible assets
 
505

 
0.5
%
 
1,316

 
1.5
 %
 
927

 
0.5
%
 
2,637

 
1.4
 %
Exit costs
 
—

 
—
%
 
(938
)
 
(1.0
)%
 
—

 
—
%
 
(778
)
 
(0.4
)%
Investigation and restatement related costs
 
26,335

 
28.6
%
 
1,131

 
1.2
 %
 
30,227

 
16.4
%
 
2,224

 
1.2
 %
Total operating expenses
 
$
74,400

 
80.7
%
 
$
46,404

 
50.7
 %
 
124,948

 
67.8
%
 
95,260

 
51.6
 %
 
Research and development expense increased $0.8 million and $1.6 million for the three and six months ended June 30, 2013, respectively, when compared to the same periods in 2012 due to increased Sports Medicine new product development costs.

Sales and marketing expense was approximately equivalent at 32.8 percent of total revenue for the three and six months ended June 30, 2013 compared to 31.5 percent and 32.0 percent for the three and six months ended June 30, 2012, respectively.  Sales and marketing expense increased in the periods as a result of efforts to expand our sales and distribution coverage and sales force training in support of anticipated future new product introductions. 
 
General and administrative expenses increased $0.5 million and decreased $0.5 million for the three and six month periods ended June 30, 2013, respectively, when compared to the same periods in 2012.  The increase in general and administrative expenses for the three months ended June 30, 2013 is primarily due to acquisition costs incurred during the period.       
 
Amortization of intangible asset expense decreased $0.8 million and $1.7 million for the three and six month periods ended June 30, 2013, respectively, when compared to the same periods in 2012.  In the fourth quarter of 2012, certain intangible assets related to the acquisition of Opus Medical were fully amortized and written off.
 
Investigation and restatement expenses increased $25.2 million and $28.0 million for the three and six month periods ended June 30, 2013, respectively when compared to the same periods in 2012.  The Company has recently engaged in preliminary resolution discussions with the DOJ regarding the DOJ investigation. As a result of these discussions, management believes that a final resolution of this matter will include a financial component, and management's current best estimate of this financial component is $30 million. Accordingly, the balance of the insurance dispute reserve as of June 30, 2013 was increased to reflect this estimate and a charge of $20.2 million recorded in the second quarter of 2013 as investigation and restatement related expenses. The actual amount could be greater or less, and the timing of the final resolution and payment cannot yet be determined. The increase in investigation and restatement expenses is also a result of additional legal costs related to our indemnification agreements with certain former officers as described in Note 7 of our condensed consolidated financial statements.  We expect the indemnification expenses to continue until the matters concerning the former officers are concluded.
 
Non-operating gains (losses)
 
Non-operating gains (losses) were a loss of $0.4 million and a gain of $0.1 million for the three and six month periods ended June 30, 2013, respectively, compared to losses of $1.1 million and $0.8 million for the same periods in 2012.  The non-

16

operating loss for the three months ended June 30, 2013 is primarily a result of foreign currency losses reported by foreign subsidiaries on U.S. dollar inter-company net payables as the U.S. dollar strengthened against the euro, British pound and Australian dollar. The non-operating gain for the six months ended June 30, 2013 includes a gain of $1.7 million received from the extinguishment of our membership interests in a mutual insurance company offset by foreign currency losses reported by foreign subsidiaries on U.S. dollar inter-company net payables as the U.S. dollar strengthened against the euro, British pound and Australian dollar.
 
Income Tax Provision
 
In April 2013, the Company reached a settlement to conclude an IRS examination for the cumulative 2006 – 2011 tax years and recorded a $10 million net tax benefit in the second quarter of 2013 related to these tax years. As a result, our tax benefit for the three and six month periods ended June 30, 2013 was $4.7 million and $1.9 million, respectively. We also reversed $3.7 million of deferred tax assets in the second quarter of 2013 related to amounts accrued previously as insurance dispute reserves. We currently estimate that amounts accrued as insurance dispute reserves will be paid to settle the DOJ investigation and as a result we will obtain no income tax deduction when this settlement is paid. Excluding these items, our effective tax rate was 17.6 percent and 19.3 percent for the three and six months ended June 30, 2013, respectively, compared to 27.0 percent for the same periods in 2012.
 
Income tax expense was lower for the six months ended June 30, 2013 due to the signing into law of the American Taxpayer Relief Act of 2012 on January 2, 2013 (the Act).  The Act retroactively extended the federal research and development tax credit from January 1, 2012 through December 31, 2013.   As a result of the Act, we recorded research and development tax credits related to 2012 of $0.8 million as a reduction of income tax expense for the six months ended June 30, 2013.
 
Liquidity and Capital Resources
 
Our operating cash flow has historically been affected by the overall profitability of the sales of our products, our ability to invoice and collect from customers in a timely manner, and our ability to efficiently implement our acquisition strategy and manage costs.  We expect that our cash flows from operations together with cash on hand will be sufficient to satisfy our short-term and long-term normal operating requirements.
 
As of June 30, 2013 we had $283.1 million in working capital compared to $287.7 million at December 31, 2012.  Our cash and cash equivalents balance was $251.0 million at June 30, 2013 and $218.8 million at December 31, 2012.  In the first quarter of 2013, we paid $7.0 million to acquire Eleven Blade as discussed in Note 4 of our consolidated condensed financial statements.
 
Cash provided by operating activities for the six months ended June 30, 2013 was $45.5 million and differed from net income primarily as a result of non-cash items affecting net income during the period, including the charge recorded in the second quarter to revise the insurance dispute reserve to reflect our current best estimate of the financial component of the potential resolution with the DOJ, net income tax benefit recorded in the second quarter resulting from the settlement of IRS examination of the 2006-2011 federal tax returns, and the period's normally recurring depreciation and amortization expense and stock based compensation expense.  Cash used by operating activities was $33 million for the six month period ended June 30, 2012, due to the payment of $74 million required under the settlement of the private securities actions.  Adjusted for this payment, our cash provided by operating activities would have been $41.0 million in the first half of 2012.

Cash used in investing activities for the six months ended June 30, 2013 was $16.8 million which consisted of $9.8 million in property and equipment purchases and $7.0 million paid to acquire Eleven Blade.  Cash used by investing activities was $6.6 million for the six month period ended June 30, 2012 of which $5.3 million related to purchases of property and equipment and $1.3 million paid to acquire an orthopedic sales and marketing entity in Finland.
 
Cash provided by financing activities for the six months ended June 30, 2013 and 2012 was $4.0 million and $1.6 million, respectively, related to proceeds from exercises of stock options and purchases under the employee stock purchase plan.
 
Critical Accounting Policies and Estimates
 
There have been no other material updates to our critical accounting policies and estimates set forth in “Part II—Item 7—Management Discussion and Analysis of Financial Condition and Results of Operations — Critical Accounting Policies and Estimates” in our 2012 Form 10-K.
 

17

Disclosures about Contractual Obligations and Commercial Commitments
 
We have various contractual obligations, which are recorded as liabilities in our condensed consolidated financial statements.  Other items, such as certain purchase commitments with suppliers and minimum lease payments under operating leases, are not recognized as liabilities in our condensed consolidated financial statements but are required to be disclosed.  There were no material changes from our contractual obligations presented in our 2012 Form 10-K.
 
ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 
We are exposed to certain market risks as part of our ongoing business operations, primarily risks from changing foreign currency exchange rates that may impact, adversely or otherwise, our financial condition, results of operations, or cash flows.  We have not historically used derivative financial instruments to manage these market risks.
 
Our interest income is dependent on changes in the general level of U.S. dollar interest rates. Our cash and cash equivalents consist of money market funds and various deposit accounts.  Due to the nature and value of our investments, we have concluded that we do not have material interest rate risk exposure.  An immediate 10 percent increase or decrease in interest rates would not have a material adverse impact on our future operating results or cash flows.
 
Our weighted average interest rate earned on our cash and cash equivalents for the period ended June 30, 2013 was less than 1 percent.
 
A significant portion of our international sales and operating expenses are denominated in currencies other than the U.S. dollar.  To the extent that the U.S. dollar exchange rates for these currencies fluctuate, we will experience variations in our earnings and financial condition.
 
Our cash and cash equivalents at June 30, 2013 are denominated primarily in U.S. dollars; however, we also maintain balances in euros, British pounds, Swedish kroner, Swiss francs, Australian dollars and Costa Rican colones.  A 10 percent change in the June 30, 2013 exchange rates for these currencies would have an impact on pre-tax income of approximately $0.7 million.

ITEM 4. CONTROLS AND PROCEDURES
 
Evaluation of Disclosure Controls and Procedures
 
As required by Rule 13a-15(b) under the Securities Exchange Act of 1934, management has evaluated, with the participation of our Chief Executive Officer and Chief Financial Officer, the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report. Disclosure controls and procedures refer to controls and other procedures designed to ensure that information required to be disclosed in the reports we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the SEC. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is accumulated and communicated to management, including our CEO and CFO, as appropriate, to allow timely decisions regarding our required disclosure. In designing and evaluating our disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management is required to apply its judgment in evaluating and implementing possible controls and procedures. Pursuant to this evaluation, our CEO and CFO concluded that, as of June 30, 2013, the end of the period covered by this report, our disclosure controls and procedures were effective at the reasonable assurance level.
 
Changes in Internal Control Over Financial Reporting
 
Management has evaluated, with the participation of our CEO and CFO, whether any changes in our internal control over financial reporting have occurred during the quarter ended June 30, 2013 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. Based on that evaluation, management concluded that there have been no changes in our internal control over financial reporting during the quarter ended June 30, 2013 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.


PART II. OTHER INFORMATION
 
FORWARD-LOOKING STATEMENTS
 
The information provided herein includes forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended. Statements that are not historical facts are forward-looking statements. Forward-looking statements are based on beliefs and assumptions by management and on information currently available to management. Forward-looking statements speak only as of the date they are made, and the Company undertakes no obligation to update any of them publicly in light of new information or future events. Additional factors that could cause actual results to differ materially from those contained in any forward-looking statement include, without limitation: the resolution of litigation pending against the Company; the impact upon the Company’s operations of legal compliance matters which may require improvement and remediation; the ability of the Company to control expenses relating to legal or compliance matters; the Company’s ability to remain current in its periodic reporting requirements under the Exchange Act and to file required reports with the Securities and Exchange Commission on a timely basis; the results of the investigation being conducted by the United States Department of Justice; the impact on the Company of additional civil and criminal investigations by state and federal agencies and civil suits by private third parties involving the Company’s financial reporting and its previously announced restatement and its insurance billing and healthcare fraud-and-abuse compliance practices; the results of the civil investigation by the Department of Justice related to the Civil Investigative Demand we received arising under the False Claims Act; the possibility that the Department of Justice could institute civil proceedings against us, based on the results of the investigation related to the Civil Investigative Demand; the risk that we could be subject to qui tam suits involving the False Claims Act; the possibility that the Department of Justice could institute a criminal enforcement action against us based on the results of the civil investigation related to the Civil Investigative Demand;  the resolution of any litigation related to the civil investigation; the ability of the Company to attract and retain qualified senior management and to prepare and implement appropriate succession planning for its Chief Executive Officer; general business, economic and political conditions; competitive developments in the medical devices market; changes in applicable legislative or regulatory requirements; the Company’s ability to effectively and successfully implement its business strategies, and manage the risks in its business; and the reactions of the marketplace to the foregoing.
 
ITEM 1.  LEGAL PROCEEDINGS
 
We discuss our material legal proceedings in Note 7, “Litigation and Contingencies,” in the notes to the condensed consolidated financial statements.  In addition to the matters specifically described in Note 7 we are involved in other legal and regulatory proceedings that arise in the ordinary course of business that do not have a material impact on our business.  Litigation claims and proceedings of all types are subject to many factors that generally cannot be predicted accurately. We record reserves for claims and lawsuits when they are probable and reasonably estimable.  Except as otherwise specifically noted, we currently cannot determine the ultimate resolution of the matters described in Note 7.  For matters where the likelihood or extent of a loss is not probable or cannot be reasonably estimated, we have not recognized in our condensed consolidated financial statements the potential liability that may result from these matters.  If one or more of these matters is determined against us, it could have a material adverse effect on our earnings, liquidity and financial condition. 

ITEM 1A.  RISK FACTORS
 
There have been no material changes from risk factors as previously disclosed in the Company’s annual report on Form 10-K for the year ended December 31, 2012.

ITEM 2.  UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
 
None.
 
ITEM 3.  DEFAULTS UPON SENIOR SECURITIES
 
None.
 
ITEM 4.  MINE SAFETY DISCLOSURES
 
None.
 
ITEM 5.  OTHER INFORMATION
 
None.

19

ITEM 6. EXHIBITS
 
Exhibit
Number
 
Description
31.1
 
Certification of the Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2
 
Certification of the Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1
 
Certification of the Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2
 
Certification of the Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
101
 
XBRL Instance Document


SIGNATURES
 
Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
 
 
ARTHROCARE CORPORATION
 
a Delaware corporation
 
 
Date: August 5, 2013
/s/ David Fitzgerald
 
David Fitzgerald
 
President and Chief Executive Officer
 
 
Date: August 5, 2013
/s/ Todd Newton
 
Todd Newton
 
Executive Vice President, Chief Financial Officer and Chief Operating Officer

21

EXHIBIT INDEX
 
EXHIBIT NO.
 
DOCUMENT DESCRIPTION
 
 
 
31.1
 
Certification of Chief Executive Officer Pursuant to Rule 13a-14(a) as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
 
 
 
31.2
 
Certification of Chief Financial Officer Pursuant to Rule 13a-14(a) 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
 
 
 
101
 
XBRL Instance Document

22