10-Q 1 a11-7328_110q.htm QUARTERLY REPORT PURSUANT TO SECTIONS 13 OR 15(D)

Table of Contents

 

 

 

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 March 31, 2011

 

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: 0-27422

 

ArthroCare Corporation

(Exact name of registrant as specified in its charter)

 

Delaware

 

94-3180312

(State of incorporation)

 

(I.R.S. Employer Identification No.)

 

7500 Rialto Blvd., Building Two, Suite 100, 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 April 25, 2011, the number of outstanding shares of the Registrant’s Common Stock was 27,311,514.

 

 

 



Table of Contents

 

ARTHROCARE CORPORATION

 

Form 10-Q Quarterly Report

For the quarter ended March 31, 2011

 

TABLE OF CONTENTS

 

PART 1. FINANCIAL INFORMATION

1

 

ITEM 1. FINANCIAL STATEMENTS

1

 

CONDENSED CONSOLIDATED BALANCE SHEETS

1

 

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

2

 

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

3

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

4

 

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

13

 

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

19

 

ITEM 4. CONTROLS AND PROCEDURES

21

PART II. OTHER INFORMATION

22

 

ITEM 1. LEGAL PROCEEDINGS

22

 

ITEM 1A. RISK FACTORS

22

 

ITEM 2. UNREGISTERED SALES OF SECURITIES AND USE OF PROCEEDS

35

 

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

35

 

ITEM 4. RESERVED

 

 

ITEM 5. OTHER INFORMATION

35

 

ITEM 6. EXHIBITS

36

SIGNATURES

37

EXHIBIT INDEX

38

 

Exhibit 10.43

 

 

Exhibit 31.1

 

 

Exhibit 31.2

 

 

Exhibit 32.1

 

 

Exhibit 32.2

 

 

Exhibit 101

 

 



Table of Contents

 

PART I.  FINANCIAL INFORMATION

 

ITEM 1.  FINANCIAL STATEMENTS

 

ARTHROCARE CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(unaudited)

 (in thousands, except par value data)

 

 

 

March 31,
2011

 

December 31,
2010

 

 

 

 

 

 

 

ASSETS

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

147,529

 

$

132,536

 

Accounts receivable, net of allowances of $2,291 and $2,445 at March 31, 2011 and December 31, 2010, respectively

 

48,101

 

48,870

 

Inventories, net

 

33,409

 

34,087

 

Deferred tax assets

 

22,390

 

24,661

 

Prepaid expenses and other current assets

 

6,986

 

4,424

 

Assets held for sale

 

2,833

 

3,081

 

Total current assets

 

261,248

 

247,659

 

 

 

 

 

 

 

Property and equipment, net

 

40,638

 

41,582

 

Intangible assets, net

 

9,447

 

10,733

 

Goodwill

 

119,495

 

119,020

 

Deferred tax assets

 

16,019

 

16,019

 

Other assets

 

1,960

 

4,182

 

Total assets

 

$

448,807

 

$

439,195

 

 

 

 

 

 

 

LIABILITIES, REDEEMABLE CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS' EQUITY

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Accounts payable

 

$

13,828

 

$

13,819

 

Accrued liabilities

 

32,606

 

40,197

 

Deferred tax liabilities

 

149

 

149

 

Income tax payable

 

1,421

 

1,555

 

Total current liabilities

 

48,004

 

55,720

 

 

 

 

 

 

 

Deferred tax liabilities

 

225

 

213

 

Other non-current liabilities

 

13,846

 

13,766

 

Total liabilities

 

62,075

 

69,699

 

 

 

 

 

 

 

Commitments and contingencies (Notes 8 and 9)

 

 

 

 

 

 

 

 

 

 

 

Series A 3% Redeemable Convertible Preferred Stock, par value $0.001; Authorized: 100 shares; Issued and outstanding: 75 shares at March 31, 2011 and December 31, 2010; Redemption value: $87,089

 

74,608

 

73,768

 

 

 

 

 

 

 

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: 31,225 and 31,102 shares Outstanding: 27,235 and 27,112 shares at March 31, 2011 and December 31, 2010, respectively

 

27

 

27

 

Treasury stock: 3,990 shares at March 31, 2011 and 3,990 shares at December 31, 2010

 

(107,731

)

(107,899

)

Additional paid-in capital

 

389,795

 

386,395

 

Accumulated other comprehensive income

 

5,145

 

4,246

 

Retained earnings

 

24,888

 

12,959

 

Total stockholders' equity

 

312,124

 

295,728

 

Total liabilities, redeemable convertible preferred stock and stockholders' equity

 

$

448,807

 

$

439,195

 

 

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)

 

 

 

Three Months Ended
March 31,

 

 

 

2011

 

2010

 

 

 

 

 

 

 

Revenues:

 

 

 

 

 

Product sales

 

$

83,507

 

$

85,165

 

Royalties, fees and other

 

4,425

 

3,949

 

Total revenues

 

87,932

 

89,114

 

 

 

 

 

 

 

Cost of product sales

 

24,744

 

26,579

 

 

 

 

 

 

 

Gross profit

 

63,188

 

62,535

 

Operating expenses:

 

 

 

 

 

Research and development

 

6,810

 

8,615

 

Sales and marketing

 

28,098

 

26,855

 

General and administrative

 

9,188

 

9,255

 

Amortization of intangible assets

 

1,311

 

1,315

 

Investigation and restatement-related costs

 

1,204

 

1,043

 

Total operating expenses

 

46,611

 

47,083

 

 

 

 

 

 

 

Income from operations

 

16,577

 

15,452

 

 

 

 

 

 

 

Foreign exchange gain (loss)

 

664

 

(2,960

)

Other expense, net

 

(174

)

(101

)

Other income (expense), net

 

490

 

(3,061

)

 

 

 

 

 

 

Income from continuing operations before income taxes

 

17,067

 

12,391

 

 

 

 

 

 

 

Income tax provision

 

4,608

 

3,314

 

 

 

 

 

 

 

Net income from continuing operations

 

12,459

 

9,077

 

 

 

 

 

 

 

Income (loss) from discontinued operations, net of taxes

 

311

 

(250

)

 

 

 

 

 

 

Net income

 

12,770

 

8,827

 

 

 

 

 

 

 

Accrued dividend and accretion charges on Series A 3% Redeemable Convertible Preferred Stock

 

(840

)

(802

)

 

 

 

 

 

 

Net income available to common stockholders

 

$

11,930

 

$

8,025

 

 

 

 

 

 

 

Weighted average shares outstanding:

 

 

 

 

 

Basic

 

27,168

 

26,922

 

Diluted

 

27,586

 

27,221

 

 

 

 

 

 

 

Earnings per share from continuing operations applicable to common stockholders:

 

 

 

 

 

Basic

 

$

0.35

 

$

0.25

 

Diluted

 

$

0.35

 

$

0.25

 

 

 

 

 

 

 

Earnings per share applicable to common stockholders:

 

 

 

 

 

Basic

 

$

0.36

 

$

0.25

 

Diluted

 

$

0.36

 

$

0.24

 

 

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)

 

 

 

Three Months Ended
March 31,

 

 

 

2011

 

2010

 

 

 

 

 

 

 

Cash flows from operating activities:

 

 

 

 

 

Net income

 

$

12,770

 

$

8,827

 

Adjustments to reconcile net income to net cash provided by operating activities:

 

 

 

 

 

Depreciation and amortization

 

5,499

 

5,901

 

Provisions for doubtful accounts receivable, product returns, and inventory valuation

 

251

 

2,519

 

Non-cash stock compensation expense

 

1,729

 

1,297

 

Deferred taxes

 

2,283

 

3,206

 

Other

 

(1,065

)

(1,859

)

Changes in operating assets and liabilities:

 

 

 

 

 

Changes in operating assets

 

602

 

7,356

 

Changes in operating liabilities

 

(6,836

)

(16,004

)

Net cash provided by operating activities

 

15,233

 

11,243

 

 

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

Purchases of property and equipment

 

(2,989

)

(3,601

)

Other

 

46

 

17

 

Net cash used in investing activities

 

(2,943

)

(3,584

)

 

 

 

 

 

 

Cash flows from financing activities:

 

 

 

 

 

Proceeds from exercise of stock options and issuance of common stock

 

1,632

 

298

 

Net cash provided by financing activities

 

1,632

 

298

 

 

 

 

 

 

 

Effect of exchange rate changes on cash and cash equivalents

 

1,071

 

(91

)

 

 

 

 

 

 

Net increase in cash and cash equivalents

 

14,993

 

7,866

 

Cash and cash equivalents, beginning of period

 

132,536

 

57,386

 

Cash and cash equivalents, end of period

 

$

147,529

 

$

65,252

 

 

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 — 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 therefore 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 2010 Annual Report on Form 10-K filed on February 14, 2011 (“2010 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 March 31, 2011 and December 31, 2010, the results of its operations for the three month periods ended March 31, 2011 and 2010, and its cash flows for the three month periods ended March 31, 2011 and 2010.  The results of operations for the periods presented are not necessarily indicative of results that may be expected for the year ending December 31, 2011.

 

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.

 

4



Table of Contents

 

ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)

 

NOTE 2 — DISCONTINUED OPERATIONS

 

In the fourth quarter of 2010, the Company determined that its non-Coblation spine products met the criteria under GAAP to be reported as discontinued operations. The Company’s non-Coblation spine products consist of its Parallax and Contour product lines.  As a result of this determination, the impact from these discontinued product lines on the Company’s current and previously reported net income in all periods is separately reported as “Income (loss) from discontinued operations, net of taxes” in our condensed consolidated statements of operations.  Assets identifiable with these discontinued product lines are reported as “Assets held for sale” in our March 31, 2011 and December 31, 2010 condensed consolidated balance sheets.

 

The following table presents assets held for sale by major class (in thousands):

 

 

 

March 31,

 

December 31,

 

 

 

2011

 

2010

 

 

 

 

 

 

 

Inventory

 

$

1,471

 

$

1,719

 

Equipment, net of accumulated depreciation of $349

 

63

 

63

 

Intangible assets, net of accumulated amortization of $6,800

 

1,299

 

1,299

 

Assets held for sale

 

$

2,833

 

$

3,081

 

 

Revenues, income (loss) and income taxes related to discontinued operations for the three month period ended March 31, 2011 and 2010 were as follows (in thousands):

 

 

 

Three Months Ended March 31,

 

 

 

2011

 

2010

 

Revenue

 

$

1,131

 

$

1,497

 

Income (loss) from discontinued operations before income taxes

 

501

 

(357

)

Income tax provision (benefit)

 

190

 

(107

)

Income (loss) from discontinued operations, net of income taxes

 

$

311

 

$

(250

)

 

NOTE 3 — COMPREHENSIVE INCOME

 

The following table presents comprehensive income (in thousands):

 

 

 

Three Months Ended

 

 

 

March 31,

 

 

 

2011

 

2010

 

 

 

 

 

 

 

Comprehensive income:

 

 

 

 

 

Net income

 

$

12,770

 

$

8,827

 

Foreign currency translation adjustments

 

899

 

1,902

 

Comprehensive income

 

$

13,669

 

$

10,729

 

 

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Table of Contents

 

ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)

 

NOTE 4 — 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 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):

 

 

 

Three Months Ended

 

 

 

March 31,

 

 

 

2011

 

2010

 

 

 

 

 

 

 

Income from continuing operations allocated to common stockholders (net of $2,046 and $1,466 attributable to Series A Preferred Stock for the quarter ending March 31, 2011 and 2010, respectively)

 

$

9,573

 

$

6,809

 

Income (loss) from discontinued operations (net of $55 and ($44) attributable to Series A Preferred Stock for the quarter ending March 31, 2011 and 2010, respectively)

 

256

 

(206

)

Net income allocated to common stockholders (net of $2,101 and $1,422 of undistributed earnings to Series A Preferred Stock for the quarter ending March 31, 2011 and 2010, respectively)

 

$

9,829

 

$

6,603

 

 

 

 

 

 

 

Basic:

 

 

 

 

 

Weighted-average common shares outstanding

 

27,168

 

26,922

 

Earnings from continuing operations per share allocated to common stockholders

 

$

0.35

 

$

0.25

 

Earnings (loss) from discontinued operations per share allocated to common stockholders

 

0.01

 

 

Earnings per share allocated to common stockholders

 

$

0.36

 

$

0.25

 

 

 

 

 

 

 

Diluted:

 

 

 

 

 

Weighted-average shares outstanding used in basic calculation

 

27,168

 

26,922

 

Dilutive effect of options

 

109

 

244

 

Dilutive effect of unvested restricted stock

 

309

 

55

 

Weighted-average common stock and common stock equivalents

 

27,586

 

27,221

 

Earnings from continuing operations per share allocated to common stockholders

 

$

0.35

 

$

0.25

 

Earnings (loss) from discontinued operations per share allocated to common stockholders

 

0.01

 

(0.01

)

Earnings per share allocated to common stockholders

 

$

0.36

 

$

0.24

 

 

 

 

 

 

 

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

 

1,029

 

2,120

 

Stock issuable upon conversion of the Series A Preferred Stock

 

5,806

 

5,806

 

 

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Table of Contents

 

ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)

 

NOTE 5 — INVENTORIES

 

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

 

 

 

March 31,

 

December 31,

 

 

 

2011

 

2010

 

 

 

 

 

 

 

Raw materials

 

$

8,065

 

$

9,387

 

Work-in-process

 

9,050

 

7,687

 

Finished goods

 

25,395

 

27,372

 

 

 

42,510

 

44,446

 

Inventory valuation reserves

 

(9,101

)

(10,359

)

Inventories, net

 

$

33,409

 

$

34,087

 

 

NOTE 6 — LOAN RECEIVABLE

 

The Company loaned $2.5 million to a sterilization subcontractor with proceeds used to construct the subcontractor’s Costa Rican sterilization facility. The loan, which is recorded in prepaid expenses and other current assets in the accompanying March 31, 2011 condensed consolidated balance sheet and in long term other assets in the accompanying December 31, 2010 condensed consolidated balance sheet, bears interest at a fixed rate of 7.0 percent.  The balance of the loan receivable, including accrued interest, at March 31, 2011 and December 31, 2010 was $2.3 million and $2.5 million, respectively.  On April 7, 2011, the loan balance and accrued interest were repaid in full.

 

NOTE 7 — ACCRUED LIABILITIES

 

The following summarizes the Company’s accrued liabilities (in thousands):

 

 

 

March 31,
2011

 

December 31,
2010

 

 

 

 

 

 

 

Compensation

 

$

10,556

 

$

19,236

 

Insurance dispute reserve

 

9,900

 

9,830

 

Legal fees and arbitration accrual

 

2,624

 

2,041

 

Agent commissions

 

2,050

 

1,837

 

Royalties and discounts

 

1,455

 

1,660

 

Accounting and reporting costs

 

996

 

863

 

Other

 

5,025

 

4,730

 

 

 

$

32,606

 

$

40,197

 

 

NOTE 8 — 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 $1.5 million and $1.6 million for the quarters ended March 31, 2011 and 2010, respectively.

 

The Company entered into a new lease agreement on April 4, 2011, for facilities located in Austin, Texas.  The anticipated use commencement date is August 1, 2011.  Minimum rental payments for this operating lease are as follows (in thousands):

 

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Table of Contents

 

ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)

 

 

 

Minimum Rental

 

 

 

Payments

 

2011

 

$

 

2012

 

1,310

 

2013

 

2,285

 

2014

 

2,353

 

2015

 

2,421

 

Thereafter

 

17,145

 

 

 

$

25,514

 

 

There were no other material changes from the Company’s lease obligations presented in its 2010 Form 10-K.

 

Purchase Commitments

 

The Company is a party to a variety of agreements pursuant to which it may be obligated to purchase products from other parties.  Typically, these obligations arise in the context of contracts entered into by the Company in the normal course of business.  During the quarter ended March 31, 2011, there were no material changes from the Company’s contractual obligations presented in its 2010 Form 10-K.

 

Contingent Payments

 

Certain of the Company’s agreements for purchase business combinations and intangible asset purchases include provisions to provide additional consideration if contractually specified conditions related to the acquired business or assets are achieved.

 

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 quarter ended March 31, 2011 the Company advanced $1.3 million and has recorded additional liabilities of $1.1 million under these indemnity agreements as of March 31, 2011.  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 9 — 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. 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.

 

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Table of Contents

 

ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)

 

SEC Investigation

 

The Fort Worth Regional Office of the Securities and Exchange Commission’s (the “SEC”) Division of Enforcement conducted a formal investigation into accounting matters related to the restatement of financial results as announced by the Company on July 21, 2008 and completed on November 18, 2009, when the Company filed its Annual Report on Form 10-K for the fiscal year ended December 31, 2008, in which it provided a detailed description of these matters with respect to the Review and the restatement. The Company entered a settlement with the SEC that fully resolves the SEC investigation against the Company. Under the settlement, the Company consented to the entry by the SEC of an administrative order (the “Order”), on February 9, 2011, directing the Company to cease and desist from committing or causing violations of the reporting, books and records and internal control provisions of the federal securities laws in Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Securities Exchange Act of 1934 and under Rules 12b-20, 13a-1 and 13a-13 promulgated under the Exchange Act. The Company consented to the entry of the Order without admitting or denying the Order’s assertions of factual findings. No monetary penalty or fine was imposed on the Company, and none of the Company’s current officers or employees were charged.

 

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 Spine product sales. The DOJ is also reviewing the Company’s relationship with its DiscoCare subsidiary. The Company is cooperating with this investigation. At this stage of the investigation, the Company cannot predict the ultimate outcome and is unable to estimate any potential liability the Company may incur.

 

Private Securities Class Action and Shareholder Derivative Lawsuits

 

Federal Court Actions

 

On April 4, 2008, a putative securities class action was filed in Federal court in the Southern District of Florida 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, the court granted the Company’s motion to transfer this case to the U.S. District Court, Western District of Texas. (McIlvaine v. ArthroCare, et al).

 

On July 25, 2008, a putative securities class action was filed in Federal court in the Western District of Texas against the Company, and certain of its current and 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. (Strong v. ArthroCare, et al).

 

On August 7, 2008, a derivative action was filed in Federal court in the Southern District of Florida against the Company and its then-current directors alleging breach of fiduciary duty based on the Company’s alleged improper revenue recognition, improper reporting of such revenue in SEC filings and press releases, failure to maintain adequate internal controls, and failure to supervise management. On October 14, 2008, the court granted the Company’s motion to transfer this case to the U.S. District Court, Western District of Texas. (Weil v. Baker, et al).

 

On March 4, 2009, a derivative action was filed in Federal court in the Western District of Texas against the Company’s current directors, a former director, certain of its current and former executive officers and other employees and PricewaterhouseCoopers LLP alleging (i) disgorgement under Section 304 of the Sarbanes-Oxley Act; (ii) violations of Section 10(b) of the Exchange Act and Rule 10b-5; (iii) breach of fiduciary duty; (iv) abuse of control; (v) gross mismanagement of the Company; (vi) waste of corporate assets; (vii) insider trading; and (viii) unjust enrichment. (King v. Baker, et al).

 

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ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)

 

On April 29, 2009, a derivative action was filed in Federal court in the Western District of Texas against the Company’s current directors and a former director alleging breach of fiduciary duty based on the Company’s improper revenue recognition, improper reporting of such revenue in SEC filings and press releases, failure to maintain adequate internal controls, and failure to supervise management. (Barron v. Baker, et al).

 

On October 28, 2008, and thereafter, the two putative securities class actions and the shareholder derivative actions were consolidated and designated: In Re ArthroCare Corporation Securities Litigation, Case No. 1:08-cv-00574-SS (consolidated) in the U.S. District Court, Western District of Texas. On December 10, 2008, Lead Plaintiffs and Lead Plaintiffs’ counsel were appointed in the putative consolidated securities class action. The Lead Plaintiff filed an Amended Consolidated Class Action Complaint on December 18, 2009, seeking unspecified monetary damages and interest. ArthroCare filed a Motion to Dismiss the Amended Consolidated Class Action Complaint on February 16, 2010. On July 20, 2010, the federal court issued a ruling granting in part and denying in part ArthroCare’s Motion to Dismiss, permitting certain claims related to statements after December 11, 2007 to continue.

 

State Court Actions

 

On September 23, 2008, a derivative action was filed in Texas State District Court against the Company, and its then current directors and certain of its current and former officers. (Wieser v. Baker). In this action, one of the Company’s shareholders alleged derivative claims on behalf of the Company that its directors and officers breached their fiduciary duties to shareholders by allowing improper financial reporting, failing to maintain adequate financial controls over revenue recognition, disseminating false financial statements, abuse of control, gross mismanagement, waste of corporate assets, and engaging in insider trading.

 

On October 20, 2008, a derivative action was filed in Texas State District Court against the Company, its then directors and certain of its current and former executive officers. (Bocklet v. Baker). In this action, one of the Company’s shareholders alleged derivative claims on behalf of the Company that its directors and officers breached their fiduciary duties to shareholders by failing to maintain adequate financial controls over revenue recognition, allowing improper financial reporting, disseminating false financial statements, and engaging in insider trading.

 

On October 27, 2008, a derivative action was filed in Texas State District Court against the Company, its then directors and certain of its current and former executive officers. (Guthrie v. Baker). In this action, one of the Company’s shareholders alleged derivative claims on behalf of the Company that its directors and officers breached their fiduciary duties to shareholders by failing to maintain adequate financial controls over revenue recognition, allowing improper financial reporting, disseminating false financial statements, and engaging in insider trading.

 

On March 18, 2009, these three shareholder derivative actions were consolidated and designated: In Re ArthroCare Corporation Derivative Litigation, Case No. D-1-GN-08-3484 (consolidated), Travis County District Court. The consolidated action seeks financial compensation, certain governance changes and removal of certain directors. On the Company’s motion, the state shareholder derivative actions were stayed pending resolution of all motions to dismiss the federal Amended Consolidated Class Action Complaint and class certification, if any, of a class in the federal Amended Consolidated Class Action Complaint.

 

Proposed Settlement of Shareholder Derivative Actions

 

On October 18, 2010, the Company, its directors’ and officers’ insurance carriers, and the plaintiffs in the Federal Court and State Court derivative actions agreed in principal to a settlement. Under the terms of the proposed settlement, the director and officer insurers will collectively pay $8.0 million to the Company, on behalf of the individuals named as defendants in the Federal Court and State Court derivative actions, to settle the State and Federal Derivative actions. The lawyers for the plaintiffs will be entitled to seek an award of legal fees and costs from the Federal Court in an amount not to exceed $2.25 million. The agreement also provides that the directors’ and officers’ insurers will pay the Company an additional $2.0 million for a broad mutual release by the Company and the insurers of any further rights or obligations under the directors’ and officers’ liability insurance policies. The settlement calls for certain mutually acceptable governance changes and is subject to approval of the former officers and directors who are parties to the derivative actions, an agreement by those former officers and directors to release the Company’s directors’ and officers’ liability insurance carriers of any further rights or obligations under the applicable directors’ and officers’ liability

 

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Table of Contents

 

ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)

 

insurance policies, the execution of a full and final settlement agreement, and the approval of the settlement of the derivative actions by the U.S. District Court, Western District of Texas. On March 22, 2011, the Federal Court informed the parties that it would de-consolidate the derivative actions (Weil, Barron and King described above) from the consolidated securities action in light of the settlement in principal.  Upon approval of this settlement agreement, we will incur any further litigation cost, settlement cost, fines, injunctions, orders or damages allegedly resulting from or based on the restatement or related events, including the ongoing DOJ investigation, the consolidated securities Class Action case and any ongoing indemnification obligations without the benefit of further insurance coverage.

 

NOTE 10 —RESTRUCTURING ACTIVITIES

 

The Company entered into a new lease agreement on April 4, 2011, for facilities located in Austin, Texas with the intent to consolidate the activities currently conducted at its Sunnyvale, California facility with those activities currently conducted in Austin, Texas at the newly leased facilities.  The Company currently estimates it will incur exit costs such as severance, lease termination and relocation costs ranging from $10 million to $10.5 million, and accelerate amortization of $2 million on leasehold improvements related to the former facilities.  The Company anticipates completing the activities and recognizing the costs associated with the program during the remainder of 2011.

 

NOTE 11 — 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 disposable devices for less invasive surgical procedures.  Each of the Company’s business units has similar economic characteristics, technology, manufacturing processes, customers, distribution and marketing strategies, regulatory environments, and shared infrastructures. These operating segments are Sports Medicine - Americas, Ear Nose and Throat (“ENT”) - Americas, Other — Americas and International.

 

Product sales by operating segment and product area for the periods shown were as follows (in thousands):

 

 

 

Three Months Ended

 

Three Months Ended

 

 

 

March 31, 2011

 

March 31, 2010

 

 

 

Americas

 

International

 

Total
Product
Sales

 

% Net
Product
Sales

 

Americas

 

International

 

Total
Product
Sales

 

% Net
Product
Sales

 

Sports Medicine

 

$

37,381

 

$

19,328

 

$

56,709

 

67.9

%

$

44,391

 

$

16,058

 

$

60,449

 

71.0

%

ENT

 

20,037

 

4,267

 

24,304

 

29.1

%

18,415

 

3,330

 

21,745

 

25.5

%

Other

 

685

 

1,809

 

2,494

 

3.0

%

969

 

2,002

 

2,971

 

3.5

%

Total product sales

 

$

58,103

 

$

25,404

 

$

83,507

 

100.0

%

$

63,775

 

$

21,390

 

$

85,165

 

100.0

%

 

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 or regional area where the Company’s customer is domiciled.  Product sales by geography for the periods shown were as follows (in thousands):

 

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ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)

 

 

 

Three Months Ended

 

 

 

March 31,

 

 

 

2011

 

2010

 

 

 

 

 

 

 

United States

 

$

55,285

 

$

61,584

 

Non-United States (1)

 

28,222

 

23,581

 

Total product sales

 

$

83,507

 

$

85,165

 

 


(1) No additional locations are individually significant.

 

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

 

 

 

March 31,
2011

 

December 31,
2010

 

 

 

 

 

 

 

United States

 

$

26,382

 

$

27,285

 

Costa Rica

 

10,314

 

12,750

 

Other

 

5,902

 

5,729

 

Total long-lived assets

 

$

42,598

 

$

45,764

 

 

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Table of Contents

 

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”. 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. We have grown beyond our roots in arthroscopy to capitalize on market opportunities across several medical specialties, improving many existing soft-tissue surgical procedures and enabling new minimally invasive procedures. Our innovative technologies improve the lives of individuals as diverse as world class athletes suffering from torn rotator cuffs or anterior cruciate ligaments to senior citizens suffering from herniated discs and children suffering from tonsillitis.

 

Our business consists of two core product areas: Sports Medicine and Ear Nose and Throat, or ENT. We also manufacture and sell products based on our technology for other procedures, such as certain spine procedures. Our Sports Medicine, ENT and Other products are marketed and sold through two principal geographic markets: Americas (North and South America) and International (all other geographies).

 

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 direct sales employees, independent sales agents and independent distributors.  We anticipate that disposable device sales and implants will remain the key component of our product sales for the foreseeable future.  We also contract manufacture disposable surgical devices for use in Sports Medicine procedures for another medical device company.   In the quarter ended March 31, 2011, product revenue from contract manufacturing was $5.4 million compared to $4.8 million in the same quarter in 2010.

 

Reported product sales were $83.5 million for the quarter ended March 31, 2011 compared to $85.2 million in the same period in 2010.  In the first quarter of 2010, we recognized $6.6 million of product sales that were previously deferred pending the resolution of certain contract issues.  Excluding the effects of the deferred revenue, product sales increased 6.3 percent.   We also generate revenue from royalties and fees from licensing of our products and technology to other companies and earn other revenues from shipping and handling cost billed to customers.

 

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Table of Contents

 

Gross Product Margin

 

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, and certain stock based compensation costs associated with manufacturing and operations personnel.  Cost of product sales also includes the amortization of controller units that have been placed at customer locations to enable the use of our disposable surgical products. We maintain ownership of all placed controllers and the cost of controller units are capitalized and amortized into cost of product sales over the useful life of the controller unit. Most of our manufactured products are produced at our Costa Rica facility which has experienced stable operations. Raw materials used to produce our products are generally not subject to substantial commodity price volatility.

 

Gross product margin as a percentage of product sales for the quarter ended March 31, 2011 was 70.4 percent compared to 68.8 percent for the same period in 2010.   The comparability of gross product margin between periods will be impacted by several items, including the mix between proprietary and contract manufactured products sales; the stability of our average sales price on proprietary products; changes in the estimated percentage of research and engineering activities associated with the manufacturing process and allocated to manufacturing overhead; and, changes in our product emphasis that may result in obsolescence charges being included in 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 for the quarter ended March 31, 2011 was 18.9 percent compared to 17.3 percent for the same period in 2010.

 

In April 2011, we entered into a new lease agreement for facilities located in Austin, Texas with the intent to consolidate the activities currently conducted at our Sunnyvale, California facility with those activities currently conducted in Austin, Texas.  We currently estimate that we will incur exit costs such as severance, lease termination and relocation costs in conjunction with the consolidation ranging from $10 million to $10.5 million, and accelerate amortization of $2 million on leasehold improvements related to the former facilities.  We anticipate completing the activities and recognizing the costs associated with the program during the remainder of 2011.  Once completed, we anticipate the program will result in lower annual expenses of approximately $5 million.

 

Net Earnings

 

Net earnings will be affected by the same trends that impact our revenues, gross product margin and operating margin. In addition, net earnings will also be affected by 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 the first quarter of 2011, income from continuing operations before taxes increased by $4.7 million, from $12.4 million in the first quarter of 2010 to $17.1 million. Of this increase, $1.1 million was due to an increase in income from operations.  Changes in the amount reported as foreign exchange gain (loss) increased our income from continuing operations before income taxes by $3.6 million in the quarter ended March 31, 2011 when compared to the quarter ended March 31, 2010.

 

Our effective income tax rate is 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 have a tax holiday that extends through December 2015.  In years of loss, our effective tax rate may exceed the U.S. statutory rate depending on the apportionment of income or loss between jurisdictions in which we operate. We expect to be able to fully utilize our deferred tax assets.

 

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Table of Contents

 

Results of Operations

 

Results of operations for the three months ended March 31, 2011 and 2010 (in thousands, except percentages and per-share data) were as follows:

 

 

 

Three Months Ended

 

 

 

March 31,

 

 

 

2011

 

2010

 

 

 

Dollars

 

% Total
Revenue

 

Dollars

 

% Total
Revenue

 

 

 

 

 

 

 

 

 

 

 

Revenues:

 

 

 

 

 

 

 

 

 

Product sales

 

$

83,507

 

95.0

%

$

85,165

 

95.6

%

Royalties, fees and other

 

4,425

 

5.0

%

3,949

 

4.4

%

Total revenues

 

87,932

 

100.0

%

89,114

 

100.0

%

 

 

 

 

 

 

 

 

 

 

Cost of product sales

 

24,744

 

28.1

%

26,579

 

29.8

%

 

 

 

 

 

 

 

 

 

 

Gross profit

 

63,188

 

71.9

%

62,535

 

70.2

%

 

 

 

 

 

 

 

 

 

 

Operating expenses:

 

 

 

 

 

 

 

 

 

Research and development

 

6,810

 

7.7

%

8,615

 

9.7

%

Sales and marketing

 

28,098

 

32.0

%

26,855

 

30.1

%

General and administrative

 

9,188

 

10.4

%

9,255

 

10.4

%

Amortization of intangible assets

 

1,311

 

1.5

%

1,315

 

1.6

%

Investigation and restatement-related costs

 

1,204

 

1.4

%

1,043

 

1.1

%

Total operating expenses

 

46,611

 

53.0

%

47,083

 

52.9

%

 

 

 

 

 

 

 

 

 

 

Income from operations

 

16,577

 

18.9

%

15,452

 

17.3

%

 

 

 

 

 

 

 

 

 

 

Foreign exchange gain (loss)

 

664

 

 

 

(2,960

)

 

 

Other expense, net

 

(174

)

 

 

(101

)

 

 

Other income (expense), net

 

490

 

 

 

(3,061

)

 

 

 

 

 

 

 

 

 

 

 

 

Income from continuing operations before income taxes

 

17,067

 

 

 

12,391

 

 

 

 

 

 

 

 

 

 

 

 

 

Income tax provision

 

4,608

 

 

 

3,314

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income from continuing operations

 

12,459

 

 

 

9,077

 

 

 

 

 

 

 

 

 

 

 

 

 

Income (loss) from discontinued operations, net of taxes

 

311

 

 

 

(250

)

 

 

 

 

 

 

 

 

 

 

 

 

Net Income

 

12,770

 

 

 

8,827

 

 

 

 

 

 

 

 

 

 

 

 

 

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

 

(840

)

 

 

(802

)

 

 

 

 

 

 

 

 

 

 

 

 

Net income available to common stockholders

 

$

11,930

 

 

 

$

8,025

 

 

 

 

 

 

 

 

 

 

 

 

 

Weighted-average shares outstanding:

 

 

 

 

 

 

 

 

 

Basic

 

27,168

 

 

 

26,922

 

 

 

Diluted

 

27,586

 

 

 

27,221

 

 

 

 

 

 

 

 

 

 

 

 

 

Earnings per share from continuing operations applicable to common stockholders:

 

 

 

 

 

 

 

 

 

Basic

 

$

0.35

 

 

 

$

0.25

 

 

 

Diluted

 

$

0.35

 

 

 

$

0.25

 

 

 

 

 

 

 

 

 

 

 

 

 

Earnings per share applicable to common stockholders:

 

 

 

 

 

 

 

 

 

Basic

 

$

0.36

 

 

 

$

0.25

 

 

 

Diluted

 

$

0.36

 

 

 

$

0.24

 

 

 

 

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Table of Contents

 

Product Sales

 

Product sales by product group and geographic market for the periods shown were as follows (in thousands, except percentages):

 

 

 

Three Months Ended

 

Three Months Ended

 

 

 

March 31, 2011

 

March 31, 2010

 

 

 

Americas

 

International

 

Total
Product
Sales

 

% Net
Product
Sales

 

Americas

 

International

 

Total
Product
Sales

 

% Net
Product
Sales

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Sports medicine

 

$

37,381

 

$

19,328

 

$

56,709

 

67.9

%

$

44,391

 

$

16,058

 

$

60,449

 

71.0

%

ENT

 

20,037

 

4,267

 

24,304

 

29.1

%

18,415

 

3,330

 

21,745

 

25.5

%

Other

 

685

 

1,809

 

2,494

 

3.0

%

969

 

2,002

 

2,971

 

3.5

%

Total product sales

 

$

58,103

 

$

25,404

 

$

83,507

 

100.0

%

$

63,775

 

$

21,390

 

$

85,165

 

100.0

%

 

Sports Medicine product sales decreased during the quarter ended March 31, 2011 compared to the same period in 2010 as the first quarter of 2010 included the recognition of $6.6 million of Americas product sales that had previously been deferred pending the resolution of certain contract issues in dispute.    Excluding the effects of the deferred revenue recognized in the quarter ended March 31, 2010, proprietary Sports Medicine product sales in the Americas decreased $0.9 million as a result of lower sales to stocking distributors and lower average sales prices that offset a modest increase in sales volumes.  The decline in Americas proprietary product sales was offset by an increase of $0.5 million in contract manufactured product sales pursuant to an existing supply and distribution agreement with Smith & Nephew.  For the three month period ended March 31, 2011, International product sales increased by $3.3 million, due to increased volume and increased average selling price in our existing direct and distributor markets.

 

ENT product sales increased 11.8 percent during the quarter ended March 31, 2011 compared to the same period in 2010.  Product sales in the Americas increased 8.8 percent as a result of an increase in our user and customer base and higher average selling prices for our products.  International ENT product sales increased due to higher sales  in the Asia Pacific region.

 

Other product sales decreased $0.5 million or 16.1 percent during the quarter ended March 31, 2011 compared with the same period of 2010.  Other product sales declined in the Americas as we continue to de-emphasize our spine products in the United States.  Other International product sales decreased primarily due to lower product sales in our European direct markets.

 

In total, International product sales increased $4.0 million or 18.8 percent during the quarter ended March 31, 2011 compared with the same period of 2010.  In our direct markets, product sales increased $2.8 million between periods while sales to distributors increased $1.3 million. In the first quarter of 2011, direct markets represented approximately 72.7% of International product sales compared to approximately 73.4% in the first quarter of 2010.  Changes in foreign currency rates increased the U.S. dollar reported value of International’s local currency product sales by $0.7 million for the quarter ended March 31, 2011 compared to the same period in 2010.

 

Royalties, Fees and Other Revenues

 

Royalties, fees, and other revenues consist mainly of revenue from the licensing of our products and technology, plus shipping and handling costs billed to customers. Royalties, fees, and other revenues increased by 12.1 percent to $4.4 million during the quarter ended March 31, 2011 compared with the same period of 2010, primarily as a result of increased royalties from a party who licensed certain of our patents for use in the urology and hysteroscopic gynecology fields.

 

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Table of Contents

 

Cost of Product Sales

 

 

 

Three Months Ended

 

 

 

March 31,

 

 

 

2011

 

2010

 

 

 

Dollars

 

% Net
Product
Sales

 

Dollars

 

% Net
Product
Sales

 

 

 

 

 

 

 

 

 

 

 

Product cost

 

$

20,674

 

24.8

%

$

21,908

 

25.7

%

Controller amortization

 

2,185

 

2.5

%

2,359

 

2.8

%

Other

 

1,885

 

2.3

%

2,312

 

2.7

%

Total cost of product sales

 

$

24,744

 

29.6

%

$

26,579

 

31.2

%

 

Product margin as a percentage of product sales were 70.4 percent during the quarter ended March 31, 2011compared to 68.8 percent for the same period in 2010.  Inventory obsolescence charges in the first quarter of 2010 were $1.4 million higher than in the first quarter of 2011.

 

Operating Expenses

 

 

 

Three Months Ended

 

 

 

March 31,

 

 

 

2011

 

2010

 

 

 

Dollars

 

% Total
Revenue

 

Dollars

 

% Total
Revenue

 

 

 

 

 

 

 

 

 

 

 

Research and development

 

$

6,810

 

7.7

%

$

8,615

 

9.7

%

Sales and marketing

 

28,098

 

32.0

%

26,855

 

30.1

%

General and administrative

 

9,188

 

10.4

%

9,255

 

10.4

%

Amortization of intangible assets

 

1,311

 

1.5

%

1,315

 

1.6

%

Investigation and restatement-related costs

 

1,204

 

1.4

%

1,043

 

1.1

%

Total operating expenses

 

$

46,611

 

53.0

%

$

47,083

 

52.9

%

 

Research and development expense decreased $1.8 million during the quarter ended March 31, 2011, compared to the same period in 2010.  Materials and services consumed by our research and development efforts were lower in the first quarter of 2011 due to project timing.   In addition, a higher proportion of engineering and other personnel costs were estimated as being associated with manufacturing activities in the current quarter, which increased the allocation of engineering costs to inventory and cost of goods sold.

 

Sales and marketing expense increased $1.2 million, to 32.0 percent of total revenues during the quarter ended March 31, 2011, compared to 30.1 percent of total revenues for the same period in 2010, primarily due to increased sales commission costs.

 

Investigation and restatement expenses increased to $1.2 million or 1.4 percent of total revenues during the quarter ended March 31, 2011.  We expect to continue to incur legal defense costs in connection with the DOJ and shareholder and derivative class action matters related to the Review and restatement which will be classified as investigation and restatement expense.

 

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Other Income (Expense), Net

 

 

 

Three Months Ended

 

 

 

March 31,

 

 

 

2011

 

2010

 

 

 

 

 

 

 

Foreign exchange gain (loss)

 

$

664

 

$

(2,960

)

Interest and other expense, net

 

(174

)

(101

)

Other income (expense), net

 

$

490

 

$

(3,061

)

 

Other income was $0.5 million in the quarter ended March 31, 2011 compared to expense of $3.1 million in the quarter ended March 31, 2010 due primarily to the amount of foreign exchange gain (loss).  During the quarter ended March 31, 2011, the U.S. Dollar weakened against the British pound, euro, and Australian dollar, which resulted in the recognition of foreign exchange gains at certain of our international subsidiaries whereas in the first quarter of 2010, the U.S. Dollar strengthened against these same currencies.  Partially offsetting the impact of changing currency rates between the periods was a comparative decrease in U.S. Dollar denominated payables at our international subsidiaries.

 

Income Tax Provision (Benefit)

 

Our effective tax rate for the quarter ended March 31, 2011 and 2010 was 27.0 percent and 26.7 percent, respectively.

 

Liquidity and Capital Resources

 

Historically, our liquidity needs have been to finance the costs of operations, to acquire complementary businesses or assets and to make repurchases of our common stock.  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 requirements and, excluding the uncertainty related to the ongoing litigation and investigations to which we are a party, long-term normal operating liquidity requirements.

 

As of March 31, 2011 we had $213.2 million in working capital, compared to $191.9 million at December 31, 2010.  Cash and cash equivalents increased from $132.5 million at December 31, 2010 to $147.5 million at March 31, 2011.  The change in working capital is primarily a result of cash received from operating activities.  As of March 31, 2011, we reclassified a loan receivable of $2.3 million from other non-current assets to prepaid expenses and other current assets as it was repaid in April 2011. Cash provided by operating activities for the three months ended March 31, 2011 was $15.2 million and differed from our net income of $12.8 million due to non-cash expenses of $8.6 million, offset by changes in operating assets and liabilities of $6.2 million.  We typically experience a reduction in accrued liabilities in the first quarter as we fund accrued compensation expense related to the prior year’s annual bonus compensation program.   Cash provided by operating activities included cash provided by discontinued operations of $0.7 million and cash used for discontinued operations of $0.4 million for the three months ended March 31, 2011 and 2010, respectively. Cash used in investing activities for the three months ended March 31, 2011 and 2010 was $2.9 million and $3.6 million, and consisted primarily of purchases of property and equipment.

 

Cash provided by financing activities for the three months ended March 31, 2011 and 2010 was $1.6 million and $0.3 million, and consisted primarily of proceeds from exercise of stock options.

 

In April 2011, we entered into a new lease agreement for facilities located in Austin, Texas with the intent to consolidate the activities currently conducted at our Sunnyvale, California facility with those activities currently conducted in Austin, Texas.  We currently estimate that we will incur exit costs such as severance, lease termination and relocation costs in conjunction with the consolidation ranging from $10 million to $10.5 million, and accelerate amortization of $2 million on leasehold improvements related to the former facilities.  We anticipate completing the

 

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activities and recognizing the costs associated with the program during the remainder of 2011.  Of the total exit costs we expect to recognize under this program, we estimate $5 million to $6 million will require cash outlay during 2011.

 

Critical Accounting Policies and Estimates

 

There have been no 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 2010 Form 10-K.

 

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.

 

The Company entered into a new lease agreement on April 4, 2011, for facilities located in Austin, Texas with the intent to consolidate the activities currently conducted at its Sunnyvale, California facility with those activities currently conducted in Austin, Texas at the newly leased facilities. The anticipated use commencement date is August 1, 2011. Minimum rental payments for this operating lease are as follows (in thousands):

 

 

 

Minimum Rental

 

 

 

Payments

 

2011

 

$

 

2012

 

1,310

 

2013

 

2,285

 

2014

 

2,353

 

2015

 

2,421

 

Thereafter

 

17,145

 

 

 

$

25,514

 

 

There were no other material changes from our contractual obligations presented in our 2010 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 interest rates and foreign currency exchange rates that may impact, adversely or otherwise, our financial condition, results of operations, or cash flows. Although payments under the operating leases for our facilities are tied to market indices, we are not exposed to material interest rate risk associated with operating leases.  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.

 

The table below presents principal amounts and related weighted average interest rates as of March 31, 2011 for our cash and cash equivalents.

 

Cash and cash equivalents

 

$

147,529

 

Average interest rate earned on cash and cash equivalents

 

0.2

%

 

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Foreign Currency Risk

 

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 exchange rates for these currencies fluctuate against the U.S. dollar, we will experience variations in our results of operations and financial condition.

 

Our cash and cash equivalents at March 31, 2011 are denominated primarily in U.S. dollars; however, we also maintain significant balances in euros, British pounds, Swedish kroner, Swiss francs, Australian dollars and Costa Rican colones.  A 10 percent change in the March 31, 2011 exchange rates for these currencies would have an impact on pre-tax income of approximately $1.3 million.

 

We have not used derivative financial instruments to hedge against foreign currency exchange risk. Our objective to minimize foreign currency gains and losses has been managed by maintaining only enough cash necessary for immediate working capital requirements in accounts denominated in currencies other than the U.S. dollar and holding the majority of our cash and cash equivalents in U.S. dollar accounts.

 

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ITEM 4. CONTROLS AND PROCEDURES

 

Evaluation of Disclosure Controls and Procedures

 

As required by Rule 13a-15 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 was 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 March 31, 2011, 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 that occurred during the quarter ended March 31, 2011 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 March 31, 2011 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

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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 ability of the Company to fulfill its obligations with respect to the rights of the holders of the Series A Convertible Preferred Stock, including but not limited to the redemption rights and registration rights of the holders of the Series A Convertible Preferred Stock; the resolution of litigation pending against the Company; the Company’s ability to design or improve internal controls to address issues detected in its reviews of internal controls and insurance reimbursement practices or by management in its reassessment of the Company’s internal controls; the impact upon the Company’s operations of legal compliance matters or internal controls review, improvement and remediation; the ability of the Company to control expenses relating to legal compliance matters or internal controls review, improvement and remediation; 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 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 financial and strategic alternatives, as well as 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 9, “Litigation and Contingencies,” in the notes to the condensed consolidated financial statements.  In addition to the matters specifically described in Note 9 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 9.  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

 

This section identifies specific risks that should be considered carefully in evaluating our business. Any of these risks could adversely affect our business, results of operations or financial condition. Although we believe that these risks represent the material risks relevant to us, our business and our industry, new material risks may emerge that we are currently unable to predict. As a result, this description of the risks that affect our business and our industry is not

 

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exhaustive. The risks discussed below could cause our actual results to differ materially from our historical results or the results contemplated by the forward-looking statements contained in Exhibit 99.1, “Forward-Looking Statements”.

 

The restatement of our previous financial statements, the Audit Committee’s review of certain accounting, financial reporting and insurance billing and healthcare compliance practices and the DOJ and other investigations, legal and administrative proceedings have increased our costs and could result in fines, injunctions, orders, and penalties which could materially adversely affect our business, financial condition, results of operations, and liquidity.

 

As previously reported, during 2009 and 2008, we experienced substantial delays in filing our periodic reports as a result of issues identified during a review of certain accounting and financial reporting matters as well as certain insurance billing and healthcare compliance practices conducted under the direction of our Audit Committee (the “Review”), which began in July 2008. The Review was completed in August 2009 and the results were reported to the Audit Committee and to the Board. In July 2008, we also commenced a separate comprehensive review of our accounting policies and procedures, financial reporting, internal controls and corporate governance. We completed this comprehensive review in November 2009, and as a result of our comprehensive review and the Review, we made extensive organizational and operational changes and improved our internal controls. As a result of errors and possible irregularities identified by the Review and management’s review and analysis of certain accounting matters, we restated our financial statements for: the years ended December 31, 2007, 2006, 2005, and 2004; the quarter ended March 31, 2008 and each of the quarters for the years ended December 31, 2007 and 2006 in our Form 10-K for the year ended December 31, 2008 filed on November 18, 2009, or the 2008 Form 10-K.

 

We are involved in ongoing material legal proceedings and the actions currently pending result primarily from matters relating to our restatement and Review. See Note 9, “Litigation and Contingencies,” in the notes to the condensed consolidated financial statements. These proceedings and other legal actions may harm our business or liquidity in the future.

 

We have incurred substantial costs and expenses for legal and accounting services due to the Review and resulting DOJ investigation. These matters will likely continue to divert our management’s time and attention periodically and cause us to continue to incur substantial costs and expenses. Such investigations can also lead to fines or injunctions or orders with respect to future activities. We could incur substantial additional costs to defend and resolve litigation, investigations or proceedings arising out of or related to these matters. In addition, we could be exposed to enforcement or other actions with respect to these matters by the DOJ or other federal or state agencies. At this point, we are unable to predict the duration, scope or result of these investigations or whether any of these agencies will commence any legal action. Any such investigations may result in us being subject to criminal and civil penalties and other remedial measures, which could have an adverse impact on our business, results of operations, financial condition and liquidity.

 

On October 18, 2010, we, our directors’ and officers’ insurance carriers, and the plaintiffs in the Federal Court and State Court derivative actions agreed in principal to a settlement. Under the terms of the proposed settlement, the director and officer insurers will collectively pay us $8.0 million, on behalf of the individuals named as defendants in the Federal Court and State Court derivative actions, to settle the State and Federal Derivative actions. The lawyers for the plaintiffs will be entitled to seek an award of legal fees and costs from the Federal Court in an amount not to exceed $2.25 million. The agreement also provides that the directors’ and officers’ insurers will pay the Company an additional $2.0 million for a broad mutual release by us and the insurers of any further rights or obligations under the directors’ and officers’ liability insurance policies. The settlement calls for certain mutually acceptable governance changes and is subject to approval of the former officers and directors who are parties to the derivative actions, an agreement by those former officers and directors to release our directors’ and officers’ liability insurance carriers of any further rights or obligations under the applicable directors’ and officers’ liability insurance policies, the execution of a full and final settlement agreement, and the approval of the settlement of the derivative actions by the U.S. District Court, Western District of Texas. Upon approval of this settlement agreement, any further litigation cost, settlement cost,  or damages we incur that is based on the restatement or related events, including the ongoing DOJ investigation, the consolidated securities Class Action case described in Note 9, and any ongoing indemnity obligations related to these matters will be funded without the benefit of further insurance coverage.

 

Many of our pending legal proceedings are in the early stages and we cannot predict their outcomes. However, irrespective of the outcomes, we may incur substantial costs, including defense and indemnity costs, and these matters

 

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may divert the attention of our technical and management personnel, which could materially harm our business. We may continue to incur ongoing indemnity obligations with respect to certain former officers or employees of ours who are still subject to potential legal action against them. Moreover, if we do not prevail in any of the actions still pending against us, we could be required to pay substantial damages or settlement costs. Adverse outcomes or other developments during the course of litigation or other proceedings may harm our business, financial condition, results of operations or liquidity as well as investors’ perception of our business, any of which could harm our stock price.

 

Our failure to comply with extensive government regulations could subject us to penalties and materially adversely affect our business, results of operations and financial condition.

 

Our medical device products and operations are subject to extensive regulation by the FDA and various other federal, state and foreign governmental authorities. Government regulations and foreign requirements specific to medical devices are wide ranging and govern, among other things: design, development and manufacturing; testing, labeling and storage; clinical trials; product safety; marketing, sales and distribution; pre-market clearance and approval; record keeping procedures; advertising and promotions; recalls and field corrective actions; post-market surveillance, including reporting of deaths or serious injuries and malfunctions that, if they were to recur, could lead to death or serious injury; and product import and export.

 

We must also comply with the U.S. federal Anti-Kickback Statute and the Foreign Corrupt Practices Act and similar foreign anti-bribery statutes in the sales and distribution of our products. The FDA, DOJ and other governmental authorities have broad enforcement powers, and our failure to comply with these regulatory requirements could result in governmental agencies or a court taking action, including any of the following, which would adversely affect our business: issuing public warning letters to us; imposing fines and penalties on us; obtaining an injunction preventing us from manufacturing or selling our products; bringing civil or criminal charges against us; delaying the introduction of our products into the market; delaying pending requests for clearance or approval of new uses or modifications to our existing products; recalling, detaining or seizing our products; or withdrawing or denying approvals or clearances for our products.

 

If we fail to comply with complex and rapidly evolving laws and regulations, we could suffer civil and criminal penalties, be required to pay substantial damages and make significant changes to our products and operations.

 

During the past several years, the U.S. health care industry has been subject to an increase in governmental regulation at both the federal and state levels. We are subject to numerous federal and state regulations. As part of our internal compliance program, we review our sales and marketing materials, contracts and programs with counsel, and require employees and marketing representatives to participate in regular training. We also have adopted and train our personnel on the Code of Ethics on Interactions with Health Care Professionals promulgated by the Advanced Medical Technology Association or AdvaMed, a leading trade association representing medical device manufacturers. Most recently, we amended our Code of Business Conduct and Ethics the “Code of Ethics,” in August 2009. Originally adopted in 2004 to qualify as a “code of ethics” within the meaning of Section 406 of the Sarbanes-Oxley Act of 2002, the Code of Ethics was amended to qualify as well as a “code of conduct” under the current Federal Sentencing Guidelines and “Compliance Program Guidance for Pharmaceutical Manufacturers” 68 FR 23731 (May 5, 2003) applicable to medical device companies as published by the Office of Inspector General for the Department of Human Services. The Code of Ethics applies to all of our directors, officers, employees and agents. It also serves as an essential element of our Corporate Compliance Program, as announced in August 2009. However, we can give no assurances that our compliance program will ensure that the Company is in compliance with existing or future applicable laws and regulations. If our compliance program fails to meet its objectives, or if we otherwise fail to comply with existing or future applicable laws and regulations, we could suffer civil or criminal penalties. We devote significant operational and managerial resources to comply with these laws and regulations. Different interpretations and enforcement policies of these laws and regulations could subject our current practices to allegations of impropriety or illegality or could require us to make significant changes to our products and operations. In addition, we cannot predict the impact of future legislation and regulatory changes on our business or assure you that we will be able to obtain or maintain the regulatory approvals required to operate our business.

 

Our accounting policies and methods require management to make judgments and estimates about matters that are inherently uncertain, which may result in our actual results differing significantly from those generated by our judgments and estimates.

 

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We are required to exercise judgment in the application of our accounting policies and methods to comply with generally accepted accounting principles in the U.S. (GAAP) and to reflect management’s judgment of the most appropriate manner to report our financial condition and results of operations. See Note 3, “Summary of Significant Accounting Policies” in the notes to the consolidated financial statements in our 2010 Form 10-K for a description of our significant accounting policies.

 

The accounting policies we have identified as critical to the presentation of our financial condition and results of operations are described in “Part II—Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies and Estimates” of our 2010 Form 10-K. We believe these policies are critical because they require management to make particularly subjective or complex judgments about matters that are inherently uncertain at the end of a period and because of the likelihood that materially different amounts would be reported under different conditions or using different assumptions. Due to the complexity of these critical accounting policies, our accounting methods relating to these policies involve substantial use of estimates. Estimates are inherently imperfect predictors of actual results because they are based on assumptions, including assumptions about future events. Our estimates may not include assumptions that reflect very positive or very negative market conditions and, accordingly, our actual results could differ significantly from those generated by our estimates. As a result, the estimates that we use to prepare our financial statements, as well as our estimates of our future results of operations, may be significantly inaccurate.

 

We may be the subject of federal, state and/or foreign government civil and criminal enforcement efforts against health care companies, which could result in civil and/or criminal penalties which could have a material negative impact on our operations and financial condition.

 

In addition to uncertainties surrounding coverage policies, both federal and state government agencies have heightened civil and criminal enforcement efforts against health care companies, as well as their executives and managers. These efforts generally relate to a wide variety of matters, including referral and billing practices, and implicate a variety of state and federal laws, including state insurance fraud provisions, common law fraud theories, as well as both state and federal fraud-and-abuse, anti-kickback, false claims statutes, and the Foreign Corrupt Practices Act and similar international anti-bribery laws and regulations. Although we no longer directly bill any payor, some of our prior activities could become the subject of additional governmental investigations or inquiries. In addition, even though we no longer directly bill any payor, we are still subject to health care fraud and abuse regulation and enforcement by both the federal government and the states in which we conduct our business.

 

The risk of our being found in violation of these laws is increased by the fact that many of them have not been fully interpreted by the regulatory authorities or the courts, and their provisions are open to a variety of interpretations. Moreover, recent health care reform legislation has strengthened these laws. For example, the Patient Protection and Affordable Care Act (PPACA) which was signed into law in March 2010, among other things, amends the intent requirement of the federal anti-kickback and criminal health care fraud statutes; a person or entity no longer needs to have actual knowledge of this statute or specific intent to violate it. In addition, the PPACA provides that the government may assert that a claim including items or services resulting from a violation of the federal anti-kickback statute constitutes a false or fraudulent claim for purposes of the false claims statutes. Moreover, we expect there will continue to be federal and state laws and/or regulations, proposed and implemented, that could impact our operations and business. The extent to which future legislation or regulations if any relating to health care fraud abuse laws and/or enforcement may be enacted or what effect such legislation or regulation would have on our business remains uncertain. If our operations are found to be in violation of any of the laws described above or any other governmental regulations that apply to us, we may be subject to penalties, including civil and criminal penalties, damages, fines, exclusion from governmental health care programs, and the curtailment or restructuring of our operations, any of which could adversely affect our ability to operate our business and our financial results.

 

We may in the future be subject to intellectual property claims, which are costly to defend, could require us to pay damages and could limit our ability to use certain technologies in the future.

 

The medical device industry has been characterized by extensive litigation regarding patents and other intellectual property rights, and companies and other intellectual property holders in the medical device industry have employed intellectual property litigation to gain a competitive advantage.

 

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We cannot assure you that we will not become subject to additional patent infringement claims or other litigation, including interference proceedings declared by the U.S. Patent and Trademark Office, (USPTO) or similar proceedings in foreign jurisdictions to determine the priority of inventions. The defense and prosecution of intellectual property lawsuits, USPTO reexamination and interference proceedings and related legal and administrative proceedings, generally are costly and time-consuming. If other parties violate our proprietary rights, further litigation may be necessary to enforce our patents, to protect trade secrets or know-how we own or to determine the enforceability, scope and validity of the proprietary rights of others. Any litigation or reexamination or interference proceedings will be costly and cause significant diversion of effort by our technical and management personnel.

 

An adverse determination in existing claims, additional litigation or reexamination or interference proceedings to which we may become a party could subject us to significant liabilities to third parties, require disputed rights to be licensed from third parties or require us to cease using certain technology. Furthermore, we cannot assure you that we could obtain necessary licenses on satisfactory terms, if at all. Adverse determinations in judicial or administrative proceedings or failure to obtain necessary licenses could prevent us from manufacturing and selling our products, which would have a material adverse effect on our business, financial condition, results of operations, and future growth prospects.

 

Our intellectual property rights are valuable, and any inability to protect them could reduce the value of our products, business, financial condition, results of operations and future growth prospects.

 

Our ability to compete effectively depends in part on developing and maintaining the proprietary aspects of our Coblation technology and our acquired technologies. We believe that our issued patents are directed at the core technology used in our soft-tissue surgery systems, as well as the use of Coblation technology in specific surgical procedures. In addition, we believe that our issued patents are directed at many of the core features of our acquired technologies Opus, Parallax, Atlantech and Applied Therapeutics, Inc. (ATI). Our earliest Coblation-related patents will begin to expire in 2012. The majority of our royalty income is associated with licenses that include core Coblation patent rights which extend through the end of 2014.

 

There is no assurance that the patents we have obtained, or any patents we may obtain as a result of our pending U.S. or international patent applications, will provide adequate protection to insure any competitive advantages for our products. We also cannot assure investors that those patents will not be successfully challenged, invalidated or circumvented prior to their expiration. In addition, we cannot provide assurance that competitors, many of which have substantial resources and have made substantial investments in competing technologies, have not already applied for or obtained, or will not seek to apply for and obtain, patents that will prevent, limit or interfere with our ability to make, use and sell our products either in the U.S. or in international markets. In Sports Medicine, many of our competitors have licensed our technology for limited fields of use. Patent applications are maintained in secrecy for a period after filing. We may not be aware of all of the patents and patent applications potentially adverse to our interests.

 

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

 

In addition to patents, we rely on trade secrets and proprietary know-how, which we seek to protect, in part, through confidentiality and proprietary information agreements. We require our key employees and consultants to execute confidentiality agreements upon the commencement of an employment or consulting relationship with us. These agreements generally provide that all confidential information, developed or made known to the individual during the

 

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course of the individual’s relationship with us, is to be kept confidential and not disclosed to third parties. These agreements also generally provide that inventions conceived by the individual in the course of rendering services to us shall be our exclusive property. We cannot assure investors that employees and consultants will not breach such agreements, that we would have adequate remedies for any breach or that our trade secrets will not otherwise become known to or be independently developed by competitors.

 

We may not be able to keep pace with technological change or successfully develop new products with wide market acceptance, which could cause us to lose business to competitors.

 

We compete in a market characterized by rapidly changing technology. We may not be able to keep pace with technology or to develop viable new products. Our future financial performance will depend in part on our ability to develop and manufacture new products in a cost-effective manner, to introduce these products to the market on a timely basis, and to achieve market acceptance of these products. Factors which may result in delays of new product introductions or cancellation of our plans to manufacture and market new products include capital constraints, research and development delays, and delays in acquiring regulatory approvals. Our new products and new product introductions may fail to achieve expected levels of market acceptance. Factors impacting the level of market acceptance include our ability to successfully implement new technologies, the timeliness of our product introductions, our product pricing strategies, our available financial and technological resources for product promotion and development, our ability to show clinical benefit from our products, and the availability of coverage and reimbursement for our products as discussed in the risk factor titled “ Changes in coverage and reimbursement for procedures using our products could affect use of our devices and our future revenue” below.

 

The markets for our products are intensely competitive, which may result in our competitors developing technologies and products that are more effective than ours or that make our technologies and products obsolete. Many of our competitors have significantly greater resources and market power than we do.

 

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

 

Our primary competitors across all of our operating units consist of Medtronic, Inc., Smith & Nephew, Stryker Corporation, Johnson & Johnson, Olympus (through their subsidiary Gyrus), and Arthrex, Inc. These competitors tend to be large, well-financed companies with diverse product lines who may have significantly greater financial, manufacturing, marketing, distribution and technical resources than we do. Some of these companies offer broad product lines that they may offer as a single package and frequently offer significant price discounts as a competitive tactic. Furthermore, some of our competitors utilize purchasing contracts that link discounts on the purchase of one product to purchases of other products in their broad product lines. Many of the hospitals in the U.S. have purchasing contracts with our competitors. Accordingly, customers may be dissuaded from purchasing our products instead of our competitors’ products to the extent the purchase would cause them to lose discounts on our competitors’ products. In addition, we are aware of several small companies that may directly or indirectly compete with our products.

 

If we were to be unable to continue to compete for any of the above reasons, it could have a material adverse effect on our business, financial condition, results of operations and future growth prospects.

 

Until we resolve our contingencies, we may not have access to a cost effective credit facility and we will be required to fund a significant amount of cash to fund our working capital needs and planned expenditures with cash on hand. Our ability to generate cash depends on many factors beyond our control.

 

In the absence of a credit facility as a possible source of liquidity, our ability to meet our working capital needs and to fund capital expenditures will depend on our ability to generate cash from operations and effectively manage our cash balances. This is subject to general economic, financial, competitive and other factors that may be beyond our control. We are unable to predict the outcome of ongoing litigation and investigations to which we are a party and these matters could have a material adverse effect on our liquidity and cash flows. See Note 9, “Litigation and Contingencies,” in the notes to the condensed consolidated financial statements for further discussion on legal proceedings. We expect that our cash flows from operations together with cash on hand will be sufficient to satisfy our short-term and, excluding the uncertainty related to the ongoing litigation and investigations to which we are a party, long-term normal operating

 

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liquidity requirements; however, we cannot assure you that our business will generate sufficient cash flow from operations in an amount sufficient to enable us to fund our other liquidity needs.

 

As a result, from time to time, we may be required to seek financing from alternative sources. We cannot assure you that such alternative funding will be available to us on terms and conditions acceptable to us, or at all.

 

In addition, we maintain deposit accounts with numerous financial institutions around the world in amounts that exceed applicable governmental deposit insurance levels. While we actively monitor our deposit relationships, the unanticipated failure of a financial institution in which we maintain deposits could cause us to suffer losses that could materially harm our results of operations and financial condition.

 

Any control deficiencies relating to our internal control over financial reporting could result in errors in our reported results and could have a material adverse effect on our operations, investor confidence in our business and the trading prices of our securities.

 

Internal control over financial reporting cannot provide absolute assurance of achieving financial reporting objectives because of its inherent limitations. Internal control over financial reporting is a process that involves human diligence and compliance and is subject to lapses in judgment and breakdowns resulting from human failures. Internal control over financial reporting can also be circumvented by collusion or improper management override. Because of such limitations, there is a risk that material misstatements will not be prevented or detected on a timely basis by internal control over financial reporting.

 

A failure to remain current in our filings may have material impacts on our business and liquidity.

 

If we are not able to remain current in our filings with the SEC, we will face several adverse consequences and restrictions. We will not be able to have a registration statement under the Securities Act of 1933, as amended (the “Securities Act”), covering a public offering of securities, declared effective by the SEC, or make offerings pursuant to existing registration statements; we will not be able to make an offering to any purchasers not qualifying as “accredited investors” under certain “private placement” rules of the SEC under Regulation D; we will not be eligible to use a “short form” registration statement on Form S-3 for a period of at least 12 months after the time we become current in our periodic and current reports under the Securities Exchange Act of 1934, as amended (the “Exchange Act”); we will not be able to deliver the requisite annual report and proxy statement to our stockholders to hold our annual stockholders meeting; our employees cannot be granted stock options, nor will they be able to exercise stock options registered on Form S-8, because Form S-8 would not be available to us; and our Common Stock may be delisted from the NASDAQ Stock Market. These restrictions may impair our ability to raise funds in the public markets, should we desire to do so, and to attract and retain employees.

 

In addition, pursuant to the Registration Rights Agreement between us and the holders of our Series A Preferred Stock, if our registration statement ceases to be available to the holders of our Series A Preferred Stock, a Registration Default occurs. If we are not able to cure this Registration Default in a timely manner we are obligated to pay the holders of the Series A Preferred Stock 2.00 percent per annum of the original liquidation preference of the Series A Preferred Stock, accruing from the date of the Registration Default until the Registration Default is cured.

 

Medical device reprocessors that reprocess our single-use devices and then provide them to customers at a lower cost than a new device may adversely affect our business.

 

Certain medical device reprocessors routinely collect used or opened but unused single-use devices from customers and reprocess and repackage these products to customers at a price lower than the price of a new device. These reprocessed devices may be confused with our authorized products, reduce our product sales and harm our reputation with key physicians who may not have knowledge that the devices have been reprocessed. In addition, this may increase time and expense spent investigating and addressing performance issues, including product liability issues, related to reprocessed devices. We may be required to incur additional expense to protect ourselves against performance claims associated with reprocessed devices and to enforce infringements by reprocessors of our proprietary and contractual rights.

 

 

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Failure to obtain FDA clearance or approval for our products could materially adversely affect our business, results of operations, financial condition, and future growth prospects.

 

In the U.S., before we can market a new medical device, or a new use of, or claim for, or significant modification to, an existing product, we must first receive either premarket clearance under Section 510(k) of the U.S. Federal Food, Drug, and Cosmetic Act, or FDCA, or approval of a Premarket Approval (PMA) submission from the FDA, unless an exemption applies. In the 510(k) clearance process, the FDA must determine that a proposed device is “substantially equivalent” to a device legally on the market, known as a “predicate” device, with respect to intended use, technology and safety and effectiveness, in order to clear the proposed device for marketing. Clinical data is sometimes required to support substantial equivalence. However, as was the case in our recent submission for 510(k) clearance of Coblator IQ ENT Plasma Wands, the FDA has a high degree of latitude when evaluating submissions and may determine that a proposed device submitted for 510(k) clearance is not substantially equivalent, or NSE, to a predicate device.

 

Recent trends in FDA’s review of 510(k) submissions suggest that FDA is often requiring manufacturers to provide new, more expansive or different information regarding a particular device than what the manufacturer anticipated. This has resulted in increasing uncertainty and delay in the premarket notification review process. In January 2011, the FDA announced twenty-five specific action items it intends to take with respect to the 510(k) process to add greater transparency and certainty to the review process. These reforms, when fully implemented, could impose additional regulatory requirements upon us which could delay our ability to obtain new clearances, increase the costs of compliance, or restrict our ability to maintain current clearances.

 

An FDA NSE determination means that the device is automatically reclassified into Class III and we cannot market the device unless it is either approved through the PMA process or reclassified into Class I or Class II based on further submissions with supporting data. A new submission may require clinical data. The PMA approval pathway requires an applicant to demonstrate the safety and effectiveness of the device based, in part, on data obtained in clinical trials. Both of these processes can be expensive and lengthy and entail significant user fees, unless exempt. The FDA’s 510(k) clearance process usually takes from three to twelve months, but it can last longer. The process of obtaining PMA approval is much more costly and uncertain than the 510(k) clearance process. It generally takes from one to three years, or even longer, from the time the PMA application is submitted to the FDA until an approval is obtained. There is no assurance that we will be able to obtain FDA clearance or approval for any of our new products on a timely basis, or at all. Failure to obtain FDA clearance or approval for our new products could materially adversely affect our business, results of operations, financial condition, and future growth prospects.

 

Modifications to our currently FDA-cleared products may require new regulatory clearance or approvals or require us to recall or cease marketing our current products until clearances or approvals are obtained.

 

After a device receives 510(k) premarket notification clearance from the FDA, any modification that could significantly affect its safety or effectiveness, or that would constitute a major change in the intended use of the device, technology, materials, packaging, and certain manufacturing processes may require a new 510(k) clearance or PMA. The FDA requires every manufacturer to make the determination regarding the need for a new 510(k) clearance or PMA approval in the first instance, but the FDA may review any manufacturer’s decision and may retroactively require the manufacturer to submit a premarket notification requesting 510(k) clearance or an application for PMA approval. The FDA also can require the manufacturer to cease marketing and/or recall the modified device until 510(k) clearance or approval is obtained. FDA guidance documents define when to submit premarket notifications for new or modified devices. These guidance documents also define modifications for which a new 510(k) is not required. We have modified some of our marketed devices, and have determined that in certain instances new 510(k) clearances or PMA approvals are not required. No assurance can be made that the FDA would agree with any of our decisions not to seek 510(k) clearance or PMA approval. If the FDA requires us to cease marketing and/or recall the modified device until we obtain a new 510(k) clearance or PMA approval, our business, financial condition, results of operations and future growth prospects could be materially adversely affected.

 

We may be subject to fines, penalties or injunctions if we are determined to be promoting the use of our products for unapproved or “off-label” uses, which would adversely affect our financial condition.

 

Our promotional materials and training methods must comply with FDA regulations and other applicable laws and regulations, including the prohibition of the promotion of a medical device for a use that has not been cleared or

 

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approved by the FDA. Use of a device outside its cleared or approved indications is known as “off-label” use. Physicians may use our products off-label, as the FDA does not restrict or regulate a physician’s choice of treatment within the practice of medicine. However, if the FDA determines that our promotional materials or training constitutes the promotion of an off-label use, it could subject us to certain sanctions ranging from a request that we modify our training or promotional materials to further regulatory or enforcement actions, including the issuance of an untitled letter, a warning letter, injunction, seizure, civil fine and/or criminal penalties against us or our officers or employees. It is also possible that other federal, state or foreign enforcement authorities might take action if they consider our promotional or training materials to constitute promotion of an unapproved use, which could result in significant fines or penalties under other statutory authorities, such as laws prohibiting false claims for reimbursement. In that event, our reputation could be damaged and adoption of the products would be impaired. Although our policy is to refrain from statements that could be considered off-label promotion of our products, the FDA or another regulatory agency could disagree and conclude that we have engaged in off-label promotion. In addition, the off-label use of our products may increase the risk of injury to patients, and, in turn, the risk of product liability claims. Product liability claims are expensive to defend and could divert our management’s attention and result in substantial damage awards against us.

 

Our products may in the future be subject to product recalls that could harm our reputation, business operations and financial results, and if our products cause or contribute to a death or serious injury, we will be subject to medical device reporting regulations, which can result in voluntary corrective actions or FDA enforcement actions.

 

The FDA and similar foreign governmental authorities have the authority to require the recall of commercialized products in the event of material deficiencies or defects in design or manufacture or in the event that a product poses an unacceptable risk to health. Manufacturers may, under their own initiative, recall a product if any material deficiency in a device is found. A government mandated or voluntary recall by us or one of our distributors could occur as a result of an unacceptable risk to health, component failures, manufacturing errors, design or labeling defects or other deficiencies and issues. Recalls of any of our products would divert managerial and financial resources and have an adverse effect on our financial condition and results of operations. Any of these sanctions could impair our ability to produce our products in a cost-effective and timely manner in order to meet our customers’ demands. We may also be required to bear other costs or take other actions that may have a negative impact on our future sales and our ability to generate profits.

 

Further, under the FDA medical device reporting regulations (“MDR”) we are required to report to the FDA any incident in which our product may have caused or contributed to a death or serious injury or in which our product malfunctioned and, if the malfunction were to recur, would likely cause or contribute to death or serious injury. Any adverse event involving our products could result in future voluntary corrective actions, such as recalls or customer notifications, or agency action, such as inspection, mandatory recall or other enforcement action. Any corrective action, whether voluntary or involuntary, as well as defending ourselves in a lawsuit, will require the dedication of our time and capital, distract management from operating our business, and may harm our reputation and financial results.

 

If we or our third-party suppliers fail to comply with the FDA’s Quality System Regulations, our manufacturing operations could be interrupted and our sales and our ability to generate profits could suffer.

 

We and certain of our third-party suppliers are required to comply with the FDA’s Quality System Regulation, (“QSR”) which covers the methods and documentation of the design, testing, production, control, quality assurance, labeling, packaging, sterilization, storage and shipping of our products. We and our suppliers are also subject to the regulations of foreign jurisdictions regarding the manufacturing process if we market our products in these jurisdictions. The FDA enforces the QSR through periodic and unannounced inspections of manufacturing facilities. If our facilities or those of our suppliers fail to take satisfactory corrective action in response to an adverse QSR inspection, the FDA could take enforcement action, including any of the following sanctions: untitled letters; warning letters, fines, injunctions, consent decrees and civil penalties; customer notifications or repair, replacement, refunds, recall, detention or seizure of our products; operating restrictions or partial suspension or total shutdown of production; refusing or delaying our requests for 510(k) clearance or premarket approval of new products or modified products; withdrawing 510(k) clearances on PMA approvals that have already been granted; refusal to grant export approval for our products; or criminal prosecution.

 

Any of these sanctions could impair our ability to produce our products in a cost-effective and timely manner in order to meet our customers’ demands. We may also be required to bear other costs or take other actions that may have a negative impact on our future sales and our ability to generate profits.

 

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We require foreign regulatory approvals to market and sell our products in other countries. Failure to obtain and maintain these regulatory approvals could harm our ability to generate revenue.

 

To be able to market and sell our products in other countries, we must obtain regulatory approvals and comply with the regulations of those countries. These regulations, including the requirements for approvals and the time required for regulatory review, vary from country to country. Obtaining and maintaining foreign regulatory approvals is expensive, and we cannot be certain that we will receive regulatory approvals in any foreign country in which we plan to market our products. If we fail to obtain or maintain regulatory approval in any foreign country in which we plan to market our products, our ability to generate revenue could be harmed.

 

Changes in coverage and reimbursement for procedures using our products could affect use of our devices and our future revenue.

 

The demand for our products is highly dependent on the policies of third-party payors such as Medicare, Medicaid, private insurance, and managed care organizations that reimburse our customers when they use our products. Failure by physicians, hospitals and other users of our products to obtain sufficient coverage and reimbursement from healthcare payors for procedures in which our products are used, or adverse changes in environmental and private third-party payors’ policies toward coverage and reimbursement for such procedures would have a material adverse effect on our business, financial condition, results of operations and future growth prospects.

 

In the U.S., third-party payors continue to implement initiatives that restrict the use of certain technologies to those that meet certain clinical evidentiary requirements. We are aware of several third-party payors in the U.S., including governmental payors such as Medicare and Medicaid and private health insurance companies, who consider Coblation technology used in certain procedures to treat certain clinical conditions to be experimental or investigational. These payors have developed policies that deny coverage and therefore make no reimbursement for such procedures using our devices. Procedures using our devices that are not covered by some payors include such procedures as plasma disc decompression, or Coblation nucleoplasty, as well as Coblation or radiofrequency volumetric tissue reduction for (1) removing soft tissue during arthroscopic surgery, (2) hypertrophied nasal turbinates for the treatment of chronic nasal obstruction or obstructive sleep apnea and (3) soft palate and tongue for the treatment of obstructive sleep apnea. However, some payors in the U.S. provide coverage and reimbursement for Coblation tonsillectomy for certain clinical indications and percutaneous vertebroplasty for patients that meet specified criteria. In addition, some payors are moving toward a managed care system and control their health care costs by limiting authorizations for surgical procedures, including elective procedures using our devices. Failure to obtain favorable payor policies could have a material adverse effect on our business and operations.

 

In addition to uncertainties surrounding coverage policies, third-party payors from time to time update reimbursement amounts and also revise the methodologies used to determine reimbursement amounts. This includes annual updates to payments to ambulatory surgical centers and physicians for procedures using our products. Because reimbursement for our products generally is included as part of the payments for procedures, these updates directly impact the amounts recognized for the costs of our products. An example of payment updates is the Medicare program updates to physician payments, which is done on an annual basis using a prescribed statutory formula. In the past, when the application of the formula resulted in lower payment, Congress has passed interim legislation to prevent the reductions. For 2010, the Center for Medicare and Medicaid Services, or CMS, projected a rate reduction of 21.2 percent under the statutory formula and a number of legislative measures were passed to prevent this reduction. For the second half of 2010, the update factor was increased by 2.2 percent. For 2011, the Medicare and Medicaid Extenders Act of 2010 which was signed into law on December 15, 2010, froze the 2010 update through 2011. Because CMS was required to make its other changes to the Medicare Physician Fee Schedule (including adjustments made to certain codes identified to be misvalued) budget neutral, CMS made a downward adjustment to what is known as the “conversion factor,” which translates values into dollar amounts. Whereas the conversion factor for the end of 2010 was $36.8729, it is $33.9764 for 2011. At this time, is it uncertain how the change would affect our business. If Congress fails to intervene to prevent the negative update factor in the future, the resulting decrease in payment may adversely affect our revenues and results of operations.

 

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New laws, regulations and judicial decisions, or new interpretations of existing laws, regulations and decisions that relate to healthcare availability, methods of delivery or payment for products and services, or sales, marketing or pricing may cause our revenue to decline. In addition, we may need to revise our research and development plans if a program or programs no longer are commercially viable. Such changes could cause our stock price to decline or experience periods of volatility.

 

The PPACA legislation, among other things, imposes significant new taxes on medical device makers which will result in a significant increase in the tax burden on our industry, and could have a material, negative impact on our results of operations and our cash flows. Other elements of this legislation such as comparative effectiveness research, an independent payment advisory board, payment system reforms including shared savings pilots and other provisions could significantly change the way healthcare is developed and delivered, and may materially impact many aspects of our business.

 

If we obtain the necessary international regulatory approvals, market acceptance of our products in international markets would be dependent, in part, upon the availability of coverage and reimbursement within prevailing health care payment systems. Reimbursement and health care payment systems in international markets vary significantly by country and include both government sponsored health care and private insurance. We intend to seek international reimbursement approvals, although we cannot assure investors that any such approvals will be obtained in a timely manner, if at all. We are also unable to predict at this time the impact on our business of any future changes, if any, that are made to coverage and reimbursement policies by government action in key international markets.

 

Product liability claims could adversely impact our financial condition and impair our reputation.

 

Our business exposes us to potential product liability risks which are inherent in the design, manufacture and marketing of medical devices. In addition, many of our products are designed to be implanted in the human body for long periods of time. Component failures, manufacturing flaws, design defects or inadequate disclosure of product related risks or product related information with respect to these or other products we manufacture or sell could result in an unsafe condition or injury to a patient. The occurrence of such a problem could result in product liability claims or a recall of one or more of our products, which could ultimately result in the removal from the body of such products and claims regarding associated costs and damages, which could materially adversely impact our business, financial condition, results of operations, our ability to attract and retain customers for our products, and future growth prospects.

 

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

 

We are dependent on key suppliers, and supply disruptions could materially adversely affect our business, financial condition, results of operations and future growth prospects.

 

Some of the key components of our products are purchased from single vendors. If the supply of materials from a single source supplier were interrupted, replacement or alternative sources might not be readily obtainable due to the regulatory and other requirements applicable to our manufacturing operations or the availability of certain product drawings and/or specifications. A new or supplemental filing with applicable regulatory authorities may require us to obtain clearance prior to our marketing a product containing new material. This clearance process may take a substantial period of time and we cannot assure investors that we would be able to obtain the necessary regulatory approval for a new material to be used in our products on a timely basis, if at all. This could create supply disruptions that would materially adversely affect our business, financial condition, results of operations and future growth prospects.

 

In addition, we primarily use a subcontractor located in Costa Rica to sterilize our disposable devices. We have the ability to use alternative sterilization service providers for most of our products. If our Costa Rica sterilization service were to be disrupted for any reason, we would be required to use alternative sources with longer processing and logistics cycles, which could lead to a disruption in our ability to supply products for a period of time.

 

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We are dependent on warehouses in the U.S. and Belgium owned and operated by Deutsche Post DHL, Inc. If our ability to use these warehouses is disrupted, we may be unable to supply products to our customers on a timely basis, which could materially adversely affect our business.

 

The complex nature of the underlying support technologies utilized to exchange critical product information with third party transportation and logistics providers, such as Electronic Data Interchange, has, at times, caused disruptions in our ability to deliver products to customers on a timely basis. Failure of these supporting systems could impair our business for the duration of the failure.

 

Our business is susceptible to risks associated with international operations.

 

International operations are generally subject to a number of risks, including: protectionist laws, business practices, licenses, tariffs and other trade barriers that favor local competition; multiple, conflicting and changing governmental laws and regulations, such as tax laws regulating intercompany transactions; difficulties in managing foreign operations, including staffing, seasonality of operations, dependence on local vendors, and collecting accounts receivable; loss of proprietary information due to piracy, misappropriation or weaker laws regarding intellectual property protection; foreign currency exchange rate fluctuations; and political and economic instability.

 

We derived 28.0 percent, 27.1 percent and 26.5 percent of our total product sales for the year ended December 31, 2010, 2009 and 2008, respectively, from customers located outside of the Americas. We expect international revenue to remain a significant 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.

 

Disruptions or other adverse developments at our Costa Rica facility could materially adversely affect our business.

 

Our high-volume disposable devices and controllers are manufactured at our Company owned facility in an industrial park in San Jose, Costa Rica. If our Costa Rica facility is not able to produce sufficient quantities of our controllers and products with adequate quality, or if our Costa Rica operations are disrupted for any reason, then we may be forced to locate alternative manufacturing facilities, including facilities operated by third parties. Disruptions may include, but are not limited to: changes in the legal and regulatory environment in Costa Rica; slowdowns or work stoppages within the Costa Rican customs authorities; acts of God (including but not limited to potential disruptive effects from an active volcano near the facility or earthquakes, hurricanes and other natural disasters); and other issues associated with significant operations that are remote from our headquarters and operations centers. Additionally, continued growth in product sales could outpace the ability of our Costa Rican operation to supply ordered products on a timely basis or cause us to take actions within our supply and manufacturing operations which increase costs, complexity and timing. Locating alternative facilities would be time-consuming, would disrupt our production and cause shipment delays and could result in damage to our reputation and profitability. Additionally, we cannot assure you that alternative manufacturing facilities would offer the same cost structure as our Costa Rica facility.

 

Future changes in technology or market conditions could result in adjustments to our recorded asset balance for intangible assets, including goodwill, resulting in additional non-cash charges that could significantly impact our operating results.

 

Our balance sheet includes significant intangible assets, including goodwill and other acquired intangible assets. The determination of related estimated useful lives and whether these assets are impaired involves significant judgments. Our ability to accurately predict future cash flows related to these intangible assets may be adversely affected by unforeseen and uncontrollable events. In the highly competitive medical device industry, new technologies could impair the value of our intangible assets if they create market conditions that adversely affect the competitiveness of our products. We test our goodwill for impairment in the fourth quarter of each year, but we also test goodwill and other

 

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intangible assets for impairment at any time when there is a change in circumstances that indicates that the carrying value of these assets may be impaired. Any future determination that these assets are carried at greater than their fair value could result in substantial non-cash impairment charges, which could significantly impact our reported operating results.

 

Delaware law and provisions in our charter could make the acquisition of our company by another company more difficult, which could adversely affect our stock price.

 

Certain provisions of our certificate of incorporation and bylaws may have the effect of making it more difficult for a third party to acquire, or of discouraging a third party from attempting to acquire, control of our company. This could limit the price that certain investors might be willing to pay in the future for shares of our Common Stock. Certain provisions of our certificate of incorporation and bylaws allow us to issue preferred stock without any vote or further action by the stockholders, to eliminate the right of stockholders to act by written consent without a meeting, to specify advance notice and other procedures for director nominations by stockholders and submission of other proposals for consideration at stockholder meetings, and to eliminate cumulative voting in the election of directors. Certain provisions of Delaware law applicable to us could also delay or make more difficult a merger, tender offer or proxy contest involving us, including Section 203, which prohibits a Delaware corporation from engaging in any business combination with any interested stockholder for a period of three years unless certain conditions are met. The procedures required for director nominations and stockholder proposals and Delaware law could have the effect of delaying, deferring or preventing a change in control of the company, including without limitation, discouraging a proxy contest or making more difficult the acquisition of a substantial block of our Common Stock. These provisions of Delaware law, our certificate of incorporation, and our bylaws may have the effect of delaying or preventing changes in control or management of the Company, which could have an adverse effect on the market price of our stock.

 

One Equity Partners, a private equity firm, may have influence on our major corporate decisions.

 

As previously reported, on September 1, 2009, an affiliate of One Equity Partners, or OEP a private equity firm, acquired our Series A Preferred Stock. See “Part II—Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources” in our 2009 Form 10-K for a description of this transaction. As a result of this transaction, OEP became the largest beneficial owner of our stock. At this time, assuming conversion of the Series A Preferred Stock to our Common Stock, including make-whole amounts as defined in the Certificate of Designation for the Series A Preferred Stock but excluding outstanding options and warrants held by other parties, OEP would represent an ownership interest of approximately 17.6 percent of our voting stock. In connection with this transaction, we expanded the Board of Directors to eight members and granted OEP the right to nominate two directors. Effective September 1, 2009, Messrs. Gregory Belinfanti and Christian Ahrens, both partners of OEP, were appointed to our Board of Directors.

 

Consequently, OEP may have the ability to influence our Board of Directors and matters requiring stockholder approval, subject to the restrictions placed on OEP by the Securities Purchase Agreement, including without limitation OEP’s agreement to vote for any director nominated by the Board and to comply with the terms of the standstill.  Since September 1, 2010, OEP is free to convert the Series A Preferred Stock into our Common Stock and, subject to the registration requirements of the federal securities laws, dispose of such stock, which could result in a decrease of the market price of our Common Stock, particularly if such dispositions are made in the open market and are substantial.

 

We are dependent upon key management, technical personnel and advisors, and loss of our key personnel and advisors could have a material adverse effect on our business and results of operations.

 

The loss of the services of one or more key employees or consultants could have a material adverse effect on us. Our success also depends on our ability to attract and retain additional highly qualified management and technical personnel. We face intense competition for qualified personnel, any of whom often receive competing employment offers. We cannot assure you that we will continue to be able to attract and retain such personnel. Loss of key personnel would materially impact our ability to meet our financial and operational objectives and could have a material adverse effect on our business and our results of operations.

 

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Circumstances associated with our integration of acquisitions may adversely affect our operating results.

 

An element of our growth strategy in the future may be the pursuit of acquisitions of other businesses that expand or complement our existing products and distribution channels. Integrating businesses, however, involves a number of special risks, including: the possibility that management attention may be diverted from regular business concerns by the need to integrate operations; unforeseen costs, difficulties and liabilities in integrating our and the acquired company’s employees, operations and systems; accounting, regulatory, or compliance issues that could arise in connection with, or as a result of, the acquisition of the acquired company; challenges in retaining our customers or the customers of the acquired company following the acquisition; the difficulty of incorporating acquired technology and rights into our products and services; and impairment charges if our acquisitions are not successful due to these risks.

 

In addition, we may finance future acquisitions by issuing equity securities, which may dilute the holdings of our current stockholders. If we are unable to successfully complete and integrate strategic acquisitions in a timely manner, our business, financial condition or operating results may be adversely affected.

 

Our operating results may fluctuate.

 

In our experience, our results of operations may fluctuate significantly from period to period. Adverse fluctuations due to these factors may adversely affect our level of revenues and profitability, results of operations, financial condition, and future growth prospects in the short and long term: the introduction of new product lines and increased penetration in existing applications; achievement of research and development milestones; the amount and timing of expenditures and the receipt and recognition of license fees; and timing of the receipt of orders and product shipments, absence of a backlog of orders, and the rate of product returns.

 

Factors may make the market price of our stock highly volatile.

 

The market price of our Common Stock could fluctuate substantially in the future. Investors may be unable to resell our Common Stock at or above their purchase price. This volatility may subject our stock price to material fluctuations due to the factors discussed in this “Risk Factors” section, and other factors including market reaction to acquisitions and trends in sales, marketing, and research and development; rumors or dissemination of false information; changes in coverage or earnings estimates by analysts; our ability to meet analysts’ or market expectations; and sales of Common Stock by existing stockholders.

 

As previously reported, as of September 1, 2009, OEP owns all of our outstanding Series A Preferred Stock. Since September 1, 2010, OEP may convert the Series A Preferred Stock into our Common Stock and, subject to the registration requirements of the federal securities laws, dispose of such stock, which could result in a decrease of the market price of our Common Stock, particularly if such dispositions are made in the open market and are substantial.

 

ITEM 2.  UNREGISTERED SALES OF SECURITIES AND USE OF PROCEEDS

 

None.

 

ITEM 3.  DEFAULTS UPON SENIOR SECURITIES

 

None.

 

ITEM 4.  RESERVED

 

ITEM 5.  OTHER INFORMATION

 

None.

 

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Table of Contents

 

ITEM 6. EXHIBITS

 

Exhibit
Number

 

Description

10.43

 

Lease Agreement between CarrAmerica Lantana, LP and the Company.

 

 

 

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

 

The following financial statements from the ArthroCare Corporation Quarterly Report on Form 10-Q for the quarter ended March 31, 2011, filed on May 2, 2011, formatted in Extensible Business Reporting Language (XBRL): (i) condensed consolidated balance sheets, (ii) condensed consolidated statements of income, (iii) condensed consolidated statements of cash flows, and (iv) notes to condensed consolidated financial statements.**

 


**Furnished not filed herewith.

 

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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: May 2, 2011

/s/ David Fitzgerald

 

David Fitzgerald

 

President and Chief Executive Officer

 

 

Date: May 2, 2011

/s/ Todd Newton

 

Todd Newton

 

Senior Vice President and Chief Financial Officer

 

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Table of Contents

 

EXHIBIT INDEX

 

EXHIBIT NO.

 

DOCUMENT DESCRIPTION

 

 

 

10.43

 

Lease agreement between CarrAmerica Lantana, LP and the Company.

 

 

 

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

 

The following financial statements from the ArthroCare Corporation Quarterly Report on Form 10-Q for the quarter ended March 31, 2011, filed on May 2, 2011, formatted in Extensible Business Reporting Language (XBRL): (i) condensed consolidated balance sheets, (ii) condensed consolidated statements of income, (iii) condensed consolidated statements of cash flows, and (iv) notes to condensed consolidated financial statements.**

 


**Furnished not filed herewith.

 

38