10-K/A 1 d10ka.htm AMENDMENT NO. 1 TO THE FORM 10-K Amendment No. 1 to the Form 10-K

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


 

FORM 10-K/A

(Amendment No. 1)

 

ANNUAL REPORT

PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the fiscal year ended December 31, 2004

 

Commission File Number: 0-27422

 


 

ARTHROCARE CORPORATION

(Exact name of Registrant as specified in its charter)

 

Delaware   94-3180312

(State or other jurisdiction of

Incorporation or organization)

 

(I.R.S. employer

Identification number)

 

111 Congress Avenue, Suite 510, Austin, Texas 78701

(Address of principal executive offices and zip code)

 

(512) 391-3900

(Registrant’s telephone number, including area code)

 


 

Securities registered pursuant to 12 (b) of the Act:

     None
Securities registered pursuant to section 12 (g) of the Act:      Common Stock, $0.001 Par Value; Preferred Share Purchase Rights

 


 

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

 

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

 

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

 

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

 

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

 


 

DOCUMENTS INCORPORATED BY REFERENCE

 

None.

 



EXPLANATORY NOTE

 

We are filing this Amendment No. 1 to our Annual Report on Form 10-K for the year ended December 31, 2004, originally filed with the Securities and Exchange Commission (“SEC”) on March 31, 2004 (the “Original Report”), to (1) provide the information required by Part III, and certain information required by Item 5, of Form 10-K, (2) revise our disclosure in Item 9A under the heading “Controls and Procedures” and (3) include the attestation of our independent registered public accounting firm, PricewaterhouseCoopers LLP. We have included the information required by Part III, and certain information required by Item 5, of Form 10-K herein because our definitive proxy statement for the year ended December 31, 2004 will not be filed within 120 days of year end. The revised disclosure in Item 9A under the heading “Controls and Procedures” and the inclusion of the attestation of our independent registered public auditors has been made in reliance upon the Order of the SEC under Section 36 of the Securities Exchange Act of 1934 (Release No. 34-50754, November 30, 2004). We have also updated the signature page and Exhibits 31.1, 31.2, 32.1 and 32.2 to the Original Report. No other changes to the Original Report have been made.

 

Except as otherwise expressly stated in this Amendment No. 1, this Amendment No. 1 continues to speak as of the date of the Original Report and we have not updated the disclosure contained herein to reflect events that have occurred since the filing of the Original Report. Accordingly, this Amendment No. 1 should be read in conjunction with our other filings made with the SEC subsequent to the filing of the Original Report, including any amendments and exhibits to those filings.

 

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PART I

 

ITEM 1.    BUSINESS

 

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

 

Overview

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

ArthroCare Strategy

 

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

 

    Expand our product offering to address large and rapidly growing markets.    We are continuously expanding our portfolio of products and enhancing our existing products to serve the needs of physicians. For example, we have increased our penetration of arthroscopic procedures in the knee through the addition of disposable devices with suction capability and devices that provide low levels of tissue injury.

 

    Replace current technology with Coblation technology.    Coblation technology offers a variety of options for physicians performing soft-tissue surgery. Currently, our systems are being used to perform many types of arthroscopic, cosmetic, ENT, spinal, neurosurgery and general surgery procedures, which were traditionally performed by mechanical, electrosurgical or laser surgery tools. We believe that soft tissue anywhere in the body potentially can be treated with and benefit from our technology.

 

    Focus on disposable device sales.    We have utilized an aggressive promotional product placement program for placing our controllers in hospitals throughout the world. Once a controller is placed, it may be utilized by a variety of physicians who focus on different medical specialties. The same System 2000 controller may be used to perform arthroscopic, ENT, spinal, neurosurgery or general surgery. However, the Coblator II and Atlas, two controllers of ours introduced in 2003, are designed only for ENT and arthroscopic surgery, respectively.

 

   

Layer growth opportunities.    We have established an extensive distributor network, supported by our regional managers, in selected markets. We have been executing a global distribution strategy in which we have been expanding our direct sales presence in arthroscopy, spinal surgery and ENT markets. We have signed agreements with several marketing partners to assist with regulatory requirements and to market and distribute our products internationally. In addition, in October and November 2002, respectively, we acquired two of our European Distributors, Atlantech Medical Devices Ltd in the United Kingdom and Atlantech GmbH in Germany, providing us with an immediate direct sales force in two key European Markets. During the second quarter of 2003, we also acquired our Austrian distributor. In January 2004, we acquired Medical Device Alliance Inc. (MDA) and its majority-owned

 

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subsidiary, Parallax Medical, Inc. (Parallax), a business focused on the treatment of vertebral compression fractures. In November 2004, we acquired Opus Medical, Inc. (Opus), a business focused on soft tissue to bone repair systems, including systems for the treatment of rotator cuff injuries.

 

    Establish strategic partnerships to commercialize our Coblation technology.    Our urology products are currently being commercialized through a strategic partnership with ACMI. We also developed our gynecology products for commercialization through an agreement with GyneCare until the expiration of this agreement in September 2004. We intend to establish additional strategic partnerships, where beneficial, in the future.

 

Overview of Coblation Technology

 

Our products are based on our patented soft-tissue surgical controlled ablation technology, which we call Coblation technology. Coblation technology involves an innovative use of a non-thermal process, and has the capability of performing at temperatures lower than traditional electrosurgical tools.

 

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

 

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

 

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

 

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

 

To achieve increasing disposable device sales over time, we believe we must continue to penetrate the market in knee procedures, expand physicians’ education with respect to Coblation technology and continue working on new product development efforts specifically for knee applications. Furthermore, in order to maintain and increase current market penetration we must be aggressive in increasing our installed base of controllers to generate increased disposable device revenue. Currently, we place controller units with our customers at no cost or at substantial discounts in order to stimulate demand for our disposable devices.

 

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

 

The Sports Medicine Market

 

Overview

 

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

 

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

 

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

 

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

 

Knee

 

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

 

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Shoulder

 

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

 

Elbow, Ankle, Wrist and Hip

 

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

 

Non-Traumatic Soft Tissue Injuries

 

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

 

Conventional Arthroscopic Treatment Methodologies: The Problem

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

The ArthroCare Arthroscopic System: A Solution

 

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

 

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

 

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

 

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

 

The Atlantech Medical Devices, Ltd. Acquisition

 

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

 

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The Opus Medical, Inc. Acquisition

 

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

 

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

 

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

 

The Spinal Surgery Market

 

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

 

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

 

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

 

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

 

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

 

The ArthroCare Spinal Surgery System: A Solution

 

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

 

The Parallax Medical, Inc. Acquisition

 

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

 

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

 

The Ear, Nose and Throat (ENT) Market

 

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

 

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

 

The ArthroCare ENT Surgery System

 

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

 

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

 

The Cosmetic Surgery Market

 

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

 

Conventional Treatment Techniques for Resurfacing: The Problem

 

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

 

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The Visage Coblation Cosmetic Surgery System: A Solution

 

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

 

The Coblation Technology Market

 

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

 

Benefits of Our Coblation Technology

 

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

 

    Ease of use.    Our Coblation-based soft-tissue surgery systems perform many of the functions of mechanical tools, power tools and electrosurgery instruments, allowing a surgeon to use a single instrument. The lightweight device is simple to use and complements a surgeon’s existing tactile skills without the need for extensive training.

 

    Precision.    In contrast to conventional tools, our Coblation-based soft-tissue surgery systems permit surgeons to perform more precise tissue ablation and sculpting. We believe this may result in more rapid patient rehabilitation.

 

    Benefits to patients.    Coblation technology operates at cooler temperatures than traditional electrosurgical tools. This can lead to significant benefits for patients treated with Coblation-based disposable devices due to the minimal amount of thermal injury to surrounding tissue. As a result, we believe that patients are likely to experience less trauma and pain following surgery and may recover more quickly.

 

    Ablation and sealing of bleeding vessels.    Our Coblation-based soft-tissue surgery systems allow for the efficient sealing of small bleeding vessels without changing tools.

 

    Cost reduction.    Our Coblation soft-tissue surgery systems eliminate the need to introduce multiple instruments to remove and sculpt tissue and seal bleeding vessels. We believe this may reduce operating time and thereby produce cost savings for health care providers.

 

Research and Development

 

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

 

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

 

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

 

Manufacturing

 

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

 

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

 

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

 

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

 

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

 

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

 

Marketing and Sales

 

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

 

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

 

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

 

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

 

Patents and Proprietary Rights

 

Our ability to compete effectively depends in part on developing and maintaining the proprietary aspects of our Coblation technology. We own over 125 issued U.S. patents and over 50 issued international patents. In addition, we have over 150 U.S. and international pending patent applications. We believe that our issued patents are directed at, among other things, the core technology used in our soft-tissue surgery systems, including both multi-electrode and single electrode configurations of our disposable devices, as well as the use of Coblation technology in many different surgical procedures.

 

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

 

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

 

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

 

The medical device industry has been characterized by extensive litigation regarding patents and other intellectual property rights, and companies in the medical device industry have employed intellectual property litigation to gain a competitive advantage. We cannot assure you that we will not become subject to patent infringement claims or litigation or interference proceedings declared by the United States Patent and Trademark office, or USPTO, to determine the priority of inventions. In July 2001, we filed a lawsuit against Smith & Nephew alleging infringement of several of our patents. On May 12, 2003, the jury held that the use, manufacture and sale of the Dyonics Control RF System, the ElectroBlade and the Saphyre electrosurgical devices infringed all 16 asserted claims of the three patents in suit. In addition, the jury upheld the validity of all 16 asserted claims. The court entered this verdict in June 2003 and held a hearing on September 15, 2003 to consider Smith & Nephew’s motions to overturn the jury’s verdict. On March 10, 2004, the U.S. District Court in Delaware granted our motion to permanently enjoin Smith & Nephew from manufacturing, using or selling in the United States surgical devices (the Saphyre, Dyonics Control RF and ElectroBlade) that infringe our patents. In addition, the Court denied all of Smith & Nephew’s post-trial motions, including those requesting a new trial and for judgment as a matter of law. The Court also granted our motions for judgment of no inequitable conduct and dismissal of the antitrust counterclaim. On April 27, 2004, the Court rejected Smith & Nephew’s request for a stay of the permanent injunction pending appeal. On June 10, 2004, the Court issued an injunction order enjoining Smith & Nephew from the use, manufacture and sale of the infringing products in the United States. Smith & Nephew has appealed the above rulings in the Federal Circuit Court of Appeals. The U.S. District Court is to hold a second trial to award damages to us for the infringing activity of Smith & Nephew. On April 3, 2003, Smith & Nephew filed a lawsuit against us in the United States District Court, Western Tennessee alleging that we infringed two Smith & Nephew patents. In addition, Smith & Nephew has alleged that we are in violation of Section 43(A) of the Lanham Act for allegedly making false or misleading statements to deceive potential purchasers of Smith & Nephew’s medical devices. Smith & Nephew has requested that the Court issue a preliminary and permanent injunction preventing us from further infringement of the above mentioned patents and from making further false or misleading statements concerning Smith & Nephew’s medical devices. We believe these claims to be without merit and will defend ourselves vigorously. A jury trial is scheduled for October 2005.

 

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

 

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

 

Competition

 

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

 

    Acceptance by leading physicians;

 

    Improved patient outcomes;

 

    Superior product quality;

 

    The publication of peer-reviewed clinical studies;

 

    Product innovation;

 

    Sales and marketing capability; and

 

    Strong intellectual property.

 

Sports Medicine

 

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

 

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

 

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

 

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

 

Spinal Surgery

 

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

 

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

 

Ear, Nose and Throat Surgery (ENT)

 

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

 

Cosmetic Surgery

 

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

 

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

 

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Coblation Technologies

 

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

 

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

 

Third-Party Reimbursement

 

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

 

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

 

Government Regulation

 

United States

 

Our products are considered medical devices and are subject to extensive regulation in the United States. We must obtain premarket clearance or approval by the FDA for each of our products and indications before they can be commercialized. FDA regulations are wide-ranging and govern, among other things:

 

    Product design and development;

 

    Product testing;

 

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    Product labeling;

 

    Product storage;

 

    Premarket clearance or approval;

 

    Advertising and promotion; and

 

    Product sales and distribution.

 

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

 

    Warning letters;

 

    Fines, injunctions and civil penalties against us;

 

    Recall or seizure of our products;

 

    Operating restrictions, partial suspension or total shutdown of our production;

 

    Refusing our requests for premarket clearance or approval of new products;

 

    Withdrawing product approvals already granted; and

 

    Criminal prosecution.

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

International

 

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

 

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

 

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

 

Product Liability Risk and Insurance Coverage

 

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

 

Employees

 

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

 

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

 

Additional Factors That Might Affect Future Results

 

We Are Dependent Upon Our Arthroscopic System

 

We commercially introduced our Arthroscopic System in December 1995. Since our Arthroscopic System accounted for 56% of our product sales in 2004, we are highly dependent on its sales. We cannot assure you that we will be able to continue to manufacture arthroscopy products in commercial quantities at acceptable costs, or that we will be able to continue to market such products successfully.

 

To achieve increasing disposable device sales over time, we believe we must continue to penetrate the market in knee procedures, expand physicians’ education with respect to Coblation technology and continue working on new product development efforts specifically for knee applications. Furthermore, in order to maintain and increase current market penetration we must be aggressive in increasing our installed base of controllers to generate increased disposable device revenue. To date, we have placed at no charge or have priced our arthroscopic controllers at substantial discounts in order to stimulate demand for our disposable devices.

 

We believe that surgeons will not use our products unless they determine, based on experience, clinical data and other factors, that these systems are an attractive alternative to conventional means of tissue ablation. There are only a few independently published clinical reports and limited long-term clinical follow-up to support the marketing efforts for our Arthroscopic System. We believe that if continued recommendations and endorsements

 

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by influential surgeons or long-term data do not support our current claims of efficacy, our business, financial condition, results of operations and future growth prospects could be materially adversely affected.

 

Commercial Success of Products Outside of Our Core Businesses Is Uncertain

 

We have developed several applications for our Coblation technology in spinal surgery, neurosurgery, ENT surgery, cosmetic surgery, gynecology, urology and general surgery. Additionally we have established a program to explore the application of our Coblation technology in various areas within cardiac surgery through our Coblation Technologies business unit. At the present time, we consider sports medicine, spine surgery and ENT surgery to be our core businesses. Sales of our spinal surgery and ENT surgery products accounted for 15% and 19%, respectively, of our product sales in 2004 such that product sales in our three core businesses accounted for approximately 100% of our product sales in 2004. Our products for neurosurgery, cosmetic surgery, gynecology, urology, general surgery and cardiac surgery, our non-core business, are in various stages of commercialization and development, and we may be required to undertake time-consuming and costly commercialization, development and additional regulatory approval activities for any of these products. If we do not receive future clearances we may be unable to market these and other products for specific indications and our business, financial condition, results of operations and future growth prospects could be materially adversely affected. We cannot assure you that product development will ever be successfully completed, that regulatory clearances or approvals, if applied for, will be granted by the FDA or foreign regulatory authorities on a timely basis, if at all, or that the products will ever achieve commercial acceptance.

 

We may have to make a significant investment in additional preclinical and clinical testing, regulatory, physician training and sales and marketing activities to further develop and commercialize our neurosurgery, gynecology, urology, cosmetic surgery, general surgery and cardiovascular product offerings. Although we believe that these products offer certain advantages, we cannot assure you that these advantages will be realized, or if realized, that these products will result in any meaningful benefits to physicians or patients.

 

Development and commercialization of our current and future non-core business products are subject to the risks of failure inherent in the development for new medical devices. These risks include the following:

 

    Such products may not be easy to use, may require extensive training or may not be cost-effective;

 

    New products may experience delays in testing or marketing;

 

    There may be unplanned expenditures or in expenditures above those anticipated by us;

 

    Such products may not be proven safe or effective;

 

    Third parties may develop and market superior or equivalent products;

 

    Such products may not receive necessary regulatory clearances or approvals; and

 

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

 

In addition, the success of our non-core business products will depend on their adoption as alternatives to conventional means of tissue ablation. Clinical experience and follow-up data for our non-core business indications are limited, and we have sold only a small number of units to date. We believe that recommendations and endorsement of influential physicians are essential for market acceptance of such products.

 

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

 

We Have Limited Marketing and Sales Experience

 

We currently have limited experience in marketing and selling our products. To the extent that we have established or will enter into distribution arrangements for the sale of our products, we are and will be dependent

 

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upon the efforts of third parties. We are marketing and selling our arthroscopic surgery, spinal surgery and ENT surgery product lines in the United States through a combination of a direct sales force and a network of independent distributors supported by regional sales managers. These distributors sell arthroscopy, spinal surgery and ENT surgery products for a number of other manufacturers. We cannot assure you that these distributors will commit the necessary resources to effectively market and sell our sports medicine, spinal surgery and ENT surgery product lines, or that they will be successful in selling our products.

 

We Are Dependent on Key Suppliers

 

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

 

In addition, we currently single source our product sterilization requirements. While there are alternate sources available, we would be required to qualify and validate a new supplier(s), which could lead to a disruption in our operation and ability to supply products for a period of time.

 

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

 

We Face Risks due to Business Integration

 

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

 

We Face Intense Competition

 

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

 

In arthroscopy, we compete against companies, such as Johnson & Johnson, Smith & Nephew, Inc., Conmed Corporation, Stryker Corp., and Arthrex. Specifically, Johnson & Johnson, Smith & Nephew and Stryker are currently marketing bipolar electrosurgical systems for tissue ablation and shrinkage. We are also aware of additional competitors that may commercialize products using technology similar to ours. In spinal surgery, we compete against companies that market products to remove tissue and treat spinal disorders. We

 

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compete against Stryker, which markets the Dekompressor device, which uses a mechanical auger to perform percutaneous discectomy. In addition, the Oratec division of Smith & Nephew, and the Radionics division of Tyco, are currently marketing percutaneous thermal heating products for treating certain types of disc pain. Our Coblation-assisted microdiscectomy (CAM) procedure competes indirectly with large spine companies and their mechanical instruments, such as DePuy Acromed, Medtronic Sofamor Danek, Centerpulse Spine Tech, Stryker Spine and Synthes. In ENT surgery, we compete against companies that offer manual instruments, such as Smith & Nephew, Inc., Stryker Corp., Conmed Corporation, and Xomed Surgical Products Inc., which was acquired by Medtronic, Inc. In addition, we compete with companies that develop and market lasers for various ENT surgery applications, including Lumenis. Smaller companies, including Somnus Medical Technologies Inc. (purchased by Gyrus Group International, Inc., a company based in Cardiff, Wales), also sell medical devices for the treatment of various ENT disorders, including snoring and obstructive sleep apnea.

 

Many of our competitors have significantly greater financial, manufacturing, marketing, distribution and technical resources than we do. Some of these companies offer broad product lines that they may offer as a single package and frequently offer significant discounts as a competitive tactic. For example, in order to compete successfully, we anticipate that we may have to continue to offer substantial discounts on our controllers, place controllers at customers sites at no cost or in return for a minimum purchase commitment of our surgical wands in order to increase demand for our disposable devices, and that this competition could have a material adverse effect on our business, financial condition, results of operations and future growth prospects. Furthermore, some of our competitors utilize purchasing contracts that link discounts on the purchase of one product to purchases of other products in their broad product lines. Many of the hospitals in the United States have purchasing contracts with our competitors. Accordingly, customers may be dissuaded from purchasing our products rather than the products of these competitors to the extent the purchase would cause them to lose discounts on products.

 

We Face Uncertainty Over Reimbursement

 

Failure by physicians, hospitals and other users of our products to obtain sufficient reimbursement from health care payers for procedures in which our products are used, or adverse changes in environmental and private third-party payers’ policies toward reimbursement for such procedures would have a material adverse effect on our business, financial condition, results of operations and future growth prospects. Reimbursement for arthroscopic, spinal surgery, neurosurgery, ENT surgery, gynecology, urology, cardiology and general surgery procedures performed using our devices that have received FDA clearance has generally been available in the United States. Typically, cosmetic surgery procedures are not reimbursed.

 

We are unable to predict what changes will be made in the reimbursement methods used by third-party health care payors. In addition, some health care providers are moving toward a managed care system in which providers contract to provide comprehensive health care for a fixed cost per person. Managed care providers are attempting to control the cost of health care by authorizing fewer elective surgical procedures. We anticipate that in a prospective payment system, such as the diagnosis related group system utilized by Medicare, and in many managed care systems used by private health care payers, the cost of our products will be incorporated into the overall cost of the procedure and that there will be no separate, additional reimbursement for our products.

 

If we obtain the necessary international regulatory approvals, market acceptance of our products in international markets would be dependent, in part, upon the availability of reimbursement within prevailing health care payment systems. Reimbursement and health care payment systems in international markets vary significantly by country and include both government-sponsored health care and private insurance. We intend to seek international reimbursement approvals, although we cannot assure you that any such approvals will be obtained in a timely manner, if at all.

 

Nucleoplasty is our version of percutaneous discectomy, where tissue is removed from the nucleus to decompress the disc. Several payors consider percutaneous discectomy in any form investigational, and others cover percutaneous discectomy, but consider Nucleoplasty investigational. There is no assurance that we will be able to obtain coverage with these payors for percutaneous discectomy in general, and Nucleoplasty specifically.

 

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Our Operating Results Will Fluctuate

 

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

 

    The introduction of new product lines;

 

    Increased penetration in existing applications;

 

    Product returns;

 

    Achievement of research and development milestones;

 

    The amount and timing of receipt and recognition of license fees;

 

    Manufacturing or supply disruptions;

 

    Internal systems availability and uptimes;

 

    Timing of expenditures;

 

    Absence of a backlog of orders;

 

    Receipt of necessary regulatory approvals;

 

    The level of market acceptance for our products;

 

    Timing of the receipt of orders and product shipments; and

 

    Promotional programs for our products.

 

We cannot assure you that future quarterly fluctuations will not adversely affect our business, financial condition, results of operations of future growth prospects. Our revenues and profitability will be critically dependent on whether or not we can successfully continue to market our Coblation-based technology product lines and continue to integrate our recent acquisitions. We cannot assure you that we will maintain or increase our revenues or level of profitability.

 

We May Be Unable to Effectively Protect Our Intellectual Property

 

Our ability to compete effectively depends in part on developing and maintaining the proprietary aspects of our Coblation technology. We believe that our issued patents are directed at the core technology used in our soft-tissue surgery systems, including both multi-electrode and single electrode configurations of our disposable devices, as well as the use of Coblation technology in specific surgical procedures.

 

We cannot assure you that the patents we have obtained, or any patents we may obtain as a result of our pending U.S. or international patent applications, will provide any competitive advantages for our products. We also cannot assure you that those patents will not be successfully challenged, invalidated or circumvented in the future. In addition, we cannot assure you that competitors, many of which have substantial resources and have made substantial investments in competing technologies, have not already applied for or obtained, or will not seek to apply for and obtain, patents that will prevent, limit or interfere with our ability to make, use and sell our products either in the United States or in international markets. Patent applications are maintained in secrecy for a period after filing. We may not be aware of all of the patents and patent applications potentially adverse to our interests.

 

A number of medical device and other companies, universities and research institutions have filed patent applications or have issued patents relating to monopolar and/or bipolar electrosurgical methods and apparatus. We have received, and we may receive in the future, notifications of potential conflicts of existing patents, pending patent applications and challenges to the validity of existing patents. In addition, we have become aware of, potential conflicts of existing patents, pending patent applications and challenges to the validity of existing

 

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

 

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

 

We May Become Subject to Patent Litigation

 

The medical device industry has been characterized by extensive litigation regarding patents and other intellectual property rights, and companies in the medical device industry have employed intellectual property litigation to gain a competitive advantage. We cannot assure you that we will not become subject to patent infringement claims or litigation or interference proceedings declared by the United States Patent and Trademark office, the USPTO, to determine the priority of inventions. In February 1998, we filed a lawsuit against Ethicon, Inc., Mitek Surgical Products, a division of Ethicon, Inc., and GyneCare, Inc. alleging, among other things, infringement of several of our patents. The parties subsequently settled this lawsuit. Under the terms of the settlement, Ethicon, Inc. has licensed a portion of our U.S. patents for current products in the arthroscopy and hysterocopic gynecology markets. The settlement agreement also established a procedure for resolution of certain potential intellectual property disputes in these two markets without litigation. Under this procedure, the licenses granted in the Ethicon settlement have been extended to Australia, Canada and Japan. In June 2000, we filed a lawsuit against Stryker, alleging infringement of several of our patents. The lawsuit has been settled and under the terms of the settlement, Stryker has licensed a portion of our worldwide patents for products in the arthroscopy market.

 

In July 2001, we filed a lawsuit against Smith & Nephew alleging infringement of several of our patents. On May 12, 2003, the jury held that the use, manufacture and sale of the Dyonics Control RF System, the ElectroBlade and the Saphyre electrosurgical devices infringed all 16 asserted claims of the three patents in suit. In addition, the jury upheld the validity of all 16 asserted claims. The court entered this verdict in June 2003 and held a hearing on September 15, 2003 to consider Smith & Nephew’s motions to overturn the jury’s verdict. On March 10, 2004, the U.S. District Court in Delaware granted our motion to permanently enjoin Smith & Nephew from manufacturing, using or selling in the United States surgical devices (the Saphyre, Dyonics Control RF and ElectroBlade) that infringe our patents. In addition, the Court denied all of Smith & Nephew’s post-trial motions, including those requesting a new trial and for judgment as a matter of law. The Court also granted our motions for judgment of no inequitable conduct and dismissal of the antitrust counterclaim. On April 27, 2004, the Court rejected Smith & Nephew’s request for a stay of the permanent injunction pending appeal. On June 10, 2004, the Court issued an injunction order enjoining Smith & Nephew from the use, manufacture and sale of the infringing products in the United States. Smith & Nephew’s has appealed the above rulings in the Federal Circuit Court of Appeals. In addition, the U.S. District Court is to hold a second trial to award damages to us for the infringing activity of Smith & Nephew.

 

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

 

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

 

The Market Price of Our Stock May Be Highly Volatile

 

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

 

    Quarterly fluctuations in results of our operations;

 

    Our ability to successfully commercialize our products;

 

    Announcements regarding results of regulatory approval filing, clinical studies or other testing, technological innovations or new products commercialized by us or our competitors;

 

    Developments concerning government regulations, proprietary rights or public concern as to the safety of our technology;

 

    The execution of new collaborative agreements and material changes in our relationships with our business partners;

 

    Market reaction to acquisitions and trends in sales, marketing, and research and development;

 

    Changes in coverage or earnings estimates by analysts;

 

    Sales of common stock by existing stockholders; and

 

    Economic and political conditions.

 

The market price for our common stock may also be affected by our ability to meet analysts’ expectations. Any failure to meet such expectations, even slightly, could have an adverse effect on the market price and volume fluctuations. This volatility has had a significant effect on the market prices of securities issued by many companies for reasons unrelated to the operating performance of these companies. In the past, following periods of volatility in the market price of a company’s securities, securities class action litigation has often been instituted against us. If similar litigation were instituted against us, it could result in substantial costs and a diversion of our management’s attention and resources, which could have an adverse effect on our business, results of operations and financial condition. See “Item 5: Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities,” for more information regarding fluctuations in the price of our common stock.

 

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Delaware Law, Provisions in Our Charter and Our Stockholder Rights Plan Could Make the Acquisition of Our Company By Another Company More Difficult

 

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

 

We Must Obtain Governmental Clearances or Approvals Before We Can Sell Our Products; We must Continue To Comply With Applicable Laws and Regulations

 

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

 

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

 

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

 

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

 

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ITEM 2.    PROPERTIES

 

We lease an approximately 4,800 square foot facility in Austin, Texas for general and administrative purposes. Our lease for this building will expire in June 2006. We lease an approximately 52,000 square foot facility in Sunnyvale, California for administrative offices, research and development, general and administrative purposes, advanced manufacturing, warehousing, and distribution. Our lease for this building will expire in February 2007.

 

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

 

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

 

We believe these facilities are sufficient for our operations through 2005.

 

ITEM 3.    LEGAL PROCEEDINGS

 

On July 25, 2001, we filed a lawsuit against Smith & Nephew, Inc. (Smith & Nephew) in the United States District Court of Delaware. The lawsuit alleges, among other things, that Smith & Nephew has been, and is currently, infringing three patents issued to ArthroCare. Specifically, Smith & Nephew uses, imports, markets and sells electrosurgical products under the names of Dyonics Control RF System, ElectroBlade and Saphyre that infringe these patents. We seek the following remedies: (1) a judgment that Smith & Nephew has infringed these patents; (2) a permanent injunction precluding Smith & Nephew from using, importing, marketing and selling the above-referenced products; and (3) an award of damages (including attorneys’ fees) to compensate us for lost profits and Smith & Nephew’s use of our inventions with the damages to be trebled because of Smith & Nephew’s willful infringement. On May 12, 2003, the jury held that the use, manufacture and sale of the Dyonics Control RF System, the ElectroBlade and the Saphyre electrosurgical devices infringed all 16 asserted claims of the three patents in suit. In addition, the jury upheld the validity of all 16 asserted claims. The court entered this verdict in June 2003 and held a hearing on September 15, 2003 to consider Defendant’s motions to overturn the jury’s verdict. On March 10, 2004, the U.S. District Court in Delaware granted our motion to permanently enjoin Smith & Nephew from manufacturing, using or selling in the United States surgical devices (the Saphyre, Dyonics Control RF and ElectroBlade) that infringe our patents. In addition, the Court denied all of Smith & Nephew’s post-trial motions, including those requesting a new trial and for judgment as a matter of law. The Court also granted our motions for judgment of no inequitable conduct and dismissal of the antitrust counterclaim. On April 27, 2004, the Court rejected Smith & Nephew’s request for a stay of the permanent injunction pending appeal. On June 10, 2004, the Court issued an injunction order enjoining Smith & Nephew from the use, manufacture and sale of the infringing products in the United States. Smith & Nephew’s has appealed the above rulings in the Federal Circuit Court of Appeals. In addition, the U.S. District Court is to hold a second trial to award damages to us for the infringing activity of Smith & Nephew.

 

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

 

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

 

In July 2003, a product liability suit was brought against us in the New York State Supreme Court, County of Westchester. The lawsuit alleged that a patient suffered injury to her shoulder as a result of a defective ArthroCare probe used in an arthroscopic procedure on the patient. We believe these claims to be without merit and will defend ourselves vigorously.

 

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

 

In connection with a medical malpractice suit against a physician, a product liability suit was brought against us in the 269th Judicial District Court, Harris County, Texas in September 2002. The lawsuit alleged that a patient suffered internal and external injury to the patient’s ankle as a result of a defective ArthroCare probe used in an arthroscopic procedure on the patient. The parties settled this suit in 2004.

 

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

 

On October 27, 2003, a product liability suit was brought against us in the 9th Judicial Circuit, Orange County, Florida. The lawsuit alleges, among other things, that a patient died on July 27, 2001 as a result of a defective ArthroCare product used in a tonsillectomy procedure on the patient. We believe these claims to be without merit and will defend ourselves vigorously.

 

On March 1, 2004, a product liability suit was brought against us in the Circuit Court of Tennessee for the 30th Judicial District at Memphis. The lawsuit alleges that a patient suffered injury to her shoulder as a result of a defective ArthroCare probe used in an arthroscopic procedure on the patient. We believe these claims to be without merit and intend to defend ourselves vigorously.

 

On April 12, 2004, a product liability suit was brought against us in the 4th Judicial District Court, Utah County, Utah. The lawsuit alleges, among other things, that a patient was injured as a result of a defective ArthroCare product used in an arthroscopic procedure on the patient in September 1999. Upon initial review, we believe these claims to be without merit and intend to defend ourselves vigorously.

 

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

 

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

 

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

 

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

 

As part of our acquisition of MDA, we inherited two product liability suits filed against Lysonix, Inc., a manufacturer of ultrasonic liposuction equipment and a wholly-owned subsidiary of MDA. At the time of our acquisition of MDA, MDA had sold the assets of Lysonix and was no longer selling any Lysonix equipment. In one of the cases, a product liability suit was brought against Lysonix in the 120th Judicial District Court, El Paso County, Texas. The lawsuit alleges, among other things, that a patient died after an ultrasonic-assisted liposuction procedure on October 16, 2000 at least partly as a result of Lysonix’s failure to timely warn the physician of the potential risks associated with the product. This case was settled in 2004. In the other case, a product liability suit was brought against Lysonix in the Circuit Court of Jefferson County, Alabama. The lawsuit alleges, among other things, that a patient died on January 20, 2001 after a liposuction procedure at least partly as a result of a design defect with a pressure garment sold by Lysonix. This case was settled in 2004.

 

We believe that we have meritorious defenses against the above claims and intend to vigorously contest them. The outcomes of the outstanding litigation matters discussed above are not considered probable or cannot be reasonably estimated for the purpose of recording a liability. Also, except as otherwise described above, we have product liability insurance coverage in amounts we consider necessary to prevent material losses. We record a liability when a loss is known or considered probable and the amount can be reasonably estimated. If a loss is not probable or a probable loss cannot be reasonably estimated, a liability is not recorded.

 

ITEM 4.    SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

 

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

 

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PART II

 

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

 

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

 

     2004

     Quarter 1

   Quarter 2

   Quarter 3

   Quarter 4

High

   $ 27.30    $ 29.35    $ 29.94    $ 33.11

Low

     21.54      19.76      22.56      26.98
     2003

     Quarter 1

   Quarter 2

   Quarter 3

   Quarter 4

High

   $ 12.75    $ 18.20    $ 21.37    $ 25.88

Low

     8.65      12.38      12.65      17.67

 

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

 

EQUITY COMPENSATION PLAN INFORMATION

 

The following table provides information as of December 31, 2004 regarding the common stock that may be issued upon the exercise of options, warrants and rights under our existing equity compensation plans, including the Company’s 2003 Incentive Stock Plan, 1993 Incentive Stock Plan, 1995 Director Option Plan and 1996 Employee Stock Purchase Plan.

 

Plan category


  

Number of securities
to be issued upon
exercise of
outstanding options,
warrants and rights

(a)


  

Weighted-average
exercise price of
outstanding
options, warrants
and rights

(b)


  

Number of securities
remaining available
for future issuance
under equity
compensation plans
(excluding securities
reflected in column (a))

(c)


 

Equity compensation plans approved by security holders

   2,908,066    $ 13.44    1,077,404 (1)

Equity compensation plans not approved by security holders (2)

   2,455,253    $ 18.11    302,307  
    
  

  

Total

   5,363,319    $ 17.40    1,379,711  
    
  

  


(1) Includes 131,775 shares remaining available for future issuance under the Company’s 1996 Employee Stock Purchase Plan.
(2) Consists of shares issuable under our Amended and Restated Non-statutory Option Plan, which does not require the approval of and has not been approved by our stockholders.

 

AMENDED AND RESTATED NONSTATUTORY OPTION PLAN

 

The Company’s Amended and Restated Nonstatutory Option Plan (the “NSO Plan”) provides for the grant of options to employees and consultants of the Company. The NSO Plan was initially adopted by the Board of Directors of the Company in May 1999. As of April 1, 2005, a total of 3,550,000 shares of common stock are reserved for issuance under the NSO Plan, options for 2,455,253 shares were outstanding under the NSO Plan,

 

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and 302,307 remained available for future grants. The NSO Plan is not required to be and has not been approved by the Company’s stockholders.

 

Options granted under the NSO Plan will be non-statutory stock options. Incentive stock options, within the meaning of Section 422 of the Code, may not be granted under the NSO Plan. The NSO Plan also authorizes the grant of stock purchase rights to our employees and consultants.

 

Eligibility; Administration.    The NSO Plan provides that awards may be granted to employees and consultants of the Company or any parent or subsidiary of the Company. However, officers and directors of the Company are not eligible to receive awards under the NSO Plan. As of April 1, 2005, approximately 295 people were eligible to participate in the NSO Plan. The NSO Plan may be administered by the Board or Board Committees (the “Administrator”). The Administrator of the NSO Plan will have full power to select, from among the employees and consultants of the Company eligible for awards, the individuals to whom awards will be granted, to make any combination of awards to any participant and to determine the specific terms of each grant, subject to the provisions of the NSO Plan. The interpretation and construction of any provision of the NSO Plan by the Administrator will be final and conclusive.

 

Exercise Price.    The exercise price of options granted under the NSO Plan is determined by the Administrator. Non-statutory options may be granted with a per share exercise price below the fair market value per share of the common stock at the time of grant. In the event of any such below fair market value grant, the difference between fair market value on the date of grant and the exercise price will be treated as the compensation expense for accounting purposes and will therefore affect the Company’s earnings.

 

Exercisability.    The Administrator has discretion in determining the vesting schedule for each option granted. Options granted to new optionees under the NSO Plan generally become exercisable starting one year after the date of grant with 25% of the shares covered thereby becoming exercisable at that time and with an additional 1/48 of the total number of options becoming exercisable at the beginning of each full month thereafter, with full vesting occurring on the fourth anniversary of the date of grant. The term of an option will be determined by the Administrator.

 

Exercisability Following Termination of Employment.    If an optionee’s employment or consulting relationship terminates for any reason (other than death or disability), then all options held by the optionee under the NSO Plan expire on the earlier of (1) the date set forth in his or her notice of grant, or (2) the expiration date of such option. In the absence of a specified time in the notice of grant, an option will remain exercisable for 90 days following an optionee’s termination (other than for death or disability). To the extent the option is exercisable at the time of the optionee’s termination, the optionee may exercise all or part of his or her option at any time before it terminates.

 

Exercisability Following Disability.    If an optionee’s employment or consulting relationship terminates as a result of disability, then all options held by such optionee under the NSO Plan expire on the earlier of (1) 12 months from the date of such termination or (2) the expiration date of such option. The optionee (or the optionee’s estate or a person who has acquired the right to exercise the option by bequest or inheritance) may exercise all or part of the option at any time before such expiration to the extent that the option was exercisable at the time of such termination.

 

Exercisability Following Death.    In the event of an optionee’s death, the option may be exercised at any time within 12 months of the date of death (but no later than the expiration date of such option) by the optionee’s estate or a person who has acquired the right to exercise the option by bequest or inheritance, but only to the extent that the option was exercisable at the time of such death.

 

Stock Purchase Rights.    The NSO Plan permits the Company to grant rights to purchase common stock. After the Administrator determines that it will offer stock purchase rights under the NSO Plan, it will advise the

 

33


offeree in writing or electronically of the terms, conditions and restrictions related to the offer, including the number of shares that the offeree will be entitled to purchase, and the time within which the offeree must accept such offer. The Administrator will establish the purchase price, if any, and form of payment for each stock purchase right. The offer will be accepted by execution of a stock purchase agreement or a stock bonus agreement in the form determined by the Administrator.

 

Unless the Administrator determines otherwise, the stock purchase agreement or a stock bonus agreement will grant the Company a repurchase option exercisable upon the voluntary or involuntary termination of the purchaser’s employment with the Company for any reason. The purchase price for shares repurchased pursuant to the stock purchase agreement or a stock bonus agreement will be the original price paid by the purchaser and may be paid by cancellation of any indebtedness of the purchaser to the Company. The repurchase option will lapse at such rate as the Administrator may determine.

 

Transferability of Awards.    No award may be transferred by the holder other than by will or the laws of descent or distribution. Each award may be exercised, during the lifetime of the holder only by such holder.

 

Adjustments Upon Changes in Common Stock.    If any change is made in the common stock subject to the NSO Plan, without receipt of consideration by the Company (through merger, consolidation, reorganization, recapitalization, stock dividend, dividend in property other than cash, stock split, liquidating dividend, combination of shares, exchange of shares, change in corporate structure or otherwise), the number of shares reserved for issuance under the NSO Plan and awards outstanding thereunder and the class, number of shares and price per share of common stock subject to outstanding awards will be appropriately adjusted. The conversion of convertible securities of the Company will not be deemed to have been “effected without receipt of consideration.”

 

In the event of the dissolution or liquidation of the Company, each outstanding award will terminate immediately prior to the consummation of such proposed action. The Administrator may provide that the vesting of outstanding awards will be accelerated and such awards will be fully exercisable prior to such transaction.

 

In the event of a merger of the Company with or into another corporation or the sale of all or substantially all of the assets of the Company, then outstanding options will be assumed or substituted for by the acquiring company or one of its affiliates. In the absence of or in lieu of any such assumption or substitution, the Administrator may provide that the vesting of outstanding awards will be accelerated and such awards will be fully exercisable for a period of at least 15 days prior to such transaction. Awards that are not assumed or substituted for and accelerated options not exercised before the closing of such a transaction will terminate automatically at the closing of the transaction.

 

Amendment and Termination of the NSO Plan.    The Board may amend or terminate the NSO Plan at any time. However, no action by the Board may alter or impair any option previously granted under the NSO Plan. The Administrator may accelerate any option or waive and condition or restriction pertaining to such option at any time. Any options outstanding under the Plan at the time of its termination will remain outstanding until they expire by their terms.

 

FEDERAL INCOME TAX CONSEQUENCES

 

Non-Statutory Stock Options.    An optionee does not recognize any taxable income at the time he or she is granted a non-statutory stock option. Upon exercise, the optionee recognizes taxable income generally measured by the excess of the then fair market value of the shares over the exercise price. Any taxable income recognized in connection with an option exercise by an employee of the Company is subject to tax withholding by the Company. The Company is generally entitled to a deduction in the same amount as the ordinary income recognized by the optionee. Upon a disposition of such shares by the optionee, any difference between the sale price and the optionee’s exercise price, to the extent not recognized as taxable income as provided above, is treated as long-term or short-term capital gain or loss, depending on the holding period.

 

34


Stock Purchase Rights.    For federal income tax purposes, if an individual is granted a stock purchase right, the recipient generally will recognize taxable ordinary income equal to the excess of the common stock’s fair market value over the purchase price, if any. However, to the extent the common stock is subject to certain types of restrictions, such as a repurchase right in favor of the Company, the taxable event will be delayed until the vesting restrictions lapse unless the recipient makes a valid election under Section 83(b) of the Code. If the recipient makes a valid election under Section 83(b) of the Code with respect to restricted stock, the recipient generally will recognize ordinary income at the date of acquisition of the restricted stock in an amount equal to the difference, if any, between the fair market value of the shares at that date over the purchase price for the restricted stock. If, however, a valid Section 83(b) election is not made by the recipient, the recipient will generally recognize ordinary income when the restrictions on the shares of restricted stock lapse, in an amount equal to the difference between the fair market value of the shares at the date such restrictions lapse over the purchase price for the restricted stock. With respect to employees, the Company is generally required to withhold from regular wages or supplemental wage payments an amount based on the ordinary income recognized. Generally, the Company will be entitled to a business expense deduction equal to the taxable ordinary income realized by the recipient. Upon disposition of the common stock, the recipient will recognize a capital gain or loss equal to the difference between the selling price and the sum of the amount paid for such common stock, if any, plus any amount recognized as ordinary income upon acquisition (or the lapse of restrictions) of the common stock. Such gain or loss will be long-term or short-term depending on how long the common stock was held. Slightly different rules may apply to recipients who are officers, directors or 10% stockholders of the Company.

 

The foregoing is only a summary of the effect of federal income taxation upon optionees, holders of restricted stock awards or stock bonus awards and the Company with respect to the grant and exercise of awards under the NSO Plan. It does not purport to be complete, and does not discuss the tax consequences of the employee’s or consultant’s death or the provisions of the income tax laws of any municipality, state or foreign country in which the employee or consultant may reside.

 

35


ITEM 6.    SELECTED FINANCIAL DATA

 

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

 

     Year Ended December 31,

 
     2004

    2003

   2002

   2001

   2000

 
     (in thousands, except per share data)  

Statements of Operations Data:

                                     

Product sales

   $ 147,830     $ 114,719    $ 84,965    $ 70,300    $ 62,164  

Royalties, fees and other

     6,318       4,134      3,822      8,075      3,615  

Total revenues

     154,148       118,853      88,787      78,375      65,779  

Gross profit

     103,048       80,912      55,378      50,684      40,117  

Operating expenses

     126,801       72,767      56,225      42,994      32,619  

Income/(Loss) before cumulative effect of change in accounting principle

     (26,189 )     7,456      1,132      10,060      15,845  

Cumulative effect of the application of SAB 101

     —         —        —        —        (4,300 )

Net income/(loss)

     (26,189 )     7,456      1,132      10,060      11,545  

Basic net income (loss) per share

   $ (1.21 )   $ 0.36    $ 0.05    $ 0.45    $ 0.53  

Diluted net income (loss) per share

   $ (1.21 )   $ 0.34    $ 0.05    $ 0.43    $ 0.50  
     December 31,

 
     2004

    2003

   2002

   2001

   2000

 
     (in thousands)  

Balance Sheet Data:

        

Cash, cash equivalents and available-for-sale securities (including long-term portion)

   $ 21,836     $ 31,318    $ 52,851    $ 76,695    $ 86,814  

Working capital

     80,912       67,670      72,939      98,642      97,013  

Total assets

     240,531       138,138      135,952      133,697      140,462  

Long-term liabilities

     34,290       155      161      53      4,758  

Total stockholders’ equity(1)

     175,252       120,648      118,163      125,093      126,345  

(1) We have not declared any cash dividends on our common stock since our inception and we do not anticipate paying cash dividends in the foreseeable future.

 

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

 

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

 

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Overview

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Results of Operations

 

     Year Ended December 31,

 
(Dollar amounts in thousands)    2004

    2003

    2002

 

Revenues:

                                         

Product sales

   $ 147,830     96 %   $ 114,719    97 %   $ 84,965     96 %

Royalties, fees and other

     6,318     4 %     4,134    3 %     3,822     4 %
    


       

        


     

Total revenues

     154,148     100 %     118,853    100 %     88,787     100 %

Cost of product sales

     51,100     33 %     37,941    32 %     33,409     38 %
    


       

        


     

Gross profit

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


       

        


     

Operating expenses:

                                         

Research and development

     13,346     9 %     10,642    9 %     8,826     10 %

Sales and marketing

     58,087     38 %     46,100    39 %     36,519     41 %

General and administrative

     16,310     10 %     14,845    12 %     10,679     12 %

Amortization of intangible assets

     2,658     2 %     1,180    1 %     201     0 %

Acquired in-process research & development costs

     36,400     23 %     —              —          
    


       

        


     

Total operating expenses

     126,801     82 %     72,767    61 %     56,225     63 %
    


       

        


     

Income (loss) from operations

     (23,753 )   -15 %     8,145    7 %     (847 )   -1 %

Interest income and other, net

     824     0 %     2,357    2 %     2,545     3 %
    


       

        


     

Income (loss) before income taxes

     (22,929 )   -15 %     10,502    9 %     1,698     2 %

Income tax provision

     3,260     2 %     3,046    3 %     566     1 %
    


       

        


     

Net income (loss)

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


       

        


     

 

Revenues

 

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

 

     Year Ended December 31,

 
     2004

    2003

    2002

 

Sports Medicine

   $ 97,574    66 %   $ 82,114    72 %   $ 65,412    77 %

ENT

     28,357    19 %     17,169    15 %     10,195    12 %

ArthroCare Spine

     21,614    15 %     14,229    12 %     8,606    10 %

Coblation Technology

     285    0 %     1,207    1 %     752    1 %
    

        

        

      

Total Product Sales

   $ 147,830    100 %   $ 114,719    100 %   $ 84,965    100 %
    

        

        

      

 

38


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

 

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

 

     Year Ended December 31,

 
     2004

    2003

    2002

 

United States

   $ 111,453    75 %   $ 86,687    76 %   $ 70,088    82 %

United Kingdom

     11,053    8 %     8,476    7 %     2,627    3 %

Rest of World

     25,324    17 %     19,556    17 %     12,250    15 %
    

        

        

      

Total Product Sales

   $ 147,830    100 %   $ 114,719    100 %   $ 84,965    100 %
    

        

        

      

 

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

 

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

 

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

 

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

 

39


Cost of Product Sales

 

Cost of product sales consists of manufacturing costs, material costs, labor costs, manufacturing overhead, warranty and other direct product costs. Additionally, cost of product sales includes amortization of controller unit placements under a program whereby we maintain ownership of controller units shipped to customers, with the costs being capitalized and amortized into cost of product sales over the useful life of the controller unit. Cost of product sales for the quarters in 2003 and 2004 included amortization of capitalized controllers as follows (Dollar amounts in thousands):

 

     2003

    2004

 

Product Sales

   $ 114,719     $ 147,830  

Controller Depreciation

     4,968       6,331  

Depreciation as % of Product Sales

     4 %     4 %

 

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

 

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

 

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

 

Operating Expenses

 

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

 

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

 

40


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

 

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

 

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

 

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

 

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

 

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

 

41


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

 

     (In thousands)
Acquired IPR&D
Project Type

   Projected
Cost to
Complete


  

Estimated

Completion Date


   Value

Shoulder joint repairs

   $ 784    December 31, 2005    $ 11,000

Implantables

     392    December 31, 2005      25,000

Tendon repairs

     392    December 31, 2005      400
    

       

Total

   $ 1,568         $ 36,400
    

       

 

Interest and Other Income, Net

 

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

 

Income Tax Provision

 

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

 

Liquidity and Capital Resources

 

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

 

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

 

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

 

Accounts receivable, net of allowances, increased to $34.0 million at December 31, 2004 from $24.1 million at December 31, 2003. The increase in accounts receivable in 2004 was due to the significant increase in sales, slightly offset by an improvement in average collection times. In addition, in connection with a review of outstanding U.S. accounts receivable, we wrote-off old credits of approximately $0.6 million in 2004. See Schedule II on page 101 for a summary of activity in this account.

 

42


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

 

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

 

In the past, we have financed our operating and capital needs principally with cash from product sales, cash, cash equivalents, and available-for-sale securities and related interest income, and existing capital resources. However, in October 2003, we announced our intent to acquire MDA, an acquisition which was completed in January 2004, pursuant to which we were to make an initial cash payment of approximately $24.2 million in cash, net of certain holdbacks, which used a significant portion of our cash reserves. In anticipation of this acquisition, we entered into a $15.0 million revolving credit facility and a $15.0 million term credit facility with Bank of America, N.A. and Wells Fargo Bank, National Association, as co-lenders. Under the terms of the revolving credit facility, we were able to borrow up to $15.0 million at the Bank of America prime rate plus 0.0% to 0.5% or at LIBOR plus 1.75% to 2.25%, at our discretion, for operating needs. The increase over the base rate is determined by our leverage ratio, as defined in the credit facility. Under the terms of the term credit facility, we could borrow $15.0 million for specified acquisitions at the same rates as noted above. The credit facility contained covenants which specify minimum financial ratios and limit our ability to take on additional debt, or make future acquisitions or dispositions. On January 28, 2004, in connection with the acquisition of MDA, we borrowed $15.0 million under the term credit facility. In September 2004, we repaid the entire $15.0 million borrowed under the term credit facility.

 

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

 

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

 

43


We believe that the above-described credit and term facilities, in addition to cash generated from operations, will be sufficient to fund our operations through fiscal year 2005 and in the near future. Our future liquidity and capital requirements will depend on numerous factors, including our success in commercializing our products, development and commercialization of products in fields other than arthroscopy, the ability of our suppliers to continue to meet our demands at current prices, obtaining and enforcing patents important to our business, the status of regulatory approvals and competition.

 

Disclosures about Contractual Obligations and Commercial Commitments

 

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

 

    

Payments Due by Period

(In thousands)


     Total

   Less
than 1
Year


   1-3
Years


   4-5
Years


  

After

5 Years


Operating Lease Obligations

   $ 4,798    $ 2,348    $ 2,450    $ —      $ —  

Contractual Obligations to Former Atlantech Owners

   $ 2,176    $ 1,064    $ 1,112    $ —      $ —  

Debt Obligations

   $ 28,929    $ 4,286    $ 12,857    $ 8,571    $ 3,214

Payments to MDA Shareholders and other assumed liabilities

   $ 3,451    $ 3,451    $ —      $ —      $ —  

Payments to Opus Medical Shareholders

   $ 40,316    $ 316    $ 40,000    $ —      $ —  
    

  

  

  

  

Total

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

  

  

  

  

 

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

 

Critical Accounting Policies

 

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

 

Revenue Recognition

 

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

 

44


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

 

Inventory Allowance

 

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

 

Warranty Costs

 

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

 

Acquired In-Process Research and Development (IPR&D)

 

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

 

Goodwill Impairment

 

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

 

Impairment of Long-Lived Assets.

 

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

 

45


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

 

Contingencies

 

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

 

Stock-Based Compensation.

 

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

 

Recent Accounting Pronouncements

 

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

 

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

 

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

 

46


ITEM 7A.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

Our exposure to market risk for changes in interest rates relates primarily to our investment portfolio, including short-term investments and cash and cash equivalents. We do not use derivative financial instruments in our investment portfolio.

 

We are subject to fluctuating interest rates that may impact, adversely or otherwise, our results of operations or cash flows for our cash and cash equivalents.

 

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

 

Cash and cash equivalents

   $ 21,836  

Average interest rate

     2.2 %

 

Although payments under the operating leases for our facility are tied to market indices, we are not exposed to material interest rate risk associated with operating leases.

 

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

 

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

 

ITEM 8.    FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

 

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

 

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

 

None.

 

ITEM 9A.    CONTROLS AND PROCEDURES

 

Evaluation of Disclosure Controls and Procedures

 

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

 

47


We carried out an evaluation under the supervision and with the participation of our management, including the CEO and CFO, of the effectiveness of the design and operation of our disclosure controls and procedures as of December 31, 2004. Based upon this evaluation, our CEO and CFO have concluded that, because of the material weakness described below, our disclosure controls and procedures were not effective as of December 31, 2004. In light of the material weakness described below, we performed additional analysis and other post-closing procedures to ensure that the consolidated financial statements were prepared in accordance with generally accepted accounting principles. Accordingly, management believes that the financial statements included in this report fairly present in all material respects our financial condition, results of operations and cash flows for the periods presented.

 

Management’s Report on Internal Control Over Financial Reporting

 

Our management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) of the Exchange Act. Our internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness of internal control over financial reporting to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

Management has assessed the effectiveness of our internal control over financial reporting as of December 31, 2004. In making its assessment of internal control over financial reporting, management used the criteria described in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations (“COSO”) of the Treadway Commission.

 

Management has excluded Opus Medical, Inc. (“Opus”) from its assessment of the Company’s internal control over financial reporting as of December 31, 2004 because Opus was acquired through a purchase business combination in November 2004. Opus’s total assets and total revenue represent approximately 17% and 2%, respectively, of our related consolidated financial statements amounts as of and for the year ended December 31, 2004.

 

A material weakness is a control deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. As of December 31, 2004, we identified a material weakness in our internal control over financial reporting, which is described below.

 

At December 31, 2004, we did not maintain effective controls over the recording of certain foreign exchange transactions. Specifically, we did not perform adequate analysis and review of the accuracy of the recording of the translation of our foreign subsidiaries’ financial information denominated in currencies other than U.S. dollars. This control deficiency resulted in the restatement of our consolidated financial statements for the quarters ended March 31, 2004 and June 30, 2004. Additionally, this control deficiency could result in a misstatement to the other income or related accounts that would result in a material misstatement of annual or interim financial statements that would not be prevented or detected. Because of this material weakness, we have concluded that the Company did not maintain effective internal control over financial reporting as of December 31, 2004, based on criteria in Internal Control—Integrated Framework.

 

Management’s assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2004, has been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, as stated in their report which appears herein.

 

48


Changes in Internal Control Over Financial Reporting

 

There were no changes in our internal control over financial reporting that occurred during the quarter ended December 31, 2004 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

However, to remediate the material weakness described above, management is implementing an internal control that requires our finance group to complete a top down review of the reasonableness of foreign currency transactions on a monthly basis and our Swedish subsidiary will maintain its original accounting records in US Dollars, rather than in Swedish Krona, beginning in 2005. Management believes that these planned changes will be sufficient to correct the internal control design deficiency underlying the material weakness described above.

 

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

 

ITEM 9B.    OTHER INFORMATION

 

None.

 

49


PART III

 

ITEM 10.    EXECUTIVE OFFICERS AND DIRECTORS OF THE REGISTRANT

 

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

 

DIRECTORS OF THE COMPANY

 

The Company’s Board of Directors currently consists of seven members. The directors of the Company and their ages as of April 1, 2005 are as follows:

 

Name of Nominee


   Age

   Position and Offices Held in the Company

   Director Since

Michael A. Baker (2)

   46    President and Chief Executive Officer, Director    July 1997

Barbara D. Boyan, Ph.D. (1)

   57    Director    March 2004

David F. Fitzgerald (3) (4)

   71    Director    April 2003

James G. Foster (2) (3)

   58    Director    August 2002

Tord B. Lendau (1) (2)

   48    Director    June 2001

Jerry P. Widman (1) (4)

   62    Director    November 2002

Peter L. Wilson (2) (3) (4)

   60    Director    June 2001

(1) Member of Nominating and Corporate Governance Committee
(2) Member of Corporate Strategy Committee
(3) Member of Compensation Committee
(4) Member of Audit Committee

 

There are no family relationships among any directors or executive officers of the Company.

 

Michael A. Baker has served as President, Chief Executive Officer and a director of the Company since July 1997. From 1989 to 1997, Mr. Baker held several positions in planning, corporate development and senior management at Medtronic, Inc., a multi-billion dollar medical technology company specializing in implantable and invasive therapies. His most recent position at Medtronic, Inc., was Vice President, General Manager of Medtronic’s Coronary Vascular Division. Since September 30, 2003, Mr. Baker has served as a director, and a member of the Audit Committee, of Conceptus, Inc. Mr. Baker holds a B.S. from the United States Military Academy at West Point and a M.B.A. from the University of Chicago.

 

Barbara D. Boyan, Ph.D. became a director of the Company in March 2004. From 2002, Dr. Boyan has been a Professor in the Wallace H. Coulter Department of Biomedical Engineering at Georgia Tech and Emory University, Georgia Institute of Technology in Atlanta, Georgia. During the same timeframe, Dr. Boyan has also held the Price Gilbert, Jr. Chair in Tissue Engineering at the Georgia Institute of Technology and Dr. Boyan has been Deputy Director for Research, Georgia Tech/Emory Center for Engineering of Living Tissues, Georgia Institute of Technology. From 1981 to 2002, Dr. Boyan was Professor and Vice Chair for Research, Department of Orthopaedics, and the University of Texas Health Science Center at San Antonio, San Antonio, Texas, where she also served as Director, Industry University Cooperative Research Center and Director, Center for the Enhancement of the Biology/Biomaterials Interface. Dr. Boyan is a founder of Osteobiologics, Inc. and a founder

 

50


and Chief Scientific Officer of Orthonics, Inc., two companies that specialize in orthopedics. Dr. Boyan is a consultant to several companies and institutes, including: EBI, LLP; Exactech, Inc.; Musculoskeletal Transplant Foundation; Spinology, Inc.; Biomimetics Pharmaceuticals, Inc; OrthoLogic Corporation; Chrysalis BioTechnology, Inc.; and Institut Straumann AG. These companies and institutes focus on a variety of biomedical technologies, including, among other things, bone graft substitutes, cartilage repair and electromagnetic fields, and dental implant materials. Dr. Boyan has also served on the board of directors of various charitable and non-profit organizations, and educational institutions, including the International Conferences on the Chemistry and Biology of Mineralized Tissue, the International Conferences on the Growth Plate and the Dentistry Division of the American Association for the Advancement of Science. Dr. Boyan is also a member of the following committees of the American Academy of Orthopedic Surgeons: Women’s Health Initiatives; Orthopedic Device Forum and Biologic Implants. Dr. Boyan holds a B.A., M.A. and Ph.D. in biology from Rice University.

 

David F. Fitzgerald became a director of the Company in April 2003. Mr. Fitzgerald spent twenty-five years in management positions at Pfizer, Inc., serving as President and Chief Executive Officer of its Howmedica division during his last fifteen years with the company, prior to retiring in 1996. Mr. Fitzgerald also serves on the boards of LifeCell Corporation and Orthovita, Inc. He holds a B.S. from American International College and a M.B.A. from New York University.

 

James G. Foster became a director of the Company in August 2002. From December 1994 until he retired in June 2001, Mr. Foster was Vice President and General Manager of Medtronic Heart Valves, a division of Medtronic, Inc., a medical device company. From February 1984 to December 1994, Mr. Foster held various positions at Medtronic, including Vice President of Cardiac Surgery Sales & Strategic Planning in 1994, Vice President and General Manager of Medtronic Neurological Implantables from 1992 to 1994, Vice President and General Manager of Medtronic Interventional Vascular from 1990 to 1992 and Vice President and General Manager of Medtronic Blood Systems from 1983 to 1989. Since March 1995, Mr. Foster has also been a director of LifeCell Corporation, a company engaged in the development and commercialization of biological products to repair and replace damaged human tissue. Since July 2003, Mr. Foster has been a director of Neothermia Corp., a company engaged in the development and marketing of a unique, state-of-the-art breast biopsy technology and products. Mr. Foster also serves on the boards of the International Heart Institute of Montana Foundation and Life Coaches. He holds a master’s degree in management from the Sloan School at MIT and a B.S. from St. Joseph’s University in Philadelphia.

 

Tord B. Lendau became a director of the Company in June 2001. Mr. Lendau is the Chief Executive Officer of Artimplant AB, a biomaterials company listed on the O-list of the Stockholm Stock Exchange. From 1998 to 2001, Mr. Lendau was President of Noster Systems AB, a medical device company developing a system to detect the bacteria that causes stomach ulcers. During 1998, Mr. Lendau was president of Bottnia Internet Provider AB, a media and internet provider. From 1997 to 1998, he acted as president of ArthroCare Europe AB, overseeing the start-up of its international operations. Mr. Lendau was vice president and general manager of Medtronic/Synectics from 1996 to 1997 after the acquisition of Synectics Medical AB by Medtronic, Inc. Prior to this acquisition, from 1991 to 1996, Mr. Lendau was the CEO of Synectics Medical AB, a Swedish public company. Mr. Lendau also serves on the board of directors of ArthroCare Europe AB, Diamyd AB and Noster Systems AB. Mr. Lendau studied in M.Sc. at Linköping University and has a B.S. degree in Electronics from Sw. Gymnasieingenjör El-Tele in Borlänge, Sweden.

 

Jerry P. Widman became a director of the Company in November 2002. From 1982 to 2001, Mr. Widman served as the Chief Financial Officer of Ascension Health, a large U.S. not-for-profit multi-hospital system. Mr. Widman currently serves as a member of the board of directors and the audit committee of United Surgical Partners International, Inc., a publicly-traded ambulatory surgery centers company, Cutera, Inc., a publicly-traded laser and other light-based products company, and The TriZetto Group, Inc., a publicly-traded company in the information technology business serving health plans and benefits administrators. Mr. Widman also serves as a member of the board of directors of several privately-held companies and is on the advisory board of Seneca

 

51


Health Partners, a private equity firm. Mr. Widman holds a B.A. in Business from Case-Western Reserve University, a M.B.A. from the University of Denver, and a J.D. from Cleveland State University, and is a Certified Public Accountant.

 

Peter L. Wilson became a director of the Company in June 2001. Mr. Wilson currently serves on the board of directors of Conceptus, Inc., a marketer of The Essure permanent birth control device, and of Microban International, a marketer of antimicrobial compounds for use in plastics and synthetic fibers. Mr. Wilson was President and Chief Executive Officer of Patient Education Systems from 1995 to 1998. Between 1992 and 1994, Mr. Wilson was an independent consultant in healthcare business development and marketing. From 1972 to 1992, Mr. Wilson worked for Proctor & Gamble / Richardson Vicks, where he held various positions, including President of Richardson Vicks, Vice President/General Manager of Proctor & Gamble Vicks Healthcare, President/General Manager of the Vidal Sassoon Division and President/General Manager of the Personal Care Division. Mr. Wilson holds a M.B.A in marketing from Columbia University and a B.A. from Princeton University.

 

BOARD MEETINGS AND COMMITTEES

 

The Board of Directors of the Company held 15 meetings during the year ended December 31, 2004 (the “Last Fiscal Year”). The Board of Directors has an Audit Committee, a Compensation Committee, a Nominating and Corporate Governance Committee and a Corporate Strategy Committee. From time to time, the Board has created other ad hoc committees for special purposes. The Board of Directors has no such ad hoc committees at this time.

 

Audit Committee.    During the Last Fiscal Year, the Audit Committee consisted of Messrs. Widman, Wilson and Fitzgerald. The Audit Committee is responsible for, among other duties, reviewing the results and scope of the audit and other services provided by the Company’s independent registered public accounting firm and reviewing and discussing audited financial statements and other accounting matters with the management of the Company. During the Last Fiscal Year, the Audit Committee held 19 meetings during which they reviewed and discussed financial presentations and related matters. The Audit Committee also met with the Company’s independent registered public accounting firm to discuss the audit for the Last Fiscal Year.

 

Our board has determined that the three members who have served on the Audit Committee during the Last Fiscal Year, Messrs. Fitzgerald, Widman and Wilson, are independent under SEC rules and Nasdaq listing standards. Furthermore, our Board of Directors has determined that at least one Audit Committee member qualifies as an independent “audit committee financial expert” under SEC rules and has accounting or related financial expertise under Nasdaq listing standards. Mr. Widman has been identified as an independent audit committee financial expert. No member of the Audit Committee serves on more than three audit committees of publicly-held companies.

 

The Company has adopted an Audit Committee Charter. Our Audit Committee Charter is available on our website at www.arthrocare.com. We intend to post all amendments, if any, to our Audit Committee Charter on our website.

 

Compensation Committee.    During the Last Fiscal Year, the Compensation Committee consisted of Messrs. Foster, Wilson and Fitzgerald. The Compensation Committee is responsible for, among other duties, reviewing and approving the compensation arrangements for the Company’s senior management and any compensation plans in which the executive officers and directors are eligible to participate. The Compensation Committee held 12 meetings during the Last Fiscal Year.

 

The Company has adopted a Compensation Committee Charter, a copy of which is available on our website at www.arthrocare.com. We intend to post all amendments, if any, to our Compensation Committee Charter on our website.

 

52


Corporate Strategy Committee.    During the Last Fiscal Year, the Corporate Strategy Committee consisted of Messrs. Baker, Foster, Lendau and Wilson. The Corporate Strategy Committee is responsible for, among other duties, assisting the Company’s management in forming and implementing corporate strategy, and in evaluating possible strategic transactions. The Corporate Strategy Committee held 2 meetings during the Last Fiscal Year.

 

The Company has adopted a Corporate Strategy Committee Charter, a copy of which is available on our website at www.arthrocare.com. We intend to post all amendments, if any, to our Corporate Strategy Committee Charter on our website.

 

Nominating and Corporate Governance Committee.    During the Last Fiscal Year, the Nominating and Corporate Governance Committee consisted of Mr. Lendau, Mr. Widman and Dr. Boyan. The Nominating and Corporate Governance Committee is responsible for, among other duties, identifying appropriate candidates for nomination to membership on the Board of Directors. The Nominating and Corporate Governance Committee held three meetings during the Last Fiscal Year. The Nominating and Corporate Governance Committee is also responsible for reviewing director nominees recommended by stockholders of the Company. The procedures for making such a recommendation are described in the Company’s bylaws and below in the section entitled “Process for Identification and Recommendation of Director Candidates.” Our board has determined that the three members who serve on the Nominating and Corporate Governance Committee during the Last Fiscal Year, Mr. Lendau, Mr. Widman and Dr. Boyan, are independent under SEC rules and Nasdaq listing standards.

 

The Company has adopted a Nominating and Corporate Governance Committee Charter, a copy of which is available on our website at www.arthrocare.com. We intend to post all amendments, if any, to our Nominating and Corporate Governance Committee charter on our website.

 

EXECUTIVE OFFICERS OF THE COMPANY

 

The executive officers of the Company and their ages as of April 1, 2005 are as follows:

 

Name


   Age

   Position

   Executive Officer
Since


Michael A. Baker

   46    President and Chief Executive Officer    July 1997

Richard A. Christensen

   45    Senior Vice President, Operations    November 2002

John H. Giroux

   60    Senior Vice President, Surgical Business Units    November 2002

John T. Raffle, Esq.

   36    Vice President, Corporate Development and Legal Affairs    July 2000

Fernando V. Sanchez

   52    Senior Vice President and Chief Financial Officer    March 2002

John R. Tighe

   44    Senior Vice President, Sales & Marketing    April 2000

 

Michael A. Baker has served as our President, Chief Executive Officer and a director since July 1997. From 1989 to 1997, Mr. Baker held several positions in planning, corporate development and senior management at Medtronic, Inc., a multi-billion dollar medical technology company specializing in implantable and invasive therapies. His most recent position at Medtronic, Inc., was Vice-President, General Manager of Medtronic’s Coronary Vascular Division. Since September 30, 2003, Mr. Baker has served as a director of Conceptus, Inc. Mr. Baker holds a B.S. from the United States Military Academy at West Point and an M.B.A. from the University of Chicago.

 

Richard A. Christensen joined our Company in August 2002 as Senior Vice President, Operations. Mr. Christensen became our Administrative Manager for ArthroCare Costa Rica SRL in August 2003. From February to August 2002, Mr. Christensen oversaw the operational aspects of the launch of a new American car company as Vice President Operations for Build-To-Order, Inc. From September 2001 to February 2002, he was Executive-In-Charge of GM/Build-To-Order Project for General Motors Corporation (GM). From August 2000 to September 2001, Mr. Christensen was General Manager, Personal Calling Business Unit of GM’s OnStar Division. From June 1999 to August 2000, he was Director, Business Alliances and New Ventures GM e-commerce business unit. From January 1998 to June 1999, Mr. Christensen was Executive-In-Charge GM North American Project Center. Mr. Christensen holds a B.A. in Economics from the University of Illinois (Champaign) and an M.B.A. from the University of Chicago.

 

53


John H. Giroux joined our Company in October 2002 as Senior Vice President, Surgical Business Units. From October 2000 to June 2002, Mr. Giroux was Executive Vice President, Commercial Operations at Guava Technologies Inc. While at Guava Technologies, he established and supervised the Sales and Marketing functions, Manufacturing Operations, Customer Service and Technical Support and Finance functions. From 1995 to 1999, he was President, North America at ReSound Corporation, during which time he held complete responsibility for the sales and profits of its North American business. Between 1991 and 1995 Mr. Giroux was Vice President Sales and Marketing at ReSound Corporation. Mr. Giroux holds a B.A. in Economics from Providence College in Providence, Rhode Island.

 

John T. Raffle, Esq. joined our Company in September 1997 as Director, Intellectual Property. He was promoted in January 2001 to Managing Director, Corporate Development and Legal Affairs and to Vice President, Corporate Development and Legal Affairs in June 2001. From June 1993 to September 1997, Mr. Raffle was an associate at Townsend and Townsend and Crew LLP. Mr. Raffle holds a B.S. degree in Aeronautical Engineering from M.I.T. and a J.D. from Duke University School of Law.

 

Fernando V. Sanchez joined our Company in March 2002 as a Senior Vice President. In May 2002 Mr. Sanchez was elected as our Chief Financial Officer. Mr. Sanchez has also served as our Assistant Secretary since August 2002. Prior to joining ArthroCare, and beginning in 2000, Mr. Sanchez was Chief Financial Officer and Treasurer for Novopoint.com, Inc., a private internet supply chain solution provider. From 1997 to 1999, Mr. Sanchez was the Chief Financial Officer for Esoterix, Inc., a private medical laboratory company. Mr. Sanchez was Vice President, Finance of the Vascular Group of Medtronic, Inc. from 1996 to 1997. Mr. Sanchez holds an M.B.A. in Corporate Policy and Finance from the University of Michigan and a B.S. in Mechanical and Ocean Engineering from the University of Miami.

 

John R. Tighe joined our Company in May 1995 as the Director of Sales. He was appointed Vice President, Worldwide Sales and Marketing in January 1999 and Senior Vice President, General Manager of Strategic Business Units in September 2004. From December 1988 to April 1995, Mr. Tighe held various sales positions with Acufex Microsurgical, Inc., a manufacturer of arthroscopic instruments. His most recent position at Acufex Microsurgical, Inc. was National Sales Manager. Mr. Tighe holds a B.S. degree in Civil Engineering from the University of Maryland.

 

SECTION 16(a) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE

 

Section 16(a) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), requires the Company’s directors and officers and persons who own more than 10% of a registered class of the Company’s equity securities to file reports of ownership and reports of changes in the ownership with the Securities and Exchange Commission (the “SEC”). Such persons are required by SEC regulations to furnish the Company with copies of all Section 16(a) forms they file. Based solely on its review of the copies of such forms submitted to it during the Last Fiscal Year, the Company believes that, during the Last Fiscal Year, all such reports were timely filed.

 

54


ITEM 11.    EXECUTIVE COMPENSATION

 

The following table sets forth the compensation for fiscal years 2004, 2003 and 2002 received by the Company’s Chief Executive Officer and the four most highly compensated executive officers of the Company, other than the Chief Executive Officer, each of whom was serving as an executive officer at the end of the fiscal year 2004 and whose total annual salary and bonus exceeded $100,000 for fiscal year 2004 (the “Named Executive Officers”):

 

    

Fiscal
Year


   Annual Compensation

   Long Term Compensation Awards

           Restricted
Stock
Awards


    Securities
Underlying
Options
(# of shares)


   All Other
Compensation
($)(2)


Name and Principal Position


      Salary ($)

   Bonus
($)(1)


       

Michael A. Baker

President and Chief Executive Officer

   2004
2003
2002
   $
 
 
387,715
395,000
362,019
   $
 
 
231,445
252,405
—  
   15,000
30,000
—  
(4)
(3)
 
  115,000
30,808
60,000
   $
 
 
—  
15,466
28,985

Fernando V. Sanchez

Chief Financial Officer and Senior Vice President

   2004
2003
2002
   $
 
 
213,208
215,476
167,795
   $
 
 
120,043
119,019
—  
   4,000
10,250
—  
(4)
(3)
 
  20,000
21,208
180,000
   $
 
 
—  
15,948
8,789

Richard A. Christensen

Senior Vice President—Operations

   2004
2003
2002
   $
 
 
210,005
211,236
76,928
   $
 
 
168,479
117,231
—  
   4,000
5,000
—  
(4)
(3)
 
  60,000
21,208
160,000
   $
 
 
—  
—  
—  

John H. Giroux

Senior Vice President—
Surgical Business Units

   2004
2003
2002
   $
 
 
211,506
210,718
45,383
   $
 
 
117,799
116,673
—  
   4,000
5,000
—  
(4)
(3)
 
  20,000
21,208
160,000
   $
 
 
—  
12,333
—  

John R. Tighe

Senior Vice President—
Sales and Marketing

   2004
2003
2002
   $
 
 
205,706
201,770
188,015
   $
 
 
113,930
112,505
—  
   5,000
8,500
—  
(4)
(3)
 
  25,000
24,208
35,000
   $
 
 
—  
500
836

(1) Except as otherwise noted, all bonuses were earned by the named officer in the fiscal year indicated and approximately 75% of which were paid to the named officer in the subsequent year.
(2) Consists of 401(k) matching company payments, life insurance premiums paid in excess of $50,000 coverage and Employee Stock Purchase gains beyond the excess of the market price at the time of purchase over the price paid by the Executive.
(3) Consists of one grant of the Company’s common stock on February 27, 2003 (market value of $8.94 per share), entire amount to be vested five years after grant date based on such individual’s continued employment with the company.
(4) Consists of one grant of the Company’s common stock on April 1, 2004 (market value of $23.25 per share), entire amount to be vested five years after grant date based on such individual’s continued employment with the company.

 

55


OPTION/SAR GRANTS IN LAST FISCAL YEAR

 

The following table provides information pertaining to option grants made to each of the Named Executive Officers in 2004. No stock appreciation rights were granted to these individual during such year.

 

     Individual Grants

  

Expiration

Date


   Potential Realizable Value at
Assumed Annual Rates of
Stock Price Appreciation for
Option Term (3)


    

Number of
Underlying
Options

Granted


    % of Total
Options Granted
to Employees in
Fiscal 2004 (1)


   

Exercise
Price
Per

Share (2)


     

Name


             5%

   10%

Michael A. Baker

   75,000
40,000
(4)
(5)
  8.6
4.6
%
%
  $
$
24.50
24.38
   1/2/2014
3/10/2014
   $
 
1,155,594
613,298
   $
 
2,928,502
1,554,218

Fernando V. Sanchez

   20,000 (6)   2.3 %   $ 24.38    3/10/2014      306,649      777,109

Richard A. Christensen

   20,000
40,000
(7)
(8)
  2.3
4.6
%
%
  $
$
24.38
21.05
   3/10/2014
4/29/2014
    
 
306,649
529,529
    
 
777,109
1,341,931

John H. Giroux

   20,000 (9)   2.3 %   $ 24.38    3/10/2014      306,649      777,109

John R. Tighe

   25,000 (10)   2.9 %   $ 24.38    3/10/2014      383,311      971,386

(1) Based on an aggregate of 868,000 options granted by the Company during 2004 to employees and non-employee directors of and consultants to the Company, including options granted to the Named Executive Officers.
(2) Options are granted at an exercise price equal to the closing market price per share on the day before the date of grant.
(3) The 5% and 10% assumed annual rates of compounded stock price appreciation are mandated by rules of the Securities and Exchange Commission. There can be no assurance provided to any executive office or any other holder of the Company’s securities that the actual stock price appreciation over the 10-year option term will be at the assumed 5% and 10% levels or at any other defined level. Unless the market price of the common stock appreciates over the option term, no value will be realized from the option grants made to the executive officers.
(4) Consists of one option to purchase shares of the Company’s common stock granted on January 2, 2004 at an exercise price of $24.50 per share. The option vests at the rate of one forty-eighth (1/48) of the total number of shares subject to the option commencing 30 days after the grant date and on the first day of each month thereafter until all such shares are exercisable based upon such individual’s continued employment by the Company.
(5) Consists of one option to purchase shares of the Company’s common stock granted on March 10, 2004 at an exercise price of $24.50 per share. The option vests at the rate of one forty-eighth (1/48) of the total number of shares subject to the option commencing 30 days after the grant date and on the first day of each month thereafter until all such shares are exercisable based upon such individual’s continued employment by the Company.
(6) Consists of one option for shares of the Company’s common stock granted on March 10, 2004 at an exercise price of $24.38 per share. This option vests at the rate of one forty-eighth (1/48) of the total number of shares subject to the option commencing 30 days after the grant date and on the first day of each month thereafter until all such shares are exercisable based upon such individual’s continued employment by the Company.
(7) Consists of one option for shares of the Company’s common stock granted on March 10, 2004 at an exercise price of $24.38 per share. This option vests at the rate of one forty-eighth (1/48) of the total number of shares subject to the option commencing 30 days after the grant date and on the first day of each month thereafter until all such shares are exercisable based upon such individual’s continued employment by the Company.
(8)

Consists of one option for shares of the Company’s common stock granted on April 29, 2004 at an exercise price of $21.05 per share. This option vests at the rate of one forty-eighth (1/48) of the total number of shares subject to the option commencing 30 days after the grant date and on the first day of each month

 

56


 

thereafter until all such shares are exercisable based upon such individual’s continued employment by the Company.

(9) Consists of one option for shares of the Company’s common stock granted on March 10, 2004 at an exercise price of $24.38 per share. This option vests at the rate of one forty-eighth (1/48) of the total number of shares subject to the option commencing 30 days after the grant date and on the first day of each month thereafter until all such shares are exercisable based upon such individual’s continued employment by the Company.
(10) Consists of one option for shares of the Company’s Common Stock granted on March 10, 2004 at an exercise price of $24.38 per share. This option vests at the rate of one forty-eighth (1/48) of the total number of shares subject to the option commencing 30 days after the grant date and on the first day of each month thereafter until all such shares are exercisable based upon such individual’s continued employment by the Company.

 

AGGREGATED OPTION/SAR EXERCISES IN LAST FISCAL YEAR AND FISCAL YEAR-END VALUES

 

The following table provides information on option exercises in the Last Fiscal Year by the Named Executive Officers and the number and value of such officers’ unexercised options at December 31, 2004. No stock appreciation rights were granted to these individual during such year.

 

     Shares
Acquired
on
Exercise
(#)


  

Value
Realized

($)(1)


   Number of Unexercised
Options at December 31,
2004 (#)


   Value of Unexercised
In-The-Money Options at
December 31, 2004 ($) (2)


Name


         Exercisable

   Unexercisable

   Exercisable

   Unexercisable

Michael A. Baker

   44,000    $ 1,082,496    741,005    146,535    $ 14,444,378    $ 1,518,509

Fernando V. Sanchez

   —        —      141,120    80,088      2,548,580      1,311,060

Richard A. Christensen

   50,000      682,408    55,794    135,414      1,114,703      2,219,089

John H. Giroux

   10,000      208,691    89,127    102,081      1,873,896      1,966,496

John R. Tighe

   32,001      290,841    125,828    51,937      1,500,951      709,534

(1) Based upon the fair market value of one share of the Company’s common stock on the date that the option was exercised, less the exercise price per share multiplied by the number of shares received upon exercise of the option.
(2) Based upon a fair market value of $32.06 per share as of December 31, 2004 minus the exercise price per share multiplied by the number of shares underlying the option.

 

The Company has not established any long-term incentive plans or defined benefit or actuarial plans covering any of the Named Executive Officers.

 

DIRECTOR COMPENSATION

 

As of April 1, 2005, eachnon-employee director who does not occupy a leadership position on the Board of Directors, as described hereafter, receives an annual retainer of $10,000. The Audit Committee chairman and the lead independent director each receive an annual retainer of $25,000. The Compensation Committee chairman receives an annual retainer of $20,000. The Nominating and Corporate Governance Committee chairman receives an annual retainer of $15,000. Non-employee directors’ attendance at meetings of the Board of Directors is compensated, in addition to the annual retainers noted above, at the rates of $2,000 for in-person meetings and $500 for telephonic attendance in the event the board meeting is less than two hours in length and $1,000 if it is more than two hours in length. In addition, non-employee directors’ attendance at committee meetings is compensated at the rate of $500 per meeting, unless the committee meeting is held in conjunction with an in-person board meeting, in which case no compensation is paid for attendance at the committee meeting. Directors are reimbursed for out-of-pocket expenses they incur in connection with their attendance at meetings of the Board of Directors and committees of the Board of Directors. To the extent a telephonic meeting is less than a

 

57


half hour in length, it will be added together with another similar length telephonic meeting to constitute one meeting of an hour in length. Telephonic meetings that run over two hours will be billed at $500 per hour over two hours, with only extra half hours accrued towards the next meeting.

 

Under our Amended and Restated Director Option Plan, which is described below, each member of our Board of Directors who is not an employee will automatically receive an option to purchase 25,000 shares of the Company’s common stock (an “Initial Option”) and 2,500 shares of restricted stock (an “Initial Equity Grant”) on the date on which he or she first becomes a director, whether through election by the stockholders of the Company or appointment by the Board of Directors to fill a vacancy. The exercise price per share of the Initial Option is equal to the closing price of the common stock subject to the option on the day before the date of the grant of the Initial Option. Assuming continued service with the Board of Directors, the Initial Equity Grant vests as to 25% of the shares on each anniversary of its grant date. Thereafter, each non-employee director automatically receives an option to purchase 10,000 shares of the Company’s common stock (a “Subsequent Option”) and 1,500 shares of restricted stock (a “Subsequent Equity Grant”) on the date of the Company’s annual meeting of stockholders, upon such director’s re-election to the Board of Directors, if, on such date, he or she has been on the Board for at least six months. The exercise price per share of the Subsequent Option is equal to the closing price of one share of the Company’s common stock on the day before the date of the grant of the Subsequent Option. Assuming the director’s continued service with the Board of Directors, the Subsequent Option Grant vests as to 12.5% of the shares on the first day of each month following its grant date. Also assuming the director’s continued service with the Board of Directors, the Subsequent Equity Grant vests in sixty (60) equal monthly installments beginning on the first day of the month following its grant. Options granted prior to 2005 have a term of 10 years. Options granted in 2005 and beyond have a term of 7 years. If elected to our Board of Directors at the 2005 Annual Meeting of Stockholders, outside director nominees Dr. Boyan and Messrs. Fitzgerald, Foster, Lendau, Widman and Wilson each will be granted a Subsequent Option and a Subsequent Equity Grant.

 

EMPLOYMENT AND CHANGE OF CONTROL AGREEMENTS

 

In January 2003, the Company entered into a new Employment Agreement with Mr. Baker, which superseded Mr. Baker’s prior Employment Agreement. The new agreement provides for a base salary to be reviewed, and adjusted as necessary, annually by the Company’s Board of Directors or Compensation Committee, a potential annual cash bonus of up to 60% of the base salary and a potential annual equity bonus of up to 40% of the base salary, to be determined by the Board or the Compensation Committee, with reference to certain performance objectives established each year. The agreement also provides for the accelerated vesting of 50% of Mr. Baker’s then-current unvested and outstanding stock options and/or restricted stock upon a Change of Control (as defined below). In the event of a hostile takeover, all of Mr. Baker’s unvested and outstanding stock options and/or restricted stock will vest in full. If Mr. Baker is involuntarily terminated within 24 months following a Change of Control, he would continue to receive compensation at his then-current salary for the next 36 months and three times his maximum annual cash bonus for the year of termination. He would also continue to receive medical coverage at the Company’s expense for the next 36 months. In the event of an involuntary termination that does not follow within 24 months of a Change of Control, Mr. Baker would be entitled to receive, in a lump sum, 18 months of his then-current monthly salary, an amount equal to his base salary for the fiscal year in which such involuntary termination occurs, continued medical benefits for 18 months, and all of his then-current unvested and outstanding stock options and/or restricted stock will vest in full. The agreement provides for no severance benefits in the event Mr. Baker voluntarily terminates without good reason his employment or is terminated for cause, regardless of whether the termination follows a Change of Control.

 

The Company has also entered into Continuity Agreements with each of the Company’s executive officers that are Senior Vice Presidents of the Company or Vice Presidents of the Company, including each of the four named executives listed in the “Summary Compensation” table above. These Continuity Agreements provide certain compensation and benefits in the event of a Change of Control of the Company. A Change of Control is defined as (i) a change of beneficial ownership of at least 15% of the voting power of the Company without the

 

58


approval of the Board, (ii) a merger or sale of the Company whereby the Company stockholders immediately prior to such merger or sale do not maintain at least 50% of the voting power of the surviving Company, (iii) the approval by the stockholders of the Company of a plan of complete liquidation of the Company or an agreement for the sale or disposition of all or substantially all of the Company’s assets, or (iv) a change in the composition of the Board of Directors such that at least 50% of the members are not incumbents or elected by incumbent directors. In the event of a Change of Control, the Continuity Agreements provide for accelerated vesting of 50% of the then-current unvested and outstanding stock options of each executive officer. In the event of a hostile takeover, the vesting is accelerated as to 100% of the outstanding unvested options of each executive officer. Further, in the event of an involuntary termination of employment of an executive officer within 24 months of a Change of Control, certain severance benefits will be provided. These benefits include 24 months of continued monthly compensation, continued medical benefits during the severance period and immediate vesting of all outstanding and unvested stock options.

 

Executive officers who are also Senior Vice Presidents also receive additional severance benefits under their Continuity Agreements in the event of a termination of their employment by the Company without cause that does not follow within 24 months of a Change of Control. In the event of such a termination, the executive would be entitled to receive compensation at his or her then-current salary for the next six months and continued medical benefits for 6 months. The Continuity Agreements with the Company’s Senior Vice Presidents also contain standard non-solicitation and non-disparagement provisions.

 

COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION

 

During the Last Fiscal Year, each of Messrs. Fitzgerald, Foster and Wilson served as members of the Compensation Committee of the Board of Directors. None of such Compensation Committee members has ever been an officer or employee of the Company or any of its subsidiaries. In addition, during the Last Fiscal Year, no member of our Board of Directors or of our Compensation Committee, and none of our executive officers, served as a member of the board of directors or compensation committee of an entity that has one or more executive officers serving as members of our Board of Directors or our Compensation Committee. Tord Lendau is a director of ArthroCare Europe AB, a wholly owned subsidiary of the Company.

 

59


COMPENSATION COMMITTEE REPORT

 

The following is a report of the Compensation Committee of the Board of Directors (the “Compensation Committee”). The Compensation Committee is currently comprised of Messrs. Foster, Fitzgerald and Wilson, none of whom is currently an officer or employee of the Company and each of whom is a “non-employee director” for purposes of Rule 16b-3 under the Securities Exchange Act of 1934 and an “outside director” for purposes of Section 162(m) of the Internal Revenue Code. The Compensation Committee’s purpose is to recommend salaries, incentives and other forms of compensation for the Company’s directors, officers and other senior management employees, administer various incentive compensation and benefit plans (including stock plans) and recommend policies relating to such incentive compensation and benefit plans.

 

Executive Compensation Policy

 

Philosophy

 

The Compensation Committee believes the Company’s executive compensation policy should ensure that an appropriate relationship exists between executive pay and the creation of long-term investor value, while at the same time helping to recruit, reward, motivate and retain key employees. In determining compensation levels, we consider individual job duties and responsibilities as well as individual and Company performance. We believe that ours is a competitive marketplace for skilled and employees and that the Company must remain competitive with the compensation levels provided by other employers with whom we are competing for talented employees. Finally, we believe that compensation packages should include both annual and long-term components, consistent with our desire to encourage key employees to remain with the Company while promoting long-term value for our shareholders.

 

Executive compensation is current comprised of two primary elements: (1) cash and (2) equity compensation. Cash compensation paid to the Company’s executives consists, in turn, of base salary and annual performance-based bonuses. Equity compensation consists of grants of stock options and restricted stock. Executive compensation does not include forms of compensation such as SERPs or nonqualified deferred compensation plans. Nor does the Company sponsor any defined benefit pension plans.

 

Methodology

 

At the end of each fiscal year, the Compensation Committee engages in a comprehensive performance review of all executive employees of the Company. The Chief Executive Officer provides the Compensation Committee with his assessment of the performance of officers reporting directly to him and other key executives, together with his recommendations regarding compensation levels.

 

The Compensation Committee reviewed all components of the Chief Executive Officer’s and other officers’ and senior management employees’ compensation, including annual base salary, bonuses based on corporate and individual performance, equity compensation, accumulated realized and unrealized stock option and restricted stock gains, the dollar value to the executive and cost to the Company of all perquisites and other personal benefits and the actual and projected payouts obligations under several potential severance and change-in-control scenarios. A tally sheet setting forth all the above components was prepared and reviewed affixing dollar amounts under various payment scenarios. Revisions to compensation levels are proposed based on review of Company and individual performance against previously established goals, objectives and job criteria.

 

In addition, a market analysis was conducted to ascertain the relative compensation positions of the Chief Executive Officer and other officers compared to peers at similar organizations. All elements of officers’ pay were considered. In order to determine the competitive market within the peer groups, data from multiple sources was considered, including private compensation survey data and reference information for senior positions and officers at comparable medical device companies and other peer companies with relevant geography and similar United States employee populations.

 

60


The Compensation Committee, from time to time, uses the services of an independent executive compensation consultant to prepare and advise on the competitive compensation data described above and assist us in setting the Chief Executive Officer’s and other officers’ compensation. The consultant reports directly to the Compensation Committee and the Compensation Committee has sole authority to engage and terminate outside compensation consultants.

 

Base Salaries for Fiscal 2004

 

Executive officer salaries are reviewed based on the methodology described above. In order to attract, retain, and motivate its executives, the Compensation Committee believes that aggregate executive remuneration should fall between the 50th and 75th percentile of remuneration provided by comparator companies to their own executives. While it is the Compensation Committee’s intent to continue to review periodically base salary information to monitor competitive ranges within the applicable market, including information related to geographic location and individual job responsibilities, it is further the intent of the Compensation Committee to maintain a close relationship between the Company’s performance and the base salary component of the Company’s executive officers’ compensation.

 

Annual Incentive Bonuses

 

Cash bonuses for our executive officers, normally tied to a fiscal year, will be paid for the 15 month period January 1, 2004 through March 31, 2005 pursuant to the modified 2004 Executive Officer Bonus Plan. This extended period was used to align incentive bonuses with key goals pertaining to the integration of the Opus Medical acquisition, which occurred in the last quarter of 2004 and first quarter of 2005. For the period commencing January 1, 2005 through December 31, 2005, executive officers are eligible to receive bonuses under our 2005 Executive Officer Bonus Plan. Each of the 2004/2005 Executive Officer Bonus Plan and the 2005 Executive Officer Bonus Plan have been filed as attachments to the Form 8-K filing made by the Company on February 22, 2005 (and subsequently amended by Form 8-K/A filed February 28, 2005).

 

Under each of these plans, all named executive officers, except the Chief Executive Officer, are eligible to receive a cash bonus equal to up to 50% of their base salary, subject to certain bonus multipliers. The Chief Executive Officer is eligible to receive a bonus equal to up to 60% of his base salary under these plans, subject to certain bonus multipliers. The actual bonus awarded under these plans generally depends on the level of achievement attained by the Company as it relates to the Company’s sales, earnings per share and return on net working capital goals, as set forth in the Company’s operating budget for the applicable period, as approved by the Board.

 

Equity Compensation Awards

 

The Company grants executive officers and other key employees stock options and restricted stock as part of its policy to provide management with longer-term incentives that promote shareholder value. These grants are normally made after the close of a fiscal year and are closely tied to job position and the individual’s performance. Grants of stock options are made with a per share exercise price of 100% of market value of our underlying stock on the day before the date of grant, have a ten year term and typically vest over four years. Restricted stock awards are generally issued for a nominal purchase price, if any, and typically vest over a three-year period. Beginning in 2005 stock option grants will have a term of seven years while restricted stock awards will vest over a five-year period.

 

The Compensation Committee believes that awards of stock options and restricted stock are essential in aligning the interests of management and the stockholders in enhancing the long-term value of the Company’s equity. In determining the amount of individual grants, the Compensation Committee considers job position, corporate, financial and individual performance, peer group data and the amount of historical equity grants made to each individual. The Board of Directors has the ultimate responsibility of administering the Company’s stock incentive plans and has granted authority to the Compensation Committee to carry out these responsibilities.

 

61


Compensation of the Chief Executive Officer

 

Compensation for Michael A. Baker, the Company’s Chief Executive Officer is reviewed annually and the levels of cash and equity compensation are set in the context of performance against pre-established goals and objectives that have been approved by the Board. The fiscal year 2004 compensation of the Chief Executive Officer consisted of base salary of $387,715 and the grant of 15,000 shares of restricted stock and options to purchase 115,000 shares of common stock. Results of the analysis performed by the Compensation Committee suggest that the Chief Executive’s base salary approximates the fiftieth percentile of the comparator groups. As with the Company’s other executive officers, the Chief Executive Officer’s cash compensation and stock awards are based on the Compensation Committee’s review of the Company’s and the Chief Executive Officer’s performance and analysis under the methodology described above. The Summary Compensation Table includes additional information regarding the other compensation and benefits paid to the Company’s Chief Executive Officer.

 

Deductibility of Executive Compensation

 

The Compensation Committee has considered the impact of Section 162(m) of the Internal Revenue Code, which section disallows a deduction for any publicly held corporation for individual compensation exceeding $1 million in any taxable year for the Chief Executive Officer and four other most highly compensated executive officers, unless such compensation meets the requirements for the “performance-based” exception to the general rule. The cash compensation paid to its Chief Executive Officer for 2004 did not exceed $1 million. Since the cash compensation the Company paid to each of the Company’s other executive officers in 2004 is expected to be well below $1 million, the Compensation Committee believes that this section otherwise will not affect the tax deductions available to the Company. The cash compensation payable to each of the Company’s executive officers, including the Chief Executive Officer, in 2005 is expected to be well below $1 million. It will be the Compensation Committee’s policy to qualify, to the extent reasonable, the executive officers’ compensation for deductibility under applicable tax law.

 

Summary and Conclusion

 

Based on its review, the Compensation Committee believes that the Chief Executive Officer and other officers are paid fairly, competitively, and not excessively, considering the Company’s business complexity and results. The Compensation Committee believes that the Company’s compensation policy as practiced to date has been successful in attracting and retaining qualified employees and in tying compensation to corporate and individual performance. The Company’s compensation policy will evolve over time as the Company attempts to achieve the many short-term goals it has set while maintaining its focus on building long-term stockholder value through technological leadership and development and expansion of the market for the Company’s products.

 

The Compensation Committee,

James G. Foster, Chairman

David F. Fitzgerald

Peter L. Wilson

 

The foregoing Report of the Compensation Committee shall not be deemed to be “soliciting material” or to be “filed” with the SEC, nor shall such information be incorporated by reference into any future filing under the Securities Act, or the Exchange Act, except to the extent the Company specifically incorporates it by reference into such filing.

 

62


PERFORMANCE GRAPH

 

The following graph shows a comparison of total stockholder return for holders of the Company’s common stock for the five years ended December 31, 2004 compared with the NASDAQ Stock Market, U.S. Index, the Hambrecht & Quist Healthcare Index (excluding Biotechnology) and the NASDAQ Health Services Index. This graph is presented pursuant to SEC rules. The Company believes that while total stockholder return can be an important indicator of corporate performance, the stock prices of medical device stocks like that of the Company are subject to a number of market-related factors other than Company performance, such as competitive announcements, mergers and acquisitions in the industry, the general state of the economy, and the performance of other medical device and small-cap stocks.

 

COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN*

AMONG ARTHROCARE CORPORATION, THE NASDAQ STOCK MARKET (U.S.) INDEX

AND THE NASDAQ HEALTH SERVICES INDEX

 

LOGO


* $100 invested on December 31, 1999 in stock or in index—including reinvestment of dividends. The Company’s most recent fiscal year ended December 31, 2004.

 

     Cumulative Total Return

     12/99

   12/00

   12/01

   12/02

   12/03

   12/04

ArthroCare Corporation

   100.00    63.93    58.79    32.30    80.33    105.11

NASDAQ Stock Market (U.S.)

   100.00    59.19    44.90    25.97    37.93    40.26

NASDAQ Health Services

   100.00    78.34    82.81    74.97    95.07    111.29

 

The information contained in the Performance Graph shall not be deemed to be “soliciting material” or to be “filed” with the SEC, nor shall such information be incorporated by reference into any future filing under the Securities Act, or the Exchange Act, except to the extent the Company specifically incorporates it by reference into such filing.

 

63


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

 

The following table sets forth certain information known to the Company regarding the beneficial ownership of the Company’s common stock as of April 1, 2005 by:

 

    each of the Company’s directors,

 

    each Named Executive Officer named in the Summary Compensation Table appearing herein,

 

    all directors and executive officers of the Company as a group, and

 

    each person known by the Company to beneficially own more than 5% of the Company’s common stock (based on information supplied in Schedules 13D and 13G filed with the SEC).

 

The address for all executive officers and directors is c/o ArthroCare Corporation, 680 Vaqueros Avenue, Sunnyvale, CA 94085.

 

Name and Address


   Common Stock
Beneficially Owned
Excluding Options
Exercisable Within
60 Days of
April 1, 2005


   Stock Options
Exercisable
Within
60 Days of
April 1, 2005


   Total
Common Stock
Beneficially
Owned (1)


   Approximate
Percentage
of Class
Owned (2)


 

Kern Capital Management, LLC (3)

   1,828,600    —      1,828,600    7.7 %

Brown Advisory Holdings Incorporated (4)

   1,624,839    —      1,624,839    6.8 %

Wellington Management Company, LLP (5)

   1,337,400    —      1,337,400    5.6 %

Veredus Asset Management, LLC (6)

   1,262,250    —      1,262,250    5.3 %

Board of Directors

                     

Michael A. Baker

   214,874    782,476    997,350    4.0 %

Barbara D. Boyan, Ph.D.

   —      12,500    12,500    *  

David F. Fitzgerald

   —      35,000    35,000    *  

James G. Foster

   —      50,000    50,000    *  

Tord B. Lendau

   —      77,500    77,500    *  

Jerry Widman

   —      50,000    50,000    *  

Peter L. Wilson

   5,000    77,500    82,500    *  

Named Executive Officers

                     

Fernando V. Sanchez

   38,865    164,477    203,342    *  

Richard Christensen

   1,334    77,689    79,023    *  

John H. Giroux

   1,334    111,334    112,668    *  

John R. Tighe

   13,337    139,282    152,619    *  

All directors and executive officers as a group (12 persons)

   276,411    1,713,048    1,989,459    7.8 %

* Represents less than 1% of class.
(1) Except as otherwise indicated in the footnotes to this table and pursuant to applicable community property laws, the persons named in the table have sole voting and investment power with respect to all shares of common stock shown as beneficially owned by them.
(2) Applicable percentage ownership is based on 23,902,930 shares of common stock outstanding as of April 1, 2005 together with applicable options for such stockholder. Beneficial ownership is determined in accordance with the rules of the Securities and Exchange Commission, based on factors including voting and investment power with respect to shares. Shares of common stock subject to the options currently exercisable, or exercisable within 60 days of April 1, 2005, are deemed outstanding for computing the percentage ownership of the person holding such options, but are not deemed outstanding for computing the percentage ownership of any other person.

 

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(3) As reported in a Schedule 13G on February 14, 2005. Kern Capital Management, LLC (“KCM”) has shared power to vote or direct the vote of 1,779,200 shares, and shared power to dispose or to direct the disposition of 1,828,600 shares. KCM’s address is 114 West 47th Street Suite 1926, New York, New York 10036.
(4) As reported in a Schedule 13G filed on February 15, 2005. Brown Advisory Holding Incorporated (“BAHI”) has sole power to vote or direct the vote of 1,312,384 shares, sole power to dispose of or to direct the disposition of 1,607,308 shares, and shared power to dispose or to direct the disposition of 16,575 shares. BAHI’s address is 901 South Bond Street, Suite 400 Baltimore, Maryland 21231.
(5) As reported in a Schedule 13G filed on February 14, 2005. Wellington Management Company, LLP (“WMC”) has shared power to vote or direct the vote of 1,276,500 shares, and shared power to dispose or direct the disposition of 1,337,400 shares. WMC’s address is 75 State Street, Boston, Massachusetts 02109.
(6) As reported in a Schedule 13G filed on February 1, 2005. Veredus Asset Management, LLC (“VAM”) has sole power to vote or direct the vote of 1,016,450 shares, shared power to vote or direct the vote of 245,800 shares, and sole power to dispose or direct the disposition of 1,262,250 shares. VAM’s address is 6060 Dutchmans Lane, St. 320, Louisville, Kentucky 40205.

 

ITEM 13.    CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

 

On January 1, 2003, the Company entered into a new Employment Agreement with Mr. Baker, the Company’s President and Chief Executive Officer, which superseded Mr. Baker’s prior Employment Agreement. The new agreement provides for a base salary to be reviewed, and adjusted as necessary, annually by the Company’s Board of Directors or Compensation Committee, a potential annual cash bonus of up to 60% of the base salary and a potential annual equity bonus of up to a 40% of the base salary, to be determined by the Board or the Compensation Committee, with reference to certain performance objectives established each year. The agreement also provides for the accelerated vesting of 50% of Mr. Baker’s then current unvested and outstanding stock options and/or restricted stock upon a Change of Control (as defined below). In the event of a hostile takeover, all of Mr. Baker’s unvested and outstanding stock options and/or restricted stock will vest in full. If Mr. Baker is involuntarily terminated within 24 months following a Change of Control, he would continue to receive compensation at his then-current salary for the next 36 months and three times his maximum annual cash bonus for the year of termination. He would also continue to receive medical coverage at the Company’s expense for the next 36 months. In the event of an involuntary termination that does not follow within 24 months of a Change of Control, Mr. Baker would be entitled to receive, in a lump sum, 18 months of his then-current monthly salary, an amount equal to his base salary for the fiscal year in which such involuntary termination occurs, continued medical benefits for 18 months, and all of his then-current unvested and outstanding stock options and/or restricted stock will vest in full. The agreement provides for no severance benefits in the event Mr. Baker voluntarily terminates without good reason his employment or is terminated for cause, regardless of whether the termination follows a Change of Control.

 

The Company has entered into Continuity Agreements with each of the Company’s executive officers that are Senior Vice Presidents of the Company or Vice Presidents of the Company, including each of the four Named Executive Officers listed in the “Summary Compensation” table above. These Continuity Agreements provide certain compensation and benefits in the event of a Change of Control of the Company. A Change of Control is defined as (i) a change of beneficial ownership of at least 15% of the voting power of the Company without the approval of the Board of Directors, (ii) a merger or sale of the Company whereby the Company stockholders immediately prior to such merger or sale do not maintain at least 50% of the voting power of the surviving Company, (iii) the approval by the stockholders of the Company of a plan of complete liquidation of the Company or an agreement for the sale or disposition of all or substantially all of the Company’s assets, or (iv) a change in the composition of the Board of Directors such that at least 50% of the members are not incumbents or elected by incumbent directors. In the event of a Change of Control, the Continuity Agreements provide for accelerated vesting of 50% of the then-current unvested and outstanding stock options of each executive officer. In the event of a hostile takeover, the vesting is accelerated as to 100% of the outstanding unvested options of each executive officer. Further, in the event of an involuntary termination of employment of an executive officer within 24 months of a Change of Control, certain severance benefits will be provided. These benefits include 24

 

65


months of continued monthly compensation, continued medical benefits during the severance period and immediate vesting of all outstanding and unvested stock options. Executive officers who are also Senior Vice Presidents also receive additional severance benefits under their Continuity Agreements in the event of a termination of their employment by the Company without cause that does not follow within 24 months of a Change of Control. In the event of such a termination, the executive would be entitled to receive compensation at his or her then-current salary for the next six months and continued medical benefits for 6 months. The Continuity Agreements with the Company’s Senior Vice Presidents also contain standard non-solicitation and non-disparagement provisions.

 

On June 20, 1997, the Company and Mr. Baker entered into an employment offer letter, which, in addition to an annual salary and bonus, benefits and vacation time, provided for an interest-free loan by the Company in the principal amount of $500,000 in connection with Mr. Baker’s purchase of a home, payable upon the earlier of termination of employment or sale of the home.

 

In February 1999, the Company and Dr. Woloszko, the Company’s Vice President Research and Development, entered into an employment offer letter, which, in addition to an annual salary and bonus, benefits and vacation time, provided for an interest-free loan by the Company in the principal amount of $225,000 in connection with Dr. Woloszko’s purchase of a home, payable upon the earlier of termination of employment or sale of the home.

 

In February 1999, the Company and Mr. Tighe, the Company’s Vice President Sales and Marketing, entered into an employment offer letter, which, in addition to an annual salary and bonus, benefits and vacation time, provided for an interest-free loan by the Company in the principal amount of $350,000 in connection with Mr. Tighe’s purchase of a home, payable upon the earlier of termination of employment or sale of the home.

 

CERTAIN LEGAL PROCEEDINGS

 

There are currently no material proceedings in which any director, director nominee or executive officer is a party or has a material interest that is adverse to the Company or any of its subsidiaries.

 

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PART IV

 

ITEM 14.    PRINCIPAL ACCOUNTANT FEES AND SERVICES

 

AUDIT AND NON-AUDIT FEES

 

The following table presents fees for professional audit services rendered by PricewaterhouseCoopers LLP (“PwC”) for the audit of the Company’s annual financial statements and the reviews of the financial statements included in the Company’s quarterly reports on Form 10-Q during the fiscal years ended December 31, 2004 and 2003, and fees billed for other services rendered by PwC during those periods.

 

     Fiscal
2004


   Fiscal
2003


Audit Fees (1)

   $ 889,961    $ 326,088

Audit-Related Fees (2)

     212,213      336,536

Tax Fees (3)

     35,000      79,750

All Other Fees (4)

     —        3,185

(1) Audit fees consist of fees billed for professional services rendered for the audit of the Company’s consolidated annual financial statements and review of interim consolidated financial services that are normally provided by PwC in connection with statutory and regulatory filings or engagements. The increase in 2004 over 2003 is primarily attributable to fees associated with services rendered to comply with the Sarbanes Oxley Act of 2002. The Company’s Audit Committee approved 100% of the services described in this paragraph.
(2) Audit-Related Fees consist of fees billed for professional services that are reasonably related to the performance of the audit or review of the Company’s consolidated financial statements and are not reported under “Audit Fees”, including those associated with acquisitions, employee benefit plans, Sarbanes Oxley advisory services and due diligence. The Company’s Audit Committee approved 100% of the services described in this paragraph.
(3) Tax Fees consist of fees billed for professional services rendered for the preparation of federal and state income tax returns and tax planning. The Company’s Audit Committee approved 100% of the services described in this paragraph.
(4) All Other Fees consist of fees for products and services other than the services reported above. In 2004, there were no Other Fees incurred. In 2003, the Other Fees related to a subscription for PwC’s online accounting database.

 

The Company did not incur any other fees for professional services rendered by PwC other than those disclosed above for the fiscal years 2004 and 2003.

 

AUDIT COMMITTEE PRE-APPROVAL PROCESS

 

Pursuant to our Audit Committee Charter, before the independent auditor is engaged by the Company or its subsidiaries to render audit or non-audit services, the Audit Committee pre-approves the engagement. Audit Committee pre-approval of audit and non-audit services is not required if the engagement for the services is entered into pursuant to pre-approval policies and procedures established by the Audit Committee regarding the Company’s engagement of the independent auditor, provided the policies and procedures are detailed as to the particular service, the Audit Committee is informed of each service provided and such policies and procedures do not include delegation of the Audit Committee’s responsibilities under the Exchange Act to the Company’s management. The Audit Committee may delegate to one or more designated members of the Audit Committee the authority to grant pre-approvals, provided such approvals are presented to the Audit Committee at a subsequent meeting. If the Audit Committee elects to establish pre-approval policies and procedures regarding non-audit services, the Audit Committee must be informed of each non-audit service provided by the independent auditor. Audit Committee pre-approval of non-audit services (other than review and attest services) also is not be required if such services fall within available exceptions established by the SEC.

 

67


PART IV

 

ITEM 15.    EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K

 

(a)  The following documents are filed as part of this Report.

 

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

 

     Page

Report of Independent Registered Public Accounting Firm

   73

Consolidated Balance Sheets as of December 31, 2004 and December 31, 2003

   75

Consolidated Statements of Operations for the years ended December 31, 2004, 2003 and 2002

   76

Consolidated Statements of Stockholders’ Equity for the years ended December 31, 2004, 2003, and 2002

   77

Consolidated Statements of Cash Flows for the years ended December 31, 2004, 2003 and 2002

   78

Notes to the Consolidated Financial Statements

   79

 

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

 

Schedule

  

Title


   Page

II    Valuation and Qualifying Accounts    100

 

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

 

3.  Exhibits (in accordance with Item 601 of Regulation S-K).

 

  2.1   

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

  2.2   

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

  3.1   

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

  3.2   

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

  4.1   

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

 

68


10.1*   

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

10.2*   

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

10.3*   

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

10.4*   

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

10.5   

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

10.6   

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

10.7   

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

10.8   

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

10.9   

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

10.10   

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

10.11   

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

10.12   

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

10.13   

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

10.14   

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

 

69


10.15   

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

10.16*   

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

10.17*   

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

10.18   

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

10.19*   

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

10.20*   

Reserved.

10.21*   

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

10.22†   

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

10.23   

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

10.24   

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

10.25†   

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

10.26   

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

10.27*   

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

10.28†   

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

10.29*   

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

10.30*   

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

 

70


10.31*   

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

10.32††   

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

10.33*   

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

10.34*   

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

10.35*   

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

10.36   

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

10.37   

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

10.38   

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

10.39   

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

10.40††   

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

10.41   

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

10.42   

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

10.43   

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

10.44   

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

10.45††   

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

10.46   

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

 

71


10.47   

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

10.48   

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

10.49   

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

10.50   

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

10.51††**   

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

21.1**   

Subsidiaries of the Registrant.

23.1   

Consent of PricewaterhouseCoopers LLP, Independent Registered Public Accounting Firm.

31.1   

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

31.2   

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

32.1   

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

32.2   

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


Confidential treatment has been granted as to portions of this exhibit.
†† Confidential treatment has been requested as to portions of this exhibit.
 * Management contract or compensatory plan or arrangement.
** Previously filed as an Exhibit to the Company’s report on Form 10-K for the fiscal year ended December 31, 2004.

 

72


REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

To the Board of Directors and Stockholders of ArthroCare Corporation:

 

We have completed an integrated audit of ArthroCare Corporation’s 2004 consolidated financial statements and of its internal control over financial reporting as of December 31, 2004, and audits of its 2003 and 2002 consolidated financial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.

 

Consolidated financial statements and financial statement schedule

 

In our opinion, the consolidated financial statements listed in the index appearing under Item 15(a)(1) present fairly, in all material respects, the financial position of ArthroCare Corporation and its subsidiaries (the “Company”) at December 31, 2004 and 2003, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2004 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the index appearing under Item 15(a)(2) presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

Internal control over financial reporting

 

Also, we have audited management’s assessment, included in Management’s Report on Internal Control Over Financial Reporting appearing under Item 9A, that ArthroCare Corporation did not maintain effective internal control over financial reporting as of December 31, 2004, because of the effect of a material weakness in its controls surrounding foreign currency transactions, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting based on our audit.

 

We conducted our audit of internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. An audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.

 

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail,

 

73


accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

A material weakness is a control deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. The following material weakness has been identified and included in management’s assessment. At December 31, 2004, the Company did not perform adequate analysis and review of the accuracy of the recording of the translation of its foreign subsidiaries’ financial information denominated in currencies other than U.S. dollars. This control deficiency resulted in the restatement of the Company’s consolidated financial statements for the quarters ended March 31, 2004 and June 30, 2004. Additionally, this control deficiency could result in a misstatement to other income or related accounts that would result in a material misstatement of annual or interim financial statements that would not be prevented or detected. This material weakness was considered in determining the nature, timing, and extent of audit tests applied in our audit of the 2004 consolidated financial statements, and our opinion regarding the effectiveness of the Company’s internal control over financial reporting does not affect our opinion on those consolidated financial statements.

 

As described in Management’s Report on Internal Control Over Financial Reporting, management has excluded Opus Medical, Inc. from its assessment of internal control over financial reporting as of December 31, 2004 because it was acquired by the Company in a purchase business combination in November 2004. We have also excluded Opus Medical, Inc. from our audit of internal control over financial reporting. Opus Medical, Inc. is a wholly-owned subsidiary whose total assets and total revenues represent approximately 17% and 2%, respectively, of the related consolidated financial statement amounts as of and for the year ended December 31, 2004.

 

In our opinion, management’s assessment that ArthroCare Corporation did not maintain effective internal control over financial reporting as of December 31, 2004, is fairly stated, in all material respects, based on the criteria established in Internal Control—Integrated Framework issued by the COSO. Also, in our opinion, because of the effect of the material weakness described above on the achievement of the objectives of the control criteria, ArthroCare Corporation has not maintained effective internal control over financial reporting as of December 31, 2004, based on the criteria established in Internal Control—Integrated Framework issued by the COSO.

 

/s/    PRICEWATERHOUSECOOPERS LLP

 

San Jose, California

March 31, 2005 with respect to our opinion

relating to the consolidated financial statements

and financial statement schedule and

April 28, 2005 with respect to our

opinions relating to internal control over

financial reporting

 

74


ARTHROCARE CORPORATION

 

CONSOLIDATED BALANCE SHEETS

(in thousands, except per share data)

 

     December 31,

 
     2004

    2003

 
ASSETS                 

Current assets:

                

Cash and cash equivalents

   $ 21,836     $ 20,890  

Accounts receivable, net of allowance for doubtful accounts of $400 in 2004 and $289 in 2003

     34,032       24,122  

Inventories

     40,484       33,072  

Deferred tax assets

     10,685       3,604  

Prepaid expenses and other current assets

     4,864       3,317  
    


 


Total current assets

     111,901       85,005  

Available-for-sale securities

     —         10,428  

Property and equipment, net

     29,396       23,493  

Related party receivables

     1,075       1,205  

Deferred tax assets

     —         1,409  

Intangible assets

     39,959       5,864  

Goodwill

     57,859       10,383  

Other assets

     341       351  
    


 


Total assets

   $ 240,531     $ 138,138  
    


 


LIABILITIES AND STOCKHOLDERS’ EQUITY                 

Current liabilities:

                

Accounts payable

   $ 9,517     $ 6,808  

Accrued liabilities

     9,925       4,082  

Accrued compensation

     6,783       5,323  

Income taxes payable

     478       1,122  

Current portion of loan payable

     4,286       —    
    


 


Total current liabilities

     30,989       17,335  

Loan payable, net of current portion

     24,643       —    

Deferred tax liabilities

     9,493       —    

Deferred rent

     154       155  
    


 


Total liabilities

     65,279       17,490  

Commitments and contingencies

                

Preferred stock, par value $0.001:

                

Authorized: 5,000 shares;

                

Issued and outstanding: none

     —         —    

Common stock, par value $0.001:

                

Authorized: 75,000 shares;

                

Issued and outstanding: 24,086 shares in 2004 and 21,025 shares in 2003

     24       21  

Treasury stock: 2,704 shares in 2004 and 2003

     (42,158 )     (42,158 )

Additional paid-in capital

     238,355       156,283  

Deferred compensation

     (2,477 )     (951 )

Accumulated other comprehensive loss

     (592 )     (836 )

Retained earnings (Accumulated deficit)

     (17,900 )     8,289  
    


 


Total stockholders’ equity

     175,252       120,648  
    


 


Total liabilities and stockholders’ equity

   $ 240,531     $ 138,138  
    


 


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

 

75


ARTHROCARE CORPORATION

 

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

 

     Year Ended December 31,

 
     2004

    2003

    2002

 

Revenues:

                        

Product sales

   $ 147,830     $ 114,719     $ 84,965  

Royalties, fees and other

     6,318       4,134       3,822  
    


 


 


Total revenues

     154,148       118,853       88,787  

Cost of product sales

     51,100       37,941       33,409  
    


 


 


Gross profit

     103,048       80,912       55,378  
    


 


 


Operating expenses:

                        

Research and development

     13,346       10,642       8,826  

Sales and marketing

     58,087       46,100       36,519  

General and administrative

     16,310       14,845       10,679  

Amortization of intangible assets

     2,658       1,180       201  

Acquired in-process research and development costs

     36,400       —         —    
    


 


 


Total operating expenses

     126,801       72,767       56,225  
    


 


 


Income (loss) from operations

     (23,753 )     8,145       (847 )

Interest income

     379       518       1,828  

Interest expense

     (930 )     (84 )     (94 )

Foreign exchange gains, net

     1,417       1,596       237  

Other income (expense), net

     (42 )     326       574  
    


 


 


Income (loss) before income taxes

     (22,929 )     10,502       1,698  

Income tax provision

     3,260       3,046       566  
    


 


 


Net income (loss)

   $ (26,189 )   $ 7,456     $ 1,132  
    


 


 


Basic net income (loss) per share

   $ (1.21 )   $ 0.36     $ 0.05  
    


 


 


Shares used in computing basic net income (loss) per share

     21,594       20,885       21,467  
    


 


 


Diluted net income (loss) per share

   $ (1.21 )   $ 0.34     $ 0.05  
    


 


 


Shares used in computing diluted income (loss) per share

     21,594       21,942       22,330  
    


 


 


 

 

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

 

76


ARTHROCARE CORPORATION

 

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

(in thousands, except per share data)

 

    Common
Stock
Shares


    Common
Stock
Amount


    Treasury
Stock
Amount


    Additional
Paid-In
Capital


  Deferred
Stock
Compensation


    Accumulated
Other
Comprehensive
Income


    Retained
Earnings/
(Accumulated
Deficit)


    Total
Stockholders’
Equity


    Comprehensive
Income (Loss)


 

Balances, December 31, 2001

  21,855     $ 22     $ (18,987 )   $ 146,081   $ —       $ (1,724 )   $ (299 )   $ 125,093          

Issuance of common stock through:

                                                                   

Exercise of options

  293       —         —         1,989     —         —         —         1,989          

Employee stock purchase plan

  51       —         —         542     —         —         —         542          

Restricted stock expense

  —         —         —         23     —         —         —         23          

Stock compensation

  —         —         —         83     —         —         —         83          

Income tax benefit resulting from exercise of stock options

  —         —         —         679     —         —         —         679          

Change in unrealized gain on available-for-sale securities

  —         —         —         —       —         (80 )     —         (80 )   $ (80 )

Currency translation adjustment

  —         —         —         —       —         820       —         820       820  

Purchase of common stock

  (1,027 )     (1 )     (12,117 )     —       —         —         —         (12,118 )        

Net income

  —         —         —         —       —         —         1,132       1,132       1,132  
   

 


 


 

 


 


 


 


 


Balances, December 31, 2002

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


Issuance of common stock through:

                                                                   

Exercise of warrants and options

  387       1       —         3,007     —         —         —         3,008          

Employee stock purchase plan

  67       —         —         752     —         —         —         752          

Issuance of restricted stock

  126       —         —         1,138     (1,138 )     —         —         —            

Stock compensation

  —         —         —         392     187       —         —         579          

Income tax benefit resulting from exercise of stock options

  —         —         —         1,597     —         —         —         1,597          

Change in unrealized gain on available-for-sale securities

  —         —         —         —       —         (194 )     —         (194 )     (194 )

Currency translation adjustment

  —         —         —         —       —         342       —         342       342  

Purchase of common stock

  (727 )     (1 )     (11,054 )     —       —         —         —         (11,055 )        

Net income

  —         —         —         —       —         —         7,456       7,456       7,456  
   

 


 


 

 


 


 


 


 


Balances, December 31, 2003

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


Issuance of common stock through:

                                                                   

Exercise of options

  1,009       1       —         14,266     —         —         —         14,267          

Employee stock purchase plan

  44       —         —         879     —         —         —         879          

Issuance of restricted stock

  71       —         —         2,123     (2,123 )     —         —         —            

Purchase of Opus Medical

  1,937       2       —         59,998     —         —         —         60,000          

Stock compensation

  —         —         —         176     597       —         —         773          

Income tax benefit resulting from exercise of stock options

  —         —         —         4,630     —         —         —         4,630          

Change in unrealized gain on available-for-sale securities

  —         —         —         —       —         173       —         173       173  

Currency translation adjustment

  —         —         —         —       —         71       —         71       71  

Net loss

  —         —         —         —       —         —         (26,189 )     (26,189 )     (26,189 )
   

 


 


 

 


 


 


 


 


Balances, December 31, 2004

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

 


 


 

 


 


 


 


 


 

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

 

77


ARTHROCARE CORPORATION

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

 

     Year Ended December 31,

 
     2004

    2003

    2002

 

Cash flows from operating activities:

                        

Net income (loss)

   $ (26,189 )   $ 7,456     $ 1,132  

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

                        

Acquired in-process research and development projects

     36,400       —         —    

Depreciation and amortization

     13,523       9,772       7,589  

Loss on disposition of equipment

     85       30       —    

Provision for doubtful accounts receivable and product returns

     586       —         683  

Provision for excess and obsolete inventory

     246       193       143  

Non-cash stock compensation expense

     773       579       106  

Realized gain on sale of long-term investment

     (333 )     —         —    

Income tax benefit relating to employee stock options

     4,630       1,597       679  

Deferred rent

     (1 )     41       61  

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

                        

Accounts receivable

     (7,624 )     (5,470 )     1,614  

Inventories

     (2,627 )     (10,028 )     (5,832 )

Deferred tax asset

     3,766       301       —    

Prepaid expenses and other current assets

     (1,166 )     (1,399 )     437  

Other assets

     175       (58 )     (99 )

Accounts payable

     (1,242 )     (1,350 )     2,619  

Accrued liabilities

     2,575       (390 )     1,501  

Income taxes payable and deferred tax liability

     (6,376 )     1,122       (1,144 )
    


 


 


Net cash provided by operating activities

     17,201       2,396       9,489  
    


 


 


Cash flows from investing activities:

                        

Purchases of property and equipment

     (14,956 )     (13,779 )     (12,235 )

Payment for purchase of Opus Medical, net of cash acquired

     (30,910 )     —         —    

Payment for purchase of MDA, net of cash acquired

     (25,183 )     —         —    

Purchases of intangible assets

     —         (2,150 )     —    

Payment for purchase of Atlantech, net of cash acquired

     —         (630 )     (12,506 )

Purchases of available-for-sale securities

     (50,932 )     (73,938 )     (133,516 )

Sales or maturities of available-for-sale securities

     61,866       75,514       156,526  
    


 


 


Net cash used in investing activities

     (60,115 )     (14,983 )     (1,731 )
    


 


 


Cash flows from financing activities:

                        

Purchase of treasury stock

     —         (11,055 )     (12,118 )

Repayment of loan from bank

     (16,071 )     (56 )     —    

Proceeds from loan from bank

     44,750       —         47  

Proceeds from issuance of common stock, net of issuance costs

     879       752       542  

Proceeds from exercise of options and warrants to purchase common stock, net of issuance costs

     14,267       3,008       1,989  
    


 


 


Net cash provided by (used in) financing activities

     43,825       (7,351 )     (9,540 )
    


 


 


Effect of exchange rate on cash and cash equivalents

     35       75       1,028  

Net increase (decrease) in cash and cash equivalents

     946       (19,863 )     (754 )
    


 


 


Cash and cash equivalents, beginning of year

     20,890       40,753       41,507  
    


 


 


Cash and cash equivalents, end of year

   $ 21,836     $ 20,890     $ 40,753  
    


 


 


 

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

 

78


ARTHROCARE CORPORATION

 

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

 

1.    FORMATION AND BUSINESS OF THE COMPANY:

 

ArthroCare Corporation (“we” or the “company”) was incorporated on April 29, 1993 and our principal operations commenced in August 1995. We design, develop, manufacture and market medical devices for use in soft-tissue surgery. Our products are based on our patented soft-tissue surgical controlled ablation technology, which we call Coblation technology. Coblation technology involves an innovative use of a non-thermal process and has the capability of performing at temperatures lower than traditional electrosurgical tools. Our strategy includes applying Coblation technology to a broad range of soft-tissue surgical markets, including sports medicine, spinal surgery, neurosurgery, cosmetic surgery, ear, nose and throat (ENT) surgery, gynecology, urology, general surgery and various cardiology applications. We are a global company with manufacturing facilities in the United States and Costa Rica and sales offices in the United States and Europe.

 

2.    SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:

 

Basis of Presentation.    We use the calendar year as our fiscal year.

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

79


ARTHOCARE CORPORATION

 

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

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

 

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

 

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

 

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

 

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

 

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

 

Stock-Based Compensation.    We account for stock-based employee compensation using the intrinsic value method of accounting. Under this method, employee stock-based compensation expense is based on the difference, if any, on the date of the grant between the fair value of the Company’s stock and the exercise price of the award. We account for stock options issued to non-employees using the fair value method of accounting. Assumptions used in determining the fair value of non-employee stock option grants in 2004, using the Black-Scholes pricing model, were: risk-free interest rate of 2.9%, expected life of 5 years, expected dividends of zero, and expected volatility of 70%.

 

80


ARTHOCARE CORPORATION

 

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

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

 

     Year Ended December 31,

 
     2004

    2003

    2002

 
     (in thousands, except per share data)  

Net income (loss)—as reported

   $ (26,189 )   $ 7,456     $ 1,132  

Employee stock-based compensation expense determined under the fair value method, net of related tax effects

     (11,887 )     (12,688 )     (12,236 )
    


 


 


Pro forma net loss

   $ (38,076 )   $ (5,232 )   $ (11,104 )
    


 


 


Earnings (loss) per share:

                        

Basic—as reported

   $ (1.21 )   $ 0.36     $ 0.05  

Basic—pro forma

   $ (1.76 )   $ (0.25 )   $ (0.52 )

Diluted—as reported

   $ (1.21 )   $ 0.34     $ 0.05  

Diluted—pro forma

   $ (1.76 )   $ (0.25 )   $ (0.52 )

 

In determining the pro forma net loss, the fair value of each employee option grant was estimated on the date of grant using the Black-Scholes model with the following weighted-average assumptions:

 

Stock Option Plans

 

     Year Ended December 31,

     2004

   2003

   2002

Risk-free interest rate

   2.7% - 4.0%    2.4% - 3.5%    2.6% - 5.0%

Expected life

   5 years    5 years    5 years

Expected dividends

   —      —      —  

Expected volatility

   70%    70%    70%

 

Employee Stock Purchase Plan

 

     Year Ended December 31,

     2004

   2003

   2002

Risk-free interest rate

   1.1% - 2.4%    1.2% - 1.3%    1.1% - 2.2%

Expected life

   0.5 years    0.5 years    0.5 years

Expected dividends

   —      —      —  

Expected volatility

   45%    45%    45%

 

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

 

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

 

81


ARTHOCARE CORPORATION

 

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Foreign Currency Translation.    Certain of the company’s wholly owned subsidiaries have functional currencies other than the U.S. dollar. The functional currency of Atlantech Medical Devices, Ltd. (UK) is the British Pound. The functional currency of Atlantech GmbH (Germany), Atlantech Medizinische Produkte Vertreibs (Austria), ArthroCare Italy SPA and ArthroCare France SRL is the Euro. Accordingly, all balance sheet accounts of these operations are translated into U.S. dollars using the current exchange rate in effect at the balance sheet date, and revenues and expenses are translated using the average exchange rate in effect during the period. The gains and losses from foreign currency translation of Atlantech’s financial statements are recorded directly into a separate component of stockholders’ equity under the caption accumulated other comprehensive income.

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

82


ARTHOCARE CORPORATION

 

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

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

 

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

 

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

 

83


ARTHOCARE CORPORATION

 

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

3.    COMPUTATION OF NET INCOME PER SHARE:

 

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

 

     Year Ended December 31,

     2004

    2003

   2002

Net Income (loss)

   $ (26,189 )   $ 7,456    $ 1,132
    


 

  

Basic:

                     

Weighted-average common shares outstanding

     21,594       20,885      21,467
    


 

  

Basic net income (loss) per share

   $ (1.21 )   $ 0.36    $ 0.05
    


 

  

Diluted:

                     

Weighted-average common shares outstanding used in basic calculation

     21,594       20,885      21,467

Options

     —         978      832

Warrants

     —         28      31

Unvested restricted stock

     —         51      —  
    


 

  

Weighted-average common stock and common stock equivalents

     21,594       21,942      22,330
    


 

  

Diluted net income (loss) per share

   $ (1.21 )   $ 0.34    $ 0.05
    


 

  

Options excluded from calculation as their effect would be anti-dilutive

     5,363       2,556      4,359
    


 

  

Price range of excluded options

   $ 0.20—$48.56     $ 16.22-$48.56    $ 13.42-$48.56
    


 

  

 

4.    AVAILABLE-FOR-SALE SECURITIES:

 

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

 

     2003

     Amortized
Cost


   Gross
Unrealized
Gains


   Gross
Unrealized
Losses


    Fair
Market
Value


Maturity date greater than 1 year but less than 5 years:

                            

Corporate notes and bonds

   $ 10,590    $ —      $ (162 )   $ 10,428
    

  

  


 

Total

   $ 10,590    $ —      $ (162 )   $ 10,428
    

  

  


 

 

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

 

84


ARTHOCARE CORPORATION

 

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

5.    INVENTORY:

 

The following summarizes our inventories at December 31 (in thousands):

 

     December 31,

     2004

   2003

Inventories

             

Raw materials

   $ 10,809    $ 9,451

Work-in-progress

     5,349      6,062

Finished goods

     24,326      17,559
    

  

     $ 40,484    $ 33,072
    

  

 

6.    PROPERTY AND EQUIPMENT:

 

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

 

     December 31,

    Estimated
Useful Lives
(Years)


     2004

    2003

   

Property and equipment:

                    

Controller placements

   $ 40,971     $ 31,452     3 to 4

Computer equipment and software

     11,674       7,760     3 to 5

Machinery and equipment

     6,585       4,618     5

Furniture, fixtures and leasehold improvements

     3,447       2,988     5

Construction in process

     1,286       2,985    

Building and improvements

     2,435       1,930     30

Tooling and molds

     2,683       1,779     5

Land

     406       760    
    


 


   
       69,487       54,272      

Less accumulated depreciation

     (40,091 )     (30,779 )    
    


 


   

Property and equipment, net

   $ 29,396     $ 23,493      
    


 


   

 

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

 

85


ARTHOCARE CORPORATION

 

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

7.    INTANGIBLE ASSETS:

 

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

 

     December 31,

 
     2004

    2003

 

Intellectual property rights

   $ 23,700     $ 1,700  

Patents

     10,500       200  

Trade name/trademarks

     4,400       700  

Distribution/customer network

     3,700       2,900  

OEM contractual agreements

     1,160       1,100  

Distribution license

     450       450  

Employment agreements

     300       300  

Non-competition agreements

     300       100  
    


 


       44,510       7,450  

Accumulated amortization

     (4,551 )     (1,586 )
    


 


Net intangible assets

   $ 39,959     $ 5,864  
    


 


 

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

 

2005

   $ 6,122

2006

     6,011

2007

     5,784

2008

     4,962

2009

     4,815

Thereafter

     12,265
    

     $ 39,959
    

 

8.    ACCRUED LIABILITIES:

 

The following summarizes our accrued liabilities at December 31 (in thousands):

 

     December 31,

     2004

   2003

Accrued liabilities:

             

Accrued acquisition fees

   $ 4,234    $ —  

Accrued dealer commissions

     2,157      1,470

Accrued professional fees

     1,406      1,104

Accrued warranty

     207      252

Accrued value added taxes

     458      258

Other

     1,463      998
    

  

     $ 9,925    $ 4,082
    

  

 

86


ARTHOCARE CORPORATION

 

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

9.    COMMITMENTS AND CONTINGENCIES:

 

Operating Leases

 

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

 

2005

   $ 2,235

2006

     1,912

2007

     406
    

     $ 4,553
    

 

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

 

Warranties

 

The Company generally provides customers with a limited 90-day warranty on devices sold and a limited 1-year warranty on controller units sold. We accrue for the estimated cost of product warranties at the time revenue is recognized. Our warranty obligation is affected by product failure rates, material usage and service delivery costs incurred in correcting a product failure. We periodically evaluate and adjust the warranty reserve to the extent actual warranty expense varies form the original estimates. The following table describes the activity in our warranty accrual for the years ended December 31 (in thousands):

 

     2004

    2003

    2002

 

Balance at beginning of year

   $ 252     $ 243     $ 238  

Accruals for warranties issued during the period

     746       576       482  

Settlements made during the period

     (791 )     (567 )     (477 )
    


 


 


Balance at end of year