**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**Washington,
      D.C. 20549**





**FORM
      10-K**





**ANNUAL
      REPORT**


**PURSUANT
      TO SECTION 13 OR 15(d)**


**OF
      THE SECURITIES EXCHANGE ACT OF 1934**





**For
      the fiscal year ended December 31, 2007**


**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)**





**7500
      Rialto Blvd., Building Two, Suite 100, Austin, TX 78735**


**(Address
      of principal executive offices and zip code)**





**(512)
      391-3900**


**(Registrant’s
      telephone number, including area code)**





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




Indicate
      by check mark if the Registrant is a well-known seasoned issuer, as defined
      in
      Rule 405 of the Securities Act. Yes x No  ̈





Indicate
      by check mark if the Registrant is not required to file reports pursuant to
      Section 13 or Section 15(d) of the Act. Yes  ̈   No x





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





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 a large accelerated filer, an
      accelerated filer, or a non-accelerated filer (as defined in Rule 12b-2 of
      the
      Act).  Large accelerated filer  x Accelerated
      filer  ̈ Non-accelerated filer  ̈





Indicate
      by check mark whether the registrant is a shell company (as defined in Rule
      12b-2 of the Act). Yes  ̈ No x





As
        of
        June 30, 2007, the aggregate market value of the voting and non-voting common
        equity held by non-affiliates of the Registrant was approximately $1,104,895,343
        (based upon the closing sales price of such stock as reported by The NASDAQ
        Stock Exchange on such date). Shares of Common Stock held by each officer,
        director and holder of 5 percent 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 19, 2008, the number of outstanding shares of the Registrant’s Common
      Stock was 26,585,219.





**DOCUMENTS
      INCORPORATED BY REFERENCE**




Portions
      of the definitive proxy statement for our 2007 annual meeting of stockholders,
      which we expect to file with the Commission within 120 days after December
      31,
      2007, are incorporated by reference into Part III of this Annual
      Report.







**ARTHROCARE
      CORPORATION**




**FORM 10-K
      ANNUAL REPORT**




**TABLE
      OF CONTENTS**


**Page****PART
                      I.**ITEM
                      1.
                  
                  Business
                  3ITEM
                      1A.
                  
                  Risk
                      Factors
                  13ITEM
                      1B.
                  
                  Unresolved
                      Staff Comments
                  20ITEM
                      2.
                  
                  Properties
                  20ITEM
                      3.
                  
                  Legal
                      Proceedings
                  21ITEM
                      4.
                  
                  Submission
                      of Matters to a Vote of Security Holders
                  21**PART II.**ITEM
                      5.
                  
                  Market
                      for Registrant’s Common Equity, Related Stockholder Matters and Issuer
                      Purchases of Equity Securities
                  21ITEM
                      6.
                  
                  Selected
                      Consolidated Financial Data
                  23ITEM
                      7.
                  
                  Management’s
                      Discussion and Analysis of Financial Condition and Results
                      of
                      Operations
                  24ITEM
                      7A.
                  
                  Quantitative
                      and Qualitative Disclosures about Market Risk
                  35ITEM
                      8.
                  
                  Financial
                      Statements and Supplementary Data
                  35ITEM
                      9.
                  
                  Changes
                      in and Disagreements with Accountants on Accounting and Financial
                      Disclosure
                  35ITEM
                      9A.
                  
                  Controls
                      and Procedures
                  36ITEM
                      9B.
                  
                  Other
                      Information
                  36**PART III.**ITEM
                      10.
                  
                  Directors,
                      Executive Officersand
                      Corporate Governance
                  37ITEM
                      11.
                  
                  Executive
                      Compensation
                  37ITEM
                      12.
                  
                  Security
                      Ownership of Certain Beneficial Owners and Management and Related
                      Stockholder Matters
                  37ITEM
                      13.
                  
                  Certain
                      Relationships and Related Transactions,
                      and Director Independence
                  40ITEM
                      14.
                  
                  Principal
                      Accountant Fees and Services
                  40**PART IV.**ITEM
                      15.
                  
                  Exhibits
                      and Financial Statement Schedules
                  40


2




**PART
      I**




**ITEM 1.    BUSINESS**





This
      Report on Form 10-K contains certain forward-looking statements regarding future
      events and our future operating results that are subject to the safe harbors
      created under the Securities Act of 1933 (the “Securities Act”) and the
      Securities Exchange Act of 1934 (the “Exchange Act”) with respect to ArthroCare
      Corporation (“ArthroCare,” “we,” “us,” “our,” and “Company” refer to ArthroCare
      Corporation, a Delaware corporation, unless the context otherwise requires).
      Readers are cautioned that these forward-looking statements are only predictions
      and are subject to risks, uncertainties, and assumptions that are difficult
      to
      predict, including those identified below, under “Risk Factors”. 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.





**Overview**





We
      are a
      multi-business medical device company that develops, manufactures and markets
      minimally invasive surgical products, many of which are based on our patented
      Coblation® technology. We have grown well beyond our roots in arthroscopy to
      capitalize on numerous market opportunities across several medical specialties,
      improving many existing soft-tissue surgical procedures and enabling new
      minimally invasive procedures. With our innovative technologies, we are
      committed to improving the lives of individuals suffering from conditions as
      diverse as torn rotator cuffs and anterior cruciate ligaments, or ACLs, to
      herniated discs and enlarged tonsils/tonsillitis.




We
      currently market minimally invasive surgical products across three core business
      units—ArthroCare Sports Medicine, ArthroCare Spine and ArthroCare Ear, Nose and
      Throat, or ENT — but also have developed, manufactured and marketed
      Coblation-based and complementary products for application in neurology,
      cosmetic surgery, urology and gynecology, with research continuing in additional
      areas. In each of our core business units, we are focused on driving the
      application of enabling technologies, primarily for plasma-based soft tissue
      removal, and increasing the number of minimally invasive procedures being
      performed.





We
      focus
      on executing a mission-driven business strategy featuring the following key
      elements:





·
            Expanding
                our product offering to address large and rapidly growing
                markets;





·
            Targeting
                established procedures and replacing current technology with value-added
                ArthroCare technologies;





·
            Driving
                disposable device sales with a direct sales
                force;





·
            Augmenting
                growth with complementary and compatible acquisitions to expand margins
                and provide additional opportunity to capitalize on emerging and
                existing
                business opportunities; and





·
            Establishing
                strategic partnerships to further commercialize our minimally invasive
                technologies.





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, or SEC: 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 100 F Street, NE,
      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.




3


**Coblation
      Technology**





Many
      of
      our minimally invasive products are based on ArthroCare’s patented Coblation
      technology, which uses radiofrequency energy to create a precisely focused
      plasma to ablate soft tissue. The use of Coblation allows surgeons to operate
      with a high level of precision and accuracy, limiting damage to surrounding
      healthy tissue and thereby potentially reducing patient pain and recovery times.
      Our Coblation-based products operate at lower temperatures than traditional
      electrosurgical or laser surgery tools that use heat to burn away targeted
      tissue, which often results in thermal damage to tissue surrounding the surgical
      area. Our Coblation-based systems consist of a controller unit and an assortment
      of sterile, single-use disposable devices that are specialized for specific
      types of procedures. We believe our Coblation technology can replace the
      multiple surgical tools traditionally used in soft-tissue surgery procedures
      with one multi-purpose surgical system.





We
      have
      applied Coblation technology for soft-tissue surgery throughout the body,
      primarily in the areas of arthroscopy/sports medicine, spinal surgery and ENT
      applications. We also are exploring the use of Coblation technology in other
      markets, such as neurosurgery, cosmetic surgery, urology, gynecology, cardiac
      surgery and general surgical procedures.





**The
      Sports Medicine Market**





*Overview*





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
      is performed through several small incisions, called portals, and can be
      performed on an outpatient basis. We believe arthroscopic surgery has gained
      widespread market acceptance because it can offer shorter hospital stays and
      reduced recovery time, which may result in reduced costs and improved medical
      outcomes.





The
      advantages of arthroscopic surgery over open surgery can be 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, less
      muscle atrophy, less surrounding tissue damage, a lower rate of complication
      and
      generally quicker rehabilitation.





*Our
      Solution to Arthroscopic Surgery*





Our
      Arthroscopic System is used to treat a number of orthopedic conditions,
      including those involving knees, ankles, elbows, wrists, tendons and hips.
      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 radiofrequency controller. Our controller delivers
      radiofrequency 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. The
      incorporation of ablation, suction and fluid management into a single disposable
      device potentially reduces operating time and expense.




*Complementary
      Enabling Sports Medicine Technologies*





The
      Opus
      Collection





In
      November of 2004, we acquired Opus Medical, Inc., a manufacturer of products
      designed to facilitate the arthroscopic repair, including the Opus Autocuff
      System, for knotless repair 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. These products may
      enhance efficacy, decrease complications, reduce costs, reduce procedure time
      and broaden the treatable patient base. In 2005, we introduced a sequel device
      to the AutoCuff Anchoring System known as the LabraFix System. The LabraFix
      System provides knotless arthroscopic repair of the labrum.




4




The
      Atlantech Collection





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 AG, our German distributor. The acquisitions
      accelerated 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 more than 1,500 individual
      arthroscopic surgical items.




*Distribution
      for Sports Medicine Products*





We
        sell
        our Arthroscopic System through our Sports Medicine business unit by means
        of a
        network of direct sales representatives and independent orthopedic distributors
        supported by regional managers. Additionally, we offer certain of our customers
        the ability to draw on our expertise in billing private third-party insurance
        companies and other payers for devices that qualify for reimbursement separate
        from a global fee by assigning the right to bill for such devices to us. 
This allows facilities that do not have sophisticated reimbursement
        processes to focus their efforts on providing patient care. Upon reimbursement
        from the third-party payers, the customer is rebated the reimbursement amount,
        up to the price they paid for the device.





*Competition
      in the Sports Medicine Market*





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., Dyonics, Inc. and 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 DePuy Mitek, a division of its Ethicon, Inc. unit, Stryker
      Corporation and Smith & Nephew market bipolar electrosurgical systems
      that compete directly with our tissue ablation and coagulation technology in
      Sports Medicine. In addition, the Linvatec unit of Conmed Corporation,
      Smith & Nephew and Arthrex are marketing monopolar electrosurgical
      tools for tissue ablation that compete with our products in this field. These
      same competitors also compete against our Opus collection with rotator cuff
      repair systems that include suture passers and bone anchors to complete the
      repair.





**The
      Spinal Surgery Market**





*Overview*





We
      believe the spine surgery market represents the most rapidly growing segment
      of
      the orthopedic surgery market. 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 or ruptures. Disc herniation can eventually cause back pain
      and
      pain that radiates to the extremities, including the buttocks, legs, shoulders
      and arms **.**





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. In more severe cases, the adjacent vertebral bodies
      must be stabilized following excision of the disc material to avoid recurrence
      of the disabling back pain. One approach to stabilizing the vertebrae, termed
      spinal fusion, is to insert an interbody graft or implant into the space vacated
      by the degenerative disc. In this procedure, a small amount of bone may be
      grafted from other portions of the body, such as the hip, and packed into the
      implants. This process 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.




5





*Our
      Solution to Spinal Surgery*





Disc
      Decompression





Randomized
        controlled studies have indicated minimally invasive disc decompression is
        an
        effective alternative to microdiscectomy for patients with contained herniated
        discs who have symptoms of back or radicular pain. Disc decompression is
        a
        minimally invasive procedure where disc material is removed without the patient
        having to undergo major open surgery. The disc is accessed through a
        narrow cannula and the physician performs the procedure under fluoroscopic
        (live x-ray) guidance. We created the DLR, DLG and DC SpineWand® Convenience
        Packs for minimally invasive disc decompression. Plasma Disc Decompression,
        a
        minimally invasive disc decompression procedure using 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.
        Plasma Disc Decompression can be performed in both the lumbar and cervical
        spine
        either percutaneously or through a small incision with or without an access
        port. Plasma Disc Decompression can be performed as a stand alone procedure
        or
        in conjunction with other surgical procedures such as a spinal
        fusion.





Microdisectomy





In
      cases
      where the surgeon determines that a microdiscectomy is indicated, the surgeon
      requires a device that can remove a greater amount of tissue than the devices
      we
      market for Plasma Disc Decompression. For microdiscectomy cases, we market
      the
      MD SpineWand surgical device. The MD SpineWand, which is also based on our
      Coblation technology, is designed to quickly and efficiently remove disc
      material through an annulotomy that is typically much smaller than the one
      required with the mechanical instruments that are used in these procedures.





*Complementary
      Enabling Spinal Surgery Technologies*





Vertebral
      Compression Fractures





In
      January 2004, we completed the acquisition of Medical Device Alliance, Inc.
      and
      its majority-owned subsidiary, Parallax Medical, a leader in products for the
      minimally invasive treatment of vertebral compression fractures. It is estimated
      that 750,000 Americans suffer from vertebral compression fractures which are
      caused by osteoporosis, trauma or, increasingly, metastatic disease.
      Approximately 260,000 of these patients are treated annually. Parallax’s product
      line includes vertebral access and bone biopsy needles, cement delivery systems,
      bone cement and opacifiers and ancillary devices permitting minimally invasive
      repair of vertebral compression fractures.





In
      May of
      2007 ArthroCare received clearance from the Food and Drug Administration, or
      FDA, to market the Cavity SpineWand, a Coblation-based device, to reduce
      malignant lesions within a vertebra in patients suffering from compression
      fractures secondary to tumors. Medical grade cement is then injected to
      stabilize the fracture.





*Distribution
      for Spinal Surgery Products*




We
          sell our
          spinal surgery products through our Spine business unit by means of a network
          of
          direct sales representatives and**independent orthopedic
          distributors supported by regional managers. Additionally, prior to December
          31,
          2007 a third-party billing and reimbursement service provider known as
          DiscoCare, Inc. would purchase devices from ArthroCare and provide them
          to
          customers generally at no charge in return for either the agreement by
          the
          facility to assign the right to bill private third-party insurance companies
          and
          other payers for the device or a letter of protection in a personal injury
          case.  More specifically, a third-party billing and reimbursement service
          provider, such as DiscoCare, deals with insurance pre-authorizations, device
          procurement, inventory management and claims processing to help reduce
          device
          costs and the financial collection risk for facilities who use the service
          in
          conjunction with a procedure. Many of ArthroCare’s spinal surgery products are
          leading edge technologies which have not yet received routine coverage
          decisions
          from insurance companies and other payers making reimbursement dependent
          on case
          by case decisions from various third-party payors.  In part because of
          DiscoCare’s history of success in demonstrating the efficacy of the procedures
          using the ArthroCare devices and their ability to receive reimbursement
          for such
          devices, on December 31, 2007, ArthroCare acquired DiscoCare to augment
          our
          internal reimbursement resources.  Utilizing DiscoCare’s services allows
          facilities who do not have sophisticated reimbursement processes to focus
          their
          efforts on patient care.





6


*Competition
      in the Spinal Surgery Market*




In
          the Plasma Disc Decompression market, we directly compete with Stryker,
          Clarus,
          Smith and Nephew and other small companies. We may indirectly compete with
          large
          companies in the spine fusion and discectomy markets such as DePuy Spine,
          Medtronic Sofamor Danek, Stryker, Zimmer 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, Smith & Nephew
          Endoscopy and Radionics, a division of Integra, manufacture and sell catheters
          that use 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, which was recently acquired by Medtronic, is our leading competitor
      in
      the overall vertebral compression fracture market with its balloon kyphoplasty
      procedure.





**The
      ENT Market**





*Overview*





The
      most
      common ENT procedures are placement of ear tubes, and the removal of tonsils
      and
      adenoids. We estimate that there are more than 600,000 tonsillectomies performed
      in the United States each year, many of which are accompanied by an
      adenoidectomy. The majority of tonsillectomies are performed on pediatric
      patients, which results in these procedures typically being performed more
      often
      in the late spring and winter months of the 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 ENT surgeons, typically in an outpatient or
      ambulatory surgery center, perform these procedures. For decades, monopolar
      electrosurgical instruments (e.g. the 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.





*Our
      Solution to ENT Surgery*





We
      market
      ENT products through a network of direct sales representatives and independent
      distributors supported by sales managers for use in general head, neck and
      oral
      surgical procedures, including sinus surgery, the treatment of snoring,
      reduction of nasal turbinates, adenoidectomy and tonsillectomy. We have three
      categories of disposable devices, or wands, to address the ENT Market—suction
      wands, channeling wands and excision wands. 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.





*Complementary
      Enabling ENT Technologies*





The
      Applied Therapeutics Collection




In
      August
      2005, we completed the purchase of substantially all of the assets of Applied
      Therapeutics, Inc., or ATI, a maker of sinus surgery treatment products. ATI’s
      carboxymethyl-cellulose based packing and tamponade products promote platelet
      aggregation directly at the wound site while remaining moist for the duration
      of
      insertion. We believe this minimizes patient discomfort and re-bleeding during
      removal, as compared to traditional treatments. The ATI collection includes
      the
      dissolvable Stammberger Sinus Dressing and dissolvable Sinu Knit. These products
      are used after endoscopic sinus surgery to control minor bleeding, facilitate
      epithelial healing and preserve the spatial integrity of the sinus.





*Competition
      in the ENT Market*





There
      are
      large companies, such as Gyrus and Medtronic, which have shares of the market
      for manual and powered instruments for ENT, head and neck surgical procedures.
      Gyrus 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. In addition, Gyrus has introduced a
      radiofrequency system for treating tonsils that competes directly with some
      of
      our products in the ENT business.




7




**Additional
      Markets for Coblation Technology**





We
      developed and commercialized Coblation-based urology products through a
      strategic partnership with ACMI until the termination of that agreement in
      August 2005 following Gyrus Medical’s acquisition of ACMI. We also developed
      gynecology products for commercialization through an agreement with GyneCare,
      a
      unit of Johnson & Johnson, until the expiration of that agreement in
      September 2004. We may establish strategic partnerships in these markets and
      others, where beneficial, in the future or enter the market directly, as
      appropriate.





*Potential
      Competition in Non Core-Coblation Markets*





We
      believe Coblation-based 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-Surgery,
      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, and ultrasonic and laser devices for a variety of
      urological procedures, including transurethral prostatectomy, or TURP, and
      transurethral incisions in the prostate, or TUIP. These companies include Karl
      Storz, Olympus Medical Systems Group, C.R. Bard, Gyrus, Medtronic, Urologix
      and
      Laserscope. We expect 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.





**Research
      and Development**





We
      have
      focused our research and development efforts in four areas. First, in response
      to physician feedback, we modify and enhance the performance of our
      generator/controller platforms and introduce new platforms from time to time.
      Second, we have continued to design new disposable devices that incorporate
      added functionalities for faster and easier use. Third, we have developed and
      continue to explore new applications of our Coblation technology in surgical
      markets. Fourth, we incorporate complementary technologies and products into
      our
      portfolio in order to provide more value to our customers and participate to
      a
      greater extent in certain surgical procedures. Research and development expenses
      were $26.9 million in 2007, $23.2 million in 2006, and $21.0 million in
      2005.





We
      also
      have 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.





**Manufacturing**





Our
      disposable devices are primarily manufactured at our facility located in an
      industrial park in San Jose, Costa Rica. In 2004, we transferred the
      manufacturing of our controllers from our Sunnyvale, California facility to
      our
      Costa Rica facility. As of December 31, 2005, our Costa Rica facility was
      also producing essentially all of the disposable products associated with the
      Opus product line.





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. In 2005, the lease for this facility was extended
      through February 2014. Approximately 50 percent of this facility is devoted
      to
      research and new product development. We believe our existing operations will
      provide adequate capacity for our manufacturing needs at least through 2008.





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 13485 and CMDCAS certification and are in conformance with
      applicable regulatory requirements.





Our
      products are manufactured from several components, most of which are supplied
      to
      us from third parties. Most of the components 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 is 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.




8





DHL
      Worldwide Express, Inc., or DHL, is our primary provider of logistic services,
      including warehousing of finished goods, shipment of finished products to
      customers and field returns, along with management of a portion of our in-bound
      freight requirements. We have experienced favorable cost performance and have
      gained an ability to scale our business at a faster pace due to this
      relationship. 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.





**Marketing
      and Sales**





We
      are
      marketing and selling our arthroscopic/sports medicine, spinal surgery and
      ENT
      products using a combination of distributors supported by regional sales
      managers, a direct sales force and corporate partners to sell our products
      both
      domestically and internationally. In the U.S. and Europe, we principally use
      distributors and field sales representatives to sell our products.





Outside
      of the United States and Europe, we have established distribution capability
      in
      certain countries by means of exclusive and non-exclusive distribution
      agreements for the distribution of our arthroscopy, spinal surgery and ENT
      surgery products in Japan. We have also established distribution capability
      through relationships with distributors in New Zealand, Russia, China, Korea,
      Taiwan, Canada, Mexico, the Caribbean, North Africa, South Africa, the Middle
      East, South America and Central America. During the years ended
      December 31, 2007, 2006 and 2005, approximately 21 percent, 20 percent and
      21 percent, respectively, of our product sales were derived internationally.
      For
      information regarding product sales in certain product markets and geographic
      areas, see Note 15, “Segment Information,” in the notes to the consolidated
      financial statements in this Form 10-K.





**Reimbursement
      Assistance**




Many
        of
        ArthroCare’s products are leading edge technologies which have not yet received
        routine coverage decisions from insurance companies and other payers.  As a
        result, reimbursement may be dependent on case by case decisions from various
        private third-party payers.  In 2007, we established a new subsidiary,
        Device Reimbursement Services (“DRS”), to provide principally our Sports
        Medicine devices that we sell in exchange for an assignment of the right
        to bill
        for such devices. DRS offers certain of our customers the ability to draw
        on our expertise in billing private third-party insurance companies and other
        payers for devices that qualify for reimbursement separate from a global
        fee by
        assigning the right to bill for such devices to us.  Utilizing DRS’
services allows facilities that do not have sophisticated reimbursement
        processes to focus their efforts on providing patient care.  Upon
        reimbursement from the third-party payers, the customer is typically rebated
        the
        reimbursement amount, up to the price they paid for the
        device.


Since
              2006,
              DiscoCare, Inc., another third-party billing and reimbursement service
              provider,
              has purchased devices from ArthroCare and provided them to their customers
              generally at no charge in return for either the agreement by the
              facility to assign to DiscoCare the right to bill private third-party
              insurance companies and other payers for the device or a letter of
              protection in
              a personal injury case.  After a procedure is completed, DiscoCare bills
              either the applicable insurer or other third-party payer.   More
              specifically, a third-party billing and reimbursement service provider,
              such as
              DiscoCare, deals with insurance pre-authorizations, device procurement,
              inventory management and claims processing to help reduce device costs
              and the
              financial collection risk for facilities who use the service in conjunction
              with
              a procedure. DiscoCare originally worked with ArthroCare on a limited
              geographical basis and, in the fourth quarter of 2006, DiscoCare approached
              ArthroCare about providing their services to ArthroCare customers on
              a national
              basis.  The resulting agreement provided for DiscoCare to purchase the
              devices and provide the billing and reimbursement services to ArthroCare’s
              customers and receive a service fee paid by ArthroCare.   Many of the
              ArthroCare products purchased by DiscoCare consisted of leading edge
              technologies which have not yet received routine coverage decisions
              from
              insurance companies and other payers making reimbursement dependent
              on case by
              case decisions from various third-party payers.  In part because of
              DiscoCare’s history of success in demonstrating the efficacy of the procedures
              using the ArthroCare devices and their ability to receive reimbursement
              for such
              devices, and in part to augment our internal reimbursement resources,
              ArthroCare
              acquired DiscoCare in December 2007.


9




In
        connection
        with our reimbursement activities, we have adopted the ArthroCare Corporation
        Health Care Compliance Program, implementing the key elements of a model
        health
        care compliance plan developed by the Office of Inspector General of the
        United
        States Department of Health and Human Services, or OIG, which oversees
        compliance with applicable Federal laws in connection with the payment for
        products by government funded programs.




**Patents
      and Proprietary Rights**





Our
      ability to compete effectively depends in part on developing and maintaining
      the
      proprietary aspects of our technologies, including Coblation technology and
      our
      acquired technologies. We own over 160 issued U.S. patents and over 100 issued
      international patents. In addition, we have over 200 U.S. and international
      pending patent applications. We believe 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. In addition, we believe that our issued patents are
      directed at many of the core features of our acquired technologies from Opus,
      Atlantech, Parallax and ATI.





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





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





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





The
      medical device industry has been characterized by extensive litigation regarding
      patents and other intellectual property rights, and companies in the medical
      device industry have employed intellectual property litigation to gain a
      competitive advantage. We cannot assure you that we will not become subject
      to
      patent infringement claims or litigation or reexamination or interference
      proceedings declared by the United States Patent and Trademark office, or USPTO,
      to determine the priority of inventions.





The
      defense and prosecution of this lawsuit and intellectual property suits
      generally, USPTO reexamination and interference proceedings and related legal
      and administrative proceedings are both costly and time-consuming. 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 reexamination 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
      reexamination or interference proceedings to which we may become a party could
      subject us to significant liabilities to third parties, require disputed rights
      to be licensed from third parties or require us to cease using certain
      technology. Furthermore, we cannot 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.




10





**Government
      Regulation**





*United
      States*





Our
      products are considered medical devices and are subject to extensive regulation
      in the United States. We must comply with FDA regulations to market our products
      or obtain pre-market 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;




•
            
            Product
                labeling;




•
            
            Product
                storage;




•
            
            Premarket
                clearance or approval;




•
            
            Advertising
                and promotion; and




•
            
            Product
                sales and distribution.




Non-compliance
      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. 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.




11





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. We have received 510(k) clearance to market our interventional
      therapy devices for percutaneous, intraoperative and spinal procedures. 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. 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
      Coblation-based products for a variety of laparoscopic 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
      TURP and TUIP.





We
      cannot
      assure you we will be able to obtain necessary clearances or approvals to market
      any other products, or existing products for new intended uses, on a timely
      basis, if at all.  Delays in receipt or failure to receive clearances or
      approvals, the loss of previously received clearances or approvals, or failure
      to comply with existing or future regulatory requirements could have a material
      adverse effect on our business, financial condition, results of operations
      and
      future growth prospects.





After
      a
      device receives 510(k) clearance, any modification that could significantly
      affect its safety or effectiveness, or that would constitute a major change
      in
      the intended use of the device, technology, materials, packaging, and certain
      manufacturing process may require a new 510(k) clearance and the FDA may
      retroactively require the manufacturer to submit a premarket notification
      requesting 510(k) clearance. The FDA also can require the manufacturer to cease
      marketing and/or recall the modified device until 510(k) clearance is obtained.
      FDA guidance documents define when to submit premarket notifications for new
      or
      modified devices. These guidance documents also define modifications for which
      a
      new 510(k) is not required. We have modified some of our marketed devices,
      and
      have determined that in certain instances new 510(k) clearances are not
      required. When a 510(k) clearance has been required, premarket notifications
      have been submitted to the FDA documenting the specific device modifications.
      No
      assurance can be given that the FDA would agree with any of our decisions not
      to
      seek 510(k) clearance. If the FDA requires us to cease marketing and/or recall
      the modified device until we obtain a new 510(k) clearance, our business,
      financial condition, results of operations and future growth prospects could
      be
      materially adversely affected.





If
      we
      cannot establish that a proposed device is substantially equivalent to a legally
      marketed device, we must seek premarket approval through submission of a PMA
      application. A PMA application must be supported by extensive data, including,
      in many instances, preclinical and clinical trial data, as well as extensive
      literature to prove the safety and effectiveness of the device. Often, clinical
      testing will require the submission and approval of an Investigational Device
      Exemption, or IDE, which defines the scope and conditions of the clinical trial.
      If necessary, we will file an IDE and seek a PMA application for approval to
      sell our potential products at the successful conclusion of the study and the
      submission of the completed IDE. 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 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, including post-market surveillance. 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.





12


*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 spinal surgery products in Europe, Canada, Japan,
      South America, Australia, Korea, Mexico, the Middle East and Taiwan; to market
      our ENT surgery products in Europe, Australia, Canada, China, Israel, Japan,
      Middle East, Korea Taiwan, Australia and South America; to market our cosmetic
      surgery products in Europe, Australia, Canada, the Middle East, Korea, South
      America and Israel; 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.





**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 million per occurrence and $10 million 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 our ability to attract and retain customers for our products.





**Employees**





As
      of
      December 31, 2007, in North America, we had 413 employees, of which 29 were
      engaged in manufacturing activities, 96 in research and development activities,
      196 in sales and marketing activities, 35 in regulatory affairs and quality
      assurance and 57 in administration and finance. In Europe, we had 145 employees
      in sales, marketing, product development, customer service, manufacturing and
      administration who are responsible for our international business. In Costa
      Rica, we had 507 employees engaged in manufacturing and administration. In
      Asia
      Pacific we had 9 employees engaged in sales and marketing activities. We have
      no
      employees covered by collective bargaining agreements, and we believe we
      maintain good relations with our employees.





**ITEM
      1A. RISK FACTORS**





We
      operate in a dynamic and rapidly changing industry that involves numerous risks
      and uncertainties. The risks and uncertainties described below are those that
      we
      currently believe may materially affect us. Other risks and uncertainties that
      we do not presently consider to be material or of which we are not presently
      aware, may become important factors that affect us in the future.





*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 and Arthrex and Conmed are currently marketing monopolar
        electrosurgical systems for tissue ablation. Arthrex, Smith & Nephew,
        Conmed, Stryker and DePuy Mitek, a division of Johnson & Johnson, market
        products that directly compete with our shoulder anchors, acquired as part
        of
        our Opus acquisition. In spinal surgery, we compete against companies that
        market products to remove tissue and treat spinal disorders. We compete against
        Stryker, which markets the Dekompressor® device, which uses a
        mechanical auger, as well as Clarus, which markets the Nucleotome®
        device, to perform disc decompression procedures. In addition, Smith &
Nephew Endoscopy and the Radionics division of Integra are currently marketing
        percutaneous thermal heating products for treating certain types of disc
        pain.
        Our MD SpineWand for microdiscectomy competes indirectly with large spine
        companies and their mechanical instruments, such as DePuy Spine, Medtronic
        Sofamor Danek, Zimmer, Stryker Spine and Synthes. Stryker, Cardinal Health,
        Cook
        and Kyphon, which was recently acquired by Medtronic, market products that
        compete directly with our Parallax product line. In ENT surgery, we compete
        against companies that offer manual instruments, such as Smith & Nephew,
        Inc., Stryker Corp., Conmed Corporation, and Medtronic Neurosurgery. In
        addition, we compete with companies that develop and market lasers for various
        ENT surgery applications, including Lumenis and Gyrus Group International,
        Inc.,
        also sell medical devices for the treatment of various ENT disorders, including
        snoring and obstructive sleep apnea. In addition, Gyrus has introduced a
        bipolar
        system for tonsillectomy procedures that competes directly with our
        Coblation-based tonsillectomy products. Medtronic and Gyrus both market sinus
        surgery packing products that compete with our ATI
        products.




13




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
      May Not Be Able to Keep Pace with Technological Change or to Successfully
      Develop New Products with Wide Market Acceptance, Which Could Cause Us to Lose
      Business to Competitors*




We
      may
      not be able to keep pace with technology or to develop viable new products,
      as
      we compete in a market characterized by rapidly changing technology. Our future
      financial performance will depend in part on our ability to develop and
      manufacture new products in a cost-effective manner, to introduce them to the
      market on a timely basis, and to achieve market acceptance. Factors which may
      result in delays of new product introductions or cancellation of our plans
      to
      manufacture and market new products include capital constraints, research and
      development delays or delays in acquiring regulatory approvals. Our new products
      and new product introductions may fail to achieve expected levels of market
      acceptance. Factors impacting the level of market acceptance include our ability
      to successfully implement new technologies, the timeliness of our product
      introductions, our product pricing strategies, and the financial and
      technological resources for product promotion and development
      available.





*We
      Are Dependent Upon Our Core Coblation Technology*




We
      commercially introduced our Coblation technology product lines in December
      1995.
      Since these product lines accounted for over 70 percent of our product sales
      in
      2007, 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 continue
      to
      increase 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 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. **





14


*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 payers. 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 investors that any such approvals will be obtained
      in
      a timely manner, if at all.





Plasma
          Disc
          Decompression is our version of minimally invasive disc decompression,
          where
          tissue is removed from the nucleus to decompress the disc. Several payers
          consider these procedures, regardless of the method used to remove tissue,
          to be
          investigational, and others cover specific methods of disc decompression,
          but
          consider Plasma Disc Decompression investigational. DiscoCare, the reimbursement
          service provider acquired by the Company in December 2007, has had some
          success
          in obtaining authorizations for Plasma Disc Decompression procedures, by
          following a strict medical and documentation regimen, from all major private
          health insurance carriers and most workers compensation plans, including
          carriers who consider Plasma Disc Decompression, or disc decompression
          procedures in general, to be experimental. However, there is no assurance
          that
          we will continue to be successful in obtaining authorizations for these
          cases in
          the future. In addition, there is no assurance that we will be able to
          obtain
          positive coverage decisions from major insurance companies for Plasma Disc
          Decompression at any point in the future.





*We
      Rely Exclusively on Our 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 manufactured at our
      Company-owned facility in an industrial park in San Jose, Costa Rica. If our
      Costa Rica facility is not able to produce sufficient quantities of our
      controllers and other high-volume Coblation products with adequate quality,
      or
      if our Costa Rica operations are disrupted for any reason, then we may be forced
      to locate alternative manufacturing facilities, including facilities operated
      by
      third parties. Disruptions may include, but are not limited to, changes in
      the
      legal and regulatory environment in Costa Rica; slowdowns or work stoppages
      within the Costa Rican customs authorities; acts of God and other issues
      associated with significant operations that are remote from our headquarters
      and
      operations centers. Locating alternative facilities would be time-consuming,
      would disrupt our production and cause shipment delays and could result in
      damage to our reputation and profitability. We cannot guarantee that alternative
      manufacturing facilities offering the cost and tax advantages associated with
      our Costa Rica facility would be available on favorable terms, or at all.





*We
      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 investors that we
      would be able to obtain the necessary regulatory approval for a new material
      to
      be used in our products on a timely basis, if at all. This could create supply
      disruptions that would materially adversely affect our business, financial
      condition, results of operations and future growth prospects.




15





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 DHL, our logistics partner. Should this
      supplier experience a work stoppage for whatever reason, we would be unable
      to
      supply products to our 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.





*Circumstances
      Associated with Our Acquisition Strategy and Internal Growth May Adversely
      Affect Our Operating Results*





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





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





In
      2005,
      we acquired substantially all of the assets of ATI, a maker of wound care
      products for ENT indications. In 2004 and 2002, 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 businesses has been a significant
      challenge to our 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 dispersed 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.





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




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


•
              
              protectionist
                  laws and business practices that favor local competition;•
              
              changes
                  in jurisdictional tax laws including laws regulating intercompany
                  transactions;•
              
              dependence
                  on local vendors;•
              
              multiple,
                  conflicting and changing governmental laws and regulations;•
              
              difficulties
                  in collecting accounts receivable;
  16
  •
              
              seasonality
                  of operations;•
              
              difficulties
                  in staffing and managing foreign operations;•
              
              licenses,
                  tariffs, and other trade barriers;•
              
              loss
                  of proprietary information due to piracy, misappropriation or weaker
                  laws
                  regarding intellectual property protection;•
              
              foreign
                  currency exchange rate fluctuations;•
              
              political
                  and economic instability; and•
              
              acquisitions
                  and related IPR&D.




We
      derived 21 percent, 20 percent and 21 percent of our total product sales for
      the
      years ended December 31, 2007, 2006 and 2005, respectively, from customers
      located outside of the Americas. We expect international revenue to remain
      a
      large percentage of total revenue and we believe that we must continue to expand
      our international sales activities to be successful. Historically, a majority
      of
      our international revenues and costs have been denominated in foreign
      currencies, and we expect future international revenues and costs will be
      denominated in foreign currencies. Our international sales growth will be
      limited if we are unable to establish appropriate foreign operations, expand
      international sales channel management and support organizations, hire
      additional personnel, develop relationships with international sales
      representatives, and establish relationships with additional distributors.
      In
      that case, our business, operating results and financial condition could be
      materially adversely affected. Even if we are able to successfully expand
      international operations, we cannot be certain that we will be able to maintain
      or increase international market demand for our products.





*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 and our acquired technologies.
      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. In addition, we believe
      that our issued patents are directed at many of the core features of our
      acquired technologies from Opus, Parallax, Atlantech and ATI.





There
      is
      no assurance that the patents we have obtained, or any patents we may obtain
      as
      a result of our pending U.S. or international patent applications, will provide
      any competitive advantages for our products. We also cannot assure investors
      that those patents will not be successfully challenged, invalidated or
      circumvented in the future. In addition, we cannot provide assurance that
      competitors, many of which have substantial resources and have made substantial
      investments in competing technologies, have not already applied for or obtained,
      or will not seek to apply for and obtain, patents that will prevent, limit
      or
      interfere with our ability to make, use and sell our products either in the
      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, 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
      investors that we will not have to defend ourselves in court against allegations
      of infringement of third-party patents, or that such defense would be
      successful.




17




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 investors 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 investors that we will not become
      subject to patent infringement claims or litigation or interference proceedings
      declared by the USPTO, to determine the priority of inventions.





*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. Information about the U.S. and foreign regulatory requirements
      pertaining to our products and indications before they can be commercialized
      can
      be found under the heading “Government Regulations” in Item 1,
      above.





*Product
      Liability Claims Could Adversely Impact our Financial Condition and Impair
      our
      Reputation*





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





*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.





*Our
      Operating Results May Fluctuate*




We
      achieved profitability in 1999 and, as of December 31, 2007, we had retained
      earnings of $78.4 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;
  18
  •
              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;•
              Acquisition
                  related in-process research and development write-offs;•
              Timing
                  of the receipt of orders and product shipments; and•
              Promotional
                  programs for our products.




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




*The
      Market Price of Our Stock May Be Highly Volatile*




During
      the fiscal year ended December 31, 2007 our common stock traded in a closing
      price range of $33.93 to $64.84 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;•
              Rumors
                  or dissemination of false information;•
              Changes
                  in coverage or earnings estimates by analysts;•
              Sales
                  of common stock by existing stockholders; and•
              Economic
                  and political conditions.




19




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, the risk of securities class action litigation
      has increased. If similar litigation were instituted against us, it could result
      in substantial costs and a diversion of our management’s attention and
      resources, which could have an adverse effect on our business, results of
      operations and financial condition. See “Item 5: Market for Registrant’s Common
      Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities,”
for more information regarding fluctuations in the price of our common
      stock.




*Delaware
      Law and Provisions in Our Charter Could Make the Acquisition of Our Company
      by
      Another Company More Difficult*




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. 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.




**ITEM
      1B. UNRESOLVED STAFF COMMENTS**





None.





**ITEM
      2.    PROPERTIES**





We
      lease
      a facility in Austin, Texas, which serves as our corporate headquarters. The
      Austin, Texas facility is used for general and administrative purposes as well
      as for research and development activities. Our lease for this building will
      expire in June 2016.





We
      lease
      a facility in Sunnyvale, California for administrative offices, research and
      development, general and administrative purposes and prototype manufacturing.
      Our lease for this building will expire in February 2014. We also lease, on
      a
      month-to-month basis, a warehouse in a neighboring building in Sunnyvale,
      California for warehousing and distribution.





As
      a
      result of our acquisition of Opus Medical we lease a facility in Irvine,
      California, which is used for product development and prototype manufacturing
      associated with the Opus product line. This lease expires at the end of 2011.




Internationally,
        we lease a facility in Stockholm, Sweden, which serves as our headquarters
        for
        international operations. We lease additional international properties in
        Harrogate, England, for administrative, sales and marketing purposes as well
        as
        contributions to the product development process for a portion of our Sports
        Medicine product line. In Glenfield, England we lease a plant that is used
        for
        manufacturing the Rapid Rhino product set and in Opglabbeek, Belgium we lease
        a
        facility that is used for a European repair center.  Expiration dates
        related to these international leases range from two to five years.


In
            Costa
            Rica we own a building located in a tax-advantaged business park. This
            facility
            serves as our principal manufacturing location for disposable
            devices.
 
 We
            believe these facilities, in addition to multiple less significant facilities
            leased in various countries around the world for sales, marketing and
            administrative purposes, are sufficient for our operations at least through
            2008.


20





**ITEM
      3.    LEGAL PROCEEDINGS**





From
      time
      to time, we are a defendant in certain lawsuits alleging product liability,
      patent infringement or other claims incurred in the ordinary course of business.
      These claims are generally covered by certain insurance policies, subject to
      certain deductible amounts and maximum policy limits. When there is no insurance
      coverage, as would typically be the case primarily in lawsuits alleging patent
      infringement, we establish sufficient reserves to cover probable losses
      associated with such claims. Except as otherwise described above, we have
      product liability insurance coverage in amounts we consider necessary to prevent
      material losses. We recognize losses when they are known or considered probable
      and the amount can be reasonably estimated.




Defending
      and prosecuting intellectual property suits, USPTO interference proceedings
      and
      related legal and administrative proceedings are 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
      provide assurance that we can obtain any necessary licenses on satisfactory
      terms, if at all.




While
          we are
          not aware of any pending investigation concerning DiscoCare, we are responding
          to a request from the NASDAQ Stock Exchange regarding
          DiscoCare.


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




No
      matters were submitted to a vote of security holders during the fourth quarter
      of the fiscal year covered by this Annual Report on Form 10-K.




**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 Exchange 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.




**2007****Quarter 1**
            
            **Quarter 2**
            
            **Quarter 3**
            
            **Quarter 4**High
            
            $
            40.05
            
            $
            44.53
            
            $
            58.99
            
            $
            64.84Low
            
            
            33.93
            
            
            36.68
            
            
            43.77
            
            
            45.97




**2006****Quarter
                1**
            
            **Quarter
                2**
            
            **Quarter
                3**
            
            **Quarter
                4**High
            
            $
            48.05
            
            $
            48.64
            
            $
            47.88
            
            $
            48.06Low
            
            
            41.03
            
            
            38.53
            
            
            39.11
            
            
            39.92




As
      of
      February 19, 2008, there were no outstanding shares of preferred stock and
      249
      holders of record of 26,585,219 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.





**ISSUER
      PURCHASES OF EQUITY SECURITIES**





In
      December 2007, our Board of Directors approved a discretionary share repurchase
      program that allows us to purchase up to $75.0 million of our outstanding common
      stock on a periodic basis in the open market. Pursuant to the program, in
      December 2007 we purchased 1,255,982 shares at an average cost of $47.49 per
      share. In January 2008, we purchased an additional 243,918 shares at an average
      price of $48.29 per share. We repurchased the shares based on an evaluation
      of
      our long-term cash forecast and balance sheet capacity, including anticipated
      capital requirements.




21





The
      description of equity compensation plans required by Item 201(d) of Regulation
      S-K is incorporated herein by reference to Part III, Item 12 of this Form 10-K.





**PERFORMANCE
      GRAPH**




The
        following graph shows a comparison of total stockholder return for holders
        of
        our common stock for the five years ended December 31, 2007 compared with
        the
        NASDAQ Stock Exchange, U.S. Index and the NASDAQ Health Services Index. This
        graph is presented pursuant to SEC rules. We believe that while total
        stockholder return can be an important indicator of corporate performance,
        the
        stock prices of medical device companies like ours are subject to a number
        of
        market-related factors other than company performance, such as those discussed
        in “Risk Factors” in Item I above.









*****
            $100
                invested on December 31, 2002 in stock or in index - including
                reinvestment of dividends. Our most recent fiscal year ended December
                31,
                2007.


Cumulative
                    Total Return12/02
                
                12/03
                
                12/04
                
                12/05
                
                12/06
                
                12/07ArthroCare
                    Corporation
                
                
                100.00
                
                
                248.73
                
                
                325.48
                
                
                427.82
                
                
                405.28
                
                
                487.82NASDAQ
                    Stock Exchange (U.S.)
                
                
                100.00
                
                
                149.75
                
                
                164.64
                
                
                168.60
                
                
                187.83
                
                
                205.22NASDAQ
                    Health Services
                
                
                100.00
                
                
                135.61
                
                
                168.24
                
                
                184.41
                
                
                186.06
                
                
                181.42




22




**ITEM
      6.    SELECTED CONSOLIDATED 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, 2007, 2006 and 2005 and the balance sheet data as
      of
      December 31, 2007 and 2006 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, 2004 and 2003 and the balance
      sheet data as of December 31, 2005, 2004 and 2003 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 income for 2005 and net loss for 2004 reflect
      significant charges related to acquisitions during those periods.





**Year
                Ended December 31,****2007**
            
            **2006**
            
            **2005**
            
            **2004**
            
            **2003****(in
                thousands, except per share data)****Statements
                of Operations Data:**Product
                sales
            
            $
            307,596
            
            $
            253,376
            
            $
            206,533
            
            $
            147,830
            
            $
            114,719Royalties,
                fees and other
            
            
            11,646
            
            
            9,625
            
            
            7,801
            
            
            6,318
            
            
            4,134Total
                revenues
            
            
            319,242
            
            
            263,001
            
            
            214,334
            
            
            154,148
            
            
            118,853Gross
                profit
            
            
            234,518
            
            
            186,163
            
            
            150,128
            
            
            103,048
            
            
            80,912Operating
                expenses
            
            
            181,343
            
            
            143,693
            
            
            117,069
            
            
            126,801
            
            
            72,767Net
                income (loss)
            
            
            43,180
            
            
            31,675
            
            
            23,530
            
            
            (26,189
            )
            
            7,456Basic
                net income (loss) per share
            
            $
            1.57
            
            $
            1.21
            
            $
            0.97
            
            $
            (1.21
            )
            $
            0.36Diluted
                net income (loss) per share
            
            $
            1.50
            
            $
            1.14
            
            $
            0.89
            
            $
            (1.21
            )
            $
            0.34




**December
                31,****2007**
            
            **2006**
            
            **2005**
            
            **2004**
            
            **2003****(in
                thousands)****Balance
                Sheet Data:**Cash,
                cash equivalents and available-for-sale securities (including long-term
                portion)
            
            $
            43,250
            
            $
            30,756
            
            $
            23,317
            
            $
            21,836
            
            $
            31,318Working
                capital
            
            
            148,348
            
            
            113,744
            
            
            98,841
            
            
            80,912
            
            
            67,670Total
                assets
            
            
            450,068
            
            
            375,046
            
            
            266,978
            
            
            240,531
            
            
            138,138Long-term
                liabilities
            
            
            67,393
            
            
            2,870
            
            
            4,092
            
            
            34,290
            
            
            155Total
                stockholders’ equity (1)
            
            
            340,503
            
            
            322,503
            
            
            228,894
            
            
            175,252
            
            
            120,648


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




23




**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 and are
      subject to the safe harbors created under the Securities Act of 1933 and the
      Securities Exchange Act of 1934. Readers are cautioned that these
      forward-looking statements are only predictions and are subject to risks,
      uncertainties, and assumptions that are difficult to predict. As such, actual
      events or results may differ materially as a result of the risks and
      uncertainties described herein and elsewhere including, but not limited to,
      those factors discussed in “Risk Factors” set forth in Part I of this Report as
      well as other risks and uncertainties in the documents incorporated herein
      by
      reference.*





**Overview**





We
      are a
      multi-business medical device company that develops, manufactures and markets
      minimally invasive surgical products, many of which are based on our patented
      Coblation® technology. We currently market minimally invasive surgical products
      across three core business units — ArthroCare Sports Medicine, ArthroCare Spine,
      and ArthroCare Ear, Nose and Throat, or ENT — but also have developed,
      manufactured and marketed Coblation-based and complementary products for
      application in neurology, cosmetic surgery, urology and gynecology, with
      research continuing in additional areas. In each of our core business units
      we
      are focused on driving the application of enabling technologies, primarily
      for
      plasma-based soft tissue removal, and increasing the number of minimally
      invasive procedures being performed.





In
      December 1995, we introduced our Arthroscopy System commercially in the United
      States and have derived a significant portion of our sales from this system.
      Our
      strategy includes placing controller units, which enable use of our disposable
      Coblation products, at substantial discounts or placing controllers at customer
      sites at no cost in order to generate future disposable product revenue. Our
      strategy also includes applying our patented Coblation technology to a range
      of
      other soft-tissue surgical markets, including the products we have introduced
      in
      the fields of spinal surgery, neurosurgery, gynecology, urology, cosmetic
      surgery, ENT surgery, cardiology and general surgery. We 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.





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. In
      August 2005, we completed the purchase of substantially all of the assets of
      Applied Therapeutics, Inc., or ATI, a maker of sinus surgery treatment products.





We
      have
      received 510(k) clearance from the FDA to market several of our products and
      several of our products are CE marked, which is a requirement to sell our
      products in most of Western Europe. Specifically, we have received 510(k)
      clearance from the FDA to market our Coblation-based Arthroscopic Surgery
      System, or Arthroscopic System, for use in arthroscopic surgery of the knee,
      shoulder, ankle, elbow, wrist and hip. In addition, our Arthroscopic System
      is
      CE marked for use in arthroscopic surgery. We have also received 510(k)
      clearances in the United States and a CE mark in Europe to market and sell
      our
      Coblation-based Spinal Surgery System for spinal surgery and neurosurgery.
      We
      have received 510(k) clearance and a CE mark to market our interventional
      therapy devices for percutaneous, intraoperative and spinal procedures.  Our
      ENT
      Surgery System has received 510(k) clearances from the FDA and a CE mark for
      use
      in general head, neck, oral and sinus surgery procedures, including
      tonsillectomy and adenoidectomy, turbinate reduction to relieve nasal
      obstruction, and soft tissue removal to treat snoring. The FDA also has cleared
      our Cosmetic Surgery System for general dermatologic procedures and skin
      resurfacing in connection with wrinkle reduction procedures. In addition, the
      Cosmetic Surgery System has received a CE Mark. We also have received 510(k)
      clearance from the FDA, and applied for a CE mark, to market products based
      on
      our Coblation technology for use in urology, gynecology, plastic and
      reconstructive surgery, orthopedic surgery and general surgery.




24




Many
          of
          ArthroCare’s products are leading edge technologies which have not yet received
          routine coverage decisions from insurance companies and other payers.  As a
          result, reimbursement may be dependent on case by case decisions from various
          private third-party payers.  In 2007, we established a new subsidiary,
          Device Reimbursement Services, to provide certain of the devices we sell
          in
          exchange for an assignment of the right to bill for such devices. 
Additionally, in December 2007 we acquired another third-party billing
          and
          reimbursement service provider, DiscoCare, Inc.  In addition, we have
          adopted the ArthroCare Corporation health Care Compliance Program, implementing
          the key elements of a model health care compliance plan developed by the
          Office
          of Inspector General of the United States Department of Health and Human
          Services, or OIG, which oversees compliance with applicable Federal laws
          in
          connection with the payment for products by government funded
          programs.





**Critical
      Accounting Policies and Estimates**





The
      preparation of financial statements and related disclosures in conformity with
      accounting principles generally accepted in the United States of America
      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. The most significant areas involving management judgments
      and estimates are described below and are impacted significantly by judgments,
      assumptions, and estimates used in the preparation of the consolidated financial
      statements. Actual results could differ materially from these
      estimates.




*Revenue
      Recognition*




We
      recognize product revenue in accordance with SEC Staff Accounting
      Bulletin No. 104, *Revenue
      Recognition in Financial Statements* ,
      or SAB
      104. Under SAB 104, revenue is recognized when there is persuasive evidence
      of
      an arrangement, delivery has occurred or services have been rendered, the sales
      price is fixed and determinable and collectibility is reasonably assured.
      Generally, the criteria are met upon shipment of the Company’s products. For
      amounts due from third-party payors, revenues are recorded at estimated net
      amounts due for devices utilized with allowances determined using historical
      collection amounts for each type of payor. Estimated allowances are adjusted
      to
      actual allowances as cash is received and claims are reconciled. We evaluate
      the
      following criteria in developing the estimated allowance percentages each month:
      historical allowance trends based on actual claims paid by third-party payors;
      consideration and analysis of changes in payor mix reimbursement levels; and
      other issues that may impact allowances. In certain cases, at the customer’s
      request, we will enter into bill and hold transactions whereby title and risk
      of
      loss transfers to the customer, but the product does not ship until a specified
      later date. Revenue on such transactions is recognized only after ArthroCare
      has
      met all conditions for bill and hold transactions set forth in SAB 104,
      specifically that ArthroCare has no further performance obligations, that the
      product is complete and ready for shipment, and that a fixed schedule for
      delivery of the product is set. As of December 31, 2007, 2006 and 2005,
      respectively, there were no undelivered bill and hold transactions. Revenue
      is
      reported net of a provision for estimated product returns.





We
      recognize license fees and other revenue over the term of the associated
      agreement unless the fee is in exchange for products delivered or services
      performed that represent the culmination of a separate earnings process.
      Royalties are recognized as earned, generally based on the licensees’ product
      shipments. The items are classified as royalties, fees and other revenues in
      the
      accompanying statements 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 costs of product sales in
      the
      accompanying statements of operations.





We
      maintain an allowance for doubtful accounts receivable based on our assessment
      of the collectibility of customer accounts. The Company regularly reviews the
      allowance, considering such factors as historical collection experience, a
      customer’s current credit-worthiness, customer concentrations, the age of the
      receivable balances, both individually and in the aggregate, and general
      economic conditions that may affect a customer’s ability to pay. Actual customer
      collections could differ from our estimates. We believe that the allowance
      for
      doubtful accounts receivable of $4.0 million at December 31, 2007 is adequate
      to
      provide for probable losses associated with accounts receivable.




25





*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.





*Business
      Combinations*





Accounting
      for our business acquisitions requires extensive accounting estimates and
      judgments to allocate the purchase price between net tangible assets, in-process
      research and development, other identifiable intangible assets, and goodwill.
      Assets and liabilities of acquired businesses are recorded under the purchase
      method of accounting at their estimated fair value at the date of acquisition.





The
      Company accounts for business combinations in accordance with Statement of
      Financial Accounting Standards No. 142, *Goodwill
      and Other Intangible Assets* ,
      or
      FAS 142 *.* As
      of
      December 31, 2007, we had recorded goodwill of $166.8 million and other
      intangible assets of $37.7 million, net of accumulated amortization. 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
      or
      other intangible assets.





We
      test
      goodwill for impairment at the reporting unit level at least annually during
      the
      fourth quarter of each fiscal year and more frequently if impairment indicators
      are identified. The first step of the goodwill impairment test is a comparison
      of the fair value of a reporting unit to its carrying value. We estimate the
      fair values of each reporting unit using discounted cash flow valuation models.
      These methods require estimates of our future revenues, profits, capital
      expenditures, working capital, and other relevant factors. We estimate these
      amounts by evaluating historical trends, current budgets, operating plans,
      industry data, and other relevant factors. The estimated fair value of each
      reporting unit exceeded its respective carrying value in fiscal 2007, indicating
      the underlying goodwill of each reporting unit was not impaired as of December
      31, 2007. Accordingly, we were not required to complete the second step of
      the
      goodwill impairment test. The timing and frequency of our goodwill impairment
      test is based on an ongoing assessment of events and circumstances that would
      more than likely reduce the fair value of a reporting unit below its carrying
      value. We will continue to monitor our goodwill balance and conduct formal
      tests
      on at least an annual basis or more often when impairment indicators are
      present. There are various assumptions and estimates underlying the
      determination of an impairment loss, and estimates using different, but each
      reasonable, assumptions could produce significantly different results and
      materially affect the determination of fair value and/or goodwill impairment
      for
      each reporting unit. Therefore, the timing and recognition of impairment losses
      by us in the future, if any, may be highly dependent upon our estimates and
      assumptions. We believe that the assumptions and estimates utilized were
      appropriate based on the information available to management.




Intangible
      assets with finite lives are amortized over the estimated useful life of each
      asset. We monitor conditions related to these assets to determine whether events
      and circumstances warrant a revision to the remaining amortization period.
      Under
      Statement No. 144, *Accounting
      for the Impairment or Disposal of Long-Lived Assets* ,
      intangible assets with finite lives must be tested for potential impairment
      whenever events or changes in circumstances indicate that the carrying amount
      may not be recoverable. To date, no events or circumstances have been noted
      that
      would indicate the potential for impairment of our intangible assets.





In
      connection with the ATI acquisition, we made an estimate of $2.4 million related
      to the valuation of purchased in-process research and development, or IPR&D,
      projects. Our policy defines IPR&D as the value assigned to those projects
      which have no alternative future use, including those for which the related
      products have not reached technological feasibility or have not received
      regulatory approval. Determining the portion of the purchase price allocated
      to
      IPR&D requires significant estimates. The amount of the purchase price
      allocated to IPR&D is determined by estimating the amount and timing of
      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.




26





On
          December
          31, 2007, we acquired a third-party billing and reimbursement service provider,
          DiscoCare, Inc. Since 2006, DiscoCare has been providing surgical devices
          to
          facilities, generally at no charge in exchange for the right to bill for
          such
          device. ArthroCare paid $24.5 million in cash, net of acquisition costs
          paid and
          cash acquired with the potential for future earnouts based on achievement
          of
          contractually specified milestones.  In accordance with Emerging Issues
          Task Force 04-01, *Accounting for Preexisting Relationships between the
          Parties to a Business Combination*, we evaluated the purchase as a multiple
          element contract to separately account for settlement of the preexisting
          relationship and for the acquisition. Based on our analysis, there was
          no gain
          or loss required to be recognized for settling the preexisting relationship.
          Therefore, the entire purchase price was allocated to the net assets of
          DiscoCare based on fair market value as of the date of acquisition, primarily
          accounts receivable, inventory, identified intangible assets, and liabilities
          assumed with the balance applied to goodwill.


*Contingencies*




We
      are
      subject to the possibility of various loss contingencies arising in the ordinary
      course of business. In determining loss contingencies, 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. 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 accrual estimates should be adjusted.





*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.





In
      addition, we make an evaluation at the end of each reporting period as to
      whether or not some or all of the undistributed earnings of our foreign
      subsidiaries are permanently reinvested (as that term is defined in generally
      accepted accounting principles). While we may have concluded in the past that
      some of such undistributed earnings are permanently reinvested, facts and
      circumstances can change in the future, and it is possible that a change in
      facts and circumstances, such as a change in the expectation regarding the
      capital needs of our foreign subsidiaries, could result in a conclusion that
      some or all of such undistributed earnings are no longer permanently reinvested.
      In such an event, we would be required to recognize a deferred income tax
      liability in an amount equal to the estimated incremental U.S. income tax and
      withholding tax liability that would be generated if all of such
      previously-considered permanently reinvested undistributed earnings were
      distributed to the U.S.





In
      July
      2006, the Financial Accounting Standards Board, or FASB, issued Interpretation
      No. 48, *Accounting
      for Uncertainty in Income Taxes,* or
      FIN
      48. FIN 48 clarifies the accounting for uncertainty in income taxes recognized
      in an enterprise’s financial statements in accordance with Statement of
      Financial Accounting Standards No. 109, *Accounting
      for Income Taxes* .
      This
      interpretation prescribes a recognition threshold and measurement attribute
      for
      the financial statement recognition and measurement of a tax position taken
      or
      expected to be taken in a tax return. FIN 48 also provides guidance on
      derecognition of tax benefits, classification on the balance sheet, interest
      and
      penalties, accounting in interim periods, disclosure, and transition. We adopted
      FIN 48 effective January 1, 2007. In accordance with FIN 48, paragraph 19,
      we have decided to classify interest and penalties as a component of tax
      expense. As a result of the implementation of FIN 48, we recognized a
      $2.1 million increase in liability for unrecognized tax benefits, which was
      accounted for as a reduction to the January 1, 2007 balance of retained
      earnings.





As
      of
      December 31, 2007, we had unrecognized tax benefits of approximately $8.4
      million, of which $7.6 million, if recognized, would result in a reduction
      of
      our effective tax rate. The Company recorded an increase in its unrecognized
      tax
      benefits of approximately $0.5 million for the year ended December 31, 2007.
      Interest and penalties were immaterial as of December 31, 2007 and are included
      in the unrecognized tax benefits. The Company is subject to audit by the
      Internal Revenue Service and California Franchise Tax Board for the years 1994
      through 2007 and by the Texas State Comptroller for the years 2006 and 2007.
      As
      the Company has operations in most other U.S. states, other state tax
      authorities may assess deficiencies related to prior year activities; however,
      the years open to assessment vary with each state.   The Company also files
      income tax returns for non-U.S. jurisdictions; the most significant of which
      are
      the UK, Sweden, and Germany. The years open to adjustment for the UK and Germany
      are 2003 through 2007.  The years open to adjustment for Sweden are 1999
      through 2007.




27




*Stock-Based
      Compensation*





On
      January 1, 2006, we adopted Statement
      of Financial Accounting Standards No. 123
      (revised 2004), *Share-Based
      Payment* ,
      or FAS
      123R, which requires the measurement and recognition of compensation expense
      for
      all share-based payment awards made to employees, including employee stock
      options, restricted stock awards and employee stock purchases related to the
      Employee Stock Purchase Plan, or ESPP, based on estimated grant date fair
      values. Stock-based compensation expense recognized under FAS 123R for the
      years
      ended December 31, 2007 and 2006 was $10.2 million and $9.8 million,
      respectively. Stock-based compensation expense relating to restricted stock
      awards and non-employee stock options for the year ended December 31, 2005
      was
      $1.4 million. There was no stock-based compensation expense related to employee
      stock options recognized during the year ended December 31, 2005. See Note
      11,
“Stockholders’ Equity,” in the notes to the consolidated financial statements
      for additional information.





Upon
      adoption of FAS 123R, we began estimating the value of employee stock options
      on
      the date of grant using the Black Scholes model, as we had previously used
      for
      the purpose of disclosing pro forma financial information. The determination
      of
      the fair value of share based payment awards on the date of grant using an
      option pricing model is affected by our stock price as well as assumptions
      regarding a number of highly complex and subjective variables. These variables
      include, but are not limited to, the expected stock price volatility and
      employee stock option exercise behavior.





The
      weighted average fair value of stock awards, excluding restricted stock, granted
      for the year ended December 31, 2007 was $12.21 per share and $6.20 per share
      for the ESPP, using the Black Scholes model with the following weighted average
      assumptions:





**Year
                ended**
              **December
                31, 2007****Options**
            
            **ESPP**Expected
                term (in years)(1)
            
            
            3.8
            
            
            0.5Expected
                volatility(2)
            
            
            33
            %
            
            35
            %Risk-free
                interest rate(3)
            
            
            4.7
            %
            
            4.8
            %Expected
                dividends
            
            
            -
            
            
            -





(1)
            The
                expected term assumption for options was determined based on historical
                data, adjusted for the recent reduction of the contractual life for
                options from 10 to seven years.


(2)
            The
                expected volatility was determined using a blend of implied volatility
                and
                historical volatility over the expected term, which we consider a
                better
                indictor of expected volatility than using only historical
                volatility.


(3)
            The
                risk-free interest rate is based upon observed interest rates appropriate
                for the term of the Company’s
                awards.





As
      stock-based compensation expense recognized in the consolidated statement of
      operations for 2007 is based on awards ultimately expected to vest, it has
      been
      reduced for estimated forfeitures at a rate of 6.6 percent. FAS 123R requires
      forfeitures to be estimated at the time of grant and revised, if necessary,
      in
      subsequent periods if actual forfeitures differ from those estimates.
      Forfeitures were estimated based on historical experience but actual forfeitures
      could differ materially and result in volatility in our stock-based compensation
      expense amounts.




28


***Overview
      of 2007 Financial Results***





Total
      revenue for the year ended December 31, 2007 was $319.2 million, an increase
      of
      21.4 percent compared to the year-ended December 31, 2006. The increase was
      driven by the combined performance of all business units. International product
      sales represented approximately 20.9 percent of net product sales for the year.
      No single customer accounted for more than 10 percent of our net product sales
      for the year ended December 31, 2007.





Total
      operating expenses were approximately $181.3 million for 2007, compared to
      $143.7 million in 2006. This $37.6 million increase was driven by a combination
      of factors: approximately $15.4 million represents increased salaries,
      commissions and other employee-related expenses due to increased headcount,
      $12.6 million relates to additional commissions and fees related to increased
      sales volume and new sales agency agreements, $5.5 million is attributable
      to
      increased clinical testing, marketing and promotions related to new product
      lines, and $1.6 million relates to a net increase in legal, accounting and
      other
      outside consulting costs.





Our
      cash,
      cash equivalents and short-term investments balance at December 31, 2007 was
      $43.3 million, an increase of approximately $12.5 million from December 31,
      2006.








**Results
                of Operations****Year
                Ended December 31,**(Dollar
                amounts in thousands)
            
            **2007**
            
            
            **2006**
            
            **2005**Revenues:Product
                sales
            
            $
            307,596
            
            
            96.4
            %
            
            $
            253,376
            
            
            96.3
            %
            $
            206,533
            
            
            96.4
            %Royalties,
                fees and other
            
            
            11,646
            
            
            3.6
            %
            
            
            9,625
            
            
            3.7
            %
            
            7,801
            
            
            3.6
            %Total
                revenues
            
            
            319,242
            
            
            100.0
            %
            
            
            263,001
            
            
            100.0
            %
            
            214,334
            
            
            100.0
            %Cost
                of product sales
            
            
            84,724
            
            
            26.5
            %
            
            
            76,838
            
            
            29.2
            %
            
            64,206
            
            
            30.0
            %Gross
                profit
            
            
            234,518
            
            
            73.5
            %
            
            
            186,163
            
            
            70.8
            %
            
            150,128
            
            
            70.0
            %Operating
                expenses:Research
                and development
            
            
            26,886
            
            
            8.4
            %
            
            
            23,247
            
            
            8.9
            %
            
            21,015
            
            
            9.8
            %Sales
                and marketing
            
            
            123,213
            
            
            38.6
            %
            
            
            91,915
            
            
            35.0
            %
            
            75,302
            
            
            35.1
            %General
                and administrative
            
            
            24,033
            
            
            7.5
            %
            
            
            21,355
            
            
            8.1
            %
            
            12,202
            
            
            5.7
            %Amortization
                of intangible assets
            
            
            7,211
            
            
            2.3
            %
            
            
            7,176
            
            
            2.7
            %
            
            6,150
            
            
            2.9
            %Acquired
                in-process research and development costs
            
            
            —
            
            
            0.0
            %
            
            
            —
            
            
            0.0
            %
            
            2,400
            
            
            1.1
            %Total
                operating expenses
            
            
            181,343
            
            
            56.8
            %
            
            
            143,693
            
            
            54.7
            %
            
            117,069
            
            
            54.6
            %Income
                from operations
            
            
            53,175
            
            
            16.7
            %
            
            
            42,470
            
            
            16.1
            %
            
            33,059
            
            
            15.4
            %Interest
                and other income (expense), net
            
            
            2,184
            
            
            0.6
            %
            
            
            (1,809
            )
            
            (0.7
            %)
            
            (2,336
            )
            
            (1.1
            %)Income
                before income taxes
            
            
            55,359
            
            
            17.3
            %
            
            
            40,661
            
            
            15.4
            %
            
            30,723
            
            
            14.3
            %Income
                tax provision
            
            
            12,179
            
            
            3.8
            %
            
            
            8,986
            
            
            3.4
            %
            
            7,193
            
            
            3.3
            %Net
                income
            
            $
            43,180
            
            
            13.5
            %
            
            $
            31,675
            
            
            12.0
            %
            $
            23,530
            
            
            11.0
            %





29


*Revenues*





*Product
      sales* consist
      principally of sales of disposable devices. Product sales for fiscal 2007 were
      $307.6 million compared to $253.4 million and $206.5 million in fiscal 2006
      and
      2005, respectively. Product sales by product market for the periods shown were
      as follows (dollar amounts in thousands):


**Year
                Ended December 31,****2007**
            
            
            **2006**
            
            
            **2005**Sports
                Medicine
            
            $
            189,588
            
            
            61.6
            %
            
            $
            166,665
            
            
            65.8
            %
            
            $
            139,868
            
            
            67.7
            %ENT
            
            
            73,065
            
            
            23.8
            %
            
            
            59,886
            
            
            23.6
            %
            
            
            43,546
            
            
            21.1
            %Spine
            
            
            44,653
            
            
            14.5
            %
            
            
            26,635
            
            
            10.5
            %
            
            
            23,110
            
            
            11.2
            %Coblation
                Technology
            
            
            290
            
            
            0.1
            %
            
            
            190
            
            
            0.1
            %
            
            
            9
            
            
            0.0
            %Total
                Product Sales
            
            $
            307,596
            
            
            100.0
            %
            
            $
            253,376
            
            
            100.0
            %
            
            $
            206,533
            
            
            100.0
            %




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


**Year
                Ended December 31,****2007**
            
            
            **2006**
            
            
            **2005**Americas
            
            $
            243,209
            
            
            79.1
            %
            
            $
            202,333
            
            
            79.9
            %
            
            $
            164,072
            
            
            79.4
            %United
                Kingdom
            
            
            17,561
            
            
            5.7
            %
            
            
            12,478
            
            
            4.9
            %
            
            
            11,863
            
            
            5.7
            %Germany
            
            
            14,179
            
            
            4.6
            %
            
            
            11,405
            
            
            4.5
            %
            
            
            9,007
            
            
            4.4
            %Rest
                of World
            
            
            32,647
            
            
            10.6
            %
            
            
            27,160
            
            
            10.7
            %
            
            
            21,591
            
            
            10.5
            %Total
                Product Sales
            
            $
            307,596
            
            
            100.0
            %
            
            $
            253,376
            
            
            100.0
            %
            
            $
            206,533
            
            
            100.0
            %





Our
      sustained increase in direct sales presence has continued to have a positive
      effect on product sales since inception, as has the execution of our strategic
      plan to build market share through promotional programs of controller
      placements, commercialization of our technology in fields outside of
      arthroscopy, and the introduction of new products designed to address surgical
      procedures that have traditionally been difficult to perform. Additionally,
      our
      acquisitions of Atlantech, Parallax, ATI and Opus Medical product lines have
      continued to have a positive effect on sales growth. We anticipate that
      disposable device sales will remain a key component of our product sales in
      the
      near future.





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 more than ten years of product shipments, we have penetrated 30 to 35
      percent of the facilities that perform arthroscopic procedures in the United
      States. We believe that approximately 45 percent 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 2008, as we continue to increase
      our presence in Europe and the South Pacific and benefit from the integration
      of
      our acquisitions.





*Royalties,
      fees, and other revenues* consist
      mainly of revenue from the licensing of our products and technology, plus
      shipping and handling costs billed to customers. Royalties, fees, and other
      revenues increased to $11.6 million in 2007 from $9.6 million and $7.8 million
      in 2006 and 2005, respectively, as a result of increased sales of our products
      and growth in the markets for which we receive royalties.




*Cost
      of Product Sales*




Cost
      of
      product sales consist
      of manufacturing costs, material costs, labor costs, manufacturing overhead,
      warranty and other direct product costs. Additionally, cost of product sales
      includes amortization of controller unit placements under a program whereby
      we
      maintain ownership of controller units shipped to customers, with the costs
      being capitalized and amortized into cost of product sales over the useful
      life
      of the controller unit.





Cost
      of
      product sales was $84.7 million, or 26.5 percent of total revenues, for 2007,
      compared to $76.8 million, or 29.2 percent of total revenues, in 2006 and $64.2
      million, or 30.0 percent of total revenues, in 2005. Gross product margin as
      a
      percentage of sales increased to 72.5 percent in 2007 from 69.7 percent in
      2006
      and 68.9 percent in 2005. The
      increase in gross product margin percentage for the year ended December 31,
      2007
      compared to the same period in 2006 is primarily a result of increased
      manufacturing efficiencies, a rise in average selling prices, and increased
      sales volume associated with our higher gross margin products. The
      favorable increase in gross product margin percentage in 2006 as compared to
      2005 is primarily due to an increase in average selling prices accompanied
      by a
      decrease in component costs.




30





Amortization
      of controllers was $7.4 million in 2007, compared to $6.6 million and $5.8
      million in 2006 and 2005, respectively. Controller amortization represented
      2.4
      percent of product sales in 2007. This is compared to 2006 and 2005, when
      controller amortization represented 2.6 percent and 2.8 percent of product
      sales, respectively. The
      decrease as a percent of cost of sales for 2007 is due to lower
      controller placements with existing customers in anticipation of our new
      controller launched in the first quarter of 2008. Cost
      of
      product sales for the year ended December 31, 2007 includes $0.7 million of
      stock-based compensation expense related to employee stock options. In 2006,
      cost of product sales included $0.6 million of stock-based compensation expense.





We
      expect
      gross margin to continue to increase as we continue to increase our average
      selling prices and improve operating efficiencies.





*Operating
      Expenses*




*Research
      and development expense* increased in 2007 to $26.9 million, or 8.4 percent of total revenues, from
      $23.2
      million, or 8.9 percent of total revenues, in 2006 and $21.0 million, or 9.8
      percent of total revenues, in 2005. The absolute dollar increase in research
      and
      development expenses in 2007 compared to 2006 is primarily attributable to
      $1.9
      million in increased clinical testing supplies and services associated with
      our
      new products and $1.5 million in additional employee compensation due to
      increased research and development headcount to support new product development
      initiatives. The increase in research and development costs in 2006 as compared
      to 2005 is primarily due to $1.3 million in increased stock compensation expense
      due to our adoption of FAS 123R, along
      with a
      continued investment in our Coblation-based products and in the MDA product
      line, resulting in an increase of $0.6
      million in consulting and outside service costs and $0.2 million in
      patent-related and product development charges.





We
      expect
      research and development expenses to increase through continued expenditures
      on
      new product development, 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 $123.2 million, or 38.6 percent of total revenues, in 2007 from $91.9
      million, or 35.0 percent of total revenues, in 2006, and from $75.3 million,
      or
      35.1 percent of total revenues, in 2005. The increase for 2007 compared to
      2006
      related primarily to $12.6 million in additional commissions and fees due to
      increased sales volume and new sales agency agreements, $7.8 million in
      additional salaries and employee-related expenses and $5.2 million in additional
      commissions associated with increased sales and marketing headcount, and $3.6
      million in additional marketing costs related to trade shows, samples and
      demonstrations to promote new product lines. Increased expenses in 2006 as
      compared to 2005 related primarily to $6.7 million in training and promotion
      costs, $4.4 million in additional compensation and related expenses associated
      with our increased direct sales force, $2.7 million in stock-based compensation
      expense associated with our adoption of FAS 123R, and $2.7 million in settlement
      fees associated with the Settlement and License Agreement between ArthroCare
      and
      MarcTec, LLC (formerly Bonutti IP, LLC).





We
      anticipate that sales and marketing spending will continue to increase 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 commercialize
      and market future products. This
      increase will be partially offset by a reduction in service fees previously
      paid
      to DiscoCare which we acquired on December 31, 2007.





*General
      and administrative expense* increased in absolute dollars to $24.0 million, or 7.5 percent of total
      revenues, in 2007, from $21.4 million, or 8.1 percent of total revenues, in
      2006
      and $12.2 million, or 5.7 percent of total revenues, in 2005 .
      The
      absolute dollar increase is primarily due to a $1.6 million net increase in
      legal, accounting and other outside service costs and a $0.9 million increase
      in
      employee-related expenses associated with increased headcount in administrative
      functions. The
      increase in general and administrative expenses in 2006 as compared to 2005 is
      primarily due to a net increase of $3.5 million in legal, accounting and other
      outside services costs, $3.3 million of stock-based compensation expense
      associated with our adoption of FAS 123R, and $1.6 million of additional compensation
      and related expenses associated with increasing our headcount in our accounting
      and other administrative functions.




31





We
      expect
      that general and administrative expenses will remain essentially flat as a
      percentage of total revenues during 2008 due to continued investments in our
      infrastructure to support further revenue growth.




*Amortization
      of intangible assets* was $7.2
      million, or 2.3 percent of total revenues, in 2007, compared with $7.2 million,
      or 2.7 percent of total revenues, in 2006, and $6.2 million, or 2.9 percent
      of
      total revenues, in 2005. The decrease as a percentage of total revenues over
      the
      last two years is primarily due to fewer acquisitions of intangible assets
      during periods of increasing revenues each year since 2005.





*Acquired
      in-process research and development costs (IPR&D* )
      were
      not incurred during the years ended December 31, 2007 or 2006. During the third
      quarter of 2005 we incurred $2.4 million of acquired in-process research and
      development costs in connection with the research and development efforts
      acquired in our acquisition of substantially all of the assets of ATI. Prior
      to
      the acquisition, we did not have a comparable product under development. This
      expense related to the development of technology for arresting bleeding that
      had
      not yet reached technological feasibility at ATI and had no alternative future
      use. As of December 31, 2005, the research and development of this technology
      was completed and the Stammberger Foam product, which utilizes this technology,
      was commercialized for use in ENT procedures.





*Interest
      and Other Income (Expense), Net*





*Interest
      and other income (expense), net* was a
      net benefit of $2.2 million in 2007 compared to a net expense of $1.8 million
      in
      2006 and a net expense of $2.3 million in 2005. The $4.0 million increase in
      net
      interest income in 2007 is primarily attributable to the funding of our
      operations through operating cash flows for the majority of 2007 as opposed
      to
      borrowing against our credit facility. The $0.5 million decrease in expense
      in
      2006 was primarily attributable to foreign exchange gains in 2006, whereas
      in
      2005 we had foreign exchange losses. We expect to see a net interest expense
      in
      2008 as a result of borrowing $60.0 million against our credit facility in
      December 2007.





*Income
      Tax Provision*





The
      provision for income taxes was $12.2 million for 2007, compared to $9.0 million
      for 2006 and $7.2 million for 2005. The effective tax rate was 22.0 percent
      in
      2007, 22.1 percent in 2006 and 23.4 percent in 2005. The yearly improvement
      in
      our tax rate from 2005 to 2007 is primarily due to the continued expansion
      of
      business activities in our Costa Rica operations and tax credits for research
      and development activities.





**Liquidity
      and Capital Resources**




As
      of
      December 31, 2007, we had $148.3 million in working capital, compared to
      $113.7 million at December 31, 2006. Our principal sources of liquidity
      consisted of $43.3 million in cash, cash equivalents, and short-term investments
      at December 31, 2007. Cash equivalents are highly liquid with original
      maturities of ninety days or less. Our short-term investments consist primarily
      of corporate bonds.





Cash
      generated by operating activities in 2007 was $52.7 million, as compared to
      $43.8 million in 2006 and $37.2 million in 2005. The cash generated in 2007
      was
      primarily attributable to $43.2 million of net income, $21.2 million of
      depreciation and amortization and $10.2 million of stock based compensation,
      partially offset by $23.8 million in increased accounts receivable and $6.2
      million in increased inventory. The cash generated in 2006 was primarily
      attributable to $31.7 million of net income and non-cash items such as $21.3
      million of depreciation and amortization and stock-based compensation of $9.8
      million, partially offset by a $17.2 million increase in accounts receivable
      and
      $8.6 million in increased inventory. The cash generated in 2005 was primarily
      attributable to $23.5 million in net income adjusted for non-cash items,
      including $16.8 million of depreciation and amortization and $9.6 million in
      income tax benefits related to employee stock options, partially offset by
      increases in accounts receivable and inventories of $14.8 million and $7.7
      million, respectively.




32





Cash
      used
      in investing activities was $49.9 million in 2007, as compared to $86.5 million
      in 2006 and $16.4 million in 2005. Cash used in investing activities in 2007
      was
      primarily due to $26.5 million for purchases of intangible assets and other
      purchase business combinations, $20.2 million for purchases of property and
      equipment, and $14.8 million in payments to ATI shareholders in satisfaction
      of
      acquisition-related contractual contingencies, partially offset by $12.8 million
      in sales of available-for-sale securities. Cash used in investing activities
      in
      2006 was primarily due to a $55.2 million payment to former Opus Medical
      shareholders, $17.2 million for the purchase of property and equipment, and
      $26.9 million for the purchase of available-for-sale securities, partially
      offset by $15.0 million of sales of available-for-sale securities. Cash used
      in
      investing activities in 2005 was primarily due to the $10.0 million payment
      made
      for the purchase of ATI’s assets in August 2005, accompanied by $9.6 million
      associated with the capitalization of controllers and $3.7 million in fixed
      asset investments, offset by net sales of $7.4 million in available for
      sale securities.





The
      fair
      value of our investments in marketable securities at December 31, 2007 was
      $3.9 million. Investments with maturities beyond one year may be classified
      as
      short-term based on their highly liquid nature and because such marketable
      securities represent the investment of cash that is available for current
      operations. Our investment policy is to manage our investment portfolio to
      preserve principal and liquidity while maximizing the return on the investment
      portfolio through the full investment of available funds.





Cash
      provided by financing activities was $22.8 million in 2007, as compared to
      $37.7
      million in 2006 and $11.2 million in cash used in financing activities in 2005.
      Cash provided by financing activities in 2007 was due primarily to $60.0 million
      in proceeds from borrowings against our revolving line of credit, $14.3 million
      of proceeds from stock option purchases, and $7.8 million in tax benefits
      related to stock option expenses, partially offset by $59.6 million used for
      the
      purchase of shares of our common stock on the open market. Cash provided by
      financing activities in 2006 was primarily due to $28.1 million of proceeds
      from
      stock option purchases and a $9.5 million tax benefit related to the stock
      option expenses. Cash used in financing activities in 2005 was primarily due
      to
      $28.9 million of loan repayments, partially offset by $16.5 million of proceeds
      from stock option exercises.





On
      January 13, 2006, the Company entered into a Revolving Credit Agreement
      (the “Credit Agreement”) with a syndicate of banks (collectively, the
“Lenders”). Under the terms of the Credit Agreement, we may borrow up to $100.0
      million under a revolving line of credit from the named Lenders at the lead
      Lender’s Prime Rate or the British Bankers Association LIBOR Rate, plus a
      spread. The spread over the Prime Rate or LIBOR Rate is determined by the
      Company’s leverage ratio, as defined in the Credit Agreement. In December 2007,
      in connection with our purchase of shares of our common stock on the open
      market, we borrowed $60.0 million against the line of credit. At December 31,
      2007, we had $60.0 million in outstanding balances under the Credit Agreement
      and the weighted average interest rate applicable to borrowings under the Credit
      Agreement was 5.5 percent.





The
      Credit Agreement has a five-year maturity and includes additional terms under
      which we may request an increase of up to $75.0 million in commitments from
      the
      Lenders, as business needs dictate. The Credit Agreement also contains various
      covenants that specify minimum or maximum financial ratios.  We were in
      compliance with all such covenants at December 31, 2007.





33


**Disclosures
      about Contractual Obligations and Commercial Commitments**




Our
      cash
      flows from operations are dependent on a number of factors, including
      fluctuations in our operating results, accounts receivable collections,
      inventory management, expensing of stock options, and the timing of tax and
      other payments. As a result, the impact of contractual obligations on our
      liquidity and capital resources in future periods should be analyzed in
      conjunction with such factors. The following table aggregates all material
      contractual obligations and commercial commitments that affected our financial
      condition and liquidity as of December 31, 2007:




**Payments
                Due by Period**
              **(in
                thousands)****Total**
            
            **Less**
              **than
                1**
              **Year**
            
            **1-3**
              **Years**
            
            **4-5**
              **Years**
            
            **After**
              **5
                Years**Long-term
                debt obligations
            
            $
            60,000
            
            $
            —
            
            $
            —
            
            $
            60,000
            
            $
            —Operating
                lease obligations
            
            
            15,368
            
            
            3,158
            
            
            4,651
            
            
            3,582
            
            
            3,977Purchase
                commitments with suppliers (1)
            
            
            12,169
            
            
            6,297
            
            
            4,088
            
            
            1,784
            
            
            —Total
            
            $
            87,537
            
            $
            9,455
            
            $
            8,739
            
            $
            65,366
            
            $
            3,977





(1)
      Represents agreements to purchase products that are enforceable, legally binding
      and specify terms, including: fixed or minimum quantities to be purchased and
      the approximate timing of the payments.





We
      believe that the above-described credit and term facilities, in addition to
      cash
      generated from operations, as well as our existing cash balances and short-term
      investments, will be sufficient to fund our operations through fiscal year
      2008
      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.





**Recently
      Issued Accounting Pronouncements**





In
      September 2006, the FASB issued Statement of Financial Accounting Standards
      No.
      157, *Fair
      Value Measurements* ,
      or FAS
      157. FAS 157 defines fair value, establishes a framework for measuring fair
      value in generally accepted accounting principles, and expands disclosures
      about
      fair value measurements. FAS 157 is effective for us beginning January 1,
      2008 for financial assets and liabilities and January 1, 2009 for non-financial
      assets and liabilities. We do not believe that FAS 157 will have a material
      effect on our operating results or financial position.





In
      February 2007, the FASB issued Statement of Financial Accounting Standards
      No.
      159, *The
      Fair Value Option for Financial Assets and Financial Liabilities - Including
      an
      amendment of FASB No. 115* ,
      or FAS
      159. FAS 159 permits companies to choose to measure many financial instruments
      and certain other items at fair value in order to mitigate volatility in
      reported earnings caused by measuring related assets and liabilities differently
      without having to apply complex hedge accounting provisions. FAS 159 is
      effective for us beginning January 1, 2008. We are currently evaluating the
      impact of FAS 159 on our operating results and financial position. We do not
      believe that FAS 159 will have a material effect on our operating results or
      financial position.





In
      December 2007, the FASB issued Statement of Financial Accounting Standards
      No.
      141(R), *Business
      Combination,* or ** FAS
      141R. FAS 141R is effective for us as of January 1, 2009 and is applied
      prospectively for business combinations completed after January 1, 2009. Under
      FAS 141, organizations utilized the announcement date as the measurement date
      for the purchase price of the acquired entity. FAS 141R requires
      measurement at the date the acquirer obtains control of the acquiree, generally
      referred to as the acquisition date. FAS 141R will have a significant
      impact on the accounting for transaction costs, restructuring costs as well
      as
      the initial recognition of contingent assets and liabilities assumed during
      a
      business combination completed after January 1, 2009.




34


**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 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, 2007 for our cash, cash equivalents, and short-term investments
      (in thousands):





Cash,
                cash equivalents, and short-term investments
            
            $
            43,250Average
                interest rate
            
            
            3.9
            %




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




Borrowings
      under our Credit Agreement 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.





*Foreign
      Currency Risk*





A
      significant portion of our international sales and operating expenses are
      denominated in currencies other than the U.S. Dollar. In 2007, most of these
      currencies strengthened relative to the U.S. Dollar. To the extent that the
      exchange rates for these currencies fluctuate against the U.S. Dollar, we will
      experience variations in our results of operations and financial condition.





Our
      cash
      and cash equivalents in 2007 are denominated primarily in U.S. Dollars; however,
      we also maintain significant balances in Euros, British Pounds, Swedish Krona,
      Australian Dollars and Costa Rican Colones. A 10 percent change in the December
      31, 2007 exchange rates for these currencies would have an impact on pre-tax
      income of approximately $0.8 million.





**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.





35


**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) adopted by the SEC 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
      SEC’s rules and forms, and that such information is accumulated and communicated
      to management, including our Chief Executive Officer, or CEO, and Chief
      Financial Officer, or CFO, as appropriate, to allow timely decisions regarding
      required disclosure.





We
      carried out an evaluation under the supervision and with the participation
      of
      our management, including our CEO and CFO, of the effectiveness of the design
      and operation of our disclosure controls and procedures as of December 31,
      2007.  Based upon this evaluation, our CEO and CFO have concluded that the
      design and operation of our disclosure controls and procedures were effective
      as
      of December 31, 2007. 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 and for our assessment of the effectiveness of internal control
      over financial reporting. 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 accounting principles generally accepted in the
      United States of America.





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,
      including our CEO and CFO, has assessed the effectiveness of our internal
      control over financial reporting as of December 31, 2007. In making its
      assessment of internal control over financial reporting, management used the
      criteria established in Internal Control - Integrated Framework issued by the
      Committee of Sponsoring Organizations of the Treadway Commission, or COSO.
      This
      assessment included an evaluation of the design of our internal control over
      financial reporting and testing of the operational effectiveness of those
      controls. Based on the results of this assessment, management has concluded
      that
      our internal control over financial reporting was effective as of December
      31,
      2007.





**Changes
      in Internal Control Over Financial Reporting**





There
      were no changes in our internal control over financial reporting during the
      quarter ended December 31, 2007 that materially affected, or are reasonably
      likely to materially affect, our internal control over financial
      reporting.





**ITEM
      9B. OTHER INFORMATION**





None.




36


**PART
      III**





**ITEM
      10.** **DIRECTORS,
      EXECUTIVE OFFICERS** **AND
      CORPORATE GOVERNANCE**





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 there under as well as under applicable rules
        of
        the NASDAQ Stock Exchange. Our code of conduct is available on the Investor
        Relations section of our website ( *www.arthrocare.com* ).
        To the
        extent required by law or the rules of the NASDAQ Stock Exchange, any amendments
        to, or waivers from, any provision of the code will be promptly disclosed
        publicly. To the extent permitted by such requirements, we intend to make
        such
        public disclosure by posting the relevant material on the Investor Relations
        section of our website in accordance with SEC rules.




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





**ITEM
      11.    EXECUTIVE COMPENSATION**




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




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





Except
      as
      set forth below regarding securities authorized for issuance under equity
      compensation plans, the information required by this item is incorporated by
      reference into our definitive Proxy Statement to be filed pursuant to Regulation
      14A under the Exchange Act in connection with our annual meeting of
      stockholders.





**EQUITY
      COMPENSATION PLAN INFORMATION**




The
      following table provides information as of December 31, 2007 regarding the
      common stock that may be issued upon the exercise of options, warrants and
      rights under our existing equity compensation plans .





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
                (1)**
            
            
            2,249,851
            
            $
            29.11
            
            
            804,001**Equity
                compensation plans not approved by security holders
                (2)**
            
            
            745,394
            
            $
            27.79
            
            
            19,906**Total**
            
            
            2,995,245
            
            $
            28.78
            
            
            823,907





(1)
            Includes
                72,756 shares remaining available for future issuance under the Company’s
                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.




37




**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 Board of Directors of the Company initially adopted the NSO Plan in May
      1999. As of December 31, 2007, a total of 3,550,000 shares of common stock
      are
      reserved for issuance under the NSO Plan, options for 893,295 were outstanding
      under the NSO Plan, and 19,906 shares 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 December 31, 2007, approximately 1,074 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.




*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 percent 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 expires.




*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 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.




38




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 any 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 OF NSO PLAN**




*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 current 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.




*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.




39




**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.**




**ITEM
      13.    CERTAIN RELATIONSHIPS, RELATED TRANSACTIONS, AND
      DIRECTOR** **INDEPENDENCE**




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




**ITEM
      14.    PRINCIPAL ACCOUNTANT FEES AND SERVICES**




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





**PART
      IV**




**ITEM
      15.    EXHIBITS AND FINANCIAL STATEMENT SCHEDULES**





(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
      Registered Public Accounting Firm are included in this Report on the pages
      indicated.





**Page**Report
                of Independent Registered Public Accounting Firm
            46Consolidated
                Balance Sheets as of December 31, 2007 and December 31,
                2006
            47Consolidated
                Statements of Operations for the years ended December 31, 2007, 2006
                and
                2005
            48Consolidated
                Statements of Stockholders’ Equity for the years ended December 31, 2007,
                2006 and 2005
            49Consolidated
                Statements of Cash Flows for the years ended December 31, 2007, 2006
                and
                2005
            50Notes
                to the Consolidated Financial Statements
            51








2. *Financial
      Statement Schedule.* The
      following financial statement schedule of the company as of and for the years
      ended December 31, 2007, 2006 and 2005, is included in Part IV of this Report
      on
      the pages indicated. This financial statement schedule should be read in
      conjunction with the consolidated financial statements, and notes thereto,
      of
      the Company.




40




**Schedule**
            
            **Title**
            
            **Page**II
            
            Valuation
                and Qualifying Accounts
            
            69




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
      consolidated 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).2.3
            Asset
                Purchase Agreement, dated as of August 16, 2005, by and among ArthroCare
                Corporation, a Delaware corporation, ArthroCare (Deutschland) GmbH,
                a
                corporation organized under the laws of Germany and a wholly-owned
                subsidiary of ArthroCare, ArthroCare UK, Ltd., a corporation registered
                in
                England & Wales and a wholly-owned subsidiary of ArthroCare, Applied
                Therapeutics, Inc., a Florida corporation, Applied Therapeutics,
                Ltd., a
                corporation registered in England & Wales, Applied Therapeutics GmbH,
                a corporation organized under the laws of Germany and BHK Holding,
                a
                corporation organized under the laws of the Cayman Islands. (Incorporated
                herein by reference to Exhibit 2.1 to the Registrant’s Current Report on
                Form 8-K filed on August 22, 2005).





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 Bylaws 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).3.3
            Certificate
                of Amendment of the Amended and Restated Bylaws of the Registrant
                (Incorporated herein by reference to Exhibit 3.1 filed previously
                with the
                Registrant’s Current Report on Form 8-K filed on December 13,
                2006).4.1
            Specimen
                Common Stock Certificate. (Incorporated herein by reference to Exhibit
                4.1
                filed previously with the Registrant’s Registration Statement on Form 8-A
                (Registration No. 000-27422)).10.1*
            Form
                of Indemnification Agreement between the registrant and each of its
                directors and officers. (Incorporated herein by reference to Exhibit
                10.1
                filed previously with the Registrant’s Registration Statement on Form S-1
                (Registration No. 33-80453)).10.2*
            Incentive
                Stock Plan and form of Stock Option Agreement there under. (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 there under.
                (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 there under. (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)).




41




10.7
            Consulting
                Agreement dated May 10, 1993, between the Registrant and Philip E.
                Eggers,
                and amendment thereto. (Incorporated herein by reference to Exhibit
                10.7
                filed previously with the Registrant’s Registration Statement on Form S-1
                (Registration No. 33-80453)).10.8
            Consulting
                Agreement dated May 20, 1993, between the Registrant and Eggers &
                Associates, Inc., and amendment thereto. (Incorporated herein by
                reference
                to Exhibit 10.8 filed previously with the Registrant’s Registration
                Statement on Form S-1 (Registration No. 33-80453)).10.9
            Lease
                Agreement, dated May 20, 1993, between the Registrant and Eggers
&
                Associates, Inc., and amendment thereto. (Incorporated herein by
                reference
                to Exhibit 10.9 filed previously with the Registrant’s Registration
                Statement on Form S-1 (registration No. 33-80453)).10.10
            Amended
                and Restated Stockholder Right Agreement dated October 16, 1995,
                between
                the Registrant and certain holders of the Registrant’s securities.
                (Incorporated herein by reference to Exhibit 10.20 filed previously
                with
                the Registrant’s Registration Statement on form S-1 (Registration No.
                33-80453)).10.11
            Contribution
                Agreement, dated March 31, 1995, by and among Philip E. Eggers, Robert
                S.
                Garvie, Anthony J. Manlove, Hira V. Thapliyal and the Registrant.
                (Incorporated herein by reference to Exhibit 10.21 filed previously
                with
                the Registrant’s Registration Statement on Form S-1 (Registration No.
                33-80453)).10.12
            Amended
                and Restated Stockholder Rights Agreement dated October 2, 1998,
                between
                the Registrant and Norwest Bank Minnesota, N.A. (Incorporated herein
                by
                reference to Exhibit 10.20 filed previously with the Registrant’s
                Registration Statement on Form 8-A filed October 21, 1998 (Registration
                No. 000-27422)).





10.13
            Exclusive
                Distributor Agreement dated August 21, 1997, between the Registrant
                and
                Kobyashi Pharmaceutical Company, Ltd. (Incorporated herein by reference
                to
                Exhibit 10.25 filed previously with the Registrant’s Quarterly Report on
                Form 10-Q for the period ended September 27, 1997).10.14
            License
                Agreement dated February 9, 1998, between the Registrant and Boston
                Scientific Corporation. (Incorporated herein by reference to Exhibit
                10.26
                filed previously with the Registrant’s Annual Report on form 10-K for the
                period ended January 3, 1998).10.15
            Development
                and Supply Agreement dated February 9, 1998, between the Registrant
                and
                Boston Scientific Corporation. (Incorporated herein by reference
                to
                Exhibit 10.27 filed previously with the Registrant’s Annual report on form
                10-K for the period ended January 3, 1998).10.16*
            Change
                of Control Agreement between the Registrant and the CEO. (Incorporated
                herein by reference to Exhibit 10.28 filed previously with the
                Registrant’s Annual Report on Form 10-K for the period ended January 2,
                1999).10.17*
            The
                form of “VP Continuity Agreement” between the Registrant and its Vice
                Presidents. (Incorporated herein by reference to Exhibit 10.29 filed
                previously with the Registrant’s Annual Report on Form 10-K for the period
                ended January 2, 1999).10.18
            Letter
                Agreement dated February 9, 1999 between the Registrant and Collagen
                Aesthetics. (Incorporated herein by reference to Exhibit 10.30 filed
                previously with the Registrant’s Annual Report on Form 10-K/A for the
                period ended January 2, 1999).10.19*
            Employment
                Letter Agreement, between the Registrant and John R. Tighe dated
                January
                26, 1999. (Incorporated herein by reference to Exhibit 10.30 filed
                previously with the registrant’s Quarterly Report on Form 10-Q for the
                period ended April 3, 1999).10.20*
            Reserved.10.21*
            Employment
                Letter Agreement, between the Registrant and Bruce P. Prothro amended
                May
                19, 1999. (Incorporated herein by reference to Exhibit 10.32 filed
                previously with the Registrant’s Quarterly Report on Form 10-Q for the
                period ended April 3, 1999).10.22†
            Litigation
                Settlement Agreement, between the Registrant and ETHICON Inc. dated
                June
                24, 1999 (Incorporated herein by reference to Exhibit 10.33 previously
                filed with the Registrant’s Quarterly Report on Form 10-Q for the period
                ended July 3, 1999).




42


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





10.28†
            License
                Agreement between ArthroCare Corporation and Stryker Corporation,
                dated
                June 28, 2000. (Incorporated herein by reference to Exhibit 10.36
                filed
                previously with this the Registrant’s Quarterly Report on Form 10-Q for
                the period ended July 1, 2000).10.29*
            Change
                of Control Agreement between the Registrant and Michael Baker, CEO,
                dated
                September 25, 2001. (Incorporated herein by reference to Exhibit
                10.37
                filed previously with the Registrant’s Quarterly Report on Form 10-Q for
                the period ended September 29, 2001).10.30*
            Amendment
                to the 1993 Incentive Plan (Incorporated herein by reference to Exhibit
                4.2 to the Registrant’s Registration Statement on Form S-8 filed on August
                8, 2000).10.31*
            Amendment
                to the 1995 Director Option Plan (Incorporated herein by reference
                to
                Exhibit 4.3 to the Registrant’s Statement on Form S-8 filed on August 8,
                2000).10.32†
            Share
                Purchase Agreement relating to the entire issued share capital of
                Atlantech Medical Devices Limited and Atlantech Medical Devices (UK),
                Limited, dated October 21, 2002.10.33*
            Amended
                and Restated Nonstatutory Option Plan (Incorporated herein by reference
                to
                Exhibit 4.5 to the Registrant’s Registration Statement on Form S-8 filed
                on May 8, 2003).10.34*
            2003
                Incentive Stock Plan (Incorporated herein by reference to Exhibit
                4.4 to
                the Registrant’s Registration Statement on Form S-8 filed with the
                Securities and Exchange Commission on June 24, 2003).10.35*
            Second
                Amendment to the 1995 Director Option Plan (Incorporated herein by
                reference to Exhibit 4.3 to the Registrant’s Registration Statement on
                Form S-8 filed with the Securities and Exchange Commission on May
                8,
                2003).10.36
            Agreement
                and Plan of Merger, dated as of October 23, 2003, as amended by Amendment
                No. 1 to Agreement and Plan of Merger, dated as of January 5, 2004,
                by and
                among ArthroCare Corporation, Alpha Merger Sub Corporation and Medical
                Device Alliance Inc. (Incorporated herein by reference to Exhibit
                2.1 to
                the Registrant’s Current Report on Form 8-K filed on February 11,
                2004).10.37
            Contingent
                Value Rights Agreement, dated as of January 28, 2004, by and among
                ArthroCare Corporation, Alpha Merger Sub Corporation, Medical Device
                Alliance Inc., Wells Fargo Bank, N.A. and Frank Bumstead (Incorporated
                herein by reference to Exhibit 2.2 to the Registrant’s Current Report on
                Form 8-K filed on February 11, 2004).




43




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 and Exhibit
                10.44
                to the Registrant’s Quarterly Report on Form 10-Q/A filed on May 11,
                2006.)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
                22, 2005).10.47
            2005
                Executive Officer Bonus Plan (Incorporated herein by reference to
                Exhibit
                10.47 to the Registrant’s Current Report on Form 8-K filed on February 22,
                2005).10.48
            Form
                of Option Agreement under the Amended and Restated 2003 Incentive
                Plan
                (Incorporated herein by reference to Exhibit 10.48 to the Registrant’s
                Current Report on Form 8-K filed on February 22, 2005).10.49
            Form
                of Restricted Stock Bonus Agreement under the Amended and Restated
                Director Option Plan (Incorporated herein by reference to Exhibit
                10.49 to
                the Registrant’s Current Report on Form 8-K filed on February 22,
                2005).10.50
            Form
                of Restricted Stock Bonus Agreement under the Amended and Restated
                2003
                Incentive Stock Plan (Incorporated herein by reference to Exhibit
                10.50 to
                the Registrant’s Current Report on Form 8-K filed on February 22,
                2005).10.51†
            First
                Amendment to Amended and Restated Credit Agreement between the Registrant,
                Bank of America, N.A. and Wells Fargo Bank, National Association,
                dated
                March 30, 2005.10.52†
            Settlement
                and License Agreement between the Registrant, ArthroCare Caymans,
                a
                corporation organized under the laws of the Cayman Islands and a
                wholly-owned subsidiary of the Registrant and Smith & Nephew, Inc.,
                dated September 2, 2005 (Incorporated herein by reference to Exhibit
                10.52
                to the Registrant’s Quarterly Report on Form 10-Q filed November 3,
                2005).10.53†
            Settlement
                and Distribution Agreement between the Registrant, ArthroCare Caymans,
                a
                corporation organized under the laws of the Cayman Islands and a
                wholly-owned subsidiary of the Registrant and Smith & Nephew, Inc.,
                dated September 2, 2005 (Incorporated herein by reference to Exhibit
                10.53
                to the Registrant’s Quarterly Report on Form 10-Q filed November 3,
                2005).10.54
                *
            2006
                Executive Officer Bonus Plan (Incorporated herein by reference to
                Exhibit
                10.54 to the Registrant’s Current Report on Form 8-K filed on February 24,
                2006).




44




10.55
                    *
                2006
                    Director Compensation Plan (Incorporated herein by reference
                    to Exhibit
                    10.55 to the Registrant’s Current Report on Form 8-K filed on February 24,
                    2006).10.56
                Credit
                    Agreement between the Registrant, Bank of America, N.A., Wells
                    Fargo Bank
                    National Association, and certain other lenders dated January
                    13,
                    2006.10.57
                Amended
                    and Restated 2003 Incentive Stock Plan (Incorporated herein by
                    reference
                    to Exhibit 10.58 to the Registrant’s Current Report on Form 8-K filed on
                    May 25, 2006).10.58
                Lease
                    Agreement between Lantana Office properties I, L.P. and the Registrant
                    (Incorporated herein by reference to Exhibit 10.57 to the Registrant’s
                    Quarterly Report on 10-Q filed on June 30, 2006).10.59
                Employment
                    Agreement between the Registrant and Mike Baker, effective January
                    1, 2007
                    (Incorporated herein by reference to Exhibit 10.1 to the Registrant’s
                    Current Report on Form 8-K filed on September 1, 2006).10.60†
                Settlement
                    and License Agreement between the Registrant, ArthroCare Corporation
                    Cayman Islands and MarcTec, LLC effective January 3, 2007.10.61
                    *
                2007
                    Executive Officer Bonus Plan (Incorporated herein by reference
                    to Exhibit
                    10.61 to the Registrant’s Current Report on Form 8-K filed on March 1,
                    2007).10.62
                Certificate
                    of Amendment of the Amended and Restated Bylaws of the Registrant
                    (Incorporated herein by reference to Exhibit 3.4 to the Registrant’s
                    Current Report on Form 8-K filed on April 5, 2007).10.63
                    *
                Form
                    of “Amended VP Continuity Agreement” between ArthroCare Corporation and
                    its vice presidents (Incorporated herein by reference to Exhibit
                    10.61 to
                    the Registrant’s Current Report on Form 8-K filed on April 5,
                    2007.10.64
                    *
                Form
                    of “Amended Senior VP Continuity Agreement” between ArthroCare Corporation
                    and its senior vice presidents (Incorporated herein by reference
                    to
                    Exhibit 10.62 to the Registrant’s Current Report on Form 8-K filed on
                    April 5, 2007).10.65††
                Stock
                    Purchase Agreement, dated as of December 31, 2007 by and among
                    ArthroCare
                    Corporation and DiscoCare, Inc.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.




45




**Report
      of Independent Registered Public Accounting Firm**





To
      the
      Board of Directors and Stockholders of ArthroCare Corporation





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 at December 31, 2007
      and
      2006, and the results of their operations and their cash flows for each of
      the
      three years in the period ended December 31, 2007 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. Also in our opinion, the Company maintained, in all
      material respects, effective internal control over financial reporting as of
      December 31, 2007, 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 these
      financial statements and financial statement schedule, for maintaining effective
      internal control over financial reporting and for its assessment of the
      effectiveness of internal control over financial reporting, included in
      Management's Report on Internal Control over Financial Reporting appearing
      under
      Item 9A. Our responsibility is to express opinions on these financial
      statements, on the financial statement schedule, and on the Company's internal
      control over financial reporting based on our integrated audits. We conducted
      our audits in accordance with the standards of the Public Company Accounting
      Oversight Board (United States). Those standards require that we plan and
      perform the audits to obtain reasonable assurance about whether the financial
      statements are free of material misstatement and whether effective internal
      control over financial reporting was maintained in all material respects. Our
      audits of the financial statements included 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. Our audit of internal
      control over financial reporting included obtaining an understanding of internal
      control over financial reporting, assessing the risk that a material weakness
      exists, and testing and evaluating the design and operating effectiveness of
      internal control based on the assessed risk. Our audits also included performing
      such other procedures as we considered necessary in the circumstances. We
      believe that our audits provide a reasonable basis for our
      opinions.





As
        discussed in Note 2 to the consolidated financial statements, the Company
        changed the manner in which it accounts for uncertain tax positions in 2007
        and
        the manner in which it accounts for stock-based compensation in
        2006.





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, 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.




/s/ PricewaterhouseCoopers
      LLP


Austin,
      Texas


February
      29, 2008




46


**ARTHROCARE
      CORPORATION**


**CONSOLIDATED
      BALANCE SHEETS**


**(in
      thousands, except per share data)**


**December
                    31,****2007**
                
                **2006****ASSETS**Current
                    assets:Cash
                    and cash equivalents
                
                $
                39,375
                
                $
                15,531Short-term
                    investments
                
                
                3,875
                
                
                15,225Accounts
                    receivable, net of allowances of $3,980 and $2,701 at 2007 and
                    2006,
                    respectively
                
                
                69,924
                
                
                61,935Inventories,
                    net
                
                
                61,776
                
                
                51,542Deferred
                    tax assets
                
                
                10,406
                
                
                13,795Prepaid
                    expenses and other current assets
                
                
                5,164
                
                
                5,389Total
                    current assets
                
                
                190,520
                
                
                163,417Property
                    and equipment, net
                
                
                43,405
                
                
                36,071Related
                    party receivables
                
                
                —
                
                
                500Intangible
                    assets, net
                
                
                37,705
                
                
                35,982Goodwill
                
                
                166,771
                
                
                137,831Deferred
                    tax assets
                
                
                4,940
                
                
                —Other
                    assets
                
                
                6,727
                
                
                1,245Total
                    assets
                
                $
                450,068
                
                $
                375,046LIABILITIES
                    AND STOCKHOLDERS’ EQUITYCurrent
                    liabilities:Accounts
                    payable
                
                $
                15,876
                
                $
                12,993Accrued
                    liabilities
                
                
                12,909
                
                
                26,347Accrued
                    compensation
                
                
                12,727
                
                
                7,906Deferred
                    tax liabilities
                
                
                530
                
                
                —Income
                    taxes payable
                
                
                130
                
                
                2,427Total
                    current liabilities
                
                
                42,172
                
                
                49,673Notes
                    payable
                
                
                60,000
                
                
                —Deferred
                    tax liabilities
                
                
                383
                
                
                1,991Other
                    non-current liabilities
                
                
                7,010
                
                
                879Total
                    liabilities
                
                
                109,565
                
                
                52,543Commitments
                    and contingencies (Note 9)Stockholders’
                    equity: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: 26,808 shares at 2007 and 27,394 shares at 2006
                
                
                27
                
                
                27Treasury
                    stock: 3,936 shares at 2007 and 2,692 shares at 2006
                
                
                (100,682
                )
                
                (41,644
                )Additional
                    paid-in capital
                
                
                360,374
                
                
                324,823Accumulated
                    other comprehensive income
                
                
                2,382
                
                
                1,992Retained
                    earnings
                
                
                78,402
                
                
                37,305Total
                    stockholders’ equity
                
                
                340,503
                
                
                322,503Total
                    liabilities and stockholders’ equity
                
                $
                450,068
                
                $
                375,046





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




47


**ARTHROCARE
      CORPORATION**


**CONSOLIDATED
      STATEMENTS OF OPERATIONS**


**(in
      thousands, except per share data)**




**Year
                  Ended December 31,****2007**
              
              **2006**
              
              **2005**Revenues:Product
                  sales
              
              $
              307,596
              
              $
              253,376
              
              $
              206,533Royalties,
                  fees and other
              
              
              11,646
              
              
              9,625
              
              
              7,801Total
                  revenues
              
              
              319,242
              
              
              263,001
              
              
              214,334Cost
                  of product sales
              
              
              84,724
              
              
              76,838
              
              
              64,206Gross
                  profit
              
              
              234,518
              
              
              186,163
              
              
              150,128Operating
                  expenses:Research
                  and development
              
              
              26,886
              
              
              23,247
              
              
              21,015Sales
                  and marketing
              
              
              123,213
              
              
              91,915
              
              
              75,302General
                  and administrative
              
              
              24,033
              
              
              21,355
              
              
              12,202Amortization
                  of intangible assets
              
              
              7,211
              
              
              7,176
              
              
              6,150Acquired
                  in-process research and development costs
              
              
              —
              
              
              —
              
              
              2,400Total
                  operating expenses
              
              
              181,343
              
              
              143,693
              
              
              117,069Income
                  from operations
              
              
              53,175
              
              
              42,470
              
              
              33,059Interest
                  income
              
              
              2,101
              
              
              1,376
              
              
              631Interest
                  expense
              
              
              (977
              )
              
              (2,423
              )
              
              (1,593
              )Other
                  income (expense), net
              
              
              1,060
              
              
              (762
              )
              
              (1,374
              )Income
                  before income taxes
              
              
              55,359
              
              
              40,661
              
              
              30,723Income
                  tax provision
              
              
              12,179
              
              
              8,986
              
              
              7,193Net
                  income
              
              $
              43,180
              
              $
              31,675
              
              $
              23,530Basic
                  net income per share
              
              $
              1.57
              
              $
              1.21
              
              $
              0.97Shares
                  used in computing basic net income per share
              
              
              27,452
              
              
              26,207
              
              
              24,375Diluted
                  net income per share
              
              $
              1.50
              
              $
              1.14
              
              $
              0.89Shares
                  used in computing diluted income per share
              
              
              28,870
              
              
              27,900
              
              
              26,407




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




48


**ARTHROCARE
      CORPORATION**


**CONSOLIDATED
      STATEMENTS OF STOCKHOLDERS’ EQUITY**


**(in
      thousands)**


**Common**
                  **Stock**
                  **Shares**
                
                **Common**
                  **Stock**
                  **Amount**
                
                **Treasury**
                  **Stock**
                  **Amount**
                
                **Additional**
                  **Paid-In**
                  **Capital**
                
                **Deferred**
                  **Stock**
                  **Compensation**
                
                **Accumulated**
                  **Other**
                  **Comprehensive**
                  **Income
                    (Loss)**
                
                **Retained**
                  **Earnings**
                  **(Deficit)**
                
                **Total**
                  **Stockholders’**
                  **Equity**
                
                **Comprehensive**
                  **Income****Balances,
                    December 31, 2004**
                
                
                24,086
                
                $
                24
                
                $
                (42,158
                )
                $
                238,355
                
                $
                (2,477
                )
                $
                (592
                )
                $
                (17,900
                )
                $
                175,252Issuance
                    of common stock through:Exercise
                    of options
                
                
                1,020
                
                
                1
                
                
                —
                
                
                16,459
                
                
                —
                
                
                —
                
                
                —
                
                
                16,460Employee
                    stock purchase plan
                
                
                48
                
                
                —
                
                
                —
                
                
                1,291
                
                
                —
                
                
                —
                
                
                —
                
                
                1,291Issuance
                    of restricted stock
                
                
                101
                
                
                —
                
                
                —
                
                
                3,392
                
                
                (3,392
                )
                
                —
                
                
                —
                
                
                —Stock
                    compensation
                
                
                —
                
                
                —
                
                
                —
                
                
                90
                
                
                1,326
                
                
                —
                
                
                —
                
                
                1,416Income
                    tax benefit resulting from exercise of stock options
                
                
                —
                
                
                —
                
                
                —
                
                
                9,583
                
                
                —
                
                
                —
                
                
                —
                
                
                9,583Currency
                    translation adjustment
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                1,362
                
                
                —
                
                
                1,362
                
                $
                1,362Net
                    income
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                23,530
                
                
                23,530
                
                
                23,530**Balances,
                    December 31, 2005**
                
                
                25,255
                
                
                25
                
                
                (42,158
                )
                
                269,170
                
                
                (4,543
                )
                
                770
                
                
                5,630
                
                
                228,894
                
                $
                24,892Issuance
                    of common stock through:Exercise
                    of options and restricted stock
                
                
                1,955
                
                
                2
                
                
                —
                
                
                28,095
                
                
                —
                
                
                —
                
                
                —
                
                
                28,097Employee
                    stock purchase plan
                
                
                4
                
                
                —
                
                
                —
                
                
                151
                
                
                —
                
                
                —
                
                
                —
                
                
                151Shares
                    issued for Opus Medical
                
                
                180
                
                
                —
                
                
                —
                
                
                8,054
                
                
                —
                
                
                —
                
                
                —
                
                
                8,054Contributions
                    to employee benefit plan
                
                
                —
                
                
                —
                
                
                514
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                514Stock
                    compensation
                
                
                —
                
                
                —
                
                
                —
                
                
                10,052
                
                
                —
                
                
                —
                
                
                —
                
                
                10,052Income
                    tax benefit resulting from exercise of stock options
                
                
                —
                
                
                —
                
                
                —
                
                
                13,844
                
                
                —
                
                
                —
                
                
                —
                
                
                13,844Reclassification
                    at adoption of FAS 123R
                
                
                —
                
                
                —
                
                
                —
                
                
                (4,543
                )
                
                4,543
                
                
                —
                
                
                —
                
                
                —Currency
                    translation adjustment
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                1,222
                
                
                —
                
                
                1,222
                
                $
                1,222Net
                    income
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                31,675
                
                
                31,675
                
                
                31,675**Balances,
                    December 31, 2006**
                
                
                27,394
                
                
                27
                
                
                (41,644
                )
                
                324,823
                
                
                —
                
                
                1,992
                
                
                37,305
                
                
                322,503
                
                $
                32,897Issuance
                    of common stock through:Exercise
                    of options and restricted stock
                
                
                638
                
                
                1
                
                
                —
                
                
                14,297
                
                
                —
                
                
                —
                
                
                —
                
                
                14,298Employee
                    stock purchase plan
                
                
                7
                
                
                —
                
                
                —
                
                
                306
                
                
                —
                
                
                —
                
                
                —
                
                
                306Contributions
                    to employee benefit plan
                
                
                25
                
                
                —
                
                
                607
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                607Stock
                    compensation
                
                
                —
                
                
                —
                
                
                —
                
                
                10,279
                
                
                —
                
                
                —
                
                
                —
                
                
                10,279Income
                    tax benefit resulting from exercise of stock options
                
                
                —
                
                
                —
                
                
                —
                
                
                10,669
                
                
                —
                
                
                —
                
                
                —
                
                
                10,669Purchase
                    of common stock
                
                
                (1,256
                )
                
                (1
                )
                
                (59,645
                )
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                (59,646
                )Reclassification
                    at adoption of FIN 48
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                (2
                    ,083
                )
                
                (2,083
                )Currency
                    translation adjustment
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                390
                
                
                —
                
                
                390
                
                $
                390Net
                    income
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                43,180
                
                
                43,180
                
                
                43,180**Balances,
                    December 31, 2007**
                
                
                26,808
                
                $
                27
                
                $
                (100,682
                )
                $
                360,374
                
                $
                —
                
                $
                2,382
                
                $
                78,402
                
                $
                340,503
                
                $
                43,570





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




49


**ARTHROCARE
      CORPORATION**


**CONSOLIDATED
      STATEMENTS OF CASH FLOWS**


**(in
      thousands)** ****


**Year
                  Ended December 31,****2007**
              
              **2006**
              
              **2005**Cash
                  flows from operating activities:Net
                  income
              
              $
              43,180
              
              $
              31,675
              
              $
              23,530Adjustments
                  to reconcile net income to net cash provided by operating
                  activities:Acquired
                  in-process research and development projects
              
              
              —
              
              
              —
              
              
              2,400Depreciation
                  and amortization
              
              
              21,203
              
              
              21,339
              
              
              16,768Provision
                  for doubtful accounts receivable and product returns
              
              
              2,498
              
              
              1,887
              
              
              1,111Provision
                  for inventory reserves
              
              
              3,760
              
              
              4,191
              
              
              856Non-cash
                  stock compensation expense
              
              
              10,215
              
              
              9,824
              
              
              1,416Deferred
                  taxes
              
              
              (630
              )
              
              (4,741
              )
              
              (5,871
              )Income
                  tax benefit relating to employee stock options
              
              
              (7,811
              )
              
              (9,476
              )
              
              9,583Other
              
              
              (714
              )
              
              351
              
              
              1,135Changes
                  in operating assets and liabilities, net of assets acquired and
                  liabilities assumed in business combinations:Accounts
                  receivable
              
              
              (23,765
              )
              
              (17,200
              )
              
              (14,753
              )Inventories
              
              
              (6,155
              )
              
              (8,617
              )
              
              (7,655
              )Prepaid
                  expenses and other current assets
              
              
              220
              
              
              (2,049
              )
              
              1,290Other
                  assets
              
              
              (4,965
              )
              
              197
              
              
              28Accounts
                  payable
              
              
              2,736
              
              
              1,121
              
              
              3,397Accrued
                  liabilities
              
              
              4,568
              
              
              3,131
              
              
              317Income
                  taxes payable
              
              
              8,372
              
              
              12,167
              
              
              3,626Net
                  cash provided by operating activities
              
              
              52,712
              
              
              43,800
              
              
              37,178Cash
                  flows from investing activities:Payments
                  for purchases of property and equipment
              
              
              (20,198
              )
              
              (17,240
              )
              
              (13,281
              )Payments
                  for business combinations and purchases of intangible
                  assets
              
              
              (41,267
              )
              
              (57,307
              )
              
              (10,521
              )Payments
                  for purchases of available-for-sale securities
              
              
              (1,301
              )
              
              (26,926
              )
              
              —Proceeds
                  from sales of available-for-sale securities
              
              
              12,839
              
              
              15,000
              
              
              7,400Net
                  cash used in investing activities
              
              
              (49,927
              )
              
              (86,473
              )
              
              (16,402
              )Cash
                  flows from financing activities:Payments
                  on notes payable
              
              
              —
              
              
              (38,500
              )
              
              (28,928
              )Proceeds
                  from notes payable
              
              
              60,000
              
              
              38,500
              
              
              —Payments
                  for purchases of treasury stock
              
              
              (59,646
              )
              
              —
              
              
              —Proceeds
                  from issuance of common stock, net of issuance costs
              
              
              306
              
              
              151
              
              
              1,291Proceeds
                  from exercise of options to purchase common stock, net of issuance
                  costs
              
              
              14,298
              
              
              28,097
              
              
              16,460Income
                  tax benefit relating to employee stock options
              
              
              7,811
              
              
              9,476
              
              
              —Net
                  cash provided by (used in) financing activities
              
              
              22,769
              
              
              37,724
              
              
              (11,177
              )Effect
                  of exchange rate changes on cash and cash equivalents
              
              
              (1,710
              )
              
              (237
              )
              
              (718
              )Net
                  increase (decrease) in cash and cash equivalents
              
              
              23,844
              
              
              (5,186
              )
              
              8,881Cash
                  and cash equivalents, beginning of year
              
              
              15,531
              
              
              20,717
              
              
              11,836Cash
                  and cash equivalents, end of year
              
              $
              39,375
              
              $
              15,531
              
              $
              20,717





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




50


**ARTHROCARE
      CORPORATION**


**NOTES
      TO THE CONSOLIDATED FINANCIAL STATEMENTS**




**NOTE
      1 - FORMATION AND BUSINESS OF THE COMPANY**




ArthroCare
      Corporation (“ArthroCare” or the “Company”) was incorporated on April 29, 1993
      and its principal operations commenced in August 1995. The Company designs,
      develops, manufactures and markets medical devices for use in soft-tissue
      surgery. Its products are based on the Company’s patented soft-tissue surgical
      controlled ablation technology, which it calls 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. ArthroCare’s strategy includes applying Coblation technology to a broad
      range of soft-tissue surgical markets, including sports medicine, spinal
      surgery, cavity surgery, neurosurgery, cosmetic surgery, ear, nose and throat,
      or ENT, surgery, gynecology, urology, general surgery and various cardiology
      applications. ArthroCare is a global company with manufacturing facilities
      in
      Costa Rica and the United States and sales offices in the United States, Europe
      and the South Pacific.




**NOTE
      2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**




*Basis
      of Presentation.* The
      consolidated financial statements include the accounts of ArthroCare and all
      of
      its wholly-owned subsidiaries. All significant intra-company transactions and
      accounts have been eliminated. The Company uses the calendar year as its 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.




*Cash
      and Cash Equivalents* .   The
      Company considers 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.





*Short-term
      Investments* .    Short-term
      investments consist primarily of corporate bonds with readily determinable
      fair
      market values. The Company’s investments are classified as “available-for-sale”
and accordingly are reported at fair value, with unrealized gains and losses
      reported as a component of stockholders’ equity. Unrealized losses are charged
      against income when a decline in the fair market value of an individual security
      is determined to be other than temporary. Realized gains and losses on
      investments are included in interest income and are determined on the specific
      identification method. For the years ended December 31, 2007, 2006 and 2005,
      the
      Company had no significant realized gains or losses.




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




*Property
      and Equipment.* Property
      and equipment is stated at cost and is depreciated on a straight-line basis
      over
      the estimated useful lives of three to five years, except buildings which have
      an estimated useful life of 30 years. The Company places the majority of its
      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 product sales 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. Upon retirement or sale, the cost of disposed assets and their
      accumulated depreciation are removed from the balance sheet and any gain or
      loss
      is recognized in current operations.





*Revenue
      Recognition and Allowance for Doubtful Accounts.* The
      Company recognizes product revenue in accordance with SEC Staff Accounting
      Bulletin No. 104, *Revenue
      Recognition in Financial Statements* ,
      or SAB
      104. Under SAB 104, revenue is recognized when there is persuasive evidence
      of
      an arrangement, delivery has occurred or services have been rendered, the sales
      price is fixed and determinable and collectibility is reasonably assured.
      Generally, the criteria are met upon shipment of the Company’s products. For
      amounts due from third-party payors, revenues are recorded at estimated net
      amounts due for devices utilized with allowances determined using historical
      collection amounts for each type of payor. Estimated allowances are adjusted
      to
      actual allowances as cash is received and claims are reconciled. We evaluate
      the
      following criteria in developing the estimated allowance percentages each month:
      historical allowance trends based on actual claims paid by third-party payors;
      consideration and analysis of changes in payor mix reimbursement levels; and
      other issues that may impact allowances. In certain cases, at the customer’s
      request, we will enter into bill and hold transactions whereby title and risk
      of
      loss transfers to the customer, but the product does not ship until a specified
      later date. Revenue on such transactions is recognized only after ArthroCare
      has
      met all conditions for bill and hold transactions set forth in SAB 104,
      specifically that ArthroCare has no further performance obligations, that the
      product is complete and ready for shipment, and that a fixed schedule for
      delivery of the product is set. As of December 31, 2007, 2006 and 2005, there
      were no undelivered bill and hold transactions. Revenue is reported net of
      a
      provision for estimated product returns.




51





The
      Company recognizes license fees and other revenue over the term of the
      associated agreement unless the fee is in exchange for products delivered or
      services performed that represent the culmination of a separate earnings
      process. Royalties are recognized as earned, generally based on the licensees’
product shipments. These items are classified as royalties, fees and other
      revenues in the accompanying condensed consolidated statements 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 in the accompanying condensed consolidated
      statements of operations.





The
      Company maintains an allowance for doubtful accounts receivable based on our
      assessment of the collectibility of customer accounts. The Company regularly
      reviews the allowance, considering such factors as historical collection
      experience, a customer’s current credit-worthiness, customer concentrations, the
      age of the receivable balances, both individually and in the aggregate, and
      general economic conditions that may affect a customer’s ability to pay. Actual
      customer collections could differ from our estimates. The Company believes
      that
      the allowance for doubtful accounts of $4.0 million at December 31, 2007 is
      adequate to provide for probable losses associated with accounts
      receivable.




*Goodwill.* The
      Company’s methodology for allocating the purchase price relating to business
      acquisitions is consistent with established valuation techniques in the medical
      device industry. Goodwill is measured as the excess of the cost of the business
      acquired over the sum of the amounts assigned to tangible and identifiable
      intangible assets acquired less liabilities assumed.





In
      accordance with Statement of Financial Accounting Standards No. 142, *Goodwill
      and Other Intangible Assets* ,
      or FAS
      142, the Company performs an annual impairment test of goodwill. The Company
      evaluates goodwill in the fourth quarter of each year or more frequently if
      events or changes in circumstances indicate that goodwill might be impaired.
      As
      required by FAS 142, the impairment test is accomplished using a two-stepped
      approach. The first step screens for impairment and, when impairment is
      indicated, a second step is employed to measure the impairment. Using data
      as of
      December 31, 2007, the first step did not indicate an impairment of goodwill
      and
      based on other risk factors reviewed by the Company, no impairment of the
      goodwill balance was considered necessary.





*Long-Lived
      Assets* .    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, which are generally less than ten years. 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.





*Treasury
      Stock.* Treasury
      stock is accounted for under the cost method and is included as a component
      of
      stockholders’ equity.




52




*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 $5.0 million, $4.0 million and $3.9 million in 2007,
      2006 and 2005, respectively.





*Stock-Based
      Compensation.* Effective
      January 1, 2006, the Company adopted the provisions of Statement of Financial
      Accounting Standards No. 123
      (revised 2004), *Share-Based
      Payment* ,
      or FAS
      123R ,
      which
      requires the measurement and recognition of compensation expense for all
      share-based payment awards made to employees, including employee stock options
      and employee stock purchases related to the Company’s Employee Stock Purchase
      Plan, or ESPP, based on estimated fair values. Under the provisions of FAS
      123R,
      share-based compensation cost is measured at the grant date, based on the
      calculated fair value of the award, and is recognized as an expense over the
      employee’s requisite service period. Prior to January 1, 2006, the Company
      accounted for share-based compensation to employees in accordance with
      Accounting Principles Board Opinion No. 25, *Accounting
      for Stock Issued to Employees* ,
      or APB
      25 *,* and
      related interpretations. Under APB 25, when the Company issued options to its
      employees with an exercise price equal to the market value of the underlying
      common stock on the date of grant or issuance, no stock-based compensation
      costs
      were recorded. In the event stock-based awards were issued with an exercise
      price that was less than the market value of the underlying common stock on
      the
      date of grant or issuance, the Company recorded deferred compensation expense
      in
      an amount equivalent to the difference between the market value and the exercise
      price of the award.





The
      Company elected to adopt the modified prospective transition method as provided
      by FAS 123R and, accordingly, financial statement amounts for the prior periods
      presented in this Form 10-K have not been restated to reflect the fair value
      method of expensing share-based compensation. Under this transition method,
      stock-based compensation expense for the year ended December 31, 2005 includes
      compensation expense for all stock-based compensation awards granted prior
      to,
      but not yet vested as of January 1, 2006, based on the grant date fair value
      estimated in accordance with the original provisions of FAS 123, *Accounting
      for Stock-Based Compensation.* Stock-based
      compensation for all stock-based compensation awards granted subsequent to
      January 1, 2006 was based on the grant-date fair value estimated in accordance
      with the provisions of FAS 123R. The Company recognizes compensation expense
      for
      stock option awards on a straight-line basis over the requisite service period
      of the award.





*Foreign
        Currency Translation* .    Certain
        of the Company’s wholly-owned subsidiaries have functional currencies other than
        the U.S. dollar. 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 these subsidiaries’ financial statements are recorded
        directly as a separate component of stockholders’ equity under the caption
“accumulated other comprehensive income (loss).”





For
      our
      other non-U.S. operations which have a functional currency of the U.S. dollar,
      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.





*Concentration
      of Risks and Uncertainties.* A
      majority of the Company’s 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. The Company has not experienced
      any losses on deposits of cash and cash equivalents.





The
      Company purchases certain key components of its 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
      the Company’s 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 ArthroCare’s production needs during any
      prolonged interruption of supply.





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




53





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.





*Income
      Taxes.* The
      Company accounts 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 the 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.





In
      July
      2006, the Financial Accounting Standards Board, or FASB, issued Interpretation
      No. 48, *Accounting
      for Uncertainty in Income Taxes* ,
      or FIN
      48. FIN 48 clarifies the accounting for uncertainty in income taxes recognized
      in an enterprise’s financial statements in accordance with Statement of
      Financial Accounting Standards No. 109, *Accounting
      for Income Taxes* .
      This
      interpretation prescribes a recognition threshold and measurement attribute
      for
      the financial statement recognition and measurement of a tax position taken
      or
      expected to be taken in a tax return. FIN 48 also provides guidance on
      derecognition of tax benefits, classification on the balance sheet, interest
      and
      penalties, accounting in interim periods, disclosure, and transition. We adopted
      FIN 48 effective January 1, 2007. In accordance with FIN 48, paragraph 19,
      we have decided to classify interest and penalties as a component of tax
      expense. As a result of the implementation of FIN 48, we recognized a
      $2.1 million increase in liability for unrecognized tax benefits, which was
      accounted for as a reduction to the January 1, 2007 balance of retained
      earnings.





*Reclassifications.* Certain
      reclassifications have been made to prior year balances to conform to the
      current year’s presentation.  The
      effect of such reclassifications is not material to the consolidated financial
      statements.





*Accounting
      Pronouncements* .    
      In September 2006, the FASB issued Statement of Financial Accounting Standards
      No. 157, *Fair
      Value Measurements* ,
      or FAS
      157. FAS 157 defines fair value, establishes a framework for measuring fair
      value in generally accepted accounting principles, and expands disclosures
      about
      fair value measurements. FAS 157 is effective for the Company beginning
      January 1, 2008 for financial assets and liabilities and January 1, 2009
      for non-financial assets and liabilities. The Company is currently in the
      process of evaluating the impact of adopting FAS 157 on its operating results
      and financial position. The Company does not believe that FAS 157 will have
      a
      material effect on its operating results or financial position.





In
      February 2007, the FASB issued Statement of Financial Accounting Standards
      No.
      159, *The
      Fair Value Option for Financial Assets and Financial Liabilities - Including
      an
      amendment of FASB No. 115* ,
      or FAS
      159. The Statement permits companies to choose to measure many financial
      instruments and certain other items at fair value in order to mitigate
      volatility in reported earnings caused by measuring related assets and
      liabilities differently without having to apply complex hedge accounting
      provisions. FAS 159 is effective for the Company beginning January 1, 2008.
      The
      Company does not believe that FAS 159 will have a material effect on its
      operating results or financial position.





In
      December 2007, the FASB issued Statement of Financial Accounting Standards
      No.
      141(R), *Business
      Combinations* ,
      or FAS
      141R. FAS 141R is effective for the Company as of January 1, 2009 and is
      applied prospectively for business combinations completed after January 1,
      2009.
      Under FAS 141, organizations utilized the announcement date as the measurement
      date for the purchase price of the acquired entity. FAS 141R requires
      measurement at the date the acquirer obtains control of the acquiree, generally
      referred to as the acquisition date. FAS 141R will have a significant
      impact on the accounting for transaction costs, restructuring costs as well
      as
      the initial recognition of contingent assets and liabilities assumed during
      a
      business combination completed after January 1, 2009.




54





**NOTE
      3 - SHORT-TERM INVESTMENTS**





Short-term
      investments were acquired at an aggregate cost of $3.9 million and $15.2 million
      at December 31, 2007 and 2006, respectively. At December 31, 2007 and 2006,
      the
      Company’s short-term investments consisted primarily of corporate bonds. The
      fair values of these instruments are based on market interest rates and other
      market information available to management as of each balance sheet date
      presented.





Management
      classifies investments in marketable securities at the time of purchase and
      reevaluates such classification at each balance sheet date. Securities
      classified as available-for-sale are stated at fair value, and all those which
      have original maturities beyond one year have interest reset maturities of
      less
      than thirty-five days.





**NOTE
      4 - 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, and the denominator, number of
      shares, used in the calculation of basic and diluted net income per share (in
      thousands, except per share data):


**Year
                    Ended December 31,****2007**
                
                **2006**
                
                **2005**Net
                    income
                
                $
                43,180
                
                $
                31,675
                
                $
                23,530Basic:Weighted-average
                    common shares outstanding
                
                
                27,452
                
                
                26,207
                
                
                24,375Basic
                    net income per share
                
                $
                1.57
                
                $
                1.21
                
                $
                0.97Diluted:Weighted-average
                    shares outstanding used in basic calculation
                
                
                27,452
                
                
                26,207
                
                
                24,375Dilutive
                    effect of options
                
                
                1,282
                
                
                1,453
                
                
                1,933Dilutive
                    effect of unvested restricted stock
                
                
                136
                
                
                240
                
                
                99Weighted-average
                    common stock and common stock equivalents
                
                
                28,870
                
                
                27,900
                
                
                26,407Diluted
                    net income per share
                
                $
                1.50
                
                $
                1.14
                
                $
                0.89Options
                    excluded from calculation as their effect would be
                    anti-dilutive
                
                
                585
                
                
                370
                
                
                142Price
                    range of excluded options
                
                $
                46.82
                    - $54.15
                
                $
                43.68-$48.56
                
                $
                34.03-$48.56





**NOTE
      5 - INVENTORY**




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


**December
                  31,****2007**
              
              **2006**Raw
                  materials
              
              $
              11,201
              
              $
              12,126Work-in-progress
              
              
              4,308
              
              
              4,949Finished
                  goods
              
              
              52,040
              
              
              38,60567,549
              
              
              55,680Inventory
                  reserves
              
              
              (5,773
              )
              
              (4,138
              )Inventories,
                  net
              
              $
              61,776
              
              $
              51,542





The
      provision for inventory reserves for the years ended December 31, 2007, 2006
      and
      2005 was $3.8 million, $4.2 million and $0.9 million, respectively.





55


**NOTE
      6 - PROPERTY AND EQUIPMENT**




The
      following summarizes the Company’s property and equipment (in thousands, except
      lives):


**Estimated****December
                      31,**
              
              **Useful Lives****2007**
              
              **2006**
              
              **(Years)**Controller
                  placements
              
              $
              59,593
              
              $
              54,909
              
              
              3
                  to 4Computer
                  equipment and software
              
              
              15,578
              
              
              16,795
              
              
              3
                  to 5Machinery
                  and equipment
              
              
              11,665
              
              
              10,994
              
              
              5Furniture,
                  fixtures and leasehold improvements
              
              
              10,386
              
              
              6,478
              
              
              5
                  (a
              )Construction
                  in process
              
              
              8,520
              
              
              3,161
              
              
              —Building
                  and improvements
              
              
              5,991
              
              
              5,287
              
              
              30Tooling
                  and molds
              
              
              5,430
              
              
              1,922
              
              
              5Land
              
              
              745
              
              
              745
              
              
              —117,908
              
              
              100,291Less
                  accumulated depreciation
              
              
              (74,503
              )
              
              (64,220
              )Property
                  and equipment, net
              
              $
              43,405
              
              $
              36,071




(a)
            The
                estimated useful life for leasehold improvements is the shorter of
                5 years
                or the life of the lease.





Depreciation
      expense related to ArthroCare’s property and equipment was $13.8 million, $14.2
      million and $11.2 million for the years ended December 31, 2007, 2006 and 2005,
      respectively.





**NOTE
      7 - GOODWILL AND INTANGIBLE ASSETS**




*Goodwill*




The
      changes in the carrying amount of goodwill are as follows (in
      thousands):




Balance
                  at December 31, 2005
              
              $
              59,170Acquisitions
                  and purchase accounting adjustments
              
              
              77,122Translation
                  adjustments and other
              
              
              1,539Balance
                  at December 31, 2006
              
              
              137,831Acquisitions
                  and purchase accounting adjustments
              
              
              28,675Translation
                  adjustments and other
              
              
              265Balance
                  at December 31, 2007
              
              $
              166,771




In
          2006, the
          Company adjusted the purchase price of the ATI acquisition by $13.3 million
          for
          the expected additional payments that were to be made to ATI shareholders
          in
          2007 based on the net revenues earned by the Company from the acquired
          business.
          The additional accrual increased the goodwill balance associated with the
          ATI
          acquisition. In addition, during 2006, the goodwill balances related to
          the MDA
          and Opus acquisitions increased by $0.4 million and $63.2 million, respectively,
          to reflect payments made to former shareholders based on the satisfaction
          of
          contractual contingencies. In 2007, the Company adjusted the goodwill balance
          associated with its acquisition of ATI by an additional $1.5 million and
          paid
          the shareholders of ATI $14.8 million in satisfaction of the remaining
          contractual obligations associated with the acquisition. The remainder
          of the
          increases in goodwill related to the 2007 DiscoCare acquisition as well
          as other
          acquisitions, which were immaterial both individually and in the aggregate,
          and
          foreign currency translation adjustments related to
          goodwill.




56


*Intangible
        assets with definite lives*
 
 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, and all of the Company’s intangible
        assets are subject to amortization ratably over their estimated useful lives.
        Intangible assets consist of the following (in thousands):
  **December
                  31,**
              
              **Estimated****2007**
              
              **2006**
              
              **Useful
                  Life**Intellectual
                  property rights
              
              $
              30,826
              
              $
              31,300
              
              
              8
                  yearsPatents
              
              
              11,700
              
              
              11,700
              
              
              8
                  yearsTrade
                  name/trademarks
              
              
              6,800
              
              
              4,800
              
              
              7-8
                  yearsDistribution/customer
                  relationships and backlog
              
              
              6,042
              
              
              5,785
              
              
              1-5
                  yearsLicensing,
                  employment and non-competition agreements
              
              
              2,588
              
              
              1,685
              
              
              1-10
                  years57,956
              
              
              55,270Accumulated
                  amortization
              
              
              (20,251
              )
              
              (19,288
              )Net
                  intangible assets
              
              $
              37,705
              
              $
              35,982
  Total
        amortization expense for the years ended December 31, 2007, 2006 and 2005
        was
        approximately $7.2 million, $7.2 million and $6.2 million,
        respectively.
  Estimated
        future amortization expense is as follows (in thousands):
 2008
              
              $
              10,5382009
              
              
              6,7372010
              
              
              6,6302011
              
              
              6,6082012
              
              
              5,205Thereafter
              
              
              1,987$
              37,705
 
 **NOTE
        8 - ACCRUED LIABILITIES**
 
 The
        following summarizes the Company’s accrued liabilities (in
        thousands):
 **December
                  31,****2007**
              
              **2006**Accrued
                  liabilities:Accrued
                  acquisition costs
              
              $
              1,639
              
              $
              14,992Accrued
                  dealer commissions
              
              
              2,592
              
              
              2,816Accrued
                  legal fees
              
              
              502
              
              
              3,225Accrued
                  professional fees and other
              
              
              8,176
              
              
              5,314$
              12,909
              
              $
              26,347
 
  57
  **NOTE
        9 - COMMITMENTS AND CONTINGENCIES**
  *Operating
        Leases*
  The
        Company leases certain facilities and equipment under operating leases. The
        Company recognizes rent expense on a straight-line basis over the lease term.
        At
        December 31, 2007, total future minimum lease payments were as follows (in
        thousands):
 2008
              
              $
              3,1582009
              
              
              2,4992010
              
              
              2,1522011
              
              
              1,9772012
              
              
              1,605Thereafter
              
              
              3,977$
              15,368
  Rent
        expense was $5.6 million, $3.5 million and $2.1 million in 2007, 2006 and
        2005,
        respectively.
 
 *Purchase
        Commitments*
  In
        the
        ordinary course of business, the Company enters into agreements to purchase
        materials in the future that are enforceable, legally binding and specify
        terms
        with fixed or minimum quantities to be purchased and the approximate timing
        of
        the payments. At December 31, 2007, total future minimum purchase commitments
        with suppliers were as follows (in thousands):
 2008
              
              $
              6,2972009
              
              
              2,1742010
              
              
              1,9142011
              
              
              1,7842012
              
              
              —$
              12,169
 
 *Warranties*
  The
        Company generally provides customers with a limited 90-day warranty on devices
        sold and a limited one-year warranty on controller units sold. ArthroCare
        accrues for the estimated cost of product warranties at the time revenue
        is
        recognized. The Company’s warranty obligation is affected by product failure
        rates, material usage and service delivery costs incurred in correcting a
        product failure. ArthroCare periodically evaluates and adjusts the warranty
        reserve to the extent actual warranty expense varies from the original
        estimates.
 
 The
        following table describes the activity in ArthroCare’s warranty accrual (in
        thousands):
 
 **Year
                  ended December 31,****2007**
              
              **2006**
              
              **2005**Balance
                  at beginning of year
              
              $
              250
              
              $
              175
              
              $
              207Accruals
                  for warranties issued during the period
              
              
              1,856
              
              
              1,078
              
              
              929Settlements
                  made during the period
              
              
              (1,665
              )
              
              (1,003
              )
              
              (961
              )Balance
                  at end of year
              
              $
              441
              
              $
              250
              
              $
              175
  *Litigation*
 
 From
        time
        to time, the Company is a defendant in certain lawsuits alleging product
        liability, patent infringement or other claims incurred in the ordinary course
        of business. These claims are generally covered by certain insurance policies,
        subject to certain deductible amounts and maximum policy limits. The Company
        establishes sufficient reserves to cover probable losses associated with
        such
        claims. Except as otherwise described above, the Company has product liability
        insurance coverage in amounts it considers necessary to prevent material
        losses.
        The Company recognizes losses when they are known or considered probable
        and the
        amount can be reasonably estimated.
  58
  Defending
        and prosecuting intellectual property suits, United States Patent and Trademark
        office, or USPTO, interference proceedings and related legal and administrative
        proceedings is generally costly and time-consuming. Further litigation may
        be
        necessary to enforce the Company’s patents, to protect its 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 ArthroCare 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 the Company’s 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. There can be no assurance ArthroCare can obtain any necessary
        licenses on satisfactory terms, if at all.
 
 *Contingent
        Consideration*
 
 Certain
        of the Company’s agreements for purchase business combinations and intangible
        asset purchases include provisions to provide additional consideration if
        contractually specified conditions related to the acquired business or assets
        are achieved. At December 31, 2007, liabilities have been recorded for
        conditions which have been met or are expected to be met based on current
        information available.
 
 **NOTE
        10 - DEBT**
 
 On
        January 13, 2006, the Company entered into a Revolving Credit Agreement
        (the “Credit Agreement”) with a syndicate of banks (collectively, the
“Lenders”). Under the terms of the Credit Agreement, the Company may borrow up
        to $100.0 million under a revolving line of credit from the named Lenders
        at the
        lead Lender’s Prime Rate or the British Bankers Association LIBOR Rate, plus a
        spread. The spread over the Prime Rate or LIBOR Rate is determined by the
        Company’s leverage ratio, as defined in the Credit Agreement. In connection with
        the Company’s repurchase of outstanding common stock, the Company borrowed $60.0
        million in December 2007. At December 31, 2007, the Company had $60.0 million
        in
        outstanding balances under the Credit Agreement and the weighted average
        interest rate applicable to borrowings under the Credit Agreement was 5.5
        percent. The estimated fair value of this debt approximates the carrying
        value
        presented in our consolidated balance sheet based on discounting the expected
        future cash flows using current market rates as of December 31,
        2007.
 
 Future
        contractual debt payments are as follows:
 2008
              
              $
              —2009
              
              
              —2010
              
              
              —2011
              
              
              60,0002012
              
              
              —$
              60,000
 
 The
        Credit Agreement has a five-year maturity and includes additional terms under
        which the Company may request an increase of up to $75.0 million in commitments
        from the Lenders, as business needs dictate. The Credit Agreement also contains
        various covenants that specify minimum or maximum financial ratios.  The
        Company was in compliance with all such covenants at December 31,
        2007.
 
 **NOTE
        11 - STOCKHOLDERS’ EQUITY**
  *Preferred
        Stock*
 
 As
        of
        December 31, 2007, 5,000,000 shares of preferred stock were authorized and
        no
        preferred stock was issued and outstanding.
  59
  *Treasury
        Stock*
 
 In
        2007,
        the Board of Directors authorized the purchase of up to $75.0 million in
        shares
        of the Company’s common stock. In December 2007, the Company purchased 1,255,982
        treasury shares at a cost of $59.6 million and in January 2008, the Company
        purchased an additional 243,918 treasury shares at a cost of $11.8 million.
        The
        Company repurchased shares based on an evaluation of the Company’s long-term
        cash forecast and balance sheet capacity, including anticipated capital
        requirements.
 
 In
        2007
        and 2006, the Company issued 12,102 shares at a value of $0.6 million and
        12,633
        shares at a value of $0.5 million, respectively, in order to fulfill the
        Company’s obligations to match employees’ 401(k) contributions with shares of
        Company stock.
 
 *Stock
        Option Plans*
 
 In
        August
        1999, the Company adopted the Nonstatutory Option Plan, or the 1999 Plan.
        In
        June 2001, it authorized an amendment to the plan, effective April 26, 2001,
        increasing the aggregate number of shares authorized under the 1999 Plan
        to
        3,550,000. As of December 31, 2007, 19,906 shares remained available for
        future
        grant under the 1999 Plan .
 
 In
        May
        2003, the Company adopted the 2003 Incentive Stock Plan, or the 2003 Plan,
        under
        which the Board of Directors is authorized to grant incentive and nonstatutory
        stock option awards and restricted stock awards to employees and consultants.
        In
        May 2004, the Company’s stockholders approved an amendment to the 2003 Plan to
        increase the number of shares available for issuance by 750,000 shares, to
        a
        total of 1,250,000 shares. In May 2006, the Company’s stockholders approved an
        amendment to the 2003 plan to increase the number of shares available for
        issuance by 1,250,000, to a total of 2,500,000. Options granted under the
        2003
        Plan generally become exercisable over a 48-month period and restricted stock
        awards generally become exercisable over a 60-month period. As of December
        31,
        2007, the Company had 731,245 shares available for future grant under the
        2003
        Plan.
 
 The
        1999
        Plan and the 2003 Plan authorize the Company to issue Stock Appreciation
        Rights,
        or SARs, to directors, employees and consultants of the Company. SARs granted
        under the plans have an expiration term of seven years and generally become
        exercisable over a 48 month period.
 
 All
        options and awards granted under each of the Company’s plans have a legal life
        of seven years, effective February 2005. Prior to that, options granted had
        a
        legal life of 10 years from the grant date.
 
 *Employee
        Stock Purchase Plan.* In
        December 1995, ArthroCare approved the ESPP and reserved 300,000 shares of
        common stock for issuance thereunder. In May 2004, the Company’s stockholders
        approved an amendment to the ESPP to increase the number of shares available
        for
        issuance by 150,000 shares, to a total of 450,000 shares. Under the plan,
        regular full-time employees (subject to certain exceptions) may contribute
        up to
        10 percent of base compensation to the semi-annual purchase of shares of
        ArthroCare common stock. In February 2006, the Company amended the ESPP to
        increase the purchase price from 85 percent to 95 percent of the fair market
        value at certain plan-defined dates. During the years ended December 31,
        2007
        approximately 7,461 shares were issued under the Company’s ESPP. As of December
        31, 2007, approximately 72,756 shares remained available for future grant
        under
        the ESPP.
  60
  *Plan
        Activity*
 
 Stock
        option and stock appreciation rights activity for all plans for the years
        ended
        December 31, 2007, 2006 and 2005 is as follows (in thousands, except per
        share
        data):
 
 **Awards
                  Outstanding****Number
                  of Shares**
              
              **Weighted-Average
                  Exercise Price**
 Balance
                  as of December 31, 2004
              
              
              5,361,319
              
              $
              17.40Awards
                  granted
              
              
              609,384
              
              
              31.55Awards
                  exercised
              
              
              (1,020,303
              )
              
              16.12Awards
                  canceled/forfeited
              
              
              (131,345
              )
              
              18.30Balance
                  as of December 31, 2005
              
              
              4,819,055
              
              
              19.50Awards
                  granted
              
              
              459,034
              
              
              45.23Awards
                  exercised
              
              
              (1,877,759
              )
              
              14.93Awards
                  canceled/forfeited
              
              
              (224,069
              )
              
              31.43Balance
                  as of December 31, 2006
              
              
              3,176,261
              
              
              24.94Awards
                  granted
              
              
              647,264
              
              
              37.92Awards
                  exercised
              
              
              (747,827
              )
              
              20.48Awards
                  canceled/forfeited
              
              
              (80,453
              )
              
              28.74Balance
                  as of December 31, 2007
              
              
              2,995,245
              
              
              28.78
 
 Net
        cash
        proceeds from the exercise of stock option awards were $14.3 million, $28.1
        million, and $16.5 million for the years ended December 31, 2007, 2006 and
        2005,
        respectively.
 
 For
        the
        year ended December 31, 2007, there was $13.8 million of total unrecognized
        compensation expense related to unvested share-based compensation arrangements
        granted under the Company’s stock plans related to stock option awards. That
        cost is expected to be recognized over a weighted-average period of 1.4 years.
        As of December 31, 2007, 2.8 million awards were vested or expected to vest
        with
        a weighted average exercise price of $28.26. At December 31, 2007, the aggregate
        intrinsic value associated with these options was $56.3 million.
 
 Awards
        outstanding and currently exercisable by exercise price for all plans at
        December 31, 2007 were as follows:
  **Outstanding
                  Awards**
              
              **Exercisable
                  Awards****Exercise
                  Price**
              
              **Number**
                **Outstanding**
              
              **Weighted**
                **Average**
                **Remaining**
                **Contractual**
                **Life**
              
              **Weighted**
                **Average**
                **Exercise**
                **Price**
              
              **Number**
                **Exercisable**
                **As of**
                **December
                  31, 2007**
              
              **Weighted**
                **Average**
                **Exercise**
                **Price**
 $5.56
                  - $13.29
              
              
              278,564
              
              
              4.23
              
              $
              11.28
              
              
              278,564
              
              $
              11.28$13.31
                  - $17.30
              
              
              256,937
              
              
              4.85
              
              $
              14.41
              
              
              256,937
              
              $
              14.41$17.38
                  - $22.46
              
              
              260,598
              
              
              3.46
              
              $
              19.31
              
              
              252,976
              
              $
              19.25$22.60
                  - $24.38
              
              
              320,449
              
              
              4.25
              
              $
              23.36
              
              
              308,675
              
              $
              23.33$24.50
                  - $27.56
              
              
              336,102
              
              
              4.99
              
              $
              26.33
              
              
              318,715
              
              $
              26.32$27.75
                  - $31.00
              
              
              297,159
              
              
              5.99
              
              $
              30.14
              
              
              206,078
              
              $
              30.24$31.50
                  - $35.71
              
              
              198,932
              
              
              4.31
              
              $
              33.10
              
              
              134,875
              
              $
              33.39$36.08
                  - $39.92
              
              
              563,317
              
              
              6.11
              
              $
              37.04
              
              
              96,303
              
              $
              37.17$39.96
                  - $46.63
              
              
              296,967
              
              
              5.70
              
              $
              42.96
              
              
              94,217
              
              $
              43.20$46.84
                  - $54.15
              
              
              186,220
              
              
              5.33
              
              $
              47.42
              
              
              65,306
              
              $
              46.922,995,245
              
              
              5.05
              
              $
              28.78
              
              
              2,012,646
  61
  During
        the year ended December 31, 2007, the Company issued 142,614 restricted common
        stock shares, which were valued at $6.1 million when reduced by estimated
        forfeitures.  These awards vest over a period of five years. Restricted
        stock awards and units activity for the years ended December 31, 2007, 2006
        and
        2005, is as follows:
  **Number
                  of Shares**
              
              **Weighted-
                  Average Grant Date Fair Value**Unvested
                  at December 31, 2004
              
              
              191,430
              
              $
              16.12Awards
                  granted
              
              
              106,731
              
              
              31.68Awards
                  vested
              
              
              (22,699
              )
              
              23.76Awards
                  canceled/forfeited
              
              
              (6,000
              )
              
              12.61Unvested
                  at December 31, 2005
              
              
              269,462
              
              
              20.84Awards
                  granted
              
              
              127,429
              
              
              45.34Awards
                  vested
              
              
              (65,400
              )
              
              24.78Awards
                  canceled/forfeited
              
              
              (42,767
              )
              
              21.92Unvested
                  at December 31, 2006
              
              
              288,724
              
              
              19.21Awards
                  granted
              
              
              142,614
              
              
              46.17Awards
                  vested
              
              
              (63,919
              )
              
              45.66Awards
                  canceled/forfeited
              
              
              (8,549
              )
              
              31.01Unvested
                  at December 31, 2007
              
              
              358,870
              
              
              16.46
 
 At
        December 31, 2007, there was total unrecognized compensation expense of $9.7
        million, net of estimated forfeitures, related to unvested restricted stock
        awards and units.  At December 31, 2007, unrecognized compensation expense
        was expected to be recognized over a weighted-average period of 2.9 years.
        The
        aggregate intrinsic value associated with the restricted stock awards was
        $14.6
        million.
 
 ***Valuation
        and Expense Information***
  In
        the
        year ended December 31, 2007, the Company recognized total stock-based
        compensation expense of approximately $10.2 million in our consolidated
        financial statements, which included approximately $7.5 million for employee
        stock options and stock appreciation rights and approximately $2.7 million
        for
        restricted stock awards and units. In the year ended December 31, 2006, the
        Company recognized total stock-based compensation expense of approximately
        $9.8
        million, which included approximately $8.0 million for employee stock options
        and stock appreciation rights and approximately $1.8 million for restricted
        stock awards and units. Prior to its adoption of FAS 123R on January 1, 2006,
        the Company did not recognize expense related to employee stock options having
        exercise prices equal to the fair value of the stock.
  62
  The
        following table summarizes the total stock-based compensation expense resulting
        from employee stock options, including stock appreciation rights, and restricted
        stock awards and units that the Company recorded in accordance with the
        provisions of FAS 123R for the years ended December 31, 2007 and 2006. (in
        thousands):
 
 **Year
                  Ended December 31,****2007**
              
              **2006****Employee
                  Stock Options**
              
              **Restricted
                  Stock Awards and Units**
              
              **Employee
                  Stock Options**
              
              **Restricted
                  Stock Awards and Units**Cost
                  of product sales
              
              $
              709
              
              $
              210
              
              $
              618
              
              $
              150Research
                  and development
              
              
              1,111
              
              
              498
              
              
              1,308
              
              
              320Sales
                  and marketing
              
              
              2,170
              
              
              856
              
              
              2,720
              
              
              412General
                  and administrative
              
              
              3,491
              
              
              1,152
              
              
              3,315
              
              
              942Stock-based
                  compensation expensebefore
                  income taxes
              
              
              7,481
              
              
              2,716
              
              
              7,961
              
              
              1,824Income
                  tax benefit
              
              
              2,522
              
              
              918
              
              
              2,581
              
              
              677Total
                  stock-based compensationexpense
                  after income taxes
              
              $
              4,959
              
              $
              1,798
              
              $
              5,380
              
              $
              1,147
 
 At
        December 31, 2007 and 2006, approximately $0.3 million and $0.2 million,
        respectively, of stock-based compensation cost related to employee awards
        was
        capitalized into inventory based on units produced and will be amortized
        to cost
        of product sales based on units sold.
 
 The
        income tax benefit realized from stock option exercises was $10.7 million
        for
        the year ended December 31, 2007 and $13.8 million for the year ended December
        31, 2006. In accordance with FAS 123R, the Company presents excess tax benefits
        from the exercise of stock options, if any, as financing cash flows rather
        than
        operating cash flows.
 
 The
        weighted-average fair value of options granted to employees during the years
        ended December 31, 2007 and 2006 were $12.21 and $15.39, respectively. The
        fair
        value of each stock option was estimated on the grant date using the
        Black-Scholes option-pricing model with the following weighted-average
        assumptions for the years ended December 31, 2007 and 2006:
  **2007**
              
              **2006**Expected
                  term (in years)(1)
              
              
              3.8
              
              
              3.8Expected
                  volatility(2)
              
              
              33
              %
              
              36
              %Risk-free
                  interest rate(3)
              
              
              4.7
              %
              
              4.7
              %Expected
                  dividends
              
              
              —
              
              
              —
  (1)
                The
                    expected term assumption for options was determined based on
                    historical
                    data, adjusted for the recentreduction
                    of the contractual life for options from 10 to seven
                    years.
 (2)
              The
                  expected volatility was determined using a blend of implied volatility
                  and
                  historical volatility over theexpected
                  term, which the Company considers a better indictor of expected
                  volatility
                  than using only historicalvolatility.
 (3)
              The
                  risk-free interest rate is based upon observed interest rates appropriate
                  for the term of the Company’sawards.
 
 Stock-based
        compensation expense recognized in the consolidated statement of operations
        is
        based on awards ultimately expected to vest. Consequently, it has been reduced
        for estimated forfeitures at a rate of 6.6 percent. FAS 123R requires
        forfeitures to be estimated at the time of grant and revised, if necessary,
        in
        subsequent periods if actual forfeitures differ from those estimates.
        Forfeitures have been estimated based on the Company’s historical experience.
        Prior to fiscal 2006, the expected term and expected volatility of stock
        options
        were primarily based upon historical data. Forfeitures of employee stock
        options
        were accounted for on an as-incurred basis.
  63
  The
        weighted average fair value of purchase rights granted under the ESPP during
        the
        years ended December 31, 2007, 2006 and 2005 were $6.20, $6.79 and $8.93,
        respectively. The following assumptions were used in determining the fair
        value
        associated with shares granted under the ESPP as estimated on the date of
        grant
        using the Black-Scholes model with
        the
        following weighted average assumptions, or range of assumptions:
 
 **2007**
              
              **2006**
              
              **2005**Expected
                  term (in years)
              
              
              0.5
                  years
              
              
              0.5
                  years
              
              
              0.5
                  yearsExpected
                  volatility
              
              
              35
              %
              
              35
              %
              
              46
              %Risk-free
                  interest rate
              
              
              4.8
              %
              
              5.2
              %
              
              2.4
                  - 3.1
              %Expected
                  dividends
              
              
              —
              
              
              —
              
              
              —
 
 The
        following table illustrates net income and net income per share as if the
        Company had adopted the fair value recognition provision of FAS 123 for the
        year
        ended December 31, 2005 (in thousands, except per share
        data):
 **2005**Net
                  income—as reported
              
              $
              23,530Add:
                  Stock-based employee compensation expense recognized in net income
                  (loss),
                  net of tax effects
              
              
              751Less:
                  Total employee stock-based compensation expense determined under
                  the fair
                  value method for all awards, net of related tax effects
              
              
              (8,462
              )Pro
                  forma net income
              
              $
              15,819Net
                  income per share:Basic-as
                  reported
              
              $
              0.97Basic-pro
                  forma
              
              
              0.65Diluted-as
                  reported
              
              
              0.89Diluted-pro
                  forma
              
              
              0.60
 
 The
        weighted-average fair value of options granted to employees during the year
        ended December 31, 2005 was $17.59 per share. In determining the pro forma
        net
        income for the year ended December 31, 2005, the fair value of each employee
        stock option grant was estimated on the date of grant using the Black-Scholes
        model with the following weighted average assumptions, or range of assumptions:
  **2005**Risk-free
                  interest rate
              
              
              3.6%
                  - 4.1
              %Expected
                  life
              
              
              5
                  yearsExpected
                  dividends
              
              
              —Expected
                  volatility
              
              
              63
              %
  **NOTE
        12 - RELATED PARTIES**
  In
        June
        1997, the Company loaned an officer $500,000 pursuant to a provision in the
        officer’s employment agreement. The promissory note, which bore no interest, was
        collateralized by a mortgage on the officer’s residence and was due and payable
        upon either the officer’s termination of employment or the sale of the officer’s
        residence. If the Company terminated the officer or if it is acquired, the
        loan
        was due and payable within 12 months thereafter. In January 2007, the officer
        repaid the loan in its entirety.
  64
  **NOTE
        13 - INCOME TAXES**
 
 The
        income tax provision consisted of the following (in thousands):
 
 **Year
                  Ended December 31,****2007**
              
              **2006**
              
              **2005**CurrentFederal
              
              $
              10,897
              
              $
              11,241
              
              $
              1,852State
              
              
              1,246
              
              
              2,353
              
              
              766Foreign
              
              
              607
              
              
              971
              
              
              3,379Total
                  current
              
              
              12,750
              
              
              14,565
              
              
              5,997DeferredFederal
              
              
              162
              
              
              (5,686
              )
              
              4,571State
              
              
              (992
              )
              
              (1,578
              )
              
              (1,402
              )Foreign
              
              
              259
              
              
              1,685
              
              
              (1,973
              )Total
                  deferred
              
              
              (571
              )
              
              (5,579
              )
              
              1,196Total
                  income tax provision
              
              $
              12,179
              
              $
              8,986
              
              $
              7,193
 
 The
        income tax provision differed from a provision computed at the U.S. statutory
        tax rate as follows (in thousands):
  **Year
                  Ended December 31,****2007**
              
              **2006**
              
              **2005**Statutory
                  rate tax provision
              
              $
              19,376
              
              $
              14,231
              
              $
              10,754State
                  income taxes
              
              
              1,291
              
              
              1,040
              
              
              870Differences
                  in foreign tax rates
              
              
              (8,363
              )
              
              (5,934
              )
              
              (4,088
              )Nondeductible
                  expenses
              
              
              257
              
              
              214
              
              
              172Research
                  and development credits
              
              
              (1,291
              )
              
              (1,269
              )
              
              (1,304
              )Stock
                  compensation
              
              
              435
              
              
              456
              
              
              —Charges
                  for acquired IPR&D projects
              
              
              —
              
              
              —
              
              
              840Other
              
              
              474
              
              
              248
              
              
              (51
              )Total
                  income tax provision
              
              $
              12,179
              
              $
              8,986
              
              $
              7,193
 
 Of
        the
        Company’s 2007 pre-tax earnings of $55.4 million, $26.7 million was related to
        foreign tax jurisdictions. For 2006, these amounts were $40.7 million and
        $21.4
        million, respectively. For 2005, these amounts were $30.7 million and $12.8
        million, respectively.
 
 The
        Company’s 2007 tax expense was significantly reduced due to a tax holiday for
        its Costa Rica manufacturing operations. Under its holiday, the Company will
        not
        be subject to Costa Rican income tax until 2010. At that time, the Company
        will
        be subject to normal Costa Rican corporate taxes, which are currently imposed
        at
        a rate of 30 percent.
 
 Had
        the
        Company not benefited from this tax holiday, its 2007 tax liability would
        have
        been increased by $9.0 million and diluted earnings per share would have
        been
        decreased by $0.31. For 2006, the income related to Costa Rica would have
        increased the Company’s tax liability by $5.5 million and decreased earnings per
        share by $0.20. For 2005, the income related to Costa Rica would have increased
        the Company’s tax liability by $2.6 million and decreased earnings per share by
        $0.11.
 
 The
        Company’s cash tax payments during 2007 were limited to $4.9 million due
        primarily to stock option benefits and prior year overpayments that have
        been
        applied to estimated taxes.
  65
 
 At
        December 31, 2007, the Company had federal net operating loss carryforwards
        of
        approximately $17.6 million, $14.1 million of which will be subject to an
        annual
        utilization limitation of approximately $1.7 million under Section 382 of
        the
        Internal Revenue Code. These loss carryforwards will expire during the period
        2011 through 2023 if not utilized.
 
 At
        December 31, 2007, the Company had federal and state research and development
        credit carryforwards of approximately $7.7 million and $7.9 million,
        respectively. These federal credits will expire during the period 2009 through
        2027; the state credits are not subject to expiration.
 
 Under
        the
        Internal Revenue Code, certain substantial changes in the Company’s ownership
        could result in an annual limitation on the amount of net operating loss
        carryforwards and income tax credits that could be utilized to offset future
        tax
        liabilities.
 
 The
        Company’s deferred tax assets and liabilities consist of the following (in
        thousands):
  **December
                  31,****2007**
              
              **2006**Deferred
                  tax assets (liabilities):Net
                  operating loss carryforwards
              
              $
              4,923
              
              $
              10,151R&D
                  and MIC credits
              
              
              9,878
              
              
              8,723Allowances
                  and reserves
              
              
              2,636
              
              
              2,051Deferred
                  intercompany transactions
              
              
              130
              
              
              472Alternative
                  minimum tax credits
              
              
              840
              
              
              362Stock
                  compensation
              
              
              4,028
              
              
              3,130Cost
                  recovery
              
              
              222
              
              
              (307
              )Non-goodwill
                  intangible assets
              
              
              (8,702
              )
              
              (11,343
              )Other
              
              
              478
              
              
              (1,435
              )Net
                  deferred tax assets
              
              $
              14,433
              
              $
              11,804
 
 Income
        tax benefits resulting from the exercise of employee stock options of $10.7
        million, $13.8 million and $9.6 million were credited to additional paid-in
        capital for 2007, 2006 and 2005, respectively.
 
 Deferred
        U.S. income taxes and foreign withholding taxes are not provided on the
        undistributed cumulative earnings of foreign subsidiaries because those earnings
        are considered to be permanently reinvested in those operations. The permanently
        reinvested undistributed earnings were approximately $58.2 million as of
        December 31, 2007. These earnings could become subject to additional tax
        if
        remitted (or deemed remitted) as a dividend to the United States parent company;
        the resulting tax liability would be approximately $19.6 million.
 
 As
        a
        result of the implementation of FIN 48, we recognized a $2.1 million
        increase in liability for unrecognized tax benefits, which was accounted
        for as
        a reduction to the January 1, 2007 balance of retained earnings. As of
        December 31, 2007, we had unrecognized tax benefits of approximately $8.4
        million, of which $7.6 million, if recognized, would result in a reduction
        of
        our effective tax rate. Interest and penalties were immaterial as of December
        31, 2007 and are included in the unrecognized tax benefits. The Company recorded
        an increase in its unrecognized tax benefits of approximately $0.5 million
        for
        the year ended December 31, 2007.
 
 A
        reconciliation of the Company’s beginning and ending amount of unrecognized tax
        benefits is as follows (in thousands):
  Balance
                  at January 1, 2007
              
              $
              7,924Additions
                  for tax positions of current period
              
              
              527Balance
                  at December 31, 2007
              
              $
              8,451
  66
  The
        Company is subject to audit by the IRS and California Franchise Tax Board
        for
        the years 1994 through 2007 and by the Texas State Comptroller for the years
        2006 and 2007. As the Company has operations in most other US states, other
        state tax authorities may assess deficiencies related to prior year activities;
        however, the years open to assessment vary with each state.   The Company
        also files income tax returns for non-US jurisdictions; the most significant
        of
        which are the UK, Sweden, and Germany.  The years open to adjustment for
        the UK and Germany are 2003 through 2007.  The years open to adjustment for
        Sweden are 1999 through 2007.
 
 In
        February 2008, the Company submitted an application with the IRS for an Advanced
        Pricing Agreement, or APA, relating to the transfer pricing policies between
        the
        Company and its foreign subsidiaries. Discussions and conclusions reached
        with
        the IRS
        may
        impact the Company’s determination of related services for prior periods.
 
 **NOTE
        14 - EMPLOYEE BENEFIT PLAN**
 
 ArthroCare
        maintains a Retirement Savings and Investment Plan (“401(k) Plan”), which covers
        all United States based employees. Eligible employees may defer salary (before
        tax) up to a federally specified maximum. Management, at its discretion,
        may
        make matching contributions on behalf of the participants in the 401(k) Plan.
        The Company matched approximately $0.6 million, $0.5 million and $0.1 million
        of
        employee contributions to the 401(k) Plan in 2007, 2006 and 2005, respectively.
 
 **NOTE
        15 - SEGMENT INFORMATION**
 
 ArthroCare
        has organized its marketing and sales efforts based on four operating segments
        which are aggregated into one reportable segment—the development, manufacture
        and marketing of disposable devices for less invasive surgical procedures.
        Each
        of the Company’s business units has similar economic characteristics,
        technology, manufacturing processes, customers, distribution and marketing
        strategies, regulatory environments, and shared infrastructures. These business
        units are Sports Medicine (shoulder and knee arthroscopic products), ENT
        (to
        include ear, nose, throat and the Visage ® cosmetic
        products), Spine (to include spinal and neuro surgery products) and Coblation
        Technology (to include gynecology, urology, laparoscopic, general surgical
        and
        cardiology products).
 
 Product
        sales by business unit for the periods shown were as follows (in thousands):
 
 **Year
                  Ended December 31,****2007**
              
              
              **2006**
              
              
              **2005**Sports
                  Medicine
              
              $
              189,588
              
              
              61.6
              %
              
              $
              166,665
              
              
              65.8
              %
              
              $
              139,868
              
              
              67.7
              %ENT
              
              
              73,065
              
              
              23.8
              %
              
              
              59,886
              
              
              23.6
              %
              
              
              43,546
              
              
              21.1
              %Spine
              
              
              44,653
              
              
              14.5
              %
              
              
              26,635
              
              
              10.5
              %
              
              
              23,110
              
              
              11.2
              %Coblation
                  Technology
              
              
              290
              
              
              0.1
              %
              
              
              190
              
              
              0.1
              %
              
              
              9
              
              
              0.0
              %Total
                  Product Sales
              
              $
              307,596
              
              
              100.0
              %
              
              $
              253,376
              
              
              100.0
              %
              
              $
              206,533
              
              
              100.0
              %
  67
  Internationally,
        the Company markets and supports its products primarily through its subsidiaries
        and various distributors. Revenues attributed to geographic areas are based
        on
        the country in which subsidiaries are domiciled. Product sales by geography
        for
        the periods shown were as follows (in thousands):
 
 **2007**
              
              
              **2006**
              
              
              **2005****Year
                  ended December 31:**Product
                  sales:Americas
              
              $
              243,209
              
              
              79.1
              %
              
              $
              202,333
              
              
              79.9
              %
              
              $
              164,072
              
              
              79.4
              %United
                  Kingdom
              
              
              17,561
              
              
              5.7
              %
              
              
              12,478
              
              
              4.9
              %
              
              
              11,863
              
              
              5.7
              %Germany
              
              
              14,179
              
              
              4.6
              %
              
              
              11,405
              
              
              4.5
              %
              
              
              9,007
              
              
              4.4
              %Rest
                  of World
              
              
              32,647
              
              
              10.6
              %
              
              
              27,160
              
              
              10.7
              %
              
              
              21,591
              
              
              10.5
              %Total
                  product sales
              
              $
              307,596
              
              
              100.0
              %
              
              $
              253,376
              
              
              100.0
              %
              
              $
              206,533
              
              
              100.0
              %**December
                  31:**Long-lived
                  assets:United
                  States
              
              $
              36,843
              
              
              73.5
              %
              
              $
              26,851
              
              
              71.0
              %
              
              $
              23,305
              
              
              68.4
              %Costa
                  Rica
              
              
              9,400
              
              
              18.8
              %
              
              
              7,685
              
              
              20.3
              %
              
              
              5,347
              
              
              15.7
              %Rest
                  of World
              
              
              3,889
              
              
              7.7
              %
              
              
              3,280
              
              
              8.7
              %
              
              
              5,422
              
              
              15.9
              %Total
                  long-lived assets
              
              $
              50,132
              
              
              100.0
              %
              
              $
              37,816
              
              
              100.0
              %
              
              $
              34,074
              
              
              100.0
              %
 
 **NOTE
        16 - QUARTERLY FINANCIAL INFORMATION (Unaudited)**
 
 The
        following tables present certain unaudited consolidated quarterly financial
        information for each quarter in the years ended December 31, 2007 and 2006.
        In
        the Company’s opinion, this unaudited quarterly information has been prepared on
        the same basis as the consolidated financial statements and includes all
        adjustments necessary to present fairly the information for the periods
        presented.
 
 (in
                  thousands, except per share data)**2007**
              
              **1****st****Quarter**
              
              **2****nd****Quarter**
              
              **3****rd****Quarter**
              
              **4****th****Quarter**Total
                  revenues
              
              $
              73,743
              
              $
              79,542
              
              $
              78,461
              
              $
              87,496Gross
                  profit
              
              
              52,987
              
              
              57,839
              
              
              57,261
              
              
              66,431Net
                  income
              
              
              7,136
              
              
              10,413
              
              
              11,122
              
              
              14,509Basic
                  net income per share
              
              
              0.26
              
              
              0.38
              
              
              0.40
              
              
              0.52Diluted
                  net income per share
              
              
              0.25
              
              
              0.37
              
              
              0.39
              
              
              0.50**2006**
              
              
              **1****st****Quarter**
              
              
              **2****nd****Quarter**
              
              
              **3****rd****Quarter**
              
              
              **4****th****Quarter**Total
                  revenues
              
              $
              62,481
              
              $
              66,005
              
              $
              64,695
              
              $
              69,820Gross
                  profit
              
              
              44,776
              
              
              46,249
              
              
              44,762
              
              
              50,376Net
                  income
              
              
              7,133
              
              
              7,699
              
              
              8,676
              
              
              8,167Basic
                  net income per share
              
              
              0.28
              
              
              0.29
              
              
              0.33
              
              
              0.31Diluted
                  net income per share
              
              
              0.26
              
              
              0.28
              
              
              0.31
              
              
              0.29
  **NOTE
        17 - SUPPLEMENTAL CASH FLOW INFORMATION**
 
 Information
        below is in thousands:
 
 **Year
                  ended December 31,****2007**
              
              **2006**
              
              **2005**Cash
                  paid for interest
              
              $
              —
              
              $
              1,926
              
              $
              1,027Cash
                  paid for income taxes
              
              
              4,902
              
              
              1,254
              
              
              114Non-cash
                  investing and financing activities:Stock
                  issued for acquisition of a business
              
              
              —
              
              
              8,054
              
              
              —
  68
  **Schedule
        II**
 
 **ARTHROCARE
        CORPORATION**
 
 **VALUATION
        AND QUALIFYING ACCOUNTS**
 **(in
        thousands)**
 
 **Balance at**
                **Beginning**
                **of
                  Period**
              
              **Additional**
                **Charged to**
                **Costs and**
                **Expenses**
              
              **Deductions**
              
              **Balance at**
                **End**
                **of
                  Period****Year
                  Ended December 31, 2007**Deducted
                  from asset accounts:Allowance
                  for doubtful accounts and product returns
              
              $
              2,701
              
              $
              2,498
              
              $
              (1,219
              )
              $
              3,980Inventory
                  reserves
              
              
              4,138
              
              
              3,760
              
              
              (2,125
              )
              
              5,773**Year
                  Ended December 31, 2006**Deducted
                  from asset accounts:Allowance
                  for doubtful accounts and product returns
              
              $
              1,365
              
              $
              1,887
              
              $
              (551
              )
              $
              2,701Inventory
                  reserves
              
              
              1,455
              
              
              4,191
              
              
              (1,508
              )
              
              4,138**Year
                  Ended December 31, 2005**Deducted
                  from asset accounts:Allowance
                  for doubtful accounts and product returns
              
              $
              400
              
              $
              1,111
              
              $
              (146
              )
              $
              1,365Inventory
                  reserves
              
              
              1,000
              
              
              856
              
              
              (401
              )
              
              1,455
 
 69
  **SIGNATURES**
  Pursuant
        to the requirements of Section 13 or 15(d) of the Securities Exchange Act
        of
        1934, the Registrant has duly caused this report to be signed on its behalf by
        the undersigned, thereunto duly authorized:
 ARTHROCARE
                    CORPORATIONa
                    Delaware CorporationBy:
                /s/
                    Michael A. Baker**Michael
                    A. Baker****President
                    and Chief Executive
                    Officer**
  Date:
        February 29, 2008
 
 Pursuant
        to the requirements of the Securities Exchange Act of 1934, the following
        persons on behalf of the Registrant and in the capacities and on the dates
        indicated have signed this Report below:
  **Signature**
                    
                    **Title**
                    
                    **Date**/s/
                        Michael A. Baker
                    
                    President,
                        Chief Executive Officer and
                    
                    February
                        29, 2008**Michael
                        A. Baker**
                    
                    Director
                        (Principal Executive Officer)/s/
                        Michael Gluk
                    
                    Senior
                        Vice President Finance, Chief
                    
                    February
                        29, 2008**Michael
                        Gluk**
                    
                    Financial
                        Officer and Assistant Secretary(Principal
                        Financial and AccountingOfficer)/s/
                        David F. Fitzgerald
                    
                    Director
                    
                    February
                        29, 2008**David
                        F. Fitzgerald**/s/
                        James Foster
                    
                    Director
                    
                    February
                        29, 2008**James
                        Foster**/s/
                        Peter L. Wilson
                    
                    Director
                    
                    February
                        29, 2008**Peter
                        L. Wilson**/s/
                        Tord B. Lendau
                    
                    Director
                    
                    February
                        29, 2008**Tord
                        B. Lendau**/s/
                        Barbara D. Boyan
                    
                    Director
                    
                    February
                        29, 2008**Barbara
                        D. Boyan**/s/
                        Terrence E. Geremski
                    
                    Director
                    
                    February
                        29, 2008**Terrence
                        E. Geremski**  70
 **ARTHROCARE
        CORPORATION**
  **INDEX
        TO EXHIBITS***
  **Exhibit**
                    **Number**
                  
                  **Exhibit
                      Name**10.65
                      ††
                  
                  Stock
                        Purchase Agreement, dated as of December 31, 2007, by and
                        among ArthroCare
                        Corporation and DiscoCare, Inc.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-15(f) 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-15(f) of
                      the Exchange
                      Act, as adopted pursuant to Section 302 of the Sarbanes-Oxley
                      Act of
                      2002.32.1
                  
                  Certification
                      of the Chief Executive Officer pursuant to 18 U.S.C. Section
                      1350, as
                      adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
                      2002.32.2
                  
                  Certification
                      of the Chief Financial Officer pursuant to 18 U.S.C. Section
                      1350, as
                      adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
                      2002.
 ††
                Confidential treatment has been
                  requested as to portions of this exhibit. *
                Only
                      exhibits actually filed are listed. Exhibits incorporated by
                      reference are
                      set forth in the exhibit listing included in Item 15 of the
                      Report on Form
                      10-K.