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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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Form 10-Q



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|x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ---------------------------------------------------------------------------------------

For the quarter ended June 30, 2006

OR



| ̈ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ----------------------------------------------------------------------------------------

For the transition period from  to

Commission File Number: 0-27422



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ArthroCare Corporation

(Exact name of registrant as specified in its charter)



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|                         |  |                                     
|------------------------ |  | ------------------------------------
|Delaware                 |  | 94-3180312                          
|(State of incorporation) |  | (I.R.S. Employer Identification No.)

111 Congress Avenue, Suite 510, Austin, TX 78701

(Address of principal executive offices)

(512) 391-3900

(Registrants telephone number, including area code)



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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 whether the Registrant is a large
accelerated filer, an accelerated filer, or a non-accelerated filer (as defined in Exchange Act Rule 12b-2).

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 Exchange Act).    Yes ̈No  x

The number of shares outstanding of the
registrants common stock as of July 31, 2006 was 26,431,572.



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##### Table of Contents

ARTHROCARE CORPORATION

Form 10-Q Quarterly Report

For the quarter ended June 30, 2006

TABLE OF CONTENTS



|                           |  |                                                                                                                  |  |     
|-------------------------- |  | ---------------------------------------------------------------------------------------------------------------- |  | ----
|                           |  |                                                                                                                  |  | Page
|Forward-Looking Statements |  | 1                                                                                                               
|                           |  |                                                                                                                 
|PART I:                    |  | Financial Information                                                                                            |  |     
|Item 1.                    |  | Financial Statements                                                                                             |  |     
|                           |  | Condensed Consolidated Balance Sheets as of June 30, 2006 and December 31, 2005                                  |  | 2   
|                           |  | Condensed Consolidated Statements of Operations for the three and six month periods ended June 30, 2006 and 2005 |  | 3   
|                           |  | Condensed Consolidated Statements of Cash Flows for the three and six month periods ended June 30, 2006 and 2005 |  | 4   
|                           |  | Notes to Condensed Consolidated Financial Statements                                                             |  | 5   
|Item 2.                    |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                            |  | 17  
|Item 3.                    |  | Quantitative and Qualitative Disclosures About Market Risk                                                       |  | 28  
|Item 4.                    |  | Controls and Procedures                                                                                          |  | 29  
|                           |  |                                                                                                                 
|PART II:                   |  | Other Information                                                                                                |  |     
|Item 1.                    |  | Legal Proceedings                                                                                                |  | 30  
|Item 1A.                   |  | Risk Factors                                                                                                     |  | 30  
|Item 2.                    |  | Unregistered Sales of Securities and Use of Proceeds                                                             |  | 30  
|Item 3.                    |  | Defaults Upon Senior Securities                                                                                  |  | 30  
|Item 4.                    |  | Submission of Matters to a Vote of Securities Holders                                                            |  | 31  
|Item 5.                    |  | Other Information                                                                                                |  | 31  
|Item 6.                    |  | Exhibits                                                                                                         |  | 32  
|                           |  |                                                                                                                 
|                           |  | Signatures                                                                                                       |  | 33  
|                           |  | Certifications                                                                                                   |  |     



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##### Table of Contents

Forward-Looking Statements

This report contains information that may constitute forward-looking
statements. Generally, the words believe, expect, intend, estimate, anticipate, project, will and similar expressions identify forward-looking statements,
which generally are not historical in nature. Our forward-looking statements generally relate to our growth strategies, financial results, product development, regulatory approvals, competitive strengths, the scope of our intellectual property
rights, and sales efforts. One must carefully consider forward-looking statements and understand that such statements involve a variety of risks and uncertainties, known and unknown, and may be affected by inaccurate assumptions, including,
among others, those discussed in the sections entitled Government Regulation, Patents and Proprietary Rights, Competition and Additional Factors That Might Affect Future Results in Part 1 of our Annual
Report on Form 10-K for the year ended December 31, 2005. Consequently, no forward-looking statement can be guaranteed and actual results may vary materially.

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



1



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##### Table of Contents

PART 1. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

ARTHROCARE CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(unaudited)

(in thousands, except
per share data)



|                                                                            |  |              |         |   |                  |   |         |  
|--------------------------------------------------------------------------- |  | ------------ | ------- | - | ---------------- | - | ------- | -
|                                                                            |  | June 30,2006 |         |   | December 31,2005 |  
|ASSETS                                                                      |  |              |         |   |                  |   |         |  
|Current assets:                                                             |  |              |         |   |                  |   |         |  
|Cash and cash equivalents                                                   |  | $            | 12,329  |   |                  | $ | 20,717  |  
|Short-term investments                                                      |  |              | 21,463  |   |                  |   | 2,600   |  
|Accounts receivable, net of allowances of $2,160 at 2006 and $1,365 at 2005 |  |              | 51,232  |   |                  |   | 47,138  |  
|Inventories, net                                                            |  |              | 53,075  |   |                  |   | 47,834  |  
|Prepaid expenses and other current assets                                   |  |              | 16,847  |   |                  |   | 14,544  |  
|                                                                            |  |              |         |   |                  |   |         |  
|Total current assets                                                        |  |              | 154,946 |   |                  |   | 132,833 |  
|                                                                            |  |             
|Property and equipment, net                                                 |  |              | 34,906  |   |                  |   | 32,604  |  
|Related party receivables                                                   |  |              | 500     |   |                  |   | 1,075   |  
|Intangible assets, net                                                      |  |              | 38,181  |   |                  |   | 40,901  |  
|Goodwill                                                                    |  |              | 117,987 |   |                  |   | 59,170  |  
|Other assets                                                                |  |              | 894     |   |                  |   | 395     |  
|                                                                            |  |              |         |   |                  |   |         |  
|Total assets                                                                |  | $            | 347,414 |   |                  | $ | 266,978 |  
|                                                                            |  |              |         |   |                  |   |         |  
|LIABILITIES AND STOCKHOLDERS EQUITY                                        |  |              |         |   |                  |   |         |  
|Current liabilities:                                                        |  |              |         |   |                  |   |         |  
|Accounts payable                                                            |  | $            | 13,932  |   |                  | $ | 12,332  |  
|Accrued liabilities                                                         |  |              | 6,313   |   |                  |   | 6,548   |  
|Accrued compensation                                                        |  |              | 8,597   |   |                  |   | 11,008  |  
|Current portion of long-term debt                                           |  |              | 35,000  |   |                  |   |        |  
|Income taxes payable                                                        |  |              | 3,602   |   |                  |   | 4,104   |  
|                                                                            |  |              |         |   |                  |   |         |  
|Total current liabilities                                                   |  |              | 67,444  |   |                  |   | 33,992  |  
|                                                                            |  |             
|Deferred taxes and other liabilities                                        |  |              | 4,092   |   |                  |   | 4,092   |  
|                                                                            |  |              |         |   |                  |   |         |  
|Total liabilities                                                           |  |              | 71,536  |   |                  |   | 38,084  |  
|                                                                            |  |              |         |   |                  |   |         |  
|                                                                            |  |             
|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: 26,424 shares at 2006 and 24,619 shares at 2005     |  |              | 26      |   |                  |   | 25      |  
|Treasury stock: 2,704 shares at 2006 and 2005                               |  |              | (42,158 | ) |                  |   | (42,158 | )
|Additional paid-in capital                                                  |  |              | 296,174 |   |                  |   | 269,170 |  
|Deferred stock-based compensation                                           |  |              |        |   |                  |   | (4,543  | )
|Accumulated other comprehensive income                                      |  |              | 1,374   |   |                  |   | 770     |  
|Retained earnings                                                           |  |              | 20,462  |   |                  |   | 5,630   |  
|                                                                            |  |              |         |   |                  |   |         |  
|Total stockholders equity                                                  |  |              | 275,878 |   |                  |   | 228,894 |  
|                                                                            |  |              |         |   |                  |   |         |  
|Total liabilities and stockholders equity                                  |  | $            | 347,414 |   |                  | $ | 266,978 |  
|                                                                            |  |              |         |   |                  |   |         |  

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



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##### Table of Contents

ARTHROCARE CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(unaudited)

(in thousands, except
per share data)



|                                                      |  |                             |        |   |                           |   |        |      |  |   |         |   |  |   |         |  
|----------------------------------------------------- |  | --------------------------- | ------ | - | ------------------------- | - | ------ | ---- |  | - | ------- | - |  | - | ------- | -
|                                                      |  | Three Months Ended June 30, |        |   | Six Months Ended June 30, |  
|                                                      |  | 2006                        |        |   | 2005                      |   |        | 2006 |  |   | 2005    |  
|Revenues                                              |  |                             |        |   |                           |   |        |      |  |   |         |   |  |   |         |  
|Product sales                                         |  | $                           | 63,821 |   |                           | $ | 49,683 |      |  | $ | 124,078 |   |  | $ | 97,517  |  
|Royalties, fees, and other                            |  |                             | 2,184  |   |                           |   | 2,049  |      |  |   | 4,408   |   |  |   | 3,898   |  
|                                                      |  |                             |        |   |                           |   |        |      |  |   |         |   |  |   |         |  
|Total revenues                                        |  |                             | 66,005 |   |                           |   | 51,732 |      |  |   | 128,486 |   |  |   | 101,415 |  
|                                                      |  |                             |        |  
|Cost of product sales                                 |  |                             | 19,756 |   |                           |   | 15,296 |      |  |   | 37,461  |   |  |   | 30,773  |  
|                                                      |  |                             |        |   |                           |   |        |      |  |   |         |   |  |   |         |  
|Gross profit                                          |  |                             | 46,249 |   |                           |   | 36,436 |      |  |   | 91,025  |   |  |   | 70,642  |  
|                                                      |  |                             |        |  
|Operating expenses                                    |  |                             |        |   |                           |   |        |      |  |   |         |   |  |   |         |  
|Research and development                              |  |                             | 6,125  |   |                           |   | 5,155  |      |  |   | 12,327  |   |  |   | 10,007  |  
|Sales and marketing                                   |  |                             | 22,796 |   |                           |   | 18,601 |      |  |   | 44,701  |   |  |   | 36,951  |  
|General and administrative                            |  |                             | 5,377  |   |                           |   | 4,708  |      |  |   | 10,438  |   |  |   | 9,269   |  
|Amortization of intangible assets                     |  |                             | 1,718  |   |                           |   | 1,458  |      |  |   | 3,540   |   |  |   | 2,916   |  
|                                                      |  |                             |        |   |                           |   |        |      |  |   |         |   |  |   |         |  
|Total operating expenses                              |  |                             | 36,016 |   |                           |   | 29,922 |      |  |   | 71,006  |   |  |   | 59,143  |  
|                                                      |  |                             |        |  
|Income from operations                                |  |                             | 10,233 |   |                           |   | 6,514  |      |  |   | 20,019  |   |  |   | 11,499  |  
|Interest and other income (expense), net              |  |                             | (11    | ) |                           |   | (366   | )    |  |   | (322    | ) |  |   | (1,135  | )
|                                                      |  |                             |        |   |                           |   |        |      |  |   |         |   |  |   |         |  
|Income before income tax provision                    |  |                             | 10,222 |   |                           |   | 6,148  |      |  |   | 19,697  |   |  |   | 10,364  |  
|                                                      |  |                             |        |  
|Income tax provision                                  |  |                             | 2,523  |   |                           |   | 1,330  |      |  |   | 4,865   |   |  |   | 2,384   |  
|                                                      |  |                             |        |   |                           |   |        |      |  |   |         |   |  |   |         |  
|Net income                                            |  | $                           | 7,699  |   |                           | $ | 4,818  |      |  | $ | 14,832  |   |  | $ | 7,980   |  
|                                                      |  |                             |        |   |                           |   |        |      |  |   |         |   |  |   |         |  
|Basic net income per share                            |  | $                           | 0.29   |   |                           | $ | 0.20   |      |  | $ | 0.58    |   |  | $ | 0.33    |  
|                                                      |  |                             |        |   |                           |   |        |      |  |   |         |   |  |   |         |  
|Shares used in computing basic net income per share   |  |                             | 26,180 |   |                           |   | 24,176 |      |  |   | 25,756  |   |  |   | 24,044  |  
|                                                      |  |                             |        |   |                           |   |        |      |  |   |         |   |  |   |         |  
|Diluted net income per share                          |  | $                           | 0.28   |   |                           | $ | 0.19   |      |  | $ | 0.53    |   |  | $ | 0.31    |  
|                                                      |  |                             |        |   |                           |   |        |      |  |   |         |   |  |   |         |  
|Shares used in computing diluted net income per share |  |                             | 27,803 |   |                           |   | 25,877 |      |  |   | 27,773  |   |  |   | 25,833  |  
|                                                      |  |                             |        |   |                           |   |        |      |  |   |         |   |  |   |         |  

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



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ARTHROCARE CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)

(in thousands)



|                                                                                                             |  |                           |         |   |      |   |         |  
|------------------------------------------------------------------------------------------------------------ |  | ------------------------- | ------- | - | ---- | - | ------- | -
|                                                                                                             |  | Six Months Ended June 30, |        
|                                                                                                             |  | 2006                      |         |   | 2005 |  
|Cash flows from operating activities:                                                                        |  |                           |         |   |      |   |         |  
|Net income                                                                                                   |  | $                         | 14,832  |   |      | $ | 7,980   |  
|Adjustments to reconcile net income to net cash provided by operating activities:                            |  |                           |         |   |      |   |         |  
|Depreciation and amortization                                                                                |  |                           | 9,534   |   |      |   | 8,030   |  
|Provision for doubtful accounts and product returns                                                          |  |                           | 420     |   |      |   | 336     |  
|Provision for excess and obsolete inventory                                                                  |  |                           |        |   |      |   | 200     |  
|Excess tax benefit from employee stock plans                                                                 |  |                           | (4,536  | ) |      |   |        |  
|Stock-based compensation expense                                                                             |  |                           | 5,035   |   |      |   | 620     |  
|Other                                                                                                        |  |                           | (364    | ) |      |   | 426     |  
|Changes in operating assets and liabilities, net of assets and liabilities acquired in business combination: |  |                           |         |   |      |   |         |  
|Accounts receivable                                                                                          |  |                           | (4,244  | ) |      |   | (4,860  | )
|Inventories                                                                                                  |  |                           | (4,599  | ) |      |   | 219     |  
|Prepaid expenses and other current assets                                                                    |  |                           | (2,247  | ) |      |   | (220    | )
|Other assets                                                                                                 |  |                           | 304     |   |      |   | 11      |  
|Accounts payable                                                                                             |  |                           | 1,033   |   |      |   | (282    | )
|Accrued and other liabilities                                                                                |  |                           | (2,804  | ) |      |   | (1,719  | )
|Income taxes payable                                                                                         |  |                           | 4,033   |   |      |   | 2,052   |  
|                                                                                                             |  |                           |         |   |      |   |         |  
|Net cash provided by operating activities                                                                    |  |                           | 16,397  |   |      |   | 12,793  |  
|                                                                                                             |  |                           |         |   |      |   |         |  
|Cash flows from investing activities:                                                                        |  |                           |         |   |      |   |         |  
|Purchases of property and equipment                                                                          |  |                           | (7,976  | ) |      |   | (6,277  | )
|Purchases of intangible assets                                                                               |  |                           | (1,089  | ) |      |   |        |  
|Payment for purchase of Opus, net of cash acquired                                                           |  |                           | (52,403 | ) |      |   |        |  
|Purchases of available-for-sale securities                                                                   |  |                           | (18,714 | ) |      |   | (12,120 | )
|                                                                                                             |  |                           |         |   |      |   |         |  
|Net cash provided by (used in) investing activities                                                          |  |                           | (80,182 | ) |      |   | (18,397 | )
|                                                                                                             |  |                           |         |   |      |   |         |  
|Cash flows from financing activities:                                                                        |  |                           |         |   |      |   |         |  
|Repayment on loan from bank                                                                                  |  |                           |        |   |      |   | (2,143  | )
|Proceeds from loan from bank                                                                                 |  |                           | 35,000  |   |      |   |        |  
|Proceeds from issuance of common stock, net of issuance costs                                                |  |                           |        |   |      |   | 637     |  
|Income tax benefit relating to employee stock options                                                        |  |                           | 4,536   |   |      |   |        |  
|Proceeds from exercise of options to purchase common stock                                                   |  |                           | 15,860  |   |      |   | 6,209   |  
|                                                                                                             |  |                           |         |   |      |   |         |  
|Net cash provided by financing activities                                                                    |  |                           | 55,396  |   |      |   | 4,703   |  
|                                                                                                             |  |                           |         |   |      |   |         |  
|Effect of exchange rate changes on cash and cash equivalents                                                 |  |                           | 1       |   |      |   | (465    | )
|                                                                                                             |  |                           |         |   |      |   |         |  
|Net increase (decrease) in cash and cash equivalents                                                         |  |                           | (8,388  | ) |      |   | (1,366  | )
|Cash and cash equivalents, beginning of period                                                               |  |                           | 20,717  |   |      |   | 11,836  |  
|                                                                                                             |  |                           |         |   |      |   |         |  
|Cash and cash equivalents, end of period                                                                     |  | $                         | 12,329  |   |      | $ | 10,470  |  
|                                                                                                             |  |                           |         |   |      |   |         |  
|Supplemental disclosure of non-cash investing activities:                                                    |  |                           |         |   |      |   |         |  
|Issuance of common stock to former shareholders of Opus Medical                                              |  | $                         | 5,803   |   |      | $ |        |  

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



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ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 1  Description of Business

ArthroCare Corporation (ArthroCare, we or the Company) was incorporated on April 29, 1993 and
its principal operations commenced in August 1995. ArthroCare designs, develops, manufactures and markets medical devices for use in soft-tissue surgery. Many of ArthroCares products are based on its patented soft-tissue surgical controlled
ablation technology, which it calls Coblation technology. Coblation technology has the capability of performing at temperatures lower than traditional electrosurgical tools. The Companys strategy includes applying Coblation technology to a
broad range of soft-tissue surgical markets, including sports medicine, spinal surgery, neurosurgery, cosmetic surgery, ear, nose and throat (ENT) surgery, gynecology, urology, general surgery and various cardiology applications. ArthroCare is an
international company with manufacturing facilities in the United States and Costa Rica and sales offices in the United States and Europe.

NOTE 2
 Summary of Significant Accounting Policies

Basis of Presentation

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

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the
instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the
opinion of management, the unaudited interim condensed consolidated financial statements reflect all adjustments (consisting of only normal recurring adjustments) necessary for a fair statement of the Companys financial position, results of
operations and cash flows for the periods presented. These financial statements should be read in conjunction with the Companys consolidated financial statements and notes thereto filed with the United States Securities and Exchange Commission
(SEC) in the Companys annual report on Form 10-K for the year ended December 31, 2005. Operating results for the three and six month periods ended June 30, 2006 are not necessarily indicative of the results that may be
expected for the year ended December 31, 2006.

The condensed consolidated balance sheet at December 31, 2005 was derived from
the Companys audited consolidated financial statements as of that date; however, the accompanying financial statements do not include all annual disclosures required by accounting principles generally accepted in the United States of America.

Use of Estimates

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

Share-Based Payment

In December 2004, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 123 (revised
2004), Share-Based Payment (Statement 123R). Generally, Statement 123R requires companies to recognize compensation expense in the statements of operations based on the grant date fair value of share-based payments to employees,
including grants of employee stock options and the right to purchase shares under an employee stock purchase plan. In January 2005, the SEC issued Staff Accounting Bulletin No. 107, which provides supplemental implementation guidance for
Statement 123R. In addition, the adoption of Statement 123R requires additional accounting related to the income tax effects and disclosures regarding the cash flow effects resulting from share-based payment arrangements.



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##### Table of Contents

ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (Continued)



The Company adopted Statement 123R in the first quarter of fiscal 2006. The pro forma disclosures
previously permitted under Statement 123 are no longer an alternative to financial statement recognition. The Company adopted the standard using the modified prospective method beginning January 1, 2006 and selected the Black-Scholes
option-pricing model as the most appropriate fair-value estimation method for its awards and recognizes compensation cost on a straight-line basis over its awards vesting periods. The Companys assessment of the estimated compensation
charges is affected by its stock price as well as assumptions regarding a number of uncertainties, including, stock price volatility, estimated forfeitures, employee stock option exercise behavior, and related tax implications. Refer to Note 9 for
additional information.

Reclassifications

Certain reclassifications have been made to prior year balances to conform to the current years presentation. These are related to short-term investments reclassified out of cash and cash equivalents as of and
for the quarter ended June 30, 2005. This is described in our Annual Report on Form 10-K for the year ended December 31, 2005. The effect of such reclassifications is not material to the condensed consolidated financial statements.

NOTE 3  Short-term Investments

Short-term investments were acquired at an aggregate cost of $21.5 million and $2.6 million at June 30, 2006 and December 31, 2005, respectively. At June 30, 2006, the Companys short-term investments consist primarily
of commercial paper, whereas at December 31, 2005 they consisted primarily of tax-exempt municipal 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 and approximate aggregate cost at June 30, 2006 and December 31, 2005.

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 have maturities beyond five years, and have
interest rate reset maturities of less than 35 days.

NOTE 4  Comprehensive Income

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

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



|                                                                                            |  |                            |       |                         |   |       |  |      |        |  |   |      
|------------------------------------------------------------------------------------------- |  | -------------------------- | ----- | ----------------------- | - | ----- |  | ---- | ------ |  | - | -----
|                                                                                            |  | Three Months EndedJune 30, |       | Six Month EndedJune 30,
|                                                                                            |  | 2006                       |       | 2005                    |   | 2006  |  | 2005
|Net income                                                                                  |  | $                          | 7,699 |                         | $ | 4,818 |  | $    | 14,832 |  | $ | 7,980
|                                                                                            |  |                            |       |                        
|Net unrealized gains on available-for-sale securities arising during the period, net of tax |  |                            | 136   |                         |   |      |  |      | 149    |  |   |     
|Foreign currency translation adjustment                                                     |  |                            | 601   |                         |   | 146   |  |      | 607    |  |   | 126  
|                                                                                            |  |                            |       |                         |   |       |  |      |        |  |   |      
|Comprehensive income                                                                        |  | $                          | 8,436 |                         | $ | 4,964 |  | $    | 15,588 |  | $ | 8,106
|                                                                                            |  |                            |       |                         |   |       |  |      |        |  |   |      



6



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##### Table of Contents

ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (Continued)



NOTE 5 - Computation of Net Income Per Share

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

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):



|                                                                         |  |                             |               |                           |   |              |  |      |               |  |   |             
|------------------------------------------------------------------------ |  | --------------------------- | ------------- | ------------------------- | - | ------------ |  | ---- | ------------- |  | - | ------------
|                                                                         |  | Three Months Ended June 30, |               | Six Months Ended June 30,
|                                                                         |  | 2006                        |               | 2005                      |   | 2006         |  | 2005
|Net Income                                                               |  | $                           | 7,699         |                           | $ | 4,818        |  | $    | 14,832        |  | $ | 7,980       
|                                                                         |  |                             |               |                           |   |              |  |      |               |  |   |             
|Basic:                                                                   |  |                             |               |                           |   |              |  |      |               |  |   |             
|Weighted-average shares outstanding                                      |  |                             | 26,180        |                           |   | 24,176       |  |      | 25,756        |  |   | 24,044      
|                                                                         |  |                             |               |                           |   |              |  |      |               |  |   |             
|Basic net income per share                                               |  | $                           | 0.29          |                           | $ | 0.20         |  | $    | 0.58          |  | $ | 0.33        
|                                                                         |  |                             |               |                           |   |              |  |      |               |  |   |             
|Diluted:                                                                 |  |                             |               |                           |   |              |  |      |               |  |   |             
|Weighted-average shares outstanding used in basic calculation            |  |                             | 26,180        |                           |   | 24,176       |  |      | 25,756        |  |   | 24,044      
|Dilutive effect of potential shares of common stock                      |  |                             | 1,623         |                           |   | 1,701        |  |      | 2,017         |  |   | 1,789       
|                                                                         |  |                             |               |                           |   |              |  |      |               |  |   |             
|Weighted-average shares and equivalents                                  |  |                             | 27,803        |                           |   | 25,877       |  |      | 27,773        |  |   | 25,833      
|                                                                         |  |                             |               |                           |   |              |  |      |               |  |   |             
|Diluted net income per share                                             |  | $                           | 0.28          |                           | $ | 0.19         |  | $    | 0.53          |  | $ | 0.31        
|                                                                         |  |                             |               |                           |   |              |  |      |               |  |   |             
|Options excluded from calculation as their effect would be anti-dilutive |  |                             | 444           |                           |   | 558          |  |      | 336           |  |   | 512         
|                                                                         |  |                             |               |                           |   |              |  |      |               |  |   |             
|Price range of excluded options                                          |  | $                           | 43.27 -$48.56 |                           | $ | 31.44-$48.56 |  | $    | 43.97 -$48.56 |  | $ | 30.35-$48.56
|                                                                         |  |                             |               |                           |   |              |  |      |               |  |   |             

NOTE 6  Inventories

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



|                |  |               |        |                  |   |       
|--------------- |  | ------------- | ------ | ---------------- | - | ------
|                |  | June 30, 2006 |        | December 31,2005
|Raw materials   |  | $             | 10,583 |                  | $ | 11,771
|Work-in-process |  |               | 4,656  |                  |   | 4,455 
|Finished goods  |  |               | 37,836 |                  |   | 31,608
|                |  |               |        |                  |   |       
|Total           |  | $             | 53,075 |                  | $ | 47,834
|                |  |               |        |                  |   |       



7



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##### Table of Contents

ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (Continued)



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.

The Companys reserve for excess and obsolete inventories was approximately $1.4 million at June 30, 2006 and $1.5 million at
December 31, 2005, respectively.

NOTE 7  Goodwill and Intangible Assets

Goodwill

During the quarter ended March 31, 2006, the Company disbursed $58.3 million to the
former Opus Medical shareholders in cash and approximately 126,000 shares of its common stock valued at $5.8 million. This disbursement satisfied requirements set forth in the merger agreement and upon resolution of certain contingency factors,
which were recorded as an increase to the purchase price and were allocated to goodwill. The value recognized for the shares issued was approximately $46 per share based on the average market price in the measurement period. In accordance with
Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets(Statement 142), the Company assesses its goodwill on December 31st each year or more frequently if events or changes in
circumstances indicate that goodwill might be impaired. During the quarter and six months ended June 30, 2006, there were no indications that the Companys goodwill balance is impaired.

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 are subject to amortization. Intangible assets
consist of the following (in thousands):



|                                                     |  |              |         |   |                  |   |         |                      |  |           
|---------------------------------------------------- |  | ------------ | ------- | - | ---------------- | - | ------- | -------------------- |  | ----------
|                                                     |  | June 30,2006 |         |   | December 31,2005 |   |         | EstimatedUseful Life
|Intellectual property rights                         |  | $            | 29,253  |   |                  | $ | 29,137  |                      |  | 8 years   
|Patents                                              |  |              | 11,700  |   |                  |   | 11,700  |                      |  | 8 years   
|Trade name/trademarks                                |  |              | 4,800   |   |                  |   | 4,800   |                      |  | 7-8 years 
|Distribution/customer network                        |  |              | 4,185   |   |                  |   | 4,018   |                      |  | 5 years   
|OEM contractual agreements                           |  |              | 1,940   |   |                  |   | 1,160   |                      |  | 2-7 years 
|Licensing, employment and non-competition agreements |  |              | 1,517   |   |                  |   | 1,495   |                      |  | 1-10 years
|                                                     |  |              |         |   |                  |   |         |                      |  |           
|                                                     |  |              | 53,395  |   |                  |   | 52,310  |                      |  |           
|Accumulated amortization                             |  |              | (15,214 | ) |                  |   | (11,409 | )                    |  |           
|                                                     |  |              |         |   |                  |   |         |                      |  |           
|Net intangible assets                                |  | $            | 38,181  |   |                  | $ | 40,901  |                      |  |           
|                                                     |  |              |         |   |                  |   |         |                      |  |           

Intangible assets with definite lives are being amortized ratably over the assets estimated
useful lives, which range between one and ten years as indicated in the table above. The Company periodically reviews the estimated useful lives of its identifiable intangible assets, taking into consideration any events or circumstances that might
result in either a diminished fair value or revised useful life. Total amortization expense for the three and six months ended June 30, 2006 was approximately $1.7 million and $3.6 million, respectively. Total



8



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##### Table of Contents

ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (Continued)



amortization expense for the three and six months ended June 30, 2005 was approximately $1.5 million and $2.9
million, respectively. At June 30, 2006, total future amortization expense is as follows for all intangible assets (in thousands):



|                                            |  |   |       
|------------------------------------------- |  | - | ------
|For the six months ending December 31, 2006 |  | $ | 3,644 
|For the year ended December 31, 2007        |  |   | 6,723 
|For the year ended December 31, 2008        |  |   | 6,003 
|For the year ended December 31, 2009        |  |   | 5,715 
|For the year ended December 31, 2010        |  |   | 5,628 
|For the year ended December 31, 2011        |  |   | 5,607 
|Thereafter                                  |  |   | 4,861 
|                                            |  |   |       
|Total                                       |  | $ | 38,181
|                                            |  |   |       

NOTE 8 - Commitments and Contingencies

Operating Leases

The Company leases facilities and certain equipment under operating leases. It
recognizes rent expense on a straight-line basis over the lease term. Rent expense was $0.8 million for both the three months ended June 30, 2006 and June 30, 2005. Rent expense was $1.2 million for the six months ended June 30, 2006
and $1.4 million for the six months ended June 30, 2005.

At June 30, 2006, total future minimum lease payments are as follows
(in thousands):



|                                            |  |   |      
|------------------------------------------- |  | - | -----
|For the six months ending December 31, 2006 |  | $ | 1,272
|For the year ended December 31, 2007        |  |   | 1,670
|For the year ended December 31, 2008        |  |   | 1,068
|For the year ended December 31, 2009        |  |   | 826  
|For the year ended December 31, 2010        |  |   | 817  
|Thereafter                                  |  |   | 1,906
|                                            |  |   |      
|Total                                       |  | $ | 7,559
|                                            |  |   |      

The Company does not have any significant contractual obligations other than the lease payments
disclosed above.

Warranties

The
Company generally provides customers with a limited 90-day warranty on devices sold and a limited 1-year warranty on controller units sold. It accrues for the estimated cost of product warranties at the time revenue is recognized. The Companys
warranty obligation is impacted by product failure rates, material usage and service delivery costs incurred in correcting a product failure. The Company periodically evaluates and adjusts the warranty reserve to the extent actual warranty expense
varies from the original estimates.

The activity in its warranty accrual for the three and six months ended June 30, 2006 and 2005 was as follows (in
thousands):



|                                                 |  |                            |      |   |                          |   |      |      |  |   |      |   |  |   |      |  
|------------------------------------------------ |  | -------------------------- | ---- | - | ------------------------ | - | ---- | ---- |  | - | ---- | - |  | - | ---- | -
|                                                 |  | Three Months EndedJune 30, |      |   | Six Months EndedJune 30, |  
|                                                 |  | 2006                       |      |   | 2005                     |   |      | 2006 |  |   | 2005 |  
|Balance at beginning of period                   |  | $                          | 200  |   |                          | $ | 153  |      |  | $ | 175  |   |  | $ | 207  |  
|Accruals for warranties issued during the period |  |                            | 154  |   |                          |   | 269  |      |  |   | 269  |   |  |   | 651  |  
|Warranty costs incurred during the period        |  |                            | (154 | ) |                          |   | (231 | )    |  |   | (244 | ) |  |   | (667 | )
|                                                 |  |                            |      |   |                          |   |      |      |  |   |      |   |  |   |      |  
|Balance at end of period                         |  | $                          | 200  |   |                          | $ | 191  |      |  | $ | 200  |   |  | $ | 191  |  
|                                                 |  |                            |      |   |                          |   |      |      |  |   |      |   |  |   |      |  



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##### Table of Contents

ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (Continued)



Acquisition-related Contingent Payments

Under the terms of two of the Companys acquisition agreements, the Company may be obligated to make additional purchase price payments. These
potential payments have not been recorded as of June 30, 2006, as they have not yet been earned.

The Opus Medical, Inc. acquisition
specifies a $5.0 million payment to the former Opus Medical shareholders in the fourth quarter of 2006 subject to the release of certain purchase contingencies. If the contingency is satisfied, the Company will adjust the purchase price of this
acquisition for the amount of contingent consideration issued.

The Applied Therapeutics, Inc. (ATI) acquisition details
certain circumstances that would require the Company to make an additional contingent payment in cash to the shareholders of ATI in the first quarter of 2007 (the Contingent Consideration) based on the net revenue earned by the Company
from the acquired business from February 1, 2006 to January 31, 2007 (the Earnout Period). The Contingent Consideration, if any, to be paid by the Company to the stockholders of Applied Therapeutics will be equal to a multiple
of net revenue derived from the sale of ATI products during the Earnout Period minus the initial payment of $10.0 million, but in no event will the Contingent Consideration exceed $15.0 million. If the contingency is satisfied, the Company will
adjust the purchase price of this acquisition for the amount of contingent consideration issued.

Litigation

On December 15, 2005, Bonutti IP, LLC filed a lawsuit against ArthroCare in the United States District Court, Southern District of Illinois alleging
that its Opus AutoCuff anchoring system infringed ten Bonutti patents (Nos. 5,527,343; 5,543,012; 5,948,002; 6,010,525; 6,117,160; 6,464,713; 6,569,187; 6,638,279; 5,814,072 and 5,948,001). Bonutti requested the Court to award damages and to issue a
permanent injunction preventing ArthroCare from further infringement of the above-mentioned patents. ArthroCare has begun its initial review of these allegations. Upon initial review, the Company believes that these claims have no merit and intends
to defend itself vigorously. The trial date has been set for August 2007.

Additionally, 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 product liability and other claims incurred in the ordinary course of business are generally covered by certain
insurance policies, subject to certain deductible amounts and maximum policy limits. 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. For the six months ended June 30, 2006, the Company has recognized estimated losses of approximately $0.3 million related to various
product liability and general business claims.

Defending and prosecuting intellectual property suits, United States Patent and Trademark
office (USPTO) interference proceedings and related legal and administrative proceedings is 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 could 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 that ArthroCare can obtain any necessary licenses on satisfactory terms, if at all.



10



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##### Table of Contents

ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (Continued)



NOTE 9  Employee Stock Benefit Plans

Stock Option Plans

In December 1995, the Company adopted the Director Option Plan (Director
Plan) and reserved 200,000 shares of common stock for issuance to directors under this plan. The Director Plan allows for an initial grant and automatic annual grants of options to outside directors of the Company. In May 2004, the
Companys stockholders approved an amendment to the Director Plan to increase the number of shares available for issuance by 150,000 shares, to a total of 690,000 shares. The Director Plan, and the related shares available for grant under the
plan, expired in December 2005.

In August 1999, the Company adopted the Nonstatutory Option Plan (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 June 30, 2006, 232,428 shares remain available for future grant under the 1999
Plan.

In May 2003, the Company adopted the 2003 Incentive Stock Plan (2003 Plan) under which the Board of Directors is
authorized to grant incentive and nonstatutory stock option 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 June 30, 2006, 1,265,194 shares remain available for future grant under the 2003 Plan.

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 Employee Stock Purchase Plan (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% of base compensation to the semi-annual purchase of shares of ArthroCare
common stock. The purchase price is 95% of the fair market value at certain plan-defined dates. As of June 30, 2006, approximately 84,000 shares remained available for future grant under the ESPP. During the three and six months ended
June 30, 2006, no shares were issued under the Companys ESPP. During the three and six months ended June 30, 2005, approximately 24,000 shares were issued under the Companys ESPP.

Stockholders Rights Plan. In November 1996, ArthroCares Board of Directors approved a Stockholders Rights Plan, declaring a dividend
distribution of one preferred share purchase right for each outstanding share of its common stock, which would issue on certain triggering events. This plan was amended in January 2000. Each right will entitle stockholders to buy one-thousandth of
one share of the Companys Series A participating preferred stock at an exercise price of $185.00. This Plan was designed to assure that the Companys stockholders receive fair and equal treatment in the event of any proposed takeover of
the Company and to guard against partial tender offers and other tactics to gain control of the Company without paying all stockholders the fair value of their shares, including a control premium.



11



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##### Table of Contents

ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (Continued)



Plan Activity

Stock option and stock appreciation rights activity for all plans for the three and six months ended June 30, 2006, is as follows (in thousands, except per share data):



|                                        |  |                  |   |  |                                  |      
|--------------------------------------- |  | ---------------- | - |  | -------------------------------- | -----
|                                        |  | Number of Shares |   |  | Weighted- Average Exercise Price
|Outstanding at December 31, 2005        |  | 4,819            |   |  | $                                | 19.50
|Awards granted                          |  | 231              |   |  |                                  | 46.83
|Awards exercised                        |  | (540             | ) |  |                                  | 14.26
|Awards canceled/forfeited               |  | (3               | ) |  |                                  | 17.62
|                                        |  |                  |   |  |                                  |      
|Awards exercisable as of March 31, 2006 |  | 4,507            |   |  | $                                | 21.61
|Awards granted                          |  | 65               |   |  |                                  | 42.66
|Awards exercised                        |  | (408             | ) |  |                                  | 16.17
|Awards canceled/forfeited               |  | (73              | ) |  |                                  | 28.91
|                                        |  |                  |   |  |                                  |      
|Awards exercisable as of June 30, 2006  |  | 4,091            |   |  | $                                | 22.38
|                                        |  |                  |   |  |                                  |      

Net cash proceeds from the exercise of stock option awards were $6.5 million and $15.9 million for
the three and six months ended June 30, 2006, respectively. Net cash proceeds from the exercise of stock option awards were $5.6 million and $6.2 million for the three and six months ended June 30, 2005, respectively.

As of June 30, 2006, there was $15.9 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 1.8 years. As of June 30, 2006, 3,882,069 awards are expected to vest with a weighted average
exercise price of $22.10. At June 30, 2006, the aggregate intrinsic value associated with these options is $78.4 million. The intrinsic values associated with option awards vested and exercised during the period were $12.9 million and $26.2
million, respectively, for the six months ended June 30, 2006. The weighted average fair value of option awards granted for the three and six months ended June 30, 2005 was $14.32 and $15.82, respectively, and $17.59 as of
December 31, 2005.

Awards outstanding and currently exercisable by exercise price for all plans at June 30, 2006 were as follows
(in thousands, except per share data and contractual life):



|               |  |                    |  |                                             |  |                                 |       |                                        |       |                                 |   |      
|-------------- |  | ------------------ |  | ------------------------------------------- |  | ------------------------------- | ----- | -------------------------------------- | ----- | ------------------------------- | - | -----
|Exercise Price |  | Number Outstanding |  | Weighted Average Remaining Contractual Life |  | Weighted Average Exercise Price |       | Number Exercisable As of June 30, 2006 |       | Weighted Average Exercise Price
|$3.12 - $10.00 |  | 447                |  | 2.66                                        |  | $                               | 6.71  |                                        | 434   |                                 | $ | 6.62 
|10.01 - 13.05  |  | 406                |  | 6.20                                        |  |                                 | 11.42 |                                        | 341   |                                 |   | 11.39
|13.06 - 14.10  |  | 496                |  | 6.30                                        |  |                                 | 13.77 |                                        | 415   |                                 |   | 13.79
|14.11 - 21.41  |  | 401                |  | 5.32                                        |  |                                 | 17.42 |                                        | 326   |                                 |   | 17.14
|21.42 - 23.00  |  | 426                |  | 4.96                                        |  |                                 | 22.64 |                                        | 384   |                                 |   | 22.68
|23.01 - 27.11  |  | 415                |  | 7.61                                        |  |                                 | 24.91 |                                        | 247   |                                 |   | 24.90
|27.12 - 28.42  |  | 408                |  | 5.34                                        |  |                                 | 27.81 |                                        | 314   |                                 |   | 27.65
|28.43 - 31.50  |  | 480                |  | 6.92                                        |  |                                 | 30.80 |                                        | 186   |                                 |   | 30.90
|31.51 - 46.84  |  | 611                |  | 6.08                                        |  |                                 | 42.28 |                                        | 170   |                                 |   | 40.03
|46.85 - 48.56  |  | 1                  |  | 3.71                                        |  |                                 | 48.56 |                                        | 1     |                                 |   | 48.56
|               |  |                    |  |                                             |  |                                 |       |                                        |       |                                 |   |      
|               |  | 4,091              |  | 5.72                                        |  | $                               | 22.38 |                                        | 2,818 |                                 | $ | 19.23
|               |  |                    |  |                                             |  |                                 |       |                                        |       |                                 |   |      



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##### Table of Contents

ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (Continued)



During the three and six months ended June 30, 2006, the Company issued 9,500 and 71,950
restricted common stock shares, respectively, to certain employees under its 2003 Incentive Stock Plan. These awards vest over a period of five years. Restricted stock awards and units activity for the six months period ended June 30, 2006, is
as follows:



|                              |  |                  |   |  |                                         |      
|----------------------------- |  | ---------------- | - |  | --------------------------------------- | -----
|                              |  | Number of Shares |   |  | Weighted- Average Grant Date
Fair Value
|Unvested at December 31, 2005 |  | 269,462          |   |  | $                                       | 20.84
|Awards granted                |  | 62,450           |   |  |                                         | 46.84
|Awards vested                 |  | (21,350          | ) |  |                                         | 31.37
|Awards canceled/forfeited     |  | (150             | ) |  |                                         | 34.57
|                              |  |                  |   |  |                                         |      
|Unvested at March 31, 2006    |  | 310,412          |   |  | $                                       | 19.91
|Awards granted                |  | 9,500            |   |  |                                         | 42.47
|Awards vested                 |  | (23,392          | ) |  |                                         | 24.14
|Awards canceled/forfeited     |  | (19,716          | ) |  |                                         | 16.99
|                              |  |                  |   |  |                                         |      
|Unvested at June 30, 2006     |  | 276,804          |   |  | $                                       | 19.60
|                              |  |                  |   |  |                                         |      

As of June 30, 2006, there was total unrecognized compensation expense of $5.8 million, net
of estimated forfeitures, related to unvested restricted stock awards and units. That cost is expected to be recognized over a weighted-average period of 1.9 years. At June 30, 2006, the aggregate intrinsic value associated with these awards is
$11.1 million. The 71,950 restricted stock awards granted in the six months ended June 30, 2006 were valued at $3.1 million when reduced by estimated forfeitures. The intrinsic value associated with awards that vested during the six months
ended June 30, 2006 was $2.0 million.

Valuation and Expense Information under Statement 123R

Effective January 1, 2006, the Company adopted the provisions of Statement 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 ESPP based on estimated fair values. Under the provisions of Statement 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 (APB) No. 25, Accounting for Stock Issued to Employees, and related interpretations.

The Company elected to adopt the modified prospective transition method as provided by Statement 123R and, accordingly, financial statement amounts for
the prior periods presented in this Form 10-Q 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 three and six months ended
June 30, 2006 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
Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation(Statement 123). 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 Statement 123R. The Company recognizes compensation expense for stock option awards on a straight-line basis over the requisite service period of the award.

In the three months ended June 30, 2006, the Company recognized total stock-based compensation expense of $2.5 million in our
condensed consolidated financial statements, which included $2.0 million for employee stock options and $0.4 million for restricted stock awards and units. In the six months ended June 30, 2006, the Company recognized total stock-based
compensation expense of $5.0 million in our condensed consolidated



13



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##### Table of Contents

ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (Continued)



financial statements, which included $4.1 million for employee stock options and $0.9 million for restricted stock
awards and units. Prior to its adoption of Statement 123R, the Company did not recognize expense related to employee stock options in its financial statements.

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 Statement 123R for the three and six months ended June 30, 2006 (in thousands):



|                                                          |  |                                 |       |   |                                   |   |      |                        |  |   |                                   |   |  |   |      |  
|--------------------------------------------------------- |  | ------------------------------- | ----- | - | --------------------------------- | - | ---- | ---------------------- |  | - | --------------------------------- | - |  | - | ---- | -
|                                                          |  | Three months endedJune 30, 2006 |       |   | Six months ended June 30, 2006    |  
|                                                          |  | Employee Stock Options          |       |   | Restricted Stock Awards and
Units |   |      | Employee Stock Options |  |   | Restricted Stock Awards and
Units |  
|Cost of product sales                                     |  | $                               | 176   |   |                                   | $ | 36   |                        |  | $ | 176                               |   |  | $ | 74   |  
|Research and development                                  |  |                                 | 333   |   |                                   |   | 80   |                        |  |   | 724                               |   |  |   | 164  |  
|Sales and marketing                                       |  |                                 | 793   |   |                                   |   | 50   |                        |  |   | 1,580                             |   |  |   | 169  |  
|General and administrative                                |  |                                 | 733   |   |                                   |   | 288  |                        |  |   | 1,606                             |   |  |   | 506  |  
|                                                          |  |                                 |       |   |                                   |   |      |                        |  |   |                                   |   |  |   |      |  
|Stock-based compensation expense before incomes taxes     |  |                                 | 2,035 |   |                                   |   | 454  |                        |  |   | 4,086                             |   |  |   | 913  |  
|Income tax benefit                                        |  |                                 | (711  | ) |                                   |   | (169 | )                      |  |   | (1,473                            | ) |  |   | (353 | )
|                                                          |  |                                 |       |   |                                   |   |      |                        |  |   |                                   |   |  |   |      |  
|Total stock-based compensation expense after income taxes |  | $                               | 1,324 |   |                                   | $ | 285  |                        |  | $ | 2,613                             |   |  | $ | 560  |  
|                                                          |  |                                 |       |   |                                   |   |      |                        |  |   |                                   |   |  |   |      |  

For the quarter ended June 30, 2006, approximately $0.2 million of stock-based compensation
expense related to employee stock options was capitalized into inventory based on units produced and will be amortized to cost of product sales based on units sold. The Company did not capitalize stock-based compensation expense under previous
Statement 123 pro forma disclosures.

For the three and six months ended June 30, 2006, the Company recognized stock-based
compensation expense of $0.4 million and $0.9 million associated with restricted stock awards and units, respectively, as shown above. For the three and six months ended June 30, 2005, the Company recognized stock-based compensation expense of
$0.3 million and $0.6 million, respectively, associated with restricted stock awards and units.

The income tax benefit realized from stock
option exercises was $2.3 million and $4.5 million for the three and six months ended June 30, 2006, respectively. There was no income tax benefit realized from stock option exercises for the three and six months ended June 30, 2005. In
accordance with Statement 123R, the Company presents excess tax benefits from the exercise of stock options, if any, as financing cash flows rather than operating cash flows.

Stock options issued to non-employees are accounted for using the fair value method of accounting. To date, all such awards have been classified within
stockholders equity. Non-employee stock-based compensation expense is recognized over the four-year vesting period of the options granted. Non-employee stock-based compensation expense for the three and six months ended June 30, 2006 was
$34,000 and $35,000, respectively. Non-employee stock-based compensation expense for the three and six months ended June 30, 2005 was $52,000 and $64,000, respectively. Stock-based compensation is included in cost of product sales and sales and
marketing, general and administrative, and research and development expense in the condensed consolidated statements of operations.



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##### Table of Contents

ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (Continued)



The fair value of each stock-based award, excluding restricted stock, was estimated on the grant date
using the Black-Scholes option-pricing model with the following weighted-average assumptions, or range of assumptions, for the three and six months ended June 30, 2006:



|                                       |  |                                 |       |   |                                |   |           |         |  |   |       |   |  |   |           |  
|-------------------------------------- |  | ------------------------------- | ----- | - | ------------------------------ | - | --------- | ------- |  | - | ----- | - |  | - | --------- | -
|                                       |  | Three months endedJune 30, 2006 |       |   | Six months ended June 30, 2006 |  
|                                       |  | Options                         |       |   | ESPP                           |   |           | Options |  |   | ESPP  |  
|Expected term (in years) (1)           |  |                                 | 3.8   |   |                                |   | 0.5       |         |  |   | 3.8   |   |  |   | 0.5       |  
|Expected volatility (2)                |  |                                 | 35    | % |                                |   | 46        | %       |  |   | 36    | % |  |   | 46        | %
|Risk-free interest rate (3)            |  |                                 | 4.9   | % |                                |   | 2.4 -3.05 | %       |  |   | 4.8   | % |  |   | 2.4 3.05 | %
|Expected dividends                     |  |                                 |      | % |                                |   |          | %       |  |   |      | % |  |   |          | %
|Weighted average grant date fair value |  | $                               | 14.32 |   |                                | $ | 8.93      |         |  | $ | 15.82 |   |  | $ | 8.93      |  

---

|(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 the Company considers 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.
|--- | -------------------------------------------------------------------------------------------------------------------

Stock-based compensation expense recognized in the condensed consolidated statement of operations for the first quarter of fiscal 2006 is based on awards
ultimately expected to vest. As such, it has been reduced for estimated forfeitures. Statement 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.

The following table illustrates net income and net income per share as if the Company
had adopted the fair value recognition provisions of Statement 123 for the three and six months ended June 30, 2005 (in thousands, except per share data):



|                                                                                                                                        |  |                                 |        |   |                               |   |        |  
|--------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------------------- | ------ | - | ----------------------------- | - | ------ | -
|                                                                                                                                        |  | Three MonthsEnded June 30, 2005 |        |   | Six MonthsEnded June 30, 2005 |  
|Net incomeas reported                                                                                                                  |  | $                               | 4,818  |   |                               | $ | 7,980  |  
|Add: Stock-based employee compensation expense recognized in net income, net of tax effects                                             |  |                                 | 192    |   |                               |   | 323    |  
|Less: Total employee stock-based compensation expense determined under the fair value method for all awards, net of related tax
effects |  |                                 | (2,094 | ) |                               |   | (4,033 | )
|                                                                                                                                        |  |                                 |        |   |                               |   |        |  
|Pro forma net income                                                                                                                    |  | $                               | 2,916  |   |                               | $ | 4,270  |  
|                                                                                                                                        |  |                                 |        |   |                               |   |        |  
|Net income per share:                                                                                                                   |  |                                 |        |   |                               |   |        |  
|Basicas reported                                                                                                                       |  | $                               | 0.20   |   |                               | $ | 0.33   |  
|Basicpro forma                                                                                                                         |  | $                               | 0.12   |   |                               | $ | 0.18   |  
|Dilutedas reported                                                                                                                     |  | $                               | 0.19   |   |                               | $ | 0.31   |  
|Dilutedpro forma                                                                                                                       |  | $                               | 0.11   |   |                               | $ | 0.17   |  



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##### Table of Contents

ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (Continued)



The fair value of stock-based awards, excluding restricted stock, was estimated using the
Black-Scholes model with the following weighted-average assumptions, or range of assumptions, for the six months ended June 30, 2005:



|                                       |  |         |       |   |      |   |      |  
|-------------------------------------- |  | ------- | ----- | - | ---- | - | ---- | -
|                                       |  | Options |       |   | ESPP |  
|Expected term (in years)               |  |         | 5.0   |   |      |   | 0.5  |  
|Expected volatility                    |  |         | 65    | % |      |   | 45   | %
|Risk-free interest rate                |  |         | 3.8   | % |      |   | 3.1  | %
|Expected dividends                     |  |         |      | % |      |   |     | %
|Weighted average grant date fair value |  | $       | 17.37 |   |      | $ | 9.10 |  

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 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. On January 18, 2006, the Company borrowed $35.0 million. On April 4, 2006, the Company borrowed an additional $3.5 million, which was subsequently
repaid on May 12, 2006. It is managements intention to repay the $35.0 million loan within the next 12 months. As such, this loan has been reclassified to current liabilities as of June 30, 2006. Borrowings under the Credit Agreement
mature on January 13, 2011.

The Credit Agreement has a five-year maturity and includes additional terms under which the Company may
request an increase of up to $75 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 June 30, 2006.

NOTE 11 - Segment Information

ArthroCare has organized its marketing and sales efforts based on four operating segments which are aggregated into one reportable segmentdeveloping, manufacturing, and marketing of disposable devices for less
invasive surgical procedures. Each of the Companys business units has similar economic characteristics, technologies, 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 and throat and the Visage®cosmetic products), ArthroCare Spine(to include spinal and neurosurgery products) and Coblation Technology (to include gynecology, urology, laparoscopic, general surgical and cardiology products).

Product sales by business unit for the periods shown were as follows (in thousands):



|                     |  |                             |        |  |                           |   |  |      |        |  |      |   |  |   |         |  |     |   |  |   |        |  |     |  
|-------------------- |  | --------------------------- | ------ |  | ------------------------- | - |  | ---- | ------ |  | ---- | - |  | - | ------- |  | --- | - |  | - | ------ |  | --- | -
|                     |  | Three Months Ended June 30, |        |  | Six Months Ended June 30, |  
|                     |  | 2006                        |        |  | 2005                      |   |  | 2006 |        |  | 2005 |  
|Sports Medicine      |  | $                           | 41,235 |  | 65                        | % |  | $    | 32,976 |  | 66   | % |  | $ | 81,822  |  | 66  | % |  | $ | 66,348 |  | 68  | %
|ENT                  |  |                             | 16,410 |  | 26                        | % |  |      | 10,785 |  | 22   | % |  |   | 29,825  |  | 24  | % |  |   | 19,717 |  | 20  | %
|ArthroCare Spine     |  |                             | 6,096  |  | 9                         | % |  |      | 5,922  |  | 12   | % |  |   | 12,393  |  | 10  | % |  |   | 11,408 |  | 12  | %
|Coblation Technology |  |                             | 80     |  | 0                         | % |  |      |       |  | 0    | % |  |   | 38      |  | 0   | % |  |   | 44     |  | 0   | %
|                     |  |                             |        |  |                           |   |  |      |        |  |      |   |  |   |         |  |     |   |  |   |        |  |     |  
|Total Product Sales  |  | $                           | 63,821 |  | 100                       | % |  | $    | 49,683 |  | 100  | % |  | $ | 124,078 |  | 100 | % |  | $ | 97,517 |  | 100 | %
|                     |  |                             |        |  |                           |   |  |      |        |  |      |   |  |   |         |  |     |   |  |   |        |  |     |  



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##### Table of Contents

ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (Continued)



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):



|                    |  |                             |        |  |                           |   |  |      |        |  |      |   |  |   |         |  |     |   |  |   |        |  |     |  
|------------------- |  | --------------------------- | ------ |  | ------------------------- | - |  | ---- | ------ |  | ---- | - |  | - | ------- |  | --- | - |  | - | ------ |  | --- | -
|                    |  | Three Months Ended June 30, |        |  | Six Months Ended June 30, |  
|                    |  | 2006                        |        |  | 2005                      |   |  | 2006 |        |  | 2005 |  
|Americas            |  | $                           | 51,288 |  | 80                        | % |  | $    | 39,149 |  | 79   | % |  | $ | 99,116  |  | 80  | % |  | $ | 76,656 |  | 78  | %
|United Kingdom      |  |                             | 3,195  |  | 5                         | % |  |      | 2,618  |  | 5    | % |  |   | 6,418   |  | 5   | % |  |   | 5,785  |  | 6   | %
|Germany             |  |                             | 2,844  |  | 5                         | % |  |      | 2,341  |  | 5    | % |  |   | 5,501   |  | 4   | % |  |   | 4,594  |  | 5   | %
|Rest of World       |  |                             | 6,494  |  | 10                        | % |  |      | 5,575  |  | 11   | % |  |   | 13,043  |  | 11  | % |  |   | 10,482 |  | 11  | %
|                    |  |                             |        |  |                           |   |  |      |        |  |      |   |  |   |         |  |     |   |  |   |        |  |     |  
|Total Product Sales |  | $                           | 63,821 |  | 100                       | % |  | $    | 49,683 |  | 100  | % |  | $ | 124,078 |  | 100 | % |  | $ | 97,517 |  | 100 | %
|                    |  |                             |        |  |                           |   |  |      |        |  |      |   |  |   |         |  |     |   |  |   |        |  |     |  

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



|                        |  |               |        |  |                  |   |  |   |        |  |     |  
|----------------------- |  | ------------- | ------ |  | ---------------- | - |  | - | ------ |  | --- | -
|                        |  | June 30, 2006 |        |  | December 31,2005 |  
|United States           |  | $             | 23,781 |  | 66               | % |  | $ | 23,305 |  | 68  | %
|Rest of World           |  |               | 12,519 |  | 34               | % |  |   | 10,769 |  | 32  | %
|                        |  |               |        |  |                  |   |  |   |        |  |     |  
|Total long-lived assets |  | $             | 36,300 |  | 100              | % |  | $ | 34,074 |  | 100 | %
|                        |  |               |        |  |                  |   |  |   |        |  |     |  

NOTE 12  Recently Issued Accounting Pronouncement

In July 2006, the FASB issued FASB Interpretation No. 48, Accounting for Income Tax Uncertainties (FIN 48). FIN 48, an
interpretation of FASB Statement 109, prescribes a comprehensive model for recognizing, measuring, presenting, and disclosing in the financial statements tax positions taken or expected to be taken on a tax return, including a decision whether to
file or not to file in a particular jurisdiction. FIN 48 also includes guidance concerning accounting for income tax uncertainties in interim periods and increases the level of disclosures associated with any recorded income tax uncertainties.

FIN 48 is effective for fiscal years beginning after December 15, 2006. The differences between the amounts recognized in the
statements of financial position prior to the adoption of FIN 48 and the amounts reported after adoption will be accounted for as a cumulative-effect adjustment recorded to the beginning balance of retained earnings. As this guidance was recently
issued, the Company has not yet determined the impact, if any, of adopting the provisions of FIN 48 on its financial position, results of operations and liquidity.

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

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



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ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (Continued)



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, significantly improving many existing soft-tissue surgical procedures and enabling new minimally invasive procedures. With our highly innovative technologies, we are committed to
improving the lives of individuals suffering from conditions as diverse as torn rotator cuffs and anterior cruciate ligaments (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 (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: 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.

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



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##### Table of Contents

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. (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. 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 palate stiffening 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.

Overview of Second Quarter Results

Relative to the first quarter, total revenue for the second quarter of 2006 increased 6% to $66.0 million. The increase was driven by the combined
performance of all business units. Total revenue for the second quarter of 2006 increased 28% compared to the second quarter of 2005. International revenue represented approximately 20% of net product sales in the quarter. No single customer
accounted for more than 10% of our net product sales.

Total operating expenses were approximately $36.0 million for the second quarter of
2006, compared to $29.9 million in the second quarter of 2005. This $6.1 million increase was driven by a combination of factors: approximately $1.8 million of the increase was due to stock-based compensation expense associated with our adoption of
Statement 123R; $1.9 million represents increased sales and marketing expenses driven by our larger sales force; $1.2 million represents increased advertising and promotion expenses; and approximately $1.0 million was associated with a variety of
activities including increases in outside services, fixed charges associated with our Sunnyvale, California facility, training and accounts receivable reserves and increased intangible asset amortization associated with our acquisition of ATI.

Our cash, cash equivalents and short-term investments balance at June 30, 2006 was $33.8 million, an increase of approximately $10.5
million from December 31, 2005.

Our headcount at June 30, 2006 was 903, an increase of 2% from 883 at December 31, 2005 and
an increase of 23% from 737 at June 30, 2005. Headcount increases are primarily attributable to increases in manufacturing personnel in Costa Rica and additions of personnel in administration and finance.



19



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##### Table of Contents

Results of Operations and Financial Condition

Comparison of the three and six months ended June 30, 2006 to the three and six months ended June 30, 2005 (in thousands, unless otherwise
noted).



|                                         |  |                             |        |   |                           |     |   |      |   |        |      |  |     |    |  |   |         |   |  |     |   |  |   |         |   |  |     |   
|---------------------------------------- |  | --------------------------- | ------ | - | ------------------------- | --- | - | ---- | - | ------ | ---- |  | --- | -- |  | - | ------- | - |  | --- | - |  | - | ------- | - |  | --- | --
|                                         |  | Three Months Ended June 30, |        |   | Six Months Ended June 30, |    
|                                         |  | 2006                        |        |   | 2005                      |     |   | 2006 |   |        | 2005 | 
|Revenues:                                |  |                             |        |   |                           |     |   |      |   |        |      |  |     |    |  |   |         |   |  |     |   |  |   |         |   |  |     |   
|Product Sales                            |  | $                           | 63,821 |   |                           | 97  | % |      | $ | 49,683 |      |  | 96  | %  |  | $ | 124,078 |   |  | 97  | % |  | $ | 97,517  |   |  | 96  | % 
|Royalties, fees, and other               |  |                             | 2,184  |   |                           | 3   | % |      |   | 2,049  |      |  | 4   | %  |  |   | 4,408   |   |  | 3   | % |  |   | 3,898   |   |  | 4   | % 
|                                         |  |                             |        |   |                           |     |   |      |   |        |      |  |     |    |  |   |         |   |  |     |   |  |   |         |   |  |     |   
|Total revenues                           |  |                             | 66,005 |   |                           | 100 | % |      |   | 51,732 |      |  | 100 | %  |  |   | 128,486 |   |  | 100 | % |  |   | 101,415 |   |  | 100 | % 
|                                         |  |                             |        |   |                           |     |   |     
|Cost of product sales                    |  |                             | 19,756 |   |                           | 30  | % |      |   | 15,296 |      |  | 30  | %  |  |   | 37,461  |   |  | 29  | % |  |   | 30,773  |   |  | 30  | % 
|                                         |  |                             |        |   |                           |     |   |      |   |        |      |  |     |    |  |   |         |   |  |     |   |  |   |         |   |  |     |   
|Gross profit                             |  |                             | 46,249 |   |                           | 70  | % |      |   | 36,436 |      |  | 70  | %  |  |   | 91,025  |   |  | 71  | % |  |   | 70,642  |   |  | 70  | % 
|                                         |  |                             |        |   |                           |     |   |     
|Operating expenses:                      |  |                             |        |   |                           |     |   |      |   |        |      |  |     |    |  |   |         |   |  |     |   |  |   |         |   |  |     |   
|Research and development                 |  |                             | 6,125  |   |                           | 9   | % |      |   | 5,155  |      |  | 10  | %  |  |   | 12,327  |   |  | 10  | % |  |   | 10,007  |   |  | 10  | % 
|Sales and marketing                      |  |                             | 22,796 |   |                           | 34  | % |      |   | 18,601 |      |  | 36  | %  |  |   | 44,701  |   |  | 35  | % |  |   | 36,951  |   |  | 36  | % 
|General and administrative               |  |                             | 5,377  |   |                           | 8   | % |      |   | 4,708  |      |  | 9   | %  |  |   | 10,438  |   |  | 8   | % |  |   | 9,269   |   |  | 9   | % 
|Amortization of intangible assets        |  |                             | 1,718  |   |                           | 3   | % |      |   | 1,458  |      |  | 3   | %  |  |   | 3,540   |   |  | 3   | % |  |   | 2,916   |   |  | 3   | % 
|                                         |  |                             |        |   |                           |     |   |      |   |        |      |  |     |    |  |   |         |   |  |     |   |  |   |         |   |  |     |   
|Total operating expenses                 |  |                             | 36,016 |   |                           | 54  | % |      |   | 29,922 |      |  | 58  | %  |  |   | 71,006  |   |  | 56  | % |  |   | 59,143  |   |  | 58  | % 
|                                         |  |                             |        |   |                           |     |   |     
|Income from operations                   |  |                             | 10,233 |   |                           | 16  | % |      |   | 6,514  |      |  | 12  | %  |  |   | 20,019  |   |  | 15  | % |  |   | 11,499  |   |  | 11  | % 
|Interest and other income (expense), net |  |                             | (11    | ) |                           | 0   | % |      |   | (366   | )    |  | (1  | )% |  |   | (322    | ) |  | 0   | % |  |   | (1,135  | ) |  | (1  | )%
|                                         |  |                             |        |   |                           |     |   |      |   |        |      |  |     |    |  |   |         |   |  |     |   |  |   |         |   |  |     |   
|Income before income tax provision       |  |                             | 10,222 |   |                           | 16  | % |      |   | 6,148  |      |  | 11  | %  |  |   | 19,697  |   |  | 15  | % |  |   | 10,364  |   |  | 10  | % 
|Income Tax provision                     |  |                             | 2,523  |   |                           | 4   | % |      |   | 1,330  |      |  | 2   | %  |  |   | 4,865   |   |  | 4   | % |  |   | 2,384   |   |  | 2   | % 
|                                         |  |                             |        |   |                           |     |   |      |   |        |      |  |     |    |  |   |         |   |  |     |   |  |   |         |   |  |     |   
|Net income                               |  | $                           | 7,699  |   |                           | 12  | % |      | $ | 4,818  |      |  | 9   | %  |  | $ | 14,832  |   |  | 11  | % |  | $ | 7,980   |   |  | 8   | % 
|                                         |  |                             |        |   |                           |     |   |      |   |        |      |  |     |    |  |   |         |   |  |     |   |  |   |         |   |  |     |   

Revenues

Product salesconsist primarily of sales of disposable devices and controllers. Product sales for the quarter ended June 30,
2006 were $63.8 million, compared to $49.7 million for the three months ended June 30, 2005. Product sales for the six months ended June 30, 2006 were $124.1 million, compared to $97.5 million for the six months ended June 30, 2005.

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



|                     |  |                             |        |  |                           |   |  |      |        |  |      |   |  |   |         |  |     |   |  |   |        |  |     |  
|-------------------- |  | --------------------------- | ------ |  | ------------------------- | - |  | ---- | ------ |  | ---- | - |  | - | ------- |  | --- | - |  | - | ------ |  | --- | -
|                     |  | Three Months Ended June 30, |        |  | Six Months Ended June 30, |  
|                     |  | 2006                        |        |  | 2005                      |   |  | 2006 |        |  | 2005 |  
|Sports Medicine      |  | $                           | 41,235 |  | 65                        | % |  | $    | 32,976 |  | 66   | % |  | $ | 81,822  |  | 66  | % |  | $ | 66,348 |  | 68  | %
|ENT                  |  |                             | 16,410 |  | 26                        | % |  |      | 10,785 |  | 22   | % |  |   | 29,825  |  | 24  | % |  |   | 19,717 |  | 20  | %
|ArthroCare Spine     |  |                             | 6,096  |  | 9                         | % |  |      | 5,922  |  | 12   | % |  |   | 12,393  |  | 10  | % |  |   | 11,408 |  | 12  | %
|Coblation Technology |  |                             | 80     |  | 0                         | % |  |      |       |  | 0    | % |  |   | 38      |  | 0   | % |  |   | 44     |  | 0   | %
|                     |  |                             |        |  |                           |   |  |      |        |  |      |   |  |   |         |  |     |   |  |   |        |  |     |  
|Total Product Sales  |  | $                           | 63,821 |  | 100                       | % |  | $    | 49,683 |  | 100  | % |  | $ | 124,078 |  | 100 | % |  | $ | 97,517 |  | 100 | %
|                     |  |                             |        |  |                           |   |  |      |        |  |      |   |  |   |         |  |     |   |  |   |        |  |     |  



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



|                    |  |                             |        |  |                           |   |  |      |        |  |      |   |  |   |         |  |     |   |  |   |        |  |     |  
|------------------- |  | --------------------------- | ------ |  | ------------------------- | - |  | ---- | ------ |  | ---- | - |  | - | ------- |  | --- | - |  | - | ------ |  | --- | -
|                    |  | Three Months Ended June 30, |        |  | Six Months Ended June 30, |  
|                    |  | 2006                        |        |  | 2005                      |   |  | 2006 |        |  | 2005 |  
|Americas            |  | $                           | 51,288 |  | 80                        | % |  | $    | 39,149 |  | 79   | % |  | $ | 99,116  |  | 80  | % |  | $ | 76,656 |  | 78  | %
|United Kingdom      |  |                             | 3,195  |  | 5                         | % |  |      | 2,618  |  | 5    | % |  |   | 6,418   |  | 5   | % |  |   | 5,785  |  | 6   | %
|Germany             |  |                             | 2,844  |  | 5                         | % |  |      | 2,341  |  | 5    | % |  |   | 5,501   |  | 4   | % |  |   | 4,594  |  | 5   | %
|Rest of World       |  |                             | 6,494  |  | 10                        | % |  |      | 5,575  |  | 11   | % |  |   | 13,043  |  | 11  | % |  |   | 10,482 |  | 11  | %
|                    |  |                             |        |  |                           |   |  |      |        |  |      |   |  |   |         |  |     |   |  |   |        |  |     |  
|Total Product Sales |  | $                           | 63,821 |  | 100                       | % |  | $    | 49,683 |  | 100  | % |  | $ | 124,078 |  | 100 | % |  | $ | 97,517 |  | 100 | %
|                    |  |                             |        |  |                           |   |  |      |        |  |      |   |  |   |         |  |     |   |  |   |        |  |     |  

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

We generally sell our disposable devices at or near list price, except for sales to international distributors and marketing partners, which are sold at
discounted prices. We anticipate that disposable device sales will remain a key component of our product sales in the near future.

Royalties, fees and other revenues consist mainly of revenue from the licensing of our products and technology. Royalties, fees and other revenues were $2.2 million for the quarter ended June 30, 2006, compared to $2.0 million for the
quarter ended June 30, 2005. The percentage of royalties, fees and other revenues as a percentage of income was 3% for the quarter ended June 30, 2006 and 4% for the quarter ended June 30, 2005. The quarter over quarter dollar
increase is related to growth in the markets in which the Company receives royalties, whereas the percentage decline is due to increased product revenue associated with our core business activities. Royalties, fees and other revenues were $4.4
million for the six months ended June 30, 2006, compared to $3.9 million for the six months ended June 30, 2005. The period over period increase is related to growth in the markets in which the Company receives royalties. The percentage of
royalties, fees and other revenues as a percentage of income was 3% and 4% for the six months ended June 30, 2006 and June 30, 2005, respectively.

Cost of Product Sales

Cost of product sales consists of manufacturing costs, material costs, labor costs,
manufacturing overhead, warranty and other direct product costs. Additionally, cost of product sales includes amortization of controller unit placements under a program whereby we maintain ownership of controller units shipped to customers. The
costs are being capitalized and amortized into cost of product sales over the useful life of the controller unit, which is defined as three or four years, depending on the controller model. Amortization of controllers was $1.6 million and $3.2
million for the three and six months ended June 30, 2006, respectively. This compares to amortization of $1.6 million and $3.4 million for the three and six months ended June 30, 2005, respectively. Controller amortization represented 3%
of product sales for both the three and six months ended June 30, 2006. This compares to 2005 where for the three and six months ended June 30, 2005, controller amortization represented 3% and 4% of product sales, respectively. The year to
date decrease as a percent of cost of sales for the six months ended June 30, 2006 compared to the same period in 2005 is driven by increased revenue reported for the period.

Cost of product sales was $19.8 million, or 30% of revenue for the three months ended June 30, 2006, as compared to $15.3 million, or 30% of revenue
for the three months ended June 30, 2005. Gross product margin as



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a percentage of product sales was 70% in both the second quarter of 2006 and the same period in the prior year. Cost of
product sales was $37.5 million, or 29% of revenue for the six months ended June 30, 2006, as compared to $30.8 million, or 30% of revenue, for the six months ended June 30, 2005. Gross product margin as a percentage of product sales
increased to 71% in the first six months of 2006 from 70% during the same period in the prior year. Cost of product sales for the three and six months ended June 30, 2006 includes $0.2 million of stock-based compensation expense related to
employee stock options that has been capitalized into inventory. The increase in the gross margin percentage in the first half of 2006 compared to the same period in 2005 is due primarily to the decline in controller amortization as a percentage of
product revenue.

We do not anticipate any material changes in our gross margin for the remainder of 2006.

Operating Expenses

Research and
developmentexpenses were $6.1 million, or 9% of total revenues, for the quarter ended June 30, 2006, compared to $5.2 million, or 10% of total revenues, for the three months ended June 30, 2005. The dollar increase is due to a
continued investment in our Coblation-based products and in the Parallax product line. Specifically, the increase is primarily attributable to $0.3 million in stock-based compensation expense associated with our adoption of Statement 123R, $0.2
million in outside services, and $0.4 million in fixed and allocated charges associated with our Sunnyvale, California facility.

Research
and development expenses were $12.3 million, or 10% of total revenues, for the six months ended June 30, 2006, compared to $10.0 million, or 10% of total revenues, for the same period in 2005. The increase is primarily attributable to $0.7
million in stock-based compensation expense associated with our adoption of Statement 123R, $0.5 million in increased compensation and related expenses due to additional headcount, $0.4 million in outside services and increased prototype development
costs, accompanied by $0.5 million in fixed and allocated charges associated with our Sunnyvale, California facility, and various other smaller charges totaling $0.2 million.

We expect to increase the dollar amount of research and development expenses through continued expenditures on new product development, regulatory
affairs, clinical studies and patents. Additionally, a portion of the expected increase in operating expenses in 2006 compared to 2005 is expected to be attributable to our January 1, 2006 adoption of Statement 123R. We expect these expenses as
a percentage of product sales to remain essentially flat.

Sales and marketingexpenses were $22.8 million, or 34% of total
revenues, for the quarter ended June 30, 2006, compared to $18.6 million, or 36% of total revenues, for the quarter ended June 30, 2005. The increase in absolute dollars for the second quarter of 2006 compared to the second quarter of 2005
related primarily to $1.2 million in increased sales commissions associated with increased sales volume, $0.7 million in additional compensation and related expenses associated with our increased direct sales force, $0.8 million in stock-based
compensation expense associated with our adoption of Statement 123R, $1.2 million in increased advertising and promotion expenses and $0.3 million in increased training and accounts receivable reserves.

Sales and marketing expenses were $44.7 million, or 35% of total revenues, for the six months ended June 30, 2006, compared to $37.0 million, or 36%
of total revenues, for the six months ended June 30, 2005. The increase in absolute dollars for the first half of 2006 compared to the first half of 2005 related primarily to $2.2 million in increased sales commissions associated with increased
sales volume, $1.3 million in additional compensation and related expenses associated with our increased direct sales force, $1.6 million in stock-based compensation expense associated with our adoption of Statement 123R, $1.9 million in increased
advertising and promotion expenses, and $0.7 million in increased training costs, accounts receivable reserves, and various other smaller charges.

We anticipate that sales and marketing spending will continue to increase in absolute dollars as a result of the expansion of our distribution capabilities to address the spinal surgery and ear, nose and throat markets, higher



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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. Further absolute dollar increases in sales and marketing expenses are expected to be
driven by increased sales volumes from all product lines. Additionally, a portion of the expected increase in 2006 compared to 2005 will be attributable to our January 1, 2006 adoption of Statement 123R.

General and administrativeexpenses were $5.4 million, or 8% of total revenues, for the quarter ended June 30, 2006, compared to $4.7
million, or 9% of total revenues, for the quarter ended June 30, 2005. The increase in general and administrative expenses for the three months ended June 30, 2006 compared to the three months ended June 30, 2005 is due primarily to
approximately $0.7 million increase in stock-based compensation expense associated with our adoption of Statement 123R, $0.3 million in increased legal and litigation settlement costs, offset by $0.3 million decline in rent and related costs,
primarily associated with the payment made in 2005 resulting from an early lease termination.

General and administrative expenses were
$10.4 million, or 8% of total revenues, for the six months ended June 30, 2006, compared to $9.3 million, or 9% of total revenues, for the six months ended June 30, 2005. The increase in general and administrative expenses is due primarily
to approximately $1.6 million increase in stock-based compensation expense associated with our adoption of Statement 123R and $0.6 million in additional compensation and related expenses due to increased staffing in the United States and
international locations. These increases are offset by a net decrease in legal expenses of $0.3 million, which includes a settlement payment associated with the Smith & Nephew License and Settlement Agreement, recorded as a reduction of
legal fees in the first quarter of 2006, and a $0.8 million decrease in rent and related costs, primarily associated with a payment made in 2005 resulting from an early lease termination and reductions in rent expense associated with the
renegotiation of our Sunnyvale, California office lease.

We expect that general and administrative expenses will increase slightly as a
percentage of total revenues during 2006 and a portion of the expected increase in 2006 compared to 2005 will be attributable to our January 1, 2006 adoption of Statement 123R.

Amortization of intangible assets increased to $1.7 million or 3% of total revenues, for the quarter ended June 30, 2006, compared to $1.5
million, or 3% of total revenues, in the second quarter of 2005. Amortization of intangible assets increased to $3.5 million or 3% of total revenues, for the six months ended June 30, 2006, compared to $2.9 million, or 3% of total revenues, in
the first six months of 2005. The increase in amortization for the three and six months ended June 30, 2006 as compared to the same period in 2005 is attributable to amortization of intangible assets acquired in the ATI acquisition. We expect
that amortization of intangible assets will remain at current levels, due to our acquired assets.

Interest and other income
(expense), net decreased to a net expense of $11,000 for the quarter ended June 30, 2006, compared to net expense of $0.4 million for the three months ended June 30, 2005. The decrease in net interest and other expense of $0.4 million
for the quarter ended June 30, 2006 compared to the three months ended June 30, 2005 is primarily a result of foreign exchange gains recognized in the second quarter of 2006 where we incurred losses in the same period of 2005.

Interest and other income (expense), net decreased to a net expense of $0.3 million for the six months ended June 30, 2006, compared to net
expense of $1.1 million for the six months ended June 30, 2005. The net decrease of $0.8 million for the six months ended June 30, 2006 compared to the six months ended June 30, 2005 is a result of foreign exchange gains recognized in
the first half of 2006 where we incurred losses in the same period of 2005, offset by an increase in interest expense associated with debt incurred due to our acquisitions of MDA and Opus Medical for the six months ended June 30, 2005.



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We anticipate interest and other income to stabilize for the remainder of the year as we do not
anticipate any additional borrowings under our revolving credit facility.

Income Tax Provision

The provision for income taxes was $2.5 million for an effective tax rate of 25% for the quarter ended June 30, 2006, compared to $1.3 million for an
effective tax rate of 22% for the quarter ended June 30, 2005. The provision for income taxes was $4.9 million for an effective tax rate of 25% for the six months ended June 30, 2006, compared to $2.4 million for an effective tax rate of
23% for the six months ended June 30, 2005. The U.S. legislation permitting companies to record an R&D credit expired at the end of 2005. As such, the effective tax rate for the three and six months ended June 30, 2006 does not include
any benefit related to this credit. If the credit is legislatively extended in its present form, we anticipate that our effective tax rate for the year will be reduced below 25%.

Liquidity and Capital Resources

As of June 30, 2006, we had $87.5 million in working capital,
compared to $98.8 million at December 31, 2005. Our principal sources of liquidity consisted of $33.8 million in cash, cash equivalents, and short-term investments at June 30, 2006. Cash equivalents are highly liquid with original
maturities of ninety days or less. Our short-term investments consist primarily of tax-exempt municipal bonds.

Cash provided by operating
activities for the six months ended June 30, 2006 was $16.4 million, primarily attributable to net income adjusted for non-cash items, including increased stock-based compensation expense due to the adoption of Statement 123R, the income tax
benefit received from stock options, and increases in accounts receivable and inventory, partially offset by a decrease in accrued liabilities. Cash generated by operating activities for the six months ended June 30, 2005 was $12.8 million,
primarily attributable to net income adjusted for non-cash items and an increase in income tax payable, partially offset by an increase in accounts receivable and a decrease in accrued liabilities.

Cash used in investing activities for the six months ended June 30, 2006 was $80.2 million, due primarily to the cash payment of $52.4 million made
to the former Opus shareholders, $18.7 million in purchases of available for sale securities, and $9.1 million in purchases of property and equipment and intangible assets. Cash used in investing activities for the six months ended June 30,
2005 was $18.4 million, due primarily to the manufacturing of controllers offset by the purchase of available for sale securities.

Cash
provided by financing activities for the six months ended June 30, 2006 was $55.4 million, due primarily to cash proceeds of $35.0 million borrowed through our revolving credit facility, $15.9 million associated with proceeds from the exercise
of stock options, and $4.5 million of income tax benefit related to employee stock options. Cash provided by financing activities for the six months ended June 30, 2005 was $4.7 million, due primarily to stock option purchases, partially offset
by loan repayments.

The fair value of our investments in marketable securities at June 30, 2006 was $21.5 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.

On January 13, 2006, the Company entered into a $100.0 million, five-year, secured revolving credit facility to fund earn-out payments associated with the Opus Medical acquisition and general corporate purposes.
On January 18, 2006, the Company borrowed $35.0 million and is permitted to repay this amount in 2007 or later. On April 4, 2006, the Company borrowed an additional $3.5 million, which was subsequently repaid on May 12, 2006. It is
managements intention to repay the $35.0 million loan within the next 12 months. As such, this loan has been reclassified to current liabilities as of June 30, 2006. Borrowings under the Credit Agreement mature on January 13, 2011.
See Note 10 to the condensed consolidated financial statements for additional information.



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We believe that the above-described credit and term facilities, in addition to cash generated from
operations, will be sufficient to fund our operations through fiscal year 2006 and in the near future. Our future liquidity and capital requirements will depend on numerous factors, including our success in commercializing our products, development
and commercialization of products in fields other than arthroscopy, the ability of our suppliers to continue to meet our demands at current prices, obtaining and enforcing patents important to our business, the status of regulatory approvals and
competition.

There have been no significant changes in our contractual obligations and other commitments as previously disclosed in our
Annual Report on Form 10-K for the fiscal year ended December 31, 2005. We have no off-balance sheet financing arrangements other than certain operating leases as previously disclosed in our Annual Report on Form 10-K for the fiscal year ended
December 31, 2005.

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 condensed consolidated financial statements describes the significant accounting policies and methods used in the preparation
of the condensed 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
condensed consolidated financial statements. Actual results could differ materially from these estimates.

Revenue Recognition

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

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. These 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
cost of product sales in the accompanying statements of operations. Additionally, we assess risks of loss on accounts receivable and make adjustments to our allowance for doubtful accounts based on our assessment. In estimating this allowance, we
consider factors such as historical collection experience, a customers current credit-worthiness, customer concentrations, the age of the receivable balance, 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 of $2.2 million at June 30, 2006 is adequate to provide for probable losses associated
with accounts receivable.

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



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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.

We adopted Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible
Assets(Statement 142), on January 1, 2002. In accordance with Statement 142, we replaced the ratable amortization of goodwill and other indefinite-lived intangible assets with a periodic review and analysis for possible
impairment. We assess our goodwill for impairment on December 31st of each year and during an interim period if facts or circumstances would more likely than not suggest that the fair value of an identified reporting unit is below its carrying
value. We currently have recorded goodwill related to our acquisitions of Atlantech, MDA and Opus Medical. In response to changes in industry and market conditions, we may be required to strategically realign our resources and consider
restructuring, disposing, or otherwise exiting businesses, which could result in an impairment of goodwill. Impairment is measured by the difference between the recorded value of goodwill and its implied fair value when the fair value of the
reporting unit is less than its net book value. We have accumulated goodwill of $118.0 million and other intangible assets of $38.2 million as of June 30, 2006.

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. To date, we have not had an impairment associated with these intangible assets.

In connection with the Opus
and ATI acquisitions, we made significant estimates of $36.4 million and $2.4 million, respectively, related to the valuation of purchased in-process research and development (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 the Company to make 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.

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. During the six months ended June 30, 2006, the Company recognized estimated losses of approximately $0.3 million related to
various product liability and general business claims.

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



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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.

Stock-Based
Compensation

On January 1, 2006, we adopted Statement of Financial Accounting Standards No. 123 (revised 2004),
Share-Based Payment (Statement 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 ESPP based on estimated grant date fair values. Stock-based compensation expense recognized under Statement 123R for the three and six months ended June 30, 2006 was $2.0 million and $4.1 million, respectively. There was no
stock-based compensation expense related to employee stock options and employee stock purchases recognized during the three and six months ended June 30, 2005. See Note 9 to the condensed consolidated financial statements for additional
information.

Upon adoption of Statement 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, employee stock option exercise behavior, and related tax implications.

The weighted average fair value of options granted for the three and six months ended June 30, 2006 was $14.32 and $15.82 per share,
respectively, using the Black Scholes model with the following weighted average assumptions:



|                                       |  |                                 |       |   |                                |   |           |         |  |   |       |   |  |   |           |  
|-------------------------------------- |  | ------------------------------- | ----- | - | ------------------------------ | - | --------- | ------- |  | - | ----- | - |  | - | --------- | -
|                                       |  | Three months endedJune 30, 2006 |       |   | Six months ended June 30, 2006 |  
|                                       |  | Options                         |       |   | ESPP                           |   |           | Options |  |   | ESPP  |  
|Expected term (in years) (1)           |  |                                 | 3.8   |   |                                |   | 0.5       |         |  |   | 3.8   |   |  |   | 0.5       |  
|Expected volatility (2)                |  |                                 | 35    | % |                                |   | 46        | %       |  |   | 36    | % |  |   | 46        | %
|Risk-free interest rate (3)            |  |                                 | 4.9   | % |                                |   | 2.4 -3.05 | %       |  |   | 4.8   | % |  |   | 2.4 3.05 | %
|Expected dividends                     |  |                                 |      | % |                                |   |          | %       |  |   |      | % |  |   |          | %
|Weighted average grant date fair value |  | $                               | 14.32 |   |                                | $ | 8.93      |         |  | $ | 15.82 |   |  | $ | 8.93      |  

---

|(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 condensed consolidated statement of operations for the first quarter of 2006 is based on awards
ultimately expected to vest, it has been reduced for estimated forfeitures. Statement 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.



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Risk Factors

There are numerous factors that affect ArthroCares business and the results of its operations. These factors include general economic and business conditions; our dependency upon our Arthroscopic Surgery System; uncertainty of the
commercial success of products outside of our core businesses; our limited marketing and sales experience; our dependency on key suppliers; the level and intensity of competition in our core businesses; uncertainty over reimbursement from health
care payers for procedures in which our products are used or adverse changes in environmental and private third-party payers policies toward reimbursement; business integration risks; fluctuating operating results due to many factors,
including, but not limited to, product and production-related as well as research and development activities; risks associated with our ability to protect our intellectual property; risks associated with potential patent litigation; the potential
volatility of our stock; Delaware law provisions in our charter and our stockholder rights plan could make the acquisition of our company by another company more difficult; the requirement that we must obtain governmental clearances or approvals
before we can sell our products and we must continue to comply with applicable laws and regulations; and, future changes in the accounting treatment for employee stock options may cause adverse unexpected fluctuations and affect our reported results
of operations. For a discussion of these and other factors affecting ArthroCares business, see Item 1  Business  Additional Factors That Might Affect Future Results  in our Form 10-K for the fiscal year ended
December 31, 2005. There have not been any material changes in our risk factors from those disclosed in our 2005 Annual Report on Form 10K.

Recently Issued Accounting Pronouncement

In July 2006, the FASB issued FASB Interpretation No. 48, Accounting
for Income Tax Uncertainties (FIN 48). FIN 48, an interpretation of FASB Statement 109, prescribes a comprehensive model for recognizing, measuring, presenting, and disclosing in the financial statements tax positions taken or
expected to be taken on a tax return, including a decision whether to file or not to file in a particular jurisdiction. FIN 48 also includes guidance concerning accounting for income tax uncertainties in interim periods and increases the level of
disclosures associated with any recorded income tax uncertainties.

FIN 48 is effective for fiscal years beginning after December 15,
2006. The differences between the amounts recognized in the statements of financial position prior to the adoption of FIN 48 and the amounts reported after adoption will be accounted for as a cumulative-effect adjustment recorded to the beginning
balance of retained earnings. Since the guidance was recently issued, we have not yet determined the impact, if any, of adopting the provisions of FIN 48 on our financial position, results of operations and liquidity.

ITEM 3. 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, and our debt. We do not use derivative financial instruments in our investment portfolio.

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

The table below presents principal amounts and related weighted average interest rates as of June 30, 2006
for our cash, cash equivalents, and short-term investments (in thousands):



|                                                   |  |   |        |  
|-------------------------------------------------- |  | - | ------ | -
|Cash, cash equivalents, and short-term investments |  | $ | 33,792 |  
|                                                   | 
|Average interest rate                              |  |   | 4.7    | %



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

The table below presents principal amounts and related weighted
average interest rates as of June 30, 2006 for our loan payable (in thousands):



|                      |  |   |        |  
|--------------------- |  | - | ------ | -
|Loan payable          |  | $ | 35,000 |  
|                      | 
|Average interest rate |  |   | 6.5    | %

Borrowings under our amended and restated credit facility incur interest based on current market
interest rates. To the extent that these rates fluctuate, our results of operations and cash flows, as well as our ability to borrow needed capital at a critical time, could be significantly affected.

Foreign Currency Risk

A significant portion of our
international sales and operating expenses are denominated in currencies other than the U.S. Dollar. During the first and second quarters of 2006, most of these currencies strengthened against the U.S. Dollar. To the extent that these currencies
continue to become stronger or become weaker against the U.S. Dollar, we will experience variations in our results of operations and financial condition.

Our cash and cash equivalents at June 30, 2006 are denominated primarily in U.S. Dollars and Euros. A 10% change in our June 30, 2006 Euro-denominated cash and cash equivalents balance would have an impact
on pre-tax income of approximately $0.3 million.

ITEM 4. CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and
Procedures

We maintain disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities
Exchange Act of 1934, as amended (the Exchange Act)) that are designed to ensure that information required to be disclosed in our filings under the Exchange Act is recorded, processed, summarized and reported within the time periods
specified in the Securities and Exchange Commissions rules and forms, and that such information is accumulated and communicated to management, including our Chief Executive Officer (CEO) and Chief Financial Officer (CFO), as appropriate, to
allow timely decisions regarding required disclosure. It should be noted that, because of inherent limitations, our disclosure controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving
the desired control objectives, and that management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures. As a consequence of the material weakness in internal control over
financial reporting described in the next paragraph, management has concluded that our disclosure controls and procedures were not effective at June 30, 2006.

As of December 31, 2005, we reported that management had identified a material weakness in its internal controls over financial reporting. At that time we concluded that we did not maintain effective internal
control over financial reporting. Specifically, we did not maintain effective controls over the preparation and review of intercompany account reconciliations. This control deficiency could have resulted in a misstatement to our intercompany and
related accounts that could result in a material misstatement to the annual or interim consolidated financial statements that would not be prevented or detected. As a result, we reported in our 2005 Annual Report on Form 10-K that as a result
of such material weakness, our internal control over financial reporting was not effective as of December 31, 2005.



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As required by SEC Rule 13a-15(b), we carried out an evaluation under the supervision and with the
participation of our management, including the CEO and CFO, of the effectiveness of the design and operation of our disclosure controls and procedures as of June 30, 2006. As part of our evaluation, our management has evaluated whether the
control deficiencies related to the reported material weakness in our internal controls over financial reporting continue to exist. Although we have devoted significant time and resources toward remediating our reported material weakness and made
progress in that regard, our management has concluded that the control deficiency relating to the reported material weakness had not been effectively remediated as of June 30, 2006.

In light of the material weakness described above, we performed additional analysis and other post-closing procedures to ensure that the condensed
consolidated financial statements were prepared in accordance with generally accepted accounting principles. Accordingly, management believes that the financial statements included in this report fairly present in all material respects our financial
condition, results of operations and cash flows for the periods presented.

Changes in Internal Control Over Financial Reporting

There were no changes in our internal control over financial reporting that occurred during the quarter ended June 30, 2006 that have materially
affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

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

ITEM 1A. RISK FACTORS

There are many factors that affect our business and the results of our operations,
many of which are beyond our control. In this regard, Item 1A. Risk Factors to Part I of our Annual Report on Form 10-K for the year ended December 31, 2005 contained a description of significant factors that might cause the actual
results of operations in future periods to differ materially from those currently expected or desired. We urge you to read the risk factors contained in our 2005 Annual Report on Form 10-K, as there have not been any material changes in our risk
factors.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

None.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None.



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



| | (a) | We held our 2006 Annual Meeting of Stockholders on May 25, 2006.
| | --- | ----------------------------------------------------------------



| | (b) | Votes regarding the election of our directors for terms expiring at our 2006 annual meeting of stockholders:
| | --- | ------------------------------------------------------------------------------------------------------------



|                        |  |            |  |         
|----------------------- |  | ---------- |  | --------
|NOMINEE                 |  | FOR        |  | WITHHELD
|Michael A. Baker        |  | 23,526,716 |  | 41,401  
|                        |  |            |  |         
|Barbara D. Boyan, Ph.D. |  | 22,909,925 |  | 658,192 
|                        |  |            |  |         
|David F. Fitzgerald     |  | 22,787,873 |  | 780,244 
|                        |  |            |  |         
|James G. Foster         |  | 22,899,610 |  | 668,507 
|                        |  |            |  |         
|Tord B. Lendau          |  | 23,527,374 |  | 40,743  
|                        |  |            |  |         
|Jerry Widman            |  | 23,345,908 |  | 222,209 
|                        |  |            |  |         
|Peter L. Wilson         |  | 22,789,023 |  | 779,094 
|                        |  |            |  |         

The above directors constitute the entire board of directors and are the only directors whose
terms continued after our annual meeting of stockholders.



| | (c) | In addition to the election of directors described above, the following matters were voted upon at our annual meeting of stockholders:
| | --- | --------------------------------------------------------------------------------------------------------------------------------------



| | (i) | Votes on the proposal to amend and restate the Companys 2003 Incentive Stock Plan to increase the number of shares of common stock reserved for issuance thereunder by
1,250,000 shares and to increase the maximum number of shares with respect to one or more awards that may be granted to a participant under the 2003 Incentive Stock Plan during a calendar year by 150,000 shares were as follows:
| | --- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|    |  |            |  |         |  |           |  |         |  |       
|--- |  | ---------- |  | ------- |  | --------- |  | ------- |  | ------
|FOR |  | 11,474,033 |  | AGAINST |  | 8,783,460 |  | ABSTAIN |  | 24,919



| | (ii) | Votes on the proposal to ratify the appointment of PricewaterhouseCoopers LLP as our independent accountants for the 2006 fiscal year were as follows:
| | ---- | ------------------------------------------------------------------------------------------------------------------------------------------------------



|    |  |            |  |         |  |         |  |         |  |      
|--- |  | ---------- |  | ------- |  | ------- |  | ------- |  | -----
|FOR |  | 23,364,839 |  | AGAINST |  | 201,210 |  | ABSTAIN |  | 2,068

ITEM 5. OTHER INFORMATION

None.



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ITEM 6. EXHIBITS

Exhibits



|              |  |                                                                                                        
|------------- |  | -------------------------------------------------------------------------------------------------------
|ExhibitNumber |  | Description                                                                                            
|10.57         |  | Lease Agreement, dated May 9, 2006, between the Registrant and Lantana Office Properties I, L.P.       
|              | 
|31.1          |  | Certification of the Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
|              | 
|31.2          |  | Certification of the Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
|              | 
|32.1          |  | Certification of the Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
|              | 
|32.2          |  | Certification of the Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.



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SIGNATURES

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



|                     |  |                                                  
|-------------------- |  | -------------------------------------------------
|                     |  | ARTHROCARE CORPORATION                           
|                     |  | a Delaware corporation                           
|                     | 
|Date: August 4, 2006 |  | /s/ Michael A. Baker                             
|                     |  | Michael A. Baker                                 
|                     |  | President, Chief Executive Officer and Director  
|                     |  | (Principal Executive Officer)                    
|                     | 
|Date: August 4, 2006 |  | /s/ Michael Gluk                                 
|                     |  | Michael Gluk                                     
|                     |  | Senior Vice President and Chief Financial Officer
|                     |  | (Principal Financial and Accounting Officer)     



33