##### Table of Contents

---

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



---

Form 10-Q



---



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

For the quarter ended September 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



---

ArthroCare Corporation

(Exact name of registrant as specified in its charter)



---



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

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

(Address of principal executive offices)

(512) 391-3900

(Registrants telephone number, including area code)

111 Congress Avenue, Suite 510, Austin, TX 78701

(Former address of principal executive offices)



---

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 October 27, 2006 was 26,966,898.



---



---

##### Table of Contents

ARTHROCARE CORPORATION

Form 10-Q Quarterly Report

For the quarter ended September 30, 2006

TABLE OF CONTENTS



|                              |  |                                                                                                                        |  |     
|----------------------------- |  | ---------------------------------------------------------------------------------------------------------------------- |  | ----
|                              |  |                                                                                                                        |  | Page
|Forward-Looking Statements    |  | 1                                                                                                                     
|                              | 
|PART I: Financial Information |  |                                                                                                                       
|Item 1.                       |  | Financial Statements                                                                                                   |  |     
|                              |  | Condensed Consolidated Balance Sheets as of September 30, 2006 and December 31, 2005                                   |  | 2   
|                              |  | Condensed Consolidated Statements of Operations for the three and nine month periods ended September 30, 2006 and 2005 |  | 3   
|                              |  | Condensed Consolidated Statements of Cash Flows for the nine month period ended September 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                                  |  | 21  
|Item 3.                       |  | Quantitative and Qualitative Disclosures About Market Risk                                                             |  | 32  
|Item 4.                       |  | Controls and Procedures                                                                                                |  | 33  
|                              | 
|PART II: Other Information    |  |                                                                                                                       
|Item 1.                       |  | Legal Proceedings                                                                                                      |  | 34  
|Item 1A.                      |  | Risk Factors                                                                                                           |  | 34  
|Item 2.                       |  | Unregistered Sales of Securities and Use of Proceeds                                                                   |  | 35  
|Item 3.                       |  | Defaults Upon Senior Securities                                                                                        |  | 35  
|Item 4.                       |  | Submission of Matters to a Vote of Securities Holders                                                                  |  | 35  
|Item 5.                       |  | Other Information                                                                                                      |  | 35  
|Item 6.                       |  | Exhibits                                                                                                               |  | 35  
|                              |  |                                                                                                                       
|                              |  | Signatures                                                                                                             |  | 35  
|                              |  | Certifications                                                                                                         |  |     



---

##### 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



---

##### Table of Contents

PART 1. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

ARTHROCARE CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(unaudited)

(in thousands, except
per share data)



|                                                                            |  |                   |         |   |                  |   |         |  
|--------------------------------------------------------------------------- |  | ----------------- | ------- | - | ---------------- | - | ------- | -
|                                                                            |  | September 30,2006 |         |   | December 31,2005 |  
|ASSETS                                                                      |  |                   |         |   |                  |   |         |  
|Current assets:                                                             |  |                   |         |   |                  |   |         |  
|Cash and cash equivalents                                                   |  | $                 | 14,491  |   |                  | $ | 20,717  |  
|Short-term investments                                                      |  |                   | 22,441  |   |                  |   | 2,600   |  
|Accounts receivable, net of allowances of $2,060 at 2006 and $1,365 at 2005 |  |                   | 53,754  |   |                  |   | 47,138  |  
|Inventories, net                                                            |  |                   | 53,700  |   |                  |   | 47,834  |  
|Prepaid expenses and other current assets                                   |  |                   | 16,190  |   |                  |   | 14,544  |  
|                                                                            |  |                   |         |   |                  |   |         |  
|Total current assets                                                        |  |                   | 160,576 |   |                  |   | 132,833 |  
|                                                                            |  |                  
|Property and equipment, net                                                 |  |                   | 35,604  |   |                  |   | 32,604  |  
|Related party receivables                                                   |  |                   | 500     |   |                  |   | 1,075   |  
|Intangible assets, net                                                      |  |                   | 37,773  |   |                  |   | 40,901  |  
|Goodwill                                                                    |  |                   | 124,369 |   |                  |   | 59,170  |  
|Other assets                                                                |  |                   | 1,073   |   |                  |   | 395     |  
|                                                                            |  |                   |         |   |                  |   |         |  
|Total assets                                                                |  | $                 | 359,895 |   |                  | $ | 266,978 |  
|                                                                            |  |                   |         |   |                  |   |         |  
|LIABILITIES AND STOCKHOLDERS EQUITY                                        |  |                   |         |   |                  |   |         |  
|Current liabilities:                                                        |  |                   |         |   |                  |   |         |  
|Accounts payable                                                            |  | $                 | 10,894  |   |                  | $ | 12,332  |  
|Accrued liabilities                                                         |  |                   | 15,099  |   |                  |   | 6,548   |  
|Accrued compensation                                                        |  |                   | 8,259   |   |                  |   | 11,008  |  
|Current portion of long-term debt                                           |  |                   | 20,000  |   |                  |   |        |  
|Income taxes payable                                                        |  |                   | 4,657   |   |                  |   | 4,104   |  
|                                                                            |  |                   |         |   |                  |   |         |  
|Total current liabilities                                                   |  |                   | 58,909  |   |                  |   | 33,992  |  
|                                                                            |  |                  
|Deferred taxes and other liabilities                                        |  |                   | 5,235   |   |                  |   | 4,092   |  
|                                                                            |  |                   |         |   |                  |   |         |  
|Total liabilities                                                           |  |                   | 64,144  |   |                  |   | 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: 26,937 shares at 2006 and 25,255 shares at 2005     |  |                   | 27      |   |                  |   | 25      |  
|Treasury stock: 2,704 shares at 2006 and 2005                               |  |                   | (42,158 | ) |                  |   | (42,158 | )
|Additional paid-in capital                                                  |  |                   | 307,116 |   |                  |   | 269,170 |  
|Deferred stock-based compensation                                           |  |                   |        |   |                  |   | (4,543  | )
|Accumulated other comprehensive income                                      |  |                   | 1,628   |   |                  |   | 770     |  
|Retained earnings                                                           |  |                   | 29,138  |   |                  |   | 5,630   |  
|                                                                            |  |                   |         |   |                  |   |         |  
|Total stockholders equity                                                  |  |                   | 295,751 |   |                  |   | 228,894 |  
|                                                                            |  |                   |         |   |                  |   |         |  
|Total liabilities and stockholders equity                                  |  | $                 | 359,895 |   |                  | $ | 266,978 |  
|                                                                            |  |                   |         |   |                  |   |         |  

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



2



---

##### Table of Contents

ARTHROCARE CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(unaudited)

(in thousands, except
per share data)



|                                                           |  |                                  |        |   |                                 |   |        |      |  |   |         |   |  |   |         |  
|---------------------------------------------------------- |  | -------------------------------- | ------ | - | ------------------------------- | - | ------ | ---- |  | - | ------- | - |  | - | ------- | -
|                                                           |  | Three Months Ended September 30, |        |   | Nine Months Ended September 30, |  
|                                                           |  | 2006                             |        |   | 2005                            |   |        | 2006 |  |   | 2005    |  
|Revenues                                                   |  |                                  |        |   |                                 |   |        |      |  |   |         |   |  |   |         |  
|Product sales                                              |  | $                                | 62,117 |   |                                 | $ | 51,621 |      |  | $ | 186,196 |   |  | $ | 149,139 |  
|Royalties, fees, and other                                 |  |                                  | 2,577  |   |                                 |   | 2,003  |      |  |   | 6,985   |   |  |   | 5,900   |  
|                                                           |  |                                  |        |   |                                 |   |        |      |  |   |         |   |  |   |         |  
|Total revenues                                             |  |                                  | 64,694 |   |                                 |   | 53,624 |      |  |   | 193,181 |   |  |   | 155,039 |  
|                                                           |  |                                  |        |  
|Cost of product sales                                      |  |                                  | 19,932 |   |                                 |   | 16,402 |      |  |   | 57,394  |   |  |   | 47,175  |  
|                                                           |  |                                  |        |   |                                 |   |        |      |  |   |         |   |  |   |         |  
|Gross profit                                               |  |                                  | 44,762 |   |                                 |   | 37,222 |      |  |   | 135,787 |   |  |   | 107,864 |  
|                                                           |  |                                  |        |  
|Operating expenses                                         |  |                                  |        |   |                                 |   |        |      |  |   |         |   |  |   |         |  
|Research and development                                   |  |                                  | 5,625  |   |                                 |   | 5,261  |      |  |   | 17,953  |   |  |   | 15,268  |  
|Sales and marketing                                        |  |                                  | 20,369 |   |                                 |   | 18,258 |      |  |   | 65,069  |   |  |   | 55,208  |  
|General and administrative                                 |  |                                  | 5,014  |   |                                 |   | (1,014 | )    |  |   | 15,452  |   |  |   | 8,255   |  
|Acquired in-process research and development costs (IPR&D) |  |                                  |       |   |                                 |   | 2,400  |      |  |   |        |   |  |   | 2,400   |  
|Amortization of intangible assets                          |  |                                  | 1,784  |   |                                 |   | 1,564  |      |  |   | 5,324   |   |  |   | 4,480   |  
|                                                           |  |                                  |        |   |                                 |   |        |      |  |   |         |   |  |   |         |  
|Total operating expenses                                   |  |                                  | 32,792 |   |                                 |   | 26,469 |      |  |   | 103,798 |   |  |   | 85,611  |  
|                                                           |  |                                  |        |  
|Income from operations                                     |  |                                  | 11,970 |   |                                 |   | 10,753 |      |  |   | 31,989  |   |  |   | 22,253  |  
|Interest and other income (expense), net                   |  |                                  | (440   | ) |                                 |   | (693   | )    |  |   | (761    | ) |  |   | (1,829  | )
|                                                           |  |                                  |        |   |                                 |   |        |      |  |   |         |   |  |   |         |  
|Income before income tax provision                         |  |                                  | 11,530 |   |                                 |   | 10,060 |      |  |   | 31,228  |   |  |   | 20,424  |  
|                                                           |  |                                  |        |  
|Income tax provision                                       |  |                                  | 2,854  |   |                                 |   | 2,866  |      |  |   | 7,720   |   |  |   | 5,250   |  
|                                                           |  |                                  |        |   |                                 |   |        |      |  |   |         |   |  |   |         |  
|Net income                                                 |  | $                                | 8,676  |   |                                 | $ | 7,194  |      |  | $ | 23,508  |   |  | $ | 15,174  |  
|                                                           |  |                                  |        |   |                                 |   |        |      |  |   |         |   |  |   |         |  
|Basic net income per share                                 |  | $                                | 0.33   |   |                                 | $ | 0.29   |      |  | $ | 0.90    |   |  | $ | 0.63    |  
|                                                           |  |                                  |        |   |                                 |   |        |      |  |   |         |   |  |   |         |  
|Shares used in computing basic net income per share        |  |                                  | 26,681 |   |                                 |   | 24,538 |      |  |   | 25,985  |   |  |   | 24,199  |  
|                                                           |  |                                  |        |   |                                 |   |        |      |  |   |         |   |  |   |         |  
|Diluted net income per share                               |  | $                                | 0.31   |   |                                 | $ | 0.27   |      |  | $ | 0.84    |   |  | $ | 0.58    |  
|                                                           |  |                                  |        |   |                                 |   |        |      |  |   |         |   |  |   |         |  
|Shares used in computing diluted net income per share      |  |                                  | 28,265 |   |                                 |   | 26,470 |      |  |   | 28,069  |   |  |   | 26,155  |  
|                                                           |  |                                  |        |   |                                 |   |        |      |  |   |         |   |  |   |         |  

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



3



---

##### Table of Contents

ARTHROCARE CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)

(in thousands)



|                                                                                                             |  |                                |         |   |      |   |         |  
|------------------------------------------------------------------------------------------------------------ |  | ------------------------------ | ------- | - | ---- | - | ------- | -
|                                                                                                             |  | Nine Months EndedSeptember 30, |        
|                                                                                                             |  | 2006                           |         |   | 2005 |  
|Cash flows from operating activities:                                                                        |  |                                |         |   |      |   |         |  
|Net income                                                                                                   |  | $                              | 23,508  |   |      | $ | 15,174  |  
|Adjustments to reconcile net income to net cash provided by operating activities:                            |  |                                |         |   |      |   |         |  
|Depreciation and amortization                                                                                |  |                                | 15,036  |   |      |   | 12,325  |  
|Provision for doubtful accounts and product returns                                                          |  |                                | 1,116   |   |      |   | 401     |  
|Provision for excess and obsolete inventory                                                                  |  |                                | 1,461   |   |      |   | 770     |  
|Excess tax benefit from stock-based compensation                                                             |  |                                | (5,050  | ) |      |   |        |  
|Stock-based compensation expense                                                                             |  |                                | 7,718   |   |      |   | 1,008   |  
|Acquired in-process research and development costs                                                           |  |                                |        |   |      |   | 2,400   |  
|Other                                                                                                        |  |                                | (319    | ) |      |   | 735     |  
|Changes in operating assets and liabilities, net of assets and liabilities acquired in business combination: |  |                                |         |   |      |   |         |  
|Accounts receivable                                                                                          |  |                                | (5,109  | ) |      |   | (8,137  | )
|Inventories                                                                                                  |  |                                | (5,578  | ) |      |   | (2,127  | )
|Prepaid expenses and other current assets                                                                    |  |                                | (1,560  | ) |      |   | 291     |  
|Other assets                                                                                                 |  |                                | 244     |   |      |   |        |  
|Accounts payable                                                                                             |  |                                | (5,752  | ) |      |   | 2,013   |  
|Accrued and other liabilities                                                                                |  |                                | 5,542   |   |      |   | (2,612  | )
|Income taxes payable                                                                                         |  |                                | 7,070   |   |      |   | 4,860   |  
|                                                                                                             |  |                                |         |   |      |   |         |  
|Net cash provided by operating activities                                                                    |  |                                | 38,327  |   |      |   | 27,101  |  
|                                                                                                             |  |                                |         |   |      |   |         |  
|Cash flows from investing activities:                                                                        |  |                                |         |   |      |   |         |  
|Purchases of property and equipment                                                                          |  |                                | (12,408 | ) |      |   | (9,284  | )
|Purchases of intangible assets                                                                               |  |                                | (2,149  | ) |      |   | (121    | )
|Payment for purchase of ATI, net of cash acquired                                                            |  |                                | (5,952  | ) |      |   | (10,000 | )
|Payment for purchasing Opus, net                                                                             |  |                                | (52,407 | ) |      |   |        |  
|Maturities (purchases) of available-for-sale securities                                                      |  |                                | (19,395 | ) |      |   | 7,400   |  
|Net cash used in investing activities                                                                        |  |                                | (92,311 | ) |      |   | (12,005 | )
|                                                                                                             |  |                                |         |   |      |   |         |  
|                                                                                                             |  |                               
|Cash flows from financing activities:                                                                        |  |                                |         |   |      |   |         |  
|Repayment on loan from bank                                                                                  |  |                                |        |   |      |   | (3,215  | )
|Proceeds from loan from bank                                                                                 |  |                                | 20,000  |   |      |   |        |  
|Proceeds from issuance of common stock, net of issuance costs                                                |  |                                |        |   |      |   | 637     |  
|Excess tax benefit from stock-based compensation                                                             |  |                                | 5,050   |   |      |   |        |  
|Proceeds from exercise of options to purchase common stock                                                   |  |                                | 22,205  |   |      |   | 13,218  |  
|                                                                                                             |  |                                |         |   |      |   |         |  
|Net cash provided by financing activities                                                                    |  |                                | 47,255  |   |      |   | 10,640  |  
|                                                                                                             |  |                                |         |   |      |   |         |  
|Effect of exchange rate changes on cash and cash equivalents                                                 |  |                                | 503     |   |      |   | (488    | )
|                                                                                                             |  |                                |         |   |      |   |         |  
|Net increase (decrease) in cash and cash equivalents                                                         |  |                                | (6,226  | ) |      |   | 25,248  |  
|Cash and cash equivalents, beginning of period                                                               |  |                                | 20,717  |   |      |   | 11,836  |  
|                                                                                                             |  |                                |         |   |      |   |         |  
|Cash and cash equivalents, end of period                                                                     |  | $                              | 14,491  |   |      | $ | 37,084  |  
|                                                                                                             |  |                                |         |   |      |   |         |  
|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.



4



---

##### Table of Contents

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, UK 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 nine month periods ended September 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.

Cash and Cash Equivalents

The
Company considers all highly liquid investments purchased with original maturities of ninety days or less to be cash equivalents. Cash and cash equivalents include money market funds and various deposit accounts. During the third quarter, the
Company recorded a $1.5 million correction to the classification of its cash flows from operating activities and cash flows from financing activities in its Condensed Consolidated Statements of Cash Flows for the nine months ended September 30,
2006. This correction had the effect of increasing cash flows from operating activities. It was required as a result of the Companys adoption of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment
(Statement 123R) with respect to the excess tax benefit from stock-based compensation.

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.



5



---

##### Table of Contents

ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Share-Based Payment

In December 2004, the
Financial Accounting Standards Board issued 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.

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 September 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 $ 22.4 million and $2.6 million at September 30, 2006 and December 31, 2005, respectively. At September 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 September 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.



6



---

##### Table of Contents

ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (Continued)



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



|                                                                                            |  |                                 |       |      |                               |       |      |  |      |        |  |   |       
|------------------------------------------------------------------------------------------- |  | ------------------------------- | ----- | ---- | ----------------------------- | ----- | ---- |  | ---- | ------ |  | - | ------
|                                                                                            |  | Three Months EndedSeptember 30, |       |      | Nine Month EndedSeptember 30,
|                                                                                            |  | 2006                            |       | 2005 |                               |       | 2006 |  | 2005
|Net income                                                                                  |  | $                               | 8,676 |      | $                             | 7,194 |      |  | $    | 23,508 |  | $ | 15,714
|                                                                                            |  |                                 |       |     
|Net unrealized gains on available-for-sale securities arising during the period, net of tax |  |                                 | 297   |      |                               |      |      |  |      | 446    |  |   |      
|Foreign currency translation adjustment                                                     |  |                                 | 254   |      |                               | (20   | )    |  |      | 861    |  |   | 106   
|                                                                                            |  |                                 |       |      |                               |       |      |  |      |        |  |   |       
|Comprehensive income                                                                        |  | $                               | 9,227 |      | $                             | 7,174 |      |  | $    | 24,815 |  | $ | 15,820
|                                                                                            |  |                                 |       |      |                               |       |      |  |      |        |  |   |       

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 September 30, |                | Nine Months Ended September 30,
|                                                                         |  | 2006                             |                | 2005                            |   | 2006           |  | 2005
|Net income                                                               |  | $                                | 8,676          |                                 | $ | 7,194          |  | $    | 23,508         |  | $ | 15,174        
|                                                                         |  |                                  |                |                                 |   |                |  |      |                |  |   |               
|Basic:                                                                   |  |                                  |                |                                 |   |                |  |      |                |  |   |               
|Weighted-average shares outstanding                                      |  |                                  | 26,681         |                                 |   | 24,538         |  |      | 25,985         |  |   | 24,199        
|                                                                         |  |                                  |                |                                 |   |                |  |      |                |  |   |               
|Basic net income per share                                               |  | $                                | 0.33           |                                 | $ | 0.29           |  | $    | 0.90           |  | $ | 0.63          
|                                                                         |  |                                  |                |                                 |   |                |  |      |                |  |   |               
|Diluted:                                                                 |  |                                  |                |                                 |   |                |  |      |                |  |   |               
|Weighted-average shares outstanding used in basic calculation            |  |                                  | 26,681         |                                 |   | 24,538         |  |      | 25,985         |  |   | 24,199        
|Dilutive effect of options                                               |  |                                  | 1,482          |                                 |   | 1,833          |  |      | 1,969          |  |   | 1,863         
|Dilutive effect of unvested restricted stock                             |  |                                  | 102            |                                 |   | 99             |  |      | 115            |  |   | 93            
|                                                                         |  |                                  |                |                                 |   |                |  |      |                |  |   |               
|Weighted-average shares and equivalents                                  |  |                                  | 28,265         |                                 |   | 26,470         |  |      | 28,069         |  |   | 26,155        
|                                                                         |  |                                  |                |                                 |   |                |  |      |                |  |   |               
|Diluted net income per share                                             |  | $                                | 0.31           |                                 | $ | 0.27           |  | $    | 0.84           |  | $ | 0.58          
|                                                                         |  |                                  |                |                                 |   |                |  |      |                |  |   |               
|Options excluded from calculation as their effect would be anti-dilutive |  |                                  | 445            |                                 |   | 85             |  |      | 336            |  |   | 117           
|                                                                         |  |                                  |                |                                 |   |                |  |      |                |  |   |               
|Price range of excluded options                                          |  | $                                | 44.12 - $48.56 |                                 | $ | 36.90 - $48.56 |  | $    | 44.02 - $48.56 |  | $ | 32.57  $48.56
|                                                                         |  |                                  |                |                                 |   |                |  |      |                |  |   |               



7



---

##### Table of Contents

ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (Continued)



NOTE 6  Inventories

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



|                |  |                    |        |                  |   |       
|--------------- |  | ------------------ | ------ | ---------------- | - | ------
|                |  | September 30, 2006 |        | December 31,2005
|Raw materials   |  | $                  | 11,920 |                  | $ | 11,771
|Work-in-process |  |                    | 4,337  |                  |   | 4,455 
|Finished goods  |  |                    | 37,443 |                  |   | 31,608
|                |  |                    |        |                  |   |       
|Total           |  | $                  | 53,700 |                  | $ | 47,834
|                |  |                    |        |                  |   |       

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 $1.5 million at September 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 nine months ended September 30, 2006, there were no indications that the Companys goodwill balance is impaired.

During the quarter ended September 30, 2006, the Company increased its goodwill balance by approximately $6.0 million related to consideration
that will be issued to the stockholders of ATI based on ATI product sales in accordance with the acquisition agreement.



8



---

##### Table of Contents

ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (Continued)



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):



|                                                     |  |                   |         |   |                  |   |         |                      |  |           
|---------------------------------------------------- |  | ----------------- | ------- | - | ---------------- | - | ------- | -------------------- |  | ----------
|                                                     |  | September 30,2006 |         |   | December 31,2005 |   |         | EstimatedUseful Life
|Intellectual property rights                         |  | $                 | 29,334  |   |                  | $ | 29,137  |                      |  | 8 years   
|Patents                                              |  |                   | 11,700  |   |                  |   | 11,700  |                      |  | 8 years   
|Trade name/trademarks                                |  |                   | 4,800   |   |                  |   | 4,800   |                      |  | 7-8 years 
|Distribution/customer network                        |  |                   | 5,586   |   |                  |   | 4,018   |                      |  | 5 years   
|OEM contractual agreements                           |  |                   | 1,940   |   |                  |   | 1,160   |                      |  | 2-7 years 
|Licensing, employment and non-competition agreements |  |                   | 1,605   |   |                  |   | 1,495   |                      |  | 1-10 years
|                                                     |  |                   |         |   |                  |   |         |                      |  |           
|                                                     |  |                   | 54,965  |   |                  |   | 52,310  |                      |  |           
|Accumulated amortization                             |  |                   | (17,192 | ) |                  |   | (11,409 | )                    |  |           
|                                                     |  |                   |         |   |                  |   |         |                      |  |           
|Net intangible assets                                |  | $                 | 37,773  |   |                  | $ | 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 nine months ended September 30, 2006 was approximately $1.8 million and $5.4 million, respectively. Total amortization expense for the
three and nine months ended September 30, 2005 was approximately $1.6 million and $4.7 million, respectively. At September 30, 2006, total future amortization expense is as follows for all intangible assets (in thousands):



|                                              |  |   |       
|--------------------------------------------- |  | - | ------
|For the three months ending December 31, 2006 |  | $ | 1,892 
|For the year ended December 31, 2007          |  |   | 6,986 
|For the year ended December 31, 2008          |  |   | 6,241 
|For the year ended December 31, 2009          |  |   | 5,946 
|For the year ended December 31, 2010          |  |   | 5,842 
|For the year ended December 31, 2011          |  |   | 5,821 
|Thereafter                                    |  |   | 5,045 
|                                              |  |   |       
|Total                                         |  | $ | 37,773
|                                              |  |   |       



9



---

##### Table of Contents

ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (Continued)



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 $1.0 million for the three months ended September 30, 2006 and $0.4 million for the three months ended September 30, 2005. Rent expense was $2.2 million
for the nine months ended September 30, 2006 and $1.8 million for the nine months ended September 30, 2005.

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



|                                              |  |   |       
|--------------------------------------------- |  | - | ------
|For the three months ending December 31, 2006 |  | $ | 553   
|For the year ended December 31, 2007          |  |   | 2,282 
|For the year ended December 31, 2008          |  |   | 1,880 
|For the year ended December 31, 2009          |  |   | 1,618 
|For the year ended December 31, 2010          |  |   | 1,478 
|For the year ended December 31, 2011          |  |   | 1,505 
|Thereafter                                    |  |   | 4,376 
|                                              |  |   |       
|Total                                         |  | $ | 13,692
|                                              |  |   |       

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 nine months ended September 30, 2006 and
2005 was as follows (in thousands):



|                                                 |  |                                 |      |   |                                |   |     |      |  |   |      |   |  |   |      |  
|------------------------------------------------ |  | ------------------------------- | ---- | - | ------------------------------ | - | --- | ---- |  | - | ---- | - |  | - | ---- | -
|                                                 |  | Three Months EndedSeptember 30, |      |   | Nine Months EndedSeptember 30, |  
|                                                 |  | 2006                            |      |   | 2005                           |   |     | 2006 |  |   | 2005 |  
|Balance at beginning of period                   |  | $                               | 200  |   |                                | $ | 191 |      |  | $ | 175  |   |  | $ | 207  |  
|Accruals for warranties issued during the period |  |                                 | 227  |   |                                |   | 74  |      |  |   | 496  |   |  |   | 725  |  
|Warranty costs incurred during the period        |  |                                 | (227 | ) |                                |   | (83 | )    |  |   | (471 | ) |  |   | (750 | )
|                                                 |  |                                 |      |   |                                |   |     |      |  |   |      |   |  |   |      |  
|Balance at end of period                         |  | $                               | 200  |   |                                | $ | 182 |      |  | $ | 200  |   |  | $ | 182  |  
|                                                 |  |                                 |      |   |                                |   |     |      |  |   |      |   |  |   |      |  

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 September 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.



10



---

##### Table of Contents

ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (Continued)



The acquisition agreement with Applied Therapeutics, Inc. (ATI) details certain
circumstances that would require the Company to make an additional contingent payment in cash to the stockholders 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 ATI 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. As noted above, the Company recorded $6.0 million as an adjustment to the purchase price during the quarter ended September 30, 2006 for satisfied contingencies associated
with ATI product sales targets.

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 nine months ended September 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.



11



---

##### 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 September 30, 2006, 181,677 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 and restricted stock awards to employees and consultants. In May 2004, the Companys stockholders approved an amendment to the 2003 Plan to increase the number of shares
available for issuance by 750,000 shares, to a total of 1,250,000 shares. In May 2006, the Companys stockholders approved an amendment to the 2003 plan to increase the number of shares available for issuance by 1,250,000, to a total of
2,500,000. Options granted under the 2003 Plan generally become exercisable over a 48-month period and restricted stock awards generally become exercisable over a 60-month period. As of September 30, 2006, 1,244,625 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 September 30, 2006, approximately 80,217 shares remained available for future grant under the
ESPP. During the three and nine months ended September 30, 2006, 3,603 shares were issued under the Companys ESPP, all of which were issued in the three months ended September 30, 2006. During the three months ended
September 30, 2005, no shares were issued under the Companys ESPP, and during the nine months ended September 30, 2005, approximately 24,188 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. At its meeting on October 25, 2006,
the Board of Directors voted unanimously to allow the Stockholders Rights Plan to expire by its terms on November 14, 2006. The Board of Directors also intends to consider adoption of appropriate defensive measures under circumstances in
which the Board believes that such measures may be necessary to protect stockholders interests.



12



---

##### 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 nine months ended September 30, 2006 is as follows (in thousands, except per share data):



|                                            |  |                 |   |  |                                  |      
|------------------------------------------- |  | --------------- | - |  | -------------------------------- | -----
|                                            |  | Numberof 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
|Awards granted                              |  | 107             |   |  |                                  | 45.48
|Awards exercised                            |  | (436            | ) |  |                                  | 14.45
|Awards canceled/forfeited                   |  | (76             | ) |  |                                  | 30.22
|                                            |  |                 |   |  |                                  |      
|Awards exercisable as of September 30, 2006 |  | 3,686           |   |  | $                                | 23.84
|                                            |  |                 |   |  |                                  |      

Net cash proceeds from the exercise of stock option awards were $6.3 million and $22.2 million for
the three and nine months ended September 30, 2006, respectively. Net cash proceeds from the exercise of stock option awards were $7.0 million and $13.2 million for the three and nine months ended September 30, 2005, respectively.

As of September 30, 2006, there was $16.5 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 1.6 years. As of September 30, 2006, 3,496,244 awards are expected
to vest with a weighted average exercise price of $23.53. At September 30, 2006, the aggregate intrinsic value associated with these options is $81.6 million. The intrinsic values associated with option awards vested and exercised during the
period were $13.2 million and $61.7 million, respectively, for the nine months ended September 30, 2006. The weighted average fair value of option awards granted for the three and nine months ended September 30, 2005 was $15.53 and $15.74,
respectively, and $17.59 as of December 31, 2005.



13



---

##### Table of Contents

ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (Continued)



Awards outstanding and currently exercisable by exercise price for all plans at September 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 September 30,2006 |       | Weighted Average Exercise Price
|$  3.12 - $10.00 |  | 335                |  | 2.72                                        |  | $                               | 7.25  |                                            | 330   |                                 | $ | 7.21 
|10.01 - 13.05    |  | 263                |  | 5.92                                        |  |                                 | 11.96 |                                            | 239   |                                 |   | 12.00
|13.06 - 14.10    |  | 456                |  | 6.01                                        |  |                                 | 13.77 |                                            | 397   |                                 |   | 13.80
|14.11 - 21.05    |  | 366                |  | 5.04                                        |  |                                 | 17.46 |                                            | 300   |                                 |   | 17.12
|21.06 - 23.00    |  | 405                |  | 4.65                                        |  |                                 | 22.66 |                                            | 372   |                                 |   | 22.70
|23.01 - 27.11    |  | 385                |  | 7.36                                        |  |                                 | 24.92 |                                            | 243   |                                 |   | 24.90
|27.12 - 28.42    |  | 333                |  | 5.04                                        |  |                                 | 27.74 |                                            | 288   |                                 |   | 27.64
|28.43 - 31.50    |  | 455                |  | 6.73                                        |  |                                 | 30.79 |                                            | 191   |                                 |   | 30.86
|31.51 - 46.84    |  | 687                |  | 6.04                                        |  |                                 | 42.85 |                                            | 179   |                                 |   | 40.29
|46.85 - 48.56    |  | 1                  |  | 3.46                                        |  |                                 | 48.56 |                                            | 1     |                                 |   | 48.56
|                 |  |                    |  |                                             |  |                                 |       |                                            |       |                                 |   |      
|                 |  | 3,686              |  | 5.59                                        |  | $                               | 23.84 |                                            | 2,540 |                                 | $ | 20.25
|                 |  |                    |  |                                             |  |                                 |       |                                            |       |                                 |   |      

During the three and nine months ended September 30, 2006, the Company issued 36,630
and 108,580 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 nine months ended
September 30, 2006, is as follows:



|                               |  |                 |   |  |                                      |      
|------------------------------ |  | --------------- | - |  | ------------------------------------ | -----
|                               |  | Numberof Shares |   |  | Weighted-Average GrantDate FairValue
|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
|Awards granted                 |  | 36,630          |   |  |                                      | 45.70
|Awards vested                  |  | (3,599          | ) |  |                                      | 35.71
|Awards canceled/forfeited      |  | (7,500          | ) |  |                                      | 26.35
|                               |  |                 |   |  |                                      |      
|Unvested at September 30, 2006 |  | 302,335         |   |  | $                                    | 19.43
|                               |  |                 |   |  |                                      |      



14



---

##### Table of Contents

ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (Continued)



As of September 30, 2006, there was total unrecognized compensation expense of $6.6 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 1.8 years. At September 30, 2006, the aggregate intrinsic value associated with these
awards was $13.4 million. The 108,580 restricted stock awards granted in the nine months ended September 30, 2006 were valued at $4.7 million when reduced by estimated forfeitures. The intrinsic value associated with awards that vested during
the nine months ended September 30, 2006 was $2.1 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 nine months ended
September 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 September 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 $0.5 million for restricted stock awards and units. In the nine months ended September 30, 2006, the Company recognized total stock-based
compensation expense of $7.5 million in our condensed consolidated financial statements, which included $6.1 million for employee stock options and $1.4 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.



15



---

##### Table of Contents

ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (Continued)



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 nine months ended September 30, 2006 (in thousands):



|                                                          |  |                                      |       |   |                                     |   |      |                      |  |   |                                |   |  |   |       |  
|--------------------------------------------------------- |  | ------------------------------------ | ----- | - | ----------------------------------- | - | ---- | -------------------- |  | - | ------------------------------ | - |  | - | ----- | -
|                                                          |  | Three months endedSeptember 30, 2006 |       |   | Nine months endedSeptember 30, 2006 |  
|                                                          |  | EmployeeStockOptions                 |       |   | RestrictedStockAwardsand Units      |   |      | EmployeeStockOptions |  |   | RestrictedStockAwardsand Units |  
|Cost of product sales                                     |  | $                                    | 261   |   |                                     | $ | 38   |                      |  | $ | 437                            |   |  | $ | 112   |  
|Research and development                                  |  |                                      | 297   |   |                                     |   | 67   |                      |  |   | 1,021                          |   |  |   | 230   |  
|Sales and marketing                                       |  |                                      | 619   |   |                                     |   | 127  |                      |  |   | 2,199                          |   |  |   | 297   |  
|General and administrative                                |  |                                      | 833   |   |                                     |   | 283  |                      |  |   | 2,439                          |   |  |   | 789   |  
|                                                          |  |                                      |       |   |                                     |   |      |                      |  |   |                                |   |  |   |       |  
|Stock-based compensation expense before incomes taxes     |  |                                      | 2,010 |   |                                     |   | 515  |                      |  |   | 6,096                          |   |  |   | 1,428 |  
|                                                          |  |                                      |       |  
|Income tax benefit                                        |  |                                      | (659  | ) |                                     |   | (181 | )                    |  |   | (2,132                         | ) |  |   | (534  | )
|                                                          |  |                                      |       |   |                                     |   |      |                      |  |   |                                |   |  |   |       |  
|Total stock-based compensation expense after income taxes |  | $                                    | 1,351 |   |                                     | $ | 334  |                      |  | $ | 3,964                          |   |  | $ | 894   |  
|                                                          |  |                                      |       |   |                                     |   |      |                      |  |   |                                |   |  |   |       |  

For the quarter ended September 30, 2006, approximately $190,000 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 nine months ended September 30, 2006, the Company recognized stock-based
compensation expense of $0.5 million and $1.4 million associated with restricted stock awards and units, respectively, as shown above. For the three and nine months ended September 30, 2005, the Company recognized stock-based compensation
expense of $0.4 million and $0.9 million, respectively, associated with restricted stock awards and units.

The income tax benefit realized
from stock option exercises was $0.5 million and $5.1 million for the three and nine months ended September 30, 2006, respectively. There was no income tax benefit realized from stock option exercises for the three and nine months ended
September 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 nine months ended September 30,
2006 was $7,354 and $42,610, respectively. Non-employee stock-based compensation expense for the three and nine months ended September 30, 2005 was $20,777 and $84,420, 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.



16



---

##### 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 nine months ended September 30, 2006:



|                                       |  |                                      |       |   |                                     |   |      |         |  |   |       |   |  |   |      |  
|-------------------------------------- |  | ------------------------------------ | ----- | - | ----------------------------------- | - | ---- | ------- |  | - | ----- | - |  | - | ---- | -
|                                       |  | Three months endedSeptember 30, 2006 |       |   | Nine months endedSeptember 30, 2006 |  
|                                       |  | Options                              |       |   | ESPP                                |   |      | Options |  |   | ESPP  |  
|Expected term (in years) (1)           |  |                                      | 3.8   |   |                                     |   | 0.5  |         |  |   | 3.8   |   |  |   | 0.5  |  
|Expected volatility (2)                |  |                                      | 36    | % |                                     |   | 35   | %       |  |   | 36    | % |  |   | 35   | %
|Risk-free interest rate (3)            |  |                                      | 4.95  |   |                                     |   | 5.15 |         |  |   | 4.75  |   |  |   | 5.15 |  
|Expected dividends                     |  |                                      |      |   |                                     |   |     |         |  |   |      |   |  |   |     |  
|Weighted average grant date fair value |  | $                                    | 15.53 |   |                                     | $ | 7.00 |         |  | $ | 15.74 |   |  | $ | 7.00 |  

---

|(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 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.



17



---

##### Table of Contents

ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (Continued)



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 nine months ended September 30, 2005 (in thousands, except per share data):



|                                                                                                                                        |  |                                      |        |   |                                     |   |        |  
|--------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------------------------ | ------ | - | ----------------------------------- | - | ------ | -
|                                                                                                                                        |  | Three Months EndedSeptember 30, 2005 |        |   | Nine Months EndedSeptember 30, 2005 |  
|Net incomeas reported                                                                                                                  |  | $                                    | 7,194  |   |                                     | $ | 15,174 |  
|Add: Stock-based employee compensation expense recognized in net income, net of tax effects                                             |  |                                      | 193    |   |                                     |   | 517    |  
|Less: Total employee stock-based compensation expense determined under the fair value method for all awards, net of related tax
effects |  |                                      | (2,046 | ) |                                     |   | (6,080 | )
|                                                                                                                                        |  |                                      |        |   |                                     |   |        |  
|Pro forma net income                                                                                                                    |  | $                                    | 5,341  |   |                                     | $ | 9,611  |  
|                                                                                                                                        |  |                                      |        |   |                                     |   |        |  
|Net income per share:                                                                                                                   |  |                                      |        |   |                                     |   |        |  
|Basicas reported                                                                                                                       |  | $                                    | 0.29   |   |                                     | $ | 0.63   |  
|Basicpro forma                                                                                                                         |  | $                                    | 0.22   |   |                                     | $ | 0.40   |  
|Dilutedas reported                                                                                                                     |  | $                                    | 0.27   |   |                                     | $ | 0.58   |  
|Dilutedpro forma                                                                                                                       |  | $                                    | 0.20   |   |                                     | $ | 0.37   |  

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 nine months ended September 30, 2005:



|                                       |  |         |       |   |      |   |      |  
|-------------------------------------- |  | ------- | ----- | - | ---- | - | ---- | -
|                                       |  | Options |       |   | ESPP |  
|Expected term (in years)               |  |         | 5.0   |   |      |   | 0.5  |  
|Expected volatility                    |  |         | 64    | % |      |   | 45   | %
|Risk-free interest rate                |  |         | 3.9   | % |      |   | 3.1  | %
|Expected dividends                     |  |         |      |   |      |   |     |  
|Weighted average grant date fair value |  | $       | 17.73 |   |      | $ | 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. In the third quarter, the Company repaid $15.0 million of the loan and intends to repay the remaining balance of $20.0 million within the next 12 months. As such, this loan is classified as a current liability.

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 September 30,
2006.



18



---

##### Table of Contents

ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (Continued)



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 September 30, |        |  | Nine Months Ended September 30, |  
|                     |  | 2006                             |        |  | 2005                            |   |  | 2006 |        |   | 2005 |    
|Sports Medicine      |  | $                                | 41,904 |  | 67                              | % |  | $    | 34,689 |   |      | 67  | % |  | $ | 123,726 |  | 66  | % |  | $ | 101,038 |   |  | 68  | %
|ENT                  |  |                                  | 14,129 |  | 23                              | % |  |      | 11,083 |   |      | 21  | % |  |   | 43,955  |  | 23  | % |  | $ | 30,800  |   |  | 21  | %
|ArthroCare Spine     |  |                                  | 5,853  |  | 9                               | % |  |      | 5,939  |   |      | 12  | % |  |   | 18,247  |  | 10  | % |  |   | 17,346  |   |  | 11  | %
|Coblation Technology |  |                                  | 231    |  | 1                               | % |  |      | (90    | ) |      | 0   | % |  |   | 268     |  | 1   | % |  |   | (45     | ) |  | 0   | %
|                     |  |                                  |        |  |                                 |   |  |      |        |   |      |     |   |  |   |         |  |     |   |  |   |         |   |  |     |  
|Total Product Sales  |  | $                                | 62,117 |  | 100                             | % |  | $    | 51,621 |   |      | 100 | % |  | $ | 186,196 |  | 100 | % |  | $ | 149,139 |   |  | 100 | %
|                     |  |                                  |        |  |                                 |   |  |      |        |   |      |     |   |  |   |         |  |     |   |  |   |         |   |  |     |  

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 September 30, |        |  | Nine Months Ended September 30, |  
|                    |  | 2006                             |        |  | 2005                            |   |  | 2006 |        |  | 2005 |  
|Americas            |  | $                                | 50,434 |  | 81                              | % |  | $    | 41,109 |  | 80   | % |  | $ | 149,551 |  | 80  | % |  | $ | 117,792 |  | 79  | %
|United Kingdom      |  |                                  | 2,957  |  | 5                               | % |  |      | 2,900  |  | 5    | % |  |   | 9,597   |  | 5   | % |  |   | 8,685   |  | 6   | %
|Germany             |  |                                  | 2,532  |  | 4                               | % |  |      | 2,035  |  | 4    | % |  |   | 8,053   |  | 5   | % |  |   | 6,629   |  | 4   | %
|Rest of World       |  |                                  | 6,194  |  | 10                              | % |  |      | 5,577  |  | 11   | % |  |   | 18,995  |  | 10  | % |  |   | 16,033  |  | 11  | %
|                    |  |                                  |        |  |                                 |   |  |      |        |  |      |   |  |   |         |  |     |   |  |   |         |  |     |  
|Total Product Sales |  | $                                | 62,117 |  | 100                             | % |  | $    | 51,621 |  | 100  | % |  | $ | 186,196 |  | 100 | % |  | $ | 149,139 |  | 100 | %
|                    |  |                                  |        |  |                                 |   |  |      |        |  |      |   |  |   |         |  |     |   |  |   |         |  |     |  

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



|                        |  |                   |        |  |                  |   |  |   |        |  |     |  
|----------------------- |  | ----------------- | ------ |  | ---------------- | - |  | - | ------ |  | --- | -
|                        |  | September 30,2006 |        |  | December 31,2005 |  
|United States           |  | $                 | 24,032 |  | 65               | % |  | $ | 23,305 |  | 68  | %
|Rest of World           |  |                   | 13,145 |  | 35               | % |  |   | 10,769 |  | 32  | %
|                        |  |                   |        |  |                  |   |  |   |        |  |     |  
|Total long-lived assets |  | $                 | 37,177 |  | 100              | % |  | $ | 34,074 |  | 100 | %
|                        |  |                   |        |  |                  |   |  |   |        |  |     |  



19



---

##### Table of Contents

ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)



NOTE 12  Recently Issued Accounting Pronouncements

In July 2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes (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 the Company beginning January 1, 2007. 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.

In September 2006, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 157, Fair Value Measurements (FAS 157). The Statement defines fair value, establishes
a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. FAS 157 is effective for the Company beginning January 1, 2008. The Company is currently in the process of
evaluating the impact that the Statement will have on its financial statements.

In September 2006, the SEC staff issued Staff Accounting
Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements (SAB 108). SAB 108 was issued in order to eliminate the diversity of practice
surrounding how public companies quantify financial statement misstatements.

In SAB 108, the SEC staff established an approach that
requires quantification of financial statement misstatements based on the effects of the misstatements on each of the companys financial statements and the related financial statement disclosures. This model is commonly referred to as a
dual approach because it requires quantification of errors under both the iron curtain and the roll-over methods. The Company currently uses, and has historically applied, the dual method for quantifying identified financial statement
misstatements.

The Company will initially apply the provisions of SAB 108 in connection with the preparation of our annual financial
statements for the year ending December 31, 2006. The Company is currently evaluating SAB 108, but does not expect the adoption of SAB 108 to have a significant effect on its financial position, results of operations, or cash flows.



20



---

##### Table of Contents

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

The following discussion should be read in conjunction with the 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.

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



21



---

##### Table of Contents

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.

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 Third Quarter Results

Relative to the third quarter 2005, total revenue for the third quarter of 2006 increased 20% to $64.7 million. International revenue represented
approximately 19% of net product sales in the quarter. International product revenue for the third quarter of 2006 increased 11% over the third quarter of 2005 despite the discontinuation of the FMS arthroscopic pump business, a non-core product
that Arthrocare has distributed in several European countries. No single customer accounted for more than 10% of our net product sales.

Total operating expenses were approximately $32.8 million for the third quarter of 2006, compared to $26.5 million in the third quarter of 2005. This $6.3 million increase was driven by a combination of factors: approximately $1.7 million
of the increase was due to stock-based compensation expense associated with our adoption of Statement 123R; $1.7 million represents increased employee related costs due to our increased accounting and finance personnel; $1.0 million represents
increased advertising and promotion expenses; and approximately $2.1 million was associated with increases in outside services and other charges.

Our cash, cash equivalents and short-term investments balance at September 30, 2006 was $36.9 million, an increase of approximately $13.6 million from December 31, 2005.



22



---

##### Table of Contents

Our headcount at September 30, 2006 was 861, a decrease of approximately 3% from 883 at
December 31, 2005 and an increase of 6% from 812 at September 30, 2005. The decrease in headcount from year end 2005 was primarily attributable to expected attrition and the anticipated replacement rate associated with relocating
administrative functions to Austin, Texas.

Additionally, during the quarter ended September 30, 2006, we acquired an Australian
distributor, TiMax, for $1.1 million, which will allow us to further expand our direct sales presence in the Asian market. We do not anticipate this transaction to impact our sales or earnings per share in this fiscal year.

Results of Operations and Financial Condition

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



|                                               |  |                                  |        |   |                                 |     |    |      |   |        |      |  |     |    |  |   |         |   |  |     |   |  |   |         |   |  |     |   
|---------------------------------------------- |  | -------------------------------- | ------ | - | ------------------------------- | --- | -- | ---- | - | ------ | ---- |  | --- | -- |  | - | ------- | - |  | --- | - |  | - | ------- | - |  | --- | --
|                                               |  | Three Months Ended September 30, |        |   | Nine Months Ended September 30, |    
|                                               |  | 2006                             |        |   | 2005                            |     |    | 2006 |   |        | 2005 | 
|Revenues:                                      |  |                                  |        |   |                                 |     |    |      |   |        |      |  |     |    |  |   |         |   |  |     |   |  |   |         |   |  |     |   
|Product sales                                  |  | $                                | 62,117 |   |                                 | 96  | %  |      | $ | 51,621 |      |  | 96  | %  |  | $ | 186,196 |   |  | 96  | % |  | $ | 149,139 |   |  | 96  | % 
|Royalties, fees, and other                     |  |                                  | 2,577  |   |                                 | 4   | %  |      |   | 2,003  |      |  | 4   | %  |  |   | 6,985   |   |  | 4   | % |  |   | 5,900   |   |  | 4   | % 
|                                               |  |                                  |        |   |                                 |     |    |      |   |        |      |  |     |    |  |   |         |   |  |     |   |  |   |         |   |  |     |   
|Total revenues                                 |  |                                  | 64,694 |   |                                 | 100 | %  |      |   | 53,624 |      |  | 100 | %  |  |   | 193,181 |   |  | 100 | % |  |   | 155,039 |   |  | 100 | % 
|                                               |  |                                  |        |   |                                 |     |    |     
|Cost of product sales                          |  |                                  | 19,932 |   |                                 | 31  | %  |      |   | 16,402 |      |  | 31  | %  |  |   | 57,394  |   |  | 30  | % |  | $ | 47,175  |   |  | 30  | % 
|                                               |  |                                  |        |   |                                 |     |    |      |   |        |      |  |     |    |  |   |         |   |  |     |   |  |   |         |   |  |     |   
|Gross profit                                   |  |                                  | 44,762 |   |                                 | 69  | %  |      |   | 37,222 |      |  | 69  | %  |  |   | 135,787 |   |  | 70  | % |  |   | 107,864 |   |  | 70  | % 
|                                               |  |                                  |        |   |                                 |     |    |     
|Operating expenses:                            |  |                                  |        |   |                                 |     |    |      |   |        |      |  |     |    |  |   |         |   |  |     |   |  |   |         |   |  |     |   
|Research and development                       |  |                                  | 5,625  |   |                                 | 9   | %  |      |   | 5,261  |      |  | 10  | %  |  |   | 17,953  |   |  | 9   | % |  |   | 15,268  |   |  | 10  | % 
|Sales and marketing                            |  |                                  | 20,369 |   |                                 | 31  | %  |      |   | 18,258 |      |  | 34  | %  |  |   | 65,069  |   |  | 34  | % |  |   | 55,208  |   |  | 36  | % 
|General and administrative                     |  |                                  | 5,014  |   |                                 | 8   | %  |      |   | (1,014 | )    |  | (2  | )% |  |   | 15,452  |   |  | 8   | % |  |   | 8,255   |   |  | 5   | % 
|Acquired in-process research development costs |  |                                  |       |   |                                 | 0   | %  |      |   | 2,400  |      |  | 4   | %  |  |   |        |   |  | 0   | % |  |   | 2,400   |   |  | 2   | % 
|Amortization of intangible assets              |  |                                  | 1,784  |   |                                 | 3   | %  |      |   | 1,564  |      |  | 3   | %  |  |   | 5,324   |   |  | 3   | % |  |   | 4,480   |   |  | 3   | % 
|                                               |  |                                  |        |   |                                 |     |    |      |   |        |      |  |     |    |  |   |         |   |  |     |   |  |   |         |   |  |     |   
|Total operating expenses                       |  |                                  | 32,792 |   |                                 | 51  | %  |      |   | 26,469 |      |  | 49  | %  |  |   | 103,798 |   |  | 54  | % |  |   | 85,611  |   |  | 56  | % 
|                                               |  |                                  |        |   |                                 |     |    |     
|Income from operations                         |  |                                  | 11,970 |   |                                 | 18  | %  |      |   | 10,753 |      |  | 20  | %  |  |   | 31,989  |   |  | 16  | % |  |   | 22,253  |   |  | 14  | % 
|Interest and other income (expense), net       |  |                                  | (440   | ) |                                 | (1  | )% |      |   | (693   | )    |  | (1  | )% |  |   | (761    | ) |  | 0   | % |  |   | (1,829  | ) |  | (1  | )%
|                                               |  |                                  |        |   |                                 |     |    |      |   |        |      |  |     |    |  |   |         |   |  |     |   |  |   |         |   |  |     |   
|Income before income tax provision             |  |                                  | 11,530 |   |                                 | 17  | %  |      |   | 10,060 |      |  | 19  | %  |  |   | 31,228  |   |  | 16  | % |  |   | 20,424  |   |  | 13  | % 
|Income Tax provision                           |  |                                  | 2,854  |   |                                 | 4   | %  |      |   | 2,866  |      |  | 5   | %  |  |   | 7,720   |   |  | 4   | % |  |   | 5,250   |   |  | 3   | % 
|                                               |  |                                  |        |   |                                 |     |    |      |   |        |      |  |     |    |  |   |         |   |  |     |   |  |   |         |   |  |     |   
|Net income                                     |  | $                                | 8,676  |   |                                 | 13  | %  |      | $ | 7,194  |      |  | 14  | %  |  | $ | 23,508  |   |  | 12  | % |  | $ | 15,174  |   |  | 10  | % 
|                                               |  |                                  |        |   |                                 |     |    |      |   |        |      |  |     |    |  |   |         |   |  |     |   |  |   |         |   |  |     |   



23



---

##### Table of Contents

Revenues

Product salesconsist primarily of sales of disposable devices and controllers. Product sales for the quarter ended September 30, 2006 were $62.1 million, compared to $51.6 million for the three months
ended September 30, 2005. Product sales for the nine months ended September 30, 2006 were $186.2 million, compared to $149.1 million for the nine months ended September 30, 2005.

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



|                     |  |                                  |        |  |                                 |   |  |      |        |   |      |     |   |  |   |         |  |     |   |  |   |         |   |  |     |  
|-------------------- |  | -------------------------------- | ------ |  | ------------------------------- | - |  | ---- | ------ | - | ---- | --- | - |  | - | ------- |  | --- | - |  | - | ------- | - |  | --- | -
|                     |  | Three Months Ended September 30, |        |  | Nine Months Ended September 30, |  
|                     |  | 2006                             |        |  | 2005                            |   |  | 2006 |        |   | 2005 |    
|Sports Medicine      |  | $                                | 41,904 |  | 67                              | % |  | $    | 34,689 |   |      | 67  | % |  | $ | 123,726 |  | 66  | % |  | $ | 101,038 |   |  | 68  | %
|ENT                  |  |                                  | 14,129 |  | 23                              | % |  |      | 11,083 |   |      | 21  | % |  |   | 43,955  |  | 23  | % |  |   | 30,800  |   |  | 21  | %
|ArthroCare Spine     |  |                                  | 5,853  |  | 9                               | % |  |      | 5,939  |   |      | 12  | % |  |   | 18,247  |  | 10  | % |  |   | 17,346  |   |  | 11  | %
|Coblation Technology |  |                                  | 231    |  | 1                               | % |  |      | (90    | ) |      | 0   | % |  |   | 268     |  | 1   | % |  |   | (45     | ) |  | 0   | %
|                     |  |                                  |        |  |                                 |   |  |      |        |   |      |     |   |  |   |         |  |     |   |  |   |         |   |  |     |  
|Total Product Sales  |  | $                                | 62,117 |  | 100                             | % |  | $    | 51,621 |   |      | 100 | % |  | $ | 186,196 |  | 100 | % |  | $ | 149,139 |   |  | 100 | %
|                     |  |                                  |        |  |                                 |   |  |      |        |   |      |     |   |  |   |         |  |     |   |  |   |         |   |  |     |  

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



|                    |  |                                  |        |  |                                 |   |  |      |        |  |      |   |  |   |         |  |     |   |  |   |         |  |     |  
|------------------- |  | -------------------------------- | ------ |  | ------------------------------- | - |  | ---- | ------ |  | ---- | - |  | - | ------- |  | --- | - |  | - | ------- |  | --- | -
|                    |  | Three Months Ended September 30, |        |  | Nine Months Ended September 30, |  
|                    |  | 2006                             |        |  | 2005                            |   |  | 2006 |        |  | 2005 |  
|Americas            |  | $                                | 50,434 |  | 81                              | % |  | $    | 41,109 |  | 80   | % |  | $ | 149,551 |  | 80  | % |  | $ | 117,792 |  | 79  | %
|United Kingdom      |  |                                  | 2,957  |  | 5                               | % |  |      | 2,900  |  | 5    | % |  |   | 9,597   |  | 5   | % |  |   | 8,685   |  | 6   | %
|Germany             |  |                                  | 2,532  |  | 4                               | % |  |      | 2,035  |  | 4    | % |  |   | 8,053   |  | 5   | % |  |   | 6,629   |  | 4   | %
|Rest of World       |  |                                  | 6,194  |  | 10                              | % |  |      | 5,577  |  | 11   | % |  |   | 18,995  |  | 10  | % |  |   | 16,033  |  | 11  | %
|                    |  |                                  |        |  |                                 |   |  |      |        |  |      |   |  |   |         |  |     |   |  |   |         |  |     |  
|Total Product Sales |  | $                                | 62,117 |  | 100                             | % |  | $    | 51,621 |  | 100  | % |  | $ | 186,196 |  | 100 | % |  | $ | 149,139 |  | 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 $2.6 million for the quarter ended September 30, 2006, compared to $2.0 million for
the quarter ended September 30, 2005. The percentage of royalties, fees and other revenues as a percentage of income was 4% for the quarter ended September 30, 2006 and 4% for the quarter ended September 30, 2005. The quarter over
quarter dollar increase is related to growth in the markets in which the Company receives royalties. Royalties, fees and other revenues were $7.0 million for the nine months ended September 30, 2006, compared to $5.9 million for the nine months
ended September 30, 2005. The period over period dollar 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 4% for both the
nine months ended September 30, 2006 and September 30, 2005.



24



---

##### Table of Contents

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 $4.9 million for the three and nine months ended September 30, 2006, respectively. This compares to amortization of $1.2 million and
$4.6 million for the three and nine months ended September 30, 2005, respectively. Controller amortization represented 3% of product sales for both the three and nine months ended September 30, 2006. This compares to 2005 where for the
three and nine months ended September 30, 2005, controller amortization represented 2% and 3% of product sales, respectively. The quarter over quarter increase is primarily related to increased revenue reported for the current period, offset by
write downs of inventory and physical count adjustments of approximately $0.7 million associated with the move of inventory from the UK to Belgium.

Cost of product sales was $19.9 million, or 31% of revenue, for the three months ended September 30, 2006, as compared to $16.4 million, or 31% of revenue, for the three months ended September 30, 2005. Gross product margin as a
percentage of product sales was 68% in the third quarter of 2006 and in the third quarter of 2005. Cost of product sales was $57.4 million, or 30% of revenue, for the nine months ended September 30, 2006, as compared to $47.2 million, or 30% of
revenue, for the nine months ended September 30, 2005. Gross product margin as a percentage of product sales was 69% in the first nine months of 2006 and 68% during the same period in the prior year. Cost of product sales for the three and nine
months ended September 30, 2006 includes $0.3 million and $0.4 million, respectively, of stock-based compensation expense related to employee stock options that has been capitalized into inventory. The gross margin percentage for the first nine
months ended September 30, 2006 compared to the same period in 2005 is impacted by the increase in controller amortization as a percentage of product revenue and increased stock-based compensation expense resulting from our January 1, 2006
adoption of Statement 123R, offset by inventory adjustments of approximately $0.7 million related to the move of inventory from the UK to Belgium.

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

Operating Expenses

Research and developmentexpenses were $5.6 million, or 9% of total revenues, for the quarter ended September 30, 2006, compared to $5.3
million, or 10% of total revenues, for the three months ended September 30, 2005. Specifically, the increase is primarily attributable to $0.3 million in stock-based compensation expense associated with our adoption of Statement 123R.

Research and development expenses were $17.9 million, or 9% of total revenues, for the nine months ended September 30, 2006, compared
to $15.3 million, or 10% of total revenues, for the same period in 2005. The dollar increase is primarily attributable to $1.0 million in stock-based compensation expense associated with our adoption of Statement 123R, $0.9 million in increased
compensation and related expenses, $0.4 million in patent-related and product development charges, and $0.3 million in fixed and allocated charges associated with our Sunnyvale, California facility.

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.



25



---

##### Table of Contents

Sales and marketingexpenses were $20.4 million, or 31% of total revenues, for the quarter ended
September 30, 2006, compared to $18.3 million, or 34% of total revenues, for the quarter ended September 30, 2005. The increase in absolute dollars for the third quarter of 2006 compared to the third quarter of 2005 related primarily to a
$1.0 million dollar increase in increased advertising and promotion expenses, $0.6 million in stock-based compensation expense associated with our adoption of Statement 123R, and $0.9 million in additional compensation and related expense associated
with our increased direct sales force, offset by a quarter over quarter decline of $0.4 million in various smaller charges.

Sales and
marketing expenses were $65.1 million, or 34% of total revenues, for the nine months ended September 30, 2006, compared to $55.2 million, or 36% of total revenues, for the nine months ended September 30, 2005. The increase in absolute
dollars for the first nine months of 2006 compared to the first nine months of 2005 related primarily to $2.2 million in additional compensation and related expenses associated with our increased direct sales force, $2.2 million in stock-based
compensation expense associated with our adoption of Statement 123R, $2.2 million in increased sales commissions associated with our year-over-year increased sales volume, $3.1 million in increased advertising and promotion expenses, and $0.2 net
increase in 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 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 administrative expenses were $5.0 million, or 8% of total revenues, for the quarter ended September 30, 2006, compared to $(1.0)
million, or (2)% of total revenues, for the quarter ended September 30, 2005. The increase in general and administrative expenses for the three months ended September 30, 2006 compared to the three months ended September 30, 2005 is
due primarily to approximately $4.0 million in increased legal, accounting, and other outside service costs, which includes an offset from a settlement payment associated with the Smith & Nephew License and Settlement Agreement, recorded as
a reduction in legal fees. Other factors contributing to the quarter-over-quarter increase include a $0.5 million increase in employee related costs associated with additional compensation and related expenses due to increased staffing, an $0.8
million increase in stock-based compensation expense associated with our adoption of Statement 123R, and a $0.7 million increase in fixed and allocated charges, primarily associated with rent and business insurance.

General and administrative expenses were $15.5 million, or 8% of total revenues, for the nine months ended September 30, 2006, compared to $8.3
million, or 5% of total revenues, for the nine months ended September 30, 2005. The increase in general and administrative expenses is due primarily to approximately $2.4 million increase in stock-based compensation expense associated with our
adoption of Statement 123R, $1.1 million in additional compensation and related expenses due to increased staffing in the United States and international locations, $0.9 million in accounting and other outside services, and a $2.8 million net
increase in legal services and litigation costs, which reflects a settlement payment associated with the Smith & Nephew License and Settlement Agreement, recorded in 2005 as a reduction in legal fees.

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.



26



---

##### Table of Contents

Acquired in-process research and development costs (IPR&D) incurred in connection with the
research and development efforts of a product used to arrest bleeding, acquired in our acquisition of ATI during the quarter ended September 30, 2005, totaled $2.4 million. We have not incurred any such charges in 2006.

Amortization of intangible assets increased to $1.8 million, or 3% of total revenues, for the quarter ended September 30, 2006, compared to
$1.6 million, or 3% of total revenues, in the third quarter of 2005. Amortization of intangible assets increased to $5.3 million or 3% of total revenues, for the nine months ended September 30, 2006, compared to $4.5 million, or 3% of total
revenues, in the first nine months of 2005. The increase in amortization for the three and nine months ended September 30, 2006 as compared to the same period in 2005 is primarily due to the amortization of assets acquired from TiMax in the
quarter ended September 30, 2006. We expect that amortization of intangible assets will increase slightly in future periods due to our acquired assets.

Interest and other income (expense), decreased to a net expense of $0.4 million for the quarter ended September 30, 2006, compared to net expense of $0.7 million for the three months ended
September 30, 2005. The decrease in net interest and other expense of $0.3 million for the quarter ended September 30, 2006 compared to the three months ended September 30, 2005 is primarily a result of greater foreign exchange losses
in the third quarter of 2005 compared to 2006.

Interest and other income (expense), net decreased to a net expense of $0.8 million for the
nine months ended September 30, 2006, compared to net expense of $1.8 million for the nine months ended September 30, 2005. The net decrease of $1 million for the nine months ended September 30, 2006 compared to the nine months ended
September 30, 2005 is a result of foreign exchange gains recognized in the first nine months of 2006 where we incurred losses in the same period of 2005.

We do not expect material fluctuations in interest and other income during the remainder of the year, as we anticipate interest expense incurred on our remaining debt to be offset by interest income received from
short term investments.

Income Tax Provision

The provision for income taxes was $2.9 million for an effective tax rate of 25% for the quarter ended September 30, 2006, compared to $2.9 million for an effective tax rate of 28% for the quarter ended September 30, 2005. The
provision for income taxes was $7.7 million for an effective tax rate of 25% for the nine months ended September 30, 2006, compared to $5.3 million for an effective tax rate of 26% for the nine months ended September 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 nine months ended September 30, 2006 does not include any benefit related to this credit. We now
anticipate that our effective tax rate for the year will be approximately 25%.

Liquidity and Capital Resources

As of September 30, 2006, we had $101.7 million in working capital, compared to $98.8 million at December 31, 2005. Our principal sources of
liquidity consisted of $36.9 million in cash, cash equivalents, and short-term investments at September 30, 2006. Cash equivalents are highly liquid with original maturities of ninety days or less. Our short-term investments consist primarily
of commercial paper.

Cash provided by operating activities for the nine months ended September 30, 2006 was $38.3 million, primarily
attributable to net income adjusted for non-cash items, including increased stock-based compensation expense due to the adoption of Statement 123R, and increases in accounts receivable and inventory, partially offset by a decrease in accounts
payable. Cash generated by operating activities for the nine months ended September 30, 2005 was $27.1 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.



27



---

##### Table of Contents

Cash used in investing activities for the nine months ended September 30, 2006 was $92.3 million,
due primarily to the cash payment of $52.4 million made to the former Opus shareholders, $19.4 million in purchases of available for sale securities, and $12.4 million in purchases of property and equipment and intangible assets, including the
intangible assets acquired in connection with our acquisition of TiMax. Cash used in investing activities for the nine months ended September 30, 2005 was $12.0 million, due primarily to a $10.0 million payment made for the purchase of ATI in
August 2005, accompanied by $9.3 million associated with the capitalization of controllers and offset by $7.4 million in sales of available-for-sale securities.

Cash provided by financing activities for the nine months ended September 30, 2006 was $47.3 million, due primarily to cash proceeds of $20.0 million borrowed through our revolving credit facility, $22.2 million
associated with proceeds from the exercise of stock options, and $5.1 million of income tax benefit related to employee stock options. Cash provided by financing activities for the nine months ended September 30, 2005 was $10.6 million, due
primarily to stock option purchases, partially offset by loan repayments.

The fair value of our investments in marketable securities at
September 30, 2006 was $22.4 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. In the third quarter, the Company repaid $15.0 million of the loan and intends to repay the remaining balance of $20.0 million within the next 12 months.

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.



28



---

##### Table of Contents

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 $2.1 million at September 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 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 excess of the recorded value of goodwill over its implied fair value. Measurement of an impairment is required when the fair value of the reporting unit
containing goodwill is less than the reporting units net book value. We have accumulated goodwill of $124.4 million and other intangible assets of $37.8 million as of September 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.



29



---

##### Table of Contents

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 nine months ended September 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 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 nine months ended
September 30, 2006 was $2.5 million and $7.5 million, respectively. There was no stock-based compensation expense related to employee stock options and employee stock purchases recognized during the three and nine months ended
September 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.



30



---

##### Table of Contents

The weighted average fair value of stock awards, excluding restricted stock, granted for the three and
nine months ended September 30, 2006 was $15.53 and $15.74 per share, respectively, using the Black Scholes model with the following weighted average assumptions:



|                                       |  |                                      |       |   |                                     |   |      |         |  |   |       |   |  |   |      |  
|-------------------------------------- |  | ------------------------------------ | ----- | - | ----------------------------------- | - | ---- | ------- |  | - | ----- | - |  | - | ---- | -
|                                       |  | Three months endedSeptember 30, 2006 |       |   | Nine months endedSeptember 30, 2006 |  
|                                       |  | Options                              |       |   | ESPP                                |   |      | Options |  |   | ESPP  |  
|Expected term (in years) (1)           |  |                                      | 3.8   |   |                                     |   | 0.5  |         |  |   | 3.8   |   |  |   | 0.5  |  
|Expected volatility (2)                |  |                                      | 36    | % |                                     |   | 35   | %       |  |   | 36    | % |  |   | 35   | %
|Risk-free interest rate (3)            |  |                                      | 4.94  |   |                                     |   | 5.15 |         |  |   | 4.75  |   |  |   | 5.15 |  
|Expected dividends                     |  |                                      |      |   |                                     |   |     |         |  |   |      |   |  |   |     |  
|Weighted average grant date fair value |  | $                                    | 15.53 |   |                                     | $ | 7.00 |         |  | $ | 15.74 |   |  | $ | 7.00 |  

---

|(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 third 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.

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.



31



---

##### Table of Contents

Recently Issued Accounting Pronouncements

In July 2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes (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 us beginning January 1, 2007. 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, we have not yet
determined the impact, if any, of adopting the provisions of FIN 48 on its financial position, results of operations and liquidity.

In
September 2006, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 157, Fair Value Measurements (FAS 157). The Statement defines fair value, establishes a framework for measuring
fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. FAS 157 is effective for us beginning January 1, 2008. We are currently in the process of evaluating the impact that the Statement
will have on our financial statements.

In September 2006, the SEC staff issued Staff Accounting Bulletin No. 108, Considering
the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements (SAB 108). SAB 108 was issued in order to eliminate the diversity of practice surrounding how public companies
quantify financial statement misstatements.

In SAB 108, the SEC staff established an approach that requires quantification of financial
statement misstatements based on the effects of the misstatements on each of the companys financial statements and the related financial statement disclosures. This model is commonly referred to as a dual approach because it
requires quantification of errors under both the iron curtain and the roll-over methods. We currently use, and have historically applied, the dual method for quantifying identified financial statement misstatements.

We will initially apply the provisions of SAB 108 in connection with the preparation of our annual financial statements for the year ending
December 31, 2006. We are currently evaluating SAB 108, but do not expect the adoption of SAB 108 to have a significant effect on our financial position, results of operations, or cash flows.

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.



32



---

##### Table of Contents

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



|                                                   |  |   |        |  
|-------------------------------------------------- |  | - | ------ | -
|Cash, cash equivalents, and short-term investments |  | $ | 36,932 |  
|Average interest rate                              |  |   | 5.2    | %

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

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



|                      |  |   |        |  
|--------------------- |  | - | ------ | -
|Loan payable          |  | $ | 20,000 |  
|Average interest rate |  |   | 6.0    | %

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 nine months 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 September 30, 2006 are denominated primarily in U.S. Dollars and Euros. A 10% change in our September 30, 2006 Euro-denominated cash and cash equivalents balance would have an impact on pre-tax
income of approximately $0.5 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 of December 31, 2005, we reported that management had identified a material weakness in its 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



33



---

##### Table of Contents

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/A that management concluded that as a result of such material weakness, our internal control over financial reporting was not effective as of
December 31, 2005.

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 September 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 September 30, 2006.

Based upon this evaluation, our CEO and CFO have concluded that, because of the material weakness identified as part of our annual evaluation and
discussed in Managements Report on Internal Control over Financial Reporting in Item 9A of our most recently filed 10-K/A and described above, our internal control over financial reporting was not effective as of September 30, 2006.
In light of the material weakness, we performed additional analysis and other post-closing procedures to ensure that the consolidated financial statements were prepared in accordance with generally accepted accounting principles. Accordingly,
management believes that the financial statements included in this report fairly present in all material respects our financial condition, results of operations and cash flows for the periods presented.

Changes in Internal Control Over Financial Reporting

As of September 30, 2006, we have implemented procedures designed to correct the material weakness disclosed in our Annual Report on Form 10-K/A for the year ended December 31, 2005 related to the proper reconciliation and review
of intercompany balances resulting from transactions with and between certain of our subsidiaries. Management has developed a process for reviewing the accuracy of prepared intercompany account reconciliations. We believe this process is
appropriately designed to strengthen controls surrounding the reporting and reconciliation of intercompany and related accounts. Management anticipates that, upon completion of its annual assessment of internal control over financial reporting under
Section 404 of the Sarbanes Oxley Act, the material weakness will be fully remediated.

Other than the change described in the
preceding paragraph, there were no changes in our internal control over financial reporting that occurred during the quarter ended September 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.



34



---

##### Table of Contents

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

None.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None.

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

None.

ITEM 5. OTHER INFORMATION

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. At
its meeting on October 25, 2006, the Board of Directors voted unanimously to allow the Stockholders Rights Plan to expire by its terms on November 14, 2006. The Board of Directors also intends to consider adoption of appropriate
defensive measures under circumstances in which the Board believes that such measures may be necessary to protect stockholders interests.

ITEM 6. EXHIBITS

Exhibits



|              |  |                                                                                                        
|------------- |  | -------------------------------------------------------------------------------------------------------
|ExhibitNumber |  | Description                                                                                            
|              | 
|31.1          |  | Certification of the Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
|              | 
|31.2          |  | Certification of the Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
|              | 
|32.1          |  | Certification of the Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
|              | 
|32.2          |  | Certification of the Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

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: October 31, 2006 |  | /s/ Michael A. Baker                           
|                       |  | Michael A. Baker                               
|                       |  | President, Chief Executive Officer and Director
|                       |  | (Principal Executive Officer)                  
|                       | 
|Date: October 31, 2006 |  | /s/ Michael Gluk                               
|                       |  | Michael Gluk                                   
|                       |  | Senior Vice President and Chief                
|                       |  | Financial Officer                              
|                       |  | (Principal Financial and Accounting Officer)   



35