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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



Form 10-Q



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



For the quarterly period ended September 30, 2003.



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.)



680 Vaqueros Avenue

Sunnyvale, California 94085

(Address of principal executive offices)



(408) 736-0224

(Registrants telephone number, including area code)



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



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



The number of shares outstanding of the registrants common stock as of October 31, 2003 was 20,712,425.



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ARTHROCARE CORPORATION



INDEX



|         |  |                                                                                                                     |  | Page
|-------- |  | ------------------------------------------------------------------------------------------------------------------- |  | ----
|PART 1:  |  | Financial Information                                                                                               |  |     
|         |  |                                                                                                                    
|Item 1.  |  | Financial Statements (unaudited)                                                                                    |  |     
|         |  |                                                                                                                    
|         |  | Condensed Consolidated Balance Sheets as of September 30, 2003 and December 31, 2002                                |  | 1   
|         |  |                                                                                                                    
|         |  | Condensed Consolidated Statements of Income for the three- and nine-month periods ended September 30, 2003 and 2002 |  | 2   
|         |  |                                                                                                                    
|         |  | Condensed Consolidated Statements of Cash Flows for the nine-month periods ended September 30, 2003 and 2002        |  | 3   
|         |  |                                                                                                                    
|         |  | Notes to Condensed Consolidated Financial Statements                                                                |  | 4   
|         |  |                                                                                                                    
|Item 2.  |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                               |  | 12  
|         |  |                                                                                                                    
|Item 3.  |  | Quantitative and Qualitative Disclosures About Market Risk                                                          |  | 26  
|         |  |                                                                                                                    
|Item 4.  |  | Controls and Procedures                                                                                             |  | 26  
|         |  |                                                                                                                    
|PART II: |  | Other Information                                                                                                   |  |     
|         |  |                                                                                                                    
|Item 1.  |  | Legal Proceedings                                                                                                   |  | 27  
|         |  |                                                                                                                    
|Item 6.  |  | Exhibits and Reports on Form 8-K                                                                                    |  | 27  
|         |  |                                                                                                                    
|         |  | Signatures                                                                                                          |  | 28  
|         |  |                                                                                                                    
|         |  | Certifications                                                                                                      |  |     



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|Part I. |  | FINANCIAL INFORMATION
|------- |  | ---------------------



|Item 1. |  | Financial Statements
|------- |  | --------------------



ARTHROCARE CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands)



|                                                                          |  | September 30,2003 |         |   | December 31,2002 |  
|------------------------------------------------------------------------- |  | ----------------- | ------- | - | ---------------- | -
|                                                                          |  | (Unaudited)       |         |   |                  |  
|ASSETS                                                                    |  |                   |         |   |                  |  
|Current assets:                                                           |  |                   |         |   |                  |  
|Cash and cash equivalents                                                 |  | $                 | 33,692  |   |                  | $
|Available-for-sale securities                                             |  |                   |        |   |                  |  
|Accounts receivable, net of allowances of $389 in 2003 and $1,073 in 2002 |  |                   | 19,539  |   |                  |  
|Inventories                                                               |  |                   | 32,614  |   |                  |  
|Prepaid expenses and other current assets                                 |  |                   | 3,563   |   |                  |  
|                                                                          |  |                   |         |   |                  |  
|Total current assets                                                      |  |                   | 89,408  |   |                  |  
|                                                                          |  |                  
|Available-for-sale securities                                             |  |                   |        |   |                  |  
|Property and equipment, net                                               |  |                   | 21,101  |   |                  |  
|Related party receivables                                                 |  |                   | 1,205   |   |                  |  
|Intangible assets                                                         |  |                   | 6,236   |   |                  |  
|Goodwill                                                                  |  |                   | 10,383  |   |                  |  
|Other assets                                                              |  |                   | 4,464   |   |                  |  
|                                                                          |  |                   |         |   |                  |  
|Total assets                                                              |  | $                 | 132,797 |   |                  | $
|                                                                          |  |                   |         |   |                  |  
|LIABILITIES AND STOCKHOLDERS EQUITY                                      |  |                   |         |   |                  |  
|Current liabilities:                                                      |  |                   |         |   |                  |  
|Accounts payable                                                          |  | $                 | 8,474   |   |                  | $
|Accrued liabilities                                                       |  |                   | 3,514   |   |                  |  
|Accrued compensation                                                      |  |                   | 4,715   |   |                  |  
|Income taxes payable                                                      |  |                   | 2,202   |   |                  |  
|                                                                          |  |                   |         |   |                  |  
|Total current liabilities                                                 |  |                   | 18,905  |   |                  |  
|Loan payable                                                              |  |                   | 7       |   |                  |  
|Deferred rent                                                             |  |                   | 152     |   |                  |  
|                                                                          |  |                   |         |   |                  |  
|Total liabilities                                                         |  |                   | 19,064  |   |                  |  
|                                                                          |  |                   |         |   |                  |  
|Commitments and contingencies: (Note 8)                                   |  |                   |         |   |                  |  
|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: 20,803 shares in 2003, and 21,172 shares in 2002  |  |                   | 21      |   |                  |  
|Treasury stock: 2,704 shares in 2003, 1,978 shares in 2002                |  |                   | (42,366 | ) |                  |  
|Additional paid-in capital                                                |  |                   | 152,611 |   |                  |  
|Deferred stock-based compensation                                         |  |                   | (1,007  | ) |                  |  
|Accumulated other comprehensive loss                                      |  |                   | (1,009  | ) |                  |  
|Retained earnings                                                         |  |                   | 5,483   |   |                  |  
|                                                                          |  |                   |         |   |                  |  
|Total stockholders equity                                                |  |                   | 113,733 |   |                  |  
|                                                                          |  |                   |         |   |                  |  
|Total liabilities and stockholders equity                                |  | $                 | 132,797 |   |                  | $
|                                                                          |  |                   |         |   |                  |  



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



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ARTHROCARE CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(in thousands, except per share data)



|                                                      |  | Three Months EndedSeptember 30, |        | Nine Months EndedSeptember 30,
|----------------------------------------------------- |  | ------------------------------- | ------ | ------------------------------
|                                                      |  | 2003                            |        | 2002                          
|                                                      |  | (Unaudited)                    
|Revenues:                                             |  |                                 |        |                               
|Product sales                                         |  | $                               | 28,559 |                               
|Royalties, fees and other                             |  |                                 | 881    |                               
|                                                      |  |                                 |        |                               
|Total revenues                                        |  |                                 | 29,440 |                               
|Cost of product sales                                 |  |                                 | 9,066  |                               
|                                                      |  |                                 |        |                               
|Gross profit                                          |  |                                 | 20,374 |                               
|                                                      |  |                                 |        |                               
|Operating expenses:                                   |  |                                 |        |                               
|Research and development                              |  |                                 | 3,068  |                               
|Sales and marketing                                   |  |                                 | 11,573 |                               
|General and administrative                            |  |                                 | 3,289  |                               
|                                                      |  |                                 |        |                               
|Total operating expenses                              |  |                                 | 17,930 |                               
|                                                      |  |                                 |        |                               
|Income from operations                                |  |                                 | 2,444  |                               
|Interest and other income, net                        |  |                                 | 591    |                               
|                                                      |  |                                 |        |                               
|Income before income tax provision                    |  |                                 | 3,035  |                               
|Income tax provision                                  |  |                                 | 941    |                               
|                                                      |  |                                 |        |                               
|Net income                                            |  | $                               | 2,094  |                               
|                                                      |  |                                 |        |                               
|Basic net income per share                            |  | $                               | 0.10   |                               
|                                                      |  |                                 |        |                               
|Shares used in computing basic net income per share   |  |                                 | 20,650 |                               
|                                                      |  |                                 |        |                               
|Diluted net income per share                          |  | $                               | 0.10   |                               
|                                                      |  |                                 |        |                               
|Shares used in computing diluted net income per share |  |                                 | 21,796 |                               
|                                                      |  |                                 |        |                               



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



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ARTHROCARE CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)



|                                                                                                                         |  | Nine Months Ended |        
|------------------------------------------------------------------------------------------------------------------------ |  | ----------------- | -------
|                                                                                                                         |  | September 30,2003 |        
|                                                                                                                         |  | (Unaudited)       |        
|Cash flows from operating activities:                                                                                    |  |                   |        
|Net income                                                                                                               |  | $                 | 4,650  
|Adjustments to reconcile net income to net cash provided by operating activities:                                        |  |                   |        
|Depreciation and amortization                                                                                            |  |                   | 7,523  
|Loss on disposition of equipment                                                                                         |  |                   | 5      
|Stock compensation expense                                                                                               |  |                   | 366    
|Provision for doubtful accounts receivable and product returns                                                           |  |                   |       
|Provision for excess and obsolete inventory                                                                              |  |                   | 227    
|Deferred rent                                                                                                            |  |                   | 38     
|Changes in operating assets and liabilities, excluding assets acquired and liabilities assumed in business
combinations: |  |                   |        
|Accounts receivable                                                                                                      |  |                   | (987   
|Inventories                                                                                                              |  |                   | (9,738 
|Prepaid expenses and other current assets                                                                                |  |                   | (462   
|Accounts payable                                                                                                         |  |                   | 275    
|Accrued liabilities                                                                                                      |  |                   | (1,566 
|Income taxes payable                                                                                                     |  |                   | 2,202  
|Other assets                                                                                                             |  |                   | (47    
|                                                                                                                         |  |                   |        
|Net cash provided by operating activities                                                                                |  |                   | 2,490  
|                                                                                                                         |  |                   |        
|Cash flows from investing activities:                                                                                    |  |                   |        
|Purchases of property and equipment                                                                                      |  |                   | (9,485 
|Purchases of intangible assets                                                                                           |  |                   | (2,150 
|Payment for purchase of Atlantech Austria, net of cash acquired                                                          |  |                   | (630   
|Purchases of available-for-sale securities                                                                               |  |                   | (32,170
|Sales or maturities of available-for-sale securities                                                                     |  |                   | 44,337 
|                                                                                                                         |  |                   |        
|Net cash used in investing activities                                                                                    |  |                   | (98    
|                                                                                                                         |  |                   |        
|Cash flows from financing activities:                                                                                    |  |                   |        
|Purchase of treasury stock                                                                                               |  |                   | (11,262
|Repayment of bank loan                                                                                                   |  |                   | (49    
|Proceeds from exercise of options to purchase common stock                                                               |  |                   | 1,487  
|Proceeds from issuances of common stock                                                                                  |  |                   | 352    
|                                                                                                                         |  |                   |        
|Net cash used in financing activities                                                                                    |  |                   | (9,472 
|                                                                                                                         |  |                   |        
|Effect of exchange rate changes on cash                                                                                  |  |                   | 17     
|                                                                                                                         |  |                   |        
|Net decrease in cash and cash equivalents                                                                                |  |                   | (7,061 
|Cash and cash equivalents, beginning of period                                                                           |  |                   | 40,753 
|                                                                                                                         |  |                   |        
|Cash and cash equivalents, end of period                                                                                 |  | $                 | 33,692 
|                                                                                                                         |  |                   |        



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



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ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)



|1. | Formation and Business of the Company:
|-- | --------------------------------------



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



|2. | Basis of Presentation:
|-- | ----------------------



We have prepared the accompanying condensed consolidated financial statements in accordance with accounting principles generally accepted in the United
States of America, and in accordance with the rules and regulations of Form 10-Q and Article 10 of Regulation S-X of the United States Securities and Exchange Commission. In the opinion of management, the accompanying unaudited condensed
consolidated financial statements contain all adjustments (all of which are normal and recurring in nature) necessary to present fairly the financial position, results of operations and cash flows of ArthroCare and its subsidiaries for the periods
indicated. Interim results of operations are not necessarily indicative of the results to be expected for the full year or any other interim periods. The notes to the consolidated financial statements contained in our Form 10-K for the year ended
December 31, 2002 should be read in conjunction with these condensed consolidated financial statements. The balance sheet at December 31, 2002 was derived from our 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.



In the fourth quarter of 2002 we changed our fiscal periods, month and year, to conform to calendar periods. The third quarter of 2002 began on June 30,
2002 and ended on September 28, 2002. For presentation purposes, the third quarter 2002 end date is shown as September 30, 2002.



|3. | Stock-Based Compensation:
|-- | -------------------------



We account for stock-based employee compensation using the intrinsic value method of accounting. Under the intrinsic value method of accounting, employee
stock-based compensation expense is based on the difference, if any, on the date of the grant between the fair value of the Companys stock and the exercise price of the award.



We account for stock options issued to non-employees using the fair value method of accounting. Non-employee stock-based
compensation expense is recognized over the four-year vesting period of the options granted. In the second quarter of 2003, we repurchased, at an average price of $2.30 per share, 99,629 outstanding unvested stock options that had been granted to
non-employees. This repurchase represented approximately 74 percent of the outstanding unvested options issued to non-employees. Stock-based



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compensation expense related to non-employee option grants was $0.1 million for the three months ended September 30, 2002 and less than $0.1 million for the
three months ended September 30, 2003. Stock-based compensation expense for the nine months ended September 30, 2003 and 2002 was $0.4 million and $0.2 million, respectively. Stock-based compensation is included in Sales and Marketing and Research
and Development expense.



Weighted-average assumptions used in
determining the fair value of non-employee stock option grants using the Black-Scholes pricing model, were as follows:



|                        |  | Nine MonthsEndedSeptember 30,2003
|----------------------- |  | ---------------------------------
|Risk-free interest rate |  | 2.92%                            
|Expected life           |  | 5 years                          
|Expected dividends      |  |                                 
|Expected volatility     |  | 70%                              



Had employee
stock-based compensation been determined based on the fair value method as opposed to the intrinsic value method, the companys net income (loss), net income (loss) per share and fully diluted net income (loss) per share for the three and nine
months ended September 30, 2003 and 2002 would have been as follows (in thousands, except per share amounts):



|                                                                                                             |  | Three MonthsEndedSeptember 30, |        |   | Nine MonthsEndedSeptember 30, |  
|------------------------------------------------------------------------------------------------------------ |  | ------------------------------ | ------ | - | ----------------------------- | -
|                                                                                                             |  | 2003                           |        |   | 2002                          |  
|Net incomeas reported                                                                                       |  | $                              | 2,094  |   |                               | $
|Employee stock-based compensation expense determined under the fair value method, net of related tax effects |  |                                | (3,295 | ) |                               |  
|                                                                                                             |  |                                |        |   |                               |  
|Pro forma net loss                                                                                           |  | $                              | (1,201 | ) |                               | $
|                                                                                                             |  |                                |        |   |                               |  
|Net income (loss) per share:                                                                                 |  |                                |        |   |                               |  
|Basicas reported                                                                                            |  | $                              | 0.10   |   |                               | $
|Basicpro forma                                                                                              |  | $                              | (0.06  | ) |                               | $
|Dilutedas reported                                                                                          |  | $                              | 0.10   |   |                               | $
|Dilutedpro forma                                                                                            |  | $                              | (0.06  | ) |                               | $



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



Stock Option Plans



|                            |  | Three Months EndedSeptember 30, |  | Nine Months EndedSeptember 30,
|--------------------------- |  | ------------------------------- |  | ------------------------------
|                            |  | 2003                            |  | 2002                          
|Risk-free interest rate     |  | 2.92%-3.50%                     |  | 2.79%-3.86%                   
|Expected life               |  | 5 years                         |  | 5 years                       
|Expected dividends          |  |                                |  |                              
|Expected volatility         |  | 70%                             |  | 70%                           
|Weighted-average fair value |  | $8.60                           |  | $7.26                         



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Employee Stock Purchase Plan



|                            |  | Three MonthsEndedSeptember 30, |  | Nine MonthsEndedSeptember 30,
|--------------------------- |  | ------------------------------ |  | -----------------------------
|                            |  | 2003                           |  | 2002                         
|Risk-free interest rate     |  |                               |  | 1.06%                        
|Expected life               |  |                               |  | 0.5 years                    
|Expected dividends          |  |                               |  |                             
|Expected volatility         |  |                               |  | 70%                          
|Weighted-average fair value |  |                               |  | $5.70                        



|4. | Recent Accounting Pronouncement:
|-- | --------------------------------



In January 2003, the FASB issued FASB Interpretation No. 46, Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51
(FIN 46). FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not
have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. As we have no variable interest entities, the adoption of FIN 46 will not have a material impact on our
operating results or consolidated financial statements.



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



|                                                                     |  | Three Months EndedSeptember 30, |        | Nine Months EndedSeptember 30,
|-------------------------------------------------------------------- |  | ------------------------------- | ------ | ------------------------------
|                                                                     |  | 2003                            |        |                               
|Net income                                                           |  | $                               | 2,094  |                               
|                                                                     |  |                                 |        |                               
|Basic:                                                               |  |                                 |        |                               
|Weighted-average common shares outstanding                           |  |                                 | 20,776 |                               
|Less weighted-average restricted stock outstanding                   |  |                                 | (126   | )                             
|                                                                     |  |                                 |        |                               
|Total                                                                |  |                                 | 20,650 |                               
|                                                                     |  |                                 |        |                               
|Net income per share                                                 |  | $                               | 0.10   |                               
|                                                                     |  |                                 |        |                               
|Diluted:                                                             |  |                                 |        |                               
|Weighted-average common shares outstanding used in basic calculation |  |                                 | 20,650 |                               
|Options                                                              |  |                                 | 1,051  |                               
|Warrants                                                             |  |                                 | 28     |                               
|Restricted shares                                                    |  |                                 | 67     |                               
|                                                                     |  |                                 |        |                               
|Total weighted common stock and common stock equivalents             |  |                                 | 21,796 |                               
|                                                                     |  |                                 |        |                               
|Net income per share                                                 |  | $                               | 0.10   |                               
|                                                                     |  |                                 |        |                               



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Options to purchase 2,196,991 and 2,693,691 shares of common stock outstanding during the three-month and
nine-month periods ended September 30, 2003, respectively, were not included in the computation of diluted net income per share because their effects are anti-dilutive. Options to purchase 3,776,514 and 3,196,498 shares of common stock outstanding
during the three-month and nine-month periods ended September 30, 2002, respectively, were not included in the computation of diluted net income per share because their effects are anti-dilutive.



|6. | Comprehensive Income:
|-- | ---------------------



The components of comprehensive income were as follows (in thousands):



|                                                                                                               |  | Three MonthsEndedSeptember 30, |       |   | Nine MonthsEndedSeptember 30,
|-------------------------------------------------------------------------------------------------------------- |  | ------------------------------ | ----- | - | -----------------------------
|                                                                                                               |  | 2003                           |       |   | 2002                         
|(in thousands):                                                                                                |  |                                |       |   |                              
|Net income                                                                                                     |  | $                              | 2,094 |   |                              
|Unrealized gains (losses) on available-for-sale securities arising during the period, net of tax               |  |                                |      |   |                              
|Less: Reclassification adjustment for gains on available-for-sale securities, net of tax, included in earnings |  |                                |      |   |                              
|Foreign currency translation adjustment                                                                        |  |                                | (111  | ) |                              
|                                                                                                               |  |                                |       |   |                              
|Comprehensive income                                                                                           |  | $                              | 1,983 |   |                              
|                                                                                                               |  |                                |       |   |                              



|7. | Inventories:(in thousands):
|-- | ---------------------------



|                |  | September 30,2003 |        | December 31,2002
|--------------- |  | ----------------- | ------ | ----------------
|Raw materials   |  | $                 | 9,143  |                 
|Work-in-process |  |                   | 8,952  |                 
|Finished goods  |  |                   | 14,519 |                 
|                |  |                   |        |                 
|Total           |  | $                 | 32,614 |                 
|                |  |                   |        |                 



|8. | Intangible Assets:
|-- | ------------------



Intangible assets resulting from acquisitions are estimates based on independent fair value assessments. Other intangible assets are valued at the amount
paid for the assets. Intangible assets consist of the following:



|                              |  | December 31, 2002 |       |   | Additions |   |        | September 30, 2003 | 
|----------------------------- |  | ----------------- | ----- | - | --------- | - | ------ | ------------------ | 
|Distribution/customer network |  | $                 | 2,900 |   |           |   |        |                    | 
|OEM contractual agreements    |  |                   | 1,100 |   |           |   |        |                    | 
|Patents                       |  |                   | 200   |   |           |   |        |                    | 
|Trade names/trademarks        |  |                   | 700   |   |           |   |        |                    | 
|Employment agreements         |  |                   | 300   |   |           |   |        |                    | 
|Non-competition agreements    |  |                   | 100   |   |           |   |        |                    | 
|Distributor agreements        |  |                   |      |   |           | $ | 450    |                    | 
|Intellectual property rights  |  |                   |      |   |           |   | 1,700  |                    | 
|                              |  |                   |       |   |           |   |        |                    | 
|Gross intangible assets       |  | $                 | 5,300 |   |           | $ | 2,150  |                    | 
|Accumulated amortization      |  |                   | (198  | ) |           |   | (1,016 | )                  | 
|                              |  |                   |       |   |           |   |        |                    | 
|Net intangible assets         |  | $                 | 5,102 |   |           | $ | 1,137  |                    | 
|                              |  |                   |       |   |           |   |        |                    | 



Intangible assets are
amortized on a straight-line basis over the periods benefited, which range between one and seven years. Estimated amortization expense for the next five years is $335,000 in the remaining three months of 2003, $1,387,000 in 2004, $1,370,000 in 2005,
$1,287,000 in 2006, $1,120,000 in 2007 and $307,000 in 2008.



|9. | Commitments and Contingencies:
|-- | ------------------------------



Operating Leases



We lease our facilities and certain equipment under operating leases. We recognize rent expense on a straight-line basis over the lease term. At September
30, 2003, total future minimum lease payments are as follows (in thousands):



|2003 (3 months) |  | $ | 403  
|--------------- |  | - | -----
|2004            |  |   | 1,624
|2005            |  |   | 1,548
|2006            |  |   | 1,568
|2007            |  |   | 262  
|                |  |   |      
|Total           |  | $ | 5,405
|                |  |   |      



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Warranties



We generally provide customers with a limited 90-day warranty on disposable devices and a limited one year warranty on
controller units. We accrue for the estimated cost of product warranties at the time revenue is recognized. Our warranty obligation is affected by product failure rates, material usage and service delivery costs incurred in correcting a product
failure. We evaluate and adjust the warranty reserve to the extent actual warranty expense varies from the original estimates. The activity in our warranty accrual for the three and nine months ended September 30, 2003 was as follows (in thousands):



|                                                 |  | Three MonthsEndedSeptember 30,2003 |      |   | Nine MonthsEndedSeptember 30,2003 |  
|------------------------------------------------ |  | ---------------------------------- | ---- | - | --------------------------------- | -
|Beginning balance                                |  | $                                  | 294  |   |                                   | $
|Accruals for warranties issued during the period |  |                                    | 214  |   |                                   |  
|Settlements made during the period               |  |                                    | (149 | ) |                                   |  
|                                                 |  |                                    |      |   |                                   |  
|Ending balance                                   |  | $                                  | 359  |   |                                   | $
|                                                 |  |                                    |      |   |                                   |  



Litigation



We are involved in litigation and other legal matters
arising in the normal course of business.



On July 25, 2001, we
filed a lawsuit against Smith & Nephew, Inc. (the Defendant) in the United States District Court of Delaware. The lawsuit alleges, among other things, that the Defendant has been, and is currently, infringing three patents issued to
us (U.S. Patent Nos. 5,697,536, 5,697,882 and 6,224,592). Specifically, we alleged that the Defendant uses, imports, markets and sells an electrosurgical system under the name Dyonics Control RF System that infringes these patents. We sought the
following remedies: (1) a judgment that the Defendant has infringed these patents; (2) a permanent injunction precluding the Defendant from using, importing, marketing and selling the Dyonics Control RF System, the Vulcan generator and the
Electroblade and the Saphirre RF electrosurgical devices; and (3) an award of damages (including attorneys fees) to compensate us for lost profits and the Defendants use of our inventions, with the damages to be trebled because of the
Defendants willful infringement. A jury trial commenced on April 30, 2003. On May 12, 2003, the jury held that the use, manufacture and sale of the Dyonics Control RF System, the Electroblade and the Saphirre RF electrosurgical devices
infringed all 16 asserted claims of the three patents in suit. In addition, the jury upheld the validity of all 16 asserted claims. The court entered this verdict in June 2003 and held a hearing on September 15, 2003 to consider Defendants
motions to overturn the jurys verdict. Following this decision, the court will hear our motion to enjoin the Defendant from the use, manufacture and sale of the Dyonics Control RF System and the Electroblade and the Saphirre RF electrosurgical
devices in the United States. The court is to hold a second trial to award damages to us for the infringing activity of the Defendant.



On April 3, 2003, Smith & Nephew filed a complaint against ArthroCare in the United States District Court, Western District of Tennessee for patent
infringement of two patents and for violation of Section 43(a) of the Lanham Act. Upon initial review, we believe this complaint is without merit, and we intend to defend ourselves vigorously.



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



In September 2002, a product liability suit was brought against us in the 269th Judicial District Court, Harris County,
Texas. We believe these claims to be without merit and intend to defend ourselves vigorously.



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



We believe that we have meritorious defenses against the above unsettled claims and intend to vigorously contest them. The outcomes of the outstanding
litigation matters discussed above cannot be reasonably estimated. Also, except as otherwise described above, we have product liability insurance coverage in amounts we consider necessary to prevent material losses. We record a liability when a loss
is known or considered probable and the amount can be reasonably estimated. If a loss is not probable or a probable loss cannot be reasonably estimated, a liability is not recorded. While it is not possible to predict the outcome of the actions
discussed above, we believe that costs associated with them will not have a material adverse impact on our financial position or liquidity, but could be material to the consolidated results of operations of any one period.



|10. | Product Information:
|--- | --------------------



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



Product sales are summarized in the table below (in thousands):



|                     |  | Three Months EndedSeptember 30, |        | Nine Months EndedSeptember 30,
|-------------------- |  | ------------------------------- | ------ | ------------------------------
|                     |  | 2003                            |        | 2002                          
|Product sales:       |  |                                 |        |                               
|Arthroscopy          |  | $                               | 20,091 |                               
|ENT                  |  |                                 | 4,671  |                               
|ArthroCare Spine     |  |                                 | 3,715  |                               
|Coblation Technology |  |                                 | 82     |                               
|                     |  |                                 |        |                               
|Total                |  | $                               | 28,559 |                               
|                     |  |                                 |        |                               



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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. The following table represents a summary of product sales and long-lived assets by geographical region (in thousands):



|                    |  | Three Months EndedSeptember 30, |        | Nine Months EndedSeptember 30,
|------------------- |  | ------------------------------- | ------ | ------------------------------
|                    |  | 2003                            |        | 2002                          
|Product sales:      |  |                                 |        |                               
|United States       |  | $                               | 21,283 |                               
|International       |  |                                 | 7,276  |                               
|                    |  |                                 |        |                               
|Total product sales |  | $                               | 28,559 |                               
|                    |  |                                 |        |                               



|                        |  | September 30, 2003 |        | December 31,2002
|----------------------- |  | ------------------ | ------ | ----------------
|Property and equipment: |  |                    |        |                 
|United States           |  | $                  | 14,495 |                 
|International           |  |                    | 6,606  |                 
|                        |  |                    |        |                 
|Total                   |  | $                  | 21,101 |                 
|                        |  |                    |        |                 



|11. | Stockholders Equity:
|--- | ---------------------



Restricted Stock



In the first quarter of 2003, we granted certain employees an aggregate of 127,300 shares of restricted common stock under our 1993 Incentive Stock Option
Plan. In June 2003, 1,500 of these shares were cancelled due to an employee termination. In connection with the restricted stock grant, we recorded $1.1 million of deferred compensation in the first quarter of 2003, which is being amortized to other
compensation expense over 5 years. The total amortization recorded was $55,000 and $131,000 for the three and nine months ended September 30, 2003, respectively.



Treasury Stock



In April 2001, the Board of Directors authorized the repurchase of up to 1,000,000 shares of our common stock. In June 2002, the Board of Directors
authorized the repurchase of up to 2,000,000 additional shares of our common stock, subject to certain limitations and conditions. We repurchased 926,000 shares at a cost of $10.8 million in the three months ended September 30, 2002. We repurchased
727,000 shares at a cost of $11.1 million and 1,027,000 shares at a cost of $12.1 million in the nine months ended September 30, 2003 and 2002, respectively. There were no repurchases in the three months ended September 30, 2003.



|12. | Subsequent Events:
|--- | ------------------



On October 23, 2003, we entered into an agreement and plan of merger with Medical Device Alliance, Inc. (MDA) and its wholly-owned subsidiary
Parallax Medical, Inc. Pursuant to the merger agreement, a wholly owned subsidiary of our company will merge with MDA, with MDA surviving the merger and continuing as a wholly-owned subsidiary of our company. The maximum aggregate consideration
payable by us to the stockholders of MDA upon close of the merger is $28 million in cash. In addition, the stockholders of MDA will each receive a contingent value right, which represents the right to receive certain payments relating to net revenue
on the sale of certain of the Companys products during the 2005 calendar year. We anticipate the transactions contemplated by the merger agreement will be consumated in early 2004.



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In connection with the execution of the merger agreement, we also entered into a definitive distribution
agreement with MDA, effective Novemeber 15, 2003, pursuant to which we will begin selling MDA products worldwide. We will serve as the exclusive worldwide distributor of MDA products until such time as the distribution agreement is terminated as a
result of the termination of the merger agreement or we terminate the distribution agreement with thirty (30) calendar days written notice to MDA.



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



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PART 1. FINANCIAL INFORMATION



|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. Actual events or
results may differ materially as a result of the risks and uncertainties described herein and elsewhere including, but not limited to, those factors described under Business set forth in Part I of our Annual Report on Form 10-K for the
year-ended December 31, 2002 and Additional Factors That May Affect Future Results set forth below.



Overview



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



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



We have organized our marketing and sales
efforts into product markets. These product markets are comprised of the following: Arthroscopy (to include shoulder and knee arthroscopic products), ENT (to include ear, nose, throat and the Visage® cosmetic products), ArthroCare Spine (to include spinal and neuro surgery products) and Coblation Technologies (to include
gynecology, urology, laparoscopic, general surgical and cardiology products).



We commercially introduced our Arthroscopic Surgery System in December 1995 and have derived a significant portion of our sales from this system. The ArthroCare Spine and ENT businesses are growing and represent an
increasingly larger portion of our total business. As of September 30, 2003, we have shipped more than 18,900 controllers and over 2,410,000 disposable devices for a variety of indications since we began commercialization in 1995. In the United
States we are selling our Arthroscopy products through a network of 45 distributors and a direct sales organization consisting of 17 people. Our ArthroCare Spine products are sold through a network of 30 independent distributors and a direct sales
force of 16 people. Our ENT business unit distributes its products through a direct sales force of 33 people supported by distributors in certain remote U.S. geographic markets. We have also established a distribution capability in Europe. For our
Arthroscopy business unit we have a direct sales organization in the United Kingdom, France, Germany and Austria consisting of 20 people. Our ENT business also has a direct selling organization in the United Kingdom and Germany consisting of seven
people. Our ArthroCare Spine business shares a portion of the direct sales organization with Arthroscopy and ENT in Europe. For the balance of Europe and Australia, New Zealand, China, Korea, Japan, Taiwan, Canada, Mexico, the Caribbean, Russia,
South Africa, the Middle East, Northern Africa, South America and Central America, we have established a distribution capability through independent distributors. During the first quarter of 2003, our ENT business unit introduced a new ENT
controller that provides improved performance for



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tonsillectomy procedures. Also during the first quarter of 2003, our ArthroCare Spine business unit introduced a new procedure for performing a less-invasive
microdiscectomy using our Coblation technology.



Results of Operations



Three months ended September 30, 2003 and 2002



Revenues



Product sales were $28.6 million for the quarter ended September 30, 2003, an increase of $7.2 million, or 34%, over the
same period in 2002. Arthroscopy contributed $20.1 million in net product sales in the third quarter of 2003, including $2.1 million of Atlantech Medical Devices, Ltd. (United Kingdom), Atlantech GmbH (Germany) and Atlantech Medizinische Produkte
Vertriebs, GmbH (Austria) (collectively referred to as Atlantech) sales of non-Coblation arthroscopy product, as compared to $15.6 million in the third quarter of 2002, excluding Atlantech products (acquisitions occurred post September
2002). ENT net product sales increased to $4.7 million for the three months ended September 30, 2003, from $2.7 million for the same period in 2002. Spinal surgery product sales increased to $3.7 million for the three months ended September 30,
2003, from $2.5 million for the same period in 2002. Coblation technology sales were $0.1 million for the three months ended September 30, 2003, as compared to $0.6 million for the same period in 2002.



The increase in direct sales presence, which began in 2001, continued to have
a positive effect on sales in the third quarter of 2003, as did the execution of our strategic plan to build market share through continued promotional programs of controller placements, commercialization of our technology in fields outside of
arthroscopy, introduction of new products designed to address surgical procedures that have traditionally been difficult to perform and the acquisition of technologies or businesses that complement our business.



Overall, disposable devices are consistently sold at or near list price,
except for sales to international distributors and marketing partners, which are sold at discounted prices. We expect these discounts to continue in the future. Disposable device sales were 90% of product sales, excluding Atlantech product sales,
for the third quarter of 2003 and comprised approximately 94% of third quarter 2002 product sales. We anticipate that disposable device sales will remain the primary component of our product sales in the near future.



International product sales were $7.3 million, or 25% of net product sales,
for the quarter ended September 30, 2003, compared to $3.4 million, or 16% of net product sales, for the same period in 2002. A large part of the $3.5 million increase is attributable to the acquisition of Atlantech, whose international non-
Coblation arthroscopy product sales were $2.1 million in the third quarter of 2003. International product sales for the three months ended September 30, 2003, excluding Atlantech, increased by 44% compared to the same period in 2002.



Based upon the estimated number of arthroscopic procedures performed each
year, we believe that knee procedures represent the largest segment of the arthroscopic market, while shoulder procedures represent the fastest growing segment. To achieve increasing disposable device sales in arthroscopy over time, we believe we
must continue to penetrate the market in knee procedures, expand physicians education with respect to Coblation technology, and continue to work on new product development efforts specifically for knee applications. We believe that, in our
seven years of product shipments, we have penetrated 30% to 35% of the hospitals that perform arthroscopic procedures in the United States. We believe that approximately 45% of our arthroscopy product sales are being generated by the sale of
disposables for use in knee procedures.



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Royalties, fees and other revenues were $0.9 million for both the three-month period ended September 30,
2003 and for the same period in 2002.



Cost of Product Sales



Cost of product sales was $9.1 million, or 32% of product sales, for the
three-month period ended September 30, 2003, as compared to $8.0 million, or 37% of product sales, for the same period in 2002. The decrease in cost as a percentage of product sales is attributable to the increased efficiency of the manufacturing
operations resulting mostly from the transition of manufacturing operations to our Costa Rica facility and increased production volume to cover our increased sales volumes. These increases were partially offset by the increased controller placement
costs and the lower gross margin on Atlantech sales. As planned, our Costa Rica facility continued its transition to manufacturing completed final assemblies in the third quarter of 2003 and is expected to contribute to gross margin improvements in
the future.



Operating Expenses



Research and development expenses were $3.1 million, or 11% of product
sales, for the three-month period ended September 30, 2003, as compared to $2.2 million, or 10% of product sales, for the same period in 2002. The dollar increase is due to a continued investment in our Coblation technology. We believe that
continued investment in our Coblation technology is essential for us to maintain our competitive position. 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, but anticipate expenses to decrease slightly as a percentage of product sales.



Sales and marketing expenses were $11.6 million, or 41% of product sales, during the three-month period ended September 30, 2003, as compared to $9.0
million, or 42% of product sales, during the same period in 2002. The increase in spending for the current three-month period was primarily due to expenses related to increased headcount, increases in advertising and trade shows expense, and higher
commissions due to higher product sales.



We anticipate that
sales and marketing spending will continue to increase in absolute dollars as a result of expansion of our distribution capabilities to address the spinal surgery, ENT and cosmetic surgical markets, higher commissions from increased sales, the
additional cost of penetrating international markets, higher promotional, demonstration and sample expenses, and additional investments in the sales, marketing and support staff necessary to market products and to commercialize future products. We
have entered into a strategic relationship with the GyneCare division of Ethicon, Inc. to commercialize Coblation-based products for laparoscopic and open surgical procedures for gynecological applications. We have also entered into a strategic
relationship with ACMI, under which ACMI will market and sell our products for urologic indications, including transurethral resection of the prostrate.



General and administrative expenses were $3.3 million, or 12% of product sales, during the three-month period ended September 30, 2003, compared to $2.5
million, or 12% of product sales, during the same period in 2002. The increase was attributable to higher costs of general and patent-related legal services, business development activities, expenses related to the Atlantech business acquired in the
fourth quarter of fiscal 2002 and the third quarter of 2003, and increases in non-Atlantech labor expenses. We expect general and administrative expenses to increase in absolute terms as well as a percentage of product sales as we continue business
development activities and incur additional legal costs associated with patent infringement actions.



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Interest and Other Income, Net



Interest and other income, net, increased to $0.6 million for the three-month period ended September 30, 2003, compared to
$0.4 million during the same period in 2002. The increase in interest and other income is attributable to net foreign exchange gains, partially offset by lower interest income.



Nine months ended September 30, 2003 and 2002



Revenues



Product sales were $83.4 million for the nine months ended September 30, 2003, an increase of 36% from the $61.3 million in the first nine months of 2002.
Arthroscopy contributed $60.8 million in net product sales for the nine months ended September 30, 2003, a 30% increase over the first nine months of 2002. ENT net product sales were $11.8 million for the first nine months of 2003, an increase of
62% over the first nine months of 2002. Spinal surgery product sales were $9.9 million for the first nine months of 2003, a 59% increase over the first nine months of 2002. Coblation Technology product sales increased to $0.9 million for the first
nine months of 2003, a 21% decrease over the first nine months of 2002.



The increase in direct sales presence, which began in 2001, continued to have a positive effect on sales in the first nine months of 2003, as did the execution of our strategic plan to build market share through continued promotional
programs of controller placements, commercialization of our technology in fields outside of arthroscopy and introduction of new products designed to address surgical procedures that have traditionally been difficult to perform.



International product sales were $20.5 million, or 24% of net product sales,
for the nine months ended September 30, 2003, compared to $9.5 million, or 16% of net product sales, for the same period in 2002. Our growth in the international market was stronger than in the domestic market due mostly to the acquisition of
Atlantech.



Royalties, fees and other revenues were $2.9
million for the nine-month period ended September 30, 2003, as compared to $3.1 million for the same period in 2002.



Cost of Product Sales



Cost of product sales was $26.3 million, or 32% of product sales, for the nine-month period ended September 30, 2003, as compared to $22.8 million, or 37%
of product sales, for the same period in 2002. The decrease in cost as a percentage of product sales is attributable to the increased efficiency of our manufacturing operations. As planned, our Costa Rica facility is expected to continue to
contribute to gross margin improvements in the remainder of 2003.



Operating
Expenses



Research and development expenses were $8.3
million, or 10% of product sales, for the nine-month period ended September 30, 2003, as compared to $6.5 million, or 11% of product sales for the same period in 2002. The dollar increase is due to a continued investment in our Coblation technology.
We believe that continued investment in our Coblation technology is essential for us to maintain our competitive position. 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, but anticipate expenses to decrease slightly as a percentage of product sales.



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Sales and marketing expenses were $34.6 million, or 42% of product sales, during the nine-month period
ended September 30, 2003, as compared to $26.3 million, or 43% of product sales, during the same period in 2002. The increase in spending for the current nine-month period was primarily due to expenses related to increased headcount, higher
commissions due to higher product sales, and increases in advertising and trade show expenses.



We anticipate that sales and marketing spending will continue to increase in absolute dollars due to the expansion of our distribution and sales force capabilities to address the existing surgery markets, higher
commissions from increased sales, the additional cost of penetrating international markets, higher promotional, demonstration and sample expenses and additional investments in the sales, marketing and support staff necessary to market our current
products and commercialize future products. We anticipate that sales and marketing spending will decrease as a percentage of product sales in future periods.



General and administrative expenses were $12.0 million, or 14% of product sales, during the nine-month period ended September 30, 2003, compared to $6.9
million, or 11% of product sales, during the same period in 2002. This increase was attributable to higher costs of general and patent-related legal services, business development activities, insurance and international accounting and tax-related
expenditures necessary to expand our corporate infrastructure, expenses related to the Atlantech business acquired in the fourth quarter of 2002 and the second quarter of 2003, and the headcount increase required to support the business structure.
We expect general and administrative expenses to increase as a percentage of product sales and increase in absolute dollar values in future periods as we continue business development activities and incur additional legal costs associated with
patent infringement actions.



Interest and Other Income, Net



Interest and other income, net, increased to $1.6 million for the
nine-month period ended September 30, 2003, compared to $1.2 million during the same period in 2002. The increase in interest and other income is attributable to realized gains on the sale of investments and net foreign exchange translation gains,
partially offset by lower interest income.



Liquidity and Capital
Resources



On September 30, 2003, we had $70.5 million in
working capital compared to $72.9 million at December 31, 2002. The principal sources of liquidity consisted of $33.7 million in cash and cash equivalents compared to $52.9 million in cash, cash equivalents and available-for-sale securities at
December 31, 2002. The decrease in cash, cash equivalents and available-for-sale securities is primarily due to approximately $10.6 million used for repurchases of our common stock, and $2.2 million for the purchase of intellectual property and the
acquisition of Atlantech Medizinische Produkte Vertriebs, GmbH (Atlantech Austria).



Net cash provided by operating activities for the nine-month period ended September 30, 2003 was $2.5 million, as compared to $8.3 million provided by
operating activities for the same period in 2002. The decrease in cash provided by operating activities is primarily due to increased purchases of inventories.



Inventories increased to $32.6 million as of September 30, 2003 from $22.7 million as of December 31, 2002. The increase in inventories was primarily
to support the introduction levels required to support sales volume increases and provide safety stock of sub-assemblies as we shift our manufacturing to our Costa Rica manufacturing facility.



Net cash used in investing activities for the nine-month period ended
September 30, 2003 was $0.1 million, compared to $6.2 million for the same period in 2002. The decrease in cash used in investing



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activities is primarily due to the sale of securities in 2003, partially offset by the acquisition of Atlantech, Austria, and purchases of property and
equipment and intangible assets.



Net property and equipment
increased to $21.1 million as of September 30, 2003 from $18.1 million as of December 31, 2002. The $3.0 million increase is primarily attributable to capital expenditures related to the capitalization of controllers placed under various promotional
programs along with an increase in expenditures for computer software and equipment.



On April 25, 2003, we acquired all of the outstanding shares of Atlantech Austria, a distributor of medical device products in Austria, in a cash acquisition of $0.6 million, net of cash acquired. In addition, the
former shareholders of Atlantech Austria have the right to receive an earn-out, to be paid in 2004, in the event Atlantech Austria achieves certain business goals and the former shareholders remain employed with Atlantech Austria.



Net cash used in financing activities for the nine-month period ended
September 30, 2003 was $9.5 million compared to $11.1 million for the same period in 2002. The decrease was primarily due to slightly lower purchases of stock in 2003 pursuant to our stock repurchase program, in addition to proceeds from issuances
of stock due to the exercise of options and our employee stock purchase program.



We believe that our cash flows from operations in addition to our current cash and cash equivalent balances will be adequate to meet our cash requirements for the reasonable 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 clearances/approvals and competition. If the MDA merger is consummated as expected in early 2004, our future cash requirements will be funded through
operational cash flows and the use of a bank credit facility.



Recent
Accounting Pronouncement



In January 2003, the FASB issued
FASB Interpretation No. 46, Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51. (FIN 46). FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the
entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from
other parties. As we had no variable interest entities, the adoption of FIN 46 will not have a material impact on our operating results or consolidated financial statements.



Additional Factors That Might Affect Future Results



We Are Dependent Upon Our Arthroscopic Surgery System



We commercially introduced our Arthroscopic Surgery System in December 1995. Our Arthroscopic System accounted for 77% of
our product sales in 2002, and we are highly dependent on its sales. During the past three years we began to market our spinal surgery, neurosurgery, ENT surgery, cosmetic surgery, and general surgery products. While sales of these products
collectively are growing, to date, they represent a small percentage of the total units we sold in 2002. We cannot assure you that we will be able to continue to manufacture arthroscopy products in commercial quantities at acceptable costs or that
we will be able to continue to market such products successfully.



To achieve increasing disposable device sales over time, we believe we must continue to penetrate the market in knee procedures, expand physicians education with respect to Coblation technology and continue working on new product
development efforts specifically for knee applications. Furthermore, in order to maintain and increase current market penetration we must be aggressive in increasing our installed base of



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controllers to generate increased disposable device revenue. To date, we have priced our arthroscopic controllers at substantial discounts in order to
stimulate demand for our disposable devices.



We believe that
surgeons will not use our products unless they determine, based on experience, clinical data and other factors, that these systems are an attractive alternative to conventional means of tissue ablation. There are only a few independently published
clinical reports and limited long-term clinical follow-up to support the marketing efforts for our Arthroscopic System. We believe that if recommendations and endorsements by influential surgeons do not continue or if long-term data does not support
our current claims of efficacy, our business, financial condition, results of operations and future growth prospects could be materially adversely affected.



Commercial Success of Our Non-Arthroscopic Products Is Uncertain



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



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



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



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



| |  | New products may experience delays in testing or marketing;
| | - | -----------------------------------------------------------



| |  | There may be unplanned expenditures or expenditures above those anticipated by us;
| | - | ----------------------------------------------------------------------------------



| |  | Such products may not be proven safe or effective;
| | - | --------------------------------------------------



| |  | Third parties may develop and market superior or equivalent products;
| | - | ---------------------------------------------------------------------



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



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



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



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recommendations and endorsement of influential physicians are essential for market acceptance of our products.



For information regarding the status of our regulatory approvals for our
products, see the information under the heading Government Regulation of our Annual Report on Form 10-K for the year-ended December 31, 2002.



We Have Limited Marketing and Sales Experience



We currently have limited experience in marketing and selling our products. To the extent that we have established or will enter into distribution
arrangements for the sale of our products, we are and will be dependent upon the efforts of third parties. We are marketing and selling our arthroscopic surgery, spinal surgery, neurosurgery, and ENT surgery product lines in the United States
through a network of independent distributors supported by regional sales managers and a direct sales force. These distributors sell arthroscopy, spinal surgery, neurosurgery, ENT surgery and cosmetic surgery for a number of other manufacturers. We
cannot assure you that these distributors will commit the necessary resources to effectively market and sell our arthroscopic surgery, coblation technology surgery, spinal surgery, neurosurgery, ENT surgery and cosmetic surgery product lines, or
that they will be successful in selling our products.



We have
recently established a marketing presence in various countries and we cannot assure you that these newly established operations will be successful. In order to successfully market our products internationally, we will need to address many issues
with which we have little or no experience, including securing necessary regulatory approvals in international markets and the potential reuse of our disposable devices by our customers. Even if we are able to successfully deal with these issues, we
cannot assure you that we will be able to establish successful distribution capabilities internationally or receive favorable pricing for our products. In addition, we may face currency exchange risks as part of our international expansion. To the
extent our marketing and sales efforts are unsuccessful, our business, financial condition, results of operations and future growth prospects may be materially adversely affected.



We Have Limited Manufacturing Experience



To be successful, we must manufacture our products in commercial quantities in compliance with regulatory requirements at acceptable costs. At the present
time, we have limited manufacturing experience. Our manufacturing operations consist of an in-house assembly operation for the manufacture of disposable devices and controllers. We currently produce more than 65 models of disposable devices
utilizing different functionalities, including suction and fluid management. As we increase the number of product designs for our disposable devices, the complexity of our manufacturing processes will increase. We manufacture several different
controller models. Although the manufacturing processes for the controllers designed to date are substantially the same, we cannot be certain that we will be able to continue to manufacture these controllers without additional expense and
capabilities. We could also encounter difficulties in manufacturing our current or future products which could reduce yields, result in supply disruptions and adversely affect our gross margins. If we have delays in manufacturing, we will not have
adequate finished inventory to meet our needs. If our quality assurance programs do not continue to meet the demands of the complexity and capacity of the products we manufacture, we may experience product returns.



We Are Dependent on Key Suppliers



We depend on two sole source suppliers for many of our product components,
including two components that we include in substantially all of our disposable devices. If the supply of materials from a sole source supplier were interrupted, replacement or alternative sources might not be readily obtainable due



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to the regulatory requirements applicable to our manufacturing operations. In addition, a new or supplemental filing with applicable regulatory authorities
may require clearance prior to our marketing a product containing new material. This clearance process may take a substantial period of time and we cannot assure you that we would be able to obtain the necessary regulatory approval for the new
material to be used in our products on a timely basis, if at all. This could create supply disruptions that would materially adversely affect our business, financial condition, results of operations and future growth prospects.



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



We Face Intense Competition



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



In arthroscopy, we compete against companies, such as Johnson & Johnson, Smith & Nephew, Inc., Conmed Corporation, Stryker Corp. and Arthrex,
which market products to remove or shrink tissue. Specifically, Johnson & Johnson, Smith & Nephew and Stryker are currently marketing worldwide bipolar electrosurgical systems for tissue ablation and shrinkage. We are also aware of
additional competitors that may commercialize products using technology similar to ours. In spinal surgery, we compete against companies which market products to remove tissue and treat spinal disorders. We compete against Stryker, which recently
purchased Pain Concepts, and their Dekompressor device which uses a mechanical auger to perform percutaneous discectomy. In addition, the Oratec division of Smith & Nephew and the Radionics division of Tyco are currently marketing percutaneous
thermal heating products for treating certain types of disc pain, and Stryker is marketing a new product for percutaneous removal of tissue in the disc to treat certain types of back and leg pain. Our Coblation-assisted microdiscectomy (CAM)
procedure competes indirectly with large spine companies and their mechanical instruments, such as DePuy Acromed, Medtronic Sofamor Danek, Centerpulse Spine Tech, Stryker Spine and Synthes. In ENT surgery, we compete against companies that offer
manual instruments, such as Smith & Nephew, Inc., Stryker Corp., Conmed Corporation and Xomed Surgical Products Inc., which was acquired by Medtronic, Inc. In addition, we compete with companies that develop and market lasers for various ENT
surgery applications, including Lumenis. In addition, we compete with companies that develop and market lasers for various ENT surgery applications, including Lumenis. Smaller companies, including Somnus Medical Technologies Inc., which was
purchased by Gyrus Group, a company based in Cardiff, Wales, also sell medical devices for the treatment of various ENT disorders, including snoring and obstructive sleep apnea. In cosmetic surgery, we compete against companies, such as Lumenis,
which market lasers for use in this field. In addition, other large companies manufacture and sell medical devices that use radio frequency energy for certain applications in dermatology and cosmetic surgery. In Coblation Technology, we face
competition from companies that sell general surgery and gynecology devices, including Ethicon ENDO, a division of Johnson and Johnson, Valleylab, a division of US Surgical, Gyrus, Olympus Medical Systems Group and several smaller companies that
sell mechanical, ultrasonic, monopolar and bipolar instruments. In urology, we face competition from companies that market monopolar, bipolar, mechanical, ultrasonic and laser devices for a variety of urological procedures, including Karl Storz,
Olympus Medical Systems Group, C.R. Bard, Gyrus, Medtronic, Urologix and Laserscope. In cardiology, we face competition from several large companies, including Edwards Lifescience, Medtronic, Guidant, Johnson & Johnson and St. Jude Medical, as
well as many smaller companies.



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



We Face Uncertainty Over Reimbursement



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



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



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



Our Business Depends on Attracting and Retaining Collaborators and Licensors



In order to successfully develop and commercialize certain products, we may enter into collaborative or licensing arrangements with medical device companies and other entities to fund and complete our research and
development activities, pre-clinical and clinical testing, manufacturing, regulatory approval activities and to achieve successful commercialization of future products. In addition, we have entered into distribution agreements with GyneCare and ACMI
to market and sell our gynecology and urology products, respectively. See the information under the heading Collaborative Arrangements of our Annual Report on Form 10-K for the year-ended December 31, 2002 for a discussion of these
arrangements.



Our participation in collaborative and licensing
arrangements with third parties subjects us to a number of risks. Collaborative partners typically have significant discretion in electing whether to pursue any of the



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planned activities. We cannot control the amount and timing of resources our collaborative partners may devote to our product, and we cannot assure you that
our partners will perform their obligations as expected. Business combinations or significant changes in a corporate partners business strategy may adversely affect that partners ability to meet its obligations in a timely manner, in
which case our business, financial condition, results of operations and prospects would be materially adversely affected. To the extent that we are not able to establish further collaborative arrangements or that any or all of our existing
collaborative arrangements are terminated, we would be required to seek new collaborative arrangements or to undertake commercialization at our own expense, which could significantly increase our capital requirements, place additional strain on our
human resource requirements and limit the number of products which we would be able to develop and commercialize. In addition, we cannot assure you that our existing and future collaborative partners will not pursue alternative technologies or
develop alternative products either on their own or in collaboration with others, including our competitors.



We cannot assure you that disputes will not arise in the future with respect to the ownership of rights to any technology of products developed with any
collaborative partner. Lengthy negotiations with potential new collaborative partners or disagreements between established collaborative partners and us could lead to delays in or termination of the research, development or commercialization of
certain products or result in litigation or arbitration that would be time consuming and expensive. Failure by any collaborative partner to commercialize successfully any product to which it has obtained rights from us, or the decision by a
collaborative partner to pursue alternative technologies or commercialize or develop alternative products, either on its own or in collaboration with others, could have a material adverse effect on our business, financial condition, results of
operations and future growth prospects.



Our Operating Results Will
Fluctuate



We achieved profitability in 1999 and, as of
September 30, 2003, we had retained earnings of $5.5 million. Results of operations may fluctuate significantly from quarter to quarter due to many factors, including the following:



| |  | The introduction of new product lines;
| | - | --------------------------------------



| |  | Increased penetration in existing applications;
| | - | -----------------------------------------------



| |  | Product returns;
| | - | ----------------



| |  | Achievement of research and development milestones;
| | - | ---------------------------------------------------



| |  | The amount and timing of receipt and recognition of license fees;
| | - | -----------------------------------------------------------------



| |  | Manufacturing or supply disruptions;
| | - | ------------------------------------



| |  | Timing of expenditures;
| | - | -----------------------



| |  | Absence of a backlog of orders;
| | - | -------------------------------



| |  | Receipt of necessary regulatory approvals;
| | - | ------------------------------------------



| |  | The level of market acceptance for our products;
| | - | ------------------------------------------------



| |  | Timing of the receipt of orders and product shipments; and
| | - | ----------------------------------------------------------



| |  | Promotional programs for our products.
| | - | --------------------------------------



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



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We May Be Unable to Effectively Protect Our Intellectual Property



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



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



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



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



We
May Become Subject to Patent Litigation



The medical device industry has
been characterized by extensive litigation regarding patents and other intellectual property rights, and companies in the medical device industry have employed intellectual property litigation to gain a competitive advantage. We cannot assure you
that we will not become subject to



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patent infringement claims or litigation or interference proceedings declared by the United States Patent and Trademark office, the USPTO, to determine the
priority of inventions. In February 1998, we filed a lawsuit against Ethicon, Inc., Mitek Surgical Products, a division of Ethicon, Inc., and GyneCare, Inc. alleging, among other things, infringement of several of our patents. The parties
subsequently settled this lawsuit. Under the terms of the settlement, Ethicon, Inc. has licensed a portion of our U.S. patents for current products in the arthroscopy and gynecology markets. The settlement agreement also established a procedure for
resolution of certain potential intellectual property disputes in these two markets without litigation. Under this procedure, the licenses granted in the Ethicon settlement have been extended to Australia, Canada and Japan. In June 1999, we filed a
lawsuit against Stryker alleging infringement of several of our patents. The parties settled this lawsuit within two weeks of its filing date. Under the terms of the settlement, Stryker has licensed a portion of our patents for products in the
arthroscopy market worldwide. In July 2000, we filed a lawsuit against Smith & Nephew, Inc. alleging infringement of several of our patents. A jury trial commenced on April 30, 2003. On May 12, 2003, the jury held that the use, manufacture and
sale of the Dyonics Control RF System, the Electroblade and the Saphirre RF electrosurgical devices infringed all 16 asserted claims of the three patents in suit. In addition, the jury upheld the validity of all 16 asserted claims. The court entered
this verdict in June 2003 and held a hearing on September 15, 2003 to consider our motion to enjoin Smith & Nephew from the use, manufacture and sale of these three products in the United States. Following this decision, the court will hold a
second trial to award damages to us for the infringing activity of Smith & Nephew. On April 3, 2003, Smith & Nephew filed a complaint against us in the United States District Court, Western District of Tennessee for patent infringement of
two patents and for violation of Section 43(a) of the Lanham Act. The complaint does not contain any specifics regarding the alleged infringement. Upon initial review, we believe this complaint is without merit, and we intend to defend ourselves
vigorously. We have filed a motion to dismiss the complaint and, in the event this motion is denied, a motion to transfer this litigation to the Northern District of California.



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



The Market
Price of Our Stock May Be Highly Volatile



During the 12
months ended September 30, 2003 our common stock has traded between a range of $8.82 and $20.95 per share. The market price of our common stock could continue to fluctuate substantially due to a variety of factors, including:



| |  | Quarterly fluctuations in results of our operations;
| | - | ----------------------------------------------------



| |  | Our ability to successfully commercialize our products;
| | - | -------------------------------------------------------



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



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



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



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



| |  | Changes in coverage or earnings estimates by analysts;
| | - | ------------------------------------------------------



| |  | Sales of common stock by existing stockholders; and
| | - | ---------------------------------------------------



| |  | Economic and political conditions.
| | - | ----------------------------------



The market price for our common stock may also be affected by our ability to meet analysts expectations. Any failure to meet such expectations, even
slightly, could have an adverse effect on the market price and volume fluctuations. This volatility has had a significant effect on the market prices of securities issued by many companies for reasons unrelated to the operating performance of these
companies. In the past, following periods of volatility in the market price of a companys securities, securities class action litigation has often been instituted against the company. If similar litigation were instituted against us, it could
result in substantial costs and a diversion of our managements attention and resources, which could have an adverse effect on our business, results of operations and financial condition. See Item 5: Market for Registrants Common
Equity and Related Stockholder Matters, of our Annual Report on Form 10-K for the year-ended December 31, 2002 for more information regarding fluctuations in the price of our common stock.



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



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



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



Our products are considered medical devices and are subject to extensive
regulation in the United States. We must obtain pre-market clearance or approval by the FDA for each of our products and indications before they can be commercialized. International sales of our products are also subject to strict regulatory
requirements. More information about the U.S. and foreign regulatory requirements and information pertaining to our products and indications before they can be commercialized can be found



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under the heading Government Regulations of our Annual Report on Form 10-K for the year-ended December 31, 2002.



|Item 3. |  | Quantitative and Qualitative Disclosures About Market Risk
|------- |  | ----------------------------------------------------------



Interest Rate Sensitivity



Our exposure to market risk for changes in interest rates relates primarily to our investment portfolio. 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 short-term investments. 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.



Foreign Currency Exchange Risk



Most of our revenue is realized in U.S. dollars and an increase in the value of the U.S. dollar relative to foreign currencies could make our products
less competitive in foreign markets.



The functional currency
of Atlantech Medical Devices, Ltd. is the UK Pound, Atlantech GmbH and Atlantech Austria is the Euro. Accordingly, all balance sheet accounts of this operation are translated into U.S. dollars using the current exchange rate in effect at the balance
sheet date, and revenues and expenses are translated using the average exchange rate in effect during the period. The gains and losses from foreign currency translation of Atlantechs financial statements are recorded directly into a separate
component of stockholders equity under the caption Accumulated Other Comprehensive Income.



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



|Item 4. |  | Controls and Procedures
|------- |  | -----------------------



We maintain disclosure controls and procedures (as defined in the Securities Exchange Act of 1934 Rules 13a-14(c) and 15d-14(c)) that are designed to
ensure that information required to be disclosed in our Exchange Act reports 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 our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure
controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily was required to
apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.



As required by SEC Rule 13a-15(b), we carried out an evaluation, under the supervision and with the participation of the Companys management,
including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the quarter covered by this report. Based on the foregoing, our Chief
Executive Officer and Chief



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Financial Officer concluded that our disclosure controls and procedures were effective at the reasonable assurance level.



There has been no change in our internal control over financial reporting
during our most recent fiscal quarter that has materially affected, or is reasonable likely to materially affect, our internal controls 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 6. |  | Exhibits and Reports on Form 8K
|------- |  | --------------------------------



|a) | Exhibits
|-- | --------



|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.
|---- | -------------------------------------------------------------------------------------------------------



|b) | Reports on Form 8-K
|-- | -------------------



On October 22, 2003, the Company filed a current report on Form 8-K containing a press release announcing its results of operations for the quarter ended
September 30, 2003.



On October 27, 2003, the Company filed a
current report on Form 8-K containing a press release announcing that the Company had entered into a definitive agreement to acquire Medical Device Alliance Inc.



On October 27, 2003, the Company filed a current report on Form 8-K containing a description of the merger and the merger
agreement with Medical Device Alliance Inc., and attaching as exhibits thereto the merger agreement, form of CVR agreement and certain other agreements executed in connection therewith.



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SIGNATURES



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



|                        |  |  |  | ARTHROCARE CORPORATION a Delaware corporation                                                 
|----------------------- |  |  |  | ----------------------------------------------------------------------------------------------
|                        |  | 
|Date: November 13, 2003 |  |  |  | /s/    MICHAEL A. BAKER                                                                       
|                        |  |  | 
|                        |  |  |  | Michael A. Baker President, Chief Executive Officer and Director (Principal Executive
Officer)



|                        |  |  |  |                                                                                                                            
|----------------------- |  |  |  | ---------------------------------------------------------------------------------------------------------------------------
|                        |  | 
|Date: November 13, 2003 |  |  |  | /s/    FERNANDO SANCHEZ                                                                                                    
|                        |  |  | 
|                        |  |  |  | Fernando Sanchez Senior Vice President, Operations and Chief Financial Officer (Principal
Financial and Accounting Officer)



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