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UNITED
STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



Form 10-Q



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



For the quarterly period ended March 31, 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 April 30, 2003 was 21,010,580.



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ARTHROCARE CORPORATION



INDEX



|               |  |                                                                                                                    |  | Page 
|-------------- |  | ------------------------------------------------------------------------------------------------------------------ |  | -----
|PART 1:        |  | FINANCIAL INFORMATION                                                                                              |  |      
|              
|Item 1.        |  | Financial Statements (unaudited)                                                                                   |  |      
|              
|               |  | Condensed Consolidated Balance Sheets as of March 31, 2003 and December 31, 2002                                   |  | 3    
|              
|               |  | Condensed Consolidated Statements of Operations for the three-month period ended March 31, 2003 and March 31, 2002 |  | 4    
|              
|               |  | Condensed Consolidated Statements of Cash Flows for the three-month period ended March 31, 2003 and March 31, 2002 |  | 5    
|              
|               |  | Notes to Condensed Consolidated Financial Statements                                                               |  | 6-12 
|              
|Item 2.        |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                              |  | 12-21
|              
|Item 3.        |  | Quantitative and Qualitative Disclosures About Market Risk                                                         |  | 21   
|              
|Item 4.        |  | Controls and Procedures                                                                                            |  | 21-22
|              
|PART II:       |  | OTHER INFORMATION                                                                                                  |  |      
|              
|Item 1.        |  | Legal Proceedings                                                                                                  |  | 22   
|              
|Item 6.        |  | Exhibits and Reports on Form 8-K                                                                                   |  | 22   
|              
|SIGNATURES     |  | 23                                                                                                                
|              
|CERTIFICATIONS |  | 24-25                                                                                                             



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PART
I.    FINANCIAL INFORMATION



Item
1.    Financial Statements



ARTHROCARE CORPORATION



CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands)



|                                                                          |  | March 31, 2003 |         |   | December 31, 2002 |  
|------------------------------------------------------------------------- |  | -------------- | ------- | - | ----------------- | -
|                                                                          |  | (Unaudited)    |         |   |                   |  
|ASSETS                                                                    |  |                |         |   |                   |  
|Current assets:                                                           |  |                |         |   |                   |  
|Cash and cash equivalents                                                 |  | $              | 19,064  |   |                   | $
|Available-for-sale securities                                             |  |                | 1,857   |   |                   |  
|Accounts receivable, net of allowances of $507 in 2003 and $1,073 in
2002 |  |                | 18,254  |   |                   |  
|Inventories                                                               |  |                | 24,894  |   |                   |  
|Prepaid expenses and other current assets                                 |  |                | 2,586   |   |                   |  
|                                                                          |  |                |         |   |                   |  
|Total current assets                                                      |  |                | 66,655  |   |                   |  
|                                                                         
|Available-for-sale securities                                             |  |                | 30,697  |   |                   |  
|Property and equipment, net                                               |  |                | 18,382  |   |                   |  
|Related party receivables                                                 |  |                | 1,205   |   |                   |  
|Intangible assets                                                         |  |                | 4,806   |   |                   |  
|Goodwill                                                                  |  |                | 10,082  |   |                   |  
|Other assets                                                              |  |                | 4,565   |   |                   |  
|                                                                          |  |                |         |   |                   |  
|Total assets                                                              |  | $              | 136,392 |   |                   | $
|                                                                          |  |                |         |   |                   |  
|LIABILITIES AND STOCKHOLDERS
EQUITY                                      |  |                |         |   |                   |  
|Current liabilities:                                                      |  |                |         |   |                   |  
|Accounts payable                                                          |  | $              | 8,566   |   |                   | $
|Accrued liabilities                                                       |  |                | 5,034   |   |                   |  
|Accrued compensation                                                      |  |                | 4,865   |   |                   |  
|Income taxes payable                                                      |  |                | 101     |   |                   |  
|                                                                          |  |                |         |   |                   |  
|Total current liabilities                                                 |  |                | 18,566  |   |                   |  
|                                                                         
|Loan payable                                                              |  |                | 46      |   |                   |  
|Deferred rent                                                             |  |                | 128     |   |                   |  
|                                                                          |  |                |         |   |                   |  
|Total liabilities                                                         |  |                | 18,740  |   |                   |  
|                                                                         
|Commitments and contingencies: (Note 8)                                   |  |                |         |   |                   |  
|                                                                         
|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: 21,183 shares in 2003 and 21,172 shares in 2002   |  |                | 21      |   |                   |  
|Treasury stock: 2,147 shares in 2003 and 1,978 shares in 2002             |  |                | (33,098 | ) |                   |  
|Additional paid-in capital                                                |  |                | 151,191 |   |                   |  
|Deferred stock-based compensation                                         |  |                | (1,119  | ) |                   |  
|Accumulated other comprehensive loss                                      |  |                | (770    | ) |                   |  
|Retained earnings                                                         |  |                | 1,427   |   |                   |  
|                                                                          |  |                |         |   |                   |  
|Total stockholders equity                                                |  |                | 117,652 |   |                   |  
|                                                                          |  |                |         |   |                   |  
|Total liabilities and stockholders equity                                |  | $              | 136,392 |   |                   | $
|                                                                          |  |                |         |   |                   |  



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



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ARTHROCARE CORPORATION



CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands except per share data)



|                                                      |  | Three Months Ended
|----------------------------------------------------- |  | ------------------
|                                                      |  | March 31, 2003    
|                                                      |  | (Unaudited)       
|Revenues:                                             |  |                   
|Product sales                                         |  | $                 
|Royalties, fees and other                             |  |                   
|                                                      |  |                   
|Total revenues                                        |  |                   
|Cost of product sales                                 |  |                   
|                                                      |  |                   
|Gross profit                                          |  |                   
|                                                      |  |                   
|Operating expenses:                                   |  |                   
|Research and development                              |  |                   
|Sales and marketing                                   |  |                   
|General and administrative                            |  |                   
|                                                      |  |                   
|Total operating expenses                              |  |                   
|                                                      |  |                   
|Income from operations                                |  |                   
|Interest and other income, net                        |  |                   
|                                                      |  |                   
|Income before income tax provision                    |  |                   
|Income tax provision                                  |  |                   
|                                                      |  |                   
|Net income                                            |  | $                 
|                                                      |  |                   
|Basic net income per share                            |  | $                 
|                                                      |  |                   
|Shares used in computing basic net income per share   |  |                   
|                                                      |  |                   
|Diluted net income per share                          |  | $                 
|                                                      |  |                   
|Shares used in computing diluted net income per share |  |                   
|                                                      |  |                   



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)



|                                                                                  |  | Three Months Ended |        
|--------------------------------------------------------------------------------- |  | ------------------ | -------
|                                                                                  |  | March 31, 2003     |        
|                                                                                  |  | (Unaudited)        |        
|Cash flows from operating activities:                                             |  |                    |        
|Net income                                                                        |  | $                  | 594    
|Adjustments to reconcile net income to net cash provided by operating
activities: |  |                    |        
|Depreciation and amortization                                                     |  |                    | 2,579  
|Amortization of deferred compensation and stock compensation expense              |  |                    | 327    
|Provision for doubtful accounts receivable and product returns                    |  |                    | 10     
|Provision for excess and obsolete inventory                                       |  |                    |       
|Deferred rent                                                                     |  |                    | 14     
|Changes in operating assets and liabilities:                                      |  |                    |        
|Accounts receivable                                                               |  |                    | 96     
|Inventories                                                                       |  |                    | (2,255 
|Prepaid expenses and other current assets                                         |  |                    | 494    
|Accounts payable                                                                  |  |                    | 481    
|Accrued liabilities                                                               |  |                    | 345    
|Income taxes payable                                                              |  |                    | 101    
|Other assets                                                                      |  |                    | (88    
|                                                                                  |  |                    |        
|Net cash provided by operating activities                                         |  |                    | 2,698  
|                                                                                  |  |                    |        
|Cash flows from investing activities:                                             |  |                    |        
|Purchases of property and equipment                                               |  |                    | (2,542 
|Purchases of available-for-sale securities                                        |  |                    | (30,697
|Sales or maturities of available-for-sale securities                              |  |                    | 10,516 
|                                                                                  |  |                    |        
|Net cash (used in) / provided by investing activities                             |  |                    | (22,723
|                                                                                  |  |                    |        
|Cash flows from financing activities:                                             |  |                    |        
|Purchase of treasury stock                                                        |  |                    | (1,994 
|Repayment on loan from bank                                                       |  |                    | (1     
|Proceeds from exercise of options to purchase common stock                        |  |                    | 348    
|                                                                                  |  |                    |        
|Net cash (used in) financing activities                                           |  |                    | (1,647 
|                                                                                  |  |                    |        
|Effect of exchange rate changes on cash                                           |  |                    | (17    
|                                                                                  |  |                    |        
|Net (decrease) / increase in cash and cash equivalents                            |  |                    | (21,689
|Cash and cash equivalents, beginning of period                                    |  |                    | 40,753 
|                                                                                  |  |                    |        
|Cash and cash equivalents, end of period                                          |  | $                  | 19,064 
|                                                                                  |  |                    |        



The
accompanying notes are an integral part of the 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:



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; 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 first quarter of 2002
began on December 30, 2001 and ended on March 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. Stock-based compensation expense is
recognized over the four-year vesting period. During the first quarter of 2003 and 2002 stock-based compensation expense, related to non-employee option grants, was $0.3 million and $0.1 million respectively and is included in Sales and Marketing
and Research and Development expense.



Assumptions used in determining the fair value of non-employee stock option grants, in the first quarter of 2003, using the Black-Scholes pricing model, were:



|Risk-free interest rate  |  | 2.92%
|------------------------ |  | -----
|Expected life (in years) |  | 5    
|Expected dividends       |  | 0.0  
|Expected volatility      |  | 70%  



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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)





Had
employee stock-based compensation been determined based on the fair value at the grant date the companys net income per share and fully diluted net income per share for the first quarter ended March 31, 2003 and 2002 would have been as
indicated below:



|                                                                                                             |  | Quarter Ended March 31,               |       
|------------------------------------------------------------------------------------------------------------ |  | ------------------------------------- | ------
|                                                                                                             |  | 2003                                  |       
|                                                                                                             |  | (in thousands, except per share data) |       
|Net incomeas reported                                                                                       |  | $                                     | 594   
|Employee stock-based compensation expense determined under the fair value method, net of
related tax effects |  |                                       | (3,114
|                                                                                                             |  |                                       |       
|Pro forma net loss                                                                                           |  | $                                     | (2,520
|                                                                                                             |  |                                       |       
|Net income (loss) per share:                                                                                 |  |                                       |       
|Basicas reported                                                                                            |  | $                                     | 0.03  
|Basicpro forma                                                                                              |  | $                                     | (0.12 
|Dilutedas reported                                                                                          |  | $                                     | 0.03  
|Dilutedpro forma                                                                                            |  | $                                     | (0.12 



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



|                        |  | Quarter Ended March 31,
|----------------------- |  | -----------------------
|                        |  | 2003                   
|Risk-free interest rate |  | 3.07%                  
|Expected life           |  | 5 years                
|Expected dividends      |  |                       
|Expected volatility     |  | 70%                    



Employee Stock Purchase Plan



|                        |  | Quarter Ended March 31,
|----------------------- |  | -----------------------
|                        |  | 2003                   
|Risk-free interest rate |  |                       
|Expected life           |  |                       
|Expected dividends      |  |                       
|Expected volatility     |  |                       



The
weighted average fair value of options granted to employees during the first quarter ended March 31, 2003 was $6.52 per share and during the first quarter ended March 31, 2002 was $8.62 per share.



4.    RECENT ACCOUNTING PRONOUNCEMENTS:



In November 2002, the Financial Accounting
Standards Board issued FASB Interpretation No. 45 (FIN 45), Guarantors Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others. FIN 45 requires that a liability be
recorded in the guarantors balance sheet upon issuance of a guarantee. In addition, FIN 45 requires disclosures about the guarantees that an entity has issued, including a reconciliation of changes in the entitys product warranty
liabilities. The initial recognition and initial measurement provisions of FIN 45 are applicable on a prospective basis to guarantees issued or modified after December 31, 2002, irrespective of the guarantors fiscal year-end. The disclosure
requirements of FIN 45 are effective for financial statements of interim or annual periods ending after December 15, 2002. The adoption of FIN 45 did not have a material impact on the Companys operating results or financial position.



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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)





In
November 2002, the Emerging Issues Task Force (EITF) reached a consensus on Issue No. 00-21, Revenue Arrangements with Multiple Deliverables. EITF Issue No. 00-21 provides guidance on how to account for arrangements that
involve the delivery or performance of multiple products, services and/or rights to use assets. The provisions of EITF Issue No. 00-21 will apply to revenue arrangements entered into in fiscal periods beginning after June 15, 2003. The company is in
the process of determining the financial effects, if any, on its consolidated financial statements.



In January 2003, the FASB issued FASB Interpretation No. 46 (FIN 46), Consolidation of Variable Interest Entities, an
Interpretation of ARB No. 51. 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. FIN 46 is effective immediately for all new variable interest entities created or
acquired after January 31, 2003. For variable interest entities created or acquired prior to February 1, 2003, the provisions of FIN 46 must be applied for the first interim or annual period beginning after June 15, 2003. The company is in the
process of determining the financial effects, if any, on its consolidated financial statements.



5.    COMPUTATION OF NET INCOME PER SHARE:



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



|                                                                     |  | March 31, 2003 |        | March 31, 2002
|-------------------------------------------------------------------- |  | -------------- | ------ | --------------
|Net income                                                           |  | $              | 594    |               
|                                                                     |  |                |        |               
|Basic:                                                               |  |                |        |               
|Weighted average common shares outstanding                           |  |                | 21,213 |               
|Less: weighted average restricted stock outstanding                  |  |                | 45     |               
|                                                                     |  |                |        |               
|Total                                                                |  |                | 21,168 |               
|                                                                     |  |                |        |               
|Net income per share                                                 |  | $              | 0.03   |               
|                                                                     |  |                |        |               
|Diluted:                                                             |  |                |        |               
|Weighted average common shares outstanding used in basic calculation |  |                | 21,168 |               
|Options                                                              |  |                | 520    |               
|Warrants                                                             |  |                | 28     |               
|Restricted shares                                                    |  |                | 20     |               
|                                                                     |  |                |        |               
|Total weighted common stock and common stock equivalents             |  |                | 21,736 |               
|                                                                     |  |                |        |               
|Net income per share                                                 |  | $              | 0.03   |               
|                                                                     |  |                |        |               
|Antidilutive securities:                                             |  |                |        |               
|Options to purchase common stock                                     |  |                | 6,445  |               
|                                                                     |  |                |        |               



Options
to purchase 6,445,000 shares of common stock at prices ranging from $9.56-$46.62 per share outstanding at March 31, 2003, were not included in the computation of diluted net income per share because their effects are anti-dilutive. Options to
purchase 3,137,000 shares of common stock at prices ranging from $13.75-$48.56 per share outstanding at March 31, 2002, were not included in the computation of diluted net income per share because their effects are anti-dilutive.



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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)





6.    COMPREHENSIVE INCOME:



Comprehensive income is comprised of net income and other comprehensive income consisting of foreign currency translation gain/loss and unrealized gains or losses on available-for-sale marketable securities. Our total
comprehensive income is as follows (in thousands):



|                                                                                                               |  | Three Months Ended |     
|-------------------------------------------------------------------------------------------------------------- |  | ------------------ | ----
|                                                                                                               |  | March 31, 2003     |     
|Net income                                                                                                     |  | $                  | 594 
|                                                                                                              
|Unrealized gains (loses) on available-for-sale securities arising during the period, net
of tax                |  |                    | 464 
|Less: reclassification adjustment for gains on available-for-sale securities, net of
tax, included in earnings |  |                    | (189
|Foreign currency translation adjustment                                                                        |  |                    | (61 
|                                                                                                               |  |                    |     
|Comprehensive net income                                                                                       |  | $                  | 808 
|                                                                                                               |  |                    |     



7.    INVENTORIES (in thousands):



|                 |  | March 31, 2003 |        | December 31, 2002
|---------------- |  | -------------- | ------ | -----------------
|Inventories:     |  |                |        |                  
|Raw materials    |  | $              | 7,340  |                  
|Work-in-progress |  |                | 6,084  |                  
|Finished goods   |  |                | 11,470 |                  
|                 |  |                |        |                  
|Total            |  | $              | 24,894 |                  
|                 |  |                |        |                  



8.    COMMITMENTS AND CONTINGENCIES:



Operating Leases



We lease our facilities and certain equipment under operating leases. The company recognizes rent expense on a straight-line basis over the lease term. At March 31, 2003, total future minimum lease payments are as follows
(in thousands):



|2003 (9 months) |  | $ | 1,208
|--------------- |  | - | -----
|2004            |  |   | 1,624
|2005            |  |   | 1,548
|2006            |  |   | 1,568
|2007            |  |   | 262  
|Thereafter      |  |   |     
|                |  |   |      
|Total           |  | $ | 6,210
|                |  |   |      



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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)





Warranties



The company
generally provides customers with a limited 90-day warranty on products sold and a limited 1-year warranty on loaned 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 periodically evaluate and adjust the warranty reserve to the extent actual warranty expense varies form the original
estimates. The following table describes the activity in our warranty accrual for the quarter ended March 31, 2003 (in thousands):



|Balance at beginning of year                     |  | $ | 243  |  
|------------------------------------------------ |  | - | ---- | -
|Accruals for warranties issued during the period |  |   | 126  |  
|Settlements made during the period               |  |   | (126 | )
|                                                 |  |   |      |  
|Balance at end of the first quarter              |  | $ | 243  |  
|                                                 |  |   |      |  



Litigation



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



On July 25, 2001, ArthroCare 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 ArthroCare specifically, the Defendants use, import, market and sell electrosurgical devices under the names Saphyre, ElectroBlade and Dyonics Control RF System that
infringe these patents. ArthroCare seeks 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 Electroblade and the Saphirre RF electrosurgical devices; and (3) an award of damages (including attorneys fees) to compensate us for lost profits and Defendants use of our inventions, with the damages to be trebled because
of the Defendants willful infringement. On May 12, 2003, a jury found that Smith & Nephews products (Saphyre, ElectroBlade and Control RF) infringe the 16 asserted claims of US Patent Nos. 5,697,882, 5,697,536 and 6,224,592. The jury
also upheld the validity of all asserted claims of these patents. ArthroCare is now seeking a permanent injunction and an award for damages.



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. The complaint does not contain any specifics regarding the alleged infringement. Upon initial review, we believe this complaint is without merit,
and we will defend ourselves vigorously.



In
conjunction with a medical malpractice suit against a physician, a product liability suit was brought against us in the Superior Court Arizona, County of Yavapai on August 24, 2001. The parties have reached an amicable resolution and the matter has
been dismissed.



In April 2002, a product
liability suit was brought against us in the United States District Court, District of Maine. The lawsuit includes a claim for punitive damages. Punitive damages, if awarded, are not covered by our insurance policies, and we would be required to pay
such punitive damages that were awarded. This lawsuit is pending and a jury trial is scheduled to commence on June 23, 2003. ArthroCare believes these claims to be without merit and is defending itself vigorously.



In September 2002, a product liability suit was brought
against us in the 269th Judicial District Court, Harris County, Texas. ArthroCare believes these claims to be without merit and intends to defend itself 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, ArthroCare has product liability insurance coverage in amounts its considers 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.



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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)





9.    SEGMENT INFORMATION:



We have organized our marketing and sales efforts into business units based on product markets. These business units 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). Our reportable segments include
Arthroscopy, ENT, ArthroCare Spine and Coblation Technology.



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



|                     |  | Three Months Ended |       
|-------------------- |  | ------------------ | ------
|                     |  | March 31, 2003     |       
|Product sales:       |  |                    |       
|Arthroscopy          |  | $                  | 20,426
|ENT                  |  |                    | 3,034 
|ArthroCare Spine     |  |                    | 2,636 
|Coblation Technology |  |                    | 353   
|                     |  |                    |       
|Total                |  | $                  | 26,449
|                     |  |                    |       



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 Ended
|---------------------------- |  | ------------------
|                             |  | March 31, 2003    
|Product sales:               |  |                   
|United States                |  | $                 
|International                |  |                   
|                             |  |                   
|Total product sales          |  | $                 
|                             |  |                   
|                            
|Balance as of:               |  |                   
|                             |  | March 31, 2003    
|Property and equipment:      |  |                   
|United States                |  | $                 
|International                |  |                   
|                             |  |                   
|Total property and equipment |  | $                 
|                             |  |                   



10.    STOCKHOLDERS EQUITY:



Restricted Stock.    In the first quarter of 2003, we granted employees 127,300 shares of restricted common stock under the 1993 Incentive Stock Option Plan. The Company
recorded $1.1 million of deferred compensation, which is being amortized to other compensation expense over 5 years. The total amortization recorded in the first quarter of 2003 was approximately $19,000.



Treasury Stock.    In April 2001,
the Board of Directors authorized the repurchase of up to 1,000,000 shares of 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. In the first quarter of of 2003, we repurchased 169,000 shares at a cost of $2.0 million. In the first quarter of 2002 we repurchased 49,000 shares at a cost of $0.7 million.



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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)





11.    SUBSEQUENT EVENTS:



On April 25, 2003, the company acquired all of the outstanding shares of Atlantech Austria, a distributor of medical device products in Austria, in a cash acquisition of $0.4 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.



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.



We have organized our marketing and sales efforts into business units based on product markets. These business units 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 Technology (to include gynecology, urology, laparoscopic, general surgical and
cardiology products).



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



We commercially introduced our Arthroscopic Surgery System in December 1995 and have derived a significant portion of our sales from this
system. Our Spine and ENT businesses are growing and represent an increasingly larger portion of our total business. As of March 31, 2003 we have shipped more than 16,900 controllers and over 2,130,000 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 Spine products are sold through a network of 30
independent distributors and a direct sales force of 14 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 U.K. and Germany consisting of 15 people. Our ENT business also has a direct selling organization in the U.K. and Germany of 6 people.
Our Spine business unit is sold through a network of independent distributors 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 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
tonsillectomy procedures. Also during the first quarter of 2003, our Spine business unit introduced a new procedure for performing a less-invasive microdiscectomy using our Coblation technology.



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Results of Operations



Revenues



Total revenues were $27.2 million for the first quarter ended
March 31, 2003, an increase of 35% from the $20.1 million in the first quarter of 2002. In the first quarter of 2003, total revenues included $2.7 million of non-arthroscopy product due to Atlantech Medical Devices, Ltd. and Atlantech GmbH
(collectively referred to as Atlantech), which we acquired in the fourth quarter of fiscal 2002. Product sales for first quarter of 2003 were $26.4 million, an increase of 37% from $19.3 million in the same period of the prior year. All
commercial business units posted sales increases in the first quarter of 2003. The companys Arthroscopy business unit contributed $20.4 million in net product sales in the first quarter of 2003, including $2.7 million of Atlantech sales of
non-arthroscopy product, as compared to $15.3 million in the first quarter of 2002. The companys ENT business unit contributed $3.0 million in net product sales in the first quarter of 2003 as compared to $2.2 million in the first quarter of
2002. The companys spinal surgery (ArthroCare Spine) business unit contributed $2.6 million in net product sales in the first quarter of 2003 as compared to $1.9 million in the first quarter of 2002. The companys Coblation Technology
business unit contributed $0.4 million in net product sales in the first quarter of 2003 as compared to a loss of $0.1 million in the first quarter of 2002. International sales grew by $1.1 million, or 21%, during the first quarter of 2003 as
compared to the fourth quarter of 2002 and grew by $3.2 million, or 95%, compared to the first quarter of 2002.



The increase in direct sales presence, which began in 2001, continued to have a positive effect on sales in the first 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 97.8% of product sales, excluding Atlantech product sales, for the first quarter of 2003 and comprised approximately
97.9% of first 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 $6.5 million, or 25% of total product sales, in the first quarter of 2003 as
compared to $3.3 million, or 17% of total product sales, in the first quarter of 2002. The $3.2 million increase is primarily attributable to the acquisition of Atlantech, with Atlantech non-arthroscopy product sales in the first quarter of 2003 of
$2.7 million.



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.



Royalties, fees, and other revenues were $0.8 million for the first quarters of both 2003 and 2002.



Cost of Product Sales



The increase in gross product margin as a percentage of product sales to 68% in the first quarter of 2003 from 61% in the first quarter of
2002 is mainly attributable to increased average selling prices of disposable devices, increased manufacturing efficiency and increased production volume, which was partially offset by the increased controller placement costs and the lower gross
margin on Atlantech sales. As planned, the companys new Costa Rica facility continued shipping sub-assemblies to the Sunnyvale facility in the first quarter of 2003 and is expected to contribute to gross margin improvements in the future.



Operating Expenses



Research and development expense was $2.6 million in the
first quarter of 2003, or 10% of product sales, compared to $2.2 million in the first quarter of 2002, or 11% of product sales. 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
expense was $11.5 million, or 44% of product sales, for the three months ending March 31, 2003, as compared to $8.4 million, or 43% of product sales, for the same period of the prior fiscal year. In the first quarter of 2003, sales and marketing
expense included $0.9 million due to Atlantech. Commission expenses were $1.1 million greater in the first quarter of 2003 compared to the first quarter of 2002 as a result of increased sales. Other compensation and related expense was $0.8 million



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higher in the first quarter of 2003 compared to the same fiscal period of the prior year due to increased investment in sales, marketing and
support staff. Stock-based compensation increased in the first quarter of 2003 by $0.3 million. 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, ear, nose and throat 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 (TURP).



General and administrative expense increased to $3.9 million, or 15% of product sales, in the first quarter of 2003, from $1.9 million, or 10% of product sales, in same period of the previous year. In the first quarter of 2003,
general and administrative expense included $0.4 million due to Atlantech. The remaining $1.6 million increase in the first quarter of 2003 general and administrative expenses was primarily due to a $1.5 million increase in the cost of general and
patent-related legal services. We expect that general and administrative expenses will decrease as a percentage of product sales but will increase in absolute dollar amounts as we incur additional legal expenses and continue business development
activities.



Interest and Other Income, Net



Interest and other income, net, decreased
to $0.3 million in the three months ended March 31, 2003 from $0.5 million in the same period of the previous year. The $0.2 million decrease in interest and other income in the first quarter of 2003 was primarily due to a $0.4 million decrease in
interest income as a result of a decrease in the amount of cash and investment balance resulting from our investing and financing activities and declining interest rates since the first quarter of 2002.



At the end of the first quarter of 2003, we had $51.6 million
in cash, cash equivalents, and available-for-sale securities as compared to $52.9 million at December 31, 2002.



Liquidity and Capital Resources



At the end of the first quarter of 2003, we had $48.1 million in working capital compared to $72.9 million at the end of fiscal 2002. Our principal sources of liquidity consisted of $51.6 million in
cash, cash equivalents, and short-term and long-term available-for-sale securities at March 31, 2003 as compared to $77.1 million at March 31, 2002 and $52.9 million at December 31, 2002. The cash equivalents are highly liquid with original
maturities of ninety days or less.



We generated
positive cash flows from operations during the first three months of fiscal 2003. Cash generated by operating activities was $2.7 million for the first quarter of 2003, which was mainly attributable to net income before depreciation and amortization
of $3.5 million.



Accounts receivable, net of
allowances, decreased to $18.3 million at the end of the first quarter of 2003 from $18.4 million at the end of fiscal 2002. The decrease in accounts receivable in the first three months of 2003 was due to significant increase in sales that was
offset by an improvement in the collection times.



Inventories increased to $24.9 million at the end of the first three months of 2003 compared to $22.7 million at the end of fiscal 2002. The increase in inventory was in order to support anticipated increasing product sales activity,
safety stock for our move of the manufacturing operations into our facility in Costa Rica and the introduction levels required to grow and support sales volume increases. We expect future inventory levels to increase in absolute dollar value in
order to support sales volume increases, to provide safety stock and support our expansion into additional markets.



Cash used in investing activities was $22.7 million for the first quarter of 2003, compared to $1.8 million provided in the same period of
the prior year. Net cash used in investing activities in the quarter ended March 31, 2003 included net purchases of available-for-sale securities of $20.2 million and $2.5 million for purchases of property and equipment.



Cash used in financing activities was $1.6 million for the
first quarter of 2003, compared to cash used of $0.5 million in the same period of 2002. The increased use of cash of $1.1 million was primarily due to the purchase of $2.0 million of treasury stock, which was partial offset by the proceeds from the
exercise of common stock options.



We anticipate
that existing sources of liquidity and cash flows from operations will be sufficient to satisfy our cash needs for the foreseeable future. However, risk factors mentioned below and included in our December 31, 2002 Form 10-K filed with the SEC could
adversely effect our cash position.



On April 25,
2003, the Company acquired all of the outstanding shares of Atlantech Austria, a distributor of medical device products in Austria, in a cash acquisition of $0.4 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.



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Recent Accounting
Pronouncements



In November 2002, the
Financial Accounting Standards Board issued FASB Interpretation No. 45 (FIN 45), Guarantors Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others. FIN 45 requires
that a liability be recorded in the guarantors balance sheet upon issuance of a guarantee. In addition, FIN 45 requires disclosures about the guarantees that an entity has issued, including a reconciliation of changes in the entitys
product warranty liabilities. The initial recognition and initial measurement provisions of FIN 45 are applicable on a prospective basis to guarantees issued or modified after December 31, 2002, irrespective of the guarantors fiscal year-end.
The disclosure requirements of FIN 45 are effective for financial statements of interim or annual periods ending after December 15, 2002. The adoption of FIN 45 did not have a material impact on the Companys operating results or financial
position.



In November 2002, the Emerging Issues
Task Force (EITF) reached a consensus on Issue No. 00-21, Revenue Arrangements with Multiple Deliverables. EITF Issue No. 00-21 provides guidance on how to account for arrangements that involve the delivery or performance of
multiple products, services and/or rights to use assets. The provisions of EITF Issue No. 00-21 will apply to revenue arrangements entered into in fiscal periods beginning after June 15, 2003. The company is in the process of determining the
financial effects, if any, on its consolidated financial statements.



In December 2002, the FASB issued Statement of Financial Accounting Standards No. 148 (SFAS No. 148), Accounting for Stock-Based Compensation, Transition and Disclosure. SFAS No. 148 provides
alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. SFAS No. 148 also requires that disclosures of the pro forma effect of using the fair value method of
accounting for stock-based employee compensation be displayed more prominently and in a tabular format. Additionally, SFAS No. 148 requires disclosure of the pro forma effect in interim financial statements. The transition and annual disclosure
requirements of SFAS No. 148 are effective for fiscal years ended after December 15, 2002. The interim disclosure requirements are effective for interim periods ending after December 15, 2002. The company has complied with the disclosure
requirements of SFAS No. 148.



In January 2003,
the FASB issued FASB Interpretation No. 46 (FIN 46), Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51. 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. FIN 46 is effective immediately for all new variable interest entities created or acquired after January 31, 2003. For variable interest entities created or acquired prior to February 1, 2003, the provisions of
FIN 46 must be applied for the first interim or annual period beginning after June 15, 2003. The company is in the process of determining the financial effects, if any, on its 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 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 continued recommendations and endorsements by influential surgeons or 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



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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 o a timely basis, if at all, or that the products will ever achieve
commercial acceptance.



We may have to make a
significant investment in additional preclinical and clinical testing, regulatory, physician training and sales and marketing activities to further develop and commercialize our 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
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, and 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 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



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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 of 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 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. (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.



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,



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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 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, 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 March 31, 2003, we had retained earnings of $1.4 million. Results of operations may fluctuate significantly from quarter to quarter due to many factors, including the following:



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



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



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| |  |  | 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.



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.



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We May Become Subject to
Patent Litigation



The medical device
industry has been characterized by extensive litigation regarding patents and other intellectual property rights, and companies in the medical device industry have employed intellectual property litigation to gain a competitive advantage. We cannot
assure you that we will not become subject to patent infringement claims or litigation or interference proceedings declared by the United States Patent and Trademark office, the USPTO, to determine the priority of inventions. In February 1998, we
filed a lawsuit against Ethicon, Inc., Mitek Surgical Products, a division of Ethicon, Inc., and GyneCare, Inc. alleging, among other things, infringement of several of our patents. The parties subsequently settled this lawsuit. Under the terms of
the settlement, Ethicon, Inc. has licensed a portion of our U.S. patents for current products in the arthroscopy and 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 July 2000, we filed a lawsuit against Smith & Nephew alleging
infringement of several of our patents. This lawsuit is pending and a jury trial is scheduled to commence on April 30 2003. 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. The complaint does not contain any specifics regarding the alleged infringement. Upon initial review, we believe this complaint is
without merit, and we will defend ourselves vigorously.



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 March 31, 2003 our common stock
has traded between a range of $8.82 and $18.01 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;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | 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.



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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



United States



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



Information pertaining to our products and indications before they can be commercialized can be found under the heading Government
Regulations 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. and Atlantech GmbH (together Atlantech) is the UK Pound and the Euro respectively. 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 Securities Exchange Act 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.



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Within 90 days
of the filing date of this report, 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. Based on the foregoing, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective.



There have been no significant changes in our internal
controls or in other factors that could significantly affect the internal controls subsequent to the date we completed our evaluation. There were no significant deficiencies or material weaknesses, and therefore no corrective actions were taken.



PART II.    OTHER INFORMATION



Item 1.    Legal Proceedings



Information with respect to this item is incorporated into this Part II, Item 1 by reference to the section entitled Commitments and Contingencies in Note 8 of the Condensed Consolidated
Financial Statements contained in Part I above.



Item 6.    Exhibits and Reports on Form 8-K



a)  Exhibits



|10.33* |  | Amended and Restated Nonstatutory Option Plan (Incorporated herein by reference to Exhibit 4.5 to the Registrants
Registration Statement on Form S-8 file on May 8, 2003.
|------ |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------

---

|* |  | Management contract or compensatory plan or arrangement.
|- |  | --------------------------------------------------------



b)  Reports on Form 8-K



On April 24, 2003, the Company filed a current report on Form 8-K under Item 12 with respect to a press release announcing our results of
operations for the quarter ended March 31, 2003.



On April 28, 2003, the Company filed a current report on Form 8-K under item 12 with respect to a press release summarizing the Companys stock repurchase program.



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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: |  | May 14,
2003 |  |                                              
|     
|Date: |  | May 14,
2003 |  |                                              



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CERTIFICATION OF CHIEF EXECUTIVE OFFICER

PURSUANT TO

18 U.S.C. SECTION 1350

AS ADOPTED PURSUANT TO

SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002



I, Michael A. Baker, certify that:



| | 1. |  | I have reviewed this quarterly report on Form 10-Q of ArthroCare Corporation;
| | -- |  | -----------------------------------------------------------------------------



| | 2. |  | Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the
statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;
| | -- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | 3. |  | Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the
financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;
| | -- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | 4. |  | The registrants other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act
Rules 13a-14 and 15d-14) for the registrant and we have:
| | -- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | a. |  | designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made
known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;
| | -- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | b. |  | evaluated the effectiveness of the registrants disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report
(the Evaluation Date); and
| | -- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | c. |  | presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation
Date;
| | -- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | 5. |  | The registrants other certifying officers and I have disclosed, based on our most recent evaluation, to the registrants auditors and the
registrants audit committee of the registrants board of directors (or persons performing the equivalent function):
| | -- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | a. |  | all significant deficiencies in the design or operation of internal controls which could adversely affect ArthroCare Corporations ability to record, process,
summarize and report financial data and have identified for the registrants auditors any material weaknesses in internal controls; and
| | -- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | b. |  | any fraud, whether or not material, that involves management or other employees who have a significant role in the registrants internal controls; and
| | -- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------



| | 6. |  | The registrants other certifying officers and I have indicated in the quarterly report whether or not there were significant changes in internal controls or in
other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
| | -- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|     
|-----
|Date:



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CERTIFICATION
OF CHIEF FINANCIAL OFFICER

PURSUANT TO

18 U.S.C. SECTION 1350

AS ADOPTED PURSUANT TO

SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002



I, Fernando Sanchez, certify that:



| | 1. |  | I have reviewed this quarterly report on Form 10-Q of ArthroCare Corporation;
| | -- |  | -----------------------------------------------------------------------------



| | 2. |  | Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the
statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;
| | -- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | 3. |  | Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the
financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;
| | -- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | 4. |  | The registrants other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act
Rules 13a-14 and 15d-14) for the registrant and we have:
| | -- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | a. |  | designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made
known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;
| | -- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | b. |  | evaluated the effectiveness of the registrants disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report
(the Evaluation Date); and
| | -- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | c. |  | presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation
Date;
| | -- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | 5. |  | The registrants other certifying officers and I have disclosed, based on our most recent evaluation, to the registrants auditors and the
registrants audit committee of the registrants board of directors (or persons performing the equivalent function):
| | -- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | d. |  | all significant deficiencies in the design or operation of internal controls which could adversely affect ArthroCare Corporations ability to record, process,
summarize and report financial data and have identified for the registrants auditors any material weaknesses in internal controls; and
| | -- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | e. |  | any fraud, whether or not material, that involves management or other employees who have a significant role in the registrants internal controls; and
| | -- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------



| | 6. |  | The registrants other certifying officers and I have indicated in the quarterly report whether or not there were significant changes in internal controls or in
other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
| | -- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|     
|-----
|Date:



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