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UNITED STATES

SECURITIES AND
EXCHANGE COMMISSION

Washington, D.C. 20549





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Form 10-Q





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



For the quarterly
period ended June 30, 2003.





OR





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





For the transition period from              to





Commission File Number: 0-27422





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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 July 31, 2003 was 20,645,429.





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##### Table of Contents

ARTHROCARE CORPORATION



INDEX



|         |  |                                                                                                              |  | Page
|-------- |  | ------------------------------------------------------------------------------------------------------------ |  | ----
|PART 1:  |  | Financial Information                                                                                        |  |     
|Item 1.  |  | Financial Statements (unaudited)                                                                             |  |     
|         |  | Condensed Consolidated Balance Sheets as of June 30, 2003 and December 31, 2002                              |  | 3   
|         |  | Condensed Consolidated Statements of Income for the three and six-month periods ended June 30, 2003 and 2002 |  | 4   
|         |  | Condensed Consolidated Statements of Cash Flows for the six-month periods ended June 30, 2003 and 2002       |  | 5   
|         |  | Notes to Condensed Consolidated Financial Statements                                                         |  | 6   
|Item 2.  |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                        |  | 13  
|Item 3.  |  | Quantitative and Qualitative Disclosures About Market Risk                                                   |  | 27  
|Item 4.  |  | Controls and Procedures                                                                                      |  | 27  
|         |  |                                                                                                             
|PART II: |  | Other Information                                                                                            |  |     
|Item 1.  |  | Legal Proceedings                                                                                            |  | 28  
|Item 4.  |  | Submission of Matters to a Vote of Security Holders                                                          |  | 28  
|Item 6.  |  | Exhibits and Reports on Form 8-K                                                                             |  | 29  
|         |  | Signatures                                                                                                   |  | 30  



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

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



ARTHROCARE CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands)



|                                                                          |  | June 30, 2003 |         |   | December 31, 2002 |  
|------------------------------------------------------------------------- |  | ------------- | ------- | - | ----------------- | -
|ASSETS                                                                    |  | (Unaudited)   |         |   |                   |  
|Current assets:                                                           |  |               |         |   |                   |  
|Cash and cash equivalents                                                 |  | $             | 36,499  |   |                   | $
|Available-for-sale securities                                             |  |               |        |   |                   |  
|Accounts receivable, net of allowances of $370 in 2003 and $1,073 in 2002 |  |               | 19,126  |   |                   |  
|Inventories                                                               |  |               | 28,853  |   |                   |  
|Prepaid expenses and other current assets                                 |  |               | 3,767   |   |                   |  
|                                                                          |  |               |         |   |                   |  
|Total current assets                                                      |  |               | 88,245  |   |                   |  
|Available-for-sale securities                                             |  |               |        |   |                   |  
|Property and equipment, net                                               |  |               | 19,683  |   |                   |  
|Related party receivables                                                 |  |               | 1,205   |   |                   |  
|Intangible assets                                                         |  |               | 6,610   |   |                   |  
|Goodwill                                                                  |  |               | 9,996   |   |                   |  
|Other assets                                                              |  |               | 4,461   |   |                   |  
|                                                                          |  |               |         |   |                   |  
|Total assets                                                              |  | $             | 130,200 |   |                   | $
|                                                                          |  |               |         |   |                   |  
|LIABILITIES AND STOCKHOLDERS EQUITY                                      |  |               |         |   |                   |  
|Current liabilities:                                                      |  |               |         |   |                   |  
|Accounts payable                                                          |  | $             | 9,925   |   |                   | $
|Accrued liabilities                                                       |  |               | 3,178   |   |                   |  
|Accrued compensation                                                      |  |               | 4,670   |   |                   |  
|Income taxes payable                                                      |  |               | 1,114   |   |                   |  
|                                                                          |  |               |         |   |                   |  
|Total current liabilities                                                 |  |               | 18,887  |   |                   |  
|Loan payable                                                              |  |               | 52      |   |                   |  
|Deferred rent                                                             |  |               | 142     |   |                   |  
|                                                                          |  |               |         |   |                   |  
|Total liabilities                                                         |  |               | 19,081  |   |                   |  
|                                                                          |  |               |         |   |                   |  
|Commitments and contingencies: (Note 8)                                   |  |               |         |   |                   |  
|Stockholders equity:                                                     |  |               |         |   |                   |  
|Preferred stock, par value $ 0.001:                                       |  |               |         |   |                   |  
|Authorized: 5,000 shares                                                  |  |               |         |   |                   |  
|Issued and outstanding: none                                              |  |               |        |   |                   |  
|Common stock, par value $ 0.001:                                          |  |               |         |   |                   |  
|Authorized 75,000 shares:                                                 |  |               |         |   |                   |  
|Issued and outstanding: 20,738 shares in 2003, and 21,172 shares in 2002  |  |               | 21      |   |                   |  
|Treasury stock: 2,704 shares in 2003, 1,978 shares in 2002                |  |               | (42,159 | ) |                   |  
|Additional paid-in capital                                                |  |               | 151,828 |   |                   |  
|Deferred stock-based compensation                                         |  |               | (1,062  | ) |                   |  
|Accumulated other comprehensive loss                                      |  |               | (898    | ) |                   |  
|Retained earnings                                                         |  |               | 3,389   |   |                   |  
|                                                                          |  |               |         |   |                   |  
|Total stockholders equity                                                |  |               | 111,119 |   |                   |  
|                                                                          |  |               |         |   |                   |  
|Total liabilities and stockholders equity                                |  | $             | 130,200 |   |                   | $
|                                                                          |  |               |         |   |                   |  



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



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ARTHROCARE CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(In thousands, except per share data)



|                                                      |  | Three Months EndedJune 30, |        | Six Months EndedJune 30,
|----------------------------------------------------- |  | -------------------------- | ------ | ------------------------
|                                                      |  | 2003                       |        | 2002                    
|                                                      |  | (Unaudited)               
|Revenues:                                             |  |                            |        |                         
|Product sales                                         |  | $                          | 28,401 |                         
|Royalties, fees and other                             |  |                            | 1,300  |                         
|                                                      |  |                            |        |                         
|Total revenues                                        |  |                            | 29,701 |                         
|Cost of product sales                                 |  |                            | 8,661  |                         
|                                                      |  |                            |        |                         
|Gross profit                                          |  |                            | 21,040 |                         
|                                                      |  |                            |        |                         
|Operating expenses:                                   |  |                            |        |                         
|Research and development                              |  |                            | 2,607  |                         
|Sales and marketing                                   |  |                            | 11,519 |                         
|General and administrative                            |  |                            | 4,781  |                         
|                                                      |  |                            |        |                         
|Total operating expenses                              |  |                            | 18,907 |                         
|                                                      |  |                            |        |                         
|Income from operations                                |  |                            | 2,133  |                         
|Interest and other income, net                        |  |                            | 697    |                         
|                                                      |  |                            |        |                         
|Income before income tax provision                    |  |                            | 2,830  |                         
|Income tax provision                                  |  |                            | 868    |                         
|                                                      |  |                            |        |                         
|Net income                                            |  | $                          | 1,962  |                         
|                                                      |  |                            |        |                         
|Basic net income per share                            |  | $                          | 0.09   |                         
|                                                      |  |                            |        |                         
|Shares used in computing basic net income per share   |  |                            | 20,911 |                         
|                                                      |  |                            |        |                         
|Diluted net income per share                          |  | $                          | 0.09   |                         
|                                                      |  |                            |        |                         
|Shares used in computing diluted net income per share |  |                            | 21,858 |                         
|                                                      |  |                            |        |                         



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)



|                                                                                  |  | Six Months Ended |        
|--------------------------------------------------------------------------------- |  | ---------------- | -------
|                                                                                  |  | June 30, 2003    |        
|                                                                                  |  | (Unaudited)      |        
|Cash flows from operating activities:                                             |  |                  |        
|Net income                                                                        |  | $                | 2,556  
|Adjustments to reconcile net income to net cash provided by operating activities: |  |                  |        
|Depreciation and amortization                                                     |  |                  | 4,987  
|Loss on disposition of equipment                                                  |  |                  | 4      
|Stock compensation expense                                                        |  |                  | 267    
|Provision for doubtful accounts receivable and product returns                    |  |                  |       
|Provision for excess and obsolete inventory                                       |  |                  | 173    
|Deferred rent                                                                     |  |                  | 28     
|Changes in operating assets and liabilities:                                      |  |                  |        
|Accounts receivable                                                               |  |                  | (541   
|Inventories                                                                       |  |                  | (5,879 
|Prepaid expenses and other current assets                                         |  |                  | (664   
|Accounts payable                                                                  |  |                  | 1,761  
|Accrued liabilities                                                               |  |                  | (2,382 
|Income taxes payable                                                              |  |                  | 1,114  
|Other assets                                                                      |  |                  | (41    
|                                                                                  |  |                  |        
|Net cash provided by operating activities                                         |  |                  | 1,383  
|                                                                                  |  |                  |        
|Cash flows from investing activities:                                             |  |                  |        
|Purchases of property and equipment                                               |  |                  | (5,902 
|Purchases of intangible assets                                                    |  |                  | (2,150 
|Payment for purchase of Atlantech Austria, net                                    |  |                  | (243   
|Purchases of available-for-sale securities                                        |  |                  | (32,170
|Sales or maturities of available-for-sale securities                              |  |                  | 44,337 
|                                                                                  |  |                  |        
|Net cash provided by (used in) investing activities                               |  |                  | 3,872  
|                                                                                  |  |                  |        
|Cash flows from financing activities:                                             |  |                  |        
|Purchase of treasury stock                                                        |  |                  | (10,620
|Repayment of bank loan                                                            |  |                  | (4     
|Proceeds from exercise of options to purchase common stock                        |  |                  | 750    
|Proceeds from issuances of common stock                                           |  |                  | 352    
|                                                                                  |  |                  |        
|Net cash used in financing activities                                             |  |                  | (9,522 
|                                                                                  |  |                  |        
|Effect of exchange rate changes on cash                                           |  |                  | 13     
|                                                                                  |  |                  |        
|Net increase (decrease) in cash and cash equivalents                              |  |                  | (4,254 
|Cash and cash equivalents, beginning of period                                    |  |                  | 40,753 
|                                                                                  |  |                  |        
|Cash and cash equivalents, end of period                                          |  | $                | 36,499 
|                                                                                  |  |                  |        



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



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ARTHROCARE CORPORATION



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)



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



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



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



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



In the fourth quarter of 2002 we changed our fiscal periods, month and year, to conform to calendar periods. The second quarter of 2002 began on March 31,
2002 and ended on June 29, 2002.



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



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



We account for stock options issued to non-employees using the fair value method of accounting. Non-employee stock-based
compensation expense is recognized over the four-year vesting period of the options granted. In the second quarter of 2003, we repurchased, at an average price of $2.30 per share, 99,629 outstanding stock options that had been granted to
non-employees. This repurchase represents approximately 74 percent of the outstanding unvested options issued to non-employees. Stock-based compensation expense related to non-employee option grants was $0.1 million for both the three months ended
June 30, 2003 and 2002. Stock-based compensation expense for the six months ended June 30, 2003 and 2002 was $0.4 million and $0.2 million, respectively. Stock-based compensation is included in Sales and Marketing and Research and Development
expense.



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



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



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



|                                                                                                             |  | Three MonthsEnded June 30, |        |   | Six Months EndedJune 30, |  
|------------------------------------------------------------------------------------------------------------ |  | -------------------------- | ------ | - | ------------------------ | -
|                                                                                                             |  | 2003                       |        |   | 2002                     |  
|Net incomeas reported                                                                                       |  | $                          | 1,962  |   |                          | $
|Employee stock-based compensation expense determined under the fair value method, net of related tax effects |  |                            | (3,072 | ) |                          |  
|                                                                                                             |  |                            |        |   |                          |  
|Pro forma net loss                                                                                           |  | $                          | (1,110 | ) |                          | $
|                                                                                                             |  |                            |        |   |                          |  
|Net income (loss) per share:                                                                                 |  |                            |        |   |                          |  
|Basicas reported                                                                                            |  | $                          | 0.09   |   |                          | $
|Basicpro forma                                                                                              |  | $                          | (0.05  | ) |                          | $
|Dilutedas reported                                                                                          |  | $                          | 0.09   |   |                          | $
|Dilutedpro forma                                                                                            |  | $                          | (0.05  | ) |                          | $



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



Stock Option Plans



|                            |  | Three Months Ended June 30, |  | Six Months Ended June 30,
|--------------------------- |  | --------------------------- |  | -------------------------
|                            |  | 2003                        |  | 2002                     
|Risk-free interest rate     |  | 2.43%-3.13%                 |  | 4.18%-4.88%              
|Expected life               |  | 5 years                     |  | 5 years                  
|Expected dividends          |  |                            |  |                         
|Expected volatility         |  | 70%                         |  | 70%                      
|Weighted-average fair value |  | $8.56                       |  | $7.86                    



Employee Stock Purchase Plan



|                            |  | Three Months EndedJune 30, |  | Six Months EndedJune 30,
|--------------------------- |  | -------------------------- |  | ------------------------
|                            |  | 2003                       |  | 2002                    
|Risk-free interest rate     |  | 1.18%                      |  | 1.6%                    
|Expected life               |  | 0.5 years                  |  | 0.5 years               
|Expected dividends          |  |                           |  |                        
|Expected volatility         |  | 70%                        |  | 70%                     
|Weighted-average fair value |  | $3.86                      |  | $5.95                   



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|4. |  | Recent Accounting Pronouncements:
|-- |  | ---------------------------------



In November 2002, the Emerging Issues Task Force (EITF) of the Financial Accounting Standards Board (FASB) 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 adoption of EITF Issue No. 00-21 did not have a material impact on our operating results or
consolidated financial statements.



In January 2003, the FASB
issued FASB Interpretation No. 46, Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51 (FIN 46). FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the
entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from
other parties. FIN 46 is effective immediately for all new variable interest entities created or acquired after January 31, 2003. As we have no variable interest entities, the adoption of FIN 46 did not have a material impact on our operating
results or consolidated financial statements.



|5. |  | Computation of Net Income Per Share:
|-- |  | ------------------------------------



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



|                                                                     |  | Three Months EndedJune 30, |        | Six Months EndedJune 30,
|-------------------------------------------------------------------- |  | -------------------------- | ------ | ------------------------
|                                                                     |  | 2003                       |        |                         
|Net income                                                           |  | $                          | 1,962  |                         
|Basic:                                                               |  |                            |        |                         
|Weighted-average common shares outstanding                           |  |                            | 21,037 |                         
|Less weighted-average restricted stock outstanding                   |  |                            | (126   | )                       
|                                                                     |  |                            |        |                         
|Total                                                                |  |                            | 20,911 |                         
|                                                                     |  |                            |        |                         
|Net income per share                                                 |  | $                          | 0.09   |                         
|                                                                     |  |                            |        |                         
|Diluted:                                                             |  |                            |        |                         
|Weighted-average common shares outstanding used in basic calculation |  |                            | 20,911 |                         
|Options                                                              |  |                            | 857    |                         
|Warrants                                                             |  |                            | 34     |                         
|Restricted shares                                                    |  |                            | 56     |                         
|                                                                     |  |                            |        |                         
|Total weighted common stock and common stock equivalents             |  |                            | 21,858 |                         
|                                                                     |  |                            |        |                         
|Net income per share                                                 |  | $                          | 0.09   |                         
|                                                                     |  |                            |        |                         



Options to purchase
4,486,557 and 4,791,074 shares of common stock at prices ranging from $9.84-$45.59 per share outstanding during the three-month and six-month periods ended June 30, 2003, respectively, were not included in the computation of diluted net income per
share because their effects are anti-dilutive. Options to purchase 3,210,676 and 3,176,593 shares of common stock at prices ranging from $13.75-$48.56 per share outstanding during the three-month and six-month periods ended June 30, 2002,
respectively, were not included in the computation of diluted net income per share because their effects are anti-dilutive.



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



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



|                                                                                                                |  | Three MonthsEnded June 30, |       | Six Months EndedJune 30, |     
|--------------------------------------------------------------------------------------------------------------- |  | -------------------------- | ----- | ------------------------ | ----
|                                                                                                                |  | 2003                       |       |                          | 2002
|Net income                                                                                                      |  | $                          | 1,962 |                          |     
|Unrealized gains (losses) on available-for-sale securities arising during the period, net of tax                |  |                            | 92    |                          |     
|Less:  Reclassification adjustment for gains on available-for-sale securities, net of tax, included in
earnings |  |                            | (398  | )                        |     
|Foreign currency translation adjustment                                                                         |  |                            | 175   |                          |     
|                                                                                                                |  |                            |       |                          |     
|Comprehensive income                                                                                            |  | $                          | 1,831 |                          |     
|                                                                                                                |  |                            |       |                          |     



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



|                |  | June 30, 2003 |        | December 31, 2002
|--------------- |  | ------------- | ------ | -----------------
|Inventories:    |  |               |        |                  
|Raw materials   |  | $             | 7,617  |                  
|Work-in-process |  |               | 6,892  |                  
|Finished goods  |  |               | 14,344 |                  
|                |  |               |        |                  
|Total           |  | $             | 28,853 |                  
|                |  |               |        |                  



|8. |  | Commitments and Contingencies:
|-- |  | ------------------------------



Operating Leases



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



|2003 (6 months) |  | $ | 805  
|--------------- |  | - | -----
|2004            |  |   | 1,624
|2005            |  |   | 1,548
|2006            |  |   | 1,568
|2007            |  |   | 262  
|                |  |   |      
|Total           |  | $ | 5,807
|                |  |   |      



Warranties



We generally provide 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 evaluate and adjust the warranty reserve to the extent actual warranty expense varies from the original estimates. The following table describes the activity in our warranty accrual for the
three and six months ended June 30, 2003 (in thousands):



|                                                 |  | Three MonthsEndedJune 30, 2003 |      |   | Six MonthsEndedJune 30,2003 |  
|------------------------------------------------ |  | ------------------------------ | ---- | - | --------------------------- | -
|Beginning balance                                |  | $                              | 243  |   |                             | $
|Accruals for warranties issued during the period |  |                                | 162  |   |                             |  
|Settlements made during the period               |  |                                | (111 | ) |                             |  
|                                                 |  |                                |      |   |                             |  
|Ending balance                                   |  | $                              | 294  |   |                             | $
|                                                 |  |                                |      |   |                             |  



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Litigation



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



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



On April 3, 2003, Smith & Nephew filed a complaint against
ArthroCare in the United States District Court, Western District of Tennessee for patent infringement of two patents and for violation of Section 43(a) of the Lanham Act. The complaint does not contain any specifics regarding the alleged
infringement. Upon initial review, we believe this complaint is without merit, and we intend to defend ourselves vigorously. ArthroCare has filed a motion to dismiss the complaint and, in the event this motion is denied, a motion to transfer this
litigation to the Northern District of California.



In
conjunction with a medical malpractice suit against a physician, a product liability suit was brought against us in the Superior Court of Arizona, County of Yavapai on August 24, 2001. The lawsuit alleges that a patient suffered internal and
external injury to his knee as a result of a defective ArthroCare probe used in an arthroscopy procedure on the patient. This lawsuit was settled by the parties in April 2003.



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



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



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



|9. |  | Segment Information:
|-- |  | --------------------



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



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



|                     |  | Three Months EndedJune 30, |        | Six Months EndedJune 30,
|-------------------- |  | -------------------------- | ------ | ------------------------
|                     |  | 2003                       |        | 2002                    
|Product sales:       |  |                            |        |                         
|Arthroscopy          |  | $                          | 20,273 |                         
|ENT                  |  |                            | 4,124  |                         
|ArthroCare Spine     |  |                            | 3,537  |                         
|Coblation Technology |  |                            | 467    |                         
|                     |  |                            |        |                         
|Total                |  | $                          | 28,401 |                         
|                     |  |                            |        |                         



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 EndedJune 30, |        | Six Months EndedJune 30,
|------------------- |  | -------------------------- | ------ | ------------------------
|                    |  | 2003                       |        | 2002                    
|Product sales:      |  |                            |        |                         
|United States       |  | $                          | 21,669 |                         
|International       |  |                            | 6,732  |                         
|                    |  |                            |        |                         
|Total product sales |  | $                          | 28,401 |                         
|                    |  |                            |        |                         



|                        |  | June 30, 2003 |        | December 31,2002
|----------------------- |  | ------------- | ------ | ----------------
|Property and equipment: |  |               |        |                 
|United States           |  | $             | 13,177 |                 
|International           |  |               | 6,506  |                 
|                        |  |               |        |                 
|Total                   |  | $             | 19,683 |                 
|                        |  |               |        |                 



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|10. |  | Stockholders Equity:
|--- |  | ---------------------



Restricted Stock



In the first quarter of 2003, we granted certain employees an aggregate of 127,300 shares of restricted common stock under our 1993 Incentive Stock Option
Plan. In June 2003, 1,500 of these shares were cancelled due to an employee termination. In connection with the restricted stock grant, we recorded $1.1 million of deferred compensation in the first quarter of 2003, which is being amortized to other
compensation expense over 5 years. The total amortization recorded was $57,000 and $76,000 for the three and six months ended June 30, 2003, respectively.



Treasury Stock



In April 2001, the Board of Directors authorized the repurchase of up to 1,000,000 shares of our common stock. In June 2002, the Board of Directors
authorized the repurchase of up to 2,000,000 additional shares of our common stock, subject to certain limitations and conditions. We repurchased 558,000 shares at a cost of $9.1 million and 51,700 shares at a cost of $0.6 million in the three
months ended June 30, 2003 and 2002, respectively. We repurchased 727,000 shares at a cost of $11.1 million and 100,700 shares at a cost of $1.3 million in the six months ended June 30, 2003 and 2002, respectively.



|11. |  | Subsequent Event:
|--- |  | -----------------



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



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|PART 1. |  | FINANCIAL INFORMATION
|------- |  | ---------------------



|Item 2. |  | Managements Discussion and Analysis of Financial Condition and Results of Operations
|------- |  | -------------------------------------------------------------------------------------



The following discussion should be read in conjunction with the consolidated financial statements and notes thereto
appearing elsewhere in this Form 10-Q. Statements in this Managements Discussion and Analysis of Financial Condition and Results of Operations and elsewhere in this quarterly report on Form 10-Q which express that we believe,
anticipate, expect or plan to as well as other statements which are not historical fact, are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Actual events or
results may differ materially as a result of the risks and uncertainties described herein and elsewhere including, but not limited to, those factors described under Business set forth in Part I of our Annual Report on Form 10-K for the
year-ended December 31, 2002 and Additional Factors That May Affect Future Results set forth below.



Overview



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



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



We have organized our marketing and sales efforts into 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 Technologies (to include gynecology, urology, laparoscopic, general
surgical and cardiology products).



We commercially introduced
our Arthroscopic Surgery System in December 1995 and have derived a significant portion of our sales from this system. The ArthroCare Spine and ENT businesses are growing and represent an increasingly larger portion of our total business. As of June
30, 2003, we have shipped more than 17,800 controllers and over 2,270,000 disposable devices for a variety of indications since we began commercialization in 1995. In the United States we are selling our Arthroscopy products through a network of 45
distributors and a direct sales organization consisting of 17 people. Our ArthroCare Spine products are sold through a network of 30 independent distributors and a direct sales force of 16 people. Our ENT business unit distributes its products
through a direct sales force of 33 people supported by distributors in certain remote U.S. geographic markets. We have also established a distribution capability in Europe. For our Arthroscopy business unit we have a direct sales organization in the
United Kingdom, France, Germany and Austria consisting of 20 people. Our ENT business also has a direct selling organization in the United Kingdom and Germany consisting of 7 people. Our ArthroCare Spine business shares a portion of the direct sales
organization with Arthroscopy and ENT in Europe. For the balance of Europe and Australia, New Zealand, China, Korea, Japan, Taiwan, Canada, Mexico, the Caribbean, Russia, South Africa, the Middle East, Northern Africa, South America and Central
America, we have established a distribution capability through independent distributors. During the first quarter of 2003, our ENT business unit introduced a new ENT controller that provides improved performance for tonsillectomy procedures. Also
during the first quarter of 2003, our ArthroCare Spine business unit introduced a new procedure for performing a less-invasive microdiscectomy using our Coblation technology.



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Results of Operations



Three months ended June 30, 2003 and 2002



Revenues



Product sales were $28.4 million for the quarter ended June 30, 2003, an increase of $7.7 million, or 37%, over the same period in 2002. All commercial business units posted sales increases in the second quarter of
2003 compared to the second quarter of 2002. Arthroscopy contributed $20.3 million in net product sales in the second quarter of 2003, including $2.2 million of Atlantech Medical Devices, Ltd. (United Kingdom), Atlantech GmbH (Germany) and Atlantech
Medizinische Produkte Vertriebs, GmbH (Austria) (collectively referred to as Atlantech) sales of non-arthroscopy product, as compared to $16.2 million in the second quarter of 2002. ENT net product sales increased to $4.1 million for the
three months ended June 30, 2003, an increase of 74% compared to the same period in 2002. Spinal surgery product sales increased to $3.5 million for the three months ended June 30, 2003, an increase of 93% compared to the same period in 2002.
Coblation technology sales were $0.5 million for the three months ended June 30, 2003, an increase of 34% compared to the same period in 2002.



The increase in direct sales presence, which began in 2001, continued to have a positive effect on sales in the second 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% of product sales, excluding Atlantech product sales, for the second quarter of 2003 and comprised approximately 96% of second 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 $6.7 million, or 24% of net product sales, for the quarter ended June 30, 2003, compared to $2.9 million, or 14% of
net product sales, for the same period in 2002. A large part of the $3.8 million increase is attributable to the acquisition of Atlantech, whose international non-arthroscopy product sales were $2.0 million in the second quarter of 2003.
International product sales for the three months ended June 30, 2003, excluding Atlantech, increased by 64% compared to the same period in 2002.



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



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Royalties, fees and other revenues were $1.3 million for the three-month period ended June 30, 2003, as
compared to $1.4 million for the same period in 2002.



Cost of Product
Sales



Cost of product sales was $8.7 million, or 30% of
product sales, for the three-month period ended June 30, 2003, as compared to $7.2 million, or 35% of product sales, for the same period in 2002. The decrease in cost as a percentage of product sales is attributable to the increased efficiency of
the manufacturing operations resulting mostly from the transition of operations to our Costa Rica facility and increased production volume to cover our increased sales volumes. These increases were partially offset by the increased controller
placement costs and the lower gross margin on Atlantech sales. As planned, our Costa Rica facility continued its transition to manufacturing completed final assemblies in the second quarter of 2003 and is expected to contribute to gross margin
improvements in the future.



Operating Expenses



Research and development expenses were $2.6 million, or 9% of product sales,
for the three-month period ended June 30, 2003, as compared to $2.1 million, or 10% of product sales, for the same period in 2002. The dollar increase is due to a continued investment in our Coblation technology. We believe that continued investment
in our Coblation technology is essential for us to maintain our competitive position. We expect to increase the dollar amount of research and development expenses through continued expenditures on new product development, regulatory affairs,
clinical studies and patents, but anticipate expenses to decrease slightly as a percentage of product sales.



Sales and marketing expenses were $11.5 million, or 41% of product sales, during the three-month period ended June 30, 2003, as compared to $8.9 million,
or 43% of product sales, during the same period in 2002. The increase in spending for the current three-month period was primarily due to expenses related to increased headcount, increases in advertising and trade shows expense, and higher
commissions due to higher product sales.



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



General and administrative expenses were $4.8 million, or 17% of product sales, during the three-month period ended June 30, 2003, compared to $2.5
million, or 12% of product sales, during the same period in 2002. The $2.3 million increase was attributable to higher costs of general and patent-related legal services, business development activities, expenses related to the Atlantech business
acquired in the fourth quarter of fiscal 2002 and the second quarter of 2003, and increases in non-Atlantech labor expenses. We expect general and administrative expenses to increase in absolute terms as well as a percentage of product sales as we
continue business development activities and incur additional legal costs associated with patent infringement actions.



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Interest and Other Income, Net



Interest and other income, net, increased to $0.7 million for the three-month period ended June 30, 2003, compared to $0.3
million during the same period in 2002. The increase in interest and other income is attributable to net foreign exchange gains and realized gains on the sale of investments partially offset by lower interest income.



Six months ended June 30, 2003 and 2002



Revenues



Product sales were $54.9 million for the six months ended June 30, 2003, an increase of 37% from the $40.0 million in the
first six months of 2002. Arthroscopy contributed $40.7 million in net product sales for the six months ended June 30, 2003, a 31% increase over the first six months of 2002. ENT net product sales were $7.1 million for the first six months of 2003,
an increase of 58% over the first six months of 2002. Spinal surgery product sales were $6.2 million for the first six months of 2003, a 64% increase over the first six months of 2002. Coblation Technology product sales increased to $0.9 million for
the first six months of 2003, a 45% increase over the first six months of 2002.



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



International product sales were $13.2 million, or 24% of net
product sales, for the six months ended June 30, 2003, compared to $6.1 million, or 15% of net product sales, for the same period in 2002. Our growth in the international market was stronger than in the domestic market due mostly to the acquisition
of Atlantech.



Royalties, fees and other revenues were $2.1
million for the six-month period ended June 30, 2003, as compared to $2.2 million for the same period in 2002.



Cost of Product Sales



Cost of product sales was $17.3 million, or 31% of product sales, for the six-month period ended June 30, 2003, as compared to $14.8 million, or 37% of product sales, for the same period in 2002. The decrease in cost as a percentage of
product sales is attributable to the increased efficiency of our manufacturing operations. As planned, our Costa Rica facility is expected to contribute to gross margin improvements in the second half of 2003.



Operating Expenses



Research and development expenses were $5.3 million, or 10% of product sales, for the six-month period ended June 30, 2003,
as compared to $4.3 million, or 11% of product sales for the same period in 2002. The dollar increase is due to a continued investment in our Coblation technology. We believe that continued investment in our Coblation technology is essential for us
to maintain our competitive position. We expect to increase the dollar amount of research and development expenses through continued expenditures on new product development, regulatory affairs, clinical studies and patents, but anticipate expenses
to decrease slightly as a percentage of product sales.



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Sales and marketing expenses were $23.0 million, or 42% of product sales, during the six-month period
ended June 30, 2003, as compared to $17.3 million, or 43% of product sales, during the same period in 2002. The increase in spending for the current six-month period was primarily due to expenses related to increased headcount, higher commissions
due to higher product sales, and increases in advertising and trade show expenses.



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



General and administrative expenses were $8.7 million, or 16% of product sales, during the six-month period ended June 30, 2003, compared to $4.4 million,
or 11% of product sales, during the same period in 2002. This increase was attributable to higher costs of general and patent-related legal services, business development activities, insurance and international accounting and tax-related
expenditures necessary to expand our corporate infrastructure, expenses related to the Atlantech business acquired in the fourth quarter of 2002 and the second quarter of 2003, and the headcount increase required to support the business structure.
We expect general and administrative expenses to increase as a percentage of product sales and increase in absolute dollar values in future periods as we continue business development activities and incur additional legal costs associated with
patent infringement actions.



Interest and Other Income, Net



Interest and other income, net, increased to $1.0 million for the
six-month period ended June 30, 2003, compared to $0.8 million during the same period in 2002. The increase in interest and other income is attributable to realized gains on the sale of investments and net foreign exchange translation gains,
partially offset by lower interest income.



Liquidity and Capital
Resources



On June 30, 2003, we had $69.4 million in
working capital compared to $72.9 million at December 31, 2002. The principal sources of liquidity consisted of $36.5 million in cash and cash equivalents compared to $52.9 million in cash, cash equivalents and available-for-sale securities at
December 31, 2002. The decrease in cash, cash equivalents and available-for-sale securities is primarily due to approximately $10.6 million used for repurchases of our common stock, and $2.5 million for the purchase of intellectual property and the
acquisition of Atlantech Medizinische Produkte Vertriebs, Gmbh (Atlantech Austria).



Net cash provided by operating activities for the six-month period ended June 30, 2003 was $1.4 million, as compared to $5.2 million provided by operating
activities for the same period in 2002. The decrease in cash provided by operating activities is primarily due to the increase in inventories.



Inventories increased to $28.9 million as of June 30, 2003 from $22.7 million as of December 31, 2002. The increase in inventories was primarily to
support the introduction levels required to support sales volume increases and provide safety stock of sub-assemblies as we shift our manufacturing to our Costa Rica manufacturing facility.



Net cash provided by investing activities for the six-month period ended June
30, 2003 was $3.9 million, compared to a net cash use of $1.0 million for the same period in 2002. The increase in cash provided by investing activities is primarily due to the sale of securities in 2003.



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Net property and equipment increased to $19.7 million as of June 30, 2003 from $18.1 million as of
December 31, 2002. The $1.6 million increase is primarily attributable to capital expenditures related to the capitalization of controllers placed under various promotional programs along with an increase in expenditures for computer software and
equipment.



On April 25, 2003, we acquired all of the
outstanding shares of Atlantech Austria, a distributor of medical device products in Austria, in a cash acquisition of $0.2 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. We used cash to fund the acquisition.



Net cash used in financing activities for the six-month period ended June 30, 2003 was $9.5 million compared to $0.1 million for the same period in 2002.
The increase was primarily due to purchases of stock pursuant to our stock repurchase program, partially offset by proceeds from issuances of stock due to the exercise of options and our employee stock purchase program.



We believe that our cash flows from operations in addition to our current
cash and cash equivalent balances will be adequate to meet our cash requirements for the reasonable future. Our future liquidity and capital requirements will depend on numerous factors, including our success in commercializing our products,
development and commercialization of products in fields other than arthroscopy, the ability of our suppliers to continue to meet our demands at current prices, obtaining and enforcing patents important to our business, the status of regulatory
clearances/approvals and competition.



Recent Accounting Pronouncements



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 adoption of EITF Issue No. 00-21 did not have a material
impact on our operating results or consolidated financial statements.



In January 2003, the FASB issued FASB Interpretation No. 46, Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51. (FIN 46). FIN 46 requires certain variable interest entities to be
consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without
additional subordinated financial support from other parties. FIN 46 is effective immediately for all new variable interest entities created or acquired after January 31, 2003. As we had no variable interest entities, the adoption of FIN 46 did not
have a material impact on our operating results or consolidated financial statements.



Additional Factors That Might Affect Future Results



We Are
Dependent Upon Our Arthroscopic Surgery System



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



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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 if recommendations and endorsements by influential surgeons do not continue or if long-term data does not support our current claims
of efficacy, our business, financial condition, results of operations and future growth prospects could be materially adversely affected.



Commercial Success of Our Non-Arthroscopic Products Is Uncertain



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



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



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



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



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



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



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



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



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



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



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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, ENT
surgery and cosmetic surgery for a number of other manufacturers. We cannot assure you that these distributors will commit the necessary resources to effectively market and sell our arthroscopic surgery, coblation technology surgery, spinal surgery,
neurosurgery, ENT surgery and cosmetic surgery product lines, or that they will be successful in selling our products.



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



We Have Limited
Manufacturing Experience



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



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##### Table of Contents

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., which was purchased by Gyrus Group, a company based in Cardiff, Wales, also sell medical devices for the treatment of various ENT disorders, including snoring and obstructive sleep apnea. In cosmetic
surgery, we compete against companies, such as Lumenis, which market lasers for use in this field. In addition, other large companies manufacture and sell medical devices that use radio frequency energy for certain applications in dermatology and
cosmetic surgery. In Coblation Technology, we face competition from companies that sell general surgery and gynecology devices, including Ethicon ENDO, a division of Johnson and Johnson, Valleylab, a division of US Surgical, Gyrus, Olympus Medical
Systems Group and several smaller companies that sell mechanical, ultrasonic, monopolar and bipolar instruments. In urology, we face competition from companies that market monopolar, bipolar, mechanical, ultrasonic and laser devices for a variety of
urological procedures, including Karl Storz, Olympus Medical Systems Group, C.R. Bard, Gyrus, Medtronic, Urologix and Laserscope. In cardiology, we face competition from several large companies, including Edwards Lifescience, Medtronic, Guidant,
Johnson & Johnson and St. Jude Medical, as well as many smaller companies.



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



We Face Uncertainty Over Reimbursement



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



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



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



Our Business Depends on Attracting and Retaining Collaborators and Licensors



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



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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, in which case our business, financial condition, results of operations and prospects would be materially adversely affected. To the extent that we are not able to establish further collaborative arrangements or that any or all of
our existing collaborative arrangements are terminated, we would be required to seek new collaborative arrangements or to undertake commercialization at our own expense, which could significantly increase our capital requirements, place additional
strain on our human resource requirements and limit the number of products which we would be able to develop and commercialize. In addition, we cannot assure you that our existing and future collaborative partners will not pursue alternative
technologies or develop alternative products either on their own or in collaboration with others, including our competitors.



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



Our Operating Results Will
Fluctuate



We achieved profitability in 1999 and, as of
June 30, 2003, we had retained earnings of $3.4 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;
| | - |  | -----------------------------------------------



| |  |  | 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.
| | - |  | --------------------------------------





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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 June 1999, we filed a lawsuit against Stryker alleging infringement of several of our patents. The parties settled this lawsuit
within two weeks of its filing date. Under the terms of the settlement, Stryker has licensed a portion of our patents for products in the arthroscopy market worldwide. In July 2000, we filed a lawsuit against Smith & Nephew, Inc. alleging
infringement of several of our patents. A jury trial commenced on April 30, 2003. On May 12, 2003, the jury held that the use, manufacture and sale of the Dyonics Control RF System, the Electroblade and the Saphirre RF electrosurgical devices
infringed all 16 asserted claims of the three patents in suit. In addition, the jury upheld the validity of all 16 asserted claims. The court entered this verdict in June 2003 and will hold a hearing on September 15, 2003 to consider our motion
to enjoin Smith & Nephew from the use, manufacture and sale of these three products in the United States. Following this decision, the court will hold a second trial to award damages to us for the infringing activity of Smith & Nephew. On
April 3, 2003, Smith & Nephew filed a complaint against us in the United States District Court, Western District of Tennessee for patent infringement of two patents and for violation of Section 43(a) of the Lanham Act. The complaint does not
contain any specifics regarding the alleged infringement. Upon initial review, we believe this complaint is without merit, and we intend to defend ourselves vigorously. We have filed a motion to dismiss the complaint and, in the event this motion is
denied, a motion to transfer this litigation to the Northern District of California.



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



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The Market Price of Our Stock May Be Highly Volatile



During the 12 months ended June 30, 2003 our common stock has traded between
a range of $8.82 and $17.62 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. 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.



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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. More information about the U.S. and foreign regulatory requirements and information pertaining to our products and indications before they can be commercialized can be found 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 the Securities Exchange Act of 1934 Rules 13a-14(c) and 15d-14(c)) that are
designed to ensure that information required to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commissions rules and forms, and that
such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the
disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily was
required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.



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



There has been no change in our internal control over financial reporting
during our most recent fiscal quarter that has materially affected, or is reasonable likely to materially affect, our internal controls over financial reporting.



|PART |  | II. OTHER INFORMATION
|---- |  | ---------------------



|Item 1. |  | Legal Proceedings
|------- |  | -----------------



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



|Item 4. |  | Submission of Matters to a Vote of Security Holders
|------- |  | ---------------------------------------------------



At the annual meeting of the companys stockholders, held on May 30, 2003, matters submitted to a vote of the companys stockholders and the
results of that voting were as follows:



|Proposal 1. |  | Election of Directors.
|----------- |  | ----------------------



|Nominee             |  | Votes For  |  | Votes Withheld
|------------------- |  | ---------- |  | --------------
|Michael A. Baker    |  | 16,969,953 |  | 1,770,926     
|David F. Fitzgerald |  | 18,610,400 |  | 130,480       
|James G. Foster     |  | 16,343,845 |  | 2,397,035     
|Tord B. Lendau      |  | 16,775,760 |  | 1,965,120     
|Jerry Widman        |  | 16,710,860 |  | 2,030,020     
|Peter L. Wilson     |  | 16,292,445 |  | 2,448,435     



|Proposal 2. |  | Approval of the companys 2003 Incentive Stock Plan and the reservation of 500,000 shares of common stock for issuance there under.
|----------- |  | -----------------------------------------------------------------------------------------------------------------------------------



|Votes For  |  | Votes Against |  | Abstain
|---------- |  | ------------- |  | -------
|11,445,535 |  | 7,028,439     |  | 256,916



|Proposal 3. |  | Approval of amendment to the companys 1995 Director Option Plan 2003 Incentive Stock Plan to increase the number of shares of Common Stock reserved for issuance there under by
100,000 shares.
|----------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|Votes For  |  | Votes Against |  | Abstain
|---------- |  | ------------- |  | -------
|13,273,148 |  | 5,209,241     |  | 258,491



|Proposal 4. |  | Ratification of the Appointment of PricewaterhouseCoopers, LLP as the companys Independent Accountants.
|----------- |  | --------------------------------------------------------------------------------------------------------



|Votes For  |  | Votes Against |  | Abstain
|---------- |  | ------------- |  | -------
|18,262,079 |  | 473,593       |  | 5,208  





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##### Table of Contents

|Item 6. |  | Exhibits and Reports on Form 8-K
|------- |  | --------------------------------



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



|10.34 |  | * |  | Second Amendment to the 1995 Director Option Plan (Incorporated herein by reference to Exhibit 4.3 to the registrants Registration Statement on Form S-8 filed with the
Securities and Exchange Commission on May 8, 2003.)
|----- |  | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|      |  |  
|10.35 |  | * |  | 2003 Incentive Stock Plan (incorporated herein by reference to Exhibit 4.4 to the registrants Registration Statement on Form S-8 filed with the Securities and Exchange
Commission on June 24, 2003.)                      
|      |  |  
|31.1  |  |   |  | Certification of the Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                     
|      |  |  
|31.2  |  |   |  | Certification of the Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                     
|      |  |  
|32.1  |  |   |  | Certification of the Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                     
|      |  |  
|32.2  |  |   |  | Certification of the Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                     



---

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



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



On July 31, 2003, the company filed a current report on Form 8-K under Item 12Results of Operations and Financial Condition with respect
to a press release announcing its results of operations for the quarter ended June 30, 2003.



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##### Table of Contents

SIGNATURES



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



|                         |  |  |  | ARTHROCARE CORPORATION 
|------------------------ |  |  |  | -----------------------
|                         |  |  |  | a Delaware corporation 
|                         |  | 
|Date:    August 13, 2003 |  |  |  | /s/    MICHAEL A. BAKER
|                         |  |  |  |                        
|                         |  | 
|Date:    August 13, 2003 |  |  |  | /s/    FERNANDO SANCHEZ
|                         |  |  |  |                        



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