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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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Form 10-Q



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



For the quarter ended June 30, 2005



OR



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



For the transition period from  to



Commission File Number: 0-27422



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ArthroCare Corporation

(Exact name of registrant as specified in its charter)



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



111 Congress Avenue,
Suite 510, Austin, TX 78701

(Address of principal executive offices)



(512) 391-3900

(Registrants telephone number, including area code)



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



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 29, 2005 was 24,696,667.



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##### Table of Contents

ARTHROCARE CORPORATION



Form 10-Q Quarterly Report

For the quarter ended June 30, 2005



TABLE OF CONTENTS



|         |  |                                                                                                                  |  |     
|-------- |  | ---------------------------------------------------------------------------------------------------------------- |  | ----
|         |  |                                                                                                                  |  | Page
|PART I:  |  | Financial Information                                                                                            |  |     
|Item 1.  |  | Financial Statements                                                                                             |  |     
|         |  | Condensed Consolidated Balance Sheets as of June 30, 2005 and December 31, 2004                                  |  | 1   
|         |  | Condensed Consolidated Statements of Operations for the three and six month periods ended June 30, 2005 and 2004 |  | 2   
|         |  | Condensed Consolidated Statements of Cash Flows for the three and six month periods ended June 30, 2005 and 2004 |  | 3   
|         |  | Notes to Condensed Consolidated Financial Statements                                                             |  | 4   
|Item 2.  |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                            |  | 13  
|Item 3.  |  | Quantitative and Qualitative Disclosures About Market Risk                                                       |  | 23  
|Item 4.  |  | Controls and Procedures                                                                                          |  | 23  
|         |  |                                                                                                                 
|PART II: |  | Other Information                                                                                                |  |     
|Item 1.  |  | Legal Proceedings                                                                                                |  | 24  
|Item 6.  |  | Exhibits                                                                                                         |  | 24  
|         |  |                                                                                                                 
|         |  | Signatures                                                                                                       |  | 25  
|         |  | Certifications                                                                                                   |  | 26  



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##### Table of Contents

PART 1. FINANCIAL INFORMATION



ITEM 1. FINANCIAL STATEMENTS



ARTHROCARE CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited)

(in thousands, except
per share data)



|                                                                                                            |  |              |         |   |                   |   |         |  
|----------------------------------------------------------------------------------------------------------- |  | ------------ | ------- | - | ----------------- | - | ------- | -
|                                                                                                            |  | June 30,2005 |         |   | December 31, 2004 |  
|ASSETS                                                                                                      |  |              |         |   |                   |   |         |  
|Current assets:                                                                                             |  |              |         |   |                   |   |         |  
|Cash and cash equivalents                                                                                   |  | $            | 32,590  |   |                   | $ | 21,836  |  
|Accounts receivable, net of allowances of $573 at 2005 and $400 at 2004                                     |  |              | 38,566  |   |                   |   | 34,032  |  
|Inventories, net                                                                                            |  |              | 40,309  |   |                   |   | 40,484  |  
|Prepaid expenses and other current assets                                                                   |  |              | 15,761  |   |                   |   | 15,549  |  
|                                                                                                            |  |              |         |   |                   |   |         |  
|Total current assets                                                                                        |  |              | 127,226 |   |                   |   | 111,901 |  
|                                                                                                            |  |             
|Property and equipment, net                                                                                 |  |              | 30,681  |   |                   |   | 29,396  |  
|Related party receivables                                                                                   |  |              | 1,075   |   |                   |   | 1,075   |  
|Intangible assets, net                                                                                      |  |              | 36,890  |   |                   |   | 39,959  |  
|Goodwill                                                                                                    |  |              | 57,859  |   |                   |   | 57,859  |  
|Other assets                                                                                                |  |              | 327     |   |                   |   | 341     |  
|                                                                                                            |  |              |         |   |                   |   |         |  
|Total assets                                                                                                |  | $            | 254,058 |   |                   | $ | 240,531 |  
|                                                                                                            |  |              |         |   |                   |   |         |  
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                        |  |              |         |   |                   |   |         |  
|Current liabilities:                                                                                        |  |              |         |   |                   |   |         |  
|Accounts payable                                                                                            |  | $            | 9,300   |   |                   | $ | 9,517   |  
|Accrued liabilities                                                                                         |  |              | 8,664   |   |                   |   | 9,925   |  
|Accrued compensation                                                                                        |  |              | 6,325   |   |                   |   | 6,783   |  
|Income taxes payable                                                                                        |  |              | 2,530   |   |                   |   | 478     |  
|Current portion of loan payable                                                                             |  |              | 4,286   |   |                   |   | 4,286   |  
|                                                                                                            |  |              |         |   |                   |   |         |  
|Total current liabilities                                                                                   |  |              | 31,105  |   |                   |   | 30,989  |  
|                                                                                                            |  |             
|Loan payable, net of current portion                                                                        |  |              | 22,500  |   |                   |   | 24,643  |  
|Deferred taxes and other liabilities                                                                        |  |              | 9,632   |   |                   |   | 9,647   |  
|                                                                                                            |  |              |         |   |                   |   |         |  
|Total liabilities                                                                                           |  |              | 63,237  |   |                   |   | 65,279  |  
|                                                                                                            |  |              |         |   |                   |   |         |  
|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: 27,323 and 24,619 shares at 2005 and 26,790 and 24,086 shares at 2004, respectively |  |              | 24      |   |                   |   | 24      |  
|Treasury stock: 2,704 shares at 2005 and 2004                                                               |  |              | (42,158 | ) |                   |   | (42,158 | )
|Additional paid-in capital                                                                                  |  |              | 247,618 |   |                   |   | 238,355 |  
|Deferred stock-based compensation                                                                           |  |              | (4,274  | ) |                   |   | (2,477  | )
|Accumulated other comprehensive loss                                                                        |  |              | (466    | ) |                   |   | (592    | )
|Accumulated deficit                                                                                         |  |              | (9,923  | ) |                   |   | (17,900 | )
|                                                                                                            |  |              |         |   |                   |   |         |  
|Total stockholders equity                                                                                  |  |              | 190,821 |   |                   |   | 175,252 |  
|                                                                                                            |  |              |         |   |                   |   |         |  
|Total liabilities and stockholders equity                                                                  |  | $            | 254,058 |   |                   | $ | 240,531 |  
|                                                                                                            |  |              |         |   |                   |   |         |  



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



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##### Table of Contents

ARTHROCARE CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(in thousands, except
per share data)



|                                                      |  |                             |        |   |                           |   |        |      |  |   |         |   |  |   |       
|----------------------------------------------------- |  | --------------------------- | ------ | - | ------------------------- | - | ------ | ---- |  | - | ------- | - |  | - | ------
|                                                      |  | Three Months Ended June 30, |        |   | Six Months Ended June 30,
|                                                      |  | 2005                        |        |   | 2004                      |   |        | 2005 |  |   | 2004   
|Revenues                                              |  |                             |        |   |                           |   |        |      |  |   |         |   |  |   |       
|Product sales                                         |  | $                           | 49,683 |   |                           | $ | 35,904 |      |  | $ | 97,517  |   |  | $ | 70,196
|Royalties, fees, and other                            |  |                             | 2,049  |   |                           |   | 1,761  |      |  |   | 3,898   |   |  |   | 3,058 
|                                                      |  |                             |        |   |                           |   |        |      |  |   |         |   |  |   |       
|Total revenues                                        |  |                             | 51,732 |   |                           |   | 37,665 |      |  |   | 101,415 |   |  |   | 73,254
|                                                      |  |                             |        |  
|Cost of product sales                                 |  |                             | 15,296 |   |                           |   | 11,386 |      |  |   | 30,773  |   |  |   | 24,234
|                                                      |  |                             |        |   |                           |   |        |      |  |   |         |   |  |   |       
|Gross profit                                          |  |                             | 36,436 |   |                           |   | 26,279 |      |  |   | 70,642  |   |  |   | 49,020
|                                                      |  |                             |        |  
|Operating expenses                                    |  |                             |        |   |                           |   |        |      |  |   |         |   |  |   |       
|Research and development                              |  |                             | 5,155  |   |                           |   | 3,531  |      |  |   | 10,007  |   |  |   | 6,651 
|Sales and marketing                                   |  |                             | 18,601 |   |                           |   | 13,860 |      |  |   | 36,951  |   |  |   | 27,893
|General and administrative                            |  |                             | 4,708  |   |                           |   | 3,986  |      |  |   | 9,269   |   |  |   | 7,093 
|Amortization of intangible assets                     |  |                             | 1,458  |   |                           |   | 544    |      |  |   | 2,916   |   |  |   | 1,050 
|                                                      |  |                             |        |   |                           |   |        |      |  |   |         |   |  |   |       
|Total operating expenses                              |  |                             | 29,922 |   |                           |   | 21,921 |      |  |   | 59,143  |   |  |   | 42,687
|                                                      |  |                             |        |  
|Income from operations                                |  |                             | 6,514  |   |                           |   | 4,358  |      |  |   | 11,499  |   |  |   | 6,333 
|Interest and other income (expense), net              |  |                             | (366   | ) |                           |   | (47    | )    |  |   | (1,135  | ) |  |   | 127   
|                                                      |  |                             |        |   |                           |   |        |      |  |   |         |   |  |   |       
|Income before income tax provision                    |  |                             | 6,148  |   |                           |   | 4,311  |      |  |   | 10,364  |   |  |   | 6,460 
|                                                      |  |                             |        |  
|Income tax provision                                  |  |                             | 1,330  |   |                           |   | 1,164  |      |  |   | 2,384   |   |  |   | 1,744 
|                                                      |  |                             |        |   |                           |   |        |      |  |   |         |   |  |   |       
|Net income                                            |  | $                           | 4,818  |   |                           | $ | 3,147  |      |  | $ | 7,980   |   |  | $ | 4,716 
|                                                      |  |                             |        |   |                           |   |        |      |  |   |         |   |  |   |       
|Basic net income per share                            |  | $                           | 0.20   |   |                           | $ | 0.15   |      |  | $ | 0.33    |   |  | $ | 0.22  
|                                                      |  |                             |        |   |                           |   |        |      |  |   |         |   |  |   |       
|Shares used in computing basic net income per share   |  |                             | 24,176 |   |                           |   | 21,159 |      |  |   | 24,044  |   |  |   | 21,085
|                                                      |  |                             |        |   |                           |   |        |      |  |   |         |   |  |   |       
|Diluted net income per share                          |  | $                           | 0.19   |   |                           | $ | 0.14   |      |  | $ | 0.31    |   |  | $ | 0.21  
|                                                      |  |                             |        |   |                           |   |        |      |  |   |         |   |  |   |       
|Shares used in computing diluted net income per share |  |                             | 25,877 |   |                           |   | 22,765 |      |  |   | 25,833  |   |  |   | 22,779
|                                                      |  |                             |        |   |                           |   |        |      |  |   |         |   |  |   |       



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



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ARTHROCARE CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(in thousands)



|                                                                                                             |  |                           |        |   |      |   |         |  
|------------------------------------------------------------------------------------------------------------ |  | ------------------------- | ------ | - | ---- | - | ------- | -
|                                                                                                             |  | Six Months Ended June 30, |       
|                                                                                                             |  | 2005                      |        |   | 2004 |  
|Cash flows from operating activities:                                                                        |  |                           |        |   |      |   |         |  
|Net income                                                                                                   |  | $                         | 7,980  |   |      | $ | 4,716   |  
|Adjustments to reconcile net income to net cash provided by operating activities:                            |  |                           |        |   |      |   |         |  
|Depreciation and amortization                                                                                |  |                           | 8,030  |   |      |   | 6,129   |  
|Provision for doubtful accounts and product returns                                                          |  |                           | 336    |   |      |   | 208     |  
|Provision for excess and obsolete inventory                                                                  |  |                           | 200    |   |      |   | 92      |  
|Stock compensation expense                                                                                   |  |                           | 620    |   |      |   | 305     |  
|Other                                                                                                        |  |                           | 426    |   |      |   | (109    | )
|Changes in operating assets and liabilities, net of assets and liabilities acquired in business combination: |  |                           |        |   |      |   |         |  
|Accounts receivable                                                                                          |  |                           | (4,860 | ) |      |   | (2,188  | )
|Inventories                                                                                                  |  |                           | 219    |   |      |   | (1,690  | )
|Prepaid expenses and other current assets                                                                    |  |                           | (220   | ) |      |   | (2,239  | )
|Other assets                                                                                                 |  |                           | 11     |   |      |   | 136     |  
|Accounts payable                                                                                             |  |                           | (282   | ) |      |   | (432    | )
|Accrued and other liabilities                                                                                |  |                           | (1,719 | ) |      |   | (86     | )
|Income taxes payable                                                                                         |  |                           | 2,052  |   |      |   | 521     |  
|                                                                                                             |  |                           |        |   |      |   |         |  
|Net cash provided by operating activities                                                                    |  |                           | 12,793 |   |      |   | 5,363   |  
|                                                                                                             |  |                           |        |   |      |   |         |  
|Cash flows from investing activities:                                                                        |  |                           |        |   |      |   |         |  
|Purchases of property and equipment                                                                          |  |                           | (6,277 | ) |      |   | (7,599  | )
|Payment for purchase of MDA, net of cash acquired                                                            |  |                           |       |   |      |   | (24,694 | )
|Purchases of available-for-sale securities                                                                   |  |                           |       |   |      |   | (24,694 | )
|Sales or maturities of available-for-sale securities                                                         |  |                           |       |   |      |   | 21,461  |  
|                                                                                                             |  |                           |        |   |      |   |         |  
|Net cash used in investing activities                                                                        |  |                           | (6,277 | ) |      |   | (35,526 | )
|                                                                                                             |  |                           |        |   |      |   |         |  
|Cash flows from financing activities:                                                                        |  |                           |        |   |      |   |         |  
|Repayment on loan from bank                                                                                  |  |                           | (2,143 | ) |      |   |        |  
|Proceeds from loan from bank, net of issuance costs                                                          |  |                           |       |   |      |   | 14,915  |  
|Proceeds from issuance of common stock, net of issuance costs                                                |  |                           | 637    |   |      |   | 461     |  
|Proceeds from exercise of options to purchase common stock                                                   |  |                           | 6,209  |   |      |   | 5,763   |  
|                                                                                                             |  |                           |        |   |      |   |         |  
|Net cash provided by financing activities                                                                    |  |                           | 4,703  |   |      |   | 21,139  |  
|                                                                                                             |  |                           |        |   |      |   |         |  
|Effect of exchange rate changes on cash and cash equivalents                                                 |  |                           | (465   | ) |      |   | (20     | )
|                                                                                                             |  |                           |        |   |      |   |         |  
|Net increase (decrease) in cash and cash equivalents                                                         |  |                           | 10,754 |   |      |   | (9,044  | )
|Cash and cash equivalents, beginning of period                                                               |  |                           | 21,836 |   |      |   | 20,890  |  
|                                                                                                             |  |                           |        |   |      |   |         |  
|Cash and cash equivalents, end of period                                                                     |  | $                         | 32,590 |   |      | $ | 11,846  |  
|                                                                                                             |  |                           |        |   |      |   |         |  



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



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ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)



NOTE 1  Description of Business and Basis of Presentation



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



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



The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles for
interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial
statements. In the opinion of management, the unaudited interim condensed consolidated financial statements reflect all adjustments (consisting of only normal recurring adjustments) necessary for a fair presentation of the Companys financial
position, results of operations and cash flows for the periods presented. These financial statements should be read in conjunction with the Companys consolidated financial statements and notes thereto filed with the United States Securities
and Exchange Commission in the Companys annual report on Form 10-K for the year ended December 31, 2004. Operating results for the three and six month periods ended June 30, 2005 are not necessarily indicative of the results that may be
expected for the year ended December 31, 2005.



The condensed
consolidated balance sheet at December 31, 2004 was derived from the Companys audited consolidated financial statements as of that date; however, the accompanying financial statements do not include all annual disclosures required by
accounting principles generally accepted in the United States of America.



Use of Estimates



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



Reclassifications



Certain prior year amounts have been reclassified to conform to the current period presentation. These reclassifications had no effect on reported net
income. Amortization expense related to intangible assets has been reclassified from sales and marketing and general and administrative expense to amortization of intangible assets in the accompanying condensed consolidated statements of operations.



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ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)



NOTE 2 - Stock-Based Compensation



Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (Statement
123), prescribes accounting and reporting standards for all stock-based compensation plans, including employee stock options. As allowed by Statement 123, the Company accounts for stock-based employee compensation using the intrinsic value
method of accounting in accordance with Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. When the Company issues options or its stock to its employees at an exercise price
equal to the market value of the underlying common stock on the date of grant or issuance, no stock-based compensation costs are recorded. In the event that options are granted or restricted shares are issued at an exercise price that is less than
the market value of the underlying common stock on the date of grant or issuance, the Company records deferred compensation expense in an amount equivalent to the difference between the market value and the exercise price of the respective option or
restricted stock.



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, 2005 and
2004 would have been as follows (in thousands, except per share data):



|                                                                                                                                        |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |        |  
|--------------------------------------------------------------------------------------------------------------------------------------- |  | -------------------------- | ------ | - | ------------------------ | - | ------ | ---- |  | - | ------ | - |  | - | ------ | -
|                                                                                                                                        |  | Three Months EndedJune 30, |        |   | Six Months EndedJune 30, |  
|                                                                                                                                        |  | 2005                       |        |   | 2004                     |   |        | 2005 |  |   | 2004   |  
|Net incomeas reported                                                                                                                  |  | $                          | 4,818  |   |                          | $ | 3,147  |      |  | $ | 7,980  |   |  | $ | 4,716  |  
|Add: Stock-based employee compensation expense recognized in net income, net of tax effects                                             |  |                            | 192    |   |                          |   |       |      |  |   | 323    |   |  |   |       |  
|Less: Total employee stock-based compensation expense determined under the fair value method for all awards, net of related tax
effects |  |                            | (2,094 | ) |                          |   | (3,094 | )    |  |   | (4,033 | ) |  |   | (6,125 | )
|                                                                                                                                        |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |        |  
|Pro forma net income (loss)                                                                                                             |  | $                          | 2,916  |   |                          | $ | 53     |      |  | $ | 4,270  |   |  | $ | (1,409 | )
|                                                                                                                                        |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |        |  
|Net income (loss) per share:                                                                                                            |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |        |  
|Basicas reported                                                                                                                       |  | $                          | 0.20   |   |                          | $ | 0.15   |      |  | $ | 0.33   |   |  | $ | 0.22   |  
|Basicpro forma                                                                                                                         |  | $                          | 0.12   |   |                          | $ | 0.00   |      |  | $ | 0.18   |   |  | $ | (0.07  | )
|Dilutedas reported                                                                                                                     |  | $                          | 0.19   |   |                          | $ | 0.14   |      |  | $ | 0.31   |   |  | $ | 0.21   |  
|Dilutedpro forma                                                                                                                       |  | $                          | 0.11   |   |                          | $ | 0.00   |      |  | $ | 0.17   |   |  | $ | (0.06  | )



Equity instruments
issued to non-employees are recorded at their fair value in accordance with Statement 123 and Emerging Issues Task Force Issue No. 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction
with Selling, Goods or Services.



During the six months
ended June 30, 2005, the Company issued 76,000 restricted common stock shares to certain employees under its 2003 Incentive Stock Plan, 6,000 of which were issued during the second quarter of 2005. These awards vest over a period of five years. In
connection with the restricted awards, the Company recorded an increase of approximately $2.4 million to deferred stock-based compensation for the value of these awards. Of that increase, $0.2 million related to the second quarter of 2005. Deferred
stock-based compensation will be amortized to operating expense over the vesting period of the awards.



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ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)



NOTE 3 - Computation of Net Income Per Share



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



The following is a reconciliation of the numerator (net income) and the
denominator (number of shares) used in the calculation of basic and diluted net income per share (in thousands, except per share data):



|                                                                         |  |                             |               |                           |   |                |  |      |               |  |   |               
|------------------------------------------------------------------------ |  | --------------------------- | ------------- | ------------------------- | - | -------------- |  | ---- | ------------- |  | - | --------------
|                                                                         |  | Three Months Ended June 30, |               | Six Months Ended June 30,
|                                                                         |  | 2005                        |               | 2004                      |   | 2005           |  | 2004
|Net Income                                                               |  | $                           | 4,818         |                           | $ | 3,147          |  | $    | 7,980         |  | $ | 4,716         
|                                                                         |  |                             |               |                           |   |                |  |      |               |  |   |               
|Basic:                                                                   |  |                             |               |                           |   |                |  |      |               |  |   |               
|Weighted-average shares outstanding                                      |  |                             | 24,176        |                           |   | 21,159         |  |      | 24,044        |  |   | 21,085        
|                                                                         |  |                             |               |                           |   |                |  |      |               |  |   |               
|Basic net income per share                                               |  | $                           | 0.20          |                           | $ | 0.15           |  | $    | 0.33          |  | $ | 0.22          
|                                                                         |  |                             |               |                           |   |                |  |      |               |  |   |               
|Diluted:                                                                 |  |                             |               |                           |   |                |  |      |               |  |   |               
|Weighted-average shares outstanding used in basic calculation            |  |                             | 24,176        |                           |   | 21,159         |  |      | 24,044        |  |   | 21,085        
|Dilutive effect of options                                               |  |                             | 1,614         |                           |   | 1,540          |  |      | 1,705         |  |   | 1,627         
|Dilutive effect of unvested restricted stock                             |  |                             | 87            |                           |   | 66             |  |      | 84            |  |   | 67            
|                                                                         |  |                             |               |                           |   |                |  |      |               |  |   |               
|Weighted-average shares and equivalents                                  |  |                             | 25,877        |                           |   | 22,765         |  |      | 25,833        |  |   | 22,779        
|                                                                         |  |                             |               |                           |   |                |  |      |               |  |   |               
|Diluted net income per share                                             |  | $                           | 0.19          |                           | $ | 0.14           |  | $    | 0.31          |  | $ | 0.21          
|                                                                         |  |                             |               |                           |   |                |  |      |               |  |   |               
|Options excluded from calculation as their effect would be anti-dilutive |  |                             | 558           |                           |   | 1,150          |  |      | 512           |  |   | 1,047         
|                                                                         |  |                             |               |                           |   |                |  |      |               |  |   |               
|Price range of excluded options                                          |  |                             | $31.44-$48.56 |                           |   | $23.38- $48.56 |  |      | $30.35-$48.56 |  |   | $24.01- $48.56
|                                                                         |  |                             |               |                           |   |                |  |      |               |  |   |               



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##### Table of Contents

ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)



NOTE 4 - Comprehensive Income



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



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



|                                                                                                               |  |                            |       |      |                         |       |      |  |      |       |  |   |       |  
|-------------------------------------------------------------------------------------------------------------- |  | -------------------------- | ----- | ---- | ----------------------- | ----- | ---- |  | ---- | ----- |  | - | ----- | -
|                                                                                                               |  | Three Months EndedJune 30, |       |      | Six Month EndedJune 30, |      
|                                                                                                               |  | 2005                       |       | 2004 |                         |       | 2005 |  | 2004 |      
|Net income                                                                                                     |  | $                          | 4,818 |      | $                       | 3,147 |      |  | $    | 7,980 |  | $ | 4,716 |  
|                                                                                                               |  |                            |       |     
|Net unrealized gains on available-for-sale securities arising during the period, net of tax                    |  |                            |      |      |                         | (37   | )    |  |      |      |  |   | 238   |  
|Less: Reclassification adjustment for gains on available-for-sale securities, net of tax, included in earnings |  |                            |      |      |                         |      |      |  |      |      |  |   | (113  | )
|Foreign currency translation adjustment                                                                        |  |                            | 146   |      |                         | (36   | )    |  |      | 126   |  |   | 20    |  
|                                                                                                               |  |                            |       |      |                         |       |      |  |      |       |  |   |       |  
|Comprehensive income                                                                                           |  | $                          | 4,964 |      | $                       | 3,074 |      |  | $    | 8,106 |  | $ | 4,861 |  
|                                                                                                               |  |                            |       |      |                         |       |      |  |      |       |  |   |       |  



NOTE 5  Inventories



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



|                |  |               |        |                  |   |       
|--------------- |  | ------------- | ------ | ---------------- | - | ------
|                |  | June 30, 2005 |        | December 31,2004
|Raw materials   |  | $             | 10,323 |                  | $ | 10,809
|Work-in-process |  |               | 4,060  |                  |   | 5,349 
|Finished goods  |  |               | 25,926 |                  |   | 24,326
|                |  |               |        |                  |   |       
|Total           |  | $             | 40,309 |                  | $ | 40,484
|                |  |               |        |                  |   |       



The Companys
inventories, which include material and labor costs, are stated at standard cost, which approximates actual cost determined on a first-in, first-out basis, not in excess of market value. The Company records reserves, when necessary, to reduce the
carrying value of excess or obsolete inventories to their net realizable value. The Companys reserve for excess and obsolete inventories was $1.2 million and $1.0 million at June 30, 2005 and December 31, 2004, respectively.



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##### Table of Contents

ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)



NOTE 6 - Intangible Assets



Intangible assets are originally recorded at historical cost, in the case of separately purchased intangible assets, or at
estimated fair value, in the case of assets acquired in the purchase of a business. Intangible assets consist of the following (in thousands):



|                              |  |               |        |   |                  |   |        |  
|----------------------------- |  | ------------- | ------ | - | ---------------- | - | ------ | -
|                              |  | June 30, 2005 |        |   | December 31,2004 |  
|Intellectual property rights  |  | $             | 23,700 |   |                  | $ | 23,700 |  
|Patents                       |  |               | 10,500 |   |                  |   | 10,500 |  
|Trade name/trademarks         |  |               | 4,400  |   |                  |   | 4,400  |  
|Distribution/customer network |  |               | 3,700  |   |                  |   | 3,700  |  
|OEM contractual agreements    |  |               | 1,160  |   |                  |   | 1,160  |  
|Distribution license          |  |               | 450    |   |                  |   | 450    |  
|Employment agreements         |  |               | 300    |   |                  |   | 300    |  
|Non-competition agreements    |  |               | 300    |   |                  |   | 300    |  
|                              |  |               |        |   |                  |   |        |  
|                              |  |               | 44,510 |   |                  |   | 44,510 |  
|Accumulated amortization      |  |               | (7,620 | ) |                  |   | (4,551 | )
|                              |  |               |        |   |                  |   |        |  
|Net intangible assets         |  | $             | 36,890 |   |                  | $ | 39,959 |  
|                              |  |               |        |   |                  |   |        |  



Intangible assets with
definite lives are being amortized on a straight-line basis over the assets estimated useful lives, which range between one and ten years. The Company periodically reviews the estimated useful lives of its identifiable intangible assets,
taking into consideration any events or circumstances that might result in either a diminished fair value or revised useful life. Total amortization expense for the three and six months ended June 30, 2005 was approximately $1.5 million and $2.9
million million, respectively. Total amortization expense for the three and six months ended June 30, 2004 was approximately $0.5 million and $1.1 million, respectively.



Estimated amortization expense for the six months ended December 31, 2005 and the next five years is as follows for all
intangible assets (in thousands):



|                                            |  |   |       
|------------------------------------------- |  | - | ------
|For the six months ending December 31, 2005 |  | $ | 3,053 
|For the year ending December 31, 2006       |  |   | 6,011 
|For the year ending December 31, 2007       |  |   | 5,784 
|For the year ending December 31, 2008       |  |   | 4,962 
|For the year ending December 31, 2009       |  |   | 4,815 
|For the year ending December 31, 2010       |  |   | 4,597 
|Thereafter                                  |  |   | 7,668 
|                                            |  |   |       
|                                            |  | $ | 36,890
|                                            |  |   |       



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##### Table of Contents

ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)



NOTE 7Commitments and Contingencies



Operating Leases



The Company leases facilities and certain equipment under operating leases. It recognizes rent expense on a straight-line basis over the lease term. Rent
expense was $0.8 million for the three months ended June 30, 2005 and $0.6 million for the three months ended June 30, 2004. Rent expense was $1.4 million for the six months ended June 30, 2005 and $1.2 million for the six months ended June 30,
2004. At June 30, 2005, total future minimum lease payments are as follows (in thousands):



|                                            |  |   |      
|------------------------------------------- |  | - | -----
|For the six months ending December 31, 2005 |  | $ | 1,119
|For the year ending December 31, 2006       |  |   | 1,912
|For the year ending December 31, 2007       |  |   | 406  
|                                            |  |   |      
|Total                                       |  | $ | 3,437
|                                            |  |   |      



The Company does not
have any significant contractual obligations other than those leases disclosed above and debt as discussed in Note 8.



Warranties



The Company generally provides customers with a limited 90-day warranty on devices sold and a limited 1-year warranty on controller units sold. The
Companys warranty obligation is impacted by product failure rates, material usage and service delivery costs incurred in correcting a product failure. It periodically evaluates and adjusts the warranty reserve to the extent actual warranty
expense varies from the original estimates. The activity in its warranty accrual for the three and six months ended June 30, 2005 and 2004 was as follows (in thousands):



|                                                 |  |                            |      |   |                          |   |      |      |  |   |      |   |  |   |      |  
|------------------------------------------------ |  | -------------------------- | ---- | - | ------------------------ | - | ---- | ---- |  | - | ---- | - |  | - | ---- | -
|                                                 |  | Three Months EndedJune 30, |      |   | Six Months EndedJune 30, |  
|                                                 |  | 2005                       |      |   | 2004                     |   |      | 2005 |  |   | 2004 |  
|Balance at beginning of period                   |  | $                          | 153  |   |                          | $ | 276  |      |  | $ | 207  |   |  | $ | 252  |  
|Accruals for warranties issued during the period |  |                            | 269  |   |                          |   | 72   |      |  |   | 651  |   |  |   | 411  |  
|Warranty costs incurred during the period        |  |                            | (231 | ) |                          |   | (116 | )    |  |   | (667 | ) |  |   | (431 | )
|                                                 |  |                            |      |   |                          |   |      |      |  |   |      |   |  |   |      |  
|Balance at end of period                         |  | $                          | 191  |   |                          | $ | 232  |      |  | $ | 191  |   |  | $ | 232  |  
|                                                 |  |                            |      |   |                          |   |      |      |  |   |      |   |  |   |      |  



Litigation



On July 25, 2001, ArthroCare filed a lawsuit against Smith & Nephew,
Inc. (Smith & Nephew or Defendant) in the United States District Court of Delaware. The lawsuit alleges, among other things, that Smith & Nephew has been, and is currently, infringing three patents issued to
ArthroCare. Specifically, Smith & Nephew uses, imports, markets and sells electrosurgical products under the names of Dyonics Control RF System, ElectroBlade and Saphyre that infringe these patents. ArthroCare seeks the following remedies: (1) a judgment that Smith & Nephew has
infringed these patents; (2) a permanent injunction precluding Smith & Nephew from using, importing, marketing and selling the above-referenced products; and (3) an award of damages (including attorneys fees) to compensate us for lost
profits and Defendants use of our inventions with the damages to be trebled because of Smith & Nephews willful infringement. On May 12, 2003, the jury held that the use, manufacture and sale of the Dyonics Control RF System, the
ElectroBlade and the Saphyre 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



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##### Table of Contents

ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)



verdict in June 2003 and held a hearing on September 15, 2003 to consider Defendants motions to overturn the jurys verdict. On March 10, 2004,
the U.S. District Court in Delaware granted ArthroCares motion for permanently enjoining Smith & Nephew from manufacturing, using or selling in the United States surgical devices (the Saphyre, Dyonics Control RF and ElectroBlade) that infringe ArthroCares patents. In
addition, the Court denied all of Smith & Nephews post-trial motions, including those requesting a new trial and for judgment as a matter of law. The Court also granted ArthroCares motions for judgment of no inequitable conduct and
dismissal of the antitrust counterclaim. On April 27, 2004, the Court rejected Smith & Nephews request for a stay of the permanent injunction pending appeal. On June 10, 2004, the Court issued an injunction order enjoining Smith &
Nephew from the use, manufacture and sale of the infringing products in the United States. Smith & Nephews has appealed the above rulings in the Federal Circuit Court of Appeals.



On May 10, 2005, the Federal Circuit Court of Appeals rejected Smith & Nephews challenges against two ArthroCare
patents (U.S. Patent Nos. 5,697,882 and 6,224,592), thereby affirming the jurys verdict that all of the asserted claims of those two patents are valid and were infringed by Smith & Nephew. The court also rejected the asserted claims of one
ArthroCare patent (U.S. Patent No. 5,697,536), stating because the jurys determination that the 536 patent was not invalid is not supported by substantial evidence, we reverse the district courts denial of Smith &
Nephews motion for judgment as a matter of law on that issue. In addition, the federal appeals court concluded a procedural error occurred in the U.S. District Court proceedings related to Smith & Nephews antitrust
counterclaim. As a result, the Federal Appeals Court ruled that because the district court must reconsider that counterclaim on remand, the permanent injunction against Smith & Nephew must be vacated pending the disposition of the
antitrust counterclaim. ArthroCare expects to learn how long the disposition process will take in the coming months as it ascertains the District Courts schedule.



On April 3, 2003, Smith & Nephew filed a lawsuit against the Company in the United States District Court, Western
Tennessee alleging that ArthroCare infringed two Smith & Nephew patents  nos. 5,980,504 and 6,261,311. In addition, Smith & Nephew has alleged that ArthroCare is in violation of Section 43(A) of the Lanham Act for allegedly making
false or misleading statements to deceive potential purchasers of Smith & Nephews medical devices. Smith & Nephew has requested the Court to issue preliminary and permanent injunction preventing ArthroCare from further infringement of
the above-mentioned patents and from making further false or misleading statements concerning Smith & Nephews medical devices. In addition, Smith & Nephew has requested the Court to award compensatory damages and treble damages for
willfulness, as well as legal fees. The Company believes these claims to be without merit and will defend itself vigorously.



In July 2003, a product liability suit was brought against the Company in the New York State Supreme Court, County of Westchester. The lawsuit alleged
that a patient suffered injury to her shoulder as a result of a defective ArthroCare probe used in an arthroscopic procedure on the patient. This lawsuit was settled in April of 2005 with no significant impact to ArthroCares financial
condition.



On October 27, 2003, a product liability suit was
brought against the Company in the 9th Judicial Circuit, Orange County, Florida. The lawsuit alleged, among other things, that a patient died on July 27, 2001 as a result of a defective ArthroCare product used in a tonsillectomy procedure on the
patient. This lawsuit was settled in April of 2005 with no significant impact to ArthroCares financial condition.



On April 13, 2005, a product liability suit was brought against the Company in the United States District Court, Eastern District of Texas. The lawsuit
alleges, among other things, that a patient suffered injury to his shoulder as a result of a defective ArthroCare probe used in an arthroscopic procedure on the patient. Upon initial review, the Company believes these claims to be without merit and
intends to defend itself vigorously.



The Company believes that
it has meritorious defenses against the above claims and intends to vigorously contest them. The outcomes of the outstanding litigation matters discussed above are not considered probable or cannot be reasonably estimated for the purpose of
recording a liability. Also, except as otherwise described above, the Company has product liability insurance coverage in amounts it considers necessary to prevent material losses. The Company recognizes losses when they are known or considered
probable and the amount can be reasonably estimated.



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##### Table of Contents

ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)



NOTE 8 - DEBT



In October 2004, in anticipation of the acquisition of Opus Medical, the Company amended and restated its existing credit facility with Bank of America,
N.A. and Wells Fargo Bank, National Association, as co-lenders. Under the terms of the amended and restated credit facility, ArthroCare may borrow up to $20.0 million under a revolving line of credit and we may borrow up to $30.0 million under a
term commitment loan. The Company may borrow under either of these loans at the Bank of America prime rate plus 0.0% to 1.0% or at a Eurodollar rate. The increase over the base rate of either type of loan is determined by our leverage ratio, as
defined in the amended and restated credit facility. The amended and restated credit facility contains covenants that specify minimum financial ratios and limit our ability to take on additional debt, or make significant future acquisitions or
dispositions. Violation of certain of the covenants may result in acceleration of our repayment obligation.



The revolving line of credit expires in 2007 and the term commitment loan expires in 2011. At June 30, 2005, the Company had not drawn upon the $20.0
million revolving line of credit. At June 30, 2005, the weighted average interest rate applicable to borrowings under the amended and restated credit facility was approximately 4.6%.



NOTE 9 - Segment Information



The Company has organized its marketing and sales efforts based on four operating segments which are aggregated into one reportable segment  the
development, manufacture and marketing of products based on our Coblation technology and other soft-tissue surgical products based on products obtained through the acquisitions of Opus Medical, MDA, and Atlantech. Each of the Companys
operating segments has similar economic characteristics, technology, manufacturing processes, customers, distribution and marketing strategies, regulatory environments, and shared infrastructures. These operating segments, which are referred to as
product markets, are Sports Medicine (shoulder and knee arthroscopic products), ENT, (ear, nose, throat and the Visage® cosmetic products), ArthroCare Spine (spinal and neuro surgery products) and Coblation Technology (gynecology, urology, laparoscopic, general surgical and cardiology products).



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



|                     |  |                             |        |  |                           |   |  |      |        |  |      |   |  |   |        |  |     |   |  |   |        |  |     |  
|-------------------- |  | --------------------------- | ------ |  | ------------------------- | - |  | ---- | ------ |  | ---- | - |  | - | ------ |  | --- | - |  | - | ------ |  | --- | -
|                     |  | Three Months Ended June 30, |        |  | Six Months Ended June 30, |  
|                     |  | 2005                        |        |  | 2004                      |   |  | 2005 |        |  | 2004 |  
|Sports Medicine      |  | $                           | 32,976 |  | 66                        | % |  | $    | 23,115 |  | 65   | % |  | $ | 66,348 |  | 68  | % |  | $ | 46,305 |  | 66  | %
|ENT                  |  |                             | 10,785 |  | 22                        | % |  |      | 7,158  |  | 20   | % |  |   | 19,717 |  | 20  | % |  |   | 12,818 |  | 18  | %
|ArthroCare Spine     |  |                             | 5,922  |  | 12                        | % |  |      | 5,498  |  | 15   | % |  |   | 11,408 |  | 12  | % |  |   | 10,967 |  | 16  | %
|Coblation Technology |  |                             |       |  | 0                         | % |  |      | 133    |  | 0    | % |  |   | 44     |  | 0   | % |  |   | 106    |  | 0   | %
|                     |  |                             |        |  |                           |   |  |      |        |  |      |   |  |   |        |  |     |   |  |   |        |  |     |  
|Total Product Sales  |  | $                           | 49,683 |  | 100                       | % |  | $    | 35,904 |  | 100  | % |  | $ | 97,517 |  | 100 | % |  | $ | 70,196 |  | 100 | %
|                     |  |                             |        |  |                           |   |  |      |        |  |      |   |  |   |        |  |     |   |  |   |        |  |     |  



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ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)



Internationally, the Company markets and supports its products primarily through its subsidiaries and
various distributors. Revenues attributed to geographic areas are based on the country in which subsidiaries are domiciled. Product sales by geography for the periods shown were as follows (in thousands):



|                    |  |                             |        |  |                           |   |  |      |        |  |      |   |  |   |        |  |     |   |  |   |        |  |     |  
|------------------- |  | --------------------------- | ------ |  | ------------------------- | - |  | ---- | ------ |  | ---- | - |  | - | ------ |  | --- | - |  | - | ------ |  | --- | -
|                    |  | Three Months Ended June 30, |        |  | Six Months Ended June 30, |  
|                    |  | 2005                        |        |  | 2004                      |   |  | 2005 |        |  | 2004 |  
|Americas            |  | $                           | 39,149 |  | 79                        | % |  | $    | 26,908 |  | 75   | % |  | $ | 76,656 |  | 79  | % |  | $ | 51,936 |  | 74  | %
|United Kingdom      |  |                             | 2,618  |  | 5                         | % |  |      | 3,240  |  | 9    | % |  |   | 5,785  |  | 6   | % |  |   | 5,653  |  | 8   | %
|Rest of World       |  |                             | 7,916  |  | 16                        | % |  |      | 5,756  |  | 16   | % |  |   | 15,076 |  | 15  | % |  |   | 12,607 |  | 18  | %
|                    |  |                             |        |  |                           |   |  |      |        |  |      |   |  |   |        |  |     |   |  |   |        |  |     |  
|Total Product Sales |  | $                           | 49,683 |  | 100                       | % |  | $    | 35,904 |  | 100  | % |  | $ | 97,517 |  | 100 | % |  | $ | 70,196 |  | 100 | %
|                    |  |                             |        |  |                           |   |  |      |        |  |      |   |  |   |        |  |     |   |  |   |        |  |     |  



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



|                        |  |               |        |  |                   |   |  |   |        |  |     |  
|----------------------- |  | ------------- | ------ |  | ----------------- | - |  | - | ------ |  | --- | -
|                        |  | June 30, 2005 |        |  | December 31, 2004 |  
|Americas                |  | $             | 23,384 |  | 71                | % |  | $ | 22,302 |  | 72  | %
|International           |  |               | 9,346  |  | 29                | % |  |   | 8,510  |  | 28  | %
|                        |  |               |        |  |                   |   |  |   |        |  |     |  
|Total long-lived assets |  | $             | 32,730 |  | 100               | % |  | $ | 30,812 |  | 100 | %
|                        |  |               |        |  |                   |   |  |   |        |  |     |  



NOTE 10  Recently Issued
Accounting Pronouncement



In December 2004, of the
Financial Accounting Standards Board issued Statement of Financial Accounting Standards 123R, Share-Based Payment (Statement 123R). Generally, the approach under Statement 123R will require companies to recognize as
compensation expense in the statements of operations the fair value of share-based payments to employees, including grants of employee stock options and the right to purchase shares under an employee stock purchase plan. The Company is required to
adopt Statement 123R in the first quarter of fiscal 2006. The pro forma disclosures previously permitted under Statement 123 will no longer be an alternative to financial statement recognition. See Note 2 in the notes to condensed consolidated
financial statements for the pro forma net income (loss) and net income (loss) amounts, for the three and six months ended June 30, 2005 and 2004, as if the Company had used a fair-value-based method similar to the methods required under Statement
123R to measure compensation expense for employee stock incentive awards.



Statement 123R permits adoption using one of two methods: (1) a modified prospective method in which compensation cost is recognized beginning on the effective date based on the requirements of Statement
123R for all share-based payments granted after the effective date and based on Statement 123 for all awards granted to employees prior to the effective date that remain unvested on the effective date or (2) a modified retrospective
method which includes the requirements of the modified prospective method, but also permits entities to restate all periods presented or prior interim periods of the year of adoption based on the amounts previously recognized under Statement 123 for
purposes of pro forma disclosures. The Company is evaluating the requirements of Statement 123R, including the adoption methods, and has not yet determined what effect the adoption of Statement 123R will have on its financial condition or results of
operations.



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##### Table of Contents

ARTHROCARE CORPORATION



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.



Our forward-looking statements generally relate to our growth strategies, financial
results, product development, regulatory approvals, competitive strengths, the scope of our intellectual property rights, and sales efforts. One must carefully consider forward-looking statements and understand that such statements involve a variety
of risks and uncertainties, known and unknown, and may be affected by inaccurate assumptions, including, among others, those discussed in the sections entitled Government Regulation, Patents and Proprietary Rights,
Competition and Additional Factors That Might Affect Future Results in Part 1 of our Annual Report on Form 10-K for the year ended December 31, 2004. Consequently, no forward-looking statement can be guaranteed and actual
results may vary materially.



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



Overview



We are a
medical device company that develops, manufactures and markets soft-tissue surgical products, consisting primarily of products based on our patented Coblation® technology and products obtained through the acquisitions of Opus Medical, MDA, and Atlantech. Our products allow
surgeons to operate with increased precision and accuracy, limiting damage to surrounding tissue and 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 (or disintigrate or remove), shrink, sculpt, cut, aspirate and suction soft-tissue with one multi-purpose surgical system.



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



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



In April 1998, we announced that we had entered the cosmetic surgery market and formed a business unit called Visage to commercialize Coblation technology in this field. In early 1999, we entered into a license and
distribution agreement with Collagen Aesthetics, Inc., which was subsequently purchased by Inamed Corporation. Under this agreement, Inamed Corporation acquired exclusive, worldwide, marketing rights for our cosmetic surgery line of products for the
dermatology and cosmetic surgery markets. In March 2001, we terminated this contract, alleging breach by Inamed of certain terms of the contract. We signed a settlement agreement with Inamed mutually releasing all claims against each other in 2002.
In April 2001,



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we began marketing and selling our cosmetic surgery product line through a network of distributors and direct sales representatives. In 2003, we granted
exclusive distribution rights to one U.S. distributor to sell the Visage product line exclusively for Microtouch. In 2004, we terminated this distribution agreement and granted an option to purchase the exclusive distribution rights to the Visage
product line to a small, privately-held company, NovaDermis. On December 31, 2004, this option expired and we now retain all rights to Coblation technology in this field.



In May 1998, we announced that we had entered the ear, nose and throat market and had formed a business unit called ENTec to
commercialize Coblation technology in this field.



In September
1999, we announced that we had entered the spinal surgery market. In February 2000, we announced that we were expanding our marketing efforts for our spinal surgery system to specifically address selected applications in neurosurgery. We are
marketing and selling our spinal surgery products through a network of independent distributors and direct sales representatives supported by regional managers worldwide. In January 2004, we acquired MDA and its majority-owned subsidiary, Parallax,
a business focused on the treatment of vertebral compression fractures. In November 2004, we acquired Opus Medical, a business focused on soft tissue to bone repair systems, including systems for the treatment of rotator cuff injuries.



We have received 510(k) clearance to market our Arthroscopic System in the
United States for use in arthroscopic surgery of the knee, shoulder, ankle, elbow, wrist and hip, and our Arthroscopy System is CE marked for use in arthroscopic surgery in Europe. Our Spinal Surgery System is CE marked and we have received 510(k)
clearance in the United States to market this system for spinal surgery and neurosurgery. Our ENT Surgery System has received 510(k) clearance in the United States and is CE marked for general head, neck and oral surgical procedures, including
tonsillectomy, adenoidectomy, snoring and the treatment of hypertrophic nasal turbinate and submucosal tissue channeling and shrinkage. Our Cosmetic Surgery System is CE marked for general dermatology and skin resurfacing for the purpose of wrinkle
reduction procedures and we have received 510(k) clearance for use of our Cosmetic Surgery System in general dermatology procedures and for skin resurfacing for the purpose of wrinkle reduction in the United States. We have received 510(k) clearance
to market Coblation technology for general surgery, gynecology and urology.



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



Overview of Second Quarter Results



Relative to the first quarter of 2005, total revenue for the second quarter of 2005 increased 4% to $51.7 million. The increase was driven primarily by
the performance of our sports medicine and ENT business units. Total revenue for the second quarter of 2005 increased 37% compared to the second quarter of 2004. This significant increase was driven by increased sales performance and products
associated with our acquisition of Opus Medical in 2004. International revenue represented approximately 21% of net product sales in the quarter. No single customer accounted for more than 10% of our net product sales.



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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)



Total operating expenses were approximately $29.9 million for the quarter, compared to $21.9 million
in the second quarter of 2004. This $8.0 million increase was driven by a combination of factors. Approximately $2.0 million represents increased sales and marketing expenses driven by our larger sales force; $2.7 million in increased commissions
associated with our volume-driven distributor commissions; $1.6 million of this increase is a result of higher research and development spending, $1.0 million of which relates to Opus Medical; and intangible asset amortization of $0.9 million
resulting from our Opus Medical acquisition. The remaining $0.8 million increase results from increases in general and administrative expenses due primarily to a lease termination payment, accounting services and Sarbanes-Oxley compliance costs, and
increased employee-related expenses resulting from increases in headcount.



Our cash and cash equivalents balance at June 30, 2005 was $32.6 million, an increase of approximately $10.8 million from December 31, 2004.



Our headcount at June 30, 2005 was 737, an increase of 14% from 645 at December 31, 2004. Headcount increases are primarily
attributable to increases in manufacturing personnel in Costa Rica associated with the transfer of Opus manufacturing, and additions of personnel in administration and finance.



Results of Operations and Financial Condition



Comparison of the three and six months ended June 30, 2005 to the three and six months ended June 30, 2004 (in thousands, unless
otherwise noted).



|                                         |  |                             |        |   |                           |     |    |      |   |        |      |  |     |    |  |   |         |   |  |     |    |  |   |        |  |     |  
|---------------------------------------- |  | --------------------------- | ------ | - | ------------------------- | --- | -- | ---- | - | ------ | ---- |  | --- | -- |  | - | ------- | - |  | --- | -- |  | - | ------ |  | --- | -
|                                         |  | Three Months Ended June 30, |        |   | Six Months Ended June 30, |    
|                                         |  | 2005                        |        |   | 2004                      |     |    | 2005 |   |        | 2004 | 
|Revenues:                                |  |                             |        |   |                           |     |    |      |   |        |      |  |     |    |  |   |         |   |  |     |    |  |   |        |  |     |  
|Product Sales                            |  | $                           | 49,683 |   |                           | 96  | %  |      | $ | 35,904 |      |  | 95  | %  |  | $ | 97,517  |   |  | 96  | %  |  | $ | 70,196 |  | 96  | %
|Royalties, fees, and other               |  |                             | 2,049  |   |                           | 4   | %  |      |   | 1,761  |      |  | 5   | %  |  |   | 3,898   |   |  | 4   | %  |  |   | 3,058  |  | 4   | %
|                                         |  |                             |        |   |                           |     |    |      |   |        |      |  |     |    |  |   |         |   |  |     |    |  |   |        |  |     |  
|Total revenues                           |  |                             | 51,732 |   |                           | 100 | %  |      |   | 37,665 |      |  | 100 | %  |  |   | 101,415 |   |  | 100 | %  |  |   | 73,254 |  | 100 | %
|                                         |  |                             |        |   |                           |     |    |     
|Cost of product sales                    |  |                             | 15,296 |   |                           | 30  | %  |      |   | 11,386 |      |  | 30  | %  |  |   | 30,773  |   |  | 30  | %  |  |   | 24,234 |  | 33  | %
|                                         |  |                             |        |   |                           |     |    |      |   |        |      |  |     |    |  |   |         |   |  |     |    |  |   |        |  |     |  
|Gross profit                             |  |                             | 36,436 |   |                           | 70  | %  |      |   | 26,279 |      |  | 70  | %  |  |   | 70,642  |   |  | 70  | %  |  |   | 49,020 |  | 67  | %
|                                         |  |                             |        |   |                           |     |    |     
|Operating expenses:                      |  |                             |        |   |                           |     |    |      |   |        |      |  |     |    |  |   |         |   |  |     |    |  |   |        |  |     |  
|Research and development                 |  |                             | 5,155  |   |                           | 10  | %  |      |   | 3,531  |      |  | 9   | %  |  |   | 10,007  |   |  | 10  | %  |  |   | 6,651  |  | 9   | %
|Sales and marketing                      |  |                             | 18,601 |   |                           | 36  | %  |      |   | 13,860 |      |  | 37  | %  |  |   | 36,951  |   |  | 36  | %  |  |   | 27,893 |  | 38  | %
|General and administrative               |  |                             | 4,708  |   |                           | 9   | %  |      |   | 3,986  |      |  | 11  | %  |  |   | 9,269   |   |  | 9   | %  |  |   | 7,093  |  | 10  | %
|Amortization of intangible assets        |  |                             | 1,458  |   |                           | 3   | %  |      |   | 544    |      |  | 1   | %  |  |   | 2,916   |   |  | 3   | %  |  |   | 1,050  |  | 1   | %
|                                         |  |                             |        |   |                           |     |    |      |   |        |      |  |     |    |  |   |         |   |  |     |    |  |   |        |  |     |  
|Total operating expenses                 |  |                             | 29,922 |   |                           | 58  | %  |      |   | 21,921 |      |  | 58  | %  |  |   | 59,143  |   |  | 58  | %  |  |   | 42,687 |  | 58  | %
|                                         |  |                             |        |   |                           |     |    |     
|Income from operations                   |  |                             | 6,514  |   |                           | 12  | %  |      |   | 4,358  |      |  | 12  | %  |  |   | 11,499  |   |  | 11  | %  |  |   | 6,333  |  | 9   | %
|Interest and other income (expense), net |  |                             | (366   | ) |                           | (1  | )% |      |   | (47    | )    |  | (1  | )% |  |   | (1,135  | ) |  | (1  | )% |  |   | 127    |  | 0   | %
|                                         |  |                             |        |   |                           |     |    |      |   |        |      |  |     |    |  |   |         |   |  |     |    |  |   |        |  |     |  
|Income before income tax provision       |  |                             | 6,148  |   |                           | 11  | %  |      |   | 4,311  |      |  | 11  | %  |  |   | 10,364  |   |  | 10  | %  |  |   | 6,460  |  | 9   | %
|Income Tax provision                     |  |                             | 1,330  |   |                           | 2   | %  |      |   | 1,164  |      |  | 3   | %  |  |   | 2,384   |   |  | 2   | %  |  |   | 1,744  |  | 3   | %
|                                         |  |                             |        |   |                           |     |    |      |   |        |      |  |     |    |  |   |         |   |  |     |    |  |   |        |  |     |  
|Net income                               |  | $                           | 4,818  |   |                           | 9   | %  |      | $ | 3,147  |      |  | 8   | %  |  | $ | 7,980   |   |  | 8   | %  |  | $ | 4,716  |  | 6   | %
|                                         |  |                             |        |   |                           |     |    |      |   |        |      |  |     |    |  |   |         |   |  |     |    |  |   |        |  |     |  



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Revenues



Product salesconsist primarily of sales of disposable devices and controllers. Product sales for the quarter ended June 30, 2005 were $49.7
million, compared to $35.9 million for the quarter ended June 30, 2004. Product sales for the six months ended June 30, 2005 were $97.5 million, compared to $70.2 million for the six months ended June 30, 2004.



Product sales by product market for the periods shown were as follows:



|                     |  |                             |        |  |                           |   |  |      |        |  |      |   |  |   |        |  |     |   |  |   |        |  |     |  
|-------------------- |  | --------------------------- | ------ |  | ------------------------- | - |  | ---- | ------ |  | ---- | - |  | - | ------ |  | --- | - |  | - | ------ |  | --- | -
|                     |  | Three Months Ended June 30, |        |  | Six Months Ended June 30, |  
|                     |  | 2005                        |        |  | 2004                      |   |  | 2005 |        |  | 2004 |  
|Sports Medicine      |  | $                           | 32,976 |  | 66                        | % |  | $    | 23,115 |  | 65   | % |  | $ | 66,348 |  | 68  | % |  | $ | 46,305 |  | 66  | %
|ENT                  |  |                             | 10,785 |  | 22                        | % |  |      | 7,158  |  | 20   | % |  |   | 19,717 |  | 20  | % |  |   | 12,818 |  | 18  | %
|ArthroCare Spine     |  |                             | 5,922  |  | 12                        | % |  |      | 5,498  |  | 15   | % |  |   | 11,408 |  | 12  | % |  |   | 10,967 |  | 16  | %
|Coblation Technology |  |                             |       |  | 0                         | % |  |      | 133    |  | 0    | % |  |   | 44     |  | 0   | % |  |   | 106    |  | 0   | %
|                     |  |                             |        |  |                           |   |  |      |        |  |      |   |  |   |        |  |     |   |  |   |        |  |     |  
|Total Product Sales  |  | $                           | 49,683 |  | 100                       | % |  | $    | 35,904 |  | 100  | % |  | $ | 97,517 |  | 100 | % |  | $ | 70,196 |  | 100 | %
|                     |  |                             |        |  |                           |   |  |      |        |  |      |   |  |   |        |  |     |   |  |   |        |  |     |  



The Company made two
acquisitions in fiscal 2004: MDA (acquired in January 2004) and Opus Medical (acquired in November 2004). Product sales by market for the periods presented were favorably impacted by sales of our acquired product lines. Product sales for the three
ended June 30, 2005 and 2004 included $9.3 million and $2.1 million, respectively, primarily in the Companys Sports Medicine and Spine product lines. Product sales for the six months ended June 30, 2004 included $19.1 million and $4.6 million
from these acquisitions.



Product sales by geography for the
periods shown were as follows:



|                    |  |                             |        |  |                           |   |  |      |        |  |      |   |  |   |        |  |     |   |  |   |        |  |     |  
|------------------- |  | --------------------------- | ------ |  | ------------------------- | - |  | ---- | ------ |  | ---- | - |  | - | ------ |  | --- | - |  | - | ------ |  | --- | -
|                    |  | Three Months Ended June 30, |        |  | Six Months Ended June 30, |  
|                    |  | 2005                        |        |  | 2004                      |   |  | 2005 |        |  | 2004 |  
|Americas            |  | $                           | 39,150 |  | 79                        | % |  | $    | 26,908 |  | 75   | % |  | $ | 76,655 |  | 79  | % |  | $ | 51,936 |  | 74  | %
|International       |  |                             | 10,533 |  | 21                        | % |  |      | 8,996  |  | 25   | % |  |   | 20,862 |  | 21  | % |  |   | 18,260 |  | 26  | %
|                    |  |                             |        |  |                           |   |  |      |        |  |      |   |  |   |        |  |     |   |  |   |        |  |     |  
|Total product sales |  | $                           | 49,683 |  | 100                       | % |  | $    | 35,904 |  | 100  | % |  | $ | 97,517 |  | 100 | % |  | $ | 70,196 |  | 100 | %
|                    |  |                             |        |  |                           |   |  |      |        |  |      |   |  |   |        |  |     |   |  |   |        |  |     |  



Our sustained increase
in direct sales presence has continued to have a positive effect on product sales since inception, as did the execution of our strategic plan to build market share through promotional programs of controller placements, commercialization of our
technology in fields outside of arthroscopy, and the introduction of new products designed to address surgical procedures that have traditionally been difficult to perform. Additionally, our improved presence in Europe and our acquisitions of
Atlantech, Parallax, and Opus Medical product lines have continued to have a positive effect on sales growth in the second quarter of 2005.



We generally sell our disposable devices at or near list price, except for sales to international distributors and marketing partners, which are sold at
discounted prices. We expect these discounts to continue in the future. For the three and six months ended June 30, 2005, disposable device sales comprised approximately 83% and 81% of product sales, respectively. This compares to disposable devise
sales of approximately 85% and 83% as a percentage of product sales for the three and six-month periods ended



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June 30, 2004. We anticipate that disposable device sales will remain the primary component of our product sales in the near future. We place controllers
with our customers at no cost or, infrequently, sell them to customers at substantial discounts to generate demand for our disposable devices.



Royalties, fees and other revenues consist mainly of revenue from the licensing of our products and technology. Royalties, fees and other revenues were
$2.0 million for the quarter ended June 30, 2005, compared to $1.8 million for the quarter ended June 30, 2004. The percentage of royalties, fees and other revenues as a percentage of income was 4% for the quarter ended June 30, 2005 and 5% for the
quarter ended June 30, 2004. The period over period increase is related to growth in the markets in which the Company receives royalties. Royalties, fees and other revenues were $3.9 million for the six months ended June 30, 2005, compared to $3.1
million for the six months ended June 30, 2004. The period over period increase is related to growth in the markets in which the Company receives royalties. The percentage of royalties, fees and other revenues as a percentage of income was 4% for
both the six months ended June 30, 2005 and June 30, 2004.



Cost of
Product Sales



Cost of product sales consist of
manufacturing costs, material costs, labor costs, manufacturing overhead, warranty and other direct product costs. Additionally, cost of product sales includes amortization of controller unit placements under a program whereby we maintain ownership
of controller units shipped to customers, with the costs being capitalized and amortized into cost of product sales over the useful life of the controller unit. Amortization of controllers was $1.6 million and $3.4 million for the three and six
months ended June 30, 2005, respectively. This compares to amortization of $1.5 million and $3.0 million for the three and six months ended June 30, 2004, respectively. Controller amortization represented 3.2% and 3.5% of product sales for the three
and six months ended June 30, 2005. This compares to 2004 where for the three and six months ended June 30, 2004, controller amortization represented 4.2% and 4.3% of product sales, respectively. The dollar increase for the three and six month
periods ended June 30, 2005 compared to the same periods in 2004 is driven by our customer acquisition efforts. The decrease as a percent of cost of sales for the three and six months ended June 30, 2005 compared to the same periods in 2004 is
driven by the increased revenue base generated by the Opus acquisition.



Cost of product sales was $15.3 million for the three months ended June 30, 2005, as compared to $11.4 million for the three months ended June 30, 2004, or 30% of revenue in both periods. Gross product margin as a percentage of product
sales increased to 69% in the second quarter of 2005 from 68% during the same period in the prior year. Cost of product sales was $30.1 million, or 30% of revenue for the six months ended June 30, 2005, as compared to $24.2 million, or 33% of
revenue, for the six months ended June 30, 2004. Gross product margin as a percentage of product sales increased to 68% in the first six months of 2005 from 66% during the same period in the prior year. The increase in gross margin percentage
compared to 2004 and favorable increase in cost of product sales year over year is due to lower manufacturing costs at our Costa Rica manufacturing facility. Controller manufacturing was principally conducted in Costa Rica during the first half of
fiscal year 2005, where we benefited from lower labor rates as compared to prior year.



Operating Expenses



Research and
development expenses were $5.2 million, or 10% of total revenues, for the quarter ended June 30, 2005, compared to $3.5 million, or 9% of total revenues, for the quarter ended June 30, 2004. The dollar increase is due to a continued investment
in our Coblation-based products and in the MDA product line. Specifically, the increase is primarily attributable to $1.3 million in increased compensation and related expenses due to additional headcount, $0.1 million in increased prototype
development costs, and $0.3 million in various other charges.



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Research and development expenses were $10.0 million, or 10% of total revenues, for the six months
ended June 30, 2005, compared to $6.7 million, or 9% of total revenues, for the same period in 2004. The increase is primarily attributable to $2.6 million in increased compensation and related expenses due to additional headcount, $0.5 million in
increased prototype development costs, accompanied by various other smaller charges totaling $0.2 million.



We continue to expect to increase the dollar amount of research and development expenses through additional expenditures on new product development,
including the newly-acquired MDA and Opus Medical products, regulatory affairs, clinical studies and patents. We expect these expenses as a percentage of product sales to remain essentially flat.



Sales and marketingexpenses were $18.6 million, or 36% of total
revenues, for the quarter ended June 30, 2005, compared to $13.9 million, or 37% of total revenues, for the quarter ended June 30, 2004. The increase in absolute dollars for the second quarter of 2005 compared to the second quarter of 2004 related
primarily to $2.7 million in increased sales commissions associated with increased sales volume, $1.4 million in additional compensation and related expenses associated with our increased direct sales force, and $0.6 million in increased training
and accounts receivable reserves.



Sales and marketing expenses
were $37.0 million, or 36% of total revenues, for the six months ended June 30, 2005, compared to $27.9 million, or 38% of total revenues, for the six months ended June 30, 2004. The increase in absolute dollars for the first half of 2005 compared
to the first half of 2004 related primarily to $5.2 million in increased sales commissions associated with increased sales volume, $2.9 million in additional compensation and related expenses associated with our increased direct sales force, and
$1.0 million in increased training and accounts receivable reserves.



We anticipate that sales and marketing spending will continue to increase in absolute dollars as a result of the expansion of our distribution capabilities to address the spinal surgery and ear, nose and throat markets, higher dealer
commissions from increased sales, the additional cost of penetrating international markets, higher promotional, demonstration and sample expenses, and additional investments in the sales, marketing and support staff necessary to market products and
to commercialize future products. Further absolute dollar increases in sales and marketing expenses are expected to be driven by increased sales volumes from all product lines.



General and administrative expenses were $4.7 million, or 9% of total revenues, for the quarter ended June 30, 2005,
compared to $4.0 million, or 10% of total revenues, for the quarter ended June 30, 2004. The increase in general and administrative expenses for the three months ended June 30, 2005 compared to the three months ended June 30, 2004 is due primarily
to approximately $0.3 million in additional salary-related expenses associated with strengthening our accounting and other administrative functions, $0.2 million due to a payment resulting from an early lease termination, and a $0.2 million increase
in outside services, principally related to our annual audit and Sarbanes-Oxley compliance activities.



General and administrative expenses were $9.3 million, or 9% of total revenues, for the six months ended June 30, 2005, compared to $7.1 million, or 10%
of total revenues, for the six months ended June 30, 2004. The increase in general and administrative expenses is due primarily to approximately $1.3 million in additional compensation and related expenses associated with strengthening our
accounting and other administrative functions, $0.7 million principally related to our annual audit and Sarbanes-Oxley compliance activities, and the remaining $0.2 million resulting from increased business insurance rates.



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We expect that general and administrative expenses will decrease as a percentage of total revenues,
but will increase in dollar amounts as we incur legal expenses associated with patent infringement litigation and continue business development activities.



Amortization of intangible assets increased to $1.5 million or 3% of total revenues, for the quarter ended June 30, 2005, compared to $0.5 million,
or 1% of total revenues, in the second quarter of 2004. Amortization of intangible assets increased to $2.9 million or 3% of total revenues, for the six months ended June 30, 2005, compared to $1.1 million, or 1% of total revenues, in the first half
of 2004. The increase in amortization for the three and six months ended June 30, 2005 as compared to the same periods in 2004 relates to amortization of intangible assets acquired in the Opus Medical and MDA acquisitions.



Interest and other income (expense), net increased to a net expense of
$0.4 million for the quarter ended June 30, 2005, compared to net expense of $47,000 for the quarter ended June 30, 2004. The increase in net interest and other expense of $0.3 million for the quarter ended June 30, 2005 compared to the quarter end
June 30, 2004 is primarily result of interest expense associated with debt incurred due to our acquisitions of MDA and Opus Medical.



Interest and other income (expense), net increased to a net expense of $1.1 million for the six months ended June 30, 2005, compared to net income of $0.1
million for the six months ended June 30, 2004. Of the $1.3 million increase in net interest and other expense, $0.5 million is associated with debt incurred due to our acquisitions of MDA and Opus Medical. The remaining net expense increase of $0.8
million is attributed to foreign exchange losses in the six months ended June 30, 2005, whereas we had foreign exchange gains in the same period of 2004.



We anticipate interest and other income to continue to decrease in the future due to the use of cash and borrowings in our purchase of MDA and Opus
Medical in January and November of 2004, respectively.



Income Tax Provision



The provision for income taxes was $1.3 million for an
effective tax rate of 22% for the quarter ended June 30, 2005, compared to $1.2 million for an effective tax rate of 27% for the quarter ended June 30, 2004. The provision for income taxes was $2.4 million for an effective tax rate of 23% for the
six months ended June 30, 2005, compared to $1.7 million for an effective tax rate of 27% for the six months ended June 30, 2004. The improvement in the effective tax rate is primarily due to the continued expansion of business activities in our
Costa Rican operations and to tax credits for research and development activities.



Liquidity and Capital Resources



As of June 30, 2005, we had $96.1 million in working capital, compared to $80.9 million at December 31, 2004. Our principal sources of liquidity consisted of $32.6 million in cash and cash equivalents. Cash equivalents consist of highly
liquid demand securities.



Cash generated by operating
activities for the six months ended June 30, 2005 was $12.8 million, primarily attributable to net income adjusted for non-cash items and an increase in income tax payable, partially offset by an increase in accounts receivable and a decrease in
accrued liabilities. Cash generated by operating activities for the six months ended June 30, 2004 was $5.4 million, mainly attributable to net income adjusted for non-cash items and increases in accounts receivable, inventories, and prepaid
expenses.



Cash used in investing activities for the six months
ended June 30, 2005 was $6.3 million, due primarily to the manufacturing of controllers. Cash used in investing activities for the six months ended June 30, 2004 was $35.5 million, due mainly to our purchase of MDA during the period. In addition, we
had additional capital purchases of $1.6 million in the second quarter of 2004 and net investment maturities of $3.2 million during the six months ended March 31, 2004.



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Cash generated in financing activities for the six months ended June 30, 2005 was $4.7 million, due
primarily to stock option purchases, partially offset by loan repayments. Cash provided by financing activities for the six months ended June 30, 2004 was $21.1 million, due mainly to the $15.0 million loan entered into in connection with the
purchase of MDA. In addition, we received $5.8 million for stock option purchases in the period as a result of our increasing stock price, inducing employees to exercise options.



In October 2004, in anticipation of the acquisition of Opus Medical, the Company amended and restated its existing credit
facility with Bank of America, N.A. and Wells Fargo Bank, National Association, as co-lenders. Under the terms of the amended and restated credit facility, ArthroCare may borrow up to $20.0 million under a revolving line of credit and we may borrow
up to $30.0 million under a term commitment loan. The Company may borrow under either of these loans at the Bank of America prime rate plus 0.0% to 1.0% or at a Eurodollar rate. The increase over the base rate of either type of loan is determined by
our leverage ratio, as defined in the amended and restated credit facility. The amended and restated credit facility contains covenants that specify minimum financial ratios and limit our ability to take on additional debt, or make significant
future acquisitions or dispositions. Violation of certain of the covenants may result in acceleration of our repayment obligation.



The revolving line of credit expires in 2007 and the term commitment loan expires in 2011. At June 30, 2005, the Company had not drawn upon the $20.0
million revolving line of credit. At June 30, 2005, the weighted average interest rate applicable to borrowings under the amended and restated credit facility was approximately 4.6%.



We believe that the above-described credit and term facilities, in addition to cash generated from operations, will be
sufficient to fund our operations through fiscal year 2005 and in the near future. Our future liquidity and capital requirements will depend on numerous factors, including our success in commercializing our products, development and
commercialization of products in fields other than arthroscopy, the ability of our suppliers to continue to meet our demands at current prices, obtaining and enforcing patents important to our business, the status of regulatory approvals and
competition.



There have been no significant changes in
our contractual obligations and other commitments as previously disclosed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2004. We have no off-balance sheet financing arrangements other than certain operating leases as
previously disclosed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2004.



Critical Accounting Policies and Estimates



Our consolidated financial statements are prepared in conformity with generally accepted accounting principles, which requires the use of estimates, judgments, and assumptions that affect the reported amounts of
assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the periods presented. Our accounting policies and critical accounting estimates are described in Note 2 to the 2004 Consolidated
Financial Statements in our Form 10-K for the fiscal year ended December 31, 2004. Management believes that the accounting estimates employed are appropriate and resulting balances are reasonable; however, actual results could differ from the
original estimates, requiring adjustments to these balances in future periods. Management has discussed the development, selection and disclosures of its critical accounting estimates with the Audit Committee of ArthroCares Board of Directors,
and the Audit Committee has reviewed our disclosures relating to these estimates.



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Additional Factors That Might Affect Future Results



There are numerous factors that affect ArthroCares business and the
results of its operations. These factors include general economic and business conditions; our dependency upon our Arthroscopic Surgery System; uncertainty of the commercial success of products outside of our core businesses; our limited marketing
and sales experience; our dependency on key suppliers; the level and intensity of competition in our core businesses; uncertainty over reimbursement from health care payers for procedures in which our products are used or adverse changes in
environmental and private third-party payers policies toward reimbursement; business integration risks; fluctuating operating results due to many factors, including, but not limited to, product and production-related as well as research and
development activities; risks associated with our ability to protect our intellectual property; risks associated with potential patent litigation; the potential volatility of our stock; Delaware law provisions in our charter and our stockholder
rights plan could make the acquisition of our company by another company more difficult; the requirement that we must obtain governmental clearances or approvals before we can sell our products and we must continue to comply with applicable laws and
regulations; and, future changes in the accounting treatment for employee stock options may cause adverse unexpected fluctuations and affect our reported results of operations. For a discussion of these and other factors affecting ArthroCares
business, see Item 1  Business  Additional Factors That Might Affect Future Results  in our Form 10-K for the fiscal year ended December 31, 2004. In addition to the factors listed above and discussed in detail in our Form
10-K for the fiscal year ended December 31, 2004, the following factors could also affect our business and results of operations, as discussed below.



Our Business May Become Increasingly Susceptible to Risks Associated with International Operations



International operations are generally subject to a number of risks, including:



| |  |  | protectionist laws and business practices that favor local competition;
| | - |  | -----------------------------------------------------------------------



| |  |  | changes in jurisdictional tax laws including laws regulating intercompany transactions;
| | - |  | ---------------------------------------------------------------------------------------



| |  |  | dependence on local vendors;
| | - |  | ----------------------------



| |  |  | multiple, conflicting and changing governmental laws and regulations;
| | - |  | ---------------------------------------------------------------------



| |  |  | difficulties in collecting accounts receivable;
| | - |  | -----------------------------------------------



| |  |  | seasonality of operations;
| | - |  | --------------------------



| |  |  | difficulties in staffing and managing foreign operations;
| | - |  | ---------------------------------------------------------



| |  |  | licenses, tariffs, and other trade barriers;
| | - |  | --------------------------------------------



| |  |  | loss of proprietary information due to piracy, misappropriation or weaker laws regarding intellectual property protection;
| | - |  | --------------------------------------------------------------------------------------------------------------------------



| |  |  | foreign currency exchange rate fluctuations; and
| | - |  | ------------------------------------------------



| |  |  | political and economic instability.
| | - |  | -----------------------------------



We derived 21% and 25% of our total revenue for the quarters ended June 30, 2005 and 2004, respectively, from customers located outside of the Americas.
We expect international revenue to remain a large percentage of total revenue and we believe that we must continue to expand our international sales activities to be successful. Historically, a majority of our international revenues and costs have
been denominated in foreign currencies, and we expect future international revenues and costs will be denominated in foreign currencies. Our international sales growth will be limited if we are unable to



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establish appropriate foreign operations, expand international sales channel management and support organizations, hire additional personnel, develop
relationships with international sales representatives, and establish relationships with additional distributors. In that case, our business, operating results and financial condition could be materially adversely affected. Even if we are able to
successfully expand international operations, we cannot be certain that we will be able to maintain or increase international market demand for our products.



Circumstances Associated with the Companys Acquisition Strategy and Internal Growth May Adversely Affect the Companys Operating Results



An important element of our growth strategy has been the pursuit of
acquisitions of other businesses which expand or complement our existing products. Integrating businesses, however, involves a number of special risks, including the possibility that management may be distracted from regular business concerns by the
need to integrate operations, unforeseen difficulties in integrating operations and systems, problems assimilating and retaining our employees or the employees of the acquired company, accounting issues that could arise in connection with, or as a
result of, the acquisition of the acquired company, regulatory or compliance issues that could exist at an acquired company, challenges in retaining our customers or the customers of the acquired company following the acquisition and potential
adverse short term effects on operating results through increased costs or otherwise. In addition, we may incur debt to finance future acquisitions and/or may issue securities in connection with future acquisitions which may dilute the holdings of
its current and future shareholders.



In addition to the risks
associated with acquisition-related growth, our business has grown in size and complexity over the past few years as a result of internal growth. This growth and increase in complexity have placed significant demands on management, systems, internal
controls and financial and physical resources. To meet such demands, we intend to continue to invest in new technology, make other capital expenditures and, where appropriate, hire and/or train employees with expertise to handle these particular
demands. If the Company is unable to successfully complete and integrate strategic acquisitions in a timely manner or if the Company fails to efficiently manage operations in a way that accommodates continued internal growth, its business, financial
condition or operating results could be adversely affected.



Recently Issued
Accounting Pronouncement



In December 2004, of the
Financial Accounting Standards Board issued Statement of Financial Accounting Standards 123R, Share-Based Payment (Statement 123R). Generally, the approach under Statement 123R will require companies to recognize as
compensation expense in the statements of operations the fair value of share-based payments to employees, including grants of employee stock options and the right to purchase shares under an employee stock purchase plan. We are required to adopt
Statement 123R in the first quarter of fiscal 2006. The pro forma disclosures previously permitted under Statement 123 will no longer be an alternative to financial statement recognition. See Note 2 in the notes to condensed consolidated financial
statements for the pro forma net income (loss) and net income (loss) amounts, for the three and six months ended June 30, 2005 and 2004, as if we had used a fair-value-based method similar to the methods required under Statement 123R to measure
compensation expense for employee stock incentive awards.



Statement 123R permits adoption using one of two methods: (1) a modified prospective method in which compensation cost is recognized beginning on the effective date based on the requirements of Statement 123R for all share-based
payments granted after the effective date and based on Statement 123 for all awards granted to employees prior to the effective date that remain unvested on the effective date or (2) a modified retrospective method which includes the
requirements of the modified prospective method, but also permits entities to restate all periods presented or prior interim periods of the year of adoption based on



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the amounts previously recognized under Statement 123 for purposes of pro forma disclosures. We are evaluating the requirements of Statement 123R, including
the adoption methods, and have not yet determined what effect the adoption of Statement 123R will have on our financial condition or results of operations.



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 and our outstanding variable-rate debt. We do not use derivative financial instruments in our investment
portfolio. We are subject to fluctuating interest rates that may impact, adversely or otherwise, our results of operations or cash flows for our cash and cash equivalents and available-for-sale securities in addition to our outstanding debt.
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 our United Kingdom subsidiary is the British Pound Sterling, and for our German, Italian, French, and Austrian subsidiaries, the Euro is the functional currency. Accordingly, all balance sheet accounts of these operations 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 these
entities 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 foreign-currency denominated
monetary assets and liabilities of these foreign operations are remeasured into U.S. dollars at current period-end exchange rates and foreign-currency denominated non-monetary assets and liabilities and related elements of expense are translated
using historical rates of exchange. Income and expense elements are remeasured to U.S. dollars using average exchange rates in effect during the period. Gains 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



Evaluation of
Disclosure Controls and Procedures



We maintain disclosure
controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the Exchange Act)) that are designed to ensure that information required to be disclosed in our filings under the
Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commissions rules and forms, and that such information is accumulated and communicated to management, including our
Chief Executive Officer (CEO) and Chief Financial Officer (CFO), as appropriate, to allow timely decisions regarding required disclosure. It should be noted that, because of inherent limitations, our disclosure controls and procedures, no matter how
well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and that management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and
procedures.



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As required by SEC Rule 13a-15(b), we carried out an evaluation under the supervision and with the
participation of our management, including the CEO and CFO, of the effectiveness of the design and operation of our disclosure controls and procedures as of June 30, 2005. Based upon this evaluation, our CEO and CFO have concluded that our
disclosure controls and procedures are effective as of June 30, 2005. Accordingly, management believes that the financial statements included in this report fairly present in all material respects, our financial condition, results of operations and
cash flows for the periods presented.



Changes in Internal Control Over
Financial Reporting



As of June 30, 2005, we have
implemented procedures designed to correct the material weakness disclosed in our Annual Report on Form 10-K for the year ended December 31, 2004 related to the recording of certain foreign exchange transactions and which resulted in the restatement
of our condensed consolidated financial statements for the quarters ended March 31, 2004 and June 30, 2004. Management has developed a new process for reviewing the reasonableness of foreign exchange gain or loss amounts. We believe that this new
process is appropriately designed to strengthen controls surrounding the reporting of foreign exchange transactions. Upon completion of our annual assessment of internal control over financial reporting under Section 404 of the Sarbanes Oxley Act,
management believes the material weakness will be fully remediated.



Other than the change described in the preceding paragraph, there were no changes in our internal control over financial reporting that occurred during the quarter ended June 30, 2005 that have materially affected, or are reasonably likely
to materially affect, our internal control over financial reporting.



PART II. OTHER INFORMATION



ITEM 1. LEGAL PROCEEDINGS



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



ITEM 6. EXHIBITS



Exhibits



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



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SIGNATURES



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



|                     |  |                                                
|-------------------- |  | -----------------------------------------------
|                     |  | ARTHROCARE CORPORATION                         
|                     |  | a Delaware corporation                         
|                     | 
|Date: August 8, 2005 |  | /s/ Michael A. Baker                           
|                     |  | Michael A. Baker                               
|                     |  | President, Chief Executive Officer and Director
|                     |  | (Principal Executive Officer)                  
|                     | 
|Date: August 8, 2005 |  | /s/ Fernando Sanchez                           
|                     |  | Fernando Sanchez                               
|                     |  | Senior Vice President,                         
|                     |  | Operations and Chief Financial Officer         
|                     |  | (Principal Financial and Accounting Officer)   



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