**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**Washington,
      D.C. 20549**





**Form
      10-Q**





**x**  **QUARTERLY
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES**


**EXCHANGE
      ACT OF 1934**




For
      the
      quarter ended September 30, 2007





**OR**





**o**  **TRANSITION
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES**


**EXCHANGE
      ACT OF 1934**


For
      the
      transition period from ________ to ________





Commission
      File Number: 0-27422





**ArthroCare
      Corporation**


*(Exact
      name of registrant as specified in its charter)*




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





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


*(Address
      of principal executive offices)*





**(512)
      391-3900**


*(Registrant's
      telephone number, including area code)*





Indicate
      by check mark whether the Registrant (1) has filed all reports required to
      be
      filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
      the
      preceding 12 months (or for such shorter period that the Registrant was required
      to file such reports), and (2) has been subject to such filing requirements
      for
      the past 90 days.


Yes x No o





Indicate
      by check mark whether the Registrant is a large accelerated filer, an
      accelerated filer, or a non-accelerated filer (as defined in Exchange Act Rule
      12b-2).





Large
      accelerated filer x Accelerated
      filer o Non-accelerated filer o





Indicate
      by check mark whether the registrant is a shell company (as defined in Rule
      12b-2 of the Exchange Act). Yes  ̈ No x




The
      number of shares outstanding of the registrant's common stock as of October
      24,
      2007 was 27,917,672 .












**ARTHROCARE
      CORPORATION**





**Form
      10-Q Quarterly Report**


**For
      the quarter ended September 30, 2007**





**TABLE
      OF CONTENTS**




**Page****Forward-Looking
                Statements**
            
            1**PART
                I:**
            **Financial
                Information**
            ****Item
                1.
            Financial
                StatementsCondensed
                Consolidated Balance Sheets as of September 30, 2007 and December
                31,
                2006
            
            2Condensed
                Consolidated Statements of Operations for the three and nine month
                periods
                ended
              September
                30, 2007 and 2006
            
            3Condensed
                Consolidated Statements of Cash Flows for the nine month periods
                ended
              September
                30, 2007 and 2006
            
            4Notes
                to Condensed Consolidated Financial Statements
            
            5Item
                2.
            Management’s
                Discussion and Analysis of Financial Condition and Results of Operations
            
            15Item
                3.
            Quantitative
                and Qualitative Disclosures About Market Risk
            
            25Item
                4.
            Controls
                and Procedures
            
            25**PART
                II:**
            **Other
                Information**
            ****Item
                1.
            Legal
                Proceedings
            
            26Item
                1A.
            Risk
                Factors
            
            26Item
                2.
            Unregistered
                Sales of Equity Securities and Use of Proceeds
            
            26Item
                3.
            Defaults
                Upon Senior Securities
            
            26Item
                4.
            Submission
                of Matters to a Vote of Security Holders
            
            26Item
                5.
            Other
                Information
            
            26Item
                6.
            Exhibits
            
            26Signatures
            
            27Certifications








**Forward-Looking
      Statements**





*This
      report contains information that may constitute “forward-looking statements.”
Generally, the words “believe,” “expect,” “intend,” “estimate,” “anticipate,”
“project,” “will” and similar expressions identify forward-looking statements,
      which generally are not historical in nature. Our forward-looking statements
      generally relate to our growth strategies, financial results, product
      development, regulatory approvals, competitive strengths, the scope of our
      intellectual property rights, and sales efforts.  One must carefully
      consider forward-looking statements and understand that such statements involve
      a variety of risks and uncertainties, known and unknown, and may be affected
      by
      inaccurate assumptions, including, among others, those discussed in the sections
      entitled “Government Regulation”, “* *Patents
      and Proprietary Rights”* *and
      “* *Risk
      Factors* *”
in
      our Annual Report on Form 10-K for the year ended December 31, 2006. 
Consequently, no forward-looking statement can be guaranteed and actual results
      may vary materially.*





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





1


**PART
      1.    FINANCIAL INFORMATION**





**ITEM
      1.    FINANCIAL STATEMENTS**





**ARTHROCARE
                CORPORATION**
              **CONDENSED
                CONSOLIDATED BALANCE SHEETS**
              **(unaudited)**
              *(in
                thousands, except per share data)***September
                30,**
            
            **December
                31,****2007**
            
            **2006****ASSETS**Current
                assets:Cash
                and cash equivalents
            
            $
            44,548
            
            $
            15,531Short-term
                investments
            
            
            10,390
            
            
            15,225Accounts
                receivable, net of allowances of $4,092 at 2007 and $2,701 at
                2006
            
            
            71,658
            
            
            61,935Inventories,
                net
            
            
            52,390
            
            
            51,542Deferred
                tax assets
            
            
            14,384
            
            
            13,795Prepaid
                expenses and other current assets
            
            
            4,796
            
            
            5,389Total
                current assets
            
            
            198,166
            
            
            163,417Property
                and equipment, net
            
            
            38,764
            
            
            36,071Related
                party receivables
            
            
            -
            
            
            500Intangible
                assets, net
            
            
            32,324
            
            
            35,982Goodwill
            
            
            139,829
            
            
            137,831Other
                assets
            
            
            6,808
            
            
            1,245Total
                assets
            
            $
            415,891
            
            $
            375,046**LIABILITIES
                AND STOCKHOLDERS' EQUITY**Current
                liabilities:Accounts
                payable
            
            $
            13,620
            
            $
            12,993Accrued
                liabilities
            
            
            11,113
            
            
            26,347Accrued
                compensation
            
            
            10,041
            
            
            7,906Income
                taxes payable
            
            
            1,921
            
            
            2,427Total
                current liabilities
            
            
            36,695
            
            
            49,673Deferred
                tax liabilities
            
            
            538
            
            
            1,991Other
                non-current liabilities
            
            
            5,869
            
            
            879Total
                liabilities
            
            
            43,102
            
            
            52,543Stockholders'
                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: 27,842 shares at 2007 and 27,394 shares at
                2006
            
            
            28
            
            
            27Treasury
                stock: 2,692 shares at 2007 and 2006
            
            
            (41,644
            )
            
            (41,644
            )Additional
                paid-in capital
            
            
            347,964
            
            
            324,823Accumulated
                other comprehensive income
            
            
            2,547
            
            
            1,992Retained
                earnings
            
            
            63,894
            
            
            37,305Total
                stockholders’ equity
            
            
            372,789
            
            
            322,503Total
                liabilities and stockholders’ equity
            
            $
            415,891
            
            $
            375,046





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




2


**ARTHROCARE
      CORPORATION**


**CONDENSED
      CONSOLIDATED STATEMENTS OF OPERATIONS**


**(unaudited)**


*(in
      thousands, except per share data)*





**Three
                Months Ended**
              **September
                30,**
            
            **Nine
                Months Ended**
              **September
                30,****2007**
            
            **2006**
            
            **2007**
            
            **2006**Revenues:Product
                sales
            
            $
            75,492
            
            $
            62,117
            
            $
            223,098
            
            $
            186,196Royalties,
                fees, and other
            
            
            2,969
            
            
            2,577
            
            
            8,648
            
            
            6,985Total
                revenues
            
            
            78,461
            
            
            64,694
            
            
            231,746
            
            
            193,181Cost
                of product sales
            
            
            21,200
            
            
            19,932
            
            
            63,659
            
            
            57,394Gross
                profit
            
            
            57,261
            
            
            44,762
            
            
            168,087
            
            
            135,787Operating
                expenses:Research
                and development
            
            
            6,519
            
            
            5,625
            
            
            19,608
            
            
            17,953Sales
                and marketing
            
            
            29,531
            
            
            20,369
            
            
            89,137
            
            
            65,069General
                and administrative
            
            
            6,023
            
            
            5,014
            
            
            18,332
            
            
            15,452Amortization
                of intangible assets
            
            
            1,753
            
            
            1,784
            
            
            5,588
            
            
            5,324Total
                operating expenses
            
            
            43,826
            
            
            32,792
            
            
            132,665
            
            
            103,798Income
                from operations
            
            
            13,435
            
            
            11,970
            
            
            35,422
            
            
            31,989Interest
                and other income (expense), net
            
            
            1,010
            
            
            (440
            )
            
            1,815
            
            
            (761
            )Income
                before income tax provision
            
            
            14,445
            
            
            11,530
            
            
            37,237
            
            
            31,228Income
                tax provision
            
            
            3,323
            
            
            2,854
            
            
            8,565
            
            
            7,720Net
                income
            
            $
            11,122
            
            $
            8,676
            
            $
            28,672
            
            $
            23,508Basic
                net income per share
            
            $
            0.40
            
            $
            0.33
            
            $
            1.05
            
            $
            0.90Shares
                used in computing basic net income per share
            
            
            27,570
            
            
            26,681
            
            
            27,326
            
            
            25,985Diluted
                net income per share
            
            $
            0.39
            
            $
            0.31
            
            $
            1.00
            
            $
            0.84Shares
                used in computing diluted net income per share
            
            
            28,856
            
            
            28,265
            
            
            28,685
            
            
            28,069





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


3


**ARTHROCARE
      CORPORATION**


**CONDENSED
      CONSOLIDATED STATEMENTS OF CASH FLOWS**


**(unaudited)**


*(in
      thousands)*





**Nine
                Months Ended**
              **September
                30,****2007**
            
            **2006**Cash
                flows from operating activities:Net
                income
            
            $
            28,672
            
            $
            23,508Adjustments
                to reconcile net income to net cash provided by operating
                activities:Depreciation
                and amortization
            
            
            15,979
            
            
            15,036Provision
                for doubtful accounts
            
            
            2,864
            
            
            1,116Provision
                for inventory reserves
            
            
            3,899
            
            
            1,461Excess
                tax benefit from employee stock plans
            
            
            (2,984
            )
            
            (5,050
            )Stock-based
                compensation expense
            
            
            7,559
            
            
            7,718Other
            
            
            (1,232
            )
            
            (319
            )Changes
                in operating assets and liabilities, net of assets and liabilities
                acquired in business combinations:Accounts
                receivable
            
            
            (12,007
            )
            
            (5,109
            )Inventories
            
            
            (4,821
            )
            
            (5,578
            )Prepaid
                expenses and other current assets
            
            
            502
            
            
            (1,560
            )Other
                assets
            
            
            (5,038
            )
            
            244Accounts
                payable
            
            
            664
            
            
            (5,752
            )Accrued
                and other liabilities
            
            
            1,259
            
            
            5,542Income
                taxes payable
            
            
            4,796
            
            
            7,070Net
                cash provided by operating activities
            
            
            40,112
            
            
            38,327Cash
                flows from investing activities:Purchases
                of property and equipment
            
            
            (12,797
            )
            
            (12,408
            )Purchases
                of intangible assets
            
            
            (1,795
            )
            
            (2,149
            )Payment
                for purchase of ATI
            
            
            (14,776
            )
            
            (5,952
            )Payment
                for purchase of Opus, net of cash acquired
            
            
            -
            
            
            (52,407
            )Purchases
                of available-for-sale securities
            
            
            -
            
            
            (19,395
            )Sales
                or maturities of available-for-sale securities
            
            
            4,972
            
            
            -Net
                cash used in investing activities
            
            
            (24,396
            )
            
            (92,311
            )Cash
                flows from financing activities:Proceeds
                from loan from bank
            
            
            -
            
            
            20,000Proceeds
                from issuance of common stock, net of issuance costs
            
            
            306
            
            
            -Income
                tax benefit relating to employee stock options
            
            
            2,984
            
            
            5,050Proceeds
                from exercise of options to purchase common stock
            
            
            9,885
            
            
            22,205Net
                cash provided by financing activities
            
            
            13,175
            
            
            47,255Effect
                of exchange rate changes on cash and cash equivalents
            
            
            126
            
            
            503Net
                increase (decrease) in cash and cash equivalents
            
            
            29,017
            
            
            (6,226
            )Cash
                and cash equivalents, beginning of period
            
            
            15,531
            
            
            20,717Cash
                and cash equivalents, end of period
            
            $
            44,548
            
            $
            14,491Supplemental
                disclosure of non-cash investing and financing activities:Issuance
                of common stock to former shareholders of Opus
            
            $
            -
            
            $
            5,803





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




4


**ARTHROCARE
        CORPORATION**
 **NOTES
        TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**




**NOTE
      1 - Description of Business**




ArthroCare
      Corporation (“ArthroCare” or the “Company”) was incorporated on April 29, 1993
      and its principal operations commenced in August 1995. The Company designs,
      develops, manufactures and markets medical devices for use in soft-tissue
      surgery. Its products are based on the Company’s patented soft-tissue surgical
      controlled ablation technology, which it calls Coblation technology. Coblation
      technology involves an innovative use of a non-thermal process and has the
      capability of performing at temperatures lower than traditional electrosurgical
      tools. ArthroCare’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, Europe and Asia
      Pacific.




**NOTE
      2 - Summary of Significant Accounting Policies**




***Basis
      of Presentation***




The
      unaudited interim condensed consolidated financial statements include the
      accounts of ArthroCare Corporation and its wholly-owned subsidiaries. All
      significant intercompany accounts and transactions have been eliminated in
      consolidation.




The
      accompanying unaudited condensed consolidated financial statements have been
      prepared in accordance with accounting principles generally accepted in the
      United States of America for interim financial information and with the
      instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they
      do
      not include all of the information and footnotes required by accounting
      principles generally accepted in the United States of America for complete
      financial statements. In the opinion of management, the unaudited interim
      condensed consolidated financial statements reflect all adjustments (consisting
      of only normal recurring adjustments) necessary for a fair statement of the
      Company’s financial position, results of operations and cash flows for the
      periods presented. These financial statements should be read in conjunction
      with
      the Company’s consolidated financial statements and notes thereto filed with the
      United States Securities and Exchange Commission (“SEC”) in the Company’s annual
      report on Form 10-K for the year ended December 31, 2006. Operating results
      for
      the three and nine-month periods ended September 30, 2007 are not necessarily
      indicative of the results that may be expected for the year ended December
      31,
      2007.




The
      condensed consolidated balance sheet at December 31, 2006 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.




***Revenue
      Recognition and Allowance for Doubtful Accounts*** ****




The
      Company recognizes product revenue in accordance with SEC Staff Accounting
      Bulletin No. 104, *Revenue
      Recognition in Financial Statements* (“SAB
      104”). Under SAB 104, revenue is recognized when there is persuasive evidence of
      an arrangement, delivery has occurred or services have been rendered, the sales
      price is fixed and determinable and collectibility is reasonably assured.
      Generally, the criteria are met upon shipment of the Company’s products. In
      certain cases, at the customer’s request, the Company will enter into bill and
      hold transactions whereby title and risk of loss transfers to the customer,
      but
      the product does not ship until a specified later date. Revenue on such
      transactions is recognized only after ArthroCare has met all conditions for
      bill
      and hold transactions set forth in SAB 104, specifically that ArthroCare
      has no further performance obligations, that the product is complete and ready
      for shipment, and that a fixed schedule for delivery of the product is set.
      Revenue is reported net of a provision for estimated product
      returns.




The
      Company recognizes license fees and other revenue over the term of the
      associated agreement unless the fee is in exchange for products delivered or
      services performed that represent the culmination of a separate earnings
      process. Royalties are recognized as earned, generally based on the licensees’
product shipments. These items
      are
      classified as royalties, fees and other revenues in the accompanying condensed
      consolidated statements of operations. Amounts billed to customers relating
      to
      shipping and handling costs have also been classified as royalties, fees and
      other revenues and related costs are classified as cost of product sales in
      the
      accompanying condensed consolidated statements of operations.




5




The
      Company maintains an allowance for doubtful accounts receivable based on our
      assessment of the collectibility of customer accounts. The Company regularly
      reviews the allowance, considering such factors as historical collection
      experience, a customer’s current credit-worthiness, customer concentrations, the
      age of the receivable balances, both individually and in the aggregate, and
      general economic conditions that may affect a customer’s ability to pay.




***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.




**NOTE
      3 - 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 Ended**
              **September
                30,**
            
            **Nine
                Months Ended**
              **September
                30,****2007**
            
            **2006**
            
            **2007**
            
            **2006**Net
                income
            
            $
            11,122
            
            $
            8,676
            
            $
            28,672
            
            $
            23,508Net
                unrealized gains on available-for-sale securities arising during
                the
                period, net of tax
            
            
            15
            
            
            297
            
            
            13
            
            
            446Foreign
                currency translation adjustment
            
            
            345
            
            
            254
            
            
            542
            
            
            861Comprehensive
                income
            
            $
            11,482
            
            $
            9,227
            
            $
            29,227
            
            $
            24,815




6




**NOTE
      4 - Computation of Net Income Per Share**




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




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


**Three
                    Months Ended**
                
                **Nine
                    Months Ended****September
                    30,**
                
                **September
                    30,**2007
                
                2006
                
                2007
                
                2006Net
                    income
                
                $
                11,122
                
                $
                8,676
                
                $
                28,672
                
                $
                23,508Basic:Weighted-average
                    shares outstanding
                
                
                27,570
                
                
                26,681
                
                
                27,326
                
                
                25,985Basic
                    net income per share
                
                $
                0.40
                
                $
                0.33
                
                $
                1.05
                
                $
                0.90Diluted:Weighted-average
                    shares outstanding used in basiccalculation
                
                
                27,570
                
                
                26,681
                
                
                27,326
                
                
                25,985Dilutive
                    effect of options
                
                
                1,172
                
                
                1,482
                
                
                1,251
                
                
                1,969Dilutive
                    effect of unvested restricted stock
                
                
                114
                
                
                102
                
                
                108
                
                
                115Weighted-average
                    shares and equivalents
                
                
                28,856
                
                
                28,265
                
                
                28,685
                
                
                28,069Diluted
                    net income per share
                
                $
                0.39
                
                $
                0.31
                
                $
                1.00
                
                $
                0.84Options
                    excluded from calculation as their effect would be
                    anti-dilutive
                
                
                360
                
                
                445
                
                
                910
                
                
                336Price
                    range of excluded options
                
                $
                52.16-
                    $54.15
                
                $
                44.12-
                    $48.56
                
                $
                43.61-
                    $54.15
                
                $
                44.02-$48.56




7




**NOTE
      5 - Inventories**




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




**September
                30,**
              **2007**
            
            **December
                31,**
              **2006**Raw
                materials
            
            $
            10,669
            
            $
            12,126Work-in-process
            
            
            5,282
            
            
            4,949Finished
                goods
            
            
            42,521
            
            
            38,60558,472
            
            
            55,680Inventory
                reserves
            
            
            (6,082
            )
            
            (4,138
            )Inventories,
                net
            
            $
            52,390
            
            $
            51,542




**NOTE
      6 - Goodwill**




*Goodwill*





During
      the nine months ended September 30, 2007, the Company’s goodwill balance
      increased by approximately $2.0 million. The increase was primarily a result
      of
      a $1.7 million accrual of additional consideration related to satisfied
      contractual contingencies in connection with the Company’s 2005 acquisition of
      certain assets of Applied Therapeutics, Inc. As of September 30, 2007, there
      were no indications that the Company’s goodwill was impaired.




**NOTE
      7 - Accrued Liabilities**




The
      following summarizes the Company’s accrued liabilities (in
      thousands):





**September
                30,**
              **2007**
            
            **December
                31,**
              **2006**Accrued
                liabilities:Accrued
                acquisition costs
            
            $
            1,644
            
            $
            14,992Accrued
                legal fees
            
            
            496
            
            
            3,225Accrued
                dealer commissions
            
            
            2,262
            
            
            2,816Other
            
            
            6,711
            
            
            5,314$
            11,113
            
            $
            26,347




**NOTE
      8 - Commitments and Contingencies**




*Operating
      Leases*




The
      Company leases facilities and certain equipment under operating leases. It
      recognizes rent expense on a straight-line basis over the lease term. Rent
      expense was $1.6 million for the quarter ended September 30, 2007 and $1.0
      million for the quarter ended September 30, 2006. Rent expense was $4.3 million
      for the nine months ended September 30, 2007 and $2.2 million for the nine
      months ended September 30, 2006. There have been no significant changes to
      the
      Company’s future lease commitments during the nine months ended September 30,
      2007.




8




*Acquisition-related
      Contingent Payments*




Under
      the
      terms of two of the Company’s acquisition agreements, the Company is obligated
      to make additional payments if certain contingencies are satisfied.




The Applied
      Therapeutics, Inc. (“ATI”) acquisition
      agreement detailed certain circumstances that required the Company to make
      an
      additional contingent payment in cash to the shareholders of ATI based on the
      net revenue earned by the Company from the acquired business from February
      1,
      2006 to January 31, 2007 (the “Earnout Period”). During the nine months ended
      September 30, 2007, the Company paid $14.8 million  to
      the
      shareholders of ATI, which relieved the Company of all further obligations
      related to the contingent payment arrangement. The contingent consideration
      paid
      by the Company to the shareholders of ATI was equal to a multiple of net revenue
      derived from the sale of ATI products during the Earnout Period, less the
      initial payment of $10.0 million.




On
      January 28, 2004, the Company completed its acquisition of Medical Device
      Alliance Inc. (“MDA”) and its subsidiary, Parallax Medical, Inc. (“Parallax”)
      for a total of $28.7 million, including consideration and acquisition-related
      expenses, net of cash acquired, of which a $1.6 million holdback remained unpaid
      as of September 30, 2007. If the contingency related to the holdback is
      satisfied, the Company will adjust the purchase price of this acquisition for
      the amount of contingent consideration paid.




*Warranties*




The
      Company generally provides customers with a limited 90-day warranty on devices
      sold and a limited 1-year warranty on controller units sold. It accrues for
      the
      estimated cost of product warranties at the time revenue is recognized. The
      Company’s warranty obligation is impacted by product failure rates, material
      usage and service delivery costs incurred in correcting a product failure.
      The
      Company periodically evaluates and adjusts the warranty reserve to the extent
      actual warranty expense varies from the original estimates.




The
      activity in its warranty accrual for the three and nine months ended September
      30, 2007 and 2006 was as follows (in thousands):




**Three
                Months Ended**
              **September
                30,**
            
            **Nine
                Months Ended**
              **September
                30,****2007**
            
            **2006**
            
            **2007**
            
            **2006**Balance
                at beginning of period
            
            $
            348
            
            $
            200
            
            $
            250
            
            $
            175Accruals
                for warranties issued during the period
            
            
            397
            
            
            227
            
            
            1,015
            
            
            496Warranty
                costs incurred during the period
            
            
            (391
            )
            
            (227
            )
            
            (911
            )
            
            (471
            )Balance
                at end of period
            
            $
            354
            
            $
            200
            
            $
            354
            
            $
            200




*Litigation*




From
      time
      to time, the Company is a defendant in certain lawsuits alleging product
      liability, patent infringement or other claims incurred in the ordinary course
      of business. These claims are generally covered by certain insurance policies,
      subject to certain deductible amounts and maximum policy limits. Except as
      otherwise described above, the Company has product liability insurance coverage
      in amounts it considers necessary to prevent material losses. The Company
      recognizes losses when they are known or considered probable and the amount
      can
      be reasonably estimated.




Defending
      and prosecuting intellectual property suits, United States Patent and Trademark
      office (“USPTO”) interference proceedings and related legal and administrative
      proceedings is costly and time-consuming. Further litigation may be necessary
      to
      enforce the Company’s patents, to protect its trade secrets or know-how or to
      determine the enforceability, scope and validity of the proprietary right of
      others. Any litigation or interference proceedings will be costly and will
      result in significant diversion of effort by technical and management personnel.
      An adverse determination in any of the litigation or interference proceedings
      to
      which ArthroCare may become a party could subject us to significant liabilities
      to third parties, require us to license disputed rights from third parties
      or
      require us to cease using such technology, which could have a material adverse
      effect on the Company’s business, financial condition, results of operations and
      future growth prospects. Patent and intellectual property disputes in the
      medical device area have often been settled through licensing or similar
      arrangements, and could include ongoing royalties. There can be no assurance
      ArthroCare can obtain any necessary licenses on satisfactory terms, if at all.





9




**NOTE
      9 - Employee Stock Benefit Plans**




*Stock
      Option Plans*





As
      of
      September 30, 2007, 16,210 shares remained available for future grant under
      the
      1999 Nonstatutory Option Plan (“1999 Plan”), 720,520 shares remained available
      for future grant under the 2003 Incentive Stock Plan (“2003 Plan”), and 72,756
      shares remained available for future grant under the Employee Stock Purchase
      Plan (“ESPP”). During the nine months ended September 30, 2007, 7,461 shares
      were issued under the Company’s ESPP.





Stock
      option activity for the 1999 Plan and the 2003 Plan for the three and nine
      month
      periods ended September 30, 2007, is as follows:




**Number
                of Shares**
            
            **Weighted-
                Average Exercise Price**Outstanding
                at December 31, 2006
            
            
            3,176,261
            
            $
            24.94Options
                granted
            
            
            560,110
            
            
            37.02Options
                exercised
            
            
            (50,031
            )
            
            16.31Options
                canceled/forfeited
            
            
            (23,224
            )
            
            8.93Outstanding
                at March 31, 2007
            
            
            3,663,116
            
            
            27.01Options
                granted
            
            
            89,674
            
            
            40.80Options
                exercised
            
            
            (89,664
            )
            
            19.57Options
                canceled/forfeited
            
            
            (43,511
            )
            
            41.35Outstanding
                at June 30, 2007
            
            
            3,619,615
            
            
            27.29Options
                granted
            
            
            23,473
            
            
            51.37Options
                exercised
            
            
            (412,782
            )
            
            18.84Options
                canceled/forfeited
            
            
            (7,392
            )
            
            38.32Outstanding
                at September 30, 2007
            
            
            3,222,914
            
            
            28.46Options
                exercisable as of September 30, 2007
            
            
            2,117,967
            
            
            23.64




Net
      cash
      proceeds from the exercise of stock options were $7.8 million and $6.3 million
      for the quarters ended September 30, 2007 and 2006, respectively, and $9.9
      million and $22.2 million for the nine months ended September 30, 2007 and
      2006,
      respectively. As of September 30, 2007, there was $16.1 million of total
      unrecognized compensation expense, net of estimated forfeitures, related to
      unvested share-based compensation arrangements granted under the Company’s stock
      plans related to stock options. The weighted average fair value of options
      granted during the three and nine month periods ended September 30, 2007 was
      $16.81 and $12.20, respectively.




10




Option
      awards outstanding and currently exercisable by exercise price for the 1999
      Plan
      and the 2003 Plan at September 30, 2007 were as follows:




**Outstanding
                Awards**
            
            **Exercisable
                Awards****Exercise
              Price**
            
            **Number**
              **Outstanding**
            
            **Weighted**
              **Average**
              **Remaining**
              **Contractual**
              **Life**
            
            **Weighted**
              **Average**
              **Exercise**
              **Price**
            
            **Number**
              **Exercisable**
            
            **Weighted**
              **Average**
              **Exercise**
              **Price**$
            5.00  - $13.31
            
            
            348,149
            
            
            4.38
            
            $
            11.27
            
            
            348,149
            
            $
            11.2713.32-17.38
            
            
            381,377
            
            
            4.23
            
            
            15.46
            
            
            381,377
            
            
            15.4617.39 
                -   23.00
            
            
            369,160
            
            
            4.08
            
            
            21.92
            
            
            352,955
            
            
            21.9323.01
                 -   27.56
            
            
            511,797
            
            
            5.38
            
            
            25.98
            
            
            465,494
            
            
            26.0627.57 
                -   31.50
            
            
            445,119
            
            
            5.67
            
            
            30.50
            
            
            281,491
            
            
            30.5631.51 
                -   35.71
            
            
            93,114
            
            
            4.80
            
            
            35.00
            
            
            67,193
            
            
            35.2436.08 
                -   36.08
            
            
            381,070
            
            
            6.41
            
            
            36.08
            
            
            44,856
            
            
            36.0836.09 
                -   41.45
            
            
            324,741
            
            
            6.32
            
            
            39.86
            
            
            55,971
            
            
            40.1941.46 
                -   46.84
            
            
            344,414
            
            
            5.48
            
            
            45.78
            
            
            119,981
            
            
            45.9446.85 
                -   54.15
            
            
            23,973
            
            
            6.76
            
            
            51.31
            
            
            500
            
            
            48.563,222,914
            
            
            5.25
            
            $
            28.46
            
            
            2,117,967
            
            $
            23.64




Restricted
      stock awards and units activity for the three and nine month periods ended
      September 30, 2007 is as follows:





**Number
                of Shares**
            
            **Weighted-
                Average Grant Date Fair Value**Unvested
                at December 31, 2006
            
            
            288,724
            
            $
            19.21Awards
                granted
            
            
            40,419
            
            
            36.61Awards
                vested
            
            
            (23,955
            )
            
            31.57Awards
                canceled/forfeited
            
            
            (1,320
            )
            
            28.97Unvested
                at March 31, 2007
            
            
            303,868
            
            
            18.15Awards
                granted
            
            
            9,750
            
            
            40.82Awards
                vested
            
            
            (19,678
            )
            
            24.05Awards
                canceled/forfeited
            
            
            (2,831
            )
            
            32.99Unvested
                at June 30, 2007
            
            
            291,109
            
            
            17.12Awards
                granted
            
            
            88,178
            
            
            50.66Awards
                vested
            
            
            (11,669
            )
            
            35.71Awards
                canceled/forfeited
            
            
            (4,173
            )
            
            30.97Unvested
                at September 30, 2007
            
            
            363,445
            
            
            16.96




As
      of
      September 30, 2007, there was total unrecognized compensation expense of $10.2
      million, net of estimated forfeitures, related to unvested restricted stock
      awards and units. At September 30, 2007, unrecognized compensation expense
      was
      expected to be recognized over a weighted-average period of 3.05 years and
      the
      aggregate intrinsic value associated with these awards was $16.2 million. The
      88,178 restricted stock awards and units granted in the quarter ended September
      30, 2007 were valued at $4.2 million when reduced by estimated forfeitures.
      The
      intrinsic value associated with awards that vested during the nine months ended
      September 30, 2007 was $2.2 million.




11




*Valuation
      and Expense Information*





The
      following table summarizes the total stock-based compensation expense resulting
      from employee stock options, including stock appreciation rights, and restricted
      stock awards and units that the Company recorded for the quarters ended
      September 30, 2007 and 2006 (in thousands):




**Three
                Months Ended September 30,****2007**
            
            **2006****Employee
                Stock Options**
            
            **Restricted
                Stock Awards and Units**
            
            **Employee
                Stock Options**
            
            **Restricted
                Stock Awards and Units**Cost
                of product sales
            
            $
            161
            
            $
            61
            
            $
            261
            
            $
            38Research
                and development
            
            
            268
            
            
            122
            
            
            297
            
            
            67Sales
                and marketing
            
            
            544
            
            
            208
            
            
            619
            
            
            127General
                and administrative
            
            
            918
            
            
            298
            
            
            833
            
            
            283Stock-based
                compensation expensebefore
                income taxes
            
            
            1,891
            
            
            689
            
            
            2,010
            
            
            515Income
                tax benefit
            
            
            (650
            )
            
            (227
            )
            
            (659
            )
            
            (181
            )Total
                stock-based compensationexpense
                after income taxes
            
            $
            1,241
            
            $
            462
            
            $
            1,351
            
            $
            334




The
      following table summarizes the total stock-based compensation expense resulting
      from employee stock options, including stock appreciation rights, and restricted
      stock awards and units that the Company recorded for the nine-months ended
      September 30, 2007 and 2006 (in thousands):




**Nine
                Months Ended September 30,****2007**
            
            **2006****Employee
                Stock Options**
            
            **Restricted
                Stock Awards and Units**
            
            **Employee
                Stock Options**
            
            **Restricted
                Stock Awards and Units**Cost
                of product sales
            
            $
            506
            
            $
            163
            
            $
            437
            
            $
            112Research
                and development
            
            
            843
            
            
            318
            
            
            1,021
            
            
            230Sales
                and marketing
            
            
            1,644
            
            
            558
            
            
            2,199
            
            
            297General
                and administrative
            
            
            2,604
            
            
            923
            
            
            2,439
            
            
            789Stock-based
                compensation expensebefore
                income taxes
            
            
            5,597
            
            
            1,962
            
            
            6,096
            
            
            1,428Income
                tax benefit
            
            
            (1,905
            )
            
            (651
            )
            
            (2,132
            )
            
            (534
            )Total
                stock-based compensationexpense
                after income taxes
            
            $
            3,692
            
            $
            1,311
            
            $
            3,964
            
            $
            894





As
      of
      September 30, 2007, approximately $0.3 million of stock-based compensation
      expense was capitalized into inventory based on units produced and will be
      amortized to cost of product sales based on units sold.





The
      Company presents excess tax benefits from stock-based compensation, if any,
      as
      financing cash flows rather than operating cash flows.




12




**NOTE
      10 - Segment Information**





The
      Company has organized its marketing and sales efforts based on four operating
      segments which are aggregated into one reportable segment—developing,
      manufacturing, and marketing of disposable devices for less invasive surgical
      procedures. Each of the Company’s business units has similar economic
      characteristics, technologies, manufacturing processes, customers, distribution
      and marketing strategies, regulatory environments, and shared infrastructures.
      These business units are Sports Medicine (shoulder and knee arthroscopic
      products), ENT (to include ear, nose and throat and the Visage ® cosmetic
      products), ArthroCare Spine TM (to
      include spinal and neurosurgery products) and Coblation Technology (to include
      gynecology, urology, laparoscopic, general surgical and cardiology
      products).




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




**Three
                Months Ended September 30,**
            
            **Nine
                Months Ended September 30,****2007**
            
            **2006**
            
            **2007**
            
            **2006**Sports
                Medicine
            
            $
            46,617
            
            
            61.8
            %
            $
            41,904
            
            
            67.5
            %
            $
            137,215
            
            
            61.5
            %
            $
            123,726
            
            
            66.5
            %ENT
            
            
            17,458
            
            
            23.1
            %
            
            14,129
            
            
            22.7
            %
            
            53,849
            
            
            24.1
            %
            
            43,955
            
            
            23.6
            %ArthroCare
                Spine
            
            
            11,397
            
            
            15.1
            %
            
            5,853
            
            
            9.4
            %
            
            31,824
            
            
            14.3
            %
            
            18,247
            
            
            9.8
            %Coblation
                Technology
            
            
            20
            
            
            0.0
            %
            
            231
            
            
            0.4
            %
            
            210
            
            
            0.1
            %
            
            268
            
            
            0.1
            %Total
                product sales
            
            $
            75,492
            
            
            100.0
            %
            $
            62,117
            
            
            100.0
            %
            $
            223,098
            
            
            100.0
            %
            $
            186,196
            
            
            100.0
            %




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




**Three
                Months Ended September 30,**
            
            **Nine
                Months Ended September 30,****2007**
            
            **2006**
            
            **2007**
            
            **2006**Americas
            
            $
            59,737
            
            
            79.1
            %
            $
            50,434
            
            
            81.2
            %
            $
            176,297
            
            
            79.0
            %
            $
            149,551
            
            
            80.3
            %United
                Kingdom
            
            
            4,146
            
            
            5.5
            %
            
            2,957
            
            
            4.7
            %
            
            12,838
            
            
            5.8
            %
            
            9,597
            
            
            5.2
            %Germany
            
            
            3,283
            
            
            4.4
            %
            
            2,532
            
            
            4.1
            %
            
            10,062
            
            
            4.5
            %
            
            8,053
            
            
            4.3
            %Rest
                of World
            
            
            8,326
            
            
            11.0
            %
            
            6,194
            
            
            10.0
            %
            
            23,901
            
            
            10.7
            %
            
            18,995
            
            
            10.2
            %Total
                product sales
            
            $
            75,492
            
            
            100.0
            %
            $
            62,117
            
            
            100.0
            %
            $
            223,098
            
            
            100.0
            %
            $
            186,196
            
            
            100.0
            %




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




**September
                30,**
              **2007**
            
            **December
                31,**
              **2006**United
                States
            
            $
            33,095
            
            
            72.6
            %
            $
            26,851
            
            
            71.0
            %Costa
                Rica
            
            
            9,028
            
            
            19.8
            %
            
            7,685
            
            
            20.3
            %Rest
                of World
            
            
            3,449
            
            
            7.6
            %
            
            3,280
            
            
            8.7
            %Total
                long-lived assets
            
            $
            45,572
            
            
            100.0
            %
            $
            37,816
            
            
            100.0
            %




13




**NOTE
      11 - Recently Issued Accounting Pronouncements**




In
      July
      2006, the FASB issued Interpretation No. (“FIN”) 48, *Accounting
      for Uncertainty in Income Taxes* . FIN
      48
      clarifies the accounting for uncertainty in income taxes recognized in an
      enterprise’s financial statements in accordance with Statement of Financial
      Accounting Standards No. 109, *Accounting
      for Income Taxes* .
      This
      interpretation prescribes a recognition threshold and measurement attribute
      for
      the financial statement recognition and measurement of a tax position taken
      or
      expected to be taken in a tax return. FIN 48 also provides guidance on
      derecognition of tax benefits, classification on the balance sheet, interest
      and
      penalties, accounting in interim periods, disclosure, and transition. The
      Company adopted FIN 48 effective January 1, 2007. In accordance with FIN
      48, paragraph 19, the Company has decided to classify interest and penalties
      as
      a component of tax expense. As a result of the implementation of FIN 48, the
      Company recognized a $2.1 million increase in liability for unrecognized
      tax benefits, which was accounted for as a reduction to the January 1, 2007
      balance of retained earnings.





The
      Company had unrecognized tax benefits of approximately $7.9 million as of
      January 1, 2007, of which $7.1 million, if recognized, would result in a
      reduction of the Company's effective tax rate. Interest and penalties are
      immaterial at the date of adoption and are included in the unrecognized tax
      benefits. The Company recorded an increase in its unrecognized tax benefits
      of
      approximately $0.1 million and $0.4 million in the three and nine month periods
      ended September 30, 2007, respectively. The
      Company is subject to audit by the IRS and California Franchise Tax Board for
      the years 1994 through 2006 and by the Texas State Comptroller for the year
      2006. As the Company has operations in most other US states, other state tax
      authorities may assess deficiencies related to prior year activities; however,
      the years open to assessment vary with each state.   The Company also files
      income tax returns for non-US jurisdictions; the most significant of which
      are
      the UK, Sweden, and Germany.  The years open to adjustment for the UK and
      Germany are 2003 through 2006.  The years open to adjustment for Sweden are
      1999 through 2006.





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





In
      February 2007, the FASB issued Statement of Financial Accounting Standards
      No.
      159, *The
      Fair Value Option for Financial Assets and Financial Liabilities - Including
      an
      amendment of FASB No. 115* (“FAS
      159”). The Statement permits companies to choose to measure many financial
      instruments and certain other items at fair value in order to mitigate
      volatility in reported earnings caused by measuring related assets and
      liabilities differently without having to apply complex hedge accounting
      provisions. FAS 159 is effective for the Company beginning January 1, 2008.
      The
      Company is currently evaluating the impact, if any, of FAS 159 on its operating
      results and financial position.





14


**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.
      In
      this quarterly report on Form 10-Q, the terms the “Company”, “we”, “us” and
“our” refer to ArthroCare Corporation and its subsidiaries.*





***Company
      Overview***





We
      are a
      multi-business medical device company that develops, manufactures and markets
      minimally invasive surgical products, many of which are based on our patented
      Coblation® technology. We have grown well beyond our roots in arthroscopy to
      capitalize on numerous market opportunities across several medical specialties,
      significantly improving many existing soft-tissue surgical procedures and
      enabling new minimally invasive procedures. With our highly innovative
      technologies, we are committed to improving the lives of individuals suffering
      from conditions as diverse as torn rotator cuffs and anterior cruciate ligaments
      (ACLs) to herniated discs and enlarged tonsils/tonsillitis.





We
      currently market minimally invasive surgical products across three core business
      units — ArthroCare Sports Medicine, ArthroCare Spine and ArthroCare Ear, Nose
      and Throat (ENT) — but also have developed, manufactured and marketed
      Coblation-based and complementary products for application in neurology,
      cosmetic surgery, urology and gynecology, with research continuing in additional
      areas. In each of our core business units we are focused on driving the
      application of enabling technologies, primarily for plasma-based soft tissue
      removal, and increasing the number of minimally invasive procedures being
      performed.





We
      focus
      on executing a mission-driven business strategy featuring the following key
      elements:





·
            Expanding
                our product offering to address large and rapidly growing
                markets;





·
            Targeting
                established procedures and replacing current technology with value-added
                ArthroCare technologies;





·
            Driving
                disposable device sales with a direct sales
                force;





·
            Augmenting
                growth with complementary and compatible acquisitions to expand margins
                and provide additional opportunity to capitalize on emerging and
                existing
                business opportunities; and





·
            Establishing
                strategic partnerships to further commercialize our minimally invasive
                technologies.





ArthroCare
      was incorporated in California in 1993 and reincorporated in Delaware in 1995.
      We maintain an Internet website at *www.arthrocare.com* .
      On our
      website we make available, free of charge, the following filings as soon as
      reasonably practicable after they are electronically filed with or furnished
      to
      the Securities and Exchange Commission: our annual reports on Form 10-K, our
      quarterly reports on Form 10-Q, our current reports on Form 8-K and any
      amendments to those reports filed or furnished pursuant to Section 13(a) or
      15(d) of the Exchange Act of 1934. You may also read and copy any materials
      that
      we file with the SEC at the SEC’s Public Reference Room at 100 F Street, NE,
      Washington DC 20549. You may obtain information on the operation of the Public
      Reference Room by calling the SEC at 1-800-SEC-0330. Our reports, proxy
      statements and other documents filed electronically with the SEC are available
      at the website maintained by the SEC at *www.sec.gov.*




15


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 from the U.S. Food and Drug Administration (FDA) for use of our
      technology in several fields. We cannot be sure that any of our clinical studies
      in other fields will lead to 510(k) applications or that the applications will
      be cleared by the FDA on a timely basis, if at all. In addition, we cannot
      be
      sure that the products, if cleared for marketing, will ever achieve commercial
      acceptance.




In
      May
      1998, we announced that we had entered the ear, nose and throat market and
      had
      formed a business unit called ENTec to commercialize Coblation technology in
      this field. In September 1999, we announced that we had entered the spinal
      surgery market. In February 2000, we announced that we were expanding our
      marketing efforts for our spinal surgery system to specifically address selected
      applications in neurosurgery. We are marketing and selling our spinal surgery
      products through a network of independent distributors and direct sales
      representatives supported by regional managers worldwide. In January 2004,
      we
      acquired MDA and its majority-owned subsidiary, Parallax, a business focused
      on
      the treatment of vertebral compression fractures. In November 2004, we acquired
      Opus Medical, a business focused on soft tissue to bone repair systems,
      including systems for the treatment of rotator cuff injuries. In
      August 2005, we completed the purchase of substantially all of the assets of
      Applied Therapeutics, Inc. (“ATI”), a maker of sinus surgery treatment
      products.




We
      have
      received 510(k) clearance from the FDA to market several of our products and
      several of our products are CE marked, which is a requirement to sell our
      products in most of Western Europe. Specifically, we have received 510(k)
      clearance from the FDA to market our Coblation-based Arthroscopic Surgery
      System, or Arthroscopic System, for use in arthroscopic surgery of the knee,
      shoulder, ankle, elbow, wrist and hip. In addition, our Arthroscopic System
      is
      CE marked for use in arthroscopic surgery. We have also received 510(k)
      clearances in the United States and a CE mark in Europe to market and sell
      our
      Coblation-based Spinal Surgery System for spinal surgery and neurosurgery.
      Our
      ENT Surgery System has received 510(k) clearances from the FDA and a CE mark
      for
      use in general head, neck, oral and sinus surgery procedures, including
      tonsillectomy and adenoidectomy, turbinate reduction to relieve nasal
      obstruction, and soft palate stiffening to treat snoring. The FDA also has
      cleared our Cosmetic Surgery System for general dermatologic procedures and
      skin
      resurfacing in connection with wrinkle reduction procedures. In addition, the
      Cosmetic Surgery System has received a CE Mark. We also have received 510(k)
      clearance from the FDA, and applied for a CE mark, to market products based
      on
      our Coblation technology for use in urology, gynecology, plastic and
      reconstructive surgery, orthopedic surgery and general surgery.




***Overview
      of Third Quarter Results***




Relative
      to the third quarter of 2006, total revenue for the third quarter of 2007
      increased 21.3 percent to $78.5 million. The
      increase was driven by the combined performance of the Sports Medicine, Spine
      and ENT business units. International
      product sales represented approximately 20.9 percent of net product sales in
      the
      third quarter of 2007, increasing relative to the third quarter of 2006 when
      international product sales represented approximately 18.8 percent of net
      product sales. No single customer accounted for more than 10 percent of our
      net
      product sales during the third quarter of 2007.





Total
      operating expenses were approximately $43.8 million for the third quarter of
      2007, compared to $32.8 million in the third quarter of 2006. This $11.0 million
      increase was primarily driven by $9.2 million in increased sales and marketing
      costs.





Our
      cash,
      cash equivalents and short-term investments balance at September 30, 2007 was
      $54.9 million, an increase of approximately $24.2 million from December 31,
      2006.




16




Our
      headcount at September 30, 2007 was 1,057, an increase of 20.0 percent from
      881
      at December 31, 2006 and an increase of 22.8 percent from 861 at September
      30,
      2006.  Headcount increases are primarily attributable to increases in
      manufacturing personnel in Costa Rica and additions of personnel in sales and
      marketing and research and development.




***Results
      of Operations and Financial Condition***




*Comparison
      of the three and nine months ended September 30, 2007 to the three and nine
      months ended September 30, 2006 (in thousands, unless otherwise
      noted):*




**Three
                  Months Ended September 30,**
              
              **Nine
                  Months Ended September 30,****2007**
              
              **2006**
              
              **2007**
              
              **2006**Revenues:Product
                  sales
              
              $
              75,492
              
              
              96.2
              %
              $
              62,117
              
              
              96.0
              %
              $
              223,098
              
              
              96.3
              %
              $
              186,196
              
              
              96.4
              %Royalties,
                  fees, and other
              
              
              2,969
              
              
              3.8
              %
              
              2,577
              
              
              4.0
              %
              
              8,648
              
              
              3.7
              %
              
              6,985
              
              
              3.6
              %Total
                  revenues
              
              
              78,461
              
              
              100.0
              %
              
              64,694
              
              
              100.0
              %
              
              231,746
              
              
              100.0
              %
              
              193,181
              
              
              100.0
              %Cost
                  of product sales
              
              
              21,200
              
              
              27.0
              %
              
              19,932
              
              
              30.8
              %
              
              63,659
              
              
              27.5
              %
              
              57,394
              
              
              29.7
              %Gross
                  profit
              
              
              57,261
              
              
              73.0
              %
              
              44,762
              
              
              69.2
              %
              
              168,087
              
              
              72.5
              %
              
              135,787
              
              
              70.3
              %Operating
                  expenses:Research
                  and development
              
              
              6,519
              
              
              8.3
              %
              
              5,625
              
              
              8.7
              %
              
              19,608
              
              
              8.4
              %
              
              17,953
              
              
              9.3
              %Sales
                  and marketing
              
              
              29,531
              
              
              37.7
              %
              
              20,369
              
              
              31.5
              %
              
              89,137
              
              
              38.5
              %
              
              65,069
              
              
              33.7
              %General
                  and administrative
              
              
              6,023
              
              
              7.7
              %
              
              5,014
              
              
              7.7
              %
              
              18,332
              
              
              7.9
              %
              
              15,452
              
              
              8.0
              %Amortization
                  of intangible assets
              
              
              1,753
              
              
              2.2
              %
              
              1,784
              
              
              2.8
              %
              
              5,588
              
              
              2.4
              %
              
              5,324
              
              
              2.8
              %Total
                  operating expenses
              
              
              43,826
              
              
              55.9
              %
              
              32,792
              
              
              50.7
              %
              
              132,665
              
              
              57.2
              %
              
              103,798
              
              
              53.7
              %Income
                  from operations
              
              
              13,435
              
              
              17.1
              %
              
              11,970
              
              
              18.5
              %
              
              35,422
              
              
              15.3
              %
              
              31,989
              
              
              16.6
              %Interest
                  and other income (expense), net
              
              
              1,010
              
              
              1.3
              %
              
              (440
              )
              
              (0.7
              )%
              
              1,815
              
              
              0.8
              %
              
              (761
              )
              
              (0.4
              )%Income
                  before income tax provision
              
              
              14,445
              
              
              18.4
              %
              
              11,530
              
              
              17.8
              %
              
              37,237
              
              
              16.1
              %
              
              31,228
              
              
              16.2
              %Income
                  tax provision
              
              
              3,323
              
              
              4.2
              %
              
              2,854
              
              
              4.4
              %
              
              8,565
              
              
              3.7
              %
              
              7,720
              
              
              4.0
              %Net
                  income
              
              $
              11,122
              
              
              14.2
              %
              $
              8,676
              
              
              13.4
              %
              $
              28,672
              
              
              12.4
              %
              $
              23,508
              
              
              12.2
              %





***Revenues***





*Product
      sales* consist
      primarily of sales of disposable devices and controllers. Product sales for
      the
      quarter ended September 30, 2007 were $75.5 million, compared to $62.1 million
      for the quarter ended September 30, 2006. Product sales for the nine months
      ended September 30, 2007 were $223.1 million, compared to $186.2 million for
      the
      nine months ended September 30, 2006.


17


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




**Three
                      Months Ended September 30,**
                  
                  **Nine
                      Months Ended September 30,****2007**
                  
                  **2006**
                  
                  **2007**
                  
                  **2006**Sports
                      Medicine
                  
                  $
                  46,617
                  
                  
                  61.8
                  %
                  $
                  41,904
                  
                  
                  67.5
                  %
                  $
                  137,215
                  
                  
                  61.5
                  %
                  $
                  123,726
                  
                  
                  66.5
                  %ENT
                  
                  
                  17,458
                  
                  
                  23.1
                  %
                  
                  14,129
                  
                  
                  22.7
                  %
                  
                  53,849
                  
                  
                  24.1
                  %
                  
                  43,955
                  
                  
                  23.6
                  %ArthroCare
                      Spine
                  
                  
                  11,397
                  
                  
                  15.1
                  %
                  
                  5,853
                  
                  
                  9.4
                  %
                  
                  31,824
                  
                  
                  14.3
                  %
                  
                  18,247
                  
                  
                  9.8
                  %Coblation
                      Technology
                  
                  
                  20
                  
                  
                  0.0
                  %
                  
                  231
                  
                  
                  0.4
                  %
                  
                  210
                  
                  
                  0.1
                  %
                  
                  268
                  
                  
                  0.1
                  %Total
                      product sales
                  
                  $
                  75,492
                  
                  
                  100.0
                  %
                  $
                  62,117
                  
                  
                  100.0
                  %
                  $
                  223,098
                  
                  
                  100.0
                  %
                  $
                  186,196
                  
                  
                  100.0
                  %




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




**Three
                  Months Ended September 30,**
              
              **Nine
                  Months Ended September 30,****2007**
              
              **2006**
              
              **2007**
              
              **2006**Americas
              
              $
              59,737
              
              
              79.1
              %
              $
              50,434
              
              
              81.2
              %
              $
              176,297
              
              
              79.0
              %
              $
              149,551
              
              
              80.3
              %United
                  Kingdom
              
              
              4,146
              
              
              5.5
              %
              
              2,957
              
              
              4.7
              %
              
              12,838
              
              
              5.8
              %
              
              9,597
              
              
              5.2
              %Germany
              
              
              3,283
              
              
              4.4
              %
              
              2,532
              
              
              4.1
              %
              
              10,062
              
              
              4.5
              %
              
              8,053
              
              
              4.3
              %Rest
                  of World
              
              
              8,326
              
              
              11.0
              %
              
              6,194
              
              
              10.0
              %
              
              23,901
              
              
              10.7
              %
              
              18,995
              
              
              10.2
              %Total
                  product sales
              
              $
              75,492
              
              
              100.0
              %
              $
              62,117
              
              
              100.0
              %
              $
              223,098
              
              
              100.0
              %
              $
              186,196
              
              
              100.0
              %




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




We
      generally sell our disposable devices at or near list price, except for sales
      to
      international distributors and marketing partners, which are
      sold
      at discounted prices . We
      anticipate that disposable device sales will remain a key component of our
      product sales in the near future.




Royalties,
      fees and other revenues consist mainly of revenue from the licensing of our
      products and technology. Royalties, fees and other revenues were $3.0 million
      for the quarter ended September 30, 2007, compared to $2.6 million for the
      quarter ended September 30, 2006. The percentage of royalties, fees and other
      revenues as a percentage of total revenue was 3.8 percent for the quarter ended
      September 30, 2007 and 4.0 percent for the quarter ended September 30, 2006.
      Royalties, fees and other revenues were $8.6 million for the nine months ended
      September 30, 2007, compared to $7.0 million for the nine months ended September
      30, 2006. Both the quarter over quarter and nine month period over period
      increases are related to growth in the markets in which the Company receives
      royalties.




***Cost
      of Product Sales***





Cost
      of
      product sales consists
      of manufacturing costs, material costs, labor costs, manufacturing overhead,
      warranty and other direct product costs. Additionally, cost of product sales
      includes amortization of controller unit placements under a program whereby
      we
      maintain ownership of controller units shipped to customers, with the costs
      being capitalized and amortized into cost of product sales over the useful
      life
      of the controller unit. Amortization
      of controllers was $1.9 million and $5.7 million for the three and nine months
      ended September 30, 2007, respectively. This compares to amortization of $1.6
      million and $4.9 million for the three and nine months ended September 30,
      2006,
      respectively. Controller amortization represented 2.5 percent and 2.6 percent
      of
      product sales for the three and nine month periods ended September 30, 2007,
      respectively. This compares to 2006 when controller amortization represented
      2.5
      percent of product sales in both the three and nine month periods ended
      September 30, 2006.




18




Cost
      of
      product sales was $21.2 million, or 27.0 percent of revenue, for the quarter
      ended September 30, 2007, as compared to $19.9 million, or 30.8 percent of
      revenue, for the quarter ended September 30, 2006. Gross product margin as
      a
      percentage of product sales was 71.9 percent in the third quarter of 2007 and
      67.9 percent in the same period in the prior year. The quarter over quarter
      increase in gross product margin was attributable to a combination of improved
      international profitability, lower material costs and a favorable product mix.
      Cost of product sales was $63.7 million, or 27.5 percent of revenue, for the
      nine months ended September 30, 2007, as compared to $57.4 million, or 29.7
      percent of revenue, for the nine months ended September 30, 2006. Gross product
      margin as a percentage of product sales increased to 71.5 percent in the first
      nine months of 2007 from 69.2 percent during the same period in the prior year.
      The period over period increase in gross product margin was primarily
      attributable to improved international profitability, lower material costs
      and a
      favorable product mix. We expect gross product margin to continue to increase
      as
      a result of higher average selling prices and as we improve operating
      efficiencies.




***Operating
      Expenses***





*Research
      and development* expenses
      were $6.5 million, or 8.3 percent of total revenues, for the quarter ended
      September 30, 2007, compared to $5.6 million, or 8.7 percent of total revenues,
      for the quarter ended September 30, 2006. The increase for the third quarter
      of
      2007 compared to the third quarter of 2006 is primarily attributable to $0.4
      million in increased employee-related expenses due to additional headcount
      and
      $0.3 million in increased clinical testing and outside services.





Research
      and development expenses were $19.6 million, or 8.4 percent of total revenues,
      for the nine months ended September 30, 2007, compared to $18.0 million, or
      9.3
      percent of total revenues, for the same period in 2006. The increase for the
      first nine months of 2007 compared to the first nine months of 2006 is primarily
      attributable to $1.0 million in increased employee-related expenses due to
      additional headcount and $0.5 million in increased clinical testing and outside
      services. We expect to increase the dollar amount of research and development
      expenses through continued expenditures on new product development, regulatory
      affairs, clinical studies and patents. We expect these expenses as a percentage
      of total revenue to remain essentially flat. ****




*Sales
      and marketing* expenses
      were $29.5 million, or 37.7 percent of total revenues, for the quarter ended
      September 30, 2007, compared to $20.4 million, or 31.5 percent of total
      revenues, for the quarter ended September 30, 2006. The increase for the third
      quarter of 2007 compared to the third quarter of 2006 related primarily to
      $4.7
      million in increased commissions, trade shows, samples and demos, promotions,
      and other marketing expenses, $2.1 million in additional compensation, training
      and other expenses associated with our increased direct sales force and $0.5
      million in additional accounts receivables reserves.




Sales
      and
      marketing expenses were $89.1 million, or 38.5 percent of total revenues, for
      the nine months ended September 30, 2007, compared to $65.1 million, or 33.7
      percent of total revenues, for the nine months ended September 30, 2006. The
      increase for the first nine months of 2007 compared to the first nine months
      of
      2006 related primarily to $ 13.2
      million related to commissions, trade shows, samples and demos, promotions,
      and
      other marketing expenses, $4.8
      million in additional compensation and training expenses associated with our
      increased direct sales force and $1.7 million in additional 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 commercialize and market future products.




19




*General
      and administrative* expenses
      were $6.0 million, or 7.7 percent of total revenues, for the quarter ended
      September 30, 2007, compared to $5.0 million, or 7.7 percent of total revenues,
      for the quarter ended September 30, 2006. The $1.0 million increase for the
      quarter ended September 30, 2007 compared to the quarter ended September 30,
      2006 is due primarily to a net increase in legal and other outside service
      costs.





General
      and administrative expenses were $18.3 million, or 7.9 percent of total
      revenues, for the nine months ended September 30, 2007, compared to $15.5
      million, or 8.0 percent of total revenues, for the nine months ended September
      30, 2006. The increase for the nine months ended September 30, 2007 compared
      to
      the nine months ended September 30, 2006 is primarily a result of a $1.3 million
      net increase in legal and other outside service costs, a $0.5 million increase
      in rent expense primarily related to the lease of our Austin, Texas facility,
      and $0.2 million in additional compensation and other expenses due to increased
      staffing. We expect general and administrative expenses to decrease as a
      percentage of total revenues due to continued leveraging of our existing
      infrastructure and operating procedures.




*Amortization
      of intangible assets* was $1.8
      million, or 2.2 percent of total revenues, for the quarter ended September
      30,
      2007, compared to $1.8 million, or 2.8 percent of total revenues, in the third
      quarter of 2006. Amortization of intangible assets was $5.6 million, or 2.4
      percent of total revenues, for the nine months ended September 30, 2007,
      compared to $5.3 million or 2.8 percent of total revenues, in the first nine
      months of 2006. The increase in the nine month period ended September 30, 2007
      as compared to the same period in 2006 is attributable to additional license
      agreements. We expect that amortization of intangible assets will increase
      in
      future periods as we acquire additional assets.




*Interest
      and other income (expense),* *net* , increased
      to a net benefit of $1.0 million for the quarter ended September 30, 2007,
      compared to a net expense of $0.4 million for the quarter ended September 30,
      2006. The increase in net interest and other income of $1.4 million for the
      quarter ended September 30, 2007 compared to the quarter ended September 30,
      2006 is primarily a result of a decrease in interest expense recognized in
      the
      third quarter of 2007 compared to the third quarter of 2006 as a result of
      funding our operations through our operating cash flows without needing to
      borrow under our credit facility during 2007 combined with foreign currency
      exchange gains.




Interest
      and other income (expense), net, increased
      to a net benefit of $1.8 million for the nine months ended September 30, 2007,
      compared to a net expense of $0.8 million for the nine months ended September
      30, 2006. The net increase of $2.6 million for the nine months ended September
      30, 2007 compared to the nine months ended September 30, 2006 was
      primarily a result of funding our operations through our operating cash flows
      without needing to borrow funds under our credit facility during 2007 combined
      with foreign currency exchange gains. We do not expect significant fluctuations
      in interest and other income since we plan to fund our business through our
      operating cash flows in the foreseeable future.




*Income
      Tax Provision*




The
      provision for income taxes was $3.3 million, for an effective tax rate of 23.0
      percent for the quarter ended September 30, 2007, compared to $2.9 million,
      for
      an effective tax rate of 24.8 percent for the quarter ended September 30, 2006.
      The provision for income taxes was $8.6 million, for an effective tax rate
      of
      23.0 percent for the nine months ended September 30, 2007, compared to $7.7,
      million for an effective tax rate of 24.7 percent for the nine months ended
      September 30, 2006. The
      decrease in the effective tax rate was primarily due to the legislative
      extension of R&D credits during the fourth quarter of 2006.




20




***Liquidity
      and Capital Resources***




As
      of
      September 30, 2007, we had $161.5 million in working capital, compared to $113.7
      million at December 31, 2006. Our
      principal sources of liquidity consisted of $54.9 million in cash, cash
      equivalents, and short-term investments at September 30, 2007. Cash equivalents
      are highly liquid with original maturities of ninety days or less. Our
      short-term investments consist primarily of corporate bonds and commercial
      paper.




Cash
      provided by operating activities for the nine months ended September 30, 2007
      was $40.1 million, primarily attributable to net income adjusted for non-cash
      items, including depreciation and amortization, stock-based compensation
      expense, and provisions for doubtful accounts and inventory reserves, partially
      offset by an increase in accounts receivable and inventory. Cash generated
      by
      operating activities for the nine months ended September 30, 2006 was $38.3
      million, primarily attributable to net income adjusted for non-cash items,
      including depreciation and amortization, stock-based compensation expense,
      and
      increases in accounts receivable and inventory, partially offset by an increase
      in accounts receivable and inventory.





Cash
      used
      in investing activities for the nine months ended September 30, 2007 was $24.4
      million, due primarily to a payment of $14.8 million to the shareholders of
      ATI,
      $14.6 million in purchases of property and equipment and intangible assets,
      partially offset by $5.0 million in sales and maturities of available for sale
      securities. Cash used in investing activities for the nine months ended
      September 30, 2006 was $92.3 million, due primarily to the cash payment of
      $52.4
      million made to the former Opus shareholders, $19.4 million in purchases of
      available for sale securities, and $14.6 million in purchases of property and
      equipment and intangible assets.





Cash
      provided by financing activities for the nine months ended September 30, 2007
      was $13.2 million, due primarily to cash proceeds from the exercise of stock
      options, including the associated income tax benefits. Cash provided by
      financing activities for the nine months ended September 30, 2006 was $47.3
      million, due primarily to cash proceeds of $20.0 million borrowed through our
      revolving credit facility and $27.3 million associated with proceeds from the
      exercise of stock options, including the associated income tax benefits.





We
      believe that cash generated from operations will be sufficient to fund our
      operations through fiscal year 2007 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.




***Critical
      Accounting Policies and Estimates***




The
      preparation of financial statements and related disclosures in conformity with
      accounting principles generally accepted in the United States of America
      requires management to make judgments, assumptions and estimates that affect
      the
      amounts reported in the consolidated financial statements and accompanying
      notes. Note 2 to the condensed consolidated financial statements of this Form
      10-Q and Note 2 to the consolidated financial statements of our Form 10-K for
      the year ended December 31, 2006 describe the significant accounting policies
      and methods used in the preparation of the condensed consolidated financial
      statements. The most significant areas involving management judgments and
      estimates are described below and are impacted significantly by judgments,
      assumptions, and estimates used in the preparation of the condensed consolidated
      financial statements. Actual results could differ materially from these
      estimates.




*Revenue
      Recognition*




We
      recognize product revenue in accordance with SEC Staff Accounting
      Bulletin No. 104, *Revenue
      Recognition in Financial Statements* (“SAB
      104”). Under SAB 104, revenue is recognized when there is persuasive evidence of
      an arrangement, delivery has occurred or services have been rendered, the sales
      price is fixed and determinable and collectibility is reasonably assured.
      Generally, the criteria are met upon shipment of our products. In certain cases,
      at the customer’s request, we will enter into bill and hold transactions whereby
      title and risk of loss transfers to the customer, but the product does not
      ship
      until a specified later date. Revenue on such transactions is recognized only
      after ArthroCare has met all conditions for bill and hold transactions set
      forth
      in SAB 104, specifically that ArthroCare has no further performance
      obligations, that the product is complete and ready for shipment, and that
      a
      fixed schedule for delivery of the product is set. Revenue is reported net
      of a
      provision for estimated product returns.




21




We
      recognize license fees and other revenue over the term of the associated
      agreement unless the fee is in exchange for products delivered or services
      performed that represent the culmination of a separate earnings process.
      Royalties are recognized as earned, generally based on the licensees’ product
      shipments. These items are classified as royalties, fees and other revenues
      in
      the accompanying condensed consolidated statements of operations. Amounts billed
      to customers relating to shipping and handling costs have also been classified
      as royalties, fees and other revenues and related costs are classified as cost
      of product sales in the accompanying condensed consolidated statements of
      operations.





Additionally,
      we assess risks of loss on accounts receivable and make adjustments to our
      allowance for doubtful accounts based on our assessment. In estimating this
      allowance, we consider factors such as historical collection experience, a
      customer’s current credit-worthiness, customer concentrations, the age of the
      receivable balance, both individually and in the aggregate, and general economic
      conditions that may affect a customer’s ability to pay. Actual customer
      collections could differ from our estimates. We believe that the allowance
      for
      doubtful accounts of $4.1 million at September 30, 2007 is adequate to provide
      for probable losses associated with accounts receivable.





*Inventory
      Reserves*




Inventory
      purchases and commitments are based upon future demand forecasts. We record
      reserves against our inventory value to the extent we believe that demand for
      certain inventory items has decreased or if certain inventory items have become
      obsolete. If there were to be a sudden and significant decrease in demand for
      our products, or if there were a higher incidence of inventory obsolescence
      because of rapidly changing technology and customer requirements, we could
      be
      required to increase our inventory reserves and our gross margins could be
      adversely affected.




*Business
      Combinations*





Accounting
      for our business acquisitions requires extensive accounting estimates and
      judgments to allocate the purchase price between net tangible assets, in-process
      research and development, other identifiable intangible assets and goodwill.
      Assets and liabilities of acquired businesses are recorded under the purchase
      method of accounting at their estimated fair value at the date of acquisition.





We
      assess
      our goodwill for impairment on December 31st of each year and during an interim
      period if facts or circumstances would more likely than not suggest that the
      fair value of an identified reporting unit is below its carrying value. We
      currently have recorded goodwill related to our acquisitions of ATI, Atlantech,
      MDA and Opus Medical. In response to changes in industry and market conditions,
      we may be required to strategically realign our resources and consider
      restructuring, disposing, or otherwise exiting businesses, which could result
      in
      an impairment of goodwill. Impairment is measured by the excess of the recorded
      value of goodwill over its implied fair value. Measurement of an impairment
      is
      required when the fair value of the reporting unit containing goodwill is less
      than the reporting unit’s net book value.




Intangible
      assets with finite lives are amortized over the estimated useful life of each
      asset. We monitor conditions related to these assets to determine whether events
      and circumstances warrant a revision to the remaining amortization period.
      To
      date, we have not had an impairment associated with these intangible
      assets.




22




*Contingencies*




We
      are
      subject to the possibility of various loss contingencies arising in the ordinary
      course of business. In determining loss contingencies, we consider the
      likelihood of loss or impairment of an asset or the incurrence of a liability,
      as well as our ability to reasonably estimate the amount of loss. An estimated
      loss contingency is accrued when it is probable that an asset has been impaired
      or a liability has been incurred and the amount of loss can be reasonably
      estimated. We regularly evaluate current information available to us to
      determine whether such accrual estimates should be adjusted.




*Income
      Taxes*





We
      account for income taxes under the liability method, whereby deferred tax asset
      or liability account balances are determined based on the difference between
      the
      financial statement and the tax bases of assets and liabilities using current
      tax laws and rates in effect for the year in which the differences are expected
      to affect taxable income. Valuation allowances are established, when necessary,
      to reduce deferred tax assets to the amounts expected to be
      realized.





In
      July
      2006, the Financial Accounting Standards Board (“FASB”) issued Interpretation
      No. (“FIN”) 48, *Accounting
      for Uncertainty in Income Taxes* . FIN
      48
      clarifies the accounting for uncertainty in income taxes recognized in an
      enterprise’s financial statements in accordance with Statement of Financial
      Accounting Standards No. 109, *Accounting
      for Income Taxes* .
      This
      interpretation prescribes a recognition threshold and measurement attribute
      for
      the financial statement recognition and measurement of a tax position taken
      or
      expected to be taken in a tax return. FIN 48 also provides guidance on
      derecognition of tax benefits, classification on the balance sheet, interest
      and
      penalties, accounting in interim periods, disclosure, and transition. We adopted
      FIN 48 effective January 1, 2007. In accordance with FIN 48, paragraph 19,
      we have decided to classify interest and penalties as a component of tax
      expense. As a result of the implementation of FIN 48, we recognized a
      $2.1 million increase in liability for unrecognized tax benefits, which was
      accounted for as a reduction to the January 1, 2007 balance of retained
      earnings.





We
      had
      unrecognized tax benefits of approximately $7.9 million as of January 1,
      2007, of which $7.1 million, if recognized, would result in a reduction of
      our
      effective tax rate. Interest and penalties are immaterial at the date of
      adoption and are included in the unrecognized tax benefits. The
      Company recorded an increase in its unrecognized tax benefits of approximately
      $0.1 million and $0.4 million in the three and nine month periods ended
      September 30, 2007, respectively. The Company is subject to audit by the IRS
      and
      California Franchise Tax Board for the years 1994 through 2006 and by the Texas
      State Comptroller for the year 2006. As the Company has operations in most
      other
      US states, other state tax authorities may assess deficiencies related to prior
      year activities; however, the years open to assessment vary with each state.
        The Company also files income tax returns for non-US jurisdictions; the
      most significant of which are the UK, Sweden, and Germany.  The years open
      to adjustment for the UK and Germany are 2003 through 2006.  The years open
      to adjustment for Sweden are 1999 through 2006.




*Stock-Based
      Compensation*





On
      January 1, 2006, we adopted Statement of Financial Accounting Standards No.
      123
      (revised 2004), *Share-Based
      Payment* (“FAS
      123R”), which requires the measurement and recognition of compensation expense
      for all share-based payment awards made to employees, including employee stock
      options and employee stock purchases related to the ESPP based on estimated
      grant date fair values. Stock-based compensation expense related to employee
      stock options recognized under FAS 123R for the quarter ended September 30,
      2007
      and 2006 was $1.9 million and $2.0 million, respectively, and $5.6 million
      and
      $6.1 million for the nine months ended September 30, 2007 and 2006,
      respectively. See Note 9 to the condensed consolidated financial statements
      for
      additional information.




23




Upon
      adoption of FAS 123R, we began estimating the value of employee stock options
      on
      the date of grant using the Black Scholes model, as we had previously used
      for
      the purpose of disclosing pro forma financial information. The determination
      of
      the fair value of share based payment awards on the date of grant using an
      option pricing model is affected by our stock price as well as assumptions
      regarding a number of highly complex and subjective variables. These variables
      include, but are not limited to, the expected stock price volatility, employee
      stock option exercise behavior, and related tax implications.




As
      stock-based compensation expense recognized in the condensed consolidated
      statement of operations for the first quarter of 2007 is based on awards
      ultimately expected to vest, it has been reduced for estimated forfeitures.
      FAS
      123R requires forfeitures to be estimated at the time of grant and revised,
      if
      necessary, in subsequent periods if actual forfeitures differ from those
      estimates. Forfeitures were estimated based on historical experience but actual
      forfeitures could differ materially and result in volatility in our stock-based
      compensation expense amounts.




***Disclosures
      about Contractual Obligations and Commercial Commitments***





We
      have
      various contractual obligations, which are recorded as liabilities in our
      consolidated financial statements. Other items, such as certain purchase
      commitments with suppliers and minimum lease payments under operating leases,
      are not recognized as liabilities in our consolidated financial statements
      but
      are required to be disclosed. During the nine months ended September 30, 2007,
      there were no material changes in our contractual obligations presented in
      our
      2006 Annual Report on Form 10-K. As of September 30, 2007, we have
      $4.4 million of non-current income tax liabilities as a result of our
      adoption of FIN 48 on January 1, 2007. Because of the uncertainty of
      the amounts to be ultimately paid as well as the timing of such payments, these
      liabilities are excluded from our contractual
      obligations table.




***Recently
      Issued Accounting Pronouncements***




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




In
      February 2007, the FASB issued Statement of Financial Accounting Standards
      No.
      159, *The
      Fair Value Option for Financial Assets and Financial Liabilities - Including
      an
      amendment of FASB No. 115* (“FAS
      159”). The Statement permits companies to choose to measure many financial
      instruments and certain other items at fair value in order to mitigate
      volatility in reported earnings caused by measuring related assets and
      liabilities differently without having to apply complex hedge accounting
      provisions. FAS 159 is effective for us beginning January 1, 2008. We are
      currently evaluating the impact, if any, that FAS 159 will have on our operating
      results and financial position.




Please
      refer to our discussion of accounting for income taxes in the section entitled
      “Critical Accounting Policies and Estimates” for a description of our adoption
      of FIN 48 during the nine months ended September 30, 2007.




24


**ITEM
      3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
      RISK**





Our
      exposure to market risk for changes in interest rates relates primarily to
      our
      investment portfolio, which includes cash, cash equivalents and short-term
      investments. Our investment portfolio does not currently include derivative
      financial instruments.




We
      are
      subject to fluctuating interest rates that may impact, adversely or otherwise,
      our results of operations or cash flows. The table below presents principal
      amounts and related weighted average interest rates as of September 30, 2007
      for
      our cash, cash equivalents and short-term investments (in thousands):




Cash,
                cash equivalents, and short-term investments
            
            $
            54,938Average
                interest rate
            
            
            4.7
            %




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




***Foreign
      Currency Risk***





A
      significant portion of our international sales and operating expenses are
      denominated in currencies other than the U.S. Dollar. During the first nine
      months of 2007, most of these currencies strengthened relative to the U.S.
      Dollar. To the extent that the strength of these currencies fluctuates as
      compared to the U.S. Dollar, we will experience variations in our results of
      operations and financial condition.




Our
      cash
      and cash equivalents at the quarter ended September 30, 2007 were denominated
      primarily in U.S. Dollars; however, we also maintain significant balances in
      Euros, Swedish Krona and Costa Rican Colones. A 10 percent change in the
      September 30, 2007 exchange rates for these currencies would have an impact
      on
      pre-tax income of approximately $0.5 million.




**ITEM
      4. CONTROLS AND PROCEDURES**





***Evaluation
      of Disclosure Controls and Procedures***





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




We
      carried out an evaluation under the supervision and with the participation
      of
      our management, including our CEO and CFO, of the effectiveness of the design
      and operation of our disclosure controls and procedures as of September 30,
      2007.  Based upon this evaluation, our CEO and CFO have concluded that the
      design and operation of our disclosure controls and procedures were effective
      as
      of September 30, 2007. 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.




25


***Changes
      in Internal Control Over Financial Reporting***





There
      were no changes in our internal control over financial reporting that occurred
      during the quarter ended September 30, 2007 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 1 by reference
      to the section entitled “Litigation” in Note 8 to the condensed consolidated
      financial statements contained in Part I above.




**ITEM
      1A. RISK FACTORS**




There
      are
      many factors that affect our business and the results of our operations, many
      of
      which are beyond our control. In this regard, "Item 1A. Risk Factors" to Part
      I
      of our Annual Report on Form 10-K for the year ended December 31, 2006 contained
      a description of significant factors that might cause the actual results of
      operations in future periods to differ materially from those currently expected
      or desired. We urge you to read the risk factors contained in our 2006 Annual
      Report on Form 10-K, as there have not been any material changes in our risk
      factors.




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




None.




**ITEM
      3. DEFAULTS UPON SENIOR SECURITIES**




None.




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




None.




**ITEM
      5. OTHER INFORMATION**




None.




**ITEM
      6. EXHIBITS**




Exhibits




**Exhibit
                Number**
            
            **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.




26




**SIGNATURES**





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




**ARTHROCARE
                CORPORATION**
              *a
                  Delaware corporation*Date:October 29, 2007
            
            /s/
                Michael A. BakerMichael
                A. BakerPresident,
                Chief Executive Officer and Director(Principal
              Executive Officer)


Date:October 29, 2007
            
            /s/
                Michael GlukMichael
                GlukSenior
                Vice President and ChiefFinancial
                Officer(Principal
                Financial and Accounting Officer)




27