Table ofContents

 

 

 

**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**Form 10-Q**

 

**x****      QUARTERLY REPORT PURSUANT TOSECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For the quarterly period ended September 30, 2010**

 

**OR**

 

**o****         TRANSITION REPORTPURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934**

 

**For the transition period from                to                **

 

**Commission File Number: 0-27422**

 

**ArthroCareCorporation**

(Exact name of registrant as specified inits charter)

 

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

 

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

(Address of principal executive offices)

 

**(512) 391-3900**

(Registrant’s telephone number, includingarea code)

 

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days.  Yes x No o

 

Indicateby check mark whether the registrant has submitted electronically and posted onits corporate Web site, if any, every Interactive Data File required to besubmitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 ofthis chapter) during the preceding 12 months (or for such shorter period that theregistrant was required to submit and post such files).  Yes o No o

 

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, a non-accelerated filer, or a smaller reportingcompany.  See definitions of “large accelerated filer,” “acceleratedfiler” and “smaller reporting company” in Rule 12b-2 of the Exchange Act:

 

| Large accelerated filer o    |   | Accelerated filer x         |
|------------------------------|--------|----------------------------------|
|                         |   |                             |
| Non-accelerated filer o |   | Smaller reporting company o |

 

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

 

Asof October 27, 2010, the number of outstanding shares of the Registrant’sCommon Stock was 27,031,539.

 

 

 

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**ARTHROCARE CORPORATION**

 

**Form 10-Q Quarterly Report**

**For the quarter ended September 30, 2010**

 

**TABLE OF CONTENTS**

 
| **PART I.  FINANCIAL INFORMATION**                                                                 | **1**      |
|---------------------------------------------------------------------------------------------------------|------------|
| **ITEM 1. FINANCIAL STATEMENTS**                                                                        | **1**      |
| **CONDENSED  CONSOLIDATED BALANCE SHEETS**                                                              | **1**      |
| **CONDENSED  CONSOLIDATED STATEMENTS OF OPERATIONS**                                                    | **2**      |
| **CONDENSED  CONSOLIDATED STATEMENTS OF CASH FLOWS**                                                    | **3**      |
| **NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**                                                | **4**      |
| **ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF  FINANCIAL CONDITION AND RESULTS OF OPERATIONS** | **11**     |
| **ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT  MARKET RISK**                                 | **18**     |
| **ITEM 4. CONTROLS AND PROCEDURES**                                                                     | **19**     |
| **PART II.  OTHER INFORMATION**                                                                    | **22**     |
| **ITEM  1. LEGAL PROCEEDINGS**                                                                          | **22**     |
| **ITEM  1A. RISK FACTORS**                                                                              | **22**     |
| **ITEM 2. UNREGISTERED SALES OF SECURITIES AND USE OF  PROCEEDS**                                       | **34**     |
| **ITEM 3. DEFAULTS UPON SENIOR SECURITIES**                                                             | **35**     |
| **ITEM 4.  RESERVED**                                                                                   | **35**     |
| **ITEM  5. OTHER INFORMATION**                                                                          | **35**     |
| **ITEM 6.  EXHIBITS**                                                                                   | **35**     |
| **SIGNATURES**                                                                                          | ** ** |
| **EXHIBIT INDEX**                                                                                  | ** ** |
| **Exhibit 31.1**                                                                                   | ** ** |
| **Exhibit 31.2**                                                                                   | ** ** |
| **Exhibit 32.1**                                                                                   | ** ** |
| **Exhibit 32.2**                                                                                   | ** ** |
| **Exhibit 99.1**                                                                                   | ** ** |

 

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**PART I.  FINANCIALINFORMATION**

 

**ITEM 1. FINANCIAL STATEMENTS**

 

**ARTHROCARE CORPORATION**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

**(unaudited)**

* ***(in thousands, except par value data)**

 
| ** **                                                                                                                                                                                                               | ** ** | **September 30,  2010** | ** ** | **December 31,  2009** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                                                               | ** ** | ** **                   | ** ** | ** **                  | ** ** |
| **ASSETS**                                                                                                                                                                                                               | ** ** | ** **                   | ** ** | ** **                  | ** ** |
| Current assets:                                                                                                                                                                                                          |       |                         |       |                        |       |
| Cash and cash equivalents                                                                                                                                                                                                |       | $                            | 113,036    |                        | $          | 57,386 |   |
| Accounts receivable, net of allowances of $2,697  and $4,069 at September 30, 2010 and December 31, 2009,  respectively                                                                                        |       | 42,422                       |       | 45,789                      |       |
| Inventories, net                                                                                                                                                                                                         |       | 39,563                       |       | 48,628                      |       |
| Deferred tax assets                                                                                                                                                                                                      |       | 3,812                        |       | 12,983                      |       |
| Prepaid expenses and other current assets                                                                                                                                                                                |       | 4,864                        |       | 6,563                       |       |
| Total current assets                                                                                                                                                                                                     |       | 203,697                      |       | 171,349                     |       |
|                                                                                                                                                                                                                     |       |                         |       |                        |       |
| Property and equipment, net                                                                                                                                                                                              |       | 43,097                       |       | 47,386                      |       |
| Intangible assets, net                                                                                                                                                                                                   |       | 13,329                       |       | 17,975                      |       |
| Goodwill                                                                                                                                                                                                                 |       | 119,281                      |       | 119,076                     |       |
| Deferred tax assets                                                                                                                                                                                                      |       | 34,370                       |       | 30,526                      |       |
| Other assets                                                                                                                                                                                                             |       | 4,344                        |       | 4,816                       |       |
| Total assets                                                                                                                                                                                                             |       | $                            | 418,118    |                        | $          | 391,128 |   |
|                                                                                                                                                                                                                     |       |                         |       |                        |       |
| **LIABILITIES, REDEEMABLE  CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS’ EQUITY**                                                                                                                                   |       |                         |       |                        |       |
| Current liabilities:                                                                                                                                                                                                     |       |                         |       |                        |       |
| Accounts payable                                                                                                                                                                                                         |       | $                            | 14,401     |                        | $          | 14,299 |   |
| Accrued liabilities                                                                                                                                                                                                      |       | 37,996                       |       | 46,077                      |       |
| Deferred tax liabilities                                                                                                                                                                                                 |       | 56                           |       | 3                           |       |
| Deferred revenue                                                                                                                                                                                                         |       | —                       |       | 4,508                       |       |
| Income tax payable                                                                                                                                                                                                       |       | —                       |       | 195                         |       |
| Total current liabilities                                                                                                                                                                                                |       | 52,453                       |       | 65,082                      |       |
|                                                                                                                                                                                                                     |       |                         |       |                        |       |
| Deferred tax liabilities                                                                                                                                                                                                 |       | 294                          |       | 303                         |       |
| Other non-current liabilities                                                                                                                                                                                            |       | 11,953                       |       | 4,844                       |       |
| Total liabilities                                                                                                                                                                                                        |       | 64,700                       |       | 70,229                      |       |
|                                                                                                                                                                                                                     |       |                         |       |                        |       |
| Commitments and contingencies (Notes 6 and 7)                                                                                                                                                                            |       |                         |       |                        |       |
|                                                                                                                                                                                                                     |       |                         |       |                        |       |
| Series A 3% Redeemable Convertible Preferred  Stock, par value $0.001; Authorized: 100 shares; Issued and outstanding: 75  shares at September 30, 2010 and December 31, 2009; Redemption value:  $87,089 |       | 72,938                       |       | 70,504                      |       |
|                                                                                                                                                                                                                     |       |                         |       |                        |       |
| Stockholders’ equity:                                                                                                                                                                                               |       |                         |       |                        |       |
| Preferred stock, par value $0.001; Authorized:  4,900 shares; Issued and outstanding: none                                                                                                                               |       | —                       |       | —                      |       |
| Common stock, par value $0.001; Authorized: 75,000  shares; Issued and outstanding: 27,029 shares at September 30, 2010 and  26,886 shares at December 31, 2009                                                |       | 27                           |       | 27                          |       |
| Treasury stock: 4,005 shares at September 30,  2010 and 4,019 shares at December 31, 2009                                                                                                                      |       | (108,351                     | )          | (108,724                    | )          |
| Additional paid-in capital                                                                                                                                                                                               |       | 381,994                      |       | 379,921                     |       |
| Accumulated other comprehensive income                                                                                                                                                                                   |       | 3,938                        |       | 1,645                       |       |
| Retained earnings (accumulated deficit)                                                                                                                                                                                  |       | 2,872                        |       | (22,474                     | )          |
| Total stockholders’ equity                                                                                                                                                                                          |       | 280,480                      |       | 250,395                     |       |
| Total liabilities, redeemable convertible  preferred stock and stockholders’ equity                                                                                                                                 |       | $                            | 418,118    |                        | $          | 391,128 |   |

 

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

 

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**ARTHROCARE CORPORATION**

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

**(unaudited)**

* ***(in thousands, except per-share data)**

 
| ** **                                                                                         | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                                         | ** ** | **2010**                                             | ** ** | **2009**                                            | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                                                                                         | ** ** | ** **                                           | ** ** | ** **                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Revenues:**                                                                                      | ** ** | ** **                                           | ** ** | ** **                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Product sales                                                                                      |       | $                                                    | 84,312     |                                                | $          | 76,408 |   | $ | 255,560 |   | $ | 229,489 |   |
| Royalties, fees and other                                                                          |       | 3,570                                                |       | 3,110                                               |       | 11,718 |   | 9,629 |   |
| Total revenues                                                                                     |       | 87,882                                               |       | 79,518                                              |       | 267,278 |   | 239,118 |   |
|                                                                                               |       |                                                 |       |                                                |       |   |   |   |   |
| **Cost of product sales**                                                                          |       | 29,029                                               |       | 24,316                                              |       | 84,802 |   | 68,185 |   |
|                                                                                               |       |                                                 |       |                                                |       |   |   |   |   |
| **Gross profit**                                                                                   |       | 58,853                                               |       | 55,202                                              |       | 182,476 |   | 170,933 |   |
| **Operating expenses:**                                                                            |       |                                                 |       |                                                |       |   |   |   |   |
| Research and development                                                                           |       | 9,383                                                |       | 9,229                                               |       | 27,076 |   | 27,099 |   |
| Sales and marketing                                                                                |       | 26,669                                               |       | 28,563                                              |       | 82,397 |   | 88,700 |   |
| General and administrative                                                                         |       | 9,295                                                |       | 11,981                                              |       | 27,372 |   | 36,101 |   |
| Amortization of intangible assets                                                                  |       | 1,564                                                |       | 1,583                                               |       | 4,685 |   | 4,757 |   |
| Investigation and restatement related costs                                                        |       | 317                                                  |       | 9,293                                               |       | 1,888 |   | 25,323 |   |
| Reimbursement services                                                                             |       | 25                                                   |       | 46                                                  |       | 70 |   | 312 |   |
| Total operating expenses                                                                           |       | 47,253                                               |       | 60,695                                              |       | 143,488 |   | 182,292 |   |
|                                                                                               |       |                                                 |       |                                                |       |   |   |   |   |
| **Income (loss) from operations**                                                                  |       | 11,600                                               |       | (5,493                                              | )          | 38,988 |   | (11,359 | ) |
| Interest and other expense, net                                                                    |       | (96                                                  | )          | (1,207                                              | )          | (286 | ) | (3,339 | ) |
| Foreign exchange gain (loss), net                                                                  |       | 1,323                                                |       | (446                                                | )          | (2,712 | ) | (1,581 | ) |
| Interest and other income (expense), net                                                           |       | 1,227                                                |       | (1,653                                              | )          | (2,998 | ) | (4,920 | ) |
|                                                                                               |       |                                                 |       |                                                |       |   |   |   |   |
| **Income (loss) before income taxes**                                                              |       | 12,827                                               |       | (7,146                                              | )          | 35,990 |   | (16,279 | ) |
|                                                                                               |       |                                                 |       |                                                |       |   |   |   |   |
| Income tax provision (benefit)                                                                     |       | 3,570                                                |       | (2,719                                              | )          | 9,824 |   | (2,656 | ) |
|                                                                                               |       |                                                 |       |                                                |       |   |   |   |   |
| **Net income (loss)**                                                                              |       | 9,257                                                |       | (4,427                                              | )          | 26,166 |   | (13,623 | ) |
|                                                                                               |       |                                                 |       |                                                |       |   |   |   |   |
| Accrued dividend and accretion charges on  Series A 3% Redeemable Convertible Preferred Stock |       | (820                                                 | )          | (27,252                                             | )          | (2,434 | ) | (27,252 | ) |
| **Net income (loss) available to  common stockholders**                                            |       | $                                                    | 8,437      |                                                | $          | (31,679 | ) | $ | 23,732 |   | $ | (40,875 | ) |
|                                                                                               |       |                                                 |       |                                                |       |   |   |   |   |
| **Weighted average shares  outstanding:**                                                          |       |                                                 |       |                                                |       |   |   |   |   |
| Basic                                                                                              |       | 27,017                                               |       | 26,838                                              |       | 26,972 |   | 26,798 |   |
| Diluted                                                                                            |       | 27,323                                               |       | 26,838                                              |       | 27,299 |   | 26,798 |   |
|                                                                                               |       |                                                 |       |                                                |       |   |   |   |   |
| **Earnings (loss) per common share:**                                                              |       |                                                 |       |                                                |       |   |   |   |   |
| Basic                                                                                              |       | $                                                    | 0.26       |                                                | $          | (1.18 | ) | $ | 0.72 |   | $ | (1.53 | ) |
| Diluted                                                                                            |       | $                                                    | 0.25       |                                                | $          | (1.18 | ) | $ | 0.72 |   | $ | (1.53 | ) |

 

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

 

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**ARTHROCARECORPORATION**

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(unaudited)**

**(inthousands)**

 
| ** **                                                                                                             | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                                                             | ** ** | **2010**                                            | ** ** | **2009** | ** ** |
|                                                                                                                   |       |                                                |       |   |   |
| Cash flows from operating activities:                                                                                  |       |                                                |       |   |   |
| Net income (loss)                                                                                                      |       | $                                                   | 26,166     |   | $ | (13,623 | ) |
| Adjustments to reconcile net income (loss) to net  cash provided by operating activities:                              |       |                                                |       |   |   |
| Depreciation and amortization                                                                                          |       | 18,740                                              |       | 17,695 |   |
| Provision for doubtful accounts receivable and  product returns                                                        |       | (695                                                | )          | 3,095 |   |
| Inventory and warranty provision                                                                                       |       | 6,094                                               |       | 2,571 |   |
| Non-cash stock compensation expense                                                                                    |       | 5,761                                               |       | 3,824 |   |
| Deferred taxes                                                                                                         |       | 9,824                                               |       | — |   |
| Unrealized foreign exchange gain                                                                                       |       | (2,055                                              | )          | (568 | ) |
| Other                                                                                                                  |       | 502                                                 |       | 700 |   |
| Changes in operating assets and liabilities, net  of assets acquired and liabilities assumed in business combinations: |       |                                                |       |   |   |
| Accounts receivable                                                                                                    |       | 2,550                                               |       | 7,206 |   |
| Inventories                                                                                                            |       | 3,700                                               |       | 4,367 |   |
| Prepaid expenses and other assets                                                                                      |       | 6,476                                               |       | (450 | ) |
| Accounts payable                                                                                                       |       | (1,140                                              | )          | (1,524 | ) |
| Accrued liabilities                                                                                                    |       | (7,780                                              | )          | 4,831 |   |
| Deferred revenue                                                                                                       |       | (4,508                                              | )          | 1,298 |   |
| Net cash provided by operating activities                                                                              |       | 63,635                                              |       | 29,422 |   |
|                                                                                                                   |       |                                                |       |   |   |
| Cash flows from investing activities:                                                                                  |       |                                                |       |   |   |
| Purchases of property and equipment                                                                                    |       | (8,816                                              | )          | (12,109 | ) |
| Payments for business combinations and purchases  of intangible assets                                                 |       | (83                                                 | )          | (443 | ) |
| Disbursement of loan receivable                                                                                        |       | 168                                                 |       | (180 | ) |
| Maturities and other changes in cash and cash  equivalents                                                             |       | 39                                                  |       | 2,989 |   |
| Net cash used in investing activities                                                                                  |       | (8,692                                              | )          | (9,743 | ) |
|                                                                                                                   |       |                                                |       |   |   |
| Cash flows from financing activities:                                                                                  |       |                                                |       |   |   |
| Proceeds from issuance of Series A Redeemable  Convertible 3% Preferred Stock                                     |       | —                                              |       | 69,466 |   |
| Proceeds from Employee Stock Purchase Plan                                                                             |       | 128                                                 |       | — |   |
| Repayments on revolving credit agreement                                                                               |       | —                                              |       | (55,000 | ) |
| Proceeds from exercise of options to purchase  common stock, net of issuance costs                                     |       | 972                                                 |       | — |   |
| Net cash provided by financing activities                                                                              |       | 1,100                                               |       | 14,466 |   |
|                                                                                                                   |       |                                                |       |   |   |
| Effect of exchange rate changes on cash and cash equivalents                                                           |       | (393                                                | )          | 659 |   |
|                                                                                                                   |       |                                                |       |   |   |
| Net increase in cash and cash equivalents                                                                              |       | 55,650                                              |       | 34,804 |   |
| Cash and cash equivalents, beginning of period                                                                         |       | 57,386                                              |       | 33,506 |   |
| Cash and cash equivalents, end of period                                                                               |       | $                                                   | 113,036    |   | $ | 68,310 |   |

 

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

 

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**ARTHROCARE CORPORATION**

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

 

**NOTE 1 — BASIS OF PRESENTATION**

 

***Basis of Presentation***

 

Theaccompanying unaudited condensed consolidated financial statements ofArthroCare Corporation (“ArthroCare” or the “Company”) and its subsidiaries(collectively with ArthroCare, the “Company”) have been prepared in accordancewith the instructions to Form 10-Q and therefore do not include all informationand footnotes necessary for a fair presentation of financial position, resultsof operations and cash flows in conformity with United States generallyaccepted accounting principles (“GAAP”). The condensed consolidated financial statements should be read inconjunction with the consolidated financial statements and notes theretotogether with management’s discussion and analysis of financial condition andresults of operations contained in the Company’s 2009 Annual Report on Form 10-Kfiled on March 15, 2010 (“2009 Form 10-K”). In the opinion of management, the accompanying condensed consolidatedfinancial statements reflect all adjustments of a normal recurring natureconsidered necessary to fairly state the financial position of the Company atSeptember 30, 2010 and December 31, 2009, the results of its operations for thethree and nine month periods ended September 30, 2010 and 2009, and its cashflows for the nine month periods ended September 30, 2010 and 2009.  The results of operations for the periodspresented are not necessarily indicative of results that may be expected forthe year ending December 31, 2010.

 

***Use of Estimates***

 

Theunaudited condensed consolidated financial statements have been prepared inconformity with GAAP, using management’s best estimates and judgments whereappropriate.  These estimates andjudgments affect the reported amounts of assets and liabilities and disclosureof the contingent assets and liabilities at the date of the financialstatements.  The estimates and judgmentswill also affect the reported amounts for certain revenues and expenses duringthe reporting period.  Actual resultscould differ materially from these estimates and judgments.

 

***First Quarter 2010 Accounting Corrections***

 

Our results for the ninemonths ended September 30, 2010 include reductions of stock compensationexpense to correct forfeiture calculation errors in prior periods. The impactof the error was an overstatement of operating expenses of $0.4 million in theyear ended December 31, 2008 and $0.7 million in the year ended December 31,2009. To correct this error, we recorded reductions of $0.8 million to generaland administrative expense and $0.3 million to sales and marketing expense inthe quarter ended March 31, 2010. We have determined that the impact of thisuncorrected error is immaterial to all prior periods, and the correction isimmaterial to the quarter and nine month periods ended September 30, 2010 andwe expect it to be immaterial to our results for the year ending December 31,2010.

 

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**ARTHROCARE CORPORATION**

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (continued)**

 

***Recently Issued Accounting Pronouncements***

 

In October 2009, the Financial Accounting Standards Board (“FASB”)issued amended revenue recognition guidance for arrangements with multipledeliverables. For the Company, this guidance is effective for all new ormaterially modified arrangements entered into on or after January 1, 2011with earlier application permitted as of the beginning of a fiscal year. TheCompany is currently assessing its implementation of this new guidance, butdoes not expect it to have a material impact on the consolidated financialstatements.

 

**NOTE 2 — COMPREHENSIVE INCOME (LOSS)**

 

Thefollowing table presents comprehensive income (loss) (in thousands):

 
| ** **                               | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------------|------------|---------------------------------|------------|
| ** **                               | ** ** | **September 30,**          | ** ** |
| ** **                               | ** ** | **2010**                        | ** ** | **2009** | ** ** |
| ** **                               | ** ** | ** **                      | ** ** | ** ** | ** ** |
| Comprehensive income (loss):             | ** ** | ** **                      | ** ** | ** ** | ** ** |
| Net income (loss)                        |       | $                               | 26,166     |   | $ | (13,623 | ) |
| Foreign currency translation adjustments |       | 2,293                           |       | 4,031 |   |
| Comprehensive income (loss)              |       | $                               | 28,459     |   | $ | (9,592 | ) |

 

**NOTE 3 — COMPUTATION OF EARNINGS (LOSS) PER SHARE**

 

The Company’s Series A 3% Redeemable Convertible Preferred Stock (the “SeriesA Preferred Stock”) has participation rights in dividends issued to commonstockholders.  As a result, the Companycalculates earnings per share using the two class method for periods endingafter September 1, 2009, the date on which the Company issued the Series APreferred Stock.  The following is areconciliation of net income (loss) applicable to common stockholders and thenumber of shares used in the calculation of basic and diluted earnings (loss)per share applicable to common stockholders (in thousands, except per-sharedata):

 
| ** **                                                                                    | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                                                    | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                                                                    | ** ** | **2010**                         | ** ** | **2009**                        | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                                                                                    | ** ** | ** **                       | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income (loss) available to common stockholders                                            |       | $                                | 8,437      |                            | $          | (31,679 | ) | $ | 23,732 |   | $ | (40,875 | ) |
| Series A Preferred Stock interest in undistributed  earnings                                  |       | 1,492                            |       | —                          |       | 4,196 |   | — |   |
| Net income (loss) used in computation of earnings  per share available to common stockholders | ** ** | 6,945                            |       | (31,679                         | )          | 19,536 |   | (40,875 | ) |
| ** **                                                                                    | ** ** | ** **                       | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Basic:                                                                                        | ** ** | ** **                       |       |                            | ** ** | ** ** | ** ** | ** ** | ** ** |
| Weighted-average common shares outstanding                                                    |       | 27,017                           |       | 26,838                          |       | 26,972 |   | 26,798 |   |
| Basic earnings (loss) per share available to  common stockholders                             |       | $                                | 0.26       |                            | $          | (1.18 | ) | $ | 0.72 |   | $ | (1.53 | ) |
| ** **                                                                                    | ** ** | ** **                       | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Diluted:                                                                                      | ** ** | ** **                       |       |                            | ** ** | ** ** | ** ** | ** ** | ** ** |
| Weighted-average common shares outstanding                                                    |       | 27,017                           |       | 26,838                          |       | 26,972 |   | 26,798 |   |
| Dilutive effect of options                                                                    |       | 235                              |       | —                          |       | 260 |   | — |   |
| Dilutive effect of unvested restricted stock                                                  |       | 71                               |       | —                          |       | 67 |   | — |   |
| Weighted-average common stock and common stock  equivalents                                   |       | 27,323                           |       | 26,838                          |       | 27,299 |   | 26,798 |   |
| Diluted earnings (loss) per share available to  common stockholders                           |       | $                                | 0.25       |                            | $          | (1.18 | ) | $ | 0.72 |   | $ | (1.53 | ) |
| ** **                                                                                    | ** ** | ** **                       | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Stock awards excluded from calculation as their  effect would be anti-dilutive                |       | 2,105                            |       | 1,950                           |       | 2,067 |   | 1,950 |   |
| Common stock issuable upon conversion of the  Series A Preferred Stock                        |       | 5,806                            |       | 5,806                           |       | 5,806 |   | 5,806 |   |

 

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**ARTHROCARE CORPORATION**

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (continued)**

 

**NOTE 4 —****INVENTORIES**

 

Thefollowing summarizes the Company’s inventories (in thousands):

 
| ** **                   | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                   | ** ** | **2010**               | ** ** | **2009**              | ** ** |
| ** **                   | ** ** | ** **             | ** ** | ** **            | ** ** |
| Raw materials                |       | $                      | 9,449      |                  | $          | 8,937 |   |
| Work-in-process              |       | 10,745                 |       | 6,990                 |       |
| Finished goods               |       | 28,924                 |       | 39,081                |       |
|                         |       | 49,118                 |       | 55,008                |       |
| Inventory valuation reserves |       | (9,555                 | )          | (6,380                | )          |
| Inventories, net             |       | $                      | 39,563     |                  | $          | 48,628 |   |

 

**NOTE 5 — ACCRUED LIABILITIES**

 

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

 
| ** **                         | ** ** | **September 30,  2010** | ** ** | **December 31,  2009** | ** ** |
|------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **                         | ** ** | ** **                   | ** ** | ** **                  | ** ** |
| Compensation                       |       | $                            | 16,841     |                        | $          | 15,007 |   |
| Insurance dispute reserve          |       | 10,937                       |       | 15,268                      |       |
| Agent commissions                  |       | 1,570                        |       | 2,106                       |       |
| Royalties and discounts            |       | 1,557                        |       | 2,943                       |       |
| Legal fees and arbitration accrual |       | 1,068                        |       | 2,862                       |       |
| Professional fees                  |       | 925                          |       | 2,748                       |       |
| Other                              |       | 5,098                        |       | 5,143                       |       |
|                               |       | $                            | 37,996     |                        | $          | 46,077 |   |

 

TheCompany entered into settlement and release agreements in the nine month periodended September 30, 2010 with certain private insurers related to cases inwhich letters of protection were held by its DiscoCare subsidiary.  The Company agreed to pay these insurers anaggregate of $4.8 million, which reduced the Company’s accrued insurancedispute reserve.

 

OnOctober 29, 2010 the Company entered a Settlement Agreement and Release(the “Settlement Agreement”) with Farmers Insurance, comprised of Mid-CenturyInsurance Company, Farmers Insurance Exchange, Truck Insurance Exchange,Farmers Texas County Mutual Insurance Company, 21st Century Insurance Company,21st Century Company of the Southwest, Bristol West Insurance Company, SecurityNational Insurance Company and its parents, subsidiaries (direct and indirect),affiliates, officers, directors, employees, and agents (collectively,“Farmers”) regarding prior claims for reimbursement made to Farmers related tocases in which letters of protection were held by the Company’s subsidiaryDiscoCare, Inc. Pursuant to the Settlement Agreement, Farmers and theCompany have each released the other generally from any claims, demands, lossesand liabilities occurring prior to the date of the Settlement Agreement, otherthan third party claims. In consideration of the mutual releases, and withoutadmitting any liability or wrongdoing, the Company has agreed to pay Farmers anaggregate of $1,200,000. In addition, the Company has agreed that it will notseek payment from Farmers on any pending SpineWand® claims forwhich the SpineWand® surgical device was provided in exchange for aletter of protection.

 

**NOTE 6 — COMMITMENTS**

 

*Operating Leases*

 

TheCompany leases certain facilities and equipment under operating leases andrecognizes rent expense on a straight-line basis over the lease term.  Rent expense was $1.5 million for thequarters ended September 30, 2010 and 2009, and was $4.7 million and $4.5million for the nine month periods ended September 30, 2010 and 2009,respectively.  During the nine monthperiod ended September 30, 2010, there were no material changes from theCompany’s lease obligations presented in its 2009 Form 10-K.

 

*Purchase Commitments*

 

TheCompany is a party to a variety of agreements pursuant to which it may beobligated to purchase products from other parties.  Typically, these obligations arise in thecontext of contracts entered into by the Company in the normal course ofbusiness.  During the nine months endedSeptember 30, 2010, there were no material changes from the Company’scontractual obligations presented in its 2009 Form 10-K.

 

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**ARTHROCARE CORPORATION**

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (continued)**

 

*IndemnificationAgreements*

 

TheCompany advances legal fees as required pursuant to indemnification agreementsthat were entered with certain former executives and employees while they wereemployed with the Company.  During thenine month period ended September 30, 2010, the Company advanced $2.8 millionin payments and has recorded additional liabilities for $0.3 million atSeptember 30, 2010 under these indemnity agreements.  We expect to continue to advance paymentspursuant to these agreements in future periods; however, management is unableto estimate the amount or timing of future payments under such agreements.

 

**NOTE 7 — LITIGATION AND CONTINGENCIES**

 

In addition to the matters specifically described below, the Company isinvolved in other legal and regulatory proceedings that arise in the ordinarycourse of business that do not have a material impact on the Company’sbusiness. Litigation claims and proceedings of all types are subject to manyfactors that generally cannot be predicted accurately.

 

The Company records reserves for claims and lawsuits when they areprobable and reasonably estimable. Except as otherwise specifically noted, theCompany currently cannot determine the ultimate resolution of or the amount ofmonetary damages sought as relief in the matters described below. For matterswhere the likelihood or extent of a loss is not probable or cannot bereasonably estimated, the Company has not recognized in its consolidatedfinancial statements the potential liability that may result from thesematters. If one or more of these matters is determined against the Company, itcould have a material adverse effect on the Company’s earnings, liquidity andfinancial condition.

 

The Company continues to gather additional facts and informationrelated to insurance billing and healthcare compliance issues and marketing andpromotional practices in connection with these legal and administrativeproceedings with the assistance of legal counsel.

 

**SEC Investigation**

 

The Fort Worth Regional Office of the Securities and ExchangeCommission’s (“SEC”) Division of Enforcement is conducting a formalinvestigation into accounting matters related to the restatement of financialresults as announced by the Company on July 21, 2008 and completed onNovember 18, 2009. The Company is cooperating with the SEC investigation.At this stage of the investigation, the Company cannot predict the ultimateoutcome and is unable to estimate any potential liability the Company mayincur.

 

**DOJ Investigation**

 

The Department of Justice (“DOJ”) is investigating certain of theCompany’s activities including past sales, accounting, and billing proceduresprimarily in relation to the operation of the Company’s Spine business unit.The DOJ is also reviewing the Company’s relationship with its DiscoCaresubsidiary. The Company is cooperating with this investigation. At this stageof the investigation, the Company cannot predict the ultimate outcome and isunable to estimate any potential liability the Company may incur.

 

**Private Securities Class Action and ShareholderDerivative Lawsuits**

 

***Federal Court Actions***

 

On April 4, 2008, a putative securities class action was filed inFederal court in the Southern District of Florida against the Company andcertain of its former executive officers, alleging violations ofSections 10(b) and 20(a) of the Exchange Act and Rule 10b-5 promulgatedthereunder. Plaintiffs allege that the defendants violated federal securitieslaws by issuing false and misleading financial statements and making materialmisrepresentations regarding the Company’s internal controls, business, andfinancial results. On October 28, 2008, the court granted the Company’smotion to transfer this case to the U.S. District Court, Western District ofTexas. (*McIlvaine v. ArthroCare, et al*).

 

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**ARTHROCARE CORPORATION**

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (continued)**

 

On July 25, 2008, a putative securities class action was filed inFederal court in the Western District of Texas against the Company, and certainof its current and former executive officers, alleging violations ofSections 10(b) and 20(a) of the Exchange Act and Rule 10b-5promulgated thereunder. Plaintiffs allege that the defendants violated federalsecurities laws by issuing false and misleading financial statements and makingmaterial misrepresentations regarding the Company’s internal controls,business, and financial results. (*Strong v.ArthroCare, et al*).

 

On August 7, 2008, a derivative action was filed in Federal courtin the Southern District of Florida against the Company and its then-currentdirectors alleging breach of fiduciary duty based on the Company’s allegedimproper revenue recognition, improper reporting of such revenue in SEC filingsand press releases, failure to maintain adequate internal controls, and failureto supervise management. On October 14, 2008, the court granted theCompany’s motion to transfer this case to the U.S. District Court, WesternDistrict of Texas. (*Weil v. Baker, et al*).

 

On March 4, 2009, a derivative action was filed in Federal courtin the Western District of Texas against the Company’s current directors, aformer director, certain of its current and former executive officers and otheremployees and PricewaterhouseCoopers LLP alleging (i) disgorgementunder Section 304 of the Sarbanes-Oxley Act; (ii) violations ofSection 10(b) of the Exchange Act and Rule 10b-5; (iii) breachof fiduciary duty; (iv) abuse of control; (v) gross mismanagement ofthe Company; (vi) waste of corporate assets; (vii) insider trading;and (viii) unjust enrichment. (*King v.Baker, et al*).

 

On April 29, 2009, a derivative action was filed in Federal courtin the Western District of Texas against the Company’s current directors and aformer director alleging breach of fiduciary duty based on the Company’simproper revenue recognition, improper reporting of such revenue in SEC filingsand press releases, failure to maintain adequate internal controls, and failureto supervise management. (*Barron v. Baker,et al*).

 

On October 28, 2008, and thereafter, the two putative securitiesclass actions and the shareholder derivative actions were consolidated anddesignated: *In Re ArthroCare CorporationSecurities Litigation*, Case No. 1:08-cv-00574-SS (consolidated)in the U.S. District Court, Western District of Texas. On December 10,2008, Lead Plaintiffs and Lead Plaintiffs’ counsel were appointed in theputative consolidated securities class action. The Lead Plaintiff filed anAmended Consolidated Class Action Complaint on December 18, 2009, seekingunspecified monetary damages and interest. ArthroCare filed a Motion to Dismiss the Amended Consolidated ClassAction Complaint on February 16, 2010. On July 20, 2010, the federal court issued a ruling granting in part anddenying in part ArthroCare’s Motion to Dismiss, permitting certain claimsrelated to statements after December 11, 2007 to continue.

 

***State Court Actions***

 

On September 23, 2008, a derivative action was filed in TexasState District Court against the Company, and its then current directors andcertain of its current and former officers. (*Wieserv. Baker*). In this action, one of the Company’s shareholders allegedderivative claims on behalf of the Company that its directors and officersbreached their fiduciary duties to shareholders by allowing improper financialreporting, failing to maintain adequate financial controls over revenuerecognition, disseminating false financial statements, abuse of control, grossmismanagement, waste of corporate assets, and engaging in insider trading.

 

On October 20, 2008, a derivative action was filed in Texas StateDistrict Court against the Company, its then directors and certain of itscurrent and former executive officers. (*Bockletv. Baker*). In this action, one of the Company’s shareholders allegedderivative claims on behalf of the Company that its directors and officersbreached their fiduciary duties to shareholders by failing to maintain adequatefinancial controls over revenue recognition, allowing improper financialreporting, disseminating false financial statements, and engaging in insidertrading.

 

On October 27, 2008, a derivative action was filed in Texas StateDistrict Court against the Company, its then directors and certain of itscurrent and former executive officers. (*Guthriev. Baker*). In this action, one of the Company’s shareholders allegedderivative claims on behalf of the Company that its directors and officersbreached their fiduciary duties to shareholders by failing to maintain adequatefinancial controls over revenue recognition, allowing improper financialreporting, disseminating false financial statements, and engaging in insidertrading.

 

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**ARTHROCARE CORPORATION**

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (continued)**

 

On March 18, 2009, these three shareholder derivative actions wereconsolidated and designated: *In Re ArthroCareCorporation Derivative Litigation*, Case No. D-1-GN-08-3484(consolidated), Travis County District Court. On the Company’s motion, thestate shareholder derivative actions were stayed pending resolution of allmotions to dismiss the federal Amended Consolidated Class Action Complaint andclass certification, if any, of a class in the federal Amended ConsolidatedClass Action Complaint.

 

***Proposed Settlement of Derivative Actions***

 

On October 18, 2010, the Company, its directors and officers insurancecarriers, and the plaintiffs in the Federal Court and State Court derivativeactions agreed in principal to a settlement.   Under the termsof the proposed settlement, the director and officer insurers will collectivelypay $8 million to the Company, on behalf of the individuals named asdefendants in the Federal Court and State Court derivative actions, tosettle the State and Federal Derivative actions.  From the $8 millionpayment to the Company, the lawyers for the plaintiffs will beentitled to seek an award of legal fees and costs from theFederal Court in an amount not to exceed $2.25 million.   Theagreement also provides that the directors’ and officers’  insurers willpay the Company an additional $2  millionfor a broad mutual release by the Company and the insurers of any furtherrights or obligations under the directors’ and officers’liability insurance policies. The settlement calls for certainmutually acceptable governance changes and is subject to approval of theformer officers and directors who are parties to the derivative actions, anagreement by those former officers and directors to release the Company’sdirectors’ and officers’ liability insurance carriers of any furtherrights or obligations under the applicable directors’ and officers’ liabilityinsurance policies, the execution of a full and final settlement agreement, andthe approval of the settlement of the derivative actions by the U.S.District Court, Western District of Texas.

 

At this stage of the above described Federal Court and State Courtactions, the Company cannot predict the ultimate outcome and is unable toestimate any potential liability the Company may incur.

 

**NOTE 8 —SEGMENT INFORMATION**

 

TheCompany has organized its marketing and sales efforts based on three operatingsegments which are aggregated into one reportable segment—the development,manufacture and marketing of disposable devices for less invasive surgicalprocedures.  Each of the Company’sbusiness units has similar economic characteristics, technology, manufacturingprocesses, customers, distribution and marketing strategies, regulatoryenvironments, and shared infrastructures. These business units are SportsMedicine, Ear Nose and Throat (“ENT”), and Spine.

 

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

 
| ** **          | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|---------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **          | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **          | ** ** | **2010**                         | ** ** | **2009**                        | ** ** | **2010** | ** ** | **2009** | ** ** |
|                |       |                             |       |                            |       |   |   |   |   |
| Sports Medicine     |       | $                                | 56,973     |                            | $          | 50,608 |   | $ | 172,133 |   | $ | 150,619 |   |
| ENT                 |       | 23,015                           |       | 21,276                          |       | 69,935 |   | 64,168 |   |
| Spine               |       | 4,324                            |       | 4,524                           |       | 13,492 |   | 14,702 |   |
| Total product sales |       | $                                | 84,312     |                            | $          | 76,408 |   | $ | 255,560 |   | $ | 229,489 |   |

 

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**ARTHROCARE CORPORATION**

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (continued)**

 

Internationally,the Company markets and supports its products primarily through itssubsidiaries and various distributors. Revenues attributed to geographic areas are based on the country orregional area where the Company’s customer is domiciled.  Product sales by geography for the periodsshown were as follows (in thousands):

 
| ** **            | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-----------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **            | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **            | ** ** | **2010**                         | ** ** | **2009**                        | ** ** | **2010** | ** ** | **2009** | ** ** |
|                  |       |                             |       |                            |       |   |   |   |   |
| United States         |       | $                                | 56,889     |                            | $          | 52,777 |   | $ | 175,241 |   | $ | 161,591 |   |
| Non-United States (1) |       | 27,423                           |       | 23,631                          |       | 80,319 |   | 67,898 |   |
| Total product sales   |       | $                                | 84,312     |                            | $          | 76,408 |   | $ | 255,560 |   | $ | 229,489 |   |

 

----

(1) No additional locations are individually significant.

 

Long-livedassets by geography at the balance sheet dates shown were as follows (inthousands):

 
| ** **              | ** ** | **September 30,  2010** | ** ** | **December 31,  2009** | ** ** |
|-------------------------|------------|------------------------------|------------|------------------------|------------|
| ** **              | ** ** | ** **                   | ** ** | ** **             | ** ** |
| United States           |       | $                            | 28,386     |                   | $          | 31,791 |   |
| Costa Rica              |       | 13,103                       |       | 13,693                 |       |
| Other                   |       | 5,952                        |       | 6,719                  |       |
| Total long-lived assets |       | $                            | 47,441     |                   | $          | 52,203 |   |

 

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**ITEM2.    MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIALCONDITION AND RESULTS OF OPERATIONS**

 

*The following discussion should be read in conjunction withthe condensed consolidated financial statements and notes thereto appearingelsewhere in this Form 10-Q. Readers should also review carefully Exhibit 99.1,“Forward-Looking Statements,” which provides information about theforward-looking statements in this report and a discussion of the factors thatmight cause our actual results to differ, perhaps materially, from theseforward-looking statements.  Statementsin this Management’s Discussion and Analysis of Financial Condition and Resultsof Operations and elsewhere in this quarterly report on Form 10-Q whichexpress that we “believe,” “anticipate,” “expect” or “plan to” as well as otherstatements which are not historical fact, are forward-looking statements withinthe meaning of the Private Securities Litigation Reform Act of 1995 and aresubject to the safe harbors created under the Securities Act of 1933, asamended, and the Securities Exchange Act of 1934, as amended.**** Readers are cautioned that theseforward-looking statements are only predictions and are subject to risks,uncertainties, and assumptions that are difficult to predict.** **Assuch, actual events or results may differ materially as a result of the risksand uncertainties described herein and elsewhere including, but not limited to,those factors discussed in Part II — Item 1A — “Risk Factors”. In thisquarterly report on Form 10-Q, the terms the “Company”, “we”, “us” and “our”refer to ArthroCare Corporation and its subsidiaries.*

 

***Overview***

 

We are a medical device company that develops, manufactures and marketssurgical products, many of which are based on our minimally invasive patentedCoblation® technology. Our products are used across several medicalspecialties, improving many existing soft-tissue surgical procedures andenabling new minimally invasive surgical procedures. Our business is dividedinto three business units: Sports Medicine, ENT, and Spine. Each business unitmarkets and sells its products in two principal geographic markets: Americas(North and South America) and International (all other geographies).

 

As previously reported, during 2009 and 2008, we experiencedsubstantial delays in filing our periodic reports as a result of issuesidentified during a review of certain accounting and financial reportingmatters as well as certain insurance billing and healthcare compliancepractices conducted under the direction of our Audit Committee (the “Review”),which began in July 2008. The Review was completed in August 2009 andthe results were reported to the Audit Committee and to the Board. In July 2008,we also commenced a separate comprehensive review of our accounting policiesand procedures, financial reporting, internal controls and corporategovernance. We completed this comprehensive review in November 2009, andas a result of our comprehensive review and the Review, we made extensiveorganizational and operational changes and improved our internal controls.  During the year ended December 31, 2009,our results of operations, financial position and cash flows were adverselyaffected by the effect that the Review and the restatement had on ourmanagement and employees, the significant costs of the Review and restatement,and, until its repayment on September 1, 2009, our failure to maintaincompliance with covenants in our previous five year revolving credit agreementuntil we repaid the borrowings under this facility on September 1, 2009.In connection with the Review and restatement, we identified errors in ouraccounting and material weaknesses in our internal control over financialreporting. As described in “Part I—Item 4—Controls and Procedures,”we are still in the process of remediating certain of these identified materialweaknesses.

 

***First Quarter 2010 Accounting Corrections***

 

Our results for the ninemonths ended September 30, 2010 include reductions of stock compensationexpense to correct forfeiture calculation errors in prior periods. The impactof the error was an overstatement of operating expenses of $0.4 million in theyear ended December 31, 2008 and $0.7 million in the year ended December 31,2009. To correct this error, we recorded reductions of $0.8 million to generaland administrative expense and $0.3 million to sales and marketing expense inthe condensed consolidated statement of operations for the quarter ended March 31,2010. We have determined that the impact of this uncorrected error isimmaterial to all prior periods, and that the correction is immaterial to thequarter and nine month period ended September 30, 2010 and we expect it tobe immaterial to our results for the year ending December 31, 2010.

 

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***Key Financial Items, Trends andUncertainties Affecting Our Business***

 

Our management reviews and analyzes several metrics and ratios in orderto manage our business and assess the quality of and potential variability ofour operating performance. The most important of these financial metrics andratios include:

 

*Product Sales Growth*

 

Our principal source of revenue is from sales of our products, whichprimarily include disposable surgical devices and implants. Product sales aremade through our direct sales employees, independent sales agents andindependent distributors.  We anticipatethat disposable device sales and implants will remain the key component of ourproduct sales for the indefinite future. We also generate revenue from royalties and fees from licensing of ourproducts and technology to other companies and earn other revenues fromshipping and handling costs billed to customers.

 

We also contract manufacture disposable surgical devices for use inSports Medicine procedures for another medical devices company.   In the quarter ended September 30,2010, product revenue from contract manufacturing was $10.3 million, whichrepresents an unusually high amount compared to the same quarter in 2009 when productrevenue from contract manufacturing was $3.9 million.  In the fourth quarter of 2010, we anticipatecontract manufacturing revenue will decline significantly as most of ourprojected second half of 2010 deliveries occurred in the third quarter.

 

Reported product sales increased 10.3 percent and 11.4 percent for thequarter and nine month period ended September 30, 2010, respectively,compared to the same periods in 2009. The Company’s total revenue target for 2010 is $356 million,representing an increase of 7.3% over 2009 revenue.  Total revenue through the nine-months ended September 30,2010 was $267.3 million, implying fourth quarter of 2010 total revenue at ourtarget would be approximately $88.7 million, which would be 4% lower than totalrevenue in the fourth quarter of 2009 of $92.5 million.

 

*Gross Product Margin*

 

Gross product margin as a percentage of product sales for the quarterand nine month period ended September 30, 2010 was 65.6 percent and 66.8percent, respectively, compared to 68.2 percent and 70.3 percent for the sameperiods in 2009.  Cost of product salesconsists of all product manufacturing costs (including material costs, laborcosts, manufacturing overhead, warranty and other direct product costs),adjustments to the carrying value of inventory for excess or obsolete items,certain stock based compensation costs associated with manufacturing andoperations personnel and costs of product shipped to our customers. Cost ofproduct sales also includes the amortization of controller units that have beenplaced at customer locations to enable the use of our disposable surgicalproducts. We maintain ownership of all placed controllers and the cost ofcontroller units are capitalized and amortized into cost of product sales overthe useful life of the controller unit. Most of our manufactured products areproduced at our Costa Rica facility which has experienced stable operations.Raw materials used to produce our products are generally not subject tosubstantial commodity price volatility.

 

*Operating Margin*

 

Operating margin is our income (loss) from operations as a percentageof total revenues. Our key operating expenses include expenses incurred inconnection with research and development, sales and marketing, and general andadministrative activities as well as the amortization of intangible assets.  Operating margin for the quarter and ninemonth period ended September 30, 2010 was 13.2 percent and 14.6 percent,respectively, and negative 6.9 percent and negative 4.8 percent for the sameperiods in 2009.  During the quarter andnine month period ended September 30, 2009, our operating expenses werehigher when compared to the same periods in 2010 due primarily to expensesincurred in connection with the Review and the restatement of our financialstatements.

 

In October 2010, we reduced the Americas salesand marketing personnel in our Spine unit. All affected positions will be eliminated before the end of 2010 and wewill incur approximately $0.4 million of severance expense in the fourthquarter in connection with this reduction in force.

 

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*Net Earnings*

 

Net earnings represent the net income or loss in the period. Netearnings will be affected by the same trends that impact our revenues, grossproduct margin and operating margin. In addition, net earnings will also beaffected by other income and expenses, such as interest expense, foreigncurrency gains and losses and income taxes. Interest expense and bank fees were lower in the quarter and nine monthperiod ended September 30, 2010 as we repaid all outstanding bankborrowings on September 1, 2009. We expect that we will report foreigncurrency gains or losses each period due primarily to changes in the value ofthe euro, British pound and Australian dollar versus the U.S. dollar.

 

Our effective income tax rate is less than the U.S. statutory rate as asubstantial portion of our operations are outside the U.S. in jurisdictionswith lower tax rates, including Costa Rica, where we have a tax holiday thatextends through December 2015.  Inyears of loss, our effective tax rate may exceed the U.S. statutory ratedepending on the apportionment of income or loss between jurisdictions in whichwe operate. We expect to be able to fully utilize our deferred tax assets.

 

**Results of Operations**

 

Results of operations for the three and nine monthsended September 30, 2010 and 2009 (in thousands, exceptpercentages and per-share data) wereas follows:

 
| ** **                                                                                          | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                                                          | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                                                                          | ** ** | **2010**                         | ** ** | **2009**                        | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                                                                                          | ** ** | **Dollars**                      | ** ** | **% Total  Revenue**       | ** ** | **Dollars** | ** ** | **% Total  Revenue** | ** ** | **Dollars** | ** ** | **% Total  Revenue** | ** ** | **Dollars** | ** ** | **% Total  Revenue** | ** ** |
| ** **                                                                                          | ** ** | ** **                       | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Revenues:**                                                                                       |       |                             |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Product sales                                                                                       |       | $                                | 84,312     |                            | 95.9       | % | $ | 76,408 |   | 96.1 | % | $ | 255,560 |   | 95.6 | % | $ | 229,489 |   | 96.0 | % |
| Royalties, fees and other                                                                           |       | 3,570                            |       | 4.1                             | %          | 3,110 |   | 3.9 | % | 11,718 |   | 4.4 | % | 9,629 |   | 4.0 | % |
| Total revenues                                                                                      |       | 87,882                           |       | 100.0                           | %          | 79,518 |   | 100.0 | % | 267,278 |   | 100.0 | % | 239,118 |   | 100.0 | % |
|                                                                                                |       |                             |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| **Cost of product sales**                                                                           |       | 29,029                           |       | 33.0                            | %          | 24,316 |   | 30.6 | % | 84,802 |   | 31.7 | % | 68,185 |   | 28.5 | % |
|                                                                                                |       |                             |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| **Gross profit**                                                                                    |       | 58,853                           |       | 67.0                            | %          | 55,202 |   | 69.4 | % | 182,476 |   | 68.3 | % | 170,933 |   | 71.5 | % |
|                                                                                                |       |                             |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| **Operating expenses:**                                                                             |       |                             |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Research and development                                                                            |       | 9,383                            |       | 10.7                            | %          | 9,229 |   | 11.6 | % | 27,076 |   | 10.1 | % | 27,099 |   | 11.3 | % |
| Sales and marketing                                                                                 |       | 26,669                           |       | 30.3                            | %          | 28,563 |   | 35.9 | % | 82,397 |   | 30.8 | % | 88,700 |   | 37.1 | % |
| General and administrative                                                                          |       | 9,295                            |       | 10.6                            | %          | 11,981 |   | 15.1 | % | 27,372 |   | 10.2 | % | 36,101 |   | 15.1 | % |
| Amortization of intangible assets                                                                   |       | 1,564                            |       | 1.8                             | %          | 1,583 |   | 2.0 | % | 4,685 |   | 1.8 | % | 4,757 |   | 2.0 | % |
| Investigation and restatement-related costs                                                         |       | 317                              |       | 0.4                             | %          | 9,293 |   | 11.6 | % | 1,888 |   | 0.7 | % | 25,323 |   | 10.6 | % |
| Reimbursement services                                                                              |       | 25                               |       | 0.0                             | %          | 46 |   | 0.1 | % | 70 |   | 0.1 | % | 312 |   | 0.1 | % |
| Total operating expenses                                                                            |       | 47,253                           |       | 53.8                            | %          | 60,695 |   | 76.3 | % | 143,488 |   | 53.7 | % | 182,292 |   | 76.2 | % |
|                                                                                                |       |                             |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| **Income (loss) from operations**                                                                   |       | 11,600                           |       |                            |       | (5,493 | ) |   |   | 38,988 |   |   |   | (11,359 | ) |   |   |
| Interest and other income (expense), net                                                            |       | 1,227                            |       |                            |       | (1,653 | ) |   |   | (2,998 | ) |   |   | (4,920 | ) |   |   |
|                                                                                                |       |                             |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| **Income (loss) before income taxes**                                                               |       | 12,827                           |       |                            |       | (7,146 | ) |   |   | 35,990 |   |   |   | (16,279 | ) |   |   |
|                                                                                                |       |                             |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Income tax provision                                                                                |       | 3,570                            |       |                            |       | (2,719 | ) |   |   | 9,824 |   |   |   | (2,656 | ) |   |   |
|                                                                                                |       |                             |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| **Net income (loss)**                                                                               |       | 9,257                            |       |                            |       | (4,427 | ) |   |   | 26,166 |   |   |   | (13,623 | ) |   |   |
| ** **                                                                                          |       |                             |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Accrued dividends and accretion charges on  Series A 3% Redeemable Convertible Preferred Stock |       | (820                             | )          |                            |       | (27,252 | ) |   |   | (2,434 | ) |   |   | (27,252 | ) |   |   |
| ** **                                                                                          |       |                             |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| **Net income (loss) available to  common stockholders**                                             |       | $                                | 8,437      |                            |       |   | $ | (31,679 | ) |   |   | $ | 23,732 |   |   |   | $ | (40,875 | ) |   |   |
|                                                                                                |       |                             |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| **Weighted-average shares  outstanding:**                                                           |       |                             |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic                                                                                               |       | 27,017                           |       |                            |       | 26,838 |   |   |   | 26,972 |   |   |   | 26,798 |   |   |   |
| Diluted                                                                                             |       | 27,323                           |       |                            |       | 26,838 |   |   |   | 27,299 |   |   |   | 26,798 |   |   |   |
|                                                                                                |       |                             |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| **Earnings (loss) per common share:**                                                               |       |                             |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic                                                                                               |       | $                                | 0.26       |                            |       |   | $ | (1.18 | ) |   |   | $ | 0.72 |   |   |   | $ | (1.53 | ) |   |   |
| Diluted                                                                                             |       | $                                | 0.25       |                            |       |   | $ | (1.18 | ) |   |   | $ | 0.72 |   |   |   | $ | (1.53 | ) |   |   |

 

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***Product Sales***

 

Productsales by business unit and geographic market for the periods shown were asfollows (in thousands, except percentages):

 
| ** **                 | ** ** | **Three Months Ended** | ** ** | **Three Months Ended** | ** ** |
|----------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **                 | ** ** | **September 30, 2010** | ** ** | **September 30, 2009** | ** ** |
| ** **                 | ** ** | **Americas**                     | ** ** | **International**                | ** ** | **Total  Product  Sales** | ** ** | **% Net  Product  Sales** | ** ** | **Americas** | ** ** | **International** | ** ** | **Total  Product  Sales** | ** ** | **% Net  Product  Sales** | ** ** |
| ** **                 | ** ** | ** **                       | ** ** | ** **                       | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Sports  Medicine           |       | $                                | 40,029     |                             | $          | 16,944 |   | $ | 56,973 |   | 67.6 | % | $ | 35,502 |   | $ | 15,106 |   | $ | 50,608 |   | 66.2 | % |
| ENT                        |       | 19,379                           |       | 3,636                            |       | 23,015 |   | 27.3 | % | 18,109 |   | 3,167 |   | 21,276 |   | 27.9 | % |
| Spine                      |       | 2,276                            |       | 2,048                            |       | 4,324 |   | 5.1 | % | 2,636 |   | 1,888 |   | 4,524 |   | 5.9 | % |
| Total  product sales       |       | $                                | 61,684     |                             | $          | 22,628 |   | $ | 84,312 |   | 100.0 | % | $ | 56,247 |   | $ | 20,161 |   | $ | 76,408 |   | 100.0 | % |
|                       |       |                             |       |                             |       |   |   |   |   |   |   |   |   |   |   |   |   |
|  % Net  product sales |       | 73.2                             | %          | 26.8                             | %          | 100.0 | % |   |   | 73.6 | % | 26.4 | % | 100.0 | % |   |   |

 
| ** **          | ** ** | **Nine Months Ended**  | ** ** | **Nine Months Ended**  | ** ** |
|---------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **          | ** ** | **September 30, 2010** | ** ** | **September 30, 2009** | ** ** |
| ** **          | ** ** | **Americas**                     | ** ** | **International**                | ** ** | **Total  Product  Sales** | ** ** | **% Net  Product  Sales** | ** ** | **Americas** | ** ** | **International** | ** ** | **Total  Product  Sales** | ** ** | **% Net  Product  Sales** | ** ** |
| ** **          | ** ** | ** **                       | ** ** | ** **                       | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Sports Medicine     |       | $                                | 122,121    |                             | $          | 50,012 |   | $ | 172,133 |   | 67.3 | % | $ | 106,760 |   | $ | 43,867 |   | $ | 150,627 |   | 65.6 | % |
| ENT                 |       | 58,990                           |       | 10,945                           |       | 69,935 |   | 27.4 | % | 54,882 |   | 9,278 |   | 64,160 |   | 28.0 | % |
| Spine               |       | 7,114                            |       | 6,378                            |       | 13,492 |   | 5.3 | % | 8,394 |   | 6,308 |   | 14,702 |   | 6.4 | % |
| Total product sales |       | $                                | 188,225    |                             | $          | 67,335 |   | $ | 255,560 |   | 100.0 | % | $ | 170,036 |   | $ | 59,453 |   | $ | 229,489 |   | 100.0 | % |
|                |       |                             |       |                             |       |   |   |   |   |   |   |   |   |   |   |   |   |
| % Net product sales |       | 73.7                             | %          | 26.3                             | %          | 100.0 | % |   |   | 74.1 | % | 25.9 | % | 100.0 | % |   |   |

 

Productsales in our Sports Medicine business unit increased $6.4 million, or 12.6percent, and $21.5 million, or 14.3 percent, for the quarter and nine monthperiod ended September 30, 2010, respectively, compared to the sameperiods in 2009.  For the quarter ended September 30, 2010, theproduct sales increase is attributable to a $6.4 million increase in contractmanufacturing volume pursuant to an existing supply and distribution agreementwith Smith & Nephew.   Worldwide sales of our proprietaryproducts were flat, as a decline in Americas products sales was offset byhigher International product sales.

 

Forthe nine months ended September 30, 2010, Sports Medicine product sales inthe Americas increased by $15.4 million, due largely to a $14.5 millionincrease in contract manufacturing volume pursuant to an existing supply anddistribution agreement with Smith & Nephew and included $6.6 millionfor the recognition of product sales from prior periods that were deferredpending resolution of certain contract issues with customers during the quarterended March 31, 2010.  Excluding the recognition of deferred revenue,proprietary product sales in the Americas decreased $5.8 million for the ninemonth period ended September 30, 2010.  Approximately half of thisdecline was related to lower volume and half related to reductions in averagesales prices.  For the nine month period ended September 30, 2010,international product sales increased by $6.1 million, due primarily toincreases in our direct international markets.

 

Product sales in our ENT business unit increased $1.7 million, or 8.2percent, and $5.8 million, or 9.0 percent, for the quarter and nine monthperiod ended September 30, 2010, respectively, compared to the sameperiods in 2009.  For both the quarterand nine month period ended September 30, 2010 product sales increased inthe Americas as a result of increased Coblation sales and higher average salesprice as well as increased product revenue from our Rapid Rhino product line.  International product sales increased due to higherENT product demand, particularly in the Asia Pacific region.

 

Product sales in our Spine business unit decreased $0.2 million, or 4.4percent, and $1.2 million, or 8.2 percent, in the quarter and nine month periodended September 30, 2010, respectively, compared to the same periods in

 

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2009.  In the Americas, PDDSpineWand sales continue to be negatively affected by the Centers forMedicare & Medicaid Services, or CMS, negative reimbursement determinationin September 2008.  Demand forParallax products in the United States, our primary Parallax market, continueto be negatively impacted by studies published in 2009 that challenged whetherpatient outcomes were positively impacted by vertebroplasty procedures.

 

In total, International product sales across all business unitsincreased $2.5 million or 12.2 percent and $7.9 million or 13.3 percent duringthe quarter and nine month period ended September 30, 2010, respectively,compared with the same periods in 2009. Product sales increased by $1.7 million and $6.7 million for the quarterand nine month period ended September 30, 2010, respectively, in ourdirect International markets, while sales to distributors increased by $0.8million and $1.2 million. Had the same foreign currency rates been in effect inthe quarter ended September 30, 2010 as were in effect in the same quarterin 2009,  the U.S. dollar reported valueof product sales would have been higher by $0.9 million, for the quarter ended September 30,2010.  Similarly, had the same foreigncurrency rates been in effect for the nine-month period ended September 30,2010 as were in effect in the same period of 2009, the U.S. dollar reportedvalue of  product sales would havedecreased by $0.6 million for the nine month period ended September 30,2010.

 

***Royalties, Fees and Other Revenues***

 

Royalties, fees, and other revenues consist mainly of revenue from thelicensing of our products and technology, shipping and handling costs billed tocustomers. Such revenues increased $0.5 million and $2.1 million during thequarter and nine month period ended September 30, 2010, respectively,compared to the same periods in 2009. The increase for both the quarter and nine month period ended September 30,2010 was primarily a result of increased royalties from third parties that useour radio frequency, or RF, technology pursuant to a license.

 

***Cost of Product Sales***

 

Cost of product sales for the periods shown were as follows (inthousands, except percentages):

 
| ** **                  | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                  | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                  | ** ** | **2010**                         | ** ** | **2009**                        | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                  | ** ** | **Dollars**                      | ** ** | **% Net  Product  Sales**  | ** ** | **Dollars** | ** ** | **% Net  Product  Sales** | ** ** | **Dollars** | ** ** | **% Net  Product   Sales** | ** ** | **Dollars** | ** ** | **% Net  Product  Sales** | ** ** |
| ** **                  | ** ** | ** **                       | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Product cost                |       | $                                | 24,151     |                            | 28.6       | % | $ | 19,981 |   | 26.1 | % | $ | 70,402 |   | 27.5 | % | $ | 55,817 |   | 24.3 | % |
| Controller amortization     |       | 3,074                            |       | 3.6                             | %          | 2,369 |   | 3.1 | % | 8,079 |   | 3.2 | % | 6,763 |   | 2.9 | % |
| Other                       |       | 1,804                            |       | 2.2                             | %          | 1,966 |   | 2.6 | % | 6,321 |   | 2.5 | % | 5,605 |   | 2.5 | % |
| Total cost of product sales |       | $                                | 29,029     |                            | 34.4       | % | $ | 24,316 |   | 31.8 | % | $ | 84,802 |   | 33.2 | % | $ | 68,185 |   | 29.7 | % |

 

Grossproduct margin as a percentage of product sales for the quarter and nine monthperiod ended September 30, 2010 was 65.6 percent and 66.8 percent,respectively, compared to 68.2 percent and 70.3 percent for the same periods in2009.  Gross product margin was lower for both thequarter and nine month period ended September 30, 2010 due to increasedrevenue from contract manufactured product which generally are sold at a loweraverage sales price, but for which we do not incur sales commission ormarketing expense.  Additionally chargesfor excess and obsolete inventory increased $1.6 million and $4.0 million forthe quarter and nine month period ended September 30, 2010, respectively,compared to the same periods in 2009.

 

***Operating Expenses***

 

Operatingexpenses for the periods shown were as follows (in thousands, exceptpercentages):

 

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| ** **                                  | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|---------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                  | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                  | ** ** | **2010**                         | ** ** | **2009**                        | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                                  | ** ** | **Dollars**                      | ** ** | **% Total  Revenue**       | ** ** | **Dollars** | ** ** | **% Total  Revenue** | ** ** | **Dollars** | ** ** | **% Total  Revenue** | ** ** | **Dollars** | ** ** | **% Total  Revenue** | ** ** |
| ** **                                  | ** ** | ** **                       | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Research and development                    |       | $                                | 9,383      |                            | 10.7       | % | $ | 9,229 |   | 11.6 | % | $ | 27,076 |   | 10.1 | % | $ | 27,099 |   | 11.3 | % |
| Sales and marketing                         |       | 26,669                           |       | 30.3                            | %          | 28,563 |   | 35.9 | % | 82,397 |   | 30.8 | % | 88,700 |   | 37.1 | % |
| General and administrative                  |       | 9,295                            |       | 10.6                            | %          | 11,981 |   | 15.1 | % | 27,372 |   | 10.2 | % | 36,101 |   | 15.1 | % |
| Amortization of intangible assets           |       | 1,564                            |       | 1.8                             | %          | 1,583 |   | 2.0 | % | 4,685 |   | 1.8 | % | 4,757 |   | 2.0 | % |
| Investigation and restatement-related costs |       | 317                              |       | 0.4                             | %          | 9,293 |   | 11.6 | % | 1,888 |   | 0.7 | % | 25,323 |   | 10.6 | % |
| Reimbursement services                      |       | 25                               |       | 0.0                             | %          | 46 |   | 0.1 | % | 70 |   | 0.0 | % | 312 |   | 0.1 | % |
| Total operating expenses                    |       | $                                | 47,253     |                            | 53.8       | % | $ | 60,695 |   | 76.3 | % | $ | 143,488 |   | 53.6 | % | $ | 182,292 |   | 76.2 | % |

 

*Research and development expense* increased approximately $0.2 million during the quarter ended September 30,2010, compared to the quarter ended September 30, 2009.  Research and development expense increased asa result of higher short-term incentive accruals in the quarter.  Research and development expenses for thenine months ended September 30, 2010 were essentially flat compared to thesame period in 2009.  Research anddevelopment costs as a percentage of sales decreased.

 

*Sales and marketing expense* decreased $1.9million and $6.3 million, to 30.3 percent and 30.8 percent of total revenues,during the quarter and nine month period ended September 30, 2010,respectively, compared to 35.9 percent and 37.1 percent of total revenues forthe same period in 2009.  Sales andmarketing expense as a percentage of total revenues decreased as a result ofpreviously deferred revenue that was recognized in the first quarter of 2010and an increase in contract manufacturing product revenues neither of whichincurred commission or other selling expense. Additionally sales and marketing expenses decreased as a result of lowerproduct demonstration costs and a decrease in bad debt allowance requirementsdue to improved accounts receivable performance.  Finally, Spine sales and marketing expense inthe Americas decreased $1.3 million and $4.3 million for the quarter and ninemonth period ended September 30, 2010, respectively, compared to the sameperiods in 2009 as we restructured our Spine distribution channel fromprimarily a direct sales organization to agents.

 

*General and administrative expense* decreased $2.7million and $8.7 million, to 10.6 percent and 10.2 percent of total revenuesduring the quarter and nine month period ended September 30, 2010,respectively, compared to 15.1 percent of total revenues for the sameperiods in 2009.  The decrease for boththe quarter and nine month period ended September 30, 2010 was primarily aresult of a decrease in legal fees related to certain patent matters that weresettled in December 2009, partially offset by an increase in accountingand compliance personnel.

 

*Investigation and restatement**expense* was $0.3 million and $1.9 million during the quarterand nine month period ended September 30, 2010, respectively, compared to$9.3 million and $25.3 million for the same periods in 2009.  The decrease in both periods is primarily asa result of completing the Review and restatement process in November of2009.  We expect to continue to incurlegal defense costs in connection with the DOJ, SEC and shareholder andderivative class action matters arising from the Review and restatement, whichwill continue to be classified as investigation and restatement-related expensein future periods.

 

***Interest and Other Expense, Net***

*** ***
| ** **                               | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                               | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                               | ** ** | **2010**                         | ** ** | **2009**                        | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                               | ** ** | ** **                       | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Interest and other expense, net          |       | $                                | (96        | )                               | $          | (1,207 | ) | $ | (286 | ) | $ | (3,339 | ) |
| Foreign exchange gain (loss), net        |       | 1,323                            |       | (446                            | )          | (2,712 | ) | (1,581 | ) |
| Interest and other income (expense), net |       | $                                | 1,227      |                            | $          | (1,653 | ) | $ | (2,998 | ) | $ | (4,920 | ) |

 

Interest and other expense, netdecreased to $0.1 million and $0.3 million for the quarter and nine monthperiod ended September 30, 2010, respectively, compared to $1.2 millionand $3.3 million for the same periods in 2009, primarily as a result ofrepaying our Credit Agreement borrowings in September 2009.  During the fourth quarter of 2009, weidentified an error related to the translation of foreign currencies into U.S.dollars for certain

 

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subsidiaries.  The impact of this error was recorded in thequarter ended December 31, 2009 as management determined that the impactof the error was not material to the year. Had management recorded the impact of the error in proper periods in2009 the foreign exchange loss would have been a foreign currency gain of $0.4million and $2.6 million for the quarter and nine month period ended September 30,2009, respectively.

 

***Income Tax Provision (Benefit)***

 

Oureffective tax rate for the nine month period ended September 30, 2010 was27.3 percent compared to 16.3 percent for the same period in 2009.  The federal research and experimentationcredit expired on December 31, 2009, and as of September 30, 2010,the credit had not been extended.  In January 2009,the U.S. Treasury issued temporary cost-sharing regulations and we decided toadjust our intercompany payments for all open tax years, resulting in  additional income tax expense ofapproximately $3.6 million in the quarter ended March 31, 2009.  Excluding the effect of the changes in thetemporary cost-sharing regulations, our effective tax rate for the nine monthperiod ended September 30, 2009 was 38.4%.

 

**Liquidityand Capital Resources**

 

Asof September 30, 2010, we had $151.2 million in working capital, comparedto $106.3 million at December 31, 2009. Cash and cash equivalents increased from $57.4 million at December 31,2009 to $113.0 million at September 30, 2010.  Since the repayment and termination of ourCredit Agreement on September 1, 2009, cash and cash equivalents are ourprincipal source of liquidity.  We expectthat our cash flows from operations together with cash on hand will besufficient to satisfy our short-term and, excluding the uncertainty related tothe ongoing litigation and investigations to which we are a party, long-termnormal operating liquidity requirements.

 

Cashprovided by operating activities for the nine months ended September 30,2010 was $63.6 million and differed from our net income of $26.2 million due todepreciation and amortization of $18.7 million, non-cash stock-basedcompensation expense of $5.8 million, provisions for bad debt and excess andobsolete inventory totaling $6.1 million, and changes in non-cash workingcapital accounts.

 

Cashused in investing activities for the nine months ended September 30, 2010and 2009 was $8.7 million and $9.7 million, respectively, which was primarilyrelated to the purchase of property and equipment, including controllerunits.  Cash used in investing activitiesfor the nine months ended September 30, 2009 also included approximately$3.0 million related to maturities of short term investments that had beenclassified as available-for-sale.

 

Cashprovided by financing activities for the nine months ended September 30,2010 and 2009 was $1.1 million and $14.5 million, respectively.  Cash provided by financing activities for thenine months ended September 30, 2009 included $69.5 million proceeds fromissuance of Series A Redeemable Convertible 3% Preferred Stock, offset by$55.0 million of principal repayments on our revolving credit agreement.

 

**Critical Accounting Policies and Estimates**

 

Therehave been no material updates to our critical accounting policies and estimatesset forth in “Part II—Item 7—Management Discussion and Analysis ofFinancial Condition and Results of Operations—Critical Accounting Policies andEstimates” in our 2009 Form 10-K.

 

**RecentlyIssued Accounting Pronouncements**

 

SeeNote 1 of Notes to Condensed Consolidated Financial Statements included in “Part I—Item 1—FinancialStatements” for a description of recently issued accounting pronouncements,including the expected dates of adoption and estimated effects on our resultsof operations, financial position, and cash flows.

 

**Disclosures about Contractual Obligations andCommercial Commitments**

 

Wehave various contractual obligations, which are recorded as liabilities in ourcondensed consolidated financial statements. Other items, such as certain purchase commitments with suppliers andminimum lease payments under operating leases, are not recognized asliabilities in our condensed consolidated financial statements but are

 

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requiredto be disclosed.  During the nine monthsended September 30, 2010, there were no material changes from ourcontractual obligations presented in our 2009 Form 10-K.

 

**ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURESABOUT MARKET RISK**

 

Weare exposed to certain market risks as part of our ongoing business operations,primarily risks from changing interest rates and foreign currency exchangerates that may impact, adversely or otherwise, our financial condition, resultsof operations or cash flows. Although payments under the operating leases forour facilities are tied to market indices, we are not exposed to materialinterest rate risk associated with operating leases.  We have not historically used derivativefinancial instruments to manage these market risks and we do not plan to do soin the future.

 

Ourinterest income is dependent on changes in the general level of U.S. dollarinterest rates. Our cash and cash equivalents consist of money market funds andvarious deposit accounts.  Due to thenature and value of our investments, we have concluded that we do not havematerial interest rate risk exposure.  Animmediate 10 percent increase or decrease in interest rates would not have amaterial adverse impact on our future operating results or cash flows.

 

Thetable below presents principal amounts and related weighted average interestrates as of September 30, 2010 for our cash and cash equivalents as wellas the balance of our loan receivable (in thousands, except percentages):

 
| Cash and cash equivalents                                  |   | $              | 113,036 |   |
|------------------------------------------------------------|--------|----------------|---------|--------|
| Average interest rate earned on cash and cash  equivalents |   | less than 0.01 | %       |
| Loan receivable                                            |   | $              | 2,601   |   |
| Average interest rate on loan receivable                   |   | 7.0            | %       |

 

***Foreign Currency Risk***

 

Asignificant portion of our international sales and operating expenses aredenominated in currencies other than the U.S. dollar.  To the extent thatthe exchange rates for these currencies fluctuate against the U.S. dollar, wewill experience variations in our results of operations and financialcondition.

 

Ourcash and cash equivalents at September 30, 2010 are denominated primarilyin U.S. dollars; however, we also maintain balances in euros, British pounds,Swedish kroner, Swiss francs, Australian dollars and Costa Rican colones insupport of local subsidiary operations.  A 10 percent change in the September 30,2010 exchange rates for these currencies would have an impact on pre-tax incomeof approximately $0.3 million.

 

We have not used derivativefinancial instruments to hedge against foreign currency exchange risk and donot anticipate doing so in the future. Our objective to minimize foreigncurrency gains and losses has been managed by maintaining only enough cashnecessary for immediate working capital requirements in accounts denominated incurrencies other than the U.S. dollar and holding the majority of our cash andcash equivalents in U.S. dollar accounts.

 

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**ITEM4.  CONTROLS AND PROCEDURES**

 

**Evaluationof Disclosure Controls and Procedures**

 

As required by Rule 13a-15under the Securities Exchange Act of 1934, as amended, management hasevaluated, with the participation of our Chief Executive Officer and ChiefFinancial Officer, the effectiveness of our disclosure controls and proceduresas of the end of the period covered by this report.  Disclosure controls and procedures refer tocontrols and other procedures designed to ensure that information required tobe disclosed in the reports we file or submit under the Exchange Act isrecorded, processed, summarized and reported within the time periods specifiedin the rules and forms of the SEC. Disclosure controls and procedures include,without limitation, controls and procedures designed to ensure that informationrequired to be disclosed by us in the reports that we file or submit under theExchange Act is accumulated and communicated to management, including our CEOand CFO, as appropriate, to allow timely decisions regarding our requireddisclosure.  In designing and evaluatingour disclosure controls and procedures, management recognizes that any controlsand procedures, no matter how well designed and operated, can provide only reasonableassurance of achieving the desired control objectives, and management wasrequired to apply its judgment in evaluating and implementing possible controlsand procedures.

 

Pursuant to this evaluation,our CEO and CFO concluded that, as of September 30, 2010, the end of theperiod covered by this report, our disclosure controls and procedures were noteffective at the reasonable assurance level as a result of the materialweaknesses that management has identified in our internal control over financialreporting.

 

We have taken steps and aretaking the actions described more fully below under “Remediation Activities” toremediate the material weaknesses in our internal control over financialreporting.

 

To address the materialweaknesses described in this Item 4, management performed additional analysesand other post-closing procedures designed to provide reasonable assurance thatour consolidated financial statements were prepared in accordance withGAAP.  As a result of these procedures,management believes that the consolidated financial statements included in thisreport fairly present, in all material respects, our financial position,results of operations and cash flows as of the dates and for the periodspresented, in conformity with GAAP.

 

Management identified thefollowing control deficiencies that constitute material weaknesses that existedas of December 31, 2009 and are not fully remediated.

 

1.              We did not maintain an effective controlenvironment with the sufficient complement of personnel, procedures forgathering and disseminating information pertinent to our financial reporting(information and communication) or activities that effectively monitor theperformance of controls. Specifically:

 

·                  *Control environment*. We did not maintain the sufficient complement of personnel with theappropriate level of accounting knowledge, experience, and training in theapplication of GAAP commensurate with our financial reporting requirements.

 

·                  *Informationand communication.*   We did notmaintain effective procedures for communicating to all relevant personnel ouraccounting policies, the importance of consistent application of our accountingpolicies, and essential data required to properly apply GAAP to ourtransactions. Specifically, we did not have appropriate procedures to providereasonable assurance that non-routine terms in business arrangements withfinancial reporting implications are communicated completely, accurately or ina timely manner to our accounting personnel. As a result, accounting personneldid not have the necessary information to determine the financial reportingconsequences of certain transactions.

 

·                  *Monitoringof controls.*   We did notmaintain effective monitoring activities to provide reasonable assurance thatbreakdowns in the operation of controls would be timely detected and corrected.As a result, we did not detect deficiencies in compliance with our accountingpolicies on a timely basis.

 

These material weaknessesled to erroneous judgments regarding the application of GAAP and resulted inerrors in the preparation of our financial statements. These materialweaknesses also contributed to the continued existence of the materialweaknesses described in items 2 and 3 below.

 

The previously disclosedmaterial weaknesses relating to accounting for

 

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revenue were remediated asof the date of June 30, 2010. Accordingly, we have concluded these material weaknesses related to thecontrol environment, information and communication and monitoring of controlsno longer impact accounting for revenue.

 

2.              *Period-end financialreporting process.*  We did not maintain effective controls overthe period-end financial reporting process, including controls with respect tothe preparation, review, supervision, and monitoring of accounting operations.Specifically:

 

·                  We did not maintain effective controls to providereasonable assurance that account reconciliations were properly performed andthat reconciliations and journal entries were consistently reviewed forcompleteness and accuracy.

 

·                  We did not maintain effective controls to providereasonable assurance that foreign currency transactions and balances werevalued accurately in our consolidated financial statements.

 

·                  We did not maintain effective controls related to ouraccounting for stockholders’ equity to provide reasonable assurance thatstock-based compensation expense was accurately recorded.

 

·                  We did not maintain effective controls to providereasonable assurance that expenses were recognized in the proper reportingperiod, which affected the accuracy and valuation of certain intangible assetsand also the completeness, accuracy and timely recording of prepaid expenses,accrued liabilities and the associated operating expenses.

 

3.              *Acquisition accounting*. We did not maintain effective controls related to our accounting forbusiness acquisitions to provide reasonable assurance that (a) businesscombination accounting identified and considered all pertinent facts related topre-acquisition business arrangements between the parties to determine appropriateacquisition date accounting for the settlement of a pre-existing businessarrangement; and (b) the rationale for an acquisition transaction wasadequately considered, documented and communicated to properly assess the fairvalue of the net assets acquired.

 

These material weaknessesresulted in material errors in and the restatement of our annual and interimfinancial statements for 2006, 2007 and the first quarter of 2008, and resultedin adjustments and revisions to our annual and interim financial statements forthe second, third and fourth quarters of 2008, and fourth quarter of 2009.  Additionally, these material weaknesses couldresult in a material misstatement to the annual or interim financial statementsthat would not be prevented or detected on a timely basis.

 

**CHANGES ININTERNAL CONTROL OVER FINANCIAL REPORTING**

 

Management has evaluated,with the participation of our CEO and CFO, whether any changes in our internalcontrol over financial reporting that occurred during the quarter ended September 30,2010 have materially affected, or are reasonably likely to materially affect,our internal control over financial reporting. Based on this evaluation,management has concluded that there are no material changes in our internal controlover financial reporting which occurred during the quarter ended September 30,2010.

 

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**REMEDIATIONACTIVITIES**

 

**Overview**

 

Management continues tomonitor, evaluate and improve upon certain remediation measures that have beenimplemented to address the above-described material weaknesses that remain asof the end of the period covered by this report and the date of this filing.These measures include (a) further enhancements to our financial reportingpolicies, procedures and processes involving account reconciliations, journalentries and corresponding supporting documentation; (b) designingappropriate training programs; and (c) changing monitoring practices concerningthe review of key accounting controls and processes to ensure consistentcompliance to established procedures and policies.

 

Management believes theremediation measures described below will remediate the identified controldeficiencies and strengthen our internal control over financial reporting. Asmanagement continues to evaluate and work to enhance our internal control overfinancial reporting, it may be determined that additional measures must betaken to address control deficiencies or it may be determined that we need tomodify or otherwise adjust the remediation measures described below.

 

**RemediationActions for Existing Material Weaknesses**

 

Management believes thatsubstantial progress has been made in addressing the deficiencies describedabove.  Personnel have been added to theaccounting function with knowledge, experience and training suitable to ourfinancial reporting requirements and design changes have been made in theaccounting organization to better align personnel to specific accountingactivities and responsibilities.  Effortshave been made to strengthen communication flow between business and accountingpersonnel to provide a sufficient level of assurance that essential datarequired to properly apply GAAP to our transactions is completely andaccurately communicated to our accounting personnel in a timely manner. Morerigorous routines have been implemented to detect and correct breakdowns in theoperation of controls and to detect deficiencies in compliance with our accountingpolicies.  In addition, we have now fullystaffed our internal audit department.

 

We have revised and, in somecases, are continuing to revise our policies and procedures with respect to thepreparation, review, supervision, and monitoring of accounting operations,including those related to acquisition accounting.  Specific policies and procedures are beingdeveloped for the purpose of providing reasonable assurance that accountreconciliations are properly performed and that such reconciliations andresulting journal entries are reviewed for completeness and accuracy; thatforeign currency transactions and balances are valued accurately in ourconsolidated financial statements; that stock-based compensation expense isaccurately recorded each period; and that expenses are recorded in the properaccounting period.  Although theevaluation of the sufficiency of this progress is ongoing, management believesthat significant progress has been made toward remediating this materialweakness.

 

The material weaknessesidentified by management and discussed above are not fully remediated as of thedate of the filing of this quarterly report. The Audit Committee continues tooversee management’s implementation plan for the above-referenced remedialmeasures and continues to monitor their implementation. In addition, under thedirection of the Audit Committee, management will continue to review and makenecessary changes to the overall design of the internal controls environment,as well as policies and procedures that are designed to enhance the overalleffectiveness of our internal control over financial reporting.

 

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**PART II. OTHER INFORMATION**

 

**ITEM 1.  LEGALPROCEEDINGS**

 

Wediscuss our material legal proceedings in Note 7, “Litigation andContingencies,” in the notes to the condensed consolidated financialstatements.  In addition to the mattersspecifically described in Note 7, we are involved in other legal and regulatoryproceedings that arise in the ordinary course of business that do not have amaterial impact on our business. Litigation claims and proceedings of all types are subject to manyfactors that generally cannot be accurately predicted.  We record reserves for claims and lawsuitswhen they are probable and reasonably estimable.  Except as otherwise specifically noted, wecurrently cannot determine the ultimate resolution of the matters described inNote 7.  For matters where the likelihoodor extent of a loss is not probable or cannot be reasonably estimated, we havenot recognized in our condensed consolidated financial statements the potentialliability that may result from these matters. If one or more of these matters is determined against us, it could havea material adverse effect on our earnings, liquidity and financial condition.

 

**ITEM 1A.  RISK FACTORS**

 

This section identifies specific risks that should be consideredcarefully in evaluating our business. Any of these risks could adversely affectour business, results of operations or financial condition. Although we believethat these risks represent the material risks relevant to us, our business andour industry, new material risks may emerge that we are currently unable topredict. As a result, this description of the risks that affect our businessand our industry is not exhaustive. The risks discussed below could cause ouractual results to differ materially from our historical results or the resultscontemplated by the forward-looking statements contained in Exhibit 99.1, “Forward-LookingStatements”.

 

***Material weaknesses and othercontrol deficiencies relating to our internal control over financial reportingcould result in errors in our reported results and could have a materialadverse effect on our operations, investor confidence in our business and thetrading prices of our securities.***

 

Internal control over financial reporting cannot provide absoluteassurance of achieving financial reporting objectives because of its inherentlimitations. Internal control over financial reporting is a process thatinvolves human diligence and compliance and is subject to lapses in judgmentand breakdowns resulting from human failures. Internal control over financialreporting can also be circumvented by collusion or improper managementoverride. Because of such limitations, there is a risk that material misstatementswill not be prevented or detected on a timely basis by internal control overfinancial reporting. However, these inherent limitations are known features ofthe financial reporting process, and it is possible to design into the processsafeguards to reduce, though not eliminate, the risk.

 

Management’s assessment of our internal control over financialreporting as of December 31, 2009 concluded that our internal control overfinancial reporting was not effective and that material weaknesses existed.Until these material weaknesses and other control deficiencies are remediated,they could lead to errors in our reported financial results and could have amaterial adverse effect on our operations, investor confidence in our businessand the trading prices of our securities.

 

As described in “Part I—Item 4—Controls and Procedures,” weare currently in the process of remediating our identified material weaknesses.Management’s continuing evaluation and work to enhance our internal controlover financial reporting will require the dedication of additional resourcesand management time and expense. If we fail to establish and maintain adequateinternal control over financial reporting, including any failure to implementremediation measures and enhancements for internal controls, or if weexperience difficulties in their implementation, our business, financialcondition and operating results could be harmed.

 

Any material weakness or unsuccessful remediation could affect investorconfidence in the accuracy and completeness of our financial statements. As aresult, our ability to obtain any additional financing, or additional financingon favorable terms, could be materially and adversely affected, which in turncould materially and adversely affect our business, our strategic alternatives,our financial condition and the market value of our securities. In addition,perceptions of us among customers, lenders, investors, securities analysts andothers could also be adversely affected. Current material weaknesses or anyweaknesses or deficiencies identified in the future could also hurt confidencein our business and the accuracy and completeness of our financial statements,and adversely affect our ability to do business with these groups.

 

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We can give no assurances that the measures we have taken to date, orany future measures we may take, will remediate the material weaknessesidentified or that any additional material weaknesses will not arise in thefuture due to our failure to implement and maintain adequate internal controlover financial reporting. In addition, even if we are successful instrengthening our controls and procedures, those controls and procedures maynot be adequate to prevent or identify irregularities or ensure the fair andaccurate presentation of our financial statements included in our periodicreports filed with the SEC.

 

***A failure to remain current in ourfilings may have material impacts on our business and liquidity.***

 

If we are not able to remain current in our filings with the SEC, wewill face several adverse consequences and restrictions. We will not be able tohave a registration statement under the Securities Act of 1933, as amended (the“Securities Act”), covering a public offering of securities, declared effectiveby the SEC, or make offerings pursuant to existing registration statements; wewill not be able to make an offering to any purchasers not qualifying as “accreditedinvestors” under certain “private placement” rules of the SEC underRegulation D; we will not be eligible to use a “short form” registrationstatement on Form S-3 for a period of at least 12 months after thetime we become current in our periodic and current reports under the SecuritiesExchange Act of 1934, as amended (the “Exchange Act”); we will not be able todeliver the requisite annual report and proxy statement to our stockholders tohold our annual stockholders meeting; our employees cannot be granted stockoptions, nor will they be able to exercise stock options registered onForm S-8, because Form S-8 would not be available to us; and ourCommon Stock may be delisted from the NASDAQ Stock Market. These restrictionsmay impair our ability to raise funds in the public markets, should we desireto do so, and to attract and retain employees.

 

Inaddition, pursuant to the Registration Rights Agreement between us and theholders of our Series A Preferred Stock, if our registration statementceases to be available to the holders of our Series A Preferred Stock, aRegistration Default occurs, then we shall pay the holders of the Series APreferred Stock 2.00 percent per annum of the original liquidationpreference of the Series A Preferred Stock, accruing from the date of theRegistration Default until the Registration Default is cured.

 

***The Review and resultingrestatement, SEC and DOJ  investigationsand other investigations, legal and administrative proceedings have increasedour costs and could result in fines, injunctions, orders, and penalties whichcould materially adversely affect our business, financial condition, results ofoperations, and liquidity.***

 

As previously reported, during 2009 and 2008, we experienced substantialdelays in filing our periodic reports as a result of issues identified duringthe Review.  The Review was completed in August 2009and the results were reported to the Audit Committee and to the Board. In July 2008,we also commenced a separate comprehensive review of our accounting policiesand procedures, financial reporting, internal controls and corporategovernance. We completed this comprehensive review in November 2009, andas a result of our comprehensive review and the Review, we made extensiveorganizational and operational changes and improved our internal controls. As aresult of errors and possible irregularities identified by the Review andmanagement’s review and analysis of certain accounting matters, we restated ourfinancial statements for: the years ended December 31, 2007, 2006, 2005,and 2004; the quarter ended March 31, 2008 and each of the quarters forthe years ended December 31, 2007 and 2006 in our Form 10-K for theyear ended December 31, 2008 filed on November 18, 2009, or the 2008 Form 10-K.

 

We are involved in ongoing material legal proceedings and the actionscurrently pending result primarily from matters relating to our restatement andReview. See Note 7, “Litigation and Contingencies,” in the notes to thecondensed consolidated financial statements. These proceedings and other legal actions may harm our business orliquidity in the future.

 

We have incurred substantial cost and expenses for legal and accountingservices due to the Review and resulting SEC and DOJ investigations. Thesematters will likely continue to divert our management’s time and attention andcause us to continue to incur substantial costs and expenses. Suchinvestigations can also lead to fines or injunctions or orders with respect tofuture activities. We could incur substantial additional costs to defend andresolve litigation, investigations or proceedings arising out of or related tothese matters. In addition, we could be exposed to enforcement or other actionswith respect to these matters by the SEC’s Division of Enforcement, the DOJ orother federal or state agencies. At this point, we are unable to predict theduration, scope or result of these investigations or whether any of theseagencies will commence any legal action. Any such investigations may result inus being subject to criminal and civil penalties and other remedial measures,which could have an adverse impact on our business, results of operations,financial condition and liquidity.

 

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In connection with our pending legal proceedings, including any furtherlitigation that is pursued or other relief sought by persons asserting claimsfor damages allegedly resulting from or based on the restatement or relatedevents, we will incur defense costs that may exceed our insurance coverage. Wemay also incur costs if the insurers of our directors and our liabilityinsurers deny coverage for the costs and expenses related to any litigation.

 

Many of our pending legal proceedings are in the early stages and wecannot predict their outcomes. However, irrespective of the outcomes, we mayincur substantial costs, including defense and indemnity costs, and thesematters may divert the attention of our technical and management personnel,which could materially harm our business. Moreover, if we do not prevail in anysuch actions, we could be required to pay substantial damages or settlementcosts. Adverse outcomes or other developments during the course of litigationor other proceedings may harm our business, financial condition, results ofoperations or liquidity as well as investors’ perception of our business, anyof which could harm our stock price.

 

***Our failure to comply with extensivegovernment regulations could subject us to penalties and materially adverselyaffect our business, results of operations and financial condition.***

 

Our medical device products and operations are subject to extensiveregulation by the Food and Drug Administration, or FDA, and various otherfederal, state and foreign governmental authorities. Government regulations andforeign requirements specific to medical devices are wide ranging and govern,among other things: design, development and manufacturing; testing, labelingand storage; clinical trials; product safety; marketing, sales anddistribution; pre-market clearance and approval; record keeping procedures;advertising and promotions; recalls and field corrective actions; post-marketsurveillance, including reporting of deaths or serious injuries andmalfunctions that, if they were to recur, could lead to death or seriousinjury; and product import and export.

 

The FDA and other governmental authorities have broad enforcement powers,and our failure to comply with these regulatory requirements could result ingovernmental agencies or a court taking action, including any of the following,which would adversely affect our business: issuing public warning letters tous; imposing fines and penalties on us; obtaining an injunction preventing usfrom manufacturing or selling our products; bringing civil or criminal chargesagainst us; delaying the introduction of our products into the market; delayingpending requests for clearance or approval of new uses or modifications to ourexisting products; recalling, detaining or seizing our products; or withdrawingor denying approvals or clearances for our products.

 

***If we fail to comply with complexand rapidly evolving laws and regulations, we could suffer civil and criminalpenalties, be required to pay substantial damages and make significant changesto our products and operations.***

 

During the past several years, the U.S. health care industry has beensubject to an increase in governmental regulation at both the federal and statelevels. We are subject to numerous federal and state regulations. As part ofour internal compliance program, we review our sales and marketing materials,contracts and programs with counsel, and require employees and marketingrepresentatives to participate in regular training. We also have adopted andtrain our personnel on the code of conduct for Interactions with Health CareProfessionals promulgated by the Advanced Medical Technology Association, orAdvaMed, a leading trade association representing medical device manufacturers.Most recently, we amended our Code of Business Conduct and Ethics, the “Code ofEthics,” in August 2009. Originally adopted in 2004 to qualify as a “codeof ethics” within the meaning of Section 406 of the Sarbanes-Oxley Act of2002, the Code of Ethics was amended to qualify as well as a “code of conduct”under the current Federal Sentencing Guidelines and “Compliance ProgramGuidance for Pharmaceutical Manufacturers” 68 FR 23731 (May 5, 2003)applicable to medical device companies as published by the Office of InspectorGeneral for the Department of Human Services. The Code of Ethics applies to allof our directors, officers, employees and agents. It also serves as anessential element of our Corporate Compliance Program, as announced in August 2009.However, we can give no assurances that our compliance program will ensure thatthe Company is in compliance with existing or future applicable laws andregulations. If our compliance program fails to meet its objectives, or if weotherwise fail to comply with existing or future applicable laws andregulations, we could suffer civil or criminal penalties. We devote significantoperational and managerial resources to comply with these laws and regulations.Different interpretations and enforcement policies of these laws andregulations could subject our current practices to allegations of improprietyor illegality or could require us to make significant changes to our productsand operations. In addition, we cannot predict the impact of future legislationand regulatory changes on our business or assure you that we will be able toobtain or maintain the regulatory approvals required to operate our business.

 

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***Our accounting policies and methodsrequire management to make judgments and estimates about matters that areinherently uncertain, which may result in our actual results differingsignificantly from those generated by our judgments and estimates.***

 

Our accounting policies and methods require management to exercisejudgment in applying many of these accounting policies and methods so thatthese policies and methods comply with generally accepted accounting principlesin the U.S., or GAAP, and reflect management’s judgment of the most appropriatemanner to report our financial condition and results of operations. SeeNote 3, “Summary of Significant Accounting Policies” in the notes to theconsolidated financial statements in our 2009 Form 10-K for a descriptionof our significant accounting policies.

 

The accounting policies we have identified as critical to thepresentation of our financial condition and results of operations are describedin “Part II — Item 7 - Management’s Discussion and Analysis of FinancialCondition and Results of Operations—Critical Accounting Policies and Estimates”in our 2009 Form 10-K.  We believethese policies are critical because they require management to makeparticularly subjective or complex judgments about matters that are inherentlyuncertain at the end of a period and because of the likelihood that materiallydifferent amounts would be reported under different conditions or usingdifferent assumptions. Due to the complexity of these critical accountingpolicies, our accounting methods relating to these policies involve substantialuse of estimates. Estimates are inherently imperfect predictors of actualresults because they are based on assumptions, including assumptions aboutfuture events. Our estimates may not include assumptions that reflect verypositive or very negative market conditions and, accordingly, our actualresults could differ significantly from those generated by our estimates. As aresult, the estimates that we use to prepare our financial statements, as wellas our estimates of our future results of operations, may be significantlyinaccurate.

 

***We may be the subject of federal,state and/or foreign government civil and criminal enforcement efforts againsthealth care companies, which could result in civil and/or criminal penaltieswhich could have a material negative impact on our operations and financialcondition.***

 

In addition to uncertainties surrounding coverage policies, bothfederal and state government agencies have heightened civil and criminalenforcement efforts against health care companies, as well as their executivesand managers. These efforts generally relate to a wide variety of matters, includingreferral and billing practices, and implicate a variety of state and federallaws, including state insurance fraud provisions, common law fraud theories, aswell as both state and federal fraud-and-abuse, anti-kickback, false claimsstatutes, and the foreign corrupt practices act and similar internationalanti-bribery laws and regulations. Although we no longer directly bill anypayor, some of our prior activities could become the subject of additionalgovernmental investigations or inquiries. If we do not comply with the laws andregulations relevant to our business, we could be subject to civil and/orcriminal penalties which could have a material negative impact on ouroperations and financial condition.

 

***We are, and may in the future be,subject to intellectual property claims, which are costly to defend, couldrequire us to pay damages and could limit our ability to use certaintechnologies in the future.***

 

The medical device industry has been characterized by extensivelitigation regarding patents and other intellectual property rights, andcompanies in the medical device industry have employed intellectual propertylitigation to gain a competitive advantage.

 

We cannot assure you that we will not become subject to additionalpatent infringement claims or other litigation, including interferenceproceedings declared by the U.S. Patent and Trademark Office, or USPTO, todetermine the priority of inventions. The defense and prosecution ofintellectual property lawsuits, USPTO reexamination and interferenceproceedings and related legal and administrative proceedings, generally arecostly and time-consuming. If other parties violate our proprietary rights,further litigation may be necessary to enforce our patents, to protect tradesecrets or know-how we own or to determine the enforceability, scope andvalidity of the proprietary rights of others. Any litigation or reexaminationor interference proceedings will be costly and cause significant diversion ofeffort by our technical and management personnel.

 

An adverse determination in existing litigation, additional litigationor reexamination or interference proceedings to which we may become a partycould subject us to significant liabilities to third parties, require disputedrights to be licensed from third parties or require us to cease using certaintechnology. Furthermore, we cannot assure you that we could obtain necessarylicenses on satisfactory terms, if at all. Adverse determinations in judicialor

 

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administrativeproceedings or failure to obtain necessary licenses could prevent us frommanufacturing and selling our products, which would have a material adverseeffect on our business, financial condition, results of operations, and futuregrowth prospects.

 

***Our intellectual property rights arevaluable, and any inability to protect them could reduce the value of ourproducts, business, financial condition, results of operations and futuregrowth prospects.***

 

Our ability to compete effectively depends in part on developing andmaintaining the proprietary aspects of our Coblation technology and ouracquired technologies. We believe that our issued patents are directed at thecore technology used in our soft-tissue surgery systems, including bothmulti-electrode and single electrode configurations of our disposable devices,as well as the use of Coblation technology in specific surgical procedures. Inaddition, we believe that our issued patents are directed at many of the corefeatures of our acquired technologies from Opus, Parallax, Atlantech andApplied Therapeutics, Inc. (“ATI”). Our earliest Coblation patents beginto expire in 2012. The majority of our royalty income is associated withlicenses that include core Coblation patent rights which extend through the endof 2014.

 

There is no assurance that the patents we have obtained, or any patentswe may obtain as a result of our pending U.S. or international patentapplications, will provide any competitive advantages for our products. We alsocannot assure investors that those patents will not be successfully challenged,invalidated or circumvented prior to their expiration. In addition, we cannotprovide assurance that competitors, many of which have substantial resourcesand have made substantial investments in competing technologies, have notalready applied for or obtained, or will not seek to apply for and obtain,patents that will prevent, limit or interfere with our ability to make, use andsell our products either in the U.S. or in international markets. In SportsMedicine, many of our competitors have licensed our technology for limitedfields of use. Patent applications are maintained in secrecy for a period afterfiling. We may not be aware of all of the patents and patent applicationspotentially adverse to our interests.

 

A number of medical device and other companies, universities andresearch institutions have filed patent applications or have issued patentsrelating to monopolar and/or bipolar electrosurgical methods and apparatus. Wehave received, and we may receive in the future, notifications of potentialconflicts of existing patents, pending patent applications and challenges tothe validity of existing patents. In addition, we have become aware of, and maybecome aware of in the future, patent applications and issued patents thatrelate to our products and/or the surgical applications and issued patents and,in some cases, have obtained internal and/or external opinions of counselregarding the relevance of certain issued patents to our products. We do notbelieve that our products currently infringe any valid and enforceable claimsof the issued patents that we have reviewed. However, if third-party patents orpatent applications contain claims infringed by our technology and such claimsare ultimately determined to be valid, we may not be able to obtain licenses tothose patents at a reasonable cost, if at all, or be able to develop or obtainalternative technology. Our inability to do either would have a materialadverse effect on our business, financial condition, results of operations andfuture growth prospects. We cannot assure investors that we will not have todefend ourselves in court against allegations of infringement of third-partypatents, or that such defense would be successful.

 

In addition to patents, we rely on trade secrets and proprietaryknow-how, which we seek to protect, in part, through confidentiality andproprietary information agreements. We require our key employees andconsultants to execute confidentiality agreements upon the commencement of anemployment or consulting relationship with us. These agreements generallyprovide that all confidential information, developed or made known to theindividual during the course of the individual’s relationship with us, is to bekept confidential and not disclosed to third parties. These agreements alsogenerally provide that inventions conceived by the individual in the course ofrendering services to us shall be our exclusive property. We cannot assureinvestors that employees will not breach such agreements, that we would haveadequate remedies for any breach or that our trade secrets will not otherwisebecome known to or be independently developed by competitors.

 

***We will require a significant amountof cash to fund our working capital needs and planned expenditures. Our abilityto generate cash depends on many factors beyond our control.***

 

In the absence of a credit facility as a possible source of liquidity,our ability to meet our working capital needs and to fund capital expenditureswill depend on our ability to generate cash from operations and effectivelymanage our cash balances. This is subject to general economic, financial,competitive and other factors that may be beyond our control. We are unable topredict the outcome of ongoing litigation and investigations to which we are aparty and these

 

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matterscould have a material adverse effect on our liquidity and cash flows. See Note7, “Litigation and Contingencies,” in the notes to the condensed consolidatedfinancial statements for further discussion on legal proceedings. We expectthat our cash flows from operations together with cash on hand will besufficient to satisfy our short-term and, excluding the uncertainty related tothe ongoing litigation and investigations to which we are a party, long-termnormal operating liquidity requirements; however, we cannot assure you that ourbusiness will generate sufficient cash flow from operations in an amountsufficient to enable us to fund our other liquidity needs.

 

As a result, from time to time, we may be required to seek financingfrom alternative sources. In light of the current capital and credit marketdisruption and volatility, we cannot assure you that such alternative fundingwill be available to us on terms and conditions acceptable to us, or at all.

 

In addition, we maintain deposit accounts with numerous financialinstitutions around the world in amounts that exceed applicable governmentaldeposit insurance levels. While we actively monitor our deposit relationships,the unanticipated failure of a financial institution in which we maintaindeposits could cause us to suffer losses that could materially harm our resultsof operations and financial condition.

 

***We may not be able to keep pace withtechnological change or successfully develop new products with wide marketacceptance, which could cause us to lose business to competitors.***

 

We compete in a market characterized by rapidly changing technology. Wemay not be able to keep pace with technology or to develop viable new products.Our future financial performance will depend in part on our ability to developand manufacture new products in a cost-effective manner, to introduce theseproducts to the market on a timely basis, and to achieve market acceptance ofthese products. Factors which may result in delays of new product introductionsor cancellation of our plans to manufacture and market new products includecapital constraints, research and development delays, and delays in acquiringregulatory approvals. Our new products and new product introductions may failto achieve expected levels of market acceptance. Factors impacting the level ofmarket acceptance include our ability to successfully implement newtechnologies, the timeliness of our product introductions, our product pricingstrategies, our available financial and technological resources for productpromotion and development, our ability to show clinical benefit from ourproducts, and the availability of coverage and reimbursement for our productsas discussed in the risk factor titled “Changes in coverage and reimbursementfor procedures using our products could affect physicians” below.

 

***The markets for our products areintensely competitive, which may result in our competitors developingtechnologies and products that are more effective than ours or that make ourtechnologies and products obsolete. Many of our competitors have significantlygreater resources and market power than we do.***

 

The markets for our current products in our core businesses areintensely competitive. These markets include arthroscopy, spinal surgery andENT surgery. We cannot assure you that other companies will not succeed indeveloping technologies and products that are more effective than ours, or thatwould render our technologies or products obsolete or uncompetitive in thesemarkets.

 

Our primary competitors across all of our operating units consist ofMedtronic, Inc., Smith & Nephew, Stryker Corporation,Johnson & Johnson, Cardinal Health/Allegiance, Olympus (through theirsubsidiary Gyrus), Arthrex, Inc., Cook Medical and various reprocessingoperations.  These competitors tend to belarge, well-financed companies with diverse product lines who may havesignificantly greater financial, manufacturing, marketing, distribution andtechnical resources than we do. Some of these companies offer broad productlines that they may offer as a single package and frequently offer significantprice discounts as a competitive tactic. Furthermore, some of our competitorsutilize purchasing contracts that link discounts on the purchase of one productto purchases of other products in their broad product lines. Many of thehospitals in the U.S. have purchasing contracts with our competitors.Accordingly, customers may be dissuaded from purchasing our products instead ofour competitors’ products to the extent the purchase would cause them to losediscounts on our competitors’ products. In addition, we are aware of severalsmall companies offering alternative treatments for back pain and otherailments or indications that may indirectly compete with our products.

 

If we were to be unable to continue to compete for any of the abovereasons, it could have a material adverse effect on our business, financialcondition, results of operations and future growth prospects.

 

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***Medical device reprocessors that reprocess our single-use devices andthen provide them to customers at a lower cost than a new device may adverselyaffect our business, financial condition and results of operations*****.**

 

Certainmedical device reprocessors have been collecting our used or opened but unusedsingle-use devices from customers and reprocessing, repackaging and providingthem to customers at a price lower than the price of a new device.  Thesereprocessed devices may lead to confusion with our authorized products, reducerevenue and harm customer relationships.  In addition, this may increasetime and expense spent investigating and addressing performance issues relatedto reprocessed wands and in enforcing our proprietary and contractual rightsagainst such reprocessors.

 

***Failure to obtain FDA clearance orapproval for our products could materially adversely affect our business,results of operations, financial condition, and future growth prospects.***

 

In the U.S., before we can market a new medical device, or a new useof, or claim for, or significant modification to, an existing product, we mustfirst receive either premarket clearance under Section 510(k) of theU.S. Federal Food, Drug, and Cosmetic Act, or FDCA, or approval of a PMAsubmission from the FDA, unless an exemption applies. In the 510(k) clearanceprocess, the FDA must determine that a proposed device is “substantiallyequivalent” to a device legally on the market, known as a “predicate” device,with respect to intended use, technology and safety and effectiveness, in orderto clear the proposed device for marketing. Clinical data is sometimes requiredto support substantial equivalence. However, as was the case in our recentsubmission for 510(k) clearance of Coblator IQ ENT Plasma Wands, the FDAhas a high degree of latitude when evaluating submissions and may determinethat a proposed device submitted for 510(k) clearance is not substantiallyequivalent (“NSE”) to a predicate device. This NSE determination means that the device is automaticallyreclassified into Class III and the Company cannot market the deviceunless it is either approved through the PMA process or reclassified into Class Ior Class II based on further submissions with supporting data.  A new submission may require clinical data.The PMA approval pathway requires an applicant to demonstrate the safety andeffectiveness of the device based, in part, on data obtained in clinicaltrials. Both of these processes can be expensive and lengthy and entailsignificant user fees, unless exempt. The FDA’s 510(k) clearance processusually takes from three to twelve months, but it can last longer. The FDA iscurrently considering changes to the 510(k) process which may make it moredifficult or time consuming to obtain 510(k) clearance.  The process of obtaining PMA approval is muchmore costly and uncertain than the 510(k) clearance process. It generallytakes from one to three years, or even longer, from the time the PMAapplication is submitted to the FDA until an approval is obtained. There is noassurance that we will be able to obtain FDA clearance or approval for any ofour new products on a timely basis, or at all. Failure to obtain FDA clearanceor approval for our new products could materially adversely affect ourbusiness, results of operations, financial condition, and future growthprospects.

 

***Modifications to our currentlyFDA-cleared products may require new regulatory clearance or approvals orrequire us to recall or cease marketing our current products until clearancesor approvals are obtained.***

 

After a device receives 510(k) premarketnotification clearance from the FDA, any modification that could significantlyaffect its safety or effectiveness, or that would constitute a major change inthe intended use of the device, technology, materials, packaging, and certainmanufacturing processes may require a new 510(k) clearance or PremarketApproval, or PMA. The FDA requires every manufacturer to make the determinationregarding the need for a new 510(k) clearance or PMA approval in the firstinstance, but the FDA may review any manufacturer’s decision and may retroactivelyrequire the manufacturer to submit a premarket notification requesting 510(k) clearanceor an application for PMA approval. The FDA also can require the manufacturercease marketing and/or recall the modified device until 510(k) clearanceor approval is obtained. FDA guidance documents define when to submit premarketnotifications for new or modified devices. These guidance documents also definemodifications for which a new 510(k) is not required. We have modifiedsome of our marketed devices, and have determined that in certain instances new510(k) clearances or PMA approvals are not required. No assurance can bemade that the FDA would agree with any of our decisions not to seek 510(k) clearanceor PMA approval. If the FDA requires us to cease marketing and/or recall themodified device until we obtain a new 510(k) clearance or PMA approval,our business, financial condition, results of operations and future growthprospects could be materially adversely affected.

 

***We may be subject to fines,penalties or injunctions if we are determined to be promoting the use of ourproducts for unapproved or “off-label” uses, which would adversely affect ourfinancial condition.***

 

Our promotional materials and training methods must comply with FDA andother applicable laws and regulations, including the prohibition of thepromotion of a medical device for a use that has not been cleared or 

 

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approvedby the FDA. Use of a device outside its cleared or approved indications isknown as “off-label” use. Physicians may use our products off-label, as the FDAdoes not restrict or regulate a physician’s choice of treatment within the practiceof medicine. However, if the FDA determines that our promotional materials ortraining constitutes promotion of an off-label use, it could request that wemodify our training or promotional materials or subject us to regulatory orenforcement actions, including the issuance of an untitled letter, a warningletter, injunction, seizure, civil fine and criminal penalties. It is alsopossible that other federal, state or foreign enforcement authorities mighttake action if they consider our promotional or training materials toconstitute promotion of an unapproved use, which could result in significantfines or penalties under other statutory authorities, such as laws prohibitingfalse claims for reimbursement. In that event, our reputation could be damagedand adoption of the products would be impaired. Although our policy is torefrain from statements that could be considered off-label promotion of ourproducts, the FDA or another regulatory agency could disagree and conclude thatwe have engaged in off-label promotion. In addition, the off-label use of ourproducts may increase the risk of injury to patients, and, in turn, the risk ofproduct liability claims. Product liability claims are expensive to defend andcould divert our management’s attention and result in substantial damage awardsagainst us.

 

***Our products may in the future besubject to product recalls that could harm our reputation, business operationsand financial results, and if our products cause or contribute to a death orserious injury, we will be subject to medical device reporting regulations,which can result in voluntary corrective actions or FDA enforcement actions.***

 

The FDA and similar foreign governmental authorities have the authorityto require the recall of commercialized products in the event of materialdeficiencies or defects in design or manufacture or in the event that a productposes an unacceptable risk to health. Manufacturers may, under their owninitiative, recall a product if any material deficiency in a device is found. Agovernment-mandated or voluntary recall by us or one of our distributors couldoccur as a result of an unacceptable risk to health, component failures,manufacturing errors, design or labeling defects or other deficiencies andissues. Recalls of any of our products would divert managerial and financialresources and have an adverse effect on our financial condition and results ofoperations. Any of these sanctions could impair our ability to produce ourproducts in a cost-effective and timely manner in order to meet our customers’demands. We may also be required to bear other costs or take other actions thatmay have a negative impact on our future sales and our ability to generateprofits.

 

Further, under the FDA medical device reporting regulations, or MDR, weare required to report to the FDA any incident in which our product may havecaused or contributed to a death or serious injury or in which our productmalfunctioned and, if the malfunction were to recur, would likely cause orcontribute to death or serious injury. Any adverse event involving our productscould result in future voluntary corrective actions, such as recalls orcustomer notifications, or agency action, such as inspection, mandatory recallor other enforcement action. Any corrective action, whether voluntary orinvoluntary, as well as defending ourselves in a lawsuit, will require thededication of our time and capital, distract management from operating ourbusiness, and may harm our reputation and financial results.

 

***If we or our third-party suppliersfail to comply with the FDA’s Quality System Regulations, our manufacturingoperations could be interrupted and our sales and our ability to generateprofits could suffer.***

 

We and certain of our third-party suppliers are required to comply withthe FDA’s Quality System Regulation, or QSR, which covers the methods anddocumentation of the design, testing, production, control, quality assurance,labeling, packaging, sterilization, storage and shipping of our products. Weand our suppliers are also subject to the regulations of foreign jurisdictionsregarding the manufacturing process if we market our products in thesejurisdictions. The FDA enforces the QSR through periodic and unannouncedinspections of manufacturing facilities. If our facilities or those of oursuppliers fail to take satisfactory corrective action in response to an adverseQSR inspection, the FDA could take enforcement action, including any of thefollowing sanctions: untitled letters; warning letters, fines, injunctions,consent decrees and civil penalties; customer notifications or repair,replacement, refunds, recall, detention or seizure of our products; operatingrestrictions or partial suspension or total shutdown of production; refusing ordelaying our requests for 510(k) clearance or premarket approval of newproducts or modified products; withdrawing 510(k) clearances on PMAapprovals that have already been granted; refusal to grant export approval forour products; or criminal prosecution.

 

Any of these sanctions could impair our ability to produce our productsin a cost-effective and timely manner in order to meet our customers’ demands.We may also be required to bear other costs or take other actions that may havea negative impact on our future sales and our ability to generate profits.

 

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***Changes in coverage andreimbursement for procedures using our products could affect use of our devicesand our future revenue.***

 

The demand for our products is highly dependent on the policies ofthird-party payors such as Medicare, Medicaid, private insurance, and managedcare organizations that reimburse our customers when they use our products.Failure by physicians, hospitals and other users of our products to obtainsufficient coverage and reimbursement from healthcare payors for procedures inwhich our products are used, or adverse changes in environmental and privatethird-party payors’ policies toward coverage and reimbursement for suchprocedures would have a material adverse effect on our business, financialcondition, results of operations and future growth prospects.

 

In the U.S., third-party payors continue to implement initiatives thatrestrict the use of certain technologies to those that meet certain clinicalevidentiary requirements. We are aware of several third-party payors in theU.S., including governmental payors such as Medicare and Medicaid and privatehealth insurance companies, who consider Coblation technology used in certainprocedures to treat certain clinical conditions to be experimental orinvestigational. These payors have developed policies that deny coverage andtherefore make no reimbursement for such procedures using our devices.Procedures using our devices that are not covered by some payors include suchprocedures as plasma disc decompression, or Coblation nucleoplasty, as well asCoblation or radiofrequency volumetric tissue reduction for (1) removingsoft tissue during arthroscopic surgery, (2) hypertrophied nasalturbinates for the treatment of chronic nasal obstruction or obstructive sleepapnea and (3) soft palate and tongue for the treatment of obstructivesleep apnea. However, some payors in the U.S. provide coverage andreimbursement for Coblation tonsillectomy for certain clinical indications andpercutaneous vertebroplasty for patients that meet specified criteria. Inaddition, some payors are moving toward a managed care system and control theirhealth care costs by limiting authorizations for surgical procedures, includingelective procedures using our devices. Failure to obtain favorable payorpolicies could have a material adverse effect on our business and operations.

 

In addition to uncertainties surrounding coverage policies, third-partypayors from time to time update reimbursement amounts and also revise themethodologies used to determine reimbursement amounts. This includes annualupdates to payments to ambulatory surgical centers and physicians forprocedures using our products. Since reimbursement for our products generallyis included as part of the payments for procedures, these updates directlyimpact the amounts recognized for the costs of our products. An example ofpayment updates is the Medicare program updates to physician payments, which isdone on an annual basis using a prescribed formula that results in loweredpayments for physician services. In the past, Congress has passed legislationto prevent certain reductions in Medicare payments to physicians.  For 2010, CMS projected a rate reduction of21.2% under the statutory formula unless Congress intervened again to avoid thepayment reduction.  A number oflegislative initiatives have prevented this reduction thus far, but on anincremental basis.  The latest was thePreservation of Access to Care for Medicare Beneficiaries and Pension ReliefAct of 2010, signed into law on June 25, 2010, which not only preventedthe rate reduction, but also increased payment rates by 2.2%, effective June 1,2010 through November 30, 2010.  For2011, CMS is projecting a rate reduction of 6.1%, but this projection does notaccount for the 2010 legislative changes to the Physician Fee Scheduleupdates.  If Congress fails to interveneto prevent the negative update factor in the future, the resulting decrease inpayment may adversely impact our revenues and results of operations.

 

New laws, regulations and judicial decisions, or new interpretations ofexisting laws, regulations and decisions, that relate to healthcareavailability, methods of delivery or payment for products and services, orsales, marketing or pricing may cause our revenue to decline. In addition, wemay need to revise our research and development plans if a program or programsno longer are commercially viable. Such changes could cause our stock price todecline or experience periods of volatility.

 

PresidentObama signed the Patient Protection and Affordable Care Act in March of2010. The legislation imposes significant new taxes on medical device makerswhich will result in a significant increase in the tax burden on ourindustry, and could have a material, negative impact on our results ofoperations and our cash flows. Other elements of this legislation such ascomparative effectiveness research, an independent payment advisory board,payment system reforms including shared savings pilots and other provisionscould significantly change the way healthcare is developed and delivered,and may materially impact many aspects of our business.

 

If we obtain the necessary international regulatory approvals, marketacceptance of our products in international markets would be dependent, inpart, upon the availability of coverage and reimbursement within prevailinghealth care payment systems. Reimbursement and health care payment systems ininternational markets vary significantly by country and include bothgovernment-sponsored health care and private insurance. We intend to seekinternational reimbursement approvals, although we cannot assure investors thatany such approvals will be obtained in

 

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atimely manner, if at all. We are also unable to predict at this time the impacton our business of any future changes, if any, that are made to coverage andreimbursement policies by government action in key international markets.

 

***Product liability claims couldadversely impact our financial condition and impair our reputation.***

 

Our business exposes us to potential product liability risks which areinherent in the design, manufacture and marketing of medical devices. Inaddition, many of our products are designed to be implanted in the human bodyfor long periods of time. Component failures, manufacturing flaws, designdefects or inadequate disclosure of product-related risks or product-relatedinformation with respect to these or other products we manufacture or sellcould result in an unsafe condition or injury to a patient. The occurrence ofsuch a problem could result in product liability claims or a recall of one ormore of our products, which could ultimately result in the removal from thebody of such products and claims regarding associated costs and damages, whichcould materially adversely impact our business, financial condition, results ofoperations, our ability to attract and retain customers for our products, andfuture growth prospects.

 

We cannot assure you that our current product liability insurancecoverage limits are adequate to protect us from any liabilities we might incurin connection with the development, manufacture and sale of our products. Inaddition, we may require increased product liability coverage as products aresuccessfully commercialized in additional applications. Product liabilityinsurance is expensive and in the future may not be available to us onacceptable terms, if at all. A successful product liability claim or series ofclaims brought against us in excess of our insurance coverage could have amaterial adverse effect on our business, financial condition, results ofoperations, our ability to attract and retain customers for our products, andfuture growth prospects.

 

***We are dependent on key suppliers,and supply disruptions could materially adversely affect our business,financial condition, results of operations and future growth prospects.***

 

Some of the key components of our products are purchased from singlevendors. If the supply of materials from a single source supplier wereinterrupted, replacement or alternative sources might not be readily obtainabledue to the regulatory and other requirements applicable to our manufacturingoperations or the availability of certain product drawings and/or specifications.A new or supplemental filing with applicable regulatory authorities may requireus to obtain clearance prior to our marketing a product containing newmaterial. This clearance process may take a substantial period of time and wecannot assure investors that we would be able to obtain the necessaryregulatory approval for a new material to be used in our products on a timelybasis, if at all. This could create supply disruptions that would materiallyadversely affect our business, financial condition, results of operations andfuture growth prospects.

 

In addition, we primarily use a subcontractor located in Costa Rica tosterilize our disposable devices. We have the ability to use alternativesterilization service providers for most of our products. If our Costa Ricasterilization service were to be disrupted for any reason, we would be requiredto use alternative sources with longer processing and logistics cycles, whichcould lead to a disruption in our ability to supply products for a period oftime.

 

We are dependent on warehouses in the U.S. and Belgium owned andoperated by Deutsche Post DHL, Inc. If our ability to use these warehousesis disrupted, we may be unable to supply products to our customers on a timelybasis, which could materially adversely affect our business.

 

The complex nature of the underlying support technologies utilized toexchange critical product information with third party transportation andlogistics providers, such as “Electronic Data Interchange,” has, at times,caused disruptions in our ability to deliver products to customers on a timelybasis. Failure of these supporting systems could impair our business for theduration of the failure.

 

***Our business is susceptible to risksassociated with international operations.***

 

International operations are generally subject to a number of risks,including: protectionist laws, business practices, licenses, tariffs and othertrade barriers that favor local competition; multiple, conflicting and changinggovernmental laws and regulations, such as tax laws regulating intercompanytransactions; difficulties in managing foreign operations, including staffing,seasonality of operations, dependence on local vendors, and collecting accountsreceivable; loss of proprietary information due to piracy, misappropriation orweaker laws regarding intellectual property protection; foreign currencyexchange rate fluctuations; and political and economic instability.

 

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We derived 26.3 percent and 25.9 percent of our total product sales forthe nine months ended September 30, 2010 and 2009, respectively, fromcustomers located outside of the Americas. We expect international revenue toremain a significant percentage of total revenue and we believe that we mustcontinue to expand our international sales activities to be successful.Historically, a majority of our international revenues and costs have beendenominated in foreign currencies and we expect future international revenuesand costs will be denominated in foreign currencies. Our international salesgrowth will be limited if we are unable to establish appropriate foreign operations,expand international sales channel management and support organizations, hireadditional personnel, develop relationships with international salesrepresentatives, and establish relationships with additional distributors. Inthat case, our business, operating results and financial condition could bematerially adversely affected. Even if we are able to successfully expandinternational operations, we cannot be certain that we will be able to maintainor increase international market demand for our products.

 

***We require foreign regulatoryapprovals to market and sell our products in other countries. Failure to obtainand maintain these regulatory approvals would harm our ability to generaterevenue.***

 

To be able to market and sell our products in other countries, we mustobtain regulatory approvals and comply with the regulations of those countries.These regulations, including the requirements for approvals and the timerequired for regulatory review, vary from country to country. Obtaining and maintainingforeign regulatory approvals is expensive, and we cannot be certain that wewill receive regulatory approvals in any foreign country in which we plan tomarket our products. If we fail to obtain or maintain regulatory approval inany foreign country in which we plan to market our products, our ability togenerate revenue will be harmed.

 

***Disruptions or other adversedevelopments at our Costa Rica facility could materially adversely affect ourbusiness.***

 

Our high-volume disposable devices and controllers are manufactured atour Company-owned facility in an industrial park in San Jose, Costa Rica. Ifour Costa Rica facility is not able to produce sufficient quantities of ourcontrollers and products with adequate quality, or if our Costa Rica operationsare disrupted for any reason, then we may be forced to locate alternativemanufacturing facilities, including facilities operated by third parties.Disruptions may include, but are not limited to: changes in the legal andregulatory environment in Costa Rica; slowdowns or work stoppages withinthe Costa Rican customs authorities; acts of God (including but not limited topotential disruptive effects from an active volcano near the facility orearthquakes, hurricanes and other natural disasters); and other issuesassociated with significant operations that are remote from our headquartersand operations centers. Additionally, continued growth in product sales couldoutpace the ability of our Costa Rican operation to supply ordered products ona timely basis or cause us to take actions within our supply and manufacturingoperations which increase costs, complexity and timing. Locating alternativefacilities would be time-consuming, would disrupt our production and causeshipment delays and could result in damage to our reputation and profitability.Additionally, we cannot assure you that alternative manufacturing facilitieswould offer the same cost structure as our Costa Rica facility.

 

***Future changes in technology ormarket conditions could result in adjustments to our recorded asset balance forintangible assets, including goodwill, resulting in additional non-cash chargesthat could significantly impact our operating results.***

 

Our balance sheet includes significant intangible assets, includinggoodwill and other acquired intangible assets. The determination of relatedestimated useful lives and whether these assets are impaired involvessignificant judgments. Our ability to accurately predict future cash flowsrelated to these intangible assets may be adversely affected by unforeseen anduncontrollable events. In the highly competitive medical device industry, newtechnologies could impair the value of our intangible assets if they createmarket conditions that adversely affect the competitiveness of our products. Wetest our goodwill for impairment in the fourth quarter of each year, but wealso test goodwill and other intangible assets for impairment at any time whenthere is a change in circumstances that indicates that the carrying value ofthese assets may be impaired. Any future determination that these assets arecarried at greater than their fair value could result in substantial non-cashimpairment charges, which could significantly impact our reported operatingresults.

 

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***Delaware law and provisions in ourcharter could make the acquisition of our company by another company moredifficult, which could adversely affect our stock price.***

 

Certain provisions of our certificate of incorporation and bylaws mayhave the effect of making it more difficult for a third party to acquire, or ofdiscouraging a third party from attempting to acquire, control of our company.This could limit the price that certain investors might be willing to pay inthe future for shares of our Common Stock. Certain provisions of ourcertificate of incorporation and bylaws allow us to issue preferred stockwithout any vote or further action by the stockholders, to eliminate the rightof stockholders to act by written consent without a meeting, to specify advancenotice and other procedures for director nominations by stockholders andsubmission of other proposals for consideration at stockholder meetings, and toeliminate cumulative voting in the election of directors. Certain provisions ofDelaware law applicable to us could also delay or make more difficult a merger,tender offer or proxy contest involving us, including Section 203, which prohibitsa Delaware corporation from engaging in any business combination with anyinterested stockholder for a period of three years unless certain conditionsare met. The procedures required for director nominations and stockholderproposals and Delaware law could have the effect of delaying, deferring orpreventing a change in control of the company, including without limitation,discouraging a proxy contest or making more difficult the acquisition of asubstantial block of our Common Stock. These provisions of Delaware law, ourcertificate of incorporation, and our bylaws may have the effect of delaying orpreventing changes in control or management of the Company, which could have anadverse effect on the market price of our stock.

 

***One Equity Partners, a privateequity firm, may have influence on our major corporate decisions.***

 

As previously reported, on September 1, 2009, an affiliate of OneEquity Partners, or OEP, a private equity firm, acquired our Series APreferred Stock. See “Part II — Item 7 — Management’s Discussion andAnalysis of Financial Condition and Results of Operations—Liquidity and CapitalResources” in our 2009 Form 10-K for a description of this transaction. Asa result of this transaction, OEP became the largest beneficial owner of ourstock. At this time, assuming conversion of the Series A Preferred Stockto our Common Stock, including make-whole amounts as defined in the Certificateof Designation for the Series A Preferred Stock but excluding outstandingoptions and warrants held by other parties, OEP would represent an ownershipinterest of approximately 17.7 percent of our voting stock. In connectionwith this transaction, we expanded the Board of Directors to eight members andgranted OEP the right to nominate two directors. Effective September 1,2009, Messrs. Gregory Belinfanti and Christian Ahrens, both partners ofOEP, were appointed to our Board of Directors.

 

Consequently, OEP may have the ability to influence our Board ofDirectors and matters requiring stockholder approval, subject to therestrictions placed on OEP by the Securities Purchase Agreement, includingwithout limitation OEP’s agreement to vote for any director nominated by theBoard and to comply with the terms of the standstill.

 

Since September 1, 2010, OEP is free to convert the Series APreferred Stock into our Common Stock and, subject to the registrationrequirements of the federal securities laws, dispose of such stock, which couldresult in a decrease of the market price of our Common Stock, particularly ifsuch dispositions are made in the open market and are substantial.

 

***We may not be able to comply withthe redemption rights, registration rights, and other rights of our holders ofSeries A Preferred Stock and our obligations under the Registration RightsAgreement with our holders of Series A Preferred Stock.***

 

After September 1, 2014, or in connection with a change incontrol, the holders of our Series A Preferred Stock may require us toredeem any or all outstanding shares of Series A Preferred Stock at theliquidation preference of such redeemed Series A Preferred Stock includingany applicable make-whole adjustment. We may not have sufficient liquidity tocomply with the redemption right of our holders of Series A PreferredStock at that time if such right is exercised. Alternatively, if we are able tocomply with the redemption right of the holders of our Series A PreferredStock, we may have insufficient remaining liquidity to conduct our business,which would materially adversely affect our business, liquidity, and financialcondition.

 

In addition, pursuant to the Registration Rights Agreement between usand the holders of our Series A Preferred Stock, if our registrationstatement ceases to be available to the holders of our Series A PreferredStock, a Registration Default occurs, then we shall pay the holders of theSeries A Preferred Stock 2.00 percent per annum of the

 

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originalliquidation preference of the Series A Preferred Stock, accruing from thedate of the Registration Default until the Registration Default is cured.

 

***We are dependent upon keymanagement, technical personnel and advisors, and loss of our key personnel andadvisors could have a material adverse effect on our business and results ofoperations.***

 

The loss of the services of one or more key employees or consultantscould have a material adverse effect on us. Our success also depends on ourability to attract and retain additional highly qualified management andtechnical personnel. We face intense competition for qualified personnel, anyof whom often receive competing employment offers. We cannot assure you that wewill continue to be able to attract and retain such personnel. Loss of keypersonnel would materially impact our ability to meet our financial andoperational objectives and could have a material adverse effect on our businessand our results of operations.

 

***Circumstances associated with ourintegration of acquisitions may adversely affect our operating results.***

 

An element of our growth strategy has been and in the future may be thepursuit of acquisitions of other businesses that expand or complement ourexisting products and distribution channels. Integrating businesses, however,involves a number of special risks, including: the possibility that managementattention may be diverted from regular business concerns by the need tointegrate operations; unforeseen costs, difficulties and liabilities inintegrating our and the acquired company’s employees, operations and systems;accounting, regulatory, or compliance issues that could arise in connectionwith, or as a result of, the acquisition of the acquired company; challenges inretaining our customers or the customers of the acquired company following theacquisition; the difficulty of incorporating acquired technology and rightsinto our products and services; and impairment charges if our acquisitions arenot successful due to these risks.

 

In addition, we may incur debt to finance future acquisitions and mayissue securities in connection with future acquisitions, which may dilute theholdings of our current and future stockholders. If we are unable tosuccessfully complete and integrate strategic acquisitions in a timely manner,our business, financial condition or operating results may be adverselyaffected.

 

***Our operating results may fluctuate.***

 

In our experience, our results of operations may fluctuatesignificantly from period to period. Adverse fluctuations due to these factorsmay adversely affect our level of revenues and profitability, results ofoperations, financial condition, and future growth prospects in the short andlong term: the introduction of new product lines and increased penetration inexisting applications; achievement of research and development milestones; theamount and timing of expenditures and the receipt and recognition of licensefees; and timing of the receipt of orders and product shipments, absence of abacklog of orders, and the rate of product returns.

 

***Factors may make the market price ofour stock highly volatile.***

 

The market price of our Common Stock could fluctuate substantially inthe future. Investors may be unable to resell our Common Stock at or abovetheir purchase price. This volatility may subject our stock price to materialfluctuations due to the factors discussed in this “Risk Factors” section, andother factors including market reaction to acquisitions and trends in sales,marketing, and research and development; rumors or dissemination of falseinformation; changes in coverage or earnings estimates by analysts; our abilityto meet analysts’ or market expectations; and sales of Common Stock by existingstockholders.

 

As previously reported, as of September 1, 2009, OEP owns all ofour outstanding Series A Preferred Stock. Since September 1, 2010,OEP may convert the Series A Preferred Stock into our Common Stock and,subject to the registration requirements of the federal securities laws,dispose of such stock, which could result in a decrease of the market price ofour Common Stock, particularly if such dispositions are made in the open marketand are substantial.

 

**ITEM 2.  UNREGISTEREDSALES OF SECURITIES AND USE OF PROCEEDS**

 

None.

 

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**ITEM 3.  DEFAULTS UPONSENIOR SECURITIES**

 

None.

 

**ITEM 4.  RESERVED**

 

**ITEM 5.  OTHERINFORMATION**

 

None.

 

**ITEM 6. 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. |
| 99.1                |       | Forward-Looking  Statements                                                                                    |

 

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**SIGNATURES**

 

Pursuantto the requirements of the Securities Exchange Act of 1934, as amended, theregistrant has duly caused this report to be signed on its behalf by theundersigned thereunto duly authorized.

 
|                         | **ARTHROCARE CORPORATION**                        |
|------------------------------|---------------------------------------------------|
|                         | *a Delaware corporation*                          |
|                         |                                              |
| Date:  November 1, 2010 | /s/  David Fitzgerald                             |
|                         | David  Fitzgerald                                 |
|                         | President and Chief Executive Officer             |
|                         |                                              |
| Date:  November 1, 2010 | /s/  Todd Newton                                  |
|                         | Todd  Newton                                      |
|                         | Senior Vice President and Chief Financial Officer |

 

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**EXHIBIT INDEX**

 
| **EXHIBIT NO.** | ** ** | **DOCUMENT DESCRIPTION**                                                                                                                                      |
|----------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                 |       |                                                                                                                                                               |
| 31.1                 |       | Certification  of Chief Executive Officer Pursuant to Rule 13a-14(a) as Adopted  Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.         |
|                 |       |                                                                                                                                                               |
| 31.2                 |       | Certification  of Chief Financial Officer Pursuant to Rule 13a-14(a) as Adopted  Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.         |
|                 |       |                                                                                                                                                               |
| 32.1                 |       | Certification  of the Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as  Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
|                 |       |                                                                                                                                                               |
| 32.2                 |       | Certification  of the Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as  Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
|                 |       |                                                                                                                                                               |
| 99.1                 |       | Forward-Looking  Statements                                                                                                                                        |

 

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