Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

Form 10-Q

 

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

 

For the quarterly period ended September 30, 2012

 

OR

 

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

 

For the transition period from                  to                 

 

Commission File Number: 0-27422

 

ArthroCare Corporation

(Exact name of registrant as specified in its charter)

 

 

7000 W. William Cannon, Building One, Austin, Texas 78735

(Address of principal executive offices)

 

(512) 391-3900

(Registrant’s telephone number, including area code)

 

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

 

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

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b.2 of the Exchange Act (check one): 

 

 

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

 

As of October 25, 2012, the number of outstanding shares of the Registrant’s Common Stock was 27,880,643.

 

 

Table of Contents

 

ARTHROCARE CORPORATION

 

Form 10-Q Quarterly Report

For the quarter ended September 30, 2012

 

TABLE OF CONTENTS

 

PART 1. FINANCIAL INFORMATION		1
ITEM 1. FINANCIAL STATEMENTS		1
CONDENSED CONSOLIDATED BALANCE SHEETS		1
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME		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		9
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK		15
ITEM 4. CONTROLS AND PROCEDURES		17
PART II. OTHER INFORMATION		18
ITEM 1. LEGAL PROCEEDINGS		18
ITEM 1A. RISK FACTORS		18
ITEM 2. UNREGISTERED SALES OF SECURITIES AND USE OF PROCEEDS		19
ITEM 3. DEFAULTS UPON SENIOR SECURITIES		19
ITEM 4. MINE SAFETY DISCLOSURES		19
ITEM 5. OTHER INFORMATION		19
ITEM 6. EXHIBITS		19
SIGNATURES		20
EXHIBIT INDEX		21
Exhibit 10.1
Exhibit 31.1
Exhibit 31.2
Exhibit 32.1
Exhibit 32.2
Exhibit 101

 

 

Table of Contents

 

PART I.  FINANCIAL INFORMATION

 

ITEM 1.  FINANCIAL STATEMENTS

 

ARTHROCARE CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(unaudited)

(in thousands, except par value data)

 

		September 30, 2012			December 31, 2011
ASSETS
Current assets:
Cash and cash equivalents		$	203,163		$	219,605
Accounts receivable, net of allowances of $2,002 and $2,251 at September 30, 2012 and December 31, 2011, respectively		41,196			51,350
Inventories, net		49,591			35,761
Deferred tax assets		28,321			40,622
Prepaid expenses and other current assets		5,136			5,532
Total current assets		327,407			352,870
Property and equipment, net		30,946			35,769
Intangible assets, net		2,685			5,457
Goodwill		119,924			119,159
Deferred tax assets		18,178			18,159
Other assets		2,064			1,587
Total assets		$	501,204		$	533,001
LIABILITIES, REDEEMABLE CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable		$	13,665		$	15,258
Accrued liabilities		38,203			112,586
Deferred revenue		451			742
Deferred tax liabilities		76			—
Income tax payable		—			1,542
Total current liabilities		52,395			130,128
Deferred tax liabilities		296			29
Other non-current liabilities		18,976			18,922
Total liabilities		71,667			149,079
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, 2012 and December 31, 2011; Redemption value: $87,089		79,850			77,184
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: 31,801 and 31,523 shares Outstanding: 27,851 and 27,562 shares at September 30, 2012 and December 31, 2011, respectively		28			28
Treasury stock: 3,950 and 3,968 shares at September 30, 2012 and December 31, 2011, respectively		(106,645		)	(107,126		)
Additional paid-in capital		409,942			400,580
Accumulated other comprehensive income		5,180			4,615
Retained earnings		41,182			8,641
Total stockholders’ equity		349,687			306,738
Total liabilities, redeemable convertible preferred stock and stockholders’ equity		$	501,204		$	533,001

 

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

 

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ARTHROCARE CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(unaudited)

(in thousands, except per-share data)

 

		Three Months Ended September 30,						Nine Months Ended September 30,
		2012			2011			2012			2011
Revenues:
Product sales		$	82,602		$	79,432		$	258,448		$	249,864
Royalties, fees and other		4,338			3,835			13,070			12,609
Total revenues		86,940			83,267			271,518			262,473
Cost of product sales		26,204			25,529			80,210			76,170
Gross profit		60,736			57,738			191,308			186,303
Operating expenses:
Research and development		8,184			8,037			23,677			21,460
Sales and marketing		27,175			25,752			86,217			81,124
General and administrative		8,191			9,479			24,833			26,372
Amortization of intangible assets		1,363			1,338			4,000			3,972
Exit costs		—			2,814			(778		)	5,304
Investigation and restatement related costs		2,139			5,963			4,363			12,145
Total operating expenses		47,052			53,383			142,312			150,377
Income from operations		13,684			4,355			48,996			35,926
Non-operating gains (losses)		183			(1,028		)	(578		)	(661		)
Income from continuing operations before income taxes		13,867			3,327			48,418			35,265
Income tax provision		3,882			898			13,211			9,677
Net income from continuing operations		9,985			2,429			35,207			25,588
Income from discontinued operations, net of taxes		—			—			—			1,911
Net income		9,985			2,429			35,207			27,499
Accrued dividend and accretion charges on Series A 3% Redeemable Convertible Preferred Stock		(900		)	(857		)	(2,666		)	(2,546		)
Net income available to common stockholders		9,085			1,572			32,541			24,953
Other comprehensive income
Foreign currency adjustments		951			751			565			365
Total comprehensive income		$	10,936		$	3,180		$	35,772		$	27,864
Weighted average shares outstanding:
Basic		27,714			27,466			27,698			27,335
Diluted		28,087			27,855			28,096			27,755
Earnings per share from continuing operations applicable to common stockholders:
Basic		$	0.27		$	0.05		$	0.97		$	0.70
Diluted		$	0.27		$	0.05		$	0.96		$	0.68
Earnings per share applicable to common stockholders:
Basic		$	0.27		$	0.05		$	0.97		$	0.75
Diluted		$	0.27		$	0.05		$	0.96		$	0.74

 

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

 

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ARTHROCARE CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)

(in thousands)

 

		Nine Months Ended September 30,
		2012			2011
Cash flows from operating activities:
Net income		$	35,207		$	27,499
Adjustments to reconcile net income to net cash (used in) provided by operating activities:
Depreciation and amortization		15,793			18,804
Provision for doubtful accounts receivable, product returns, and inventory valuation		2,032			1,582
Non-cash stock compensation expense		6,585			5,023
Deferred taxes		12,347			6,165
Gain on sale of assets held for sale		—			(2,177		)
Other		2,280			345
Changes in operating assets and liabilities, net of assets acquired and liabilities assumed in business combinations:
Change in operating assets		(5,576		)	5,370
Change in operating liabilities		(79,226		)	7,143
Net cash (used in) provided by operating activities		(10,558		)	69,754
Cash flows from investing activities:
Purchases of property and equipment		(7,189		)	(9,306		)
Payments for business combinations		(1,252		)	—
Proceeds from sale of assets held for sale		—			5,500
Proceeds from repayment of loan		—			2,275
Other		—			14
Net cash used in investing activities		(8,441		)	(1,517		)
Cash flows from financing activities:
Proceeds from exercise of stock options and issuance of common stock		2,777			6,669
Net cash provided by financing activities		2,777			6,669
Effect of exchange rate changes on cash and cash equivalents		(220		)	232
Net (decrease) increase in cash and cash equivalents		(16,442		)	75,138
Cash and cash equivalents, beginning of period		219,605			132,536
Cash and cash equivalents, end of period		$	203,163		$	207,674

 

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

 

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ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)

 

NOTE 1 — BASIS OF PRESENTATION

 

Basis of Presentation

 

The accompanying unaudited condensed consolidated financial statements of ArthroCare Corporation (“ArthroCare”) and its subsidiaries (collectively with ArthroCare, the “Company”) have been prepared in accordance with the instructions to Form 10-Q and do not include all information and footnotes necessary for a fair presentation of financial position, results of operations and cash flows in conformity with United States generally accepted accounting principles (“GAAP”).  The condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto together with management’s discussion and analysis of financial condition and results of operations contained in the Company’s 2011 Annual Report on Form 10-K filed on February 16, 2012 (“2011 Form 10-K”).  In the opinion of management, the accompanying condensed consolidated financial statements reflect all adjustments of a normal recurring nature considered necessary to fairly state the financial position of the Company at September 30, 2012 and December 31, 2011, and the results of its operations for the three month and nine month periods ended September 30, 2012 and 2011 and its cash flows for the nine month periods ended September 30, 2012 and 2011.  The results of operations for the periods presented are not necessarily indicative of results that may be expected for the year ending December 31, 2012.

 

Use of Estimates

 

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

 

Significant Accounting Policies

 

The Company accounts for stock-based compensation by measuring and recognizing as compensation expense the grant date fair value of all share-based payment awards made to employees, including employee stock options and restricted stock awards. The determination of fair value involves a number of significant estimates. The Company uses the Black-Scholes option pricing model to estimate the fair value of employee stock options that have service or performance conditions and the Company uses the Monte Carlo pricing model to estimate the fair value of options or awards that have market based conditions.  The inputs to both pricing models require a number of assumptions such as volatility, risk free interest rate and expected term.  As stock-based compensation expense is based on the number of options or awards expected to vest, the Company must make estimates regarding whether or not the performance and service conditions will be achieved.  These estimates are made at the time of grant and revised, if necessary, in subsequent periods which might result in a significant change in stock-based compensation expense in future periods.

 

There have been no other significant changes or updates to the Company’s significant accounting policies disclosed in its 2011 Form 10-K.

 

NOTE 2 — DISCONTINUED OPERATIONS

 

In the fourth quarter of 2010, the Company determined that its non-Coblation ® spine products met the criteria under GAAP to be reported as discontinued operations.  On June 30, 2011 the Company completed the sale of its non-Coblation spine products which consisted of its Parallax and Contour product lines.  Revenues, gain on the sale of assets, income and income taxes related to discontinued operations for the nine month period ended September 30, 2011 was as follows (in thousands):

 

 

		Nine Months Ended September 30,
		2011
Revenue		$	2,271
Gain on sale of assets		2,177
Income from discontinued operations		3,084
Income tax provision		1,173
Income from discontinued operations		1,911

 

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ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)

 

NOTE 3 — COMPUTATION OF EARNINGS PER SHARE

 

The Company’s Series A 3% Redeemable Convertible Preferred Stock (the “Series A Preferred Stock”) has participation rights in dividends issued to common stockholders.  As a result, the Company calculates earnings per share using the two class method.  The following is a reconciliation of net income applicable to common stockholders and the number of shares used in the calculation of basic and diluted earnings per share applicable to common stockholders (in thousands, except per-share data):

 

		Three Months Ended						Nine Months Ended
		September 30,						September 30,
		2012			2011			2012			2011
Income from continuing operations allocated to common stockholders, net of $2,467, $1,131, $8,279 and $6,583 attributable to Series A Preferred Stock, respectively.		$	7,518		$	1,298		$	26,928		$	19,005
Income from discontinued operations, net of $0, $0, $0, and $335 attributable to Series A Preferred Stock, respectively.		—			—			—			1,576
Net income allocated to common stockholders, net of $2,467, $1,131, $8,279, and $6,918 attributable to Series A Preferred Stock, respectively.		7,518			1,298			26,928			20,581
Basic:
Weighted-average common shares outstanding		27,714			27,466			27,698			27,335
Earnings from continuing operations per share allocated to common stockholders		0.27			0.05			0.97			0.70
Earnings from discontinued operations per share allocated to common stockholders		—			—			—			0.05
Earnings per share allocated to common stockholders		$	0.27		$	0.05		$	0.97		$	0.75
Diluted:
Weighted-average shares outstanding used in basic calculation		27,714			27,466			27,698			27,335
Dilutive effect of options		248			112			221			114
Dilutive effect of unvested restricted stock		125			277			177			306
Weighted-average common stock and common stock equivalents		28,087			27,855			28,096			27,755
Earnings from continuing operations per share allocated to common stockholders		0.27			0.05			0.96			0.68
Earnings from discontinued operations per share allocated to common stockholders		—			—			—			0.06
Earnings per share allocated to common stockholders		$	0.27		$	0.05		$	0.96		$	0.74
Stock issuable upon conversion of the Series A Preferred Stock		5,806			5,806			5,806			5,806
Stock awards excluded from calculation as their effect would be anti-dilutive		937			1,325			880			1,026

 

Awards approved under the Company’s Long Term Incentive Program (see Note 8) are excluded from diluted shares until both the market conditions and performance conditions have been met.

 

NOTE 4 — INVENTORIES

 

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

 

		September 30,			December 31,
		2012			2011
Raw materials		$	10,730		$	9,146
Work-in-process		14,899			10,293
Finished goods		28,940			20,852
		54,569			40,291
Inventory valuation reserves		(4,978		)	(4,530		)
Inventories, net		$	49,591		$	35,761

 

NOTE 5 — ACCRUED LIABILITIES

 

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

 

		September 30, 2012			December 31, 2011
Compensation		$	16,287		$	16,751
Insurance dispute reserve		9,706			9,627
Proposed settlement of private securities class actions		—			74,000
Other		12,210			12,208
		$	38,203		$	112,586

 

NOTE 6 — COMMITMENTS

 

Operating Leases

 

The Company leases certain facilities and equipment under operating leases.  The Company recognizes rent expense on a straight-line basis over the lease term.  Rent expense was $1.6 million and $1.9 million for the quarters ended September 30, 2012 and 2011, respectively, and was $5.3 million and $4.9 million for nine month periods ended September 30, 2012 and 2011, respectively.  There were no material changes from the Company’s lease obligations presented in its 2011 Form 10-K.

 

Indemnification Agreements

 

The Company advances legal fees as required pursuant to indemnification agreements that were entered with certain former executives and employees while they were employed with the Company.  During the nine months ended September 30, 2012 the Company advanced $2.3 million and as of September 30, 2012 has accrued $1.3 million under these indemnity agreements.  The Company expects to continue to advance payments pursuant to these agreements in future periods; however, management is unable to estimate the amount or timing of future payments under such agreements.

 

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ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)

 

NOTE 7 — LITIGATION AND CONTINGENCIES

 

In addition to the matters specifically described below, the Company is involved in other legal and regulatory proceedings that arise in the ordinary course of business that do not have a material impact on the Company’s business. Litigation claims and proceedings of all types are subject to many factors that generally cannot be predicted accurately.

 

The Company records reserves for claims and lawsuits when they are probable and reasonably estimable. Except as otherwise specifically noted, the Company currently cannot determine the ultimate resolution of the matters described below. For matters where the likelihood or extent of a loss is not probable or cannot be reasonably estimated, the Company has not recognized in its condensed consolidated financial statements the potential liability that may result from these matters. Further, for such matters where a loss is believed to be reasonably possible, but not probable, no accrual has been made and an estimate of the reasonably possible loss cannot be made at this time. If one or more of these matters is determined against the Company, it could have a material adverse effect on the Company’s earnings, liquidity and financial condition.

 

The Company continues to gather additional facts and information related to insurance billing and healthcare compliance issues and marketing and promotional practices in connection with these legal and administrative proceedings with the assistance of legal counsel.

 

DOJ Investigation

 

The Department of Justice (the “DOJ”) is investigating certain of the Company’s activities including past sales, accounting, and billing procedures primarily in relation to the operation of the Company’s Spine product sales. The DOJ is also reviewing the Company’s relationship with its DiscoCare subsidiary. The Company is cooperating with this investigation. In connection with such cooperation, and pursuant to a request from the DOJ, the Company has entered into a statute of limitations tolling agreement with the DOJ effective until February 1, 2013. At this stage of the investigation, the Company cannot predict the ultimate outcome and is unable to estimate any potential liability the Company may incur.

 

Private Securities Class Action

 

In 2008, two putative securities class actions were filed in Federal court against the Company and certain of its former executive officers, alleging violations of Sections 10(b) and 20(a) of the Exchange Act and Rule 10b-5 promulgated thereunder.  Plaintiffs allege that the defendants violated federal securities laws by issuing false and misleading financial statements and making material misrepresentations regarding the Company’s internal controls, business, and financial results. On October 28, 2008, and thereafter, the two putative securities class actions and the federal shareholder derivative actions were consolidated and designated: In Re ArthroCare Corporation Securities Litigation, Case No. 1:08-cv-00574-SS (consolidated) in the U.S. District Court, Western District of Texas.

 

Settlement of Private Securities Actions

 

The Company reached an agreement to settle the private securities class action suits consolidated into the action titled In Re ArthroCare Corporation Securities Litigation, Case No. 1:08-cv-00574-SS (consolidated) in the U.S. District Court, Western District of Texas.

 

The settlement resolves all claims arising from the purchase or sale of ArthroCare securities of a class of all purchasers of ArthroCare common stock and call options, and sellers of put options on ArthroCare common stock between December 11, 2007 and February 18, 2009, inclusive (the Class), except those members of the Class who opt out, for a payment of $74 million to a settlement fund to be created for the settlement.  Counsel for the plaintiff applied for and received an award of attorneys’ fees and reimbursement of expenses from the settlement fund.   On February 10, 2012, the Court entered an order of preliminary approval of the settlement and ordered that Notice be sent to all class members.   Pursuant to the preliminary approval order, the Company paid the $74 million in settlement funds into the applicable settlement escrow account on February 23, 2012.  The settlement was approved by the United States District Court for the Western District of Texas and entered as a final judgment on June 4, 2012.

 

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ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)

 

False Claims Act Investigation

 

The Company received a Civil Investigative Demand from the DOJ, requesting information related to the marketing of its radio-frequency ablation devices, which could implicate the False Claims Act, 31 U.S.C. § 3729. The Company is cooperating fully with the investigation, although no assurances can be given regarding the duration of the investigation or whether proceedings will be instituted against the Company. Management intends to represent the Company’s interests vigorously in this matter. At this stage of the investigation, however, management cannot predict the ultimate outcome of the investigation or any potential liability the Company may incur.

 

NOTE 8 — LONG TERM INCENTIVE PROGRAM AWARDS

 

On January 6, 2012, the Company’s Board of Directors (the “Board”) approved a Long Term Incentive Program (the “LTIP”), which provides for shares of the Company’s Common Stock (the “Performance Shares”) to certain senior executives of the Company, under the Company’s Amended and Restated 2003 Incentive Stock Plan.

 

The Board also approved the participants, goals and award levels for the first performance period under the LTIP.  Under the 2012-2014 Performance Period, in aggregate the participants may earn up to a maximum of 600,000 shares of Common Stock pursuant to Performance Shares.  The final number of shares to be earned under the LTIP will be determined based upon the Company’s actual achievement compared to revenue, operating income and free cash flow goals, during the performance period, provided that the Company’s stock price is equal to or greater than $35 on December 31, 2014.  The number of earned shares, if any, will be determined on the date that the Company files its Form 10-K for the year ended December 31, 2014 (the “Determination Date”) and 50 percent of the earned Performance Shares vests on the thirtieth day following the Determination Date and 25 percent of the earned shares vests on each of the next two anniversaries of the Determination Date.

 

The fair value of each Performance Share was estimated to be $17.07 on the grant date using the Monte Carlo pricing model with the following assumptions:

 

Grant date price		$	31.30
Performance term (in years)		2.98
Expected volatility		33.46		%
Risk-free interest rate		0.40		%
Expected dividends		—

 

No expense was recorded for the three and nine month periods ended September 30, 2012 related to the LTIP awards.

 

NOTE 9 —EXIT COSTS

 

The Company completed the consolidation of its Sunnyvale, California activities to Austin, Texas in the fourth quarter of 2011.  In the second quarter of 2012, the Company entered into a sublease for its former Austin, Texas location which decreased the amount accrued for contract termination by $1.1 million.

 

The following table summarizes the accrued and paid exit costs during the nine month period ended September 30, 2012 (in thousands):

 

(Dollars in thousands)

 

		Nine Months Ended September 30, 2012
		Accrued									Accrued
		Exit Cost									Exit Cost
		Balance at									Balance at
		January 1, 2012			Cost Incurred			Payments			September 30, 2012
Employee-related		$	1,417		$	32		$	1,449		$	—
Contract termination and other		2,371			(810		)	589			972
		$	3,788		$	(778	)	$	2,038		$	972

 

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ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)

 

NOTE 10 — INCOME TAXES

 

As disclosed in Note 15 of the 2011 Form 10-K, the Company was notified in 2010 by the Internal Revenue Service (“IRS”) of its intention to examine the 2006 federal income tax return. This examination was subsequently extended to include the 2007 — 2010 federal tax returns. During the third quarter of 2012, the Company received Notices of Proposed Adjustments from the IRS primarily related to transfer pricing.  The Company is currently preparing its response to the IRS and plans to vigorously defend its position.

 

NOTE 11 — BUSINESS COMBINATION

 

On June 20, 2012, the Company acquired an orthopedic sales and marketing entity in Finland for $1.3 million.  The acquisition did not materially affect the Company’s financial position at September 30, 2012 and is not expected to materially affect the results of its operations for the year ending December 31, 2012.

 

NOTE 12 — SEGMENT INFORMATION

 

Our business consists of one operating and reportable segment for the development, manufacturing and marketing of disposable devices and implants for select surgical procedures.  The development, manufacturing and other supporting functions, such as regulatory affairs and distribution, are common across our Company.  We organize and manage our sales and marketing functions according to both the surgical procedure that typically employs our products and geography.  Most of the Company’s products are used in Sports Medicine or ENT procedures.

 

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

 

		Three Months Ended									Three Months Ended
		September 30, 2012									September 30, 2011
		Americas			International			Total Product Sales			Americas			International			Total Product Sales
Sports Medicine		$	36,787		$	18,414		$	55,201		$	33,251		$	18,850		$	52,101
ENT		19,677			5,846			25,523			20,046			4,851			24,897
Other		322			1,556			1,878			658			1,776			2,434
Total product sales		$	56,786		$	25,816		$	82,602		$	53,955		$	25,477		$	79,432

 

		Nine Months Ended									Nine Months Ended
		September 30, 2012									September 30, 2011
		Americas			International			Total Product Sales			Americas			International			Total Product Sales
Sports Medicine		$	113,868		$	58,357		$	172,225		$	106,980		$	58,987		$	165,967
ENT		62,985			16,629			79,614			62,732			13,903			76,635
Other		1,322			5,287			6,609			2,203			5,059			7,262
Total product sales		$	178,175		$	80,273		$	258,448		$	171,915		$	77,949		$	249,864

 

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

 

		Three Months Ended						Nine Months Ended
		September 30,						September 30,
		2012			2011			2012			2011
United States		$	53,936		$	50,579		$	169,937		$	161,427
Non-United States (1)		28,666			28,853			88,511			88,437
Total product sales		$	82,602		$	79,432		$	258,448		$	249,864

 

(1) No additional locations are individually significant.

 

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

 

		September 30, 2012			December 31, 2011
United States		$	110,823		$	117,527
Other		44,797			44,445
Total long-lived assets		$	155,620		$	161,972

 

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ITEM 2.    MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

The following discussion should be read in conjunction with the condensed consolidated financial statements and notes thereto appearing elsewhere in this Form 10-Q. Readers should also review carefully  “Forward-Looking Statements,” in Part II of this quarterly report on Form 10-Q, which provides information about the forward-looking statements in this report and a discussion of the factors that might cause our actual results to differ, perhaps materially, from these forward-looking statements.  Statements in this Management’s Discussion and Analysis of Financial Condition and Results of Operations and elsewhere in this quarterly report on Form 10-Q which express that we “believe,” “anticipate,” “expect” or “plan to” as well as other statements which are not historical fact, are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and are subject to the safe harbors created under the Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as amended.  Readers are cautioned that these forward-looking statements are only predictions and are subject to risks, uncertainties, and assumptions that are difficult to predict.  As such, actual events or results may differ materially as a result of the risks and uncertainties described herein and elsewhere including, but not limited to, those factors discussed in Part II — Item 1A — “Risk Factors” of this report on Form 10-Q and in Part I — Item 1A — “Risk Factors” of our annual report on Form 10-K for the year ended December 31, 2011.  In this quarterly 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 markets surgical products, many of which are based on our minimally invasive patented Coblation technology. Our products are used across several medical specialties, improving many existing soft-tissue surgical procedures and enabling new minimally invasive surgical procedures. Our business consists of one operating and reportable segment for the development, manufacturing and marketing of disposable devices and implants for select surgical procedures.  The product development, manufacturing and other supporting functions, such as regulatory affairs and distribution, are common across our Company.  We organize and manage our sales and marketing functions according to geography and the surgical procedure that typically employs our products.  Most of the Company’s products are used in Sports Medicine or ENT procedures.

 

Key Financial Items, Trends and Uncertainties Affecting Our Business

 

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

 

Product Sales

 

Our principal source of revenue is from sales of our products, which primarily include disposable surgical devices and implants. Product sales are made through our employed sales representatives, independent sales agents and distributors.  Product sales increased 4.0 percent and 3.4 percent for the three and nine month periods ended September 30, 2012, respectively, when compared to the same periods in 2011.  We anticipate that disposable surgical device sales and implant sales will remain key components of our product sales for the foreseeable future.  The strengthening U.S. dollar against the euro, British pound and Australian dollar reduced the U.S dollar value of product sales by $1.4 million and $3.5 million for the three and nine month periods ended September 30, 2012. In constant currency, product sales increased 5.8 and 4.9 percent for the three and nine month periods ended September 30, 2012 when compared to the same periods in 2011.  Management believes percentage sales growth in constant currency is an important metric for evaluating our operations because the impact of changing foreign currency exchange rates may not provide an accurate baseline for analyzing trends in our business. To measure percentage sales growth in constant currency, we remove the impact of changes in foreign currency exchange rates.  Percentage sales growth in constant currency is calculated by translating current year sales at prior year average foreign currency exchange rates.  Constant currency is a non-GAAP measure and should not be considered as a substitute for measures prepared in accordance with GAAP.

 

We contract manufacture disposable surgical devices and implants based on our technologies for other medical device companies.  Product sales from contract manufacturing for the three and nine month periods ended September 30, 2012 were $6.6 million and $18.0 million, respectively, compared to $4.7 million and $15.4 million during the same periods in 2011.

 

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We also generate revenue from royalties, fees and other revenues from licensing of our technology to other companies and earn other revenues from shipping and handling costs billed to customers.

 

Gross Product Margin

 

Gross product margin as a percentage of product sales for the three and nine month periods ended September 30, 2012 was 68.3 percent and 69.0 percent, respectively, compared to 67.9 percent and 69.5 percent for the same periods in 2011.  Cost of product sales consists of all product manufacturing costs (including material costs, labor costs, 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 and operations personnel and costs of product shipped to our customers.  Cost of product sales also includes the amortization of controller units and instruments that have been placed at customer locations to enable the use of our disposable surgical products. We maintain ownership of all placed controllers and instruments and the costs are amortized into cost of product sales over their estimated useful life.  Our manufactured products are mostly produced at our Costa Rica facility. Raw materials used to produce our products are generally not subject to substantial commodity price volatility.  Most of our product manufacturing costs are incurred in U.S. dollars.

 

The comparability of gross product margin between periods will be impacted by several items, including the mix between proprietary and contract manufactured product sales; the stability of the average sales price we realize on proprietary products; changes in foreign exchange rates used to translate foreign currency denominated sales into U.S. dollars; changes in the estimated percentage of engineering activities related to manufacturing process design or improvement; and changes in our product emphasis which could result in excess and obsolescence charges being included in the cost of product sales in a particular period.

 

Operating Margin

 

Operating margin is our income from operations as a percentage of total revenues. Our key operating expenses include expenses incurred in connection with research and development, sales and marketing, and general and administrative activities, as well as the amortization of intangible assets.  Operating margin for the three and nine month periods ended September 30, 2012 was 15.7 percent and 18.0 percent compared to 5.2 percent and 13.7 percent for the same periods in 2011.

 

Under the short-term incentive plan for 2012 approved by our Board of Directors, Adjusted Operating Margin is a key metric for purposes of evaluating management’s performance.  Adjusted Operating Margin is Operating Margin adjusted for investigation and restatement related costs.  Investigation and restatement related costs were 2.5 percent and 1.6 percent of total revenue for the three and nine month periods ended September 30, 2012, respectively, compared to 7.2 percent and 4.6 percent of total revenue for the same periods in 2011.  Adjusted Operating Margin was 18.2 percent and 19.6 percent for the three month and nine month periods ended September 30, 2012, respectively, compared to 12.4 percent and 18.3 percent for the same periods in 2011. Adjusted Operating Margin is a non-GAAP measure of profitability and it should not be considered as a substitute for measures prepared in accordance with GAAP.

 

We completed the relocation of our Sunnyvale, California operations to Austin, Texas in December of 2011.  In the second quarter of 2012, the Company entered into a sublease for its former Austin, Texas location which decreased the amount accrued for contract termination by $1.1 million.  We expect exit costs in future periods to be insignificant.

 

Net Earnings

 

Net earnings will be affected by the same trends that impact our revenues, gross product margin and operating margin. In addition, net earnings will also be affected by non-operating other income and expenses, such as foreign currency gains and losses, and by income taxes.  We expect that we will report foreign currency gains or losses each period due primarily to changes in the value of the 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 a substantial portion of our operations are outside the U.S. in jurisdictions with lower tax rates, including Costa Rica, where we have a tax holiday that extends through December 2015.  In years of loss, our effective tax rate has exceeded the U.S. statutory rate due to the apportionment of income or loss between jurisdictions in which we operate. We expect to be able to fully utilize our deferred tax assets, which amounted to $46.5 million as of September 30, 2012.

 

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Results of Operations

 

Results of operations for the three and nine month periods ended September 30, 2012 and 2011 (in thousands, except percentages and per-share data) were as follows:

 

		Three Months Ended										Nine Months Ended
		September 30,										September 30,
		2012					2011					2012					2011
		Dollars			% Total Revenue		Dollars			% Total Revenue		Dollars			% Total Revenue		Dollars			% Total Revenue
Revenues:
Product sales		$	82,602		95.0	%	$	79,432		95.4	%	$	258,448		95.2	%	$	249,864		95.2	%
Royalties, fees and other		4,338			5.0	%	3,835			4.6	%	13,070			4.8	%	12,609			4.8	%
Total revenues		86,940			100.0	%	83,267			100.0	%	271,518			100.0	%	262,473			100.0	%
Cost of product sales		26,204			30.1	%	25,529			30.7	%	80,210			29.5	%	76,170			29.0	%
Gross profit		60,736			69.9	%	57,738			69.3	%	191,308			70.5	%	186,303			71.0	%
Operating expenses:
Research and development		8,184			9.4	%	8,037			9.6	%	23,677			8.7	%	21,460			8.2	%
Sales and marketing		27,175			31.2	%	25,752			30.9	%	86,217			31.8	%	81,124			30.9	%
General and administrative		8,191			9.4	%	9,479			11.4	%	24,833			9.1	%	26,372			10.0	%
Amortization of intangible assets		1,363			1.6	%	1,338			1.6	%	4,000			1.5	%	3,972			1.5	%
Exit costs		—			0.0	%	2,814			3.4	%	(778		)	-0.3	%	5,304			2.0	%
Investigation and restatement related costs		2,139			2.5	%	5,963			7.2	%	4,363			1.6	%	12,145			4.6	%
Total operating expenses		47,052			54.1	%	53,383			64.1	%	142,312			52.4	%	150,377			57.2	%
Income from operations		13,684			15.7	%	4,355			5.2	%	48,996			18.0	%	35,926			13.7	%
Non-operating gains (losses)		183					(1,028		)			(578		)			(661		)
Income from continuing operations before income taxes		13,867					3,327					48,418					35,265
Income tax provision		3,882					898					13,211					9,677
Net income from continuing opertions		9,985					2,429					35,207					25,588
Income from discontinued operations, net of taxes		—					—					—					1,911
Net Income		9,985					2,429					35,207					27,499
Accrued dividends and accretion charges on Series A 3% Redeemable Convertible Preferred Stock		(900		)			(857		)			(2,666		)			(2,546		)
Net income available to common stockholders		9,085					1,572					32,541					24,953
Other comprehensive income
Foreign currency adjustments		951					751					565					365
Total comprehensive income		$	10,936				$	3,180				$	35,772				$	27,864
Weighted-average shares outstanding:
Basic		27,714					27,466					27,698					27,335
Diluted		28,087					27,855					28,096					27,755
Earnings per share from continuing operations applicable to common stockolders:
Basic		$	0.27				$	0.05				$	0.97				$	0.70
Diluted		$	0.27				$	0.05				$	0.96				$	0.68
Earnings per share applicable to common stockolders:
Basic		$	0.27				$	0.05				$	0.97				$	0.75
Diluted		$	0.27				$	0.05				$	0.96				$	0.74

 

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