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 July 4, 1998
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from ________ to _______
Commission File Number: 0-27422
ARTHROCARE CORPORATION
(Exact name of registrant as specified in its charter)
DELAWARE 94-3180312
(State of incorporation) (I.R.S. Employer Identification No.)
595 North Pastoria Avenue
Sunnyvale, California 94086
(Address of principal executive offices)
(408) 736-0224
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes X No
----- -----
The number of shares outstanding of the registrant's common stock as of
August 4, 1998 was 8,946,354.
<PAGE>
ARTHROCARE CORPORATION
INDEX
PART 1: Financial Information
Item 1. Financial Statements
Condensed Consolidated Balance Sheets as of July 4, 1998 (unaudited)
and January 3, 1998
Condensed Consolidated Statements of Operations (unaudited) for the
three and six months ended July 4, 1998 and June 27, 1997
Condensed Consolidated Statements of Cash Flows (unaudited)
for the six months ended July 4, 1998 and June 27, 1997
Notes to Condensed Consolidated Financial Statements (unaudited)
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations
PART II: Other Information
Item 1. Legal Proceedings
Item 2. Changes in Securities
Item 3. Defaults upon Senior Securities
Item 4. Submission or Matters to Vote of Security Holders
Item 5. Other Information
Item 6. Exhibits and Reports on Form 8-K
SIGNATURE
<PAGE>
Part 1. Financial Information
Item 1. Financial Statements
ARTHROCARE CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands)
<TABLE>
<CAPTION>
July 4, January 3,
1998 1998
------------- -------------
(unaudited)
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents $10,299 $8,188
Available-for-sale securities 4,575 10,674
Accounts receivable, net 3,806 2,223
Inventory 3,744 2,019
Prepaid expenses and other current assets 544 210
------------- -------------
Total current assets 22,968 23,314
Available-for-sale securities 2,635 1,010
Property and equipment, net 2,165 1,412
Related party receivables 886 876
Other assets 76 63
------------- -------------
Total assets $28,730 $26,675
============= =============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $1,742 $968
Deferred Revenue 875 --
Accrued liabilities 2,649 2,004
------------- -------------
Total current liabilities 5,266 2,972
Deferred rent 150 157
------------- -------------
Total liabilities 5,416 3,129
------------- -------------
Stockholders' equity:
Common stock 21 9
Additional paid in capital 49,678 49,153
Notes receivable from stockholders (83) (92)
Deferred compensation (148) (228)
Unrealized gain (loss) on available-for-sale
securities (7) 10
Accumulated deficit (26,147) (25,306)
------------- -------------
Total stockholders' equity 23,314 23,546
------------- -------------
Total liabilities and stockholders' equity $28,730 $26,675
============= =============
</TABLE>
The accompanying notes are an integral part of these
condensed consolidated financial statements
<PAGE>
ARTHROCARE CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share data)
(Unaudited)
<TABLE>
<CAPTION>
Three Months Ended Six Months Ended
----------------------- ------------------------
July 4, June 28, July 4, June 28,
1998 1997 1998 1997
----------- ----------- ----------- -----------
<S> <C> <C> <C> <C>
Net sales $5,673 $2,832 $10,544 $5,093
Cost of sales 3,145 1,994 5,995 3,673
----------- ----------- ----------- -----------
Gross profit 2,528 838 4,549 1,420
----------- ----------- ----------- -----------
Operating expenses:
Research and development 1,155 873 2,140 1,753
Sales and marketing 2,422 1,386 4,538 2,751
General and administrative 713 927 1,924 1,818
----------- ----------- ----------- -----------
Total operating expenses 4,290 3,186 8,602 6,322
----------- ----------- ----------- -----------
Loss from operations (1,762) (2,348) (4,053) (4,902)
Interest and other income, net 668 359 3,212 746
----------- ----------- ----------- -----------
Net loss ($1,094) ($1,989) ($841) ($4,156)
=========== =========== =========== ===========
Net loss per common share and per common
share-assuming dilution ($0.12) ($0.23) ($0.09) ($0.47)
=========== =========== =========== ===========
Shares used in computing net loss per common
share and per common share-assuming dilution 8,914 8,806 8,902 8,795
=========== =========== =========== ===========
</TABLE>
The accompanying notes are an integral part of these
condensed consolidated financial statements
<PAGE>
ARTHROCARE CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)
<TABLE>
<CAPTION>
Six Months Ended
--------------------------
July 4, June 28,
1998 1997
------------ ------------
(unaudited)
<S> <C> <C>
Cash flows from operating activities:
Net loss ($841) ($4,156)
Adjustments to reconcile net loss
to net cash used in operating activities:
Depreciation and amortization 282 304
Amortization of deferred compensation 80 79
Provision for doubtful accounts receivable
and product returns 50 52
Provision for excess and obsolete inventory 186 149
Deferred rent (7) 3
Changes in operating assets and liabilities:
Accounts Receivable (1,633) (30)
Related party receivables (10) 66
Inventory (1,911) (666)
Prepaid expenses and other current assets (334) (171)
Accounts payable 774 163
Accrued liabilities 660 246
Deferred Revenue 875 0
Other assets (13) 6
------------ ------------
Net cash provided used in
operating activities (1,842) (3,955)
------------ ------------
Cash flows from investing activities:
Purchases of property and equipment (1,035) (293)
Purchases of available-for-sale securities (22,093) (5,627)
Sale or maturities of available-for-sale securities 26,550 15,617
------------ ------------
Net cash provided by investing activities 3,422 9,697
------------ ------------
Cash flows from financing activities:
Repayment of capital leases (15) (23)
Issuance of notes receivable 9 --
Proceeds from exercise of options
to purchase common stock 537 65
------------ ------------
Net cash provided by financing activities 531 42
------------ ------------
Net increase in cash and cash equivalents 2,111 5,784
Cash and cash equivalents, beginning of period 8,188 11,359
------------ ------------
Cash and cash equivalents, end of period $10,299 $17,143
============ ============
Supplemental schedule of non-cash investing and
financing activities:
Net unrealized loss on
available-for-sale securities ($17) $40
</TABLE>
The accompanying notes are an integral part of these
condensed consolidated financial statements
<PAGE>
ARTHROCARE CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
1. Basis of Presentation
In the opinion of management, the accompanying unaudited condensed
consolidated financial statements contain all adjustments (all of which
are normal and recurring in nature) necessary to present fairly the
financial position, results of operations and cash flows of ArthroCare
Corporation (the company) for the periods indicated. Interim results of
operations are not necessarily indicative of the results to be expected
for the full year or any other interim periods. The notes to the
financial statements contained in the Form 10-K for the year ended
January 3, 1998 should be read in conjunction with these condensed
consolidated financial statements. The balance sheet at January 3, 1998
was derived from audited financial statements; however, the financial
statements in this report do not include all disclosures required by
generally accepted accounting principles.
Computation of Net Loss per Common Share and per Common Share-assuming
dilution
The company has adopted the provisions of Statement of Financial
Accounting Standards (SFAS) No. 128, "Earnings Per Share" and the
Securities and Exchange Commission Staff Accounting Bulletin (SAB) No.
98, effective January 3, 1998 and has restated all prior periods
accordingly. Net loss per common share and per common share-assuming
dilution is computed using the weighted average number of shares of
common stock outstanding. Dilutive potential common equivalent shares
consist of the incremental common shares issuable upon conversion of
stock options. The company has excluded stock options from the
computation of net loss per common share-assuming dilution because all
such securities are anti-dilutive from all periods presented.
Stock options to purchase 390,790 share of common stock at prices
ranging from $.20 per share to $24.25 per share were outstanding at July
4, 1998, but were not included in the computation of net loss per common
share-assuming dilution because they were antidilutive. The
aforementioned stock options could potentially dilute earning per share
in the future.
3. Interest and other income, net:
In February 1998, the company entered into a license agreement
under which Boston Scientific Corporation (BSC) will develop and market
products based on the company's Coblation T technology for myocardial
revascularization procedures. Under the agreement, BSC acquires
exclusive licensing rights to the company's intellectual property in
this field. BSC will pay license fees, a portion of which will be
classified as prepaid royalties, to the company upon achievement of
designated milestones and royalties on sales of resulting products, if
any. Of this amount, the company received a license fee in the quarter
ended April 4, 1998, of $3.0 million in partial consideration for the
license granted. The company recognized $2.25 million as other income
in the quarter received. The remaining $0.75 million will be recognized
as progress is made toward the next milestone of which $0.125 million
was recognized in the three-month period ended July 4, 1998.
In June 1998, the company entered into a license and distribution
agreement with Xomed whereby Xomed will acquire exclusive, worldwide,
marketing rights for the company's patented Coblation TM technology in
the ear, nose and throat (ENT) market. Under the terms of the
agreement, Xomed will pay license fees based upon the achievement of
certain milestones. During the three and six-month periods ended July
4, 1998 the company recognized, $0.25 million of such payments as other
income.
4. Balance sheet detail (in thousands):
<TABLE>
<CAPTION>
July 4, January 3,
1998 1998
------------ ------------
(Unaudited)
<S> <C> <C>
Inventory:
Raw materials $1,510 $921
Work-in-process 806 165
Finished goods 1,428 933
------------ ------------
Total $3,744 $2,019
============ ============
Accrued liabilities:
Compensation $1,351 $1,314
Deferred license fee 675 --
Legal expense 568 38
Other 55 652
------------ ------------
Total $2,649 $2,004
============ ============
</TABLE>
5. Recent Accounting Pronouncements:
Effective April 4, 1998 the company adopted SFAS No. 130,
"Reporting Comprehensive Income" which establishes standards for the
reporting and display of comprehensive income and its components in a
full set of general purpose financial statements. Comprehensive income
is defined as the change in equity of a business enterprise during a
period, resulting from transactions and other events and circumstances
from non-owner sources. As the components of comprehensive income for
the company are not material, the additional reporting and display of
comprehensive income and its components has not been reflected in the
accompanying condensed consolidated financial statements.
<PAGE>
PART 1. FINANCIAL INFORMATION
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
Overview
Statements in this Management's Discussion and Analysis of
Financial Condition and Results of Operations which express that the
company "believes", "anticipates" or "plans to." as well as other
statements which are not historical fact, are forward-looking statements
within the meaning of the Private Securities Litigation Reform Act of
1995. Actual events or results may differ materially as a result of the
risks and uncertainties described herein and elsewhere including, in
particular, those factors described under "Business" set forth in Part I
of the company's Annual Report on Form 10-K for the year ended January
3, 1998 and "ADDITIONAL FACTORS THAT MIGHT AFFECT FUTURE RESULTS".
Since commencing operations in April 1993, ArthroCare Corporation
(the company) has primarily engaged in the design, development, clinical
testing, manufacturing and marketing of its Arthroscopic System. The
Arthroscopic System uses the company's novel CoblationT technology that
allows surgeons to operate with increased precision and accuracy with
minimal damage to surrounding tissue. It is currently being used in
closed-joint surgery including many types of knee and shoulder
procedures. The Arthroscopic System consists of a disposable, multi-
electrode bipolar ArthroWand, a radio frequency controller that powers
the ArthroWand and a cable that connects the ArthroWand to the
controller. The ArthroWand ablates (removes) soft tissue with minimal
damage to surrounding healthy tissue and simultaneously achieves
hemostasis (sealing of small bleeding vessels).
In February 1998, the company entered into a license and OEM
agreement under which Boston Scientific Corporation (BSC) will develop
and market products based on the company's CoblationT technology for
myocardial revascularization procedures. In April 1998, the company
announced that it is entering the cosmetic surgery market and that it
has formed a new business unit, called Visage TM, to commercialize its
technology in this field. In May 1998, the company announced that it is
entering the otorhinolaryngology (ear, nose and throat) market and that
it has formed a new business unit, called ENTec TM, to commercialize the
technology in this field. In June 1998, the company entered into a
license and OEM agreement with Xomed Surgical Products (Xomed). Under
the terms of this agreement, Xomed will become the exclusive worldwide
marketer of ArthroCare's patented Coblation TM technology in the
otorhinolaryngology market.
The company received clearance of its 510(k) premarket
notification from the United States Food and Drug Administration (FDA)
in March 1995 to market its Model 970 Arthroscopic System in the United
States for use in arthroscopic surgery of the knee, shoulder, elbow and
ankle. The company has since received clearance for use in the wrist and
hip. In October 1996, the company received clearance of its 510(k)
premarket notification for the System 2000 Arthroscopic System in the
United States for use in arthroscopic surgery of the knee, shoulder,
elbow, ankle, wrist and hip.
In December 1995, the company commercially introduced its
Arthroscopic System through a network of distributors in the United
States. In light of the foregoing, the company has a limited history of
operations. The company's strategy includes placing with arthroscopic
surgeons, controllers that are intended to generate future wand
revenues. The company's long-term strategy includes applying its
patented platform technology to a range of other soft-tissue surgical
procedures including ear, nose and throat and cosmetic surgical
procedures. The company has received 510(k) clearance for use of its
technology in several fields and has received approval of an
Investigational Device Exemption (IDE) to conduct a clinical study which
may result in the company submitting a 510(k) application to the FDA.
There can be no assurance that any of the company's clinical studies
will lead to 510(k) applications or that the applications will be
cleared by the FDA on a timely basis, if at all, or that the products,
if cleared for marketing, will ever achieve commercial acceptance.
Results of Operations
Revenues
Revenues for the three and six-month periods ended July 4, 1998
increased to $5.7 million or 100.3% and $10.5 million or 107%,
respectively, as compared to $2.8 million and $5.1 million for the same
periods during the prior year. The increase in revenues of $2.8 million
and $5.5 million for the three and six-month periods ended July 4, 1998,
respectively, was primarily due to higher unit volume wand sales. The
higher unit volume of wand sales resulted from a larger installed base
of controllers. Wands continue to be sold at or near list price. The
company expects international sales and sales to its marketing partner,
Xomed, of wands at discounted prices to reduce wand ASP in the future.
The majority of revenues for the three and six-month periods ended
July 4, 1998 were attributable to wand sales. The company's strategy
has been, and continues to be, to increase future wand sales by
increasing the installed base of controllers through aggressive
promotional programs. During the three-month period ended July 4, 1998
the company implemented an additional controller placement program that
allows customers to pay a monthly usage fee. This program did not have
a significant impact on revenues or gross margins during the three or
the six-month period ended July 4, 1998; however, the company believes
that its placement program may have a positive impact on wand sales and
gross margins in the future. The company expects wand sales to remain
the primary component of revenues in the future.
The company believes that, in its ten quarters of product
shipments, it has penetrated 20% to 25% of hospitals that perform
arthroscopic procedures in the United States. In addition, the company
believes that approximately half of the company's wand revenue is being
generated by wands purchased for use in shoulder procedures. The company
believes that shoulder procedures are the fastest growing segment of the
arthroscopic market and knee procedures represent the largest segment of
the arthroscopic market based on the number of procedures. In order to
achieve increasing wand sales over time, the company believes it must
continue to penetrate the market for knee procedures, expand the
education of physicans of the Coblation TM technology, continue working
on articular cartilage applications and base product development focus
specifically for knee applications.
To that end, during the quarter, the company introduced five new
wand styles. The Eliminator, Saber, and Covac wands were designed to
be used primarily in knee procedures and were introduced near the end of
the quarter. The company also developed and introduced new wands for
small joint procedures and for capsular shrinkage procedures. In
November 1997, the company introduced the System 2000 controller
designed for more aggressive ablation and hemostasis. The company
believes the features found in the System 2000 as well as these
additional wands will increase wand sales in the market for knee and
shoulder procedures. There can be no assurance that the use of these new
products will be adopted by doctors. The company has limited sales and
marketing experience and can make no assurance that current trends in
sales and product acceptance will continue.
Cost of Sales
Cost of sales was $3.1 million, or 55% of sales, and $6.0 million,
or 57% of sales for the three and six-months ended July 4, 1998,
respectively. During the three and six-month periods ended June 28,
1997 cost of sales was $2.0 million, or 70% of sales and $3.7 million or
72% of sales, respectively. The dollar increase in cost of sales in the
current year quarter and for the six months ended July 4, 1998 is due to
increased sales of products. As a percentage of sales, cost of sales
decreased compared with the previous year periods primarily as a result
of the fixed and semi-fixed costs being spread over higher wand
manufacturing volume. In addition, prior to introduction of its new
controller in November 1997, the company purchased its controllers from
a subcontract manufacturer at a cost that exceeded the current internal
cost to manufacture. In 1998, the company charges expenses related to
quality control to cost of sales since most of these activities relate
to on-going manufacturing; previously, these expenses were charged to
research and development.
The company implemented an additional controller placement program
late in the first half of 1998 in which the company maintains title to
the controllers. This program did not have a significant impact on gross
margins during the three or the six-month period ending July 4, 1998;
however, the company believes that its placement program may have a
positive impact on gross margins in the future, since the cost of the
controller is amortized over a longer period of time. The company
believes the placement program will contribute to the growth of the
installed base of controllers and generate an increase in the demand for
disposable wands resulting in a decrease of cost of sales as a
percentage of sales and an improvement of gross margins. There can be
no assurance that the company will be successful in maintaining the mix
of wands as compared to controller placements or be able to increase
demand for its disposable wands.
Operating Expenses
Research and development expense increased to $1.2 million and
$2.1 million for the three and six-month periods ended July 4, 1998,
respectively, from $0.9 million and $1.8 million, respectively, for the
same periods during the prior fiscal year. The increase in spending
represents a 32% and 22% increase over the three and the six-month
periods, respectively, of the prior fiscal year. The increases over the
three and the six-month periods are attributed to the development of new
wand styles and the product lines associated with launch of two new
business units which bring the company's technology to the cosmetic
surgery and ear, nose and throat surgical markets, as well as the costs
associated with running clinical trials on certain new products. This
increase was partially offset by the decreased allocation of expenses
related to quality control, which are being charged to cost of sales in
1998 as quality activities primarily relate to manufacturing rather than
research and development.
The company believes that continued investment in its platform
technology is essential if it is to maintain its competitive position.
The company expects to continue increasing research and development
spending through substantial expenditures on new product development,
regulatory affairs, clinical studies and patents, although not at the
rate seen in the past year. The company believes that its ability to
attract and retain qualified engineers in the future is critical to the
continued success of the company.
Sales and marketing expense increased to $2.4 million or 75% and
$4.5 million or 65%, respectively, during the three and six-month
periods ended July 4, 1998, as compared to $1.4 million and $2.8 million
incurred during the same periods of the previous fiscal year. The
increases are primarily due to higher dealer commissions resulting from
increased sales, higher staffing, and promotional and trade show
expenses reflecting an increased level of sales and marketing activity
as the company introduced two new business units and several new
arthroscopy products. Additional sales and marketing expenses were
incurred during 1998 as the company expanded operations in Europe.
The company anticipates that sales and marketing spending will
continue to increase due to higher dealer commissions from increased
sales, the additional cost of penetrating international markets and new
surgical markets for the company's products, higher promotional,
demonstration and sample expenses, and additional investments in the
sales, marketing and support staff necessary to market its current
products and commercialize future products. There can be no assurance
that the company will successfully develop its own marketing and sales
capabilities and experience or that its distributors and marketing
partners will commit the necessary resources to effectively market and
sell the company's current products and future products.
General and administrative expenses were $0.7 million for the
three-month period ended July 4, 1998, a 23% decrease as compared to
$0.9 million for the three-month period ended June 28, 1997. The
decrease in expenses during the second quarter of 1998 compared with the
second quarter of 1997 is primarily due to the costs associated with
recruiting and relocating the new President and Chief Executive Officer
in the prior year period. General and administrative expense increased
to $1.9 million or 6% for the six-month period ended July 4, 1998 as
compared to $1.8 million for the six-month period ended June 28, 1997.
The $0.1 million increase during 1998 is due to legal expenses related
to on-going patent litigation brought by the company against certain
competitors offset by the relocation and recruiting expenses incurred
during the second quarter of 1997. The increased legal expense includes
the accrual of approximately $0.5 million of anticipated and estimable
legal expenses related to such patent litigation and resulting from a
number of motions that are currently before the court. For a
description of the patent litigation, refer to Part II, Item 1 this
Quarterly Report on Form 10-Q. The company expects that general and
administrative expenses will continue to increase as a result of the
patent litigation, further expansion of its staff, and business
development activities.
Interest and Other Income, net
Net interest and other income increased to $0.7 million and $3.2
million for the three-month and six-month periods ended July 4, 1998,
respectively, up from $0.4 million and $0.7 million for the three-month
and six-month periods ended June 28, 1997 primarily due to milestone
payments received from BSC and Xomed pursuant to technology licensing
agreements signed with each party during 1998.
In February 1998, the company entered into a license agreement
under which BSC will develop and market products based on the company's
Coblation T technology for myocardial revascularization procedures.
Under the agreement, BSC acquired exclusive licensing rights to the
company's intellectual property in this field. BSC will pay license
fees, a portion of which will be classified as prepaid royalties, to the
company upon achievement of designated milestones and royalties on sales
of resulting products, if any. The first milestone payment of $3.0
million was received in the first quarter of 1998. The company
recognized $2.4 million of that payment as other income during the six-
month period ended July 4, 1998. The remaining $0.6 will be recognized
as progress is made toward future milestones.
In June 1998, the company entered into a license and distribution
agreement with Xomed whereby Xomed will acquire exclusive, worldwide,
marketing rights for the company's patented Coblation TM technology in
the ear, nose and throat (ENT) market. Under the terms of the
agreement, Xomed will pay license fees based upon the achievement of
certain milestones. During the three and six-month periods ended July
4, 1998 the company recognized, $0.25 million of such payments as other
income. Excluding the aforementioned milestone payments, net interest
and other income would have been $0.3 million and $0.6 million, a $0.1
million and $0.2 million decrease for the three and six-month periods
ended July 4, 1998, respectively. The decrease in interest income is
attributable to the decrease in cash balances and henceforth the
interest earned year over year.
Net Loss
Net loss was $1.1 million and $0.8 million for the three and the
six-months ended July 4, 1998, respectively, compared to a loss of $2.0
million and $4.1 million in the three and the six-month periods ended
June 28, 1997, respectively. Net loss decreased over the prior year
period primarily due to the milestone payments received from BSC and
Xomed, which were recognized as other income and an improvement in
operating margins. See Interest and Other Income, net discussion above.
Excluding the payments detailed above, the company would have reported a
loss of $1.5 million or $0.5 million less than in the comparable three-
month period ended June 28, 1997. For the six-month period ending July
4, 1998, excluding the milestone payments and the accrual of $0.5
million patent litigation expense recorded in fiscal 1998, net loss
would have been $3.0 million or $1.1 million less than the prior year.
This decrease is primarily due to increased revenues, gross margin
improvement, and increases in operating expenses at rates lower than the
increase in revenue.
The company expects net losses to continue in the future. However,
the company believes that net losses will continue to decrease as sales
increase faster than operating expenses and gross margin continues to
improve. There can be no assurance the company will be successful in its
efforts to increase sales and gross margin or reduce the rate of growth
of operating expenses.
Liquidity and Capital Resources
On July 4, 1998, the company had $17.7 million in working capital.
Principal sources of liquidity consisted of $17.5 million in cash, cash
equivalents, and available-for-sale securities, which include long-term
available-for-sale securities. The cash and cash equivalents are highly
liquid with original maturities of ninety days or less.
Net cash used in operating activities decreased to $1.8 million
for the six-month period ended July 4, 1998 from $4.0 million for the
six-month period ended June 28, 1997. The decrease in the current year
period is due primarily to the milestone payments received from BSC and
Xomed in the current year period and the reduction of operating loss
excluding the legal accrual. See Interest and Other Income, net and
Operating Expenses, general and administrative discussions above.
Net accounts receivable increased to $3.8 million as of July 4,
1998 from $2.2 million as of January 3, 1998. The increase in accounts
receivable is due to a corresponding increase in sales as well as timing
of sales during the quarter.
Inventories increased to $3.7 million as of July 4, 1998 compared
to $2.0 million at January 3, 1998 due to higher product sales activity
along with the ramp-up for two new product markets. The company expects
future inventory levels to grow both in absolute value and as a
percentage of total assets as sales volume increases.
Net property and equipment increased to $2.2 million as of July 4,
1998 from $1.4 million on January 3, 1998. The increase is primarily
attributable to the capitalization of controllers placed subject to the
newly implemented leasing program along with an increase of computer
software and equipment for new hires and an additional facility.
The company plans to finance its capital needs principally from
cash from product sales, cash, cash equivalents, and available-for-sale
securities, which include long-term available-for-sale securities and
related interest. The company believes the existing capital resources
together with cash generated from licensing arrangements will be
sufficient to fund its operations at least through fiscal year 1999. The
company currently has no commitments for any credit facilities such as
revolving credit agreements or lines of credit that could provide
additional working capital. The company's future liquidity and capital
requirements will depend on numerous factors including the company's
success of commercializing the Arthroscopic System, development and
commercialization of products in fields other than arthroscopy, the
ability of the company's suppliers to continue to meet the demands of
the company at current prices, the cost associated with the company's
ongoing patent litigation, obtaining and enforcing patents important to
the company's business, the status of regulatory approvals and
competition. There can be no assurance that the company will not be
required to raise additional capital or that such capital will be
available on acceptable terms, if at all.
The company relies on computers and computer software to run its
business as do its vendors, suppliers and customers. These computers and
computer software may not be able to properly recognize the dates
commencing in the year 2000. The company has not completed an
assessment of the impact this may have on its business and does not have
a reasonable basis to conclude whether the impact of the year 2000 will
or will not materially effect future financial results. To date the
company has not found any material impact which may result from the
failure of its computers and computer software or that of its vendors,
suppliers, and customers. However, the company plans to make an
assessment of this issue during 1998 and, if appropriate, develop an
action plan to correct it.
In June 1997, the Financial Accounting Standards Board issued SFAS
No. 131, Disclosure about Segments of an Enterprise and Related
Information. This statement establishes standards for disclosure about
operating segments in annual financial statements and selected
information in interim financial reports. It also establishes standards
for related disclosures about products and services, geographic areas
and major customers. This statement supersedes SFAS No. 14, Financial
Reporting for Segments of a Business Enterprise. The new standard
becomes effective for the year ended January 2, 1999 for the company and
requires that comparative information from earlier years be restated to
conform to requirements of this standard. The company is evaluating the
requirements of SFAS No. 131 and the effects, if any, on the company's
current reporting and disclosures.
ADDITIONAL FACTORS THAT MIGHT AFFECT FUTURE RESULTS
ArthroCare became a public company in February 1996. Included
here are risk factors as updated from the company's Annual Report on
Form 10-K for the year ended January 3, 1998 filed April 3, 1998. The
following factors represent current challenges to the company that
create risk and uncertainty. Failure to adequately overcome any of the
following challenges, either singularly or in combination, could have a
material adverse effect on the company's results of operations,
business, or financial position.
Early Stage of Commercialization of Current Non-Arthroscopic Products;
Uncertainties Associated with Current Non-Arthroscopic Products.
In April 1998, the company announced the creation of its new
business division, Visage TM, created for the purpose of commercializing
the company's Cosmetic Surgery System ("CSS") for use in dermatology and
cosmetic surgery procedures, in May 1998, the company announced the
creation of its second new business division, ENTec TM, created for the
purpose of commercializing the company's ENT (Ear, Nose and Throat)
Surgery System ("ESS") for use in head and neck surgical procedures.
With respect to CSS, the company has obtained ISO 9001 certification and
has received CE mark certification for marketing of CSS in Europe for
skin resurfacing and wrinkle removal procedures and has received 510(k)
clearances for use of CSS in general dermatology procedures in the
United States. The company is pursuing additional clearances that will
allow CSS to be marketed in the United States specifically for wrinkle
removal. With respect to ESS, the company has applied for ISO 9001 and
CE mark certification for marketing of ESS in Europe and has received
510(k) clearances for use of ESS in general head and neck surgical
procedures in the United States. In addition, the company has received
clearances that will allow ESS to be marketed in the United States for
certain specific indications while it is pursuing additional clearances
for certain other indications. Both of these products have only
recently been commercially introduced and to date, the company has sold
only a small number of units, and these have been utilized by a limited
number of doctors. No assurance can be given that the company will be
able to manufacture CSS or ESS in commercial quantities at acceptable
costs, or that it will be able to market such products successfully. If
CSS and ESS are not commercially successful, the company's business,
financial condition and results of operations would be materially
adversely affected.
A significant investment in additional preclinical and clinical
testing, regulatory and sales and marketing activities will be necessary
in order for the company to commercialize CSS and ESS. There can be no
assurance that CSS or ESS will generate sufficient or sustainable
revenues to enable to the company to be profitable. Furthermore,
although the company believes that these products offer certain
advantages, there can be no assurance that these advantages will be
realized, or if realized, that these products will result in any
meaningful benefits to current or future collaborative partners or
patients.
Development and commercialization of CSS and ESS are subject to
the risks of failure inherent in the development of new medical devices.
These risks include the possibility that the company will experience
delays in testing or marketing, that such testing or marketing will
result in unplanned expenditures or in expenditures above those
anticipated by the company, that CSS or ESS will not be proven safe or
effective, that such products will not be easy to use or cost-effective,
that third parties will develop and market superior or equivalent
products, that such products will fail to receive necessary regulatory
approvals, that such products will be difficult or uneconomical to
manufacture on a commercial scale, that proprietary rights of third
parties will preclude the company or its collaborative partners from
marketing such products and that such products will not achieve market
acceptance. As a result of these risks, there can be no assurance that
research and development efforts conducted by the company or its
collaborative partners will result in any commercially viable products.
If required regulatory approvals are not obtained for CSS or ESS, or any
approved products are not commercially successful, there will be a
material adverse effect on company's business, financial condition and
results of operations
Dependence Upon Collaborative Arrangements
In order to successfully develop and commercialize certain
products, the company may enter into collaborative or licensing
arrangements with medical device companies and other entities to fund
and complete its research and development activities, preclinical and
clinical testing and manufacturing, to seek and obtain regulatory and to
achieve successful commercialization of future products. The company
has recently entered into collaborative arrangements with BSC and Xomed.
See "Management's Discussion and Analysis of Financial Condition and
Results of Operations- Overview" for a discussion of these arrangements.
The company's dependence on collaborative and licensing
arrangements with third parties subjects it to a number of risks.
Agreements with collaborative partners typically allow such partners
significant discretion in electing whether to pursue any of the planned
activities. The company cannot control the amount and timing of
resources its collaborative partners may devote to the products and
there can be no assurance that such partners will perform their
obligations as expected. Business combinations or significant changes in
a corporate partner's business strategy may adversely affect such
partners ability to complete its obligations under the arrangements. If
any collaborative partner were to terminate or breach its agreement with
the company, or otherwise fail to complete its obligations in a timely
manner, such conduct could have a material adverse effect on the
company's business, financial condition and results of operations. To
the extent that the company is not able to establish further
collaborative arrangements or that any or all of the company's existing
collaborative arrangements are terminated, the company would be required
to seek new collaborative arrangements or to undertake product
development and commercialization at its own expense, which could
significantly increase the company's capital requirements, place
additional strain on its human resource requirements and limit the
number of products which the company would be able to develop and
commercialize. In addition, there can be no assurance that existing and
future collaborative partners will not pursue alternative technologies
or develop alternative products either on their own or in collaboration
with others, including the company's competitors. There can also be no
assurance that disputes will not arise in the future with respect to the
ownership of rights to any technology or products developed with any
collaborative partner. Lengthy negotiations with potential new
collaborative partners or disagreements between established
collaborative partners and the company could lead to delays or
termination in the research, development or commercialization of certain
products or result in litigation or arbitration, which would be time
consuming and expensive. Failure by any collaborative partner to
develop or commercialize successfully any product candidate to which it
has obtained rights from the company or the decision by a collaborative
partner to pursue alternative technologies or commercialize or develop
alternative products, either on their own or in collaboration with
others, could have a material adverse effect on the company's business,
financial condition and results of operations.
Dependence Upon Arthroscopic System
The company commercially introduced the Arthroscopic System in
December 1995 and by the quarter ended July 4, 1998, had reported 31
months of sales. The Arthroscopic System is the company's first
commercial product and will account for a substantial portion of the
company's revenue for the near future. As such, the company is highly
dependent on its Arthroscopic System. Additionally, the company's
potential products for non-arthroscopic indications are in various
stages of development, and the company may be required to undertake
time-consuming and costly development activities and seek regulatory
approval of these devices. There can be no assurance that product
development will ever be successfully completed, that regulatory
approval, if applied for, will be granted by the United States Food and
Drug Administration (FDA) on a timely basis, if at all, or that new
products will ever achieve commercial acceptance. Failure by the company
to develop, obtain necessary regulatory approval for or to successfully
market new products could have a material adverse effect on the
company's business, financial condition and results of operations.
Currently, the majority of the company's sales come from the
United States. The company has established distribution capability in
Europe, Australia, Korea, Japan, Canada and parts of South and Central
America. Before the Arthroscopic System can be sold outside these
regions, the company will have to obtain additional international
regulatory approvals and establish additional distribution capability in
other geographic regions. If such regulatory approval is obtained,
there can be no assurance that the company will be able to establish a
successful distribution capability.
Uncertainty of Market Acceptance
Physicians will not use the company's products unless they
determine, based on experience, clinical data and other factors, that
these systems are an attractive alternative to conventional means of
tissue ablation. No independent published clinical reports exist to
support the company's marketing efforts for any of its products, which
may have an adverse effect on its ability to obtain physician
acceptance. The company believes that continued recommendations and
endorsements by influential physicians are essential for market
acceptance of its products. If the Arthroscopic System does not
continue to receive broad-based physician acceptance and endorsement by
influential physicians, the company's business, financial condition and
results of operations would be materially adversely affected. Similarly,
if CSS, ESS or the company's potential new products do not receive
broad-based physicians acceptance and endorsement by influential
physicians, the company's business, financial condition and results of
operations would be materially adversely affected.
Limited Operating History
The company's operations to date, have consisted of more than two
years of sales of its Arthroscopic System and very limited sales of CSS
and ESS. In addition the company has incurred expenses related to
research and development, product engineering, applying for and
obtaining FDA clearance of its products and potential new products,
developing a network of distributors in the United States and
internationally and assembling a direct sales force to market its
products. The company continues to generate operating losses and
anticipates generating losses in the future. Whether the company can
successfully manage the transition to a larger-scale commercial
enterprise will depend upon increasing sales of disposable ArthroWands
from its distribution network, successful commercialization of CSS, ESS
and the company's technology in additional surgical markets, obtaining
additional international regulatory approvals for the company's
products, obtaining domestic and international regulatory approvals for
its current and potential new products and maintaining its financial and
management systems, procedures and controls.
Limited Domestic and International Marketing and Sales Experience
The company has shipped over 2,500 Arthroscopic System controller
units, more than 220,000 ArthroWands, and a limited number of CSS and
ESS units through the end of the second quarter of 1998. The company is
marketing and selling CSS domestically through a direct sales force and
internationally through its subsidiary, ArthroCare Europe AB. The
company currently has very limited experience in directly marketing and
selling its products and is in the process of assembling a marketing and
sales staff for CSS. There can be no assurance that the company will
successfully develop its own marketing and sales capabilities or
experience for CSS.
The company is marketing and selling its Arthroscopic System in
the United States and internationally through a network of independent
orthopedic distributors. These distributors sell orthopedic arthroscopy
and ENT devices for a number of other manufacturers. Xomed is the
exclusive and worldwide distributor for ESS. There can be no assurance
that these distributors will commit the necessary resources to
effectively market and sell the company's Arthroscopic System or ESS, or
that they will be successful in closing sales with doctors and
hospitals. The company has offered its controller to these distributors
at substantial discounts and may be required to continue to offer such
discounts on its controller to generate demand for its wands. The
inability to sell sufficient quantities of wands would have a material
adverse effect on the company's business, financial condition and
results of operations.
The company has signed distribution agreements with independent
distributors to sell and market the Arthroscopic Systems in Europe,
Australia, Mexico, Brazil, Argentina, Canada, Taiwan, South Africa,
Israel, Japan and Korea. In other international markets, the company
intends to collaborate with one or more marketing partners to establish
marketing and distribution channels for the Arthroscopic System and to
assist with regulatory requirements in such distributors' jurisdictions.
However, regulatory requirements vary by region, and compliance with
such regulations may be costly and time-consuming. Accordingly, the
distribution, pricing and marketing structure to be established by the
company may vary from country to country. In June 1998, the company
entered into a license agreement with Xomed whereby Xomed has the
exclusive worldwide distribution rights for ESS. For a description of
additional risks and uncertainties relating to Xomed's exclusive
worldwide distribution rights for ESS, see "ADDITIONAL FACTORS THAT
MIGHT AFFECT FUTURE RESULTS - Dependence on Collaborative Arrangements"
on pages 17 and 18 of this Quarterly Report on Form 10-Q.
No assurance can be given that the company will successfully sell
CSS directly, successfully sell its Arthroscopic System through its
distributors in Europe, Australia, Mexico, Brazil, Argentina, Canada,
Taiwan, South Africa, Israel, Japan or Korea, successfully sell ESS
through Xomed, that the company will secure marketing partners for other
international markets, successfully sell its products in international
markets or that any of its international distributors and marketing
partners will commit the necessary resources to obtain additional
necessary international regulatory approvals on behalf of the company
and successfully sell the Arthroscopic System or other products in
international markets.
Limited Manufacturing Experience
The company's manufacturing operations consist of an in-house
assembly operation for the manufacturing of ArthroWands, and a separate
in-house operation for the manufacturing of the System 2000 controllers.
The company's products are manufactured from several components, some of
which are supplied to the company by third parties. Manufacture of the
System 2000 controller, of which an earlier version was manufactured by
a third party, was brought in-house in 1997 for the purposes of
maintaining process control, managing availability, and leveraging fixed
costs.
In December 1997, the company started manufacturing and selling
its System 2000 controllers. As a result, the company has limited
experience manufacturing controllers in the volumes necessary for the
company to achieve additional commercial sales, and there can be no
assurance that reliable, high-volume manufacturing can be achieved at a
commercially reasonable cost. In addition, there can be no assurance
that the company or its suppliers will not encounter any manufacturing
difficulties, including problems involving regulatory compliance,
product recalls, production yields, quality control and assurance,
supplies of components or shortages of qualified personnel.
In April 1998, the company started manufacturing its System 5000
controllers for cosmetic surgery and only a small number of this model
controllers has been manufactured and sold. In the same time period,
the company began to manufacture limited numbers of disposable wands for
ENT and cosmetic surgery applications. As a result, the company has
limited experience manufacturing its current products for ENT and
cosmetic surgery in the volumes necessary for the company to achieve
commercial sales, and there can be no assurance that reliable, high-
volume manufacturing for these products can be achieved at a
commercially reasonable cost. In addition, there can be no assurance
that the company or its suppliers will not encounter any manufacturing
difficulties, including problems involving regulatory compliance,
product recalls, production yields, quality control and assurance,
supplies of components or shortages of qualified personnel.
The company and its component suppliers are required to operate in
conformance with Quality System Regulation (QS Regulations)
requirements, in order to produce products for sale in the United
States, and ISO 9001 standards, in order to produce products for sale in
Europe. There can be no assurance that the company or its component
suppliers will remain in compliance with QS Regulations or ISO 9001
standards. Any failure by the company or its component suppliers to
remain in compliance with QS Regulation or ISO 9001 standards could have
a material adverse effect on the company's business, financial condition
and results of operations.
The cable used to connect the disposable wands to the controllers
for CSS and ESS are manufactured by a single contract manufacturer. In
addition, the ArthroWand is sterilized by a single subcontractor and the
connector housings at each end of the cable in the Arthroscopic System
are supplied from a single source. There can be no assurance that an
alternate contract manufacturer, sterilizer or connector housing
supplier could be established if necessary or that available inventories
would be adequate to meet the company's product needs during any
prolonged interruption of supply. The company's inability to secure an
alternative contract manufacturer or sterilizer, if required, would
limit its ability to manufacture the company's Arthroscopic System, CSS
and/or ESS and would have a material adverse effect on the company's
business, financial condition and results of operations.
In connection with regulatory inspections of the company's
manufacturing facility in Sunnyvale, California, the FDA issued the
company FDA Form 483, which detailed specific areas where the FDA
observed that the company's operations were not in full compliance with
some areas of QS Regulations. The company has responded to the FDA and
has implemented corrective changes and believes that it is in good
standing with the FDA.
History of Losses; Fluctuations in Operating Results; Losses Expected to
Continue
The company has experienced significant operating losses since
inception and, as of July 4, 1998, had an accumulated deficit of $26.1
million. The company expects to generate additional losses due to
increased operating expenditures primarily attributable to the expansion
of marketing and sales activities, the launch of additional product
lines (including CSS and ESS), increased research and development and
activities to support regulatory applications. Results of operations
may fluctuate significantly from quarter to quarter due to the timing of
such expenditures, absence of a backlog of orders, timing of the receipt
of orders, promotional programs for the company's products. The
company's revenues and profitability will be critically dependent on
whether it can successfully continue to market its soft-tissue surgery
systems. In addition, the company's gross margins may be adversely
affected due to the necessity to promote and sell its products at
significantly reduced prices. There can be no assurance that
significant profitability will ever be achieved.
Patents and Proprietary Rights
The company's ability to compete effectively depends in part on
developing and maintaining the proprietary aspects of its platform
Coblation technology. The company owns eleven issued United States
patents, more than 40 pending United States patent applications and
international patent applications in Europe (covering 16 separate
countries), Japan, Canada, Australia and New Zealand corresponding to
eight of the United States filings relating to its Coblation technology.
The initial patent is currently set to expire in 2008, three issued
patents are currently expected to expire between 2008 and 2012 and the
other seven patents are expected to expire between 2014 and 2016. The
company believes that the issued patents cover both the core technology
used in the company's soft-tissue surgery systems, including both
multielectrode and single-electrode configurations of its wand tools, as
well as the use of Coblation technology in specific surgical procedures.
There can be no assurance that the patents that have been issued
to the company or any patents which may be issued as a result of the
company's United States or international patent applications will
provide any competitive advantages for the company's products or that
they will not be successfully challenged, invalidated or circumvented in
the future. In addition, there can be no assurance that competitors,
many of which have substantial resources and have made significant
investments in competing technologies, will not seek to apply for and
obtain patents that will prevent, limit or interfere with the company's
ability to make, use and sell its products either in the United States
or in international markets.
A number of medical device and other companies, universities and
research institutions have filed patent applications or have issued
patents relating to monopolar and/or bipolar electrosurgical methods and
apparatus. If third-party patents or patent applications contain claims
infringed by the company's technology and such claims are ultimately
determined to be valid, there can be no assurance that the company would
be able to obtain licenses to those patents at a reasonable cost, if at
all, or be able to develop or obtain alternative technology, either of
which would have a material adverse effect on the company's business,
financial condition and results of operations. There can be no
assurance that the company will not be obligated to defend itself in
court against allegations of infringement of third-party patents.
In addition to patents, the company relies on trade secrets and
proprietary know-how, which it seeks to protect, in part, through
confidentiality and proprietary information agreements. The company
requires its key employees and consultants to execute confidentiality
agreements upon the commencement of an employment or consulting
relationship with the company. These agreements generally provide that
all confidential information, developed or made known to the individual
by the company during the course of the individual's relationship with
the company, is to be kept confidential and not disclosed to third
parties. These agreements also generally provide that inventions
conceived by the individual in the course of rendering services to the
company shall be the exclusive property of the company. There can be no
assurance that such agreements will not be breached, that the company
would have adequate remedies for any breach or that the company's trade
secrets will not otherwise become known to or be independently developed
by competitors.
Patent Litigation
The medical device industry has been characterized by extensive
litigation regarding patents and other intellectual property rights, and
companies in the medical device industry have employed intellectual
property litigation to gain a competitive advantage. There can be no
assurance that the company will not become subject to patent
infringement claims or litigation or interference proceedings declared
by the United States Patent and Trademark Office ("USPTO") to determine
the priority of inventions. On February 13, 1998 the company filed a
lawsuit (the "Lawsuit") against Ethicon, Inc., Mitek Surgical Products,
a division of Ethicon, Inc. and GyneCare, Inc. alleging among other
things, infringement of several of the company's patents. See Part II,
Item 1 of this Quarterly Report on Form 10-Q. The defense and
prosecution of the Lawsuit and intellectual property suits generally,
USPTO interference proceedings and related legal and administrative
proceedings are both costly and time-consuming. The company believes
that the Lawsuit is necessary and if others violate the proprietary
rights of the company, further litigation may be necessary to enforce
patents issued to the company, to protect trade secrets or know-how
owned by the company or to determine the enforceability, scope and
validity of the proprietary rights of others. Any litigation or
interference proceedings will result in substantial expense to the
company and significant diversion of effort by the company's technical
and management personnel. An adverse determination in the Lawsuit or
other litigation or interference proceedings to which the company may
become a party could subject the company to significant liabilities to
third parties, require disputed rights to be licensed from third parties
or require the company to cease using such technology. Although patent
and intellectual property disputes in the medical device area have often
been settled through licensing or similar arrangements, costs associated
with such arrangements may be substantial and could include ongoing
royalties. Furthermore, there can be no assurance that necessary
licenses would be available to the company on satisfactory terms, if at
all. Adverse determinations in a judicial or administrative proceeding
or failure to obtain necessary licenses could prevent the company from
manufacturing and selling its products, which would have a material
adverse effect on the company's business, financial condition and
results of operations.
Competition
The arthroscopic medical device industry is intensely competitive.
The company competes with providers of laser systems, electrosurgical
systems, manual instruments and power shavers. Many of these competitors
have significantly greater financial, manufacturing, marketing,
distribution and technical resources than the company. There can be no
assurance that the company can effectively compete against such
competitors. In addition, there can be no assurance that these or other
companies will not succeed in developing technologies and products that
are more effective than the company's or that would render the company's
technology or products obsolete or uncompetitive.
Smith & Nephew Endoscopy, Inc. (which owns Acufex Microsurgical,
Inc. and Dyonics, Inc.), Conmed Corporation (including its Linvatec
unit) and Stryker Corp. each have large shares of the market for manual
instruments, power shavers and arthroscopes. These companies offer broad
product lines, which they may offer as a single package; have
substantially greater resources and name recognition than the company;
and frequently offer significant discounts as a competitive tactic. In
addition, United States Surgical Corporation (including its Valley Labs
unit) and Conmed Corporation each have large shares of the market for
electrosurgical systems, and Trimedyne, Inc. and Coherent, Inc. each
have large shares of the market for laser systems. The company expects
that competition from these and other well-established competitors will
increase as will competition from start-up and development stage medical
device companies such as Gyrus Medical Ltd., a company based in the
United Kingdom, and Oratec Interventions, Inc., a company based in Menlo
Park, California. The company is aware that Johnson & Johnson (including
its Ethicon unit) is marketing a bipolar electrosurgical tool developed
by Gyrus Medical Ltd. In order to successfully compete in the
arthroscopic medical device industry, the company anticipates that it
may have to continue to offer substantial discounts on its controller in
order to increase demand for the disposable ArthroWand, and that such
competition could have a material adverse effect on the company's
business, financial condition and results of operations. Furthermore,
certain of the company's competitors, including Ethicon utilize
purchasing contracts that link discounts on the purchase of one product
to purchases of other products in their broad product lines. Many of
the hospitals in the United States have purchasing contracts with such
competitors of the company. Accordingly, customers may be dissuaded
from purchasing the company's products rather than the products of such
competitors to the extent the purchase would cause them to lose
discounts on products that they regulary purchase from such competitors.
The ENT medical device industry is rapidly becoming more
competitive. The company has an exclusive license and distribution
agreement with Xomed, which is currently the largest company focused
solely on the ENT market, see "ADDITIONAL FACTORS THAT MIGHT AFFECT
FUTURE RESULTS - Dependence on Collaborative Arrangements" on pages 17
and 18 of this Quarterly Report on Form 10-Q. However, other large
companies, such as Smith & Nephew, Stryker Corp. and Conmed Corporation
(including its Linvatec unit) each have shares of the market for manual
instruments, such as microdebriders for endoscopic sinus surgery. The
company expects that competition from these and other well-established
competitors will increase as will competition from start-up and small
cap medical device companies, such as Somnus Medical Technologies, a
company based in Sunnyvale, California, Elmed Inc. of Addison, Illinois
and Ellman International, Inc. of Hewlett, New York. Somnus
manufactures and sells medical devices that utilize RF technology for
the treatment of upper airway disorders, such as snoring, enlarged
turbinates, and obstructive sleep apnea. Elmed and Ellman both
manufacture and sell a variety of medical devices that use conventional
RF technology for tissue dessication, cutting and/or coagulation in
turbinate surgery, the treatment of snoring and other ENT procedures.
The cosmetic surgery industry includes a number of large and well
established companies that provide devices for rejuvenating facial skin,
hair removal, scar removal, the treatment of vascular and pigmented
lesions and other applications, including companies that manufacture
and sell dermabrasion equipment or chemical peels, and companies that
manufacture and sell CO2 and Er:YAG lasers. In skin resurfacing, the
company will directly compete with much larger companies that
manufacture lasers for medical use, such as Coherent Medical Group of
Santa Clara, California and ESC Medical Systems of Tel Aviv, Isreal.
ESC recently merged with Laser Industries, Ltd, already one of the
largest medical laser manufacturers in the world. The combined company
develops and markets lasers for a broad range of cosmetic applications
including the non-invasive treatment of varicose veins and other benign
vascular lesions, hair removal, skin rejuvenation, laser assisted
uvuloplasty (LAUP). In addition, other large companies manufacture and
sell medical devices that use RF energy for certain applications in
dermatology and cosmetic surgery. One such company is Conmed
Corporation, which currently sells medical devices for
electrodessication, fulguration and coagulation in office based
dermatology procedures.
The company has received 510(k) premarket notifications for
clearance to market tissue ablation products to treat certain
urological, periodontal, dermatological, ear/nose/throat and general
surgical conditions and has filed 510(k) premarket notification for
clearance to market products for gynecological conditions; the FDA has
indicated that the 510(k) submission for certain gynecological
conditions must be supported by data from clinical trials. These fields
are intensely competitive and no assurance can be given that these
potential products, if approved, would be successfully marketed.
Uncertainty of Approvals; Extensive Governmental Regulation
United States
The company's products are regulated in the United States as
medical devices by the FDA under the Federal Food, Drug, and Cosmetic
Act (FDC Act) and require premarket clearance or approval by the FDA
prior to commercialization. In addition, certain material changes or
modifications to medical devices also are subject to FDA review and
clearance or approval. Pursuant to the FDC Act, the FDA regulates the
research, testing, design, manufacture, safety, labeling, storage,
record keeping, advertising, distribution and production of medical
devices in the United States. Noncompliance with applicable requirements
can result in warning letters, fines, injunctions, civil penalties,
recall or seizure of products, total or partial suspension of
production, failure of the government to grant premarket clearance or
premarket approval for devices, and criminal prosecution. Failure to
comply with the regulatory requirements could have a material adverse
effect on the company's business, financial condition and results of
operations.
Generally, before a new device can be introduced into the market
in the United States, the manufacturer or distributor must obtain FDA
clearance of a 510(k) notification or approval of a premarket approval
application (PMA). If a medical device manufacturer or distributor can
establish that a device is "substantially equivalent" to a legally
marketed Class I or Class II device, or to a Class III device for which
the FDA has not called for PMAs, the manufacturer or distributor may
seek clearance from the FDA to market the device by filing a 510(k)
notification. The 510(k) notification will need to be supported by
appropriate data establishing the claim of substantial equivalence to
the satisfaction of the FDA. The FDA recently has been requiring a more
rigorous demonstration of substantial equivalence. Following submission
of the 510(k) notification, the manufacturer or distributor may not
place the device into commercial distribution until an order is issued
by the FDA. At this time, the FDA typically responds to the submission
of a 510(k) notification within 90 to 120 days, but it may take longer.
The FDA order may declare that the device is substantially equivalent to
another legally marketed device and allow the proposed device to be
marketed in the United States. The FDA, however, may determine that the
proposed device is not substantially equivalent or require further
information, including clinical data, to make a determination regarding
substantial equivalence. Such determination or request for additional
information could be costly and delay market introduction of the
products that are the subject of the 510(k) notification.
The company has received clearance of 510(k) premarket
notifications to market its Arthroscopic System for surgery of the knee,
shoulder, elbow, wrist, hip and ankle joints. In addition, the company
has received 510(k) premarket notifications to market CSS in general
dermatology procedures and is pursuing additional clearances that will
allow CSS to be marketed in the United States specifically for wrinkle
removal. With respect to ESS, the company has received clearance of
510(k) premarket notifications to market ESS in general head and neck
surgical procedures, and has received labeling approval that will allow
ESS to be marketed in the United States for certain specific indications
while it is pursuing additional clearances for certain other
indications. There can be no assurance that the company will be able to
obtain necessary clearances or approvals to market any other products on
a timely basis, if at all, and delays in receipt or failure to receive
such clearances or approvals, the loss of previously received clearances
or approvals, or failure to comply with existing or future regulatory
requirements could have a material adverse effect on the company's
business, financial condition and results of operations.
If a manufacturer or distributor of medical devices cannot
establish that a proposed device is substantially equivalent to a
legally marketed device, the manufacturer or distributor must seek
premarket approval of the proposed device through submission of a PMA
application. The PMA application approval process can be expensive,
uncertain and lengthy. A number of devices for which premarket approval
has been sought have never been approved for marketing. The review time
is often significantly extended by the FDA, which may require more
information or clarification of information already provided in the
submission. In addition, the FDA will inspect the manufacturing facility
prior to approval to ensure compliance with the FDA's QS Regulations.
If granted, the approval of the PMA application may include significant
limitations on the indicated uses for which a product may be marketed.
If necessary, the company may file a PMA application with the FDA
for approval to sell its potential products commercially in the United
States when it has developed such products. There can be no assurance
that the company will be able to obtain necessary PMA application
approvals to market such products on a timely basis, if at all, and
delays in receipt or failure to receive such approvals, the loss of
previously received approvals, or failure to comply with existing or
future regulatory requirements could have a material adverse effect on
the company's business, financial condition and results of operations.
The company is also required to register as a medical device
manufacturer with the FDA and state agencies, such as the California
Department of Health Services (CDHS) and to list its products with the
FDA. As such, the company is subject to periodic inspections by both the
FDA and the CDHS for compliance with the FDA's QS Regulations and other
applicable regulations. These regulations require that the company
maintain its documents in a prescribed manner with respect to
manufacturing, testing and control activities. There can be no
assurance that the company will not encounter any manufacturing
difficulties, or that they will not experience difficulties, including
problems involving regulatory compliance, product recalls, production
yields, quality control and assurance, supplies of components or
shortages of qualified personnel.
Regulations regarding the manufacture and sale of the company's
products are subject to change. The company cannot predict the effect,
if any, that such changes might have on its business, financial
condition or results of operations.
International
International sales of the company's products are subject to the
regulatory agency product registration requirements of each country. The
regulatory review process varies from country to country. The company
has obtained regulatory clearance to market the Arthroscopic System in
Australia, Europe, Canada and Mexico, to market CSS in Europe and Canada
and is currently seeking approval for ESS in Europe but has not obtained
any other international regulatory approvals permitting sales of its
products outside of the United States. The company is seeking and
intends to seek regulatory approvals in certain other international
markets. There can be no assurance, however, that such approvals will be
obtained on a timely basis or at all.
For European distribution, the company has received ISO 9001
certification and the CE mark. ISO 9001 certification standards for
quality operations have been developed to ensure that companies know, on
a worldwide basis, the standards of quality to which they will be held.
The European Union has promulgated rules requiring medical products to
receive the CE mark, an international symbol of quality and compliance
with applicable European medical device directives. Failure to maintain
the CE mark will prohibit the company from selling its products in
Europe. ISO 9001 certification in conjunction with demonstrated
performance to the medical device directive is one of the alternatives
available to meet the CE mark requirements. There can be no assurance
that the company will be successful in maintaining certification
requirements.
Uncertainty Relating to Third-Party Reimbursement
In the United States, health care providers, such as hospitals and
physicians, that purchase medical devices, such as the company's
products, generally rely on third-party payors, principally federal
Medicare, state Medicaid and private health insurance plans, to
reimburse all or part of the cost of the procedure in which the medical
device is being used. Reimbursement for arthroscopic, cosmetic and ENT
procedures performed using devices that have received FDA approval has
generally been available in the United States. In addition, certain
health care providers are moving toward a managed care system in which
such providers contract to provide comprehensive health care for a fixed
cost per person. Managed care providers are attempting to control the
cost of health care by authorizing fewer elective surgical procedures,
such as certain knee and shoulder, ankle, wrist, elbow and hip
arthroscopic procedures.
The company is unable to predict what changes will be made in the
reimbursement methods used by third-party health care payors. The
company anticipates that in a prospective payment system, such as the
diagnosis related group (DRG) system utilized by Medicare, and in many
managed care systems used by private health care payors, the cost of the
company's products will be incorporated into the overall cost of the
procedure and that there will be no separate, additional reimbursement
for the company's products. The company anticipates that hospital
administrators and physicians will justify the use of the company's
products by the apparent cost savings and clinical benefits that the
company believes will be derived from the use of its products. However,
there can be no assurance that this will be the case. Furthermore, the
company could be adversely affected by changes in reimbursement policies
of governmental or private health care payors, particularly to the
extent any such changes affect reimbursement for procedures in which the
company's products are used. Failure by physicians, hospitals and other
users of the company's products to obtain sufficient reimbursement from
health care payors for procedures in which the company's products are
used or adverse changes in governmental and private third-party payors,
policies toward reimbursement for such procedures would have a material
adverse effect on the company's business, financial condition and
results of operations.
If the company obtains the necessary international regulatory
approvals , market acceptance of the company's products in international
markets would be dependent, in part, upon the availability of
reimbursement within prevailing health care payment systems.
Reimbursement and health care payment systems in international markets
vary significantly by country, and include both government-sponsored
health care and private insurance. The company intends to seek
international reimbursement approvals, although there can be no
assurance that any such approvals will be obtained in a timely manner,
if at all.
Uncertainty of New Product Development
The company has undertaken preliminary animal studies and
development for the use of its Coblation technology with its controller
in several fields. The company has received 510(k) clearance for use of
its technology in certain of these fields. The company has received
approval of an Investigational Device Exemption (IDE) to conduct a
clinical study on a specific indication. Following the completion of
this study, the company may submit a 510(k) application to the FDA.
Each of the company's potential products that may result from
these investigations are in early stages of development, and the company
may be required to undertake time-consuming and costly development
activities and seek regulatory approval of these devices. There can be
no assurance that product development will ever be successfully
completed, that PMA or 510(k) application, if applied for, will be
granted by the FDA on a timely basis, if at all, or that the products
will ever achieve commercial acceptance. Failure by the company to
develop, obtain necessary regulatory approval for or to successfully
market new products could have a material adverse effect on the
company's business, financial condition and results of operations.
Product Liability Risk; Limited Insurance Coverage
The development, manufacture and sale of medical products entail
significant risk of product liability claims. The company's current
product liability insurance coverage limits are $7,000,000 per
occurrence and $7,000,000 in the aggregate. There can be no assurance
that such coverage limits are adequate to protect the company from any
liabilities it might incur in connection with the development,
manufacture and sale of its products. In addition, the company may
require increased product liability coverage if any potential products
are successfully commercialized. Product liability insurance is
expensive and in the future may not be available to the company on
acceptable terms, if at all. The company has been selling its
Arthroscopic System since December 1995 and recently commenced sales of
CSS and ESS and has not experienced any product liability claims to
date. However, a successful product liability claim or series of claims
brought against the company in excess of its insurance coverage could
have a material adverse effect on the company's business, financial
condition and results of operations.
Dependence on Key Personnel and Key Consultants
The company is dependent upon a number of key management and
technical personnel. The loss of the services of one or more key
employees or consultants could have a material adverse effect on the
company. The company's success will also depend on its ability to
attract and retain additional highly qualified management and technical
personnel. The company faces intense competition for qualified
personnel, many of whom are often subject to competing employment
offers, and there can be no assurance that the company will be able to
attract and retain such personnel. Furthermore, the company's
scientific advisory board members all are otherwise employed on a
full-time basis. As a result, the scientific advisory board members are
not available to devote their full time or attention to the company's
affairs.
Control by Directors, Executive Officers and Affiliated Entities
The company's directors, executive officers and entities
affiliated with them, in the aggregate, beneficially own approximately
45% of the company's common stock. These stockholders, if acting
together, will have significant influence over all matters requiring
approval by the stockholders of the company, including the election of
directors and the approval of mergers or other business combination
transactions.
Potential Volatility of Stock Price
The stock markets have experienced price and volume fluctuations
that have particularly affected medical technology companies, resulting
in changes in the market prices of the stocks of many companies that may
not have been directly related to the operating performance of those
companies. Such broad market fluctuations may adversely affect the
market price of the company's common stock. In addition, the market
price of the company's common stock may be highly volatile. Factors
such as variations in the company's financial results, comments by
security analysts, announcements of technological innovations or new
products by the company or its competitors, changing government
regulations and developments with respect to FDA submissions, patents,
proprietary rights or litigation may have a significant adverse effect
on the market price of the common stock.
Anti-Takeover Effect of Stockholder Rights Plan and Certain Charter and
Bylaw Provisions
In November 1996, the company's Board of Directors adopted a
Stockholder Rights Plan. The Stockholder Rights Plan provides for a
dividend distribution of one Preferred Shares Purchase Right (a Right)
on each outstanding share of the company's common stock. Each Right
entitles shareholders to buy 1/1000th of a share of the company's Series
A participating preferred stock at an exercise price of $50.00. The
Rights will become exercisable following the tenth day after a person or
group announces acquisition of 15% or more of the company's common
stock, or announces commencement of a tender offer, the consummation of
which would result in ownership by the person or group of 15% or more of
the company's common stock. The company will be entitled to redeem the
Rights at $0.01 per Right at any time on or before the tenth day
following acquisition by a person or group of 15% or more of the
company's common stock.
The Stockholder Rights Plan and certain provisions of the
company's Certificate of Incorporation and Bylaws may have the effect of
making it more difficult for a third party to acquire, or of
discouraging a third party from attempting to acquire control of the
company. This could limit the price that certain investors might be
willing to pay in the future for shares of the company's common stock.
Certain provisions of the company's Certificate of Incorporation and
Bylaws allow the company to issue preferred stock without any vote or
further action by the stockholders, eliminate the right of stockholders
to act by written consent without a meeting, specify procedures for
director nominations by stockholders and submission of other proposals
for consideration at stockholder meetings, and eliminate cumulative
voting in the election of directors. Certain provisions of Delaware law
applicable to the company could also delay or make more difficult a
merger, tender offer or proxy contest involving the company, including
Section 203, which prohibits a Delaware corporation from engaging in any
business combination with any interested stockholder for a period of
three years unless certain conditions are met. The Stockholder Rights
Plan, the possible issuance of preferred stock, the procedures required
for director nominations and stockholder proposals and Delaware law
could have the effect of delaying, deferring or preventing a change in
control of the company, including without limitation, discouraging a
proxy contest or making more difficult the acquisition of a substantial
block of the company's common stock. These provisions could also limit
the price that investors might be willing to pay in the future for
shares of the company's common stock.
Lack of Dividends
The company has not paid any dividends and does not anticipate
paying any dividends in the foreseeable future
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
On February 13, 1998, the company filed a lawsuit against Ethicon, Inc.
Mitek Surgical Products, a division of Ethicon, Inc. and GyneCare, Inc.
("the Defendants") in the United States District Court for the Northern
District of California. The lawsuit alleges, among other things, that
the Defendants have been and are currently infringing four patents
issued to the company in December 1997. Specifically, the Defendants
use, market and sell two separate electrosurgical systems under the
names of "VAPR" and "VersaPoint" which infringe these patents. The
company seeks: (1) a judgment that the Defendants have infringed these
patents; (2) to preliminarily and permanently restrain and enjoin the
Defendants from marketing and selling the VAPR and VersaPoint systems;
and (3) an award of damages (including attorneys' fees) to compensate
the company for lost profits, the damages to be trebled because of the
Defendants' willful infringement. In addition, the company filed a
motion on March 5, 1998 for preliminary injunction against the
Defendants marketing and selling of the VAPR system. On June 15, 1998,
the court held a claim construction hearing ("Markman hearing") to
determine the meaning of the claims of the patents in suit as a matter
of law. On July 6, 1998, the court issued a Memorandum Decision and
Order in which all of the claims were construed in ArthroCare's favor.
Item 2. Changes in Securities
None
Item 3. Defaults upon Senior Securities
None
Item 4. Submission of Matters to a Vote of Security Holders
With respect to stockholder proposals not included in the
company's proxy statement for the 1999 Annual Meeting of Stockholders,
the persons named in management's proxy for the 1999 Annual Meeting of
Stockholders will be entitled to exercise the discretionary voting power
conferred by such proxy under the circumstances` specified in Rule 14a-
4(c ) under the Securities Exchange Act of 1934, as amended, including
with respect to proposals received by the company within forty-five (45)
days of the date of mailing of the proxy statement for the 1999 Annual
Meeting of Stockholders.
Item 5. Other Information
The annual meeting of stockholders was held May 21, 1998.
Matters voted on at that meeting were (i) the election of six directors,
(ii) the approval of an amendment to the company's Incentive Stock Plan
to increase the number of shares of Common Stock reserved for issuance
thereunder by 750,000 shares and (iii) the ratification of the
appointment of PricewaterhouseCoopers LLP as the Company's independent
auditors for the fiscal year ending January 2, 1999. Tabulation for
each proposal and individual directors were as follows:
PROPOSAL I. ELECTION OF DIRECTORS
VOTES
NOMINEE VOTES WITHHELD
- ---------------------------- ---------- ---------
Michael A. Baker 7,764,068 166,061
Hira V. Thapliyal 7,764,068 166,061
Philip E. Eggers 7,763,918 166,211
Annette J. Campbell-White 7,763,879 166,250
C. Raymond Larkin Jr. 7,763,379 166,750
John S. Lewis 7,762,729 167,400
Robert R. Momsen 7,762,879 167,250
PROPOSAL II. APPROVAL OF AMENDMENT TO INCENTIVE STOCK PLAN
VOTES
---------
FOR 5,718,221
AGAINST 691,029
BROKER NON-VOTE 19,876
PROPOSAL III. RATIFICATION OF APPOINTMENT OF PRICEWATERHOUSECOOPERS LLP
VOTES
---------
FOR 7,884,860
AGAINST 16,250
BROKER NON-VOTE 17,885
Item 6. Exhibits and Reports on Form 8 - K
a) Exhibits
3.2 (1) Certificate of Incorporation of the Registrant.
3.3 (1) Bylaws of the Registrant.
4.1 (1) Specimen Common Stock Certificate.
10.1 (1) Form of Indemnification Agreement between the Registrant and each of
its directors and officers.
10.2 (1) Incentive Stock Plan and form of Stock Option Agreement thereunder.
10.3 (1) Director Option Plan and form of Director Stock Option Agreement
thereunder.
10.4 (1) Employee Stock Purchase Plan and forms of agreements thereunder.
10.5 (1) Form of Exclusive Distribution Agreement.
10.6 (1) Form of Exclusive Sales Representative Agreement.
10.7 (1) Consulting Agreement, dated May 10, 1993, between the Registrant and
Philip E. Eggers, and amendment thereto.
10.8 (1) Consulting Agreement, dated May 20, 1993, between the Registrant and
Eggers & Associates, Inc., and amendment thereto.
10.9 (1)+ Development and Supply Agreement, dated March 1, 1994, between the
Registrant and SeaMed Corporation.
10.10 (1) Lease Agreement, dated September 15, 1994, between Registrant and The
Arrillaga Foundation and the Perry Foundation for the Registrant's
facility located at 595 North Pastoria Avenue, Sunnyvale, California
94086.
10.11 (1) Employment Letter Agreement, dated October 21, 1994, between the
Registrant and Allan Weinstein and amendment thereto.
10.12 (1) Purchase Assistance Promissory Note, dated January 19, 1995, between
Registrant and Allan Weinstein.
10.13 (1) Sublease Agreement, dated February 1, 1995, between Registrant and
Guided Medical Systems, Inc. for the Registrant's former facility at
453 Ravendale Drive, Mountain View, California 94043.
10.14 (1) Mortgage Assistance Promissory Note Agreement, dated February 5,
1995, between the Registrant and Allan Weinstein.
10.15 (1) Restricted Stock Purchase and Security Agreement, dated February 5,
1995, between the Registrant and Allan Weinstein.
10.16 (1) Employment Letter Agreement, dated July 18, 1995, between the
Registrant and Robert T. Hagan.
10.17 (1) Restricted Stock Purchase and Security Agreement, dated August 1,
1995, between the Registrant and Robert T. Hagan.
10.18 (1) Employment Letter Agreement, dated September 3, 1995, between the
Registrant and A. Larry Tannenbaum.
10.19 (1) + Radiation Services Agreement, dated September 13, 1995, between
the Registrant and SteriGenics International.
10.20 (1) Amended and Restated Stockholder Rights Agreement, dated October 16,
1995, between the Registrant and certain holders of the Registrant's
securities.
10.21 (1) Contribution Agreement, dated March 31, 1995, by and among Philip E.
Eggers, Robert S. Garvie, Anthony J. Manlove, Hira V. Thapliyal and
the Registrant.
10.22 (2) Preferred Stock Rights Agreement, dated November 14, 1996, between
the Registrant and Norwest Bank Minnesota, N.A.
10.23 (3) + Exclusive Distributor Agreement, dated April 15, 1997, between the
Registrant and Arthrex, Gmbh.
10.24 (4) Employment Letter Agreement, dated June 20, 1997, between the
Registrant and Michael A. Baker.
10.25 (5) + Exclusive Distributor Agreement, dated August 21, 1997, between the
Registrant and Kobayashi Pharmaceutical Company, Ltd.
10.26 (6) + License Agreement dated February 9, 1998, between the Registrant
and Boston Scientific Corporation.
10.27 (6) + Development and Supply Agreement dated February 9, 1998, between
the Registrant and Boston Scientific Corporation.
10.28 (6) Lease Agreement dated March 25, 1998 between the Registrant and Aetna
Life Insurance company for the Registrant's facility located at 840
Del Rey Avenue, Sunnyvale, California 94086.
10.29 ++ Term sheet for License and Distribution Agreement between Xomed
Surgical Products and the Registrant dated June 25, 1998.
27.1 Financial Data Schedule.
(1) Incorporated herein by reference to the same-numbered exhibit
previously filed with the Registrant's Registration Statement on
Form S-1 (Registration No. 33-80453).
(2) Incorporated herein by reference to Exhibit 5 previously filed
with the Registrant's Registration Statement on Form 8-A
(Registration No. 000-27422).
(3) Incorporated herein by reference to the same-numbered exhibit
previously filed with the Registrant's Quarterly Report on Form
10-Q for the period ended March 29, 1997.
(4) Incorporated herein by reference to the same-numbered exhibit
previously filed with the Registrant's Quarterly Report on Form
10-Q for the period ended June 28, 1997.
(5) Incorporated herein by reference to the same numbered exhibit
previously filed with the Registrant's Quarterly Report on Form
10-Q for the period ended September 27, 1997.
(6) Incorporated herein by reference to the same numbered exhibit
previously filed with the Registrant's Annual Report on Form 10-K
for the year ended January 3, 1998.
+ Confidential treatment granted.
++ Confidential treatment requested.
b) Reports on Form 8-K
None
<PAGE>
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
ARTHROCARE CORPORATION
a Delaware corporation
Date: August 18, 1998
/s/ CHRISTINE E. HANNI
Christine E. Hanni
Vice President of Finance,
Chief Financial Officer and
Assistant Secretary
(Principal Financial Officer
and Accounting Officer)
Date: August 18, 1998
/s/ MICHAEL A. BAKER
Michael A. Baker
President, Chief Executive
Officer and Director
(Principal Executive Officer)
<PAGE>
EXHIBIT INDEX
Exhibit
Number Exhibit Description
10.29 Term sheet for License and Distribution Agreement between Xomed
Surgical Products and the Registrant dated June 25, 1998.
27.1 Financial Data Schedule.
CONFIDENTIAL
TERM SHEET
LICENSE AND DISTRIBUTION AGREEMENT
BETWEEN XOMED AND ARTHROCARE
June 25, 1998
1. License Grant: ArthroCare shall grant to Xomed an exclusive,
worldwide, non-transferable, license, without the right of sublicense or
right to manufacture,under the Intellectual Property Rights, with the
right to use, market, sell and distribute ArthroCare's Products (as
defined in section 3) solely for use in the Field ("License Rights").
The Field shall mean the use of Coblation TM technology in
Otorhinolaryngology and head and neck procedures, and ENT surgeons in
the AAFPRS that practice facial plastic surgery.
The Intellectual Property Rights shall include all of ArthroCare's
patents and patent applications in the Field and all of ArthroCare's
registered trademarks and trademark applications in the Field.
ArthroCare will have direct access to Xomed accounts to gain market and
clinical feedback.
Under the License Rights, ArthroCare will have the initial right, but
not the obligation, to enforce the Intellectual Property Rights
including the right to sue for patent infringement. In the event
ArthroCare chooses not to initiate any Action involving the License
Rights, Xomed shall have the right, but not the obligation, to enforce
these rights.
2. License Consideration: In consideration for the exclusive nature of
the license and distribution agreement, Xomed will pay ArthroCare a
License Fee of [*****] shall be non-refundable even in the event of a
Xomed termination as outlined in section 11. During the period between
the execution of the term sheet and the execution of the definitive
agreement, the parties will rely upon and operate in good faith under
this term sheet as outlined in section 14.
The remaining [*****] of the License Fee shall be payable to ArthroCare
based upon the first achievement of each of the following milestones:
[*****]
*Conversion Units will allow ArthroCare and ENTec Model 2000 Controllers
to be used for dermatology and cosmetic surgery.
In addition to the License Fee, Xomed will pay running royalties on
ArthroCare Disposable Wands sold by Xomed. The running royalties shall
be [*****]of the Net Sales of Disposable Wands, payable on a quarterly
basis.
"Net Sales" shall mean revenues on an accrual basis, in accordance with
U.S. generally accepted accounting principles, as follows: the invoice
price of ArthroCare Disposable Wands sold by Xomed to third parties
(including sales made in connection with clinical trials), less, to the
extent included in such invoice price the total of: (a) ordinary and
customary trade discounts actually allowed; (b) credits, rebates and
returns (including, but not limited to, wholesaler and retailer
returns); (c) freight, postage, insurance and duties paid for and
separately identified on the invoice or other documentation maintained
in the ordinary course of business, and (d) excise taxes, other
consumption taxes, customs duties and compulsory payments to
governmental authorities actually paid and separately identified on the
invoice or other documentation maintained in the ordinary course of
business. Net Sales shall also include the fair market value of all
other consideration received by Xomed in respect of ArthroCare
Disposable Wands, whether such consideration is in cash, payment in
kind, exchange or another form.
3. Product Manufacture and Sale: ArthroCare will agree to manufacture
and sell to Xomed, and Xomed will agree to exclusively purchase from
ArthroCare, Xomed's requirements for Products in the Field. Products
shall include Controllers, Conversion Units, Cables (standard cable and
handpiece cable) and Disposable Wands, and ArthroCare will supply
Products to Xomed at the following prices:
System 2000 Controllers (incl.1 standard cable): [*****]
VisageT Conversion Units: [*****]
Disposable Wands: See Section 4
Rep. Cables: [*****]
[*****]
ArthroCare and Xomed recognize that the manufacturing cost of
Controllers may change as volumes increase, and as new models are
introduced. Accordingly, ArthroCare and Xomed agree to meet and discuss
new Controller pricing as ArthroCare introduces new models, and as
ArthroCare realizes manufacturing efficiencies.
4. Disposable Wand Transfer Price: ArthroCare will sell the
Disposable Wands identified below at the prices set forth below.
ArthroCare may add to this list from time to time as new products are
developed.
AccESST wands(9, 12 channel): [*****]
Plasma ScalpelT: [*****]
HummingbirdO Tip: [*****]
CollagENTO: [*****]
ReFLEXO: [*****]
Visage Stylet: [*****]
5. Forecasts and Stocking Order: : Xomed will make an initial stocking
order of [*****] upon the signing of the term sheet. [*****].
ArthroCare will agree to relabel these Controllers, at its expense, once
the Xomed labels are available, and the payment terms for these initial
[*****] Controllers shall be net 60 days. The mix of wands may be
selected by Xomed. During the course of the Agreement, Xomed shall
furnish ArthroCare with a 6-month forecast with estimated purchase dates
and quantities of Products, and shall deliver an updated forecast on a
monthly basis. The first two months of each forecast will
be binding on Xomed. ArthroCare agrees to use its best efforts to
support any demand that is higher than the forecast.
6. Product Development: ArthroCare, at its expense and initiative,
will continue to pursue clinical studies and product development efforts
in collaboration with Xomed. If Xomed requests additional product
development beyond ArthroCare's planned efforts, ArthroCare will provide
a budget for such product development based on its direct cost plus
[*****] for overhead.
7. Minimum Royalties: During each period specified below, in
addition to any payments of the License Fee in section 2, Xomed's
minimum running royalty payments for ENTec and Visage Disposable Wands
will total at least the following:
Q2-Q4 98: [*****]
Q1-Q4 99: [*****]
Q1-Q4 00: [*****]
Q1-Q4 01: [*****]
Q1-Q4 02: [*****]
[*****]
* Xomed is not required to actually sell the Disposable Wands during
this specified period. In this case, the parties can compute the
required minimum purchase based on average ASP during the specified
period.
8. Conflict of Interest: Xomed agrees that any efforts by Xomed
itself, or through its distributors, to sell Electrosurgical products
that compete with ArthroCare's products will constitute a breach of
Xomed's obligations to market ArthroCare's Products and consequently a
breach of this term sheet. ArthroCare recognizes that Xomed already
distributes RF products that are not competitive with ArthroCare's
products, and these existing products will be listed in the
definitive agreement and will be deemed non-competitive.
9. Visage: [*****]
10. Trademarks: ArthroCare has granted Xomed the right to use all of
ArthroCare's registered and pending trademarks and tradenames during the
term of this Agreement. In return, Xomed agrees to advertise and
promote the Products, where appropriate, under ArthroCare's trademarks
and tradenames. Notwithstanding the above, ArthroCare agrees to label
ENTec products sold to Xomed with the Xomed tradename.
11. Term and Termination: This agreement shall continue in full force
and effect for a period of five years from the effective date of this
term sheet, and will be automatically renewable on a yearly basis
thereafter provided that: [*****]
ArthroCare will have the right to terminate this agreement prior to that
time if Xomed fails to [*****]. If ArthroCare terminates this Agreement
for either of these reasons, ArthroCare shall [*****]. In addition,
ArthroCare shall [*****].
[*****]
12. Change of Control: Both parties agree not to acquire greater
than 15% of the other party's stock unless such acquisition is pursuant
to a friendly tender offer endorsed by the other party's board, or
unless such acquisition is in response to an unsolicited Change in
Control attempt by a third party. To the extent not prohibited under
applicable law, both parties shall use their best efforts to give the
other party not less than 30 days prior notice of any Change in
Control. All such information will be treated as confidential by the
receiving party. Notwithstanding any such Change in Control, both
parties shall continue to be obligated to perform its obligations under
this Agreement. However, both parties would have the option to
terminate this Agreement upon the Change in Control of either party, and
in such event, ArthroCare shall have the duty to buy back all
controllers owned by Xomed according to the formula in Section 11.
In addition, if ArthroCare terminates this agreement because of any such
change of control, ArthroCare shall be required to pay Xomed a
termination fee as described in section 11.
"Change in Control" means: (a) the sale, lease, exchange or other
transfer, directly or indirectly, of substantially all of the assets of
one of the parties (in one transaction or in a series of related
transactions) to one or more persons or entities that are not affiliates
of that party; (b) the approval by the shareholders of one of the
parties of any plan or proposal for its liquidation or dissolution; or
(c) a merger or consolidation of one of the parties if the shareholders
of that party immediately prior to the effective date of such merger or
consolidation have beneficial ownership, immediately following the
effective date of such merger or consolidation, of securities of
the surviving corporation representing 50% or less of the combined
voting power of the surviving corporation's then outstanding securities
ordinarily having the right to vote at elections of directors.
[*****]
13. Confidential Treatment: Other than disclosures that may be
required by securities or other applicable laws, both parties agree to
use reasonable efforts to maintain the confidentiality of the final
agreement and any other confidential information obtained from the other
party during the course of the agreement (e.g., sales forecasts,
proprietary information, etc). In addition, both parties agree to use
reasonable efforts to receive confidential treatment of the substantive
portions of this term sheet and the definitive agreement from the SEC.
Neither party shall issue any press release: (1) relating to this
term sheet or the definitive agreement; or (2) referring to the other
party, without providing the other party with the opportunity to review
and comment on the press release.
14. Effect of Term Sheet: This term sheet will be considered a binding
contract on the parties until the definitive agreement is executed.
* The parties shall rely upon and operate in good faith under the
terms of this term sheet, and shall attempt in good faith to negotiate a
definitive agreement reflecting the terms of this term sheet as well as
terms incorporating standard covenants, representations and warranties.
* Once the term sheet is executed by both parties, while the
definitive agreement is being drafted, Xomed shall: (1) pay the [*****]
license payment outlined in section 2 to ArthroCare; (2) shall make the
stocking order in section 5; and (3) will cease all discussions with
competitive RF companies. In exchange, ArthroCare shall: (1) cease all
discussions with other potential ENT distributors; (2) cease the sale of
ENT products; (3) cease the execution of any further agreements with
distributors for ENT products, and (4) shall not hire any direct sales
representatives for ENT.
ARTHROCARE CORPORATION XOMED SURGICAL PRODUCTS
By: By:
Print Name: Print Name:
Title: Title:
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND> THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED
FROM THE ACCOMPANYING FINANCIAL STATEMENTS AND IS QUALIFIED IN
ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS.
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<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 6-MOS
<FISCAL-YEAR-END> JAN-2-1999
<PERIOD-START> JAN-4-1998
<PERIOD-END> JUL-4-1998
<CASH> 10,299
<SECURITIES> 7,210
<RECEIVABLES> 3,806
<ALLOWANCES> 0
<INVENTORY> 3,744
<CURRENT-ASSETS> 22,968
<PP&E> 2,165
<DEPRECIATION> 0
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<CURRENT-LIABILITIES> 5,266
<BONDS> 0
0
0
<COMMON> 21
<OTHER-SE> 23,293
<TOTAL-LIABILITY-AND-EQUITY> 28,730
<SALES> 10,544
<TOTAL-REVENUES> 10,544
<CGS> 5,995
<TOTAL-COSTS> 5,995
<OTHER-EXPENSES> 8,602
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 0
<INCOME-PRETAX> (841)
<INCOME-TAX> 0
<INCOME-CONTINUING> (841)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (841)
<EPS-PRIMARY> ($0.09)
<EPS-DILUTED> ($0.09)
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