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ArthroCare (ARTC) develops, manufactures and markets a proprietary line of surgical devices based  on its patented Coblation technology, which uses low-temperature, radio-frequency energy to dissolve, rather than burn, soft tissue. These products have become popular with the medical community because they minimize damage to healthy tissue. Over the past few years, the company has developed a host of new uses for its technology, and now markets devices for sports medicine, spine/neurologic, ear, nose, and throat, cosmetic, urologic, and gynecologic procedures.    

In late 2008, the company announced that was restating a number of its financial reports, and it delayed filing subsequent 10-Qs until the restatement was completed. The audit committee also identified certain improper practices in the insurance billing and healthcare compliance practices associated with ARTC’s Spine business unit. Moreover, the committee determined that personnel at all levels did not have appropriate healthcare compliance training and that billing personnel lacked adequate training and supervision in insurance reimbursement requirements. As a result of these revelations, the previous President and CEO resigned from his position, as did the former Vice President and General Manager of the Spine business unit and the former Director of Sales Development and Training.

Subsequently, ArthroCare completed most of the restatements of the required financial statements in November of last year, and appointed David FitzGerald, a board member with many years experience in the medical device industry, as President and CEO. With it recent difficulties now hopefully behind it, the company was relisted on the NASDAQ on January 22nd of this year.

Restatement-related expenses took a hefty toll on ArthroCare’s bottom lines in 2008 and 2009. However, the company now seems set to post a strong earnings turnaround in the current year, as impressive results are expected at both the Sports Medicine and ENT businesses and across all geographic regions. What’s more, margins are likely to widen going forward, thanks to ARTC’s ongoing initiatives to improve the cost effectiveness of its sales and marketing efforts.

The company’s finances are in good shape, after having entered into an agreement with One Equity Partners (OEP), the global private equity investment arm of JPMorgan Chase & Co. According to the terms of the deal, OEP bought $75 million of newly issued ArthroCare series A convertible preferred stock. The proceeds were used to repay an existing credit agreement, with the balance earmarked for general purposes. However, this arrangement came at a price—ARTC recently set aside the preferred stock for OEP, which it will be able to convert to common shares at $15 a share, and then sell them in September at the market price. This will increase the company’s share count, as well as have a dilutive effect on its bottom line. As a result, we have scaled back our 3 to 5-year earnings projections, which lowered our Target Price Range for that period. And since the stock is currently trading in close proximity to that range, it now offers below-average appreciation potential through 2013-2015. Investors may want to take advantage of price weakness here, as we like the company’s long-term prospects. However, over its trading history, the stock has proven rather volatile.

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