Description

[The following is a result of collaboration between my girlfriend (an MD) and me. She was invaluable in helping me understand (and pronounce!) some key terms and ideas.]

ArthroCare, based in Sunnyvale, California, has developed an innovative technology based on radio frequency, which combines the advantages of laser (which “ablates” or vaporizes tissue) with those of monopolar (which “coagulates” or causes “hemostasis” of tissue) devices at a very cost-effective price point. This technology utilizes multipolar electrodes, consisting of multiple wires, each independently powered, as opposed to a single large electrode. This enables it to work at lower powers than traditional monopolar and faster than both monopolar and lasers.

ArthroCare sells a control unit for a list price of $7,500 and disposable, single-use wands with an average selling price of approximately $137. The nearly 3 million procedures performed annually in the U.S. make arthroscopy the single most commonly performed surgical procedure after biopsy. The number of arthroscopic procedures is expected to grow over 10% annually, making it the fastest growing segment of the orthopedic market. ArthroCare’s device, in the opinion of many doctors, has utility both in the knee segment (over 1.5 million procedures per year) and the shoulder segment (over 500,000 procedures annually). The company’s current ArthroWand line addresses up to 80% of shoulder arthroscopies and over 50% of knee arthroscopies. The company continues to introduce additional wand designs, which should further drive the company’s penetration of the broader knee market and increase ArthroCare’s addressable arthroscopy market to over $400 million in the years ahead. Areas outside of arthroscopy--including the company’s products for cardiology, cosmetic surgery, ENT (ear, nose, and throat) applications, spinal surgery, and neurosurgery--offer significant upside as ArthroCare leverages its bipolar multi-electrode technology platform.

ArthroCare specializes in minimally invasive “coblation” technology, which enables surgeons to ablate (disintegrate), shrink, sculpt, and suction soft tissue and seal small bleeding vessels. ARTC’s multi-purpose system can replace the multiple surgical tools traditionally used in soft-tissue surgical procedures, including arthroscopy; cosmetic surgery; ENT; spinal; neurosurgery; and some cardiology applications.

In 1999, about 2.9 million arthroscopic procedures were performed in the U.S. to remove torn cartilage and ligament tears and remove loose or degenerative tissue. Historically, joint injuries (knee, shoulder, elbow, ankle, wrist, and hip) have been treated using open surgery in a hospital setting. However, arthroscopic surgery, introduced in the 1980’s, is performed through several small incisions, usually in an outpatient setting at a lower cost and with a shorter recovery period. The company introduced its arthroscopic surgery system in late 1995. As of September 30, 2000, ARTC had shipped more than 9,800 systems and about one million disposable devices for a variety of indications. The arthroscopic surgery system accounts for 80% of product sales.

The spinal surgery market, estimated at $1 billion in 1999, is growing more than 25% annually. Chronic back pain affects nine million people in the U.S. and is the number-one reason for health care expenses. The main cause of persistent back pain is inflammation of the disc or instability of the disc wall. Often, herniated discs can be treated by non-surgical means. In more severe cases, a disc needs to be removed and surrounding vertebrae fused together (known as “spinal fusion”). ARTC’s system targets the population for which non-surgical treatment has been unsuccessful but does not want to undergo spinal fusion. ARTC’s spinal system removes some of the inner “jelly like” part of the disc to relieve pressure on the spinal column. ARTC entered the spinal surgery market in September 1999.

About 110,000 metastic brain tumors are diagnosed annually in the U.S.; ARTC believes its system can offer minimally invasive access to ablate the tumors. The company aims to use its system to treat ENT disorders by ablating excess tissue that obstructs passages, such as sleep apnea and snoring. In 1998, 1.4 million ENT procedures were performed. ARTC’s cosmetic system removes facial tissue in an attempt to reduce wrinkles and treat imperfections. About 325,000 laser resurfacing procedures are performed in the U.S. annually. The company is also exploring the use of coblation in certain cardiology procedures through its agreement with Boston Scientific.

Unfortunately for ArthroCare, accounting changes, weaker than anticipated sales in new products, and a shift in the sales strategy obscured a year of accomplishment. During 2000, ArthroCare grew product sales 45% over 1999 and introduced a whopping 22 new products. The year saw new product line launches in cosmetic surgery, ENT surgery, and spinal surgery. However, as with many new product launches, it was very difficult to predict the initial sales ramp and weakness in these three areas contributed to a disappointing second half of 2000. Cosmetic surgery (Visage), which accounted for 6% of product sales in 2000, was launched early in the year with marketing partner Inamed. A longer than expected delay in FDA approval and strategic distractions at Inamed appeared to dampen sales in this segment.

During 2000, ArthroCare announced several new ENT products that show promise, especially in the areas of tonsilectomies and tonsilotomies. ENT seems to have finished strong in 2000 and accounted for 5% of product sales during the year. Spinal surgery lagged company expectations in 2000, representing only 3% of product sales. Projecting the initial sales ramp for products in this area proved challenging, however this remains one of ArthroCare’s most promising opportunities. ArthroCare’s unique approach to percutaneous microdiscectomy (Nucleoplasty) made significant strides with the spinal surgery community late in the year. In fact, ArthroCare has trained over 100 accounts to date, with 50 actively performing the procedure. The Company’s neurosurgery products are being marketed with Integra LifeSciences and also shows signs of promise. Cosmetic, ENT, spinal, and other areas such as cardiovascular will be important sources of future growth as ArthroCare broadens its product line beyond the core arthroscopy business. ArthroCare appears to be on track to deliver impressive top line and bottom line growth, especially if the company can further penetrate its core arthroscopy market and execute on its multiple non-arthroscopy growth opportunities.

The accounting and sales organization changes that were announced last year and precipitated a sharp decline in the stock price have now been substantially completed by ArthroCare. The adoption of a new accounting rule (SAB Number 101) caused a reshuffling in the revenue line that further confused a Q3:2000 revenue shortfall. With this new rule in place, the Company will likely be able to report a more normalized revenue line going forward. In mid-2000, ArthroCare decided to shift its sales strategy in key markets away from distributors to direct sales reps. As a consequence, there was a disruption in the revenue line in Q3:2000 and Q4:2000. The move toward direct sales reps should prove beneficial over time, as it will allow the company to retain greater control over its sales activities. The company expects to add 25-30 people to its direct sales force throughout 2001. The sum of these changes took its toll on management credibility and fanned the flames of negative investor sentiment over the past year or so. The worst appears to be over.

In 2001, product sales are expected to increase 35%, to more than $86 million, due to further penetration of the arthroscopic surgery market and a full-year contribution from the previously discussed new rapidly growing non-arthroscopic markets. Despite the slower than anticipated ramp-up of new non-arthroscopic product sales in the second half of 2000 (hurt by a sales force transition and a seasonal slowdown in cosmetic surgery), these new businesses are poised to deliver substantial growth after the first quarter of 2001. International sales should benefit from regulatory approvals in various countries. Strong revenue growth should drive substantial operating profit margin improvements, despite higher SG&A and R&D expenses.

Summary:
The company has a leading position in the arthroscopic surgery market and opportunities to leverage its products into new high-growth areas. Despite disappointing second half 2000 results--due to slower than anticipated acceptance of new non-arthroscopic surgical procedures, transition from distributor to direct sales in spinal and ENT markets, and a seasonal slowdown in elective procedures--ARTC’s core arthroscopic surgery business continued to deliver strong, stable revenue growth. While non-arthroscopic application sales growth failed to meet original projections, market opportunities remain favorable and the conversion to direct sales will be beneficial over the long term. With 35% revenue growth and 46% EPS growth expected in 2001 (and approximately 40% long-term EPS growth), ARTC represents a great buying opportunity.

Valuation:
Price/sales: 5.5x vs. 5-year range of 2.7 to 25.6
P/E: 20.6x vs. 5-year range of 15 to 294
Price/cash flow: 20.2x vs. 5-year range of 14.6 to 103.9
Price/book: 3.2x vs. 5-year range of 1.3 to 15.1

Among the risks are:
1. dependence upon the arthroscopic system as the company’s principal commercial product
2. management of network of independent sales agents
3. continued demonstration of cost effectiveness
4. untested assumptions of probe consumption/controller
5. risk of ramping manufacturing
6. intense competition from larger companies
7. dependence on sole source suppliers
8. managing overseas distribution agreements
9. managing partnership agreements
10. limited marketing experience
11. uncertainties related to regulatory approvals for future products

Catalyst

*Growing collection of profitable, non-arthroscopic products
*Transition to direct sales force and away from distributors should add to margins
*Accounting change completed, which should add visibility
*Ramp-up of international sales opportunities