ArthroCare develops, manufactures, and markets products based on their patented Coblation technology. Coblation combines bipolar radiofrequency energy with a saline solution to gently and precisely remove soft tissue at low temperatures, typically 40 to 70 degrees Celsius. Coblation products operate at lower temperatures than electrosurgical or laser surgery tools. Coblation allows surgeons to disintegrate, shrink, cut, sculpt, or aspirate and suction soft tissue, as well as to seal small bleeding vessels. The soft-tissue surgery systems consist of a controller unit, and of assorted specialized, sterile, single-use, disposable devices. Coblation is applicable to many soft-tissue surgical markets, including arthroscopy, spinal surgery, neurosurgery, cosmetic surgery, ENT (ear, nose, and throat) surgery, gynecology, urology, and general surgery, including cardiac uses. The company first introduced its Coblation technology in December 1995 for arthroscopic shoulder and knee procedures. The company has since expanded the approved indications, and today has U.S. FDA approval to market its Arthroscopic System for use in knee, shoulder, ankle, elbow, wrist, and hip surgery. The company also has Western Europe CE Mark-approval for arthroscopic surgery. The Cosmetic Surgery System has been cleared by the FDA, and is CE-marked for general dermatologic procedures and skin resurfacing in connection with wrinkle reduction procedures. ARTC's ENT Surgery System is also CE- marked, and they have received clearance from the FDA for use of the ENT Surgery System in general head, neck, oral, and sinus surgery procedures, including tonsillectomy and adenoidectomy, turbinate reduction to relieve nasal obstruction, and soft palate stiffening to treat snoring. The company's Spinal Surgery System is CE-marked, and has obtained approval in the United States to market this system for spinal surgery and neurosurgery. The company applied for the CE-mark and received clearance from the FDA to market Coblation technology products for use in general surgery, gynecology, urology, plastic and reconstructive surgery, and orthopedic surgery. Today, the company operates through four segments: Sports Medicine (63% of 2006 sales) ENT (23% of sales) Spine (10% of sales) and Other (royalties / fees making up 4% of total 2006 revenues). At the end of 2006, domestic revenues were 80% of product sales, and international revenues contributed 20%.
Coblation technology offers a variety of options for physicians performing soft-tissue surgery. Soft tissue, anywhere in the body, can potentially be treated with, and can benefit from, this technology. Beyond the initial arthroscopic market-offering that is now somewhat mature (growing in the mid double-digit area), the company has focused on showing that use of Coblation in new markets, like Spine and ENT, can address the needs of physicians, and can provide tremendous growth and profit opportunities. ENT revenues grew 30% in Q306, 23% in Q406 and 28% in Q107. While the PROcise XP wand went into high-volume production in late Q207, second quarter ENT revenues grew only 17% owing to tough year-over-year comparisons. Despite physician trialing of a competitor's (Gyrus) product that the company believed adversely affected Q3 revenues by $500,000, strong international sales drove ENT growth to 24% in Q307. ArthroCare has reached its estimated target of 40% penetration share in U.S. tonsillectomies (less than 15% share worldwide) during the fourth quarter 2006, up from the estimated 35% share in Q306. Substantial opportunity remains internationally with international tonsillectomy penetration only in the single-digit range. ARTC has not only expanded rapidly into a new market, but has shown excellent clinical benefits that should establish Coblation technology as the gold standard in ENT treatment both domestically and internationally. With the rollout of the PROcise Wand, the company continues to access new avenues of growth with Coblation in the sinus surgery market. Of potentially large impact with an estimated patient pool of 2.4 million, the company introduced a treatment for snoring and sleep apnea. The company is also looking for access into the 200,000 turbinate procedures performed in the U.S every year. Turbinates are small structures in the nose and sinus that can restrict airflow when they become inflamed because of an illness or allergy. Typically treated with medication in children, the Coblation treatment involves reduction in the size of the turbinate to avoid the need for chronic drug use. Although Spine revenues declined nearly 2% in Q306, spine revenues increased 46% in the fourth quarter, 58% in first quarter 2007, 72% in second quarter 2007 and 95% in third quarter 2007. Positive clinical results and subsequent reimbursement has helped the company's nucleoplasty procedure called Plasma Disc Decompression (PDD), to treat herniated discs, gain traction. For some time, lack of clinical evidence did not support 3rd-party reimbursement, but the company has built a strong base of clinical data for PDD, and believes the reimbursement environment has improved considerably domestically. As well, in the second quarter 2006, the National Institute for Health and Clinical Excellence (NICE) recommended the use of nucleoplasty as a safe and effective treatment option for patients suffering from lower back pain. NICE is an advisory organization and the U.K. National Health System generally follows its recommendations. Ultimately, we expect the UK National Health System will cover the nucleoplasty procedure. Given the better reimbursement improvement, management expects Spine to grow approximately 50% in 2007. The company introduced its microdiscectomy wand in September 2006 and a new version, the MD SpineWand, began a limited rollout in Q307.
The company has looked and continues to look for complementary acquisitions to supplement Coblation products. In late 2003, ARTC acquired Parallax Medical. Parallax s products are used for the treatment of spine vertebral compression fractures (VCF). The company's Cavity SpineWand, combined with the Parallax treatment, could provide superior differentiation from competitors. The company also acquired Opus Medical, the developer of the AutoCuff Anchoring System, in November 2004. The company also acquired the business and assets of Applied Therapeutics, a maker of ENT sinus surgery products, in the third quarter 2005.
In Sports Medicine, the company continues to develop new products to stimulate growth of a fairly mature segment. The Opus AutoCuff enables surgeons to more easily perform arthroscopic shoulder rotator cuff surgery, in combination with ArthroCare's Coblation technology. Building on AutoCuff, the company launched its new LabraFix System in the third quarter of 2005. LabraFix is a knotless arthroscopic repair for shoulder labral (ligament) tears, without the requirement of time-consuming and complex surgical knots. A labral tear usually occurs when the shoulder separates. Seeing a preference for non-metallic anchors used in shoulder repair, the company is launching new products. In Q306, the company rolled out LabraLock P, a non-metallic anchor implant that makes labral repairs simpler and faster. The company also received 510(k) clearance from the FDA for its Magnum PI, the new nonmetallic rotator cuff repair product. The company has started high-volume production for Magnum PI and also launched Perfect Passer during the third quarter of 2007. Perfect Passer allows Opus users to treat vertical tears with a side to side stitch, allowing surgeons to secure more of the tissue in the arthroscopic rotator cuff repair. In late October 2007, the company launched new Opus TwinLock knotless fixation system. The Opus TwinLock simplifies rotator cuff repairs by providing a dual implant system that can be placed directly through the rotator cuff. Management believes that 70,000 shoulder injuries currently untreated or performed as open repairs can now be repaired arthroscopically.
Introduced in 2005, the Topaz Microdebrider, based on the company's Coblation technology, targets the tendonitis market. Severe tendonitis, if not responsive to more conservative earlier treatments like rest, compression, non-steroidal anti-inflammatory medications (NSAIDS), bracing, or therapy, will be treated in open surgery. About 10-15% of the estimated 4 million tendonitis sufferers do not respond to conservative treatment but only 5% seek surgery. Topaz will initially target patients who seek surgery but, through education about the benefits of minimally invasive Coblation use, the company believes it can expand Topaz use to the larger group of non-responders.
Seeing additional opportunities in oncology, ARTC formed an interventional therapies unit for cancer. The company has seen strong interest in the Cavity SpineWand to treat vertebral compression fractures caused by spinal tumors. In 2006, the Cavity treatment was used by less than 17,000 patients but the company believes this is a 125,000 tumor-related VCF patient market opportunity with an ASP over $2,000. The American Cancer Society estimates 30%-70% of the more than 0.5 million people who die annually of cancer have skeletal metastases and 10% of the 700,000 VCFs that occur each year are believed to be caused by metastatic spine tumors. The tumors cause the vertebrae to weaken and collapse. In May 2007, the company received FDA clearance for Cavity SpineWand to reduce malignant lesions within the vertebrae. The Cavity SpineWand is used in a minimally invasive surgical procedure to remove malignant tissue within vertebrae, creating a small cavity. Medical grade cement can then be injected into the cavity, stabilizing the fracture. The company is also looking to expand the Cavity treatment to treat other tumors like the brain. Although the company is investing in targeted oncology products in 2007, this unit is not expected to generate substantial revenues in 2007. However, we do believe it will become a solid growth area for the company.
ArthroCare has an aggressive promotional product placement program, in order for controllers to reside in hospitals and clinics. ArthroCare will usually (despite the average controller cost of about $8,000) place the controller with the customer at little or no cost. Once a controller is placed within an institution, it may be utilized by a variety of physicians who focus on different medical specialties. The same controller may be used to perform arthroscopic, ENT, spinal, cosmetic, neurosurgery, or general surgery. Each type of surgery requires a different disposable wand that can cost $150 or more. ArthroCare generates nearly all its revenue from sales of the disposable wands.
ArthroCare has defended its technology patent portfolio successfully, deriving several licensing agreements in the process, including a royalty licensing agreement from Stryker. The latest major patent defense involved Smith & Nephew (SNN). In September, 2005 ARTC and SNN settled their case by entering into an agreement whereby ARTC will manufacture both bipolar and monopolar products for SNN. As part of a joint licensing agreement, ArthroCare also will receive royalty payments for all bipolar products Smith & Nephew sells in the United States and for bipolar shaver products manufactured and sold by Smith & Nephew worldwide. ArthroCare was also granted a license for the worldwide sale of spine products. In addition to product sales from the supply agreement and royalties, ArthroCare received a one-time (undisclosed) cash settlement payment and a series of related milestone payments. In November 2007, ARTC filed an ENT patent infringement suit against Gyrus. Shortly thereafter, however, in a November 19, 2007 announcement, Gyrus agreed to be acquired by Olympus Corporation. Olympus is a licensee of ArthroCare's Coblation technology, so we believe that ultimately the licensing could extend to Gyrus products. Gyrus' ENT business was approximately 16% of its total revenues, and the possible licensing/royalty agreement could expand beyond the Gyrus ENT product line. However, it is also possible that Olympus, given limited success to date, discontinues the Gyrus ENT products.
The company has a clear strategy to leverage its patented Coblation technology and other innovative, clinically superior surgical devices, for the surgical treatment of soft-tissue conditions throughout the body. Patent litigation settlements have limited competition, in our opinion, and the company has substantial leverage opportunities. Our 2008 top-line expectations are in-line with management's recently reiterated 20% forward expectations. In part, in December 2007, concerns over an alleged investigation into ARTC's selling practices and concerns over difficulties in obtaining 3rd-party reimbursement for its Plasma Disc Decompression product caused the stock's downward movement. We believe the reimbursement negatives are overstated and the company is seeking factual corrections to a New York Post article on its selling practices. Treated currently by many reimbursement agents as non-covered or investigational, PDD may remain reimbursed case-by-case, or even non-covered, until a formal Medicare coverage decision is reached and subsequent non-Medicare coverage is obtained. Although possibly bumpy, we believe the company is building spine PDD utilization and reimbursement traction, domestically and internationally. Given the recent stock downward move, our recommendation moves to Buy from Hold.