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ArthroCare Corporation (NASDAQ:ARTC)

Q4 2012 Results Earnings Call

February 14, 2013 8:30 AM ET

Executives

Misty Romines - Investor Relations

David Fitzgerald - President and CEO

Todd Newton - EVP, Chief Operating Officer and CFO

Analysts

Joanne Wuensch - BMO Capital Markets

Raj Denhoy - Jefferies

Matt Hewitt - Craig-Hallum Capital Group

Dave Turkaly - JMP Securities

Bill Plovanic - Canaccord Adams

Charles Croson - Sidoti & Co LLC

Matthew O'Brien - William Blair

Matt Miksic - Piper Jaffray

Bill Plovanic - Canaccord Adams

Matthew O'Brien - William Blair

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the ArthroCare Corporation Fourth Quarter 2012 Financial Results and Business Update Conference call. During the presentation all participants will be in a listen-only mode. Afterwards we will conduct a question and answer session. (Operator Instructions)

As a reminder this conference is being recorded, Thursday, February 14, 2013. I would now like to turn the conference over to Misty Romines. Please go ahead, ma'am.

Misty Romines

Good morning, and welcome to ArthroCare's Conference Call to discuss our Fourth Quarter and Full Year 2012 operating results. Joining us on this is call are David Fitzgerald, President and Chief Executive Officer of ArthroCare, and Todd Newton, ArthroCare's Executive Vice-President, Chief Financial Officer and Chief Operating Officer.

By now you all should've seen a copy of our press release which was released yesterday afternoon. But if you haven't, it is available on our website www.arthrocare.com. A live and on-demand webcast of the conference call is also available on our website.

Following introductory comments by management, we will open up the lines for a short question-and-answer session. In order to give as many of you as possible an opportunity to ask questions, we will accept one question and one follow-up per caller, after which we welcome callers to rejoin the queue.

Before we begin, we would like to advise you of our forward-looking statements. Other than historical information, the matters we will be discussing today consist of forward-looking statements. These statements are subjects to the risks and uncertainties detailed in our Securities and Exchange Commission filings, including our 10-K for the year ended December 31, 2012 that was filed this morning. Actual results could differ materially from our forward-looking statements.

The statements made in this conference call are based on the information available to ArthroCare today, and the company does not undertake any obligation to update or correct them before its regularly scheduled call at the end of next quarter. Certain non-GAAP measures may be used during today's call. A reconciliation of these measures to the most directly comparable GAAP measures can be found in the investor relations section of our website.

I will now turn the call over to David Fitzgerald.

David Fitzgerald

Thank you, Misty. Good morning ladies and gentlemen and thank you for joining us this morning. Our 2012 revenue was $368.5 million or 3.8% higher than 2011. As Todd will detail in just a moment, our fourth quarter revenue increase was slightly greater than a year as a whole. At 3.8% our total revenue increased for 2012 was consistent with the outlook of low single digit top-line growth that we've provided at this last year.

This year's reported revenues from our International Operations, particularly, in the first nine months of the year were reduced by stronger U.S. dollar exchange rate. In constant currency terms product sales increased 4.8% in 2012. Our key profitability indicator is adjusted operating margin. This metric is GAAP operating margin, adding back the effect of the investigation and restatement related cost, which we think is a good profitability indicator of current operating activities.

At this time last year, we said we expected operating, adjusted operating margin in 2012 will be equivalent to the 2011 year, which was 18.4%. Our actually adjusted operating margin for 2012 was 20.3%.

Last year we said we would take the estimated cost savings from the closure of our Sunnyvale, California facility and invest it back into the business. We said we expected these investments to result in higher R&D expenses and higher sales and marketing expenses and this is what happened in 2012. R&D expenses were a little more than $3 million higher in 2012 and sales and marketing expenses were roughly $7.5 million higher in 2012.

Overall, adjusted operating expansion 2012 was $185.6 million versus $186.2 million in 2011 when both are adjusted for investigation and restatement related cost. Our adjusted free cash flow target, which is adjusted for the effect of investigation and restatement cost was $80 million for 2012, our actual achievement was just shy of this target at $79 million.

I will now turn the call over to Todd to run through the fourth quarter results in more details and then I will give our outlook for 2013. Todd?

Todd Newton

Thank you, David. Total revenues in our fourth quarter were $96.9 million versus $92.4 million for the fourth quarter of last year, an increase of $4.5 million or 4.9%, of our total revenues product sales were $92.2 million in the fourth quarter compared to $88.5 million in the fourth quarter of 2011, an increase of 4.3%.

In the fourth quarter the effect of the stronger U.S. dollar against the euro, British pound and Australian dollar, the primary currencies in which our international markets operate was not as pronounced as it had been during the first nine months of 2012. In constant currency terms product sales this quarter increased 4.5% compared to the 4.3% increase on our as reported GAAP basis.

Worldwide, our Sports Medicine product sales increased 1.9% this fourth quarter versus the fourth quarter of 2011 on an as reported basis. In constant currencies Sports Medicine products sales increased 2.1% this quarter. In the fourth quarter of 2012 proprietary Sports Medicine product sales in the Americas increased $1.5 million or 4.5% while contract manufacture product deliveries were significantly lower compared to the fourth quarter of 2011 decreasing by $2.2 million.

In the fourth quarter of 2011 contract manufactured product sales were unusually high at $8 million as a result of the initial stocking order under a supply agreement with Wright Medical of $2.1 million, which did not recur in the fourth quarter of 2012.

Overall, our number of active Sports Medicine customers in the Americas in the fourth quarter was flat compared to the fourth quarter of 2011, however our revenue per customer was higher this quarter. We attribute the increase in the Americas proprietary Sports Medicine product sales in the quarter to a combination of improving procedure volumes as well as improvements in our product portfolio that allowed us to participate in more of the procedures that are customer base performs.

In Coblation, the Ambient MegaVac 90 Degree Wands which are primarily designed for shoulder arthroscopies. In addition, Sports Medicine product sales also increased as a result of higher sales volumes launched in the U.S. market which resulted in higher sales volumes from our family of 90 degree once which are primarily designed for shoulder arthroscopies.

In addition, Sports Medicine product sales also increased as a result of higher sales volumes of Coblation products designed for knee and hip arthroscopies. Overall, our average selling price for Coblation products remain mostly unchanged as compared to the fourth quarter of 2011.

Fixation unit volumes in the Americas increased as a result of the introduction of a MultiFIX P, and the positive effect that the product had on a sales of our traditional corkscrew anchors such as Spartan and Titan. Overall, the average selling price of the fixation portfolio increased by approximately 2% as a result of new products, partially offsetting the increase I just described was a decline in sales volumes of older generation fixation products.

International Sports Medicine products sales increased $1.9 million or 9.5% on an as reported basis in the fourth quarter of 2012 due to higher sales volume in Asia-Pacific markets. In Europe product sales increased in most of our direct markets while distributor sales were mostly unchanged.

For ENT worldwide product sales increased $2.5 million or 10.6% in the fourth quarter of 2012 compared to the same period in 2011. Americas ENT product sales increased to $800,000 or 4.3% in the fourth quarter due to higher Rapid Rhino product sales.

Rapid Rhino sales in the fourth quarter of last year were unusually low due to raw material supply issues we were experiencing and a product backorder situation that resulted there from. In the fourth quarter of 2012 Rapid Rhino product sales returned to more normal levels and partially offsetting the increase in Rapid Rhino product sales in the America's was a decline in Coblation product sales due to lower tonsillectomy wand sales.

Internationally, ENT product sales increased $1.7 million or 37.1%. ENT product sales increased in nearly all of our direct markets and most of our distributed markets with the exception of sales to certain of our Southern European and Middle Eastern distributors.

Asia Pacific markets, and China in particular, experienced continued strong demand for ENT product sales in the fourth quarter. Other product sales which consist primarily of our Coblation-based spine products, were mostly unchanged this quarter when compared to the fourth quarter of 2011.

In royalties, fees and other revenues increased approximately $800,000 this quarter over the same quarter of 2011, due to higher reported sales by our licensees. Gross product margin for the fourth quarter 2012 was 69.9% compared to 69.3% in the fourth quarter of 2011. Operating income for the fourth quarter of 2012 was $15.1 million for an operating margin of 15.6% compared to a loss from operations of $51.4 million in the fourth quarter of 2011.

In the fourth quarter of 2012, we reported investigation and restatement-related costs of $6.4 million as compared to $68.7 million in the fourth quarter of 2011, when we accrued the $74 million settlement of the consolidated Private Securities Class actions brought against the company.

Operating income adjusted for investigation restatement-related cost was $21.6 million in the fourth quarter of 2012 compared to $17.3 million in the fourth quarter of 2011 and adjusted operating margin was 22.3% compared to 18.7%.

In the fourth quarter of 2012, gross profit was $4 million higher than in the fourth quarter of 2011 due to the increase in product sales, which was offset by approximately $1 million and higher research and development expense resulting from our knee initiatives for Sports Medicine and approximately $2.4 million in higher sales of marketing expense due to our direct market expansions in 2012 in Europe and investments to expand our sales to support infrastructure in Asia Pacific.

Operating expenses in the fourth quarter of 2011 also included $3 million of exit costs related to the closure of our former Sunnyvale, California facilities. In summary, earnings applicable to common stockholders were $0.30 per diluted share in the fourth quarter of 2012, compared to a loss of $1.06 per share in the fourth quarter of 2011.

Our balance sheet as of December 31, 2012 showed $287.7 million in working capital compared to $222.7 million at December 31, 2011. Our cash and cash equivalents were $218.8 million as of December 31, 2012 versus $219.6 million at the end of 2011.

Cash flow from operating activities in 2012 was $6.3 million compared to $84.6 million in 2011. As in the first quarter of 2012 we paid $74 million to settle the consolidated Private Securities Class actions against the company and that reduced this year's cash flow from operating activities. Adjusting out the effects of this payment, cash flow from operations was $80.3 million in 2012 and our revenue base of $368.5 million.

Prior to handing the call over to David I'll refer you to our disclosures in our Form 10-K for the period regarding our outstanding contingencies. The DOJ investigation that began in December of 2008 is ongoing and we continue to cooperate with the investigation to the greatest degree possible.

As we already have disclosed on January 30, we agreed to an extension of the tolling agreement that was set to expire on February 1, until March 1 of 2013. The essential terms of the tolling agreement did not change. And basically means that the company has agreed not to raise statute of limitation defenses until after March 1, 2013 for any matter that would otherwise be subject to an expiring statute of limitations prior to that date.

We still believe the cooperation will lead to the most reasonable outcome available to the company. And we believe granting that granting the government's request for an extension of the tolling agreement is in the company's and shareholders best interest.

We are hopeful and optimistic that the investigation concerning the company can be completed within the revised term of the tolling agreement. However, the government has not given us any assurances that this will happen.

We also believe that the company to date has provided the government with the fullest cooperation possible including offering the government our view of an acceptable framework for resolving the investigation. We have not however, received any proposal from the government.

As a result although we believe the DOJ investigation is at a very advance stage as evidenced by the tolling agreement and decision made by DOJ in mid 2012 to indict two former officers of the Company. We still cannot predict the ultimate outcome from the investigation and we are unable to estimate any potential liability the Company may incur.

We expect, we will continue to incur legal defense costs in connection with this investigation, we also expect we will continue to incur costs related to the indemnity agreements with former officers and that these costs are likely to be significant.

In addition to the DOJ investigation, last February we also disclosed that we had received a civil investigative demand from the Civil Division of the U.S. Department of Justice related to a False Claims Act investigation. This demand was very broad seeking information related to our past and current sales and marketing and Coblation products covering a 10-year period of time.

As we have previously discussed the broad scope of the initial request was near to our ENT product area and we provided the data and satisfaction of the divisions more narrowed request. As of this date we do not have any further information concerning the underlying subject of the investigation or the claims that are being asserted concerning the Company's past or present sales and marketing activity. As a result, we are unable to predict any outcome of the False Claim Act investigation at this time.

With that I will now turn the call back over to David.

David Fitzgerald

Thanks Todd, through our early comments I think we have provided you a good overview of our fourth quarter. Overall we are satisfied with the cadence of new product introductions and how we have added more balance to our sports medicine product portfolio over the past year and half. I also think we have an R&D pipeline of new products for sports medicine that will continue to support our efforts to grow this business at a satisfactory rate.

On December 31, 2012, we entered into a contract to acquire Eleven Blade Solutions, Inc., which closed in January when Eleven Blade received FDA clearance to market their products. This acquisition will add and also to our soft anchor system technology, to a soft tissue fixation portfolio that can be used in a variety of sports medicine procedures. We paid $7 million at the closing and we are committed to pay an additional contingent payment in late 2016 on product sales performance.

Including the Eleven Blade products we have several new products in the sports medicine pipeline slated to launch throughout 2013 and the latter half of 2013 should be very busy in particular with new product introductions. Ambient continues to make a difference for our Sports Medicine business to new MegaVac 90 uses this differentiating technology and I anticipate this will be a feature technology in many of our new Sports Medicine wands going forward.

Our Ambient sales at the end of the 2012 accounted for almost 44% of our Coblation sales in Sports Medicine. Ambient's ability to provide surgeons with reliable and real time temperature feedback during the arthroscopic procedure is strategically important to our Coblation knee initiative. The second phase of the knee strategy involved, the medical education campaign to raise awareness, address common misconceptions and reinforce the clinical facts concerning the use of Coblation during knee arthroscopy. Demand for this program has been very good.

In the fourth quarter we held nine Coblation education events in the United States and over 90 surgeons participated. The third phase will focus on ACL construction with anticipated product release in the second half of this year. The fourth and final phase is a new platform to deliver Coblation in versatile operating modes specifically designed for knee tissue types with an expected introduction outside the U.S. late this year.

For ENT the U.S. console business had a difficult year and we expect these challenges will continue in the near-term. Outside the U.S. our ENT business continues to show good momentum. Strategically our focus is to expand ENT indications and procedures that can benefit from Coblation and thereby reduce the level of ENT's dependency on the console producer. It's a strategy that will require time as did our efforts to reset a Sports Medicine product portfolio and pipeline. We anticipate to first new Coblation products that expand our indications into new ENT procedure areas to be introduced late this year.

Our outlook for 2013 is generally a continuation of 2012 with a soft if any increase in a number of underlining arthroscopic shoulder repairs or tonsillectomy procedures performed in our major markets. Overall the analysts covering ArthroCare are escalating 2013 top-line growth at a rate ranging from 2% to 4.5% and we are comfortable with that range.

We think this outlook will certainly apply to Sports Medicine in the Americas where we expect product sales to increase at a low single-digit growth rate, with the possibility for improving Sports Medicine growth towards the end of 2013, if we are successful with our knee initiatives and new product introductions in the second half of the year.

Our current supply agreement with expires at the end of August of 2013. However, our license agreement with Smith & Nephew expires at the end of 2013. However, our license agreement with Smith & Nephew extends to the end of 2015. As a result we anticipate the supply agreement with Smith & Nephew is likely to be renewed and our contract manufacturing product sales in 2013 will likely remain close to the 2012 levels.

We anticipate our ENT Americas business to remain challenged and for product sales to be mostly flat. We intend to re-launch Rapid Rhino later in 2013 now that we think our supply issues are behind us. We also anticipate new products introductions in late 2013 for turbinate and head and neck procedures. If these new products are successful we may see better product sales in the latter part of the year.

We saw some signs of improvement in our European direct markets in the fourth quarter of 2012. But we have yet to see if this improvement has bearing on the future. AU Pacific continues to show good demand for the products. We think our other products sales which are mostly spine Coblation products will be more or less remain flat in 2013. For adjusted operating margin our outlook for '13 is that adjusted operating margin will be lower than in 2012 and will closely approximate our 2011 adjusted operating margin which was 18.4%.

First, the U.S. medical device tax will lower our operating income by approximately $3.5 million for a nearly 100 basis point reduction in adjusted operating margin. Second, we anticipate higher R&D expense and sales and marketing expense in 2013 as a result of our product development plan. Sales and marketing expense particularly in the United States will rise as we invest further in our distribution organization as part of our knee initiative in Sports Medicine. We will also continue to invest in the Asia pacific area, where we have important growth opportunities.

We anticipate free cash flow in 2013, will approximately $65 million compared to $80 million in 2012, as we begin to pay taxes some time in later half of 2013, which will reduce free cash flow. In addition, we expect 2013 capital expenditures to be higher as we commence on facility expansion projects in Costa Rica and in the latter half of 2013 we will begin to build quantities of our Sports Medicine Coblation controller platform related to our knee initiative.

We will now open the call for a brief question-and-answer session and then I will provide a few closing remarks. Operator?

Question-and-Answer Session

Operator

(Operator instruction) The first question coming from the line of Joanne Wuensch with BMO Capital Markets, please proceed with your question.

Joanne Wuensch - BMO Capital Markets

Thank you very much for taking the question. Couple of things on the civil front, I remember that at some stage the former addresses is needed to make a decision whether or not to take up the civil agreement or the civil suit. Have they made that decision yet?

David Fitzgerald

No, they have not Joanne, we haven't heard that they've made any decision about whether or not to take on and pursue the False Claims Act matter. That's really the piece of information that we think is the next piece of information that we'll receive as a company and it would be - at around that time as well, then we would become aware of the underlying complaint, but that then still has to, the event still will occur in the future.

Joanne Wuensch - BMO Capital Markets

But isn't there are time frame on when they need to notify or is it an open ended event?

David Fitzgerald

There is some statutory timeframes in here, but my understanding from our council is that extensions are quite easy for the DOJ to receive on these matters, so those are - they can simply continue to extend on the basis that they are still doing their initial investigation.

Joanne Wuensch - BMO Capital Markets

Okay, thank you. Moving on to the criminal side of it, your tolling agreement was only extended 30 days. Is there anything to be understood from that time period and not a six month extension?

David Fitzgerald

No, I don't think so. I think after a request they requested 30 days and we granted that. We'll be at -- to have any further discussions with them.

Joanne Wuensch - BMO Capital Markets

Do I understand in your comments that the government has not made a proposal on that particular investigation?

David Fitzgerald

There's no proposal on the table.

Joanne Wuensch - BMO Capital Markets

But does that mean we should anticipate is a proposal, is that the next step?

David Fitzgerald

I would expect so.

Joanne Wuensch - BMO Capital Markets

Okay, and then on a numbers question. You are talking about operating margins going back to the levels of 2011 versus what we -- the expansion we saw in 2012. But my memory has that when we were sitting here this time last year you were looking for flat operating margins this year and yet you expanded. Why should we not anticipate that same level of conservatism as you look at 2013?

David Fitzgerald

Well Joanne, I think it's important to just look at what events we anticipate for 2013. I mean, the medical device tax, we know that is a reality, it's going to come against our cost of goods sold. We have a feel for how much that will be, it's not precise but we think it's going to be in this $3.5 million range.

We know that our knee initiative is going to require us to invest in our sales and marketing organization so that they are able to represent what we think will be the new products to come out of that initiative in a highly professional way and that they are able to cover the cases that they need to cover.

So we know that there's going to be investment dollars spend in sales and marketing and of course R&D we are going to complete the projects that we already have in this pipeline. So, as we look at that on balance we just anticipate that we are looking at something closer to the 2011 operating margin.

Operator

Thank you. Our next question coming from the line of Raj Denhoy with Jefferies, please proceed with your question.

Raj Denhoy - Jefferies

Hi good morning guys.

David Fitzgerald

Good morning.

Raj Denhoy - Jefferies

I wonder if I could ask a bit about the ENT franchise. I guess it was soft last quarter I think you cited sort of similar forces behind that in terms of the tonsillectomy market. You know if you are looking into '13 it sounds like that's going to continue. I guess in terms of what's actually happening on the ground are you seeing a continued kind of decline in that market or has it taken a step down as we just try and think about how that might play out here, some detail that would be helpful.

David Fitzgerald

I don't say that we see a decline necessarily in procedures. I think the macro-economic factors affected, but for our business in tonsils it's been flattened has declined a bit, but there is a lot of factors that go into that. I think we'd discussed it before, but I'll repeat them again; there is reprocessing, there is competition, there is a variety of different things that go on. And until we see some sort of an improvement in that area I think that our view is going to remain flat for us and the economic environment hasn't changed much.

So you know that's probably a fairly big factor in all of that, but they all add up to the fact that we have flat or declining sales and that's our outlook that we look at for the next couple of quarters.

Raj Denhoy - Jefferies

And then I think you cited new product towards the end of '13 turbinate [removal], I guess general, head and neck procedure wands as well, what's the status of the term their developments as well as to the path through the FDA at this point?

David Fitzgerald

Well, we have not submitted those products to the FDA with the exception of one of them. And I think that we'll just have to wait and see when they make their way through the regulatory pathway and our anticipation is sometime late in 2013 when we hope to get those products out.

Raj Denhoy - Jefferies

Okay, thank you.

Operator

Thank you. Our next question coming from the line of Matt Hewitt with Craig-Hallum Capital Group; please proceed with your question.

Matt Hewitt - Craig-Hallum Capital Group

Good morning, just a couple from me. First, following up on the ENT segment, one of the factors that you've been facing it sounds like there's been a shift from hospitals to the ambulatory surgery centers where there is a little bit more of price issue for those centers. Is there anything that you can do or anything that you have in development to help you getting traction in those surgery centers?

David Fitzgerald

Well, that's been going on for a good while and isn't just overnight that this has happened. We do not have a product that, let's say that is priced accordingly at these surgery centers. And let me add, I mean our products are sold in the surgery centers, but price is a factor in those categories. But we have an OR based product, OR based sales force and of course we call on the clinics, but I don't think - I don't anticipate that we would have a product that would directly compete with a very, very low price product. I mean, we obviously compete on our, what we believe that Coblation is a better product for the patients and physicians.

Matt Hewitt - Craig-Hallum Capital Group

Okay. And isn't obviously then the risk would be that if you were to develop some type of a low end scale back on the functionality machine that you would potentially cannibalize the hospital setting, is that a fair assessment?

David Fitzgerald

No, I don't think so, I wouldn't agree with that. I think if we were to introduce something like that we'd have different price points obviously, but it wouldn't be the same product, it wouldn't be the same technology.

Matt Hewitt - Craig-Hallum Capital Group

Okay, fair enough. On the international side, obviously a strong quarter, Was there anything in your distribution markets or you saw maybe some big stocking orders that may not repeat here in the first half of the year or anything abnormal that occurred in Q4?

Todd Newton

In terms of our distributor sales it's natural for us to see Q4 always as a little bit of a heavy quarter compared to the other quarters of the year. Fourth quarter of 2011 was exactly the same way as well and that really relates to the fact that we have a lot of our distributor agreements on a calendar basis and they have quotas in their agreement. And so we do tend to see year-over-year-over-year the fourth quarter being a little bit of a heavier quarter for distributor sales and that was the same this year as it has been in the past.

Matt Hewitt - Craig-Hallum Capital Group

Okay, thank you.

Operator

Thank you. Our next question coming from the line of Dave Turkaly with JMP Securities, please proceed with your question.

Dave Turkaly - JMP Securities

Thanks. When you're looking at knee opportunity for fibrillation. Can you remind us is there an energy source competitor there and what exactly is the indication there, how are the products going to be used and how large is that opportunity?

David Fitzgerald

Well the use of shavers is predominant in the knee application. RF other than Coblation is not used as much as a shaver of course. We have existing wands that are used in the knee area, in fact there has been over a million procedures that has been done with Coblation in the knee. I think the -- what we're trying to address here is the fact that we would have a new controller platform that would have the ability with the wands to adopt to various different tissues that are in the knee.

And if successful. I think it will be a very good program, it's not the only part of the program that we hope because we think that we need an ACL reconstruction system to compete effectively to be in the OR. We have to train our sales force. It's a fairly big effort that we need to do in order to make this very successful, but it's based upon the premise that Coblation is safe and very effective tool to be used in knee repairs.

So the opportunity, I guess you'd compare it to the shoulder market, which is certainly a more value-driven market for us, but there are so many more procedures done in the knee area than in the shoulder. It just represents a growth opportunity for the company.

Dave Turkaly - JMP Securities

And just as a follow-up on the M&A front, I mean is there something on the knee side, I mean, you did a small deal obviously recently, but I guess would that be a primary focus point for you guys given that -- given all the effort you seem to be spending there?

Todd Newton

You know on the M&A side, I think when we look at opportunities, like when we looked at Eleven Blade, we're looking at those kinds of opportunities that would obviously enhance our current Sports Medicine or ENT franchise. To say that we are looking at anything in that particular area, I really can't say that, but certainly our M&A focus would be on things that we feel like support our current businesses and that we would have the sales and distribution capability to really maximize the value of it.

Dave Turkaly - JMP Securities

Thank you.

Operator

Thank you. Our next question coming from the line of Bill Plovanic with Canaccord. Please proceed with your question.

Bill Plovanic - Canaccord Adams

Great. Thank you. Good morning, gentlemen.

David Fitzgerald

Good morning.

Bill Plovanic - Canaccord Adams

A couple questions. Just as you look at 2013, it really -- the comments are that your back end guiding to the year for the new products really driving the growth. In addition to that, is there any less selling days in Q1, or anything else that would cause Q1 to be on the lower end of the year growth?

Todd Newton

No, I don't think so. Let me put it this way, I'm just not aware of how many selling days there are in Q1, so it's not something that I'm aware of at this point.

David Fitzgerald

If there was, it'd be one day.

Todd Newton

Yes.

David Fitzgerald

Yes.

Bill Plovanic - Canaccord Adams

Okay. And then, just as you look at the investment, the restatement expenses, the one-time charges that you had, how many of that -- how much of that is associated with kind of defense to the DOJ civil and criminal and how much of that is indemnification of previous officers, if you just had to split it like as 25:75, 10:90, how would you split that at this point in time?

David Fitzgerald

In the fourth quarter more than half of it were related to the indemnity agreements.

Bill Plovanic - Canaccord Adams

Okay, great. That's all I had. Thanks.

Operator

Thank you. Our next question coming from the line of Charles Croson with Sidoti. Please proceed with your question.

Charles Croson - Sidoti & Co LLC

Hi, guys. Thanks for taking the questions. I just have a few quick ones here since most of them might have been answered. For the contract manufacturing side, has Wright matter -- I mean, have you had any real pickup at all on the Wright Medical side of that?

David Fitzgerald

No, we have not. We've had discussions with them, but we've had no pickup.

Charles Croson - Sidoti & Co LLC

I see. And do you see that eventually picking up or is that just going to continue to be more of a smaller side of that, I'm just kind of -- because I was a decent announcement a few quarters ago, so just trying to gauge that a little bit better?

David Fitzgerald

Right now, I would not see a pickup. It's just remained to be seen, but it's been flat since that initial order. We've done training and we've had discussions with Wright. I just think it's a matter of time before they essentially get all of their sales force trained, but I am not sure, but we don't anticipate a pickup.

Charles Croson - Sidoti & Co LLC

Okay, all right. That's helpful. And then, just a couple more here, there's a comments and you had said expecting products in the back half of 2013 to help you guys out in terms of gaining top line growth up a little bit, but you typically, I mean just on how new products usually go out, it would seem that you'd need a couple months or more to really gain some product traction.

Do you think with the initiatives you have now that that will accelerate that typical trend or do you see that just picking up a little bit more after the back end of 2013, I see just picking up at the back half of '13 like all new produce developments there are always some slippages and there are unanticipated thing that you may incur with the regulatory pathway. So we're cautious about how we go out but these products I think will offer opportunities for growth for us.

Charles Croson - Sidoti & Co LLC

Okay. That's helpful and then just one more quick one. I think one of my peers have kind of touched on this, and more on the M&A front, and on top of the deal that you guys have recently done, you know we're sitting on -- if you include the converts, about almost $6.50 in cash per share, and it's pretty decent in war chest you guys have there, are you looking into something a little bit more than just tuck-ins or is it -- you just want to hold on to cash at this time.

Todd Newton

Charles, we really don't think we have anything further to add to that other than our answer to the earlier question, we're looking at M&A as our primary use of our cash. We think that that's where we can add a lot of value but it's always about finding the right think at the right price. So that's just the way that we're approaching it.

Charles Croson - Sidoti & Co LLC

Okay. All right, that's fair. Thanks guys, I'll hop back in the queue.

Operator

(Operator Instructions) Our next question coming from the line of Matthew O'Brien with William Blair. Please proceed with your question.

Matthew O'Brien - William Blair

Good morning, thanks for taking the questions. I was hoping you could talk a little bit about Sports Medicine, given the performance we've seen over the last couple of quarters here, can you help us understand, the performances we're seeing from the shoulder side of the business, versus knee and hip, is knee and hip really driving the majority of the growth, outside of maybe some of these newer products and then what do you think, rather than just growing sales within your existing customer base?

And I guess, the other question would be how far can you -- do you still have to go in terms of growing sales within your existing customer base. But when can you also start to add new accounts, given this new portfolio of products that you can offer?

Todd Newton

Well, Matt, I think one of the things we mentioned in our prepared remarks is that -- and as we're in the fourth quarter part of our sports medicine Coblation sales growth related to the shoulder and in particular the MegaVac 90 products, is a shoulder wand and it competed, we think and it continues to compete very well with some of the wands that are in the market with some of our competitors but that's all shoulder driven business.

We're also seeing -- we're also seeing that the hip and knee wands are picking up and we think a lot of that has to do with the education program and our emphasis that we're placing in those new areas. We too want to see the new accounts number grow that is a major focal point of our sales and marketing leadership team as to see new accounts grow. That's also a very much a function of new products and being able to bring in those accounts things that they are interested in trialing and hopefully adapting. So we think that Sports Medicine has growth potential still though in the shoulder as well as of course the knee and hip area.

Matthew O'Brien - William Blair

Okay. But just trying to be a little bit more specific, roughly 4.5% proprietary Americas, Sports Med growth this quarter, would you attribute the majority of that growth to shoulder versus hip and knee?

Todd Newton

I don't think I would attribute anything more than the overall proportion that shoulder business is to our Sports Medicine business, I mean our shoulder business is the largest part of our Sports Medicine business and I think if we were to break up the dollars in terms of those three product area or procedure areas, we'd probably see that dollar wise the shoulder business is still the one that grows the most.

Matthew O'Brien - William Blair

Okay.

David Fitzgerald

I would say, -- I'd say Matt that was at the -- we have seen a pickup in our existing knee wands, although small but it's as a result we think of our educational program as we get surgeon more accustomed to viewing Coblation as a good alternative to allow for some of those knee procedures. And as Todd said, we see a pickup in our hip Wand sales, but the primary driver at this point in time would still be shoulder.

Matthew O'Brien - William Blair

Okay. And then just one more on the criminal DOJ investigation. You mentioned that you haven't received the proposal yet from the DOJ. Assuming that we get that here in the next week or so, what's the process in terms of finalizing something with them? I mean, how much leverage do you have to go back to them and after some type of concession in terms of what they are asking for?

And then, is there any way of potentially handicapping the likelihood of a DPA versus an NPA? And then also within there, when you think about the business, we're not going to have a chance to talk to you hopefully until this is all resolved again on one of these calls, but does that change your outlook for the business? I know people have been asking about your M&A activates, but does it change your outlook once that's complete in terms of increased investments in technologies, potentially emerging markets or even strategic alternatives?

Todd Newton

Wow that was quite a question, Matt. Let me take part A, B and C in order, or try at least. First we obviously are going through these DOJ investigations somewhat first time. I don't know that we've ever been advised by our attorneys though that these involve some kind of negotiation like you would think of in some other kind of settlement than you, but we've yet to see how this thing is really going to unfold, so we don't really have much color to give you on that.

On the DPA, NPA question we simply cannot comment about that at this time. We have our own view, but we can't handicap the views of the Department of Justice and their views are going to probably be very important to ultimately where we shake out.

And the resolution of the DOJ matter definitely changes our outlook. For one thing it avails to the company the credit markets, the debt market I should say. And we think that with our ability to generate cash as a company that we would be also able to raise a sizeable amount of debt capital. And of course that does change then potentially the outlook of the company with that expanded availability of capital.

Matthew O'Brien - William Blair

Okay. Thank you.

Operator

Thank you. Our next question coming from the line of Matt Miksic with Piper Jaffray. Please proceed with your question.

Matt Miksic - Piper Jaffray

Hey, good morning.

Todd Newton

Good morning, Matt.

Matt Miksic - Piper Jaffray

For taking that questions, I just have a few follow-ups and clarifications here. One, I'm following up on Bill's question about the pace of growth throughout '13 you anticipate and maybe what Q1 looks like. And I think someone else was after this as well. I mean, it sounds initially as you described Dave that the products coming later in the year that you know we could see kind of improving growth heading into Q4. And with given some of the uncertainties about getting these products to market, you know maybe given some of the annualizing distributor changes that you made last year, is it fair to say that these changes are really going to impact the company's growth in '14 or should we sort of think of the even growth kind of like '12 and then pick up in '14?

David Fitzgerald

I would say that you know that our view is around that. We are comfortable with that growth of 2% to 4.5%. We think that it's not a little back-loaded. We certainly think that as we expand our product portfolio that you know that hopefully that growth rate will pick up for us, you know it probably won't happen until 2014.

Like all things there is a bit of uncertainty in getting and rolling out those products and launching them successfully. So I don't anticipate any of these distributor changes to have a significant impact. You know they were relatively small changes compared to the whole. And I think what we will see for '13 is a kind of the reflection of what we had in '12, with a bit of a pickup in the later part of the year.

Matt Miksic - Piper Jaffray

Okay, that's helpful. And then in Q1, just to again put a sort of sharper point on it, should we expect the core Sports Medicine business to kind of you know help us may be with the seasonality? Is it flat into Q1? Do we pull back a little bit from Q1 there's just been a lot of variables that have impacted the growth over the past two quarters?

David Fitzgerald

It well already. We do have a seasonal business and our -- Q4 is our largest quarter of course. And when we look at you know going into the year that you know it's hard to do any predictions for Q1. And I'd just be a little circumspect on some of the seasonalization at this time and we will know a little bit more as we get into the quarter, of course it's the middle of February, but you know we're not seeing anything one way or the other. That's going to push the quarter one way you know up or down. It will probably come out as we anticipate similar on this seasonalization area.

Matt Miksic - Piper Jaffray

Okay. And seasonal would be sort of in line with Q4 or just off slightly I think as what I've seen in the past?

David Fitzgerald

It's off a little bit in Q4, that's right.

Todd Newton

Yeah, and Q4 is the big, guy. We are off -- we certainly would be off from Q4.

Matt Miksic - Piper Jaffray

Great. And then just one clarification on these new products, particularly on the ENT side, you mentioned the launch of late in the year, I just wanted to make sure or understand whether that is the theme, if this is a CIQ launch essentially that you're going to (Inaudible) something different?

David Fitzgerald

No, these would be directly for head and neck procedures and for turbinate.

Matt Miksic - Piper Jaffray

Okay. Any update on the--

David Fitzgerald

They would be entirely new -- yeah, they'd be entirely new products for us.

Todd Newton

The products that operate -- to your question products that operate on the existing platform, probably not the CIQ platform?

Matt Miksic - Piper Jaffray

Got it. Any update on the CIQ?

David Fitzgerald

No, we're still trying to finalize you know the FDA questions and expectations are that we'll get some feedback perhaps within the quarter.

Matt Miksic - Piper Jaffray

So is that something that I guess you given us sort of a view of the pipeline as it stands today, is it possible that -- I mean, is there chance of getting that product out this year or do you expect that you're going to get feedback and then that will be a product that comes in '14?

David Fitzgerald

Well, one thing for sure is that we -- you know it's been a while with the CIQ and we have yet to determine what our positioning of that platform will be, because perhaps you know to just let you know that the CIQ platform is complete, it's really the launch that we have working through the FDA. So that's yet to be determined how we'll position that.

Matt Miksic - Piper Jaffray

Okay. Well, thanks very much for the clarifications.

Operator

Thank you. Our next question is a follow-up question coming from the line of Bill Plovanic with Canaccord. Please proceed.

Bill Plovanic - Canaccord Adams

Great, thanks. I just had a couple of housekeeping questions. As we look at the P&L for 2013, what is going to be the tax rate that we should use given the R&D tax credit coming back and all of that?

Todd Newton

Yeah, we'll have a -- we'll pick up in this year's effective tax rate a little bit of the benefit that really belonged in 2012, just like everybody else will, but I think aside from that little nuisance, we're anticipating an effective tax rate, that's going to be in the 27% to 28% range.

Bill Plovanic - Canaccord Adams

So 27% to 28% for the whole year and then Q1 is the catch up from last year, right?

Todd Newton

That's right.

Bill Plovanic - Canaccord Adams

And then if I look at your amortization, it took a dive down in Q4, is something roll off and is that roughly $900,000 kind of the new base rate going forward?

Todd Newton

Yeah, I think, that's right. I'll check and make sure that that is the right way to see it, but that's right we had some of our intangible assets fully amortized if you are in the fourth quarter. And as a result, we anticipate a slightly lower expense as a result.

Bill Plovanic - Canaccord Adams

Except for obviously just the addition of the Eleven Blades, but that would be a small amount given the size of the purchase.

David Fitzgerald

That's correct.

Bill Plovanic - Canaccord Adams

Okay. And that's all I had from me. Actually just one other question I want to ask is just a follow-up on the (Inaudible) you mentioned that greater than 50% was related to the indemnity agreements, we saw about $6.5 million -- $6.4 million this quarter. Is this - while these are one time in nature just as we're trying to gauge this? Is there going to be a point at which this starts to tail off? Is there a trial for the defendants or is there something that you're indemnifying and to it will go away and we will see a significant drop off and if so when is that expected?

David Fitzgerald

And that's a very difficult question for us to answer with any degree of precision. We know that there is a trial date set of the two former officers that's have been indicted that is in the summer of 2013. I believe it's around the July timeframe, but I maybe off a month. And likewise with two other former officers they continue to have an ongoing dispute with the SEC concerning their Section 304 of Sarbanes-Oxley and we are indemnifying the costs related to that dispute as well and I don't know how long that will continue.

Bill Plovanic - Canaccord Adams

Okay, and as you look at the one that goes to trial mid-year. Is that - how - I don't have a lot of history of something like this. How long does a trial like that typically last and then once that's over does that kind of end the spending or is there a huge appeals process or just to the best of your knowledge?

David Fitzgerald

I don't know how long the trial will typically last, but I am sure that there would be some form of appeals available to the defendant.

Bill Plovanic - Canaccord Adams

All right, we'll stop there. Thank you very much.

Operator

Thank you. Our next question is a follow-up question coming from the line of Matthew O'Brien with William Blair please proceed with your question.

Matthew O'Brien - William Blair

Thanks, I'll try to be quick here. I just wanted to be a little bit more specific on the, not having received a proposal at this point. When you entered into the extension of the tolling agreement had you expected to see a proposal from the DOJ at this point or this can we frame this is somewhat of a delay from what you're anticipating when you entered into that extension?

David Fitzgerald

Sorry Matt, no comment on that. I mean, I don't think that we had any expectation other than at some point in time we were going to receive some proposed resolution of this investigation from the department. But as far as when we expected things this is - I would also say this is an investigation that's being going on for four years. So, our expectations have been going through roller coaster ride over this period of time.

Matthew O'Brien - William Blair

Sure. So just, I mean, again you may not have an answer to this one either, but if you were to get a proposal that seemed reasonable to you February 26, your lawyers maybe taking a day or two to take a look at it and you could have this thing completed that quickly assuming that it was something that was beneficial to the Company?

David Fitzgerald

Well I think we can say this for certain Matt. If we receive a proposal from the Department of Justice that we feel like is a reasonable proposal. We will certainly want to bring it to closure as soon as possible.

Matthew O'Brien - William Blair

Okay just one more quick one on the business Eleven Blade. Can you talk about the rollout strategy of that product and then just a sense of how that compares to juggernaut from a Biomet and the newer product just coming off from Arthrex at this point. Thank you.

David Fitzgerald

On Eleven Blade, we anticipate sometime in the second half of the year we will be able to put the entire Eleven Blade say portfolio together and we need to do some work on, development work on instrumentation. So we believe we'll have a very competitive product to juggernaut. And so we look forward to anticipation of that is going to be a good product for us.

Operator

Thank you. Mr. Fitzgerald there are no further questions at this time I will now turn the call back to you for closing remarks.

David Fitzgerald

Okay. Thank you. On behalf of the entire management team, thank you for your interest in ArthroCare. We appreciate everybody taking the time to dial in for today's call, and if you have additional questions regarding any information contained in the SEC documents we recently filed please contact Misty Romines in our Investor Relations Department and she will be happy to help you out. Operator, that concludes our call for today, thank you.

Operator

Thank you. Ladies and gentlemen, that does conclude the call for today. We thank you for your participation, and ask that you please disconnect your lines. Have a great day.

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