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ArthroCare Corporation (NASDAQ:ARTC)

Q2 2013 Earnings Conference Call

August 6, 2013 8:30 AM ET

Executives

Misty Romines - IR

David Fitzgerald - President and CEO

Todd Newton - EVO, CFO and COO

Analysts

Matt Hewitt - Craig-Hallum Capital Group

William Plovanic - Canaccord Adams

Matt Miksic - Piper Jaffray

Matthew O'Brien - William Blair

Robert Scott - Sidebar Capital

Operator

Ladies and gentlemen, thank you for standing by and welcome to the Q2 2013 Financial Results 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, Tuesday, August 6, 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 second quarter 2013 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 have 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-Q for the quarter ended Jun 30, 2013 that was filed yesterday afternoon. 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 measure 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 you this morning. Our goal this morning is to discuss our second quarter, which was very active, and provide you with an update on what we are planning for the rest of the year. Obviously, as you are looking at our results for this quarter, you will see that we have taken a material charge related to our DoJ matter, that has been outstanding since 2008.

To address this issue first, as you will note from our 10-Q, we have begun resolution discussions with the DoJ, and as a result of these discussions, we think that resolution will likely involve continuing obligations for the company, such as a deferred prosecution agreement with the government. In basic terms, a deferred prosecution agreement, otherwise known as a DPA, is an agreement between prosecuting authority and a potential defendant, in which the defendant agrees to comply with certain requirements, such as the payment of the financial penalty, and the requirement to monitor implemented measures designed for future incidents of concern to the prosecuting authority.

Based on the initial resolution discussion with the DoJ, our best estimate of the financial penalty, we will be required to be pay as part of our likely DPA, is $30 million. As a result, we increased our accrued liabilities on our June 30, 2013 balance sheet to reflect this best estimate, which resulted in us recording the charge of $20.2 million in the second quarter. We are not able at this time, to estimate the length of time or other conditions that may be associated with the DPA.

However, we expect the continuation of the company's existing compliance monitoring and reporting systems will be in important condition of a final resolution. The actual amount of penalty we are required to pay, and the other terms and conditions that resolution may be greater or less than our current best estimates, and the timing of final resolution payment of any financial penalty, cannot yet be determined. We expect any resolution, resulting from ongoing discussions with the DoJ will require approval by the Federal Court, before it will be final.

Over the last four years, we believe the company has provided the government with the fullest cooperation possible, and we remain committed to full cooperation.

So I will now turn the call over to Todd, to run through the second quarter results in more detail, and I will come back before questions, with further comments. Todd?

Todd Newton

Thank you, David. Total revenues were $92.1 million this quarter versus $91.7 million for the second quarter of last year, an increase of approximately $400,000 or less than 1%. Product sales were unchanged at $87.5 million in both the second quarter of 2013 and 2012.

In Sports Medicine, worldwide product sales increased $1.2 million or 2.1% due to higher proprietary product sales. For proprietary Sports Medicine products, which are those products that are ArthroCare branded and distributed, worldwide product sales increased $2.4 million or 4.7% this quarter. However, contract manufactured product sales decreased by $1.2 million to $5.3 million this quarter, compared to $6.5 million in the second quarter of 2012, a decrease of 18.1%.

Geographically, proprietary Sports Medicine product sales in the Americas increased $1.1 million or 3.4%, which was offset by the $1.2 million decrease in contract manufactured product sales in the quarter as I just referenced. The increase in America's proprietary Sports Medicine product sales in the quarter, was a result of higher product sales of Coblation products designed for knee and hip arthroscopies, partially offset by lower average selling prices, which were down approximately 2% compared to last year. Fixation product sales were mostly unchanged this quarter.

International Sports Medicine product sales increased $1.3 million or 6.7% in the second quarter of 2013, compared to the same period in 2012. Product sales in direct markets increased 8%, and comprised approximately 84% of total international Sports Medicine product sales in the second quarter of 2013.

In ENT, worldwide product sales decreased approximately $400,000 or 1.4% in the second quarter of 2013, when compared to the same quarter last year. In the Americas, ENT product sales decreased $300,000 or 1.6% as compared to the second quarter of 2012, as a result of lower tonsillectomy Coblation product sales.

We think that the decrease in tonsillectomy product sales is due to less tonsillectomy procedures, and we expect a decrease in tonsillectomy procedures to be a trend that will continue. Our field is more often reporting that customers are being required by payors to receive prior authorization for tonsillectomy procedure. We believe that one of the factors affecting this, is the growing influence of the American Academy of Otolaryngology head and neck surgery organization's practice guidelines, which were issued in 2011, and increased the number of recommended infection episodes that should be observed in pediatric patients, before prescribing the tonsillectomy procedure for that patient.

Additionally, the proportion of tonsillectomy procedures that are being performed in surgery centers appears to be increasing. The surgery center environment remains very cost sensitive, and as a result, additional electrocautery devices have a higher market shares than in hospital settings.

International ENT product sales decreased less than $100,000 this quarter, as a result of timing of distributor shipments. We anticipate that our acquisition of ENTrigue Surgical will begin to have a positive impact on our ENT business this year. We are training our sales force on the ENTrigue portfolio of products, and are hopeful for growth from these products, that will counter some of the tonsil market challenges.

Other product sales, which are primarily spine Coblation product sales decreased to $800,000 in the second quarter of 2013, as compared to the same period a year ago. Other product sales continue to represent a small portion of total product sales. Royalty, fees and other revenue was $4.6 million in the second quarter of 2013, compared to $4.2 million in the same period of 2012, an increase of 8.6%.

As most of you will recall, our new product introductions plan for 2013 were always expected to come in the second half of the year, and shortly, David will provide an update to our revenue growth outlook for this year.

Continuing now with a review of the second quarter earnings; the company's gross profit in the second quarter of 2013 decreased $1 million compared to the second quarter of 2012. Gross product margin for the second quarter of 2013 was 67.1%, compared to 68.8% in the second quarter of 2012. The decrease in gross product margin this quarter was primarily related to the medical device packs, which came into effect on January 1, through all U.S. product sales, as well as lower planned throughput this quarter, than in the second quarter of 2012. This quarter, we reported an operating loss of $11.1 million, compared to operating income of $17.9 million in the second quarter of 2012, resulting in a negative operating margin in the second quarter of 2013 at 12%, compared to a positive operating margin of 19.6% for the same quarter in 2012.

Operating expenses were $74.4 million this quarter, compared to $46.4 million in the second quarter of 2012, an increase of $28 million, with $25.2 million of that related to an increase in investigation and restatement related expenses. Of the $25.2 million increase this quarter in investigation and restatement related costs, $20.2 million was the charge we recorded to increase our insurance dispute reserve, which David referenced in his opening remarks. This insurance dispute reserve, which was previously $9.8 million, is now $30 million as of June 30, 2013 and reflects our best estimate of the likely financial penalty we will incur to resolve the outstanding DoJ investigation.

We also incurred approximately $5.2 million in the second quarter of 2013 in legal and defense costs, in connection with both our ongoing legal matters, and to advance legal defense costs to former officers, in accordance with the indemnity agreements with these former officers. These costs will likely continue to be significant in the future.

Adjusted operating margin, which is operating margin excluding investigation and restatement related costs was 16.6% in the second quarter of 2013, compared to 20.8% for the second quarter of 2012. Research and development costs were $8.7 million in the second quarter, as compared to $7.9 million in the same quarter of last year, an increase of about $800,000. The increase in R&D expenditure is consistent with our recent quarterly trends, and consistent with our previous comments that we would invest in key clinical and product development needs of both our Sports Medicine and ENT product areas.

For Sports Medicine, the higher R&D expense can be attributed to our new initiatives that we have been discussing for the past few quarters, and for ENT, we continue to invest in Coblation applications, intended to reduce the degree of dependency we have on tonsillectomy procedures.

Sales and marketing expense as a percentage of total revenue was 32.8% of revenue in the second quarter of 2013, compared to 31.5% in the second quarter of 2012. The increase is a result of efforts to expand our sales and distribution coverage, and salesforce training in support of anticipated future product introductions. General and administrative expenses increased by $500,000 this quarter over the second quarter of 2012, due to professional fees incurred this quarter in support of the acquisition of ENTrigue Surgical, and the investment in Ortho-Space, both of which we announced in early July.

Partially offsetting our increased operating expenses was lower amortization expense of intangible assets, as we had fully amortized certain intangible assets related to our 2004 acquisition of Opus Medical as of the end of 2012.

Our loss before income tax this quarter was $11.4 million and we reported an income tax benefit this quarter of $4.7 million for an effective tax rate of approximately 41%. Income taxes this period were impacted by two discrete items; first is, as we preliminarily reported in our first quarter, in April, the company reached settlement to conclude the IRS examination of prior federal tax returns. The final settlement covered the 2006 through 2011 tax years, and we have recorded a $10 million net tax benefit in the second quarter of 2013.

Second, we reversed approximately $3.7 million of deferred tax assets, based on our current assessment that the insurance dispute reserve will most likely be part of a monetary settlement to resolve the DoJ investigation for which no tax deduction is likely to be allowed.

In summary, the net loss attributable to common stockholders was $0.27 per share in the second quarter of 2013, compared to net income available to common stockholders of $0.34 per share in the second quarter of 2012.

Turning quickly now to our balance sheet and liquidity; at June 30, 2013, we held cash and cash equivalents of $251 million, an increase of $32.2 million from the end of 2012, and for the six months ended June 30, 2013, cash flow provided by operations was $45.5 million versus adjusted cash flow provided by operating activities of $41 million for the first six months of 2012, an increase of approximately $4.5 million.

In the first quarter last year, our reported cash flow used by operations was $33 million, as that period's operating cash flow, included the $74 million payment to settle the private securities class action, that has been pending against the company.

And with that, I will now turn the call back over to David.

David Fitzgerald

Thanks Todd. We think the acquisition of ENTrigue Surgical and our investment in Ortho-Space that we announced on July 2, will both be a good fit with our existing sales channel. ENTrigue Surgical was a privately held company, based in San Antonio, Texas, that specializes in sinus surgical products. With more than 30 million Americans suffering from sinusitis, and 500,000 of those being surgically treated each year, the products that ENTrigue develops, will allow us to enter the sinus market, a market we currently do not participate in.

Sinus surgery has been an area that we have desired to enter for some time, and consistent with the current primary call of our sales organization. We think, ENTrigue products will complement our current Coblation and Rapid brand of product lines used by ENT surgeons worldwide. We paid approximately $45 million in cash, and we are obligated to make contingent payments over the next five years, the value of which will be based on annual sales growth.

While we think ENTrigue products are going to have a positive impact on our second half of 2013, their impact on our overall revenue growth assumptions for the second half of 2013 are tempered by the fact that ENTrigue did not have much distribution capability, and therefore the beginning customer base is very low. Our immediate goal for 2013 is salesforce training and scaling up supply capabilities.

We also announced on July 2, that we had invested $3.7 million in Ortho-Space to acquire 19.8% voting interest in the company. In conjunction with this transaction, we also obtained distribution rights in certain markets outside the United States. Ortho-Space InSpace product is a viral degradable balloon, that is indicated for rotator cuff syndrome and implanted simply using minimally invasive techniques, such as arthroscopy and mini-open procedures. The balloon acts as a physical barrier between tissues and the subacromial space, to act as a spacer and help alleviate pain. It is currently CE marked in Europe and in the regulatory path in the United States.

The acquisition of Eleven Blade in January of this year, and their all suture soft anchor technology is expected to be released in the early part of Q4 this year. On the pipeline front, our second half product releases are expected to include expansions to our suture passing product portfolio for use in shoulder and hip, as well as extensions to our MultiFIX suture anchor platform for those patients with poor quality bone.

We are continuing to press forward with our Knee Campaign. The medical education component of our campaign that we initiated last year, and have discussed with you in the past, is intended to raise awareness, address common misconceptions and reinforce the clinical facts concerning the use of Coblation during knee arthroscopy. In the second quarter, we held nine more education events in the United States, with nearly 90 surgeons participating. Our mobile labs has also been very busy this quarter, with more than 20 stops and 80 attendees [trained].

We have observed an increasing interest by surgeons at these events and have seen an uptick in sales of (inaudible) designed for the knee. In the latter part of the year, we anticipate a limited release of an ACL reconstruction system, which we hope will become a meaningful entrant into the knee fixation area. Our R&D efforts also include the development of a new energy platform, that can deliver Coblation in versatile operating modes, specifically designed for knee tissue types. This new Coblation platform is expected to see initial trials outside United States late this year, and then in the United States market, sometime around in the middle of 2014. We continue to believe, that knee arthroscopy is an important opportunity for ArthroCare and we are investing significantly to be able to participate in this procedure area.

In ENT, we continue to focus on expanding the ENT indications and procedures that can benefit from Coblation, such as our new product introductions towards the end of the year for both turbinate and head and neck procedures. We think both further enhance our ENT portfolio of products to the ENT surgeon. Critical to the success of our new products will be our salesforce, and as indicated by our increased expense in sales and marketing areas this quarter, we have been actively looking to prepare our U.S. and O-U.S. sales and distribution organization for the products to come, while maintaining our ability to support existing products and customers, in both Sports Medicine and ENT.

Let me finish by summing up all of the above. Early this year, we provided an outlook for 2013 year, that included an overall revenue growth outlook of between 2% and 4.5%. We think we have made some key investments and have a new product pipeline that will improve our growth outlook in the second half. But at this time, we are revising our 2013 revenue growth outlook to the low end of our original range, as a result of uncertainties concerning the timing of new product introductions in the second half of this year.

For operating margin, our outlook for 2013 was to achieve an adjusted operating margin of 18.4%. For the first half of this year, adjusted operating margin was 17.7%. The ongoing operation and integration costs related to ENTrigue will modestly add to our operating expenses in the second half, by approximately $2 million. As a result, our ability to offset these added costs and achieve our outlook, will depend on how revenue develops in the second half of the year.

Free cash flow through the second quarter was $41.7 million, in the second half of 2013, we expect to incur higher capital expenditures, in connection with our announced plans to construct a new manufacturing facility in the Coyol Free Trade Zone in Costa Rica.

Over the course of the next 18 to 24 months, we expect to spend between $35 million to $40 million on the land building and equipment, to enable this new facility. The new factory space will allow us many opportunities to address current operational inefficiencies of our existing facility, while enabling us to support new technologies, that are vital to our future business success. In addition, we expect investment will lead to the extension of many of the local tax benefits that our current Costa Rican operation receives.

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

Thank you. (Operator Instructions). We will proceed with our first question from the line of Matt Hewitt with Craig-Hallum Capital Group. Go ahead with your question.

Matt Hewitt - Craig-Hallum Capital Group

Good morning and thank you for taking our questions.

David Fitzgerald

Good morning Matt.

Matt Hewitt - Craig-Hallum Capital Group

Good morning. My first question, congratulations on the progress, it's great to hear that you are moving forward with the Department of Justice. Just curious, the $30 million number, how did you come up with that number, is that something that has come up in the discussions? What kind of confidence level do you have, that that's in the right ball park?

David Fitzgerald

Well, the number came out of discussions with the DoJ, and although I am not privy to the exact negotiations, but we think that the $30 million is the likely outcome, however it could change. But there is no detail that I can provide you.

Matt Hewitt - Craig-Hallum Capital Group

Okay, all right. Thank you. Then shifting gears a little bit. The ENTrigue acquisition I think this (inaudible) I know should be a fabulous market for you. And I am curious, what type of growth you anticipate, because something has to be very moderate, given the lack of distribution that ENTrigue had prior to your acquisition, but what are you expecting more so for 2014? I mean, is it something where you could see $5 million, $10 million in the revenues, or how should we thinking about next year?

David Fitzgerald

Well, I think you are correct in the assessment that this year is going to be very modest, and we also -- I agree with you, I think it's going to be a great fit for our company, and although I don't want to predict anything for 2014, but we think the growth that ENTrigue products will contribute, will be much greater than we have here in 2013. So I'd rather not pass on any anticipated growth that we have for 2014, but we certainly are going to train our sales force and the expectation that it will be an important contributor to our sales revenue.

Matt Hewitt - Craig-Hallum Capital Group

Do you think you will be in a position, maybe obviously it's very recent, but will you be in a position, maybe on the Q3 call or do we have to wait until your Q4 call to get some sense for what that segment can contribute and grow in 2014?

David Fitzgerald

My preference is to wait until the Q4 call, because that's generally when we will give out some guidance, in and around the late February timeframe.

Matt Hewitt - Craig-Hallum Capital Group

All right. Thank you for answering the questions.

Operator

Thank you very much. We will proceed to our next question from the line of Bill Plovanic with Canaccord. Go ahead with your question.

William Plovanic - Canaccord Adams

Great thanks. Good morning. Can you hear me okay?

David Fitzgerald

Yes we can.

William Plovanic - Canaccord Adams

Good. So just on the discussions with the DoJ, you basically shut that business down, so I just -- one of my questions was, if there is a DPA, would there be a monitor associated with that, and if so, what will they be monitoring? Then my second question is, a follow-up is, I didn't see anything in the Q or in the press release or discussion regarding the civil investigation around the ENT business, is that being wrapped into this discussion, or is that just -- you got to clear one, and then we start on the other?

Todd Newton

Well the reason Bill, that you didn't hear about the civil investigative demand, is because we just simply don't have an update, and in our prepared remarks we limited the discussion to that, where do have an update. In the 10-Q there really isn't any update to provide on civil investigative demand. As far as the monitoring question is concerned, we don't know what conditions will come with the -- any DPA. What we can report at this time, like David has mentioned is, we think that we have a relatively good estimate for the amount of the fine. We think that a DPA is probably going to result from the discussion, but as it relates to things like length of time, as it relates to things like whether there will or won't be a monitor, we don't have any clarity on those questions at this time.

William Plovanic - Canaccord Adams

Has there been any discussion of a monitor at this point?

Todd Newton

The discussions with the DoJ are just that, and we'd prefer not to get into what the discussions all involve.

William Plovanic - Canaccord Adams

Okay. And if I get to squeeze one more in, just to ask, was there an extra selling day in the quarter, and do you have what's Q3 and Q4 in terms of selling days? Thank you.

Todd Newton

All I can tell you right now is, there was not an extra selling day in the second quarter. As far as the number of selling days, Q3 and Q4, I will have to get back to you on that Bill, because I just don't have that top off mind.

William Plovanic - Canaccord Adams

Thank you.

Operator

Thank you very much. We will proceed to our next question, to the line of Matt Miksic with Piper Jaffray. Go ahead.

Matt Miksic - Piper Jaffray

Thanks for taking my question. Can you hear me okay?

David Fitzgerald

Yes we can.

Matt Miksic - Piper Jaffray

Well there is background noise here. So one follow-up on the costs kind of coming -- that continue your -- related to the DoJ investigation and the indemnity costs. Can you -- first maybe, give a sense of whether we are over the hump of those costs, what they look like maybe, trailing out from here, and speaking of the indemnity of its former executives. Then just kind of pin in this settlement if we can, it was a relatively small business, it is, as Bill pointed out, closed down. Can you give us a sense as to whether the scope of this resolution would go wider than the original business, or is the context around what used to be the spine subsidiary? I have one follow-up.

Todd Newton

Okay well, Matt I am going to deal with the first question you have about expectations on the indemnity costs going forward, and then I will let David talk about the nature of the settlement. We expect that the indemnity costs are going to continue to be significant here in the second half of the year. While it would appear that there has been some form of resolution involving two former officers, there were two other former officers that were indicted recently, and we'd expect that there would be significant amount of defense costs related to those actions. So our anticipation for the second half is more the same in terms of what we saw in the first half, and I will let David deal with the second part of your question.

David Fitzgerald

You know, when we look at this case, it isn't so much centered on a small piece of the business, because it is a securities related case, and if you review the indictment of the former officers, it clearly is about accounting issues, and so it doesn't necessarily spillover from a small amount of revenue and from the DoJ's standpoint, they calculate the loss or the fraud, however you want to characterize it, from a beginning point, where we announce a restatement, back in July of 2008, and it's a significant amount of money in their calculation, and -- if we gave them amount of money, their calculation and they put in $400 million. So it's much broader in scope, in terms of not just related to a small piece of our business in the spine area, where we closed down, and so that's how I would characterize that. Matt, I don't know if that answers your question or not?

Matt Miksic - Piper Jaffray

That's helpful. I guess -- I mean, a lot of folks I think are looking at this DPA and settlement in the context of some of the (inaudible) device settlements like that, and the one related towards the (inaudible). Maybe, is it fair to draw the assumption here that as you pointed out, (inaudible) it was related to accounting fraud, and therefore, I guess the monitoring DPA conditions, ongoing compliance requirements would be related to accounting, whereas, (inaudible) but that was anti-kickback and so therefore, if it has a great deal of more scrutiny and ongoing monitoring in the interaction between the company and its surgeons. So is that a fair distinction between the two and understanding these (inaudible)?

David Fitzgerald

Well that point of view is -- you could say that that's valid. There is a difference between what is our interaction with the DoJ and what occurred with the other orthopedic companies years ago. One of the things that I'd like to point out is that, our management or prior management has completely turned over. We are not in that business any more, in that small piece of it, so it's hard to make a comparison between the two, and I wouldn't go so far as to say that, one or the other is going to characterize how likely the outcome would be. All I can say is that, we are continuing to cooperate, and we have since the very first day, and I believe that our compliance programs and our monitoring is robust, and I think that's the consideration that DoJ will take into account. But we still don't know the end resolution here. We have our best estimates out there in the financial penalty, and the likelihood is that we will have a DPA, but as Todd said, that's all we know at this moment in time.

Matt Miksic - Piper Jaffray

That's very helpful. Thank you, David for the color. Just one product related question. You mentioned that back half launches, you tried to (inaudible) your top line expectations down at the bottom end of the range. Can you talk may be a little bit about when in the back half or how these launches -- the new products will kind of hit? Should we expect sort of a sequential improvement, should we expect just -- I suspect we are looking for a step-up in Q3, any kind of facing in the back half would be helpful. Thanks.

David Fitzgerald

Okay. To address that, we do have uncertainties. We are in the regulatory pathway, it takes a while of course, as you all know, to ramp up. My view right now is, it's all back loaded into that fourth quarter and if we have some slippage, which we have had a little bit already, I am just cautioning everybody that we are going to be on that low range. I don't think it will come (inaudible) or in Q4, but I think that we will get our products released and we will get them out the door, and we are confident that the products will have an impact at some point in time, perhaps not in -- help us in 2013, certainly in 2014.

Matt Miksic - Piper Jaffray

Great, thanks so much.

Operator

Thank you. We will proceed to our next question from the line of Matthew O'Brien with William Blair. Go ahead with your question.

Matthew O'Brien - William Blair

Good morning. Thanks for taking the question. I was hoping to start off, with just the impact to the strategic year of the company going forward, with the DPA in hand, I mean, is this change the way that you guys are thinking about the company, or your view over 12 to 18 months, and specifically would it eliminate any kind of interest on your behalf, in terms of potentially selling the company or somebody else looking at the company?

David Fitzgerald

Well I don't think that's [dragging] on us for our day-to-day management or even strategically. What we are trying to do, is create value the best we can to the shareholders, and obviously if we have a DPA and it means doing what we do right now, and that's continuing to -- there will be monitoring and there will be perhaps other conditions that may be imposed. But as far as the business is concerned, we are continue to develop products, and hopefully increase our growth outlook for the years to come.

Whatever anybody else thinks for the company as far as an acquisition, I mean, there is no way we can even speculate on that. So my answer is that, we are going to continue to do what we believe is appropriate to create value, and invest in R&D and I think that's what we are doing right now.

Matthew O'Brien - William Blair

David, just specific to you -- you come off the board to run the company, you get through this process, it appears that we are probably no closer than 18 months away from being finished with likely the other is your DPA process. I'd just like to get your sense for your energy in terms of seeing things through, all the way to the end versus trying to (inaudible) with this process at some point?

David Fitzgerald

Well that's an interesting question, because I think about it myself and I originally had come off the board to try to help the company, and hopefully that I have. We have a great management team, and they are very-very supportive of me and the board and hopefully our shareholders. So as I look forward, I hope I'm alive in 18 months, but seriously, I enjoy my work. I love this company, I have a great deal of energy, and I want to do as much as I can to help this company be successful and when and if the board and I decide that we are going to address that issue, which has not been addressed, I might add. Whether that's in the next 12 to 18 months, I can't really say. But I can tell you one thing, each and every day that I come to this company, I bring everything I can to have my energy level up high, and it's terrific. Very grateful for the fact that I was able to lead this company over the last four and a half years.

Matthew O'Brien - William Blair

Okay, very good. One more question if I may, just on the product side of things. It would just be helpful if you could give us a sense for some of the market opportunities that you are pursuing on the knee side, in terms of total opportunity, and then on the product (inaudible) side, because you are going to be facing some pretty challenging competitors in the arthroscopy and then on the (inaudible) side of things. Then within that question, how are your products compared to the incumbents?

David Fitzgerald

At a high level, Matt, and we can obviously talk more specifics in a different venue. But at a high level, our interest in the knee area is simply because there are generally three times more knee arthroscopies performed every year versus shoulder arthroscopies, and we have obviously been able to build a very good business around shoulder arthroscopy. We think our technology has a great fit for knee arthroscopy, and that's the size if you will, of potential that we are trying to go for.

On the ENT side, on the sinus surgery side, that is the fastest growing part of ENT today. There are a number of procedures being performed. It is probably where the most dollars are today. So we are talking about getting into an expanding market, where we haven't been before, and our anticipation at least, is that there is room in that market for a number of competitors, and hopefully, we will be a very good competitor in that marketplace.

Matthew O'Brien - William Blair

Great. Thank you.

Operator

Thank you very much. We will proceed to our next question from the line of Robert Scott with Sidebar Capital. Go ahead with your question.

Robert Scott - Sidebar Capital

Hi. I wanted to know, if you have had discussions with DoJ about expanding the tolling agreement, and if so, would it be extended for the duration of the prosecution of the former CEO and CFO?

Todd Newton

Robert, we have not had any discussions regarding the extension of the tolling agreement. Our tolling agreement currently runs through the end of August. If we were to say what we hope will happen, we hope that we will continue the current discussions with the DoJ, resolve the matter as far as it relates to the company, and as a result, the following agreement extension wouldn't be necessary. But we don't know whether that will happen in that timeframe, as we talked about in our prepared remarks. We continue to be cooperative with the Department of Justice. We were cooperative with the Department of Justice, before we had a tolling agreement. We intend to be cooperative with the Department of Justice, after we no longer have a tolling agreement. Our view would be that tolling agreement is not linked to cooperation in any way.

Robert Scott - Sidebar Capital

One last question, does that tolling agreement encompass anything related to the false claims investigation, the CID subpoena?

Todd Newton

No it does not. The false claims matter is a civil matter, whereas the tolling agreement relates to the original criminal investigation involving the company, and as a result, the tolling agreement really has no bearing, hasn't any relationship with the civil matter.

Robert Scott - Sidebar Capital

And I know, you mentioned that the accounting fraud that might be the subject of the prosecution of the former CEO and CFO, did I hear you correctly say that that might be as much as $400 million, and if so, could ArthroCare as a company have to face higher penalty related to the outcome of the prosecution of the former CEO and CFO?

Todd Newton

The $400 million that David referenced is the headline when you look at the Department of Justice's own press releases when they have announced indictments in the past. They reference the $400 million. So what David was referring to was, how does the DoJ frame up the size of the issue, and we base that on their headline.

Robert Scott - Sidebar Capital

Thank you very much.

Operator

Thank you. And our next question is another follow-up question by Mr. Bill Plovanic from Canaccord. Go ahead.

William Plovanic - Canaccord Adams

Great. Thanks. Just on the FX impact in the quarter, how much was it?

Todd Newton

The FX impact this quarter was really not very important to us. It was basically -- constant currency revenue growth was the same as reported.

William Plovanic - Canaccord Adams

Okay. So it was zero. So for the Medtech tax. I know you referenced it, but roughly how many bips was it?

Todd Newton

Well, in terms of bps, I think what I'd rather just say it was slightly less than $1 million in total costs.

William Plovanic - Canaccord Adams

Okay. And your gross margins were wide in the quarter, as I read through the Q, the other section was up by $600,000. I am just trying to -- as you look at the COGs, and I am just trying to figure out, you announced or restated that it was under utilization throughput down in Costa Rica, but is there anything else, is it a shift of products, is it a shift of type of customer, or I mean, -- I think you are maybe 100 bps off of what we were looking for, so I am trying to figure it out?

Todd Newton

Yeah, this quarter, there has been a couple of things. We referenced the medical device and [that's of course], I think you have been factoring into your estimates. We also mentioned that in Sports Medicine, we had a reduction in our average selling price, a little bit around 2%, and that obviously also will have a margin impact.

William Plovanic - Canaccord Adams

Is that, I mean, we saw that last quarter and the quarter before. Has that pricing been degrading more over the last couple of quarters?

Todd Newton

Actually, we saw the return of pricing pressure in the second quarter. If we go back to the first quarter of this year and really fourth quarter of last year, we had seen a moderation of the pricing pressure. Here in the second quarter, we felt like we saw more of that, than actually the last couple of quarters. If we go back to the late 2011, early 2012 timeframe, that was a period of time as well, where we were seeing a lot of pricing pressure. It sort of drifted away. Like I mentioned the latter part of last year and early part of this year, and here in the second quarter, we experienced it again.

William Plovanic - Canaccord Adams

Is there any specific driver for that? Do you think?

Todd Newton

It seems to be -- certainly in our Sports Medicine area, we don't see the same pricing pressure on the ENT side, we still don't see pricing pressure on the ENT side, even though we know that the tonsillectomy procedure is declining a little bit. So now it's just really, I think related to the age of some major portions of our portfolio, and it also emphasizes the need for us to execute well on our new products.

William Plovanic - Canaccord Adams

Okay, that's all I had. Thank you.

Operator

Thank you. We do have one more question in the queue, it is another follow-up question in the line for Robert Scott from Sidebar Capital. So go ahead.

Robert Scott - Sidebar Capital

Thanks guys. One last question, on the tolling agreement, it expires at the end of August, I believe. Is the company open to extending the tolling agreement with DoJ, and if so, do you think the tolling agreement would be extended month-to-month or could the tolling agreement be extended for the duration of the prosecution of the former CFO and CEO? I think another gentlemen on the call indicated that might be 18 months in duration. I am just trying to get a sense of, how much longer do you think the negotiations and such will go on with DoJ?

Todd Newton

Yeah, we just really don't have an answer for that question Robert. We don't know. What we do know is that, if we get to the end of the month and the DoJ does ask for an extension of the tolling agreement. At this point, we would very likely grant that extension. As far as how long will the extension be, we really don't know.

Robert Scott - Sidebar Capital

Okay. Thanks a lot guys.

Operator

Thank you very much. Mr. Fitzgerald, we have no further questions on the phone, I will turn the call back to you.

David Fitzgerald

Thank you. To conclude, our goal remains to provide the appropriate balance of growth, with improvements to operational efficiency and cash flow generation, to create value for our shareholders in both the near and long term. On behalf of the entire management team, thank you for your interest in ArthroCare. We appreciate everyone taking the time to dial into today's call, and if you have any 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.

Thank you, that concludes our call for today.

Operator

Thank you very much. And ladies and gentlemen, that does conclude the conference call for today. We thank you for your participation and ask that you disconnect your lines. Have a good day everyone.

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