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ArthroCare Corporation (NASDAQ:ARTC)

Q1 2008 Earnings Call

April 21, 2008, 4:30 pm ET

Executives

Cory Irvin – Director of Investor Relations

Michael Baker – President and CEO

Michael Gluk – Senior Vice President and CFO

Analysts

Mark Mullikin – Piper Jaffray

James Sidoti – Sidoti & Company LLC

Daj Denhoy – Bear Stearns

Steven Lichtman – Banc of America Securities LLC

Bill Plovanic – Canaccord Adams

Joanne Wuensch – BMO Capital Markets

Operator

Ladies and gentlemen, thank you for standing by and welcome to the Q1 2008 Financial Results and Business Update. (Operator Instructions) It is my pleasure to introduce Ms. Cory Irvin, Director of Investor Relations. Please go ahead, ma’am.

Cory Irvin

Good afternoon and welcome to ArthroCare’s First Quarter 2008 Conference Call. Joining us on today’s call are Mike Baker, President and CEO of ArthroCare, and Mike Gluk, ArthroCare’s CFO.

By now you all should’ve seen a copy of today’s press release which is released earlier this 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: Other than historical information, the matters we will be discussing today to consist of forward-looking statements. These statements are subjects to the risks and uncertainties detailed in our Securities and Exchange Commission filing, including our 10-K for the year ended December 31, 2007. Actual results could differ materially. 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.

I will now turn the call over to Mike Baker.

Michael Baker

Thanks, Cory. In our last conference call, we laid out our initiatives and financial expectations for 2008. These included an ambitious product development plan leveraging our technology platforms to reduce a series of compelling new products, a broad clinical research program to establish new indications like Topaz and to drive market acceptance for existing indications like plasma disc decompression and aggressive investment in strengthening our global distribution channels in each of our business segments.

We now have the first quarter in the books and we are happy to be able to report that the business is continuing to perform extremely well, tracking ahead of plan on both the revenue and earnings per share basis, and that we are on track to accomplish all of our strategic and financial objectives for the year.

In Q1, we saw significant growth in product sales across all of our business segments with all three segments reporting increases of more than 20% for the second quarter in a row. Product sales in our largest business, Sports Medicine, increased by more than 25% from Q1 of last year; and it appears likely that this segment will continue to track ahead of guidance for the balance of the year. Our Spine business continued to grow rapidly and growth in our ENT business accelerated as we saw the beginnings of traction in both new indications and European tonsillectomy penetration.

As you can see from the first quarter results, we are well positioned to accomplish all of our objectives for the year and currently believe that we are poised to turn in a very financial performance in 2008 with revenue and EPS growth percentages even greater than the excellent results that we posted in 2007.

While the long-term demographic trends are purely in our favor, as you’ll hear today, the business is currently being driven by a potent combination of market share gains and our competitive position continues to improve in each of our businesses and increased penetration of breakthrough highly proprietary new therapies into significant unmet medical needs. We also continue to aggressively pursue clinical research on the efficacy of our products, and it is also important to understand that many of our products are used in therapies that greatly improve outcomes while simultaneously costing patients in the overall healthcare system less than traditional procedures. We believe that this combination has improved outcomes, matched with diminished costs is a key part of the success of our strategy.

Before Mike Gluk takes you through the financials, I’d like to take a moment to give you a brief update on several of the key initiatives in each of our business units. Let me start with Sports Medicine. As you can tell by the numbers from the last two quarters, our Sports Medicine business is on a serious role. Sports Medicine posted quarter-over-quarter revenue growth of over 25% in Q1 making it the second quarter in a row, plus 20% organically driven revenue growth in this our largest and best established business.

This growth is clearly being driven by the compelling new products that we introduced in the last few quarters combined with the investments that we made in strengthening our distribution channel. The strength is not limited in any one area or product line. We believe that we are taking market share from competitors across the entire spectrum of this business, and we are not seeing any competitive initiatives in the horizon that could disrupt this momentum.

One of the key new products driving this growth is the Quantum system, which was introduced in the third quarter of last year. The Quantum controller represents the next generation of Coblation technology, and it offers our customers features and a level of performance not available in any competitive system. Even though we made provisions to build a significant inventory of these systems to support its introduction, demand has exceeded our expectations and our greatest struggle currently is keeping up with that demand. We spent most of Q1 on backorder for this key product and it’s interesting to speculate on how well this business might have done without the product supply limitation.

In Q2 we planned to begin the introduction of a sophisticated intelligent integrated fluid management capability to the Quantum system in the form of the new Quantum pump. In and of itself this new pump has value added features not available on existing pumps, but when integrated with the Quantum controller, the complete system has significant advantages in both ease of us and performance over all existing surgical systems.

We also have four new Coblation wants targeted for release in the balance of this year that exploit the unique capabilities of the Quantum system, including multiple mode and electrode switching and environmental sensing. However, the quantum system is only of the products and initiatives that we expect to drive revenue during 2008 in this business segment.

In the Opus product line, we expect to launch a number of new products including versions of the popular magnum anchors that allow, that will allow for independent suture tensioning and a new screw anchor featuring Opus nautilus technology.

In addition to new products, we have a number of other important initiatives that we expect to drive the growth of the business. I’d like to take a moment to highlight three of them. One in the area of distribution and infrastructure, another in the form of a new therapy, and a third that we believe represents an entirely new and highly proprietary technology platform. Some of the most important components of our distribution infrastructure are the resources that we dedicate to customer training. In Q1, we significantly augmented those resources when we launched our new Mobile Surgical Skills Center. The mobile lab is a fully functional five-station skill center where sports medicine-related surgical training and physician education purposes.

The Mobile Skill Center allows us to take high tech training to surgeons without having to ask them to take time out of their practice to travel. This is particularly important for doctors who are working in smaller hospitals or surgery centers and for those who don’t have the opportunity to attend offsite training sessions. Over 100 doctors were trained in the lab in just the last two months of the first quarter, and the Company expects to train over 500 sports medicine doctors this year in the Mobile Skills Lab.

In the area of new therapy, we see the diabetes market has a potentially significant emerging opportunity for us. As we discussed in our Q4 conference call, we are seeing very promising results in our early experience with using Coblation technology to treat diabetic foot ulcers. Diabetic foot ulcers are a significant medical problem and a huge burden on the healthcare system (inaudible) on healthcare systems worldwide. There are an estimated 18 million in the United States with diabetes and approximately 5% of them with develop foot ulcers each year. Even if these ulcers cure, the recurrence rate is 66% and a significant number of these ultimately require amputation.

Foot problems are responsible for 15% of the hospital admissions and 25% of the hospital bed usage among diabetes. Treatment cost with current therapies can average $35,000 per patient per year and the current therapies are often ineffective. At the recent American College of Foot and Ankle Surgeons, we presented the data from our earlier experiences and we saw tremendous physician interest. We are now in the process of following up on that interest and organizing additional scientific and clinical research, but we conservatively estimate that this therapy could represent a market opportunity in excess of $1 billion annually.

In the area of new platform technologies, we’re also very pleased to announce that we expect to launch before the end of this year the first of what we expect will be a long line of exciting new products based on what we believe is a new and highly proprietary technology platform. Some time ago we acquired the rights to a set of unique metal and polymer technologies which shape memory properties as part of a partnership with a private medical technology company. We believe that there are potentially a large number of compelling applications for this technology in orthopedics, and we have a number of products already in development, the first of which we expect to launch before yearend.

The first product is a shape memory device for ankle fusion that has the potential to dramatically improve the outcomes in this very common surgery. After virtually ever quarter for the last decade, there’s been at least one report published explaining why our Sports Medicine business can’t possibly continue to grow; and the offer of those have been absolutely right every time in pointing out how competitive the Sports Medicine market is and how much larger our competitors are. But we believe that they have consistently underestimated the potential of our strategy of using highly proprietary technologies to produce a stream of innovative disruptive products to drive share gains and revenue growth. The past is of course no guarantee of the future, but I’ll say again what I’ve had said on so many previous quarterly conference calls. We continue to see tremendous opportunity for growth in our Sports Medicine business.

Now let me turn to the ENT business. In the first quarter in ENT, we saw product sales growth… We saw the products sales growth rate accelerate to 23% compared to the first quarter of 2007, and we believe that this business is clearly on track to meet or exceed the annual revenue growth guidance that we’ve given for it. This acceleration and growth was driven by our Coblation product lines and it occurred despite the fact that we spent much of Q1 on backorder for ENT controllers.

We saw strong growth in tonsil sales in key European markets, continued tonsil growth in the U.S., and drawing momentum in the new Coblation indications, particularly in sinus and Pediatric Turbinate. In the balance of the year, we expect to see additional clinical publications and presentations add to this momentum; and since we expect the controller supply issue to be resolved before the end of this quarter, we believe that this business is positioned to have a very strong year.

Finally, the Spine segment: Our Spine business recorded revenue growth of just over 24% in Q1; and while the business is on track to meet its objectives for the year, the Q1 numbers were a little below what we expected to see for the quarter. We had expected Q1 growth to be impacted by the integration of DiscoCare into DRS, and it was. We had anticipated a shortage of controllers; and as in the other business, we spent much of Q1 on backorder for spine controllers.

This shortage probably impacted this business more than the others as we currently have a much smaller installed base of spine controllers and this business is largely dependent on the acquisition of new customers for its growth. In any event, the acquisition integration is now complete, the controller shortage is being resolved and we believe that this business is on track to accomplish its financial objectives for the year.

Sales of our plasma disc decompression product continued to grow briskly in Q1, and we expect to see this trend continue over the balance of the year as we have key clinical presentations and plasma disc decompression data scheduled at every major upcoming spine and neurosurgery meeting, including the Spine Arthroplasty Society meeting in Miami next month, the IASP meeting in Glasgow in August, the Congress of Neurological Surgeons Meeting in Orlando in September, and NAS in Toronto in October. We also expect to see the data from (inaudible) published in pure review spine and neurosurgery literature before the end of the year, which will help to continue to drive penetration and improvements in the global reimbursement environment.

Before we talk about the rest of the spine business, I want to take just a moment to comment on the closure of the recent NASDAQ inquiry. As some of you know, NASDAQ has very broad authority to investigate the business activities of its listed companies. In Q1, NASDAQ listing investigations opened a review related to DiscoCare. We believed NASDAQ opened its review as a result of the negative stories about the Company, including those on the Citron website and elsewhere. As is our policy, we fully cooperated with the review, including making a presentation to NASDAQ officials and providing a very large amount of data and information, including numerous documents related to DiscoCare.

A few weeks ago, NASDAQ notified the company that after reviewing the information provided by ArthroCare, it had determined to close its inquiry without further action at this time. The Company has no reason to believe that there will be any further action from NASDAQ. In addition, the Company has no reason to believe that any other government action or regulatory inquiry, investigation, or review relating to ArthroCare or DiscoCare is ongoing at this time. In our minds, this closes the matter. For the last two quarters, we spent a great deal of time talking about things that we don’t do. We look forward to spending our time going forward taking about the things that we actually are doing.

Now while the PDD product line is still the best selling product line in the Spine segment, there are two other recently released products that are currently growing faster and address much larger market opportunities in this segment. We now have two full quarters of experience with the MD SpineWand, our product for microdisectomy, and we believe that is increasingly clear that this product has the potential to become a significant growth driver. The feedback from surgeons who had a chance to use the product has been very positive, and the market opportunity that this product addresses is in excess of $1 billion annually.

We’re also very excited about what we’re seeing in our growing experience with the cavity product line. Clinical results here continue to be excellent, physician interest has been extremely strong, and sales have been brisk. This continues to be the fastest growing product in the Company and it also addresses the largest discreet market opportunity. We estimate the addressable market opportunity for this product to be in access of $1.2 billion annually and growing. This means that this product has the opportunity to be a growth driver for a long time to come.

So all in all, we believe that we have plenty of horsepower to meet our Spine growth targets for the year and that the Spine business is positioned to be a powerful growth driver for the foreseeable future.

So through the first quarter of the year, things are playing out better than we had anticipated across the overall business and we find ourselves well positioned to accomplish all of our financial and strategic objectives.

With that, I’ll hand the call over to Mike to take you through the financials. Mike.

Michael Gluk

Thanks, Mike. As we’ve already indicated, our revenue and earnings results were slightly ahead of our expectations for the quarter, a product revenue growth of 25%, total revenue growth of 23%, an EPS growth of 36%.

At this point, I’d like to provide you with some insight into some key income statement and balance sheet trends. Sports Medicine product sales growth was 25% this quarter. This was the second consecutive quarter that Sports Medicine product sales growth exceeded 20%, and we’re pleased that the growth is exceeding 20% in all of Sports Medicine’s major product lines.

ENT product sales increased 23% compared to the first quarter of last year, and this growth is attributed to a steep increase in overseas tonsillectomy sales and market acceptance of our other new initiatives.

Spine revenue growth was 24% of over the first quarter of 2007, slightly below our internal expectations due impart to the shortage of spine controllers. But again, we do expect to meet our annual guidance for revenue growth as the MD SpineWand and Cavity Wand sales accelerate over the next three quarters.

Our International product sales grew 31% over the first quarter of 2007, right about the sales of Sports Medicine products and direct overseas distribution markets, ENT sales in the United Kingdom, and the strengthening of the euro versus the dollar. So just a quick comment here on the facts: As you know, we do have a smaller international revenue footprint in the larger firms in our industry and a portion of our oversea sales are denominated in dollars. As a result, the impact of exchange on revenue is smaller than at many other firms. Having said that, on a constant currency basis, international product sales grew 24% over the first quarter of 2007 and total business product sales increased by 23%.

Let’s move on down to product margin. Our first quarter product margin of 71% represents a 200 basis point improvement over the first quarter of last year and a four-point decline in the fourth quarter of last year. This sequential decline was anticipated by us and we discussed it on the last conference call. The sales inventory which was purchased from DiscoCare is part of the acquisition and we value to market accounted for approximately two points of the deterioration. The remaining decline reflects the plant shutdown, rate surcharges related to higher fuel costs, higher inventory reserves, and various mixed and price fluctuations.

Looking forward, we expect margin to continue to improve throughout the year as the impact of the plant shutdown will be behind us while the material costs reductions and the additional volume we generate will improve our pre unit costs. As a result, after the first quarter, we believe that we are on track to meet our guidance of a one-point increase in product margin over calendar year 2007 72.5%.

Moving down the income statement: Operating expenses were $52.8 million or 58% of revenue, an increase of 20% over the first quarter of 2007, while year-over-year operating expenses increased on a dollar basis. In R&D, sales and marketing, and G&A, they have decreased as a percentage of sales, representing operational leverage over an increasing sales base. Spending was as we expected and well controlled with the exception of legal expense which was significantly higher due to the NASDAQ inquiry and the strategic alternatives review.

The other income and expense line declined by $500,000 versus the first quarter of last year due primarily to interest expense associated with the $60 million that we have drawn from the credit facility to help fund the DiscoCare acquisition and the share repurchase completed in January this year. Our tax rate for the quarter is 25%, which does not include any potential benefits associated with the renewal of the R&D credit. This represents an improvement over earlier guidance of a 28% tax rate without the R&D credit due primarily to new state tax planning initiatives. We continue to believe that the renewal of the R&D credit is highly likely.

For the calendar year, we now anticipate a 24% tax rate if the R&D credit is not renewed and a 22% rate if the R&D credit is renewed in its current quarter. Adding all that up, reported net income of $9.3 million or $0.34 per diluted share is $0.02 above the high end of our earlier guidance and $0.02 above consensus.

Turning to our attention to the balance sheet for a few minutes: Cash, cash equivalents, and short-term investments decreased $10 million to $33.2 million, primarily a result of the $12 million in cash used to fund the reminder of our $75 million share repurchase program, payment of the annual bonus and several capital investments.

Inventories: Inventories decreased $4.6 million to $57 million since December 31st due largely to shipping the inventory buildup, we had accumulated at yearend in anticipation of the Costa Rico plant shutdown.

Accounts receivable were $81 million compared to $69.9 million at yearend. Approximately one-half of the increase over the fourth quarter is a result of acquisition integration activities, absorbing the resources normally available to collect receivables in the quarter. With the integration behind us, we can now focus on improving DSOs across all customer types.

Moving down to guidance, ArthroCare’s business outlook for fiscal 2008 is as follows: We expect total revenue growth of at least 20%, and we’re obviously running ahead of that at this point in time. By unit, Sports Medicine guidance is for revenue growth in the low to mid teens, which we are also ahead of that for the first quarter and expect to continue to see strong growth throughout the year. Our ENT business is expected to grow 20% and, again, we are running ahead of guidance. Spine revenue growth is expected to grow 40%, and we do expect to meet our goal this year as a controller shortage in the introduction and the acceleration of the MD Spinal and Cavity sales accelerate in the next three quarters.

We’re also increasing our forecast operating margin improvement from 200 basis improvement to at least a 250-basis point improvement. We anticipate the product margin will improve by one-point with the remainder occurring in operating expense leverage. As I indicated earlier, our tax rate guidance was also improved to 22% with the R&D credit passage and 24% without renewal of the credit.

ArthroCare is increasing 2008 diluted EPS guidance from a range of $1.92 to $2.00 per share to a range of $1.95 to $2.00 a share at a 24% tax rate for the potential upside of $0.05 per share, if the R&D credit is renewed at its current form.

Before I give you guidance for the second quarter, I want to remind you of ArthroCare seasonality related to revenue and earnings per share so you can better divide our annual guidance into quarterly guidance for the remainder of the year.

On the revenue side, we expect that first quarter will have been our lowest. Second and third quarter will be approximately equal with a possible slight sequential downtown in the third quarter versus the second. We should then see a significant increase in the fourth quarter revenue. With that said, we are comfortable with the consensus forecast of $95 million for second quarter revenue.

On the EPS side, we should see a similar pattern. First quarter will have been our lowest quarter with improvement in the second quarter, essentially flat in the third quarter and a significant increase in the fourth quarter. Right now the consensus for the second quarter is $0.47 at a 24% tax rate. As with revenue, we are comfortable with the second quarter earnings consensus.

With that, I’ll open the call for questions. Operator, can you please take a call from our listeners.

Question-and-Answer Session

Operator

Thank you very much. (Operator Instructions) Our first question comes from the line of Mark Mullikin with Piper Jaffray; please go ahead.

Mark Mullikin – Piper Jaffray

Good afternoon. Just to start off on the receivables, this is a pretty big up tick from the fourth quarter and I just want to get a little bit more clarity from Mike that you expect the receivable level to basically level off or not see too big of an increase going forward this year.

Michael Baker

Yeah, I think we definitely think we can do better there, especially now that we the integration completed. But I’ll let Mike talk more to the specifics.

Michael Gluk

I think that’s right, Mike. You know, Mark, if you look at our calendar year, DSOs outstanding last year, they were about 77 days sales outstanding. This first quarter really represented a little over 80%, closer to 81%, so I would expect that we should be dial that back a little and get closer to where we are at the end of last year.

Mark Mullikin – Piper Jaffray

So that would be about 77 DSOs, somewhere in that range.

Michael Gluk

Somewhere between 77 and 79.

Mark Mullikin – Piper Jaffray

On the cash flow, what was the operating cash flow and capital expenditure in the quarter?

Michael Gluk

Well we actually haven’t released the statement of cash flow, so we might want to reserve that for the Q.

Mark Mullikin – Piper Jaffray

Then just one other one, on the Spine growth, obviously the deceleration here to 24%, you’re sticking with the 40% growth guidance. Were there any noticeable changes in the first quarter with all of the controversy swirling around DiscoCare etcetera? Did that fundamentally impact the business in the first quarter?

Michael Baker

No, we don’t think so. I mean we expected to see a little bit of slowdown in the first quarter, and I think we talked about that on the Q4 call, just because of the work that we had to do to integrate DiscoCare into DRS. We actually saw more impact than we expected, and I think the biggest issue was not having any controllers. If you’re in a business where you have a relatively small installed base of controllers, and you don’t have controllers open up new accounts, it’s difficult to grow the business as rapidly as you otherwise would. Having said that, we expect to have the controller supply problem resolved before the end of this quarter, and we don’t think it’s going to keep us from meeting our annual objectives.

Mark Mullikin – Piper Jaffray

So should we expect to see Spine growth accelerate in the second quarter?

Michael Baker

Through the balance of the year. Again, a little bit depends upon how quickly we get the controller backorder resolved. We expect to clear it in the next month or so. But if demand continues at the rate that it’s continuing, it could continue to be kind of impediment growth for longer than that.

Mark Mullikin – Piper Jaffray

I’ll hop back into queue.

Operator

Thank you very much. Our next question comes from the line of James Sidoti with Sidoti & Company; please go ahead.

James Sidoti – Sidoti & Company LLC

Good afternoon. Can you make any comment on the ENT business now that the acquisition of [Jarus] is complete by Olympus? Have you seen any changes to their marketing practices?

Michael Baker

No, not so far. Jarus is still out there trialing that product, so we’re still probably losing some sales, not probably, we are losing some sales to Jarus evaluation. The interesting thing is that they’re still getting basically no commercial traction. They’re able to give wands away for free in evaluations, but they’re not getting anybody to bite on buying them. So we really haven’t a change in their behavior. Obviously we’ll keep (inaudible) as time comes by. The most important thing is we’re not seeing ourselves any customers as a result of this activity and obviously it’s key to us to see the traction in tonsillectomy sales in Europe, again (inaudible), and the moment that we’re beginning to see in the new indications here in the U.S. because those are going to be key growth drivers for the future of that business.

James Sidoti – Sidoti & Company LLC

I know you put a sentence in the press release about the strategical (inaudible), I mean can you least update us on what you think the timing there is, and what the options are again?

Michael Baker

Obviously what I can say there is limited. As you know, and as we said in our press release, our Board has engaged Goldman Sachs to examine financial and strategic alternatives for the Company with a view toward enhancing shareholder value. This is obviously very sensitive and it’s confidential and my ability to comment on it is necessarily limited, but I can offer the following information: As a press release says, “The Board initiated this process because it strongly believes the trading value the Company stock does not reflect the fundamental value of the Company’s business. At this time, there are a large number of discreet financial and strategic alternatives actively being evaluated with a large number of parties. All of the parties in this process, including ArthroCare are bound by confidentiality agreements. The Board has not committed any particular alternative at this time, and we have specific expectation as to when the process will be completed. When and only when the process is completed will the Board announce its decision. Obviously as you can tell by the results today, the results do nothing but reinforce the Board’s belief in the fundamental value of the Company given the excellent performance of underlying business.

James Sidoti – Sidoti & Company LLC

All right, thank you.

Operator

Thank you. Our next question comes from the line of Ed Shenkan with Needham; please go ahead.

Ed Shenkan – Needham & Company

…products that surprised us, the ankle fusion product, maybe you could tell us a little bit more about that. Why is it unique, and what’s the approval process?

Michael Baker

The product will require an FDA approval, and we’re already in the process of obtaining that approval, and I think it’s going to be… The doctors who’ve seen this, who worked with us in the development of it are very, very excited about it. If you know anything about ankle fusions, you know that they’re problematic operations and most of them are done today with kind of pretty basic hardware that hasn’t changed very much. When you get a chance to see the [DynoNail], I think you’ll see why we’re so excited about. It’s a shape memory device that allows you to get a much better change of getting a good union of the bones there in an ankle fusion surgery and have the chance to improve the outcome in a significant number of surgeries that foot and ankle doctors do.

James Sidoti – Sidoti & Company LLC

So this would be the first application for the product in ankle fusion. What other applications might this platform have?

Michael Baker

Well we have another half dozen on the drawing board and three or four of them in active development. So you’ll see this first product before the end of this year, and then it’ll be followed by a stream of other products in new surgery, in shoulder surgery, in other orthopedic applications over the course of the next couple of years. But I think it’s really, this is really next generation type technology and you can use your imagination to think of the things you might be able to do better if you had polymer and metal devices that had embedded shape memory properties.

James Sidoti – Sidoti & Company LLC

You gave 2009 guidance for the first time with 35% EPS growth, you guys grew earnings 32% in ’07, where does the acceleration come from? We wouldn’t expect you to cut back on R&D. Is it the G&A phase at a low level becomes a smaller percentage of sales or how do we get this leverage?

Michael Baker

I think that’s exactly right. We will continue an aggressive investment in R&D because that what drives this stream of new product introductions and the clinical work that we’re doing, but we will see leverage G&A, and we will see leverage in sales and marketing, and we’re going to see continued improvement at the gross margin line as well. One of the things that Mike didn’t talk about too much in his script that gives us confidence on gross margin is really we haven’t an ongoing positive mix shift. The products and the Company that are the fastest growing products are in fact the highest margin products, and that process will continue not just through ’08 but through ’09 and beyond.

James Sidoti – Sidoti & Company LLC

The Sports Med blew it out here, was it really the Opus product that’s driving, or is it something else?

Michael Baker

As Mike said in his comments, we had revenue in excess of 20% in all of our product lines in Sports Medicine. So Opus is clearly taking share. The Coblation side of the business is clearly taking share. I mean this is not a single product. This is a broad-based acceleration of growth across the entire product line.

James Sidoti – Sidoti & Company LLC

Will jump back in queue and leave time for others.

Operator

Thank you. Our next question comes from the line Raj Denjoy with Bear Stearns; please go ahead.

Daj Denhoy – Bear Stearns

Hi. Good afternoon, guys. Wondered if I could ask a little bit about the controller shortage, I think you mentioned it pretty much impacting every line in revenue this quarter. What’s behind that? What gives you confidence we’re going to get through in pretty short order here?

Michael Baker

Good question, and I’m glad you asked it. Basically the demand for the Quantum controller has significantly exceeded our expectations, and we built a big launch quantity of these things before we launched them, but there’s just a lot of demand for them out there and that’s part of what’s helping us drive share gain on the Coblation side of the business in Sports Medicine. All three of our controller platforms, actually we have four of them in the marketplace today, have a lot of common components and some of the components are longer lead time items. So when we under forecast the band, we can end up being short not just in one line but of course all four of our lines. So we spent most of Q1 allocating controllers out of production to the business that we felt it needed the most. We’re going to be in that mode for a few more weeks, but obviously once we realize that we were going to have demand that exceeded our forecast, we’ve upped our orders with our suppliers and we’ve been doing everything we can to expedite the supply of the sort of rate limit in components, but some of them are long lead time components. But anyway, we have visibility to when we’re going to get the components and we are building a lot more controllers this quarter, and we should have the issue fully resolved before the end of this quarter.

Daj Denhoy – Bear Stearns

So they’re wouldn’t be any impact on second quarter numbers, or maybe a little bit but then by third quarter it should be completely cleared? Is that fair to say?

Michael Baker

Yes, I think actually, we’re not… You heard Mike give guidance for Q2, we’re not… This doesn’t make us uncomfortable with any of the estimates that are out there, but it is an issue that we’ll be continuing to manage through for the next few weeks and then we should have sort of no obstacles by sometime towards the end of this quarter.

Daj Denhoy – Bear Stearns

Fair enough. Then I’ll just ask one more; I hate to bring it up, but you did mention that the DiscoCare issues in your mind are largely behind the Company and that there are no pending or inquiries that you’re aware of, any existing or pending inquiries. If you believe what you read, and you probably shouldn’t too much, there are a number of lawsuits that are out there pending potentially. Does anything out there give you any concern right now? Is there anything that’s consuming your time on that front still?

Michael Baker

No. As far as we’re concerned, the NASDAQ inquiry was very comprehensive and completely closes the issue. As to the shareholder lawsuit issue, there’s actually been one shareholder lawsuit filed. There were about eight press releases done about it, but there was one lawsuit filed. Often when you get one lawsuit, a bunch of other firms will do press releases hoping to find plaintiffs. In fact, if you look at the lawsuit as it is written, companies always say that these things are without merit, but in the case this really is without merit. The lawsuit basically on the face of it is the things that it’s alleging are factually inaccurate and it doesn’t meet the standard for a lawsuit of this type. So we basically filed a motion to dismiss the lawsuit the day after it was filed, and we believe that the lawsuit should in fact be dismissed. If for any reason it’s not, then we’ll simply go to trial and win on the merits. But if you read what’s in the lawsuit, it is publicly available, and then you read our 10-K, you’ll realize that what they’re alleging is factually incorrect.

Daj Denhoy – Bear Stearns

Fair enough. Thanks a lot guys.

Operator

Thank you. Our next question comes from the line of Steven Lichtman with Banc of America; please go ahead.

Steven Lichtman – Banc of America Securities LLC

Thanks. Hi guys. Just a few follow-ups here: First on Sports Medicine, in terms of the increase in revenue here relative to Quantum, are you selling any of the Quantum units or you’re still placing them and it’s really more about just driving market share and getting the wand revenue?

Michael Baker

It is very much about wand revenue. We sell a few of them, but most of them are placed and the Quantum, one of the nice things about the Quantum is that it’s, the new platform is actually a much lower cost piece of equipment than the platform it replaces; and so as we bring new controllers into the inventory, we’re actually continuing to reduce the amount of money that we have to spend to build one, which is good.

Steven Lichtman – Banc of America Securities LLC

Great. Then you talked about the mobile training unit, the docs that you trained in the quarter and the ones you expect to train this year, are those new ArthroCare docs or what percentage of them would be considered new versus training current docs on some other products?

Michael Baker

Well most of them are new, at least to the products we’re training them on. So with all the new Opus products, there’s obviously a big demand for training to use the new Opus products and the mobile lab gives us a change to really do a much better job of meeting that demand. Obviously the great thing about having a resource like the mobile lab is that you can pull up to a doctor’s location, set the lab up and train a group of doctors and they may be coming in to get trained on the Opus products, but they also get a chance to see the Quantum Controller and some of the things that we’re doing in the foot and ankle area. You can end up training on one product line, but getting the business across several product lines because it gives you a chance to showcase all of the new things and the neat things the Company’s doing.

Steven Lichtman – Banc of America Securities LLC

On the Spine side, you mentioned some PDD publications perhaps this year, anything more definitive in terms of when and where, and not the presentations but the publications?

Michael Baker

We’re saying that we expect complications, addition pure review publications before yearend, and these will be the publications that’ll basically position us to go back to private payers that are currently approving this on a case-by-case basis and drive them to establish a national coverage for the therapy, which will obviously make our lives a lot simpler.

Steven Lichtman – Banc of America Securities LLC

But they are peer reviewed?

Michael Baker

Absolutely.

Steven Lichtman – Banc of America Securities LLC

Then lastly, international ENT, last quarter you said things were a little bit slower out of the gate then you would’ve liked on tonsillectomies, what’s changed? It sounds like you’re starting to get some up tick there?

Michael Baker

Well we started training doctors aggressively in ENT and actually in the U.K., the government began training doctors last summer and it takes a little time to get people trained, get back in their practice and get up and running. Now we’re starting to see exactly what we expected to see, which as doctors are trained in the new technique and they get comfortable with it, they’re starting practice it, and that’s what’s driving the increase in tonsillectomy sales in Europe. We really think that we’ve got a very good chance to drive the tonsillectomy market in Europe to exactly the place where it’s going in the U.S., which is making Coblation tonsillectomy the standard of care.

Steven Lichtman – Banc of America Securities LLC

Great. Thanks, guys.

Operator

Thank you. Our next question comes from the line of Bill Plovanic with Canaccord Adams; please go ahead.

Bill Plovanic – Canaccord Adams

Great. Thank you. Just a couple questions here. First, on International, I think you said Mike that International was up 24% year-over-year excluding FX?

Michael Gluk

That’s correct.

Bill Plovanic – Canaccord Adams

What was the FX contribution in the quarter?

Michael Gluk

In terms of revenue, it was about $900,000, Bill.

Bill Plovanic – Canaccord Adams

Then in the Spine business, it was down sequentially which if controller… If a shortage of controllers was the issue there, I don’t understand why it would be down sequentially and especially if ENT was up real strong OUS [sic] that would kind of imply that maybe Spine was down internationally? Kind of just a little more color there if we could.

Michael Baker

Well Mike’s actually looking to see what numbers we had so we can see to. Do you have another question while he’s looking for that?

Bill Plovanic – Canaccord Adams

Yeah, just in terms of… I mean you guys did a real good quarter in the Sports Med biz, it looks like that’s really on a roll here, so I don’t have much there, but in terms of the license fees in other, that was a pretty significant drop sequentially. Again, I’ve been following you guys forever and I don’t ever remember seeing that big of drop. Did somebody that was paying you drop off in terms of a license or just some clarity there may help in terms of what should we change how we think forward about that royalty line?

Michael Baker

Actually no one’s dropped off. That’s the consequence of share gain in this Sports Medicine business on the Coblation side because, as you know, we have licensed competitors in the Sports Medicine business that are set on their versions of Coblation technology and they pay us royalties on their sale. So if their sales are not growing or even in the case if their sales may be declining, then it’s going to have a little bit of an impact on the royalty line. But obviously that’s the trade off that we’re happy to make.

Bill Plovanic – Canaccord Adams

It was down year-over-year huge sequentially, did a royalty percentage go down for anybody or anything like that?

Michael Baker

No, there were no changes in any agreements, just the changes in the underlying sales on which those agreements are required, the licensing parties to pay royalties.

Bill Plovanic – Canaccord Adams

Mike, do you have anything on the find?

Michael Gluk

Why don’t we come back to that in a few minutes, Bill?

Bill Plovanic – Canaccord Adams

Then if I could just ask one more question. In terms of the receivables going up over $10 million sequentially, I think that’s a question everybody’s going to hone in on here. You’re revenues were up only $4 million sequentially on product sales, I mean that’s just a big jump and I beg the question of it’s hard to kind of see that just not having people focusing on collections would cause that big of a change sequentially. Is there something else at play here? I mean is this kind of the DiscoCare longer receivables that are impacting your balance sheet? Is there something else going on?

Michael Baker

Well, the short answer is that there are some healthcare receivables when you’re billing an insurance company directly that are going to be longer DSOs than when you bill a doctor. But really the big impact on the quarter was exactly what Mike described. We had basically the same people who do our collections, had to the integration of this and so we ended up with DSOs going up to just over 80 days instead of being 77 days, which is what they averaged last year. So we can obviously do better than that and that’s what we plan on doing over the balance of the rest of the year. In terms of the… Go ahead.

Bill Plovanic – Canaccord Adams

No, go ahead.

Michael Baker

In terms of the Spine revenue, basically Spine revenues were more or less flat. We did have a stronger quarter internationally in Q4 that we did in Q1, but that’s pretty normal for government pay healthcare systems. So we feel like we’re on track to make our objectives for the year, and I do think the controller issue that’s been a little bit of problem for that business this quarter is going to cease to be an issue sometime this quarter.

Bill Plovanic – Canaccord Adams

Just some housekeeping questions: Is the stock buyback complete? How many shares should we use going forward?

Michael Baker

You should use 26.5 million shares going forward, and the stock buyback is not complete and we’ll have more information in that on the Q. Potentially when we’re at our next opportunity to talk to you guys, we’ll also have some more information on that.

Bill Plovanic – Canaccord Adams

Great. I’ll jump back into queue, thanks.

Operator

Thank you. Our next question comes from the line of Brian Weinstein with William Blair; please go ahead.

Brian Weinstein – William Blair & Company

Hi. Good afternoon. Question in Sports Medicine, specifically related to DRS. Was DRS activity a reasonable contributor to growth in the quarter, and can you refresh on what and how DRS operates in that market?

Michael Baker

Well DRS, as you know, is our internal group that does building under established carve outs for Sports Medicine products and then rebates, whatever they get back to the doctors who actually purchase the product in the first place. So it’s a nice program. Customers like it. It helps to allow customers to take advantage of device carve outs that are out there that they otherwise would have to do the paperwork themselves. It’s a not a very big program at this point. I think we said in Q4 that we billed about $0.5 million. Again, whatever we collect on that building will be rebated back to the doctors who bought the products. I think this quarter we billed something around $1 million. So it’s a nice program; it’s a program similar to ones that a lot of our competitors have and particularly doctors that are in smaller practices that don’t have a sophisticated administrative staff really appreciate having a program like that available.

Bill Plovanic – Canaccord Adams

Then how or are you changing your Spine reimbursement practices now that DiscoCare is in-house? Is the mix within DiscoCare that you guys have talked about within the three buckets, is that consistent with what you guys had said in the past now, or is that shifting one way or the other among those buckets?

Michael Baker

Well the future of that business undoubtedly is broad-based private pay coverage nationally, and that’s what’s going to drive the business long-term and obviously that’s what all of our efforts are focused on achieving, and that’s why the large number of clinical presentations and publications that we have on tap for this are important because that’ll give us the ammunition to go back into payers that do not have national coverage policies that are paying for this on a pre approval or case-by-case basis and get the to establish national coverage. So there’s no question that we expect to see that mix shift dynamically, but we’re not going to go, we’re not going to be in the business of kind of giving quarterly updates on what it is. Obviously we will announce it as we get national coverage decisions for major carriers.

In terms of what’s changed with the integration, we’ve obviously integrated the DiscoCare innovative to be acquired into our DRS subsidiary and we have established a set of OIG compliant, office and (inaudible) general compliant policies and procedures to govern the activities of that area, and we also make sure that the activities of that area follow those policies and procedures are making them part of our stocks control. So we had a high degree of confidence that these things were being done correctly before the acquisition and that degree of confidence is even higher today.

Bill Plovanic – Canaccord Adams

Great. Thank you very much.

Operator

Thank you very much. We do have a follow-up question from the line of Mark Mullikin from Piper Jaffray; please go ahead.

Mark Mullikin – Piper Jaffray

Yeah, I just wanted to go back on the M&A front, do you guys have any contingencies remaining on any previous M&A deals that you’ve done, any payouts that are left?

Michael Baker

No, nothing significant. The only contingent payments that are out there are some milestones that are attached to the DiscoCare acquisition.

Mark Mullikin – Piper Jaffray

What’s the total for that? I think $25 million was the total. Did the $25 million number include all the potential contingencies or are there contingencies in addition to that?

Michael Baker

There are some payments beyond that that could made if all the milestones are achieved, but there are also, there’s also a portion of the purchase price that’s held back. Again, we have not disclosed those exact numbers for competitive purposes, but they’re not big enough that we would be required to disclose them.

Mark Mullikin – Piper Jaffray

Thank you.

Operator

Thank you. Our next question comes from the line of Joanne Wuensch from BMO Capital Markets; please go ahead.

Joanne Wuensch – BMO Capital Markets

Thank you. When I take a look at your gross margins in the quarter, I understand why they were hit. But as I think about the rest of the year, do they return to a more normalized level pretty immediately in the second quarter or is this sort of a more gradual recovery?

Michael Baker

On an apples-to-apples… Well on an as reported basis, we were, exactly where we thought we would be and we’re exactly equal to where we were in the first quarter of ’07. What we do know is that we have about two points of that that’s automatically going away because of the sale of the DiscoCare inventory mark-to-market. So that is going to go away for us and the rest of it will be relatively gradual.

Joanne Wuensch – BMO Capital Markets

The $0.05 swing between the R&D tax credit and the guidance that you’re giving us, is that something you’re likely to spend and invest in or is it more likely to be something you’ll let flow through to the bottom line?

Michael Gluk

You’re going to make me answer that question that question aren’t you? It’ll probably go to the bottom line. If we decide that we’ve got an investment that we think is compelling enough that we should spend that, then at the time the R&D tax credit gets passed, we’ll tell you what we’re going to spend it on. But as it is right now, it would flow straight to the bottom line.

Joanne Wuensch – BMO Capital Markets

The 20% growth plus in Sports Medicine, that was a very nice number, can we talk about how sustainable that is? I mean you’re giving guidance for sort of mid teens for the year, but why wouldn’t it just continue at that level?

Michael Baker

Well it very well might, and I think I said in my part of the script and Mike did too that it’s running well ahead of our guidance, and it could continue to do that for some time. I mean we’ve got an extremely strong product offering out there and we’re about to make some additional augmentations to that product line in the form of the Quantum pump, to new Opus products, some new things on the foot and ankle side that are just really, we’re really very excited about. So this business really is on a roll and it could continue at a rate well above our guidance for a long time.

Joanne Wuensch – BMO Capital Markets

Thank you. Have a good night.

Operator

That question did conclude the question-and-answer session. I’d like to turn the conference back to you.

Michael Baker

Very good. Well we, again, appreciate all of you taking the time to dial into the conference call and we appreciate the good questions. We think we’ve got some just really fun things in front of us to do this year with new products and clinical work and new therapeutic work and we really like where the Company’s positioned. I mean the Company obviously has, the business has a lot of momentum and a lot of opportunity and we looking forward to executing the rest of the year and sharing it with you at our quarterly conference calls. So if you guys have questions or there’s other information you need, feel free to give us a shout. Take care.

Operator

Ladies and gentlemen, that does conclude today’s conference call. We thank you very much for your participation, and we ask that you please disconnect your lines. Have a wonderful afternoon, everyone.

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