Medical Device Link.

Originally Published MX November/December 2005

COVER STORY

Interview by Steve Halasey

To become established in the medical device industry, it helps if a start-up company has a unique, exclusive technology at its core. But to thrive, the company must not only be able to capitalize on that technology, but also defend it.

Michael A. Baker, president and CEO of ArthroCare Corp. (Austin, TX), knows a little something about how to do both. Since taking the helm in 1997—the same year ArthroCare patented its fundamental technology, Coblation—Baker has seen to it that the company's investors receive every penny to which they're entitled. After all, it was their initial investments that funded the development of a process once considered impossible. And while ArthroCare has been leveraging that technology's applications in targeted medical fields, Coblation's potential has just begun to be tapped.

ArthroCare president and CEO Michael A. Baker on developing and defending a medtech innovation. Photo by Kent Clemenco.

ArthroCare has broad intellectual property protection on the process of Coblation. To date, it holds 107 U.S. and 45 international patents related to the technology, with numerous applications pending worldwide. The company's patent litigation history is something of a David and Goliath story, with a couple of twists. For one, it's a rare medtech David that is able to forecast annual revenues of more than $210 million. And for another, this medtech David has endured litigation involving three of industry's heaviest hitters—Ethicon (Somerville, NJ), a Johnson & Johnson company; Stryker Corp. (Kalamazoo, MI); and Smith & Nephew (London)—and emerged not only with still-valid patents, but also with new partners. Through licensing agreements, ArthroCare's investors now enjoy a slice of the pie from sales of Coblation-based devices by all three companies.

Under Baker's leadership, ArthroCare has developed more than just a good defensive strategy. The company has been growing steadily, expanding into new sectors organically and through carefully considered acquisitions. And, so far as Baker is concerned, ArthroCare is just getting started.

In this interview with MX editor-in-chief Steve Halasey, Baker discusses what it's like to uncover a never-before-seen technology and what a company has to do to fully leverage and protect it. He also describes ArthroCare's relationship with the clinical community, approach to acquisitions, and long-term game plan for growth.

MX: Tell me about the origins of Coblation technology and its intellectual property. Who developed it, where did it come from, and how did it come to ArthroCare?

Michael A. Baker: Coblation technology is the invention of the two gentlemen who founded ArthroCare, well-known medical device entrepreneurs Hira Thapliyal and Phil Eggers. These partners were working on a new generation of energy-based devices for cardiac applications to be used in a conductive fluid environment. Hira and Phil felt these devices would be highly applicable in many cardiac procedures because surgeons typically have to work in either a conductive environment or in a field of blood. What they discovered was a technology that had an effect very different from anything they had seen before. They saw tissue dissolving at a rapid and efficient rate with a high degree of precision, and they did not see the temperatures normally associated with electrocautery or radio-frequency devices.

Ultimately, Hira and Phil realized they were looking at a plasma phenomenon, which was interesting because, according to the body of physics understood at the time, it was not possible to create a stable plasma phenomenon at room temperature and atmospheric pressure. As a result, they were able to get very fundamental patents around designing energy-based radio-frequency devices that create and stabilize a plasma phenomenon at room temperature and atmospheric pressure while still being energetic enough to make incisions and dissolve volumes of tissue. This progression of events is the impetus behind Coblation technology, which in turn led to the commercialization of what would become ArthroCare.

How did that original discovery turn into today's company?

Hira and Phil originally founded the company as AngioCare, but later changed the name to ArthroCare because they were convinced, after consultations with their original venture capital investors, that the first and easiest application for Coblation technology would be in endoscopic surgery. Specifically, they felt the precision and versatility Coblation technology provides could really solve numerous practical problems in arthroscopic surgery, where doctors have to operate in environments that are normally filled with saline, as well as a nonconductive fluid, to perform electrocautery procedures. So, the company shifted gears and focused on developing tools for endoscopic orthopedic or arthroscopic surgery, and it ultimately brought those tools to market. The first commercial sales occurred toward the end of 1995, and the company became public in 1996.

The Coblation-based devices were a tremendous hit because they enabled arthroscopic surgeons to perform difficult and time-consuming procedures rapidly and with much greater ease than any preexisting mechanical or electrocautery tools. However, at the time, it was not widely understood by anyone outside of the company that these new devices were employing a fundamentally different type of physics. They actually use a plasma field rather than an electric arc during surgery.

How important is this new technology?

To give you a sense of just how fundamental that discovery was, a few years back we began talking to some scientists at Lawrence Berkeley National Laboratory, in California, who wanted to study our equipment. When they started their project, I think they believed they would discover that our marketing claims did not hold water. But after a few months, they came back to us and said, 'You know, this is really something fundamentally new. You're really creating plasma, which is important because it has not been described adequately in the physics literature, and is really not known to science at this point.'

They ended up writing articles that were published in the peer-reviewed physics journals—not medical journals—talking about this new approach to creating and using plasma in medical applications. This research ultimately led us to submit a joint grant request that is now being funded by the U.S. government. It makes ArthroCare a participant in a global collaboration with Lawrence Berkeley and two of Russia's top high-energy physics labs to study and expand our understanding of the applications of this phenomenon in medicine and other fields. Coblation technology is the core of ArthroCare and is legitimately new science. And while it is not going to solve every medical problem, it is potentially a very important addition to the toolset that doctors have as they approach different types of surgery.

You mentioned that Coblation technology had not previously been written up in the scientific literature. Was the company intentionally trying to hold its knowledge closely so it did not reveal any intellectual properties prematurely?

I think you always want to be careful, even if you have your patent application submitted, about publicly disclosing your trade secrets until the applications have actually been granted. Until the first patent was issued, the company was fairly reticent about speaking and careful about protecting a lot of the secrets behind its invention. Some of the key patents began issuing shortly after I became CEO in 1997. Then it was much easier for us to talk openly in the public domain about what our instruments were actually doing and what some of their potential advantages and possibilities might be.

At the beginning, a lot of people were skeptical. I had more than one doctor tell me, 'This is not possible. I studied physics, and you cannot do that and it cannot really be at room temperature and atmospheric pressure. This must be just another traditional electrocautery instrument.' But an awful lot of other people were using the instruments and saying it was obviously something different. They were interested in having us explain what it was, and that's what we've been doing ever since.

From a practical standpoint, what are the key advantages of Coblation technology?

Coblation-based instruments offer a degree of precision, visibility, and versatility that you cannot get with any other technology. The corollary I like to think about is the use of plasma devices in delicate manufacturing operations, like ion milling and plasma etching, when the highest degree of precision is required. For example, when you're working on prototype integrated circuits, plasma devices can be used in situations where a mechanical instrument or even a laser instrument cannot be used to perform the manufacturing operation.

The same is true in surgery. In certain types of surgical applications, these instruments simply let surgeons do things they could not do with anything else. Or they permit surgeons to do things they might do with another instrument in a way that is dramatically more beneficial for the patient in terms of reducing the amount of physical trauma, the time it takes for the patient to recover, or how much pain the patient experiences.

Our job from the beginning has been to locate the situations where Coblation technology would add the greatest value. We then put together strategic business units focused on creating and marketing a set of products in those areas of medicine—and ultimately began building a leadership position in those areas.

You mentioned that the company was originally investigating cardiology applications, but those were not the first tools to come to market. The company's first tools were in endoscopy?

Correct. Specifically in orthopedic endoscopy, which is also known as arthroscopy, which is the division that we today call sports medicine.

And from that starting point, ArthroCare now has three separate business units?

Yes. The largest and the oldest is the original sports medicine business unit, where we have established Coblation technology as the standard of care in a number of important areas. We believe the company is going to continue to establish Coblation technology in more sports medicine procedures as time goes by. The sports medicine market is a great market. Our business is growing rapidly as the population ages and people continue to be more active. There are more people out there who have orthopedic problems that they want fixed. As the technology and techniques improve, more of these fixes can be done endoscopically, which is tremendously beneficial because the patient can recover from endoscopic intervention much more rapidly and with much less pain.

Knee surgery was the first big market for Coblation in sports medicine. Shoulder surgeries were next, as the technology and techniques became better. And we are now seeing more and more doctors interested in doing surgery on smaller and more difficult joints, like hip, ankle, elbow, and wrist arthroscopy. I think that is a natural progression you are going to see continue.

We see sports medicine as a growth market in and of itself, and specifically a growth market for us, given the type of instruments we are making and the other types of products we have added to our business. We are very focused on being on the cutting edge and helping the sports medicine market expand by giving doctors tools that allow them to do more things endoscopically and help patients at earlier stages of their diseases.

ArthroCare's other two business units are in ear, nose, and throat (ENT) medicine and spinal surgery. We are earlier in the development of those business units, but each has very exciting applications of Coblation technology.

Defending IP

When you roll out products for these business units, what is your strategy for defending the company's intellectual properties? Do all of your products rely on a central core of IP or do you protect the individual products going forward?

All of the above. ArthroCare probably has one of the strongest, broadest, and deepest intellectual property sets you are going to find around any technology, and it starts with the fact that Coblation technology was fundamentally new to science. We were able to get very broad fundamental patents around the science of creating and stabilizing a plasma at room temperature and atmospheric pressure, and then using it during surgery. ArthroCare then surrounded these patents with application patents for using the technology in various medical applications, and patents on individual products. Beyond all of those patents, there is a further wall of feature patents around the technical and design innovations that are important for making the technology work well in a given application.

Because Coblation technology is protected at the fundamental, application, and feature levels, it is a very formidable intellectual property set. I would not say it is an easy set to defend, but we no doubt have a very defensible intellectual property position. We have licensed our patents more than a dozen times. And we have successfully enforced them in court three times. I think that track record over the last eight years pretty much speaks for itself.

Are the fundamental patents in your intellectual property portfolio broad enough to cover applications in other fields, like integrated circuit manufacturing, or any other industry where a plasma field like this might be useful?

Yes. We believe there may be applications outside of medicine where Coblation technology could ultimately be important. If you look at what plasma is used for now in some manufacturing operations, you see it can be important. But you also see that the plasma devices currently used to perform these operations are very specialized and extremely expensive, whereas we have demonstrated the ability to build disposable medical instruments with some of the same performance characteristics at an average cost of just $200. We do think there may be applications outside of medicine that are important, and we have included those in some of our pending intellectual property claims.

Obviously, all of our current activities today are focused on commercializing the medical applications of Coblation technology because that is what we see as being our area of expertise. However, there definitely are some other very interesting possibilities down the road.

You seem to be turning the usual flow of technology development on its head. Usually technologies are developed in some other scientific field and then brought into medicine, whereas your company has started in medicine and perhaps has a technology that is more broadly applicable and licensable in other fields.

I think it is going to be interesting. To be feasible as a medical device, Coblation technology had to be extremely safe, which it is; we have done millions of operations with a remarkable track record of safety and performance. It had to be relatively modest in its power requirements, which it is; it does not require high power to operate. It had to be relatively inexpensive because, with all of the cost pressures associated with medical care, it is really a tough sell these days to bring out a very expensive product. I think most people would tell you that our products are very cost-effective at a very modest price point. And the engineering requirements had to be relatively straightforward, because if you needed special atmospheric conditions, high temperatures, high power levels, or large, bulky devices, you really could not make a practical surgical instrument that could replace the old-fashioned mechanical, laser, or electrocautery instruments in day-to-day surgery.

The discovery of this phenomenon was, like a lot of discoveries, a little bit accidental. But once we realized what we had on our hands, we recognized we had something that was a practical medical device technology. As we have learned more about Coblation technology and have gotten better at applying it, we can see more and more opportunities.

Right now, most of our applications are focused on soft-tissue surgery, where we are basically dissolving or cutting soft tissue. But there is no theoretical reason you could not do the same thing with bone. In fact, our spine business recently released the Cavity SpineWand, which is capable of dissolving certain types of bone. This technical advancement could open the door to a range of interesting applications in spinal surgery, as well as broader orthopedic surgery.

As our research moves forward, we can see more clearly that the performance envelope for Coblation technology is going to expand over time. There will be more aspects of medicine to which we can try to apply this technology. That is a pretty exciting prospect.

You must be keeping a battery of lawyers busy to defend the company's IP portfolio. Do you have more than one outside IP firm or is most of your work done in-house?

We do have an in-house vice president of corporate development and legal affairs, John Raffle, who has been with the company for virtually my entire term as CEO.

Obviously no one enjoys litigation. It is something we have to undertake from time to time. We have been involved in three intellectual property enforcement litigations, all of which have been successful for ArthroCare. We used, in addition to internal resources, the same outside firm in all three cases, and we have been very satisfied with its support. The results have been very positive.

In our enforcement actions against Johnson & Johnson (J&J; New Brunswick, NJ), Stryker, and Smith & Nephew, we worked with Weil, Gotshal & Manges (New York City). Even with a very strong intellectual property set like the one we have, it is always nice to work with folks who have been down the path with you before and understand a lot of the ins and outs. I guess every time we have had to go through the litigation process, arguably we've gotten a little better at it.

Adversaries to Allies

The infringement case with Johnson & Johnson eventually turned into a licensing arrangement with Ethicon.

That is correct. Just before the trial was scheduled to start, we were able to agree on terms for a settlement and licensing agreement with them.

And you recently announced that you now have a new agreement with Smith & Nephew, which I assume is also a result of the litigation involving them.

Correct. Here's a quick history of our litigations: First, there was the Ethicon agreement. Then, a couple of years later, Stryker introduced a product set that we felt required a license. After a very brief enforcement action, we reached a settlement and licensing agreement with them. In 2001, Smith & Nephew introduced a product set that we also felt required a license, and we initiated an enforcement action. That case came to trial in May 2003, and the jury found that they had, in fact, infringed our patents. About a year later, the judge handed down an injunction, which ordered their product set off the U.S. market. And now, about 15 months after the original injunction, we have announced a settlement agreement, and a license and product supply agreement that will allow Smith & Nephew to sell Coblation-based products not only in the United States, but also around the world.

ArthroCare seems to have a knack for turning what could otherwise be a long-term acrimonious relationship with these companies into something that looks a little bit more like a partnership and an alliance.

Again, we are not by nature a litigious company. However, we do get involved in litigation from time to time. Our strategy for protecting Coblation is really very simple. This is an important technology that can make a contribution to medicine in a large number of applications, and we want to drive this technology to standard of care in those applications as rapidly as possible. At the same time, we want to make sure we also build our own business so that we are the leader in those markets. I think we have been very successful in doing that.

And, if anyone else is going to use this technology and drive it to standard of care in other areas, we want to be sure our shareholders get an appropriate share of the profit because they made the investment in developing Coblation technology. We feel as though all of our license and settlement agreements—particularly the one with Smith & Nephew—advance all of these objectives.

Having large, well-regarded companies with strong clinical reputations helping us promote the advantages of Coblation technology to doctors in various areas of medicine helps to drive this technology to standard of care. This arrangement allows us to facilitate better outcomes for more patients in different parts of medicine. We want our own branded instruments to be the best in the world, and we already have a significant share of the markets in which we compete, despite the presence of larger companies. Our market share in the sports medicine market, where we compete with J&J and Stryker, and now with Smith & Nephew, is more than 50%. But we have also been successful in securing partnerships with these companies to ensure our shareholders get a share of the profit from their commercialization activities. It is always good when you can convert a potentially adversarial situation into a collaborative and mutually beneficial competitive situation.

You have three business units, but you have not entered certain areas yet. For instance, your licensing agreement with Ethicon permits that company to use the technology in gynecological applications. How comfortable do you feel about the decisions you have made to go after some areas and not others?

We feel very good. We just finished visiting this question at our annual off-site strategic planning meeting. We granted Ethicon a nonexclusive license to use Coblation technology in gynecology, and they have had some degree of success there. However, there may be applications in gynecology even beyond what Ethicon is currently doing. There is nothing in the Ethicon agreement that would prevent us from either licensing our technology to somebody else or going into those applications on our own.

The same is true for urology. We now have three different licenses with companies that are pursuing certain urological applications with Coblation technology. But again, there is nothing in those agreements that would prevent us from deciding to license a fourth company or even to get into that field on our own.

The judgment about whether to directly enter a field or whether to collaborate with another player is always very complex. You have to assess the application itself and determine where your technology can make a contribution. You have to identify the clinical value of this contribution and then identify the opportunities for partnership. When evaluating these scenarios, you have to know what strengths your potential partner brings to the table in terms of complementary products, distribution presence, or clinical reputation. These are dynamic decisions that can change over time. We are very comfortable with how we have played our opportunities to date, and we are excited about new opportunities we see arising over the next three to five years.

ArthroCare also has an extraordinarily rich pipeline of organic growth opportunities, both new applications of Coblation technology in our current sectors and potential new applications in new fields. We are looking forward to exploiting these opportunities over the next three to five years, and are in a great position to do so. We have an extraordinarily good growth rate—we have averaged a nearly 39% compound annual growth rate over the last eight years—and we see a pipeline of opportunities that makes me think we are not going to see this growth slow down over the next few years.

Harvesting Clinical Feedback

How are you developing these new ideas? Are doctors coming to you with ideas for Coblation applications in other fields or is ArthroCare being active in searching out those opportunities?

A little of both. One of the great things about this business is the opportunity to work with leading researchers and physicians in various areas of medicine. On many occasions, we have had physicians come to us. They realize that we invented this technology and are probably the most capable company in the world where it is concerned. We are certainly the company most focused on its applications, and we have the deepest understanding of it. And, obviously, we own the rights to commercialize it.

Physicians will come to us with ideas about Coblation applications for other parts of the body, and those are great discussions. We have ended up developing new products as a result, such as the tonsillectomy product that is currently driving the rapid growth in our ENT business. In our original thinking about ENT, tonsillectomy was not a compelling part of that opportunity. But, as we became involved in the field and began talking to doctors, they pointed out that there was an enormous opportunity to improve a very common operation that had seen no significant advance in decades. We worked with them to develop what ultimately has become an extremely successful tonsillectomy product that looks as though it is going to become standard of care, particularly in the developed world. It's very rewarding that, because of the good work we were able to do with some really outstanding leading physicians, we have developed a product that is going to deliver a dramatically improved outcome for literally millions of patients, most of whom are kids. It's really hard not to feel good about that.

When you introduce a tool for a very common procedure, does that help to build your relationships with clinicians?

Absolutely. By working with busy surgeons, we learn how to make a better tool and expand its applications. Surgeons will give you great feedback. They'll tell you, 'The tool is great, but it could be better if you did x or if you changed y,' or, 'This application is wonderful, but why don't you make me something that will allow me to do this other application instead?' Those are very synergistic relationships. Listening carefully and using the opportunity to work with surgeons can help a company develop a technology and become a leader in the field. That's even before you begin adding complementary products to your business. We have seen this type of situation happen in sports medicine, and I am optimistic we are beginning to see the same happening in ENT.

Is the company's spine business a little further off in that regard?

The spine business is currently our smallest and slowest-growing business. But when you look at the potential opportunities and the technologies and applications that are in the pipeline, it would not surprise me in the least to look back in three to five years and see the spine business as the biggest and most profitable unit in the company. The opportunities in this market are potentially very large and lucrative. Coblation technology could really add value to an area of medicine where a lot of the surgery today is done with mechanical instruments. There are a lot of fairly major surgeries that lend themselves to endoscopic approaches or less-invasive approaches, or certainly approaches that open the door for faster recoveries and better outcomes for patients. We have the chance with our spine business to be on the leading edge of a lot of those developments.

Give me a sense of how you structure your relationships with clinicians. Are you working with medical specialty societies? Do you have a formal medical advisory board? How do those relations look from an executive's point of view?

We work with the key societies in all of the areas of medicine where we operate. They have been very supportive of the work we have done, and we are very appreciative of the support they have shown us. We do have a separate scientific or medical advisory board for each of our business units, and we try to include a mix of thought leaders in the field. These include key researchers, whether they are medical doctors or scientists who conduct research in the area. These boards also consist of practicing surgeons who can give us feedback on how to turn a potentially great product into one that every doctor is going to want to use.

It is very important for us to work with teaching institutions because that is where new surgeons are trained. I can tell we're getting traction in an area when a new procedure or product that we are working on goes from being something of research interest or something experienced doctors are comfortable using to something that is ready to become part of the curriculum every resident is going to learn. This benchmark is when I know that something has a chance to become standard of care. We've reached this point with Coblation-based tonsillectomies in the last year or two. Most of the important teaching institutions in this country are now teaching Coblation tonsillectomy to their residents. Without question, the relationships with teaching institutions, which help to convert great ideas into products that can be taught to residents, are very important.

You really do have to pay attention to the full spectrum of your relationships. To reiterate, the best feedback we get about how to make our products work well and bring them to standard of care comes from interacting with physicians who use our products.

Gaining Acceptance

How rapid is the adoption curve? Is it dependent on getting residents trained on a new procedure or are you finding institutions that are willing to adopt this technology sight unseen?

It depends a little on the product's value proposition. I will give you a couple of great examples. One of our first products was used in an endoscopic shoulder surgery called subacromial decompression. This procedure was very time-consuming and difficult, and our product made it very fast and easy. It did not take a lot of clinical work to convince people to use this product. Doctors would see it, use it, find its use intuitive, and want to adopt it because it was a better solution. This product was taken in very quickly, and, in my experience, products that solve a practical surgical problem like that can experience very rapid adoption.

With any new medical technology, there is a gestation period. Then, there is an inflection point where it goes from being something interesting to being standard of care. When you have a practical problem, that gestation period can be extremely short.

When your argument is more clinically based, when you're saying, 'We are going to improve the surgical outcome for the patient,' then obviously you have to produce some clinical documentation that is going to demonstrate to the medical community that the improvement you are talking about is actually going to occur.

Again, our tonsillectomy product is another excellent example. The product was approved by FDA in September 2001, and over the course of the next year or so, as it was gestating, we saw a series of clinical publications of independent, prospective, randomized studies demonstrating dramatic improvement in outcomes for patients treated with Coblation technology instead of traditional surgery. After the clinical publications arrived, we had to further develop the product to make it easier to use and more approachable for surgeons with less experience or skill. That way, it could be taught to residents. Then, after both the clinical documentation was completed and the product was easier to use, we saw the tonsillectomy business begin to hit the inflection point.

So, depending on the product's value proposition and how much work is required to make the device approachable for young surgeons, the adoption process can either be very fast or it can take a period of time.

How are you branding your technology and expanding its reach into the marketplace?

Knee surgery is an interesting example to highlight. If you were to visit the top knee surgeons in the world, those who routinely perform surgery on professional, college, and Olympic athletes, you would find that a high percentage of them are routinely using Coblation technology in their knee surgeries. However, the vast majority of knee surgery today is still done using the old tools.

Obviously, we are trying to change this situation. First and foremost, we have seen a steady drumbeat of studies and other medical publications talking about the safety of Coblation technology in knee surgery and the long-term benefits it can bring to patients. I do not mean just professional athletes—I am talking about average folks who hurt their knee skiing or tripped over their kid's toys. What we are finding in the published studies is that two or three years down the road, people who had knee surgery using Coblation technology have much better knee function, and much less pain and deterioration.

The other important thing we are doing is focusing on making the tools we have for knee surgery easier for physicians to use. While some tools may be approachable for very experienced physicians or high-end doctors, they may not be as easy to use as some of the mechanical tools that doctors were trained on during residency. Most physicians are most comfortable using the tools on which they were trained, and they are not open to changing the way they do a surgery—or even changing their tools—unless they see a strong clinical rationale. At the same time, the tools have to be easy to use and approachable.

To address these types of concerns, we have been releasing a new generation of knee products. Last summer, we released the Paragon ArthroWand, followed by the Super MultiVac ArthroWand this spring. And, this fall, we are releasing the Paragon Plus ArthroWand. All of these products are targeted specifically for knee surgery and are very advanced. At the same time, they are far and away the easiest to use, and the most simple and approachable new products we have ever released. For the first time, I am hearing doctors tell me these products are easier to use than the mechanical instruments they learned to use during residency.

In medicine, most advanced procedures incubate for a while among the thought leaders and high-end surgeons. Ultimately, as they become more approachable, and as the patient benefit becomes clearer, these products tend to trickle down to mainstream practices and become standard of care. I think we are right on the cusp of seeing that happen with these products in knee surgery. You are going to hear more and more things about the importance of these advanced techniques in knee surgery, not just from professional athletes, but from everyday people.

Do you do any direct-to-consumer marketing or do you mainly target the professional community?

A little bit, but it depends upon the situation. For example, we are not really doing direct-to-consumer marketing with Coblation tonsillectomies, but the tremendous improvement in patient outcomes has generated a lot of interest around the country. Local practitioners are bringing these improvements to light, and we are now seeing numerous articles in the lay press and even news stories on television talking about this new technique and the difference it is making. As a result, patients are going into their doctor's office and asking, 'Do you know how to perform a Coblation tonsillectomy?'

There are other cases where direct-to-consumer marketing can be very beneficial. A good example is Topaz, a brand new procedure from ArthroCare for treating certain types of tendonosis. By and large, this treatment is being done on patients who previously did not even know there was a medical option to treat their condition. They thought they had to live with it. So a direct-to-consumer ad may be placed by a local orthopedic practice or a local foot-and-ankle practice to raise a patient's awareness of the fact that they have a medical option, and that can be useful.

Sometimes though, and especially in the case of knee surgery, you are better off making sure you have the tools everyday surgeons are comfortable using before the awareness is raised too high.

Regulatory Trials

Are you heavily involved in FDA-regulated clinical studies or is a lot of your work to develop procedures below the level that would require an investigational device exemption (IDE)?

It depends on the application. We have conducted studies on products that required an IDE, but the majority of our products have been 510(k)-type products. They are basically surgical instruments that replace existing surgical instruments of different technical specifications. But we have a lot of situations where, even though a clinical study is not required for regulatory approval, it is a practical necessity for establishing the value proposition and driving reimbursement.

So in terms of the clinical studies that you are doing, the focus is mostly on clinical outcomes and cost?

For most of what we have done. There are situations where you are going to be required to do an IDE trial. Most of Coblation technology's potential cardiac applications—especially those for intravascular applications—are going to require some sort of IDE-type clinical trial for FDA clearance, which will obviously raise the cost and extend the timeline for those approvals.

Are those kinds of trials underway in cardiology?

We have done a fair amount of clinical work in cardiology and cardiac applications, but it is not something we spend a lot of time talking to the investment community about because none of those are commercial applications today. We have never announced what our intentions are in this area.

So you are getting a sense of what might be possible, but you've made no commitment to develop it yet?

Right. We believe there are a variety of applications in cardiac surgery and interventional cardiology where the benign safety profile of Coblation technology and the high degree of precision that it offers make it an attractive option. The costs of getting into the cardiac business or the vascular business are higher, and the landscape of potential commercial and partnership opportunities is a little more complex. Until we have an actual initiative to announce, we tend not to talk a lot about cardiac applications of our technology.

Complementary Acquisitions

How do ArthroCare's recent acquisitions complement the company's existing technology and business units?

ArthroCare is a platform technology company, and the problem we have strategically does not have to do with finding potential growth opportunities, but rather deciding which ones to tackle next—an entirely different kind of problem. We literally have long lists of things we think would be interesting to do medically, scientifically, and commercially that we have not gotten to yet. ArthroCare is emphatically an organic growth company. Even without any of our acquisitions, this company would be a rapid-revenue-growth company, profitable, and cash-flow positive.

The acquisitions contribute to the strategy of the various business units. When we start a business unit, we are using a set of Coblation instruments to establish a beachhead in an area of medicine. We enter new areas because we think these instruments have enough clinical value to allow us to build a profitable, rapidly growing business unit in that area. We look to build strong relationships with leading clinicians in that area and ultimately get the attention of the marketplace. In addition, we develop other ideas for that business unit. These include ideas for other products that might be complementary or compatible. In medical devices, given the economics of distribution, one of the ways you can add value is by adding complementary products that can be carried by your existing distribution channel. This is something of interest to our business units as they consolidate their beachhead and begin to think about building themselves into a leader in a given field.

So the acquisitions are building out the feature set for your business units, allowing you to better serve each of the various markets?

Correct. When we make an acquisition, we know it will complement and be compatible with our Coblation applications.

The problem for us is, complementary is not enough; complementary means the product is distributed at the same call point, which, in theory, is where you get the physical distribution leverage.

The problem ArthroCare has is achieving the compatible requirement. If you have a sales force that is busy selling a high-tech, high-sizzle, high-value-added, premium-performance product set that is very exciting, they will not necessarily do a good job if you give them a complementary commodity to sell as well. It will not command their attention, nor will it command the attention of their customers. Instead, our challenge is finding products that command equal amounts of sizzle in the minds of the company's customers and salespeople, which is a much more difficult proposition. This dynamic is why you see us execute very targeted acquisitions. They are designed to augment and accelerate the growth strategy and build additional value by building out the business unit.

You have spent nearly $170 million on acquisitions in the past couple of years, and in every case, going into the acquisition, you have said, 'There is going to be a period where it is neutral, but we expect it to be accretive next year.' Has that proven to be the case?

It has. We have had a remarkable acquisition track record so far. Each acquisition has met or exceeded our expectations, and part of that may be because we really do pursue acquisitions as an exception strategy. If the prize is worth the chase, and if we are absolutely convinced it is going to be complementary and compatible, and if we can negotiate a favorable deal, then we will be aggressive in pursuing an acquisition. However, I think we are careful enough that by the time we get to the point of wanting to make an acquisition, we have a high degree of confidence in what the outcome is going to be.

It has been almost a year since the Opus acquisition. How did the integration of that company go?

The integration of Opus went wonderfully. This portion of our sports medicine business is outperforming the guidance we gave the investment community for the first eight months of this year. Beyond that, we are seeing strong indications that we are achieving cross-selling synergy between our Opus products and our core Coblation technology product set. Not only is the Opus product set tracking ahead of its guidance, but our core Coblation product set also is tracking ahead of its guidance. When you make an acquisition, you always hope you are going to see that kind of strong cross-selling synergy, and I am happy to say, in this case, it is very obvious we are seeing it.

Do you think the new agreement with Smith & Nephew is going to add a lot to that distribution and sales chain?

The agreement with Smith & Nephew is going to be strategically important and beneficial for both companies. For Smith & Nephew, it gives them assured access to a technology that is an important part of their worldwide business. For ArthroCare it is financially positive, but it also advances our major strategic objective, which is driving Coblation technology to be the standard of care in as many applications in sports medicine as we can, while at the same time securing an appropriate share of the profits for our shareholders.

Site Selection

I understand that you moved all of your manufacturing to plants in Costa Rica. How did you end up manufacturing there as opposed to someplace else offshore, nearshore, or in the United States?

At the time we began studying that initiative, we had 100% of our operations in Silicon Valley, which is a very expensive place to operate. It was obvious that at the rate ArthroCare was growing, we needed a higher-volume manufacturing facility. We recognized it would be beneficial to try to put it in the lowest-cost location, consistent with low operational risk. Whenever you think about locating or constructing a new manufacturing facility, you always want to take advantage of not only the best possible operating-risk profile, but any sort of local tax or R&D incentives that are available.

I have been involved in medical device manufacturing facilities at various places around the world; so when we began our study, we looked at sites in Europe, the United States, Latin America, and Asia. Coincidentally, the government of Costa Rica had recently decided it was interested in attracting medical device manufacturers. Their interest was driven by all of the right rationales: medical device companies are good corporate citizens, they pay good wages, they are interested in high-quality and educated workers, they do not pollute the environment, they are not cyclical, and they do not have big boom and bust cycles like some of the tech and consumer companies do. As an industry, we presented a very attractive profile to a government like Costa Rica, which is one of the most stable and transparent democracies in Latin America.

What benefits does Costa Rica offer manufacturers?

It had a very strong package of incentives, which included a tax deal that would allow us to shelter our manufacturing profits from Costa Rican taxes for the first 10 years and then pay a relatively low corporate tax after that. When we visited Costa Rica, we also found a very high-quality workforce, operating in a very safe and democratic environment. We also saw other companies running very successful operations, and knew we could get not only a high-quality, very stable workforce in Costa Rica, but that we would also be able to recruit managers, engineers, and employees at all levels. The country has a strong educational system and a proud tradition of producing professional managers, scientists, and engineers.

The decision to set up a manufacturing facility, at the time, was a little bit nontraditional, but I think the results speak for themselves. Our team in Costa Rica is entirely Costa Rican. We have hired all of the management there, and the team has consistently outperformed every objective we have given them. We have a very stable, high-quality workforce, and have been able to take advantage of significant cost and tax advantages.

You have significant distribution in Europe and into Eastern Europe. As you broaden the scope of your distribution and products worldwide, do you think that Costa Rica will always remain your main manufacturing base?

About six months ago, we announced that we were expanding the Costa Rican facility. Right now, we are in the middle of a project that will double the capacity of our manufacturing facility. We expect this project to be completed in the first quarter of next year. Beyond that, though, given the rapid growth rate we are observing in the business today and the things we think are going to happen over the next three to five years, we have already begun planning for the next manufacturing facility. Even with doubling the capacity of our existing Costa Rican operation, you do not have to go too far into the future to see us potentially needing another manufacturing site, so we are now beginning the process of looking at possible additional expansion in Costa Rica or some other country, or even in the United States.

We will think about that expansion the same way we thought about our first one in Costa Rica. We will look for a high-quality, stable workforce. We'll look for the lowest possible cost profile and take advantage of whatever incentives are available. These factors will be balanced with the necessity of maintaining a low operating-risk profile. We do not need to operate in parts of the world where we face the possibility of discontinuities, interruption to supply, political risk, or even significant risk of crime.

Forecasting the Future

In conjunction with the Smith & Nephew announcement, what amount of revenue did you reproject for the coming year?

We are projecting $210 million to $215 million for this year, and $255 million to $265 million for next year.

How much of an increase does that represent over the previous projection?

The previous consensus projections were about $210 million for this year, and $254 million for next year.

You have also suggested that there are opportunities to continue the high- double-digit growth that you have had over the last few years almost indefinitely.

Yes. The guidance we gave with the Smith & Nephew announcement was a slight increase, but it was still very conservative. If there is any uncertainty as to how rapidly something is going to happen or if there is any uncertainty as to how big it will be in a certain period of time, we tend to leave all of the uncertainty on the upside so that we make as many of our guidance adjustments as possible in an upward direction. That makes for happier conference calls, and we have been fortunate to have had a pretty good run of happy conference calls over the last couple of years. We look forward to continuing this trend going forward.

We will be updating guidance again at the end of Q3, when we have a little more visibility into how rapidly the Smith & Nephew manufacturing transfer is likely to happen. Our guidance is such that if we change it again at the end of Q3, we will be increasing it again, and the same will be true at year-end.

ArthroCare occupies a very rare niche in the medical device industry—that group of companies with revenues of more than $100 million but less than $500 million. Such companies usually tend to get snapped up by one of the larger companies. Do you think ArthroCare will remain an independent, publicly owned company, or is the company potentially an acquisition target for a larger company?

There are not very many medtech companies of our size—and even fewer of our size and growth rate—that are currently operating as independent companies.

It is no secret that we have had some success. We have been fortunate, and we are probably a company of high interest to a lot of larger companies because they can see not only what we have been able to do with our technology, but they also talk to a lot of the same researchers we talk to and see some of the big potential opportunities in the pipeline. So if ArthroCare were to be for sale, there is not much doubt in my mind there would be a lot of people who would be interested.

The great thing is that we are growing rapidly, we are profitable and cash-flow positive, and we are expanding our profit and cash-flow margins as we go. We've built a platform we can leverage as we go forward, which means that we do not have to sell the company. We control our own fate.

Most of the large companies out there are looking for acquisitions, but there are not a lot of hostile deals done in medical devices—for a lot of good reasons. Most of the large, quality companies would prefer to wait and make an acquisition later, even if they have to pay a higher price. If you look at a company like ArthroCare, and at the rate at which we are growing, we are going to be a much larger company a year from now and an even larger company a year after that. If we would be a positive and meaningful acquisition for a larger company today, we would be an even more positive and meaningful acquisition a year from now.

So, we are in a position that I like a lot, which is that we are building shareholder value rapidly, and we have the opportunity to continue doing so as an independent company for the foreseeable future.

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