ArthroCare Poked by SEC Probe

The company's restatement brings some scrutiny from regulators.
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can now add a government investigation and an expanded class-action lawsuit to its long list of woes.

The Austin, Texas-based medical device maker revealed on Thursday that the

Securities and Exchange Commission

has launched an informal inquiry into accounting issues related to a looming restatement that the company announced earlier this week.

Meanwhile, securities attorneys have unveiled plans to broaden a class-action lawsuit that they filed against the company months ago.

BMO analyst Joanne Wuensch has been bracing for such fallout. Even as she upgraded Arthrocare from underperform to market perform on Tuesday, citing the stock's low price after a 40% plunge, she portrayed news of the company's restatement as "likely just the first shoe to drop."

Wuensch then set a new price target of $23 -- down a full $15 from her previous goal -- and specifically warned that possible government probes could prevent the stock from reaching that level. Although the shares quickly surpassed her target, climbing to a high of $27 on Wednesday, they fell back to $25.05 on news Thursday of the SEC inquiry.

"And so it has begun," Wuensch mused upon first learning of Arthrocare's unreliable financial statements. "To quote Sir Walter Scott: 'Oh what a tangled web we weave, when first we practice to deceive.'"

"With this piece of information in the public domain," she said of the pending restatement, "what is left is the question of what else is out there? Is there another shoe to fall? And how significant is it?"

Certainly, Arthrocare dropped the first bombshell without warning.

Before announcing its planned restatement, Arthrocare kept insisting that it faced no major problems other than unfair attacks by short-sellers looking to profit on declines in its share price. In fact, just three months ago, Arthrocare was touting the fact that the Nasdaq had investigated its purchase of DiscoCare -- a mysterious outfit suspected of inflating Arthrocare's spine sales -- and promptly closed the probe without any findings of wrongdoing.

"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," Arthrocare CEO Michael Baker proclaimed during the company's first-quarter conference call. In fact, "in our minds, this closes the matter."

At the time, Arthrocare was handily beating Wall Street estimates -- and forecasting phenomenal growth for the future -- despite a sharp slowdown in its lucrative spine business. While Arthrocare's stock rallied on that bullish update, short-sellers never believed the company.

By the time Arthrocare announced its looming restatement this week, bears had sold a full two-thirds of the company's stock short in anticipation of a big fall.

Early Clues

Gradient Analytics, a research house that specializes in dissecting corporate filings, has felt uneasy about Arthrocare for some time.

Gradient grew particularly alarmed after reviewing Arthrocare's annual 10-K filing this spring. At the time, Gradient had just noticed some new regulatory disclosures that might signal that Arthrocare was overstating its revenue and could face some major revisions down the line.

"Companies rarely make disclosure changes for no reason," Gradient observed back in March. "Further, for this issue to be disclosed in the form of a modified disclosure, the change (or expected change) is expected to be material to the firm's financial results."

Notably, in that modified disclosure, Arthrocare revealed that it sometimes books revenue before receiving payment so long as the sales price is "fixed and determinable" and the ordered goods have been shipped. This week, however, the company admitted that prices for products sold to several distributors "cannot be considered fixed or determinable" and that past sales must be restated -- and future practices changed -- as a result.

At the same time that Gradient made its prescient call about Arthrocare's revenue-recognition practices, the firm raised serious questions about Arthrocare's purchase of DiscoCare as well. After closely examining Arthrocare's balance sheet, Gradient felt that the company had overpaid for DiscoCare and could face an imminent writedown going forward.

Arthrocare shelled out $25 million for DiscoCare in late 2007, shortly after critics began exposing close ties between the two companies. After that acquisition, Gradient noted, Arthrocare listed a significant jump in goodwill and "other intangible assets" -- totaling 132% of DiscoCare's purchase price -- on the company's balance sheet. Since Arthrocare had announced no other acquisitions that could explain those increases, Gradient suggested, the company may have paid a high price for a firm with "very poor" assets on hand.

Like many, Gradient wondered what exactly Arthrocare got for its money.

"The 10-K provided only sparse details about the nature of operations acquired from DiscoCare," Gradient complained this spring. "In fact, we found that ARTC actually redacted or omitted a significant level of financial information contained within the stock-purchase agreement for DiscoCare."

On Monday, Arthrocare itself admitted that it had improperly accounted for that transaction. Specifically, Arthrocare revealed that it should not have treated the deal as a traditional "business combination" since DiscoCare served as a sales agent for the company already. Moreover, the company said that it had improperly recorded past sales to DiscoCare as well.

Damaged Goods

Arthrocare has actually been hoping to sell itself.

With its stock price under pressure despite its reports of phenomenal growth, Arthrocare announced in March that it had hired Goldman Sachs to explore strategic alternatives for the company. Immediately, Arthrocare fans began speculating that a larger device maker -- such as


(SYK) - Get Report




-- would rush to forward to buy the company. Although those offers failed to materialize, investors stuck by Arthrocare until this week's bombshell.

Even now, Canaccord Adams analyst William Plovanic is still banking on a deal.

"We continue to believe Arthrocare is a prime acquisition target for private equity," Plovanic wrote a day after the company announced its stock-battering news. "Furthermore, we believe the announced restatements could be a condition of sale and therefore remain committed to the name."

Plovanic barely even lowered his target price on Arthrocare, in fact, predicting that the shares could still fetch $45.50 -- almost double their current price -- in a private-equity deal.

But BMO's Wuensch doubts that Arthrocare will attract any buyers soon. She remembers when Bausch & Lomb wound up in a similar situation. Once the company found problems in its books, she reminds, a full 18 months passed -- bringing a slew of new problems -- before it finally sold itself.

"Once an accounting group gets into an organization to start looking at it," Wuensch concluded on Tuesday, "there are many rocks that need to be turned over in the process of giving an 'all-clear' signal."