Arthrocare's Bungle Bashes Buyout Hope

A restatement comes at a bad time for the troubled medical device maker.
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OKLAHOMA CITY --

Arthrocare

(ARTC)

needs to get its books in order -- and restate two years' worth of earnings -- if it still hopes to sell itself.

The embattled medical device maker said Monday that it has been overstating its revenue since 2006 and that its past financial statements can no longer be relied upon as a result.

The company, which posted revenue of $319 million last year, expects to lower its sales by no more than $37 million for the past nine quarters. However, it foresees a "material" hit to operating profit in the end.

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began warning months ago about serious risks that could ultimately hurt Arthrocare's stock. The shares -- no longer supported by expectations of a looming buyout -- plummeted 38% to a new multi-year low of $25.02 on Monday's news.

Arthrocare blamed its controversial relationship with DiscoCare, a firm that specializes in selling the company's SpineWands, for part of the problem. Specifically, Arthrocare said it should have treated DiscoCare as a "sales agent" for the company rather than as a traditional distributor.

Moreover, Arthrocare said it had improperly accounted for its late-2007 acquisition of Arthrocare as a "business combination" since the firm acted as a sales agent for the company already.

Arthrocare originally struggled to sell SpineWands due to lack of routine coverage by health insurance companies. In 2006 -- the year the overstatements began -- Arthrocare turned to DiscoCare for help. By focusing on nontraditional patients, such as car-wreck victims covered by pending legal settlements, DiscoCare soon found success.

DiscoCare, which is led by a former sales manager from Arthrocare, has since raised some eyebrows, however. Major car insurers, flooded with claims for high-priced surgeries involving Arthrocare's SpineWands, have started challenging both the cost and the necessity of the surgeries in court. Recently, an attorney for one of those car insurers has said the FBI has started asking questions about the operations as well.

For Arthrocare, the timing of the news could hardly be worse. With its stock under pressure on DiscoCare-related fears, Arthrocare announced four months ago that it had hired Goldman Sachs to explore strategic alternatives -- including a possible sale of the company -- to enhance shareholder returns. Since then, investors have been banking on a lucrative takeover.

Indeed, just last week, Canaccord Adams analyst William Plovanic upgraded Arthrocare to buy in anticipation of a looming deal. In that ill-timed upgrade, Plovanic predicted that Arthrocare could fetch $1.3 billion -- or $48 a share -- from private-equity investors eager to capitalize on the company's steady cash flow.

However, he did acknowledge ongoing risks posed by the company's spine business. "Considering the macro environment of increased scrutiny for medical devices and the healthcare industry in general, we believe there is an overhanging risk for Arthrocare if news is reported that DiscoCare was fleecing insurers," wrote Plovanic, whose firm makes a market in Arthrocare's stock and hopes to secure investment banking business from the company in the future. "After speaking with industry insiders, we believe that while the 'DiscoCare model' of doing business is likely legal, it may be morally questionable given the focus on personal injury claims."

Ultimately, he concluded, "we would question the sustainability of such a business model."

Williams Capital Group analyst Beth Senko has been warning about Arthrocare for months. Senko originally downgraded Arthrocare to hold in February due to a perceived "opportunity for impropriety" at the company. She then cut Arthrocare to sell in June, citing "increasing indications that impropriety may have occurred" and "meaningful risk of a write-down."

At the time, Senko offered three key reasons for her alarm: First, she noted, Arthrocare's operating cash flow had fallen short of its net income -- which can be an early indicator of financial problems -- during four of the past six quarters. Second, she calculated, the company's spine receivables seemed to be escalating with collections on those accounts nearly doubling since the fourth quarter of 2006.

Finally, Senko added, the company's accrual method of accounting had opened the door for "aggressively manage(d) revenue recognition" that could lead to serious restatements down the road.

"Revenues could continue to grow over a period of time -- particularly if the company has a consistent flow of new (personal injury) cases and reasonable evidence to support maintaining, or increasing, accruals on both new and existing transactions," Senko explained. "The problem appears when the cycle stops, and this is the basis of our concern."

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has warned about this same threat, noting that Arthrocare could be counting on big payments from car insurers that may never materialize down the road. Now, Arthrocare is revising sales to DiscoCare and at least two other firms as well.

Prior to Monday's bombshell, Arthrocare bears had sold two-thirds of the company's stock short in anticipation of a fall. Although many short-sellers continue to hold out for a bigger plunge, citing the potential for government investigations, one of the most outspoken is no longer short the stock.

Citron Research analyst Andrew Left, who began exposing problems at Arthrocare late last year, covered his short position after the stock dipped below $30 on Monday. He then offered some rare words of hope about the company.

"Arthrocare has always had some unique medical technologies," Left told

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. Now, "I hope they can get their house in order to present proper accounting and business practices to investors in the future."