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Arthrocare's Buyout Value Looks Bloated

Critics are questioning the strong growth in its spine business.

Since early March, when



suddenly decided to explore "strategic alternatives," the company has seemed eager to ink a deal.

On paper at least, Arthrocare looks like an attractive takeout target. The Austin, Texas-based medical device maker boasts a remarkable growth rate, especially in the lucrative spine space, and it has been reporting a solid profit for the past nine years.

Late last year, however, with Arthrocare riding high on yet another record quarter, short-sellers took direct aim at the company. At the time, Arthrocare had seen its spine sales almost double because of soaring demand for its disposable "SpineWands." But short-sellers claimed that Arthrocare had been leaning heavily on its DiscoCare division -- a firm suspected of supplying SpineWands for unnecessary surgeries -- to drive up that demand.

(In a special series last week,

took a close look at Arthrocare's

booming spine business

and its

core sports medicine division alike).

Arthrocare has flatly denied that it faces any operational problems. The company insists that its technology is valuable and that its growth rate -- while admittedly high -- is both sustainable and real. Ultimately, it portrays itself as the innocent victim of an unfair attack by short-sellers looking to profit on declines in its share price.

Arthrocare is quite confident that it can sell itself, if it chooses to do so. The company's loyal shareholders believe the same. At this point, they are simply waiting for a larger device maker -- such as


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-- to come along and strike a deal.

Still, while many experts believe that a buyout is imminent, others clearly have their doubts. After poring over Arthrocare's regulatory filings, critics have concluded that the company is not quite as healthy as it seems. Instead, they see a desperate company seeking an easy escape that could prove elusive in the end.

At least one mainstream analyst seems to agree.

"This alternatives exploration decision originally looked like something that may have been put together fairly quickly on a reactive basis to us -- perhaps as an attempt to prevent the company from having to publicly disclose any further details surrounding reimbursement activities, or with the primary goal potentially being to create a short squeeze," SIG Susquehanna analyst David Turkaly wrote when downgrading the company's stock earlier this month. Regardless, "both the announcement and its timing still seem strange to us."

Turkaly now has a negative rating on Arthrocare, even though his firm still owns stock in the company itself. He believes that the shares -- while supported right now by buyout rumors -- could suffer a big hit down the road. The stock, down 72 cents to $43.22 on Wednesday, currently trades in the lower half of its wide 52-week range.

Hide and Seek

Arthrocare CEO Michael Baker has long insisted that Arthrocare has nothing to hide. Indeed, during a recent interview with

, he proclaimed that Arthrocare has supplied Goldman Sachs with "linear feet" of data for a detailed review of the company.

Critics wonder if that information is enough, however. They claim that Goldman Sachs needs answers to a few key questions -- so far denied to ordinary investors -- in order to properly value the company.

First and foremost, they wonder how much Arthrocare has relied on DiscoCare for its recent boom and whether that growth will prove sustainable in the end.

Ever since it first surfaced two years ago, DiscoCare has boasted an uncanny ability to secure reimbursement for Arthrocare's SpineWands. With health insurers reluctant to cover the devices, which are used to perform investigational plasma disc decompression (PDD) surgeries, DiscoCare often turns to other sources for payment. Insurers covering injured workers and car-wreck victims have emerged as key targets.

From the start, Arthrocare has stood firmly behind DiscoCare. Ultimately, late last year, Arthrocare purchased DiscoCare outright.

Critics immediately questioned Arthrocare's motives, however. Today, they believe that the company tried to accomplish two goals when it bought DiscoCare:

For starters, they feel that Arthrocare hoped to cover up DiscoCare's escalating problems. While car insurers originally covered high-priced PDD surgeries for victims of traffic accidents, they have recently started to fight back -- and win -- in court. Knowing this, critics say, Arthrocare used DiscoCare to artificially inflate its spine sales while it still could.

They point to the company's own financial statements as evidence, focusing on reports covering the second half of 2007 in particular. Those documents capture the changes that occurred after Arthrocare's fourth-quarter purchase of DiscoCare.

According to Arthrocare's cash flow statements, the company's accounts receivable balance jumped by $11.8 million during the final three months of last year. According to the company's balance sheets, however, receivables declined by $1.73 million during that time frame.

To short-sellers, including some who specialize in accounting, only Arthrocare's acquisition of DiscoCare can explain that sizable difference. After that transaction, they explain, Arthrocare would have to write off any DiscoCare receivables -- and sacrifice the cash flow those receivables would have promised -- because it couldn't owe money to itself.

Assay Research, a Virginia-based firm that specializes in dissecting financial statements, has focused on DiscoCare's contributions in particular. In a report last month, the firm said it "questions whether sales were boosted prior to the acquisition from increased sales to the distributor." Then, "by acquiring DiscoCare on the last day of 2007, all receivables related to DiscoCare would be extinguished. Yet the revenue generated prior to the acquisition would not."

Other critics have made the same point, portraying the potential impact as huge.

By combining the rise in uncollected cash on Arthrocare's cash flow statements with the drop in receivables on the company's balance sheets, experts figure that DiscoCare owed Arthrocare $13.5 million at the time of its buyout. That sum, by itself, represents virtually all of the spine growth that Arthrocare recorded during the first nine months of last year.

Today, with Arthrocare trying to sell itself, that booming spine growth helps the company stand out from the pack.

"While we note that the spine business is not all that large for Arthrocare (15% to 17% of total sales), it is highly profitable and has been the strongest growth division over the last several years (+67% year-over-year and still expected to grow another 40% this year)," Turkaly stressed in his recent downgrade. Indeed, "the spine segment has likely been one of the most influential drivers of the stock's premium and of the company's attractiveness as an acquisition candidate.

"Given that spine remains one of the fastest growing large med-tech markets today," he continued, "any potential interruption in the progress of PDD could therefore have a negative impact on the stock."

Final Verdict

Some observers believe that setback has already occurred.

For a while, they say, DiscoCare could create the illusion of soaring demand for PDD surgeries and the SpineWands that they require. But ultimately, they suspect, even DiscoCare -- with its special pool of patients -- wound up with a bunch of extra SpineWands on its shelves.

In early January, right after the DiscoCare deal, Lazard analyst Assaf Guterman asked Arthrocare CEO Michael Baker point-blank whether DiscoCare had any "material inventory" on hand. At the time, however, Baker refused to discuss the matter.

"You know, that is not something we are going to talk about," he responded. "I guess we will give balance sheet guidance when we get to the end-of-the-quarter conference call. But why would that be a subject of concern?"

Five months later, the issue at least remains a subject of debate. While Baker ultimately claimed that DiscoCare added $1.7 million to Arthrocare's inventory -- and analysts declared that a "big number" -- the company's regulatory filings suggest far worse.

Before it purchased DiscoCare, Arthrocare reported only modest increases -- and even occasional decreases -- in its inventory on hand. After purchasing DiscoCare and assuming control of its SpineWands, however, Arthrocare saw its fourth-quarter inventory explode.

Inventory rocketed by $9.4 million that quarter, almost as much as it had risen during the previous two years combined. After scrutinizing Arthrocare's cash flow statements, which suggest that inventory should have increased by just $1.4 million instead, critics have concluded that DiscoCare caused most of that spike.

"It appears that Arthrocare had pumped $13.5 million worth of sales into DiscoCare, which still had $8 million worth of inventory sitting on its balance sheet" at the time of the buyout, stated an accounting expert with a short position in the company's stock. "That's why this acquisition was so important for them."

Of all the mainstream analysts following Arthrocare, Turkaly has fretted over that transaction the most. Shortly after news of the deal first broke, Turkaly questioned why Arthrocare would even want to purchase scandal-plagued DiscoCare in the fast place. This spring, with spine sales falling despite DiscoCare's added help, Turkaly continued to ask what Arthrocare had gained from that mysterious deal.

These days, however, Turkaly has been puzzling over an even bigger question. Specifically, he wonders why Arthrocare seems so eager to end its days as a stand-alone company when it has enjoyed so much success.

After all, he notes, Arthrocare was still reporting blowout numbers -- and investing heavily in its own stock -- when it announced the surprising news.

"While the stock was down in early March (and it had certainly been a rather tough tape for the small-cap healthcare group and equities in general), the company had still adamantly defended all of its business practices," Turkaly stressed. So "why do you need to consider selling the company?

"And why right then, if nothing is -- or ever was --going on?"