ARTHROCARE CORPORATION SELL

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Covering Analyst: Timothy Dundon Email: tdundon@uoregon.edu

The University of Oregon Investment Group (UOIG) is a student run organization whose purpose is strictly educational. Member students are not certified or licensed to give investment advice or analyze securities, nor do they purport to be. Members of UOIG may have clerked, interned or held various employment positions with firms held in UOIG’s portfolio. In addition, members of UOIG

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RTHRO

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BUSINESS OVERVIEW

ArthroCare, based Austin, Texas, is a highly innovative, multi-business medical device company that develops,

manufactures and markets products based on internationally patented Coblation technology. This platform technology precisely dissolves target tissue and minimizes damage to surrounding, healthy tissue. This minimally invasive technology has made it quite popular in surgeries across the nation. Founded in 1993, in Sunnyvalle, California, ArthroCare originally set out to develop new medical products on the market, and in just three years they became a public company, listed and traded on the NASDAQ. One year later in 1997 they patented the Coblation technology and in 1998 entered into the ENT (ear, nose, and throat) segment along with the cosmetic surgery market. After one year on the market Coblation technology began to be used in spinal surgeries. Since then ArthroCare has continued to expand acquiring Alantech Medical devices, and Opus Medical to expand into sports medicine and Parallax to expand ArthroCare’s offerings in the spine industry. The company’s revenue derives from four factors: Coblation Technology, ENT, Spine, and Sports Medicine.

Stock Data

Price (52 weeks) $ $11.90-52.18

Symbol/Exchange ARTC/NASDAQ

Beta 1.62

Shares Outstanding 26,627,468

Average daily volume (3 month average)

511,495

Current market cap $ 348,352,380

Current Price Dividend Dividend Yield $ 14.52 $ 0.00 - Valuation (per share)

DCF Analysis $8.33 (70%) Comparables Analysis Current Price Target Price Overvaluation $26.66 (30%) $14.52 $13.83 4.76% Summary Financials 2007 actual Revenue $319,242,000 Income $43,180,000

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Coblation Technolog

The technology that built ArthroCare, Coblation technology has helped to change the entire industry by altering the methods in which arthroscopic surgeries are performed. This technology is slowly starting to become an industry standard in the soft-tissue market and is often specifically requested by patients and doctors alike. The technology uses radiofrequency energy to create precisely focused plasma to ablate soft tissue, which allows for less damage than conventional electrosurgical devices. ArthroCare has applied Coblation technology successfully in the areas of sports medicine, spinal surgery and ENT applications along with several other soft-tissue surgeries. The technology itself is utilized in disposable wands used for procedures. According to the 2007 10K, they also are currently exploring the use of Coblation technology in other markets such as neurosurgery, cosmetic surgery, urology, gynecology, cardiac surgery and other general surgical procedures. The system itself is revolutionary in the soft-tissue market and will continue to be used frequently looking into the future. ArthroCare is the leading provider in Coblation technology and also collects revenues from competitors (Smith & Nephew, Stryker).

ENT

The ENT segment also known as the Ear, Nose, and Throat segment as of 2007 was approximately 24% of the company’s total revenues. This segment looks to be one of the more stable ones in terms of growth going into the future. It is expected to grow at a steady pace as the technology has been favored for its minimal surrounding tissue damage. Surgeries performed with this technology range from tonsillectomies, to adenoidectomies, to the treatment of snoring and chronic stuffy nose. The benefits of the technology during such procedures have led to their adoption by ENT physicians throughout the world. The ENT segment is mainly driven by tonsillectomies, which ArthroCare estimates there are approximately 600,000 annually in the United States alone, with thousands more happening overseas. It looks as if this segment will continue to grow as doctors begin to use ArthroCare devices in favor of their less-painful procedure and a better postoperative experience.

Spine

ArthroCare introduced its spine segment in 1999 and as of 2007 it currently makes up approximately 15 % of the company’s total revenues. The spine industry has highly favored ArthroCare’s patented Coblation technology which is much less damaging and less invasive in its surgeries which has helped to grow ArthroCare’s position. The growth of the spinal products segment has been slow due to reimbursement issues in health care plans in the United States; however its growth has been larger abroad. This segment will continue to grow but due to some controversy in ArthroCares operations, they may lose a large part of their market share in this segment.

2007 Revenues (thousands) Sports Medicine, 189,588 , 61% ENT, 73,065 , 24% Spine, 44,653 , 15% Coblation Technology, 290 , 0% Sports Medicine ENT Spine Coblation Technology Sports Medicine

The Sports Medicine segment is by far ArthroCare’s strongest segment and is one in which they control the most market share. This segment currently makes up almost 61% of the company’s revenues and will likely continue to be the revenue driver into the future. In 2007, ArthroCare acquired Ortoconcept, a Scandinavian wholesaler and distributor or medical equipment, especially in the sports medicine field. Because of the elective nature of sports medicine surgeries, the high end, less painful, less invasive, and less damaging medical equipment usually has higher demand than comparable products. ArthroCare’s business strategy has highly aligned them with this segment. However due to this segment’s elective nature combined with ArthroCare’s high-end products this segment will react more to the economy than other market segments. Expect a very small dip in the next two fiscal years in percentage of revenues.

ArthroCare’s patented Coblation technology has and will continue to provide a steady competitive edge in the industry. Revenues from its technology stand to see future growth from increased usage of the current technology and from the expansion into more medical fields.

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THE CURRENT CRISIS:

The Company is under current fire right now. In late 2006 the company began to use distributer DiscoCare for a large amount of their products and continued this practice into 2007. The company would sell their products to DiscoCare and subsequently DiscoCare would then provide the products to be used in health insurance cases. When selling a medical product to be used in an insurance case, you can make the sell, but according to current accounting standards for revenue recognition you cannot record the revenue until the medical product is paid for by insurance companies. The Company has been using DiscoCare as an entity they refer to as a “third party billing company”. As it turns out, ArthroCare had been selling the products to DiscoCare at a highly discounted rate but recording full revenues, and allowing DiscoCare to wait and fight the insurance companies for payments, many of which were are going through.

In January of this year 2008 ArthroCare purchased DiscoCare. The management has attempted to spin the story as acquiring a third party biller that possesses a special “algorithm” to get insurance approvals. Many analysts speculated this was an attempt to cover up a relationship that is has been built and established on fraud and deception. Since then the former president of DiscoCare, who is also a former executive within ArthroCare, has made a statement that he knew of no algorithm. In the month of April, the board of directors sold a large majority of their stock options in the company. In early July, ArthroCare announced that they would be restating the 2006 and 2007 FY data along with the first quarter of 2008 and that the Q2 posting would be delayed until September 30th with their Q3. After the company failed to file on this date they

signed a credit agreement to restate all of the delayed financial statements on December 1st or face a NASDAQ delisting. On

December 1st, the company got a “stay of execution” from NASDAQ and an extension until February of 09’. At that point

they will be restating 12 quarters or 3 fiscal years. There has been a lot of speculation by analysts and shareholders alike of the complete mismanagement of this company and the illegal activities that may have and did occur.

PORTFOLIO HISTORY

• Tall Firs – No Position

• DADCO

• We purchased 160 shares of ARTC on 3/19/2007 at a cost basis of $35.89 per share. 12.27% of the equity portion of the DADCO consists of ARTC and 5.03% of the entire portfolio consists of ARTC

• Svigals

• We currently own 60 shares at a cost basis of $36.24 per share. As of last Friday November 28th our return on

the stock has been -63.91%. It is classified as a small cap in the healthcare sector which we are currently overweight by 1.88%

RECENT NEWS

• ArthroCare Announces Decision from NASDAQ Granting Its Request for Continued Listing and

Announces Extension of Deadline to Deliver Financial Statements under Its Credit Agreement -AUSTIN,

Texas--(BUSINESS WIRE)--ArthroCare Corp. (NASDAQ: ARTC) Corporation announced today that the Nasdaq

Listing Qualifications Panel (the “Panel”) has conditionally granted the Company’s request for continued listing on The Nasdaq Global Select Market, and that the Company has received the consent of the lenders under its Credit Agreement to the extension of the delivery deadline for the Company’s June 30, 2008 and September 30, 2008 financial statements.

Under this news the stock price could rally as it looks as if NASDAQ will not delist them for now. However it is still bad news as they are delaying restatements that were supposed to be restated on June 30th to February of 09’, leaving investors

with 13 quarters of data needing to be restated in March.

• ArthroCare Receives Expected Additional NASDAQ Staff Determination Letter Regarding Delayed Filing of Form 10-Q; NASDAQ Panel Decision Remains Pending - 4:30 p.m. EST Nov. 18, 2008 - ArthroCare announced today that, as expected, it received an additional NASDAQ Staff Determination Letter on November12, 2008 in connection with the Company's inability to timely file its Quarterly Report on Form 10-Q for the period

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ended September 30, 2008 with the Securities and Exchange Commission (the "SEC"). The Additional Staff Determination letter states that the Company is therefore not in compliance with NASDAQ Marketplace Rule 4310(c)(14), and that this issue may serve as an additional basis for the NASDAQ Listing Qualifications Panel (the "Panel") to delist its common stock from NASDAQ.

ArthroCare had failed to file a Form of 10-Q for the third time. Most likely this is an indication that the 10-Q would not have looked favorable on the company. With plummeting stock prices due to short sellers and speculation, ArthroCare would not delay any good news it had. Also within this news the NASDAQ panel has discussed a possible delisting, a poor sign for any equity.

• ArthroCare Gets No Medicare Love – October 2nd 2008 - The federal government hasn't been ArthroCare’s

friend. The Centers for Medicare and Medicaid Services delivered the latest blow this week, when it issued a dreaded "non-coverage determination" for surgeries involving ArthroCare’s best-selling spine device. Following a review, CMS determined that "the evidence does not demonstrate that thermal intradiscal procedures improve health outcomes." The agency specifically included percutaneous disc decompression (PDD) in that group. ArthroCare sells its popular Spine Wands for that very surgery.

Not a good sign to see in this industry as the government rebates from Medicare and Medicaid result in a much lower effective tax rate. Also anybody that is on the federal government’s insurance coverage will now likely not choose ArthroCare’s products as they are not covered.

• ArthroCare Corporation Faces Class Action Lawsuit - Tuesday, 9 Sep 2008 04:45pm EDT- Stull, Stull & Brody announced a lawsuit has been filed on behalf of shareholders of ArthroCare Corporation. The complaint alleges that before the market opened on July 21, 2008 ArthroCare announced that it would be restating its previously reported financial results from the third quarter 2006 through the first quarter 2008 because it improperly recognized previously reported revenue. The Company announced that it expects to report reduced revenue and "material reductions in operating income and net income for the annual and quarterly periods being restated." Upon this announcement, shares of the Company's stock declined significantly. The complaint alleges that on July 24, 2008 the Securities and Exchange Commission (the "SEC") commenced an inquiry into the circumstances surrounding the restatement, and that ArthroCare's officers and directors sold nearly $12 million worth of their personal holdings in ArthroCare securities.

ArthroCare’s Board of Directors exercised many of their stock options right before the controversy began. This is one of many such lawsuits against the company for illegal actions by the company

• ArthroCare Corporation Announces Informal Inquiry By SEC - Thursday, 24 Jul 2008 06:00am EDT

-ArthroCare Corporation announced that it has been informed by the SEC's Fort Worth District Office that the Staff of the SEC's Division of Enforcement is conducting an informal inquiry into accounting matters related to

ArthroCare Corporation arising out of the Company's recently announced restatement of financial results. The Company stated that it will cooperate fully with the SEC.

The official beginning of ArthroCare’s “Enron-ish” ride. Three days earlier, the stock price dropped nearly 50% on speculation of this investigation and amongst confirmation of other private investigations. ]

INDUSTRY

Revenue Drivers:

The medical products industry is one that is highly driven by the technology behind your product and the distribution channels that you have set up. The technology behind your product is what will set you apart from the rest of the industry and drive your revenues, as companies have done in the past with new landmark achievements (E.g. Coblation technology) Because of this, research and development costs are fairly high as each company is trying to gain a competitive edge.

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Another important driver is the distribution channel that the Company has set up. A company may have great products but unless those products are actually being used to perform surgeries, it does them no good. A strong distribution system will provide a strong competitive edge.

Industry Growth Trends:

The industry as a whole tends to grow both organically and through acquisition. They improve and expand their own current operations but also look to acquire smaller companies with high intangible assets such as patents or copyrights. The industry as a whole is fairly fragmented with many companies but in order to gain access to new markets or to increase a product line in the past few years companies have been acquiring smaller companies.

Industry Tax Rate:

The tax rate for many companies in the medical products industry is less than many corporations because they receive tax credits lowering their overall effective tax rate

Industry Going Forward:

It appears that many of the main product segments are recession-resistant and growth is expected to continue at its current high rate in 2008 and 2009 regardless of more restrictive credit conditions, which will in the end effect the consumer bases spending decisions. However segments that are tied directly to consumer confidence will not perform as well. During the recession, elective segments will be hurt by falling consumer confidence, increased levels of unemployment and inflationary prices. Standard and Poor’s warns specifically towards areas such as cosmetic surgery, orthodontics and laser vision correction. With increasing demand for quality health care and an aging American population, there should be a steady cash flow of new diagnostic and therapeutic products in areas such as cardiology, orthopedics, oncology and minimally invasive surgery.

S.W.O.T.ANALYSIS

Strengths

• Coblation Technology Patent – this technology has been tested and proven to be a better then many other arthroscopic alternatives

• Research and Development Tax Credits – Lowers effective tax rate

• Manufacturing facilities in low tax area Weaknesses

• Current scandal – causes a loss of confidence in products and company

• Entire distribution channel in the spine segment and large parts of the sports medicine segment distribution ruined with current scandal. May need to rebuild new distribution channels.

Opportunities

• Growth opportunities during current recession as many products are fairly inelastic

• Acquisitions look favorable for large companies as many stock prices in industry are beaten down. Threats

• Poor economy reduces number of high end surgeries performed

• Intense Competition

• Possible Delisting of Stock

• Products on Medicare and Medicaid “No Coverage List”

CATALYSTS Upside

- Medicare or Medicaid Approval

- New patents on technology

- Acquisitions

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Downside

- Lawsuits

- Product Malfunction

- Delisting from NASDAQ

COMPARABLES ANALYSIS

For my comparables analysis I used Stryker, Smith and Nephew, and Medtronic. These companies all compete in similar markets and often their products compete with very similar products. These companies also have similar market risks and engage in a similar business plan as ArthroCare.

Smith and Nephew: (33%)

“Smith & Nephew plc, incorporated in 1937, is a global medical devices company engaged in the development, manufacture and marketing of medical devices in the sectors of orthopedic reconstruction, orthopedic trauma and clinical therapies, endoscopy and advanced wound management. The Company is organized into four business segments: reconstruction, trauma and clinical therapies, endoscopy and advanced wound management. Reconstruction implants offered by the Company include hip, knee and shoulder joints, as well as ancillary products, such as bone cement and mixing systems used in cemented reconstruction joint surgery. Its trauma and clinical therapies products comprise both trauma fixation products and associated clinical therapies. Smith & Nephew’s endoscopy business, headquartered in Andover, Massachusetts, develops and commercializes endoscopic (minimally invasive surgery) techniques, educational programs and value-added services for surgeons to treat and repair soft tissue and articulating joints. Its advanced wound management business offers a range of products from initial wound bed preparation through to full wound closure.” (Reuters)

Smith and Nephew’s endoscopy business directly competes with ArthroCare’s products as they both perform the same task. Their direct competition is mostly in the sports medicine segment.

Stryker: (33%)

“Stryker Corporation, together with its subsidiaries, operates as a medical technology company worldwide. It operates in two segments, Orthopedic Implants and MedSurg Equipment. The Orthopedic Implants segment provides orthopedic reconstructive, spinal, and craniomaxillofacial implant systems, as well as trauma implant systems, joint replacement products, knee implant systems, hip implant systems, bone cement, and OP-1 implants. The MedSurg Equipment segment offers surgical equipment; surgical navigation systems; endoscopic, communications, and digital imaging systems; and patient handling and emergency medical equipment. Stryker Corporation sells its products through local dealers and direct sales force to hospitals, health-care facilities, and doctors. The company was founded in 1941 and is headquartered in Kalamazoo, Michigan.” ( Yahoo)

Stryker competes in all three of ArthroCares product segments but it is also a much larger company than ArthroCare and operates in others as well exposing it to more markets and their respective risks.

Medtronic: (33%)

Medtronic, Inc. develops, manufactures, and markets medical devices worldwide. The company’ s Cardiac Rhythm Disease Management segment primarily offers pacemakers, implantable defibrillators, leads, ablation products, electrophysiology catheters, insertable cardiac monitors, and information systems for cardiac rhythm disease management. Its Spinal segment provides thoracolumbar, cervical, and interbody spinal devices; bone growth

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substitutes; and devices for vertebral compression fractures and spinal stenosis. The CardioVascular segment offers coronary and peripheral stents, and related delivery systems; endovascular stent graft systems; heart valve replacement technologies and tissue ablation systems; and open heart and coronary bypass grafting surgical products. The Neuromodulation segment provides therapeutic and diagnostic devices, including implantable neurostimulation systems, implantable drug delivery devices, and urology and gastroenterology products. The Diabetes segment offers external insulin pumps and related consumables, continuous glucose monitoring systems, and subcutaneous glucose sensors. The Surgical Technologies segment provides products to treat conditions of the ear, nose, and throat, as well as certain neurological disorders. It offers powered tissue-removal systems and other microendoscopy instruments, implantable devices, nerve monitoring systems, disposable fluid-control products, hydrocephalus shunt devices, external drainage systems, cranial fixation devices, neuroendoscopes, dura repair products, and image-guided surgery systems. The company was founded in 1949 and is headquartered in Minneapolis, Minnesota.” (Yahoo)

Medtronic is a much larger company than ArthroCare and will have different operating structure due to their size. However I decided to leave them in as a competitor as they have a similar business plans and industry risk, directly competing in some segments with ArthroCare products.

Metrics Used:

• EV/REV

• EV/OCF

• EV/EBIT

I used these ratios to compare how the companies are operating within the industry. I used the EV/EBIT over EV/EBITDA because the companies were of different size and had varying depreciation and amortization costs.

DISCOUNTED CASH FLOW ANALYSIS

Because only the first quarter of 2008 was released and it was the most overstated of all of the financials, I have elected to discount all of 2008.

Due to ArthroCares current and likely future legal proceedings and investigations, which the results of most are unknown, my projections face extreme uncertainty. I have presented in my DCF, what I believe to be the best case scenario, although many could be considered.

For my Discounted Cash Flow analysis I used the group standard percentage of revenue method to forecast into the future. In order to determine my Beta I regressed the monthly returns of ArthroCare against the monthly returns of the S&P 500 for the past five years giving me a Beta of 1.63. This was much higher than most of the competitors, however the regressions had a high T-statistic of 3.53 and a standard deviation of .46, which is also fairly high. The company’s beta has increased dramatically in the face of the more recent activities, as the company itself has become more volatile and thus more risky.

Revenues:

Because of ArthroCare’s current and previous dilemmas it was very difficult to project revenues. The company itself is exposed to an extraordinary amount of risk currently and trying to figure out where there revenues will be until the restatements for the past nine quarters are made public is very hard to determine. However based on industry revenue drivers of distribution and the nature of the scandal, I have their revenues falling dramatically in the next year. The distribution channel has been damaged with their current crisis and demand for their product will fall as their name and company have been tarnished greatly. I have the company’s revenues climbing back up rapidly in the next year except for in the spine segment, which is where most of the controversy is. Because the technology behind their products and thus the revenues is strong it is possible that the demand will not turn its back on ArthroCare. The revenue projections I have forecasted are what I believe to be a best case scenario for revenue turnaround. I choose to do this because of the high uncertainty with what the outcome of the restatements will be. After 2012, I have used the industry projections to forecast revenues into the future, as ArthroCares actual revenues will be extremely uncertain, and it becomes much more uncertain to project individual segments

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I have the gross margin increasing going into the future as the management has discussed that they will continue to improve operating efficiencies and to increase their average selling prices. Also by completing the relocation of some of their operations to Costa Rica, a more efficient facility, they should be able to lower some of their operating costs.

Expenses

I have the expenses increasing in the first two years as a percentage of revenue to a larger amount than normal. This is to counteract the dramatic decrease projected in their revenues. Many of the same expenses will still occur, just as a larger percentage of the revenue.

Research and Development:

Management has given guidance in the 2007 10-K that R&D costs are projected to remain essentially flat, neither increasing nor decreasing despite technology being a strong revenue driver.

Sales and Marketing:

In light of the most recent developments I have projected sales and marketing to increase in the next couple years and then decrease down to 37.25% of total revenue. It will then increase from there as the company will grow and thus need to increase their expense as they fight for distribution channels.

General and Administrative:

Management has given guidance in the 2007 10-K that general and administrative costs are projected to remain essentially flat going into the future. I have increased the percentage of revenue higher in this category because this is where they expense all of their legal costs. Given their current situation, the company’s legal costs are likely to increase dramatically

Amortization of Intangible Assets;

ArthroCare has many patents and a large amount of goodwill that will be amortized going into the future. I used the projected amounts from the 2007 10-K until 2012, when I set it at 2.5% which is what it has been approximately historically and left it going into the future and into the terminal year.

Current Assets and Current Liabilities:

The current assets and current liabilities were projected out assuming that management will try to continue to keep their current ratio at around 3.75 which is an approx. of what it has been in previous years. The current ratio drops during the payment of the principal of their long term debt. In the terminal year it is left at 3.75 with current liabilities of 16% or revenues and current assets 60% of revenues.

Acquisitions:

Acquisitions in the industry are fairly common as it is one of the industry growth pattern and recently ArthroCare’s method. However due to ArthroCare’s current dilemma I believe the company will spend the next three fiscal years on increasing internal value before looking towards acquisitions. In 2011, they have a note payable due, and in that year I believe they will use most of their available cash position to cover that principal. Starting in 2012 though I projected a percentage of revenue into the future and into the terminal year based off an average of previous acquisition costs.

Capital Expenditures:

The capital expenditure line item is projected to remain fairly constant going into the future as it seems to have stabilized into 2005 going into the future at 6% of revenues. This represents the property plant and equipment expenditures.

RECOMMENDATION

ArthroCare has a very strong product base with great technology behind their products. This creates a large amount of value for the company. However in the light of the recent events and the possible delisting of the stock the value of the company has fallen significantly and its prospects do not look promising. The company currently has 11 quarters of information that they are late on restating and as of December 1st they have delayed again until February of 2009. Due to these qualitative

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APPENDIX 1–COMPARABLES ANALYSIS

Multiples Implied value Weight

EV/REV $ 27.93 33.33% EV/Gross Profit $ 28.81 33.33% EV/EBIT $ 23.25 33.33% 26.66 $ Implied Price 14.52 $ Current Price 83.63%Undervalued

Arthrocare (ARTC) Stryker (SYK) Smith & Newphew (SNN) M edtronic (MDT) Weighted Average

Weight 33% 33% 33% 100%

Current Share Price $ 14.52 $ 37.69 $ 34.95 $ 30.29

Shares outstanding 26627468 403734601 176,529,856 1128294514 569519657

Market Cap $ 386,630,835 $ 15,216,757,112 $ 6,169,718,467 $ 34,176,040,829 $ 18,520,838,802

Long term debt $ 60,000,000 $ 16,800,000 $ 36,000,000 $ 5,656,000,000 $ 1,902,933,333

EV $ 446,630,835 $ 15,637,291,751 $ 6,382,248,358 $ 40,960,335,374 $ 20,993,291,827 Revenues $ 319,242,000 $ 6,005,000,000 $ 3,329,400,000 $ 13,515,000,000 $ 7,616,466,666 Gross Profit $ 234,518,000 $ 4,135,300,000 $ 2,336,000,000 $ 10,069,000,000 $ 5,513,433,333 Interest Expense $ 977,000 $ 65,000,000 $ 40,000,000 $ 258,000,000 $ 121,000,000 Depreciation $ 21,011,000 $ 229,500,000 $ 228,000,000 $ 637,000,000 $ 364,833,333 Tax Rate 26% 32.5% 31% 20% 28% Net incom e $ 43,180,000 $ 1,017,400,000 $ 353,800,000 $ 2,231,000,000 $ 1,200,733,333 EBIT $ 53,175,000 $ 1,368,500,000 $ 509,000,000 $ 2,855,000,000 $ 1,577,500,000 OCF $ 64,953,060 $ 1,290,775,000 $ 609,400,000 $ 3,073,626,000 $ 1,657,933,667 EBIT DA $ 74,186,000 $ 1,001,900,000 $ 77,500,000 $ 5,330,000,000 $ 2,136,466,667 Beta 1.63 1.01 0.77 0.79 EV/REV 1.40 2.60 1.92 3.03 2.52 EV/Gross Profit 1.90 3.78 2.73 4.07 3.53 EV/EBIT 8.40 11.43 12.54 14.35 12.77

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APPENDIX 3–DISCOUNTED CASH FLOWS ANALYSIS ASSUMPTIONS

Terminal Growth Rate 3%PVSum of FCF $ 194,706,874

Tax Rate 26.00%Terminal Value $ 329,881,678

Risk Free Rate 2.67% PV of Term Value $ 87,958,459

Risk Premium 7.00% Firm Value $ 282,665,333

Beta 1.623Long T erm Debt $ 60,000,000

CAPM 14.03%Equity Value $ 222,665,333

% of Equity 87.33%Shares Outstanding 26,627,468

Cost of Debt 5.50% Implied Share Price $ 8.36

% of Debt 12.67%Current Share Value $ 14.52

WACC 12.77%Overvaluation 42.41%

Assumptions & Calculations

APPENDIX 4–BETA SENSITIVITY ANALYSIS

DCF - 70% $ 8.33

Comparables - 30% $ 26.66

Target Price $ 13.83

Actual Share Price $ 14.52

Overvalued 4.76%

Valuation

Beta St. Dev. Implied Price Over/Under Valued

3.013 3 $ 4.16 72.07% Over 2.552 2 $ 4.93 65.53% Over 2.090 1 $ 6.29 56.71% Over 1.629 0 $ 8.36 42.41% Over 1.168 -1 $ 11.98 17.48% Over 0.706 -2 $ 20.54 41.43% Under 0.245 -3 $ 64.60 344.93% Under APPENDIX 5–SOURCES • Google Finance • Yahoo Finance • Ibis World

• Standard and Poor’s Net Advantage

• Reuters

• Bloomberg

• Citron Research

• Dun and Bradstreet

• ArthroCare’s Website

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References

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