Orthopedic and Dental Industry News Complete Archive »

ArthroCare Lands Key Ruling Versus Smith & Nephew: Raises 2005 Revenue Estimate BY JOHN MCCORMICK, JUNE 14, 2004

If you are looking to buy a Smith & Nephew Dyonics Control RF System, ElectroBlade or Saphyre™ you might as well go to ebay because Smith & Nephew has been barred from selling them by the U.S. District Court of Delaware. Pretty soon, you shouldn't even see references to these three products on the Smith & Nephew website and you certainly shouldn't be getting any sales calls from any Smith & Nephew representatives on the products.

So far the Court has awarded ArthroCare two out of three of its objectives in its patent infringement lawsuit against Smith & Nephew. The first happened over a year ago when the jury held that Smith & Nephew, by selling bipolar RF electrosurgical devices, infringed on 16 claims covered by 3 ArthroCare patents. The second occurred on Wednesday when the Courts rejected Smith & Nephew's stay of the permanent injunction on the sale of the offending products. That decision finalized the injunction. The third leg of the obstacle course (excluding the appeals process initiated by Smith & Nephew) is the damages trial where any outcomes are yet to be determined. We outline a timeline of the trial in Appendix 1.

The implication of the Court's decision is substantial. We summarize the current ruling below:

• Smith & Nephew must stop manufacturing, designing and selling the Dyonics Control RF System, ElectroBlade or Saphyre™.
• Smith & Nephew must retrieve from all sales representatives, distributors, physicians and hospitals all infringing products for which titles have not passed from Smith & Nephew (this includes consignment inventory and even demos).
• Smith & Nephew must recall all marketing materials referencing the products.
• Smith & Nephew must remove all references to these products from their website.
• Smith & Nephew must alert all employee and non-employee sales representatives and distributors of the need to discontinue selling those products.
• Smith & Nephew has a transition period from today until July 27, 2004 (this actually began on April 27 when the initial Court order was released) to allow time for the company to notify physicians (that they have ever sold this equipment to) that they are required to stop using the Saphyre™, Control RF and ElectroBlade products. During this transition period, Smith & Nephew is prohibited from manufacturing or selling these devices.
• If Smith & Nephew encourages doctors to use the product beyond July 27, 2004, the Company will be in violation of the federal court order and could be held in contempt of court.
• Copies of the Court order must be distributed to all sales reps, distributors and customers before July 27.
• Note the injunction is also against using the devices. Hospitals can't even use the devices after July 27. To the extent that it is enforced is another question; so we see the key issue here as Smith & Nephew not being allowed to encourage people to use device.
• It is critical to note that this decision applies to Smith & Nephew's bipolar wands and not the actual installed base of controllers and that Smith & Nephew has other types of wands (monopolar) that they can continue to sell.
• Finally, the Federal Circuit Court of Appeals denied Smith & Nephew's motion to delay enforcement of the injunction pending appeal. ArthroCare management believes that it could take a year or more for the appeal process to play itself out. ArthroCare management does not expect this to incur significant legal costs.

The exact financial impact to ArthroCare from this injunction cannot be determined at this time according to CEO Mike Baker. It is safe for us to assume that this can only be a positive event for ArthroCare. On a public conference call last week, management did not raise its 2004 revenue estimate for equity analysts, but did offer some guidance for 2005 for the first time.

Let's review the revenue estimates in brief. Management's current 2004 revenue estimate is 'growth in excess of 20%' of 2003 revenues. In other words the Company is expecting over $137 million of revenues in 2004. The 2005 guidance management offered on its call last week was yet another 20% revenue growth for 2005. Using some basic arithmetic, the Company is stating that it expects to make as much as $165 million in 2005. What is interesting here is management's 2005 revenue growth expectation significantly exceeds the 10% - 15% predicted by equity analysts.

Management is not tying that growth to the Delaware Court decision at this time, however. In fact, CEO Mike Baker was very careful not to quantify the impact of this judgment in either the 2004 or 2005 revenue or earnings forecasts. What we do understand, however, is that the bipolar RF ablation product sales of Smith & Nephew's subject to the injunction were in excess of $10 million in 2003. A very modest 10% growth implies over $12 million in 2005 revenues that Smith & Nephew will lose and ArthroCare could potentially pick up with its coblation products. Of course there are a few complicating features to how this will play out in the real world: (i) Stryker and/or Mitek may pick up some of this business in which case ArthroCare gets a royalty, (ii) Smith & Nephew does not have to take back their controllers and can still sell monopolar wands, (iii) hospitals will take time evaluating products given this change in the market.

To say the least, this small segment of the sports medicine market will be dynamic over the next few months.

Appendix 1 - Timeline of the ArthroCare Smith & Nephew Trial