Believe in ArthroCare Potential

ArthroCare Corp. (ARTC - Analyst Report) made a 30 percent round trip after solid first-quarter results, a string of product launches, and a recent acquisition that temporarily alleviated the stock’s litigation overhang during the past quarter. However, our model continues to reflect higher litigation risk, related expenses, and a possible restatement that might follow. The stock remains a long-term Buy based on the company’s long-term potential.

The company has a clear strategy to leverage its patented Coblation technology and other innovative, clinically superior surgical devices for the treatment of soft-tissue conditions throughout the body. The company has operational efficiencies, in addition to top-line growth, to drive EPS gains. New products in Sports Medicine are stimulating growth in a fairly mature segment. Oncology represents another growth opportunity for ARTC.

ARTC reported better-than-expected results in the first quarter on strong expense management. Margins are expected to continue improving through out the year, with the company expecting 100 basis point improvements in both gross margin and selling, gross and administrative spending. Our fiscal 2008 estimate increases $0.13 to $2.11.

Despite increasing 2008 revenues, our revenue outlook moves to inline with the management’s guidance. We believe the class-action suit related to DiscoCare reimbursement practices will increase near-term execution risk as management diverts their attention. Valuation reflects this risk.

At the current price of $36.35, ARTC trades at 17.7x our expected 2008 EPS of $2.05 and 14.5x 2009 EPS of $2.50. Given the current headline risk, we believe the company will trade at a 15 percent discount to the average of comparables 1.3x 2008 P/E/G, our long-term target moves to $55, roughly equal to 26.8x 2008 EPS and 22x 2009 EPS.

Read the full analyst report on ARTC