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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549
 FORM 10-Q (MARK ONE) [X]
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT 1934FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2004
 [  ]
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT 1934FOR THE TRANSITION PERIOD FROM TO
 Commission file number 0-10521 ADVANCED NEUROMODULATION SYSTEMS, INC. 
  Texas
    
    75-1646002(State or Other Jurisdiction of
    
    (I.R.S. Employer Identification No.)Incorporation or Organization)
 6501 Windcrest Drive, Plano, Texas 75024   (972) 309-8000   Indicate by check ü whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
YES ü NO o Indicate by check ü whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). YES ü NO o Indicate the number of shares outstanding of each of the issuers classes of
common stock, as of the latest practicable date. Number of Shares Outstanding atTitle of Each Class
    
    April 30, 2004Common stock, $.05 Par Value
    
    20,083,355




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Advanced Neuromodulation Systems, Inc. and Subsidiaries Table of Contents PART I. Financial Information
    
    
    2Item 1. Financial StatementsCondensed Consolidated Balance Sheets March 31, 2004 (Unaudited) and December 31, 2003
    
    
    3-4Condensed Consolidated Statements of Income (Unaudited) For the Three Months Ended March 31, 2004 and 2003
    
    
    5Condensed Consolidated Statements of Cash Flows (Unaudited) For the Three Months Ended March 31, 2004 and 2003
    
    
    6Condensed Consolidated Statements of Stockholders Equity For the Year Ended December 31, 2003 and the Three Months Ended March 31, 2004 (Unaudited)
    
    
    7Notes to Condensed Consolidated Financial Statements
    
    
    8-13Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    14-23Item 3. Quantitative and Qualitative Disclosures About Market Risk
    
    
    23Item 4. Controls and Procedures
    
    
    23PART II. Other Information
    
    
    24Item 1. Legal Proceedings
    
    
    24Item 6. Exhibits and Reports on Form 8-K
    
    
    24-25Signatures
    
    
    26Certification of CEO under Section 302Certification of CFO under Section 302Certification of CEO under Section 906Certification of CFO under Section 906
  -1-




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PART I FINANCIAL INFORMATION -2-




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ITEM 1. FINANCIAL STATEMENTS Advanced Neuromodulation Systems, Inc. and Subsidiaries 
 Condensed Consolidated Balance Sheets
 March 31, 2004 (Unaudited) and December 31, 2003
 March 31,
    
    December 31,2004
    
    2003AssetsCurrent assets:Cash and cash equivalents
    
    $
    79,750,480
    
    
    $
    8,588,281Marketable securities
    
    
    13,250,876
    
    
    
    86,213,841Receivables:Trade accounts, less allowances of
$459,340 in 2004 and $447,457 in 2003
    
    
    18,706,313
    
    
    
    17,892,416Interest and other
    
    
    293,010
    
    
    
    259,687Total receivables
    
    
    18,999,323
    
    
    
    18,152,103Inventories:Raw materials
    
    
    8,466,136
    
    
    
    10,766,127Work-in-process
    
    
    6,322,038
    
    
    
    3,569,111Finished goods
    
    
    8,200,642
    
    
    
    7,777,921Total inventories
    
    
    22,988,816
    
    
    
    22,113,159Deferred income taxes
    
    
    2,160,650
    
    
    
    1,423,228Income taxes receivable
    
    
    1,303,359
    
    
    
    1,324,001Prepaid expenses and other current assets
    
    
    1,369,892
    
    
    
    1,007,244Total current assets
    
    
    139,823,396
    
    
    
    138,821,857Property, equipment and fixtures:Land
    
    
    3,191,427
    
    
    
    3,191,427New facility construction in progress
    
    
    11,756,868
    
    
    
    8,825,730Furniture and fixtures
    
    
    4,762,618
    
    
    
    4,429,672Machinery and equipment
    
    
    16,024,872
    
    
    
    13,944,120Leasehold improvements
    
    
    1,826,191
    
    
    
    1,822,15237,561,976
    
    
    
    32,213,101Less accumulated depreciation and amortization
    
    
    12,046,536
    
    
    
    11,063,091Net property, plant and equipment
    
    
    25,515,440
    
    
    
    21,150,010Minority equity investments in preferred stock
    
    
    1,104,000
    
    
    
    1,104,000Goodwill
    
    
    12,078,668
    
    
    
    12,078,668Patents and licenses, net of accumulated
amortization of $1,958,712 in 2004 and
$1,848,354 in 2003
    
    
    5,787,324
    
    
    
    5,814,974Purchased technology, net of accumulated
amortization of $3,146,648 in 2004 and
$2,910,895 in 2003
    
    
    11,216,328
    
    
    
    10,319,679Tradenames, net of accumulated amortization of
$1,148,783 in 2004 and $1,110,458 in 2003
    
    
    1,837,532
    
    
    
    1,800,572Customer and supplier relations, net of
accumulated amortization of $297,867 in 2004 and
$194,303 in 2003
    
    
    2,269,994
    
    
    
    2,373,558Other assets, net of accumulated amortization of
$895,750 in 2004 and $803,797 in 2003
    
    
    1,297,138
    
    
    
    1,342,969$
    200,929,820
    
    
    $
    194,806,287
 See accompanying notes to condensed consolidated financial statements. -3-




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Advanced Neuromodulation Systems, Inc. and Subsidiaries
Condensed Consolidated Balance Sheets (continued)
March 31, 2004 (Unaudited) and December 31, 2003 March 31,
    
    December 31,2004
    
    2003Liabilities and Stockholders EquityCurrent liabilities:Accounts payable
    
    $
    3,710,924
    
    
    $
    5,717,222Accrued salary and employee benefit costs
    
    
    1,456,927
    
    
    
    4,045,361Accrued commissions
    
    
    1,305,312
    
    
    
    1,424,471Deferred revenue
    
    
    346,645
    
    
    
    503,093Warranty reserve
    
    
    252,989
    
    
    
    294,290Other accrued expenses
    
    
    361,540
    
    
    
    400,159Total current liabilities
    
    
    7,434,337
    
    
    
    12,384,596Deferred income taxes
    
    
    3,761,828
    
    
    
    3,389,255Non-current deferred revenue
    
    
    862,162
    
    
    
    907,513Commitments and contingenciesStockholders equity:Common stock $.05 par valueAuthorized 25,000,000 shares;Issued - 20,005,562 shares in 2004 and 19,712,938 in 2003
    
    
    1,000,278
    
    
    
    985,647Additional capital
    
    
    156,396,105
    
    
    
    149,644,033Retained earnings
    
    
    31,483,592
    
    
    
    27,515,001Accumulated other comprehensive income (loss), net of tax
benefit of $10,923 in 2004 and $10,181 in 2003
    
    
    (8,482
    )
    
    
    (19,758
    )Total stockholders equity
    
    
    188,871,493
    
    
    
    178,124,923$
    200,929,820
    
    
    $
    194,806,287
 See accompanying notes to condensed consolidated financial statements. -4-




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Advanced Neuromodulation Systems, Inc. and Subsidiaries 
 Condensed Consolidated Statements of Income (Unaudited)
 For the Three Months Ended March 31, 2004 and 2003
 Three Months Ended March 31,2004
    
    2003Net revenue
    
    $
    26,632,863
    
    
    $
    19,670,591Cost of revenue
    
    
    6,965,532
    
    
    
    6,881,691Gross profit
    
    
    19,667,331
    
    
    
    12,788,900Operating expenses:Sales and marketing
    
    
    8,564,046
    
    
    
    5,159,908Research and development
    
    
    2,314,950
    
    
    
    1,692,431General and administrative
    
    
    2,316,740
    
    
    
    1,765,918Amortization of other intangibles
    
    
    574,874
    
    
    
    354,93413,770,610
    
    
    
    8,973,191Income from operations
    
    
    5,896,721
    
    
    
    3,815,709Other income (expense):Foreign currency transaction loss
    
    
    (29,347
    )
    
    
    Investment and other income
    
    
    251,329
    
    
    
    281,655221,982
    
    
    
    281,655Income before income taxes
    
    
    6,118,703
    
    
    
    4,097,364Income taxes
    
    
    2,150,112
    
    
    
    1,477,550Net income
    
    $
    3,968,591
    
    
    $
    2,619,814Net income per share:Basic
    
    $
    .20
    
    
    $
    .14Diluted
    
    $
    .19
    
    
    $
    .13
 See accompanying notes to condensed consolidated financial statements. -5-




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Advanced Neuromodulation Systems, Inc. and Subsidiaries 
 Condensed Consolidated Statements of Cash Flows (Unaudited)
 For the Three Months Ended March 31, 2004 and 2003
 Three Months Ended March 31,2004
    
    2003Cash flows from operating activities:Net income
    
    $
    3,968,591
    
    
    $
    2,619,814Adjustments to reconcile net income to net cash provided by (used in)
operating activities:Depreciation and amortization
    
    
    1,563,398
    
    
    
    983,827Deferred income taxes
    
    
    (770,714
    )
    
    
    (33,292
    )Stock-based compensation
    
    
    (19,398
    )
    
    
    42,372Gain on sale of assets and marketable securities
    
    
    (1,068
    )
    
    
    Changes in operating assets and liabilities, net of acquisitions:Receivables
    
    
    (847,220
    )
    
    
    (2,134,809
    )Inventories
    
    
    (875,657
    )
    
    
    (1,251,270
    )Income taxes receivable
    
    
    20,642
    
    
    
    Prepaid expenses and other current assets
    
    
    (362,648
    )
    
    
    (972,674
    )Income taxes payable
    
    
    
    
    
    
    (822,228
    )Tax benefit from stock option exercises
    
    
    2,885,538
    
    
    
    2,102,907Accounts payable
    
    
    (2,006,298
    )
    
    
    251,666Accrued expenses
    
    
    (2,787,513
    )
    
    
    (1,770,794
    )Deferred revenue
    
    
    (201,799
    )
    
    
    (60,172
    )Total adjustments
    
    
    (3,402,737
    )
    
    
    (3,664,467
    )Net cash provided by (used in) operating activities
    
    
    565,854
    
    
    
    (1,044,653
    )Cash flows from investing activities:Purchases of marketable securities
    
    
    (24,609,473
    )
    
    
    (146,483,218
    )Proceeds from sales of marketable securities
    
    
    97,572,066
    
    
    
    146,393,497New facility construction in progress
    
    
    (2,931,138
    )
    
    
    Acquisition of certain operations of distributor
    
    
    
    
    
    
    (3,900,000
    )Minority equity investments in preferred stock
    
    
    
    
    
    
    (1,132,000
    )Additions to property, equipment, fixtures and intangible assets
    
    
    (2,580,878
    )
    
    
    (838,618
    )Net cash provided by (used in) investing activities
    
    
    67,450,577
    
    
    
    (5,960,339
    )Cash flows from financing activities:Exercise of stock options
    
    
    3,133,052
    
    
    
    992,723Net cash provided by financing activities
    
    
    3,133,052
    
    
    
    992,723Net increase (decrease) in cash and cash equivalents
    
    
    71,149,483
    
    
    
    (6,012,269
    )Effect of exchange rates on cash and cash equivalents
    
    
    12,716
    
    
    
    Cash and cash equivalents at beginning of year
    
    
    8,588,281
    
    
    
    10,972,974Cash and cash equivalents at March 31
    
    $
    79,750,480
    
    
    $
    4,960,705Supplemental cash flow information is presented below:Income taxes paid (net of refunds)
    
    $
    96,524
    
    
    $
    1,073,709Interest paid
    
    $
    
    
    
    $
    Non-cash activity:Stock issued for intangible assets
    
    $
    767,511
    
    
    $
    1,020,059
 See accompanying notes to condensed consolidated financial statements. -6-




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Advanced Neuromodulation Systems, Inc. and Subsidiaries 
 Condensed Consolidated Statements of Stockholders Equity
 Year Ended December 31, 2003 and the Three Months Ended March 31, 2004 (Unaudited)
 AccumulatedCommon Stock
    
    
    
    
    
    
    
    
    
    Other
    
    TotalAdditional
    
    Retained
    
    Comprehensive
    
    StockholdersShares
    
    Amount
    
    Capital
    
    Earnings
    
    Income (Loss)
    
    EquityBalance at
December 31, 2002
(restated for 3
for 2 stock
split)
    
    
    18,526,014
    
    
    $
    926,301
    
    
    $
    129,738,644
    
    
    $
    14,393,748
    
    
    $
    (13,885
    )
    
    $
    145,044,808Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    13,217,254
    
    
    
    
    
    
    
    13,217,254Adjustment to
unrealized
losses on
marketable
securities, net
of tax
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (5,873
    )
    
    
    (5,873
    )Comprehensive
income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    13,211,381Issuance of
shares for stock
option exercises
    
    
    1,124,372
    
    
    
    56,219
    
    
    
    7,460,722
    
    
    
    
    
    
    
    
    
    
    
    7,516,941Stock-based
compensation
    
    
    
    
    
    
    
    
    
    
    845,480
    
    
    
    
    
    
    
    
    
    
    
    845,480Shares issued
for fractional
share round-up
in 3 for 2 stock
split
    
    
    2,571
    
    
    
    128
    
    
    
    95,873
    
    
    
    (96,001
    )
    
    
    
    
    
    
    Issuance of
earn-out shares
for acquisition
    
    
    59,981
    
    
    
    2,999
    
    
    
    1,717,242
    
    
    
    
    
    
    
    
    
    
    
    1,720,241Tax benefit from
stock option
exercises
    
    
    
    
    
    
    
    
    
    
    9,786,072
    
    
    
    
    
    
    
    
    
    
    
    9,786,072Balance at December
31, 2003
    
    
    19,712,938
    
    
    
    985,647
    
    
    
    149,644,033
    
    
    
    27,515,001
    
    
    
    (19,758
    )
    
    
    178,124,923Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    3,968,591
    
    
    
    
    
    
    
    3,968,591Adjustment to
unrealized
losses on
marketable
securities, net
of tax
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1,440
    )
    
    
    (1,440
    )Foreign currency
translation
adjustment
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    12,716
    
    
    
    12,716Comprehensive
income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    3,979,867Issuance of
shares for stock
option exercises
    
    
    275,919
    
    
    
    13,796
    
    
    
    3,119,256
    
    
    
    
    
    
    
    
    
    
    
    3,133,052Issuance of
earn-out shares
for acquisition
    
    
    16,705
    
    
    
    835
    
    
    
    766,676
    
    
    
    
    
    
    
    
    
    
    
    767,511Stock-based
compensation
    
    
    
    
    
    
    
    
    
    
    (19,398
    )
    
    
    
    
    
    
    
    
    
    
    (19,398
    )Tax benefit from
stock option
exercises
    
    
    
    
    
    
    
    
    
    
    2,885,538
    
    
    
    
    
    
    
    
    
    
    
    2,885,538Balance at
March 31, 2004
    
    
    20,005,562
    
    
    $
    1,000,278
    
    
    $
    156,396,105
    
    
    $
    31,483,592
    
    
    $
    (8,482
    )
    
    $
    188,871,493
 See accompanying notes to condensed consolidated financial statements. -7-




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##### Table of Contents



Advanced Neuromodulation Systems, Inc. and Subsidiaries 
 Notes to Condensed Consolidated Financial Statements
  (1)
    
    BusinessAdvanced Neuromodulation Systems, Inc. (the Company or ANS) designs,
develops, manufactures and markets implantable neuromodulation devices.
ANS devices are used primarily to manage chronic severe pain. We also
provide contract development and custom manufacturing for other medical
device companies through our Hi-tronics Designs, Inc. (HDI) subsidiary.
ANS neuromodulation revenues are derived primarily from sales throughout
the United States, Europe and Australia while HDI revenues are derived
within the United States.On July 11, 2003, we effected a 3 for 2 stock split in the form of a 50%
stock dividend (one share of common stock paid for every two shares
held), paid to shareholders of record on June 20, 2003. All prior period shares,
share prices, and income per share figures have been restated to
reflect the split.The research and development, manufacture, sale and distribution of
medical devices is subject to extensive regulation by various public
agencies, principally the Food and
Drug Administration and corresponding state, local and foreign agencies.
Product approvals and clearances can be delayed or withdrawn for failure
to comply with regulatory requirements or the occurrence of unforeseen
problems following initial marketing.In addition, ANS neuromodulation products are purchased primarily by
hospitals and other users who then bill various third party payors
including Medicare, Medicaid, private insurance companies and managed
care organizations. These third party payors reimburse fixed amounts for
services based on a specific diagnosis. The impact of changes in third
party payor reimbursement policies and any amendments to existing
reimbursement rules and regulations that restrict or terminate the
eligibility of ANS products could have an adverse impact on the Companys
financial condition and results of operations.In January 2004, the Company began operations in Germany through its
wholly-owned subsidiary, ANS GmbH. Previously the Company utilized a
distributor in Germany, and this relationship was terminated in January
2004 at no cost to the Company. Translation adjustments result from
translating foreign subsidiaries financial statements into U.S. dollars.
The foreign subsidiaries financial position and results of operations
are measured using the local currency as the functional currency.
Transaction gains and losses are recorded in the Condensed Consolidated
Statement of Income for transactions denominated in a currency other than
the functional currency. Assets and liabilities are translated at the
exchange rate in effect at the balance sheet date, and income and expense
accounts at average exchange rates during the period. Resulting
translation adjustments are recorded directly to accumulated other
comprehensive income (loss).(2)
    
    Condensed Financial StatementsThe unaudited condensed consolidated financial information contained in
this report reflects all adjustments (consisting of normal recurring
accruals) considered necessary, in the opinion of management, for a fair
presentation of results for the interim periods presented. The
preparation of financial statements in conformity with generally accepted -8-




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Advanced Neuromodulation Systems, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements  accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities
and disclosure of contingent assets and liabilities at the date of the
financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from these
estimates.Certain information and footnote disclosures normally included in
financial statements prepared in accordance with generally accepted
accounting principles have been condensed or omitted. These financial
statements should be read in conjunction with the financial statements
and notes thereto included in our December 31, 2003 Annual Report on Form
10-K. The results of operations for the period ended March 31, 2004 are
not necessarily indicative of operations for the full year.The consolidated financial statements include the accounts of Advanced
Neuromodulation Systems, Inc. and its subsidiaries. All significant
intercompany balances and transactions have been eliminated in
consolidation.(3)
    
    AcquisitionsOn November 26, 2002, the Company completed the acquisition of MicroNet
Medical, Inc. (MicroNet), a privately-held developer of medical devices
based on proprietary micro-lead technology. MicroNet developed a line of
very thin and steerable spinal cord stimulation leads called Axxess
leads. In addition to the initial purchase price paid at closing, the
Company agreed to pay the former MicroNet shareholders additional shares
of ANS common stock if certain product, regulatory approvals, and sales
milestones are met.In January 2004, MicroNet satisfied a product milestone relating to the
development of a four-electrode lead, and the Company issued 16,705 shares of ANS common stock to the former MicroNet shareholders (of which
11,202 were released from escrow) with a value at the time of issuance
and release from escrow of $767,511. The value of ANS common stock issued
and released from escrow was allocated to certain identifiable intangible
assets in accordance with the original purchase price, and resulted in
the following additions to identifiable intangible assets: Amount
    
    Amortization PeriodPurchased technology
    
    $
    736,043
    
    
    15 yearsTradenames
    
    
    17,653
    
    
    15 yearsNon-compete agreements (included
in other assets)
    
    
    13,815
    
    
    5 yearsTotal
    
    $
    767,511
  As the MicroNet acquisition was effected through a stock-for-stock
exchange, and therefore not tax deductible beyond MicroNets existing tax
basis, the Company recorded a deferred tax liability of $405,865 for the
identified intangible assets related to the January 2004 earn-out
consideration. The recording of the deferred tax liability resulted in
additional basis in purchased technology of $396,359 and in additional
tradenames of $9,506.In May 2004, the Company and the former MicroNet shareholders agreed that
no further product milestone payments will be payable under the agreement
because no further product milestones will be met. Consequently, 89,609 shares
of ANS common stock -9-




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Advanced Neuromodulation Systems, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements  held in escrow will be returned to the Company. The former MicroNet
shareholders may still earn additional ANS common stock with an aggregate
value of $3 million if the Company generates $5 million in cumulative net
sales of MicroNet lead products by November 2006, however. As a result of
the May 2004 agreement, the Company reviewed the previously recorded
identifiable intangible assets associated with the MicroNet acquisition
and has concluded there is no impairment of these intangible assets.(4)
    
    Stock Based CompensationThe Company accounts for its stock-based compensation plans in accordance
with Accounting Principles Board Opinion No. 25, Accounting for Stock
Issued to Employees (APB 25) and related interpretations. Under APB 25,
no compensation expense is recognized for stock option grants if the
exercise price of the Companys stock option grants is at or above fair
market value of the underlying stock on the date of grant. Stock-based
compensation to non-employees is measured at fair market value over the
service period and recorded as compensation expense in the Condensed
Consolidated Statement of Income. The Company recorded $(19,398) and
$42,372 of compensation expense to non-employees in the three months
ended March 31, 2004 and 2003, respectively. The Company has adopted the
pro forma disclosure-only provisions of Statement of Financial Accounting
Standards No. 123, Accounting for Stock-Based Compensation (SFAS 123),
as amended by Statement of Financial Accounting Standards No. 148,
Accounting for Stock-Based Compensation-Transition and Disclosure. The
following table illustrates the effect on net income and net income per
share amounts if the Company had applied the fair value recognition
provisions of SFAS 123 to stock-based employee compensation: Three Months Ended March 31,2004
    
    2003Net income as reported
    
    $
    3,968,591
    
    
    $
    2,619,814Stock-based compensation
    
    
    1,166,307
    
    
    
    946,977Pro forma net income
    
    $
    2,802,284
    
    
    $
    1,672,837Basic shares
    
    
    19,928,946
    
    
    
    18,618,911Diluted shares
    
    
    21,187,163
    
    
    
    19,992,147Pro forma Basic EPS
    
    $
    .14
    
    
    $
    .09Pro forma Diluted EPS
    
    $
    .13
    
    
    $
    .08
  (5)
    
    Commitments and ContingenciesOn April 21, 2004, the Company filed a lawsuit in the U.S. District Court
for the Eastern District of Texas, Sherman Division (Docket No.
4:404-CV-00131-PNB-DDB) against Advanced Bionics Corporation, asserting
claims of patent infringement, misappropriation of trade secrets,
tortious interference with contract, misappropriation of time, labor,
skill, and money, violation of the Texas Theft Liability Act, conversion
and constructive trust. The lawsuit alleges, among other things, that
Advanced Bionics is infringing United States Patent No. 4,793,353
entitled Non-Invasive Multiprogrammable Tissue Stimulator And -10-




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Advanced Neuromodulation Systems, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements  Method. In addition, the lawsuit alleges that Advanced Bionics hired a
former ANS employee to aid in the design, development and manufacture of
its implantable stimulation lead, that Advanced Bionics misappropriated
the former employees knowledge of ANS confidential, proprietary, and
trade secret information with respect to ANS implantable stimulation
leads, and that this enabled Advanced Bionics to unfairly compete with
ANS. The lawsuit seeks injunctive relief, compensatory and punitive
damages, attorneys fees and costs.The Company is a party to certain product liability claims related to ANS
neurostimulation devices. Product liability insurers have assumed
responsibility for defending the Company against these claims. The
Company seeks to maintain appropriate levels of product liability
insurance with coverage comparable to that maintained by companies
similar in size and serving similar markets. While historically, product
liability claims for ANS neurostimulation devices have not resulted in
significant monetary liability to the Company beyond its insurance
coverage, there can be no assurances that the Company will not incur
significant monetary liability to the claimants if such insurance is
inadequate, and there can be no assurance that the Companys
neurostimulation business and future ANS product lines will not be
adversely affected by these product liability claims.Except for the matters described above, and other ordinary routine
litigation incidental or immaterial to its business, the Company is not
currently a party to any other pending legal proceeding. The Company
maintains general liability insurance against risks arising out of the
normal course of business.Under the Companys sales agreements with its independent sales agents,
the Company can terminate those agreements without cause by paying an
early termination fee equal to 100% of the commissions that would
otherwise be payable on sales in the territory for the 90 days after
termination and 50% of the commission that would otherwise be payable on
sales in the territory for the 90 day period after the first 90 day
period.In addition, under its distributor agreements, sales agent agreements and
certain other ordinary course commercial contracts with third parties,
the Company typically agrees to indemnify the other contracting party
from damages and costs that may arise from product liability claims. The
terms of the agreements and contracts vary and the potential exposure
under these indemnities cannot reasonably be estimated or determined.(6)
    
    Income TaxesThe Company recorded income tax expense during the three months ended
March 31, 2004 and 2003, of $2,150,112 and $1,477,550, respectively,
representing overall effective tax rates of 35.14% in 2004 and 36.06% in
2003. The decreased effective tax rate in 2004 is primarily due to a
research and development tax credit. The effective tax rates in 2004 and
2003 reflect a provision for federal income taxes at the statutory rate
of 35% and a provision for state taxes, offset by tax-exempt investment
income earned on our cash,
cash equivalents, and marketable securities and, in 2004, the research
and development tax credit. -11-




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Advanced Neuromodulation Systems, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements  (7)
    
    Net Income Per ShareBasic net income per share is computed based only on the weighted average
number of common shares outstanding during the period. Diluted net income
per share is computed using the additional dilutive effect, if any, of
stock options using the treasury stock method based on the average market
price of the stock during the period. The following table presents the
reconciliation of basic and diluted shares: Three Months EndedMarch 31,2004
    
    2003Weighted-average shares outstanding (basic
shares)
    
    
    19,928,946
    
    
    
    18,618,911Effect of dilutive stock options
    
    
    1,258,217
    
    
    
    1,373,236Diluted weighted-average shares outstanding
    
    
    21,187,163
    
    
    
    19,992,147
  For the three months ended March 31, 2004 and 2003, the incremental shares used for dilutive earnings per share relate to stock options whose
exercise price was less than the average market price in the underlying
quarterly computations. Options to purchase 2,000 shares at an exercise
price of $45.91 per share were outstanding for the three months ended
March 31, 2004 and options to purchase 42,000 shares at an average
exercise price of $27.21 per share were outstanding for the three months
ended March 31, 2003, but were not included in the computation of diluted
earnings per share because the options exercise price was greater than
the average market price of the common shares and, therefore, the effect
would be antidilutive.(8)
    
    Comprehensive IncomeComprehensive income is the total of net income and all other non-owner
changes in equity, and consists of net income, unrealized gains or losses
on the Companys available for sale securities, and foreign currency
translation adjustments. Comprehensive income for 2003 and for the three
months ended March 31, 2004 is reported in the Condensed Consolidated
Statements of Stockholders Equity.Comprehensive income (loss) for the three months ended March 31, 2003 is
as follows: Three Months EndedMarch 31, 2003Net income
    
    $
    2,619,814Adjustment to unrealized losses on
marketable securities, net of tax
    
    
    (11,349
    )Comprehensive income
    
    $
    2,608,465
  (9)
    
    Segment InformationThe Company operates in two business segments. The Neuro Products segment
designs, develops, manufactures and markets implantable medical devices
that are used to manage chronic intractable pain and other disorders of
the central nervous system through the delivery of electrical current or
drugs directly to targeted nerve fibers. The HDI O.E.M. segment provides
contract development and O.E.M. -12-




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Advanced Neuromodulation Systems, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements  manufacturing of electro-mechanical devices. Intersegment revenue from
HDI is billed at cost with no intercompany mark-up.Segment data for the three months ended March 31, 2004 is as follows: Neuro
    
    HDI
    
    Intercompany
    
    ConsolidatedProducts
    
    O.E.M.
    
    Eliminations
    
    TotalRevenue from
external customers
    
    $
    24,227,684
    
    
    $
    2,405,179
    
    
    $
    
    
    
    $
    26,632,863Intersegment revenues
    
    $
    
    
    
    $
    1,682,578
    
    
    $
    (1,682,578
    )
    
    $
    Segment income from
operations
    
    $
    5,477,813
    
    
    $
    418,908
    
    
    $
    
    
    
    $
    5,896,721
  Segment data for the three months ended March 31, 2003 is as follows: Neuro
    
    HDI
    
    Intercompany
    
    ConsolidatedProducts
    
    O.E.M.
    
    Eliminations
    
    TotalRevenue from
external customers
    
    $
    16,627,446
    
    
    $
    3,043,145
    
    
    $
    
    
    
    $
    19,670,591Intersegment revenues
    
    $
    
    
    
    $
    1,431,732
    
    
    $
    (1,431,732
    )
    
    $
    Segment income from
operations
    
    $
    3,451,248
    
    
    $
    364,461
    
    
    $
    
    
    
    $
    3,815,709
  (10)
    
    Subsequent EventsOn April 1, 2004, the Company acquired certain assets of its exclusive
distributor of Neuro Products for Australia and New Zealand, MedTel Pty
Limited (formerly Getz Brothers Australia) based in Sydney, Australia.
Two sales professionals from MedTel joined the Companys sales force and
additional direct sales personnel will be hired as needed. MedTel
purchased approximately $1.0 million of our Neuro Products in 2003. The
purchase price of the assets was $500,000 plus the value of the
inventory, which is estimated at approximately $500,000. The assets and
operations acquired are part of the Neuro Products segment.On April 21, 2004, the Company acquired the assets of the Cable and Wire
Division from microHelix, Inc. (microHelix), which is operated out of
Portland, Oregon for approximately $2 million in cash and assumed
liabilities of approximately $125,000. microHelix previously supplied
coated fine wire, antennas, and certain other products to ANS and its
wholly-owned subsidiary, Hi-Tronics Designs, Inc. The acquisition
represents a vertical integration of a component supplier and provides
the Company with additional engineering resources and intellectual
property for the design and development of new products, notably leads,
extensions, trial cables and related products. Approximately 33 personnel
from microHelix joined the Company upon consummation of the transaction.
The assets and operations acquired are part of the HDI O.E.M. segment. -13-




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ITEM 2.
    MANAGEMENTS DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion of the financial condition and results of operations
of the Company should be read in conjunction with the Condensed Consolidated
Financial Statements of the Company and the related Notes. On July 11, 2003, we effected a 3 for 2 stock split in the form of a 50% stock
dividend (one share of common stock paid for every two shares held), paid to
shareholders of record on
June 20, 2003. All prior period shares, share prices, and income per share
figures have been restated to reflect the split. Recent Developments On November 26, 2002, we completed the acquisition of MicroNet Medical, Inc.
(MicroNet), a privately-held developer of medical devices based on proprietary
micro-lead technology. MicroNet developed a line of very thin and steerable
spinal cord stimulation leads called Axxessleads. In addition to the initial
purchase price paid at closing, we agreed to pay the former MicroNet
shareholders additional shares of ANS common stock if certain product,
regulatory approvals, and sales milestones are met. In January 2004, MicroNet satisfied a product milestone and 16,705 shares of
our common stock were issued to the former MicroNet shareholders (of which
11,202 were released from escrow) with a value at the time of issuance and
release from escrow of $767,511. The value of ANS common stock issued and
released from escrow was allocated to certain identifiable intangible assets in
accordance with the original purchase price, and resulted in the following
additions to identifiable intangible assets: purchased technology-$736,043,
tradenames-$17,653 and non-compete agreements-$13,815. In May 2004, the Company
and the former MicroNet shareholders agreed that no further product milestone
payments will be payable under the agreement because no further product
milestones will be met. Consequently, 89,609 shares of ANS common stock held in
escrow will be returned to the Company. The former MicroNet shareholders may
still earn additional ANS common stock with an aggregate value of $3 million if
the Company generates $5 million in cumulative net sales of MicroNet lead
products by November 2006, however. On April 1, 2004, we acquired certain assets of our exclusive distributor of
Neuro Products for Australia and New Zealand, MedTel Pty Limited (formerly Getz
Brothers Australia) based in Sydney, Australia. Two sales professionals from
MedTel joined our sales force and additional direct sales personnel will be
hired as needed. MedTel purchased approximately $1.0 million of our Neuro
Products in 2003. The purchase price of the assets was $500,000 in cash plus
the value of the inventory, which is estimated at approximately $500,000. The
assets and operations acquired are part of the Neuro Products segment. On April 21, 2004, we acquired the assets of the Cable and Wire Division from
microHelix, Inc. (microHelix), which is operated out of Portland, Oregon for
approximately $2 million in cash and assumed liabilities of approximately
$125,000. microHelix previously supplied coated fine wire, antennas, and
certain other products to us and our wholly-owned subsidiary, Hi-Tronics
Designs, Inc. The acquisition represents a vertical integration of a component
supplier and provides us with additional engineering resources and intellectual
property for the design and -14-




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development of new products, notably leads, extensions, trial cables and
related products. Approximately 33 personnel from microHelix joined us upon
consummation of the transaction. The assets and operations acquired are part of
the HDI O.E.M. segment. On April 21, 2004, we filed a lawsuit in the U.S. District Court for the
Eastern District of Texas, Sherman Division, asserting, among other things,
that Advanced Bionics Corporation is infringing a patent we own and has
misappropriated certain of our trade secrets. See Part II, Item 1. Critical Accounting Policies and Estimates General Our discussion and analysis of our financial condition and results of
operations are based upon our condensed consolidated financial statements,
which have been prepared in accordance with accounting principles generally
accepted in the United States. The preparation of these financial statements
requires management to make estimates and judgments that affect the reported
amounts of assets, liabilities and related disclosure of contingent assets and
liabilities at the date of the financial statements and the reported amounts of
revenue and expenses during the reporting period. On an on-going basis,
management evaluates its estimates and judgments, including those related to
third-party reimbursement rates, bad debts, inventories, intangible assets, and
contingencies and litigation. Management bases its estimates on historical
experience and on various other factors that are believed to be reasonable
under the circumstances, the results of which form the basis for making
judgments about the carrying value of assets and liabilities that are not
readily apparent from other sources. Actual results may differ from these
estimates under different assumptions or conditions. Management believes the following critical accounting policies affect its more
significant judgments and estimates used in preparation of its condensed
consolidated financial statements. Revenue Recognition We generate revenues from product sales to end customers, product sales to
international distributors, and development contracts. We recognize revenue on product sales to end customers and distributors upon
shipment, provided an arrangement with the customer or distributor exists, the
fee is fixed and determinable, and collectibility is reasonably assured.
Certain of our customers are third-party payors who reimburse fixed amounts for
services based on a specific diagnosis. Revenue is recognized on these
third-party payor sales based on the sales price less a contractual adjustment,
which is based on our history of reimbursement with the third-party payor,
provided all other revenue recognition criteria are met. We do not have any
continuing obligation to our customers for installation or training, and there
are no acceptance clauses in our customer arrangements. We recognize revenue on development contracts at HDI using either the
percentage of completion method for fixed price development contracts, or as
the services are performed for development contracts that are completed on a
time and materials basis. We recognize revenue using the percentage of
completion method for the fixed price development -15-




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agreements as the contract term can vary from 9 to 24 months, our right to
receive payment depends on our performance in accordance with the agreement,
and we can reasonably estimate the costs applicable to various stages of the
development arrangement. Revenue is recognized based on the ratio of costs
incurred in relation to the estimated costs for the total project. If we do not
accurately estimate the resources required or the scope of work to be performed
under a fixed price development agreement, then future profit margins and
results of operations may be negatively impacted. Under the Companys shipping terms, title transfers to the end customer or
distributor at the point of shipment. Shipping and handling costs are included
in cost of revenue. Payments received in advance of revenue recognition
requirements are recorded as deferred revenue on the consolidated balance
sheet. Bad Debt We are required to estimate the collectibility of our trade receivables. A
considerable amount of judgment is required in assessing the ultimate
realization of the receivables, including the current credit-worthiness of each
customer, the aging of receivables and our historical experience. If the
financial condition of our customers were to deteriorate, resulting in an
impairment of their ability to make payments, additional allowances or
write-offs may be required. Inventory Reserve Our reserve for excess and obsolete inventory is based upon forecasted demand
for our products. If the demand for our products is less favorable than those
projected by management, additional inventory write-downs or write-offs may be
required. Intangible Assets Intangible assets consist of goodwill, patents, purchased technology,
trademarks, customer and supplier relations and covenants not to compete, and
are amortized using the straight-line method over their respective useful
lives. In assessing the recoverability of our intangible assets, we must make
assumptions regarding estimated future cash flows and other factors to
determine the fair value of the respective assets. If these estimates or their
related assumptions change in the future, we may be required to record
impairment charges for these assets. Contingencies We are subject to proceedings, lawsuits and other claims related to our
products and business. We are required to assess the likelihood of any adverse
judgments or outcomes to these matters as well as potential ranges of probable
losses. A determination of the amount of reserves required, if any, for these
contingencies are made after careful analysis of each individual issue. The
required reserves may change in the future due to new developments in each
matter or changes in approach, such as a change in settlement strategy, in
dealing with these matters. -16-




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While historically our product liability claims have not resulted in
significant monetary liability beyond our insurance coverage, an adverse
judgment beyond our insurance coverage could have a material adverse impact on
our results of operations and financial condition. Stock Compensation See Note 4 to the Condensed Consolidated Financial Statements for a discussion
of the application of Statement of Financial Accounting Standards (SFAS) No.
123, Accounting for Stock-Based Compensation and SFAS 148, Accounting for
Stock-Based Compensation  an Amendment of FASB Statement No. 123 to our stock
compensation programs. Results of Operations Comparison of the Three Months Ended March 31, 2004 and 2003 Results for the first quarter of 2004 continue to reflect the positive impact
of revenue growth from increased unit sales of our Genesisand GenesisXPIPG
systems, which we launched in the United States in January 2002 and December
2002, respectively. We believe these systems will generate most of our revenue
growth during the remainder of 2004. References below to 2003 and 2004 are
to the first quarter of each of such years, unless otherwise specified. Net revenue.Net revenue increased $6.96 million, or 35.4%, in 2004 from 2003
due to increased sales of our neuromodulation products which increased 45.7% to
a record $24.23 million in 2004 from $16.63 million in 2003, primarily due to
increased sales of our Genesisfamily of IPG systems. Revenue from our Renew RF
system grew modestly during 2004 compared to 2003. Net revenue of our HDI
O.E.M. business, as planned, decreased to $2.41 million in 2004 from $3.04
million in 2003 primarily due to lower volume of O.E.M. product sales. We
continue to use more of HDIs manufacturing and development capabilities for
our own increasing needs, and accordingly, HDI O.E.M. revenues may flatten or
decline during fiscal 2004 compared to fiscal 2003. Gross profit.Gross profit increased $6.88 million, or 53.78%, in 2004 from
2003 due to the increase in net revenue discussed above and an improvement in
gross profit margins. Gross profit margins increased to 73.85% in 2004,
compared to 65.02% in 2003, due to higher sales of our neuromodulation
products, which contribute higher margins than HDI O.E.M. product sales, higher
neuromodulation product sales from direct sales and commissioned agents which
contribute higher margins than distributor sales, and operational efficiencies
gained from higher manufacturing volumes. In March, September and November
2003, we completed three separate acquisitions of certain operations of our
remaining U.S. distributors and transitioned to a direct sales model in those
associated territories. This had the effect of improving gross margins in 2004
due to direct sales of product versus sales to distributors at reduced pricing.
Correspondingly, sales and marketing expense increased as we added direct
salespeople. Operating expenses.Total operating expenses increased $4.80 million, or
53.46%, and increased as a percentage of revenue to 51.71% in 2004 from 45.62%
in 2003, primarily due to increased investments in our sales and marketing
capabilities. During the fourth quarter of 2003 and the first quarter of 2004,
we added a total of 41 personnel in our sales efforts including sales reps,
regional sales managers and clinical specialists. We expect to leverage this
investment in the next few quarters as our new sales personnel ramp up
productivity this year. -17-




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In 2004, we slightly increased as a percentage of revenue our investments in
research and development. Amortization expense from intangibles also increased
slightly as a percentage of revenue in 2004 due to intangible assets we
acquired in our various acquisitions during 2003. We continued to leverage our
general and administrative expense in 2004 compared to 2003. Sales and marketing.Sales and marketing expense, as a percentage of net
revenue, increased to 32.16% in 2004 from 26.23% in 2003, and the expense
increased in absolute dollars by $3.4 million principally due to higher salary
and benefit expense from annual salary increases and staffing additions in
reimbursement, direct sales, clinical specialists and regional sales managers,
higher commission expense from increased neuro product sales, and higher travel
expense due to increased direct sales activities. As noted above, part of the
increase in sales and marketing expense is attributable to the addition of
direct salespeople as a result of the three acquisitions of certain operations
of our remaining U.S. distributors completed in 2003. Research and development.Research and development expense, as a percentage of
net revenue, increased slightly to 8.69% in 2004 from 8.60% in 2003, and the
expense increased in absolute dollars by $623,000 principally due to higher
salary and benefit expense from staffing additions and annual salary increases.
Our development efforts continue to focus on next-generation IPG stimulation
systems, next-generation RF stimulation systems, an IPG stimulation system for
deep brain stimulation and next generation drug pumps. We have budgeted $12
million in research and development expense in fiscal 2004. General and administrative.General and administrative expense, as a percentage
of net revenue, decreased to 8.70% in 2004 from 8.98% in 2003, while the
expense increased in absolute dollars by $551,000 principally due to higher
salary and benefit expense from annual salary increases and staffing additions
and higher recruiting fee expense. Amortization of intangibles.Amortization expense of intangibles increased
61.97% in 2004 from 2003, or $220,000, due to additional expense for intangible
assets we acquired from our three remaining U.S. distributors during 2003, and
additional intangible assets from earn-out consideration as milestones were met
pursuant to the MicroNet acquisition agreement. Other income.Other income decreased by $59,700 during 2004 compared to 2003
principally due to lower yields on invested funds and an expense in 2004 of
$29,300 associated with foreign currency transactions as we began operations of
our German subsidiary, ANS GmbH. Income tax expense.Income tax expense increased $673,000 during 2004 from 2003
as a result of increased income before taxes. Our tax rate in 2004 was 35.14%
compared to 36.06% in 2003. Our decreased effective tax rate is primarily due
to a research and development tax credit. The effective tax rates reflect a
provision for state taxes, offset by tax-exempt interest income earned on our
cash and cash equivalents, and marketable securities and, in 2004, a research
and development tax credit. Net income.Net income increased $1.35 million, or 51.5%, in 2004 from 2003
primarily due to the positive impact of revenue growth from increased unit
sales of our Genesisand GenesisXPIPG systems and increased gross margin. Net
income per diluted share increased to $.19 in 2004 from $.13 in 2003. -18-




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Liquidity and Capital Resources At March 31, 2004, our working capital increased to $132.39 million from
$126.44 million at year-end 2003. The ratio of current assets to current
liabilities was 18.81:1 at March 31, 2004, compared to 11.21:1 at December 31,
2003. Cash, cash equivalents, and marketable securities totaled $93.00 million
at March 31, 2004 compared to $94.80 million at December 31, 2003, a decrease
of $1.80 million principally due to $4.79 million used to reduce current
liabilities and $2.93 million used to finance interim construction costs of our
new corporate headquarters facility. We have increased our investment in inventories from year-end 2003 by $876,000
in anticipation of our move to our new corporate headquarters facility due to
the new facility requiring regulatory process validation before product can be
manufactured in and shipped from the new facility. We recently validated the
new facility and have initiated manufacturing and shipping from that facility.
We anticipate inventory investments will decrease during the second half of
fiscal 2004. Our investment in trade accounts receivable increased from year-end 2003 by
$814,000 due to the increase in sales of our neuromodulation products. Our days
sales outstanding (DSOs), however, remained consistent at approximately 64
days. Excluding expenditures discussed below on our new facility, we spent $2.58
million during the three months ended March 31, 2004 for capital expenditures,
which includes $1.00 million for new office furniture and machinery and
equipment for our new facility discussed below. Our budgeted expenditures for
new office furniture and machinery and equipment for the new facility is $1.5
million. The remainder of the capital expenditures during the three months
ended March 31, 2004, primarily related to tooling and equipment for our
current products and new products being developed. We are on schedule to relocate to our new corporate headquarters facility in
Plano, Texas prior to the expiration of our current lease in August 2004. The
new facility of 143,000 square feet was designed to accommodate planned growth
within a five-year horizon. The construction cost of the facility is
approximately $15 million. We have funded the interim construction costs from
our cash reserves. For the three months ended March 31, 2004, we spent $2.93
million on interim construction costs for the new facility, and through March
31, 2004, have spent in total $11.76 million. While we have not yet determined
the method by which we will permanently finance the facility, we believe our
cash position and overall balance sheet position provides us with various
financing alternatives, including financing the facility from our current cash,
financing through a debt vehicle such as a mortgage or other form of note, or a
sale-and-leaseback transaction. We received $3.13 million of cash during the three months ended March 31, 2004,
from the exercise of employee and director stock options to purchase 275,919
shares of our common stock. Liquidity may also be enhanced based on our ability to utilize all or part of a
net operating loss carryforward of $4.3 million to offset future taxable
income. We acquired $3.4 million of the net operating loss carryforward in
connection with the MicroNet acquisition, and its utilization may be subject to
a limitation under Section 382 of the Internal Revenue Code. The rules of
Section 382 of the Internal Revenue Code generally apply to limit a
corporations ability to utilize -19-




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acquired net operating loss carryforwards to reduce its federal taxable income
in the periods after an acquisition. The Companys ability to use the net
operating loss carryforwards acquired in the MicroNet acquisition to reduce its
federal taxable income is subject to these rules. Provided the Company
generates sufficient taxable income in future years, the Section 382 limitation
will have the effect of deferring the utilization of the net operating loss
carryforwards over several years. Without this limitation, the Company would be
able to immediately use the net operating loss carryforwards to reduce taxable
income in future periods. The total amount of net operating loss carryforwards
that the Company may use to reduce taxable income in any taxable year after the
acquisition is determined with reference to its purchase price of MicroNet.
Based on current estimates and assumptions, we expect to utilize at least
approximately $700,000 in net operating loss carryforwards per twelve-month tax
year, assuming we generate sufficient taxable income in any given year to
utilize such amount. Additionally, liquidity may be enhanced to the extent we realize tax benefits
from stock option exercises. Exercises of nonqualified stock options, and
exercises of incentive stock options followed by disqualifying dispositions
of the underlying common stock within one year following exercise generate
compensation expense for tax purposes in the year of exercise or disposition,
as the case may be. During the three months ended March 31, 2004, we generated
a $2.89 million tax benefit related to nonqualified stock option exercises and
disqualifying dispositions of common stock acquired on exercise of incentive
stock options. Subsequent to March 31, 2004, we consummated two acquisitions. On April 1,
2004, we acquired certain assets of our exclusive distributor of Neuro Products
for Australia and New Zealand, MedTel Pty Limited (formerly Getz Brothers
Australia) based in Sydney, Australia. With this acquisition, we are now
selling direct in the Australian marketplace. Two sales professionals from
MedTel joined our sales force and we plan to hire additional direct sales
personnel as needed. Excluding related acquisition costs, we paid $500,000 in
cash for the assets plus the value of the inventory, which is estimated at
approximately $500,000. On
April 21, 2004, we acquired the assets of the Cable and Wire Division from
microHelix, which is operated out of Portland, Oregon. Excluding related
acquisition costs, we paid approximately $2 million in cash and assumed
liabilities of approximately $125,000. microHelix previously supplied coated
fine wire, antennas, and certain other products to us and our HDI subsidiary.
The acquisition represents a vertical integration of an important component
supplier and provides us with additional engineering resources and intellectual
property for the design and development of new products, notably leads,
extensions, trial cables and related products. Approximately 33 personnel from
microHelix joined us upon consummation of the transaction. On April 21, 2004, we filed a lawsuit in U.S. District Court for the Eastern
District of Texas, Sherman Division, asserting that Advanced Bionics
Corporation infringes a patent we own and has misappropriated certain of our
trade secrets. We estimate that the pre-tax costs associated with the lawsuit
will be approximately $400,000 per quarter. We believe our current cash, cash equivalents, marketable securities and cash
generated from operations will be sufficient to fund our current levels of
operating needs and capital expenditures for the foreseeable future and to fund
the microHelix and Medtel acquisitions. We currently have no credit facilities
in place. If we decide to acquire complementary businesses, product lines or
technologies, or enter into joint ventures or strategic alliances that require
substantial capital, we intend to finance those activities by the most
attractive alternative available, which could include utilizing our current
cash, bank borrowings, or the issuance of debt or equity securities. -20-




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Cash Flows Net cash provided by operations was $566,000 in 2004 compared to a net use of
cash of $1.04 million in 2003, an increase of $1.61 million principally due to
a $1.35 million increase in net income. Net cash provided by investing activities was $67.45 million in 2004 compared
to a net use of cash of $5.96 million in 2003, an increase of $73.41 million
principally due to an increase of $73.05 million in net proceeds received from
marketable securities transactions (proceeds minus purchases). Net cash provided by financing activities was $3.13 million in 2004 and
$993,000 in 2003, an increase of $2.14 million due to higher cash received from
the exercise of stock options. Currency Fluctuations Our international sales are denominated in U.S. dollars with the exception of
Germany, where we began selling direct on January 1, 2004 for which sales are
denominated in Euros. Effective April 1, 2004, we also began selling direct in
Australia where sales are denominated in Australian dollars. Fluctuations in
currency exchange rates in other countries could reduce the demand for our
products by increasing the price of our products in the currency of the
countries in which the products are sold, although we do not believe currency
fluctuations have had a material effect on the Companys results of operations
to date. Outlook and Uncertainties The following is a safe harbor statement under the Private Securities
Litigation Reform Act of 1995: The matters discussed in this Quarterly Report
on Form 10-Q contain statements that constitute forward-looking statements
within the meaning of Section 21E of the Securities Exchange Act of 1934, as
amended. The words expect, estimate, anticipate, predict, believe,
plan, will, should, intend, potential, new market, potential
market applications and similar expressions and variations thereof are
intended to identify forward-looking statements. Such statements appear in a
number of places in this Quarterly Report on Form 10-Q and include statements
regarding our intent, belief or current expectations with respect to, among
other things: (i) trends affecting our financial condition or results of
operations; (ii) our financing plans; and (iii) our business growth strategies.
We caution our readers that any forward-looking statements are not guarantees
of future performance and involve risks and uncertainties. Actual results may
differ materially from those projected in the forward-looking statements as a
result of various factors. These risks and uncertainties include the following:  
    
    On April 28, 2004, Advanced Bionics Corporation announced that it had received FDA approval of its rechargeable implantable
SCS system for the treatment of chronic pain. The entrance into the neuromodulation market of new competitors, including
Advanced Bionics, may make it more difficult to compete in this market
    
    the launch of new competitive products by Advanced Bionics, Medtronic or others, as well as other market factors, could
impede growth in or reduce sales of our IPG and RF systems, which would adversely affect our revenues and profitability
    
    failure of our Genesisand GenesisXPIPG systems to gain and maintain market acceptance would adversely affect our revenue
growth and profitability -21-




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
    
    because our main competitor, Medtronic, Inc., has significantly greater resources than we do it may be difficult for us to
compete in this market
    
    if pain management specialists do not recommend and endorse our products, our sales could be negatively impacted and we may
be unable to increase our revenues and profitability
    
    if patients choose less invasive or less expensive alternatives to our products, our sales could be negatively impacted
    
    any adverse changes in coverage or reimbursement amounts by Medicare and Medicaid, private insurance companies and managed
care organizations, or workers compensation programs could limit our ability to market and sell our products
    
    if we fail to protect our intellectual property rights, our competitors may take advantage of our ideas and compete
directly against us
    
    other parties may sue us for infringing their intellectual property rights, or we may have to sue them to protect our
intellectual property rights
    
    the cost, uncertainty and other risks inherent in our intellectual property litigation against Advanced Bionics Corporation
    
    failure to obtain necessary government approvals for new products or for new applications for existing products would mean
we could not sell those new products, or sell our existing products for those new applications
    
    modification of any marketed device could require a new 510(k) clearance or PMA or require us to cease marketing or recall
the modified device until we obtain this clearance or approval
    
    we will be unable to sell our products if we fail to comply with manufacturing regulations
    
    our products are subject to product recalls even after receiving FDA clearance or approval, which would negatively affect
our financial performance and could harm our reputation
    
    we are subject to potential product liability and other claims and we may not have the insurance or other resources to
cover the cost of any successful claim
    
    we are subject to substantial government regulation and our failure to comply with all applicable government regulations
could subject us to numerous penalties, any of which could adversely affect our business
    
    our reliance on single suppliers for critical components used in our main products could adversely affect our ability to
deliver products on time
    
    our major competitor in the neuromodulation market currently accounts for a significant percentage of our revenue from our
O.E.M. segment
    
    we are dependent upon the success of neuromodulation technology. Our inability to continue to develop innovative
neuromodulation products, including a competitive rechargeable IPG, or the failure of the neuromodulation market to develop
as we anticipate, would adversely affect our business
    
    our success will depend on our ability to attract and retain key personnel and scientific staff
    
    if we choose to acquire complementary businesses, products or technologies instead of developing them ourselves, we may be
unable to complete these acquisitions or to successfully integrate an acquired business, product or technology in a
cost-effective and non-disruptive manner
    
    we are subject to additional risks associated with international operations
    
    our operations are conducted at three locations, and a disaster at any of these facilities could result in a prolonged
interruption of our business
    
    general economic risks
    
    other risks detailed from time to time in our SEC public filings -22-




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Certain of the foregoing risks are described in more detail in our Form 10-K
for the year ended
December 31, 2003. If our assumptions prove to be incorrect or such risks or
uncertainties materialize, anticipated results could differ materially from
those forecasted in forward-looking statements. 
 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK For the period ended March 31, 2004, the Company did not experience material
changes in market risk exposures that affect the quantitative and qualitative
disclosures presented in the Companys Annual Report on Form 10-K for the year
ended December 31, 2003. 
 ITEM 4. CONTROLS AND PROCEDURES As of the end of the period covered by this report, an evaluation was carried
out by our management, with the participation of our Chief Executive Officer
and Chief Financial Officer, of the effectiveness of our disclosure controls
and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act
of 1934). Based upon that evaluation, our Chief Executive Officer and Chief
Financial Officer concluded that these disclosure controls and procedures were
effective. There were no changes in the Companys internal control over financial
reporting (as defined in Rule 13a-15(f) under the Securities Exchange Act of
1934) that occurred during the Companys most recent fiscal quarter that has
materially affected, or is reasonably likely to materially affect, the
Companys internal control over financial reporting. -23-




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PART II OTHER INFORMATION 
 ITEM 1. LEGAL PROCEEDINGS On April 21, 2004, the Company filed a lawsuit in the U.S. District Court
for the Eastern District of Texas, Sherman Division (Docket No.
4:404-CV-00131-PNB-DDB) against Advanced Bionics Corporation, asserting
claims of patent infringement, misappropriation of trade secrets,
tortious interference with contract, misappropriation of time, labor,
skill, and money, violation of the Texas Theft Liability Act, conversion
and constructive trust. The lawsuit alleges, among other things, that
Advanced Bionics is infringing United States Patent No. 4,793,353
entitled Non-Invasive Multiprogrammable Tissue Stimulator And Method.
In addition, the lawsuit alleges that Advanced Bionics hired a former ANS
employee to aid in the design, development and manufacture of its
implantable stimulation lead, that Advanced Bionics misappropriated the
former employees knowledge of ANS confidential, proprietary, and trade
secret information with respect to ANS implantable stimulation leads,
and that this enabled Advanced Bionics to unfairly compete with ANS. The
lawsuit seeks injunctive relief, compensatory and punitive damages,
attorneys fees and costs. 
 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K  (a)
    
    Exhibit 3.1  Articles of Incorporation, as amended and
restated (1)Exhibit 3.2  Bylaws, as amended and restated (1)Exhibit 4.1  Rights Agreement dated as of August 30, 1996, between
Quest Medical, Inc. and KeyCorp Shareholder Services, Inc. as
Rights Agent (2)Exhibit 4.2  Amendment to Rights Agreement dated as of January 25,
2002, between Advanced Neuromodulation Systems, Inc and
Computershare Investor Services LLC (formerly KeyCorp Shareholder
Services, Inc.) (3)Exhibit 31.1  Certification of the Chief Executive Officer
Pursuant to Rule 13a-14 of the Securities Exchange Act of 1934, as
adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
(4)Exhibit 31.2  Certification of the Chief Financial Officer
Pursuant to Rule 13a-14 of the Securities Exchange Act of 1934, as
adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
(4)Exhibit 32.1  Certification of the Chief Executive Officer
Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section
906 of the Sarbanes-Oxley Act of 2002 (5)Exhibit 32.2  Certification of the Chief Financial Officer
Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section
906 of the Sarbanes-Oxley Act of 2002 (5) -24-




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(b)
    
    The Company furnished a report on Form 8-K on January 13,
2004, providing under Item 9. Regulation FD Disclosure, a press
release issued by the Company on January 13, 2004 disclosing
managements estimate of revenue and net income per share for 2003,
and managements initial guidance with respect to revenue and net
income per share for 2004. We also announced in this press release
that we submitted the PMA application for our AccuRx® constant flow
implantable pump to the Food and Drug Administration in December
2003.The Company filed a report on Form 8-K on March 8, 2004, reporting
under Item 5. Other Events, that on March 5, 2004, we entered into
an agreement to acquire certain assets of microHelix, Inc.s Cable
and Wire Division, which is operated out of Portland, Oregon, for
approximately $2 million in cash and assumed liabilities.   (1)
    
    Filed as an Exhibit to the report of the Company on Form 10-K for the
year ended December 31, 2000, and incorporated herein by reference.(2)
    
    Filed as an Exhibit to the report of the Company on Form 8-K dated
September 3, 1996, and incorporated herein by reference.(3)
    
    Filed as an Exhibit to the report of the Company on Form 8-K dated
January 30, 2002, and incorporated herein by reference.(4)
    
    Filed herewith.(5)
    
    Furnished herewith. -25-




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Signatures Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized. ADVANCED NEUROMODULATION SYSTEMS, INC.Date: May 10, 2004
    By:
    /s/ F. Robert Merrill IIIF. Robert Merrill IIIExecutive Vice President, Finance
Chief Financial Officer and Treasurer -26-




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EXHIBIT INDEX Exhibit 3.1
    
    Articles of Incorporation, as amended and restated (1)Exhibit 3.2
    
    Bylaws, as amended and restated (1)Exhibit 4.1
    
    Rights Agreement dated as of August 30, 1996, between Quest
Medical, Inc. and KeyCorp Shareholder Services, Inc. as
Rights Agent (2)Exhibit 4.2
    
    Amendment to Rights Agreement dated as of January 25, 2002
between Advanced Neuromodulation Systems, Inc and
Computershare Investor Services LLC (formerly KeyCorp
Shareholder Services, Inc.) (3)Exhibit 31.1
    
    Certification of the Chief Executive Officer Pursuant to Rule
13a-14 of the Securities Exchange Act of 1934, as adopted
pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (4)Exhibit 31.2
    
    Certification of the Chief Financial Officer Pursuant to Rule
13a-14 of the Securities Exchange Act of 1934, as adopted
pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (4)Exhibit 32.1
    
    Certification of the Chief Executive Officer Pursuant to 18
U.S.C. Section 1350, as adopted pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002 (5)Exhibit 32.2
    
    Certification of the Chief Financial Officer Pursuant to 18
U.S.C. Section 1350, as adopted pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002 (5)
   (1)
    
    Filed as an Exhibit to the report of the Company on Form 10-K for the
year ended December 31, 2000, and incorporated herein by reference.(2)
    
    Filed as an Exhibit to the report of the Company on Form 8-K dated
September 3, 1996, and incorporated herein by reference.(3)
    
    Filed as an Exhibit to the report of the Company on Form 8-K dated
January 30, 2002, and incorporated herein by reference.(4)
    
    Filed herewith.(5)
    
    Furnished herewith.