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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549
 FORM 10-Q (MARK ONE)þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT 1934
 FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2004
 o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT 1934
 FOR THE TRANSITION
PERIOD FROMTO
 Commission file number 0-10521 ADVANCED NEUROMODULATION SYSTEMS, INC. 
 Texas
    
    75-1646002(State or Other Jurisdiction
of Incorporation or
Organization)
    
    (I.R.S. Employer
Identification No.)
 6901 Preston Road, 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 þ    NO o Indicate by check ü whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).
YES þ     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
    
    November 2, 2004Common stock, $.05 Par Value
    
    20,222,625




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ADVANCED NEUROMODULATION SYSTEMS, INC. AND SUBSIDIARIES Table of Contents PART I. Financial Information
    
    
    2Item 1. Financial StatementsCondensed Consolidated Balance Sheets
September 30, 2004 (Unaudited) and December 31, 2003
    
    
    3-4Condensed Consolidated Statements of Income (Unaudited)
For the Three Months and Nine Months Ended
September 30, 2004 and 2003
    
    
    5Condensed Consolidated Statements of Cash Flows (Unaudited)
For the Nine Months Ended September 30, 2004 and 2003
    
    
    6Condensed Consolidated Statements of Stockholders Equity
For the Year Ended December 31, 2003 and the
Nine Months Ended September 30, 2004 (Unaudited)
    
    
    7Notes to Condensed Consolidated Financial Statements
    
    
    8-16Item 2. Managements Discussion and Analysis of Financial Condition
and Results of Operations
    
    
    17-28Item 3. Quantitative and Qualitative Disclosures About Market Risk
    
    
    28Item 4. Controls and Procedures
    
    
    28-29PART II. Other Information
    
    
    30Item 1. Legal Proceedings
    
    
    30Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of
Equity Securities
    
    
    30Item 6. Exhibits and Reports on Form 8-K
    
    
    31-32Signatures
    
    
    33Certificaton of CEO Pursuant to Section 302Certificaton of CFO Pursuant to Section 302Certificaton of CEO Pursuant to Section 906Certificaton of CFO Pursuant to 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
September 30, 2004 (Unaudited) and December 31, 2003
 September 30,
    
    December 31,Assets
    
    2004
    
    2003Current assets:Cash and cash equivalents
    
    $
    15,731,138
    
    
    $
    8,588,281Marketable securities
    
    
    106,062,253
    
    
    
    86,213,841Receivables:Trade accounts, less allowances of
$420,099 in 2004 and $447,457 in 2003
    
    
    24,954,560
    
    
    
    17,892,416Interest and other
    
    
    517,704
    
    
    
    259,687Total receivables
    
    
    25,472,264
    
    
    
    18,152,103Inventories:Raw materials
    
    
    8,356,206
    
    
    
    10,766,127Work-in-process
    
    
    5,602,811
    
    
    
    3,569,111Finished goods
    
    
    9,340,249
    
    
    
    7,777,921Total inventories
    
    
    23,299,266
    
    
    
    22,113,159Deferred income taxes
    
    
    971,088
    
    
    
    1,423,228Income taxes receivable
    
    
    
    
    
    
    1,324,001Prepaid expenses and other current assets
    
    
    2,378,893
    
    
    
    1,007,244Total current assets
    
    
    173,914,902
    
    
    
    138,821,857Property, equipment and fixtures:Land
    
    
    3,191,427
    
    
    
    3,191,427Building
    
    
    17,408,495
    
    
    
    8,825,730Furniture and fixtures
    
    
    6,192,466
    
    
    
    4,429,672Machinery and equipment
    
    
    18,122,183
    
    
    
    13,944,120Leasehold improvements
    
    
    956,384
    
    
    
    1,822,15245,870,955
    
    
    
    32,213,101Less accumulated depreciation and amortization
    
    
    13,414,558
    
    
    
    11,063,091Net property, equipment and fixtures
    
    
    32,456,397
    
    
    
    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 $2,184,984 in 2004 and
$1,848,354 in 2003
    
    
    6,122,763
    
    
    
    5,814,974Purchased technology, net of accumulated
amortization of $3,658,630 in 2004 and
$2,910,895 in 2003
    
    
    11,673,546
    
    
    
    10,319,679Tradenames, net of accumulated amortization of
$1,227,077 in 2004 and $1,110,458 in 2003
    
    
    1,776,133
    
    
    
    1,800,572Customer and supplier relations, net of
accumulated amortization of $526,034 in 2004 and
$194,303 in 2003
    
    
    2,519,709
    
    
    
    2,373,558Other assets, net of accumulated amortization of
$1,096,970 in 2004 and $803,797 in 2003
    
    
    1,415,210
    
    
    
    1,342,969$
    243,061,328
    
    
    $
    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)
September 30, 2004 (Unaudited) and December 31, 2003 September 30,
    
    December 31,Liabilities and Stockholders Equity
    
    2004
    
    2003Current liabilities:Accounts payable
    
    $
    4,446,320
    
    
    $
    5,717,222Short-term obligation
    
    
    5,020,708
    
    
    
    Accrued salary and employee benefit costs
    
    
    2,507,214
    
    
    
    4,045,361Accrued commissions
    
    
    2,134,442
    
    
    
    1,424,471Deferred revenue
    
    
    205,826
    
    
    
    503,093Warranty reserve
    
    
    95,480
    
    
    
    294,290Other accrued expenses
    
    
    558,033
    
    
    
    400,159Total current liabilities
    
    
    14,968,023
    
    
    
    12,384,596Deferred income taxes
    
    
    12,576,608
    
    
    
    3,389,255Non-current deferred revenue
    
    
    802,703
    
    
    
    907,513Commitments and contingenciesStockholders equity:Common stock $.05 par value;
Authorized  100,000,000 shares;
Issued  20,205,937 shares in 2004 and 19,712,938 in 2003
    
    
    1,010,297
    
    
    
    985,647Additional capital
    
    
    158,729,702
    
    
    
    149,644,033Retained earnings
    
    
    40,548,959
    
    
    
    27,515,001Accumulated other comprehensive income (loss), net of
tax expense of $7,469,776 in 2004 and net of tax benefit
of $10,181 in 2003
    
    
    14,425,036
    
    
    
    (19,758
    )Total stockholders equity
    
    
    214,713,994
    
    
    
    178,124,923$
    243,061,328
    
    
    $

    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 and Nine Months Ended September 30, 2004 and 2003
 Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Net revenue
    
    $
    31,330,408
    
    
    $
    23,418,505
    
    
    $
    88,451,122
    
    
    $
    65,413,557Cost of revenue
    
    
    8,414,174
    
    
    
    6,384,445
    
    
    
    23,751,017
    
    
    
    20,317,415Gross profit
    
    
    22,916,234
    
    
    
    17,034,060
    
    
    
    64,700,105
    
    
    
    45,096,142Operating expenses:Sales and marketing
    
    
    9,791,838
    
    
    
    6,970,941
    
    
    
    27,810,611
    
    
    
    18,460,993Research and development
    
    
    2,911,698
    
    
    
    2,552,951
    
    
    
    8,096,308
    
    
    
    6,597,850General and administrative
    
    
    2,974,620
    
    
    
    1,871,833
    
    
    
    7,998,316
    
    
    
    5,504,084Amortization of other intangibles
    
    
    626,191
    
    
    
    472,821
    
    
    
    1,824,838
    
    
    
    1,278,09316,304,347
    
    
    
    11,868,546
    
    
    
    45,730,073
    
    
    
    31,841,020Income from operations
    
    
    6,611,887
    
    
    
    5,165,514
    
    
    
    18,970,032
    
    
    
    13,255,122Other income (expense):Foreign currency transaction gain
    
    
    81,009
    
    
    
    
    
    
    
    26,156
    
    
    
    Other income
    
    
    
    
    
    
    969,204
    
    
    
    
    
    
    
    969,204Investment income
    
    
    482,850
    
    
    
    200,243
    
    
    
    964,021
    
    
    
    776,370563,859
    
    
    
    1,169,447
    
    
    
    990,177
    
    
    
    1,745,574Income before income taxes
    
    
    7,175,746
    
    
    
    6,334,961
    
    
    
    19,960,209
    
    
    
    15,000,696Income taxes
    
    
    2,433,791
    
    
    
    2,382,109
    
    
    
    6,926,251
    
    
    
    5,504,915Net income
    
    $
    4,741,955
    
    
    $
    3,952,852
    
    
    $
    13,033,958
    
    
    $
    9,495,781Net income per share:Basic
    
    $
    .23
    
    
    $
    .20
    
    
    $
    .65
    
    
    $
    .50Diluted
    
    $
    .23
    
    
    $
    .19
    
    
    $
    .62
    
    
    $
    .46
 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 Nine Months Ended September 30, 2004 and 2003
 Nine Months Ended September 30,2004
    
    2003Cash flows from operating activities:Net income
    
    $
    13,033,958
    
    
    $
    9,495,781Adjustments to reconcile net income to net cash provided by operating
activities:Depreciation and amortization
    
    
    5,050,411
    
    
    
    3,379,235Increase in inventory reserve
    
    
    25,016
    
    
    
    20,559Gain on sale of marketable securities
    
    
    168,857
    
    
    
    Deferred income taxes
    
    
    1,753,671
    
    
    
    (1,529,830
    )Stock-based compensation
    
    
    9,885
    
    
    
    505,430Accrued tax abatement liability
    
    
    
    
    
    
    (969,204
    )Changes in operating assets and liabilities, net of acquisitions:Receivables
    
    
    (7,267,456
    )
    
    
    (4,535,056
    )Inventories
    
    
    (549,522
    )
    
    
    (4,778,450
    )Income taxes receivable
    
    
    1,324,001
    
    
    
    (321,378
    )Prepaid expenses and other current assets
    
    
    (1,432,015
    )
    
    
    (130,560
    )Income taxes payable
    
    
    
    
    
    
    (822,228
    )Tax benefit from stock option exercises
    
    
    3,648,901
    
    
    
    7,240,918Accounts payable
    
    
    (1,352,476
    )
    
    
    (217,392
    )Accrued expenses
    
    
    (919,112
    )
    
    
    372,128Deferred revenue
    
    
    (402,077
    )
    
    
    689,228Total adjustments
    
    
    58,084
    
    
    
    (1,096,600
    )Net cash provided by operating activities
    
    
    13,092,042
    
    
    
    8,399,181Cash flows from investing activities:Purchases of marketable securities
    
    
    (290,303,534
    )
    
    
    (307,383,482
    )Purchase of Cyberonics, Inc. common stock net of short-term obligation
    
    
    (44,658,911
    )
    
    
    Proceeds from sales of marketable securities
    
    
    341,965,756
    
    
    
    303,078,026New facility construction
    
    
    (8,582,765
    )
    
    
    (3,102,432
    )Acquisition of certain assets of microHelix, Inc.
    
    
    (2,046,105
    )
    
    
    Acquisition of certain operations of distributors
    
    
    (1,086,558
    )
    
    
    (5,991,271
    )Minority equity investments in preferred stock
    
    
    
    
    
    
    (1,104,000
    )Additions to property, equipment, fixtures and intangible assets
    
    
    (5,845,969
    )
    
    
    (4,164,469
    )Net cash used in investing activities
    
    
    (10,558,086
    )
    
    
    (18,667,628
    )Cash flows from financing activities:Exercise of stock options
    
    
    4,684,022
    
    
    
    5,812,826Net cash provided by financing activities
    
    
    4,684,022
    
    
    
    5,812,826Net increase (decrease) in cash and cash equivalents
    
    
    7,217,978
    
    
    
    (4,455,621
    )Effect of exchange rates on cash and cash equivalents
    
    
    (75,121
    )
    
    
    Cash and cash equivalents at beginning of year
    
    
    8,588,281
    
    
    
    10,972,974Cash and cash equivalents at September 30
    
    $
    15,731,138
    
    
    $
    6,517,353Supplemental cash flow information is presented below:Income taxes paid (net of refunds)
    
    $
    199,274
    
    
    $
    979,373Non-cash activity:Assumed acquisition liabilities
    
    $
    131,574
    
    
    $
    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
For The Year Ended December 31, 2003 and the Nine Months Ended September 30, 2004 
(Unaudited)
 AccumulatedOther
    
    TotalCommon Stock
    
    Additional
    
    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
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    13,033,958
    
    
    
    
    
    
    
    13,033,958Adjustment to unrealized gains on marketable securities, net of tax
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    14,519,915
    
    
    
    14,519,915Foreign currency translation adjustment
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (75,121
    )
    
    
    (75,121
    )Comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    27,478,752Issuance of shares for stock option exercises
    
    
    476,294
    
    
    
    23,815
    
    
    
    4,660,207
    
    
    
    
    
    
    
    
    
    
    
    4,684,022Issuance of earn-out shares for acquisition
    
    
    16,705
    
    
    
    835
    
    
    
    766,676
    
    
    
    
    
    
    
    
    
    
    
    767,511Stock-based compensation
    
    
    
    
    
    
    
    
    
    
    9,885
    
    
    
    
    
    
    
    
    
    
    
    9,885Tax benefit from stock option exercises
    
    
    
    
    
    
    
    
    
    
    3,648,901
    
    
    
    
    
    
    
    
    
    
    
    3,648,901Balance at September 30, 2004
    
    
    20,205,937
    
    
    $
    1,010,297
    
    
    $
    158,729,702
    
    
    $
    40,548,959
    
    
    $
    14,425,036
    
    
    $
    214,713,994
 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. The Company
also provides contract development and custom manufacturing for other
medical device companies through the Hi-tronics Designs, Inc. (HDI)
subsidiary and through the ANS Portland division (formerly the Cable and
Wire Division of microHelix, Inc., which was acquired in April 2004). ANS
neuromodulation revenues are derived primarily from sales throughout the
United States, Europe and Australia while HDI and ANS Portland revenues
are derived within the United States.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 by hospitals and
other users who then bill various third party payors including Medicare,
Medicaid, private insurance companies and managed care organizations. ANS
also sells and bills its neuromodulation products directly to third party
payors including Medicare, Medicaid, private insurance companies and
managed care organizations. These third party payors reimburse fixed
amounts for products and 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 to sell its
neuromodulation devices 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. On
April 1, 2004, the Company began operations in Australia to sell its
neuromodulation devices though its wholly-owned subsidiary, ANS
Australia. Previously, the Company utilized a distributor in Australia,
MedTel Pty Limited (formerly Getz Brothers Australia) based in Sydney,
Australia (MedTel). The Company acquired certain assets of MedTel on
April 1, 2004 for approximately $1.1 million. 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). -8-




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##### Table of Contents



Advanced Neuromodulation Systems, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements  (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
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 September 30, 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)
    
    Marketable SecuritiesIn August 2004, the Company acquired 3,500,000 shares, or approximately
14.7%, of the outstanding common stock of Cyberonics, Inc. in open market
purchases. The aggregate purchase price paid for the shares was
$49,679,619, or an average price per share of $14.194. In connection with
the purchase, the Company had an obligation of $5,020,708 at September
30, 2004, due under a margin agreement with the securities firm who
purchased the shares for the Company. The obligation was fully repaid
subsequent to September 30, 2004. The investment in these marketable
securities are classified as available-for-sale and are carried at fair
value with the unrealized gains, net of tax, reported as a separate
component of shareholders equity entitled Accumulated Other
Comprehensive Income (Loss). At September 30, 2004, the fair value of
the securities had increased in value to $71,610,000 and the Company
recorded an unrealized gain, net of tax, of $14,474,051, which is
included in the Accumulated Other Comprehensive Income component of
shareholders equity.For so long as the Company is a beneficial owner of more than 10% of
Cyberonics common stock, the Company is subject to the short swing
profit provisions of Section 16(b) of the Securities Exchange Act of
1934. Under such provisions, beneficial owners of more than 10% of a
publicly-traded companys securities are required to disgorge any profits
realized on the sale of such securities within any period of less than
six months.(4)
    
    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 -9-




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Advanced Neuromodulation
Systems, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements 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. Certain
product milestones were met in March and October 2003, and the Company
paid the related milestone payments at that time. In January 2004, MicroNet satisfied another 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 held in escrow were returned to the Company.
However, 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. As a result of the May 2004 agreement with MicroNet, the
Company reviewed the previously recorded identifiable intangible assets
associated with the MicroNet acquisition and has concluded there was no
impairment of these intangible assets. On April 1, 2004, the Company acquired certain assets of its exclusive
distributor of neuromodulation devices for Australia, MedTel Pty Limited
(formerly Getz Brothers Australia) based in Sydney, Australia for
$1,086,558 cash. Two sales professionals from MedTel joined the Companys
sales force and additional direct sales personnel will be hired as
needed. The assets and operations acquired are part of the Neuro Products
segment and the Company began operations in Australia to sell its
neuromodulation devices through its wholly owned subsidiary, ANS
Australia. The purchase price allocation is as follows: -10-




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Advanced Neuromodulation
Systems, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements Amount
    
    Amortization PeriodCustomer and supplier relations
    
    $
    400,000
    
    
    7 yearsNon-compete agreements (included in other
assets)
    
    
    100,000
    
    
    1.75 yearsProduct registrations (included in other assets)
    
    
    43,537
    
    
    3.5 yearsInventory
    
    
    490,316
    
    
    
    n/aReceivables
    
    
    52,705
    
    
    
    n/aTotal
    
    $
    1,086,558
 On April 21, 2004, the Company acquired the assets of the Cable and Wire
Division from microHelix, Inc. (microHelix), which operates out of
Portland, Oregon. The purchase price was $2,177,679 consisting of
$2,006,551 in cash, assumed liabilities of $131,574 and acquisition costs

of $39,554. microHelix previously supplied coated fine wire, antennas,
and certain other products to ANS and HDI. 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. Thirty-three personnel from microHelix
joined the Company upon consummation of the transaction. The assets and
operations acquired (now known as ANS Portland Division) are part of the
O.E.M. segment. The purchase price allocation is as follows: Amount
    
    Amortization PeriodPurchased technology
    
    $
    969,200
    
    
    15 yearsMachinery and equipment
    
    
    1,008,394
    
    
    1-15 yearsInventory
    
    
    171,285
    
    
    
    n/aNon-compete agreements
(included in other assets)
    
    
    28,800
    
    
    1 yearTotal
    
    $
    2,177,679
 The results of operations for the acquisitions above have been included
in the Companys Condensed Consolidated Statements of Income after the
date of the acquisition.  (5)
    
    Stock Based Compensation The 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 $11,035 and
$264,945 of stock-based compensation expense to non-employees in the
three months ended September 30, 2004 and 2003, respectively. The Company
recorded $9,885 and $505,430 of stock-based compensation expense to
non-employees in the nine months ended September 30, 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 -11-




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Advanced Neuromodulation
Systems, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements 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 September 30,
    
    Nine Months Ended September 30,2004
    
    2003
    
    2004
    
    2003Net income as reported
    
    $
    4,741,955
    
    
    $
    3,952,852
    
    
    $
    13,033,958
    
    
    $
    9,495,781Stock-based
compensation
    
    
    (1,361,988
    )
    
    
    (1,026,105
    )
    
    
    (3,788,191
    )
    
    
    (3,018,947
    )Pro forma net income
    
    $
    3,379,967
    
    
    $
    2,926,747
    
    
    $
    9,245,767
    
    
    $
    6,476,834Basic shares
    
    
    20,189,242
    
    
    
    19,382,991
    
    
    
    20,075,223
    
    
    
    19,040,105Diluted shares
    
    
    21,032,695
    
    
    
    20,860,041
    
    
    
    21,116,735
    
    
    
    20,441,351Pro forma Basic EPS
    
    $
    .17
    
    
    $
    .15
    
    
    $
    .46
    
    
    $
    .34Pro forma Diluted EPS
    
    $
    .16
    
    
    $
    .14
    
    
    $
    .44
    
    
    $
    .32
  (6)
    
    Commitments and Contingencies 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) (the Texas Action) 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. On June 7, 2004, Advanced Bionics
filed a lawsuit with the United States District Court, Central District
of California, Case No. CV04-4054ABC (the California Action), seeking a
declaratory judgment that it is not infringing ANS patent No. 4,793,353
(the subject of ANS current patent infringement claim against Advanced
Bionics) and that such patent is invalid and unenforceable. On October
15, 2004, the judge in the Texas Action granted the Companys motion to
amend its lawsuit to add two additional patent infringement claims
against Advanced Bionics. One claim relates to the Companys patent
covering the design and structure of its electrode lead (U.S. Patent No.
6,216,045). The second claim relates to the Companys trial cable
connector patent (U.S. Patent No. 6,154,678). In addition, the judge
denied Advanced Bionics motion to dismiss the Texas Action.
Subsequently, Advanced Bionics has informed the Company that it has asked
the judge in the California Action to dismiss that case without
prejudice. 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 -12-




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Advanced Neuromodulation
Systems, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements 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.  (7)
    
    Income Taxes The Company recorded income tax expense during the three months and nine
months ended September 30, 2004 of $2,433,791 and $6,926,251,
respectively, representing an overall effective tax rate of 33.9% and
34.7%, respectively. For the three months and nine months ended September
30, 2003, the Company recorded income tax expense of $2,382,109 and
$5,504,915, respectively, representing overall effective tax rates of
37.6% and 36.7%. The decreased effective tax rate in 2004 is primarily
due to a research and development tax credit, an enhanced benefit related
to the Extraterritorial Income Exclusion (ETI), and income in Australia
where the statutory rate for corporations is lower than the U.S.
statutory rate. 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, benefits related to ETI, and the
lower corporate tax rate in Australia. The Company elected to carry forward its prior year tax loss instead of
filing amended tax returns for refunds. As such the prior year income tax
receivable was reclassified to deferred income tax asset, which is being
utilized in the current year. In addition, the Company recorded a
deferred tax liability of $7.4 million associated with the unrealized
gain on its investment in Cyberonics. -13-




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Advanced Neuromodulation
Systems, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements  (8)
    
    Net Income Per Share Basic 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 Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Weighted-average shares
outstanding (basic shares)
    
    
    20,189,242
    
    
    
    19,382,991
    
    
    
    20,075,223
    
    
    
    19,040,105Effect of dilutive stock options
    
    
    843,453
    
    
    
    1,477,050
    
    
    
    1,041,512
    
    
    
    1,401,246Diluted shares
    
    
    21,032,695
    
    
    
    20,860,041
    
    
    
    21,116,735
    
    
    
    20,441,351
 For the three months and nine months ended September 30, 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. For the three months ended
September 30, 2004 and 2003, options to purchase 1,083,475 and 0 shares,
respectively, were outstanding, and for the nine months ended September
30, 2004 and 2003, options to purchase 1,062,439 and 7,067 shares,
respectively, were outstanding, 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.  (9)
    
    Comprehensive Income Comprehensive income is the total of net income and all other non-owner
changes in equity net of tax effects, 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 nine months ended September 30, 2004 is
reported in the Condensed Consolidated Statements of Stockholders
Equity. Comprehensive income (loss) for the three months and nine months ended
September 30, 2004 and 2003 is as follows: Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Net income
    
    $
    4,741,955
    
    
    $
    3,952,852
    
    
    $
    13,033,958
    
    
    $
    9,495,781Other comprehensive
income (loss)
    
    
    14,544,817
    
    
    
    (1,473
    )
    
    
    14,444,794
    
    
    
    (6,862
    )Comprehensive income
    
    $
    19,286,772
    
    
    $
    3,951,379
    
    
    $
    27,478,752
    
    
    $
    9,488,919
  (10)
    
    Accrued Tax Abatement Liability In January 1998, the Company sold its cardiovascular operations to Atrion
Corporation, and granted Atrion a nine-month option to acquire the
Companys principal office and manufacturing facility in Allen, Texas for
$6.5 million. During October 1998, Atrion -14-




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Advanced Neuromodulation
Systems, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements exercised its option to acquire the facility. When the facility was built
in 1993, the Company entered into a ten-year agreement with the City of
Allen, which granted tax abatements to the Company if a minimum job base
and personal property base were maintained in the City of Allen. The
agreement provided for the repayment of abated taxes if the Company
defaulted under the agreement. During 1998 the Company recorded a pretax
expense of $969,204 in connection with the abated taxes. In April 1999,
the Company was successful in petitioning the City of Allen to assign the
abatement agreement to Atrion. In July 1999, the Company, Atrion and the
City of Allen executed an assignment agreement under which Atrion (as
successor in interest to the Company) must continue to meet the
conditions of the original tax abatement agreement until August 2003.
Atrion met the minimum requirements under the agreement through 2003, and
as such the Company was absolved from any liability. Accordingly, the
Company reversed the accrual of $969,204 in September 2003 to other
income in the Condensed Consolidated Statements of Income.  (11)
    
    Segment Information The 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 O.E.M. segment provides
contract development and O.E.M. manufacturing. Intersegment revenue is
billed at cost with no intercompany mark-up. Segment data for the three months ended September 30, 2004 is as follows: Neuro
    
    
    
    
    
    Intercompany
    
    ConsolidatedProducts
    
    O.E.M.
    
    Eliminations
    
    TotalRevenue from
external customers
    
    $
    28,222,826
    
    
    $
    3,107,582
    
    
    $
    
    
    
    $
    31,330,408Intersegment revenues
    
    $
    
    
    
    $
    1,759,443
    
    
    $
    (1,759,443
    )
    
    $
    Segment income
(loss) from
operations
    
    $
    7,055,180
    
    
    $
    (443,293
    )
    
    $
    
    
    
    $
    6,611,887
 Segment data for the three months ended September 30, 2003 is as follows: Neuro
    
    
    
    
    
    Intercompany
    
    ConsolidatedProducts
    
    O.E.M.
    
    Eliminations
    
    TotalRevenue from
external customers
    
    $
    20,612,131
    
    
    $
    2,806,374
    
    
    $
    
    
    
    $
    23,418,505Intersegment revenues
    
    $
    
    
    
    $
    2,300,033
    
    
    $
    (2,300,033
    )
    
    $
    Segment income from
operations
    
    $
    4,662,304
    
    
    $
    503,210
    
    
    $
    
    
    
    $
    5,165,514
 -15-




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Advanced Neuromodulation
Systems, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements Segment data for the nine months ended September 30, 2004 is as follows: Neuro
    
    
    
    
    
    Intercompany
    
    ConsolidatedProducts
    
    O.E.M.
    
    Eliminations
    
    TotalRevenue from
external customers
    
    $
    80,083,969
    
    
    $
    8,367,153
    
    
    $
    
    
    
    $
    88,451,122Intersegment revenues
    
    $
    
    
    
    $
    5,040,463
    
    
    $
    (5,040,463
    )
    
    $
    Segment income
(loss) from
operations
    
    $
    19,259,887
    
    
    $
    (289,855
    )
    
    $
    
    
    
    $
    18,970,032
 Segment data for the nine months ended September 30, 2003 follows: Neuro
    
    
    
    
    
    Intercompany
    
    ConsolidatedProducts
    
    O.E.M.
    
    Eliminations
    
    TotalRevenue from
external customers
    
    $
    56,587,484
    
    
    $
    8,826,073
    
    
    $
    
    
    
    $
    65,413,557Intersegment revenues
    
    $
    
    
    
    $
    5,781,279
    
    
    $
    (5,781,279
    )
    
    $
    Segment income from
operations
    
    $
    11,846,364
    
    
    $
    1,408,758
    
    
    $
    
    
    
    $
    13,255,122
 Foreign sales, primarily Europe and Australia, for the three months ended
September 30, 2004 and 2003 were approximately 10% and 7%, and for the nine
months ended September 30, 2004 and 2003 were approximately 10% and 8%, of net
revenue from the Neuro Products segment, respectively. The O.E.M. segment had
no foreign sales for the respective periods. -16-




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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. 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. Certain product milestones
were met in March and October 2003, and we paid the related milestone payments
at that time. In January 2004, MicroNet satisfied another product milestone and we issued
16,705 shares of our 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: 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 were returned to the Company. However, the former
MicroNet shareholders may still earn additional shares of 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. In January 2004, we began operations in Germany to sell our neuromodulation
devices through our wholly owned subsidiary, ANS GmbH. Previously, we utilized
a distributor in Germany and this relationship was terminated in January 2004
at no cost to us. On April 1, 2004, we acquired certain assets of our exclusive
distributor of Neuro Products for Australia, MedTel Pty Limited (formerly Getz
Brothers Australia) based in Sydney, Australia (MedTel). Two sales
professionals from MedTel joined our sales force and additional direct sales
personnel will be hired as needed. The purchase price of the assets was
$1,086,558. The assets and operations acquired are part of the Neuro Products
segment and we began operations in Australia to sell our neuromodulation
devices through our wholly owned subsidiary, ANS Australia in April 2004. On April 21, 2004, we acquired the assets of the Cable and Wire Division of
microHelix, Inc. (microHelix), which operates out of Portland, Oregon, for
approximately $2 million in cash and assumed liabilities of approximately
$132,000. microHelix previously supplied coated fine wire, antennas, and
certain other products to us and our wholly-owned -17-




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subsidiary, Hi-Tronics Designs, Inc (HDI). The acquisition represents a
vertical integration of a 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.
Thirty-three personnel from microHelix joined us upon consummation of the
transaction. The assets and operations acquired are part of the 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. On October 15, 2004, the judge
granted our motion to amend the lawsuit to add two additional patent
infringement claims, one relating to the design and structure of our electrode
lead and one relating to our trial cable connector. The judge also denied
Advanced Bionics motion to dismiss the lawsuit. On August 12 and 13, 2004, we acquired 3,500,000 shares, or approximately
14.7%, of the outstanding common stock of Cyberonics, Inc. (NASDAQ:CYBX) in
open market purchases. The aggregate purchase price paid for the shares was

$49,679,619, or an average price per share of $14.194. We informed Cyberonics
of this purchase on August 19, 2004, and invited management of Cyberonics to
discuss the possibility of a combination of the two companies, which
Cyberonics management declined. On September 14, 2004, in a letter to
Cyberonics management, we reiterated our suggestion that we meet to discuss a
business combination and stated that based upon publicly available information,
we were prepared to offer Cyberonics shareholders $22 per share payable in a
combination of cash and our common stock. Subsequently, the Board of Directors
of Cyberonics declined our invitation to meet to discuss a business
combination. Cyberonics has publicly stated that it intends to gain clarity
and certainty in a revised depression regulatory plan and timetable, and has
taken steps to try to persuade the FDA to reverse its decision in a
non-approvable letter relating to the application of Cyberonics vagal nerve
stimulator to treat Treatment-Resistant Depression by submitting additional
data to the FDA. Cyberonics has stated that it could take 120 to 180 days or
more to obtain a decision from the FDA. Given the amount of time that could
transpire before Cyberonics attains clarity and certainty on this matter,
Cyberonics Board of Directors decision not to discuss a business combination
with us, and our judgment that it does not make good business sense to try to
force the issue, on September 30, 2004, we notified Cyberonics that we were
withdrawing our proposal. At September 30, 2004, the fair value of our investment in Cyberonics
common stock increased to $71,610,000 and we recorded an unrealized gain, net
of tax, of $14,474,051, which is included in the accumulated other comprehensive
income component of shareholders equity. 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 -18-




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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 sell products primarily through a direct sales force in the U.S and a
combination of direct sales representatives and independent distributors in
international markets. A significant portion of revenue is generated from
consigned inventory generally maintained with field representatives, which is
recognized as revenue upon notification of implant or product usage. All other
product sales to end customers and international distributors are recorded upon
transfer of title and risk of loss to customers, provided an arrangement
exists, the fee is fixed and determinable, and collectibility is reasonably
assured. Estimated sales returns, discounts, and rebates are recorded as a
reduction of sales when the related revenue is recognized. Certain of our
customers are third-party payors who reimburse fixed amounts for products 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 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. -19-




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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 and Litigation 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. 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 5 to the Condensed Consolidated Financial Statements for a discussion
of the application of Statement of Financial Accounting Standards (SFAS) No.
123, -20-




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Accounting for Stock-Based Compensation and SFAS 148, Accounting for
Stock-Based Compensation  Transition and Disclosure to our stock compensation
programs. Results of Operations Comparison of the Three Months and Nine Months Ended September 30, 2004 and
2003 Results for the third quarter and first nine months of 2004 continue to reflect
the positive impact of revenue growth from increased unit sales of
our Genesis®
and GenesisXPIPG 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
the third quarter are comparisons of the three months ended September 30, 2004
and 2003 and references below to the first nine months are comparisons of the
nine months ended September 30, 2004 and 2003, unless otherwise specified. Net revenue.Net revenue for the third quarter increased $7.9 million, or
33.8%, and for the first nine months increased $23.0 million, or 35.2%, due to
increased sales of our neuro products during both 2004 periods. Neuro product
revenue increased 36.9% to a record $28.2 million in the third quarter of 2004
from $20.6 million in 2003, and for the first nine months neuro product revenue
increased 41.5% to a record $80.1 million in 2004 from $56.6 million in 2003,
primarily due to increased sales of our Genesisfamily of IPG systems. Revenue
from our Renew® RF system grew modestly during both the third quarter and first
nine months of 2004 compared to 2003. Net revenue of our O.E.M. business for
the third quarter increased slightly to $3.1 million in 2004 from $2.8 million
in 2003 due to higher volume of O.E.M. product sales, and for the first nine
months, decreased to $8.4 million in 2004 from $8.8 million in 2003 primarily
due to lower volume of O.E.M. product sales. We continue to use more of our
O.E.M. manufacturing and development capabilities for our own increasing needs,
and accordingly, O.E.M. revenues may flatten or decline during fiscal 2004
compared to fiscal 2003. In a press release dated October 28, 2004, we provided
a revenue outlook for the fourth quarter 2004 of $32 to $33 million and
provided our initial revenue guidance for 2005 of $145 million. We believe most
of our revenue growth in 2005 will be generated from increased sales of our
Genesisfamily of IPG systems. Gross profit.Gross profit for the third quarter increased $5.9 million, or
34.5%, and for the first nine months increased $19.6 million, or 43.5%, due to
the increase in net revenue discussed above and an improvement in gross profit
margins. Gross profit margins for the third quarter increased to 73.1% in 2004,
compared to 72.7% in 2003, and for the first nine months increased to 73.1% in
2004, compared to 68.9% in 2003 due to higher sales of our neuromodulation
products, which contribute higher margins than 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, and in April 2004, we completed the acquisition of
certain assets of our Australian distributor and transitioned to a direct sales
model in that territory. This had the effect of improving gross margins in 2004
due to direct sales of -21-




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product versus sales to distributors at reduced pricing. Correspondingly, sales
and marketing expense increased as we added direct salespeople. Operating expenses.Total operating expenses for the third quarter increased
$4.4 million, or 37.4%, and increased as a percentage of revenue to 52.0% in
2004 from 50.7% in 2003. For the first nine months, total operating expenses
increased $13.9 million, or 43.6%, and increased as a percentage of revenue to
51.7% in 2004 from 48.7% in 2003. These increased operating expenses during
both periods in 2004 compared to 2003 were primarily due to increased
investments in our sales and marketing capabilities. During late 2003 and early
2004, we added a total of 41 personnel in our sales organization 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. Sales and marketing.Sales and marketing expense for the third quarter, as a
percentage of net revenue, increased to 31.3% in 2004 from 29.8% in 2003, and
the expense increased in absolute dollars by $2.8 million. Sales and marketing
expense for the first nine months, as a percentage of net revenue, increased to
31.4% in 2004 from 28.2% in 2003, and the expense increased in absolute dollars
by $9.3 million. Increases during both periods in 2004 compared to 2003 were
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 and our Australian distributor in April 2004. Research and development.Research and development expense for the third
quarter, as a percentage of net revenue, decreased to 9.3% in 2004 from 10.9%
in 2003, while the expense increased in absolute dollars by $359,000. Research
and development expense for the first nine months, as a percentage of net
revenue, decreased to 9.2% in 2004 from 10.1% in 2003, while the expense
increased in absolute dollars by $1.5 million. The increase in expense in terms
of absolute dollars during both periods in 2004 compared to 2003 was
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, an IPG stimulation system for deep
brain stimulation and next generation drug pumps. We budgeted $12 million in
research and development expense in fiscal 2004 but now expect to spend
approximately $11 million due to a delay in the commencement of our clinical
trials on deep brain stimulation and migraine headaches. General and administrative.General and administrative expense for the third
quarter, as a percentage of net revenue, increased to 9.5% in 2004 from 8.0% in
2003, and the expense increased in absolute dollars by $1.1 million. General
and administrative expense for the first nine months, as a percentage of net
revenue, increased to 9.0% in 2004 from 8.4% in 2003, and the expense increased
in absolute dollars by $2.5 million. The increase in expense during both
periods in 2004 compared to 2003 was principally due to higher salary and
benefit expense from annual salary increases and staffing additions, higher
legal expense including expense associated with our lawsuit against -22-




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Advanced Bionics, expense related to compliance with Sarbanes-Oxley
requirements, and higher depreciation expense. Amortization of intangibles.Amortization expense of intangibles for the third
quarter, as a percentage of net revenue, remained flat in 2004 from 2003, and
the expense increased in absolute dollars by $153,000. Amortization expense for
the first nine months, as a percentage of net revenue, increased to 2.1% in
2004 from 2.0% in 2003, and the expense increased in absolute dollars by
$547,000. The increase in expense during both periods in 2004 compared to 2003
was due to additional expense for intangible assets we acquired in the April
2004 acquisitions of MedTel and microHelix, additional intangible assets from
earn-out consideration as milestones were met pursuant to the MicroNet
acquisition agreement in 2004 and additional intangible assets we acquired in
certain distributor acquisitions during the fourth quarter of 2003. Other income.Other income for the third quarter decreased by $606,000 and for
the nine months decreased by $755,000 principally due to other income in both
2003 periods of $969,000, recorded in connection with the reversal of a tax
abatement liability. Income tax expense.Income tax expense for the third quarter increased $52,000
in 2004 from 2003 as a result of increased income before taxes partially offset
by a decrease in our effective tax rate. Our tax rate in the third quarter of
2004 was 33.9% compared to 37.6% in 2003. For the nine months, income tax
expense increased $1.4 million in 2004 from 2003 as a result of increased
income before taxes partially offset by a decrease in our effective tax rate.
Our tax rate for the first nine months of 2004 was 34.7% compared to 36.7% in
2003. Our decreased effective tax rate during both periods in 2004 compared to
2003 is primarily due to a research and development tax credit, an enhanced
benefit related to ETI, and income in Australia where the statutory rate for
corporations is lower than the U.S. statutory rate. 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, benefits related to ETI, and the
lower tax rate in Australia. Net income.Net income for the third quarter increased $789,000, or 20%, in
2004 from 2003 primarily due to the positive impact of revenue growth from
increased unit sales of our Genesisand GenesisXPIPG systems, increased gross
margin and a lower tax rate. Net income per diluted share during the third
quarter increased to $.23 in 2004 from $.19 in 2003. For the nine-month period,
net income increased $3.5 million, or 37.3%, in 2004 from 2003 again due to
increased unit sales of IPG systems, increased gross margin and a lower tax
rate. Net income per diluted share for the nine-month period increased to $.62
in 2004 from $.46 in 2003. Liquidity and Capital Resources At September 30, 2004, our working capital increased to $158.95 million from
$126.44 million at year-end 2003. The ratio of current assets to current
liabilities was 11.62:1 at September 30, 2004, compared to 11.21:1 at December
31, 2003. Cash, cash equivalents, and marketable securities totaled $121.79
million at September 30, 2004 compared to $94.80 million at December 31, 2003,
an increase of $26.99 million -23-




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principally due to an increase in the fair value of our investment in
Cyberonics, Inc. of $21.93 million. In August 2004, we purchased 3,500,000 shares of Cyberonics common stock on the
open market at an aggregate cost of $49.68 million. In connection with the
purchase we used $44.66 million of our cash and borrowed $5.02 million under a
margin agreement with the securities firm which purchased the shares for us.
Subsequent to September 30, 2004, the margin obligation was fully repaid. Excluding inventory we purchased in the 2004 acquisitions of microHelix and
MedTel, we increased our investment in inventories from year-end 2003 by
$550,000. This increase is primarily related to the building of inventory for
new products we expect to launch in the fourth quarter of 2004. We purchased
inventory in the amount of $171,000 in our acquisition of microHelix and
inventory in the amount of $490,000 in our acquisition of MedTel. Our investment in trade accounts receivable increased from year-end 2003 by
$7.06 million due to the increase in sales of our neuromodulation products and
an increase in our days sales outstanding. Days sales outstanding increased to
73 days at September 30, 2004 from 64 days at December 31, 2003 due to slower
payment from hospitals, higher sales to third party payors, receivables from
going direct in Australia and receivables generated from microHelix O.E.M.
sales after we acquired microHelix in late April 2004. Excluding expenditures discussed below relating to the construction of our new
facility, we spent $5.8 million during the nine months ended September 30, 2004
for capital expenditures, which includes $2.1 million for new office furniture
and equipment for our new facility discussed below. The remainder of the
capital expenditures during the nine months ended September 30, 2004, primarily
related to tooling and equipment for current products as well as new products
being developed. We completed our relocation to our new corporate headquarters facility in
Plano, Texas in July 2004, prior to the expiration of our former lease in
August 2004. The new facility consists of 143,000 square feet and was designed
to accommodate planned growth within a five-year horizon. The total cost of the
facility is approximately $17.4 million. We funded the cost of the facility
from our cash reserves. During the nine months ended September 30, 2004, we
spent $8.6 million on construction costs for the new facility. We received $4.68 million of cash during the nine months ended September 30,
2004, from the exercise of employee and director stock options to purchase
476,294 shares of our common stock. On June 1, 2004, we issued a press release announcing that our Board of
Directors approved the repurchase of up to 1,000,000 shares of our common
stock. Any repurchases would be made from time to time in open market purchases
or privately negotiated transactions, subject to price and availability, and
financed out of working capital. Through September 30, 2004, we have not
repurchased any shares of our common stock. -24-




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Liquidity may also be enhanced based on our ability to utilize all or part of a
net operating loss carryforward of $7.9 million to offset future taxable
income. In the third quarter 2004 in conjunction with filing our 2003 tax
return, we elected to carryforward our 2003 tax loss of $4.4 million, which is
being applied against 2004 taxable income instead of re-filing previous tax
returns for refunds. We acquired $3.4 million of the net operating loss
carryforward in connection with the MicroNet acquisition, and its utilization
is 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 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 $1.6 million 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 nine months ended September 30, 2004, we
generated a $3.65 million tax benefit related to nonqualified stock option
exercises and disqualifying dispositions of common stock acquired on exercise
of incentive stock options, which will be utilized along with the prior year
net operating loss to offset current year taxes payable. As noted, on April 1, 2004, we acquired for $1.09 million cash, certain assets
of our exclusive distributor of our neuromodulation devices for Australia,
MedTel. Also as noted, on April 21, 2004, we acquired the assets of
microHelixs Cable and Wire Division for approximately $2 million in cash and
assumed liabilities of approximately $132,000. We estimate that the pre-tax costs associated with the patent
infringement/trade secret lawsuit against Advanced Bionics 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. 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. -25-




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Cash Flows Net cash provided by operations for the nine months was $13.09 million in 2004
compared to $8.40 million in 2003, an increase of $4.69 million principally due
to a $3.54 million increase in net income. We increased our use of cash for
changes in working capital in 2004 compared to 2003 by $4.4 million but the
increase was offset by higher depreciation and amortization expense and higher
deferred income taxes. Net cash used by investing activities for the nine months was $10.56 million in
2004 compared to $18.67 million in 2003, a decrease of $8.11 million
principally due to a $2.86 million reduction in the amount of cash used in
certain acquisitions, a $55.97 million change in net proceeds versus purchases
of marketable securities, offset by an increase of $5.48 million in new
facility construction in 2003 compared to 2004 and the $44.66 million net
investment in Cyberonics in 2004. Net cash provided by financing activities for the nine months was $4.68 million
in 2004 compared to $5.81 in 2003, a decrease of $1.13 million due to lower
proceeds from the exercise of stock options. Currency Fluctuations Our international sales are denominated in U.S. dollars with the exception of
Germany and Australia, where we began selling direct on January 1, 2004 and
April 1, 2004, respectively. Sales are denominated in Euros in Germany and
Australian dollars in Australia. 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. Off-Balance Sheet Arrangements The Company does not have any obligations that meet the definition of an
off-balance sheet arrangement and that have or are reasonably likely to have a
material adverse effect on the Companys financial statements. 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 27A of the Securities Act of 1933 and 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, although not all forward-looking statements contain
such identifying words. 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 -26-




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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:  
    
    the risk of adverse changes in the value or marketability of the securities of Cyberonics, Inc. owned by the Company
    
    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. In June 2004, Advanced Bionics was acquired by Boston Scientific Corporation.
The entrance into the neuromodulation market of new competitors, including Advanced Bionics/Boston Scientific, may make it
more difficult to compete in this market
    
    the launch of new competitive products by Advanced Bionics, Medtronic, Inc. 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
    
    because our principal competitors have 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 -27-




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
    
    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 principal competitor in the neuromodulation market, Medtronic, Inc., 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 manufacturing 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 Certain of the foregoing risks are described in more detail in our Annual
Report on 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 September 30, 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, with the exception of the 3,500,000
shares of common stock of Cyberonics, Inc. (NASDAQ:CYBX) purchased by the
Company in August 2004 at an aggregate cost of $49.7 million. These shares are
subject to equity price risk. At September 30, 2004, the value of the
Cyberonics shares owned by the Company had increased in value by $21.9 million
to $71.6 million. A hypothetical 10% decrease in the value of this investment
from the September 30, 2004 level would decrease the fair value of this
investment by $7.16 million. 
 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 -28-




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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. -29-




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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) (the Texas Action) 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. On June 7, 2004, Advanced Bionics filed a
lawsuit with the United States District Court, Central District of California,
Case No. CV04-4054ABC (the California Action), seeking a declaratory judgment
that it is not infringing ANS patent No. 4,793,353 (the subject of ANS
current patent infringement claim against Advanced Bionics) and that such
patent is invalid and unenforceable. On October 15, 2004, the judge in the
Texas Action granted the Companys motion to amend its lawsuit to add two
additional patent infringement claims against Advanced Bionics. One claim
relates to the Companys patent covering the design and structure of its
electrode lead (U.S. Patent No. 6,216,045). The second claim relates to the
Companys trial cable connector patent (U.S. Patent No. 6,154,678). In
addition, the judge denied Advanced Bionics motion to dismiss the Texas
Action. Subsequently, Advanced Bionics has informed the Company that it has
asked the judge in the California Action to dismiss that case without
prejudice. 
 ITEM 2. CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY
SECURITIES Share Repurchase Program On June 1, 2004, the Company issued a press release announcing that our Board
of Directors approved the repurchase of up to 1,000,000 shares of our common
stock. Any repurchases would be made from time to time in open market purchases
or privately negotiated transactions, subject to price and availability, and
financed out of working capital. A copy of this press release was filed as an
exhibit to the Companys Form 8-K filed on June 2, 2004. The Company did not
repurchase any shares of its common stock during the quarter ended September
30, 2004, and has not made any purchases since the authorization. -30-




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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 10.30  Advanced Neuromodulation Systems, Inc. 2004 Stock
Incentive Plan (4)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
(5)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
(5)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 (6)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 (6)(b)
    
    The Company furnished a report on Form 8-K on July 26,
2004, providing under Item 9. Regulation FD Disclosure and Item 12.
Results of Operations and Financial Condition, a press release
issued by the Company on July 26, 2004, disclosing information
regarding our results of operations and financial condition for the
second quarter ended June 30, 2004, and our financial outlook for
the remainder of 2004.The Company filed a report on Form 8-K on August 20, 2004,
providing under Item 2. Acquisition or Disposition of Assets and
Item 9. Regulation FD Disclosure, a press release issued by the
Company on August 20, 2004, announcing that on August 12 and 13,
2004, the Company acquired 3.5 million shares, or approximately
14.7%, of the outstanding common stock of Cyberonics, Inc. in open
market purchases at prices ranging between $13.74 and $14.52 per
share. We also announced in that press release that on August 19,
2004, our chief executive officer contacted
 -31-




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Cyberonics chief executive officer to apprise him of the
Companys investment, and to invite Cyberonics to discuss, in
general, the opportunities presented by a possible business
combination of the Company and Cyberonics.
   (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 as an Exhibit to the Definitive Proxy Statement on Schedule 14A
dated April 16, 2004, and incorporated herein by reference.(5)
    
    Filed herewith.(6)
    
    Furnished herewith. -32-




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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: November 8, 2004
    
    By: /s/ F. Robert Merrill IIIF. Robert Merrill IIIExecutive Vice President, FinanceChief Financial Officer and Treasurer
 -33-




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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 10.30
    
    Advanced Neuromodulation Systems, Inc. 2004 Stock Incentive Plan (4)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 (5)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 (5)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 (6)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 (6)
   (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 as an Exhibit to the Definitive Proxy Statement on Schedule 14A
dated April 16, 2004, and incorporated herein by reference.(5)
    
    Filed herewith.(6)
    
    Furnished herewith.