##### Table of Contents



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 THE SECURITIES EXCHANGE ACT 1934
 FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2005
 o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT 1934
 FOR THE TRANSITION PERIOD FROM  TO
 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 þ 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 þ 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
    
    April 30, 2005Common stock, $.05 Par Value

    
    19,833,869




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ADVANCED NEUROMODULATION SYSTEMS, INC. AND SUBSIDIARIES Table of Contents PART I. Financial Information
    
    
    2Item 1.
    
    Financial StatementsCondensed Consolidated Balance Sheets March 31, 2005 (Unaudited) and December 31, 2004
    
    
    3-4Condensed Consolidated Statements of Income (Unaudited) For the Three Months Ended March 31, 2005 and 2004
    
    
    5Condensed Consolidated Statements of Cash Flows (Unaudited) For the Three Months Ended March 31, 2005 and 2004
    
    
    6Condensed
Consolidated Statements of Stockholders Equity For the Year Ended December 31, 2004 and the Three Months Ended March 31, 2005 (Unaudited)
    
    
    7Notes to Condensed Consolidated Financial Statements
    
    
    8-14Item 2.
    
    Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    15-23Item 3.
    
    Quantitative and Qualitative Disclosures About Market Risk
    
    
    23Item 4.
    
    Controls and Procedures
    
    
    23PART II. Other Information
    
    
    24Item 1.
    
    Legal Proceedings
    
    
    24-25Item 2.
    
    Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    26Item 6.
    
    Exhibits
    
    
    26-27Signatures
    
    
    28Certification of CEO Pursuant to Section 302Certification of CFO Pursuant to Section 302Certification of CEO Pursuant to Section 906Certification 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
 March 31, 2005 (Unaudited) and December 31, 2004
 March 31,
    
    
    December 31,2005
    
    
    2004AssetsCurrent assets:Cash and cash equivalents
    
    $
    4,346,530
    
    
    $
    6,654,712Marketable securities
    
    
    176,330,273
    
    
    
    117,361,352Receivables:Trade accounts, less allowances of
$457,838 in 2005 and $398,627 in 2004
    
    
    25,598,912
    
    
    
    25,322,813Interest and other
    
    
    1,106,898
    
    
    
    638,987Total receivables
    
    
    26,705,810
    
    
    
    25,961,800Inventories:Raw materials
    
    
    9,280,241
    
    
    
    10,067,802Work-in-process
    
    
    6,060,797
    
    
    
    4,435,746Finished goods
    
    
    9,413,172
    
    
    
    9,420,303Total inventories
    
    
    24,754,210
    
    
    
    23,923,851Deferred income taxes
    
    
    1,994,747
    
    
    
    2,029,091Prepaid expenses and other current assets
    
    
    1,357,241
    
    
    
    1,888,957Total current assets
    
    
    235,488,811
    
    
    
    177,819,763Property, equipment and fixtures:Land
    
    
    3,191,427
    
    
    
    3,191,427Building
    
    
    17,544,484
    
    
    
    17,523,181Furniture and fixtures
    
    
    7,293,911
    
    
    
    6,829,357Machinery and equipment
    
    
    19,638,771
    
    
    
    18,757,126Leasehold improvements
    
    
    638,778
    
    
    
    638,77848,307,371
    
    
    
    46,939,869Less accumulated depreciation and amortization
    
    
    15,029,394
    
    
    
    13,764,540Net property, equipment and fixtures
    
    
    33,277,977
    
    
    
    33,175,329Minority equity investments in preferred stock
    
    
    1,104,000
    
    
    
    1,104,000Goodwill
    
    
    12,078,668
    
    
    
    12,078,668Patents and licenses, net of accumulated
amortization of $2,421,331 in 2005 and
$2,301,780 in 2004
    
    
    6,598,499
    
    
    
    6,208,520Purchased technology, net of accumulated
amortization of $4,175,907 in 2005 and
$3,917,268 in 2004
    
    
    11,156,270
    
    
    
    11,414,908Tradenames, net of accumulated amortization of
$1,308,044 in 2005 and $1,266,929 in 2004
    
    
    1,911,780
    
    
    
    1,901,470Customer and supplier relations, net of
accumulated amortization of $761,981 in 2005 and
$645,336 in 2004
    
    
    2,309,060
    
    
    
    2,429,671Other assets, net of accumulated amortization of
$1,308,711 in 2005 and $1,202,605 in 2004
    
    
    1,288,184
    
    
    
    1,354,812$
    305,213,249
    
    
    $
    247,487,141
 See accompanying notes to condensed consolidated financial statements. -3-




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Advanced Neuromodulation Systems, Inc. and Subsidiaries
Condensed Consolidated Balance Sheets (continued)
March 31, 2005 (Unaudited) and December 31, 2004 March 31,
    
    
    December 31,2005
    
    
    2004Liabilities and Stockholders EquityCurrent liabilities:Accounts payable
    
    $
    2,688,037
    
    
    $
    3,206,516Accrued salary and employee benefit costs
    
    
    1,933,556
    
    
    
    2,390,721Accrued commissions
    
    
    1,579,853
    
    
    
    2,656,112Income taxes payable
    
    
    33,526,811
    
    
    
    708,412Deferred revenue
    
    
    107,028
    
    
    
    165,861Other accrued expenses
    
    
    445,318
    
    
    
    342,075Total current liabilities
    
    
    40,280,603
    
    
    
    9,469,697Deferred income taxes
    
    
    6,056,418
    
    
    
    14,734,487Non-current deferred revenue
    
    
    670,362
    
    
    
    718,820Commitments and contingenciesStockholders equity:Common stock $.05 par value
Authorized - 100,000,000 shares;
Issued - 20,448,710 shares in 2005 and 20,337,501 in 2004
    
    
    1,022,435
    
    
    
    1,016,875Additional capital
    
    
    163,775,010
    
    
    
    161,625,018Retained earnings
    
    
    104,250,267
    
    
    
    45,681,864Accumulated other comprehensive income (loss), net of tax
benefit (expense) of $98,345 in 2005 and $(8,544,328) in 2004
    
    
    (163,909
    )
    
    
    14,240,380Treasury stock, at cost - 381,894 shares in 2005
    
    
    (10,677,937
    )
    
    
    Total stockholders equity
    
    
    258,205,866
    
    
    
    222,564,137$
    305,213,249
    
    
    $
    247,487,141
 See accompanying notes to condensed consolidated financial statements. -4-




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Advanced Neuromodulation Systems, Inc. and Subsidiaries 
 Condensed Consolidated Statements of Income (Unaudited)
 For the Three Months Ended March 31, 2005 and 2004
 Three Months EndedMarch 31,2005
    
    
    2004Net revenue
    
    $
    32,335,463
    
    
    $
    26,632,863Cost of revenue
    
    
    8,446,834
    
    
    
    6,965,532Gross profit
    
    
    23,888,629
    
    
    
    19,667,331Operating expenses:Sales and marketing
    
    
    10,090,319
    
    
    
    8,564,046Research and development
    
    
    3,324,707
    
    
    
    2,314,950General and administrative
    
    
    3,343,454
    
    
    
    2,316,740Amortization of other intangibles
    
    
    639,980
    
    
    
    574,87417,398,460
    
    
    
    13,770,610Income from operations
    
    
    6,490,169
    
    
    
    5,896,721Other income (expense):Gain on sale of investment in common stock of Cyberonics, Inc.
    
    
    85,244,301
    
    
    
    Foreign currency transaction loss
    
    
    (47,625
    )
    
    
    (29,347
    )Investment income
    
    
    546,861
    
    
    
    251,32985,743,537
    
    
    
    221,982Income before income taxes
    
    
    92,233,706
    
    
    
    6,118,703Income taxes
    
    
    33,665,303
    
    
    
    2,150,112Net income
    
    $
    58,568,403
    
    
    $
    3,968,591Net income per share:Basic
    
    $
    2.88
    
    
    $
    .20Diluted
    
    $
    2.76
    
    
    $
    .19
 See accompanying notes to condensed consolidated financial statements. -5-




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Advanced Neuromodulation Systems, Inc. and Subsidiaries 
 Condensed Consolidated Statements of Cash Flows (Unaudited)
 For the Three Months Ended March 31, 2005 and 2004
 Three Months Ended March 31,2005
    
    
    2004Cash flows from operating activities:Net income
    
    $
    58,568,403
    
    
    $
    3,968,591Adjustments to reconcile net income to net cash provided by
operating activities:Depreciation and amortization
    
    
    1,875,858
    
    
    
    1,563,398Deferred income taxes
    
    
    9,549
    
    
    
    (770,714
    )Stock-based compensation
    
    
    (79,615
    )
    
    
    (19,398
    )Decrease in inventory reserve
    
    
    (26,951
    )
    
    
    3⁄4Amortization of premiums on marketable securities
    
    
    132,539
    
    
    
    3⁄4Gain on sale of marketable securities
    
    
    (85,244,301
    )
    
    
    (1,068
    )Changes in operating assets and liabilities, net of acquisitions:Receivables
    
    
    (744,010
    )
    
    
    (847,220
    )Inventories
    
    
    (803,408
    )
    
    
    (875,657
    )Income taxes receivable
    
    
    3⁄4
    
    
    
    20,642Prepaid expenses and other current assets
    
    
    182,346
    
    
    
    (362,648
    )Income taxes payable
    
    
    32,818,399
    
    
    
    3⁄4Tax benefit from stock option exercises
    
    
    649,241
    
    
    
    2,885,538Accounts payable
    
    
    (518,479
    )
    
    
    (2,006,298
    )Accrued expenses
    
    
    (1,430,181
    )
    
    
    (2,787,513
    )Deferred revenue
    
    
    (107,291
    )
    
    
    (201,799
    )Total adjustments
    
    
    (53,286,304
    )
    
    
    (3,402,737
    )Net cash provided by operating activities
    
    
    5,282,099
    
    
    
    565,854Cash flows from investing activities:Purchases of marketable securities
    
    
    (186,547,678
    )
    
    
    (24,609,473
    )Proceeds from sale of investment in common stock of Cyberonics, Inc.
    
    
    135,287,911
    
    
    
    3⁄4Proceeds from sales of marketable securities
    
    
    54,676,579
    
    
    
    97,572,066New facility construction
    
    
    3⁄4
    
    
    
    (2,931,138
    )Additions to property, equipment, fixtures and intangible assets
    
    
    (1,932,918
    )
    
    
    (2,580,878
    )Net cash provided by investing activities
    
    
    1,483,894
    
    
    
    67,450,577Cash flows from financing activities:Purchase of treasury stock
    
    
    (10,677,937
    )
    
    
    3⁄4Exercise of stock options
    
    
    1,585,926
    
    
    
    3,133,052Net cash provided by (used in) financing activities
    
    
    (9,092,011
    )
    
    
    3,133,052Net increase (decrease) in cash and cash equivalents
    
    
    (2,326,018
    )
    
    
    71,149,483Effect of exchange rates on cash and cash equivalents
    
    
    17,836
    
    
    
    12,716Cash and cash equivalents at beginning of year
    
    
    6,654,712
    
    
    
    8,588,281Cash and cash equivalents at March 31
    
    $
    4,346,530
    
    
    $
    79,750,480Non-cash activity:Stock issued for intangible assets
    
    $
    3⁄4
    
    
    $
    767,511
 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, 2004 and the Three Months Ended March 31, 2005 (Unaudited)
 AccumulatedOther
    
    
    
    
    
    
    TotalCommon Stock
    
    
    Additional
    
    
    Retained
    
    
    Comprehensive
    
    
    Treasury
    
    
    StockholdersShares
    
    
    Amount
    
    
    Capital
    
    
    Earnings
    
    
    Income (Loss)
    
    
    Stock
    
    
    EquityBalance at
December 31, 2003
    
    
    19,712,938
    
    
    $
    985,647
    
    
    $
    149,644,033
    
    
    $
    27,515,001
    
    
    $
    (19,758
    )
    
    
    
    
    
    $
    178,124,923Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    18,166,863
    
    
    
    
    
    
    
    
    
    
    
    18,166,863Adjustment to
unrealized gains
(losses) on
marketable
securities, net of
tax
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    14,280,634
    
    
    
    
    
    
    
    14,280,634Foreign currency
translation
adjustment
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (20,496
    )
    
    
    
    
    
    
    (20,496
    )Comprehensive
income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    32,427,001Issuance of shares
for stock option
exercises
    
    
    607,858
    
    
    
    30,393
    
    
    
    5,995,463
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    6,025,856Stock-based
compensation
    
    
    
    
    
    
    
    
    
    
    115,892
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    115,892Issuance of
earn-out shares
for acquisition
    
    
    16,705
    
    
    
    835
    
    
    
    766,676
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    767,511Tax benefit from
stock option
exercises
    
    
    
    
    
    
    
    
    
    
    5,102,954
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    5,102,954Balance at
December 31, 2004
    
    
    20,337,501
    
    
    
    1,016,875
    
    
    
    161,625,018
    
    
    
    45,681,864
    
    
    
    14,240,380
    
    
    
    
    
    
    
    222,564,137Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    58,568,403
    
    
    
    
    
    
    
    
    
    
    
    58,568,403Adjustment to
unrealized gains
(losses) on
marketable
securities, net of
tax
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (14,422,125
    )
    
    
    
    
    
    
    (14,422,125
    )Foreign currency
translation
adjustment
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    17,836
    
    
    
    
    
    
    
    17,836Comprehensive
income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    44,164,114Issuance of shares
for stock option
exercises
    
    
    111,209
    
    
    
    5,560
    
    
    
    1,580,366
    
    
    
    
    
    
    
    

    
    
    
    
    
    
    
    1,585,926Stock-based
compensation
    
    
    
    
    
    
    
    
    
    
    (79,615
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (79,615
    )Tax benefit from
stock option
exercises
    
    
    
    
    
    
    
    
    
    
    649,241
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    649,241Purchase of
381,894 treasury
shares, at cost
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (10,677,937
    )
    
    
    (10,677,937
    )Balance at
March 31, 2005
    
    
    20,448,710
    
    
    $
    1,022,435
    
    
    $
    163,775,010
    
    
    $
    104,250,267
    
    
    $
    (163,909
    )
    
    $
    (10,677,937
    )
    
    $
    258,205,866
 See accompanying notes to condensed consolidated financial statements. -7-




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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, also known as O.E.M. or original equipment manufacturing, for other medical
device companies through the Hi-tronics Designs, Inc. (HDI) subsidiary and through
operations in Portland, Oregon (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 O.E.M. 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 U.S. 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, and workers compensation programs. ANS also sells
and bills its neuromodulation products directly to third-party payors including Medicare,
Medicaid, private insurance companies and managed care organizations, and workers
compensation programs. 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.(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, 2004 Annual Report on Form 10-K.
The results of operations for the -8-




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Advanced Neuromodulation Systems, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements  period ended March 31, 2005 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 $49.7 million. In February 2005, the Company sold
the 3,500,000 shares and received gross proceeds on the sale of $135.3 million, resulting in
a pre-tax gain of $85.2 million, net of acquisition costs.(4)
    Stock-Based CompensationThe Company accounts for its stock-based compensation plans in accordance with Accounting
Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB 25) and
related interpretations. Under APB 25, no compensation expense is recognized for stock
option grants if the exercise price of the Companys stock option grants is at or above fair
market value of the underlying stock on the date of grant. Stock-based compensation to
non-employees is measured at fair market value over the service period and recorded as
compensation expense in the Condensed Consolidated Statement of Income. The Company recorded
$(79,615) and $(19,398) of stock-based compensation expense (benefit) to non-employees in
the three months ended March 31, 2005 and 2004, respectively. The Company has adopted the
pro forma disclosure-only provisions of Statement of Financial Accounting Standards No. 123,
Accounting for Stock-Based Compensation (SFAS 123), as amended by Statement of Financial
Accounting Standards No. 148, Accounting for Stock-Based Compensation-Transition and
Disclosure. The following table illustrates the effect on net income and net income per
share amounts if the Company had applied the fair value recognition provisions of SFAS 123
to stock-based employee compensation: Three Months Ended March 31,2005
    
    
    2004Net income as reported
    
    $
    58,568,403
    
    
    $
    3,968,591Stock-based compensation expense
    
    
    1,368,722
    
    
    
    1,166,307Pro forma net income
    
    $
    57,199,681
    
    
    $
    2,802,284Basic shares
    
    
    20,366,990
    
    
    
    19,928,946Diluted shares
    
    
    21,192,297
    
    
    
    21,187,163Pro forma Basic EPS
    
    $
    2.81
    
    
    $
    .14Pro forma Diluted EPS
    
    $
    2.70
    
    
    $
    .13
 -9-




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Advanced Neuromodulation Systems, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements  (5)
    Commitments and ContingenciesThe Company is a party to product liability claims related to its neurostimulation devices
and other ordinary routine litigation claims arising in the ordinary
course of business.

Product liability insurers have assumed responsibility for defending the Company against
product liability claims, subject to reservation of rights in certain cases. Historically,
product liability claims related to the Companys neurostimulation devices have not resulted
in significant monetary liability beyond its insurance coverage. The Company seeks to
maintain appropriate levels of product liability insurance with coverage that it believes is
comparable to that maintained by companies similar in size and serving similar markets,
although 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.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 Act, conversion and constructive
trust. As initially filed, the lawsuit alleged, among other things, that Advanced Bionics is
infringing U.S. Patent No. 4,793,353 entitled Non-Invasive Multiprogrammable Tissue
Stimulator and Method. In addition, the lawsuit alleged 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 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. Advanced Bionics filed a
California action in federal court seeking to resolve the Companys patent claims, which was
subsequently dismissed. Advanced Bionics has also made motions to transfer the Texas Action
to a California federal court, which the judge in the Texas Action has dismissed. On January
28, 2005, the judge in the Texas Action granted Advanced Bionics motion to compel
alternative dispute resolution of our trade secrets misappropriation claims, although the
judge ruled that he retains jurisdiction over those claims. On March 11, 2005, Advanced
Bionics filed its First Amended Answer and Counterclaims in the Texas Action, asserting,
among other things, that the Company is infringing Advanced Bionics U.S. Patent Nos.
6,516,277 and 6,381,496. Advanced Bionics claims that the Company is infringing these
patents at least by marketing and selling GenesisRCrechargeable IPG systems, and Advanced
Bionics may assert that the Companys newly-approved Eonsystem does as well. These patents
relate to changing operational parameters sets (6,381,496) and to a specific type of
rechargeable spinal cord stimulation system (6,516,277). The counterclaims seek temporary
restraining orders, permanent injunctions, compensatory damages, exemplary damages including
treble damages, pre and post judgment interest, attorneys fees and such other relief as the
court may grant. The Company intends to vigorously defend itself against these claims, which
the Company believes are meritless because, among other things, the Company believes the patents
are not infringed or are invalid. -10-




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Advanced Neuromodulation Systems, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements  In late January 2005, the Company received a subpoena from the Office of the Inspector
General, Department of Health and Human Services (OIG), requesting documents related to
certain of its sales and marketing, reimbursement, Medicare and Medicaid billing, and
certain other business practices. The Company is cooperating fully with the OIGs request
for documents.Beginning March 1, 2005, several law firms announced the filing of class action securities
lawsuits against the Company and certain of its officers and directors filed on behalf of
purchasers of the Companys securities between April 24, 2003 and February 16, 2005,
inclusive (the Class Period). The Company is aware that three such lawsuits have been filed
in the United States District Court for the Eastern District of Texas as follows: PLA, LLC
vs. Advanced Neuromodulation Systems, Inc., et al, filed March 1, 2005; RAI Investment Club
vs. Advanced Neuromodulation Systems, Inc., et al, filed March 9, 2005; and Clifford a.
Leavitt vs. Advanced Neuromodulation Systems, Inc. et al, filed April 28, 2005. These suits
allege the Company violated federal securities laws by the issuance of false and misleading
statements to the market regarding the Companys financial performance throughout the Class
Period, which statements allegedly had the effect of artificially inflating the market price
of the Companys securities. In particular, the claims allege improper marketing and sales
practices accounted for the Companys revenue growth, citing, among other things, the public
announcement that management made on February 17, 2005 that the Company had received a
subpoena from the Office of the Inspector General, Department of Health and Human Services,
requesting documents related to sales and marketing, reimbursement, Medicare and Medicaid
billing and other business practices. The plaintiffs are seeking unspecified compensatory
damages and costs and expenses of litigation. No class has been certified. Based on the
various press releases, the Company believes any other lawsuits, if filed, will contain
similar allegations. The Company intends to vigorously defend itself against the claims
made in these lawsuits and believes the lawsuits are without merit.Except for the litigation discussed above, and other ordinary routine litigation incidental
or immaterial to its business, the Company is not currently a defendant 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. The Company currently
is not aware of -11-




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Advanced Neuromodulation Systems, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements  any indemnification claims, nor has the Company had any indemnification claims historically.(6)
    Income TaxesThe Company recorded income tax expense during the three months ended March 31, 2005 and
2004 of $33,665,303 and $2,150,112, respectively, representing an overall effective tax rate
of 36.5% and 35.1%, respectively. The increased effective tax rate in 2005 is due to the
$85.2 million pre-tax gain resulting from the sale of the Companys investment in
Cyberonics, Inc., which had the impact of increasing federal and state taxable income
without a significant corresponding increase in other permanent exclusions from taxable
income. The effective tax rates in 2005 and 2004 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, the research and development tax credit, and benefits related to the
extra-territorial income (ETI) exclusion.(7)
    Net Income Per ShareBasic net income per share is computed based only on the weighted average number of common shares
outstanding during the period. Diluted net income per share is computed using the additional
dilutive effect, if any, of stock options using the treasury stock method based on the average
market price of the stock during the period. The following table presents the reconciliation of
basic and diluted shares: Three Months EndedMarch 31,2005
    
    
    2004Weighted-average shares outstanding
(basic shares)
    
    
    20,366,990
    
    
    
    19,928,946Effect of dilutive stock options
    
    
    825,307
    
    
    
    1,258,217Diluted weighted-average shares
outstanding
    
    
    21,192,297
    
    
    
    21,187,163
  For the three months ended March 31, 2005 and 2004, 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
March 31, 2005 and 2004, options to purchase 638,563 and 2,142 shares, respectively, were
outstanding, but were not included in the computation of diluted earnings per share because
the options exercise price were greater than the average market price of the common shares
and, therefore, the effect would be antidilutive.(8)
    Comprehensive IncomeComprehensive income is the total of net income and all other non-owner changes in equity
net of tax effects, and consists of net income, unrealized gains or losses on the Companys
available for sale marketable securities, and foreign currency translation adjustments.
Comprehensive income for 2004 and for the three months ended March 31, 2005 is reported in
the Condensed Consolidated Statements of Stockholders Equity. Comprehensive income for the
three months ended March 31, 2004 was $3,979,867. -12-




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Advanced Neuromodulation Systems, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements  Components of Accumulated Other Comprehensive Income (Loss) are net of tax and are as
follows: March 31, 2005
    
    
    December 31, 2004Unrealized gains (losses) on marketable securities
    
    $
    (161,249
    )
    
    $
    14,260,876Foreign currency translation adjustments
    
    
    (2,660
    )
    
    
    (20,496
    )$
    (163,909
    )
    
    $
    14,240,380
  The tax benefit (expense) on the unrealized gains (losses) on marketable securities was
$96,749 at March 31, 2005 and $(8,556,625) at December 31, 2004. The tax benefit on foreign
currency translation adjustment was $1,596 at March 31, 2005 and $12,297 at December 31,
2004.In connection with the realized gain resulting from the sale of the Companys investment in
Cyberonics, Inc. in February 2005 as discussed in Note 3, $14,275,238 of the December 31,
2004 unrealized gain on marketable securities was realized into other income, and the
associated tax expense of $8,565,143 was reclassified from deferred income taxes payable to
income taxes payable(9)
    Treasury StockIn May 2004, the Companys board of directors approved the repurchase of up to 1,000,000
shares of the Companys common stock. The Company repurchased 381,894 shares of its common
stock at a cost of $10,677,937 in March 2005. The Company repurchased an additional 541,780
shares of its common stock at a cost of $14,900,112 during April 2005. Also in April 2005,
the Companys board of directors approved an increase in the amount of shares authorized to
be repurchased by the Company up to a total of 2,000,000 shares.(10)
    Segment InformationThe Company operates in two business segments. The Neuro Products segment designs, develops,
manufactures and markets implantable medical devices that are used to manage chronic
intractable pain and other disorders of the central nervous system through the delivery of
electrical current or drugs directly to targeted nerve fibers. The O.E.M. segment provides
contract development and O.E.M. manufacturing primarily of electromechanical medical
devices. Intersegment revenue is billed at cost with no intercompany mark-up.Segment data for the three months ended March 31, 2005 is as follows: -13-




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Neuro
    
    
    
    
    
    
    Intercompany
    
    
    ConsolidatedProducts
    
    
    O.E.M.
    
    
    Eliminations
    
    
    TotalRevenue from
external customers
    
    $
    28,717,032
    
    
    $
    3,618,431
    
    
    $
    
    
    
    $
    32,335,463Intersegment revenues
    
    $
    
    
    
    $
    2,864,113
    
    
    $
    (2,864,113
    )
    
    $
    Segment income from
operations
    
    $
    6,184,061
    
    
    $
    306,108
    
    
    $
    
    
    
    $
    6,490,169
 Segment data for the three months ended March 31, 2004 is as follows: Neuro
    
    
    
    
    
    
    Intercompany
    
    
    ConsolidatedProducts
    
    
    O.E.M.
    
    
    Eliminations
    
    
    TotalRevenue from
external customers
    
    $
    24,227,684
    
    
    $
    2,405,179
    
    
    $
    
    
    
    $
    26,632,863Intersegment revenues
    
    $
    
    
    
    $
    1,682,578
    
    
    $
    (1,682,578
    )
    
    $
    Segment income from
operations
    
    $
    5,477,813
    
    
    $
    418,908
    
    
    $
    
    
    
    $
    5,896,721
 Foreign sales, primarily Europe and Australia, for the three months ended
March 31, 2005 and 2004 were approximately 9.4% and 9.5% of net revenue from the Neuro
Products segment, respectively. The O.E.M. segment had no foreign sales for the respective
periods. (11) New Accounting Standard On December 16, 2004, the Financial Accounting Standards Board (FASB) issued FASB Statement
No. 123 (revised 2004), Share-Based Payment (SFAS 123(R)), which is a revision of SFAS
123. SFAS 123(R) supersedes APB 25, and amends FASB Statement No. 95, Statement of Cash
Flows. Generally, the approach in SFAS 123(R) is similar to the approach described in SFAS
123. However, SFAS 123(R) requires all share-based payments to employees, including grants
of employee stock options, to be recognized in the income statement based on their fair
values. Pro forma disclosure is no longer an alternative. SFAS 123(R) required adoption no later than July 1, 2005; however, on April 14, 2005, the
Securities and Exchange Commission announced that it would require adoption of SFAS 123(R)
no later than the beginning of the first fiscal year beginning after June 15, 2005. Early
adoption will be permitted in periods in which financial statements have not yet been
issued. The Company expects to adopt SFAS 123(R) on January 1, 2006. The adoption of SFAS
123(R)s fair value method will have a significant impact on the Companys result of
operations which the Company is currently evaluating, although it will have no impact on
the Companys overall financial position. The Company is also currently assessing the
method (either the modified prospective or modified retrospective method, as defined)
by which SFAS 123(R) will be adopted. -14-




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ITEM 2.
    
    MANAGEMENTS DISCUSSION AND ANALYSIS OFFINANCIAL 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 In March 2005, the FDA approved our second rechargeable implantable pulse generator (IPG) system,
the Eon Neurostimulation System, for sale in the U.S. The Eonsystem is indicated as an aid in
the management of chronic intractable pain of the trunk and/or limbs, including unilateral or
bilateral pain associated with failed back surgery syndrome, intractable low back pain and leg
pain. We intend to begin a limited launch of Eonin the U.S. during the second quarter of 2005, and
a full market launch during the third quarter of 2005. We have recently received FDA Investigational Device Exemptions (IDE) to implant our Libra Deep
Brain Stimulation (DBS) System to investigate the safety and efficacy of Librato treat essential
tremor and Parkinsons disease. We anticipate the first implants of both indications to occur in
the second quarter of 2005. Also during the first quarter of 2005, we received approval from the
FDA to expand our feasibility study to a pivotal study of neurostimulation for the treatment of
migraine headache. In addition to the planned pivotal studies to treat migraine headache, essential tremor, and
Parkinsons disease, we are working on the potential application of our platform technologies to
address depression, pelvic pain, obesity, tinnitus, angina, ischemic pain associated with
peripheral vascular disease, and traumatic brain injury. As a result, in 2005 we intend to
increase our investment in research and development and clinical trials to approximately $20
million. In August 2004, we acquired 3.5 million shares of the common stock of Cyberonics, Inc.
(Cyberonics), for an aggregate purchase price of $49.7 million with working capital funds on hand.
We purchased the shares for investment purposes and because we believed that ownership of the
shares could facilitate a business combination between Cyberonics and ANS that could have created
significant synergies in technology development, manufacturing, sales and marketing, regulatory,
administrative and other areas. Cyberonics decided not to enter into or pursue any merger or
combination discussions with us. On February 2, 2005, Cyberonics announced that the FDA deemed its
vagal nerve stimulation device approvable for treatment of certain types of chronic depression. Due
to the increase in the price of Cyberonics common stock following the FDAs announcement, coupled
with the Cyberonics board of directors decision not to discuss a possible combination, we sold all
3.5 million shares of the common stock of Cyberonics in open market transactions in February 2005.
Gross proceeds from the sale were $135.3 million and resulted in a pre-tax gain of $85.2 million,
net of acquisition costs. -15-




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In March 2005 we repurchased 381,894 shares of the Companys common stock for $10.7 million under
a 1,000,000-share repurchase authorization previously approved by the Companys board of directors.
In April 2005, we repurchased an additional 541,780 shares for $14.9 million. Also in April 2005,
the Companys board of directors approved an increase in the repurchase authorization to a total of
2,000,000 shares. Critical Accounting Policies and Estimates General Our discussion and analysis of our financial condition and results of operations are based upon our
condensed consolidated financial statements, which have been prepared in accordance with accounting
principles generally accepted in the United States. The preparation of these financial statements
requires management to make estimates and judgments that affect the reported amounts of assets,
liabilities and related disclosure of contingent assets and liabilities at the date of the
financial statements and the reported amounts of revenue and expenses during the reporting period.
On an on-going basis, management evaluates its estimates and judgments, including those related to
third-party reimbursement rates, bad debts, inventories, intangible assets, and contingencies and
litigation. Management bases its estimates on historical experience and on various other factors
that are believed to be reasonable under the circumstances, the results of which form the basis for
making judgments about the carrying value of assets and liabilities that are not readily apparent
from other sources. Actual results may differ from these estimates under different assumptions or
conditions. Management believes the following critical accounting policies affect its more significant
judgments and estimates used in preparation of its condensed consolidated financial statements. Revenue Recognition We generate revenues primarily from product sales to end customers and to international
distributors. 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. -16-




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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
sheets. 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 except for goodwill, which is assessed annually for impairment. 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. Income Taxes Management judgment is required to determine the Companys consolidated provision for income taxes.
Reserves are established when it is believed that certain tax positions of the Company may be
successfully challenged, despite managements belief that such tax return positions are fully
supportable. When facts and circumstances change, the reserves are adjusted through the provision
for income taxes. -17-




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Stock Compensation See Note 4 to the Condensed Consolidated Financial Statements for a discussion of the application
of Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based
Compensation and SFAS 148, Accounting for Stock-Based Compensation  Transition and Disclosure
to our stock compensation programs. Additionally, see Note 11 to the Condensed Consolidated
Financial Statements for a discussion of SFAS No. 123(R), Share Based Payment, which is expected
to be adopted on January 1, 2006, and when adopted will have a significant impact on our results of
operations, although it will have no impact on our overall financial position. Results of Operations Comparison of the Three Months Ended March 31, 2005 and 2004 Results for the first quarter of 2005 compared to 2004 continue to reflect the 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 and from a limited launch of
GenesisRCä, our first rechargeable IPG system approved by the FDA in the fourth quarter of
2004. In March 2005, we received approval for our second rechargeable IPG system, Eonä, and
are manufacturing product to support a limited launch in the second quarter and a full market
launch in the third quarter of 2005. References below to the first quarter are comparisons of the
three months ended March 31, 2005 and 2004. Net revenue.Net revenue for the first quarter increased $5.7 million, or 21.4%, due to increased
sales of our neuro products and O.E.M. products. Neuro product revenue increased 18.5% to $28.7
million in the first quarter of 2005 from $24.2 million in 2004, primarily due to increased sales
of our Genesisfamily of IPG systems and to a lesser extent from a limited launch of GenesisRC.
Revenue from our Renew® RF system declined during the first quarter and is expected to continue to
decline as rechargeable IPG systems that offer comparable features and benefits, including our own
GenesisRCand Eonsystems, begin to claim more of the market for neurostimulation devices. Net
revenue of our O.E.M. business for the first quarter increased to $3.6 million in 2005 from $2.4
million in 2004 primarily due to $1.0 million of revenue generated by our Portland, Oregon
operations (formerly the Cable and Wire Division of microHelix, Inc. which we acquired in April
2004). We continue to use more of our O.E.M. manufacturing and development capabilities for our own
increasing needs, and accordingly, we expect O.E.M. revenue of approximately $12 million in 2005,
flat with 2004 revenue. Gross profit.Gross profit for the first quarter increased $4.2 million, or 21.5% due to the
increase in net revenue discussed above. Gross profit margin for the first quarter remained the
same at 73.9%. Operating expenses.Total operating expenses for the first quarter increased $3.6 million, or
26.3%, and increased as a percentage of revenue to 53.8% in 2005 from 51.7% in 2004. In February
2005, we announced that we intend to accelerate our pursuit of new indications for our technology
by accelerating clinical studies, regulatory approval efforts and product development. As such, we
expect operating expenses as a percentage of revenue to increase in 2005. -18-




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Sales and marketing.Sales and marketing expense for the first quarter, as a percentage of net
revenue, decreased to 31.2% in 2005 from 32.2% in 2004, while the expense increased in absolute
dollars by $1.5 million. The increase in absolute dollars during the first quarter was principally
due to higher salary and benefit expense from annual salary increases and staffing additions in
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. Research and development.Research and development expense for the first quarter, as a percentage
of net revenue, increased to 10.3% in 2005 from 8.7% in 2004, and the expense increased in absolute
dollars by $1.0 million. As noted above, we intend to accelerate our investment in research and
development and clinical trials to capitalize on the opportunity to pursue several new indications
with our existing technology and products and to develop new technology and products for the
future. We expect expenditures of approximately $20 million in 2005, or 13.8% of targeted revenue
compared to expenditures of $10.8 million, or 8.9% of revenue in 2004. We believe the increased
investment is strategically important to achieving our mission in the
long-term. In the last few months, we have received FDA approval to commence three separate pivotal studies to
investigate the safety and efficacy of our technologies to treat migraine headaches, essential
tremor and Parkinsons Disease and we expect to begin implants under the three studies during the
second quarter of 2005. General and administrative.General and administrative expense for the first quarter, as a
percentage of net revenue, increased to 10.3% in 2005 from 8.7% in 2004, and the expense increased
in absolute dollars by $1.0 million. The increase in expense during the first quarter was
principally due to higher legal expense including expense associated with our lawsuit against
Advanced Bionics, audit and Sarbanes-Oxley compliance expense and depreciation expense. Amortization of intangibles.Amortization expense of intangibles for the first quarter, as a
percentage of net revenue, decreased to 2.0% in 2005 from 2.2% in 2004, while the expense in
absolute dollars increased by $65,000 due to additional expense for intangible assets we acquired
in the April 2004 acquisitions of MedTel and microHelix. Other income.Other income for the first quarter increased by $85.5 million principally due to the
$85.2 million gain we recognized on the sale of our investment in Cyberonics. Correspondingly,
investment income increased by $296,000 due to higher funds available for investment. Income tax expense.Income tax expense for the first quarter increased $31.5 million primarily due
to the significant increase in income before taxes and to a lesser extent an increase in our
effective tax rate. Our effective tax rate in the first quarter of 2005 was 36.5% compared to 35.1%
in 2004. The increase in the effective tax rate in 2005 is due to the $85.2 million pre-tax gain on
the Cyberonics investment, which had the impact of increasing federal and state taxable income
without a significant corresponding increase in other permanent
exclusions from taxable income. The
effective tax rates in the first quarter of 2005 and 2004 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, a research and development tax credit, and benefits related to the extra-territorial income
(ETI) exclusion. -19-




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Net income.Net income for the first quarter increased $54.6 million primarily due to the realized
gain on the Cyberonics investment and to a lesser extent the $871,000 increase in pre-tax income
(excluding the Cyberonics gain) from higher income from operations from higher revenue and an
increase in investment income. Net income per diluted share for the first quarter was $2.76 in 2005
compared to $.19 in 2004. Liquidity and Capital Resources At March 31, 2005, our working capital increased to $195.2 million from $168.4 million at year-end
2004. The ratio of current assets to current liabilities was 5.85:1 at March 31, 2005, compared to
18.78:1 at December 31, 2004. Cash, cash equivalents, and marketable securities totaled $180.7
million at March 31, 2005 compared to $124.0 million at December 31, 2004. In February 2005, we sold our investment in Cyberonics, Inc. We received proceeds of $135.3 million
from the sale of the 3,500,000 shares. We reported a pre-tax gain in the first quarter of $85.2
million, after acquisition related expenses. Correspondingly, our income taxes payable increased
substantially to $33.53 million at March 31, 2005 from $708,000 at December 31, 2004. In June 2005,
we will make an estimated tax payment of approximately $20 million from our cash reserves and
additional tax payments will occur as required during the remainder of 2005. We used $10.7 million of our cash reserves in the first quarter of 2005 to repurchase 381,894
shares of our common stock under a 1,000,000 share repurchase program. Subsequent to the end of the
quarter, we have acquired an additional 541,780 shares and used $14.9 million from our cash
reserves. Through April 30, 2005, we have purchased a total of 923,674 shares at a cost of $25.6
million. In April 2005, the Companys board of directors increased the repurchase authorization to
a total of 2,000,000 shares. We received $1.59 million of cash during the three months ended March 31, 2005, from the exercise
of stock options to purchase 111,209 shares of our common stock. We increased our investment in inventories from year-end 2004 by $830,000. This increase is
primarily related to the building of inventory for new products we expect to launch in the near
future and additional field inventory held by new sales representatives. Our investment in trade accounts receivable increased slightly from year-end 2004 by $276,000. Days
sales outstanding remained at 72 days. We spent $1.9 million for the three months ended March 31, 2005 for capital expenditures and
additions to intangible assets. During the first quarter we purchased additional office furniture
and equipment (including computer equipment) for new personnel and purchased additional tooling and
equipment for current products as well as new products being developed. -20-




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Liquidity may be enhanced to
the extent we realize tax benefits from stock option exercises. Exercises of nonqualified stock options, and exercises of incentive stock options
followed by disqualifying dispositions of the underlying common stock within one year following
exercise generate compensation expense for tax purposes in the year of exercise or disposition, as
the case may be. During the three months ended March 31, 2005, we generated a $649,000 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 to offset current year
taxes payable. In April 2004, we filed a patent infringement/trade secret lawsuit against Advanced Bionics. The
pre-tax costs associated with the lawsuit have been approximately $400,000 per quarter to date and
are likely to increase as we approach a trial date in January 2006. 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, capital expenditures
and share repurchases 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. 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. -21-




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Guidance On April 28, 2005, we reaffirmed our revenue guidance of $145 million for fiscal 2005, and provided
earnings guidance for 2005 in the range of $3.49 to $3.52 per diluted share. We believe our IPG
systems, both rechargeable and conventional, will generate most of our growth during 2005. Our
revenue guidance reflects a 22% growth in our neuromodulation product sales, a growth rate below
that realized in 2002 through 2004. Competition is growing. Because a new competitor has entered
the neurostimulation for chronic pain market, and because our competitors are larger and have
greater resources than we do, competitive pressure is increasing, which directly affects revenue
growth. Outlook and Uncertainties The following is a safe harbor statement under the Private Securities Litigation Reform Act of
1995: Certain 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, would,
scheduled, 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 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, but are not limited to, those discussed or identified from time to time in
our public filings, including the following:  
    failure to gain market acceptance of our new rechargeable IPGs, and to maintain continued market acceptance of our
conventional IPGs and radio-frequency powered spinal cord stimulation (SCS) systems would adversely affect our revenue
growth and profitability;
    competition from and the launch of new competitive products by Medtronic, Advanced Bionics/Boston Scientific or others,
as well as other market factors that could impede growth in or reduce sales of the Companys IPG and RF systems, which
could adversely affect revenues and profitability;
    patient or physician selection of less invasive or less expensive alternatives;
    adverse changes in coverage or reimbursement amounts by Medicare, Medicaid, private insurers, managed care
organizations or workers compensation programs could limit our ability to market and sell our products;
    intellectual property protection and potential infringement issues;
    the cost, uncertainty and other risks inherent in litigation generally, including without limitation, the intellectual
property and patent litigation against Advanced Bionics;
    successful patient enrollment in and timely implementation of the IDE clinical studies for migraine headache, essential
tremor and Parkinsons disease; physician and patient acceptance
of the Libra DBS system for the essential tremor and
Parkinsons -22-




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disease studies, for which already-approved products are already available on the market; the uncertainty of clinical results that
may ensue from these clinical studies; the risk that the FDA may not approve our PMA applications for these applications following
the completion of the clinical trials; and the satisfactory completion of feasibility,pilot and pivotal studies and/or market tests
prior to the introduction of new products generally;
    obtaining necessary government approvals for other new products or applications and maintaining compliance
with FDA product and manufacturing requirements;
    product liability;
    reliance on single suppliers for certain components;
    completion of research and development projects in an efficient and timely manner;
    successful integration of
acquired businesses, products and technologies;
    international trade risks Certain of the foregoing risks and other risks are described in more detail in our Annual Report on
Form 10-K for the year ended December 31, 2004. If our assumptions prove to be incorrect or such
risks or uncertainties materialize, anticipated results could differ materially from those
forecasted in forward-looking statements. 
 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK For the period ended March 31, 2005, 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, 2004. 
 ITEM 4. CONTROLS AND PROCEDURES The Company maintains controls and procedures designed to ensure that it is able to collect the
information it is required to disclose in the reports it files with the Securities and Exchange
Commission (SEC), and to process, summarize, and disclose this information within the time periods
specified in the rules of the SEC. As of the end of the period covered by this report, an
evaluation was carried out by our management, with the participation of our Chief Executive Officer
and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures (as
defined in Rule 13a-15(e) under the Securities Exchange Act of 1934). Based upon that evaluation,
our Chief Executive Officer and Chief Financial Officer concluded that these disclosure controls
and procedures were effective as of the end of the period covered by this report. There were no changes in the Companys internal control over financial reporting (as defined in
Rule 13a-15(f) under the Securities Exchange Act of 1934) that occurred during the Companys most
recent fiscal quarter that has materially affected, or is reasonably likely to materially affect,
the Companys internal control over financial reporting. -23-




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PART II OTHER INFORMATION 
 ITEM 1. LEGAL PROCEEDINGS On April 21, 2004, the Company filed a lawsuit in the U.S. District Court for the Eastern District
of Texas, Sherman Division (Docket No. 4:404-CV-00131-PNB-DDB) (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 Act, conversion and constructive trust. As initially filed, the lawsuit alleged,
among other things, that Advanced Bionics is infringing U.S. Patent No. 4,793,353 entitled
Non-Invasive Multiprogrammable Tissue Stimulator and Method. In addition, the lawsuit alleged
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 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. Advanced Bionics filed a California action in federal court seeking to resolve the
Companys patent claims, which was subsequently dismissed. Advanced Bionics has also made motions
to transfer the Texas Action to a California federal court, which the judge in the Texas Action has
dismissed. On January 28, 2005, the judge in the Texas Action granted Advanced Bionics motion to
compel alternative dispute resolution of our trade secrets misappropriation claims, although the
judge ruled that he retains jurisdiction over those claims. On March 11, 2005, Advanced Bionics
filed its First Amended Answer and Counterclaims in the Texas Action, asserting, among other
things, that the Company is infringing Advanced Bionics U.S. Patent Nos. 6,516,277 and 6,381,496.
Advanced Bionics claims that the Company is infringing these patents at least by marketing and
selling GenesisRCrechargeable IPG systems, and Advanced Bionics may assert that the Companys
newly-approved Eonsystem does as well. These patents relate to changing operational parameters
sets (6,381,496) and to a specific type of rechargeable spinal cord stimulation system (6,516,277).
The counterclaims seek temporary restraining orders, permanent injunctions, compensatory damages,
exemplary damages including treble damages, pre and post judgment interest, attorneys fees and
such other relief as the court may grant. The Company intends to vigorously defend itself against
these claims, which the Company believes are meritless because, among other things, the Company
believes the patents are not infringed or are invalid. -24-




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Beginning March 1, 2005, several law firms announced the filing of class action securities lawsuits
against the Company and certain of its officers and directors filed on behalf of purchasers of the
Companys securities between April 24, 2003 and February 16, 2005, inclusive (the Class Period).
The Company is aware that three such lawsuits have been filed in the United States District Court
for the Eastern District of Texas as follows: PLA, LLC vs. Advanced Neuromodulation Systems, Inc.,
et al, filed March 1, 2005; RAI Investment Club vs. Advanced Neuromodulation Systems, Inc., et al,
filed March 9, 2005; and Clifford a. Leavitt vs. Advanced Neuromodulation Systems, Inc., et al,
filed April 28, 2005. These suits allege the Company violated federal securities laws by the
issuance of false and misleading statements to the market regarding the Companys financial
performance throughout the Class Period, which statements allegedly had the effect of artificially
inflating the market price of the Companys securities. In particular, the claims allege improper
marketing and sales practices accounted for the Companys revenue growth, citing, among other
things, the public announcement that management made on February 17, 2005 that the Company had
received a subpoena from the Office of the Inspector General, Department of Health and Human
Services, requesting documents related to sales and marketing, reimbursement, Medicare and Medicaid
billing and other business practices. The plaintiffs are seeking unspecified compensatory damages
and costs and expenses of litigation. No class has been certified. Based on the various press
releases, the Company believes any other lawsuits, if filed, will contain similar allegations. The
Company intends to vigorously defend itself against the claims made in these lawsuits and believes
the lawsuits are without merit. We are also a party to product liability claims related to our neurostimulation devices and other
ordinary routine litigation claims arising in the ordinary course of business. Our product
liability insurers have assumed responsibility for defending us against product liability claims,
subject to reservation of rights in certain cases. Historically, product liability claims related
to our neurostimulation devices have not resulted in significant monetary liability beyond our
insurance coverage. We seek to maintain appropriate levels of product liability insurance with
coverage that we believe is comparable to that maintained by companies similar in size and serving
similar markets. Except as mentioned above and for other ordinary routine litigation incidental to our business, we
are not currently a party to any other pending legal proceeding. We maintain general liability
insurance against risks arising out of the normal course of business. -25-




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ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS Issuer Purchases of Equity SecuritiesTotal Number
    
    
    Maximumof Shares
    
    
    Number ofPurchased as
    
    
    Shares thatTotal
    
    
    
    
    
    
    Part of
    
    
    May Yet BeNumber of
    
    
    Average
    
    
    Publicly
    
    
    PurchasedShares
    
    
    Price Paid
    
    
    Announced
    
    
    Under thePeriod
    
    Purchased
    
    
    Per Share
    
    
    Plans
    
    
    PlansMarch 1 through
March 31, 2005
    
    
    381,894
    
    
    $
    27.96
    
    
    
    381,894
    
    
    
    1,618,106
 Subsequent to the end of the first quarter of 2005, we acquired an additional 541,780 shares
and used $14.9 million from our cash reserves. Through April 30, 2005, we have purchased a total
of 923,674 shares at a cost of $25.6 million. On June 1, 2004, we announced that our Board of Directors approved the repurchase of up to
1,000,000 shares of our common stock. Repurchases may 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. On April 28, 2005, we announced that the Board of Directors had expanded the
repurchase authorization to a total of 2,000,000 shares. 
 ITEM 6. EXHIBITS  (a)
    Exhibit 3.1  Articles of Incorporation, as amended and restated (1)Exhibit 3.2  Bylaws, as amended and restated (2)Exhibit 4.1  Rights Agreement dated as of August 30, 1996, between Quest Medical,
Inc. and KeyCorp Shareholder Services, Inc. as Rights Agent (3)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.) (4)Exhibit 10.27  Advanced Neuromodulation Systems, Inc. 2004 Stock Incentive Plan (5) -26-




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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 (6)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 (6)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
(7)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
(7)   (1)
    
    Filed as an Exhibit to the report of the Company on Form 10-K for the year ended December
31, 2004, and incorporated herein by reference.(2)
    
    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.(3)
    
    Filed as an Exhibit to the report of the Company on Form 8-K dated September 4, 1996, and
incorporated herein by reference.(4)
    
    Filed as an Exhibit to the report of the Company on Form 8-K dated January 30, 2002, and
incorporated herein by reference.(5)
    
    Filed as an Exhibit to the Definitive Proxy Statement on Schedule 14A dated April 15, 2005,
and incorporated herein by reference.(6)
    
    Filed herewith.(7)
    
    Furnished herewith. -27-




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Signatures Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused
this report to be signed on its behalf by the undersigned, thereunto duly authorized. ADVANCED NEUROMODULATION SYSTEMS, INC.Date: May 9, 2005
    By:
    /s/ F. Robert Merrill IIIF. Robert Merrill IIIExecutive Vice President, Finance

Chief Financial Officer and Treasurer -28-




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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 (2)Exhibit 4.1
    
    Rights Agreement dated as of August 30, 1996, between Quest Medical, Inc. and KeyCorp Shareholder Services,
Inc. as Rights Agent (3)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.) (4)Exhibit 10.27
    
    Advanced Neuromodulation Systems, Inc. 2004 Stock Incentive Plan (5)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 (6)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 (6)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 (7)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 (7)
   (1)
    
    Filed as an Exhibit to the report of the Company on Form 10-K for the year ended December
31, 2004, and incorporated herein by reference.(2)
    
    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.(3)
    
    Filed as an Exhibit to the report of the Company on Form 8-K dated September 4, 1996, and
incorporated herein by reference.(4)
    
    Filed as an Exhibit to the report of the Company on Form 8-K dated January 30, 2002, and
incorporated herein by reference.(5)
    
    Filed as an Exhibit to the Definitive Proxy Statement on Schedule 14A dated April 15, 2005,
and incorporated herein by reference.(6)
    
    Filed herewith.(7)
    
    Furnished herewith.