CYBERONICS INC - 10-Q Quarterly Report

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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

[X] Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934

For the quarterly period ended July 25, 2003 or

[ ] Transition report pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934

For the transition period from ______________ to _______________

Commission File Number 0-19806

CYBERONICS, INC.
(Exact name of registrant as specified in its charter)

Delaware 76-0236465
- ------------------------------- ----------------------
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification Number)

100 Cyberonics Boulevard
Houston, Texas 77058
- ---------------------------------------- ----------
(Address of principal executive offices) (Zip Code)

Registrant's telephone number, including area code: (281) 228-7200

Indicate by check mark 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 X No
--- ---
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date.

CLASS OUTSTANDING AT AUGUST 25, 2003
Common Stock - $0.01 par value 22,663,106

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CYBERONICS, INC.

INDEX

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PART I - FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

CYBERONICS, INC.

CONSOLIDATED BALANCE SHEETS

See accompanying Notes to Consolidated Financial Statements (Unaudited).

3

CYBERONICS, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS)
(UNAUDITED)

See accompanying Notes to Consolidated Financial Statements (Unaudited).

4

CYBERONICS, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)

See accompanying Notes to Consolidated Financial Statements (Unaudited).

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CYBERONICS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

JULY 25, 2003

NOTE 1 - BASIS OF PRESENTATION:

The accompanying unaudited consolidated financial statements of
Cyberonics, Inc. (the Company) have been prepared in accordance with accounting
principles generally accepted in the United States of America for interim
financial information, and with the instructions to Form 10-Q and Rule 10-01 of
Regulation S-X. Accordingly, they do not include all of the information and
footnotes required by accounting principles generally accepted in the United
States of America for complete financial statements. In the opinion of
management, all adjustments (consisting of normal recurring accruals) considered
necessary for a fair presentation have been included. Operating results for the
thirteen weeks ended July 25, 2003 are not necessarily indicative of the results
that may be expected for any other interim period or the full year ending April
30, 2004. The financial information presented herein should be read in
conjunction with the audited consolidated financial statements and notes thereto
included in our Annual Report on Form 10-K for the period ended April 25, 2003.

NOTE 2 - STOCK INCENTIVE AND PURCHASE PLAN

Stock Incentive and Purchase Plans. As of July 25, 2003, the Company
has reserved an aggregate of 14,100,000 shares of Common Stock, for issuance
pursuant to its Amended 1988 Incentive Stock Option Plan, 1996 Stock Option
Plan, 1997 Stock Option Plan, 1998 Stock Option Plan and New Employee Equity
Inducement Plan (collectively "the Stock Option Plans"). Options granted under
the Stock Option Plans generally vest ratably over four or five years following
their date of grant. The vesting of certain options occurs up to 10 years from
the grant date. Options granted under the Stock Option Plans have maximum terms
of 10 years. The Amended 1988 Incentive Stock Option Plan and the 1997 Stock
Option Plan allow issuance of either nonstatutory or incentive stock options,
while the 1996 and the 1998 Stock Option Plans provide for issuance of
nonstatutory stock options exclusively. For the thirteen weeks ended July 25,
2003, the Company has granted approximately 886,000 options at a weighted
average exercise price of approximately $20.12 per share. All grants were made
at market prices as of the date of the grant. Stock options to purchase
approximately 7.7 million shares at a weighted average exercise price of $14.63
per share were outstanding as of July 25, 2003.

The following table illustrates the effect on net income and earnings
per share if the company had applied the fair value recognition provision of
Statement of Financial Accounting Standards Board (SFAS) No. 123, "Accounting
for Stock-Based Compensation" and SFAS No. 148, "Accounting for Stock-Based
Compensation -- Transition and Disclosure," to stock-based employee
compensation.

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NOTE 3 - INVENTORIES:

Inventories consist of the following:

NOTE 4 - LINE OF CREDIT:

In September 2001, the Company established a revolving credit facility
for $10,000,000, which is collateralized by accounts receivable, inventory,
equipment, documents of title, general intangibles, subsidiary stock and other
collateral. Effective April 1, 2003, this limit was increased to $25,000,000.
Borrowings against the facility are based upon eligible Accounts Receivable. As
of July 25, 2003, the eligible balance of accounts receivable was $10,894,000.
Interest is payable at the designated bank rate of 4.0% at July 25, 2003, plus
1.5%, totaling 5.5% on the greater of $3,000,000 or the average of the net
balances owed by the Company at the close of each day during the month. Under
the amended terms of the revolving credit facility, the Company agreed to
maintain liquidity (being the aggregate of the availability under the credit
facility and Company cash) equal to or greater than $10,000,000. An unused line
of credit fee is payable at the rate of 0.5%. The term of the credit facility is
three years, expiring on September 26, 2004. At July 25, 2003, the Company had
$10,600,000 in borrowings outstanding under the credit facility and an available
borrowing capacity of approximately $294,000.

NOTE 5 - ACCRUED LIABILITIES:

Accrued liabilities are as follows:

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NOTE 6 - WARRANTIES:

Product Warranty. The Company offers warranties on its leads and
generators for two years from the date of implant. The Company provides at the
time of shipment for costs estimated to be incurred under its product
warranties. Provisions for warranty expense are made based upon projected
product warranties.

Changes in the Company's liability for product warranties during the
thirteen weeks ended July 25, 2003 and July 26, 2002 are as follows:

NOTE 7 - STOCKHOLDERS' EQUITY:

Deferred Compensation. In June 2000, the Board of Directors granted
450,000 options at $18.00 per share to purchase shares of Common Stock under a
proposed modification to the 1997 Stock Option Plan that was subject to
shareholder approval. On December 29, 2000, the shareholders approved the
modification to the plan, and the Company recorded approximately $2.4 million in
deferred compensation relating to these options. The charge reflects the
difference between the exercise price and the fair market value of the stock on
the date shareholder approval was received. The deferred compensation is being
amortized to expense over the five-year vesting period of the options.
Approximately $118,000 of compensation expense has been recognized for the
vested portion of this option grant during the thirteen weeks ended July 25,
2003 and July 26, 2002.

In June 2003, the Board of Directors granted 13,844 shares of
restricted stock at $18.94 per share to certain officers of the Company that
vest in one year and recorded approximately $262,000 in deferred compensation.
Approximately $40,000 of compensation expense has been recognized during the
thirteen weeks ended July 25, 2003.

NOTE 8 - EARNINGS PER SHARE:

SFAS No. 128, "Earnings Per Share," requires dual presentation of
earnings per share (EPS): basic EPS and diluted EPS. Basic EPS excludes dilution
and is computed by dividing net income or loss applicable to common shareholders
by the weighted average number of common shares outstanding for the period.
Diluted EPS reflects the potential dilution that could occur if options were
exercised or converted into common stock and would then share in net income of
the Company.

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The following table sets forth the computation and basic and diluted
net earnings (loss) per share of common stock:

Excluded from the computation of diluted earnings per share for the
thirteen weeks ended July 25, 2003 were outstanding options to purchase 365,250
common shares because to do so would have been anti-dilutive, due to their
exercise price exceeding their fair market value. None of the approximately 7.45
million options to purchase common shares outstanding at July 26, 2002 were
included in the computation of diluted loss per share for the thirteen weeks
ended July 26, 2002 because to do so would have been anti-dilutive.

NOTE 9 - NEW ACCOUNTING PRONOUNCEMENTS:

In December 2002, the FASB issued SFAS No. 148, "Accounting for
Stock-Based Compensation -- Transition and Disclosure." SFAS No. 148 amends FASB
Statement No. 123, "Accounting for Stock-Based Compensation," to provide
alternative methods of transition to SFAS No. 123's fair value method of
accounting for stock-based employee compensation. SFAS No. 148 also amends the
disclosure provisions of SFAS No. 123 and APB Opinion No. 28, "Interim Financial
Reporting," to require disclosure in the summary of significant accounting
policies of the effects of an entity's accounting policy with respect to
stock-based employee compensation on reported net income and earnings per share
in annual and interim financial statements. While SFAS No. 148 does not amend
SFAS No. 123 to require companies to account for employee stock options using
the fair value method, the disclosure provisions of SFAS No. 148 are applicable
to all companies with stock-based employee compensation, regardless of whether
they account for that compensation using the fair value method of SFAS No. 123
or the intrinsic value method of APB Opinion No. 25. As allowed by SFAS No. 123,
the Company has elected to continue to utilize the accounting method prescribed
by APB Opinion No. 25 and has adopted the disclosure requirements of SFAS No.
123.

In January 2003, the FASB issued FIN No. 46, "Consolidation of Variable
Interest Entities." This Interpretation of Accounting Research Bulletin No. 51,
"Consolidated Financial Statements," addresses consolidation by business
enterprises of variable interest entities. This Interpretation applies
immediately to variable interest entities created after January 31, 2003 and to
variable interest entities in which an enterprise obtains an interest after that
date. It applies in the first fiscal year or interim period beginning after June
15, 2003, to variable interest entities in which an enterprise holds a variable
interest that it acquired before February 1, 2003. The interpretation applies to
public enterprises as of the beginning of the applicable interim or annual
period and it applies to nonpublic enterprises as of the end of the applicable
annual period. The adoption of FIN No. 46 will not have a material impact on the
Company's consolidated operating results or financial condition.

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In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain
Financial Instruments With Characteristics of Both Liabilities and Equity." This
statement establishes standards for how an issuer classifies and measures
certain financial instruments with characteristics of both liabilities and
equity. This statement is effective for the first fiscal period beginning after
December 15, 2003. The Company believes that the adoption of SFAS No. 150 will
not have a material impact on the Company's consolidated operating results or
financial condition.

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS

This Quarterly Report on Form 10-Q contains 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. These statements can be identified by
the use of forward-looking terminology, including "may," "believe," "will,"
"expect," "anticipate," "estimate," "plan," "intend," and "forecast," or other
similar words. Actual results could differ materially from those projected in
the forward-looking statements as a result of a number of important factors. For
a discussion of important factors that could affect our results, please refer to
the financial statement line item discussions set forth in Management's
Discussion and Analysis of Financial Condition and Results of Operations and to
the section entitled "Factors Affecting Future Operating Results". Readers are
also encouraged to refer to our Annual Report on Form 10-K for the period ended
April 25, 2003 for a further discussion of our business and its risks and
opportunities.

SUMMARY

We were founded in 1987 to design, develop and bring to market medical
devices which provide a unique therapy, vagus nerve stimulation (VNS), for the
treatment of epilepsy and other debilitating neurological, psychiatric diseases
and other disorders. Clinical trials of the VNS Therapy System began with the
first patient implant in November 1988 under an Investigational Device Exemption
(IDE) from the U.S. Food and Drug Administration (FDA). We received FDA approval
to market the VNS Therapy System in the U.S. in July 1997 for use as an
adjunctive therapy in reducing the frequency of seizures in adults and
adolescents over 12 years of age with partial onset seizures that are refractory
or resistant to antiepileptic drugs. We were granted regulatory approval in 1994
to market and sell the VNS Therapy System in the member countries of the
European Union and we also have permission to sell in certain other
international markets with the broader indication of refractory epilepsy and
without discrimination to patient age.

In March 2001, the VNS Therapy System was approved by N.V. KEMA, an
official notified body representing the European Union countries, for the
treatment of chronic or recurrent depression in patients that are in a
treatment-resistant or treatment-intolerant major depressive episode. This CE
Mark approval, by definition includes the treatment of depression in patients
with major depressive disorder, or so-called unipolar depression, as well as
patients with bipolar disorder, or manic depression. In April 2001, the VNS
Therapy System was approved by Health Canada for the treatment of chronic or
recurrent depression in patients that are in a treatment-resistant or
treatment-intolerant major depressive episode. The Canadian approval is similar
to CE Mark European approval in that patients with unipolar depression and
bipolar depression are included. Although VNS Therapy using the VNS Therapy
System has been approved in European Union countries and Canada for the
treatment of chronic or recurrent depression, we do not anticipate significant
sales volumes in these countries until reimbursement approvals have been
received in each country and we have received regulatory approval in the U.S.

In January 2003, we announced that the one-year data from the D-02
depression pivotal study, analyzed pursuant to the D-02 analysis plan submitted
to FDA in September 2002, showed highly statistically significant and clinically
significant improvements compared to baseline. The determination of statistical
significance was the primary endpoint of the D-02 analysis plan. Statistical
significance was determined using a repeated measures linear regression analysis
to analyze improvements from pre-treatment baseline throughout the first 12
months of treatment. Statistical significance was defined as a p-value < or = to
0.05. The HRSD-24 improvements

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observed over the first year were highly significant with a p-value < 0.001. The
secondary measures of statistical significance showed similarly positive
results.

The determination of clinical significance was a key secondary endpoint
of the D-02 analysis plan. Clinical significance was determined by analyzing the
percent of patients who showed a sustained response between nine and 12 months
of treatment with VNS Therapy. In the absence of published literature that
defines a long-term success criterion, Cyberonics' psychiatric clinical advisors
suggested that a sustained response rate of approximately 30% would be
significant. Approximately 30% of the patients from the original acute treatment
group and 25% of all patients in the analysis showed a sustained response
between months nine and 12.

In July 2003, we announced that the preliminary one-year results from
the comparison of the D-02 VNS pivotal study and D-04 companion study of chronic
and recurrent treatment resistant depression, analyzed pursuant to the D-02
analysis plan submitted to the FDA in September 2002, showed a highly
statistically significant difference (p-value < 0.001) favoring the D-02
patients (treatment as usual plus VNS Therapy) over the D-04 patients (treatment
as usual without VNS Therapy). The primary efficacy analysis was a repeated
measures linear regression analysis to compare depression improvements as
measured by the Inventory of Depressive Symptomatology-Self Report (IDS-SR) over
one year in 205 D-02 patients receiving VNS Therapy and treatment as usual with
the IDS-SR outcomes of 124 patients in a companion study, D-04, receiving only
treatment as usual. In D-04, patients with chronic or recurrent treatment
resistant depression who met the critical D-02 inclusion criteria were treated
with standard medical management at 13 total study sites, including 12 of the 21
D-02 study sites. Statistically and clinically significant differences in the
physician and patient reported D-02 and D-04 patients' one-year response and
remission rates were also observed. One-year response rates, defined as at least
a 50% improvement in depression symptoms as measured by the IDS-SR and HRSD-24
(24 item clinician-rated Hamilton Rating Scale for Depression) were 21% and 30%,
respectively, in D-02 and 12% and 13%, respectively, in D-04. One-year remission
rates, defined as the percentage of patients with an IDS-SR score of 14 or less
or HRSD-24 score of 9 or less after one year of treatment, were 16% and 17%,
respectively, in D-02 and 5% and 7%, respectively, in D-04.

From inception through July 1997, our primary focus was on obtaining
FDA approval for the VNS Therapy System for the treatment of epilepsy. Since
inception, we have incurred substantial expenses, primarily for research and
development activities, which include product and process development and
clinical trials and related regulatory activities, sales and marketing
activities, manufacturing start-up costs and system infrastructure. We have also
made significant investments in recent periods in connection with clinical
research costs associated with new indications development, most notably
depression. The clinical studies for depression are for investigational
therapies that are not expected to generate significant sales prior to FDA
approval, which is not anticipated before October 2004, if at all. Furthermore,
the timing and nature of these expenditures are contingent upon several factors
outside of our control and may exceed the current expectations of securities
analysts and investors.

CRITICAL ACCOUNTING POLICIES

The Company considers the following accounting policies as the most
critical because, in management's view, they are most important to the portrayal
of the Company's consolidated financial condition and results and most demanding
in terms of requirements and other exercises of judgment.

Accounts Receivable. The Company provides an allowance for doubtful
accounts based upon specific customer risks and a general provision based upon
historical trends. An increase in losses beyond that expected by management or
that historically experienced by the Company would reduce earnings when they
become known.

Inventories. Cyberonics states its inventories at the lower of cost,
first-in, first-out (FIFO) method, or market. Cost includes the acquisition cost
of raw materials and components, direct labor and overhead. Management considers
potential obsolescence at each balance sheet date. An acceleration of
obsolescence could occur if consumer demand should differ from expectations.

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Property and Equipment. Property and equipment are carried at cost,
less accumulated depreciation. Maintenance, repairs and minor replacements are
charged to expense as incurred; significant renewals and betterments are
capitalized. For financial reporting purposes, the Company computes depreciation
using the straight-line method over useful lives ranging from two to nine years.
An unanticipated change in the utilization or expected useful life of property
and equipment could result in an acceleration in the timing of the expenses.

Fair Value of Financial Instruments. The carrying amounts reported in
the consolidated balance sheets for cash equivalents, accounts receivable,
accounts payable, and line of credit approximate their fair values due to the
short-term maturity of these financial instruments.

Revenue Recognition. Revenue from product sales is generally recognized
upon shipment to the customer, net of estimated returns and allowances. The
Company's revenues are dependent upon sales to new and existing customers
pursuant to the Company's policy. A change in this policy or sales terms could
impact the amount and timing of revenue recognized.

Research and Development. All research and development costs are
expensed as incurred. The Company has entered into contractual obligations for
the conduct of clinical studies. Costs are incurred primarily at the time of
enrollment and paid under the terms of the contracts. Research and development
expenses could vary significantly with changes in the timing of clinical
activity.

Warranty Expense. The Company provides at the time of shipment for
costs estimated to be incurred under its product warranties. Provisions for
warranty expenses are made based upon projected product warranties. Amounts
actually paid could vary subject to certain factors discussed in "Factors
Affecting Future Operating Results" discussed below.

Stock Options. The Company has adopted the disclosure-only provisions
of SFAS No. 123, "Accounting for Stock-Based Compensation" and SFAS No. 148,
"Accounting for Stock-Based Compensation -- Transition and Disclosure" which
disclosures are presented in Note 2. Because of this election, the Company
continues to account for its employee stock-based compensation plans under
Accounting Principles Board (APB) Opinion No. 25 and the related
interpretations. No stock-based compensation cost is reflected in net income for
employee stock-based compensation for grants having an exercise price equal to
the market value of the underlying common stock on the date of grant.

Income Taxes. Cyberonics accounts for income taxes under the asset and
liability method. Under this method, deferred income taxes reflect the impact of
temporary differences between financial accounting and tax bases of assets and
liabilities. Such differences relate primarily to the Company's election to
defer the deduction of certain start-up costs for federal income tax purposes,
the deductibility of certain accruals and reserves and the effect of tax loss
and tax credit carryforwards not yet utilized. Deferred tax assets are evaluated
for realization based on a more-likely-than-not criteria in determining if a
valuation allowance should be provided.

RESULTS OF OPERATIONS

Net Sales. Net sales for the thirteen weeks ended July 25, 2003 were
$26,682,000, increasing by $3,627,000 or 15.7% over the $23,056,000 for the same
period last year. First quarter net sales included $24,988,000 from the U.S.
market and $1,694,000 from international markets. U.S. net sales for the first
quarter increased by $3,595,000, or 16.8% over the $21,393,000 for the same
period last year. International net sales increased by $31,000 or 1.9% over the
$1,663,000 for the same period last year. The increase in net sales in the U.S.
for the thirteen weeks ended July 25, 2003 is primarily due to increases in
average selling prices resulting primarily from changes in product mix and
higher volume driven by patient demand. The increase in international net sales
for the thirteen weeks ended July 25, 2003 is due to a higher average selling
price and a stronger Euro as compared to the U.S. Dollar. We anticipate annual
worldwide sales growth of approximately 23% for the remainder of fiscal 2004.

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Gross Profit. Gross profit for the thirteen weeks ended July 25, 2003
was $22,688,000 or 85% of net sales compared to $19,106,000 or 82.9% for the
same period last year. The improvement in gross profit margin for the thirteen
weeks ended July 25, 2003 was due to higher average selling prices, product mix
and improvements in manufacturing efficiencies. We anticipate gross profit
margin will remain at least 85% for fiscal 2004, assuming we achieve our selling
and production objectives.

Selling, General and Administrative Expenses. Selling, general and
administrative expenses for the thirteen weeks ended July 25, 2003 totaled
$16,284,000 or 61% of net sales compared to $18,356,000 or 79.6% of net sales
for the same period last year. The decrease in selling, general and
administrative expenses for the thirteen weeks ended July 25, 2003 is primarily
due to lower expenses in selling and marketing programs.

Research and Development Expenses. Research and development expenses
are comprised of both expenses related to our product and process development
efforts and expenses associated with conducting clinical trials and certain
regulatory activities. Research and development expenses for the thirteen weeks
ended July 25, 2003 totaled $3,776,000 or 14.2% of net sales, compared to
$4,796,000 or 20.8% of net sales for the same period last year. The decrease in
research and development expenses is primarily due to reduced costs of clinical
programs activities to determine the effectiveness of VNS Therapy in new
indications, including chronic depression, anxiety, Alzheimer's Disease (AD) and
other indications covered by our proprietary patent portfolio.

Interest Income. Interest income for the thirteen weeks ended July 25,
2003 was $90,000 compared to $130,000 for the same period last year. The
decrease in interest income for the thirteen weeks ended July 25, 2003 is due to
lower interest rates.

Interest Expense. Interest expense for the thirteen weeks ended July
25, 2003 was $143,000 compared to $98,000 for the same period last year. The
increase in interest expense for the thirteen weeks ended July 25, 2003 is due
to higher borrowings under the Line of Credit Facility and fees paid on the
expanded line of credit, partially offset by lower interest rates.

Other Income, Net. Other income, net for the thirteen weeks ended July
25, 2003 was $113,000 compared to $339,000 for the same period last year. Other
income, net for the thirteen weeks ended July 25, 2003 is primarily due to
transaction gains associated with foreign currency exchange.

Income Taxes. We estimate that our effective tax rate for the thirteen
weeks ended July 25, 2003 to be approximately 4.0%, due primarily to the effects
of net operating loss carry-forwards, federal alternative minimum tax and state
income taxes. The effective tax rate represents the Company's estimate of the
rate expected to be applicable for the full fiscal year. Due to our operating
loss history to date, we have established a valuation allowance that fully
offsets our net deferred tax assets, including those related to tax loss
carry-forwards, resulting in no regular federal income tax expense or benefit
for financial reporting purposes. Current federal income tax regulations with
respect to change in ownership could limit the utilization of the operating loss
carry-forward.

LIQUIDITY AND CAPITAL RESOURCES

Since our inception, we have financed our operations primarily through
public and private placements of our securities. In September 2001, we
established a revolving credit facility for $10,000,000 with a term of three
years. This credit facility was expanded to $25,000,000 in April 2003. The
credit facility is collateralized by accounts receivable, inventory, equipment,
documents of title, general intangibles, subsidiary stock and other collateral.
Borrowings against the facility are based upon eligible accounts receivable. As
of July 25, 2003, the eligible balance of accounts receivable was $10,894,000.
Interest is payable in the amount of the designated bank rate of 4.0% plus of
1.5% for a total of 5.5% on the greater of $3,000,000 or the average of the net
balance owed by the Company at the close of each day during the period. Under
the terms of the revolving credit facility,

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we agreed to maintain liquidity (being the aggregate of availability under the
credit facility and cash) equal to or greater than $10,000,000. An unused line
of credit fee is payable at the rate of 0.5%. As of July 25, 2003, we had
$10,600,000 in borrowings outstanding under the credit facility and an available
borrowing capacity of approximately $294,000.

During the thirteen weeks ended July 25, 2003, net cash used in
operating activities was approximately $1,604,000 compared to $7,229,000 for the
same period last year. The improvement of $5,625,000 is primarily driven by
improved earnings performance during the thirteen weeks ended July 25, 2003, as
net earnings increased by $6,237,000, to approximately $2,562,000 earnings from
a net loss of $3,675,000 for the period last year. Cash flow from financing
activities included $2,230,000 in proceeds from the line of credit and
approximately $1,469,000 in proceeds in connection with shares issued pursuant
to our stock option and employee stock purchase plan.

The chart below reflects our current obligations at July 25, 2003:

Capital leases are for manufacturing equipment used in the production
of the VNS Therapy System. The capital leases bear interest at 6.56% and extend
through April 2005. Operating leases are primarily obligations applicable to the
lease of facilities and office equipment. We are a party to a number of
contracts pursuant to which we are paying for clinical studies for which current
operating obligations payable totaled $2.8 million as of July 25, 2003. We
expect a positive cash flow for the fiscal year 2004. Our cash flow could,
however, be adversely effected by the "Factors Affecting Future Operating
Results" discussed below.

IMPACT OF NEW ACCOUNTING PRONOUNCEMENTS

See Note 9 of Notes to Consolidated Financial Statements for a
discussion of the impact of new accounting pronouncements.

FACTORS AFFECTING FUTURE OPERATING RESULTS

In addition to the factors described above in this section, the
following additional factors could affect our future results and, as a result,
our common stock price.

Our common stock price constantly changes. A public market for our
common stock has existed since 1993. Our common stock is traded on the Nasdaq
National Market under the ticker symbol "CYBX." The price of stock on that
trading market fluctuates, and we expect that the market price of common stock
will continue to fluctuate. For instance, during the period from July 27, 2002
to July 25, 2003 our stock has traded from a high of $28.35 to a low of $12.20
per share. The fluctuation in our stock price is caused by a number of factors,
some of which are beyond our control, including:

o quarterly variations in our sales and operating results;

o results of studies regarding the efficacy of our VNS Therapy treatment for
other indications including depression, AD, anxiety and other disorders;

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o announcements of significant contracts, acquisitions, or capital
commitments;

o changes in financial estimates by securities analysts;

o changes in market valuations of medical device companies;

o additions or departures of key personnel;

o sales of common stock by the Company, its officers and members of its
Board of Directors; and

o changes in the general conditions of the economy.

In addition, the stock market in recent years has experienced broad
price and volume fluctuations that have often been unrelated to the operating
performance of companies. These broad market fluctuations have also adversely
affected, and may continue to adversely affect, the market price of our common
stock.

Our quarterly operating results may fluctuate in the future, which may
cause our stock price to decline. Our consolidated results of operations may
fluctuate significantly from quarter to quarter and may be below the
expectations of security analysts. If so, the market price of our shares may
decline. Our quarterly revenues, expenses and operating results may vary
significantly from quarter to quarter for several reasons including the extent
to which the VNS Therapy System gains market acceptance, the timing of obtaining
marketing approvals for the VNS Therapy System for other indications, the timing
of any approvals for reimbursement by third-party payers, the rate and size of
expenditures incurred as we expand our clinical, manufacturing, sales and
marketing efforts, our ability to retain qualified sales personnel and the
availability of key components, materials and contract services, which may
depend on our ability to forecast sales.

We rely on only one product for our revenues and if sales of this
product are not achieved, our operating results will be severely harmed. We have
only one product, the VNS Therapy System, which has been approved by FDA for a
single indication: as an adjunctive therapy in reducing the frequency of
seizures in adults and adolescents over 12 years of age with partial onset
seizures that are refractory to antiepileptic drugs. We do not expect to have
any other product or approved indication for the VNS Therapy System in the U.S.
before calendar 2005, if at all. Although sales of the VNS Therapy System have
been increasing, we cannot assure you that sales will continue to increase at
the same rate or at all. We do not yet have the regulatory or reimbursement
approvals necessary to commercialize the VNS Therapy System for the treatment of
depression. We cannot assure you that any approvals for the treatment of
depression with the VNS Therapy System will be granted, nor can we assure you
that even if the approval is granted, we will be successful in commercializing
the VNS Therapy System for the treatment of depression. The same uncertainty
surrounds our efforts in anxiety disorders, AD applications and obesity. Our
inability to commercialize successfully the VNS Therapy System for depression,
obesity and other indications will severely harm our future growth.

We may not be successful in our efforts to develop VNS Therapy for the
treatment of depression, AD, anxiety, or any other indications. We are in the
process of conducting studies to help us evaluate, and potentially obtain FDA
approval, for the use of VNS Therapy as a treatment for depression, AD, anxiety
and other neurological disorders. We cannot assure you that our test results
will be positive or that we will receive FDA approval for the use of our product
for the treatment of any other indication. Even if we receive FDA approval for
another indication, we can provide no assurances with respect to market
acceptance. If our test results are not as we anticipate, if we receive no
additional FDA approvals or if alternative indications do not prove to be
commercially viable, our revenues may not experience the growth that we would
anticipate with the successful development of any of these indications.

We may not be able to continue to expand market acceptance of the use
of the VNS Therapy System to treat epilepsy, which could cause our sales to
decrease. Continued market acceptance of the VNS Therapy System will depend on
our ability to convince the medical community of the clinical efficacy and
safety of vagus nerve stimulation and the VNS Therapy System. While the VNS
Therapy System has been used in approximately

15

22,600 patients through July 25, 2003, many physicians are still unfamiliar with
this form of therapy. We believe that existing antiepileptic drugs and surgery
are the only other approved and currently available therapies competitive with
the VNS Therapy System in the treatment of epileptic seizures. These therapies
may be more attractive to patients or their physicians than the VNS Therapy
System in terms of efficacy, cost or reimbursement availability. We cannot
assure you that the VNS Therapy System will continue to achieve expanded market
acceptance for the treatment of epilepsy or for any other indication. Failure of
the VNS Therapy System to gain additional market acceptance would severely harm
our business, financial condition and results of operations.

We may not be successful in our marketing and sales efforts, which
could severely harm our business. The realignment and reorganization of the U.S.
sales force implemented in May 2003 resulted in hiring several new sales
representatives and regional managers, who will require training and time on the
job to become effective. This reorganization also created changes in geography,
physician audience or job roles for a substantial portion of the tenured sales
force. While we believe these changes should ultimately improve productivity and
performance going forward, we cannot assure you that those outcomes will be
achieved. The disruption caused by territory realignment and expansion could
take longer than expected to yield improvements in productivity and efficiency.
The time necessary for personnel to establish new territories and relationships
of trust with new physicians may take longer than projected, which could
substantially delay improvements in U.S. sales performance or jeopardize
attainment of quarterly revenue goals. Our inability to achieve annual revenue
growth or achieve our quarterly revenue targets could substantially harm our
consolidated results of operations and financial condition.

Patient confidentiality and regulations such as the Health Insurance
Portability and Accountability Act (HIPAA) of 1996 may limit our ability to
secure third-party payment for our patients and impact our patient pull-through
selling model. HIPAA regulations are required to be fully implemented for all
health care providers by April 14, 2003. Under the HIPAA privacy rule, the
privacy of all medical records, billing records, and other identified health
information ("Protected Health Information" or "PHI") must be protected. Such
regulations may hinder our ability to utilize our Patient Identification and
Qualification (PIQ) process as well as our VNS Patient Outcomes Registry
(Registry), both of which are key elements of our patient pull-through sales
model. The discontinuation of our PIQ and Registry processes could severely
limit our ability to market and sell VNS Therapy under our existing sales model
and could harm our business growth and financial condition.

We may be unable to maintain adequate third-party reimbursement on our
product. Our ability to commercialize the VNS Therapy System successfully
depends in part on whether third-party payers, including private health care
insurers, managed care plans, the U.S. government's Medicare and Medicaid
programs and others, agree both to cover the VNS Therapy System and associated
procedures and services and to reimburse at adequate levels for the costs of the
VNS Therapy System and the related services we have in the U.S. or
internationally. If we fail to maintain favorable coverage decisions for the VNS
Therapy System in a timely manner, patients and their physicians could be
deterred from using the VNS Therapy System which could reduce our sales and
severely harm our business.

Our current and future expense estimates are based, in large part, on
estimates of future sales, which are difficult to predict. We may be unable to,
or may elect not to, adjust spending quickly enough to offset any unexpected
sales shortfall. If increased expenses are not accompanied by increased sales,
our consolidated results of operations and financial condition for any
particular quarter could be harmed.

If our suppliers and manufacturers are unable to meet our demand for
key components, materials and contract services, we may be forced to qualify new
vendors or change our product design which would impair our ability to deliver
products to our customers on a timely basis. We rely upon sole source suppliers
for certain of the key components, materials and contract services used in
manufacturing the VNS Therapy System. We periodically experience discontinuation
or unavailability of key components, materials and contract services which may
require us to qualify alternative sources or, if no such alternative sources are
identified, change our product design. We believe that pursuing and qualifying
alternative sources and/or redesigning specific components of the VNS Therapy
System if or, when necessary, could consume significant resources. In addition,

16

such changes generally require regulatory submissions and approvals. Any
extended delays in or an inability to secure alternative sources for these or
other key components, materials and contract services could result in product
supply and manufacturing interruptions, which could significantly harm our
business.

Our products may be found to have defects and result in product
recalls. The VNS Therapy System includes a complex electronic generator device
and lead device designed to be implanted in the human body. Component failures,
manufacturing or shipping problems or design defects could result in the product
not delivering the therapy for which it is indicated. The occurrence of such
problems or other adverse clinical reactions could result in a recall of our
products, possibly requiring explantation and potential reimplantation of the
VNS Therapy System which may increase risk to the patient. Any product recall
could severely harm our business and consolidated financial condition and
results of operations.

We may not be able to protect our technology from unauthorized use,
which could diminish the value of our products and impair our ability to
compete. Our success depends upon our ability to obtain and maintain patent and
other intellectual property protection for the VNS Therapy System and its
improvements, and for vagus nerve stimulation therapy. To that end, we have
acquired licenses under certain patents and have patented and intend to continue
to seek patents on our own inventions used in our products and treatment
methods. The process of seeking patent protection can be expensive and time
consuming and we cannot assure you that patents will issue from our currently
pending or future applications or that, if patents are issued, they will be of
sufficient scope or strength to provide meaningful protection of our technology,
or any commercial advantage to us. Further, the protection offered by the
licensed international patents is not as strong as that offered by the licensed
U.S. patents due to differences in patent laws. In particular, the European
Patent Convention prohibits patents covering methods for treatment of the human
body by surgery or therapy.

We may engage in litigation to protect our proprietary rights, or
defend against infringement claims by third parties, causing us to suffer
significant expenses or prevent us from selling our products. There has been
substantial litigation regarding patent and other intellectual property rights
in the medical device industry. Litigation, which could result in substantial
cost to and diversion of effort by us, may be necessary to enforce patents
issued or licensed to us, to protect trade secrets or know-how owned by us or to
defend ourselves against claimed infringement of the rights of others and to
determine the scope and validity of the proprietary rights of others. Adverse
determinations in litigation could subject us to significant liabilities to
third parties, could require us to seek licenses from third parties and could
prevent us from manufacturing, selling or using the VNS Therapy System, any of
which could severely harm our business.

Intense competition and rapid technological changes could reduce our
ability to market our products and achieve sales. We believe that existing and
future antiepileptic drugs will continue to be the primary competition for the
VNS Therapy System. We may also face competition from other medical device
companies that have the technology, experience and capital resources to develop
alternative devices for the treatment of epilepsy. Medtronic, Inc., for example,
continues to clinically assess an implantable signal generator used with an
invasive deep brain probe, or thalamic stimulator, for the treatment of
neurological disorders and has received FDA approval for the device for the
treatment of essential tremor, including that associated with Parkinson's
Disease. Many of our competitors have substantially greater financial,
manufacturing, marketing and technical resources than we do and have obtained
third-party reimbursement approvals for their therapies. In addition, the health
care industry is characterized by extensive research efforts and rapid
technological progress. Our competitors may develop technologies and obtain
regulatory approval for products that are more effective in treating epilepsy
than our current or future products. In addition, advancements in surgical
techniques may make surgery a more attractive therapy for epilepsy. The
development by others of new treatment methods with novel antiepileptic drugs,
medical devices or surgical techniques for epilepsy could render the VNS Therapy
System non-competitive or obsolete. We may not be able to compete successfully
against current and future competitors, including new products and technology,
which could severely harm our business and consolidated financial condition or
results of operations.

We are subject to claims of product liability and we may not have the
resources or insurance to cover the cost for losses under these claims. As an
implantable medical device, the manufacture and sale of the VNS

17

Therapy System entails the risk of product liability claims which we have
received from time to time in the ordinary course of our business. Our product
liability coverage may not be adequate to cover any of these claims. Product
liability insurance is expensive and in the future may only be available at
significantly higher premiums or not be available on acceptable terms, if at
all. A successful claim brought against us in excess of our insurance coverage
could significantly harm our business and financial condition.

If we do not continue to comply with changing government regulations,
we could lose our ability to market and sell our product. The preclinical and
clinical testing, manufacturing, labeling, sale, distribution and promotion of
the VNS Therapy System are subject to extensive and rigorous regulation in the
U.S. by federal agencies, primarily FDA, and by comparable state agencies. In
the future, it will be necessary for us to obtain additional government
approvals for other applications of the VNS Therapy System and for modified or
future-generation products. Commercial distribution in certain foreign countries
is also subject to obtaining regulatory approvals from the appropriate
authorities in such countries. The process of obtaining FDA and other required
regulatory approvals is lengthy, expensive and uncertain. Moreover, regulatory
approvals may include regulatory restrictions on the indicated uses for which a
product may be marketed. Failure to comply with applicable regulatory
requirements can result in, among other things, fines, suspension or withdrawal
of approvals, confiscations or recalls of products, operating restrictions and
criminal prosecution. Furthermore, changes in existing regulations or adoption
of new regulations could prevent us from obtaining, or affect the timing of,
future regulatory approvals. We may not be able to obtain additional future
regulatory approvals on a timely basis or at all. Delays in receipt of or
failure to receive such future approvals, suspension or withdrawal of previously
received approvals, or recalls of the VNS Therapy System could severely harm our
ability to market and sell our current and future products and improvements.

Our international operations are subject to risks not generally
associated with commercialization efforts in the U.S. We may not be successful
in increasing our international market sales or in obtaining reimbursement or
any regulatory approvals required in foreign countries. The anticipated
international nature of our business is also expected to subject us and our
representatives, agents and distributors to laws and regulations of the foreign
jurisdictions in which we operate or where the VNS Therapy System is sold. The
regulation of medical devices in a number of such jurisdictions, particularly in
the European Union, continues to develop and new laws or regulations may impair
our ability to market and sell our products in those jurisdictions.

If we fail to effectively manage our growth, our ability to maintain
our costs or capture new business could suffer. In connection with the
commercialization of the VNS Therapy System in the U.S., we have begun and
intend to continue to significantly expand the scope of our operations, in
particular in manufacturing and in marketing and sales. Such activities have
placed, and may continue to place, a significant strain on our resources and
operations. Our ability to effectively manage such growth will depend upon our
ability to attract, hire and retain highly qualified employees and management
personnel. We compete for such personnel with other companies, academic
institutions, government entities and other organizations and we may not be
successful in hiring or retaining qualified personnel. Our success will also
depend upon the ability of our officers and key employees to continue to
implement and improve our operational, management information and financial
control systems. If we fail to manage our growth effectively, our business would
suffer.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Our exposure to market risk for changes in interest rates relates
primarily to our short-term investments in commercial paper, our line of credit
and our fixed rate long-term debt. We do not hedge interest rate exposure or
invest in derivative securities. We are also exposed to market risk from changes
in foreign currency exchange rates. Our wholly-owned foreign subsidiary is
consolidated into our financial results. Our reported revenues, expenses and
cash flows from this subsidiary are exposed to changing exchange rates. At this
time, we have not deemed it to be cost effective to engage in a program of
hedging the effect of foreign currency fluctuations on our operating results
using derivative financial instruments.

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ITEM 4. CONTROLS AND PROCEDURES

As of the end of the period covered by this report, an evaluation was
performed under the supervision and with the participation of the Company's
management, including the Chief Executive Officer and the Chief Financial
Officer, of the effectiveness of the Company's disclosure controls and
procedures. Based on that evaluation, the Chief Executive Officer and Chief
Financial Officer have concluded that the Company's disclosure controls and
procedures are effective to ensure that information required to be disclosed by
the Company in reports that it files or submits under the Securities Exchange
Act of 1934 is recorded, processed, summarized and reported within the time
periods specified in Securities and Exchange Commission rules.

ITEM 5. OTHER INFORMATION

Our policy governing transactions in our common stock by our directors,
officers and employees permits, with Board approval, directors and officers to
enter into trading plans complying with Rule 10b5-1 under the Securities
Exchange Act of 1934, as amended. When there is no material non-public
information available, Rule 10b5-1 allows insiders to establish written plans
that permit pre-arranged sales of securities over a set period of time. An
independent broker then executes trades according to the plan's instructions,
without regard to any subsequent non-public information which the individual
might receive.

During August of 2003 and at a time when our trading window for
insiders was open, each of Robert P. Cummins, the Company's Chief Executive
Officer, and Reese S. Terry, Jr., a member of our Board of Directors, entered
into Rule 10b5-1 plans for sales of common stock pursuant to the terms of such
plans from time to time over the next year.

We anticipate that from time to time in the future, other directors,
officers and employees may establish Rule 10b5-1 plans. We do not undertake any
obligation to update or revise our disclosure regarding such plans nor to
disclose the amendment, termination or expiration of any such plan.

PART II - OTHER INFORMATION

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

(a) Exhibits

31.1 Certification of the Chief Executive Officer of Cyberonics,
Inc. pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2 Certification of the Chief Financial Officer of Cyberonics,
Inc. pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32 Certification of the Chief Executive Officer and the Chief
Financial Officer of Cyberonics, Inc. pursuant to Section 906
of the Sarbanes-Oxley Act of 2002.

(b) Reports on Form 8-K

A current report on Form 8-K was filed on July 23, 2003
announcing results of the Company's depression pivotal study.

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SIGNATURE

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.

CYBERONICS, INC.

BY: /s/ PAMELA B. WESTBROOK
--------------------------------------
Pamela B. Westbrook
Vice President, Finance and Administration,
Secretary and Chief Financial Officer (Principal
Financial and Accounting Officer)

Date: September 4, 2003

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INDEX TO EXHIBITS