UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

(Mark One)

For the quarterly period ended July 30, 2004 or

For the transition period from ______________ to _______________

Commission File Number 0-19806

CYBERONICS, INC.

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

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 þ No o

Indicate by check mark 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.

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CYBERONICS, INC.

INDEX

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PART I — FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

CYBERONICS, INC. AND SUBSIDIARY

CONSOLIDATED BALANCE SHEETS

See accompanying Notes to Consolidated Financial Statements (Unaudited).

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CYBERONICS, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)

See accompanying Notes to Consolidated Financial Statements (Unaudited).

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CYBERONICS, INC. AND SUBSIDIARY

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 30, 2004

Note 1 — Basis of Presentation:

     The accompanying unaudited consolidated financial statements of Cyberonics, Inc. (Cyberonics) 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 30, 2004 are not necessarily indicative of the results that may be expected for any other interim period or the full year ending April 29, 2005. 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 30, 2004.

Note 2 — Stock Incentive and Purchase Plan:

     Stock Incentive and Purchase Plans. As of July 30, 2004, Cyberonics has reserved an aggregate of 13,850,000 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 seven 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 30, 2004, Cyberonics has granted approximately 481,000 options at a weighted average, issued at fair market value, exercise price of approximately $20.83 per share. All grants were made at market prices as of the date of the grant. Stock options to purchase approximately 7.0 million shares at a weighted average exercise price of $16.57 per share were outstanding as of July 30, 2004.

     The following table illustrates the effect on net income and earnings per share if Cyberonics 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:

     We have a revolving credit facility of $25,000,000 with a three-year term ending in September 2004. The credit facility is collateralized by accounts receivable, inventory, equipment, documents of title, general intangibles, subsidiary stock and other collateral. The amount we can borrow under the facility is limited to 80% of eligible accounts receivable. As of July 30, 2004, the eligible balance of accounts receivable was $13,736,000, borrowings outstanding under the credit facility were $9,777,000 and the available borrowing capacity was approximately $1,161,000. Interest is payable in the amount of the designated bank rate of 4.25% plus 1.5% for a total of 5.75% on the greater of $3,000,000 or the average of the net balance owed by Cyberonics at the close of each day during the period. Under the terms of the revolving credit facility, we agreed to maintain liquidity (being the aggregate of availability under the credit facility and Cyberonics’ cash on hand) equal to or greater than $10,000,000. An unused line of credit fee is payable at the rate of 0.5%.

Note 5 — Accrued Liabilities:

     Accrued liabilities are as follows:

Note 6 — Warranties:

     Product Warranty. Cyberonics offers warranties on its leads and generators for one to two years from the date of implant. Cyberonics 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 Cyberonics’ liability for product warranties during the thirteen weeks ended July 30, 2004 and July 25, 2003 are as follows:

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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 Cyberonics recorded approximately $2.4 million in deferred compensation expense 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 30, 2004 and July 25, 2003, respectively.

     In June 2003, the Board of Directors granted 13,844 shares of restricted stock at $18.94 per share to certain officers of Cyberonics that vest in one year and recorded approximately $262,000 in deferred compensation. In October 2003, the Board of Directors granted 12,000 and 5,000 shares of restricted stock at $26.49 and $26.62 per share, respectively, to certain employees of Cyberonics that vest in one year and recorded approximately $451,000 in deferred compensation expense. Approximately $135,000 and $40,000 of compensation expense have been recognized during the thirteen weeks ended July 30, 2004 and July 25, 2003, respectively.

Note 8 — Comprehensive Income (Loss):

     Cyberonics follows Financial Accounting Standard Board (FASB) Statement No. 130, “Reporting Comprehensive Income,” in accounting for comprehensive income (loss) and its components. The comprehensive income (loss) for the thirteen weeks ended July 30, 2004 and July 25, 2003 was ($2,894,692) and $2,512,386, respectively.

Note 9 — Earnings Per Share:

     SFAS No. 128, “Earnings Per Share,” requires dual presentation of earnings per share (EPS): basic EPS and diluted EPS. Basic EPS is computed by dividing net earnings or loss applicable to common shareholders by the weighted average number of common shares outstanding for the period. Diluted EPS includes dilutive stock options and unvested restricted stock that are considered common stock equivalents using the treasury stock method.

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

     Excluded from the computation of diluted EPS for the thirteen weeks ended July 30, 2004 were outstanding options to purchase approximately 7.0 million common shares, because to include them would have been anti-dilutive. Excluded from the computation of diluted EPS for the thirteen weeks ended July 25, 2003 were outstanding options to purchase approximately 365,000 common shares, because to include them would have been anti-dilutive, meaning the exercise price exceeded their fair market value.

Note 10 — New Accounting Pronouncements:

     In December 2003, FASB issued Interpretation (FIN) No. 46 (revised), “Consolidation of Variable Interest Entities,” which addresses consolidation by business enterprises of variable interest entities which meet certain specific characteristics. The effective date of this interpretation depending on the specific entities’ conditions, varies between periods ending after December 15, 2003 and 2005. The adoption of FIN No. 46 (revised) will not have a material impact on our consolidated operating results or financial condition.

     In May 2003, the FASB issued Statement of Financial Accounting Standards (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 adoption of SFAS No. 150 did not have a material impact on Cyberonics’ 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,” included herein. Readers are also encouraged to refer to our Annual Report on Form 10-K for the period ended April 30, 2004 for a further discussion of our business and its risks and opportunities.

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Overview

     We are a neuromodulation company founded to design, develop and bring to market medical devices which provide a unique therapy, VNS, for the treatment of epilepsy and other debilitating neurological and psychiatric diseases and other disorders. VNS Therapy is currently approved for use as an adjunctive therapy in reducing the frequency of seizures in patients with partial onset seizures that are refractory or resistant to antiepileptic drugs. Product sales are primarily from sales in the epilepsy market.

     On June 15, 2004, the Panel of FDA’s Medical Devices Advisory Committee recommended approval with conditions of our VNS Therapy System as an adjunctive long-term treatment of chronic or recurrent depression for patients over the age of 18 who are experiencing a major depressive episode that has not had an adequate response to four or more adequate antidepressant treatments. On August 11, 2004, FDA’s Division of General and Restorative Neurological Devices determined that our Pre-market Application Supplement (PMA-S), absent additional information, was not-approvable, citing reasons including reported events of worsening depression, potential biases stemming from a non-randomized control and an inability to distinguish one-year VNS effects from potential placebo and concomitant treatment effects. We do not agree with the decision and intend to explore all regulatory and legal options to obtain FDA approval of our VNS Therapy System for treatment-resistant depression.

     Since 1998, we have been conducting clinical studies of the VNS Therapy System for the adjunctive treatment of depression in patients with major depressive episodes that have not responded to standard treatments. The depression study program includes acute and long-term clinical studies, acute and long-term mechanism of action research and clinical and economic outcome studies in patients with treatment-resistant depression receiving standard medical treatment that does not include VNS. We have also been conducting small pilot studies for the treatment of Alzheimer’s Disease, anxiety and chronic migraine headache. These studies are being conducted to determine the safety and effectiveness of VNS Therapy and are a principal component of our clinical research activities.

     Since inception, we have incurred substantial expenses, primarily for research and development activities that include product and process development and clinical trials and related regulatory activities, sales and marketing activities, manufacturing start-up costs and systems infrastructure. We have also made significant investments in recent periods in connection with the sales and marketing activities in the U.S. and clinical research costs associated with new indications development, most notably depression. For the period from inception through July 30, 2004, we incurred a cumulative net deficit of approximately $120.7 million. Over the next year, we anticipate potential increases in operating expenses as we continue to focus on strengthening our epilepsy business and developing and implementing a revised regulatory plan to obtain approval for VNS Therapy for treatment-resistant depression. We also expect continued investments in post-approval and pre-approval clinical studies in epilepsy, depression and other new indications. Excluding epilepsy studies, clinical studies are for investigational therapies subject to FDA approval.

Critical Accounting Policies

     We have adopted various accounting policies to prepare the Consolidated Financial Statements in accordance with accounting principles generally accepted in the United States of America (U.S.).

     The preparation of the Consolidated Financial Statements, in conformity with accounting principles generally accepted in the U.S., requires us to make estimates and assumptions that affect the amounts reported in the Consolidated Financial Statements and accompanying notes. Our estimates and assumptions are updated as appropriate, which in most cases is at least quarterly. We base our estimates on historical experience or various assumptions that are believed to be reasonable under the circumstances, and the results form the basis for making judgments about the reported values of assets, liabilities, revenues and expenses. Actual results may materially differ from these estimates.

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     We consider the following accounting policies as the most critical because, in management’s view, they are most important to the portrayal of our consolidated financial condition and results and most demanding in terms of requiring estimates and other exercises of judgment.

     Accounts Receivable. We provide 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 have been experienced by us would reduce earnings when they become known.

     Inventories. We state our 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.

     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, improvements and expansions are capitalized. For financial reporting purposes, we compute 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 acceleration in the timing of the expenses.

     Revenue Recognition. Revenue from product sales is generally recognized upon shipment to the customer, net of estimated returns and allowances. Our revenues are dependent upon sales to new and existing customers pursuant to our 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. We have 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.

     Stock Options. We have 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, “Stock Incentive and Purchase Plan.” Because of this election, we continue to account for our 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 option grants for options granted under those plans having an exercise price equal to the market value of the underlying common stock on the date of grant.

     Income Taxes. We account 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 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

     During the quarter ended July 30, 2004, U.S. net sales decreased by 10% as compared to the quarter ended July 25, 2003. Unit sales volume declined by 16% due to reductions in end-of-service generator replacement sales and new patient unit sales and were partially offset by an increase of 7% in average system prices resulting from price increases and changes in product mix. Our goal is to maintain epilepsy sales levels, despite anticipated declines in end-of-service generator sales. We do not anticipate increases in U.S. epilepsy revenues for the remainder of fiscal 2005.

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     International sales for the quarter ended July 30, 2004 increased by 53% over the same quarter last year, driven primarily by increases in unit volumes driven by new patient demand. Average system prices also increased by 5% largely due to favorable currency impact and changes in country and product mix.

     As a result of FDA’s determination that our PMA-S was not-approvable, absent additional information, we are exploring all regulatory and legal options to obtain FDA approval of our VNS Therapy System for treatment-resistant depression. Since we cannot predict if or when FDA will approve VNS Therapy for depression, we currently do not anticipate any U.S. sales in depression during fiscal 2005.

     Gross Profit

     Gross profit margin for the quarter was 81.0%, representing a decline of 403 basis points over the same quarter last year. The decline in gross profit was primarily due to a scale-up production exercise we completed during the quarter for the purpose of evaluating the scalability of our personnel, equipment and processes in manufacturing. That process, which highlighted several opportunities for improvements, also resulted in reduced production levels and caused an adverse impact on overhead absorption and product cost. Gross margin was also negatively impacted by reduced sales volumes as compared to last year and changes in sales mix between U.S. and international sales.

     Cost of sales consists primarily of direct labor, allocated manufacturing overhead, third-party contractor costs, royalties, and the acquisition cost of raw materials and components. We are obligated to pay royalties at rates of about 3% of net sales in future periods. Gross margins can be expected to fluctuate in future periods based upon the mix between U.S. and international sales, direct and distributor sales, the VNS Therapy System selling price, applicable royalty rates, and the levels of production volume.

     Operating Expenses

     Selling, General and Administrative (SG&A) Expenses. SG&A expenses are comprised of sales, marketing, development, general and administrative activities. As compared to prior year, SG&A expenses increased by 14% during the first quarter of fiscal 2005 as we incurred additional expenses associated with market shaping and recruiting initiatives supporting depression development activities and expanded corporate administrative functions associated with increasing compliance requirements and costs of doing business for publicly traded companies.

     Research and Development (R&D) Expenses. R&D expenses are comprised of expenses related to our product and process development, product design efforts, clinical trials programs and regulatory activities. As compared to prior year, R&D expenses increased by 25% during the quarter due to expanded development, regulatory and clinical activities supporting epilepsy, depression and new indications programs.

     As a result of FDA’s not-approvable determination regarding our PMA-S for treatment-resistant depression, we do not anticipate that the levels of marketing and recruiting expenses incurred during the first quarter will continue for the remainder of fiscal 2005. However, cancellation penalties and similar costs for certain programs may be incurred in the remainder of fiscal 2005. Additionally, there may be future incremental costs associated with clinical, regulatory or legal programs to support the continuing development of our PMA-S for treatment-resistant depression.

     Interest Income and Expense

     Interest income for the quarter increased by 70% over prior year as a result of higher invested cash balances and slightly higher interest rates. Interest expense for the quarter decreased by 13% over the same quarter last year due to the expanded use of our credit facility of $25 million which bears interest at the designated bank rate plus 1.5% on the greater of $3 million or the average of the net balance owed by us at the close of each day during the period and includes interest expense on capital leases for manufacturing equipment.

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     Other Income, Net

     Other income, net, primarily includes transaction gains and losses associated with the impact of changes in foreign currency exchange rates.

     Income Taxes

     We estimate that our effective tax rate for the thirteen weeks ended July 30, 2004 to be approximately 0.2%, due primarily to the effects of net operating loss carry-forwards. The effective tax rate represents our estimate of the rate expected to be applicable for the full fiscal year. Due to our operating loss history, 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

     Key performance indicators used by management to assess our liquidity are as follows:

     During the quarter ended July 30, 2004, cash on hand increased by $3,870,000 to $62,233,000. Net cash used by operating activities was $593,000, compared to $1,604,000 in the same quarter last year. The decrease in cash used in operating activities was primarily the result of significant reductions in accounts receivable and inventories in the current quarter as compared to the same quarter last year. Cash generated from our stock option and employee stock purchase plans continues to provide a major source of funds. We received approximately $5,100,000 in connection with the issuance of shares pursuant to these plans during the first quarter of fiscal 2005 and reduced the revolving credit facility by $254,000.

     We are party to a number of contracts pursuant to which we are paying for clinical studies for current operating obligations payable totaling $1.1 million as of July 30, 2004. Although we have no firm commitments, we expect to make capital expenditures of approximately $6.4 million during fiscal year 2005, primarily to expand manufacturing capabilities and to enhance business infrastructure and facilities. Our current projections indicate that we have sufficient cash and cash equivalents, net of the line of credit and cash flow resources to fund anticipated business activities through fiscal year 2006.

     The chart below reflects our current obligations under our material contractual obligations.

     “Capital Leases” are for manufacturing equipment used in the production of our VNS Therapy System. “Operating Leases” are primarily obligations applicable to the lease of facilities and office equipment. “Other” represents commitments made for future events which are reflected on our balance sheet.

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     We believe our current cash, cash equivalents and cash generated from operations will be sufficient to fund our current levels of operating needs and capital expenditures for the foreseeable future. Our liquidity could, however, be adversely affected 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. 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 26, 2003 to July 30, 2004 our stock has traded from a high of $40.07 to a low of $16.78 per share. The fluctuation in our stock price is caused by a number of factors, some of which are beyond our control, including:

	•		quarterly variations in our sales and operating results;
	•		regulatory activities and announcements, including FDA announcements;
	•		results of studies regarding the efficacy of our VNS Therapy treatment for other indications including depression, Alzheimer’s Disease, anxiety, migraine headaches and other disorders;
	•		announcements of significant contracts, acquisitions, or capital commitments;
	•		changes in financial estimates by securities analysts;
	•		changes in market valuations of medical device companies;
	•		additions or departures of key personnel;
	•		sales or purchases of common stock by Cyberonics, its officers and members of its Board of Directors;
	•		changes in the general conditions of the economy; and
	•		changes in ownership of large shareholders.

     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

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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 in the U.S. in fiscal 2005, if at all. We cannot assure you that epilepsy sales will increase. We do not have the regulatory or reimbursement approvals necessary to commercialize the VNS Therapy System for the treatment of depression in the U.S. In August 2004, FDA determined that our PMA-S for treatment-resistant depression was not-approvable, absent additional information. We cannot assure you that any approval for the treatment of depression with the VNS Therapy System will be granted, nor can we assure you that even if U.S. 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, Alzheimer’s Disease and other indications. Our inability to successfully commercialize the VNS Therapy System for depression and other indications will severely harm our future growth.

     We may not obtain FDA approval to use our VNS Therapy System as an adjunctive therapy for depression. Although the Panel of FDA’s Medical Devices Advisory Committee recently voted to recommend approval of our VNS Therapy System as an adjunctive long-term treatment of chronic or recurrent depression, on August 11, 2004, FDA chose to ignore the Panel’s recommendation and determined that our PMA-S was not-approvable, absent additional information. We do not agree with FDA‘s decision and intend to explore all regulatory and legal options available to obtain approval of VNS Therapy System for treatment-resistant depression. However, we cannot assure you that we will ultimately receive FDA approval for the use of our product to treat depression. Even if we receive final approval, the approval may contain additional conditions which we have not anticipated. If we do not receive such approval, or we receive approval with additional conditions, we may not be able to capture additional revenues for our device through the treatment of depression.

     If we obtain FDA’s approval, we may experience difficulties and delays inherent in the development, manufacturing, marketing and sale of our VNS Therapy System for the treatment of depression. If we receive approval to use our VNS Therapy System as adjunctive therapy for depression, we will be subject to extensive and rigorous ongoing regulation of the research, development, testing, manufacture, labeling, promotion, advertising, distribution and marketing of our product. Our failure to comply with these requirements or the identification of manufacturing or safety problems during commercial marketing could lead to the need for product marketing restrictions, product withdrawal or recall or other voluntary or regulatory action, which could delay further marketing until the product is brought into compliance. Our failure to comply with these requirements may also subject us to stringent penalties.

     In addition to regulatory obstacles, we may need significant additional capital in the event FDA approval is received. These capital requirements may be substantial and will depend on many factors, including market acceptance of our product. A large portion of our expenses is currently fixed, including expenses related to our facilities, equipment and personnel, and we expect to spend significant amounts to market our product for the treatment of depression. As a result, we expect that our operating expenses will continue to increase in the event of final FDA approval and, consequently, we will need to generate significant additional revenues to maintain profitability. Even if we do sustain profitability, we may not be able to increase profitability on a quarterly or annual basis. Furthermore, if additional capital is required, we may not be able to access sufficient sources or to access capital on terms which are acceptable to us.

     We may not be successful in our efforts to develop VNS Therapy for the treatment of Alzheimer’s Disease, anxiety, chronic migraine headache 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, Alzheimer’s Disease, anxiety, chronic migraine headache 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

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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 or 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 expand or maintain 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 for the treatment of epilepsy 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. 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. While we are planning to invest in epilepsy Phase IV clinical studies which may be expected to increase clinical experience with VNS Therapy, we cannot assure you that these studies will result in a significant change in physicians’ opinions or usage of our product. We cannot assure you that epilepsy sales will increase. We cannot assure you that the VNS Therapy System will 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. We endeavor to appropriately structure and staff our sales organization to maximize resources and to respond to changes in the territory markets. While we believe the structure of our sales organization should ultimately improve productivity and performance going forward, we cannot assure you that those outcomes will be achieved. Recent changes made in our sales organization could delay improvements in productivity and efficiency longer than expected. 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 or quarterly revenue targets could substantially harm our consolidated results of operations and financial condition.

     Patient confidentiality and federal and state privacy laws and regulations may adversely impact our patient pull-through selling model. The HIPAA Privacy Rule became effective in April 2003. In addition, virtually every state has enacted one or more laws to safeguard privacy, and these laws vary significantly from state to state and change frequently. The HIPAA Privacy Rule preempts a state privacy law only if the state privacy law is narrower in scope than the HIPAA Privacy Rule. Consequently, the applicable privacy rules can vary state by state, and the determination of the privacy rules applicable in any one state can be very difficult. The operation of our business involves the collection and use of substantial amounts of “protected health information,” including patient information provided by physicians to assist in the treatment of patients, information provided by patients themselves to assist them in scheduling surgery and confirming their eligibility for third-party reimbursement, patient information provided by hospitals in connection with their efforts to obtain third-party reimbursement, patient information collected by our Regulatory Affairs Department in the investigation of product complaints and the tracking of implanted devices, and patient information collected by our Clinical Affairs Department as part of a patient registry. We endeavor to conduct our business as a “covered entity” under the HIPAA Privacy Rule and consistent with the Texas privacy laws, obtaining HIPAA-compliant patient authorizations where required to support the collection and use of patient information, including in connection with our Patient Identification and Qualification (PIQ) pull-through selling model. We also sometimes act as a “business associate” for a covered entity. For example, we sometimes provide assistance to hospitals (covered entities) in connection with their claims for third-party reimbursement of VNS Therapy Systems and procedures. Even if our business model is compliant with the HIPAA Privacy Rule and the Texas privacy laws, it may not be compliant with the privacy laws of all states. In addition, despite extensive efforts to conduct our business as a covered entity under the HIPAA Privacy Rule and the Texas privacy laws, the Office of the Inspector General of the Department of Health and Human Services or another government enforcement agency may determine that we are obligated to comply with the HIPAA Privacy Rule or another law and that our business model or operations are not in compliance, which could subject us to penalties and could severely limit our ability to

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market and sell VNS Therapy under our existing business 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 healthcare 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 materials, components 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 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, such changes generally require regulatory submissions and approvals. Any extended delays in or an inability to secure alternative sources for these or other 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 that 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 our 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 be issued 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

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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 healthcare 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 our consolidated financial condition and 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 Therapy System entails the risk of product liability claims, which we have received from time to time in the ordinary course of business. We may be responsible for large deductibles for each claim, and our product liability coverage may not be adequate to cover judgments that may result from 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 laws and regulations, we could lose our ability to market and sell our product or be subject to substantial fines or other penalties. The preclinical and clinical testing, manufacturing, labeling, sale, distribution and promotion of the VNS Therapy System are subject to extensive and rigorous federal and state laws and regulations, including regulations from the Department of Health and Human Services (related to Medicare, HIPAA and FDA) and from 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. It will also be necessary for us to ensure that our marketing and sales practices comply with all laws and regulations. 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

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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 manage our growth effectively, 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 may need to expand significantly the scope of our operations. An expansion of our operations may place a significant strain on our resources and operations. Our ability to manage such growth effectively 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 will suffer.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

     We are exposed to limited market risk on interest rates and foreign currency exchange rates.

     Our exposure to market risk for changes in interest rates relates primarily to our short-term investments in commercial paper and our line of credit. We do not hedge interest rate exposure or invest in derivative securities. Based upon the average outstanding balances in cash, cash equivalents and our line of credit, a 100-basis point change in interest rates would not have a material impact on our financial results.

     Due to the global reach of our business, we are also exposed to market risk from changes in foreign currency exchange rates, particularly with the U.S. dollar over the Euro. Our wholly owned foreign subsidiary is consolidated into our financial results and is subject to risks typical of an international business including, but not limited to, differing economic conditions, changes in political climate, differing tax structures, other regulations and restrictions and foreign exchange rate volatility. Accordingly, our future results could be materially impacted by changes in these or other factors. 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. A sensitivity analysis indicates that, if the U.S. dollar uniformly weakened 10% against the Euro, the effect upon net income for the quarter ended July 30, 2004 would have been favorable by approximately $29,000 or 1%. Conversely, if the U.S. dollar uniformly strengthened 10% against the Euro, the impact on net income for the quarter ended July 30, 2004 would have been unfavorable by approximately $24,000 or 0.8%.

ITEM 4. CONTROLS AND PROCEDURES

     We maintain a system of disclosure controls and procedures (as defined in Rule 13a-15(e) of the Securities and Exchange Act of 1934) designed to ensure that we are able to record, process, summarize and report, within the applicable time periods, the information required in our annual and quarterly reports under the Securities Exchange Act of 1934.

     As of the end of the period covered by this report, an evaluation was performed under the supervision and with the participation of our management, including the Chief Executive Officer and the Chief Financial Officer, of the effectiveness of our disclosure controls and procedures. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures are effective. In addition, there have been no changes in our internal controls over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) that occurred during our last fiscal year that has materially affected, or is reasonably likely to materially affect, our internal controls over financial reporting.

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ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

     (a) Exhibits

     (b) Reports on Form 8-K

None.

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 and Chief Financial Officer (Principal Financial and Accounting Officer)

Date: September 7, 2004

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INDEX TO EXHIBITS

Exhibits