ADVANCED NEUROMODULATION SYSTEMS INC - 10-Q Quarterly Report

Indicate by check þ whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES þ NO o

Indicate by check þ whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). YES þ NO o

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.


PART I. Financial Information			2
	Item 1. Financial Statements
		Condensed Consolidated Balance Sheets September 30, 2003 (Unaudited) and December 31, 2002	3-4
		Condensed Consolidated Statements of Income (Unaudited) For the Three Months and Nine Months Ended September 30, 2003 and 2002	5
		Condensed Consolidated Statements of Cash Flows (Unaudited) For the Nine Months Ended September 30, 2003 and 2002	6
		Condensed Consolidated Statements of Stockholders’ Equity For the Year Ended December 31, 2002 and the Nine Months Ended September 30, 2003 (Unaudited)	7
		Notes to Condensed Consolidated Financial Statements	8-16
	Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		17-27
	Item 3. Quantitative and Qualitative Disclosures About Market Risk		27
	Item 4. Controls and Procedures		27
PART II.Other Information			28
	Item 6. Exhibits and Reports on Form 8-K		28
Signatures			29

Advanced Neuromodulation Systems, Inc. and Subsidiaries
Condensed Consolidated Balance Sheets
September 30, 2003 (Unaudited) and December 31, 2002


				September 30,		December 31,
Assets				2003		2002

Current assets:
	Cash and cash equivalents			$	6,517,353	$	10,972,974
	Marketable securities				90,092,003		85,796,944
	Receivables:
		Trade accounts, less allowance for doubtful accounts of $560,811 in 2003 and $295,391 in 2002			15,424,550		10,847,237
		Interest and other			146,758		189,017

			Total receivables		15,571,308		11,036,254

	Inventories:
		Raw materials			9,194,585		7,141,338
		Work-in-process			3,538,850		2,364,386
		Finished goods			7,111,405		4,217,222

			Total inventories		19,844,840		13,722,946

	Deferred income taxes				2,919,571		1,122,617
	Income tax receivable				321,378		—
	Prepaid expenses and other current assets				1,142,111		1,032,883

			Total current assets		136,408,564		123,684,618

Equipment and fixtures:
	Land				3,191,427		3,191,427
	New facility construction in progress				3,102,432		—
	Furniture and fixtures				4,247,209		4,022,901
	Machinery and equipment				13,170,159		10,343,953
	Leasehold improvements				1,821,191		1,702,965

					25,532,418		19,261,246
	Less accumulated depreciation and amortization				10,113,231		8,653,255

			Net property, plant and equipment		15,419,187		10,607,991

Minority equity investments in preferred stock					1,104,000		—
Goodwill, net					9,553,168		7,407,237
Patents, net of accumulated amortization of $1,739,813 in 2003 and $1,435,835 in 2002					5,212,682		5,323,417
Purchased technology from acquisitions, net of accumulated amortization of $2,688,319 in 2003 and $2,098,200 in 2002					9,936,628		9,033,472
Trademarks, net of accumulated amortization of $1,074,550 in 2003 and $969,952 in 2002					1,715,013		1,701,154
Customer and supplier relations, net of accumulated amortization of $107,951 in 2003					1,559,910		—
Other assets, net of accumulated amortization of $700,547 in 2003 and $529,102 in 2002					1,326,463		586,238

				$	182,235,615	$	158,344,127

Advanced Neuromodulation Systems, Inc. and Subsidiaries
Condensed Consolidated Balance Sheets (continued)
September 30, 2003 (Unaudited) and December 31, 2002


			September 30,			December 31,
Liabilities and Stockholders' Equity			2003			2002

Current liabilities:
	Accounts payable		$	2,175,187		$	2,392,579
	Accrued salary and employee benefit costs			2,843,650			3,077,603
	Deferred revenue			561,066			646,577
	Accrued commissions			1,228,473			794,521
	Accrued tax abatement liability			—			969,204
	Income taxes payable			—			822,228
	Warranty reserve			354,029			402,259
	Other accrued expenses			520,264			299,905

		Total current liabilities		7,682,669			9,404,876

Deferred income taxes				4,502,743			3,731,939
Non-current deferred revenue				937,243			162,504
Commitments and contingencies
Stockholders’ equity:
	Common stock of $.05 par value Authorized 25,000,000 shares; issued and outstanding: 19,510,072 shares in 2003 and 18,526,014 in 2002			975,503			926,301
	Additional capital			144,364,676			129,738,644
	Retained earnings			23,793,528			14,393,748
	Accumulated other comprehensive income (loss), net of tax benefit of $10,690 in 2003 and $7,155 in 2002			(20,747	)		(13,885	)

		Total stockholders’ equity		169,112,960			145,044,808

			$	182,235,615		$	158,344,127

Advanced Neuromodulation Systems, Inc. and Subsidiaries
Condensed Consolidated Statements of Income (Unaudited)
For the Three Months and Nine Months Ended September 30, 2003 and 2002


			Three Months Ended					Nine Months Ended
			September 30,					September 30,

			2003		2002			2003		2002

Net revenue			$	23,418,505	$	14,327,505		$	65,413,557	$	39,223,522
Cost of revenue				6,384,445		4,853,409			20,317,415		14,430,996

		Gross profit		17,034,060		9,474,096			45,096,142		24,792,526

Operating expenses:
	Research and development			2,552,951		1,518,610			6,597,850		4,186,833
	Sales and marketing			6,970,941		3,802,840			18,460,993		10,091,204
	Amortization of intangibles			472,821		229,464			1,278,093		686,094
	General and administrative			1,871,833		1,390,308			5,504,084		3,971,617

				11,868,546		6,941,222			31,841,020		18,935,748



		Income from operations		5,165,514		2,532,874			13,255,122		5,856,778

Other income (expense):
	Interest expense			—		(2,514	)		—		(10,759	)
	Other income			969,204		—			969,204		—
	Interest income			200,243		374,991			776,370		595,685

				1,169,447		372,477			1,745,574		584,926

		Income before income taxes		6,334,961		2,905,351			15,000,696		6,441,704
Income taxes				2,382,109		963,048			5,504,915		2,213,984

		Net income	$	3,952,852	$	1,942,303		$	9,495,781	$	4,227,720

Net income per share:
		Basic	$	.20	$	.11		$	.50	$	.27

		Diluted	$	.19	$	.10		$	.46	$	.24

Advanced Neuromodulation Systems, Inc. and Subsidiaries
Condensed Consolidated Statements of Cash Flows (Unaudited)
For the Nine Months Ended September 30, 2003 and 2002


					Nine Months Ended September 30,

					2003			2002

Cash flows from operating activities:
	Net income				$	9,495,781		$	4,227,720
	Adjustments to reconcile net income to net cash provided by operating activities:
		Depreciation and amortization				3,379,235			2,382,517
		Increase in inventory reserve				20,559			51,403
		Deferred income taxes				(1,529,830	)		425,615
		Accrued tax abatement liability				(969,204	)		—
		Stock-based compensation				505,430			31,120
		Changes in operating assets and liabilities, net of acquisitions:
			Receivables			(4,535,056	)		(2,602,695	)
			Inventories			(4,778,450	)		(2,660,865	)
			Current income tax receivable			(321,378	)		175,230
			Prepaid expenses and other assets			(130,560	)		(231,573	)
			Deferred revenue			689,228			(54,699	)
			Income taxes payable			(822,228	)		—
			Tax benefit from stock option exercises			7,240,918			1,674,689
			Accounts payable			(217,392	)		(201,155	)
			Accrued expenses			372,128			647,475

				Total adjustments		(1,096,600	)		(362,938	)

				Net cash provided by operating activities		8,399,181			3,864,782

Cash flows from investing activities:
	Purchases of marketable securities					(307,383,482	)		(110,425,666	)
	Proceeds from sales of marketable securities					303,078,026			19,793,545
	Acquisition of Sun Medical pain business					(4,857,192	)		—
	Minority equity investments in preferred stock					(1,104,000	)		—
	Acquisition of assets of Comedical, Inc.					(1,134,079	)		—
	New facility construction in progress					(3,102,432	)		—
	Additions to property, equipment, fixtures and intangible assets					(4,164,469	)		(1,713,765	)

				Net cash used in investing activities		(18,667,628	)		(92,345,886	)

Cash flows from financing activities:
	Payment of long-term obligations					—			(189,722	)
	Net proceeds from public offering of common stock					—			83,175,353
	Exercise of stock options					5,812,826			1,466,322

				Net cash provided by financing activities		5,812,826			84,451,953

Net decrease in cash and cash equivalents						(4,455,621	)		(4,029,151	)
Cash and cash equivalents at beginning of year						10,972,974			9,785,325

Cash and cash equivalents at September 30					$	6,517,353		$	5,756,174

Supplemental cash flow information is presented below:
		Income taxes paid			$	979,373		$	33,943

		Interest paid			$	—		$	10,759

Non-cash activity:
		Stock issued for intangible assets			$	1,020,059		$	—

Advanced Neuromodulation Systems, Inc. and Subsidiaries
Condensed Consolidated Statements of Stockholders’ Equity (Unaudited)


											Other			Total
		Common Stock				Additional		Retained			Comprehensive			Stockholders'
		Shares		Amount		Capital		Earnings			Income (Loss)			Equity

Balance at December 31, 2001 (restated for 3 for 2 stock split)			13,607,802	$	680,390	$	38,443,451	$	7,709,290		$	(21,250	)	$	46,811,881
	Net income		—		—		—		6,684,458			—			6,684,458
	Adjustment to unrealized losses on marketable securities		—		—		—		—			7,365			7,365

	Comprehensive Income														6,691,823

	Sale of newly issued common stock in a public offering, net of offering costs		4,312,500		215,625		82,959,728		—			—			83,175,353
	Issuance of shares for stock option exercises		371,259		18,563		1,851,329		—			—			1,869,892
	Issuance of common stock for acquisition		234,453		11,723		4,636,698		—			—			4,648,421
	Tax benefit from stock option exercises		—		—		1,847,438		—			—			1,847,438

Balance at December 31, 2002			18,526,014		926,301		129,738,644		14,393,748			(13,885	)		145,044,808
	Net income		—		—		—		9,495,781			—			9,495,781
	Adjustment to unrealized losses on marketable securities		—		—		—		—			(6,862	)		(6,862	)

	Comprehensive Income														9,488,919

	Issuance of shares for stock option exercises		938,968		46,948		5,765,878		—			—			5,812,826
	Stock-based compensation		—		—		505,430		—			—			505,430
	Issuance of earn-out shares for acquisition		42,519		2,126		1,017,933		—			—			1,020,059
	Shares issued for fractional share round-up in 3 for 2 stock split		2,571		128		95,873		(96,001	)		—			—
	Tax benefit from stock option exercises		—		—		7,240,918		—			—			7,240,918

Balance at September 30, 2003			19,510,072	$	975,503	$	144,364,676	$	23,793,528		$	(20,747	)	$	169,112,960

Advanced Neuromodulation Systems, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements

Advanced Neuromodulation Systems, Inc. (“we,” the “Company” or “ANS”) designs, develops, manufactures and markets implantable neuromodulation devices used to manage chronic intractable pain and other disorders of the central nervous system. We also provide contract development and custom manufacturing for other medical device companies through our Hi-tronics Designs, Inc. (“HDI”) subsidiary, which we acquired in January 2001. ANS neuromodulation revenues are derived primarily from sales throughout the United States, Europe and Australia while HDI revenues are derived within the United States.

On July 11, 2003, we effected a 3-for-2 stock split in the form of a 50% stock dividend (one share of common stock paid for every two shares held), paid to shareholders of record on June 20, 2003. All prior period shares and income per share figures have been restated to reflect the split.

In November 2002, the Company acquired MicroNet Medical, Inc., a privately-held developer of medical devices based on proprietary micro-lead technology based in St. Paul, Minnesota. See Note 3.

In March 2003, the Company acquired the pain management business of Sun Medical, Inc., the Company’s largest distributor of its Neuro Products. See Note 3.

In September 2003, the Company acquired certain assets of Comedical, Inc, a distributor of the Company’s Neuro Products. See Note 3.

The research and development, manufacture, sale and distribution of medical devices are subject to extensive regulation by various public agencies, principally the Food and Drug Administration and corresponding state, local and foreign agencies. Product approvals and clearances can be delayed or withdrawn for failure to comply with regulatory requirements or the occurrence of unforeseen problems following initial marketing.

In addition, ANS products are purchased primarily by hospitals, ambulatory surgery centers and other users who then bill various third party payors including Medicare, Medicaid, Workmen’s Compensation, private insurance companies and managed care organizations. These third party payors reimburse fixed amounts for services based on a specific diagnosis. The impact of changes in third party payor reimbursement policies and any amendments to existing reimbursement rules and regulations that restrict or terminate the eligibility of ANS products could have an adverse impact on the Company’s financial condition and results of operations.

The unaudited condensed consolidated financial information contained in this report reflects all adjustments (consisting of normal recurring accruals) considered necessary, in the opinion of management, for a fair presentation of results for the interim periods presented. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that

Advanced Neuromodulation Systems, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements

affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from these estimates.

Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted. These financial statements should be read in conjunction with the financial statements and notes thereto included in the Company’s December 31, 2002 Annual Report on Form 10-K/A. The results of operations for the period ended September 30, 2003 are not necessarily indicative of operations for the full year.

The consolidated financial statements include the accounts of Advanced Neuromodulation Systems, Inc. and its subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.

On September 4, 2003, we completed the purchase of certain assets of Comedical, Inc. for $1,134,079. The acquisition expanded our direct sales force. Comedical was a distributor of our Neuro Products in the Northwestern United States. As part of the acquisition, three of Comedical’s direct salespersons and three of its commissioned agents joined the Company’s direct sales force. Assets acquired consisted primarily of customer lists, non-compete agreements, inventory, contracts and equipment. The allocation of the purchase price is as follows: inventory-$352,742, customer relations-$367,860, non-compete agreements-$367,861 and equipment-$45,616. Amortization periods for the identifiable intangible assets are as follows: customer relations-7 years and non-compete agreements-4 years.

On March 27, 2003, we completed the acquisition of the pain management business of Sun Medical, Inc. for $4,857,192 (including acquisition related expenses of approximately $45,931). The acquisition expanded our direct sales force. Sun Medical was the largest distributor of our Neuro Products and accounted for $6.33 million, or 13.5% of revenue of the Neuro Products segment during the twelve months ended December 31, 2002. As part of the acquisition, we hired substantially all of the salespersons and clinical support specialists who worked for Sun Medical’s pain management business. Assets acquired consisted primarily of customer lists, non-compete agreements, inventory, contracts, equipment and other tangible assets but excluded cash and accounts receivable as of the closing date. The allocation of the purchase price is as follows: goodwill-$2,145,931, customer relations-$1,100,000, inventory-$1,011,261, other non-compete agreements-$300,000, supplier relations-$200,000, and employee non-compete agreements- $100,000. Amortization periods for the identifiable intangible assets are as follows: customer relations-7 years, other non-compete agreements-5 years, supplier relations-4 years and employee non-compete agreements-1 year.

Advanced Neuromodulation Systems, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements

applications. Under the terms of the transaction, which we structured as a merger, we acquired only MicroNet’s proprietary technology and certain associated tangible assets. The MicroNet assets are a part of our Neuro Products segment. MicroNet’s operations, other tangible assets, certain liabilities and certain employees became part of a separate unaffiliated company. We assumed no material debt, liabilities, or overhead in the transaction. At closing, we paid the former MicroNet shareholders $500,000 in cash and 234,453 shares of our common stock with a value at the time of issuance of $4,648,421. In addition, we incurred expenses of $859,460, including an investment-banking fee of $600,000. We also agreed to pay the former MicroNet shareholders additional shares of our common stock if certain product, regulatory approval and sales milestones are met. These milestones consist of three principal product milestones and a sales milestone. Each of the product milestones has four to six sub-milestones that relate to the delivery of specific products, including four 4-electrode leads (Milestone I), two 8-electrode leads (Milestone II) and a 4-electrode lead and an 8-electrode lead designed for use in specific applications (Milestone III). The product sub-milestones are met if and when we are able to submit, and if and when we receive, regulatory approvals for products that have been adapted for use directly with our electrical stimulation devices. The sales milestone will be met if and when we and our subsidiaries generate $5 million in cumulative net sales of MicroNet lead products during the four years following the closing of the MicroNet transaction.

The aggregate value of the additional potential milestone earnout payments payable in shares of our common stock was $9 million as measured at the time the transaction was completed. Of this $9 million in additional shares, we issued a fixed number of shares totaling 134,409 with an aggregate value at closing of $3 million into an escrow account. If and when the product and regulatory milestones are achieved, we will release a specified and fixed number of shares of our common stock from escrow to the former MicroNet shareholders (which for purchase price accounting will be valued at the time of release from escrow). In addition, if and when those same product and regulatory milestones are achieved, we will also issue at that time a number of shares of our common stock with an aggregate value of up to $3 million. Finally, if and when we generate $5 million in cumulative net sales of MicroNet lead products during the four years following the closing, we will issue at that time a number of shares of our common stock with an aggregate value of $3 million. In March 2003, two parts of the first major product milestones were satisfied, and we issued the former MicroNet shareholders an aggregate of 42,519 shares of our common stock (of which 22,401 shares were from escrow) with a value at the time of issuance and release from escrow of $1,020,059, which was allocated to certain identifiable intangible assets in accordance with the original purchase price allocation, resulting in additional purchased technology of $978,237, tradenames of $23,461, and non-compete agreements of $18,361. In October 2003, an additional product milestone was satisfied, and we issued the former MicroNet shareholders an aggregate of 17,463 shares of our common stock (of which 11,197 shares were from escrow) with a value at the time of issuance and release from escrow of $700,182, which will be allocated to certain identifiable intangible assets in accordance with the original purchase price allocation, which will result in additional purchased technology of $671,475, tradenames of $16,104, and non-compete agreements of $12,603. Important additional product milestone deadlines occur in November 2003 and May 2004, while other milestones depend on the receipt of regulatory approvals and meeting the aggregate sales milestone referred to above. All

Advanced Neuromodulation Systems, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements

milestones must be met by November 2006 or November 2007, depending on the milestone.

The Company accounts for its stock-based compensation plans in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB 25) and related interpretations. Under APB 25, no compensation expense is recognized for stock option grants if the exercise price of the Company’s stock option grants is at or above fair market value of the underlying stock on the date of grant. The Company has adopted the pro forma disclosure features of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (SFAS 123), as amended by Statement of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure”. The following table illustrates the effect on net income and net income per share amounts if the Company had applied the fair value recognition provisions of SFAS 123 to stock-based employee compensation:


	Three Months Ended				Nine Months Ended
	September 30,				September 30,

	2003		2002		2003		2002

Net income as reported	$	3,952,852	$	1,942,303	$	9,495,781	$	4,227,720
Stock-based compensation expense		1,026,105		570,881		3,018,947		1,515,393

Pro forma net income	$	2,926,747	$	1,371,422	$	6,476,834	$	2,712,327

Basic shares		19,382,991		18,140,091		19,040,105		15,682,565
Diluted shares		20,860,041		19,764,149		20,441,351		17,379,035

Pro forma Basic EPS	$	.15	$	.08	$	.34	$	.17



Pro forma Diluted EPS	$	.14	$	.07	$	.32	$	.16

In January 1998, the Company sold its cardiovascular operations to Atrion Corporation, and granted Atrion a nine-month option to acquire the Company’s principal office and manufacturing facility in Allen, Texas for $6.5 million. During October 1998, Atrion exercised its option to acquire the facility. When the facility was built in 1993, the Company entered a ten-year agreement with the City of Allen granting tax abatements to the Company if a minimum job base and personal property base were maintained in the City of Allen. The agreement provided for the repayment of abated taxes if the Company defaulted under the agreement. During 1998, the Company recorded a pretax expense of $969,204 in connection with the abated taxes. In April 1999, the Company was successful in petitioning the City of Allen to assign the abatement agreement to Atrion. In July 1999, the Company, Atrion and the City of Allen executed an assignment agreement under which Atrion (as successor in interest to the Company) agreed to continue to meet the conditions of the original tax abatement agreement until August 2003. The City preserved its rights to collect previously abated taxes if Atrion failed to

Advanced Neuromodulation Systems, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements

comply with its obligations any time prior to August 2003. The Company retained monetary liability for the amount of abated taxes, even after assignment, because pursuant to the purchase and sale agreement with Atrion, the Company indemnified Atrion from any tax abatement liabilities that accrued to the City of Allen prior to the sale of the cardiovascular operations in January 1998. Atrion met the conditions of the abatement agreement through August 2003, and thus in September 2003, the Company reversed the potential obligation to Atrion of $969,204, which is reflected in “other income” in the Condensed Consolidated Statements of Income.

The Company entered into a sixty-three month lease agreement on 40,000 square feet of space located in the North Dallas area during February 1999. The Company relocated its operations to the leased facility in May 1999 and the rental period under the lease commenced on June 1, 1999. Under the terms of the lease agreement, the Company received three months free rent, and the monthly rental rate for the remaining term of the lease is $48,308, subject to certain annual adjustments for increases in expenses for common area maintenance and property taxes. The monthly rental rate was increased to $52,647 in January 2003. In September 2002, the Company amended its lease agreement to add approximately 9,700 square feet of office space located in the same complex as its 40,000 square foot corporate headquarters. The lease on the additional space expires during August 2004, the same as the corporate headquarters facility. The monthly rental rate on the 9,700 square feet of office space is $11,485. In July 2003, the Company entered into a sublease to add approximately 9,800 square feet of office space located in the same complex as its 40,000 square foot corporate headquarters. The sublease on the additional space expires on July 31, 2004 and has a monthly rental rate of $10,655.

The Company also leases facilities in New Jersey as a result of the January 2001 acquisition of HDI. One of the facilities, located in Budd Lake, New Jersey, is 10,348 square feet of office space that is used for administration, design engineering, drafting, documentation and regulatory affairs. The lease expires on February 28, 2004 and has a monthly rental rate of $9,615. The Company also leases 18,582 square feet of space in Hackettstown, New Jersey used for the O.E.M. manufacturing operations. The Hackettstown lease, which expires on December 31, 2005, has a monthly rental rate of $9,517 and is renewable for one additional three-year period.

The Company leases office equipment under non-cancelable operating leases expiring through 2004. Monthly payments on the office equipment leases are $2,412.

The Company is subject to proceedings, lawsuits and other claims related to its products and business. The Company is required to assess the likelihood of any adverse judgments or outcomes to these matters as well as potential ranges of probable losses. A determination of the amount of reserves required, if any, for these contingencies are made after analysis of each individual issue. The required reserves may change in the future due to new developments in each matter or changes in approach, such as a change in settlement strategy, in dealing with these matters.

Currently, product liability claims and other ordinary routine litigation incidental to the Company’s business are the only litigation to which it is a party. While historically the Company’s product liability claims have not resulted in significant monetary liability

Advanced Neuromodulation Systems, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements

beyond its insurance coverage, an adverse judgment beyond its insurance coverage could have a material adverse impact on its results of operations and financial condition.

Under the Company’s sales agreements with its independent sales agents, the Company can terminate those agreements without cause by paying an early termination fee equal to 100% of the commissions that would otherwise be payable on sales in the territory for the 90 days after termination and 50% of the commission that would otherwise be payable on sales in the territory for the 90 day period after the first 90 day period.

In addition, under its distributor agreements, sales agent agreements and certain other ordinary course commercial contracts with third parties, the Company typically agrees to indemnify the other contracting party from damages and costs that may arise from product liability claims. The terms of the agreements and contracts vary, and the potential exposure under these indemnities cannot reasonably be estimated or determined. Historically, product liability claims for our neurostimulation devices have not resulted in significant monetary liability beyond our insurance coverage. We seek to maintain appropriate levels of product liability insurance with coverage that we believe is comparable to that maintained by companies similar in size and serving similar markets.

Financial Accounting Standards Board Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” (Interpretation 45) requires disclosures in interim and annual financial statements about obligations under certain guarantees issued by the Company. Furthermore, it requires recognition at the beginning of a guarantee of a liability for the fair value of the obligation undertaken in issuing the guarantee, with limited exceptions including: 1) a parent’s guarantee of a subsidiary’s debt to a third party, and 2) a subsidiary’s guarantee of the debt owed to a third party by either its parent or another subsidiary of that parent. The initial recognition and initial measurement provisions are only applicable on a prospective basis for guarantees issued or modified after December 31, 2002. This interpretation has had no impact on the Company’s consolidated statement of operations or condensed consolidated balance sheets.

The Company recorded income tax expense during the three months and nine months ended September 30, 2003 of $2,382,109 and $5,504,915, representing overall effective tax rates of 37.6% and 36.7%, respectively. These effective tax rates during the 2003 periods are higher than the U.S. statutory rate of 35% for corporations due to a provision for state taxes, offset by tax-exempt interest income. During the three months and nine months ended September 30, 2002, the Company recorded income tax expense of $963,048 and $2,213,984, representing overall effective tax rates of 33.2% and 34.4%, respectively. These effective tax rates during the 2002 periods include a provision for state taxes, offset by tax-exempt interest income.

On July 11, 2003, we effected a 3-for-2 stock split in the form of a 50% stock dividend (one share of common stock paid for every two shares held), paid to shareholders of

Advanced Neuromodulation Systems, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements

record on June 20, 2003. All prior period shares and income per share figures have been restated to reflect the split.

Basic net income per share is computed based only on the weighted average number of common shares outstanding during the period. Diluted net income per share is computed to reflect the additional dilutive effect, if any, of stock options and warrants using the treasury stock method based on the average market price of the stock during the period. The following table presents the reconciliation of basic and diluted shares:

For the three months and nine months ended September 30, 2003 and 2002, the incremental shares used for dilutive income per share relate to stock options whose exercise prices were less than the average market price in the underlying quarterly computations. For the three months ended September 30, 2003 and September 30, 2002, all stock options outstanding were included in the computation of diluted income per share because the options’ exercise prices were less than the average market price of the common shares for that three month period. For the nine months ended September 30, 2003, options to purchase 38,625 shares of common stock at an average exercise price of $30.30 were outstanding but were not included in the computation of diluted income per share because the options’ exercise prices were greater than the average market price of the common shares and, therefore, the effect would be antidilutive. For the nine months ended September 30, 2002, all stock options outstanding were included in the computation of diluted income per share because the options’ exercise prices were less than the average market price of the common shares.

Total comprehensive income for 2002 and for the nine months ended September 30, 2003 is reported in the Condensed Consolidated Statements of Stockholders’ Equity. Other comprehensive income (loss) is due to unrealized gains and losses on marketable securities. Comprehensive income (loss) for the three months and nine months ended September 30, 2003 and 2002 is as follows:

Advanced Neuromodulation Systems, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements

The Company operates in two business segments. The Neuro Products segment designs, develops, manufactures and markets implantable medical devices that are used to manage chronic intractable pain and other disorders of the central nervous system through the delivery of electrical current or drugs directly to targeted nerve fibers. The HDI O.E.M. segment provides contract development and O.E.M. manufacturing of electro-mechanical devices.

In January 2003, the Company invested $1 million in cash to purchase preferred stock for a minority equity position in Innovative Spine Technologies, Inc., a start-up company that develops spine technologies, products and services through intellectual property development and contract research. This investment is accounted for under the cost method of accounting due to our minimal ownership percentage.

On October 23, 2003, the Company announced that it had agreed to acquire certain assets of its sole remaining distributor of its Neuro Products in the United States, State of the Art Medical Products. As part of the transaction, which became effective November 1, 2003, six of State of the Art Medical’s direct sales people joined the Company’s direct sales force. State of the Art Medical purchased $5.3 million of the Company’s Neuro Products during the year ended December 31, 2002, and purchased $6.1 million for the nine months ended September 30, 2003. The purchase price of the assets is $3.5 million plus the value of the inventory, which we estimate at approximately $750,000.

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

The following discussion of the financial condition and results of operations of the Company should be read in conjunction with the Condensed Consolidated Financial Statements of the Company and the related Notes.

On June 6, 2003, we announced that our Board of Directors had approved a 3-for-2 stock split to be effected in the form of a 50% stock dividend (one share of common stock payable for every two shares held). The dividend was paid on July 11, 2003 to shareholders of record on June 20, 2003. We have restated all share data and net income per share data to reflect the split.

On November 25, 2002, we completed the acquisition of MicroNet Medical, Inc., a privately-held developer of medical devices based on proprietary micro-lead technology. MicroNet developed a line of very thin and steerable spinal cord stimulation leads called Axxess™ leads. These leads are the smallest diameter neurostimulation leads on the market, and because of their size, we believe they offer advantages in certain applications. Under the terms of the transaction, which we structured as a merger, we acquired only MicroNet’s proprietary technology and certain associated tangible assets. The MicroNet assets are a part of our Neuro Products segment. MicroNet’s operations, other tangible assets, certain liabilities and certain employees became part of a separate unaffiliated company. We assumed no material debt, liabilities, or overhead in the transaction. At closing, we paid the former MicroNet shareholders $500,000 in cash and 234,453 shares of our common stock with a value at the time of issuance of $4,648,421. In addition, we incurred expenses of $859,460, including an investment-banking fee of $600,000. We also agreed to pay the former MicroNet shareholders additional shares of our common stock if certain product, regulatory approval and sales milestones are met. These milestones consist of three principal product milestones and a sales milestone. Each of the product milestones has four to six sub-milestones that relate to the delivery of specific products, including four 4-electrode leads (Milestone I), two 8-electrode leads (Milestone II) and a 4-electrode lead and an 8-electrode lead designed for use in specific applications (Milestone III). The product sub-milestones are met if and when we are able to submit, and if and when we receive, regulatory approvals for products that have been adapted for use directly with our electrical stimulation devices. The sales milestone will be met if and when we and our subsidiaries generate $5 million in cumulative net sales of MicroNet lead products during the four years following the closing of the MicroNet transaction.

aggregate value of $3 million. In March 2003, two parts of the first major product milestone were satisfied, and we issued the former MicroNet shareholders an aggregate of 42,519 shares of our common stock (of which 22,401 shares were from escrow) with a value at the time of issuance and release from escrow of $1,020,059, which was allocated to certain identifiable intangible assets in accordance with the original purchase price allocation, resulting in additional purchased technology of $978,237, tradenames of $23,461, and non-compete agreements of $18,361. In October 2003, an additional product milestone was satisfied, and we issued the former MicroNet shareholders an aggregate of 17,463 shares of our common stock (of which 11,197 shares were from escrow) with a value at the time of issuance and release from escrow of $700,182, which will be allocated to certain identifiable intangible assets in accordance with the original purchase price allocation, which will result in additional purchased technology of $671,475, tradenames of $16,104, and non-compete agreements of $12,603. Important additional product milestone deadlines occur in November 2003 and May 2004, while other milestones depend on the receipt of regulatory approvals and meeting the aggregate sales milestone referred to above. All milestones must be met by November 2006 or November 2007, depending on the milestone.

On March 27, 2003, we completed the acquisition of the pain management business of Sun Medical, Inc. for $4,857,192 (including acquisition related expenses of $45,931). Sun Medical was the largest distributor of our Neuro Products and accounted for $6.33 million, or 13.5% of revenue of the Neuro Products segment during the twelve months ended December 31, 2002 and $2.87 million, or 14.5% of revenue of the Neuro Products segment during the six month period ended June 30, 2002. As part of the acquisition, we hired substantially all of the salespersons and clinical support specialists who worked for Sun Medical’s pain management business. Assets acquired consisted primarily of customer lists, non-competes, inventory, contracts, equipment and other tangible assets, but excluded cash and accounts receivable as of the closing date. The allocation of the purchase price as of March 31, 2003 is as follows: goodwill-$2,145,931, customer relations-$1,100,000, inventory-$1,011,261, other non-compete agreements-$300,000, supplier relations-$200,000, and employee non-compete agreements- $100,000. Amortization periods for the identifiable intangible assets are as follows: customer relations-7 years, other non-compete agreements-5 years, supplier relations-4 years and employee non-compete agreements-1 year.

On September 4, 2003, we completed the purchase of certain assets of Comedical, Inc. for $1,134,079. The acquisition expands the Company’s direct sales force. Comedical was a distributor of the Company’s Neuro Products in the Northwestern United States. As part of the acquisition, three of Comedical’s direct salespersons and three of its commissioned agents joined the Company’s sales force. Assets acquired consisted primarily of customer lists, non-compete agreements, inventory, contracts and equipment. The allocation of the purchase price is as follows: inventory-$352,742, customer relations-$367,860, non-compete agreements-$367,861 and equipment-$45,616. Amortization periods for the identifiable intangible assets are as follows: customer relations-7 years and non-compete agreements-4 years.

On October 23, 2003, we announced that we had agreed to acquire certain assets of our sole remaining distributor of our Neuro Products in the United States, State of the Art Medical Products. As part of the transaction, which closed on November 1, 2003, six of State of the Art Medical’s direct sales people joined the Company’s direct sales force. State of the Art Medical purchased $5.3 million of the Company’s Neuro Products during the year ended December 31, 2002 and for the nine months ended September 30, 2003, purchased $6.1 million. The

purchase price of the assets was $3.5 million plus the value of the inventory, which we estimate at approximately $750,000.

Our current neuromodulation product line includes our Genesis® Implantable Pulse Generator system, GenesisXP™ IPG system, Renew® Radio Frequency system and AccuRx® constant rate drug pump. With the launch of our Genesis and GenesisXP IPG systems, we now compete in 100% of the implantable neurostimulation market to treat chronic pain of the trunk and limbs. The launch of the Genesis IPG and GenesisXP IPG in 2002 slowed our growth rate in sales of Renew systems from an average annual percentage growth rate in the mid-teens over the past several years to single-digit annual growth in 2002. This trend has continued during the first nine-months of 2003 and we assume that it will continue during the fourth quarter of 2003.

Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities and related disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. On an on-going basis, management evaluates its estimates and judgments, including those related to product returns, bad debts, inventories, intangible assets, warranty obligations and contingencies and litigation. Management bases its estimates on historical experience and on various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

Management believes the following critical accounting policies affect its more significant judgments and estimates used in preparation of its consolidated financial statements.

We generate revenues from product sales to end customers, product sales to distributors, and development contracts.

We recognize revenue on product sales to end customers and distributors upon shipment, provided an arrangement with the customer or distributor exists, the fee is fixed and determinable, and collectibility is reasonably assured. Our shipping terms are FOB shipping point. We do not have any continuing obligation to our customers for installation or training, and there are no acceptance clauses in our customer arrangements. The only continuing obligation is a standard warranty that is offered to all customers. We accrue the estimated cost of providing that warranty at the point of sale based on our historical experience in fulfilling warranty obligations. We have not experienced warranty claims that exceeded our expectations.

End customers and distributors are granted rights of return for 60 days following the point of sale. We record, as a reduction in revenue, a provision for estimated sales returns and

adjustments on these product sales in the same period as the related revenue is recorded. These estimates are based on historical sales returns, analysis of credit memo data, and other known factors. We typically sell our products to distributors at a price equal to 75% to 78% of list price, and recognize the net amount as revenue when all the revenue recognition criteria detailed above are met. With the acquisition of State of the Art Medical’s assets in November 2003, we no longer utilize distributors to sell our products in the United States, although we continue to use distributors to sell our products in certain markets internationally.

We recognize revenue on development contracts at HDI using either the percentage of completion method for fixed price development contracts, or as the services are performed for development contracts that are completed on a time and materials basis. We recognize revenue using the percentage of completion method for the fixed price development agreements as the contract term can vary from 9 to 24 months, our right to receive payment depends on our performance in accordance with the agreement, and we can reasonably estimate the costs applicable to various stages of the development arrangement. Revenue is recognized based on the ratio of costs incurred in relation to the estimated costs for the total project. If we do not accurately estimate the resources required or the scope of work to be performed under a fixed price development agreement, then future profit margins and results of operations may be negatively impacted.

Payment received in advance of revenue recognition requirements are recorded as deferred revenue on the consolidated balance sheet.

We are required to estimate the collectibility of our trade receivables. A considerable amount of judgment is required in assessing the ultimate realization of the receivables, including the current credit-worthiness of each customer, the aging of receivables and our historical experience. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances or write-offs may be required.

Our reserve for excess and obsolete inventory is based upon forecasted demand for our products. If the demand for our products is less favorable than those projected by management, additional inventory write-downs or write-offs may be required.

Identifiable definite-life intangible assets, such as patents, purchased technology, trademarks and covenants not to compete, are amortized using the straight-line method over their useful lives.

In assessing the recoverability of our intangible assets, we must make assumptions regarding estimated future cash flows and other factors to determine the fair value of the respective assets. If these estimates or their related assumptions change in the future, we may be required to record impairment charges for these assets.

See Note 5 to the Consolidated Financial Statements for a discussion of the contingencies of proceedings, lawsuits and other claims related to our products and business.

Comparison of the Three Months and Nine Months Ended September 30, 2003 and 2002

Results for the third quarter and first nine months of 2003 continue to reflect the positive impact of revenue growth from increased unit sales of our Genesis and GenesisXP IPG systems, which we launched in the United States in January 2002 and December 2002, respectively. Based on our sales experience over the last few quarters, we increased our earnings guidance for 2003 in a press release dated October 23, 2003. We now expect net income per diluted share in a range of $.63 to $.64 for the full year, up from our previous guidance of net income per diluted share of $.59 to $.61.

Net revenue of our neuromodulation products increased 77.6% to $20.61 million in 2003 from $11.60 million in 2002 primarily due to increased sales of our Genesis and GenesisXP IPG systems. Revenue from our Renew RF system grew modestly during the quarter compared to the prior year quarter. Net revenue from our O.E.M. business increased 3.1% to $2.81 million in 2003 from $2.72 million in 2002 primarily due to higher volume of O.E.M. product sales. Net revenue of our neuromodulation products increased 80.1% to $56.59 million in 2003 year-to-date from $31.42 million in the same nine-month period in 2002, again primarily due to increased sales of our Genesis and GenesisXP IPG systems. Net revenue from our O.E.M. business increased 13.1% to $8.83 million in 2003 from $7.80 million in 2002 due to higher volume of O.E.M. product sales. We now expect net revenue in a range of $88 to $89.5 million for the full year, up from our previous guidance of $84 to $87 million.

Gross profit margins increased to 72.7% during the third quarter from 66.1% in the prior year quarter, and to 68.9% during the nine months from 63.2% in the prior year period, due to higher sales of our neuromodulation products, which contribute higher margins than O.E.M. product sales, higher neuromodulation product sales from direct sales and commissioned agents in part due to the acquisition of two of our distributors during the current periods, which contribute higher margins than distributor sales, and operational efficiencies gained from higher manufacturing volumes.

Total operating expenses increased as a percentage of revenue during the third quarter to 50.7% from 48.5% in the prior year quarter, and to 48.7% during the nine months from 48.3% in the prior year period, primarily due to increased investments in our sales and marketing capabilities, including the additional sales personnel acquired in the March 2003 Sun Medical acquisition and the September 2003 acquisition of Comedical, Inc.

Research and development expense increased in absolute dollar amounts during both periods in 2003 compared to 2002 due to higher salary and benefit expense from staffing additions and annual salary increases, higher stock based compensation expense for certain consultants and higher prototype tooling and test materials for new products under development. We also accelerated certain research and development projects, although we expect annual expenditures as a percentage of revenue to be consistent with budgeted amounts. Our development efforts continue to focus on next-generation IPG stimulation systems, next-

generation RF stimulation systems, an IPG stimulation system for deep brain stimulation and next generation drug pumps.

Sales and marketing expense increased during both the quarter and the nine-month period in 2003 compared to 2002 principally due to higher commission expense from increased Neuro Product sales, higher salary expense from annual salary increases and staffing additions in reimbursement, direct sales and clinical support specialists, higher employee benefit costs from staffing additions, higher travel expense due to increased direct sales activities and higher expense for education and training of new implanters of Neuro Products.

Amortization expense increased during both periods in 2003 compared to 2002 due to amortization expense for intangible assets we acquired in the MicroNet Medical, Inc. acquisition consummated in November 2002, the Sun Medical, Inc. acquisition consummated on March 27, 2003 and the Comedical, Inc. acquisition consummated on September 4, 2003.

General and administrative expense increased in absolute dollar amounts during both 2003 periods compared to the same periods in 2002 principally as a result of higher salary expense from annual salary increases and staffing additions, higher employee benefit costs, higher recruiting fee expense and higher depreciation expense.

Other income increased during both 2003 periods primarily due to the reversal of an accrued tax-abatement liability of $969,204 as we were legally released from our potential obligation to pay that amount during the third quarter of 2003. Interest income decreased during the third quarter of 2003 compared to 2002 due to lower yields on invested funds, but increased during the nine-month period due to higher funds invested during the 2003 period compared to 2002.

Income tax expense increased during both 2003 periods compared to the same periods in 2002 due to an increase in pretax income. The effective tax rate was 37.6% during the third quarter of 2003 compared to 33.2% during the 2002 third quarter. The effective tax rate was 36.7% during the 2003 nine-month period compared to 34.4% during the 2002 nine-month period. During both 2003 periods, we used a 35% federal income tax rate due to higher projected income while during 2002 we used a federal income tax rate of 34%. These effective tax rates in both 2003 and 2002 are higher than the U.S. statutory rate for corporations due to a provision for state taxes, offset by tax-exempt interest income.

At September 30, 2003, our working capital increased to $128.7 million from $114.3 million at December 31, 2002. The ratio of current assets to current liabilities was 17.76:1 at September 30, 2003, compared to 13.15:1 at December 31, 2002. Cash, cash equivalents, certificates of deposit and marketable securities totaled $96.61 million at September 30, 2003 compared to $96.77 million at December 31, 2002.

In 2003, we have acquired the assets of our three remaining domestic distributors, at a cost of approximately $10.2 million in cash. On October 23, 2003, we announced that we had agreed to acquire certain assets of our sole remaining distributor of our Neuro Products in the United States, State of the Art Medical Products. As part of the transaction, which was effective November 1, 2003, six of State of the Art Medical’s direct sales people joined the Company’s direct sales force. State of the Art Medical purchased $5.3 million of our Neuro Products during the year ended December 31, 2002 and $6.1 million during the nine months ended September

30, 2003. The purchase price of the assets was $3.5 million, plus the value of the inventory, which we estimate at approximately $750,000. In September 2003, we acquired certain assets of our exclusive distributor of pain management products for the Northwestern United States, Comedical, Inc. for approximately $1,134,000 in cash. In March 2003, we acquired Sun Medical’s pain management business, which expanded our direct domestic salesforce, for approximately $4,857,000 in cash, including approximately $46,000 in acquisition costs. See Notes 3 and 11 to the Notes to Condensed Consolidated Financial Statements.

In January 2003, we invested $1 million in cash to purchase preferred stock for a minority equity position in Innovative Spinal Technologies, Inc., a start-up company that develops spine technologies, products and services through intellectual property development and contract research.

We have increased our investment in inventories by approximately $4.8 million during the year in anticipation of continuing sales growth.

Our investment in trade accounts receivable increased due to increased sales and an increase in our days sales outstanding (DSOs) from 55 days at year-end 2002 to 61 days at September 30, 2003. Two factors accounted for the increase in DSOs. First, we acquired the pain management business of Sun Medical on March 27, 2003. Prior to our acquisition, Sun Medical would pay us within 10 days to take advantage of a payment discount. As such, our outstanding accounts receivable from Sun Medical at any point in time was relatively small. After this acquisition, we are now billing hospitals and insurance companies directly, and these customers tend to pay on a slower cycle than did Sun. Second, we experienced slower collections during the first nine months of 2003 from insurance companies because a larger portion of our neuro segment business revenues were derived from direct billing to insurance companies compared to the prior periods.

We spent $4.16 million during the nine months ended September 30, 2003 for capital expenditures, primarily for new office furniture and equipment for personnel we hired and additional manufacturing tooling and equipment to provide increased capacity to support our current products and for tooling and equipment for new products currently being developed. We have accelerated capital expenditures compared to our original budgeted amount of $3.3 million (excluding the facility discussed below) due to acceleration of development projects and capacity.

Because we expect our business to continue to grow at rates that will demand added office and facility space, we acquired approximately 10 acres of land in December 2002 for approximately $3.19 million. The land is located in Plano, Texas, near our current corporate headquarters. Our current lease on our 50,000 square foot corporate headquarters expires in August 2004. We intend to build a new corporate headquarters facility on the land and relocate to the new facility upon the expiration of our lease in August 2004. We are designing the new facility to accommodate planned growth within a five-year horizon and anticipate that the facility will contain 140,000 to 150,000 square feet and cost between $16 million and $17 million. While we have not yet determined the method by which we will finance the facility, we believe our cash position and overall balance sheet position provides us with various financing alternatives, including financing the facility from our current cash, financing through a debt vehicle such as a mortgage or other form of note, or a sale-and-leaseback transaction. In the interim, we are funding the construction from our cash reserves. We began construction of the facility during

the second quarter of 2003 and through September 30, 2003, we have used $3.1 million to fund the interim construction.

We received $5.81 million of cash during the nine months ended September 30, 2003 from the exercise of employee and director stock options to purchase 938,968 shares of our common stock.

Liquidity may also be enhanced based on our ability to utilize all or part of a net operating loss of $3.4 million to offset future taxable income. We acquired the net operating loss in connection with the MicroNet Medical acquisition and its utilization may be subject to a limitation under Section 382 of the Internal Revenue Code. The rules of Section 382 of the Internal Revenue Code generally apply to limit a corporation’s ability to utilize acquired net operating loss carryforwards to reduce its federal taxable income in the periods after an acquisition. The Company’s ability to use the net operating loss carryforwards acquired in the MicroNet Medical acquisition to reduce its federal taxable income is subject to these rules. Provided the Company generates sufficient taxable income in future years, the Section 382 limitation will have the effect of deferring the utilization of the net operating loss carryforwards over several years. Without this limitation, the Company would be able to use all of the net operating loss carryforwards to reduce taxable income in the tax periods immediately following the acquisition. The total amount of net operating loss carryforwards that the Company may use to reduce taxable income in any taxable year after the acquisition is determined with reference to its purchase price of MicroNet Medical. Based on current estimates and assumptions, we expect to utilize at least approximately $700,000 in net operating loss carryforwards per full tax year over the next five years, assuming we generate sufficient taxable income in any given year to utilize such amount.

Additionally, liquidity may be enhanced to the extent we realize tax benefits from employee stock option exercises. Exercises of nonqualified stock options, and exercises of incentive stock options followed by “disqualifying dispositions” of the underlying common stock within one year following exercise generate compensation expense for tax purposes in the year of exercise or disposition, as the case may be. During the nine months ended September 30, 2003, we generated a $7.24 million tax benefit related to nonqualified stock option exercises and disqualifying dispositions of common stock acquired on exercise of incentive stock options.

We believe our current cash, cash equivalents, marketable securities and cash generated from operations will be sufficient to fund our current levels of operating needs and capital expenditures for the foreseeable future. We currently have no credit facilities in place. If we decide to acquire complementary businesses, product lines or technologies, or enter into joint ventures or strategic alliances that require substantial capital, we intend to finance those activities by the most attractive alternative available, which could include utilizing our current cash, bank borrowings, or the issuance of debt or equity securities.

Net cash provided by operations increased for the first nine months of 2003 due to an increase in net income of $5.27 million. Major uses of cash for working capital components during the 2003 period were for increased accounts receivable from record sales levels and for increased investments in inventories in anticipation of continued sales growth. We also received the tax benefits from the exercise of stock options described above, and $1.2 million in cash from our distribution agreement with Boston Scientific Corporation.

Net cash used in investing activities decreased substantially during the period, principally due to a decrease of $86.32 million in net purchases of marketable securities because the prior period reflects the investing of the $83.20 million raised in a public offering during the 2002 period. In the 2003 period, we used cash of $4.86 million in the acquisition of Sun Medical’s pain management business, $3.1 million used to fund interim construction on our new facility, $1.1 million used to purchase minority investments in preferred stock, mostly related to a $1.0 million investment in Innovative Spinal Technologies, Inc., $1.13 million used in the acquisition of assets of Comedical, Inc. and a $2.45 million increase in funds used for capital expenditures.

Net cash provided by financing activities increased substantially in 2002, reflecting the $83.20 million raised in a public offering in May 2002. Exercise of stock options provided $5.81 million during the nine months ended September 30, 2003 compared to $1.47 million during the same period a year ago.

Substantially all of our international sales are denominated in U.S. dollars. Fluctuations in currency exchange rates in other countries could reduce the demand for our products by increasing the price of our products in the currency of the countries in which the products are sold, although we do not believe currency fluctuations have had a material effect on the Company’s results of operations to date.

The following is a “safe harbor” statement under the Private Securities Litigation Reform Act of 1995: The matters discussed in this Quarterly Report on Form 10-Q contain statements that constitute forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended. The words “expect”, “estimate”, “anticipate”, “predict”, “believe”, “plan”, “will”, “should”, “intend”, “potential”, “new market”, “potential market applications” and similar expressions and variations thereof are intended to identify forward-looking statements. Such statements appear in a number of places in this Quarterly Report on Form 10-Q and include statements regarding our intent, belief or current expectations with respect to, among other things: (i) trends affecting our financial condition or results of operations; (ii) our financing plans; and (iii) our business growth strategies. We caution our readers that any forward-looking statements are not guarantees of future performance and involve risks and uncertainties. Actual results may differ materially from those projected in the forward-looking statements as a result of various factors. These risks and uncertainties include the following:

•

failure of our Genesis and GenesisXP IPG systems to gain and maintain market acceptance would adversely affect our revenue growth and profitability

•

because our main competitor has significantly greater resources than we do and new competitors may enter the neuromodulation market, it may be difficult for us to compete in this market

•

if pain management specialists do not recommend and endorse our products, our sales could be negatively impacted and we may be unable to increase our revenues and profitability

•

the launch of Genesis and GenesisXP and other market factors could impede growth in or reduce sales of Renew, which would adversely affect our revenues and profitability

•

if patients choose less invasive or less expensive alternatives to our products, our sales could be negatively impacted

•

any adverse changes in coverage or reimbursement amounts by Medicare and Medicaid, private insurance companies and managed care organizations, or workers’ compensation programs could limit our ability to market and sell our products

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if we fail to protect our intellectual property rights, our competitors may take advantage of our ideas and compete directly against us

•

other parties may sue us for infringing their intellectual property rights, or we may have to sue them to protect our intellectual property rights

•

failure to obtain necessary government approvals for new products or for new applications for existing products would mean we could not sell those new products, or sell our existing products for those new applications

•

modification of any marketed device could require a new 510(k) clearance or PMA or require us to cease marketing or recall the modified device until we obtain this clearance or approval

•

we will be unable to sell our products if we fail to comply with manufacturing regulations

•

our products are subject to product recalls even after receiving FDA clearance or approval, which would negatively affect our financial performance and could harm our reputation

•

we are subject to potential product liability and other claims and we may not have the insurance or other resources to cover the cost of any successful claim

•

we are subject to substantial government regulation and our failure to comply with all applicable government regulations could subject us to numerous penalties, any of which could adversely affect our business

•

our reliance on single suppliers for critical components used in our main products could adversely affect our ability to deliver products on time

•

our major competitor in the neuromodulation market currently accounts for a significant percentage of our revenue from our O.E.M. segment

•

we are dependent upon the success of neuromodulation technology; our inability to continue to develop innovative neuromodulation products, or the failure of the neuromodulation market to develop as we anticipate, would adversely affect our business

•

our success will depend on our ability to attract and retain key personnel and scientific staff

•

if we choose to acquire complementary businesses, products or technologies instead of developing them ourselves, we may be unable to complete these acquisitions or to successfully integrate an acquired business, product or technology in a cost-effective and non-disruptive manner

•

our operations are conducted at three locations, and a disaster at any of these facilities could result in a prolonged interruption of our business

•

our shareholders’ rights plan and Texas law may inhibit a takeover that our shareholders consider favorable

•

we may be obligated to issue shares of our common stock in the future to the former shareholders of MicroNet Medical and the number of shares could increase if our stock price decreases

The foregoing risks are described in more detail in our Form 10-K/A for the year ended December 31, 2002. If our assumptions prove to be incorrect or such risks or uncertainties

materialize, anticipated results could differ materially from those forecasted in forward-looking statements.

For the period ended September 30, 2003, the Company did not experience material changes in market risk exposures that affect the quantitative and qualitative disclosures presented in the Company’s Annual Report on Form 10-K/A for the year ended December 31, 2002.

As of the end of the period covered by this report, an evaluation was carried out by our management, with the participation of our Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934). Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that these disclosure controls and procedures were effective.

There were no changes in the Company’s internal control over financial reporting (as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934) that occurred during the Company’s most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

Exhibit 4.1- Rights Agreement dated as of August 30, 1996, between Quest Medical, Inc. and KeyCorp Shareholder Services, Inc. as Rights Agent (2)

Exhibit 4.2- Amendment to Rights Agreement dated as of January 25, 2002, between Advanced Neuromodulation Systems, Inc and Computershare Investor Services LLC (formerly KeyCorp Shareholder Services, Inc.) (3)

Exhibit 31.1 — Certification of the Chief Executive Officer Pursuant to Rule 13a-14 of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (4)

Exhibit 31.2 — Certification of the Chief Financial Officer Pursuant to Rule 13a-14 of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (4)

Exhibit 32.1 — Certification of the Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (5)

Exhibit 32.2 — Certification of the Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (5)

(b)

The Company furnished a report on Form 8-K on July 28, 2003, providing under Item 9. Regulation FD Disclosure, a press release issued by the Company on July 28, 2003 disclosing information regarding our results of operations and financial condition for the second quarter of 2003 and our financial outlook for 2003.

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.


Exhibit 3.1		Articles of Incorporation, as amended and restated (1)

Exhibit 3.2		Bylaws, as amended and restated (1)

Exhibit 4.1		Rights Agreement dated as of August 30, 1996, between Quest Medical, Inc. and KeyCorp Shareholder Services, Inc. as Rights Agent (2)

Exhibit 4.2		Amendment to Rights Agreement dated as of January 25, 2002 between Advanced Neuromodulation Systems, Inc and Computershare Investor Services LLC (formerly KeyCorp Shareholder Services, Inc.) (3)

Exhibit 31.1		Certification of the Chief Executive Officer Pursuant to Rule 13a-14 of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (4)

Exhibit 31.2		Certification of the Chief Financial Officer Pursuant to Rule 13a-14 of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (4)

Exhibit 32.1		Certification of the Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (5)

Exhibit 32.2		Certification of the Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (5)


Texas		75-1646002

(State or Other Jurisdiction of		(I.R.S. Employer
Incorporation or Organization)		Identification No.)


	Number of Shares Outstanding at
Title of Each Class	October 31, 2003

Common stock, $.05 Par Value		19,549,822


PART I
FINANCIAL INFORMATION
	ITEM 1. FINANCIAL STATEMENTS
		Condensed Consolidated Balance Sheets
		Condensed Consolidated Statements of Income (Unaudited)
		Condensed Consolidated Statements of Cash Flows (Unaudited)
		Condensed Consolidated Statements of Stockholders’ Equity (Unaudited)
		Notes to Condensed Consoldiated Financial Statements
	ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
	ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
	ITEM 4. CONTROLS AND PROCEDURES
PART II
OTHER INFORMATION
	ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
Signatures
EXHIBIT INDEX
EX-31.1 Certification of CEO - Section 302
EX-31.2 Certification of CFO - Section 302
EX-32.1 Certification of CEO - Section 906
EX-32.2 Certification of CFO - Section 906


	Neuro		HDI		Intercompany			Consolidated
	Products		O.E.M.		Eliminations			Total

Revenue from external customers	$	20,612,131	$	2,806,374	$	—		$	23,418,505
Intersegment revenues	$	—	$	2,300,033	$	(2,300,033	)	$	—
Segment income from operations	$	4,662,304	$	503,210	$	—		$	5,165,514


	Neuro		HDI		Intercompany			Consolidated
	Products		O.E.M.		Eliminations			Total

Revenue from external customers	$	11,604,437	$	2,723,068	$	—		$	14,327,505
Intersegment revenues	$	—	$	1,483,118	$	(1,483,118	)	$	—
Segment income from operations	$	1,897,556	$	635,318	$	—		$	2,532,874

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x		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT 1934
		FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2003


o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT 1934

(1)		Filed as an Exhibit to the report of the Company on Form 10-K for the year ended December 31, 2000, and incorporated herein by reference.

(2)		Filed as an Exhibit to the report of the Company on Form 8-K dated September 3, 1996, and incorporated herein by reference.

(3)		Filed as an Exhibit to the report of the Company on Form 8-K dated January 30, 2002, and incorporated herein by reference.

(4)		Filed herewith.

(5)		Furnished herewith.


	ADVANCED NEUROMODULATION SYSTEMS, INC

Date: November 13, 2003	By:	/s/ F. Robert Merrill III

	F. Robert Merrill III
	Executive Vice President, Finance
	Chief Financial Officer and Treasurer