UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

Commission file number 0-10521

ADVANCED NEUROMODULATION SYSTEMS, INC.

6901 Preston Road, Plano, Texas 75024

(972) 309-8000

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

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

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

ADVANCED NEUROMODULATION SYSTEMS, INC. AND SUBSIDIARIES

Table of Contents

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PART I

FINANCIAL INFORMATION

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ITEM 1. FINANCIAL STATEMENTS

Advanced Neuromodulation Systems, Inc. and Subsidiaries

See accompanying notes to condensed consolidated financial statements.

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Advanced Neuromodulation Systems, Inc. and Subsidiaries
Condensed Consolidated Balance Sheets (continued)
September 30, 2004 (Unaudited) and December 31, 2003

See accompanying notes to condensed consolidated financial statements.

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Advanced Neuromodulation Systems, Inc. and Subsidiaries

See accompanying notes to condensed consolidated financial statements.

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Advanced Neuromodulation Systems, Inc. and Subsidiaries

See accompanying notes to condensed consolidated financial statements.

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Advanced Neuromodulation Systems, Inc. and Subsidiaries

See accompanying notes to condensed consolidated financial statements.

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Advanced Neuromodulation Systems, Inc. and Subsidiaries

(1)		Business
		Advanced Neuromodulation Systems, Inc. (the Company or ANS) designs, develops, manufactures and markets implantable neuromodulation devices. ANS devices are used primarily to manage chronic severe pain. The Company also provides contract development and custom manufacturing for other medical device companies through the Hi-tronics Designs, Inc. (HDI) subsidiary and through the ANS Portland division (formerly the Cable and Wire Division of microHelix, Inc., which was acquired in April 2004). ANS neuromodulation revenues are derived primarily from sales throughout the United States, Europe and Australia while HDI and ANS Portland revenues are derived within the United States.
		The research and development, manufacture, sale and distribution of medical devices is subject to extensive regulation by various public agencies, principally the Food and Drug Administration and corresponding state, local and foreign agencies. Product approvals and clearances can be delayed or withdrawn for failure to comply with regulatory requirements or the occurrence of unforeseen problems following initial marketing.
		In addition, ANS neuromodulation products are purchased by hospitals and other users who then bill various third party payors including Medicare, Medicaid, private insurance companies and managed care organizations. ANS also sells and bills its neuromodulation products directly to third party payors including Medicare, Medicaid, private insurance companies and managed care organizations. These third party payors reimburse fixed amounts for products and services based on a specific diagnosis. The impact of changes in third party payor reimbursement policies and any amendments to existing reimbursement rules and regulations that restrict or terminate the eligibility of ANS products could have an adverse impact on the Company’s financial condition and results of operations.
		In January 2004, the Company began operations in Germany to sell its neuromodulation devices through its wholly-owned subsidiary, ANS GmbH. Previously, the Company utilized a distributor in Germany, and this relationship was terminated in January 2004 at no cost to the Company. On April 1, 2004, the Company began operations in Australia to sell its neuromodulation devices though its wholly-owned subsidiary, ANS Australia. Previously, the Company utilized a distributor in Australia, MedTel Pty Limited (formerly Getz Brothers Australia) based in Sydney, Australia (MedTel). The Company acquired certain assets of MedTel on April 1, 2004 for approximately $1.1 million. The foreign subsidiaries’ financial position and results of operations are measured using the local currency as the functional currency. Transaction gains and losses are recorded in the Condensed Consolidated Statement of Income for transactions denominated in a currency other than the functional currency. Assets and liabilities are translated at the exchange rate in effect at the balance sheet date, and income and expense accounts at average exchange rates during the period. Resulting translation adjustments are recorded directly to accumulated other comprehensive income (loss).

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

(2)		Condensed Financial Statements
		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 affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from these estimates.
		Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted. These financial statements should be read in conjunction with the financial statements and notes thereto included in our December 31, 2003 Annual Report on Form 10-K. The results of operations for the period ended September 30, 2004 are not necessarily indicative of operations for the full year.
		The consolidated financial statements include the accounts of Advanced Neuromodulation Systems, Inc. and its subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.
(3)		Marketable Securities
		In August 2004, the Company acquired 3,500,000 shares, or approximately 14.7%, of the outstanding common stock of Cyberonics, Inc. in open market purchases. The aggregate purchase price paid for the shares was $49,679,619, or an average price per share of $14.194. In connection with the purchase, the Company had an obligation of $5,020,708 at September 30, 2004, due under a margin agreement with the securities firm who purchased the shares for the Company. The obligation was fully repaid subsequent to September 30, 2004. The investment in these marketable securities are classified as available-for-sale and are carried at fair value with the unrealized gains, net of tax, reported as a separate component of shareholders’ equity entitled “Accumulated Other Comprehensive Income (Loss).” At September 30, 2004, the fair value of the securities had increased in value to $71,610,000 and the Company recorded an unrealized gain, net of tax, of $14,474,051, which is included in the Accumulated Other Comprehensive Income component of shareholders’ equity.
		For so long as the Company is a beneficial owner of more than 10% of Cyberonics common stock, the Company is subject to the “short swing profit” provisions of Section 16(b) of the Securities Exchange Act of 1934. Under such provisions, beneficial owners of more than 10% of a publicly-traded company’s securities are required to disgorge any profits realized on the sale of such securities within any period of less than six months.
(4)		Acquisitions
		On November 26, 2002, the Company completed the acquisition of MicroNet Medical, Inc. (MicroNet), a privately-held developer of medical devices based on proprietary micro-lead technology. MicroNet developed a line of very thin and steerable spinal cord

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

stimulation leads called Axxess™ leads. In addition to the initial purchase price paid at closing, the Company agreed to pay the former MicroNet shareholders additional shares of ANS common stock if certain product, regulatory approvals, and sales milestones are met. Certain product milestones were met in March and October 2003, and the Company paid the related milestone payments at that time.

In January 2004, MicroNet satisfied another product milestone relating to the development of a four-electrode lead, and the Company issued 16,705 shares of ANS common stock to the former MicroNet shareholders (of which 11,202 were released from escrow) with a value at the time of issuance and release from escrow of $767,511. The value of ANS common stock issued and released from escrow was allocated to certain identifiable intangible assets in accordance with the original purchase price, and resulted in the following additions to identifiable intangible assets:

As the MicroNet acquisition was effected through a stock-for-stock exchange, and therefore not tax deductible beyond MicroNet’s existing tax basis, the Company recorded a deferred tax liability of $405,865 for the identified intangible assets related to the January 2004 earn-out consideration. The recording of the deferred tax liability resulted in additional basis in purchased technology of $396,359 and in additional tradenames of $9,506.

In May 2004, the Company and the former MicroNet shareholders agreed that no further product milestone payments will be payable under the agreement because no further product milestones will be met. Consequently, 89,609 shares of ANS common stock held in escrow were returned to the Company. However, the former MicroNet shareholders may still earn additional ANS common stock with an aggregate value of $3 million if the Company generates $5 million in cumulative net sales of MicroNet lead products by November 2006. As a result of the May 2004 agreement with MicroNet, the Company reviewed the previously recorded identifiable intangible assets associated with the MicroNet acquisition and has concluded there was no impairment of these intangible assets.

On April 1, 2004, the Company acquired certain assets of its exclusive distributor of neuromodulation devices for Australia, MedTel Pty Limited (formerly Getz Brothers Australia) based in Sydney, Australia for $1,086,558 cash. Two sales professionals from MedTel joined the Company’s sales force and additional direct sales personnel will be hired as needed. The assets and operations acquired are part of the Neuro Products segment and the Company began operations in Australia to sell its neuromodulation devices through its wholly owned subsidiary, ANS Australia. The purchase price allocation is as follows:

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

On April 21, 2004, the Company acquired the assets of the Cable and Wire Division from microHelix, Inc. (microHelix), which operates out of Portland, Oregon. The purchase price was $2,177,679 consisting of $2,006,551 in cash, assumed liabilities of $131,574 and acquisition costs of $39,554. microHelix previously supplied coated fine wire, antennas, and certain other products to ANS and HDI. The acquisition represents a vertical integration of a component supplier and provides the Company with additional engineering resources and intellectual property for the design and development of new products, notably leads, extensions, trial cables and related products. Thirty-three personnel from microHelix joined the Company upon consummation of the transaction. The assets and operations acquired (now known as ANS Portland Division) are part of the O.E.M. segment. The purchase price allocation is as follows:

The results of operations for the acquisitions above have been included in the Company’s Condensed Consolidated Statements of Income after the date of the acquisition.

(5)

Stock Based Compensation

The Company accounts for its stock-based compensation plans in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB 25) and related interpretations. Under APB 25, no compensation expense is recognized for stock option grants if the exercise price of the Company’s stock option grants is at or above fair market value of the underlying stock on the date of grant. Stock-based compensation to non-employees is measured at fair market value over the service period and recorded as compensation expense in the Condensed Consolidated Statement of Income. The Company recorded $11,035 and $264,945 of stock-based compensation expense to non-employees in the three months ended September 30, 2004 and 2003, respectively. The Company recorded $9,885 and $505,430 of stock-based compensation expense to non-employees in the nine months ended September 30, 2004 and 2003, respectively. The Company has adopted the pro forma disclosure-only provisions of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (SFAS 123), as amended by Statement of Financial Accounting Standards No. 148, “Accounting for Stock-Based

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

Compensation-Transition and Disclosure.” The following table illustrates the effect on net income and net income per share amounts if the Company had applied the fair value recognition provisions of SFAS 123 to stock-based employee compensation:

(6)

Commitments and Contingencies

On April 21, 2004, the Company filed a lawsuit in the U.S. District Court for the Eastern District of Texas, Sherman Division (Docket No. 4:404-CV-00131-PNB-DDB) (the Texas Action) against Advanced Bionics Corporation, asserting claims of patent infringement, misappropriation of trade secrets, tortious interference with contract, misappropriation of time, labor, skill, and money, violation of the Texas Theft Liability Act, conversion and constructive trust. The lawsuit alleges, among other things, that Advanced Bionics is infringing United States Patent No. 4,793,353 entitled “Non-Invasive Multiprogrammable Tissue Stimulator And Method.” In addition, the lawsuit alleges that Advanced Bionics hired a former ANS employee to aid in the design, development and manufacture of its implantable stimulation lead, that Advanced Bionics misappropriated the former employee’s knowledge of ANS’ confidential, proprietary, and trade secret information with respect to ANS’ implantable stimulation leads, and that this enabled Advanced Bionics to unfairly compete with ANS. The lawsuit seeks injunctive relief, compensatory and punitive damages, attorneys’ fees and costs. On June 7, 2004, Advanced Bionics filed a lawsuit with the United States District Court, Central District of California, Case No. CV04-4054ABC (the California Action), seeking a declaratory judgment that it is not infringing ANS’ patent No. 4,793,353 (the subject of ANS’ current patent infringement claim against Advanced Bionics) and that such patent is invalid and unenforceable. On October 15, 2004, the judge in the Texas Action granted the Company’s motion to amend its lawsuit to add two additional patent infringement claims against Advanced Bionics. One claim relates to the Company’s patent covering the design and structure of its electrode lead (U.S. Patent No. 6,216,045). The second claim relates to the Company’s trial cable connector patent (U.S. Patent No. 6,154,678). In addition, the judge denied Advanced Bionics’ motion to dismiss the Texas Action. Subsequently, Advanced Bionics has informed the Company that it has asked the judge in the California Action to dismiss that case without prejudice.

The Company is a party to certain product liability claims related to ANS neurostimulation devices. Product liability insurers have assumed responsibility for defending the Company against these claims. The Company seeks to maintain

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

appropriate levels of product liability insurance with coverage comparable to that maintained by companies similar in size and serving similar markets. While historically, product liability claims for ANS neurostimulation devices have not resulted in significant monetary liability to the Company beyond its insurance coverage, there can be no assurances that the Company will not incur significant monetary liability to the claimants if such insurance is inadequate, and there can be no assurance that the Company’s neurostimulation business and future ANS product lines will not be adversely affected by these product liability claims.

Except for the matters described above, and other ordinary routine litigation incidental or immaterial to its business, the Company is not currently a party to any other pending legal proceeding. The Company maintains general liability insurance against risks arising out of the normal course of business.

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

In addition, under its distributor agreements, sales agent agreements and certain other ordinary course commercial contracts with third parties, the Company typically agrees to indemnify the other contracting party from damages and costs that may arise from product liability claims. The terms of the agreements and contracts vary and the potential exposure under these indemnities cannot reasonably be estimated or determined.

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Income Taxes

The Company recorded income tax expense during the three months and nine months ended September 30, 2004 of $2,433,791 and $6,926,251, respectively, representing an overall effective tax rate of 33.9% and 34.7%, respectively. For the three months and nine months ended September 30, 2003, the Company recorded income tax expense of $2,382,109 and $5,504,915, respectively, representing overall effective tax rates of 37.6% and 36.7%. The decreased effective tax rate in 2004 is primarily due to a research and development tax credit, an enhanced benefit related to the Extraterritorial Income Exclusion (ETI), and income in Australia where the statutory rate for corporations is lower than the U.S. statutory rate. The effective tax rates in 2004 and 2003 reflect a provision for federal income taxes at the statutory rate of 35% and a provision for state taxes, offset by tax-exempt investment income earned on our cash, cash equivalents, and marketable securities and, in 2004, the research and development tax credit, benefits related to ETI, and the lower corporate tax rate in Australia.

The Company elected to carry forward its prior year tax loss instead of filing amended tax returns for refunds. As such the prior year income tax receivable was reclassified to deferred income tax asset, which is being utilized in the current year. In addition, the Company recorded a deferred tax liability of $7.4 million associated with the unrealized gain on its investment in Cyberonics.

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

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Net Income Per Share

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

For the three months and nine months ended September 30, 2004 and 2003, the incremental shares used for dilutive earnings per share relate to stock options whose exercise price was less than the average market price in the underlying quarterly computations. For the three months ended September 30, 2004 and 2003, options to purchase 1,083,475 and 0 shares, respectively, were outstanding, and for the nine months ended September 30, 2004 and 2003, options to purchase 1,062,439 and 7,067 shares, respectively, were outstanding, but were not included in the computation of diluted earnings per share because the options’ exercise price was greater than the average market price of the common shares and, therefore, the effect would be antidilutive.

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Comprehensive Income

Comprehensive income is the total of net income and all other non-owner changes in equity net of tax effects, and consists of net income, unrealized gains or losses on the Company’s available for sale securities, and foreign currency translation adjustments. Comprehensive income for 2003 and for the nine months ended September 30, 2004 is reported in the Condensed Consolidated Statements of Stockholders’ Equity.

Comprehensive income (loss) for the three months and nine months ended September 30, 2004 and 2003 is as follows:

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Accrued Tax Abatement Liability

In January 1998, the Company sold its cardiovascular operations to Atrion Corporation, and granted Atrion a nine-month option to acquire the Company’s principal office and manufacturing facility in Allen, Texas for $6.5 million. During October 1998, Atrion

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

exercised its option to acquire the facility. When the facility was built in 1993, the Company entered into a ten-year agreement with the City of Allen, which granted tax abatements to the Company if a minimum job base and personal property base were maintained in the City of Allen. The agreement provided for the repayment of abated taxes if the Company defaulted under the agreement. During 1998 the Company recorded a pretax expense of $969,204 in connection with the abated taxes. In April 1999, the Company was successful in petitioning the City of Allen to assign the abatement agreement to Atrion. In July 1999, the Company, Atrion and the City of Allen executed an assignment agreement under which Atrion (as successor in interest to the Company) must continue to meet the conditions of the original tax abatement agreement until August 2003. Atrion met the minimum requirements under the agreement through 2003, and as such the Company was absolved from any liability. Accordingly, the Company reversed the accrual of $969,204 in September 2003 to other income in the Condensed Consolidated Statements of Income.

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Segment Information

The Company operates in two business segments. The Neuro Products segment designs, develops, manufactures and markets implantable medical devices that are used to manage chronic intractable pain and other disorders of the central nervous system through the delivery of electrical current or drugs directly to targeted nerve fibers. The O.E.M. segment provides contract development and O.E.M. manufacturing. Intersegment revenue is billed at cost with no intercompany mark-up.

Segment data for the three months ended September 30, 2004 is as follows:

Segment data for the three months ended September 30, 2003 is as follows:

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

Segment data for the nine months ended September 30, 2004 is as follows:

Segment data for the nine months ended September 30, 2003 follows:

Foreign sales, primarily Europe and Australia, for the three months ended September 30, 2004 and 2003 were approximately 10% and 7%, and for the nine months ended September 30, 2004 and 2003 were approximately 10% and 8%, of net revenue from the Neuro Products segment, respectively. The O.E.M. segment had no foreign sales for the respective periods.

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

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

Recent Developments

On November 26, 2002, we completed the acquisition of MicroNet Medical, Inc. (MicroNet), a privately-held developer of medical devices based on proprietary micro-lead technology. MicroNet developed a line of very thin and steerable spinal cord stimulation leads called Axxess™ leads. In addition to the initial purchase price paid at closing, we agreed to pay the former MicroNet shareholders additional shares of ANS common stock if certain product, regulatory approvals, and sales milestones are met. Certain product milestones were met in March and October 2003, and we paid the related milestone payments at that time.

In January 2004, MicroNet satisfied another product milestone and we issued 16,705 shares of our common stock to the former MicroNet shareholders (of which 11,202 were released from escrow) with a value at the time of issuance and release from escrow of $767,511. The value of ANS common stock issued and released from escrow was allocated to certain identifiable intangible assets in accordance with the original purchase price, and resulted in the following additions to identifiable intangible assets: purchased technology-$736,043; tradenames-$17,653; and non-compete agreements-$13,815.

In May 2004, the Company and the former MicroNet shareholders agreed that no further product milestone payments will be payable under the agreement because no further product milestones will be met. Consequently, 89,609 shares of ANS common stock held in escrow were returned to the Company. However, the former MicroNet shareholders may still earn additional shares of ANS common stock with an aggregate value of $3 million if the Company generates $5 million in cumulative net sales of MicroNet lead products by November 2006.

In January 2004, we began operations in Germany to sell our neuromodulation devices through our wholly owned subsidiary, ANS GmbH. Previously, we utilized a distributor in Germany and this relationship was terminated in January 2004 at no cost to us. On April 1, 2004, we acquired certain assets of our exclusive distributor of Neuro Products for Australia, MedTel Pty Limited (formerly Getz Brothers Australia) based in Sydney, Australia (MedTel). Two sales professionals from MedTel joined our sales force and additional direct sales personnel will be hired as needed. The purchase price of the assets was $1,086,558. The assets and operations acquired are part of the Neuro Products segment and we began operations in Australia to sell our neuromodulation devices through our wholly owned subsidiary, ANS Australia in April 2004.

On April 21, 2004, we acquired the assets of the Cable and Wire Division of microHelix, Inc. (microHelix), which operates out of Portland, Oregon, for approximately $2 million in cash and assumed liabilities of approximately $132,000. microHelix previously supplied coated fine wire, antennas, and certain other products to us and our wholly-owned

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subsidiary, Hi-Tronics Designs, Inc (HDI). The acquisition represents a vertical integration of a component supplier and provides us with additional engineering resources and intellectual property for the design and development of new products, notably leads, extensions, trial cables and related products. Thirty-three personnel from microHelix joined us upon consummation of the transaction. The assets and operations acquired are part of the O.E.M. segment.

On April 21, 2004, we filed a lawsuit in the U.S. District Court for the Eastern District of Texas, Sherman Division, asserting, among other things, that Advanced Bionics Corporation is infringing a patent we own and has misappropriated certain of our trade secrets. On October 15, 2004, the judge granted our motion to amend the lawsuit to add two additional patent infringement claims, one relating to the design and structure of our electrode lead and one relating to our trial cable connector. The judge also denied Advanced Bionics’ motion to dismiss the lawsuit.

On August 12 and 13, 2004, we acquired 3,500,000 shares, or approximately 14.7%, of the outstanding common stock of Cyberonics, Inc. (NASDAQ:CYBX) in open market purchases. The aggregate purchase price paid for the shares was $49,679,619, or an average price per share of $14.194. We informed Cyberonics of this purchase on August 19, 2004, and invited management of Cyberonics to discuss the possibility of a combination of the two companies, which Cyberonics’ management declined. On September 14, 2004, in a letter to Cyberonics management, we reiterated our suggestion that we meet to discuss a business combination and stated that based upon publicly available information, we were prepared to offer Cyberonics shareholders $22 per share payable in a combination of cash and our common stock. Subsequently, the Board of Directors of Cyberonics declined our invitation to meet to discuss a business combination. Cyberonics has publicly stated that it intends to “gain clarity and certainty in a revised depression regulatory plan and timetable,” and has taken steps to try to persuade the FDA to reverse its decision in a “non-approvable” letter relating to the application of Cyberonics’ vagal nerve stimulator to treat Treatment-Resistant Depression by submitting additional data to the FDA. Cyberonics has stated that it could take 120 to 180 days or more to obtain a decision from the FDA. Given the amount of time that could transpire before Cyberonics attains clarity and certainty on this matter, Cyberonics’ Board of Directors’ decision not to discuss a business combination with us, and our judgment that it does not make good business sense to try to force the issue, on September 30, 2004, we notified Cyberonics that we were withdrawing our proposal.

At September 30, 2004, the fair value of our investment in Cyberonics common stock increased to $71,610,000 and we recorded an unrealized gain, net of tax, of $14,474,051, which is included in the accumulated other comprehensive income component of shareholders’ equity.

Critical Accounting Policies and Estimates

General

Our discussion and analysis of our financial condition and results of operations are based upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United

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States. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities and related disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. On an on-going basis, management evaluates its estimates and judgments, including those related to third-party reimbursement rates, bad debts, inventories, intangible assets, and contingencies and litigation. Management bases its estimates on historical experience and on various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

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

Revenue Recognition

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

We sell products primarily through a direct sales force in the U.S and a combination of direct sales representatives and independent distributors in international markets. A significant portion of revenue is generated from consigned inventory generally maintained with field representatives, which is recognized as revenue upon notification of implant or product usage. All other product sales to end customers and international distributors are recorded upon transfer of title and risk of loss to customers, provided an arrangement exists, the fee is fixed and determinable, and collectibility is reasonably assured. Estimated sales returns, discounts, and rebates are recorded as a reduction of sales when the related revenue is recognized. Certain of our customers are third-party payors who reimburse fixed amounts for products based on a specific diagnosis. Revenue is recognized on these third-party payor sales based on the sales price less a contractual adjustment, which is based on our history of reimbursement with the third-party payor, provided all other revenue recognition criteria are met. We do not have any continuing obligation to our customers for installation or training, and there are no acceptance clauses in our customer arrangements.

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

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Shipping and handling costs are included in cost of revenue. Payments received in advance of revenue recognition requirements are recorded as deferred revenue on the consolidated balance sheet.

Bad Debt

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

Inventory Reserve

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

Intangible Assets

Intangible assets consist of goodwill, patents, purchased technology, trademarks, customer and supplier relations and covenants not to compete, and are amortized using the straight-line method over their respective useful lives.

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

Contingencies and Litigation

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

While historically our product liability claims have not resulted in significant monetary liability beyond our insurance coverage, an adverse judgment beyond our insurance coverage could have a material adverse impact on our results of operations and financial condition.

Stock Compensation

See Note 5 to the Condensed Consolidated Financial Statements for a discussion of the application of Statement of Financial Accounting Standards (SFAS) No. 123,

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“Accounting for Stock-Based Compensation” and SFAS 148, “Accounting for Stock-Based Compensation – Transition and Disclosure” to our stock compensation programs.

Results of Operations

Comparison of the Three Months and Nine Months Ended September 30, 2004 and 2003

Results for the third quarter and first nine months of 2004 continue to reflect the positive impact of revenue growth from increased unit sales of our Genesis^® and GenesisXP^™ IPG systems, which we launched in the United States in January 2002 and December 2002, respectively. We believe these systems will generate most of our revenue growth during the remainder of 2004. References below to the third quarter are comparisons of the three months ended September 30, 2004 and 2003 and references below to the first nine months are comparisons of the nine months ended September 30, 2004 and 2003, unless otherwise specified.

Net revenue. Net revenue for the third quarter increased $7.9 million, or 33.8%, and for the first nine months increased $23.0 million, or 35.2%, due to increased sales of our neuro products during both 2004 periods. Neuro product revenue increased 36.9% to a record $28.2 million in the third quarter of 2004 from $20.6 million in 2003, and for the first nine months neuro product revenue increased 41.5% to a record $80.1 million in 2004 from $56.6 million in 2003, primarily due to increased sales of our Genesis family of IPG systems. Revenue from our Renew® RF system grew modestly during both the third quarter and first nine months of 2004 compared to 2003. Net revenue of our O.E.M. business for the third quarter increased slightly to $3.1 million in 2004 from $2.8 million in 2003 due to higher volume of O.E.M. product sales, and for the first nine months, decreased to $8.4 million in 2004 from $8.8 million in 2003 primarily due to lower volume of O.E.M. product sales. We continue to use more of our O.E.M. manufacturing and development capabilities for our own increasing needs, and accordingly, O.E.M. revenues may flatten or decline during fiscal 2004 compared to fiscal 2003. In a press release dated October 28, 2004, we provided a revenue outlook for the fourth quarter 2004 of $32 to $33 million and provided our initial revenue guidance for 2005 of $145 million. We believe most of our revenue growth in 2005 will be generated from increased sales of our Genesis family of IPG systems.

Gross profit. Gross profit for the third quarter increased $5.9 million, or 34.5%, and for the first nine months increased $19.6 million, or 43.5%, due to the increase in net revenue discussed above and an improvement in gross profit margins. Gross profit margins for the third quarter increased to 73.1% in 2004, compared to 72.7% in 2003, and for the first nine months increased to 73.1% in 2004, compared to 68.9% in 2003 due to higher sales of our neuromodulation products, which contribute higher margins than O.E.M. product sales, higher neuromodulation product sales from direct sales and commissioned agents which contribute higher margins than distributor sales, and operational efficiencies gained from higher manufacturing volumes. In March, September and November 2003, we completed three separate acquisitions of certain operations of our remaining U.S. distributors and transitioned to a direct sales model in those associated territories, and in April 2004, we completed the acquisition of certain assets of our Australian distributor and transitioned to a direct sales model in that territory. This had the effect of improving gross margins in 2004 due to direct sales of

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product versus sales to distributors at reduced pricing. Correspondingly, sales and marketing expense increased as we added direct salespeople.

Operating expenses. Total operating expenses for the third quarter increased $4.4 million, or 37.4%, and increased as a percentage of revenue to 52.0% in 2004 from 50.7% in 2003. For the first nine months, total operating expenses increased $13.9 million, or 43.6%, and increased as a percentage of revenue to 51.7% in 2004 from 48.7% in 2003. These increased operating expenses during both periods in 2004 compared to 2003 were primarily due to increased investments in our sales and marketing capabilities. During late 2003 and early 2004, we added a total of 41 personnel in our sales organization including sales reps, regional sales managers and clinical specialists. We expect to leverage this investment in the next few quarters as our new sales personnel ramp up productivity.

Sales and marketing. Sales and marketing expense for the third quarter, as a percentage of net revenue, increased to 31.3% in 2004 from 29.8% in 2003, and the expense increased in absolute dollars by $2.8 million. Sales and marketing expense for the first nine months, as a percentage of net revenue, increased to 31.4% in 2004 from 28.2% in 2003, and the expense increased in absolute dollars by $9.3 million. Increases during both periods in 2004 compared to 2003 were principally due to higher salary and benefit expense from annual salary increases and staffing additions in reimbursement, direct sales, clinical specialists and regional sales managers, higher commission expense from increased neuro product sales, and higher travel expense due to increased direct sales activities. As noted above, part of the increase in sales and marketing expense is attributable to the addition of direct salespeople as a result of the three acquisitions of certain operations of our remaining U.S. distributors completed in 2003 and our Australian distributor in April 2004.

Research and development. Research and development expense for the third quarter, as a percentage of net revenue, decreased to 9.3% in 2004 from 10.9% in 2003, while the expense increased in absolute dollars by $359,000. Research and development expense for the first nine months, as a percentage of net revenue, decreased to 9.2% in 2004 from 10.1% in 2003, while the expense increased in absolute dollars by $1.5 million. The increase in expense in terms of absolute dollars during both periods in 2004 compared to 2003 was principally due to higher salary and benefit expense from staffing additions and annual salary increases. Our development efforts continue to focus on next-generation IPG stimulation systems, an IPG stimulation system for deep brain stimulation and next generation drug pumps. We budgeted $12 million in research and development expense in fiscal 2004 but now expect to spend approximately $11 million due to a delay in the commencement of our clinical trials on deep brain stimulation and migraine headaches.

General and administrative. General and administrative expense for the third quarter, as a percentage of net revenue, increased to 9.5% in 2004 from 8.0% in 2003, and the expense increased in absolute dollars by $1.1 million. General and administrative expense for the first nine months, as a percentage of net revenue, increased to 9.0% in 2004 from 8.4% in 2003, and the expense increased in absolute dollars by $2.5 million. The increase in expense during both periods in 2004 compared to 2003 was principally due to higher salary and benefit expense from annual salary increases and staffing additions, higher legal expense including expense associated with our lawsuit against

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Advanced Bionics, expense related to compliance with Sarbanes-Oxley requirements, and higher depreciation expense.

Amortization of intangibles. Amortization expense of intangibles for the third quarter, as a percentage of net revenue, remained flat in 2004 from 2003, and the expense increased in absolute dollars by $153,000. Amortization expense for the first nine months, as a percentage of net revenue, increased to 2.1% in 2004 from 2.0% in 2003, and the expense increased in absolute dollars by $547,000. The increase in expense during both periods in 2004 compared to 2003 was due to additional expense for intangible assets we acquired in the April 2004 acquisitions of MedTel and microHelix, additional intangible assets from earn-out consideration as milestones were met pursuant to the MicroNet acquisition agreement in 2004 and additional intangible assets we acquired in certain distributor acquisitions during the fourth quarter of 2003.

Other income. Other income for the third quarter decreased by $606,000 and for the nine months decreased by $755,000 principally due to other income in both 2003 periods of $969,000, recorded in connection with the reversal of a tax abatement liability.

Income tax expense. Income tax expense for the third quarter increased $52,000 in 2004 from 2003 as a result of increased income before taxes partially offset by a decrease in our effective tax rate. Our tax rate in the third quarter of 2004 was 33.9% compared to 37.6% in 2003. For the nine months, income tax expense increased $1.4 million in 2004 from 2003 as a result of increased income before taxes partially offset by a decrease in our effective tax rate. Our tax rate for the first nine months of 2004 was 34.7% compared to 36.7% in 2003. Our decreased effective tax rate during both periods in 2004 compared to 2003 is primarily due to a research and development tax credit, an enhanced benefit related to ETI, and income in Australia where the statutory rate for corporations is lower than the U.S. statutory rate. The effective tax rates reflect a provision for state taxes, offset by tax-exempt interest income earned on our cash and cash equivalents, and marketable securities and, in 2004, a research and development tax credit, benefits related to ETI, and the lower tax rate in Australia.

Net income. Net income for the third quarter increased $789,000, or 20%, in 2004 from 2003 primarily due to the positive impact of revenue growth from increased unit sales of our Genesis and GenesisXP IPG systems, increased gross margin and a lower tax rate. Net income per diluted share during the third quarter increased to $.23 in 2004 from $.19 in 2003. For the nine-month period, net income increased $3.5 million, or 37.3%, in 2004 from 2003 again due to increased unit sales of IPG systems, increased gross margin and a lower tax rate. Net income per diluted share for the nine-month period increased to $.62 in 2004 from $.46 in 2003.

Liquidity and Capital Resources

At September 30, 2004, our working capital increased to $158.95 million from $126.44 million at year-end 2003. The ratio of current assets to current liabilities was 11.62:1 at September 30, 2004, compared to 11.21:1 at December 31, 2003. Cash, cash equivalents, and marketable securities totaled $121.79 million at September 30, 2004 compared to $94.80 million at December 31, 2003, an increase of $26.99 million

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principally due to an increase in the fair value of our investment in Cyberonics, Inc. of $21.93 million.

In August 2004, we purchased 3,500,000 shares of Cyberonics common stock on the open market at an aggregate cost of $49.68 million. In connection with the purchase we used $44.66 million of our cash and borrowed $5.02 million under a margin agreement with the securities firm which purchased the shares for us. Subsequent to September 30, 2004, the margin obligation was fully repaid.

Excluding inventory we purchased in the 2004 acquisitions of microHelix and MedTel, we increased our investment in inventories from year-end 2003 by $550,000. This increase is primarily related to the building of inventory for new products we expect to launch in the fourth quarter of 2004. We purchased inventory in the amount of $171,000 in our acquisition of microHelix and inventory in the amount of $490,000 in our acquisition of MedTel.

Our investment in trade accounts receivable increased from year-end 2003 by $7.06 million due to the increase in sales of our neuromodulation products and an increase in our days sales outstanding. Days sales outstanding increased to 73 days at September 30, 2004 from 64 days at December 31, 2003 due to slower payment from hospitals, higher sales to third party payors, receivables from going direct in Australia and receivables generated from microHelix O.E.M. sales after we acquired microHelix in late April 2004.

Excluding expenditures discussed below relating to the construction of our new facility, we spent $5.8 million during the nine months ended September 30, 2004 for capital expenditures, which includes $2.1 million for new office furniture and equipment for our new facility discussed below. The remainder of the capital expenditures during the nine months ended September 30, 2004, primarily related to tooling and equipment for current products as well as new products being developed.

We completed our relocation to our new corporate headquarters facility in Plano, Texas in July 2004, prior to the expiration of our former lease in August 2004. The new facility consists of 143,000 square feet and was designed to accommodate planned growth within a five-year horizon. The total cost of the facility is approximately $17.4 million. We funded the cost of the facility from our cash reserves. During the nine months ended September 30, 2004, we spent $8.6 million on construction costs for the new facility.

We received $4.68 million of cash during the nine months ended September 30, 2004, from the exercise of employee and director stock options to purchase 476,294 shares of our common stock.

On June 1, 2004, we issued a press release announcing that our Board of Directors approved the repurchase of up to 1,000,000 shares of our common stock. Any repurchases would be made from time to time in open market purchases or privately negotiated transactions, subject to price and availability, and financed out of working capital. Through September 30, 2004, we have not repurchased any shares of our common stock.

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Liquidity may also be enhanced based on our ability to utilize all or part of a net operating loss carryforward of $7.9 million to offset future taxable income. In the third quarter 2004 in conjunction with filing our 2003 tax return, we elected to carryforward our 2003 tax loss of $4.4 million, which is being applied against 2004 taxable income instead of re-filing previous tax returns for refunds. We acquired $3.4 million of the net operating loss carryforward in connection with the MicroNet acquisition, and its utilization is subject to a limitation under Section 382 of the Internal Revenue Code. The rules of Section 382 of the Internal Revenue Code generally apply to limit a corporation’s ability to utilize acquired net operating loss carryforwards to reduce its federal taxable income in the periods after an acquisition. The Company’s ability to use the net operating loss carryforwards acquired in the MicroNet acquisition to reduce its federal taxable income is subject to these rules. Provided the Company generates sufficient taxable income in future years, the Section 382 limitation will have the effect of deferring the utilization of the net operating loss carryforwards over several years. Without this limitation, the Company would be able to immediately use the net operating loss carryforwards to reduce taxable income in future periods. The total amount of net operating loss carryforwards that the Company may use to reduce taxable income in any taxable year after the acquisition is determined with reference to its purchase price of MicroNet. Based on current estimates and assumptions, we expect to utilize at least approximately $1.6 million in net operating loss carryforwards per twelve-month tax year, assuming we generate sufficient taxable income in any given year to utilize such amount.

Additionally, liquidity may be enhanced to the extent we realize tax benefits from stock option exercises. Exercises of nonqualified stock options, and exercises of incentive stock options followed by “disqualifying dispositions” of the underlying common stock within one year following exercise generate compensation expense for tax purposes in the year of exercise or disposition, as the case may be. During the nine months ended September 30, 2004, we generated a $3.65 million tax benefit related to nonqualified stock option exercises and disqualifying dispositions of common stock acquired on exercise of incentive stock options, which will be utilized along with the prior year net operating loss to offset current year taxes payable.

As noted, on April 1, 2004, we acquired for $1.09 million cash, certain assets of our exclusive distributor of our neuromodulation devices for Australia, MedTel. Also as noted, on April 21, 2004, we acquired the assets of microHelix’s Cable and Wire Division for approximately $2 million in cash and assumed liabilities of approximately $132,000.

We estimate that the pre-tax costs associated with the patent infringement/trade secret lawsuit against Advanced Bionics will be approximately $400,000 per quarter.

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

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Cash Flows

Net cash provided by operations for the nine months was $13.09 million in 2004 compared to $8.40 million in 2003, an increase of $4.69 million principally due to a $3.54 million increase in net income. We increased our use of cash for changes in working capital in 2004 compared to 2003 by $4.4 million but the increase was offset by higher depreciation and amortization expense and higher deferred income taxes.

Net cash used by investing activities for the nine months was $10.56 million in 2004 compared to $18.67 million in 2003, a decrease of $8.11 million principally due to a $2.86 million reduction in the amount of cash used in certain acquisitions, a $55.97 million change in net proceeds versus purchases of marketable securities, offset by an increase of $5.48 million in new facility construction in 2003 compared to 2004 and the $44.66 million net investment in Cyberonics in 2004.

Net cash provided by financing activities for the nine months was $4.68 million in 2004 compared to $5.81 in 2003, a decrease of $1.13 million due to lower proceeds from the exercise of stock options.

Currency Fluctuations

Our international sales are denominated in U.S. dollars with the exception of Germany and Australia, where we began selling direct on January 1, 2004 and April 1, 2004, respectively. Sales are denominated in Euros in Germany and Australian dollars in Australia. Fluctuations in currency exchange rates in other countries could reduce the demand for our products by increasing the price of our products in the currency of the countries in which the products are sold, although we do not believe currency fluctuations have had a material effect on the Company’s results of operations to date.

Off-Balance Sheet Arrangements

The Company does not have any obligations that meet the definition of an off-balance sheet arrangement and that have or are reasonably likely to have a material adverse effect on the Company’s financial statements.

Outlook and Uncertainties

The following is a “safe harbor” statement under the Private Securities Litigation Reform Act of 1995: The matters discussed in this Quarterly Report on Form 10-Q contain statements that constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, as amended. The words “expect”, “estimate”, “anticipate”, “predict”, “believe”, “plan”, “will”, “should”, “intend”, “potential”, “new market”, “potential market applications” and similar expressions and variations thereof are intended to identify forward-looking statements, although not all forward-looking statements contain such identifying words. Such statements appear in a number of places in this Quarterly Report on Form 10-Q and include statements regarding our intent, belief or current expectations with respect to, among other things: (i) trends affecting our financial condition or results of operations; (ii) our financing plans; and (iii) our business growth strategies. We caution

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our readers that any forward-looking statements are not guarantees of future performance and involve risks and uncertainties. Actual results may differ materially from those projected in the forward-looking statements as a result of various factors. These risks and uncertainties include the following:

•		the risk of adverse changes in the value or marketability of the securities of Cyberonics, Inc. owned by the Company
•		on April 28, 2004, Advanced Bionics Corporation announced that it had received FDA approval of its rechargeable implantable SCS system for the treatment of chronic pain. In June 2004, Advanced Bionics was acquired by Boston Scientific Corporation. The entrance into the neuromodulation market of new competitors, including Advanced Bionics/Boston Scientific, may make it more difficult to compete in this market
•		the launch of new competitive products by Advanced Bionics, Medtronic, Inc. or others, as well as other market factors, could impede growth in or reduce sales of our IPG and RF systems, which would adversely affect our revenues and profitability
•		failure of our Genesis and GenesisXP IPG systems to gain and maintain market acceptance would adversely affect our revenue growth and profitability
•		because our principal competitors have significantly greater resources than we do, it may be difficult for us to compete in this market
•		if pain management specialists do not recommend and endorse our products, our sales could be negatively impacted and we may be unable to increase our revenues and profitability
•		if patients choose less invasive or less expensive alternatives to our products, our sales could be negatively impacted
•		any adverse changes in coverage or reimbursement amounts by Medicare and Medicaid, private insurance companies and managed care organizations, or workers’ compensation programs could limit our ability to market and sell our products
•		if we fail to protect our intellectual property rights, our competitors may take advantage of our ideas and compete directly against us
•		other parties may sue us for infringing their intellectual property rights, or we may have to sue them to protect our intellectual property rights
•		the cost, uncertainty and other risks inherent in our intellectual property litigation against Advanced Bionics Corporation
•		failure to obtain necessary government approvals for new products or for new applications for existing products would mean we could not sell those new products, or sell our existing products for those new applications
•		modification of any marketed device could require a new 510(k) clearance or PMA or require us to cease marketing or recall the modified device until we obtain this clearance or approval
•		we will be unable to sell our products if we fail to comply with manufacturing regulations
•		our products are subject to product recalls even after receiving FDA clearance or approval, which would negatively affect our financial performance and could harm our reputation
•		we are subject to potential product liability and other claims and we may not have the insurance or other resources to cover the cost of any successful claim

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•		we are subject to substantial government regulation and our failure to comply with all applicable government regulations could subject us to numerous penalties, any of which could adversely affect our business
•		our reliance on single suppliers for critical components used in our main products could adversely affect our ability to deliver products on time
•		our principal competitor in the neuromodulation market, Medtronic, Inc., currently accounts for a significant percentage of our revenue from our O.E.M. segment
•		we are dependent upon the success of neuromodulation technology; our inability to continue to develop innovative neuromodulation products, including a competitive rechargeable IPG, or the failure of the neuromodulation market to develop as we anticipate, would adversely affect our business
•		our success will depend on our ability to attract and retain key personnel and scientific staff
•		if we choose to acquire complementary businesses, products or technologies instead of developing them ourselves, we may be unable to complete these acquisitions or to successfully integrate an acquired business, product or technology in a cost-effective and non-disruptive manner
•		we are subject to additional risks associated with international operations
•		our manufacturing operations are conducted at three locations, and a disaster at any of these facilities could result in a prolonged interruption of our business
•		general economic risks
•		other risks detailed from time to time in our SEC public filings

Certain of the foregoing risks are described in more detail in our Annual Report on Form 10-K for the year ended December 31, 2003. If our assumptions prove to be incorrect or such risks or uncertainties materialize, anticipated results could differ materially from those forecasted in forward-looking statements.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

For the period ended September 30, 2004, the Company did not experience material changes in market risk exposures that affect the quantitative and qualitative disclosures presented in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003, with the exception of the 3,500,000 shares of common stock of Cyberonics, Inc. (NASDAQ:CYBX) purchased by the Company in August 2004 at an aggregate cost of $49.7 million. These shares are subject to equity price risk. At September 30, 2004, the value of the Cyberonics shares owned by the Company had increased in value by $21.9 million to $71.6 million. A hypothetical 10% decrease in the value of this investment from the September 30, 2004 level would decrease the fair value of this investment by $7.16 million.

ITEM 4. CONTROLS AND PROCEDURES

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

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evaluation, our Chief Executive Officer and Chief Financial Officer concluded that these disclosure controls and procedures were effective.

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

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PART II

OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

On April 21, 2004, the Company filed a lawsuit in the U.S. District Court for the Eastern District of Texas, Sherman Division (Docket No. 4:404-CV-00131-PNB-DDB) (the Texas Action) against Advanced Bionics Corporation, asserting claims of patent infringement, misappropriation of trade secrets, tortious interference with contract, misappropriation of time, labor, skill, and money, violation of the Texas Theft Liability Act, conversion and constructive trust. The lawsuit alleges, among other things, that Advanced Bionics is infringing United States Patent No. 4,793,353 entitled “Non-Invasive Multiprogrammable Tissue Stimulator And Method.” In addition, the lawsuit alleges that Advanced Bionics hired a former ANS employee to aid in the design, development and manufacture of its implantable stimulation lead, that Advanced Bionics misappropriated the former employee’s knowledge of ANS’ confidential, proprietary, and trade secret information with respect to ANS’ implantable stimulation leads, and that this enabled Advanced Bionics to unfairly compete with ANS. The lawsuit seeks injunctive relief, compensatory and punitive damages, attorneys’ fees and costs. On June 7, 2004, Advanced Bionics filed a lawsuit with the United States District Court, Central District of California, Case No. CV04-4054ABC (the California Action), seeking a declaratory judgment that it is not infringing ANS’ patent No. 4,793,353 (the subject of ANS’ current patent infringement claim against Advanced Bionics) and that such patent is invalid and unenforceable. On October 15, 2004, the judge in the Texas Action granted the Company’s motion to amend its lawsuit to add two additional patent infringement claims against Advanced Bionics. One claim relates to the Company’s patent covering the design and structure of its electrode lead (U.S. Patent No. 6,216,045). The second claim relates to the Company’s trial cable connector patent (U.S. Patent No. 6,154,678). In addition, the judge denied Advanced Bionics’ motion to dismiss the Texas Action. Subsequently, Advanced Bionics has informed the Company that it has asked the judge in the California Action to dismiss that case without prejudice.

ITEM 2. CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY SECURITIES

Share Repurchase Program

On June 1, 2004, the Company issued a press release announcing that our Board of Directors approved the repurchase of up to 1,000,000 shares of our common stock. Any repurchases would be made from time to time in open market purchases or privately negotiated transactions, subject to price and availability, and financed out of working capital. A copy of this press release was filed as an exhibit to the Company’s Form 8-K filed on June 2, 2004. The Company did not repurchase any shares of its common stock during the quarter ended September 30, 2004, and has not made any purchases since the authorization.

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Signatures

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

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EXHIBIT INDEX