UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

(MARK ONE)

Commission file number 0-10521

ADVANCED NEUROMODULATION SYSTEMS, INC.

6901 Preston Road, Plano, Texas 75024

(972) 309-8000

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

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

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

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)
March 31, 2005 (Unaudited) and December 31, 2004

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, also known as O.E.M. or original equipment manufacturing, for other medical device companies through the Hi-tronics Designs, Inc. (HDI) subsidiary and through operations in Portland, Oregon (formerly the Cable and Wire Division of microHelix, Inc., which was acquired in April 2004). ANS neuromodulation revenues are derived primarily from sales throughout the United States, Europe and Australia while O.E.M. revenues are derived within the United States.
	The research and development, manufacture, sale and distribution of medical devices is subject to extensive regulation by various public agencies, principally the U.S. Food and Drug Administration and corresponding state, local and foreign agencies. Product approvals and clearances can be delayed or withdrawn for failure to comply with regulatory requirements or the occurrence of unforeseen problems following initial marketing.
	In addition, ANS neuromodulation products are purchased by hospitals and other users who then bill various third-party payors including Medicare, Medicaid, private insurance companies and managed care organizations, and workers’ compensation programs. ANS also sells and bills its neuromodulation products directly to third-party payors including Medicare, Medicaid, private insurance companies and managed care organizations, and workers’ compensation programs. These third-party payors reimburse fixed amounts for products and services based on a specific diagnosis. The impact of changes in third-party payor reimbursement policies and any amendments to existing reimbursement rules and regulations that restrict or terminate the eligibility of ANS products could have an adverse impact on the Company’s financial condition and results of operations.
(2)	Condensed Financial 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, 2004 Annual Report on Form 10-K. The results of operations for the

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

	period ended March 31, 2005 are not necessarily indicative of operations for the full year.
	The consolidated financial statements include the accounts of Advanced Neuromodulation Systems, Inc. and its subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.
(3)	Marketable 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 $49.7 million. In February 2005, the Company sold the 3,500,000 shares and received gross proceeds on the sale of $135.3 million, resulting in a pre-tax gain of $85.2 million, net of acquisition costs.
(4)	Stock-Based 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 $(79,615) and $(19,398) of stock-based compensation expense (benefit) to non-employees in the three months ended March 31, 2005 and 2004, respectively. The Company has adopted the pro forma disclosure-only provisions of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (SFAS 123), as amended by Statement of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure.” The following table illustrates the effect on net income and net income per share amounts if the Company had applied the fair value recognition provisions of SFAS 123 to stock-based employee compensation:

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

(5)	Commitments and Contingencies
	The Company is a party to product liability claims related to its neurostimulation devices and other ordinary routine litigation claims arising in the ordinary course of business. Product liability insurers have assumed responsibility for defending the Company against product liability claims, subject to reservation of rights in certain cases. Historically, product liability claims related to the Company’s neurostimulation devices have not resulted in significant monetary liability beyond its insurance coverage. The Company seeks to maintain appropriate levels of product liability insurance with coverage that it believes is comparable to that maintained by companies similar in size and serving similar markets, although there can be no assurances that the Company will not incur significant monetary liability to the claimants if such insurance is inadequate, and there can be no assurance that the Company’s neurostimulation business and future ANS product lines will not be adversely affected by these product liability claims.
	On April 21, 2004, the Company filed a lawsuit in the U.S. District Court for the Eastern District of Texas, Sherman Division (Docket No. 4:404-CV-00131-PNB-DDB) (the Texas Action) against Advanced Bionics Corporation, asserting claims of patent infringement, misappropriation of trade secrets, tortious interference with contract, misappropriation of time, labor, skill, and money, violation of the Texas Theft Act, conversion and constructive trust. As initially filed, the lawsuit alleged, among other things, that Advanced Bionics is infringing U.S. Patent No. 4,793,353 entitled “Non-Invasive Multiprogrammable Tissue Stimulator and Method.” In addition, the lawsuit alleged that Advanced Bionics hired a former ANS employee to aid in the design, development and manufacture of its implantable stimulation lead, that Advanced Bionics misappropriated the former employee’s knowledge of ANS’ confidential, proprietary, and trade secret information with respect to ANS’ implantable stimulation leads, and that this enabled Advanced Bionics to unfairly compete with ANS. The lawsuit seeks injunctive relief, compensatory and punitive damages, attorneys’ fees and costs. On October 15, 2004, the judge in the Texas Action granted the Company’s motion to amend its lawsuit to add two additional patent infringement claims against Advanced Bionics. One claim relates to the Company’s patent covering the design and structure of its electrode lead (U.S. Patent No. 6,216,045). The second claim relates to the Company’s trial cable connector patent (U.S. Patent No. 6,154,678). In addition, the judge denied Advanced Bionics’ motion to dismiss the Texas Action. Advanced Bionics filed a California action in federal court seeking to resolve the Company’s patent claims, which was subsequently dismissed. Advanced Bionics has also made motions to transfer the Texas Action to a California federal court, which the judge in the Texas Action has dismissed. On January 28, 2005, the judge in the Texas Action granted Advanced Bionic’s motion to compel alternative dispute resolution of our trade secrets misappropriation claims, although the judge ruled that he retains jurisdiction over those claims. On March 11, 2005, Advanced Bionics filed its First Amended Answer and Counterclaims in the Texas Action, asserting, among other things, that the Company is infringing Advanced Bionics’ U.S. Patent Nos. 6,516,277 and 6,381,496. Advanced Bionics claims that the Company is infringing these patents at least by marketing and selling GenesisRC rechargeable IPG systems, and Advanced Bionics may assert that the Company’s newly-approved Eon system does as well. These patents relate to changing operational parameters sets (6,381,496) and to a specific type of rechargeable spinal cord stimulation system (6,516,277). The counterclaims seek temporary restraining orders, permanent injunctions, compensatory damages, exemplary damages including treble damages, pre and post judgment interest, attorneys’ fees and such other relief as the court may grant. The Company intends to vigorously defend itself against these claims, which the Company believes are meritless because, among other things, the Company believes the patents are not infringed or are invalid.

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

	In late January 2005, the Company received a subpoena from the Office of the Inspector General, Department of Health and Human Services (OIG), requesting documents related to certain of its sales and marketing, reimbursement, Medicare and Medicaid billing, and certain other business practices. The Company is cooperating fully with the OIG’s request for documents.
	Beginning March 1, 2005, several law firms announced the filing of class action securities lawsuits against the Company and certain of its officers and directors filed on behalf of purchasers of the Company’s securities between April 24, 2003 and February 16, 2005, inclusive (the Class Period). The Company is aware that three such lawsuits have been filed in the United States District Court for the Eastern District of Texas as follows: PLA, LLC vs. Advanced Neuromodulation Systems, Inc., et al, filed March 1, 2005; RAI Investment Club vs. Advanced Neuromodulation Systems, Inc., et al, filed March 9, 2005; and Clifford a. Leavitt vs. Advanced Neuromodulation Systems, Inc. et al, filed April 28, 2005. These suits allege the Company violated federal securities laws by the issuance of false and misleading statements to the market regarding the Company’s financial performance throughout the Class Period, which statements allegedly had the effect of artificially inflating the market price of the Company’s securities. In particular, the claims allege improper marketing and sales practices accounted for the Company’s revenue growth, citing, among other things, the public announcement that management made on February 17, 2005 that the Company had received a subpoena from the Office of the Inspector General, Department of Health and Human Services, requesting documents related to sales and marketing, reimbursement, Medicare and Medicaid billing and other business practices. The plaintiffs are seeking unspecified compensatory damages and costs and expenses of litigation. No class has been certified. Based on the various press releases, the Company believes any other lawsuits, if filed, will contain similar allegations. The Company intends to vigorously defend itself against the claims made in these lawsuits and believes the lawsuits are without merit.
	Except for the litigation discussed above, and other ordinary routine litigation incidental or immaterial to its business, the Company is not currently a defendant to any other pending legal proceeding. The Company maintains general liability insurance against risks arising out of the normal course of business.
	Under the Company’s sales agreements with its independent sales agents, the Company can terminate those agreements without cause by paying an early termination fee equal to 100% of the commissions that would otherwise be payable on sales in the territory for the 90 days after termination and 50% of the commission that would otherwise be payable on sales in the territory for the 90 day period after the first 90 day period.
	In addition, under its distributor agreements, sales agent agreements and certain other ordinary course commercial contracts with third parties, the Company typically agrees to indemnify the other contracting party from damages and costs that may arise from product liability claims. The terms of the agreements and contracts vary and the potential exposure under these indemnities cannot reasonably be estimated or determined. The Company currently is not aware of

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

	any indemnification claims, nor has the Company had any indemnification claims historically.
(6)	Income Taxes
	The Company recorded income tax expense during the three months ended March 31, 2005 and 2004 of $33,665,303 and $2,150,112, respectively, representing an overall effective tax rate of 36.5% and 35.1%, respectively. The increased effective tax rate in 2005 is due to the $85.2 million pre-tax gain resulting from the sale of the Company’s investment in Cyberonics, Inc., which had the impact of increasing federal and state taxable income without a significant corresponding increase in other permanent exclusions from taxable income. The effective tax rates in 2005 and 2004 reflect a provision for federal income taxes at the statutory rate of 35% and a provision for state taxes, offset by tax-exempt investment income, the research and development tax credit, and benefits related to the extra-territorial income (ETI) exclusion.
(7)	Net Income Per 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 ended March 31, 2005 and 2004, the incremental shares used for dilutive earnings per share relate to stock options whose exercise price was less than the average market price in the underlying quarterly computations. For the three months ended March 31, 2005 and 2004, options to purchase 638,563 and 2,142 shares, respectively, were outstanding, but were not included in the computation of diluted earnings per share because the options’ exercise price were greater than the average market price of the common shares and, therefore, the effect would be antidilutive.
(8)	Comprehensive 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 marketable securities, and foreign currency translation adjustments. Comprehensive income for 2004 and for the three months ended March 31, 2005 is reported in the Condensed Consolidated Statements of Stockholders’ Equity. Comprehensive income for the three months ended March 31, 2004 was $3,979,867.

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

Components of Accumulated Other Comprehensive Income (Loss) are net of tax and are as follows:

	The tax benefit (expense) on the unrealized gains (losses) on marketable securities was $96,749 at March 31, 2005 and $(8,556,625) at December 31, 2004. The tax benefit on foreign currency translation adjustment was $1,596 at March 31, 2005 and $12,297 at December 31, 2004.
	In connection with the realized gain resulting from the sale of the Company’s investment in Cyberonics, Inc. in February 2005 as discussed in Note 3, $14,275,238 of the December 31, 2004 unrealized gain on marketable securities was realized into other income, and the associated tax expense of $8,565,143 was reclassified from deferred income taxes payable to income taxes payable
(9)	Treasury Stock
	In May 2004, the Company’s board of directors approved the repurchase of up to 1,000,000 shares of the Company’s common stock. The Company repurchased 381,894 shares of its common stock at a cost of $10,677,937 in March 2005. The Company repurchased an additional 541,780 shares of its common stock at a cost of $14,900,112 during April 2005. Also in April 2005, the Company’s board of directors approved an increase in the amount of shares authorized to be repurchased by the Company up to a total of 2,000,000 shares.
(10)	Segment 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 primarily of electromechanical medical devices. Intersegment revenue is billed at cost with no intercompany mark-up.
	Segment data for the three months ended March 31, 2005 is as follows:

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Segment data for the three months ended March 31, 2004 is as follows:

Foreign sales, primarily Europe and Australia, for the three months ended March 31, 2005 and 2004 were approximately 9.4% and 9.5% of net revenue from the Neuro Products segment, respectively. The O.E.M. segment had no foreign sales for the respective periods.

(11) New Accounting Standard

On December 16, 2004, the Financial Accounting Standards Board (FASB) issued FASB Statement No. 123 (revised 2004), “Share-Based Payment” (SFAS 123(R)), which is a revision of SFAS 123. SFAS 123(R) supersedes APB 25, and amends FASB Statement No. 95, “Statement of Cash Flows.” Generally, the approach in SFAS 123(R) is similar to the approach described in SFAS 123. However, SFAS 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative.

SFAS 123(R) required adoption no later than July 1, 2005; however, on April 14, 2005, the Securities and Exchange Commission announced that it would require adoption of SFAS 123(R) no later than the beginning of the first fiscal year beginning after June 15, 2005. Early adoption will be permitted in periods in which financial statements have not yet been issued. The Company expects to adopt SFAS 123(R) on January 1, 2006. The adoption of SFAS 123(R)’s fair value method will have a significant impact on the Company’s result of operations which the Company is currently evaluating, although it will have no impact on the Company’s overall financial position. The Company is also currently assessing the method (either the “modified prospective” or “modified retrospective” method, as defined) by which SFAS 123(R) will be adopted.

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

Recent Developments

In March 2005, the FDA approved our second rechargeable implantable pulse generator (IPG) system, the Eon™ Neurostimulation System, for sale in the U.S. The Eon system is indicated as an aid in the management of chronic intractable pain of the trunk and/or limbs, including unilateral or bilateral pain associated with failed back surgery syndrome, intractable low back pain and leg pain. We intend to begin a limited launch of Eon in the U.S. during the second quarter of 2005, and a full market launch during the third quarter of 2005.

We have recently received FDA Investigational Device Exemptions (IDE) to implant our Libra™ Deep Brain Stimulation (DBS) System to investigate the safety and efficacy of Libra to treat essential tremor and Parkinson’s disease. We anticipate the first implants of both indications to occur in the second quarter of 2005. Also during the first quarter of 2005, we received approval from the FDA to expand our feasibility study to a pivotal study of neurostimulation for the treatment of migraine headache.

In addition to the planned pivotal studies to treat migraine headache, essential tremor, and Parkinson’s disease, we are working on the potential application of our platform technologies to address depression, pelvic pain, obesity, tinnitus, angina, ischemic pain associated with peripheral vascular disease, and traumatic brain injury. As a result, in 2005 we intend to increase our investment in research and development and clinical trials to approximately $20 million.

In August 2004, we acquired 3.5 million shares of the common stock of Cyberonics, Inc. (Cyberonics), for an aggregate purchase price of $49.7 million with working capital funds on hand. We purchased the shares for investment purposes and because we believed that ownership of the shares could facilitate a business combination between Cyberonics and ANS that could have created significant synergies in technology development, manufacturing, sales and marketing, regulatory, administrative and other areas. Cyberonics decided not to enter into or pursue any merger or combination discussions with us. On February 2, 2005, Cyberonics announced that the FDA deemed its vagal nerve stimulation device approvable for treatment of certain types of chronic depression. Due to the increase in the price of Cyberonics’ common stock following the FDA’s announcement, coupled with the Cyberonics’ board of directors decision not to discuss a possible combination, we sold all 3.5 million shares of the common stock of Cyberonics in open market transactions in February 2005. Gross proceeds from the sale were $135.3 million and resulted in a pre-tax gain of $85.2 million, net of acquisition costs.

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In March 2005 we repurchased 381,894 shares of the Company’s common stock for $10.7 million under a 1,000,000-share repurchase authorization previously approved by the Company’s board of directors. In April 2005, we repurchased an additional 541,780 shares for $14.9 million. Also in April 2005, the Company’s board of directors approved an increase in the repurchase authorization to a total of 2,000,000 shares.

Critical Accounting Policies and Estimates

General

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

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

Revenue Recognition

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

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

Bad Debt

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

Inventory Reserve

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

Intangible Assets

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

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

Contingencies and Litigation

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

Income Taxes

Management judgment is required to determine the Company’s consolidated provision for income taxes. Reserves are established when it is believed that certain tax positions of the Company may be successfully challenged, despite management’s belief that such tax return positions are fully supportable. When facts and circumstances change, the reserves are adjusted through the provision for income taxes.

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Stock Compensation

See Note 4 to the Condensed Consolidated Financial Statements for a discussion of the application of Statement of Financial Accounting Standards (SFAS) No. 123, “Accounting for Stock-Based Compensation” and SFAS 148, “Accounting for Stock-Based Compensation – Transition and Disclosure” to our stock compensation programs. Additionally, see Note 11 to the Condensed Consolidated Financial Statements for a discussion of SFAS No. 123(R), “Share Based Payment,” which is expected to be adopted on January 1, 2006, and when adopted will have a significant impact on our results of operations, although it will have no impact on our overall financial position.

Results of Operations

Comparison of the Three Months Ended March 31, 2005 and 2004

Results for the first quarter of 2005 compared to 2004 continue to reflect the impact of revenue growth from increased unit sales of our Genesis® and GenesisXP™ IPG systems, which we launched in the United States in January 2002 and December 2002, respectively and from a limited launch of GenesisRCä, our first rechargeable IPG system approved by the FDA in the fourth quarter of 2004. In March 2005, we received approval for our second rechargeable IPG system, Eonä, and are manufacturing product to support a limited launch in the second quarter and a full market launch in the third quarter of 2005. References below to the first quarter are comparisons of the three months ended March 31, 2005 and 2004.

Net revenue. Net revenue for the first quarter increased $5.7 million, or 21.4%, due to increased sales of our neuro products and O.E.M. products. Neuro product revenue increased 18.5% to $28.7 million in the first quarter of 2005 from $24.2 million in 2004, primarily due to increased sales of our Genesis family of IPG systems and to a lesser extent from a limited launch of GenesisRC. Revenue from our Renew® RF system declined during the first quarter and is expected to continue to decline as rechargeable IPG systems that offer comparable features and benefits, including our own GenesisRC and Eon systems, begin to claim more of the market for neurostimulation devices. Net revenue of our O.E.M. business for the first quarter increased to $3.6 million in 2005 from $2.4 million in 2004 primarily due to $1.0 million of revenue generated by our Portland, Oregon operations (formerly the Cable and Wire Division of microHelix, Inc. which we acquired in April 2004). We continue to use more of our O.E.M. manufacturing and development capabilities for our own increasing needs, and accordingly, we expect O.E.M. revenue of approximately $12 million in 2005, flat with 2004 revenue.

Gross profit. Gross profit for the first quarter increased $4.2 million, or 21.5% due to the increase in net revenue discussed above. Gross profit margin for the first quarter remained the same at 73.9%.

Operating expenses. Total operating expenses for the first quarter increased $3.6 million, or 26.3%, and increased as a percentage of revenue to 53.8% in 2005 from 51.7% in 2004. In February 2005, we announced that we intend to accelerate our pursuit of new indications for our technology by accelerating clinical studies, regulatory approval efforts and product development. As such, we expect operating expenses as a percentage of revenue to increase in 2005.

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Sales and marketing. Sales and marketing expense for the first quarter, as a percentage of net revenue, decreased to 31.2% in 2005 from 32.2% in 2004, while the expense increased in absolute dollars by $1.5 million. The increase in absolute dollars during the first quarter was principally due to higher salary and benefit expense from annual salary increases and staffing additions in direct sales, clinical specialists and regional sales managers, higher commission expense from increased neuro product sales, and higher travel expense due to increased direct sales activities.

Research and development. Research and development expense for the first quarter, as a percentage of net revenue, increased to 10.3% in 2005 from 8.7% in 2004, and the expense increased in absolute dollars by $1.0 million. As noted above, we intend to accelerate our investment in research and development and clinical trials to capitalize on the opportunity to pursue several new indications with our existing technology and products and to develop new technology and products for the future. We expect expenditures of approximately $20 million in 2005, or 13.8% of targeted revenue compared to expenditures of $10.8 million, or 8.9% of revenue in 2004. We believe the increased investment is strategically important to achieving our mission in the long-term. In the last few months, we have received FDA approval to commence three separate pivotal studies to investigate the safety and efficacy of our technologies to treat migraine headaches, essential tremor and Parkinson’s Disease and we expect to begin implants under the three studies during the second quarter of 2005.

General and administrative. General and administrative expense for the first quarter, as a percentage of net revenue, increased to 10.3% in 2005 from 8.7% in 2004, and the expense increased in absolute dollars by $1.0 million. The increase in expense during the first quarter was principally due to higher legal expense including expense associated with our lawsuit against Advanced Bionics, audit and Sarbanes-Oxley compliance expense and depreciation expense.

Amortization of intangibles. Amortization expense of intangibles for the first quarter, as a percentage of net revenue, decreased to 2.0% in 2005 from 2.2% in 2004, while the expense in absolute dollars increased by $65,000 due to additional expense for intangible assets we acquired in the April 2004 acquisitions of MedTel and microHelix.

Other income. Other income for the first quarter increased by $85.5 million principally due to the $85.2 million gain we recognized on the sale of our investment in Cyberonics. Correspondingly, investment income increased by $296,000 due to higher funds available for investment.

Income tax expense. Income tax expense for the first quarter increased $31.5 million primarily due to the significant increase in income before taxes and to a lesser extent an increase in our effective tax rate. Our effective tax rate in the first quarter of 2005 was 36.5% compared to 35.1% in 2004. The increase in the effective tax rate in 2005 is due to the $85.2 million pre-tax gain on the Cyberonics investment, which had the impact of increasing federal and state taxable income without a significant corresponding increase in other permanent exclusions from taxable income. The effective tax rates in the first quarter of 2005 and 2004 reflect a provision for federal income taxes at the statutory rate of 35% and a provision for state taxes, offset by tax-exempt investment income, a research and development tax credit, and benefits related to the extra-territorial income (ETI) exclusion.

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Net income. Net income for the first quarter increased $54.6 million primarily due to the realized gain on the Cyberonics investment and to a lesser extent the $871,000 increase in pre-tax income (excluding the Cyberonics gain) from higher income from operations from higher revenue and an increase in investment income. Net income per diluted share for the first quarter was $2.76 in 2005 compared to $.19 in 2004.

Liquidity and Capital Resources

At March 31, 2005, our working capital increased to $195.2 million from $168.4 million at year-end 2004. The ratio of current assets to current liabilities was 5.85:1 at March 31, 2005, compared to 18.78:1 at December 31, 2004. Cash, cash equivalents, and marketable securities totaled $180.7 million at March 31, 2005 compared to $124.0 million at December 31, 2004.

In February 2005, we sold our investment in Cyberonics, Inc. We received proceeds of $135.3 million from the sale of the 3,500,000 shares. We reported a pre-tax gain in the first quarter of $85.2 million, after acquisition related expenses. Correspondingly, our income taxes payable increased substantially to $33.53 million at March 31, 2005 from $708,000 at December 31, 2004. In June 2005, we will make an estimated tax payment of approximately $20 million from our cash reserves and additional tax payments will occur as required during the remainder of 2005.

We used $10.7 million of our cash reserves in the first quarter of 2005 to repurchase 381,894 shares of our common stock under a 1,000,000 share repurchase program. Subsequent to the end of the quarter, we have acquired an additional 541,780 shares and used $14.9 million from our cash reserves. Through April 30, 2005, we have purchased a total of 923,674 shares at a cost of $25.6 million. In April 2005, the Company’s board of directors increased the repurchase authorization to a total of 2,000,000 shares.

We received $1.59 million of cash during the three months ended March 31, 2005, from the exercise of stock options to purchase 111,209 shares of our common stock.

We increased our investment in inventories from year-end 2004 by $830,000. This increase is primarily related to the building of inventory for new products we expect to launch in the near future and additional field inventory held by new sales representatives.

Our investment in trade accounts receivable increased slightly from year-end 2004 by $276,000. Days sales outstanding remained at 72 days.

We spent $1.9 million for the three months ended March 31, 2005 for capital expenditures and additions to intangible assets. During the first quarter we purchased additional office furniture and equipment (including computer equipment) for new personnel and purchased additional tooling and equipment for current products as well as new products being developed.

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Liquidity may be enhanced to the extent we realize tax benefits from stock option exercises. Exercises of nonqualified stock options, and exercises of incentive stock options followed by “disqualifying dispositions” of the underlying common stock within one year following exercise generate compensation expense for tax purposes in the year of exercise or disposition, as the case may be. During the three months ended March 31, 2005, we generated a $649,000 tax benefit related to nonqualified stock option exercises and disqualifying dispositions of common stock acquired on exercise of incentive stock options, which will be utilized to offset current year taxes payable.

In April 2004, we filed a patent infringement/trade secret lawsuit against Advanced Bionics. The pre-tax costs associated with the lawsuit have been approximately $400,000 per quarter to date and are likely to increase as we approach a trial date in January 2006.

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

Currency Fluctuations

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

Off-Balance Sheet Arrangements

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

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Guidance

On April 28, 2005, we reaffirmed our revenue guidance of $145 million for fiscal 2005, and provided earnings guidance for 2005 in the range of $3.49 to $3.52 per diluted share. We believe our IPG systems, both rechargeable and conventional, will generate most of our growth during 2005. Our revenue guidance reflects a 22% growth in our neuromodulation product sales, a growth rate below that realized in 2002 through 2004. Competition is growing. Because a new competitor has entered the neurostimulation for chronic pain market, and because our competitors are larger and have greater resources than we do, competitive pressure is increasing, which directly affects revenue growth.

Outlook and Uncertainties

The following is a “safe harbor” statement under the Private Securities Litigation Reform Act of 1995: Certain matters discussed in this Quarterly Report on Form 10-Q contain statements that constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, as amended. The words “expect,” “estimate,” “anticipate,” “predict,” “believe,” “plan,” “will,” “should,” “intend,” “would,” “scheduled,” “potential,” “new market,” “potential market applications,” and similar expressions and variations thereof are intended to identify forward-looking statements, although not all forward-looking statements contain such identifying words. Such statements appear in a number of places in this Quarterly Report on Form 10-Q and include statements regarding our intent, belief or current expectations with respect to, among other things: (i) trends affecting our financial condition or results of operations; (ii) our financing plans; and (iii) our business growth strategies. We caution our readers that any forward-looking statements are not guarantees of future performance and involve risks and uncertainties. Actual results may differ materially from those projected in the forward-looking statements as a result of various factors. These risks and uncertainties include, but are not limited to, those discussed or identified from time to time in our public filings, including the following:

•	failure to gain market acceptance of our new rechargeable IPGs, and to maintain continued market acceptance of our conventional IPGs and radio-frequency powered spinal cord stimulation (SCS) systems would adversely affect our revenue growth and profitability;
•	competition from and the launch of new competitive products by Medtronic, Advanced Bionics/Boston Scientific or others, as well as other market factors that could impede growth in or reduce sales of the Company’s IPG and RF systems, which could adversely affect revenues and profitability;
•	patient or physician selection of less invasive or less expensive alternatives;
•	adverse changes in coverage or reimbursement amounts by Medicare, Medicaid, private insurers, managed care organizations or workers’ compensation programs could limit our ability to market and sell our products;
•	intellectual property protection and potential infringement issues;
•	the cost, uncertainty and other risks inherent in litigation generally, including without limitation, the intellectual property and patent litigation against Advanced Bionics;
•	successful patient enrollment in and timely implementation of the IDE clinical studies for migraine headache, essential tremor and Parkinson’s disease; physician and patient acceptance of the Libra DBS system for the essential tremor and Parkinson’s

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	disease studies, for which already-approved products are already available on the market; the uncertainty of clinical results that may ensue from these clinical studies; the risk that the FDA may not approve our PMA applications for these applications following the completion of the clinical trials; and the satisfactory completion of feasibility, pilot and pivotal studies and/or market tests prior to the introduction of new products generally;
•	obtaining necessary government approvals for other new products or applications and maintaining compliance with FDA product and manufacturing requirements;
•	product liability;
•	reliance on single suppliers for certain components;
•	completion of research and development projects in an efficient and timely manner;
•	successful integration of acquired businesses, products and technologies;
•	international trade risks

Certain of the foregoing risks and other risks are described in more detail in our Annual Report on Form 10-K for the year ended December 31, 2004. If our assumptions prove to be incorrect or such risks or uncertainties materialize, anticipated results could differ materially from those forecasted in forward-looking statements.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

For the period ended March 31, 2005, the Company did not experience material changes in market risk exposures that affect the quantitative and qualitative disclosures presented in the Company’s Annual Report on Form 10-K for the year ended December 31, 2004.

ITEM 4. CONTROLS AND PROCEDURES

The Company maintains controls and procedures designed to ensure that it is able to collect the information it is required to disclose in the reports it files with the Securities and Exchange Commission (SEC), and to process, summarize, and disclose this information within the time periods specified in the rules of the SEC. As of the end of the period covered by this report, an evaluation was carried out by our management, with the participation of our Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934). Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that these disclosure controls and procedures were effective as of the end of the period covered by this report.

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

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PART II

OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

On April 21, 2004, the Company filed a lawsuit in the U.S. District Court for the Eastern District of Texas, Sherman Division (Docket No. 4:404-CV-00131-PNB-DDB) (the Texas Action) against Advanced Bionics Corporation, asserting claims of patent infringement, misappropriation of trade secrets, tortious interference with contract, misappropriation of time, labor, skill, and money, violation of the Texas Theft Act, conversion and constructive trust. As initially filed, the lawsuit alleged, among other things, that Advanced Bionics is infringing U.S. Patent No. 4,793,353 entitled “Non-Invasive Multiprogrammable Tissue Stimulator and Method.” In addition, the lawsuit alleged that Advanced Bionics hired a former ANS employee to aid in the design, development and manufacture of its implantable stimulation lead, that Advanced Bionics misappropriated the former employee’s knowledge of ANS’ confidential, proprietary, and trade secret information with respect to ANS’ implantable stimulation leads, and that this enabled Advanced Bionics to unfairly compete with ANS. The lawsuit seeks injunctive relief, compensatory and punitive damages, attorneys’ fees and costs. On October 15, 2004, the judge in the Texas Action granted the Company’s motion to amend its lawsuit to add two additional patent infringement claims against Advanced Bionics. One claim relates to the Company’s patent covering the design and structure of its electrode lead (U.S. Patent No. 6,216,045). The second claim relates to the Company’s trial cable connector patent (U.S. Patent No. 6,154,678). In addition, the judge denied Advanced Bionics’ motion to dismiss the Texas Action. Advanced Bionics filed a California action in federal court seeking to resolve the Company’s patent claims, which was subsequently dismissed. Advanced Bionics has also made motions to transfer the Texas Action to a California federal court, which the judge in the Texas Action has dismissed. On January 28, 2005, the judge in the Texas Action granted Advanced Bionic’s motion to compel alternative dispute resolution of our trade secrets misappropriation claims, although the judge ruled that he retains jurisdiction over those claims. On March 11, 2005, Advanced Bionics filed its First Amended Answer and Counterclaims in the Texas Action, asserting, among other things, that the Company is infringing Advanced Bionics’ U.S. Patent Nos. 6,516,277 and 6,381,496. Advanced Bionics claims that the Company is infringing these patents at least by marketing and selling GenesisRC rechargeable IPG systems, and Advanced Bionics may assert that the Company’s newly-approved Eon system does as well. These patents relate to changing operational parameters sets (6,381,496) and to a specific type of rechargeable spinal cord stimulation system (6,516,277). The counterclaims seek temporary restraining orders, permanent injunctions, compensatory damages, exemplary damages including treble damages, pre and post judgment interest, attorneys’ fees and such other relief as the court may grant. The Company intends to vigorously defend itself against these claims, which the Company believes are meritless because, among other things, the Company believes the patents are not infringed or are invalid.

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Beginning March 1, 2005, several law firms announced the filing of class action securities lawsuits against the Company and certain of its officers and directors filed on behalf of purchasers of the Company’s securities between April 24, 2003 and February 16, 2005, inclusive (the Class Period). The Company is aware that three such lawsuits have been filed in the United States District Court for the Eastern District of Texas as follows: PLA, LLC vs. Advanced Neuromodulation Systems, Inc., et al, filed March 1, 2005; RAI Investment Club vs. Advanced Neuromodulation Systems, Inc., et al, filed March 9, 2005; and Clifford a. Leavitt vs. Advanced Neuromodulation Systems, Inc., et al, filed April 28, 2005. These suits allege the Company violated federal securities laws by the issuance of false and misleading statements to the market regarding the Company’s financial performance throughout the Class Period, which statements allegedly had the effect of artificially inflating the market price of the Company’s securities. In particular, the claims allege improper marketing and sales practices accounted for the Company’s revenue growth, citing, among other things, the public announcement that management made on February 17, 2005 that the Company had received a subpoena from the Office of the Inspector General, Department of Health and Human Services, requesting documents related to sales and marketing, reimbursement, Medicare and Medicaid billing and other business practices. The plaintiffs are seeking unspecified compensatory damages and costs and expenses of litigation. No class has been certified. Based on the various press releases, the Company believes any other lawsuits, if filed, will contain similar allegations. The Company intends to vigorously defend itself against the claims made in these lawsuits and believes the lawsuits are without merit.

We are also a party to product liability claims related to our neurostimulation devices and other ordinary routine litigation claims arising in the ordinary course of business. Our product liability insurers have assumed responsibility for defending us against product liability claims, subject to reservation of rights in certain cases. Historically, product liability claims related to our neurostimulation devices have not resulted in significant monetary liability beyond our insurance coverage. We seek to maintain appropriate levels of product liability insurance with coverage that we believe is comparable to that maintained by companies similar in size and serving similar markets.

Except as mentioned above and for other ordinary routine litigation incidental to our business, we are not currently a party to any other pending legal proceeding. We maintain general liability insurance against risks arising out of the normal course of business.

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ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

Subsequent to the end of the first quarter of 2005, we acquired an additional 541,780 shares and used $14.9 million from our cash reserves. Through April 30, 2005, we have purchased a total of 923,674 shares at a cost of $25.6 million.

On June 1, 2004, we announced that our Board of Directors approved the repurchase of up to 1,000,000 shares of our common stock. Repurchases may be made from time to time in open market purchases or privately negotiated transactions, subject to price and availability, and financed out of working capital. On April 28, 2005, we announced that the Board of Directors had expanded the repurchase authorization to a total of 2,000,000 shares.

ITEM 6. EXHIBITS

	(a)	Exhibit 3.1 — Articles of Incorporation, as amended and restated (1)
		Exhibit 3.2 — Bylaws, as amended and restated (2)
		Exhibit 4.1 — Rights Agreement dated as of August 30, 1996, between Quest Medical, Inc. and KeyCorp Shareholder Services, Inc. as Rights Agent (3)
		Exhibit 4.2 — Amendment to Rights Agreement dated as of January 25, 2002, between Advanced Neuromodulation Systems, Inc and Computershare Investor Services LLC (formerly KeyCorp Shareholder Services, Inc.) (4)
		Exhibit 10.27 — Advanced Neuromodulation Systems, Inc. 2004 Stock Incentive Plan (5)

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		Exhibit 31.1 — Certification of the Chief Executive Officer Pursuant to Rule 13a-14 of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (6)
		Exhibit 31.2 — Certification of the Chief Financial Officer Pursuant to Rule 13a-14 of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (6)
		Exhibit 32.1 — Certification of the Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (7)
		Exhibit 32.2 — Certification of the Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (7)

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Signatures

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

	ADVANCED NEUROMODULATION SYSTEMS, INC.
Date: May 9, 2005	By:	/s/ F. Robert Merrill III
		F. Robert Merrill III
		Executive Vice President, Finance Chief Financial Officer and Treasurer

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EXHIBIT INDEX