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EX-32.2 - CERTIFICATION OF CFO PURSUANT TO SECTION 302 - CYBERONICS INCform31-2.htm
EX-23.1 - CONSENT OF KPMG LLP - CYBERONICS INCform23-1.htm
EX-31.1 - CERTIFICATION OF CEO PURSUANT TO SECTION 302 - CYBERONICS INCform31-1.htm
EX-32.1 - CERTIFICATION OF CEO AND CFO PURSUANT TO SECTION 906 - CYBERONICS INCform32-1.htm

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
_______________

Form 10-K

(Mark One)
þ
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
   
 
For the fiscal year ended April 30, 2010
 
or
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
   
 
For the transition period from                                                                to

Commission file number: 0-19806
_______________

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

Delaware
76-0236465
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification No.)

Cyberonics Building
100 Cyberonics Blvd.
Houston, Texas
77058-2072
(Address of principal executive offices)
(Zip Code)

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

Securities registered pursuant to Section 12(b) of the Act:

Title of Each Class of Stock
 
Name of Each Exchange on Which Registered
Common Stock — $0.01 par value per share
 
The NASDAQ Stock Market LLC

Securities registered pursuant to Section 12(g) of the Act:
None
_______________

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o     No þ

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes o     No þ

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes o     No o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer
o
Accelerated filer
þ
Non-accelerated filer
o (Do not check if a smaller reporting company)
Smaller reporting company
o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).  Yes o     No þ

The aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant as of October 23, 2009, the last business day of the registrant’s most recently completed second fiscal quarter, based upon the last sales price reported for such date on the NASDAQ Global Market was approximately $209.8 million. For purposes of this disclosure, shares of common stock held by persons who hold more than 5% of the outstanding shares of common stock and shares held by officers and directors of the registrant have been excluded as such persons may be deemed to be affiliates.

At June 14, 2010, 27,686,940 shares of common stock were outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the definitive proxy statement of Cyberonics, Inc. for the 2010 Annual Meeting of Stockholders, which will be filed within 120 days of April 30, 2010, are incorporated by reference into Part III of this Annual Report on Form 10-K.


 
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TABLE OF CONTENTS



PART I
Item 1.
4
Item 1A.
19
Item 1B.
29
Item 2.
29
Item 3.
29
Item 4.
29
PART II
Item 5.
30
Item 6.
31
Item 7.
32
Item 7A.
40
Item 8.
41
Item 9.
41
Item 9A.
41
Item 9B.
41
PART III
Item 10.
43
Item 11.
43
Item 12.
43
Item 13.
43
Item 14.
43
PART IV
Item 15.
44


In this Annual Report on Form 10-K, “Cyberonics,” “we,” “us” and “our” refer to Cyberonics, Inc. and
its consolidated subsidiary (Cyberonics Europe, SA).
_______________

 
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CAUTIONARY STATEMENT ABOUT FORWARD-LOOKING STATEMENTS

The Private Securities Litigation Reform Act of 1995 provides a “safe harbor” for certain forward-looking statements. This Annual Report on Form 10-K (this “Form 10-K”) contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”).  The words “believe,” “expect,” “anticipate,” “plan,” “intend,” “foresee,” “should,” “would,” “could” or other similar expressions are intended to identify forward-looking statements. These forward-looking statements are based on our current expectations and beliefs concerning future developments and their potential effects on us. There can be no assurance that future developments affecting us will be those that we anticipate. All comments concerning our expectations for future revenues and operating results are based on our forecasts for our existing operations. These forward-looking statements involve significant risks, uncertainties (some of which are beyond our control) and assumptions. They are subject to change based upon various factors, including but not limited to the risks and uncertainties described in (a) Part I, “Item 1A.  Risk Factors” and elsewhere in this Form 10-K; (b) our reports and registration statements filed from time to time with the Securities and Exchange Commission (“SEC”); and (c) other announcements we make from time to time.

No forward-looking statements can be guaranteed to be accurate and actual outcomes may vary materially. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. We will not update any of the forward-looking statements after the date of this Form 10-K to conform these statements to actual results, unless required by law.

 
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PART I

Item 1.  Business

General

We are a neuromodulation company incorporated as a Delaware corporation in 1987, engaged in the design, development, sales and marketing of implantable medical devices that provide a unique therapy, vagus nerve stimulation therapy (VNS Therapy™), for the treatment of refractory epilepsy and treatment-resistant depression.

Our proprietary VNS Therapy System includes the following:

A generator to provide the appropriate stimulation to the vagus nerve;
A lead that connects the generator to the vagus nerve;
Associated equipment to assist with implantation surgery;
Equipment to assist with setting the stimulation parameters particular to the patient;
Appropriate instruction manuals; and
Magnets to suspend or induce stimulation manually.

The generator and lead are surgically implanted into patients, generally on an outpatient basis.  The battery contained in the generator has a finite life, which varies according to the model, the stimulation parameters and the settings used for each patient. At or near the end of the useful life of a battery, a patient may, with the advice of a physician, choose to implant a new generator, with or without replacing the original lead.

The U.S. Food and Drug Administration (“FDA”) approved our VNS Therapy System in July 1997 for use as an adjunctive therapy in epilepsy patients over 12 years of age in reducing the frequency of partial onset seizures that are refractory or resistant to antiepileptic drugs. Regulatory bodies in Canada, the European Economic Area, certain countries in Eastern Europe, Russia, South America, Africa, Australia and certain countries in Asia, including Japan, China and Taiwan, have approved VNS Therapy for the treatment of epilepsy, many without age restrictions or seizure-type limitations. In July 2005, the FDA approved our VNS Therapy System for the adjunctive long-term treatment of chronic or recurrent depression for patients 18 years of age or older who are experiencing a major depressive episode and have not had an adequate response to four or more adequate anti-depressant treatments. Regulatory bodies in the European Economic Area, Canada and Israel have approved our VNS Therapy System for the treatment of chronic or recurrent depression in patients who are in a treatment-resistant or treatment-intolerant depressive episode without age restrictions.

Our ability to successfully expand the commercialization of our VNS Therapy System depends on obtaining and maintaining favorable insurance coverage, coding and reimbursement for the device, the implant procedure and follow-up care.  Currently, there is broad coverage, coding and reimbursement for VNS Therapy for the treatment of refractory epilepsy. The Centers for Medicare and Medicaid Services (“CMS”), which we estimate pays for approximately 25% of the VNS Therapy implants, issues an annual update to the reimbursement amounts to be received by our customers for the following calendar year.  In calendar year 2009, CMS announced increases in the rates reimbursed to our customers for the implant procedure for both the generator and the lead portion of the VNS Therapy System effective for calendar year 2010. A decrease in reimbursement rates could have an adverse impact on our business and our future operating results.

As a basis for maintaining and extending reimbursement, we are focused on improving the efficacy of VNS Therapy for patients with refractory epilepsy.  This involves increased investment in research and development, specifically, seizure detection with responsive stimulation and associated technology, as well as additional investment in clinical studies using VNS Therapy for the treatment of refractory epilepsy.

 
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In May 2007, CMS issued a final determination of non-coverage with respect to reimbursement of VNS Therapy for depression.  Although we are not currently engaged in active commercial efforts with respect to depression, we continue to evaluate alternative actions intended to maintain the current regulatory approval related to depression, while minimizing our required investment, and ensuring that VNS Therapy continues to be available to patients in the U.S. and certain international markets.

 In February 2009, we completed enrollment of our treatment-resistant depression (“TRD”) patient dosing study, one of two studies required by the FDA as a condition of our 2005 approval for the TRD indication, and the last patient visit was completed in March 2010. Preliminary results were released in May 2010, and a final report is due to the FDA in October 2010. Based on the preliminary results released in May 2010, we announced that we would initiate discussions with payers with the objective of seeking coverage and reimbursement of VNS Therapy for TRD, although there can be no assurance that these objectives will be met. Additionally, we are in ongoing discussions with the FDA to ensure that our TRD Registry makes adequate progress towards completion.

Our clinical development program has included pilot and pivotal studies using VNS Therapy (1) as an adjunctive therapy for reducing the frequency of seizures in patients over 12 years of age with partial onset seizures that are refractory to antiepileptic drugs and (2) as an adjunctive treatment for patients 18 years of age and older with chronic or recurrent depression who are in a major depressive episode. We have also conducted or provided support for small pilot studies for the use of VNS Therapy in the treatment of Alzheimer’s disease, anxiety, bulimia, fibromyalgia, obesity, obsessive-compulsive disorder, multiple sclerosis, traumatic brain injury and other indications. These studies have been conducted to determine the safety and effectiveness of VNS Therapy in these new indications and to determine which new indications might be considered for pivotal studies.

Proprietary protection for our products is important to our business.  We seek U.S. and foreign patents on selected inventions, acquire licenses under selected patents owned by third parties, and enter into invention and confidentiality agreements with our employees, vendors and consultants with respect to technology that we consider important to our business.  We also rely on trade secrets, unpatented know-how and continuing technological innovation to develop and maintain our competitive position.

We are actively engaged in efforts to license intellectual property rights to and from third parties in order to optimize our portfolio. This includes identifying intellectual property rights for indications we do not have plans to develop and determining whether these rights can be licensed to third parties. It also involves assessing the intellectual property rights owned by third parties to determine whether we should attempt to license those rights. We recently announced several license and technology agreements that may involve substantial future payments; see “Note 14. Commitments and Contingencies,” for additional information.

Since inception, we have incurred substantial expenses, primarily for research and development activities that include product and process development, manufacturing start-up costs and systems infrastructure. We have also made significant investments in connection with sales and marketing activities in the U.S. and clinical research costs and related regulatory activities associated with the depression indication. As of April 30, 2010, we had incurred an accumulated deficit of approximately $164.1 million.

 
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VNS Therapy Epilepsy Indication Overview

Epilepsy is a disorder of the brain characterized by recurrent seizures that are categorized as either partial or generalized at onset. Patients who continue to have unsatisfactory seizure control or intolerable side effects after treatment with appropriate antiepileptic therapies for a reasonable period of time are said to suffer from refractory epilepsy. For reasons that are not clear, partial onset seizures are generally more refractory to existing therapies than generalized seizures. Epilepsy is the second most prevalent neurological disorder in the world. According to the U.S. Centers for Disease Control and the National Epilepsy Foundation, between 2.5 and 3.0 million individuals in the U.S. have some form of epilepsy, with between 150,000 and 200,000 new cases diagnosed each year. We estimate, based on a World Health Organization study on epilepsy, that there are in excess of 3.0 million individuals with epilepsy in Western Europe with over 150,000 new cases diagnosed each year; in Japan, these number are one million and 50,000, respectively.  In addition, it is estimated that approximately 50% of patients with epilepsy suffer from partial onset seizures, and over 30% of these patients continue to suffer from seizures in spite of treatment with antiepileptic drugs. There are at least four types of treatment available to persons with epilepsy: antiepileptic drug therapy, use of a ketogenic diet, VNS Therapy and surgery. Antiepileptic drugs serve as a first-line treatment and are prescribed for virtually all individuals being treated for epilepsy. When drug therapy is not effective, VNS Therapy may be considered.  Surgery may also be an option for some patients. There are two investigational devices under development for the treatment of epilepsy, both involving the placement of stimulation electrodes in a patient’s brain: Medtronic, Inc.’s Activa® Neurostimulator for deep brain stimulation (“DBS”) and NeuroPace, Inc.’s Responsive Neurostimulator System (“RNStm”).  These treatments are not currently approved for commercial U.S. distribution; however, in March 2010, an FDA advisory panel voted 7-5 in favor of recommending that the FDA approve Medtronic’s DBS.

VNS Therapy for Epilepsy

The VNS Therapy System is indicated as an adjunctive treatment for patients who are refractory to antiepileptic drugs. In the two randomized, parallel, double-blind, active-controlled studies that led to FDA approval of our epilepsy indication, the patients who received adjunctive VNS Therapy had a mean seizure reduction of approximately 24% and 28% during the three-month acute phase of the studies. Additionally, many patients, including some who reported no change or an increase in seizure frequency, also reported a reduction in seizure severity. Long-term follow-up data derived from an uncontrolled protocol on the 440 patients in five studies showed that efficacy was maintained and, for many patients, improved over time during treatment with the VNS Therapy System. Analysis of the pooled data showed that the median percentage seizure reduction was 44% after 24 months of treatment and was sustained at that level at 36 months.  A study by physicians at New York University and published in 2009 involving 507 patients with refractory epilepsy treated with VNS Therapy reported that 66.7% of patients experienced at least a 50% reduction in seizure frequency. Our analysis of an internal database of patients who received an implant of VNS Therapy including the first model of our generator (the Model 100) indicates that over 70% have chosen to continue with VNS Therapy when the generator battery is depleted, generally 5 to 6 years after initial implant. In the treatment of refractory epilepsy, the side effects associated with the VNS Therapy System are generally mild, localized and related to the period of time in which stimulation is activated. Typical side effects include voice alteration, neck discomfort, increased cough, shortness of breath and difficulty swallowing. The VNS Therapy System has not typically been associated with the debilitating central nervous system side effects that frequently accompany antiepileptic drugs. Additionally, side effects of VNS Therapy typically decrease over time. To date, an estimated 63,000 patients worldwide have been treated with the VNS Therapy System for epilepsy.

 
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VNS Therapy Depression Indication Overview

Major depressive disorder is one of the most prevalent and serious illnesses in the U.S. It affects nearly 19 million Americans 18 years of age or older every year. Recently published data indicate that approximately one-third of patients with major depressive disorder will not achieve a remission of their depressive symptoms after four well-delivered, optimized treatment steps using standard antidepressant therapies. Standard treatment methods for depression include antidepressant drugs, psychotherapy and electroconvulsive therapy (“ECT”). First-line therapy often consists of an antidepressant drug. For patients who do not respond adequately to initial antidepressant treatment, physicians will often switch to a different drug or use two or more drugs in combination. Physicians usually reserve ECT for patients who have not had an adequate response to multiple trials of antidepressant drugs or when they determine a rapid response to treatment is desirable. There are a number of other neuromodulation treatments at various stages in the development cycle for the treatment of depression, including repetitive transcranial magnetic stimulation (“rTMS”), which has received FDA approval, and DBS, which is not currently approved for commercial distribution to treat depression.

VNS Therapy for Depression

The VNS Therapy System is indicated as an adjunctive treatment for patients 18 years of age or older who are experiencing a major depressive episode and have not had an adequate response to four or more adequate antidepressant treatments. In Canada and the European Union, VNS Therapy is indicated for the treatment of chronic or recurrent depression in patients who are in a treatment-resistant or treatment-intolerant major depressive episode. VNS Therapy was generally well tolerated in the depression clinical studies.  In the double-blind, randomized, parallel-group sham treatment-controlled, multi-center study that led to FDA approval of our depression indication, the patients who received adjunctive VNS Therapy had a response rate (as measured by HRSD24) of 15% during the twelve week acute phase of the studies and a 30% response rate during the 12-month long-term phase of the study. The most commonly reported adverse events were similar to those observed in patients being treated with VNS Therapy for epilepsy. These side effects tended to occur during stimulation, tended to be reported as mild or moderate and tended to be reported less frequently over time. To date, an estimated 3,600 patients worldwide have been treated with the VNS Therapy System for depression.

FDA Post-Approval Study Commitments and Other Clinical Research Studies

Pursuant to the post-market surveillance conditions specified as part of our FDA marketing approval, we are required to conduct two clinical studies on TRD patients.  One study originally intended to include 460 patients, the dosing study, is a randomized controlled study assessing three different stimulation intensities.  The other study, the TRD Registry, is a longitudinal registry intended to follow 500 VNS patients and 500 non-VNS patients for up to five years. We completed enrollment of our TRD patient dosing study in February 2009, and the last patient visit was completed in March 2010. Preliminary results were released in May 2010, and a final report is due to the FDA in October 2010. Based on the preliminary results, we announced that we would initiate discussions with payers with the objective of obtaining coverage and reimbursement of VNS Therapy for TRD, although there can be no assurance that these objectives will be met. Additionally, we are in ongoing discussions with the FDA to ensure that the TRD Registry makes adequate progress toward completion.

We also sponsor post-marketing studies in refractory epilepsy and support a variety of studies to further understand predictors of VNS success. Our E-06 Study is an open randomized post-marketing study being conducted in Europe to assess the efficacy and safety of adjunctive VNS Therapy versus standard antiepileptic drug treatment in children (age 17 or less) with refractory seizures. Enrollment in the study was terminated in December 2008, follow-up was completed in January 2010 and analysis of the results is ongoing. The European indication for use allows children under the age of 12 to be implanted with VNS Therapy. Our E-102 Study is a retrospective records review being conducted at several European centers to assess longer-term efficacy and safety of adjunctive VNS Therapy in children. Enrollment in E-102 was initiated in April 2010. Our E-25 study is a retrospective study that collects de-identified EEG/ECG data from US and European sites.  Data from this study will be used to support our ongoing product development efforts.  We expect to continue to invest in future research activities as appropriate.

 
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VNS Therapy System

VNS Therapy is the first treatment approved by the FDA for medically refractory epilepsy and for TRD. The safety profiles for VNS Therapy and the VNS Therapy System, including the implant procedure, are well established in clinical studies of refractory epilepsy and depression.  The VNS Therapy System has been implanted in more than 66,000 patients.

The VNS Therapy System is a proprietary, integrated system consisting of an implantable generator that delivers an electrical signal to an implanted lead attached to the left vagus nerve. The vagus nerve is the longest of the cranial nerves, extending from the brain stem through the neck to organs in the chest and abdomen. The left vagus nerve has been shown to have influence over numerous areas of the brain. Preclinical studies and mechanism-of-action research suggest that intermittent stimulation of the left vagus nerve in the neck modulates a number of structures and alters blood flow bilaterally in several areas of the brain. These studies have also shown that stimulation of the left cervical vagus nerve is effective in suppressing the intensity or frequency of seizures and results in persistent or carryover antiepileptic effects, which increase with chronic intermittent stimulation. The mechanism-of-action research associated with our depression studies has shown stimulation of the left vagus nerve results in modulation of areas of the brain thought to be important in the regulation of mood.

The VNS Therapy System consists of a pulse generator, a bipolar lead, a programming wand and software and a tunneling tool. The pulse generator and bipolar lead are surgically implanted in a procedure that typically takes from 60 to 90 minutes, during which time the patient is under general, regional or, rarely, local anesthesia. The pulse generator is surgically implanted in a subcutaneous pocket in the upper left chest. The bipolar lead is connected to the pulse generator and attached to the vagus nerve in the lower left side of the patient’s neck.

The VNS Therapy System delivers stimulation by means of electrical pulses on a chronic, intermittent basis. The initial stimulation parameters that we typically recommend are a 30-second period of stimulation, which we refer to as ON time, followed by a five-minute period without stimulation, which we refer to as OFF time. To optimize patient treatment, the current pulse width, amplitude, frequency and stimulation ON and OFF intervals of the pulse generator can be adjusted non-invasively by the treating physician with a handheld computer using our programming wand and software. In addition, epilepsy patients can use a small, handheld magnet provided with the VNS Therapy System to activate or deactivate stimulation manually. On-demand therapy can be useful for those epilepsy patients who sense an oncoming seizure and has been reported by a number of patients to abort or reduce the severity or duration of seizures. The magnet can also be used to provide epilepsy patient control of stimulation side effects by allowing the patient to deactivate stimulation temporarily.

Pulse Generator.  The pulse generator is an implantable, programmable signal generator designed to be coupled with the bipolar lead to deliver electrical current pulses to the vagus nerve. The pulse generator is a battery powered device. Shortly before or upon depletion of the battery, the pulse generator may be removed and a new generator implanted in a short, outpatient procedure.

The Model 102, 102R, Demipulse™ and Demipulse Duo™ VNS Therapy pulse generators, the only pulse generators we currently offer in the U.S., are similar in design and manufacture to a cardiac pacemaker. The generators are comprised of one printed circuit board and a battery hermetically sealed in a titanium case. Standard components are assembled on printed circuit boards using surface-mount technology. The assembled circuit boards are then tested and mounted with the battery in the titanium case, which is laser welded. A header to which the bipolar lead connects is added and each unit is subject to final release testing prior to being sterilized and packaged.

Bipolar Lead.  The bipolar lead conveys the electrical signal from the pulse generator to the vagus nerve. The lead incorporates electrodes, which are self-sizing and flexible, minimizing mechanical trauma to the nerve and allowing body fluid interchange within the nerve structure. The lead’s two electrodes and anchor tether wrap around the vagus nerve and the connector end is tunneled subcutaneously to the chest, where it attaches to the pulse generator. We currently offer three lead models in the U.S., each with differences in rigidity. The leads are available in two sizes of inner spiral diameter to ensure optimal electrode placement on different size nerves.

 
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Programming Wand and Software.  Our programming wand and proprietary software are used to interrogate the implanted pulse generator and to transmit programming information from a handheld computer to the pulse generator via electromagnetic signals. Programming capabilities include modification of the pulse generator’s programmable parameters (pulse width, amplitude, frequency and ON and OFF intervals) and storage and retrieval of telemetry data.

Tunneling Tool.  The tunneling tool is a single use, sterile, disposable surgical tool designed to be used during surgical placement of the bipolar lead. The tool is used for subcutaneous tunneling of the lead assembly between the nerve site in the neck and the pulse generator site in the chest.

Accessory Pack.  The accessory pack includes two resistor assemblies used to test the function of the device prior to implantation, the bipolar lead tie-downs and one hex screwdriver.

Patient Essentials Kit.  The patient kit includes two magnets, one watch style and one pager style.

Product Development

Our product development efforts, focused primarily on epilepsy, are directed toward improving the VNS Therapy System, improving its efficacy and developing new products that provide additional features and functionality while improving cost effectiveness.

In May 2005, we received approval from KEMA Registered Quality, Inc. (“KEMA”) to market our Demipulse and Demipulse Duo VNS Therapy System generators in the member countries of the European Union for the approved epilepsy and depression indications for use. The Demipulse generator is our newest single-connector VNS Therapy System generator, and the Demipulse Duo generator is our newest dual-connector VNS Therapy System generator for use in patients whose physicians have elected replacement of their previous dual-connector generator at the end of its battery life. Both the Demipulse and Demipulse Duo generators are capable of delivering greater functionality and are smaller and lighter than the previous models. We received FDA approval for both the Demipulse and Demipulse Duo generators in July 2007, initiated limited release in the U.S. in late 2007 and commenced commercial release in May 2008.

The VNS Therapy Perenniatm Lead  (now called PerenniaDURA™) was approved by the FDA in May 2006 and by KEMA in August 2006. Functionally, the new lead is the same as its predecessor, the Model 302 Lead, but it incorporates a new design and is constructed from more durable components. Mechanical tests conducted in a laboratory setting have shown the PerenniaDURA Lead to be more robust than its predecessor.  The next generation lead is the Perennia Flextm ,which was approved by the FDA in December 2008 and by KEMA in April 2009 and incorporates a minor design change to the commercially available Model 302 Lead. Additionally, the Perennia Flex lead incorporates some elements of the VNS Therapy PerenniaDURA Lead.

We are conducting ongoing product development activities to enhance the VNS Therapy System pulse generator, the bipolar lead and the programming software. In connection with the introduction of new and improved products, we will be required to file for the appropriate U.S. and international regulatory approvals, and some projects may require clinical trials.

We are focused on developing new and improved products for patients with epilepsy, in particular by:

examining whether significant variations in the stimulation parameters improve the efficacy of the device;
evaluating methods of detecting and predicting seizures and delivering responsive therapy, recording the seizure, or alerting the patient, caregiver or physician; and
incorporating telemedicine or wireless telemetry into our devices.


 
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These new product development efforts are still in the early stage and may require significant funding to complete. Further, we are collaborating with other entities on several of these projects, any one of which may not be successful. Even if successful, additional clinical trials may be needed to bring any or all of these products to market, and we are not yet able to determine when any such products will be ready for market launch. We have provided investors with information concerning these development efforts, including estimated five-year expenditures of approximately $100 million and possible dates on which various products could be ready for market launch. This information will be updated for investors, from time to time, and is likely to change in material ways, both as to the funding requirements and possible launch dates.

Manufacturing and Sources of Components and Raw Materials

We manufacture our products at our manufacturing facility located in our corporate headquarters in Houston, Texas, with the exception of the handheld computer used for programming, which is a purchased component. We purchase the components and raw materials used in manufacturing these products from various suppliers.  For reasons of quality, product availability and expense control, certain components and raw materials are purchased from sole source suppliers. We work closely with our suppliers, including our sole source suppliers, to ensure continuity of supply and quality. Due to the FDA’s rigorous quality requirements regarding the manufacture of medical devices, including the VNS Therapy System, we may not be able to change suppliers or identify alternate suppliers quickly or easily. Although component or raw material supply has not historically been an issue, any reduction or interruption in supply could adversely impact our business.

Our manufacturing operations are required to comply with the FDA’s Quality System Regulation (“QSR”).  The QSR is promulgated under section 520 of the Federal Food, Drug and Cosmetic Act (“FDCA”), which requires manufacturers to have a quality system for the design and production of medical devices. The FDCA requires that:

various specifications and controls be established for devices;
devices be designed under a quality system to meet these specifications;
devices be manufactured under a quality system;
finished devices meet these specifications;
devices be correctly implanted, checked and serviced;
quality data be analyzed to identify and correct quality problems;
complaints be reviewed, evaluated and investigated;  and
certain product and process changes, complaints and product problems be reported to FDA.

Thus, the QSR helps assure that medical devices are safe and effective for their intended use. In addition, certain international markets have regulatory, quality assurance and manufacturing requirements that may be more or less rigorous than those in the U.S. Specifically, we have authorized KEMA to act as our notified body to ensure that our products and quality systems comply with the requirements of International Standards Organization – ISO 13485:2003, Medical devices — Quality management systems — Requirements for regulatory purposes, the European Council Directive 90/385/EEC, which relates to active implantable medical devices, and to the Canadian medical devices regulations.

Marketing and Sales

U.S.

We market and sell our products for refractory epilepsy through direct sales and marketing forces. We no longer actively sell or market our product for depression in the U.S. market.

In the U.S., our sales and marketing plan focuses on creating awareness and demand for the VNS Therapy System among epileptologists and neurologists who treat refractory epilepsy, implanting surgeons, nurses, third-party payers, hospitals and patients and their families. In particular, our efforts are primarily directed to comprehensive epilepsy treatment centers.

 
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To reach each of these groups, we conduct direct selling activities using a specialized sales force consisting of:

sales personnel with medical device, pharmaceutical, or nursing experience;
field clinical engineers and marketing personnel focused on educational and promotional marketing programs; and
case managers experienced in patient education, insurance verification and authorization issues.

In addition to our direct selling activities, we facilitate and support peer-to-peer interactions such as symposia, conference presentations, journal articles and patient support groups to provide experienced clinicians and patients the opportunity to share their perspectives on the VNS Therapy System with others.

We do not anticipate actively marketing VNS Therapy for the treatment of TRD unless we obtain favorable coverage policies for VNS Therapy in depression.  With the preliminary results of our TRD patient dosing study released in May 2010, we announced that we would initiate discussions with payers with the objective of seeking coverage and reimbursement of VNS Therapy for TRD, although there can be no assurance that these objectives will be met.

International

We are approved to market our products in more than 70 countries through a combination of a direct sales force in certain European countries and independent distributors elsewhere.  Our objectives include increasing sales and expanding the number of countries where VNS Therapy can be made available to patients. We no longer actively market our products internationally for the treatment of depression.

The VNS Therapy System is currently sold by a direct sales force in Austria, Belgium, Denmark, France, Germany, Ireland, Luxemburg, The Netherlands, Norway, Spain, Sweden, Switzerland and the United Kingdom. The sales price in each direct country is based on local market conditions, including public and private reimbursement, and is generally lower than the sales price in the U.S.

We have distribution agreements with independent distributors covering a number of other territories including Canada, Mexico, Australia, parts of Central and South America, China, Japan, and other parts of Asia, the Middle East and the remaining areas of Europe not serviced by our direct sales force. The distribution agreements generally grant the distributor exclusive rights for the particular territory for a specified period of time, generally one to three years.  Under the terms of the agreement and local law, we may be required to compensate the distributor in the event that the agreement is terminated by us or is not renewed upon expiration. The distributor generally assumes responsibility for obtaining regulatory and reimbursement approvals for the relevant territory and agrees to certain minimum marketing and sales expenditures and purchase commitments. Our pricing to distributors is generally fixed under the terms of the distribution agreements, but may change at our election with as little as 30 days prior notice under most agreements. Sales incentives, if provided, are recorded as reductions to net sales in the same period net sales are recognized.

In November 2008, we facilitated an application for regulatory approval for the epilepsy indication in Japan. This application was filed by Nihon Kohden Corporation and was approved by the Japanese Ministry of Health, Labour and Welfare in January 2010. Additionally, in April 2009, we entered into a distribution agreement granting Nihon Kohden Corporation exclusive distribution rights for the epilepsy indication in Japan. In January 2010, along with our distributor, we applied to the Japanese Ministry of Health, Labour and Welfare for appropriate reimbursement coverage in Japan, and in May 2010 we received reimbursement approval, effective on July 1, 2010.

Government Regulation

The products we manufacture and market are subject to regulation by the FDA under the FDCA, and, in some instances, state authorities and foreign governments.

 
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United States FDA Regulation

Before a new medical device can be introduced into the market, a manufacturer generally must obtain marketing clearance or approval from the FDA through either a 510(k) submission (a premarket notification) or a premarket approval application or PMA.

The PMA application procedure is more comprehensive than the 510(k) procedure and typically takes several years to complete. The PMA application must be supported by scientific evidence, typically in the form of pre-clinical and clinical data relating to the safety and efficacy of the device, and must include other information about the device and its components, design, manufacturing and labeling. The FDA will approve a PMA application only if a reasonable assurance that the device is safe and effective for its intended use can be provided. As part of the PMA application review, the FDA will inspect the manufacturer’s facilities for compliance with its QSR. As part of the PMA approval, the FDA may place restrictions on the device, such as requiring additional patient follow-up for an indefinite period of time. If the FDA’s evaluation of the PMA application or the manufacturing facility is not favorable, the FDA may deny approval of the PMA application or issue a “not approvable” letter. The FDA may also require additional clinical trials, which can delay the PMA approval process by several years. After the PMA is approved, if significant changes are made to a device, its manufacturing or labeling, a PMA supplement containing additional information must be filed for FDA approval prior to implementation of the changes.

The VNS Therapy System was introduced into the market using the PMA procedure.  The FDA clearance and approval processes for a medical device are expensive, uncertain and lengthy. There can be no assurance that we will be able to obtain necessary regulatory clearances or approvals for any new or improved product on a timely basis or at all.

After a product is placed on the market, the product and its manufacturer are subject to pervasive and continuing regulation by the FDA. Device manufacturers must register their facilities and list their products with the FDA and certain state agencies.  Labeling and promotional activities for devices are subject to scrutiny by the FDA. The FDA actively enforces regulations prohibiting the marketing of devices for unapproved uses. We are required by the FDA to track our implantable devices after distribution as required by the Device Tracking regulation.

The FDA enforces its QSR requirements by inspection and market surveillance. The FDA periodically inspects manufacturing facilities, potentially including our suppliers. If there are alleged violations, the operator of a facility must correct them or satisfactorily demonstrate the absence of the violations or face regulatory action. We are subject to inspection and marketing surveillance by the FDA to determine our compliance with all regulatory requirements. Recently, the FDA has placed an increased emphasis on enforcement of the QSR and other postmarket regulatory requirements. Non-compliance with applicable FDA requirements can result in, among other things, fines, injunctions, civil penalties, recall or seizure of products, total or partial suspension of production, failure of the FDA to grant marketing approvals, withdrawal of marketing approvals, a recommendation by the FDA to disallow us to enter into government contracts, and criminal prosecutions. The FDA also has the authority to request repair, replacement or refund of the cost of any device manufactured or distributed by us.

We must therefore continue to expend resources to maintain compliance with the various FDA regulations outlined above.

Other

We and our products are also subject to a variety of state and local laws in those jurisdictions where our products are or will be marketed, and federal, state and local laws relating to matters such as safe working conditions, manufacturing practices, environmental protection, fire hazard control and disposal of hazardous or potentially hazardous substances. We are also subject to various federal and state laws governing our relationships with the physicians and others who purchase or make referrals for our products. For instance, federal law prohibits payments of any form that are intended to induce a referral for any item payable under Medicare, Medicaid or any other federal healthcare program. Many states have similar laws. There can be no assurance that we will not be required to incur significant costs to comply with such laws and regulations now or in the future or that such laws or regulations will not have a material adverse effect on our ability to do business.

 
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Non-U.S. Regulation

Internationally, the VNS Therapy System is considered to be a medical device under applicable regulations and directives. We anticipate that this will be true for all of our future products. Sales of medical devices are subject to regulatory requirements in many countries. The regulatory review process may vary greatly from country to country. For example, the European Union has adopted numerous directives and standards relating to medical devices, regulating their design, manufacture, clinical trials, labeling and adverse event reporting. Devices that comply with these requirements are entitled to bear a Conformité Européenne (CE Mark) indicating that the device conforms to the essential requirements of the applicable directives and can be commercially distributed in countries that are members of the European Union.

In some cases, we rely on our non-U.S. distributors to obtain regulatory approvals, complete product registrations, comply with clinical trial requirements and complete those steps that are customarily taken in the applicable jurisdictions.

There can be no assurance that new laws or regulations regarding the release or sale of medical devices will not delay or prevent sale of our current or future products. We continually monitor international regulatory developments to mitigate against any such delays.

Certain international markets have regulatory, quality assurance and manufacturing requirements that may be more or less rigorous than those in the U.S.  Specifically, we have authorized KEMA to act as our notified body to ensure that our products and quality systems comply with the requirements of International Standards Organization – ISO 13485:2003, Medical devices — Quality management systems — Requirements for regulatory purposes, the European Council Directive 90/385/EEC, which relates to active implantable medical devices and to the Canadian medical devices regulations.

Third-Party Reimbursement in the U.S. Market

We sell the VNS Therapy System for refractory epilepsy to hospitals and ambulatory surgery centers (“ASCs”) on payment terms that are generally 30 days from the shipment date. Our ability to successfully expand the commercialization of the VNS Therapy System depends on obtaining and maintaining favorable coding, reimbursement and coverage for the VNS Therapy System, the associated implant procedure and follow-up care. Favorable reimbursement coverage allows our customers to invoice and be paid by third-party payers for the costs of the VNS Therapy System, the associated surgery and patient care. We believe reimbursement or payment rates from private insurers were largely unchanged over the past year, although CMS has made significant changes to the amounts that are reimbursed to hospitals for the generator and the lead in each of the last two calendar years. The most recent of these changes, effective from January 1, 2010, include an increase from $12,545 to $13,892 in the amount paid for the generator, and an increase from $7,234 to $10,646 in the amount paid for a lead and the implant procedure. The reimbursement rates vary depending on geographic area. There can be no assurance that future changes to CMS reimbursement will not have an adverse effect on our future operating results. We continue to work with the CMS to ensure favorable and appropriate reimbursement for our products and related procedures.

Coverage for VNS Therapy in depression has been extremely difficult to obtain, and we have elected to discontinue active commercial efforts for depression until more favorable coverage is available. With the preliminary results released in May 2010 we announced that we would undertake discussions with payers with the objective of seeking coverage and reimbursement, although there can be no assurance that these objectives will be met.

We employ case managers, available through our reimbursement hotline, to help with coverage, coding and reimbursement issues on a case-by-case basis or policy level.

 
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Medicare

Under the current CMS policy, VNS Therapy is covered for patients with medically refractory partial onset seizures for whom surgery is not recommended or for whom surgery has failed. In May 2007, the CMS issued its Decision Memorandum for Vagus Nerve Stimulation for Treatment of Resistant Depression (CAS-00313R), concluding that Medicare coverage is not available for VNS Therapy as a treatment for depression. For additional information, see “General” above.

Medicaid

Medicaid programs generally cover hospital inpatient and outpatient services that are medically necessary and appropriate. With respect to epilepsy, most state Medicaid agencies have developed their own coverage policy for VNS Therapy or have adopted the national CMS coverage policy, although payment amounts vary from state to state. With respect to depression, a small number of Medicaid programs provide coverage for VNS Therapy on a case-by-case basis, but most are still evaluating a coverage policy or have issued a non-coverage policy. CMS’s non-coverage determination on Medicare coverage for the treatment of depression has made gaining coverage with Medicaid programs more difficult.

Medicaid reimbursement mechanisms vary state by state. Medicaid policy and payment methodologies change on a regular basis, so we are engaged in vigilant and ongoing work to ensure continued access and acceptable reimbursement for patients covered by Medicaid programs. Recent financial problems at various state Medicaid programs have limited payments for VNS from time to time, and these problems may continue.

Private Payers

Private payers (commercial, managed care and other third-party payers) generally cover hospital inpatient and outpatient services that are considered to be medically necessary. Currently, we estimate that private payers account for 50% to 60% of patients implanted with the VNS Therapy System. As with other payers, many private payers have developed clinical guidelines for coverage or have adopted the national CMS coverage policy for use of VNS Therapy in epilepsy. Over the last twelve months, private payers in several states have adopted less restrictive guidelines as to which patients would be eligible for VNS Therapy, particularly including children aged 12 and under.

As of the end of the fiscal year 2010, coverage for VNS Therapy for depression is still very limited. Most plans have either no policy or a non-coverage policy with respect to coverage for depression.

Payment rates vary among third-party plans based on contracts and payment methods of specific providers. Audits of providers have revealed that the average reimbursement rates for VNS Therapy-related procedures are generally acceptable to the providers.

In deciding to cover a new product or therapy, private payers base their initial coverage decision on several factors, including, but not limited to:

the status of the FDA’s review of the product;
CMS’s national coverage determinations, as well as local coverage determinations by Medicare contractors;
BlueCross BlueShield Technology Evaluation Center recommendations;
other technology assessments, including but not limited to those provided by Hayes, Inc., the ECRI Institute and the California Technology Assessment Forum;
the product’s safety and efficacy;
the number of clinical studies performed and peer-reviewed articles published with respect to the product; and
how the product and therapy compare to alternative therapies.


 
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Payment for VNS Therapy Outside the U.S.

Payment by customers for VNS Therapy Systems outside the U.S. varies on a country-by-country basis and depends on the method of product distribution chosen by the company for that country. In certain countries governments are involved in setting the final reimbursement rates generally resulting in lower reimbursement rates than in the U.S. market. In the fiscal year 2010, our international net product sales accounted for 19% of total net product sales, and the three largest individual country markets were the United Kingdom, France and Germany. In those countries, we sell directly to hospitals, and the amount received may vary even within that country.  Total sales are also affected by national and local health budgets.

Increasing prices for the VNS Therapy System, or setting a higher price for new models, such as the Demipulse and Demipulse Duo generators, can be a difficult and time-consuming process, in some instances involving submissions to government agencies.

Although the VNS Therapy System has been approved for commercial distribution in European Union countries and Canada for the treatment of chronic or recurrent depression, we do not actively market the device in those countries for this indication because of the lingering effect of the negative reimbursement environment in the U.S. for the depression indication and because of the extent of the investment that would be required.

Competition

We believe that in the fields of refractory epilepsy, existing and future drug therapies are and will continue to be the primary competition for the VNS Therapy System. We expect to face competition from other medical device companies for the treatment of partial seizures and depression. Medtronic, Inc., for example, has completed a clinical study involving DBS for the treatment of epilepsy and continues to conduct a similar study of a DBS system for the treatment of depression. Medtronic has received FDA approval for its Activa Neurostimulator DBS therapy device for the treatment of essential tremor and Parkinson’s Disease and has submitted a PMA for FDA approval of its Activa Neurostimulator for the treatment of epilepsy.  In March 2010, an FDA advisory panel recommended that the FDA approve Medtronic’s Activa Neurostimulator for epilepsy. We have been advised that a company based in Europe, NeuroTech, S.A., plans to submit a VNS device for regulatory approval in Europe in 2010. Another company, cerboMed GmbH, based in Erlangen, Germany, is focused on the development of transcutaneous vagus nerve stimulation, or t-VNS Therapy.  cerboMed has received CE Mark approval for its device for the treatment of epilepsy and depression. St. Jude Medical, Inc. has announced the initiation of a clinical study for a DBS system for the treatment of depression, and NeuroPace, Inc. has completed a pivotal study for its closed-loop RNS device with implanted deep brain electrodes.

We could also face competition from other small, emerging or large medical device or pharmaceutical companies that have the technology, experience and capital resources to develop alternative devices for the treatment of epilepsy and depression. Many of our competitors have substantially greater financial, manufacturing, marketing and technical resources than we have. In addition, the healthcare industry is characterized by extensive research efforts and rapid technological progress. Our competitors may develop technologies and obtain patents and regulatory approval for products that are more effective in treating epilepsy or depression than our current or future products. In addition, advancements in surgical techniques could make surgery a more attractive therapy for epilepsy or depression. The development by others of new treatment methods with novel antiepileptic and depression drugs, medical devices or surgical techniques for epilepsy or depression could render the VNS Therapy System noncompetitive or obsolete.

We believe that the primary competitive factors within the epilepsy treatment markets are the safety and efficacy of the treatment relative to alternative therapies, physician and patient acceptance of the product and procedure, availability of third-party reimbursement, quality of life improvements and product reliability. We also believe that the VNS Therapy System compares favorably with competitive products as to these factors.

 
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At least one other device-based therapy has been cleared by the FDA since October 2008 for depression. Repetitive transcranial magnetic stimulation (rTMS) consists of an externally-applied coil that delivers a pulsed magnetic field and is indicated for depression that has not responded to one adequate treatment trial. Likewise, a well-established array of antidepressant drugs, typically combined with other antidepressants of complementary action or with atypical antipsychotic drugs and/or mood stabilizers, are frequently used for patients with unresponsive, or treatment-resistant, depression. For patients with certain types of severe depression or those at acute risk for suicide, ECT (electroconvulsive therapy) is often used. These treatment modalities may pose a competitive threat in the near term, to the extent that they may delay a decision to offer VNS Therapy to patients with depression or be more readily accessible due to more favorable reimbursement and coverage by third-party payers.

As other forms of neurostimulation are investigated and developed for epilepsy or depression, these may emerge as competition for VNS Therapy. Other less invasive treatments, such as magnetic seizure therapy, may compete for a similar place in the depression treatment market as they are developed. Finally, ECT is undergoing refinements in technique to increase specificity and reduce the cognitive deficit side effects; if successful, the tolerability and patient acceptance of ECT could improve in the future. These neurostimulation techniques could prove to be more effective, more predictable, or more rapidly acting than VNS Therapy.

Patents, Licenses and Proprietary Rights

As of April 30, 2010, we owned or licensed approximately 70 U.S. patents and 116 pending U.S. patent applications, covering various aspects of the VNS Therapy System, improvements to the VNS Therapy System and methods of treatment for a variety of disorders through electrical stimulation of the vagus nerve or other cranial nerves. In addition to epilepsy and neuropsychiatric disorders (including depression), other method patents cover the fields of eating disorders (including obesity and bulimia), endocrine disorders, migraine headaches, dementia, motility disorders, sleep disorders, coma, chronic pain, cardiac disorders and hypertension. We have filed counterparts of certain of our key U.S. patent applications in certain international jurisdictions and currently own or license 12 patents issued by the European Patent Office or other international authorities and 121 patent applications pending in the European Patent Office or before other national or international authorities.

We have an exclusive license agreement with Jacob Zabara, Ph.D., a co-founder and consultant to us, pursuant to which we currently maintain exclusive licenses on six U.S. patents (and such international counterparts that have been or may be issued) covering the VNS Therapy System for vagus nerve and other cranial nerve stimulation for the control of movement disorders (including epilepsy), neuropsychiatric disorders (including depression) and other disorders, and two pending U.S. patent applications.  We believe that these patents give us an advantage by limiting competition in VNS to treat refractory epilepsy and depression in the U.S. The license agreement will give us coverage for movement disorders until expiration of the applicable patent in July 2011 and coverage for neuropsychiatric disorders until expiration of the applicable patent in May 2011.  We do not have indication-specific patent coverage for movement disorders outside the U.S. or for neuropsychiatric disorders outside the U.S. and Japan. Pursuant to the license agreement, we are obligated to pay Dr. Zabara a royalty equal to 3.0% of sales of generators and leads through July 2011, after which our royalty obligation to Dr. Zabara will end unless, in the meantime, we commence the sale of VNS Therapy Systems for an indication covered by another patent issued to Dr. Zabara.

Effective December 13, 2007, we licensed from Southern Illinois University the exclusive rights to three additional U.S. patents pertaining to VNS for the treatment of traumatic brain injury, modulating brain neural plasticity, and improving memory and learning. During the fiscal years 2009 and 2010, we entered into agreements with other third parties licensing intellectual property (“IP”) rights pertaining to seizure detection and prediction and to new VNS stimulation parameters for the control of epilepsy and other disorders.

We cannot assure you that patents will be issued from any of the pending applications or if patents issued, that they will be of sufficient scope or strength to provide meaningful protection for our technology. Notwithstanding the scope of the patent protection available to us, a competitor could develop treatment methods or devices that are not covered by our patents.

 
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There has been substantial litigation regarding patent and other IP rights in the medical device industry. In the future, we may need to engage in litigation to enforce patents issued or licensed to us, to protect our trade secrets or know-how, to defend us against claims of infringement of the rights of others or to determine the scope and validity of the proprietary rights of others. Litigation could be costly and could divert our attention from other functions and responsibilities. Adverse determinations in litigation could subject us to significant liabilities to third parties, could require us to seek licenses from third parties and could prevent us from manufacturing, selling or using the VNS Therapy System, any of which could severely harm our business. We are not currently a party to any patent litigation or other litigation regarding proprietary rights and are not aware of any challenge to our patents or proprietary rights.

Licenses Granted by Us to Other Persons

Effective December 17, 2007, we entered into an Exclusive Patent License Agreement (the “EES License Agreement”) with Ethicon Endo-Surgery, Inc. (“EES”), granting EES an exclusive, worldwide license, with the right to grant non-exclusive sublicenses, for a specified field of use (treatment by means of nerve stimulation for weight reduction or for hypertension or diabetes in patients having a body mass index of 25 or more) under nine U.S. patents and nine U.S. patent applications, and future related patents and international counterparts. Under the terms of the EES License Agreement, EES paid us a non-refundable fee of $9.5 million. EES also agreed to pay us a royalty on future net sales of products covered by any of the subject patents, and EES will reimburse us for future patent-related expenses associated with the filing, prosecution, and maintenance of the licensed patents and patent applications outside the U.S. EES has also been granted a right of first refusal to negotiate for a license under any patent rights acquired by us within the specified field of use and offered for licensing.

Product Liability and Insurance

The manufacture and sale of our products subjects us to the risk of product liability claims. We are currently named as a defendant in several product liability lawsuits in the U.S. and Europe. As the manufacturer of a medical device, we likely will be named in the future as a defendant in other product liability lawsuits. We do not believe that our products involved in the current lawsuits are defective; however, the outcome of litigation is inherently unpredictable and could result in an adverse judgment and an award of substantial and material damages against us. Although we maintain product liability insurance in amounts that we believe to be reasonable, coverage limits may prove not to be adequate in some circumstances. Product liability insurance is expensive and in the future may be available only at significantly higher premiums or not be available on acceptable terms, if at all. A successful claim brought against us in excess of our insurance coverage could severely harm our business and consolidated results of operations and financial position.

Additionally, after a product is placed on the market, the product and its manufacturer are subject to pervasive and continuing regulation by the FDA.  Among other things, we must comply with the FDA’s corrections and removal reporting regulation, which requires that manufacturers report to the FDA field corrections and product recalls or removals if undertaken to reduce a risk to health posed by a device or to remedy a violation of the FDCA that may present a risk to health.  We have undertaken field corrections and there can be no assurance that we will not be required to perform field corrections and product recalls or removals in the future.  Since the introduction of the VNS Therapy System, we have sent safety alert letters and recommendations and published field notifications for our products.  The letters and notifications issued since the beginning of our fiscal year ended April 30, 2010 are discussed below.  All of our field notifications and safety alerts are available on our website, www.cyberonics.com.

In July 2009, we sent physicians a safety alert letter warning of instances of some Demipulse generators reporting low lead impedance readings. In rare instances, a system diagnostic test using Model 250 Programming Software (versions 7.1 and earlier) may report "Lead Impedance: OK" when a short-circuit condition actually exists.  The FDA classified this as a Class II recall and concurred with our decision to address this by means of a safety alert letter explaining the event, risks presented and recommended actions to take.  We are not aware of any permanent injuries as a result of this issue, but a claim with material adverse consequences to our business could be asserted in the future. In April 2010, we obtained FDA approval for a labeling update that provides more detailed instructions for troubleshooting lead issues.

 
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In November 2009, we sent physicians a safety alert letter warning that the use of electrocautery near the VNS Therapy pulse generator can cause electrostatic discharge and reduced battery life.  The FDA classified this as a Class II recall and concurred with our decision to address this by means of a safety alert letter explaining the event, risks presented and recommended actions to take.  We are not aware of any permanent injuries as a result of this issue, but a claim with material adverse consequences to our business could be asserted in the future. In April 2010, we obtained FDA approval for a labeling update that provides additional precautionary language regarding static electricity and its potential impact to product performance.

In April 2010, we sent physicians a safety alert letter warning of a software issue that can result in an inaccurate battery life projection for the VNS Therapy Demipulse generators. The FDA classified this as a Class II recall and concurred with our decision to address this by means of a safety alert letter explaining the event, risks presented and recommended actions to take.  We are not aware of any permanent injuries as a result of this issue, but a claim with material adverse consequences to our business could be asserted in the future.

We may in the future identify other product defects, and any such defects may result in legal claims with material adverse consequences to our business.

We endeavor to maintain executive and organization liability insurance in a form and with aggregate coverage limits that we believe are adequate for our business purposes, but our coverage limits may prove not to be adequate in some circumstances. In addition, executive and organization liability insurance is expensive and in the future may be available only at significantly higher premiums or not be available on acceptable terms, if at all. Further, insurance companies have been subject to extreme financial stress during the last fiscal year, and our insurers may be unable to meet their obligations under the policies they have issued or will issue in the future.

Employees

As of April 30, 2010, we had 465 active full-time employees.  We believe that the success of our business depends, in part, on our ability to attract and retain qualified personnel. We believe our relationship with our employees is generally good. We are also engaged in an ongoing effort to identify, hire, manage and maintain the talent necessary to meet the company’s objectives. However, we cannot assure you that we will be successful in hiring or retaining qualified personnel. The loss of key personnel, or the inability to hire or retain qualified personnel, could significantly harm our business.

Financial Information about Segments and Geographical Areas

We operate our business as a single segment with similar economic characteristics, technology, manufacturing processes, customers, distribution and marketing strategies, regulatory environments and shared infrastructures. We are a neurostimulation business focused on creating new markets, improving our products, developing other medical devices for patients suffering from epilepsy and expanding our business into other neuromodulation opportunities.

Our financial information, including our net sales and long-lived assets by geographical area, is included in the Consolidated Financial Statements and the related Notes beginning on page F-1, especially “Note 17.  Geographic Information.”

 
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Website and Availability of Public Filings with the SEC

Our website address is www.cyberonics.com. We make available free of charge on or through our website our proxy statements, Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and reports relating to beneficial ownership of our securities filed or furnished pursuant to Section 16 of the Exchange Act, as soon as reasonably practicable after electronically filing such material with the SEC. Our website also contains the charters for each standing committee of our Board of Directors, our Business Practice Standards, our Code of Ethics, our Corporate Governance Guidelines and our Financial Code of Ethics.

Materials we file with the SEC may be read and copied at the SEC’s Public Reference Room at 100 F Street, NE, Washington, D.C. 20549. Information on the operation of the Public Reference Room may be obtained by calling the SEC at 1-800-SEC-0330. The SEC also maintains a website at www.sec.gov that contains reports, proxy and information statements, and other information regarding our company filed electronically with the SEC.

We may from time to time provide important disclosures to investors by posting them in the investor relations section of our website, as allowed by SEC rules. Information on our website is not incorporated into this Form 10-K.

Item 1A.  Risk Factors

Our common stock price constantly changes.

Our common stock is traded on the NASDAQ Global Market under the ticker symbol “CYBX.” The price of stock on that trading market fluctuates, and we expect that the market price of our common stock will continue to fluctuate. For example, during the fiscal year ended April 30, 2010, our stock traded from a high of $21.63 to a low of $12.32 per share. Our stock price may be affected by a number of factors, some of which are beyond our control, including, without limitation:

changes in the general conditions of the economy, including the valuation of the dollar versus other currencies;
regulatory activities and announcements, including activities related to the QSR;
governmental enforcement initiatives related to medical device companies;
changes in market conditions and valuations of medical device companies in general;
national and regional coverage determinations by third-party payers, including private insurance companies, Medicare, state Medicaid programs and other international bodies responsible for coverage determinations;
results of studies regarding the safety and efficacy of our VNS Therapy treatment for various indications including epilepsy, depression, fibromyalgia, multiple sclerosis, obesity, bulimia, Alzheimer’s disease, anxiety, obsessive-compulsive and other disorders;
results of studies regarding the safety and efficacy of drugs or devices that are competitive or potentially competitive to our VNS Therapy System;
clinical trial results, and/or regulatory approvals regarding devices that are potential competitors to our VNS Therapy System;
quarterly variations in our sales and operating results;
announcements of significant contracts, acquisitions or capital commitments;
our ability to develop an alternative strategy for VNS Therapy for depression;
our ability to find licensees for some of our technology and the terms or any licenses we grant;
changes in financial estimates by securities analysts;
additions or departures of key management or other personnel;
the potential identification of material weaknesses in our internal controls over financial reporting; 
uncertainties associated with governmental and regulatory inquiries; and
uncertainties associated with litigation.


 
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In addition, the stock market in recent years has experienced broad price and volume fluctuations that have often been unrelated to the operating performance of companies. The market price and trading volume of our common stock may continue to be subject to significant fluctuations due not only to general stock market conditions but also to variability in the prevailing sentiment regarding our operations or business prospects, as well as potential further sales of our common stock due to margin calls on loans secured by pledges of our common stock. These broad market fluctuations have also adversely affected, and may continue to adversely affect, the market price of our common stock.

Our quarterly operating results may fluctuate in the future, which may cause our stock price to decline.

Our quarterly net sales, expenses and operating results may vary significantly from quarter to quarter for several reasons, including, without limitation:

the ability of our sales force to effectively market and promote VNS Therapy, and the extent to which the VNS Therapy System gains market acceptance;
the existence and timing of any approvals, changes, or non-coverage determinations for reimbursement by third-party payers;
the rate and size of expenditures incurred on our clinical, manufacturing, sales, marketing and product development efforts;
our ability to retain qualified personnel;
the availability of key components, materials and contract services, which depends on our ability to forecast sales, among other things;
investigations of our business and business-related activities by regulatory or other governmental authorities;
variations in quantity of product orders at quarter end;
temporary manufacturing interruptions or disruptions;
the timing of new product and new market introductions, as well as delays in obtaining domestic or foreign regulatory approvals for such introductions;
increased competition, patent expiration, new technology or treatments;
product recalls or safety alerts;
litigation, including product liability, securities class action, stockholder derivative, general commercial and other lawsuits; and
the financial health of our customers, and their ability to purchase VNS Therapy Systems, in the current economic environment.

As a result of any of these factors, our consolidated results of operations may fluctuate significantly and may be below security analyst expectations, which may in turn cause our stock price to decline.

We may fail to comply with one or more of the many regulations that govern our business activities.

We are subject to extensive and rigorous ongoing regulation of the research, development, testing, manufacture, labeling, promotion, advertising, distribution and marketing of VNS Therapy System. Our failure to comply with regulations or to identify and resolve manufacturing or safety problems could lead to the need for product marketing restrictions, product withdrawal or recall or other voluntary or regulatory action, any of which could delay further marketing until VNS Therapy System is brought into compliance. Our failure to comply with these requirements could have a significant negative impact on our future operating results and may also subject us to stringent penalties and lawsuits.

 
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In addition, the stock market in recent years has experienced broad price and volume fluctuations that have often been unrelated to the operating performance of companies. The market price and trading volume of our common stock may continue to be subject to significant fluctuations due not only to general stock market conditions but also to variability in the prevailing sentiment regarding our operations or business prospects, as well as potential further sales of our common stock due to margin calls on loans secured by pledges of our common stock. These broad market fluctuations have also adversely affected, and may continue to adversely affect, the market price of our common stock.
 
We may not be able to access sufficient additional capital sources or to access capital on terms which are acceptable to us.

Our capital requirements will depend on many factors, including market acceptance of our product and clinical and strategic development opportunities. A large portion of our expenses is currently fixed, including expenses related to our facilities, equipment and personnel, and we may need to spend significant amounts to conduct our post-marketing clinical studies or for product improvement and development.  If we are unable to generate sufficient profits to fund our capital requirements internally, then we will be forced to turn to outside sources of capital.  We may be unable to access sufficient sources of capital or to access capital on terms that are acceptable to us.  Additionally, unfavorable disclosures by international financial institutions concerning the sub-prime mortgage market may lead to a contraction in credit availability, thereby further impacting our ability to fund our capital requirements.  If additional capital sources are unavailable, we may be forced to abandon our efforts with respect to clinical studies or product improvement and development.

Healthcare reform legislation could adversely affect our revenue and financial condition.

Political, economic and regulatory influences are subjecting the health care industry to fundamental changes. There have been numerous initiatives on the federal and state levels for comprehensive reforms affecting the reimbursement for healthcare services in the U.S. These initiatives have ranged from changing federal and state healthcare reimbursement programs, including providing coverage to the public under governmental funded programs, to minor modifications to existing programs. Recently, the U.S. Congress passed, and President Obama signed into law, a healthcare reform bill that has a wide-ranging impact on the U.S. healthcare system. Many of the provisions of the law will phase-in over the next several years.  This legislation includes expanded public healthcare measures. In addition, the law includes an excise tax of 2.3% on U.S. sales of medical device manufacturers to commence in 2013. At this point, it is not fully possible to predict their impact, but these reforms may have an adverse effect on our consolidated financial condition and operating results.

We may not be successful in implementing our open market share repurchase program.

The number of shares actually repurchased and the timing of any repurchases under our open market share repurchase program will depend on factors such as the stock price, economic and market conditions, and corporate and regulatory requirements.  The repurchase program may be also suspended or discontinued at any time. We may be unable to complete the repurchase program as planned.  There can be no assurance that any repurchases will have a positive impact on our stock price.  Failure to complete the program may negatively impact investor confidence in us and negatively impact our stock price.

We may not develop VNS Therapy for the treatment of other indications and, as such, we may not experience revenue growth from these other indications.

We have conducted or supported animal studies or small human pilot studies for the treatment of a number of therapeutic indications beyond refractory epilepsy and depression. Regulatory approval for any new indications would require us to conduct one or more-large scale pivotal trials. We have not conducted such pivotal trials for any indication beyond refractory epilepsy and depression, nor do we have any immediate plans to do so. In the event that we do invest in future studies for new indications, we cannot assure you that our study results will be positive. If we elect not to conduct research with regard to new indications, our study results are not positive, we do not receive additional regulatory approvals, or alternative indications do not prove to be commercially viable, our revenue growth, if any, would be limited to revenue from our existing approved indications in refractory epilepsy and possibly depression.

 
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We may not be able to maintain or expand market acceptance for the use of the VNS Therapy System, which could cause our sales to be lower than expectations.

Market acceptance of the VNS Therapy System depends on our ability to convince the medical community and third-party payers of the clinical efficacy and safety of vagus nerve stimulation and the VNS Therapy System. While the VNS Therapy System has been implanted in more than an estimated 66,000 patients, many physicians are still unfamiliar with this form of therapy. Other therapies, including pharmacologic options, may be more attractive to patients or their physicians than the VNS Therapy System in terms of efficacy, cost or reimbursement availability. Furthermore, we have not funded significant post-market clinical research that could change physicians’ opinions or use of our product for refractory epilepsy. We cannot assure you that we will ever receive broad reimbursement coverage for depression or that our sales will increase for epilepsy or depression. Additionally, we cannot assure you that the VNS Therapy System will achieve expanded market acceptance for the treatment of epilepsy, depression or for any other indication. Failure of the VNS Therapy System to gain additional market acceptance could severely harm our business, our consolidated financial position and results of operations.

Patient confidentiality and federal and state privacy and security laws and regulations may adversely impact our selling model.

The Health Insurance Portability and Accountability Act of 1996 (“HIPAA”) establishes federal rules protecting the privacy and security of personal health information. The privacy and security rules address the use and disclosure of individual health care information and the rights of patients to understand and control how such information is used and disclosed. HIPAA provides both criminal and civil fines and penalties for covered entities that fail to comply with HIPAA. If we fail to comply with the applicable regulations, we could suffer civil penalties up to $25,000 per calendar year for each violation and criminal penalties with fines up to $250,000 and potential imprisonment.

In addition to HIPAA, virtually every state has enacted one or more laws to safeguard privacy, and these laws vary significantly from state to state and change frequently. Even if our business model is compliant with the HIPAA Privacy and Security Rule and the Texas privacy laws, it may not be compliant with the privacy laws of all states. Because the operation of our business involves the collection and use of substantial amounts of “protected health information,” we endeavor to conduct our business as a “covered entity” under the HIPAA Privacy and Security Rule and consistent with the Texas privacy laws, obtaining HIPAA-compliant patient authorizations where required to support the collection and use of patient information. We also sometimes act as a “business associate” for a covered entity. The Office for Civil Rights of the Department of Health and Human Services or another government enforcement agency may determine that our business model or operations are not in compliance with the HIPAA Privacy and Security Rules, which could subject us to penalties, could severely limit our ability to market and sell VNS Therapy under our existing business model and could harm our business growth and consolidated financial position.

We may be unable to obtain and maintain adequate third-party reimbursement on our product, which could have a significant negative impact on our future operating results.

Our ability to commercialize the VNS Therapy System successfully depends, in large part, on whether third-party payers, including private healthcare insurers, managed care plans, Medicare and Medicaid programs and others, agree to cover the VNS Therapy System and associated procedures and services and to reimburse at adequate levels for the costs of the VNS Therapy System and the related services in the U.S. or internationally. While we currently have reimbursement approval for epilepsy, we do not have any meaningful reimbursement coverage for the treatment of depression. In May 2007, CMS issued a national non-coverage determination with respect to VNS Therapy for depression. This non-coverage determination means that Medicare will not cover VNS Therapy for depression. Since the national non-coverage determination is binding on all local Medicare contractors, patients are not able to obtain Medicare coverage for depression. In addition, the CMS non-coverage determination also had a detrimental effect on coverage by Medicaid and private payers. In addition, periodic changes to reimbursement methodology for medical devices under the Medicare and Medicaid programs occur and may reduce the rate of increase in federal expenditures for health care costs. Such changes, as well as any future regulatory changes and the failure of the VNS Therapy System to continue to qualify for reimbursement under these programs, may have an adverse impact on our business.


 
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Apart from the recently passed healthcare reform bill that has a wide-ranging impact on the U.S. healthcare system, healthcare, as one of the largest industries in the U.S., continues to attract substantial legislative interest and public attention. Congress and state legislatures are constantly reassessing the propriety of coverage for various health services and the payment level for such services. Certain reform proposals and other policy shifts, if enacted, could limit coverage for VNS Therapy or the reimbursement available for VNS Therapy from governmental agencies or third-party payers. Changes in Medicare, Medicaid and other programs, cost-containment initiatives by public and private payers, a failure to obtain substantial regional and national coverage policies for VNS Therapy in depression, and proposals to limit payments and health care spending could have a significant negative impact on our future operating results.

Our current and future expense estimates are based, in large part, on estimates of our future sales, which are difficult to predict.

We may be unable to adjust spending quickly enough to offset any unexpected sales shortfall. If increased expenses are not accompanied by increased sales, our consolidated results of operations and financial position for any particular fiscal quarter could be harmed.

If our suppliers and manufacturers are unable to meet our demand for materials, components and contract services, we may be forced to qualify new vendors or change our product design, which would impair our ability to deliver products to our customers on a timely basis.

We rely upon sole source suppliers for certain of the key components, materials and contract services used in manufacturing the VNS Therapy System. We periodically experience discontinuation or unavailability of components, materials and contract services, which may require us to qualify alternative sources or, if no such alternative sources are identified, change our product design. We believe that pursuing and qualifying alternative sources and/or redesigning specific components of the VNS Therapy System, if or when necessary, could consume significant resources. In addition, such changes generally require regulatory submissions and approvals. Any extended delays in securing or an inability to secure alternative sources for these or other components, materials and contract services could result in product supply and manufacturing interruptions, which could significantly harm our business.

We may not be able to meet regulatory quality standards applicable to our manufacturing process.
 
We are required to register with the FDA as a device manufacturer and as a result, we are subject to periodic inspection by the FDA for compliance with the FDA’s QSR requirements, which require manufacturers of medical devices to adhere to certain regulations, including testing, quality control and documentation procedures.  In addition, the federal Medical Device Reporting regulations require us to provide information to the FDA whenever there is evidence that reasonably suggests that a device may have caused or contributed to a death or serious injury, or may contain an anomaly which, if a malfunction were to occur, could cause or contribute to a death or serious injury.  Compliance with applicable regulatory requirements is subject to continual review and is rigorously monitored through periodic inspections by the FDA.  In the European Community, we are required to maintain certain ISO certifications in order to sell products, and we undergo periodic inspections by notified bodies to obtain and maintain these certifications. If we fail to adhere to QSR or ISO requirements, this could delay production of our products and lead to fines, difficulties in obtaining regulatory clearances, recalls or other consequences, which could in turn have a material adverse effect on our consolidated financial condition and results of operations.


 
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Our products may have defects that result in product recalls, which may result in substantial costs and reduced sales.

The VNS Therapy System includes an electronic pulse generator and a lead designed to be implanted in the human body and a programming wand connected to a handheld computer for programming the pulse generator. Component failures, manufacturing or shipping problems or hardware or software design defects could result in the product not delivering the therapy for which it is indicated or the product delivering a therapy that is not intended. The occurrence of such problems or other adverse clinical reactions could result in a recall of our VNS Therapy System, possibly requiring explantation and potential reimplantation of the VNS Therapy System, which may increase risk to the patient. Any product recall could result in a substantial loss of physician and patient confidence in our products, with a consequential substantial decrease in sales, and could result in substantial litigation, with liabilities well in excess of our insurance coverage limits, any or all of which could severely harm our business and our consolidated financial position and results of operations.

We may not be able to protect our technology from unauthorized use, which could diminish the value of our products and impair our ability to compete.

Our success depends on our ability to obtain and maintain patent and other IP protection for the VNS Therapy System and its improvements. To that end, we have acquired licenses under certain patents and have patented and intend to continue to seek patents on our own inventions used in our VNS Therapy System and treatment methods. The process of seeking patent protection can be expensive and time-consuming, and we cannot assure you that patents will be issued from our currently pending or future applications or that, if patents are issued, they will be of sufficient scope or strength to provide meaningful protection for our technology or any commercial advantage to us. Further, the protection offered by the licensed international patents is not as strong as that offered by the licensed U.S. patents due to differences in patent laws. In particular, the European Patent Convention prohibits patents covering methods for treatment of the human body by surgery or therapy. Without effective patent protection, whether in the U.S. or abroad, we may be subject to competition that negatively affects our business, our consolidated financial position and results of operations.

We may be subject to competition outside the U.S., reducing our sales and earnings.

Our patent protection outside the U.S. for the epilepsy and depression indications has expired.  As a result, we are subject to competition in some countries without legal recourse to challenge our competitors based on patent infringement.  For example, we are aware of an entity in Turkey manufacturing and selling implantable devices for delivering VNS Therapy in that market, and we have been made aware of a company based in Europe that plans to submit a device similar to our VNS product for regulatory approval in Europe in 2010.  In the future, we may be subject to competition in other countries, reducing our sales and earnings or limiting our growth.

Additionally, certain countries, including China, do not enforce compliance with laws that protect IP rights with the same degree of vigor as is available under the U.S. patent system. For this reason, there is a risk that our IP may be subject to misappropriation in such countries. This may permit others to produce copies of our products that are not covered by currently valid patent registrations. There is also a risk that such products may be exported from such countries to other countries.

We may engage in litigation to protect our proprietary rights, or defend against infringement claims by third parties, causing us to suffer significant liabilities or expenses or preventing us from selling our products.

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

 
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Intense competition and rapid technological changes could reduce our ability to market our products successfully and achieve sales.

We believe that existing and future pharmaceutical therapies will continue to be the primary competition for the VNS Therapy System. However, we may also face competition from other medical device companies that have the technology, experience and capital resources to develop alternative devices for the treatment of epilepsy and depression. Many of our competitors have substantially greater financial, manufacturing, marketing and technical resources than we do and have obtained third-party reimbursement approvals for their therapies. We may not have invested in the past, or may not be investing in the future, sufficient resources in engineering research and development to prepare the VNS Therapy System for competition in the future with other neurostimulation technologies. In addition, the healthcare industry is characterized by extensive research efforts and rapid technological progress. Our competitors may develop technologies and obtain regulatory approval for products that are more effective in treating epilepsy and depression than our current or future products. In addition, advancements in surgical techniques may make surgery a more attractive therapy for epilepsy and depression. The development by others of new treatment methods with novel drugs, medical devices or surgical techniques for epilepsy and depression could render the VNS Therapy System non-competitive or obsolete. We may not be able to compete successfully against current and future competitors, including new products and technology, which could severely harm our business and our consolidated financial position and results of operations.

We are subject to claims of product liability, and we may not have the resources or insurance to cover the cost for losses under these claims.

The manufacture and sale of the VNS Therapy System entails the risk of product liability claims, which arise from time to time in the ordinary course of business. We may be responsible for large self-insured retentions for each claim, and our product liability coverage limit may not be adequate to pay defense costs and judgments that may result from these claims. Product liability insurance is expensive and in the future may only be available at significantly higher premiums or may not be available on acceptable terms, if at all. A successful claim brought against us in excess of our insurance coverage could significantly harm our business and consolidated financial position.

If we do not continue to comply with the applicable laws and regulations, we could lose our ability to market and sell our product or be subject to substantial fines or other penalties.

The preclinical and clinical design, testing, manufacturing, labeling, sale, distribution, servicing and promotion of the VNS Therapy System are subject to extensive and rigorous laws and regulations, including regulations from the Department of Health and Human Services (related to Medicare, Medicaid, HIPAA and FDA), comparable state agencies and international agencies. In the future, it will be necessary for us to obtain additional government approvals for other indications of the VNS Therapy System, if we choose to develop new indications, and for modified or future-generation products. It is also necessary for us to ensure that our marketing and sales practices comply with all applicable laws and regulations. Commercial distribution in foreign countries is also subject to regulatory approvals from the appropriate authorities in such countries.


 
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The process of obtaining FDA and other required regulatory approvals is lengthy, expensive and uncertain. Moreover, regulatory approvals may include regulatory restrictions on the indicated uses for which a product may be marketed. Failure to comply with applicable regulatory requirements can result in, among other things, fines, suspension or withdrawal of approvals, confiscations or recalls of products, operating restrictions and criminal prosecution. Adverse results in post-approval studies may result in limitations on or withdrawal of previously granted approvals. Furthermore, changes in existing regulations or adoption of new regulations could prevent us from obtaining, or affect the timing of, future regulatory approvals. We may not be able to obtain additional future regulatory approvals on a timely basis or at all. Delays in receipt of or failure to receive such future approvals, suspension or withdrawal of previously received approvals or recalls of the VNS Therapy System could severely harm our ability to market and sell our current and future products and improvements. As a condition of approval for the depression indication, the FDA required us to conduct a post-approval patient dosing study and a patient registry. The results of these studies may be included in our product labeling. If we fail to complete the patient registry in a timely manner, we may be subject to regulatory action, including withdrawal of our depression indication approval.  Also, any adverse regulatory action, depending on its breadth, may be detrimental to our business.

We are subject to governmental laws addressing our sales and marketing practices, and failure to adhere to these laws could result in substantial fines and other penalties.

We are subject to certain laws and regulations, including the federal Anti-Kickback Statute, the federal False Claims Act, the HIPAA Privacy Rule and the federal Foreign Corrupt Practices Act, that govern the sales and marketing practices of healthcare companies. The Anti-Kickback Statute contains both civil and criminal sanctions, which are enforced by the Office of the Inspector General of Health and Human Services Department (“OIG”) and the U.S. Department of Justice (“DOJ”). Over the past several years, the U.S. government has accused an increasing number of pharmaceutical and medical device manufacturers of violating the federal Anti-Kickback Statute and the Foreign Corrupt Practices Act based on certain marketing and sales practices and compensation arrangements with referral sources. The Foreign Corrupt Practices Act prohibits payments or the provision of anything of value to foreign officials for the purpose of obtaining or keeping business. Pharmaceutical and medical device manufacturers also have been accused of alleged violations of the federal False Claims Act, which imposes civil liability (including substantial monetary penalties and damages) on any person or corporation that (a) knowingly presents a false or fraudulent claim for payment to the U.S. government, (b) knowingly uses a false record or statement to obtain payment or (c) engages in a conspiracy to defraud the federal government to obtain allowance for a false claim. Under the whistleblower provisions of the federal False Claims Act, private parties may bring actions on behalf of the U.S. government. These private parties are entitled to share in any amounts recovered by the government through trial or settlement. Both direct enforcement activity by the government and whistleblower lawsuits have increased significantly in recent years and have increased the risk that we may be forced to defend a prosecution under the federal Anti-Kickback Statute, the Foreign Corrupt Practices Act, to defend against a false claims action, be liable for monetary fines or be excluded from the Medicare and Medicaid programs as a result of an investigation resulting from an enforcement action or a whistleblower case.

In January 2006, we adopted revisions to our Business Practice Standards that we believe more thoroughly address our compliance risks with respect to healthcare laws. Additionally, in October 2008, we adopted International Business Practice Standards that we believe address our compliance risks with respect to international laws and rules. We endeavor to conduct our business in compliance with our Business Practice Standards and International Business Practice Standards and to ensure continued compliance through regular education of our employees, audits of employee activities, and appropriate responses to violations of the Business Practice Standards and International Business Practice Standards. Given the complexity of our business model, including extensive interactions with patients and healthcare professionals, and the large number of field personnel we employ, violations of our policy and the law could occur. We could be subject to investigation by the OIG or the DOJ or a comparable state or international agency. If investigated, we could be forced to incur substantial expense responding to the investigation and defending our actions. If unsuccessful in our defense, we could be found to be in violation of the healthcare laws and be subject to substantial fines and penalties, including exclusion of the VNS Therapy System from Medicare and Medicaid reimbursement.


 
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Our international operations are subject to risks not generally associated with commercialization efforts in the U.S.

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

We are subject to the risks of international economic and political conditions.    

Our international operations are subject to risks which are inherent in conducting business overseas and under foreign laws, regulations and customs. These risks include possible nationalization, expropriation, importation limitations, violations of U.S. or local laws, including, but not limited to the U.S. Foreign Corrupt Practices Act, pricing restrictions, and other restrictive governmental actions. Any significant changes in the competitive, political, legal, regulatory, reimbursement or economic environment where we conduct international operations may have a material impact on our business and our consolidated financial condition or results of operations.   

Our international business is subject to foreign currency fluctuations.

The majority of our international sales are invoiced in euros. The strengthening of the U.S. dollar against the euro generally has an unfavorable impact on our sales. The weakening of the U.S. dollar against the euro generally has a favorable impact on our sales.  The impact of foreign currency fluctuations on sales is offset by the foreign currency impact on operating costs and expenses.  Additionally, if currencies weaken against the U.S. dollar, a foreign distributor whose payables are denominated in U.S. dollars may not be able to meet their obligations in a timely manner.

We sell our products in certain emerging economies.    

Emerging economies have less mature product regulatory systems, and can have more volatile financial markets. Our ability to sell products in these economies is dependent on our ability to hire qualified employees or agents to represent our products locally, and our ability to obtain the necessary regulatory approvals in a less mature regulatory environment. If we are unable to retain qualified representatives or maintain the necessary regulatory approvals, we will not be able to continue to sell products in these markets. We are exposed to a higher degree of financial risk if we extend credit to customers in these economies.

In many of the international markets in which we do business, including certain parts of Europe, Russia and Asia, we sell our products through agents or distributors who may misrepresent our products.    

Selling our products through agents or distributors, particularly in public tenders, can expose us to a higher degree of risk. Our agents and distributors are third parties who we retain to work in many markets. However, agents and distributors are independent third parties. If they misrepresent our products, do not provide appropriate service and delivery, or commit a violation of local or U.S. law, our reputation could be harmed, and we could be subject to fines, sanctions or both.

Our failure to attract and retain qualified personnel and any changes in our key personnel including officers, could adversely affect our operations.

Our ability to grow in the future will depend upon our ability to attract, hire and retain highly qualified employees and management personnel. We compete for such personnel with other companies, academic institutions, government entities and other organizations and we may not be successful in hiring or retaining qualified personnel.


 
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We are the subject of governmental investigations related to our stock option granting practices and procedures and other matters, the outcome of which could adversely affect our business.

In June 2006, the staff of the SEC advised us that it had commenced an informal inquiry of some of our stock option grants, and we received a subpoena from the Office of the U.S. Attorney for the Southern District of New York requesting documents related to our stock option grants practices and procedures. In October 2006, the SEC staff made an additional request for certain documents and information. We complied with the requests and have not had any communication with the SEC staff since August 2008; however, we will continue to cooperate if requested by the SEC staff or the U.S. Attorney’s Office. Although it is not possible to predict the likely outcome of these inquiries, an adverse result could have a material adverse effect on us, our consolidated financial position, results of operations and cash flows. Even if the result of such inquiries is not adverse, the cost of defending against such inquiries has been and may continue to be expensive and could have a material adverse effect on our consolidated financial position.

Disruption in the global financial markets may adversely impact the availability and cost of credit, customer spending patterns and our suppliers’ ability to provide us with necessary materials.

During the fiscal year ending April 30, 2010, continued concerns about the systemic impact of inflation, geopolitical issues, the availability and cost of credit, the insurance industry, the U.S. mortgage market and a declining real estate market in the U.S. have contributed to increased market volatility and continued concerns for the U.S. economy.

As a result of these conditions, the cost and availability of credit has been and may continue to be adversely affected by illiquid credit markets and wider credit spreads. Concern about the stability of the markets generally and the strength of counterparties specifically has led many lenders and institutional investors to reduce, and in some cases, cease to provide funding to borrowers. Continued turbulence in the U.S. and international markets and economies may adversely affect our liquidity and financial condition, and the liquidity and financial condition of our customers and suppliers. If these market conditions continue, they may limit our ability to access the capital markets to meet liquidity needs and timely replace maturing liabilities, resulting in an adverse effect on our consolidated financial condition and results of operations.

We have exposure to the credit risks of some of our customers and suppliers and such risks could be exacerbated by these volatile economic conditions. Although we have programs in place that are designed to monitor and mitigate the associated risk, there can be no assurance that such programs will be effective in reducing our credit risks adequately. If there is a significant deterioration of customer creditworthiness or actual defaults are higher than expected, future resulting losses, if incurred, could harm our business and have a material adverse effect on our operating results. In addition, the recent economic crisis could also adversely impact our suppliers’ ability to provide us with materials and components, which may negatively impact our business.

Given the ramifications of the recent financial crisis, we also have exposure to any instability in the insurance industry.  This unprecedented volatility may impact an insurer’s ability to honor coverage of losses incurred under a policy.  If we have losses that our insurers are unable to cover, this could negatively impact our business and have a material adverse effect on our operating results.


 
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Our manufacturing facility is located at a single site, and the occurrence of a catastrophic disaster or other similar event could cause damage to our facility and equipment, which would require us to cease or curtail operations.

We are vulnerable to damage from various types of disasters, including fires, terrorist acts, floods, power losses, communications failures and similar events. For example, in September 2008, Hurricane Ike hit the Texas Gulf Coast and caused significant property damage and a number of fatalities near the area in which our facility is located. If any such disaster were to occur, we may not be able to operate our business at our facility. Our manufacturing facilities require FDA approval which could result in significant delays before we could manufacture products from a replacement facility. The insurance we maintain may not be adequate to cover our losses resulting from disasters or other business interruptions. Therefore, any such catastrophe could seriously harm our business and consolidated results of operations.

Item 1B.  Unresolved Staff Comments

Currently, there are no outstanding, unresolved written comments by the SEC regarding any of our periodic or current reports filed under the Exchange Act.  We have, however, previously disclosed that we are subject to an inquiry by the SEC relating to our accounting for stock option grants. We are cooperating with the SEC in such inquiry.

Item 2.  Properties

We lease 114,500 square feet of office and manufacturing space at 100 Cyberonics Blvd in Houston, Texas with a lease term ending in December 2014.  We also lease 8,800 square feet of warehouse and office facilities in Houston, Texas. As part of our international operations, we lease 17,500 square feet for administrative and sales offices in Brussels, Belgium and elsewhere in Europe with terms ending in September 2010 through May 2013. All leased properties include the appropriate space to accommodate expected growth in our respective domestic and international businesses.

Item 3.  Legal Proceedings

For a description of our material pending legal and regulatory proceedings and settlements, see “Note 15. Litigation.”

Item 4.  [Removed and Reserved]


 
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PART II

Item 5.  Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

Our common stock is quoted on the NASDAQ Global Market under the symbol “CYBX.” The high and low sale prices for our common stock during the fiscal years 2009 and 2010 are set forth below. Price data reflect actual transactions, but do not reflect mark-ups, mark-downs or commissions.

   
High
   
Low
Fiscal Year Ended April 24, 2009
         
First Quarter
 
28.12
   
15.27
Second Quarter
   
28.95
     
9.85
Third Quarter
   
18.27
     
9.84
Fourth Quarter
   
16.45
     
12.31
Fiscal Year Ended April 30, 2010
             
First Quarter
   
18.07
     
12.32
Second Quarter
   
18.29
     
14.01
Third Quarter
   
21.63
     
14.08
Fourth Quarter
   
21.19
     
16.55

As of June 14, 2010, according to data provided by our transfer agent, there were 376 stockholders of record.

During the fiscal years 2009 and 2010, we did not pay any cash dividends to our stockholders. We currently intend to retain future earnings to fund the development and growth of our business and, therefore, do not anticipate paying cash dividends within the foreseeable future. Any future payment of dividends will be determined by our Board of Directors and will depend on our consolidated financial position and results of operations and other factors deemed relevant by our Board of Directors.

 
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The table below presents purchase of equity securities by us and our affiliated purchasers:

Period
 
Total Number of Shares (or Units) Purchased
   
Average Price Paid per Share (or Unit) (1)
   
Total number of Shares (or Units) Purchased as Part of Publicly Announced Plans or Programs
   
Maximum Number (or Approximate Dollar Value) of Shares (or Units) that may yet be Purchased under the Plans or Programs (2)
April 25 – May 29, 2009
   
––
     
––
     
––
     
485,275
May 30 – June 26, 2009
   
––
     
––
     
––
     
485,275
June 27 – July 24, 2009
   
––
     
––
     
––
     
485,275
July 25 – August 28, 2009
   
––
     
––
     
––
     
485,275
August 29 – September 25, 2009
   
––
     
––
     
––
     
485,275
September 26 – October 23, 2009
   
––
     
––
     
––
     
485,275
October 24 – November 27, 2009
   
––
     
––
     
––
     
485,275
November 28 – December 25, 2009
   
––
     
––
     
––
     
485,275
December 26 – January 22, 2010
   
––
     
––
     
––
     
485,275
January 23 – February 26, 2010
   
––
     
––
     
––
     
1,000,000
February 27 – March 26, 2010
   
18,944
     
18.81
     
18,944
     
981,056
March 27 – April 30, 2010
   
67,711
     
19.26
     
67,711
     
913,345
Total
   
86,655
     
19.16
     
86,655
     
913,345
____________________________

(1)
Shares are purchased at market price.
(2)
In February 2008, we announced an open market share repurchase program for the repurchase of up to 1.0 million shares of our outstanding common stock of which 514,725 had been repurchased. In February, 2010 the Board of Directors cancelled the previous program and authorized a new share repurchase program of up to 1.0 million shares.

Item 6.  Selected Financial Data

The following table summarizes certain selected financial data and is qualified by reference to, and should be read in conjunction with, the Consolidated Financial Statements and related Notes and with “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in this Form 10-K. The selected financial data and the related Notes for the 53 weeks ended April 30, 2010 and the 52 weeks ended April 24, 2009 and April 25, 2008 are derived from audited consolidated financial statements that are included in this Form 10-K. The selected financial data for the 52 weeks ended April 27, 2007 and April 28, 2006 are derived from audited consolidated financial statements that are not included in this Form 10-K.

 
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53 Weeks Ended
 
52 Weeks Ended
Consolidated Statement of Operations Data:
   
April 30,
2010
     
April 24,
2009
     
April 25,
2008
     
April 27,
2007
     
April 28,
2006
 
Net sales
 
$
167,775,672
   
$
143,600,979
   
$
121,229,742
   
$
130,968,437
   
$
123,441,575
 
Cost of sales
   
20,907,595
     
20,040,636
     
21,092,374
     
18,258,374
     
15,822,045
 
Gross profit
   
146,868,077
     
123,560,343
     
100,137,368
     
112,710,063
     
107,619,530
 
Operating expenses:
                                       
Selling, general and administrative
   
87,941,405
     
84,837,694
     
85,944,866
     
134,144,315
     
137,310,196
 
Research and development
   
22,064,800
     
19,732,941
     
22,421,199
     
28,092,243
     
29,541,707
 
Total operating expenses
   
110,006,205
     
104,570,635
     
108,366,065
     
162,236,558
     
166,851,903
 
Income (loss) from operations
   
36,861,872
     
18,989,708
     
(8,228,697
)
   
(49,526,495
)
   
(59,232,373
)
Interest income
   
92,602
     
1,235,757
     
3,844,508
     
4,649,394
     
3,211,956
 
Interest expense
   
(1,430,590
)
   
(3,394,837
)
   
(5,818,272
)
   
(5,913,119
)
   
(3,018,969
)
Gain on early extinguishment of debt
   
3,172,231
     
11,000,698
     
     
     
 
Other income (expense), net
   
(207,644
)
   
(381,265
)
   
(397,141
)
   
(311,112
)
   
69,460
 
Income (loss) before income taxes
   
38,488,471
     
27,450,061
     
(10,599,602
)
   
(51,101,332
)
   
(58,969,926
)
Income tax expense (benefit)
   
(39,960,413
)
   
729,441
     
(264,837
)
   
78,775
     
99,266
 
Net income (loss)
 
$
78,448,884
   
$
26,720,620
   
$
(10,334,765
)
 
$
(51,180,107
)
 
$
(59,069,192
)
Basic income (loss) per share
 
$
2.83
   
$
1.00
   
$
(0.39
)
 
$
(2.01
)
 
$
(2.37
)
Diluted income (loss) per share
 
$
2.67
   
$
0.61
   
$
(0.39
)
 
$
(2.01
)
 
$
(2.37
)
Shares used in computing basic income (loss) per share
   
27,702,731
     
26,632,115
     
26,568,746
     
25,514,232
     
24,916,938
 
Shares used in computing diluted income (loss) per share
   
28,696,375
     
27,542,198
     
26,568,746
     
25,514,232
     
24,916,938
 
Consolidated Balance Sheet Data (as of Year End):
                                       
Cash, cash equivalents and marketable securities
 
$
59,229,911
   
$
66,225,479
   
$
91,058,692
   
$
84,804,876
   
$
92,355,071
 
Total assets
   
155,763,977
     
112,043,628
     
136,231,087
     
137,644,883
     
152,300,284
 
Convertible notes (1)
   
15,460,000
     
62,339,000
     
125,000,000
     
125,000,000
     
125,000,000
 
Line of credit
   
     
     
     
7,500,000
     
2,500,000
 
Deferred Revenue and Other (2)
   
6,119,077
     
7,647,544
     
9,166,440
     
295,184
     
1,148,457
 
Accumulated deficit
   
(164,071,933
)
   
(242,520,817
)
   
(269,241,437
)
   
(258,646,256
)
   
(207,466,149
)
Stockholders’ equity (deficit)
   
110,859,647
     
24,411,844
     
(15,223,305
)
   
(16,062,229
)
   
4,629,866
 
 
(1)  
Convertible notes were presented in our balance sheet as current liabilities prior to the fiscal year 2008 due to the Default Notice from the Trustee.  The Convertible notes are presented as long-term liabilities after the fiscal year 2007 after agreement was reached with the Trustee.  See “Debt Instruments and Related Covenants.”
   
(2)  
Deferred Revenue and Other as of April 30, 2010, April 24, 2009 and April 25, 2008 include deferred license revenue in the approximate amount of $5.9, $7.5 and $9.0 million, respectively.
 
 
Item 7.  Management’s Discussion and Analysis of Financial Condition and Results of Operations

You should read the following discussion and analysis together with Part I of this Form 10-K, including the matters set forth in “Cautionary Statement About Forward-Looking Statements,” “Item 1A. Risk Factors” and our Consolidated Financial Statements and the related Notes included elsewhere in this Form 10-K.

This item provides material historical and prospective disclosures enabling investors and other users to assess our consolidated financial position and results of operations. The Consolidated Financial Statements include the consolidated balance sheets, consolidated statements of operations, consolidated statements of stockholders’ equity (deficit) and comprehensive income (loss) and consolidated statements of cash flows. The Notes are an integral part of the Consolidated Financial Statements and provide additional information required to fully understand the nature of amounts included in the Consolidated Financial Statements.

 
32

 
 
Overview

We are a neuromodulation company founded to design, develop and bring to market medical devices that provide a unique therapy, VNS Therapy, for the treatment of epilepsy, depression and other disorders as approved by the applicable regulatory bodies.

Our ability to successfully expand the commercialization of the VNS Therapy System depends on obtaining and maintaining favorable insurance coverage, coding and reimbursement for the device, the implant procedure and follow-up care.  Currently, there is broad coverage, coding and reimbursement for VNS Therapy for the treatment of refractory epilepsy. The Centers for Medicare and Medicaid Services (“CMS”), which we estimate pays for approximately 25% of the VNS Therapy implants, issues an annual update to the reimbursement amounts received by our customers.  In calendar year 2009, CMS announced increases in the rates reimbursed to our customers for the implant procedure for both the generator and the lead portion of the VNS Therapy System effective for calendar year 2010.  Future decreases in reimbursement rates could have an adverse impact on our business and our future operating results.

We are focused on improving the efficacy of VNS Therapy for patients with refractory epilepsy as a basis for maintaining and extending reimbursement.  This involves increased investment in research and development, specifically, seizure detection, responsive stimulation and associated technology, and likely includes additional investment in clinical studies using VNS Therapy for the treatment of refractory epilepsy.

Since inception, we have incurred substantial expenses, primarily for research and development activities that include product and process development, clinical studies and related regulatory activities, sales and marketing activities, manufacturing start-up costs and systems infrastructure. As of April 30, 2010, we incurred an accumulated deficit of approximately $164.1 million.

Significant Accounting Policies and Critical Accounting Estimates

We have adopted various accounting policies to prepare the Consolidated Financial Statements in accordance with accounting principles generally accepted in the U.S. (“GAAP”). Our most significant accounting policies are disclosed in “Note 1. Summary of Significant Accounting Policies and Related Data” in the Notes to the Consolidated Financial Statements.

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

Estimates are considered to be critical if they meet both of the following criteria: (1) the estimate requires assumptions about material matters that are uncertain at the time the accounting estimates are made, and (2) material changes in the estimates are reasonably likely to occur from period to period.

Results of Operations

Net Sales

Net sales for the 53 weeks ended April 30, 2010 were $167.8 million, which consisted of U.S. net product sales of $135.1 million, international net product sales of $31.2 million and licensing revenue of $1.5 million. Net sales for the 52 weeks ended April 24, 2009 were $143.6 million, which consisted of U.S. net product sales of $114.9 million, international net product sales of $27.2 million and licensing revenue of $1.5 million.  Net sales for the 52 weeks ended April 25, 2008 were $121.2 million, which consisted of U.S. net product sales of $94.4 million, international net sales of $26.3 million and licensing revenue of $0.5 million.

 
33

 

U.S. net product sales for the 53 weeks ended April 30, 2010 increased by $20.2 million, or 17.6%, as compared to the 52 weeks ended April 24, 2009, due to a sales volume increase of 6.9% and increased average selling prices of 10.7%. The volume increase was partially due to the extra week in the fiscal year 2010 as compared to the fiscal year 2009. The average selling price increased, in part, due to higher market penetration of our new models, the Demipulse and Demipulse Duo. International net product sales for the 53 weeks ended April 30, 2010 increased by $4.0 million, or 14.6%, as compared to the 52 weeks ended April 24, 2009, due to a sales volume increase of 16.0%, offset by a decrease in the average selling prices of 1.4%. The average selling prices decreased due to increasing sales to distributors and unfavorable foreign currency movements. Sales to distributors are generally at lower prices than sales through our own employees.

U.S. net product sales for the 52 weeks ended April 24, 2009 increased by $20.5 million, or 21.7%, compared to the 52 weeks ended April 25, 2008 due to a volume increase of 8.2% and increased average selling prices of 13.5%.  The average selling price increased, in part, due to the market penetration of our new models, the Demipulse and Demipulse Duo generators. International net sales for the 52 weeks ended April 24, 2009 increased by $0.9 million, or 3.4%, compared to the 52 weeks ended April 25, 2008, due primarily to an increase in the average selling price.  The increase in international pricing was due to market penetration of our new models, offset by the effect of unfavorable foreign currency movements.

U.S. net sales attributable to the depression indication have continued to decline significantly since the CMS’s May 2007 issuance of a national non-coverage determination with respect to VNS Therapy for depression. We estimate that our net domestic sales attributable to depression for the 53 weeks ended April 30, 2010 were approximately $1.1 million compared to $1.5 million for the 52 weeks ended April 25, 2009 and $4.7 million for the 52 weeks ended April 26, 2008.

Gross Profit Margin

The gross profit margins for the 53 weeks ended April 30, 2010 and the 52 weeks ended April 24, 2009 and April 25, 2008 were 87.5%, 86.0% and 82.6%, respectively. These increases in the gross profit margin have been primarily a result of increasing production volumes and increased sales of the newer Demipulse generators that have slightly higher margins as compared to older models. Cost of sales, a component of our gross profit margin, consists primarily of direct labor, allocated manufacturing overhead, third-party contractor costs, royalties and the acquisition cost of raw materials and components.  Gross profit margins can be expected to fluctuate in future periods based on the mix between the newer Demipulse generators and older models, U.S. and international sales, direct and distributor sales, the VNS Therapy System selling price, applicable royalty rates and the levels of production volume. We are currently paying a 3% royalty covering our generator and lead net sales; however, we do not expect this royalty payment to be due under the terms of our license agreement after July 16, 2011.  If we were to market products utilizing non-expired patents covered by our agreements, additional royalties would be due.

Operating Expenses

Selling, General and Administrative (“SG&A”) Expenses.  SG&A expenses are comprised of sales, marketing, general and administrative activities. SG&A expenses were $87.9 million for the 53 weeks ended April 30, 2010, which represented an increase in expenses of $3.1 million, or a 3.7% increase as compared to SG&A expenses of $84.8 million for the 52 weeks ended April 24, 2009. The increase in SG&A was primarily due to increased compensation expense, including commissions, incurred as a result of the extra week in the fiscal year 2010. SG&A expenses for the 52 weeks ended April 24, 2009 decreased $1.1 million, or 1.3%, compared to the SG&A expenses of $85.9 million for the 52 weeks ended April 25, 2008, primarily due to reduced marketing and selling expenses related to depression offset by an increase in compensation expenses.

 
34

 
 
Research and Development (“R&D”) Expenses.  R&D expenses are comprised of expenses related to our product and process development, product design efforts, clinical trial programs and regulatory activities. R&D expenses were $22.1 million for the 53 weeks ended April 30, 2010, an increase in expense of $2.3 million, or 11.8%, as compared to $19.7 million for the 52 weeks ended April 24, 2009.  This increase was due to an increase in compensation expense incurred as a result of the extra week in the fiscal year 2010 and an increased emphasis on product development efforts with respect to the treatment of refractory epilepsy, which was partly offset by a decrease of clinical and regulatory expenses related primarily to the dosing study. R&D expenses for the 52 weeks ended April 24, 2009 decreased by approximately $2.7 million, or 12.0%, as compared to the R&D expenses of $22.4 million for the 52 weeks ended April 25, 2008. This decrease was primarily due to decreased clinical expenses relating to depression post-approval studies and decreased international clinical expenses partially offset by increased engineering expenses for product development.

Early Extinguishment of Debt

During the year ended April 30, 2010, we repurchased approximately $46.9 million of aggregate principal amount of our Convertible Notes in privately-negotiated transactions at a purchase price of approximately $43.0 million.  As a result of the purchases, we wrote off approximately $0.7 million in unamortized bond issue costs, resulting in a gain on early extinguishment of debt of approximately $3.2 million.  During the year ended April 24, 2009, we repurchased approximately $62.7 million of aggregate principal amount of our Convertible Notes in privately-negotiated transactions at a purchase price of approximately $50.4 million.  As a result of the purchases, we wrote off approximately $1.3 million in unamortized bond issue costs resulting in a gain on early extinguishment of debt of approximately $11.0 million. We did not retire any Convertible Notes during the year ended, April 25, 2008. After our fiscal year end on April 30, 2010, we repurchased $8.4 million additional aggregate principal amount of Convertible Notes resulting in a gain on early extinguishment of debt of approximately $83,000. For further discussion, see “Note 7.  Convertible Notes.”

Interest Expense

Interest expense consists primarily of interest due on the principal amount of our Convertible Notes at the rate of 3% per year. Interest expense of $1.4 million for the 53 weeks ended April 30, 2010 decreased by approximately $2.0 million, or 57.9%, as compared to the 52 weeks ended April 24, 2009. Interest expense of approximately $3.4 million for the fiscal year 2009 decreased by approximately $2.4 million, or 41.7%, as compared to fiscal year 2008. These decreases in interest expense are due to our repurchase and retirement of approximately $46.9 million and $62.7 million principal value of our Convertible Notes in fiscal years 2010 and 2009, respectively.

Other Expense, Net

Other expense, net for the 53 weeks ended April 30, 2010 and for the 52 weeks ended April 24, 2009 consisted of net foreign currency transaction losses associated with the effects of a strengthening U.S. dollar as compared to the euro. Other expenses, net for the 53 weeks ended April 30, 2010 decreased by $174,000, or 45.5%, as compared to the 52 weeks ended April 24, 2009 due to the decreased movement in the relative value of the U.S. dollar vs. the euro in the fiscal year 2010 as compared to the fiscal year 2009. For the 52 weeks ended April 25, 2008, other expense, net, consisted of the effects of gains and losses associated with changes in foreign currency exchange rates and of leasehold abandonment expenses. For the 52 weeks ended April 24, 2009, other expense, net decreased $16,000, or 4.0%, as compared to other expense, net of $397,000 for the 52 weeks ended April 25, 2008.  The decrease is primarily due to the reduction of leasehold abandonment expenses of approximately $109,000, offset by transaction losses associated with changes in foreign currency exchange rates.

 
35

 
 
Income Taxes

During the 53 weeks ended April 30, 2010 we evaluated the recoverability of our deferred tax assets, and as a result, reduced our valuation allowance by approximately $40.5 million due to the expected realization of deferred tax assets in the fiscal years after April 30, 2010. This partial reduction in the valuation allowance was a discrete event and was recorded as a tax benefit in the consolidated statement of operations during the thirteen weeks ended October 23, 2009. Our effective tax rate for the 53 weeks ended April 30, 2010 was approximately 1.3%, not including the discrete adjustment to the valuation allowance, consisting primarily of federal alternative minimum tax and state income taxes. As a result of the reversal of valuation allowance, we expect that our effective tax rate in the fiscal year ending April 29, 2011 will be approximately 36% to 38%, subject to a possible recognition of future deferred tax assets by a partial or full reduction of the remaining balance of the valuation allowance.

We increased our federal tax rate to 35% from 34%, and as a result, our estimated federal taxable income increased by approximately $393,000 for the 53 weeks ended April 30, 2010, and our deferred tax assets increased by approximately $2.5 million, the effects of which were offset in the consolidated statement of operations and financial position by a change in the valuation allowance.
 
    The following is a reconciliation of statutory federal income tax rates to our effective income tax rate expressed as a percentage of income (loss) before income taxes:

   
For the 53 Weeks Ended
 
For the 52 Weeks Ended
   
April 30, 2010
 
April 24, 2009
 
April 25, 2008
Income tax expense (benefit)
 
$
(39,960,413
 
$
729,441
   
$
(264,837
U.S. statutory rate
   
35.0
%
   
34.0
%
   
(34.0
)%
Change in deferred tax valuation allowance excluding impact of shortfall
   
(35.7
)
   
(34.1
   
29.1
 
Shortfall on settlement of options and restricted stock
   
2.9
     
2.4
     
30.8
 
Reduction in valuation allowance due to shortfall
   
(2.9
)
   
(2.4
)
   
(30.8
)
Federal income tax provision (1)
   
0.7
     
1.4
     
0.6
 
Foreign taxes
   
0.1
     
0.3
     
0.3
 
State and local tax provision
   
1.1
     
1.0
     
(3.4
Research and development tax credit
   
(0.6
)
   
     
 
Other, net
   
0.7
     
0.1
     
4.9
 
Release of valuation allowance (2)
   
(105.1
)
   
     
 
Effective tax rate
   
(103.8
)%
   
2.7
%
   
(2.5
)%


(1)
The federal income tax provision for the fiscal years 2010, 2009 and 2008 consist of federal alternative minimum income tax.
(2) The discrete adjustment to the valuation allowance related to the period subsequent to April 30, 2010 was recorded as a tax benefit in the consolidated statement of operations in the fiscal year ending April 30, 2010.
 


 
36

 
 
Non-GAAP Financial Measures

We disclose financial measurements in our press announcements and conference calls that present financial information that is not in accordance with GAAP.  Management uses and presents non-GAAP net income and non-GAAP income per diluted share because management believes that in order to properly understand our short and long-term financial trends, the impact of these unusual items should be eliminated from on-going operating activities. These measurements are not a substitute for GAAP measurements, although we use these measurements as aids in monitoring our on-going financial performance on a regular basis and for benchmarking against other medical technology companies. Non-GAAP net income and non-GAAP income per diluted share measure the income and income per share of the company excluding the gain on early extinguishment of our Convertible Notes and the impact of the discreet reduction in valuation allowance which was recorded in the fiscal year ended April 30, 2010, which are considered by management to be outside of our normal on-going operations of the company.  We also use earnings before interest, other income (expense), the income tax provision, depreciation and amortization, non-cash equity compensation and gain on early extinguishment of our Convertible Notes to arrive at adjusted non-GAAP EBITDA.

Non-GAAP financial measures used by us may be calculated differently from, and therefore may not be comparable to, similarly titled measures used by other companies.  Investors should consider non-GAAP measures in addition to, and not a substitute for, or superior to, financial performance measures prepared in accordance with GAAP.

The following table sets forth the reconciliation between GAAP and non-GAAP financial measures:

   
53 Weeks Ended
 
52 Weeks Ended
     
April 30, 2010
     
April 24, 2009
     
April 25, 2008
 
Net income (loss)
 
$
78,448,884
   
$
26,720,620
   
$
(10,334,765
)
Deduct gain on early extinguishment of debt, includes tax, interest  and amortization
   
(2,439,862
   
(9,895,370
   
––
 
Deduct tax benefit for the reduction in the valuation allowance
   
(40,450,068
   
––
     
––
 
Non-GAAP adjusted net income:
 
$
35,558,954 
   
16,825,250 
   
 $
(10,334,765
)
Diluted shares outstanding
   
28,696,375
     
27,542,198
     
26,568,746
 
Effect of removing the tax benefit for reduction of the valuation allowance on the convertible notes outstanding at April 30, 2010
   
(372,530
)
   
––
     
––
 
Non-GAAP adjusted diluted shares outstanding
   
28,323,845
     
27,542,198
     
26,568,746
 
                         
Diluted income per share
 
$
2.67
   
$
0.61
   
$
(0.39
)
Non-GAAP adjusted diluted income per share
 
$
1.26
   
$
0.61
   
$
(0.39
)
                         
Income from Operations
 
$
36,861,872
   
18,989,708
   
(8,228,697
)
Depreciation and Amortization
   
2,598,192
     
3,086,256
     
3,995,914
 
Equity based compensation
   
8,622,949
     
9,681,593
     
11,263,127
 
Adjusted EBITDA
 
$
48,083,013
   
31,757,557
   
$
7,030,344
 

Changes in the non-GAAP adjusted net income, non-GAAP adjusted diluted shares outstanding, non-GAAP adjusted diluted income per share and non-GAAP adjusted EBITDA are primarily due to increasing sales and gross margins as discussed above in detail.

 
37

 
 
Liquidity and Capital Resources

Cash

Cash decreased by $7.0 million during the 53 weeks ended April 30, 2010 to $59.2 million, primarily due to cash used to repurchase $46.9 million principal value of our Convertible Notes at a purchase price of $43.0 million and the purchases of property and equipment and intellectual property of $6.1 million, offset by cash provided by operations of $42.9 million. Cash decreased by $24.8 million during the 52 weeks ended April 24, 2009 to $66.2 million primarily due to cash used to repurchase $62.7 million principal value of our Convertible Notes at a purchase price of $50.4 million and the purchases of property and equipment of $2.7 million, offset by increases in cash provided by operations of $24.6 million and stock option exercises of $4.3 million.

We believe our current financial and capital resources, including cash, cash equivalents and cash flow from operations, will be adequate to fund anticipated business activities, including increased investing activities, through the fiscal year 2011, although there can be no assurance of this, as this estimate is based on a number of assumptions that may not hold true. Our liquidity could be adversely affected by the factors affecting future operating results that are discussed in “Item 1A. Risk Factors.”

Cash Flows
 
    Cash provided by (used in) operating, investing and financing activities were as follows:

   
53 Weeks Ended
 
52 Weeks Ended
   
April 30, 2010
 
April 24, 2009
 
April 25, 2008
Operating activities
 
$
42,885,487
   
$
24,589,950
   
$
14,455,207
 
Investing activities
   
(6,222,607
)
   
(2,918,266
)
   
(817,064
Financing activities
   
(43,719,151
)
   
(46,627,016
)
   
(7,429,200

Operating Activities

    Cash provided by operating activities during the 53 weeks ended April 30, 2010 increased $18.3 million as compared to the 52 weeks ended April 24, 2009, primarily due to a $17.9 million increase in income from operations. Cash provided by operating activities during the 52 weeks ended April 24, 2009 increased $10.1 million as compared to the 52 weeks ended April 25, 2008, primarily due to an increase in sales and gross margin improvement resulting in overall profitable operations in fiscal year 2009.

Investing Activities

Cash used in investing activities during the 53 weeks ended April 30, 2010 increased by $3.3 million, as compared to the 52 weeks ended April 24, 2009, primarily due to increased investment for business infrastructure, research capabilities, acquisition of rights to product components and to license selected patents from third parties. We expect to increase our investment in these areas by $4.2 million for a total investment of approximately $10.4 million in the 52 weeks ending April 29, 2011, as compared to $6.2 million for the 53 weeks ended April 30, 2010. Cash used in investing activities during the 52 weeks ended April 24, 2009 increased $2.1 million, as compared to the 52 weeks ended April 25, 2008, as we increased investment in our business infrastructure including information technology and manufacturing capabilities.

Financing Activities

Cash used in financing activities during the 53 weeks ended April 30, 2010 decreased by $2.9 million, as compared to the 52 weeks ended April 24, 2009, primarily due to decreased repurchases of our Convertible Notes, offset by a an increase in cash used to purchase treasury stock and a decrease in cash proceeds from stock option exercises. Cash used in financing activities during the 52 weeks ended April 24, 2009 increased $39.2 million, as compared to the 52 weeks ended April 25, 2008, primarily due to the start of our Convertible Notes repurchase program in the fiscal year 2009.

 
38

 
 
Debt Instruments and Contractual Obligations

Convertible Notes

In September 2005, we issued $125.0 million of Convertible Notes. See “Note 7. Convertible Notes” in the Notes to Consolidated Financial Statements for a description of the Convertible Notes.

During the 53 weeks ended April 30, 2010, we repurchased $46.9 million of aggregate principal amount of our Convertible Notes in privately-negotiated transactions at a purchase price of approximately $43.0 million.  As a result of the purchases, we wrote off $0.7 million in unamortized bond issue costs for a gain on early extinguishment of debt of $3.2 million. During the 52 weeks ended April 24, 2009, we repurchased $62.7 million of aggregate principal amount of our Convertible Notes in privately-negotiated transactions at a purchase price of $50.4 million.  As a result of the purchases, we wrote off $1.3 million in unamortized bond issue costs resulting in a gain on early extinguishment of debt of $11.0 million.

After our fiscal year end 2010, we repurchased an additional $8.4 million aggregate principal amount of our Convertible Notes resulting in a gain on early extinguishment of debt of approximately $83,000.

Contractual Obligations

A summary of contractual obligations as of April 30, 2010 are as follows:

   
Less Than
One Year
   
One to Three Years
   
Four to Five
Years
   
Over Five
Years
   
 Total Contractual Obligations
Contractual obligations related to off-balance sheet arrangements:
                                       
Operating leases (1)
 
3,361,204
   
6,238,496
   
4,776,470
   
   
14,376,170
 
Inventory purchases (2)
   
2,313,600
     
     
     
     
2,313,600
 
Interest on Notes issuance (3)
   
420,016
     
350,867
     
     
     
770,883
 
Other (4)
   
1,974,571
     
609,524
     
     
     
2,584,095
 
Contractual obligations reflected in the balance sheet:
                                       
Notes issuance (5)
   
43,784
     
15,460,000
     
     
     
15,503,784
 
Total
 
$
8,113,175
   
$
22,658,887
   
$
4,776,470
   
$
   
35,548,532
 

(1)
Reflects operating lease obligations related to facilities and office equipment.
(2)
Reflects certain of our inventory purchase commitments that are material, legally binding and specify minimum purchase quantities.  These purchase commitments do not exceed our projected manufacturing requirements and are in the normal course of business.
(3)
Reflects interest obligations related to the Convertible Notes issuance.
(4)
Reflects certain material purchase contracts that are legally binding and specify minimum purchase amounts primarily in connection with sales, marketing and training events, an information technology service agreement and license and technology agreements with collaboration partners.
(5)
Reflects principal and interest obligations currently reported on the Consolidated Balance Sheet related to the Convertible Notes issuance presented as if the Convertible Notes were to become due and payable on December 27, 2011, in accordance with the Supplemental Indenture.


 
39

 
 
Factors Affecting Future Operating Results and Common Stock Price

The factors affecting our future operating results and common stock prices are disclosed in “Item 1A. Risk Factors.”

Item 7A.  Quantitative and Qualitative Disclosures About Market Risk

We are exposed to market risk on interest rates, foreign currency exchange rates and our Convertible Notes.

Interest Rate Risk

Our exposure to market risk for changes in interest rates relates primarily to our short-term investments. We do not hedge our interest rate exposure or invest in derivative securities. Based on the average outstanding balances in cash and cash equivalents as of April 30, 2010, a 100-basis point change in interest rates as of April 30, 2010 would not have a material impact on our consolidated results of operations.

Foreign Currency Exchange Rate Risk

Due to the global reach of our business, we are also exposed to market risk from changes in foreign currency exchange rates, particularly with respect to the U.S. dollar versus the euro. Our wholly-owned foreign subsidiary is consolidated into our financial results and is subject to risks typical of an international business, including, but not limited to, differing economic conditions, changes in political climate, differing tax structures, other regulations and restrictions and foreign exchange rate volatility. Accordingly, our future results could be materially impacted by changes in these or other factors. At this time, we have not deemed it to be cost effective to engage in a program of hedging the effect of foreign currency fluctuations on our operating results using derivative financial instruments. A sensitivity analysis indicates that, if the U.S. dollar uniformly weakened 10% against the euro, the effect upon net income for the 53 weeks ended April 30, 2010 would have been favorable by approximately $130,000, or 0.2%. Conversely, if the U.S. dollar uniformly strengthened 10% against the euro, the impact on net income for the 53 weeks ended April 30, 2010 would have been unfavorable by approximately $118,000, or 0.2%.  We measure the foreign currency exchange risk of our foreign currency balances using period end rates and we measure the translation risk associated with our subsidiary in Belgium, which uses the euro for its functional currency, using yearly average rates.

Convertible Notes Risk

The estimated fair value of our Convertible Notes was approximately $15.2 million, based on the outstanding liability of approximately $15.5 million as of April 30, 2010.  Because we pay fixed interest coupons on the Convertible Notes, market interest rate fluctuations do not impact our debt interest payments.  However, the fair value of our Convertible Notes fluctuates as a result of changes in the price of our common stock, changes in market interest rates, changes in our credit worthiness and changes in the overall credit market.  Generally, the fair market value of our Convertible Notes increases as interest rates fall and decreases as interest rates rise. The fair market value of our Convertible Notes may also increase as the market price of our common stock rises and decrease as the market price of our common stock falls. At April 30, 2010, a 10% decrease or a 10% increase in the price of our common stock would not have resulted in a material change in the fair value of our Convertible Notes.

We are required by the Fair Value Measurements and Disclosures Topic of the Financial Accounting Standards Board’s Accounting Standard Codification to disclose the level of inputs used to determine fair value of our Convertible Notes.  We believe the inputs fall into Level 2, meaning that the inputs to the fair value measurement are observable, either directly or indirectly.

 
40

 
 
Item 8.  Financial Statements and Supplementary Data

The information required by this Item is incorporated by reference to the Consolidated Financial Statements beginning on page F-1.

Item 9.  Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

None.

Item 9A.  Controls and Procedures

Disclosure Controls and Procedures

(a)  Evaluation of Disclosure Controls and Procedures

We maintain a system of disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) of the Exchange Act, that are designed to ensure that information required to be disclosed in our reports filed under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. This information is also accumulated and communicated to management, including our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), as appropriate, to allow timely decisions regarding required disclosure. Our management, under the supervision and with the participation of our CEO and CFO, evaluated the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this Form 10-K. Based on that evaluation, our CEO and CFO concluded that our disclosure controls and procedures were effective as of April 30, 2010.

(b)  Management’s Report on Internal Control Over Financial Reporting

Our management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In connection with the preparation of our annual consolidated financial statements, our management, under the supervision and with the participation of our CEO and CFO, assessed the effectiveness of our internal control over financial reporting based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this assessment, our management has concluded that our internal control over financial reporting was effective as of April 30, 2010.

KPMG LLP, the independent registered public accounting firm who audited the consolidated financial statements included in this Form 10-K, has issued a report on our internal control over financial reporting as of April 30, 2010. This report, dated June 17, 2010, appears on page 42.

(c)  Changes in Internal Control Over Financial Reporting

We implemented an upgrade to our integrated enterprise system in October 2009 affecting most major processes, including: Revenue, Expenditure, Inventory Tracking/Costing, and Financial Reporting. During the 53 weeks ended April 30, 2010, there have been no other changes that have materially affected or are reasonably likely to materially affect our internal control over financial reporting.

Item 9B.  Other Information

None.

 
41

 
 
Report of Independent Registered Public Accounting Firm
 
The Board of Directors and Stockholders
Cyberonics, Inc.:
 
We have audited Cyberonics, Inc.’s internal control over financial reporting as of April 30, 2010, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Cyberonics, Inc.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control Over Financial Reporting (Item 9A(b)). Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.
 
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
 
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
 
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
 
In our opinion, Cyberonics, Inc. maintained, in all material respects, effective internal control over financial reporting as of April 30, 2010, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
 
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Cyberonics, Inc. and subsidiary as of April 30, 2010 and April 24, 2009, and the related consolidated statements of operations, stockholders’ equity (deficit) and comprehensive income (loss), and cash flows for the 53 weeks ended April 30, 2010 and the 52 weeks ended April 24, 2009, and April 25, 2008, and our report dated June 17, 2010 expressed an unqualified opinion on those consolidated financial statements.
 

/s/  KPMG LLP

Houston, Texas
June 17, 2010

 
42

 

PART III

Item 10.  Directors, Executive Officers and Corporate Governance

Pursuant to general instruction G to Form 10-K, we incorporate by reference into this item the information to be disclosed in our definitive proxy statement for our 2010 Annual Meeting of Stockholders.

Financial Code of Ethics

Our Board has adopted a Financial Code of Ethics, which represents the code of ethics applicable to our principal executive officer, principal financial officer, principal accounting officer or controller and other senior financial officers (“senior financial officers”).  A copy of the Financial Code of Ethics is available on our website, www.cyberonics.com, and a copy will be mailed without charge, upon written request, to our investor relations department.  We intend to disclose any amendments to or waivers of the Financial Code of Ethics on behalf of our senior financial officers on our website, at www.cyberonics.com promptly following the date of the amendment or waiver.

Item 11.  Executive Compensation

Pursuant to general instruction G to Form 10-K, we incorporate by reference into this Item the information to be disclosed in our definitive proxy statement for our 2010 Annual Meeting of Stockholders.

Item 12.  Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

Pursuant to general instruction G to Form 10-K, we incorporate by reference into this Item the information to be disclosed in our definitive proxy statement for our 2010 Annual Meeting of Stockholders.

Item 13.  Certain Relationships and Related Transactions, and Director Independence

Pursuant to general instruction G to Form 10-K, we incorporate by reference into this Item the information to be disclosed in our definitive proxy statement for our 2010 Annual Meeting of Stockholders.

Item 14.  Principal Accounting Fees and Services

Pursuant to general instruction G to Form 10-K, we incorporate by reference into this Item the information to be disclosed in our definitive proxy statement for our 2010 Annual Meeting of Stockholders.

 
43

 

PART IV

Item 15.  Exhibits, Financial Statement Schedules

(1) Financial Statements

The Consolidated Financial Statements of Cyberonics, Inc. and its subsidiary, and the Report of Independent Registered Public Accounting Firm are included in this Form 10-K beginning on page F-1:

Description
Page No.
Report of Independent Registered Public Accounting Firm
F-2
Consolidated Balance Sheets
F-3
Consolidated Statements of Operations
F-4
Consolidated Statements of Stockholders’ Equity (Deficit) and Comprehensive Income (Loss)
F-5
Consolidated Statements of Cash Flows
F-6
Notes to Consolidated Financial Statements
F-7

(2) Financial Statement Schedules

All schedules required by Regulation S-X have been omitted as not applicable or not required, or the information required has been included in the Notes to the financial statements.

(3) Index to Exhibits

The exhibits marked with the asterisk symbol (*) are filed or furnished (in the case of Exhibit 32.1) with this Form 10-K. The exhibits marked with the cross symbol (†) are management contracts or compensatory plans or arrangements filed pursuant to Item 601(b)(10)(iii) of Regulation S-K.  The exhibits marked with the pound symbol (#) have been redacted and are the subject of an application for confidential treatment filed with the SEC pursuant to Rule 24b-2 of the general rules and regulations promulgated under the Exchange Act.

Exhibit
Number
 
Document Description
 
 
Report or Registration Statement
SEC File or
Registration
Number
Exhibit
Reference
3.1
Amended and Restated Certificate of Incorporation of Cyberonics, Inc.
 
Cyberonics, Inc.’s Registration Statement on Form S-3 filed on February 21, 2001
333-56022
3.1
3.2
Amended and Restated Bylaws of Cyberonics, Inc.
 
Cyberonics, Inc.’s Current Report on Form 8-K filed on October 26, 2007
000-19806
3.2(i)
4.1
Indenture dated September 27, 2005 between Cyberonics, Inc. and Wells Fargo Bank, National Association, as Trustee
 
Cyberonics, Inc.’s Current Report on Form 8-K filed on October 3, 2005
000-19806
10.1
4.2
Supplemental Indenture dated April 18, 2008 to the Indenture dated September 27, 2005 between Cyberonics, Inc. and Wells Fargo Bank, National Association, as Trustee
 
Cyberonics, Inc.’s Current Report on Form 8-K filed on April 24, 2008
000-19806
10.2
4.3
Registration Rights Agreement dated September 27, 2005 between Cyberonics, Inc. and Merrill Lynch, Pierce, Fenner & Smith Incorporated, as the Initial Purchaser
 
Cyberonics, Inc.’s Current Report on Form 8-K filed on October 3, 2005
000-19806
10.2
4.4
Form of Confirmation of OTC Convertible Note Hedge executed September 21, 2005 to be effective September 27, 2005
 
Cyberonics, Inc.’s Current Report on Form 8-K filed on October 3, 2005
000-19806
10.3
4.5
Form of Confirmation of OTC Warrant Transaction executed September 21, 2005 to be effective September 27, 2005
 
Cyberonics, Inc.’s Current Report on Form 8-K filed on October 3, 2005
000-19806
10.4
10.1
License Agreement dated March 15, 1988 between Cyberonics, Inc. and Dr. Jacob Zabara
 
Cyberonics, Inc.’s Annual Report on
Form 10-K for the fiscal period ended April 28, 2006
000-19806
10.1
10.2
License Agreement dated August 22, 2000 between Cyberonics, Inc. and Dr. Mitchell S. Roslin
 
Cyberonics, Inc.’s Annual Report on
Form 10-K for the fiscal period ended April 28, 2006
000-19806
10.2


 
44

 

Exhibit
Number
 
Document Description
 
 
Report or Registration Statement
SEC File or
Registration
Number
Exhibit
Reference
10.3#
Exclusive Patent License Agreement dated December 17, 2007, by and between Cyberonics, Inc. and Ethicon Endo-Surgery, Inc.
 
Cyberonics, Inc.’s Quarterly Report on Form 10-Q for the quarter ended January 25, 2008
000-19806
10.1
10.4
Lease Agreement dated December 5, 2002 between Cyberonics, Inc., as Lessee, and Space Center Operating Associates, LP, as Lessor, commencing on December 8, 2002 for Space “A” and January 1, 2004 for Space “B,” as amended March 3, 2003 (First Amendment), October 2, 2003 (Second Amendment), March 11, 2004 (Third Amendment), March 17, 2004 (Subordination, Non-Disturbance and Attornment), March 19, 2004 (Transfer of Ownership to Triple Net Properties, LLC), March 23, 2005 (Fourth Amendment), May 5, 2005 (Fifth Amendment) and July 13, 2005 (Sixth Amendment)
 
Cyberonics, Inc.’s Annual Report on
Form 10-K for the fiscal period ended April 28, 2006
000-19806
10.3
10.5
Seventh Amendment, dated December 28, 2007, to that certain Lease Agreement dated December 5, 2002 between Cyberonics, Inc., as Lessee, and Space Center Operating Associates, LP, as Lessor
 
Cyberonics, Inc.’s Annual Report on Form 10-K for the fiscal year ended April 25, 2008
000-19806
10.5
10.6
Eighth Amendment, dated March 31, 2008, to that certain Lease Agreement dated December 5, 2002 between Cyberonics, Inc., as Lessee, and Space Center Operating Associates, LP, as Lessor
 
Cyberonics, Inc.’s Annual Report on Form 10-K for the fiscal year ended April 25, 2008 
000-19806
10.6
10.7†
Cyberonics, Inc. Amended and Restated 1996 Stock Option Plan
 
Cyberonics, Inc.’s Registration Statement on Form S-8 filed on April 29, 1999
333-77361
4.1
10.8†
First Amendment to the Cyberonics, Inc. Amended and Restated 1996 Stock Option Plan dated October 2, 2000
 
Cyberonics, Inc.’s Quarterly Report on
Form 10-Q for the quarter ended September 30, 2000
000-19806
10.2
10.9†
Second Amendment to the Cyberonics, Inc. Amended and Restated 1996 Stock Option Plan dated March 21, 2001
 
Cyberonics, Inc.’s Annual Report on
Form 10-K for the fiscal period ended April 30, 2004
000-19806
10.12
10.10†
Third Amendment to the Cyberonics, Inc. Amended and Restated 1996 Stock Option Plan dated July 27, 2001
 
Cyberonics, Inc.’s Registration Statement on Form S-8 filed on January 22, 2002
333-81158
4.4
10.11†
Fourth Amendment to the Cyberonics, Inc. Amended and Restated 1996 Stock Option Plan dated January 2002
 
Cyberonics, Inc.’s Registration Statement on Form S-8 filed on January 22, 2002
333-81158
4.5
10.12†
Fifth Amendment to the Cyberonics, Inc. Amended and Restated 1996 Stock Option Plan dated July 19, 2002
 
Cyberonics, Inc.’s Registration Statement on Form S-8 filed on July 25, 2002
333-97095
4.1
10.13†
Form of Stock Option Agreement under the Cyberonics, Inc. Amended and Restated 1996 Stock Option Plan between Cyberonics, Inc. and the executive officers listed on the schedule attached thereto
 
Cyberonics, Inc.’s Annual Report on
Form 10-K for the fiscal period ended April 28, 2006
000-19806
10.69
10.14†
Cyberonics, Inc. Amended and Restated 1997 Stock Plan
 
Cyberonics, Inc.’s Registration Statement on Form S-8 filed on March 8, 2001
333-56694
4.5
10.15†
First Amendment to the Cyberonics, Inc. Amended and Restated 1997 Stock Plan dated March 21, 2001
 
Cyberonics, Inc.’s Quarterly Report on
Form 10-Q for the quarter ended July 26, 2002
000-19806
10.1
10.16†
Second Amendment to the Cyberonics, Inc. Amended and Restated 1997 Stock Plan dated November 21, 2002
 
Cyberonics, Inc.’s Proxy Statement for the Annual Meeting of Stockholders filed on October 15, 2002
000-19806
Annex B
10.17†
Third Amendment to the Cyberonics, Inc. Amended and Restated 1997 Stock Plan dated August 19, 2008
 
Cyberonics, Inc.’s Quarterly Report on Form 10-Q for the quarter ended October 24, 2008
000-19806
10.1
10.18†
Form of Executive Restricted Stock Agreement under the Cyberonics, Inc. Amended and Restated 1997 Stock Plan between Cyberonics, Inc. and the executive officers listed on the schedule attached thereto
 
Cyberonics, Inc.’s Quarterly Report on Form 10-Q for the quarter ended July 27, 2007
000-19806
10.5
10.19†
Form of Director Restricted Stock Agreement under the Cyberonics, Inc. Amended and Restated 1997 Stock Plan between Cyberonics, Inc. and the directors listed on the schedule attached thereto (three-year vesting)
 
Cyberonics, Inc.’s Quarterly Report on Form 10-Q for the quarter ended July 27, 2007
000-19806
10.6
10.20†
Form of Director Restricted Stock Agreement under the Cyberonics, Inc. Amended and Restated 1997 Stock Plan between Cyberonics, Inc. and the directors listed on the schedule attached thereto (four-year vesting)
 
Cyberonics, Inc.’s Quarterly Report on Form 10-Q for the quarter ended July 27, 2007
000-19806
10.7


 
45

 

Exhibit
Number
 
Document Description
 
 
Report or Registration Statement
SEC File or
Registration
Number
Exhibit
Reference
10.21†
Form of Employee Restricted Stock Agreement under the Cyberonics, Inc. Amended and Restated 1997 Stock Plan
 
Cyberonics, Inc.’s Quarterly Report on Form 10-Q for the quarter ended July 27, 2007
000-19806
10.8
10.22†
Cyberonics, Inc. 1998 Stock Option Plan
 
Cyberonics, Inc.’s Registration Statement on Form S-8 filed on November 3, 1998
333-66691
4.1
10.23†
First Amendment to the Cyberonics, Inc. 1998 Stock Option Plan dated March 21, 2001
 
Cyberonics, Inc.’s Annual Report on
Form 10-K for the fiscal period ended April 30, 2004
000-19806
10.23
10.24†
Cyberonics, Inc. New Employee Equity Inducement Plan
 
Cyberonics, Inc.’s Registration Statement on Form S-8 filed on August 27, 2003
333-108281
4.3
10.25†
Amended and Restated Cyberonics, Inc. New Employee Equity Inducement Plan
 
Cyberonics, Inc.’s Registration Statement on Form S-8 filed on June 18, 2007
333-143821
4.1
10.26†
First Amendment to the Amended and Restated Cyberonics, Inc. New Employee Equity Inducement Plan dated August 19, 2008
 
Cyberonics, Inc.’s Quarterly Report on Form 10-Q for the quarter ended October 24, 2008
000-19806
10.3
10.27†
Form of Executive Restricted Stock Agreement under the Cyberonics, Inc. New Employee Equity Inducement Plan between Cyberonics, Inc. and the executive officers listed on the schedule attached thereto dated as of the dates so indicated.
 
Cyberonics, Inc.’s Annual Report on Form 10-K for the fiscal year ended April 25, 2008
000-19806
10.30
10.28†
Form of Executive Restricted Stock Agreement dated September 10, 2007 under the Cyberonics, Inc. New Employee Equity Inducement Plan between Cyberonics, Inc. and the executive officers listed on the schedule attached thereto relating to Cyberonics’ Common Stock Price
 
Cyberonics, Inc.’s Quarterly Report on Form 10-Q for the quarter ended October 26, 2007
000-19806
10.1
10.29†
Form of Executive Restricted Stock Agreement dated September 10, 2007 under the Cyberonics, Inc. New Employee Equity Inducement Plan between Cyberonics, Inc. and the executive officers listed on the schedule attached thereto relating to Cyberonics’ Net Income
 
Cyberonics, Inc.’s Quarterly Report on Form 10-Q for the quarter ended October 26, 2007
000-19806
10.2
10.30†
Form of Executive Restricted Stock Agreement dated September 10, 2007 under the Cyberonics, Inc. New Employee Equity Inducement Plan between Cyberonics, Inc. and the executive officers listed on the schedule attached thereto relating to Cyberonics’ Net Sales
 
Cyberonics, Inc.’s Quarterly Report on Form 10-Q for the quarter ended October 26, 2007
000-19806
10.3
10.31†
Form of Executive Restricted Stock Agreement dated September 10, 2007 under the Cyberonics, Inc. New Employee Equity Inducement Plan between Cyberonics, Inc. and the executive officers listed on the schedule attached thereto relating to Cyberonics’ Net Sales and Earnings
 
Cyberonics, Inc.’s Quarterly Report on Form 10-Q for the quarter ended October 26, 2007
000-19806
10.4
10.32†
Cyberonics, Inc. 2005 Stock Plan
 
Cyberonics, Inc.’s Proxy Statement for the Special Meeting of Stockholders filed on April 14, 2005
000-19806
Annex A
10.33†
First Amendment to the Cyberonics, Inc. 2005 Stock Plan dated August 19, 2008
 
Cyberonics, Inc.’s Quarterly Report on Form 10-Q for the quarter ended October 24, 2008
000-19806
10.2
10.34†
Form of Director Restricted Stock Agreement effective June 1, 2005
 
Cyberonics, Inc.’s Quarterly Form 10-Q for the quarter ended July 29, 2005
000-19806
10.1
10.35†
Form of Amendment to Director Stock Option Agreement dated December 2006 between Cyberonics, Inc. and the directors listed on the schedule attached thereto
 
Cyberonics, Inc.’s Annual Report on
Form 10-K for the fiscal period ended April 28, 2006
000-19806
10.68
10.36†
Form of Stock Option Agreement under the Cyberonics, Inc. 2005 Stock Plan between Cyberonics, Inc. and the executive officers listed on the schedule attached thereto
 
Cyberonics, Inc.’s Annual Report on
Form 10-K for the fiscal period ended April 28, 2006
000-19806
10.70
10.37†
Form of Employee Restricted Stock Agreement under the Cyberonics, Inc. 2005 Stock Plan (one-year vesting)
 
Cyberonics, Inc.’s Quarterly Form 10-Q for the quarter ended July 29, 2005
000-19806
10.2
10.38†
Form of Employee Restricted Stock Agreement under the Cyberonics, Inc. 2005 Stock Plan (five-year vesting) and the executive officers listed on the schedule attached thereto
 
Cyberonics, Inc.’s Annual Report on
Form 10-K for the fiscal period ended April 28, 2006
000-19806
10.72
10.39†
Cyberonics, Inc. 2009 Stock Plan
 
Cyberonics, Inc.’s Current Report on Form 8-K filed on September 29, 2009
000-19806
10.1
10.40†
Form of Indemnification Agreement for directors of Cyberonics, Inc.
 
Cyberonics, Inc.’s Annual Report on
Form 10-K for the fiscal period ended April 28, 2006
000-19806
10.66


 
46

 

Exhibit
Number
 
Document Description
 
 
Report or Registration Statement
SEC File or
Registration
Number
Exhibit
Reference
10.41†
Summary of Non-Equity Incentive Compensation Plans
 
Cyberonics, Inc.’s Annual Report on Form 10-K for the year ended April 27, 2007
000-19806
10.64
10.42†
Executive Restricted Stock Agreement between Cyberonics, Inc. and Daniel J. Moore dated June 18, 2007
 
Cyberonics, Inc.’s Annual Report on Form 10-K for the year ended April 27, 2007
000-19806
10.66
10.43†
Employment Agreement dated April 26, 2007 by and between Cyberonics, Inc. and Daniel J. Moore
 
Cyberonics, Inc.’s Current Report on Form 8-K filed on May 1, 2007
000-19806
10.1
10.44†
First Amendment to Employment Agreement dated April 26, 2007 by and between Cyberonics, Inc. and Daniel J. Moore
 
Cyberonics, Inc.’s Current Report on Form 8-K filed on July 19, 2007
000-19806
10.1
10.45†
Second Amendment to Employment Agreement dated December 19, 2008 between Cyberonics, Inc. and Daniel J. Moore
 
Cyberonics, Inc.’s Current Report on Form 8-K filed on December 29, 2008
000-19806
10.1
10.46†
Stock Option Amendment and Cash Bonus Agreement dated October 22, 2007 between Cyberonics, Inc. and Randal L. Simpson
 
Cyberonics, Inc.’s Quarterly Report on Form 10-Q for the quarter ended October 26, 2007
000-19806
10.5
10.47†
Cyberonics 1998 Stock Option Notice of Stock Option Grant and Stock Options Agreement dated October 22, 2007 between Cyberonics, Inc. and Randal L. Simpson
 
Cyberonics, Inc.’s Quarterly Report on Form 10-Q for the quarter ended October 26, 2007
000-19806
10.6
10.48†
Indemnification Agreement effective August 1, 2003 between Cyberonics, Inc. and David S. Wise
 
Cyberonics, Inc.’s Annual Report on
Form 10-K for the fiscal period ended April 28, 2006
000-19806
10.61
10.49†
New Employee Equity Inducement Plan Agreement dated September 17, 2003 between Cyberonics, Inc. and David S. Wise
 
Cyberonics, Inc.’s Annual Report on
Form 10-K for the fiscal period ended April 28, 2006
000-19806
10.65
10.50†
Form of Amendment of Restricted Stock Agreement (Messrs. Browne and Reinstein)
 
Cyberonics, Inc.’s Current Report on Form 8-K filed on December 29, 2008
000-19806
10.5
10.51†
Form of Employment Agreement (Messrs. Browne, Reinstein, Simpson and Wise)
 
Cyberonics, Inc.’s Current Report on Form 8-K filed on June 24, 2009.
000-19806
10.1
10.52†
Release Agreement dated June 1, 2009 between Cyberonics, Inc. and George E. Parker, III
 
Cyberonics, Inc.’s Quarterly Report on Form 10-Q for the quarter ended July 24, 2009
000-19806
10.2
10.53†
Form of Non-Competition, No Solicitation and Confidential Information Agreement (Olsen and Strauss)
 
Cyberonics, Inc.’s Current Report on Form 8-K filed on September 29, 2009
000-19806
10.2
10.54†
Form of Stock Option Agreement Amendment (Olsen and Strauss)
 
Cyberonics, Inc.’s Current Report on Form 8-K filed on September 29, 2009
000-19806
10.3
10.55†
Form of Restricted Stock Agreement Amendment (Olsen and Strauss)
 
Cyberonics, Inc.’s Current Report on Form 8-K filed on September 29, 2009
000-19806
10.4
10.56†
Summary of Non-Employee Director Compensation as of June 24, 2008
 
Cyberonics, Inc.’s Annual Report on Form 10-K for the fiscal year ended April 25, 2008
000-19806
10.83
10.57†
Summary of Fiscal Year 2008 Executive Bonus Program
 
Cyberonics, Inc.’s Annual Report on Form 10-K for the fiscal year ended April 25, 2008
000-19806
10.84
10.58#
International Distributor Agreement effective April 24, 2009 between and Cyberonics, Inc. and Nihon Kohden Corporation
 
Cyberonics, Inc.’s Annual Report on Form 10-K for the fiscal year ended April 24, 2009
000-19806
10.72
21.1
List of Subsidiaries of Cyberonics, Inc.
 
Cyberonics, Inc.’s Annual Report on
Form 10-K for the fiscal period ended April 28, 2006
000-19806
21.1
23.1*
Consent of Independent Registered Public Accounting Firm, KPMG LLP
       
24.1*
Powers of Attorney (included on the Signature Page to this Annual Report on Form 10-K)
       
31.1*
Certification of the Chief Executive Officer of Cyberonics, Inc. pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
       
31.2*
Certification of the Chief Financial Officer of Cyberonics, Inc. pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
       
32.1*
Certification of the Chief Executive Officer and Chief Financial Officer of Cyberonics, Inc. pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
       

 

 
47

 
SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 
CYBERONICS, INC.
     
 
 By:
/s/ GREGORY H. BROWNE
   
Gregory H. Browne
   
Vice President, Finance and Chief Financial Officer
   
(Principal Financial Officer and Principal Accounting Officer)

Date: June 17, 2010

POWER OF ATTORNEY

KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Daniel J. Moore and Gregory H. Browne, jointly and severally, his attorneys-in-fact, each with the power of substitution, for him in any and all capacities, to sign any amendments to this Annual Report on Form 10-K, and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact, or his substitute or substitutes, any do or cause to be done by virtue hereof.

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated:


Signature
Title
Date
     
/s/  HUGH M. MORRISON
Hugh M. Morrison
Chairman of the Board of Directors
June 17, 2010
     
/s/  DANIEL J. MOORE
Daniel J. Moore
Director, President and Chief Executive Officer
(Principal Executive Officer)
June 17, 2010
     
/s/  GREGORY H. BROWNE
Gregory H. Browne
Vice President, Finance and Chief Financial Officer (Principal Financial Officer and
Principal Accounting Officer)
June 17, 2010
     
/s/  GUY C. JACKSON
Guy C. Jackson
Director
June 17, 2010
     
/s/  JOSEPH E. LAPTEWICZ
Joseph E. Laptewicz
Director
June 17, 2010
     
/s/  ALFRED J. NOVAK
Alfred J. Novak
Director
June 17, 2010
     
/s/  ARTHUR L. ROSENTHAL PH.D.
Arthur L. Rosenthal, Ph.D.
Director
June 17, 2010
     
/s/  REESE S. TERRY, JR.
Reese S. Terry, Jr.
Director
June 17, 2010


 
48

 















CONSOLIDATED FINANCIAL STATEMENTS
April 30, 2010, April 24, 2009 and April 25, 2008
TOGETHER WITH INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM’S REPORT
















 
 
F-1

 

Report of Independent Registered Public Accounting Firm


The Board of Directors and Stockholders
Cyberonics, Inc.:
 
We have audited the accompanying consolidated balance sheets of Cyberonics, Inc. and subsidiary as of April 30, 2010 and April 24, 2009, and the related consolidated statements of operations, stockholders’ equity (deficit) and comprehensive income (loss), and cash flows for the 53 weeks ended April 30, 2010, and for the 52 weeks ended April 24, 2009 and April 25, 2008. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
 
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
 
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Cyberonics, Inc. and subsidiary as of April 30, 2010 and April 24, 2009, and the results of their operations and their cash flows for the 53 weeks ended April 30, 2010, and for the 52 weeks ended April 24, 2009 and April 25, 2008, in conformity with U.S. generally accepted accounting principles.
 
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Cyberonics, Inc.’s internal control over financial reporting as of April 30, 2010, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated June 17, 2010 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.
 

 
/s/  KPMG LLP

Houston, Texas
June 17, 2010


 
 
F-2

 
CYBERONICS, INC. AND SUBSIDIARY

CONSOLIDATED BALANCE SHEETS


   
April 30, 2010
   
April 24, 2009
 
             
ASSETS
           
Current Assets:
               
Cash and cash equivalents
 
$
59,229,911
   
$
66,225,479
 
Restricted cash
   
1,000,000
     
1,000,000
 
Accounts receivable, net
   
26,185,143
     
22,250,653
 
Inventories
   
14,207,759
     
12,841,064
 
Deferred tax assets
   
12,126,758
     
9,804
 
Other current assets
   
2,495,019
     
2,206,902
 
Total Current Assets
   
115,244,590
     
104,533,902
 
Property and equipment, net
   
7,510,864
     
5,612,791
 
Intellectual Property, net
   
1,948,266
     
 
Deferred tax assets
   
29,624,489
     
406,336
 
Other assets
   
1,435,768
     
1,490,599
 
Total Assets
 
$
155,763,977
   
$
112,043,628
 
LIABILITIES AND STOCKHOLDERS' EQUITY
               
Current Liabilities:
               
Accounts payable
 
$
4,197,986
   
$
3,046,736
 
Accrued liabilities
   
19,127,267
     
14,598,504
 
Total Current Liabilities
   
23,325,253
     
17,645,240
 
Long-Term Liabilities:
               
Convertible notes
   
15,460,000
     
62,339,000
 
Deferred license revenue and other
   
6,119,077
     
7,647,544
 
Total Long-Term Liabilities
   
21,579,077
     
69,986,544
 
Total Liabilities
   
44,904,330
     
87,631,784
 
Commitments and Contingencies
               
Stockholders’ Equity:
               
Preferred Stock, $.01 par value per share; 2,500,000 shares authorized; no shares issued and outstanding
   
     
 
Common Stock, $.01 par value per share; 50,000,000 shares authorized; 28,611,475 shares issued and 27,699,911 shares outstanding at April 30, 2010; and 28,175,552 shares issued and 27,353,215 outstanding at April 24, 2009
   
286,115
     
281,755
 
Additional paid-in capital
   
268,038,251
     
258,519,876
 
Common stock warrants
   
25,200,000
     
25,200,000
 
Treasury stock, 911,564 and 822,337 common shares at April 30, 2010 and April 24, 2009, respectively, at cost
   
(18,528,989
)
   
(16,831,128
)
Accumulated other comprehensive loss
   
(63,797
)
   
(237,842
)
Accumulated deficit
   
(164,071,933
)
   
(242,520,817
)
Total Stockholders’ Equity
   
110,859,647
     
24,411,844
 
Total Liabilities and Stockholders’ Equity
 
$
155,763,977
   
$
112,043,628
 


See accompanying Notes to Consolidated Financial Statements


 
 
F-3

 

CYBERONICS, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF OPERATIONS


   
53 Weeks Ended
 
52 Weeks Ended
   
April 30, 2010
 
April 24, 2009
 
 April 25, 2008
Net sales
 
$
167,775,672
   
$
143,600,979
   
$
121,229,742
 
Cost of sales
   
20,907,595
     
20,040,636
     
21,092,374
 
Gross profit
   
146,868,077
     
123,560,343
     
100,137,368
 
Operating expenses:
                       
Selling, general and administrative
   
87,941,405
     
84,837,694
     
85,944,866
 
Research and development
   
22,064,800
     
19,732,941
     
22,421,199
 
Total operating expenses
   
110,006,205
     
104,570,635
     
108,366,065
 
Income (loss) from operations
   
36,861,872
     
18,989,708
     
(8,228,697
)
Interest income
   
92,602
     
1,235,757
     
3,844,508
 
Interest expense
   
(1,430,590
)
   
(3,394,837
)
   
(5,818,272
)
Gain on early extinguishment of debt
   
3,172,231
     
11,000,698
     
 
Other expense, net
   
(207,644
)
   
(381,265
)
   
(397,141
)
Income (loss) before income taxes
   
38,488,471
     
27,450,061
     
(10,599,602
)
Income tax expense (benefit)
   
(39,960,413
)
   
729,441
     
(264,837
)
Net income (loss)
 
$
78,448,884
   
$
26,720,620
   
$
(10,334,765
)
Basic income (loss) per share
 
$
2.83
   
$
1.00
   
$
(0.39
)
Diluted income (loss) per share
 
$
2.67
   
$
0.61
   
$
(0.39
)
Shares used in computing basic income (loss) per share
   
27,702,731
     
26,632,115
     
26,568,746
 
Shares used in computing diluted income (loss) per share
   
28,696,375
     
27,542,198
     
26,568,746
 



See accompanying Notes to Consolidated Financial Statements


 
 
F-4

 
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (DEFICIT) AND
COMPREHENSIVE INCOME (LOSS)

                                 
Accumulated
             
         
Additional
   
Common
   
Hedges on
         
Other
         
Total
 
   
Common Stock
   
Paid-In
   
Stock
   
Convertible
   
Treasury
   
Comprehensive
   
Accumulated
   
Stockholders’
 
   
Shares
   
Amount
   
Capital
   
Warrants
   
Notes
   
Stock
   
Income (Loss)
   
Deficit
   
Equity
 
Balance at April 27, 2007
   
26,701,054
   
$
267,011
   
$
265,608,804
   
$
25,200,000
   
$
(38,200,000
)
 
$
(9,993,200
)
 
$
(298,588
)
 
$
(258,646,256
)
 
$
(16,062,229
)
Cumulative Effect of Change in Accounting Principle
   
     
     
     
     
     
     
     
(260,416
)
   
(260,416
)
Balance at April 27, 2007
   
26,701,054
     
267,011
     
265,608,804
     
25,200,000
     
(38,200,000
)
   
(9,993,200
)
   
(298,588
)
   
(258,906,672
)
   
(16,322,645
)
Stock options exercised
   
491,064
     
4,910
     
6,388,226
     
     
     
     
     
     
6,393,136
 
Issuance of Common Stock under Employee Stock Purchase Plan
   
2,735
     
27
     
42,415
     
     
     
     
     
     
42,442
 
Issuance of Restricted Stock
   
575,100
     
5,751
     
(5,751
)
   
     
     
     
     
     
 
Cancellation of Restricted Stock
   
(57,705
)
   
(577
)
   
577
     
     
     
     
     
     
 
Purchase of Treasury Stock
   
     
     
     
     
     
(6,305,635
)
   
     
     
(6,305,635
)
Non-Cash Compensation Expense
   
     
     
11,063,306
     
     
     
     
     
     
11,063,306
 
Excise Tax Remediation
   
     
     
(309,126
)
   
     
     
     
     
     
(309,126
)
Net loss
   
     
     
     
     
     
     
     
(10,334,765
)
   
(10,334,765
)
Translation adjustment
   
     
     
     
     
     
     
549,982