10-K 1 d13606e10vk.htm FORM 10-K e10vk
Table of Contents



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

Form 10-K

     
[x]   ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
     
  For the Fiscal Year Ended December 31, 2003
     
  OR
     
[  ]   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: 0-10521

ADVANCED NEUROMODULATION SYSTEMS, INC.

(Exact name of registrant as specified in its charter)
     
Texas
(State or other jurisdiction of
incorporation or organization)
  75-1646002
(I.R.S. Employer Identification No.)
 
   
6501 Windcrest Drive, Plano, Texas
(Address of principal executive offices)
  75024
(Zip Code)

Registrant’s telephone number, including area code: (972) 309-8000

SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE EXCHANGE ACT:

         
Title of Each Class
  Name of Each Exchange on Which Registered
NONE
  NONE

SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE EXCHANGE ACT:

Title of Class

Common Stock, $.05 Par Value

     Indicate by checkmark 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 [x] No [  ]

     Indicate by checkmark if disclosure of delinquent filers pursuant to Item 405 of the 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. [  ]

     Indicate by checkmark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2) Yes [x] No [  ]

     Aggregate market value of the registrant’s Common Stock held by non-affiliates of the registrant as of June 30, 2003: $644,543,537

     Number of shares outstanding of the registrant’s Common Stock as of March 5, 2004: 19,998,791

DOCUMENTS INCORPORATED BY REFERENCE

     Portions of the registrant’s definitive Proxy Statement for the registrant’s 2004 Annual Meeting of Shareholders are incorporated by reference into Part III.



 


TABLE OF CONTENTS

PART I
ITEM 1. BUSINESS
ITEM 2. FACILITIES
ITEM 3. LEGAL PROCEEDINGS
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
PART II
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
ITEM 6. SELECTED FINANCIAL DATA
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
ITEM 11. EXECUTIVE COMPENSATION
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTSON FORM 8-K
Signatures
Appendix A
Appendix B
Appendix C
INDEX TO EXHIBITS
Sublease Agreement dated as of June 18, 2003
Fixed Price Contract dated as of December 17, 2003
Fixed Price Contract dated as of December 10, 2003
Standard Form of Agreement-Owner and Contractor
Standard Form of Agreement-Owner and Architect
Standard Form of Agreement-Owner/Construction Mgr.
Change Order dated as of August 27, 2003
Abbreviated Standard Form of Agreement
Change Order dated as of December 15, 2003
Change Order dated as of February 20, 2004
Code of Ethics
Subsidiaries
Consent of Independent Auditors
Certification of the CEO Pursuant to Rule 13a-14
Certification of the CFO Pursuant to Rule 13a-14
Certification of the CEO Pursuant to Section 906
Certification of the CFO Pursuant Section 906


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Advanced Neuromodulation Systems, Inc.

Annual Report

Form 10-K

Year Ended December 31, 2003

PART I

ITEM 1. BUSINESS

Overview

We design, develop, manufacture and market advanced implantable neuromodulation devices that improve the quality of life for people suffering from chronic pain. Neuromodulation devices include implantable neurostimulation devices, which deliver electric current directly to targeted nerves, and implantable drug pumps, which deliver small, precisely controlled doses of drugs directly to targeted sites within the body. Our products utilize innovative technologies that offer advanced programming features, user-friendly interfaces and smaller implanted devices, resulting in greater patient comfort. We are leveraging our neuromodulation product platforms to develop new pain management products and to expand into new applications.

We market our products to physicians who specialize in managing chronic pain. We define chronic pain as pain that persists or recurs for more than six months, is resistant to conservative therapies and significantly restricts a patient’s normal activities. There are approximately 3,000 pain management specialists in the U.S., approximately 80% of whom are anesthesiologists and approximately 20% of whom are neurosurgeons or orthopedic surgeons, and the number of pain management specialists is growing steadily.

In 2003, we acquired certain operations of our three remaining U.S. distributors who marketed our neuromodulation products in the United States. In March 2003, we acquired certain operations of Sun Medical, Inc. (Sun Medical), our largest distributor for approximately $4.9 million. In September 2003, we acquired certain operations of Comedical, Inc. (Comedical) for approximately $1.1 million. In November 2003, we acquired certain operations of our sole remaining distributor in the U.S., State of the Art Medical Products, for approximately $4.2 million. As part of these acquisitions, substantially all of the direct sales persons who represented our products joined us as direct employees. We believe that these acquisitions will strengthen our sales capabilities and allow us to focus the sales priorities of those personnel on our products, expand sales coverage in those former distributor territories and invest in customer and market development.

We currently market three principal product lines: our Renew® radio frequency (RF) system, our Genesis® and GenesisXP™ implantable pulse generator (IPG) systems and our AccuRx® implantable drug pump. We have sold Renew in the U.S. since June 1999 for treatment of chronic pain of the trunk and limbs. Renew’s advanced features effectively manage complex and multi-extremity pain patterns and provide pain management specialists with significant programming flexibility. We began selling Genesis in Europe in the first quarter of 2001 and in the U.S. and Australia in January 2002 for treatment of chronic pain of the trunk and limbs. We believe that Genesis offers a superior size-to-function ratio, greater patient comfort, more flexibility in addressing different pain patterns and other technological advances, which provide us with a competitive advantage. Additionally, we received

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approval from the U.S. Food and Drug Administration (FDA) in July 2002 to market an enhanced version of Genesis, the GenesisXP IPG system for treatment of chronic pain of the trunk and limbs, which we launched in the U.S. in the fourth quarter of 2002. The GenesisXP offers substantially more battery capacity than Genesis, resulting in enhanced longevity and/or additional power to treat more complex pain. We began selling AccuRx in certain international markets in the second quarter of 2001 and in 2003 completed all implants in a 109 patient clinical trial we conducted of AccuRx in the U.S. under an investigational device exemption (IDE) from the FDA. AccuRx is smaller than the other constant rate drug pumps currently on the market, and it incorporates a new polymeric diaphragm technology that makes it more precise under varying conditions than other constant rate drug pumps. We filed our pre-market approval (PMA) application for AccuRx with the FDA in December 2003.

Our Hi-tronics Designs, Inc. (HDI) subsidiary designs and manufactures medical devices for us, and for other companies on an O.E.M. (original equipment manufacturer) basis. HDI’s core strength is in developing highly sophisticated electromechanical devices featuring electronic circuits with very low power requirements. The acquisition of HDI allowed us to leverage its expertise in development and manufacturing and benefit from its technology platforms.

We were incorporated in the State of Texas on May 2, 1979.

The Neuromodulation Market Opportunity

When treating patients suffering from chronic pain, pain management specialists can select from several therapy options, ranging from the least invasive and lowest-cost therapies to the most aggressive and expensive therapies. Initially, patients typically try over-the-counter medications and physical therapy. If these therapies fail, patients generally try some combination of prescription medications, TENS therapy (application of electrical impulses to the skin), psychological therapy and nerve blocks (injections that provide temporary pain relief). If these therapies do not succeed in relieving pain, patients may then try narcotic and opioid drugs, neurolysis (destruction of the affected nerve) and thermal procedures. At some point during their course of treatment, patients may use neuromodulation products or undergo more invasive surgical procedures.

Patients who opt for neurostimulation or drug pumps to treat chronic pain typically range in age from 25 to 55, have suffered back or neck injuries or otherwise suffer from degenerative spine conditions, and are in constant pain that has not been alleviated by other therapies, including back surgeries. A growing number of patients are choosing neuromodulation over prolonged systemic use of narcotic or opioid drugs, which have negative side effects, or back surgeries involving vertebral fusion or nerve destruction, which are irreversible and often unsuccessful.

The use of neuromodulation devices to manage chronic pain is growing rapidly. According to an independent study, spinal cord stimulation products were forecasted to account for $357.0 million in revenues in 2003 in the United States, up from $293.2 million in 2002. Total neurostimulation revenues for all currently approved indications in the U.S. (including deep brain stimulation, sacral nerve stimulation and other applications) were forecasted to account for $553.4 million in 2003, up from $435.7 million in 2002, according to the same study. A separate study forecasted that in 2002 worldwide sales of drug pumps were approximately $270 million.

The primary factors driving this growth include the following:

    Increased physician and patient awareness of the benefits of neuromodulation. Neuromodulation can manage pain effectively, is minimally invasive, has few side effects and is generally reversible. As physicians and their patients are becoming more aware of these benefits and more accepting of this treatment option, neuromodulation is being used earlier in the process of managing chronic pain. Consequently, the number of pain management specialists worldwide

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      who understand and are trained to use neuromodulation products and techniques is growing steadily.

    Expanded indications for the use of neuromodulation products. Neuromodulation products have demonstrated success in the treatment of indications outside of chronic pain. Other companies have recently received regulatory approvals to use these products to address new indications, including essential tremor, Parkinson’s Disease, and incontinence, and future approvals are expected for angina and severe headaches, which should expand the neuromodulation market.

    Technological advances in neuromodulation products. Advances in technology have decreased the size of neuromodulation devices, increased the longevity of their power sources and enhanced programmability and other functional components of the devices, leading to better results for patients.

    Patients’ increased focus on quality of life. In the past, chronic pain sufferers were often resigned to long-term use of pain-killing drugs, often bedridden and unable to maintain a normal lifestyle. Today, many chronic pain patients hope to resume an active lifestyle following an injury or illness, and thus are more likely to consider and accept neuromodulation therapy.

Our Strategy

Our objective is to be a leading provider of a full range of innovative neuromodulation devices for the management of chronic pain and nervous system disorders. To achieve this objective, we are pursuing the following business strategies:

    Expand our presence in the chronic pain market. Through the recent launches of our IPG systems, we have entered a market that is estimated to be nearly five times larger than the RF market, and thus significantly expanded our potential market opportunity. We intend to continue increasing our penetration of the chronic pain market by enhancing our sales and marketing resources. We also intend to leverage our relationships with pain management specialists as well as our favorable track record with our RF systems to grow our market share in the IPG portion of the neurostimulation market and to further strengthen our position in the RF portion of this market.

    Pursue regulatory approvals for new treatment indications. We believe our neurostimulation technology platforms have broad applicability for multiple treatment indications beyond chronic pain conditions. We will pursue regulatory approvals for new clinical applications to treat disorders affecting large patient populations, including essential tremor, Parkinson’s Disease, pelvic pain and severe headaches, where neuromodulation has demonstrated success.

    Continue to build and expand our technology leadership. We have focused on building a corporate infrastructure and core competency in research and development, manufacturing, sales and marketing, reimbursement and regulatory affairs to provide our customers with the highest quality products and services. We believe this strategy will enable us to expand our existing product platforms into new applications and product offerings. We will continue to invest significant resources in the development of our infrastructure and technology platforms to maintain our reputation as a leader in the neuromodulation market.

    Evaluate and pursue acquisitions and strategic alliances. We will pursue acquisitions and strategic alliances that complement our existing neuromodulation business, products and technology platforms and that enhance our product development, and our technological and marketing capabilities.

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Our Products

Within the neuromodulation market, there are two main categories of treatment: neurostimulation, in which an implanted device delivers electrical current directly to targeted nerve sites, and implantable drug pumps, in which an implanted pump delivers drugs directly to a targeted site. We currently market products in both of these treatment categories.

Neurostimulation Therapy Overview

Neurostimulation involves delivering small, mild electrical pulses to the spinal cord or peripheral nerves to inhibit or block the sensation of pain. This stimulation of nerves at or near the site where pain is perceived masks the sensation of pain by generating a tingling sensation or “paresthesia.” Neurostimulation is generally used to manage sharp, intense and constant pain arising from nerve damage or nervous system disorders.

A neurostimulation system typically consists of a pulse generator that produces electrical current, and an external or internal power source. The pulse generator is generally implanted under the patient’s skin in the abdominal area. Leads, which are catheters that contain electrodes and connecting wires, extend from the pulse generator to the targeted therapy site in the epidural space along the spinal cord. The electrodes are centered on the therapy site and deliver electrical current from the pulse generator to the prescribed area. An external programmer allows the physician and patient to adjust the electrical current to the electrodes to optimize the therapeutic effect.

Implant procedures are most often performed at hospitals on an outpatient basis, with a small percentage of procedures also performed at ambulatory surgery centers and at hospitals on an inpatient basis. In most cases, a patient will receive a trial device for a period of up to two weeks. Based on our experience, more than 70% of patients who undergo a trial procedure elect to receive a permanent implant. Implant procedures cost between $30,000 and $50,000, including the cost of the system. The cost of the system generally ranges from $10,000 to $20,000, depending on whether an IPG or RF system is used, the components utilized and the sophistication of the system selected.

Clinical results demonstrate that the majority of patients who are implanted with a neurostimulation system experience a substantial reduction in pain, an increase in activity level, a reduction in use of narcotics and a reduction in hospitalization. We believe these benefits translate into an overall reduction in healthcare costs as well as a significant improvement in the patient’s quality of life.

Our Neurostimulation Products

We currently have two neurostimulation product platforms that we market worldwide: our Renew RF system, which uses an external power source, and our family of totally implantable IPG systems, Genesis and GenesisXP.

Renew

Renew is the latest generation system in our RF stimulation product line, which we believe is the leading technology in the RF stimulation market. We introduced Renew in the U.S. during June 1999 and began selling it in international markets during 2000. The Renew system consists of an implanted RF receiver/pulse generator and leads, and a transmitter containing a power source that is worn externally. The system is powered with the help of an antenna that is attached to the patient’s skin with adhesive tape. Because Renew has a rechargeable, external power source, we believe it is best suited for patients with complex, changing or multi-extremity pain patterns that require higher power levels for treatment.

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Genesis

In late 2000, we received regulatory approvals to begin selling our Genesis IPG system in certain international markets, and we commenced sales during the first quarter of 2001. In November 2001, we received FDA approval of Genesis for treatment of chronic pain of the trunk and limbs, and we launched Genesis in the U.S. in January 2002. Additionally, we received approval in July 2002 from the FDA to market an enhanced version of Genesis, the GenesisXP IPG system for the treatment of chronic pain of the trunk and limbs, which we launched in the U.S. in the fourth quarter of 2002. The GenesisXP offers substantially more battery capacity than Genesis, resulting in enhanced longevity and/or additional power to treat more complex pain. As a result, we now participate in the largest part of the implantable neurostimulation market, as approximately 80% of neurostimulation implantation procedures performed involve IPG systems and the remainder involves RF systems.

Like other IPGs, Genesis is totally implanted and contains a power source with a life of two to five years, depending on stimulation parameters. Generally, simple, localized pain sufferers require less power output than complex, multi-site pain sufferers. These patients and their physicians will usually select an IPG in order to benefit from the convenience of a totally implantable system.

Our Neurostimulation Technologies

Although our Renew and Genesis systems differ in certain significant respects, they share similar technology platforms and benefits, including:

    Greatest number of electrodes. Our Renew system is the only product on the market that can accommodate up to 16 electrodes. In addition, our IPG systems not only allow the use of two 4-electrode leads, but also allow the use of one 8-electrode lead. A greater number of electrodes results in more comprehensive coverage along the spine, and provides physicians with increased flexibility in accommodating a patient’s changing pain patterns. This advantage can, in some cases, also enable a physician to address the problem of lead “migration”, or lead movement along the spine after implant, noninvasively by reprogramming the patient’s stimulation, rather than using an invasive procedure to revise the placement of the lead. We estimate that lead migration occurs in 10% to 15% of cases.

    Advanced programmability. Our Renew, Genesis, and GenesisXP systems feature MultiStim technology. This technology allows clinicians to create multiple stimulation programs, which can be delivered rapidly and sequentially to cover complex pain patterns. These systems also feature PC-Stim, which enables patients to select from a number of clinician-prescribed stimulation programs to optimize treatment as their pain patterns change. Additionally, we have also developed PainDoc®, a proprietary, Windows-based computerized support system, and Rapid Programmer™, a palm-sized programming tool, which facilitate programming and therapy management.

    Innovative and patented technology. Our neurostimulation devices offer our advanced patented technology, which allows programmability of each individual electrode to a “tri-state” position, either positive, negative or neutral. This provides added flexibility in directing the flow of stimulation and is a valuable tool in addressing lead migration.

    Reduced size of implanted device. Our Renew receiver, our Genesis IPG and GenesisXP offer smaller “size-to-power” ratios than comparable products currently on the market, which results in enhanced patient comfort.

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    Ease of lead implantation. Our leads are designed for ease of implantation, which makes the procedure easier for physicians to perform and reduces the time required to complete the procedure.

    User-friendly interface. Our neurostimulation devices have easy-to-use controls and interactive displays that include a stimulation diagram for quick visual confirmation of stimulation coverage.

The following table summarizes some of the key features of the Renew and Genesis systems:

         
PRODUCT FEATURES
  RENEW
  GENESIS
Implanted Elements
  Receiver/pulse
generator, leads
  Pulse generator/power
supply, leads
 
       
External Elements
  Programmer,
transmitter/power
supply, antenna
  Programmer
 
       
Battery
  External, rechargeable
and replaceable
  Internal with 2-5 year
life, depending on
program settings and
system use
 
       
Programming Control
  Up to 24 programs, plus some patient
control
  Up to 24 programs
 
       
Lead and Electrode
Capacity
  1 to 4 leads utilizing up to 16 electrodes   1 or 2 leads utilizing up
to 8 electrodes

Our Implantable Drug Pump Product — AccuRx

Implantable drug pumps deliver precise doses of medication directly to a targeted site. This direct drug delivery creates a higher drug concentration at the site, which can often provide faster relief with much lower quantities of medication. For example, the difference in intraspinal versus oral morphine dosage is approximately 1:300. These lower dosages help to minimize side effects, and are more economical for the patient and the third-party reimbursement system. Today, implantable drug pumps are used for the delivery of morphine for the treatment of pain (such as cancer pain), baclofen for spasticity and other movement disorders, and for the intra-arterial delivery of various drugs for chemotherapy.

Implantable drug pumps consist of the pump and a catheter. The pump contains a reservoir that holds the drug and regulates the drug’s delivery rate. The pump is implanted under the skin in the abdominal area and is connected to the catheter, which is tunneled under the skin into either the epidural or intrathecal space of the spinal column. Implantation procedures are most often performed at hospitals on an outpatient basis, with a small percentage of procedures also performed at ambulatory surgery centers and at hospitals on an inpatient basis. The pump is refilled by placing a needle through the skin into an access port on the pump and injecting the drug into the reservoir.

Currently, there are two basic types of implantable drug pumps — constant rate and programmable. Constant rate pumps provide drug infusion at a single, continuous flow rate that cannot be changed once the pump has been implanted in the patient. Programmable pumps allow the rate of drug delivery to be non-invasively changed to meet the patient’s needs. According to an industry report, worldwide

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sales of programmable drug pumps in 2002 were forecasted to be approximately $243 million, as compared with worldwide sales of constant rate drug pumps of $27 million.

We currently offer one drug pump product, our AccuRx constant rate drug pump. We received regulatory approvals to distribute AccuRx in certain international markets for the delivery of morphine and began selling AccuRx in those markets in the second quarter of fiscal 2001. We also received an IDE from the FDA to initiate clinical trials in the U.S. for the delivery of morphine. The clinical trials included 15 sites and 109 patients, all of whom have now been implanted with AccuRx systems. We filed our PMA application with the FDA in December 2003, and must receive approval from the FDA before we can market AccuRx within the United States. We currently expect a late 2004 or early 2005 launch of AccuRx within the United States, assuming the FDA approves our PMA application.

AccuRx is currently the only constant rate drug pump that is powered by our proprietary polymeric diaphragm, rather than by pressurized gas in a chamber surrounding the drug reservoir. The advantages of this design are that our pump is more precise under varying conditions (because its operation is not affected by changes in the body’s temperature or pressure), simpler to manufacture, smaller than other drug pumps on the market and can hold more drug for its size than competing products.

Financial Segments

We operate in two business segments. The Neuro Products segment designs, develops, manufactures and markets implantable medical devices that are used to manage chronic intractable pain and other disorders of the central nervous system through the delivery of electrical current or drugs directly to targeted nerve fibers. The HDI O.E.M. segment provides contract development and O.E.M. manufacturing of electro-mechanical devices. See Note 12 to the Consolidated Financial Statements for segment financial data for the years ended December 31, 2003, 2002 and 2001.

Sales and Marketing

General

We target our sales and marketing efforts at pain management specialists, which include anesthesiologists, neurosurgeons and orthopedic surgeons. Because most pain management specialists implant both RF and IPG devices, as well as drug pumps, we expect to leverage our relationships and experience with pain management specialists and track record with our RF systems to establish our position in the IPG portion of the neurostimulation market. Additionally, by rounding out our product offerings with our IPG systems, we are now able to target physicians who have historically implanted only IPGs.

In 2003, we derived 93% of our net revenues for neuromodulation products from domestic sales and approximately 7% from international sales.

U.S.

With our acquisitions of certain operations of our remaining three domestic distributors in 2003, we have expanded our domestic sales force. In the U.S., we currently use a hybrid sales force, which now consists of 55 direct sales employees and 37 commissioned sales agents. We typically have contracts with all of our sales agents that provide for exclusive territories and sales quotas.

Our sales agents cover defined geographic territories and focus predominantly on the pain management market. Many of our sales agents sell our products as their flagship product line. We pay

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our sales agents commissions at contractual rates, and we invoice and collect revenues from end users.

We employ 26 clinical specialists, who support our direct and commissioned sales agents by providing intra-operative technical and clinical assistance and post-operative programming support.

In addition, we employ eight regional sales managers who interact with our customers and oversee our commissioned sales agents and direct sales employees, a Director of North American Sales and a Vice President of North American Sales, who both coordinate the sales efforts of our distribution network in North America.

Our domestic marketing programs include:

    medical marketing programs intended to educate physicians and their staffs about our products and their use;

    surgical training programs offered to physicians interested in improving their surgical techniques;

    education materials, such as brochures and videos, to educate patients and physicians;

    reimbursement assistance, with the help of outside consultants, to assist physicians in obtaining appropriate reimbursement for our products and their services;

    consulting relationships with opinion leaders who provide us feedback about our current and future products, diagnostic and treatment trends and other areas of interest;

    web site marketing focused on educating both physicians and patients about our product alternatives, reimbursement for our procedures and our company;

    medical journal advertisements; and

    involvement in medical device societies and conferences.

International

Internationally, we market our products through 20 independent distributors who represent us in 26 countries. We are represented by direct salespersons employed by us in Germany. Our Director of International Operations, who is based in the United Kingdom, manages our international distribution network. We are in the process of training and signing independent distributors to market our products in additional countries.

Customer Service

Our sales representatives and clinical specialists are responsible for training physicians and nurses on programming and trouble-shooting any problems with our RF and IPG systems. Both the RF and IPG systems have up to 24 different program settings, which can be programmed and saved into memory. Therefore, significant training of physicians and nurses is required for new users of our products. We typically provide a warranty against defects in workmanship and materials for one year from the date of sale of our products to end-users.

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Major Customers

During 2003, we had no customer with net sales greater than 10% of net revenue for our Neuro Products segment. During 2002 and 2001, we had one customer that accounted for 10% or more of our net revenue from our Neuro Products segment. Sun Medical, a specialty distributor, accounted for $6.3 million, or 13.5% of our Neuro Products segment revenue for the year ended December 31, 2002 and $4.2 million, or 15.3% of our Neuro Products segment revenue for the year ended December 31, 2001. In March 2003, we acquired certain operations of Sun Medical and hired substantially all of the salespeople who had accounted for sales of our Neuro Products. See Note 3 to the Consolidated Financial Statements.

During the year ended December 31, 2003, we had two customers that together accounted for $9.84 million, or 88.8% of net revenue of our HDI O.E.M. segment. Medtronic, Inc. (Medtronic), our most significant competitor, accounted for $8.40 million, or 75.8%, and Arrow International, Inc. (Arrow) accounted for $1.44 million, or 13.0%. During the year ended December 31, 2002, we had two customers that together accounted for $9.52 million, or 89.3% of net revenue of our HDI O.E.M. segment. Medtronic accounted for $6.74 million, or 63.2%, and Arrow accounted for $2.78 million, or 26.1%. During the year ended December 31, 2001, we had three customers that collectively accounted for 10% or more of net revenue of our HDI O.E.M. segment. Medtronic accounted for $6.3 million, or 60.3%, Arrow accounted for $1.8 million, or 17.2%, and Transneuronix, Inc. accounted for $1.1 million, or 10.5%.

HDI currently manufactures two products for Medtronic, one of which accounts for substantially all of the revenue generated from this customer. This product is manufactured under an exclusive Supply Agreement that expires on January 1, 2005. The terms of the Supply Agreement require Medtronic to purchase its requirements for the device from us through March 31, 2004 and then at least 50% of its requirements through January 1, 2005. The device is sold in the cardiology market and is not competitive with any of our products. The Supply Agreement provides that either party may terminate the agreement prior to January 1, 2005 in the event of a material breach or nonperformance. Additionally, Medtronic can terminate the Supply Agreement prior to January 1, 2005 by paying us a termination fee. Medtronic has indicated its desire to extend the agreement and HDI and Medtronic are currently discussing the terms of a new supply agreement. Arrow engaged HDI in October 2000 to develop several products for a new cardiology system under a Product Development and Manufacturing Agreement. Development is likely to be completed during the first half of 2004. At the conclusion of the development, Arrow will likely seek PMA approval from the FDA to market and sell the system. Under the agreement with Arrow, HDI has ongoing exclusive rights to manufacture the products for clinical trials and subsequent market release if the system is approved, until Arrow meets certain purchase minimums.

Research and Development

We currently have an in-house research and development staff of 70 people. In 2003, we spent $9.53 million (10.5% of total net revenue) on research and development and clinical trials, and we expect to increase our investment in research and development and clinical trials for 2004 to approximately $12 million. In 2002 and 2001, we spent $5.84 million (10.2% of total net revenue) and $4.93 million (13.0% of total net revenue), respectively, on research and development and clinical trials.

Our current research and development efforts include work on the following:

    An IPG stimulation system to address migraine headaches. During the first quarter of 2001, we initiated a pilot clinical study in the U.S., which consisted of 10 patients at 2 sites, to evaluate the efficacy of Genesis for treating migraine headaches. We completed the pilot study during the second quarter of 2002, and the data will be used to determine the parameters for a larger pivotal

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      clinical study to support a PMA application for Genesis to treat migraine headaches. There are approximately one million patients in the U.S. alone who suffer from migraine headaches. We plan to initiate clinical trials in 2004 for migraine headaches upon approval of an IDE by the FDA.

    IPG stimulation systems for deep brain stimulation to address essential tremor, Parkinson’s Disease and other indications. We plan to initiate clinical trials in 2004 for deep brain stimulation to treat essential tremor and Parkinson’s Disease upon approval of an IDE by the FDA.

    Exploring new applications of our neurostimulation systems to address angina, peripheral vascular disease and sacral nerve stimulation for pelvic pain and incontinence.

    Next-generation IPG and RF neurostimulation systems.

    Next-generation drug pumps, including a prototype programmable pump that will take several years to develop, and new applications for drug pumps.

    Clinical trials that we expect to initiate on several of our new products upon IDE approval from the FDA.

Hi-tronics Designs, Inc.

Our HDI subsidiary developed and is the manufacturer of our Genesis IPG and GenesisXP IPG, and is also the manufacturer of the transmitter used with Renew. HDI’s core strength is in developing highly sophisticated electromechanical devices featuring electronic circuits with very low power requirements, utilizing both discrete and highly integrated technology. Combined with our capabilities in the design and manufacture of implantable leads, electronic device control and communication systems and implantable drug pumps, we believe this expertise allows us to develop more sophisticated products in less time.

As an O.E.M. manufacturer, HDI has developed and introduced more than 60 medical devices for leading medical device companies in the fields of cardiology, neurology and orthopedics. Through HDI, we offer our customers complete development and manufacturing services, beginning with product definition and design and continuing through validation, prototyping, regulatory approval and manufacturing. In 2003, our HDI O.E.M. operations accounted for 12.2% of our consolidated revenues. We expect revenue at HDI to grow modestly and we expect the percentage of HDI O.E.M. revenue to our total revenue to decrease further as our neuromodulation sales continue to grow and as we continue to utilize more of HDI’s manufacturing and development capabilities for our own needs. We currently use approximately 55% of HDI’s manufacturing capacity to supply products on an intercompany basis.

Manufacturing

We operate two manufacturing facilities: one in Plano, Texas and the other in Hackettstown, New Jersey. We assemble and package the majority of our neurostimulation devices and implantable drug pumps at our Plano facility. We also manufacture a variety of medical devices and products on an O.E.M. basis in our Hackettstown facility.

Our manufacturing processes largely consist of the assembly of standard and custom components that we purchase from third-party subcontractors, functional testing to ensure adherence to specifications and inspection of completed products, and the manufacture of our own leads and drug pumps. Our implantable devices are assembled and sterilized in a “clean room” environment designed and maintained to reduce product exposure to particulate matter.

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We rely on third-party suppliers for most of our products’ components and on single suppliers for several critical components used in our main products, including the computer chip used in the receiver of our RF system, the computer chip used in the IPG programmer and Renew transmitter, the batteries used in our IPG systems and the medical-grade polyurethane (bionate) that we and our competitors use in our products. We have been notified by the supplier of the computer chip used in the receiver of our RF system that at some point in the future it intends to cease manufacturing and supplying the computer chip, but to date it has not determined when this will occur. This supplier has agreed to allow us to place a final one-time purchase order for the computer chip. In the interim, we are maintaining a higher than normal inventory of the computer chip and are working to develop a new product design that uses an alternative computer chip. We currently have enough of the chips in stock to meet our projected requirements through the end of 2005.

We currently have sufficient manufacturing capacity to support our business plan, and we plan to relocate our Plano facilities to our new corporate headquarters in mid-2004 which will increase our capacity. See Item 2 “Facilities”. We have no backlog.

Intellectual Property

We rely on a combination of patents, trade secrets, know-how, trademarks and agreements to protect our intellectual property. We currently own or hold exclusive field of use licenses to 33 U.S. and 8 foreign patents relating to our stimulation systems’ electrode, receiver, transmitter and programmer technology and our fully implantable drug pump technology. These and other co-owned and non-exclusively licensed patents cover important aspects of both our RF and IPG stimulation systems for a wide range of current and future applications. We currently have 52 pending U.S. patent applications and over 18 pending foreign patent applications. These pending patent applications cover new stimulation lead technology, methods of using our products to address specific indications, implant accessories, improved connector mechanisms and implantable drug delivery technology.

U.S. Patent No. 4,793,353 covers a non-invasive multiprogrammable tissue stimulator and method wherein only the programming data need be transmitted. The programming data may define the stimulator’s electrode selection, electrode polarity as either positive, negative or high impedence state, and simulation pulse parameter. This patent is scheduled to expire on December 27, 2005. The expiration of this patent may allow competitors to offer programmable stimulators that define electrode selection, polarity and stimulation pulse parameters, and thus could have an adverse effect on our business. A request for an extension of the term of this patent has been filed with the United States Patent Office pursuant to a federal statute that permits us to seek such an extension based on a regulatory approval delay. A final ruling on the extension request has not been made at the present time. While five other U.S. patents owned or licensed by us are due to expire prior to 2006, the expiration of these other patents would not have a material effect on our ability to protect the intellectual property rights currently utilized in our business, because the patents cover technologies that are not currently utilized in our existing products or services.

We have developed technical knowledge, which, although non-patentable, we consider to be significant in enabling us to compete. However, the proprietary nature of such knowledge may be difficult to protect. We have entered into agreements with each of our key employees prohibiting them from disclosing any of our confidential information or trade secrets or engaging in any competitive business (as defined in the agreements) while the employee is working for us and for a period of one year thereafter. In addition, these agreements also provide that any inventions or discoveries by these individuals relating to our business will be assigned to us and become our sole property.

We own a number of U.S. trademark registrations, including AccuRx®, Advanced Neuromodulation Systems®, ANS & Design®, PainDoc®, Renew®, and Genesis®. U.S. trademark applications are pending for various trademarks that we believe have, or will have, value in the marketplace, including

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Life Gets Better™. We also own trademark registrations and applications in countries outside of the U.S. One of our trademarks, “Quattrode,” is due to expire prior to 2006. Two trademarks, PC-Stim® and Compustim®, will require a Section 8 statement of use prior to 2006. We intend to renew the trademarks prior to their expiration and retain our trademark registration rights.

Competition

We are a small company competing in a large and rapidly growing market. We believe that the principal competitive factors in the neuromodulation market are the quality, performance, cost-effectiveness, ease of use, customer service and technical innovation of neuromodulation devices and the existence and benefits of cost-effective alternative therapies.

Our only significant competitor at this time in the neurostimulation market is Medtronic, one of the world’s largest medical device companies, which has substantially greater resources and marketing power than we do. The neuromodulation market is one of Medtronic’s fastest growing segments. Competitive pressures could increase in the future as Medtronic attempts to secure and grow its position in the neuromodulation market. In the constant rate drug pump portion of the market, our principal competitors are Medtronic and Johnson & Johnson.

We believe the neuromodulation market is a high growth-potential market and that other companies are attempting and will attempt in the future to bring new products or therapies into this market. Barriers to entry by new competitors are high, due to a long and expensive product development and regulatory approval process and the intellectual property and patent positions existing in the market. However, other medical device companies may be able to enter the neuromodulation market by leveraging their existing technologies into neuromodulation platforms, thereby decreasing the time and resources required to enter the market. For example, Advanced Bionics, Inc., a privately held California-based company that currently manufactures and markets a cochlear implant, has publicly stated that it is developing and may be testing an IPG system for the treatment of chronic pain.

Government Regulation

In the U.S., we are subject to regulation by numerous governmental authorities, principally the FDA. The research and development, manufacturing, promotion, marketing and distribution of our products in the U.S. are governed by the Federal Food, Drug and Cosmetic Act and the regulations promulgated thereunder (the FDC Act and Regulations). We are subject to inspection by the FDA for compliance with the procedures set forth in the FDC Act and Regulations. Both of our manufacturing operations are required to comply with the FDA’s Quality System Regulations, commonly referred to as QSR. QSR addresses design controls and methods, facilities and quality assurance controls used in manufacturing medical devices.

The FDA has traditionally pursued a rigorous enforcement program to ensure that regulated entities comply with the FDC Act and Regulations. A company not in compliance may face a variety of regulatory actions, including warning letters, product detentions, device alerts, mandatory recalls or field corrections, product seizures, rescission of marketing permits, injunctive actions or civil penalties and criminal prosecutions of the company or responsible employees, officers and directors. The FDA last inspected our Plano facility in 2003 and our Budd Lake and Hackettstown facilities in 2002, and no Inspectional Observations were found at any of these locations.

The process of obtaining FDA clearance can be lengthy, expensive and uncertain. Under the FDA’s requirements, a new medical device cannot be released for commercial use until a PMA application has been filed with the FDA and the FDA has approved the device’s release. If a manufacturer can establish that a newly developed device is “substantially equivalent” to a legally marketed device, the manufacturer may seek marketing clearance from the FDA to market the device by filing a 510(k)

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premarket notification with the FDA, which usually takes less time to receive than a PMA clearance. Either a 510(k) or a PMA, if granted, may include significant limitations on the indicated uses for which a product may be marketed, and FDA enforcement policy strictly prohibits the promotion of approved medical devices for unapproved uses. In addition, product approvals can be withdrawn for failure to comply with regulatory requirements or the occurrence of unforeseen problems following initial marketing. Although all of our currently marketed products, with the exception of our Genesis and GenesisXP IPGs, have been the subject of successful 510(k) submissions, we believe that because the products we are currently developing are more innovative, some of these products will require us to undertake the lengthier and more costly PMA submission process.

On October 26, 2002, President Bush signed The Medical Device User Fee and Modernization Act of 2002 (MDUFMA), amending the FDC Act. Under MDUFMA, we and other medical device manufacturers with gross sales or receipts of $30 million or more are required to pay a user fee to the FDA for PMA and 510(k) reviews. According to the FDA, the user fees provided by MDUFMA, and the additional appropriations that go with the new law, are intended to ensure that safe and effective medical treatments will reach patients more rapidly, provide greater certainty that manufacturers will receive timely, high quality reviews, and provide resources to ensure that devices marketed in the United States continue to meet high standards for safety and effectiveness.

On August 1, 2003, the FDA announced the fee rates and payment procedures for medical device user fees for 2004. The fee for a PMA application increased to $206,811 from $154,000 in 2003 and the fee for a 510(k) application increased to $3,480 from $2,187 in 2003. Fees for supplements in 2004 will range from $14,890 to $206,811, depending on the type of supplement, compared to $11,088 to $154,000 in 2003. The FDA adjusts these fees annually to account for inflation, changes in workloads, and other factors and announces the new fees for the next fiscal year in a Federal Register notice by August 1 of each year. While we do not anticipate that compliance with MDUFMA will have a material adverse effect on our financial results, MDUFMA increases the cost of regulatory compliance.

Under FDA guidance statements, we will be required to track our AccuRx implantable drug pump when it is approved by the FDA for commercial distribution in the U.S. Prior to commercial distribution in the U.S., we will establish written procedures for tracking our drug pumps in accordance with FDA’s guidance statements.

Medical device laws are also in effect in many of the countries outside the U.S. in which we do business. These laws range from comprehensive device approval and quality system requirements for some or all of our products to simpler requests for product data or certifications. The number and scope of these requirements are increasing and, as we expand our business into new jurisdictions, we will be subject to additional laws. In June 1998, the European Union Medical Device Directive became effective, and all medical devices sold in Europe must now meet the Medical Device Directive standards and receive CE Mark certification. CE Mark certification involves a comprehensive quality system program and submission of data on a product to the Notified Body in Europe. The Medical Device Directive and the ISO 13485 standard are recognized international quality standards that are designed to ensure that companies develop and manufacture quality medical devices. Our Plano facility was audited in 2003, and our Budd Lake and Hackettstown facilities were audited in 2003, for compliance with the Medical Device Directive and ISO 13485, and all three facilities are certified to these standards.

The financial arrangements through which we market, sell and distribute our products are subject to federal and state laws and regulations in the U.S. with respect to patients who are Medicare or Medicaid beneficiaries. These laws include “fraud and abuse” and physician anti-referral laws and regulations. Violations of these laws and regulations may result in civil and criminal penalties, including substantial fines and imprisonment. In a number of states, the scope of fraud and abuse or physician anti-referral laws and regulations, or both, have been extended to include all patients, as opposed to just Medicare and Medicaid beneficiaries. Additionally, our financial arrangements with our customers may be subject to increasing regulation in the future, due to proposed health reform initiatives. Although we do not believe that we will need to undertake any significant expense or modification to our manufacturing operations or the conduct of our business to comply with current or proposed federal or state fraud and abuse or physician anti-referral laws or regulations, if we do not comply with

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any such laws or regulations, our business practices could be adversely affected, and we may also be affected in other respects not presently foreseeable that could have an adverse impact on our business, financial condition and results of operations.

Third-Party Reimbursement

Hospitals and ambulatory surgery centers are the primary purchasers of neuromodulation products. These primary purchasers then bill various third-party payors for the neuromodulation products and procedures they provide to their patients. In the U.S., these third-party payors include Medicare and Medicaid, private insurance companies and managed care organizations, and workers’ compensation programs. Third-party payors carefully scrutinize whether to cover new products and the level of reimbursement for covered products, and coverages and reimbursement levels for neuromodulation products vary among these three primary purchasing groups and the healthcare setting in which physicians perform procedures, and change from year to year. In some cases, we bill Medicare and Medicaid, private insurance companies and managed care organizations, and workers’ compensation programs directly and pursue reimbursement for our products.

Internationally, reimbursement levels and coverages for neuromodulation products vary significantly among the countries in which we do business due to the wide variety of health care payment systems in these countries, which include both government-sponsored health care and private insurance.

We currently employ 13 individuals within our sales and marketing department who work solely on issues related to third-party reimbursement. The responsibilities of these employees include assisting and training physician practices and medical facility staffs in obtaining pre-authorization and confirmation of amount of reimbursement for our products, working with third-party payors as they periodically evaluate reimbursement coverages and levels, and communicating updates on reimbursement information to our sales force.

Employees

As of March 5, 2004, we employed 437 full-time employees, including 70 in research and development, 128 in sales and marketing (including support personnel), 202 in manufacturing and related operations, and the remainder in executive and administrative positions. None of our employees are represented by a labor union and we consider our employee relations to be good.

Website and Availability of SEC Reports

Our website is located at www.ans-medical.com. We post our most recent annual report on Form 10-K, quarterly reports on Form 10-Q filed subsequent to our most recent annual report on Form 10-K, Forms 8-K, all amendments to those reports, and certain other SEC filings on our website under the heading Investors/Financial Information and SEC Filings. We make other SEC filings available through our website free of charge by way of a link to www.sec.gov under the heading “Click here for a list of our SEC filings.”

ITEM 2. FACILITIES

We entered a 63-month lease agreement, which became effective on June 1, 1999, for our 40,000 square foot corporate headquarters and manufacturing facility in Plano, Texas. In September 2002, we amended our lease agreement to add approximately 9,700 square feet of office space located in the same complex. The lease on the additional space as well as the corporate headquarters facility expires in August 2004. We have two five-year renewal options on the facilities. In addition, in June 2003, we entered into a sublease agreement to add approximately 9,800 square feet of office space located in the same complex. The term of the sublease expires on July 31, 2004. We expect to vacate these three spaces during mid-2004.

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Because we expect our business to continue to grow at rates that will demand added office and facility space, we acquired approximately 10 acres of land in December 2002 for approximately $3.19 million. The land is located in Plano, Texas near our current corporate headquarters. We began construction of a new corporate headquarters facility on the land in April 2003 and plan to relocate to the new facility before the expiration of our principal lease in August 2004. The new facility will be approximately 143,000 square feet with an estimated construction cost of approximately $15 million. We also plan to spend approximately $1.5 million for furniture and equipment for the new facility. The new facility was designed to accommodate planned growth within a five-year horizon.

We also lease facilities in New Jersey for our HDI O.E.M. segment. One of the facilities, located in Budd Lake, New Jersey, is 10,730 square feet of office space that is used for administration, design engineering, drafting, documentation and regulatory affairs. We renewed the lease on March 1, 2004 and the lease expires on February 28, 2006. Our Budd Lake lease contains no renewal option. We also lease 18,582 square feet of space in Hackettstown, New Jersey used for our HDI O.E.M. manufacturing operations. We renewed the Hackettstown lease on December 31, 2002 and the lease expires on December 31, 2005 and is renewable for one additional three-year period.

ITEM 3. LEGAL PROCEEDINGS

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

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

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

Inapplicable.

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PART II

ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

Our common stock is currently quoted on the Nasdaq National Market under the symbol “ANSI.” On March 5, 2004, there were approximately 550 holders of record of our common stock. The following table sets forth the quarterly high and low closing sales prices for our common stock. These prices do not include adjustments for retail mark-ups, markdowns or commissions.

                 
2002:
  High
  Low
First Quarter
  $ 24.13     $ 19.01  
Second Quarter
  $ 22.53     $ 19.00  
Third Quarter
  $ 24.61     $ 16.61  
Fourth Quarter
  $ 25.15     $ 19.01  
                 
2003:
  High
  Low
First Quarter
  $ 28.60     $ 22.77  
Second Quarter
  $ 35.34     $ 25.87  
Third Quarter
  $ 43.16     $ 35.44  
Fourth Quarter
  $ 46.51     $ 36.25  
                 
2004:
  High
  Low
First Quarter
(through March 5, 2004)
  $ 47.87     $ 41.00  

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

To date, we have not declared or paid any cash dividends on our common stock and the Board of Directors does not anticipate paying cash dividends on our common stock in the foreseeable future.

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Equity Compensation Plan Information

As of December 31, 2003

                         
    Number of securities           Number of securities
    to be issued upon   Weighted-average   remaining available for
    exercise of   exercise price of   future issuance under
Plan category
  outstanding options
  outstanding options
  equity compensation plans
Equity compensation
plans approved by
security holders(2)
    2,469,572     $ 17.76       44,417  
 
                       
Equity compensation
plans not approved
by security holders(1)(2)
    820,693     $ 19.03       145  
 
   
 
             
 
 
Total
    3,290,265     $ 18.08       44,562  
 
   
 
     
 
     
 
 

(1)   Executive officers and members of the Board of Directors are not eligible to receive stock option grants under non-shareholder approved plans.

(2)   Certain of the plans allow the aggregate number of shares of common stock reserved for options under the plan to be increased by the same percentage that the total number of issued and outstanding shares of common stock increased from the preceding January 1 to the following December 31 (if such percentage is positive).

Equity Compensation Plans Not Approved by Security Holders In April 2001, the Board of Directors adopted the 2001 Employee Stock Option Plan (the 2001 Plan). The purpose of the 2001 Plan is to furnish additional equity incentives to key employees of the Company, other than executive officers of the Company. Members of the Board of Directors are also ineligible to participate in the 2001 Plan. The additional equity incentives are designed to increase shareholder value and to advance the interests of the Company by furnishing incentives to attract and retain the best available personnel for positions of substantial responsibility and to provide incentives to such personnel to promote the success of the business of the Company and its subsidiaries. The total number of shares of common stock issuable under the 2001 Plan is 270,000, subject to an adjustment on January 1 of each year (commencing on January 1, 2002), when the aggregate number of shares of common stock then issuable upon the exercise of options will be increased by the same percentage that the total number of issued and outstanding shares of common stock increased from the preceding January 1 to the following December 31 (if the percentage is positive). On January 1, 2002, 2003 and 2004, 49,788 shares, 115,572 shares and 27,907 shares, respectively were added to the 2001 Plan pursuant to this provision. All options granted under the 2001 Plan will be “nonqualified stock options” under the Internal Revenue Code of 1986, as amended from time to time. All stock option grants under the 2001 Plan expire ten years from the date of grant and for the most part are exercisable one-fourth each year over a four-year period of continuous service. The exercise price of an option granted under the 2001 Plan is determined by the Stock Option Committee, but in no event can be less than the fair market value of the common stock at the time the stock option is granted.

In June 2002, the Board of Directors adopted the 2002 Stock Option Plan (the 2002 Plan). The purpose of the 2002 Plan is to furnish additional equity incentives to advisory directors, consultants and key employees of the Company, other than executive officers of the Company. Members of the Board of Directors are also ineligible to participate in the 2002 Plan. The additional equity incentives are designed to increase shareholder value and to advance the interests of the Company by furnishing incentives to attract and retain the best available advisory directors, consultants and key employees for

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positions of substantial responsibility and to provide incentives to such advisory directors, consultants and key employees to promote the success of the business of the Company and its subsidiaries. The total number of shares of common stock issuable under the 2002 Plan is 337,500, subject to an adjustment on January 1 of each year (commencing on January 1, 2003), when the aggregate number of shares of common stock then issuable upon the exercise of options will be increased by the same percentage that the total number of issued and outstanding shares of common stock increased from the preceding January 1 to the following December 31 (if the percentage is positive). On January 1, 2003 and 2004, 121,973 shares and 29,452 shares, respectively, were added to the 2002 Plan pursuant to this provision. All options granted under the 2002 Plan will be “nonqualified stock options” under the Internal Revenue Code of 1986, as amended from time to time. All stock option grants under the 2002 Plan expire six years from the date of grant for advisory directors and consultants and ten years from the date of grant for key employees. For the most part, stock option grants to key employees under the 2002 Plan are exercisable one-fourth each year over a four-year period of continuous service while stock option grants to advisory directors and consultants vary from cliff vesting in eighteen months, one-half each year over a two-year period of service, one-third each year over a three-year period of service, one-fourth each year over a four-year period of service to one-fifth each year over a five-year period of service. The exercise price of an option granted under the 2002 Plan is determined by the Stock Option Committee, but in no event can be less than the fair market value of the common stock at the time the stock option is granted.

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ITEM 6. SELECTED FINANCIAL DATA

                                         
    Years Ended December 31,
    2003
  2002
  2001
  2000
  1999(2)
            (in thousands, except per share data)        
Statements of Income Data:(1)
                                       
Net revenue(2)
  $ 91,082     $ 57,372     $ 37,916     $ 31,827     $ 26,879  
Total net revenue
    91,082       57,372       37,916       31,827       35,779  
Gross profit
    63,947       36,713       22,241       17,127       23,852  
Research and development expense
    9,525       5,843       4,928       3,854       4,097  
Sales and marketing expense
    26,553       14,932       9,056       6,851       6,290  
General and administrative expenses and amortization of intangibles
    9,460       6,690       5,448       5,477       4,996  
Income from operations
    18,409       9,248       2,809       945       8,469  
Net income
  $ 13,217     $ 6,684     $ 1,518     $ 832     $ 5,817  
Diluted income per share:(3)
                                       
Net income
  $ .64     $ .37     $ .10     $ .06     $ .43  
                                         
    December 31,
    2003
  2002
  2001
  2000
  1999
                    (in thousands)                
Balance Sheet Data: (1)
                                       
Cash, cash equivalents, certificates of deposit and marketable securities
  $ 94,802     $ 96,770     $ 11,937     $ 11,599     $ 9,736  
Working capital
    126,437       114,280       24,906       22,211       17,626  
Total assets
    194,806       158,344       55,865       49,565       48,407  
Short-term notes payable and current maturities of long-term notes payable
                52       30        
Notes payable, excluding current maturities
                137       212        
Stockholders’ equity
  $ 178,125     $ 145,045     $ 46,812     $ 40,442     $ 36,536  

    (1) On January 2, 2001, we completed the acquisition of Hi-tronics Designs, Inc. The transaction was accounted for on a pooling of interests basis and accordingly, prior periods have been restated.

    (2) Net revenue excludes contract research and development revenue in 1999 from our former agreement with Sofamor Danek.

    (3) On July 11, 2003, we effected a 3 for 2 stock split. All prior period shares, share prices, and income per share figures have been restated to reflect the split.

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The following is a reconciliation of previously reported amounts with restated amounts for total net revenue and net income resulting from the January 2, 2001 acquisition of Hi-tronics Designs, Inc. accounted for on a pooling of interests basis.

                 
    Years Ended December 31,
    2000
  1999
    (in thousands)
Reconciliation of total net revenue:
               
As previously reported by the Company
  $ 23,082     $ 29,478  
HDI, for the year ended November 30
    10,366       7,989  
Elimination of intercompany transactions
    (1,621 )     (1,688 )
 
   
 
     
 
 
Total net revenue as restated
  $ 31,827     $ 35,779  
 
   
 
     
 
 
Reconciliation of net income:
               
As previously reported by the Company
  $ 954     $ 6,003  
HDI, for the year ended November 30
    28       328  
Elimination of intercompany transactions
    (150 )     (514 )
 
   
 
     
 
 
Net income as restated
  $ 832     $ 5,817  
 
   
 
     
 
 

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ITEM 7.
  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

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

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

Background

We entered the neuromodulation market in 1995 through the acquisition of a company that had developed and marketed a radio-frequency (RF) neurostimulation system. Through our initiatives, we developed and launched our next generation neurostimulation system, the Renew® RF spinal cord stimulation system, in 1999. We also recently developed our Genesis® and GenesisXP™ totally implantable pulse generator (IPG) spinal cord stimulation systems. We began selling Genesis in Europe in 2001 and in the U.S. in 2002 subsequent to the FDA’s approval of our PMA application in November 2001, and our GenesisXP IPG system following FDA approval in the fourth quarter of 2002.

In 2000, we completed development of AccuRx, our constant rate implantable drug pump, in part using proprietary technology we licensed from Implantable Devices Limited Partnership (IDP). We began selling AccuRx in certain international markets in the second quarter of 2001. In January 2001, we strengthened our position in the neuromodulation market by acquiring the assets of IDP and ESOX Technology Holdings, LLC (ESOX). This acquisition provided us with intellectual property surrounding implantable drug pump technologies in all applications, including pain and cancer therapy.

Also in January 2001, we completed the acquisition of Hi-tronics Designs, Inc. (HDI). We accounted for this acquisition using the pooling of interests method. Acquiring HDI provided us with additional in-house expertise in the design and manufacture of highly sophisticated electromechanical devices. Additionally, HDI continues to provide contract development and manufacturing services to third parties, which we report as a separate segment for financial reporting purposes (the HDI O.E.M. segment). In the future, we expect our HDI O.E.M. segment revenue to decrease as a percentage of our total revenue as we grow revenue from our proprietary neurostimulation systems and drug pumps and increasingly utilize HDI’s research and development capabilities for internal product development.

In November 2002, we completed the acquisition of MicroNet Medical, Inc. (MicroNet), a privately held developer of medical devices based on proprietary micro-lead technology. MicroNet developed a line of very thin and steerable spinal cord stimulation leads called Axxess™. These leads are the smallest neurostimulation leads on the market, which we believe offers advantages in certain applications.

In 2003, we acquired certain operations of our three remaining U.S. distributors who marketed our neuromodulation products in the United States. In March 2003, we acquired certain operations of Sun Medical, our largest U.S. distributor. In September 2003, we acquired certain operations of Comedical, our northwestern U.S. distributor and in November 2003, we acquired certain operations of our sole remaining distributor in the northeastern U.S., State of the Art Medical Products. As part of these acquisitions, substantially all of the direct sales persons that represented our products joined us as direct employees. We believe that these acquisitions will strengthen our sales capabilities and allow us to focus the sales priorities of those personnel on our products, expand sales coverage in those former distributor territories and invest in customer and market development.

Our current neuromodulation product line includes our Genesis IPG system, GenesisXP IPG system, Renew RF system and AccuRx constant rate drug pump. With the launch of our Genesis and

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GenesisXP IPG systems, we compete in 100% of the implantable neurostimulation market to treat chronic pain of the trunk and limbs. The launch of the Genesis IPG and GenesisXP IPG in 2002 slowed our growth rate in sales of Renew systems from an average percentage growth rate of the mid-teens over the past several years to single-digit growth in both 2002 and 2003. Management believes this trend may continue in 2004 and has assumed similar single-digit growth in Renew sales during 2004.

Critical Accounting Policies and Estimates

General

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

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

Revenue Recognition

We generate revenues from product sales to end customers, product sales to international distributors, and development contracts. Until we completed the acquisition of certain operations of our remaining U.S. distributors in 2003, we also generated revenue from product sales to U.S. distributors.

We recognize revenue on product sales to end customers and distributors upon shipment, provided an arrangement with the customer or distributor exists, the fee is fixed and determinable, and collectibility is reasonably assured. Certain of our customers are third-party payors who reimburse fixed amounts for services based on a specific diagnosis. Revenue is recognized on these third-party payor sales based on the sales price less a contractual adjustment, which is based on our history of reimbursement with the third-party payor, provided all other revenue recognition criteria are met. We do not have any continuing obligation to our customers for installation or training, and there are no acceptance clauses in our customer arrangements.

We recognize revenue on development contracts at HDI using either the percentage of completion method for fixed price development contracts, or as the services are performed for development contracts that are completed on a time and materials basis. We recognize revenue using the percentage of completion method for the fixed price development agreements as the contract term can vary from 9 to 24 months, our right to receive payment depends on our performance in accordance with the agreement, and we can reasonably estimate the costs applicable to various stages of the

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development arrangement. Revenue is recognized based on the ratio of costs incurred in relation to the estimated costs for the total project. If we do not accurately estimate the resources required or the scope of work to be performed under a fixed price development agreement, then future profit margins and results of operations may be negatively impacted.

Under the Company’s shipping terms, title transfers to the end customer or distributor at the point of shipment. Shipping and handling costs are included in cost of revenue. Payments received in advance of revenue recognition requirements are recorded as deferred revenue on the consolidated balance sheet.

Bad Debt

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

Inventory Reserve

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

Intangible Assets

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

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

Contingencies

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

Currently, product liability claims and other ordinary routine litigation incidental to our business are the only litigation to which we are a party. While historically our product liability claims have not resulted in significant monetary liability beyond our insurance coverage, an adverse judgment beyond our insurance coverage could have a material adverse impact on our results of operations and financial condition.

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Stock Compensation

See Note 2 to the Consolidated Financial Statements for a discussion of the application of Statement of Financial Accounting Standards (SFAS) No. 123, “Accounting for Stock-Based Compensation” and SFAS 148, “Accounting for Stock-Based Compensation – an Amendment of FASB Statement No. 123” to our stock compensation programs.

Results of Operations

Comparison of the Years Ended December 31, 2003 and 2002

Results for 2003 continue to reflect the positive impact of revenue growth from increased unit sales of our Genesis and GenesisXP IPG systems, which we launched in the United States in January 2002 and December 2002, respectively. We believe these systems will also generate most of our growth during 2004.

Net revenue. Net revenue increased $33.71 million, or 58.8%, in 2003 from 2002 due to increased sales of our neuromodulation products which increased 71.3% to a record $80.00 million in 2003 from $46.71 million in 2002 primarily due to increased sales of our Genesis family of IPG systems. Revenue from our Renew RF system grew modestly year over year. Net revenue of our HDI O.E.M. business, as planned, increased modestly to $11.08 million in 2003 from $10.66 in 2002 primarily due to higher volume of O.E.M. product sales. We continue to use more of HDI’s manufacturing and development capabilities for our own increasing needs and as such we anticipate only modest growth in our HDI O.E.M. business.

Gross profit. Gross profit increased $27.23 million, or 74.2%, in 2003 from 2002 due to the increase in net revenue discussed above and an improvement in gross profit margins. Gross profit margins increased to 70.2% in 2003, compared to 64.0% in 2002, due to higher sales of our neuromodulation products, which contribute higher margins than HDI O.E.M. product sales, higher neuromodulation product sales from direct sales and commissioned agents which contribute higher margins than distributor sales due to three acquisitions in 2003 of certain operations of our remaining U.S. distributors, and operational efficiencies gained from higher manufacturing volumes.

Operating expenses. Total operating expenses increased $18.07 million, or 65.8%, and increased as a percentage of net revenue to 50.0% in 2003 from 47.9% in 2002, primarily due to increased investments in our sales and marketing capabilities, including the additional sales personnel acquired in the three acquisitions in 2003 of certain operations of our remaining U.S. distributors, and to a lesser extent increased investments in research and development and increased amortization expense from intangibles acquired in our various acquisitions. We continued to leverage our general and administrative expense in 2003.

Sales and marketing. Sales and marketing expense, as a percentage of net revenue, increased to 29.2% in 2003 from 26.0% in 2002, and the expense increased in absolute dollars by $11.62 million principally due to higher commission expense from increased Neuro Product sales, higher salary expense from annual salary increases and staffing additions in reimbursement, direct sales and clinical support specialists, higher employee benefit costs from staffing additions, higher travel expense due to increased direct sales activities and higher expense for education and training of new implanters of Neuro Products. In 2003, we expanded our sales and marketing capabilities with the acquisitions of certain operations from our three remaining U.S. distributors and added substantially all of the salespersons of those businesses to our direct sales force. We expect to continue to add additional salespersons in the future.

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Research and development. Research and development expense, as a percentage of net revenue, increased slightly to 10.5% in 2003 from 10.2% in 2002, and the expense increased in absolute dollars by $3.68 million principally due to higher salary and benefit expense from staffing additions and annual salary increases, higher stock-based compensation expense for certain consultants and higher prototype tooling and test materials for new products under development. Our development efforts in 2003 continued to focus on next-generation IPG stimulation systems, an IPG stimulation system for deep brain stimulation and next-generation drug pumps.

General and administrative. General and administrative expense, as a percentage of net revenue, decreased to 8.4% in 2003 from 10.0% in 2002, while the expense increased in absolute dollars by $1.89 million principally due to higher salary expense from annual salary increases and staffing additions, higher employee benefit costs, higher recruiting fee expense and higher depreciation expense.

Amortization of other intangibles. Amortization expense of intangibles increased 92.4% in 2003 from 2002, or $879,000, due to a full year of amortization expense for intangible assets we acquired in the November 2002 MicroNet acquisition, plus amortization of additional intangible assets from earn-out consideration paid in 2003 as milestones were met pursuant to the MicroNet acquisition agreement. In addition we recorded amortization expense for intangible assets we acquired in 2003 from the acquisition of certain operations of our three remaining U.S. distributors. We expect amortization expense to increase in 2004 by approximately $168,000 due to having a full year of amortization expense from the above-mentioned 2003 acquisitions, excluding additional amortization expense that may be generated as we issue additional earn-out consideration that is recorded as intangible assets under the MicroNet acquisition agreement.

Other income. Other income increased $1.05 million in 2003 from 2002 primarily due to the reversal of an accrued tax-abatement liability of $969,000 as we were legally released from our potential obligation to pay that amount in 2003.

Income tax expense. Income tax expense increased $3.67 million in 2003 from 2002 as a result of increased income before taxes and an increase in the overall effective tax rate to 35.1% in 2003 from 34.3% in 2002. Our increased effective tax rate is primarily due to our federal statutory tax rate being 35% in 2003 compared to 34% in 2002. The effective tax rates reflect a provision for state taxes, offset by tax-exempt interest income earned on our cash, cash equivalents and marketable securities.

Net income. Net income increased $6.53 million, or 97.7%, in 2003 from 2002 primarily due to the positive impact of revenue growth from increased unit sales of our Genesis and GenesisXP IPG systems, increased gross margin, and to a lesser extent from the reversal of the tax-abatement liability discussed above. Net income per diluted share increased to $.64 in 2003 from $.37 in 2002. Excluding the one-time tax-abatement reversal, net income per share increased to $.61 in 2003 from $.37 in 2002.

Comparison of the Years Ended December 31, 2002 and 2001

Net revenue. Net revenue increased $19.46 million, or 51.3%, in 2002 from 2001 due to increased sales of our neuromodulation products which increased 70.1% to $46.71 million in 2002 from $27.46 million in 2001 due to the U.S. launch of our Genesis IPG system in January 2002 and our GenesisXP IPG system in December 2002. The launch of the Genesis IPG in 2002 slowed our growth rate in sales of Renew systems from an average percentage growth rate in the mid-teens over the past several years to single-digit growth in 2002. Net revenue from our HDI O.E.M. business increased marginally to $10.66 million in 2002 from $10.46 million in 2001 as we focused more of HDI’s resources on our own manufacturing and research and development needs.

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Gross profit. Gross profit increased $14.47 million, or 65.1%, in 2002 from 2001 due to the increase in net revenue discussed above and an improvement in gross profit margins. Gross profit margins increased to 64.0% in 2002, compared to 58.7% in 2001, due to higher sales of our neuromodulation products, which contribute higher margins than HDI O.E.M. product sales, higher neuromodulation product sales from direct sales and commissioned agents, which contribute higher margins than distributor sales, and operational efficiencies gained from higher manufacturing volumes.

Operating expenses. Total operating expenses increased $8.03 million in 2002 from 2001, but decreased as a percentage of net revenue to 47.9% in 2002 from 51.3% in 2001 due to leveraging of research and development expense, leveraging of general and administrative expense, and to a lesser extent, eliminating amortization expense of goodwill.

Sales and marketing. Sales and marketing expense, as a percentage of net revenue, increased to 26.0% in 2002 from 23.9% in 2001, and the expense increased in absolute dollars by $5.88 million principally due to higher salary and benefit expense from staffing additions in direct sales, reimbursement and sales support positions, higher commission expense from increased product sales, and higher sample and promotional expense in support of the Genesis and GenesisXP IPG launches.

Research and development. Research and development expense, as a percentage of net revenue, decreased to 10.2% in 2002 from 13.0% in 2001, while the expense increased in absolute dollars by $914,000 principally due to higher salary and benefit expense from staffing additions, higher test material expense and higher expense associated with our clinical trials of AccuRx.

General and administrative. General and administrative expense, as a percentage of net revenue, decreased to 10.0% in 2002 from 10.4% in 2001, while the expense increased in absolute dollars by $1.78 million principally due to higher salary expense from staffing additions (including a new executive officer position), higher employee benefit costs, higher bonus expense, higher property tax expense and higher fees for accounting and tax services.

Amortization of intangibles. No amortization expense of goodwill was recorded in 2002 due to the adoption of SFAS No. 142 on January 1, 2002. During 2001, we recorded $557,000 for amortization expense of goodwill.

Amortization expense of other intangibles increased modestly by $19,000 in 2002 from 2001 due to additional amortization expense for intangible assets acquired in November 2002 when we completed the acquisition of MicroNet.

Other income. Other income increased to $923,000 in 2002 from an expense of $26,000 in 2001 primarily due to a $451,000 increase in interest income from higher funds available for investment from our public offering during the second quarter of 2002 and the expense in 2001 of $484,000 for costs associated with the acquisition of HDI. These costs were expensed instead of capitalized because the acquisition was accounted for under the pooling of interests method.

Income tax expense. Income tax expense increased $2.22 million in 2002 from 2001, but the overall effective tax rate decreased to 34.3% in 2002 compared to 45.5% in 2001. The decrease in the effective tax rate in 2002 compared to 2001 was the result of three factors. First, our amortization of goodwill in the 2001 period was not deductible for tax purposes. Second, the HDI acquisition costs expensed in the 2001 period of $484,000 were not fully deductible for tax purposes. Finally, the 2002 period included tax-free interest income.

Net income. Net income increased $5.17 million, or 340.4%, in 2002 from 2001 reflecting the positive impact of revenue growth from increased unit sales of our Genesis and GenesisXP IPG systems, increased gross margin, and leveraging of operating expenses. Net income per diluted share increased

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to $.37 in 2002 from $.10 in 2001. Results for the 2001 period reflect amortization expense for goodwill of $556,604. The 2002 results contain no similar expense since we eliminated the amortization of goodwill on January 1, 2002 when we adopted the new accounting standards for intangible assets described above. If the amortization expense for goodwill were eliminated from the 2001 period, pro forma net income would be $2.07 million and pro forma net income per diluted share would be $.14.

Liquidity and Capital Resources

At December 31, 2003 our working capital increased to $126.44 million from $114.28 million at year-end 2002. The ratio of current assets to current liabilities was 11.21:1 at December 31, 2003 compared to 13.15:1 at December 31, 2002. Cash, cash equivalents, and marketable securities totaled $94.80 million at December 31, 2003 compared to $96.77 million at December 31, 2002. In 2003, we made numerous investments discussed below which were funded to a large extent from operations.

In March, September and November 2003, we acquired certain operations of our three remaining U.S. distributors. These acquisitions expanded our direct domestic sales force. The total cost of these acquisitions was approximately $10.23 million, which we funded from our cash reserves.

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

We increased our investment in inventories to $22.11 million at December 31, 2003, from $13.72 million at December 31, 2002. This increase from year-end 2002 was primarily the result of three factors. First, we increased our investment in inventories held by direct and commissioned sales agents during 2003 as a result of an increased sales force. Second, we increased our investment in raw materials and finished goods for our Genesis and GenesisXP IPG systems to support our continued success of these products in the U.S. market and in anticipation of continued sales growth. Finally, we increased our overall investment in inventories in anticipation of our move to our new corporate facility in 2004 due to the new facility requiring regulatory process validation before product can be manufactured in and shipped from the facility.

Our investment in trade accounts receivable increased to $17.89 million at December 31, 2003, from $10.85 million at December 31, 2002 due to the increase in sales of our neuromodulation products resulting from the launch of the Genesis and GenesisXP IPG systems. Our days sales outstanding increased from 55 days at year-end 2002 to 64 days at year-end 2003 due to higher receivables due from insurance companies and hospitals as a result of us acquiring all of our U.S. distributors in 2003. Hospitals and insurance companies have slower payment cycles than our former U.S. distributors, who typically paid us within 10 to 30 days.

In November 2002, we completed the acquisition of MicroNet. At closing we paid the former MicroNet shareholders $500,000 in cash and 234,453 shares of our common stock with a value at the time of issuance of $4,648,421. In addition, we incurred expenses of $859,460, including an investment-banking fee of $600,000. In March 2003, we paid the former MicroNet shareholders an aggregate of 42,519 shares of our common stock with a value at the time of issuance and release from escrow of $1,020,059 upon the successful completion of half of the first product milestone, and in October 2003, we paid the former MicroNet shareholders an aggregate of 17,462 shares of our common stock with a value at the time of issuance and release from escrow of $700,182 upon the successful completion of another product sub-milestone. The former MicroNet shareholders may receive additional shares of our common stock if additional product and sales milestones are met. The aggregate value of the additional potential milestone earnout payments was $9 million as measured at the time the transaction was completed. Of this $9 million in additional shares, a fixed number of our common shares totaling 134,409 with an aggregate value at closing of $3 million were issued into an

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escrow account. Shares that are released from escrow if such milestones are met will be valued at the time of release from escrow. At December 31, 2003, 100,811 shares remained in escrow. The product and sales milestones referred to above consist of three principal product milestones and a sales milestone. Each of the product milestones has three to four sub-milestones that relate to the delivery of specific products, including four separate 4-electrode leads (Milestone I), two separate 8-electrode leads (Milestone II) and three separate leads and a trial cable (Milestone III). The product sub-milestones are met if and when we are able to submit, and if and when we receive, regulatory approvals for products that have been adapted for use with our electrical stimulation devices. The sales milestone will be met if and when we and our subsidiaries generate $5 million in cumulative net sales of MicroNet lead products during the four years following the closing of the MicroNet transaction.

An important product milestone deadline occurred under the MicroNet acquisition agreement in November 2003, which was not met. We are currently in discussions with the former MicroNet shareholders regarding this product milestone. If this product milestone had been achieved by the deadline, the value of the milestone payment at December 31, 2003 was approximately $1,552,684, or 33,894 shares, which would have been allocated to certain identifiable intangible assets in accordance with the original purchase price allocation.

Excluding expenditures discussed below on our new facility, we spent $5.80 million during 2003 for capital expenditures primarily for new furniture and equipment for personnel we hired during 2003 and additional manufacturing tooling and equipment to support our current products and new products we expect to introduce in 2004.

Because we expect our business to continue to grow at rates that will demand added office and facility space, in April 2003 we began construction on a new 143,000 square foot corporate headquarters facility on the 10 acres of land we acquired in December 2002. The land is located in Plano, Texas, near our current corporate headquarters. Our current lease on our 49,700 square foot corporate headquarters expires in August 2004 and we plan to relocate to the new facility prior to the expiration of the lease. We designed the new facility to accommodate planned growth within a five-year horizon. The construction cost of the facility is approximately $15 million, and we expect to spend approximately $1.5 million on office furniture and equipment for the new facility. We have funded the interim construction costs from our cash reserves and through December 31, 2003 have spent approximately $8.8 million. While we have not yet determined the method by which we will permanently finance the facility, we believe our cash position and overall balance sheet position provides us with various financing alternatives, including financing the facility from our current cash, financing through a debt vehicle such as a mortgage or other form of note, or a sale-and-leaseback transaction.

We received $7.52 million of cash during 2003 from the exercise of employee, advisory director and director stock options to purchase 1,124,372 shares of our common stock.

Liquidity may also be enhanced based on our ability to utilize all or part of a net operating loss carryforward of $4.3 million to offset future taxable income. We acquired $3.4 million of the net operating loss carryforward in connection with the MicroNet acquisition and its utilization may be subject to a limitation under Section 382 of the Internal Revenue Code. The rules of Section 382 of the Internal Revenue Code generally apply to limit a corporation’s ability to utilize acquired net operating loss carryforwards to reduce its federal taxable income in the periods after an acquisition. The Company’s ability to use the net operating loss carryforwards acquired in the MicroNet acquisition to reduce its federal taxable income is subject to these rules. Provided the Company generates sufficient taxable income in future years, the Section 382 limitation will have the effect of deferring the utilization of the net operating loss carryforwards over several years. Without this limitation, the Company would be able to immediately use the net operating loss carryforwards to reduce taxable income in future tax periods. The total amount of net operating loss carryforwards that

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the Company may use to reduce taxable income in any taxable year after the acquisition is determined with reference to its purchase price of MicroNet. Based on current estimates and assumptions, we expect to utilize at least approximately $700,000 in net operating loss carryforwards per full twelve-month tax years, assuming we generate sufficient taxable income in any given year to utilize such amount.

Additionally, liquidity may be enhanced to the extent we realize tax benefits from stock option exercises. Exercises of nonqualified stock options, and exercises of incentive stock options followed by “disqualifying dispositions” of the underlying common stock within one year following exercise generate compensation expense for tax purposes in the year of exercise or disposition, as the case may be. During 2003, we generated a $9.79 million tax benefit related to nonqualified stock option exercises and disqualifying dispositions of common stock acquired on exercise of incentive stock options.

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

The following table sets forth certain information concerning our contractual obligations at December 31, 2003.

                                 
    Maturity by Fiscal Year
                            2006 and
(in thousands)
  Total
  2004
  2005
  Thereafter
Operating leases (1)
  $ 1,096     $ 814     $ 260     $ 22  
Inventory purchases (2)
    8,017       7,857       160        
Commitments for construction of new corporate headquarters facility (3)
    6,094       6,094              
 
   
 
     
 
     
 
     
 
 
Total
  $ 15,207     $ 14,765     $ 420     $ 22  
 
   
 
     
 
     
 
     
 
 

  (1)   In accordance with accounting principles generally accepted in the U.S., these obligations are not reflected in the consolidated balance sheets. These obligations are for operating lease payments primarily related to facilities.
 
  (2)   Our inventory purchase commitments do not exceed our projected requirements over the related terms and are in the normal course of business.
 
  (3)   Contractual commitments for construction of our new corporate headquarter facility of 143,000 square feet.

Cash Flows

Net cash provided by operating activities was $16.48 million in 2003, $7.59 million in 2002, and $3.06 million in 2001. Net cash provided by operating activities increased by $8.89 million in 2003 from 2002 principally due to a $6.53 million increase in net income and a $7.94 million increase in tax benefits from the exercise of stock options. These increases were partially offset by increases in accounts receivable and inventory. Net cash provided by operating activities increased by $4.53 million in 2002 from 2001 principally due to a $5.17 million increase in net income.

Net cash used in investing activities was $26.38 million in 2003, $91.14 million in 2002 and $3.09 million in 2001. In 2003, our primary investing activities using cash were the purchase of marketable securities ($382.65 million), the purchase of certain operations of three of our U.S. distributors ($10.23 million), funds used to finance the interim construction of our new corporate headquarters facility ($8.83 million), capital expenditures ($5.80 million), and the purchase of minority equity investments in

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preferred stock of two privately-held companies ($1.10 million), while net proceeds from the sale of marketable securities provided cash of $382.22 million. In 2002, our primary investing activities using cash were the purchase of marketable securities ($188.39 million), the purchase of land ($3.19 million), capital expenditures ($2.94 million) and cash used in the purchase of MicroNet ($1.36 million), while net proceeds from the sale of marketable securities provided cash of $104.75 million. In 2001, our primary investing activities using cash were the purchase of marketable securities ($3.90 million) and capital expenditures ($3.11 million) for additional manufacturing tooling and equipment, office furniture and equipment, non-compete agreements and patents, while maturing certificates of deposit and sales of marketable securities provided cash of $3.92 million. The non-compete agreements discussed in this section for fiscal year 2001 relate to a $200,000 expenditure incurred in 2001 to purchase a non-compete agreement from a former distributor of our Neuro Products. In reference to the patents, we incurred $191,000 in cash expenditures (in addition to the stock we issued with a value of $2,426,662) related to the purchase of ESOX in January 2001, which was allocated to the patents we acquired in the transaction. Prior to the transaction, we had licensed the technology from ESOX. The patents we acquired in the ESOX transaction relate to our implantable drug pump technologies. We are currently seeking FDA approval to commercialize an implantable drug pump in the United States.

Net cash provided by financing activities was $7.52 million in 2003, $84.73 million in 2002, and $957,000 in 2001. During 2003, all of the cash provided by financing activities was the result of the exercise of stock options. During 2002, we used $190,000 to repay our entire outstanding long-term debt, while we received $83.18 million in net proceeds from a public offering and $1.75 million from the exercise of stock options. During 2001, we used $48,000 to reduce certain debt obligations, while we received $1.00 million from the exercise of stock options.

Currency Fluctuations

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

Outlook and Uncertainties

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

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

We formally introduced our Genesis IPG system in the U.S. in January 2002 and our GenesisXP IPG system (offering increased battery capacity and longevity) in the U.S. in December 2002. We believe

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that the size and potential for growth of the IPG portion of the neurostimulation market are greater than in the RF portion. Accordingly, our ability to generate increased revenue and profitability, and thus our general success, will depend, in large part, on the market’s acceptance of our IPG systems. As a new entrant into the IPG portion of the neurostimulation market, there are many reasons we might not achieve market acceptance on a timely basis, if at all, including the following:

    competing products, technologies and therapies are available, and others may be introduced that gain greater and faster physician and patient acceptance than our IPG systems; and
 
    our only competitor in the IPG portion of the market has had its IPG product on the market for some time and enjoys significant brand awareness and other advantages among pain management specialists.

If the IPG portion of the neurostimulation market grows at a faster rate than the RF portion, our failure to successfully market and sell our IPG systems could negatively affect our revenue growth and profitability.

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

The medical device market is highly competitive, subject to rapid change and significantly affected by new product introductions and other market activities of industry participants. Medtronic, is one of the largest competitors in the medical device sector, and is currently our sole competitor in the neurostimulation market and our largest competitor in the implantable drug pump market. Medtronic is a large publicly-traded company and enjoys several competitive advantages over us, including:

    substantially greater name recognition;
 
    greater resources for product research and development, sales and marketing, distribution, patent protection and pursuing regulatory approvals;
 
    a greater number of established relationships with health care professionals and third-party payors; and
 
    multiple product lines and the ability to bundle products together or offer discounts, rebates or other incentives to secure a competitive advantage.

Medtronic will continue to develop new products that compete directly with our products, and its greater resources may allow it to respond more quickly to new technologies, new treatment indications or changes in customer requirements. Further, we generally price our products at a premium to those of Medtronic. Additionally, because the neuromodulation market is a high growth-potential market, other companies may attempt to bring new products or therapies into this market. For example, Advanced Bionics, Inc., a privately-held company that currently manufactures and markets a cochlear implant product, has publicly stated that it is developing and may be testing an IPG system for the treatment of chronic pain. For all of these reasons, we may not be able to compete successfully against Medtronic or against future competitors.

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

Our products are based on evolving concepts and techniques in pain management. Acceptance of our products depends on educating the medical community as to the distinctive features, benefits, clinical

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efficacy, safety and cost-effectiveness of our products compared to alternative therapies and competing products, and on training pain management specialists in the proper use of our products. To sell our products, we must successfully educate and train pain management specialists so that they will understand our products and feel comfortable recommending and endorsing them. We may not be able to accomplish this, and even if we are successful in educating and training pain management specialists, there is no guarantee that we will obtain their recommendations and endorsements.

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

Our Genesis and GenesisXP IPG systems are currently the newest neurostimulation products on the market. Although Genesis and our Renew RF system are targeted towards patients with different types of pain and Genesis is not intended to replace Renew in the neurostimulation market, some pain management specialists may recommend Genesis to their patients when they would have otherwise recommended Renew, and, consequently, Genesis may “cannibalize” or substitute for some sales of Renew. Further, we believe our principal market competitor has chosen to emphasize the IPG as the therapy of choice in the neurostimulation market. These factors could lead to a slowdown in growth, or a reduction, in sales of Renew and similar RF-based neurostimulation products. Although Renew and Genesis are targeted for different patients, sales growth of Renew has slowed since the launch of Genesis. If Renew sales growth continues to slow or sales are reduced, and we do not gain enough market share through IPG sales to compensate for these reduced sales, our revenues and profitability will be adversely affected.

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

We sell medical devices for invasive and minimally-invasive surgical procedures. Patient acceptance of our products depends on a number of factors, including device and associated procedure costs, the failure of less invasive therapies to help the patient, the degree of invasiveness involved in the procedures used to implant our products, the rate and severity of complications from the procedures used to implant our products and any adverse side effects caused by the implanting of our products. If patients choose to use existing less invasive or less expensive alternatives to our products, or if effective new alternatives are developed, our revenues and profitability could be materially adversely affected.

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

In the U.S., our products are generally covered by Medicare and Medicaid and other third-party payors, such as private insurance companies and managed care organizations, and workers’ compensation programs, which reimburse patients for all or part of the cost of our products and related medical procedures. The cost of our products and related procedures are significant, and third-party payors carefully scrutinize whether to cover new products and the level of reimbursement for covered products. Further, for certain types of procedures, gaps exist between the rate of reimbursement paid by Medicare and Medicaid and the rates paid by private insurers. In addition, gaps exist in reimbursement levels depending on the health care setting in which physicians perform procedures using our products. In the future, these gaps may narrow and public and private payors may reduce levels of reimbursement for neuromodulation devices in an effort to control increasing costs. If Medicare or other third-party payors decide to eliminate or reduce coverage amounts on patient reimbursements for our products, this could limit our ability to market and sell our products in the U.S., which would materially adversely affect our revenues and profitability. In November 2003, for example, the Center for Medicare and Medicaid Services issued a final ruling establishing new 2004

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reimbursement rates for Medicare hospital outpatient procedures, including spinal cord stimulation procedures. Reimbursement levels for permanent implants of spinal cord stimulation devices in the hospital outpatient setting were generally reduced as a result of the ruling, which decreased the amount that hospitals would be reimbursed by Medicare for these procedures. However, because the new rates continue to provide hospitals with adequate margins to cover their facility costs and yield a fair profit to the hospitals, the new rates have not had an adverse effect on the prices we charge hospitals for our systems. If in the future CMS reduces rates to such an extent that hospitals’ ability to continue operating profitably in these procedures were at risk, then there could be price pressure on our products at that time.

International market acceptance of our products may also depend, in part, upon the availability of reimbursement within prevailing health care payment systems. Reimbursement and health care payment systems in international markets vary significantly by country, and include both government-sponsored health care and private insurance. We may not obtain international reimbursement approvals in a timely manner, if at all. Where reimbursement in foreign markets is available, it tends to be at levels significantly below those in the U.S. Our failure to receive international reimbursement approvals may negatively impact market acceptance of our products in the international markets in which those approvals are sought.

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

We rely in part on patents, trade secrets and proprietary technology to remain competitive. We may not be able to obtain or maintain adequate U.S. patent protection for new products or ideas, or prevent the unauthorized disclosure or use of our technical knowledge or other trade secrets by employees. Additionally, the laws of foreign countries may not protect our intellectual property rights to the same extent as the laws of the U.S. Even if our intellectual property rights are adequately protected, litigation may be necessary to enforce them, which could result in substantial costs to us and substantial diversion of the attention of our management and key technical employees. If we are unable to adequately protect our intellectual property, our competitors could use our intellectual property to develop new products or enhance their existing products. This could harm our competitive position, decrease our market share or otherwise harm our business.

U.S. Patent No. 4,793,353 covers a non-invasive multiprogrammable tissue stimulator and method wherein only the programming data need be transmitted. The programming data may define the stimulator’s electrode selection, electrode polarity as either positive, negative or high impedence state, and simulation pulse parameter. This patent is scheduled to expire on December 27, 2005. The expiration of this patent may allow competitors to offer programmable stimulators that define electrode selection, polarity and stimulation pulse parameters, and thus could have an adverse effect on our business. A request for an extension of the term of this patent has been filed with the United States Patent Office pursuant to a federal statute that permits us to seek such an extension based on a regulatory approval delay. A final ruling on the extension request has not been made at the present time. While five other U.S. patents owned or licensed by us are due to expire prior to 2006, the expiration of these other patents would not have a material effect on our ability to protect the intellectual property rights currently utilized in our business, because the patents cover technologies that are not currently utilized in our existing products or services.

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

There has been a substantial amount of litigation in the medical technology industry regarding patents and intellectual property rights. The neuromodulation market is characterized by extensive patent and other intellectual property rights, which can create greater potential than in less-developed markets for

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possible allegations of infringement, particularly with respect to newly-developed technology. We may be forced to defend ourselves against allegations that we are infringing the intellectual property rights of others. In addition, we may find it necessary, if threatened, to initiate a lawsuit seeking a declaration from a court that we are not infringing the intellectual property rights of others or that these rights are invalid or unenforceable, or to protect our own intellectual property rights. Intellectual property litigation is expensive and complex and its outcome is difficult to predict. If we do not prevail in any litigation, in addition to any damages we might have to pay, we would be required to stop the infringing activity, obtain a license, or concede intellectual property rights. Any required license may not be available to us on acceptable terms, if at all. In addition, some licenses may be nonexclusive, and, therefore, our competitors may have access to the same technology licensed to us. If we fail to obtain a required license or are unable to design around a patent, we may be unable to sell some of our products, which could adversely affect our revenues and profitability.

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

Our products are medical devices, which are subject to extensive government regulation in the U.S. and in foreign countries where we do business. Unless an exemption applies, each medical device that we wish to market in the U.S. must first receive either a PMA or a 510(k) clearance from the FDA with respect to each application for which we intend to market it. Either process can be lengthy and expensive. According to the FDA, the average 510(k) review period was 96 days in 2003, but reviews may take longer and approvals may be revoked if safety or effectiveness problems develop. The PMA process is much more costly, lengthy and uncertain. According to the FDA, the average PMA submission-to-decision period was 359 days in 2003; however, reviews may take much longer and completing a PMA application can require numerous clinical trials and require the filing of amendments over time. The result of these lengthy approval processes is that a new product, or a new application for an existing product, often cannot be brought to market for a number of years after it is developed. Additionally, we anticipate that many of the products we bring to market in the future will require us to seek PMA approvals rather than 510(k) clearances. If we fail to obtain or maintain necessary government approvals of our new products or new applications for existing products on a timely and cost-effective basis, we will be unable to market the affected products for their intended applications.

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

Any modification we want to make to an FDA-cleared or approved device that could significantly affect its safety or effectiveness, or that would constitute a major change in its intended use, would require a new 510(k) clearance, or possibly a new or supplemental PMA. Under FDA procedures, we would make the initial determination of whether to seek a new 510(k) clearance or PMA, but the FDA could review our decision. If the FDA disagrees with our decision not to seek a new 510(k) clearance or PMA and requires us to seek either 510(k) clearance or PMA for modifications we have already made to a previously-cleared product, we might be required to cease marketing or recall the modified device until we obtain this clearance or approval. We could also be subject to significant regulatory fines or penalties.

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

To commercially manufacture our products, we must comply with government manufacturing regulations that govern design controls, quality systems and documentation policies and procedures. The FDA and equivalent foreign governmental authorities periodically inspect our manufacturing facilities. Our failure to comply with these manufacturing regulations may prevent or delay our marketing or distribution of our products, which would negatively impact our business.

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

Any of our products may be found to have significant deficiencies or defects in design or manufacture. The FDA and similar governmental authorities in other countries have the authority to require the recall of any such defective product. A government-mandated or voluntary recall could occur as a result of component failures, manufacturing errors or design defects. We do not maintain insurance to cover losses incurred as a result of product recalls. Any product recall would divert managerial and financial resources and negatively affect our financial performance, and could harm our reputation with customers.

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

Defects in our implantable medical devices could subject us to potential product liability claims that our devices were ineffective or caused some harm to the human body. Our current product liability litigation involves assertions that our products did not perform as intended and, in some cases, that they caused discomfort or harm to the patient. Our product liability insurance may not be adequate to cover current or future claims. Product liability insurance is expensive and, in the future, may not be available on terms that are acceptable to us, if it is available to us at all. Plaintiffs may also advance other legal theories supporting their claims that our products or actions resulted in some harm. A successful claim brought against us in excess of our insurance coverage could significantly harm our business and financial condition.

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

We are subject to numerous government regulations relating to, among other things, our ability to sell our products, third-party reimbursement, fraud and abuse of Medicare or Medicaid and patient privacy. If we do not comply with all applicable government regulations, government authorities could do any of the following:

    impose fines and penalties on us;
 
    prevent us from manufacturing our products;
 
    bring civil or criminal charges against us;
 
    delay the introduction of our new products into the market;
 
    recall or seize our products;
 
    disrupt the manufacture or distribution of our products; or
 
    withdraw or deny approvals for our products.

Any one of these results could materially adversely affect our revenues and profitability and harm our reputation.

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

We continue to rely upon sole source suppliers for certain materials and services used in manufacturing our products, including the custom chip used in the receiver of our RF system, the computer chip used in the IPG programmer and Renew transmitter, the batteries used in our IPG system and the medical-grade polyurethane (bionate) that we use in all of our products, for reasons of quality assurance, component availability or cost effectiveness. We work closely with our vendors to assure continuity of supply while maintaining high quality and reliability. With the exception of the custom chip used in our RF receiver, which we discuss below, we believe that alternative suppliers exist for the other components used to manufacture our products. FDA requirements regarding the design and manufacture of our products require an investment in time and money to establish additional or replacement sources for certain components or materials. We believe that in some cases, the cost of pursuing and qualifying alternative sources and/or redesigning specific components of our products would significantly outweigh the benefits of doing so and consume significant resources that are better devoted to other aspects of our business. Similarly, qualifying alternative sources or product designs require costly and time-consuming regulatory submissions and approvals that again may not be justified from a cost-benefit standpoint for all components used in our products. The reduction or interruption in supply, or our inability to develop alternative sources of supply, could adversely affect our operations.

Although there are currently no alternative suppliers for the custom chip used in our RF system, we have sufficient chips in stock to meet our near-term requirements and we believe we will be able to order more chips to meet our future needs. In the meantime, we are designing and developing our own replacement chip. The sole supplier of this chip first indicated its desire to cease manufacturing and supplying the RF system chip several years ago. The supplier has continued to supply the chip, however, and to date has not determined if and when it will cease to supply the chip. The supplier has agreed to notify us when it does decide to cease supplying the chip and has promised to permit us to place a final one-time purchase order for the chip. In the interim, we have maintained and will continue to maintain a higher than normal inventory of the chip. We currently have enough of the chips in stock to meet our requirements through the end of 2005. Our engineers are developing a new chip to be used with our next-generation RF receiver. Our engineers estimate that this new chip and the next-generation RF receiver would be completed and have received the appropriate regulatory approvals by the second half of 2005. Consequently, under the circumstances, we do not believe that a single source of supply for the RF system chip poses a serious risk to our business. Our RF system sales accounted for approximately 37% of our total Neuro Product segment sales in 2003, and approximately 33% of our total sales.

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

During 2003, we had two major customers that together accounted for $9.84 million, or 88.8%, of our net revenue from our HDI O.E.M. segment. Medtronic, our most significant competitor, accounted for $8.40 million, or 75.8% and Arrow accounted for $1.44 million, or 13.0%. Either of these customers could cease doing business with us at any time. If this were to occur, our revenues and profitability could be materially adversely affected, at least in the short term.

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

Our current products focus on the treatment of chronic pain using neuromodulation. Our development efforts focus on leveraging our neuromodulation expertise. The neuromodulation market is subject to

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rapid technological change and product innovation. Our competitors may succeed in developing or marketing products, using neuromodulation technology or other technologies that may be superior to ours. If we are unable to compete successfully in the development of new neuromodulation products, or if new and effective therapies not based on neuromodulation are developed, our products could be rendered obsolete or non-competitive. This would materially adversely affect our business.

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

We believe our future success will depend on our ability to manage our growth successfully, including attracting and retaining scientists, engineers and other highly skilled personnel. Our key employees are subject to confidentiality, trade secret and non-competition agreements, but may terminate their employment with us at any time. Hiring qualified management and technical personnel is difficult due to the limited number of qualified professionals. Competition for these types of employees is intense in the medical device field. If we fail to attract and retain personnel, particularly management and technical personnel, we may not be able to continue to succeed in the neuromodulation market.

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

Our success depends on our ability to continually enhance and broaden our product offerings in response to changing technologies, customer demands and competitive pressures. Accordingly, we may, as we have in the past, acquire complementary businesses, products or technologies instead of developing them ourselves. We do not know if we will be able to identify prospective acquisition targets or complete any future acquisitions, or whether we will be able to successfully integrate any acquired business, operate it profitably or retain its key employees. Integrating any business, product or technology we acquire could be expensive and time-consuming, disrupt our ongoing business and distract our management and key technical personnel. If we are unable to integrate any acquired entities, products or technologies effectively, our business will suffer. In addition, any impairment of goodwill or other intangible assets or charges resulting from the costs of acquisitions could harm our business and operating results.

We are subject to additional risks associated with international operations.

Internationally, we market our products through 20 independent distributors who represent us in 26 countries, except in Germany where we are represented by direct salespersons. In 2003, 7% of our sales revenue from our neuromodulation products segment came from international sales. International sales are subject to a number of additional risks, including the following:

    establishment by foreign regulatory agencies of requirements different from those in place in the U.S.;
 
    fluctuations in exchange rates of the U.S. dollar against foreign currencies that may affect demand for our products overseas;
 
    export license requirements, changes in tariffs, and other general trade restrictions;
 
    difficulties in staffing and managing international operations;
 
    political or economic instability; and
 
    lower and more restrictive third-party reimbursement for our products.

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Any of these risks could make it difficult or impossible for us to continue to expand our overseas operations, which could have an adverse effect on our revenues.

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

We currently conduct all of our development, manufacturing and management activities at our facilities in Plano, Texas and Budd Lake and Hackettstown, New Jersey. However, a natural disaster, such as a tornado, fire or flood, or a man-made disaster, could cause substantial delays in our operations, damage or destroy our manufacturing equipment or inventory and cause us to incur significant additional expenses. A disaster could seriously harm our business and affect our reputation with customers. The insurance we maintain may not be adequate to cover our losses in any particular case.

We may be obligated to issue shares of our common stock in the future and the number of shares could increase if our stock price decreases.

In connection with the acquisition of MicroNet in November 2002, as part of the purchase price, we agreed to pay the former MicroNet shareholders additional shares of our common stock if certain product, regulatory approval and sales milestones are met. The aggregate value of the additional potential milestone earnout payments payable in shares of our common stock was $9 million as measured at the time the transaction was completed. Of this $9 million in additional shares, we issued a fixed number of shares totaling 134,409 with an aggregate value at closing of $3 million into an escrow account. If and when specified product and regulatory milestones are achieved, we will release a specified and fixed number of shares of common stock from escrow to the former MicroNet shareholders. In addition, if and when those same product and regulatory milestones are achieved, we will also issue at that time a number of shares of our common stock with an aggregate value of up to $3 million. Finally, if and when we generate $5 million in cumulative net sales of MicroNet lead products during the four years following the closing, we will issue at that time a number of shares of our common stock with an aggregate value of $3 million. Thus, we agreed to issue shares of our common stock with an aggregate value of up to $6 million in the future upon the achievement of specific milestones, the number of shares of which will depend on the average trading price of our common stock. The average trading price for this purpose is the per share average closing price of our common stock on the Nasdaq National Market for the 30 consecutive trading days immediately prior to two business days before the applicable milestone payment date. Because the number of shares we could be required to issue depends on the average trading price at the time of payment, if the average trading price of our common stock declines significantly, we could be required to issue more shares of our common stock. For example, if our stock price were $40 per share and we were required to issue $3 million of our common stock on satisfaction of the sales milestone, we would be required to issue 75,000 shares of our common stock to the former MicroNet shareholders. If our stock price declined 50% from that level to $20 per share, however, we would be required to issue twice as many shares, or 150,000 shares.

     
ITEM 7A.
  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We invest our cash reserves in high quality short-term liquid money market instruments with major financial institutions, a high quality short-term municipal bond fund with a major financial institution and certificates of deposit. At December 31, 2003, we had $71,695 invested in money market funds, $1,677,894 in certificates of deposit with maturities less than 90 days from the purchase date and $3,735,875 in a tax-free municipal bond fund with daily liquidity. The rate of interest earned on these investments will vary with overall market rates. A hypothetical 100-basis point change in the interest rates earned on these investments would not have a material effect on our income or cash flows.

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We also have certain investments in available-for-sale securities. These investments primarily consist of investment grade municipal bonds with maturities less than one year from the date of purchase, 7-day and 35-day AAA municipal bond floaters and Freddie Mac Notes with maturities less than one-year from the date of purchase. The cost of these investments is $86,243,780 and the fair value at December 31, 2003 was $86,213,841. The investments are subject to overall bond market and interest rate risk, however the Company believes the risk to be limited since a large portion of the investments, $82,747,000, are in 7-day and 35-day municipal floaters which have no principal risk. The investment grade municipal bonds and Freddie Mac Notes may have risk of principal depending on the overall bond market. A hypothetical 10% decrease in the value of these investments from their prices at December 31, 2003 would decrease the fair value by $346,628.

We do not use derivative financial instruments to manage the impact of interest rate changes on our investments or debt instruments.

At December 31, 2003, we had no interest bearing debt.

     
ITEM 8.
  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

The information required by this item is set forth in Appendices A, B and C.

     
ITEM 9.
  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

None.

     
ITEM 9A.
  CONTROLS AND PROCEDURES

We maintain disclosure controls and procedures designed to ensure that we are able to collect the information we are required to disclose in the reports we file with the SEC and to process, summarize and disclose this information within the time periods specified in the rules of the SEC. Based on their evaluation of our disclosure controls and procedures which took place as of the end of the period covered by this report, the Chief Executive and Chief Financial Officers believe that these controls and procedures are effective to ensure that we are able to collect, process and disclose the information we are required to disclose in the reports we file with the SEC within the required time periods.

No changes in our internal controls over financial reporting have occurred during our most recently completed fiscal quarter that have materially affected or are reasonably likely to materially affect our internal controls over financial reporting.

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PART III

     
ITEM 10.
  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

The information required by this item is contained in our definitive proxy statement to be filed in connection with our 2004 annual meeting of shareholders, which information is incorporated herein by reference.

     
ITEM 11.
  EXECUTIVE COMPENSATION

The information required by this item is contained in our definitive proxy statement to be filed in connection with our 2004 annual meeting of shareholders, which information is incorporated herein by reference. Information under the captions “Compensation Committee Report” and “Performance Graph” are not incorporated herein by reference.

     
ITEM 12.
  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS

The information required by this item is contained in our definitive proxy statement to be filed in connection with our 2004 annual meeting of shareholders, which information is incorporated herein by reference.

     
ITEM 13.
  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

Inapplicable.

     
ITEM 14.
  PRINCIPAL ACCOUNTANT FEES AND SERVICES

The information required by this item is contained in our definitive proxy statement to be filed in connection with our 2004 annual meeting of shareholders, which information is incorporated herein by reference.

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PART IV

     
ITEM 15.
  EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K

(a)   Documents filed as part of this report.

  1.   Financial Statements:
See Index to Financial Statements on the second page of Appendix A.
See Appendix C.
 
  2.   Financial Statement Schedules:*
Schedule II — Valuation and Qualifying Accounts.
See Appendix B.
 
      * Those schedules not listed above are omitted as not applicable or not required.
 
  3.   Exhibits: See (c) below.

(b)   Reports on Form 8-K.

  (1)   The Company furnished a report on Form 8-K on October 23, 2003, providing under Item 12. “Results of Operations and Financial Condition”, a press release issued by the Company on October 23, 2003 disclosing information regarding our results of operations and financial condition for the third quarter ended September 30, 2003 and our outlook for 2003.
 
  (2)   The Company filed a report on Form 8-K on November 25, 2003, reporting under Item 5. “Other Events”, that Christopher G. Chavez, President and Chief Executive Officer of the Company, and James P. Calhoun, Vice President-Human Resources of the Company, each entered into a “Preset Diversification Program” (PDP) during August 2003, a stock disposition plan intended to qualify for the safe harbor offered by Rule 10b5-1 under the Securities Exchange Act of 1934, as amended. Both of the PDP plans became effective as of November 28, 2003.

(c)   Exhibits:

     
Exhibit    
Number
  Description
2.1
  Agreement and Plan of Merger, dated as of November 30, 2000, by and among Advanced Neuromodulation Systems, Inc., ANS Acquisition Corp. and Hi-tronics Designs, Inc. (10)
2.2
  Agreement and Plan of Merger, dated as of November 4, 2002, by and among Advanced Neuromodulation Systems, Inc., MicroNet Acquisition, Inc. and MicroNet Medical, Inc. (14)
3.1
  Articles of Incorporation, as amended and restated(11)
3.2
  Bylaws(11)
4.1
  Rights Agreement dated as of August 30, 1996, between Quest Medical, Inc. and KeyCorp Shareholder Services, Inc. as Rights Agent(5)
4.2
  Amendment To Rights Agreement dated as of January 25, 2002 between Advanced Neuromodulation Systems, Inc. and Computershare Investor Services LLC (formerly KeyCorp Shareholder Services, Inc) (12)
10.1
  Quest Medical, Inc. 1979 Amended and Restated Employees Stock Option Plan(2)
10.2
  Form of 1979 Employees Stock Option Agreement(3)
10.3
  Quest Medical, Inc. Directors Stock Option Plan (as amended)(2)

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Exhibit    
Number
  Description
10.4
  Form of Directors Stock Option Agreement(1)
10.6
  Quest Medical, Inc. 1995 Stock Option Plan(4)
10.7
  Form of 1995 Employee Stock Option Agreement(4)
10.8
  Quest Medical, Inc. 1998 Stock Option Plan(7)
10.9
  Advanced Neuromodulation Systems, Inc. 2000 Stock Option Plan(9)
10.10
  Employment Agreement dated April 9, 1998 between Scott F. Drees and Quest Medical, Inc.(6)
10.11
  Employment Agreement dated April 9, 1998 between F. Robert Merrill III and Quest Medical, Inc.(6)
10.12
  Employment Agreement dated April 1, 2002 between Christopher G. Chavez and Advanced Neuromodulation Systems, Inc.(13)
10.13
  Employment Agreement dated April 1, 2002 between Kenneth G. Hawari and Advanced Neuromodulation Systems, Inc.(13)
10.14
  Special Termination Agreement dated April 1, 2002 between Christopher G. Chavez and Advanced Neuromodulation Systems, Inc.(13)
10.15
  Special Termination Agreement dated April 1, 2002 between Kenneth G. Hawari and Advanced Neuromodulation Systems, Inc.(13)
10.16
  Form of Employment Agreement and Covenant Not to Compete, between the Company and key employees(1)
10.17
  Lease Agreement dated as of February 4, 1999, between Advanced Neuromodulation Systems, Inc. and Legacy Lincoln I, LTD. (8)
10.18
  Second Amendment to Lease Agreement dated as of September 1, 2002, between Advanced Neuromodulation Systems, Inc. and Plano R&D Associates, LTD. (15)
10.19
  Escrow Agreement dated November 25, 2002, among Advanced Neuromodulation Systems, Inc., Thomas E. Brust and Computershare Trust Company (16)
10.20
  Sublease Agreement dated as of June 18, 2003, between Advanced Neuromodulation Systems, Inc. and Integrated Device Technology, Inc. (17)
10.21
  Fixed Price Contract dated as of December 17, 2003, between Advanced Neuromodulation Systems, Inc. and Trane, a Division of American Standard, Inc. (17)
10.22
  Fixed Price Contract dated as of December 10, 2003, between Advanced Neuromodulation Systems, Inc. and Dallas Security Systems, Inc. (17)
10.23
  Standard Form of Agreement Between Owner and Contractor dated as of April 30, 2003, between Advanced Neuromodulation Systems, Inc. and Rogers O’Brien Construction Co., Inc. (17)
10.24
  Standard Form of Agreement Between Owner and Architect dated as of January 15, 2003, between Advanced Neuromodulation Systems, Inc. and Good Fulton & Farrell Architects (17)
10.25
  Standard Form of Agreement Between Owner and Construction Manager dated as of October 15, 2002, between Advanced Neuromodulation Systems, Inc. and Koll Development Company (17)
10.26
  Change Order dated as of August 27,2003, between Advanced Neuromodulation Systems, Inc. and Rogers O’Brien Construction Company (17)
10.27
  Abbreviated Standard Form of Agreement Between Owner and Contractor for Construction Projects of a Limited Scope dated as of June 25, 2003, between Advanced Neuromodulation Systems, Inc. and Performance Contracting, Inc. (17)
10.28
  Change Order dated as of December 15, 2003, between Advanced Neuromodulation Systems, Inc. and Rogers O’Brien Construction Company (17)
10.29
  Change Order dated as of February 20, 2004, between Advanced Neuromodulation Systems, Inc. and Rogers O’Brien Construction Company (17)
14.1
  Code of Ethics (17)
21.1
  Subsidiaries (17)
23.1
  Consent of Independent Auditors(17)
31.1
  Certification of the Chief Executive Officer Pursuant to Rule 13a-14 of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002(17)
31.2
  Certification of the Chief Financial Officer Pursuant to Rule 13a-14 of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002(17)
32.1
  Certification of the Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002(18)
32.2
  Certification of the Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002(18)

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(1)   Filed as an Exhibit to the Company’s Registration Statement on Form S-18, Registration No. 2-71198-FW, and incorporated herein by reference.
 
(2)   Filed as an Exhibit to the report of the Company on Form 10-K for the year ended December 31, 1987, and incorporated herein by reference.
 
(3)   Filed as an Exhibit to the Company’s Registration Statement on Form S-1, Registration No. 2-78186, and incorporated herein by reference.
 
(4)   Filed as an Exhibit to the Company’s Registration Statement on Form SB-2, Registration No. 33-62991, and incorporated herein by reference.
 
(5)   Filed as an Exhibit to the report of the Company on Form 8-K dated September 3, 1996, and incorporated herein by reference.
 
(6)   Filed as an Exhibit to the report of the Company on Form 10-Q for the quarter ended March 31, 1998, and incorporated herein by reference.
 
(7)   Filed as an Exhibit to the Definitive Proxy Statement on Schedule 14A dated April 27, 1998, and incorporated herein by reference.
 
(8)   Filed as an Exhibit to the report of the Company on Form 10-K for the year ended December 31, 1998, and incorporated herein by reference.
 
(9)   Filed as an Exhibit to the Definitive Proxy Statement on Schedule 14A dated April 17, 2000, and incorporated herein by reference.
 
(10)   Filed as an Exhibit to the report of the Company on Form 8-K dated January 9, 2001, and incorporated herein by reference. Upon request, the Company will furnish a copy of any omitted schedule to the Commission.
 
(11)   Filed as an Exhibit to the report of the Company on Form 10-K for the year ended December 31, 2000, and incorporated herein by reference.
 
(12)   Filed as an Exhibit to the report of the Company on Form 8-K dated January 30, 2002, and incorporated herein by reference.
 
(13)   Filed as an Exhibit to the report of the Company on Form 10-Q for the quarter ended March 31, 2002, and incorporated herein by reference.
 
(14)   Filed as an Exhibit to the report of the Company on Form 8-K dated November 26, 2002, and incorporated herein by reference.
 
(15)   Filed as an Exhibit to the report of the Company on Form 10-K for the year ended December 31, 2002, and incorporated herein by reference.
 
(16)   Filed as an Exhibit to the report of the Company on Form 10-K/A for the year ended December 31, 2002, and incorporated herein by reference.
 
(17)   Filed herewith.
 
(18)   Furnished herewith.

-43-


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Signatures

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

         
ADVANCED NEUROMODULATION SYSTEMS, INC.
 
       
  By:   /s/ Christopher G. Chavez
     
 
Date:March 15, 2004   Christopher G. Chavez
President and Chief Executive Officer

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

         
Signature
  Title
  Date
         
/s/ Christopher G. Chavez

Christopher G. Chavez
  Chief Executive Officer, President and Director of Advanced Neuromodulation Systems, Inc. (Principal Executive Officer)   March 15, 2004
/s/ F. Robert Merrill III

F. Robert Merrill III
  Executive Vice President-Finance, Chief Financial Officer and Treasurer of Advanced Neuromodulation Systems, Inc. (Principal Financial and Accounting Officer)   March 15, 2004
/s/ Hugh M. Morrison

Hugh M. Morrison
  Chairman of the Board and Director of Advanced Neuromodulation Systems, Inc.   March 15, 2004
/s/ Robert C. Eberhart

Robert C. Eberhart
  Director of Advanced Neuromodulation Systems, Inc.   March 15, 2004
/s/ Joseph E. Laptewicz, Jr.

Joseph E. Laptewicz, Jr.
  Director of Advanced Neuromodulation Systems, Inc.   March 15, 2004
/s/ J. Philip McCormick

J. Philip McCormick
  Director of Advanced Neuromodulation Systems, Inc.   March 15, 2004
/s/ Richard D. Nikolaev

Richard D. Nikolaev
  Director of Advanced Neuromodulation Systems, Inc.   March 15, 2004
/s/ Michael J. Torma

Michael J. Torma
  Director of Advanced Neuromodulation Systems, Inc.   March 15, 2004

-44-


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Appendix A

 

Consolidated Financial Statements
Independent Auditors’ Report

Three Years Ended December 31, 2003

Forming a Part of the Annual Report on

Form 10-K

Item 8

 

of

ADVANCED NEUROMODULATION SYSTEMS, INC.
(Name of issuer)

 

Filed with the

Securities and Exchange Commission

Washington, D.C. 20549

 

under

The Securities Exchange Act of 1934

 


Table of Contents

Advanced Neuromodulation Systems, Inc. and Subsidiaries

Table of Contents
to
Consolidated Financial Statements

Form 10-K — Item 8

 

 

Report of Ernst & Young LLP, Independent Auditors

 

Consolidated Financial Statements:

Consolidated Balance Sheets — December 31, 2003 and 2002
Consolidated Statements of Income — Years ended December 31, 2003, 2002 and 2001
Consolidated Statements of Cash Flows — Years ended December 31, 2003, 2002 and 2001
Consolidated Statements of Stockholders’ Equity — Three years ended December 31, 2003
Notes to Consolidated Financial Statements

 


Table of Contents

Report of Ernst & Young LLP, Independent Auditors

 

The Board of Directors Advanced Neuromodulation Systems, Inc.

We have audited the accompanying consolidated balance sheets of Advanced Neuromodulation Systems, Inc. and subsidiaries (the Company) as of December 31, 2003 and 2002, and the related consolidated statements of income, stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2003. Our audits also included the financial statement schedule listed in the Index at Item 15(a). These consolidated financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.

We conducted our audits in accordance with auditing standards generally accepted in the 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 financial statements referred to above present fairly, in all material respects, the consolidated financial position of Advanced Neuromodulation Systems, Inc. and subsidiaries at December 31, 2003 and 2002, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2003, in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.

As discussed in Note 2 to the consolidated financial statements, the Company changed its method of accounting for goodwill as of January 1, 2002, as required by Statement of Financial Accounting Standards No. 142, “Accounting for Goodwill and Other Intangible Assets.”

/s/ Ernst & Young LLP


Ernst & Young LLP

Dallas, Texas
March 8, 2004

 


Table of Contents

Advanced Neuromodulation Systems, Inc. and Subsidiaries
Consolidated Balance Sheets
December 31, 2003 and 2002

                 
Assets
  2003
  2002
Current assets:
               
Cash and cash equivalents
  $ 8,588,281     $ 10,972,974  
Marketable securities
    86,213,841       85,796,944  
Receivables:
               
Trade accounts, less allowances of $447,457 in 2003 and $295,391 in 2002
    17,892,416       10,847,237  
Interest and other
    259,687       189,017  
 
   
 
     
 
 
Total receivables
    18,152,103       11,036,254  
 
   
 
     
 
 
Inventories:
               
Raw materials
    10,766,127       7,141,338  
Work-in-process
    3,569,111       2,364,386  
Finished goods
    7,777,921       4,217,222  
 
   
 
     
 
 
Total inventories
    22,113,159       13,722,946  
 
   
 
     
 
 
Deferred income taxes
    1,423,228       1,122,617  
Income taxes receivable
    1,324,001        
Prepaid expenses and other current assets
    1,007,244       1,032,883  
 
   
 
     
 
 
Total current assets
    138,821,857       123,684,618  
 
   
 
     
 
 
Property, equipment and fixtures:
               
Land
    3,191,427       3,191,427  
New facility construction in progress
    8,825,730        
Furniture and fixtures
    4,429,672       4,022,901  
Machinery and equipment
    13,944,120       10,343,953  
Leasehold improvements
    1,822,152       1,702,965  
 
   
 
     
 
 
 
    32,213,101       19,261,246  
Less accumulated depreciation and amortization
    11,063,091       8,653,255  
 
   
 
     
 
 
Net property, equipment and fixtures
    21,150,010       10,607,991  
 
   
 
     
 
 
Minority equity investments in preferred stock
    1,104,000        
Goodwill
    12,078,668       7,407,237  
Patents and licenses, net of accumulated amortization of $1,848,354 in 2003 and $1,435,835 in 2002
    5,814,974       5,323,417  
Purchased technology, net of accumulated amortization of $2,910,895 in 2003 and $2,098,200 in 2002
    10,319,679       9,033,472  
Tradenames, net of accumulated amortization of $1,110,458 in 2003 and $969,952 in 2002
    1,800,572       1,701,154  
Customer and supplier relations, net of accumulated amortization of $194,303 in 2003
    2,373,558        
Other assets, net of accumulated amortization of $803,797 in 2003 and $529,102 in 2002
    1,342,969       586,238  
 
   
 
     
 
 
 
  $ 194,806,287     $ 158,344,127  
 
   
 
     
 
 

See accompanying notes to consolidated financial statements.

 


Table of Contents

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

                 
Liabilities and Stockholders' Equity
  2003
  2002
Current liabilities:
               
Accounts payable
  $ 5,717,222     $ 2,392,579  
Accrued salary and employee benefit costs
    4,045,361       3,077,603  
Accrued tax abatement liability
          969,204  
Accrued commissions
    1,424,471       794,521  
Income taxes payable
          822,228  
Deferred revenue
    503,093       646,577  
Warranty reserve
    294,290       402,259  
Other accrued expenses
    400,159       299,905  
 
   
 
     
 
 
Total current liabilities
    12,384,596       9,404,876  
 
   
 
     
 
 
Deferred income taxes
    3,389,255       3,731,939  
Non-current deferred revenue
    907,513       162,504  
 
               
Commitments and contingencies
               
 
               
Stockholders’ equity:
               
Common stock, $.05 par value
               
Authorized – 25,000,000 shares; Issued – 19,712,938 shares in 2003 and 18,526,014 in 2002
    985,647       926,301  
Additional capital
    149,644,033       129,738,644  
Retained earnings
    27,515,001       14,393,748  
Accumulated other comprehensive income (loss), net of tax benefit of $10,181 in 2003 and $7,155 in 2002
    (19,758 )     (13,885 )
 
   
 
     
 
 
Total stockholders’ equity
    178,124,923       145,044,808  
 
   
 
     
 
 
 
  $ 194,806,287     $ 158,344,127  
 
   
 
     
 
 

See accompanying notes to consolidated financial statements.

 


Table of Contents

Advanced Neuromodulation Systems, Inc. and Subsidiaries
Consolidated Statements of Income
Years Ended December 31

                         
    2003
  2002
  2001
Net revenue
  $ 91,081,969     $ 57,372,013     $ 37,916,435  
Cost of revenue
    27,135,320       20,658,798       15,675,436  
 
   
 
     
 
     
 
 
Gross profit
    63,946,649       36,713,215       22,240,999  
 
   
 
     
 
     
 
 
Operating expenses:
                       
Sales and marketing
    26,552,873       14,931,826       9,055,932  
Research and development
    9,525,411       5,842,576       4,928,432  
General and administrative
    7,628,127       5,738,392       3,957,867  
Amortization of other intangibles
    1,831,644       952,214       933,257  
Amortization of goodwill
                556,604  
 
   
 
     
 
     
 
 
 
    45,538,055       27,465,008       19,432,092  
 
   
 
     
 
     
 
 
Income from operations
    18,408,594       9,248,207       2,808,907  
 
               
Other income (expense):
                       
Acquisition related costs
                (483,766 )
Interest expense
          (10,759 )     (24,346 )
Investment income
    995,318       933,668       482,417  
Other income
    974,846              
 
   
 
     
 
     
 
 
 
    1,970,164       922,909       (25,695 )
 
   
 
     
 
     
 
 
Income before income taxes
    20,378,758       10,171,116       2,783,212  
Income taxes
    7,161,504       3,486,658       1,265,466  
 
   
 
     
 
     
 
 
Net income
  $ 13,217,254     $ 6,684,458     $ 1,517,746  
 
   
 
     
 
     
 
 
Net income per share:
                       
Basic
  $ .69     $ .41     $ .11  
 
   
 
     
 
     
 
 
Diluted
  $ .64     $ .37     $ .10  
 
   
 
     
 
     
 
 

See accompanying notes to consolidated financial statements.

 


Table of Contents

Advanced Neuromodulation Systems, Inc. and Subsidiaries
Consolidated Statements of Cash Flows
Years Ended December 31

                         
    2003
  2002
  2001
Cash flows from operating activities:
                       
Net income
  $ 13,217,254     $ 6,684,458     $ 1,517,746  
Adjustments to reconcile net income to net cash provided by operating activities:
                       
Depreciation
    3,054,078       2,299,335       1,932,452  
Amortization
    1,831,644       952,214       1,489,861  
Deferred income taxes
    (1,169,197 )     645,134       (455,003 )
Stock-based compensation
    845,480       123,492        
Accrued tax abatement liability
    (969,204 )            
Non-operating loss included in net income
          8,666        
Increase in inventory reserve
    84,132       51,403       107,880  
Changes in operating assets and liabilities:
                       
Receivables
    (7,115,849 )     (4,306,888 )     (1,027,050 )
Inventories
    (6,461,212 )     (4,025,504 )     (2,672,605 )
Income taxes receivable
    (1,324,001 )     678,341       (318,388 )
Prepaid expenses and other current assets
    4,306       (387,323 )     564,866  
Income taxes payable
    (822,228 )     822,228       (89,380 )
Tax benefit from stock option exercises
    9,786,072       1,847,438       1,669,405  
Accounts payable
    3,324,643       557,542       493,227  
Accrued expenses
    1,589,993       1,874,533       553,380  
Deferred revenue
    601,525       (233,609 )     (706,916 )
 
   
 
     
 
     
 
 
Total adjustments
    3,260,182       907,002       1,541,729  
 
   
 
     
 
     
 
 
Net cash provided by operating activities
    16,477,436       7,591,460       3,059,475  
 
   
 
     
 
     
 
 
Cash flows from investing activities:
                       
Proceeds from certificates of deposits with maturities over 90 days
                1,040,000  
Purchases of marketable securities
    (382,648,595 )     (188,390,536 )     (3,896,199 )
Proceeds from sales of marketable securities
    382,222,800       104,747,808       2,876,720  
Purchase of land
          (3,191,427 )      
New facility construction in progress
    (8,825,730 )            
Additions to property, equipment, fixtures and intangible assets
    (5,796,645 )     (2,942,227 )     (3,108,055 )
Minority equity investments in preferred stock
    (1,104,000 )            
Acquisition of MicroNet
          (1,359,460 )      
Acquisition of certain operations of distributors
    (10,226,900 )            
 
   
 
     
 
     
 
 
Net cash used in investing activities
    (26,379,070 )     (91,135,842 )     (3,087,534 )
 
   
 
     
 
     
 
 
Cash flows from financing activities:
                       
Payment of long-term notes
          (189,722 )     (47,807 )
Net proceeds from public offering of common stock
          83,175,353        
Exercise of stock options and warrants
    7,516,941       1,746,400       1,004,914  
 
   
 
     
 
     
 
 
Net cash provided by financing activities
    7,516,941       84,732,031       957,107  
 
   
 
     
 
     
 
 
Net increase (decrease) in cash and cash equivalents
    (2,384,693 )     1,187,649       929,048  
Net cash used by Hi-tronics in December 2000 (see Note 3)
                (672,444 )
Cash and cash equivalents at beginning of year
    10,972,974       9,785,325       9,528,721  
 
   
 
     
 
     
 
 
Cash and cash equivalents at end of year
  $ 8,588,281     $ 10,972,974     $ 9,785,325  
 
   
 
     
 
     
 
 
Supplemental cash flow information is presented below:
                       
Income taxes paid (net of refunds)
  $ 732,944     $ (415,311 )   $ 815,000  
 
   
 
     
 
     
 
 
Interest paid
  $     $ 10,759     $ 24,346  
 
   
 
     
 
     
 
 
Non-cash activity:
                       
Stock issued for patents and intangible assets
  $ 1,720,241     $ 4,648,421     $ 2,426,662  
 
   
 
     
 
     
 
 

See accompanying notes to consolidated financial statements.

 


Table of Contents

Advanced Neuromodulation Systems, Inc. and Subsidiaries
Consolidated Statements of Stockholders' Equity
Three Years Ended December 31, 2003

                                                         
                                    Accumulated Other            
                                    Comprehensive           Total
    Common Stock   Additional   Retained   Income   Treasury   Stockholders'
    Shares
  Amount
  Capital
  Earnings
  (Loss)
  Stock
  Equity
Balance at December 31, 2000 (restated for 3 for 2 stock split)
    13,324,589     $ 666,229     $ 34,247,395     $ 6,539,223     $ (83,241 )   $ (927,793 )   $ 40,441,813  
Net income
                      1,517,746                   1,517,746  
Net loss of Hi-tronics for December 2000 (see Note 3)
                      (347,679 )                 (347,679 )
Adjustment to unrealized losses on marketable securities, net of tax
                            61,991             61,991  
 
                                                   
 
 
Comprehensive income
                                                    1,232,058  
 
                                                   
 
 
Compensation expense resulting from changes to Hi-tronics stock options in December 2000
                37,029                         37,029  
Issuance of shares for stock option exercises
    283,213       14,161       990,753                         1,004,914  
Tax benefit from stock option exercises
                1,669,405                         1,669,405  
Issuance of 178,650 shares from treasury for acquisition
                1,498,869                   927,793       2,426,662  
 
   
 
     
 
     
 
     
 
     
 
     
 
     
 
 
Balance at December 31, 2001
    13,607,802       680,390       38,443,451       7,709,290       (21,250 )           46,811,881  
Net income
                      6,684,458                   6,684,458  
Adjustment to unrealized losses on marketable securities, net of tax
                            7,365             7,365  
 
                                                   
 
 
Comprehensive income
                                                    6,691,823  
 
                                                   
 
 
Sale of newly issued common stock in a public offering, net of offering costs
    4,312,500       215,625       82,959,728                         83,175,353  
Issuance of shares for stock option exercises
    371,259       18,563       1,727,837                         1,746,400  
Stock-based compensation
                123,492                         123,492  
Issuance of 234,453 shares for acquisition
    234,453       11,723       4,636,698                         4,648,421  
Tax benefit from stock option exercises
                1,847,438                         1,847,438  
 
   
 
     
 
     
 
     
 
     
 
     
 
     
 
 
Balance at December 31, 2002
    18,526,014       926,301       129,738,644       14,393,748       (13,885 )           145,044,808  
Net income
                      13,217,254                   13,217,254  
Adjustment to unrealized losses on marketable securities, net of tax
                            (5,873 )           (5,873 )
 
                                                   
 
 
Comprehensive income
                                                    13,211,381  
 
                                                   
 
 
Issuance of shares for stock option exercises
    1,124,372       56,219       7,460,722                         7,516,941  
Stock-based compensation
                845,480                         845,480  
Shares issued for fractional share round-up in 3 for 2 stock split
    2,571       128       95,873       (96,001 )                  
Issuance of earn-out shares for acquisition
    59,981       2,999       1,717,242                         1,720,241  
Tax benefit from stock option exercises
                9,786,072                         9,786,072  
 
   
 
     
 
     
 
     
 
     
 
     
 
     
 
 
Balance at December 31, 2003
    19,712,938     $ 985,647     $ 149,644,033     $ 27,515,001     $ (19,758 )   $     $ 178,124,923  
 
   
 
     
 
     
 
     
 
     
 
     
 
     
 
 

See accompanying notes to consolidated financial statements.

 


Table of Contents

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

(1) Business

Advanced Neuromodulation Systems, Inc. (the Company or ANS) designs, develops, manufactures and markets implantable neuromodulation devices. ANS devices are used primarily to manage chronic severe pain. ANS revenues are derived primarily from sales throughout the United States, Europe and Australia.

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

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

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

(2) Summary of Significant Accounting Policies

Principles of Consolidation

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

Use of Estimates

The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.

Reclassification

Certain amounts in the prior years financial statements have been reclassified to conform to the Company’s 2003 presentation.

Cash Equivalents

The Company considers all highly liquid investments with maturities of three months or less at the time of purchase to be cash equivalents.

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Advanced Neuromodulation Systems, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)

Revenue Recognition

The Company generates revenues from product sales to end customers, product sales to distributors, and development contracts. The Company recognizes revenue from neuro product sales when the goods are shipped to its customers or distributors, provided an arrangement exists, the fee is fixed and determinable, and collectibility is reasonably assured. Certain of the Company’s customers are third-party payors who reimburse fixed amounts for services based on a specific diagnosis. Revenue is recognized on these third-party payor sales based on the sales price less a contractual adjustment, which is based on the Company’s history of reimbursement with the third-party payor, provided all other revenue recognition criteria are met. The Company also records, as a reduction in revenue, a provision for estimated sales returns and adjustments on product sales in the same period as the related revenue is recorded. These estimates are based on historical sales returns, analysis of credit memo data, and other known factors. Payments received in advance of revenue recognition requirements are recorded as deferred revenue on the consolidated balance sheets. In the second quarter of 2003, the Company received a payment of $1,200,000 related to a distribution agreement under which the Company has granted the exclusive rights to market certain of its neuromodulation products in Japan. Of such payment, $1,100,000 was recorded as deferred revenue and is being amortized into revenue over the length of the distribution agreement, which at the date of payment was 9.25 years. At December 31, 2003, the balance of the deferred revenue under this agreement was $1,010,811.

The Company recognizes revenue from custom manufactured products at HDI when the goods are shipped to the customer. HDI also develops products for certain customers under fixed price research and development contracts. The Company recognizes revenue and profit under the development agreements using the percentage-of-completion method, which relies on estimates of total expected revenue and costs. The Company follows this method since reasonably dependable estimates of revenue and costs applicable to various stages of a development agreement can be made. If the Company does not accurately estimate the resources required or the scope of work to be performed under a development agreement, then future profit margins and results of operations may be negatively impacted. In certain cases, HDI will undertake a development project on a cost plus basis. In these cases, the Company invoices and recognizes revenue for actual time and material expended on the project at contractual hourly billing rates and markups.

Under the Company’s shipping terms, title transfers to the end customer or distributor at the point of shipment. Shipping and handling costs are included in cost of revenue.

Investments

The Company’s investments in marketable and debt securities are classified as available-for-sale and are carried at fair value with the unrealized gains and losses, net of tax, reported in a separate component of stockholders’ equity entitled “Accumulated Other Comprehensive Income (losses).” The cost of debt securities in this category is adjusted for amortization of premiums and accretion of discounts to maturity. Such amortization is included in investment income. Realized gains and losses and declines in value judged to be other than temporary are included in other income. The cost of securities sold is based on the specific identification method. Interest and dividends are included in investment income. The Company acquires marketable and debt securities having contractual terms less than one year, and as such all of the Company’s marketable and debt securities are classified as short-term marketable investments.

The Company holds minority investments in preferred stock, which are stated at cost given the ownership percentage is less than 10%, and represents a long-term investment in two private companies made for business purposes. Consistent with the Company’s policies for other long-lived assets, the carrying value of these long-term strategic investments is periodically reviewed for

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

impairment whenever triggering events occur that may indicate the fair value of the investment is less than the carrying value.

Accounts Receivable

The Company estimates the collectibility of its trade receivables. A considerable amount of judgment is required in assessing the ultimate realization of the receivables, including the current credit-worthiness of each customer. The Company’s historical bad debt experience has been within management’s expectations.

Inventories

Inventories are recorded at the lower of standard cost or market. Standard cost approximates actual cost determined on the first-in, first-out (FIFO) basis. Cost includes the acquisition cost of raw materials and components, direct labor and overhead. The Company reserves for excess and obsolete inventory based upon forecasted demand for its products.

Property, Equipment and Fixtures

Equipment and fixtures are stated at cost. Additions and improvements extending asset lives are capitalized while maintenance and repairs are expensed as incurred. The cost and accumulated depreciation of assets sold or retired are removed from the accounts and any gain or loss is reflected in the Statement of Income.

Depreciation is provided using the straight-line method over the estimated useful lives of the various assets as follows:

     
Leasehold improvements
  The lesser of 3 to 5 years or the term of the lease
Furniture and fixtures
  2 to 10 years
Machinery and equipment
  3 to 10 years

Construction in process represents costs incurred to fund the Company’s new headquarters facility. Depreciation of the facility will begin upon completion of construction.

Goodwill and Other Intangible Assets

Goodwill represents the excess of the purchase price over the fair value of net assets of acquired businesses. Effective January 1, 2002 the Company adopted Statement of Financial Accounting Standards No. 142 (SFAS 142), “Goodwill and Other Intangible Assets.” Under the provision of SFAS 142, goodwill and intangible assets deemed to have indefinite lives are no longer amortized but are subject to annual impairment tests in accordance with the statement.

During the first quarter of 2004, the Company performed its annual review for impairment of goodwill as of December 31, 2003 and, based on this review, no impairment was recorded. The Company must make assumptions regarding estimated future cash flows and other factors to determine the fair value of the respective assets in assessing the recoverability of its goodwill. If these estimates or the related assumptions change, the Company may be required to record impairment charges for these assets in the future.

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

Prior to the adoption of SFAS 142, amortization expense was recorded for goodwill. Had SFAS 142 been effective January 1, 2001, net income and income per share for fiscal 2001 would have been reported as follows:

         
Reported net income
  $ 1,517,746  
Goodwill amortization
    556,604  
 
   
 
 
Adjusted net income
  $ 2,074,350  
 
   
 
 
Basic net income per share:
       
Reported
  $ .11  
Goodwill amortization
    .04  
 
   
 
 
Adjusted
  $ .15  
 
   
 
 
Diluted net income per share:
       
Reported
  $ .10  
Goodwill amortization
    .04  
 
   
 
 
Adjusted
  $ .14  
 
   
 
 

The Company’s definite-lived intangible assets are reviewed for impairment whenever events indicate that their carrying amount may not be recoverable. In such reviews, the related undiscounted cash flows expected are compared with their carrying values to determine if a write-down to fair value is required. At December 31, 2003, the Company does not believe there has been any impairment of its intangible assets. The cost of purchased intangibles related to acquisitions is amortized on a straight-line basis over the following estimated useful life:

     
Purchased technology
  15 years
Tradenames
  15-20 years
Patents
  15-17 years
Customer and supplier relations
  4-7 years
Non-compete agreements (included in Other assets)
  Term of agreement

The cost of certain licensed patents is amortized on a straight-line basis over the estimated useful life (20 years) of such patents. Costs of patents that are the result of internal development are charged to current operations.

The Company expects to record annual amortization expense of approximately $1,999,000 in 2004, $1,950,000 in 2005, $1,947,000 in 2006, $1,874,000 in 2007 and $1,657,000 in 2008 related to its intangible assets as of December 31, 2003.

Warranty Obligations

The Company’s products are generally covered by a one-year warranty. The Company accrues a warranty reserve for estimated costs to provide warranty services. The estimated costs to service the Company’s warranty obligations are based on historical experience and expectation of future conditions.

Research and Development

Product development costs including start-up and research and development are charged to operations in the year in which such costs are incurred.

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

Advertising

Advertising expense is charged to operations in the year in which such costs are incurred. Total advertising expense, included in sales and marketing expense was $108,333, $74,673, and $20,592 at December 31, 2003, 2002 and 2001, respectively.

Deferred Taxes

The Company accounts for income taxes using the liability method as required by Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes” (SFAS 109). Under the liability method, deferred taxes are determined based on differences between financial reporting and tax basis of assets and liabilities and are measured using the enacted tax laws that will be in effect when the differences are expected to reverse.

Stock-Based Compensation

The Company accounts for its stock-based employee compensation plans in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB 25) and related interpretations. Under APB 25, no compensation expense is recognized for stock option grants to employees if the exercise price of the Company’s stock option grants is at or above fair market value of the underlying stock on the date of the grant. Stock-based compensation to non-employees is measured at fair market value over the service period and recorded as compensation expense in the Statement of Income. The Company recorded $845,480, $123,492 and $0 of compensation expense for stock compensation to non-employees in 2003, 2002 and 2001, respectively. The Company has adopted the pro-forma disclosure-only provisions of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (SFAS 123), as amended by Statement of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure.” The following table illustrates the effect on net income and net income per share amounts if the Company had applied the fair value recognition provisions of SFAS 123 to stock-based employee compensation:

                         
    2003
  2002
  2001
Net income as reported
  $ 13,217,254     $ 6,684,458     $ 1,517,746  
Stock-based compensation expense
    4,104,009       2,107,799       1,613,378  
 
   
 
     
 
     
 
 
Pro-forma net income (loss)
  $ 9,113,245     $ 4,576,659     $ (95,632 )
 
   
 
     
 
     
 
 
Basic shares
    19,180,041       16,350,060       13,390,478  
Diluted shares
    20,589,887       17,837,456       14,875,511  
Pro-forma Basic EPS
  $ .48     $ .28     $ (.01 )
 
   
 
     
 
     
 
 
Pro-forma Diluted EPS
  $ .44     $ .26     $ (.01 )
 
   
 
     
 
     
 
 

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

For purposes of the pro-forma disclosures above, the weighted average fair value per stock option granted in fiscal 2003, 2002, and 2001 was $11.54, $8.78, and $4.16, respectively. The fair value was estimated using the Black-Scholes option-pricing model with the following assumptions:

             
    2003
  2002
  2001
Risk-free interest rate
  2.09%   4.50%   4.40%
Average life of options (years)
  3.0   3.0   3.0
Volatility
  64.9%   67.6%   74.5%
Dividend yield
     

Earnings Per Share

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

                         
    2003
  2002
  2001
Weighted-average shares outstanding (basic shares)
    19,180,041       16,350,060       13,390,478  
Effect of dilutive instruments:(1)
                       
Stock options
    1,409,846       1,487,396       1,485,033  
 
   
 
     
 
     
 
 
Diluted weighted-average shares outstanding
    20,589,887       17,837,456       14,875,511  
 
   
 
     
 
     
 
 

(1) See Note 7 for a description of these instruments.

For 2003, 2002 and 2001 the incremental shares used for dilutive earnings per share relate to stock options whose exercise price was less than the average market price in the underlying quarterly computations. Options to purchase 29,781 shares at an average price of $30.63 per share were outstanding in 2003 and options to purchase 37,125 shares at an average price of $13.19 per share were outstanding in 2001, but were not included in the computation of diluted earnings per share because the options’ exercise prices were greater than the average market price of the common shares and, therefore, the effect would be antidilutive. In 2002, all options were included in the computation of diluted earnings per share.

Following is the Company’s computation of basic and diluted income per share for the years ended December 31:

                         
    2003
  2002
  2001
Basic income per share:
                       
Basic weighted average shares outstanding
    19,180,041       16,350,060       13,390,478  
Net income
  $ 13,217,254     $ 6,684,458     $ 1,517,746  
Net income per share
  $ 0.69     $ 0.41     $ 0.11  
 
Diluted income per share:
                       
Diluted weighted average shares outstanding
    20,589,887       17,837,456       14,875,511  
Net income
  $ 13,217,254     $ 6,684,458     $ 1,517,746  
Net income per share
  $ 0.64     $ 0.37     $ 0.10  

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

Comprehensive Income

Comprehensive income is the total of net income and all other non-owner changes in equity, and consists of net income, unrealized gains or losses on the Company’s available for sale securities, and, for 2001, the effect of the change in fiscal year end of a company acquired (see Note 3).

(3) Business Combinations and Asset Acquisitions

During 2003, the Company completed the following three acquisitions of certain operations of the Company’s existing Neuro distributors:

             
        Purchase Price
November 1, 2003
  State of the Art Medical Products   $ 4,235,627  
September 4, 2003
  Comedical, Inc.     1,134,081  
March 27, 2003
  Sun Medical, Inc.     4,857,192  
 
       
 
 
Total
      $ 10,226,900  
 
       
 
 

These transactions enable the Company to focus sales priorities on the Company’s products, expand sales coverage and invest in customer and market development. The assets and operations acquired are part of the Neuro Products segment. The purchase price of these acquisitions was recorded as follows:

                 
            Weighted
            Average
            Amortization
    Amount
  Period
Inventory
  $ 2,013,133       n/a  
Customer and supplier relations
    2,567,861     6.75 years
Non-compete agreements (included in other assets)
    857,861     4.0 years
Equipment
    116,614       n/a  
Goodwill (tax deductible)
    4,671,431       n/a  
 
   
 
         
Total
  $ 10,226,900          
 
   
 
         

On November 26, 2002, the Company completed the acquisition of MicroNet Medical, Inc. (MicroNet), a privately held developer of medical devices based on proprietary micro-lead technology. Under the terms of the transaction, which was structured as a merger, the Company acquired only MicroNet’s proprietary technology and certain associated tangible assets, which are part of the Neuro Products segment. MicroNet’s operations, other tangible assets, certain liabilities and certain employees became part of a separate, unaffiliated company. ANS assumed no material debt, liabilities, or overhead in the transaction. At closing, the Company paid the former MicroNet shareholders $500,000 in cash and 234,453 shares of ANS common stock valued at $4,648,421. The Company also paid acquisition related costs of $859,460, including an investment-banking fee of $600,000. In addition to the initial purchase price paid at closing, the Company agreed to pay the former MicroNet shareholders additional shares of ANS common stock if certain product, regulatory approval, and sales milestones are met. These milestones consist of three principal product milestones and a sales milestone. Each of the product milestones has four to six sub-milestones that relate to the delivery of specific products, and are met if and when the Company is able to submit, and when the Company receives regulatory approvals for products that have been adapted for use directly with the Company's devices. The sales milestone will be met if

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

and when $5 million in cumulative net sales are generated of MicroNet lead products during the four-year following the closing of the MicroNet transaction.

The aggregate value of the additional potential milestone earn out payments payable in shares of ANS common stock was $9 million as measured at the closing of the MicroNet transaction. Of this $9 million in additional shares, a fixed number of ANS common shares totaling 134,409 with an aggregate value at closing of $3 million were issued into an escrow account. If and when the product and regulatory milestones are met, a specified and fixed number of ANS common shares will be released from the escrow (which for purchase price accounting will be valued at the time of release from escrow). In addition, if and when those same product and regulatory milestones are achieved, at that time a number of ANS common shares will be issued with an aggregate value of up to $3 million. Finally, if and when $5 million in cumulative net sales are generated of MicroNet lead products during the four years after closing, at that time a number of ANS common shares will be issued with an aggregate value of up to $3 million.

The initial purchase price of the MicroNet acquisition was recorded in 2002 as follows:

                 
    Amount
  Amortization Period
Purchased technology
  $ 5,761,558     15 years
Tradenames
    138,181     15 years
Non-compete agreements (included in other assets)
    108,142     5 years  
 
   
 
         
Total
  $ 6,007,881          
 
   
 
         

As the MicroNet acquisition was effected through a stock-for-stock exchange, and therefore not tax deductible beyond MicroNet’s existing tax basis, the Company recorded a deferred tax liability of $2,651,720 for the identified intangible assets related to the initial purchase price. The recording of the deferred tax liability resulted in additional basis in purchased technology of $1,396,224 and in additional tradenames of $74,410. In addition, the Company acquired MicroNet’s net operating loss carryforward of approximately $3.4 million, which was recorded as a deferred tax asset of $1,181,086 (see Note 6).

In March 2003, two parts of the first major product milestone were satisfied, and 42,519 of ANS common shares were issued (of which 22,401 shares were released from escrow) with a value at the time of issuance and release from escrow of $1,020,059. In October 2003, an additional product milestone was satisfied, and 17,462 shares of ANS common shares were issued (of which 11,197 shares were released from escrow) with a value at the time of issuance and release from escrow of $700,182. The value of ANS common shares issued and released from escrow during 2003 was allocated to certain identifiable intangible assets in accordance with the original purchase price allocation, and resulted in the following additions to identifiable intangible assets:

                 
    Amount
  Amortization Period
Purchased technology
  $ 1,649,712     15 years
Tradenames
    39,565     15 years
Non-compete agreements (included in other assets)
    30,964     5 years  
 
   
 
         
Total
  $ 1,720,241          
 
   
 
         

As indicated above, the Company recorded a deferred tax liability for the identified intangible assets related to the additional earn-out consideration issued. The deferred tax liability was allocated in accordance with the original purchase price allocation resulting in an additional $449,190 and $21,305 of purchased technology and tradenames, respectively.

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

An important product milestone deadline occurred under the MicroNet acquisition agreement in November 2003, which was not met. The Company is currently in discussions with the former MicroNet shareholders regarding this product milestone. If this product milestone had been achieved by the deadline, the value of the milestone payment at December 31, 2003 was approximately $1,552,684, or 33,894 shares, which would have been allocated to certain identifiable intangible assets in accordance with the original purchase price allocation.

Another important product milestone deadline will occur in May 2004, while other milestones depend on the receipt of regulatory approvals and meeting the aggregate sales milestone referred to above. All milestones must be met by November 2006 or November 2007, depending on the milestone.

On January 1, 2001, the Company acquired the assets (primarily intellectual property consisting of patents) of Implantable Devices Limited Partnership (IDP) and ESOX Technology Holdings, LLC (ESOX), two privately-held companies, for 178,650 shares of the Company’s common stock. Based on the closing price of ANS common stock on December 29, 2000, the value of the stock issued to acquire the assets was $2,426,662. The assets purchased consisted primarily of intellectual property and developed technology, and are part of the Neuro Products segment. The purchase price of these acquisitions was recorded to patents, and is being amortized over a 15-year period.

Also on January 1, 2001, the Company completed the acquisition of Hi-tronics Designs, Inc. (HDI), a privately held contract developer and original equipment manufacturer (O.E.M) of electro-mechanical devices with headquarters in Budd Lake, New Jersey. The Company acquired all of HDI’s outstanding stock through a merger in exchange for 1,657,088 shares of ANS common stock. The transaction was accounted for on a pooling of interest basis and accordingly, prior periods were restated. Prior to the Company’s acquisition of HDI, HDI’s fiscal year ended on November 30. The Consolidated Balance Sheet at December 31, 2000 combined the balance sheet of HDI at November 30, 2000 with the Balance Sheet of the Company at December 31, 2000. Beginning in 2001, the fiscal year-ends were conformed to December 31. As a result, the results of operations of HDI for the one-month period ending December 31, 2000 have been recorded directly to retained earnings in the Consolidated Statement of Stockholders’ Equity for the period ended December 31, 2001 and are not reflected in the Consolidated Statements of Income. Summary operating results of HDI for this one-month period ending December 31, 2000, were as follows:

         
Net revenue
  $ 119,481  
Loss before income tax benefit
    (591,600 )
Net loss
    (347,679 )

For the one-month period ended December 31, 2000, cash flows for HDI were as follows:

         
Net cash used by operating activities
  $ (647,210 )
Net cash used by investing activities
    (14,516 )
Net cash used by financing activities
    (10,718 )
 
   
 
 
Net decrease in cash
  $ (672,444 )
 
   
 
 

The results of operations for the acquisitions above have been included in the Company’s consolidated Statements of Income after the date of the acquisition, with the exception of the HDI acquisition accounted for as a pooling of interest, for which prior periods have been restated.

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

(4) Marketable Securities

The following is a summary of the Company’s marketable and debt securities classified as available-for-sale securities at December 31, 2003:

                                 
            Gross   Gross    
    Amortized   Unrealized   Unrealized   Estimated
    Cost
  Gains
  Losses
  Fair Value
Freddie Mac notes
  $ 256,250     $     $ 6,562     $ 249,688  
Investment grade municipal bonds
    3,240,396       6,510       30,318       3,216,588  
7-day and 35-day AAA municipal bond floaters
    82,747,134       431             82,747,565  
 
   
 
     
 
     
 
     
 
 
 
  $ 86,243,780     $ 6,941     $ 36,880     $ 86,213,841  
 
   
 
     
 
     
 
     
 
 

Estimated fair value for the investment grade municipal bonds, 7-day and 35-day municipal bond floaters and Freddie Mac notes is provided by the brokerage firms holding such bonds and notes at each reporting period by utilizing a standard pricing service.

At December 31, 2003, no individual security represented more than 7.5% of the total portfolio or 3.25% of total assets. The Company did not have any investments in derivative financial instruments at December 31, 2003.

The following is a summary of the Company’s marketable and debt securities classified as available-for-sale securities at December 31, 2002:

                                 
            Gross   Gross    
    Amortized   Unrealized   Unrealized   Estimated
    Cost
  Gains
  Losses
  Fair Value
Freddie Mac and Federal Home Loan Bank notes
  $ 770,814     $     $ 15,474     $ 755,340  
Investment grade municipal bonds
    2,222,170       5,349       10,915       2,216,604  
7-day and 35-day AAA municipal bond floaters
    82,825,000                   82,825,000  
 
   
 
     
 
     
 
     
 
 
 
  $ 85,817,984     $ 5,349     $ 26,389     $ 85,796,944  
 
   
 
     
 
     
 
     
 
 

At December 31, 2002, no individual security represented more than 6.5% of the total portfolio or 3.5% of total assets. The Company did not have any investments in derivative financial instruments at December 31, 2002.

(5) Minority Investments in Preferred Stock

In January 2003, the Company invested $1 million in cash to purchase preferred stock for a minority equity position in Innovative Spinal Technologies, Inc., a privately held start-up company that develops spine technologies, products and services through intellectual property development and contract research. This investment is accounted for under the cost method of accounting due to the Company’s minimal ownership percentage. The Company periodically reviews the valuation of this investment using available financial information from Innovative Spine Technologies, Inc. As of December 31, 2003, there were no indicators that the fair value of the investment is less than the carrying value.

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

(6) Federal Income Taxes

The significant components of the net deferred tax liability at December 31, were as follows:

                 
    2003
  2002
Deferred tax assets:
               
Net operating loss carry forwards
  $ 1,504,601     $ 1,181,086  
Accrued expenses and reserves
    411,853       692,576  
Inventory
    456,449       236,615  
Deferred revenue
    480,978       122,680  
Marketable securities
    10,178       8,303  
Stock-based compensation
    353,990       46,309  
Other
    311,871       95,500  
 
   
 
     
 
 
Total deferred tax assets
    3,529,920       2,383,069  
 
   
 
     
 
 
Deferred tax liabilities:
               
Purchased intangible assets
    (4,224,642 )     (4,464,083 )
Equipment and fixtures
    (1,271,305 )     (528,308 )
 
   
 
     
 
 
Total deferred tax liabilities
    (5,495,947 )     (4,992,391 )
 
   
 
     
 
 
Net deferred tax liabilities
  $ (1,966,027 )   $ (2,609,322 )
 
   
 
     
 
 

As of December 31, 2003, the Company had a net operating loss carry forward of approximately $4.3 million which expires in years through 2021. Of the $4.3 million net operating loss carry forward approximately $3.4 million was acquired by the Company in connection with the MicroNet acquisition and its utilization in any future year may be subject to a limitation under Section 382 of the Internal Revenue Code or other provisions which may limit the use of the net operating loss carry forward in any tax year.

The provision (benefit) for income taxes for the years ended December 31 consists of the following:

                         
    2003
  2002
  2001
Current
  $ 7,749,925     $ 2,841,524     $ 1,747,285  
Deferred
    (588,421 )     645,134       (481,819 )
 
   
 
     
 
     
 
 
 
  $ 7,161,504     $ 3,486,658     $ 1,265,466  
 
   
 
     
 
     
 
 

A reconciliation of the provision for income taxes to the expense calculated at the U.S. statutory rate follows:

                         
    2003
  2002
  2001
Income tax expense at statutory rate
  $ 7,132,565     $ 3,458,179     $ 946,292  
Tax effect of:
                       
State taxes
    511,812       275,481       42,959  
Nondeductible amortization of goodwill
                189,245  
Tax-exempt interest
    (326,340 )     (291,745 )      
Other
    (156,533 )     44,743       86,970  
 
   
 
     
 
     
 
 
Income tax expense
  $ 7,161,504     $ 3,486,658     $ 1,265,466  
 
   
 
     
 
     
 
 

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Table of Contents

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

(7) Stockholders’ Equity

The Company has a Shareholder’s Rights Plan, adopted in 1996 and amended in 2002, which permits shareholders to purchase shares of the Company’s common stock at significant discounts in the event a person or group acquires more than 15% of the Company’s common stock or announces a tender or exchange offer for more than 20% of the Company’s common stock.

At December 31, 2000, the Company had 178,650 treasury shares. These shares were reissued on January 2, 2001 in connection with the acquisition of IDP and ESOX (see Note 3).

The Company issued 4,312,500 shares of common stock during May 2002 in an underwritten public offering. The Company received net proceeds from the offering of approximately $83.2 million.

The Company has various stock option plans (the Plans) pursuant to which stock options may be granted to key employees, officers, directors and advisory directors of the Company. In accordance with the Plans, on January 1 of each year the aggregate number of shares of common stock reserved for options under the Plans is increased by the same percentage that the total number of issued and outstanding shares of common stock increased from the preceding January 1 to the following December 31 (if such percentage is positive). On January 1, 2003 and 2004, options to purchase 1,374,353 shares and 331,859 shares of common stock, respectively, were added to the Plans.

Several of the Plans allow for the grant of incentive stock options to key employees and officers intended to qualify for preferential tax treatment under Section 422 of the Internal Revenue Code of 1986. Under all of the Company’s Plans, the exercise price of options granted must equal or exceed the fair market value of the common stock at the time of the grant. Options granted to employees and officers expire ten years from the date of grant and for the most part are exercisable one-fourth each year over a four-year period of continuous service. Options granted to directors and advisory directors expire six years from the date of grant and for the most part are exercisable one-fourth each year over a four-year period of continuous service. Certain options, however, have an eighteen-month, two-year, three-year, four year or five year vesting schedule.

At December 31, 2003, under all of the Company’s Plans, 3,290,265 shares had been granted and were outstanding, 4,852,623 shares of common stock had been issued upon exercise, and 44,562 shares were reserved for future grants.

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Table of Contents

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

Data with respect to stock option plans of the Company are as follows:

                                 
Options Outstanding
  Exercisable Options
            Weighted           Weighted
            Average           Average
    Shares
  Exercise Price
  Shares
  Exercise Price
January 1, 2001
    2,196,956     $ 5.39       911,496     $ 3.49  
Granted
    620,250     $ 8.34                  
Exercised
    (283,214 )   $ 3.72                  
Forfeited
    (30,230 )   $ 5.80                  
 
 
   
 
     
 
     
 
     
 
 
January 1, 2002
    2,503,762     $ 6.29       1,125,323     $ 4.41  
Granted
    925,500     $ 18.36                  
Exercised
    (371,259 )   $ 4.87                  
Forfeited
    (18,375 )   $ 11.46                  
 
   
 
     
 
     
 
     
 
 
 
January 1, 2003
    3,039,628     $ 10.11       1,304,607     $ 5.77  
Granted
    1,406,125     $ 26.20                  
Exercised
    (1,124,372 )   $ 6.72                  
Forfeited
    (31,116 )   $ 18.05                  
 
   
 
     
 
     
 
     
 
 
December 31, 2003
    3,290,265     $ 18.08       821,285     $ 9.07  
 
   
 
     
 
     
 
     
 
 
                                                 
                                    Exercisable Options at
Options Outstanding at December 31, 2003
  December 31, 2003
                    Weighted                    
                    Average   Weighted           Weighted
    Range of           Remaining Life   Average           Average
Exercise Prices
  Shares
  (Years)
  Exercise Price
  Shares
  Exercise Price
 
  $ 3.33-4.42       262,827       4.09     $ 3.97       262,827     $ 3.97  
 
  $ 5.02-7.42       404,398       6.79     $ 6.94       148,742     $ 6.68  
 
  $ 8.17-10.67       317,770       5.50     $ 9.46       194,851     $ 9.37  
 
  $ 12.67-16.61       340,381       7.58     $ 15.20       114,841     $ 14.61  
 
  $ 19.00-23.42       1,442,264       8.41     $ 21.33       99,274     $ 19.07  
 
  $ 25.17-37.17       480,875       9.10     $ 31.31       750     $ 25.87  
 
  $ 38.00-42.58       41,750       9.83     $ 39.31           $  
 
           
 
                     
 
         
 
            3,290,265       7.62     $ 18.08       821,285     $ 9.07  
 
           
 
                     
 
         

(8) Commitments and Contingencies

The Company leases offices, manufacturing and research facilities, as well as office equipment under operating leases. Future minimum rental payments related to these operating leases at December 31, 2003 are as follows:

                         
            Office    
    Facility Leases
  Equipment
  Total
2004
  $ 809,514     $ 4,823     $ 814,337  
2005
    259,489             259,489  
2006
    21,907             21,907  
2007 and thereafter
                 
 
   
 
     
 
     
 
 
 
  $ 1,090,910     $          4,823     $ 1,095,733  
 
   
 
     
 
     
 
 

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Table of Contents

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

Total rent expense for offices, manufacturing and research facilities, and office equipment for the years ended December 31, 2003, 2002 and 2001 was $1,190,319, $1,063,097 and $858,761, respectively.

In connection with the construction of a new corporate headquarters and manufacturing facility of 143,000 square feet located in Plano, Texas, the Company entered into various agreements in 2003 for architectural and construction services. The total amount of the agreements at inception totaled approximately $15 million. At December 31, 2003, the remaining commitment under these agreements was approximately $6.1 million. The construction on the new facility commenced in April 2003 and the Company anticipates moving its operations to the new facility before its currently leased facilities in Plano, Texas expire in August 2004.

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

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

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

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

(9) Financial Instruments, Risk Concentration and Major Customers

In the United States, the Company’s accounts receivable from its Neuro Products segment are due primarily from hospitals, insurance companies and Medicare. Internationally, the Company’s accounts receivable from its Neuro Products segment are due primarily from distributors located in Europe and Australia. For the HDI O.E.M segment, all of the accounts receivable are due from privately held and publicly traded medical device companies based in the United States. The Company generally does not require collateral for trade receivables. The Company maintains an allowance for doubtful accounts based upon expected collectibility. Any losses from bad debts have historically been within management’s expectations.

In 2003, the Company had no customer with net sales greater than 10% of net revenue for its Neuro Products segment as a result of the March 2003 acquisition of the pain management business of Sun Medical, Inc. (Sun Medical), the Company’s largest distributor. Net sales of implantable neurostimulation systems to

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Table of Contents

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

one major customer, Sun Medical for each of the years ended December 31, as a percentage of net revenue from the Neuro Products segment, were as follows: 2002- 14% and 2001- 15%.

Net sales of HDI O.E.M. products and services to two major customers for the year ended December 31, 2003, as a percentage of net revenue from the HDI O.E.M. segment were 76% and 13%, respectively. Net sales of HDI O.E.M. products and services to two major customers for the year ended December 31, 2002, as a percentage of net revenue from the HDI O.E.M. segment were 63% and 26%, respectively. Net sales of HDI O.E.M products and services to three major customers for the year ended December 31, 2001, as a percentage of net revenue from the HDI O.E.M. segment were 60%, 17% and 11%, respectively.

Foreign sales, primarily Europe and Australia, for the years ended December 31, 2003, 2002 and 2001 were approximately 7%, 8% and 10% of net revenue from the Neuro Products segment, respectively. The HDI O.E.M. segment had no foreign sales for the years ended December 31, 2003, 2002 and 2001, respectively.

(10) Employee Benefit Plans

The Company has a defined contribution retirement savings plan (the Plan) available to substantially all employees of its Neuro Products segment. The Plan permits employees to elect salary deferral contributions of up to 15% of their compensation and requires the Company to make matching contributions equal to 50% of the participants’ contributions to a maximum of 6% of the participants’ compensation. The Company also has a defined contribution retirement savings plan (the HDI Plan) available to substantially all employees of HDI. The HDI Plan permits employees to elect salary deferral contributions of up to 15% of their eligible compensation, subject to statutory limitations, and requires the Company to make matching contributions equal to 100% of the participants’ contributions to a maximum of 5% of the participants’ eligible compensation. The Board of Directors may change the percentage of matching contribution under either of the plans at their discretion. The expense of the Company’s contribution for the years ended December 31 was $475,012 in 2003, $346,125 in 2002 and $305,091 in 2001.

(11) Accrued Tax Abatement Liability

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

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Table of Contents

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

(12) Segment Information

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

Segment data as of and for the year ended December 31, 2003 is as follows:

                                 
    Neuro   HDI   Intercompany   Consolidated
    Products
  O.E.M.
  Eliminations
  Total
Revenue from external customers
  $ 80,000,647     $ 11,081,322     $     $ 91,081,969  
Intersegment revenues
  $     $ 8,054,406     $ (8,054,406 )   $  
Segment income from operations
  $ 16,406,245     $ 2,002,349     $     $ 18,408,594  
Segment assets
  $ 191,842,645     $ 11,133,803     $ (8,170,161 )   $ 194,806,287  

Segment data as of and for the year ended December 31, 2002 is as follows:

                                 
    Neuro   HDI   Intercompany   Consolidated
    Products
  O.E.M.
  Eliminations
  Total
Revenue from external customers
  $ 46,712,158     $ 10,659,855     $     $ 57,372,013  
Intersegment revenues
  $     $ 5,663,216     $ (5,663,216 )   $  
Segment income from operations
  $ 7,013,895     $ 2,234,312     $     $ 9,248,207  
Segment assets
  $ 154,451,136     $ 8,982,629     $ (5,089,638 )   $ 158,344,127  

Segment data as of and for the year ended December 31, 2001 is as follows:

                                 
    Neuro   HDI   Intercompany   Consolidated
    Products
  O.E.M.
  Eliminations
  Total
Revenue from external customers
  $ 27,460,618     $ 10,455,817     $     $ 37,916,435  
Intersegment revenues
  $     $ 2,862,652     $ (2,862,652 )   $  
Segment income from operations
  $ 1,040,036     $ 1,768,871     $     $ 2,808,907  
Segment assets
  $ 51,246,012     $ 6,847,014     $ (2,227,941 )   $ 55,865,085  

(13) Subsequent Event

In March 2004, the Company agreed to acquire microHelix, Inc.’s (microHelix) cable and wire division, which is operated out of Portland, Oregon, for approximately $2 million in cash and assumed liabilities. The transaction is subject to customary terms and conditions, including shareholder approval by microHelix shareholders. The acquisition is expected to close in April 2004. The acquisition of microHelix represents a vertical integration of a component supplier to the Company and other third parties, and provides the Company with additional research and development resources and intellectual property for the design and development of existing and new products.

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Table of Contents

Appendix B

Schedule II — Valuation and Qualifying Accounts

Forming a Part of the Annual Report

Form 10-K

Item 14

of

ADVANCED NEUROMODULATION SYSTEMS, INC.
(Name of issuer)

Filed with the

Securities and Exchange Commission

Washington, D.C. 20549

under

The Securities Exchange Act of 1934

 


Table of Contents

Schedule II — Valuation and Qualifying Accounts
Advanced Neuromodulation Systems, Inc. and Subsidiaries
December 31, 2003

                                         
    Balance at           Charged to            
    Beginning of   Charged to   Other           Balance at
Description
  Year
  Expenses
  Accounts
  Deductions
  End of Year
Year ended December 31, 2003:
                                       
Allowance for doubtful accounts
  $ 295,391     $ 199,503     $         —     $ 47,437     $ 447,457  
Year ended December 31, 2002:
                                       
Allowance for doubtful accounts
  $ 124,111     $ 186,336     $     $ 15,056     $ 295,391  
Year ended December 31, 2001:
                                       
Allowance for doubtful accounts
  $ 213,249     $ 10,000     $     $ 99,138     $ 124,111  

 


Table of Contents

Appendix C

Quarterly Financial Data
(unaudited)

Forming a Part of the Annual Report

Form 10-K

Item 8

of

ADVANCED NEUROMODULATION SYSTEMS, INC.
(Name of issuer)

Filed with the

Securities and Exchange Commission

Washington, D.C. 20549

under

The Securities Exchange Act of 1934

 


Table of Contents

                                 
2003
  1st Qtr.
  2nd Qtr.
  3rd Qtr.
  4th Qtr.
Net revenue
  $ 19,670,591     $ 22,324,461     $ 23,418,505     $ 25,668,412  
Gross profit
    12,788,900       15,273,182       17,034,060       18,850,507  
Income from operations
    3,815,709       4,273,899       5,165,514       5,153,472  
Income from operations before income taxes (1)
    4,097,364       4,568,371       6,334,961       5,378,062  
Net income
  $ 2,619,814     $ 2,923,115     $ 3,952,852     $ 3,721,473  
 
   
 
     
 
     
 
     
 
 
Basic income per share
  $ 0.14     $ 0.15     $ 0.20     $ 0.19  
 
   
 
     
 
     
 
     
 
 
 
                               
 
   
 
     
 
     
 
     
 
 
Diluted income per share
  $ 0.13     $ 0.14     $ 0.19     $ 0.18  
 
   
 
     
 
     
 
     
 
 

(1) Q3 2003 includes other income of $969,204 from the reversal of an accrued tax abatement liability.

                                 
2002
  1st Qtr.
  2nd Qtr.
  3rd Qtr.
  4th Qtr.
Net revenue
  $ 11,472,646     $ 13,423,371     $ 14,327,505     $ 18,148,491  
Gross profit
    6,958,486       8,359,944       9,474,096       11,920,689  
Income from operations
    1,239,225       2,084,679       2,532,874       3,391,429  
Income from operations before income taxes
    1,308,425       2,227,928       2,905,351       3,729,412  
Net income
  $ 836,976     $ 1,448,441     $ 1,942,303     $ 2,456,738  
 
   
 
     
 
     
 
     
 
 
Basic income per share
  $ .06     $ .10     $ .11     $ .13  
 
   
 
     
 
     
 
     
 
 
 
                               
 
   
 
     
 
     
 
     
 
 
Diluted income per share
  $ .05     $ .09     $ .10     $ .12  
 
   
 
     
 
     
 
     
 
 

 


Table of Contents

INDEX TO EXHIBITS

     
Exhibit    
Number
  Description
2.1
  Agreement and Plan of Merger, dated as of November 30, 2000, by and among Advanced Neuromodulation Systems, Inc., ANS Acquisition Corp. and Hi-tronics Designs, Inc. (10)
2.2
  Agreement and Plan of Merger, dated as of November 4, 2002, by and among Advanced Neuromodulation Systems, Inc., MicroNet Acquisition, Inc. and MicroNet Medical, Inc. (14)
3.1
  Articles of Incorporation, as amended and restated(11)
3.2
  Bylaws(11)
4.1
  Rights Agreement dated as of August 30, 1996, between Quest Medical, Inc. and KeyCorp Shareholder Services, Inc. as Rights Agent(5)
4.2
  Amendment To Rights Agreement dated as of January 25, 2002 between Advanced Neuromodulation Systems, Inc. and Computershare Investor Services LLC (formerly KeyCorp Shareholder Services, Inc) (12)
10.1
  Quest Medical, Inc. 1979 Amended and Restated Employees Stock Option Plan(2)
10.2
  Form of 1979 Employees Stock Option Agreement(3)
10.3
  Quest Medical, Inc. Directors Stock Option Plan (as amended)(2)
10.4
  Form of Directors Stock Option Agreement(1)
10.6
  Quest Medical, Inc. 1995 Stock Option Plan(4)
10.7
  Form of 1995 Employee Stock Option Agreement(4)
10.8
  Quest Medical, Inc. 1998 Stock Option Plan(7)
10.9
  Advanced Neuromodulation Systems, Inc. 2000 Stock Option Plan(9)
10.10
  Employment Agreement dated April 9, 1998 between Scott F. Drees and Quest Medical, Inc.(6)
10.11
  Employment Agreement dated April 9, 1998 between F. Robert Merrill III and Quest Medical, Inc.(6)
10.12
  Employment Agreement dated April 1, 2002 between Christopher G. Chavez and Advanced Neuromodulation Systems, Inc.(13)
10.13
  Employment Agreement dated April 1, 2002 between Kenneth G. Hawari and Advanced Neuromodulation Systems, Inc.(13)
10.14
  Special Termination Agreement dated April 1, 2002 between Christopher G. Chavez and Advanced Neuromodulation Systems, Inc.(13)
10.15
  Special Termination Agreement dated April 1, 2002 between Kenneth G. Hawari and Advanced Neuromodulation Systems, Inc.(13)
10.16
  Form of Employment Agreement and Covenant Not to Compete, between the Company and key employees(1)
10.17
  Lease Agreement dated as of February 4, 1999, between Advanced Neuromodulation Systems, Inc. and Legacy Lincoln I, LTD. (8)
10.18
  Second Amendment to Lease Agreement dated as of September 1, 2002, between Advanced Neuromodulation Systems, Inc. and Plano R&D Associates, LTD. (15)
10.19
  Escrow Agreement dated November 25, 2002, among Advanced Neuromodulation Systems, Inc., Thomas E. Brust and Computershare Trust Company (16)
10.20
  Sublease Agreement dated as of June 18, 2003, between Advanced Neuromodulation Systems, Inc. and Integrated Device Technology, Inc. (17)
10.21
  Fixed Price Contract dated as of December 17, 2003, between Advanced Neuromodulation Systems, Inc. and Trane, a Division of American Standard, Inc. (17)
10.22
  Fixed Price Contract dated as of December 10, 2003, between Advanced Neuromodulation Systems, Inc. and Dallas Security Systems, Inc. (17)
10.23
  Standard Form of Agreement Between Owner and Contractor dated as of April 30, 2003, between Advanced Neuromodulation Systems, Inc. and Rogers O’Brien Construction Co., Inc. (17)
10.24
  Standard Form of Agreement Between Owner and Architect dated as of January 15, 2003, between Advanced Neuromodulation Systems, Inc. and Good Fulton & Farrell Architects (17)
10.25
  Standard Form of Agreement Between Owner and Construction Manager dated as of October 15, 2002, between Advanced Neuromodulation Systems, Inc. and Koll Development Company (17)

 


Table of Contents

     
Exhibit    
Number
  Description
10.26
  Change Order dated as of August 27,2003, between Advanced Neuromodulation Systems, Inc. and Rogers O’Brien Construction Company (17)
10.27
  Abbreviated Standard Form of Agreement Between Owner and Contractor for Construction Projects of a Limited Scope dated as of June 25, 2003, between Advanced Neuromodulation Systems, Inc. and Performance Contracting, Inc. (17)
10.28
  Change Order dated as of December 15, 2003, between Advanced Neuromodulation Systems, Inc. and Rogers O’Brien Construction Company (17)
10.29
  Change Order dated as of February 20, 2004, between Advanced Neuromodulation Systems, Inc. and Rogers O’Brien Construction Company (17)
14.1
  Code of Ethics (17)
21.1
  Subsidiaries (17)
23.1
  Consent of Independent Auditors (17)
31.1
  Certification of the Chief Executive Officer Pursuant to Rule 13a-14 of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002(17)
31.2
  Certification of the Chief Financial Officer Pursuant to Rule 13a-14 of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002(17)
32.1
  Certification of the Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002(18)
32.2
  Certification of the Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002(18)


(1)   Filed as an Exhibit to the Company’s Registration Statement on Form S-18, Registration No. 2-71198-FW, and incorporated herein by reference.
(2)   Filed as an Exhibit to the report of the Company on Form 10-K for the year ended December 31, 1987, and incorporated herein by reference.
(3)   Filed as an Exhibit to the Company’s Registration Statement on Form S-1, Registration No. 2-78186, and incorporated herein by reference.
(4)   Filed as an Exhibit to the Company’s Registration Statement on Form SB-2, Registration No. 33-62991, and incorporated herein by reference.
(5)   Filed as an Exhibit to the report of the Company on Form 8-K dated September 3, 1996, and incorporated herein by reference.
(6)   Filed as an Exhibit to the report of the Company on Form 10-Q for the quarter ended March 31, 1998, and incorporated herein by reference.
(7)   Filed as an Exhibit to the Definitive Proxy Statement on Schedule 14A dated April 27, 1998, and incorporated herein by reference.
(8)   Filed as an Exhibit to the report of the Company on Form 10-K for the year ended December 31, 1998, and incorporated herein by reference.
(9)   Filed as an Exhibit to the Definitive Proxy Statement on Schedule 14A dated April 17, 2000, and incorporated herein by reference.
(10)   Filed as an Exhibit to the report of the Company on Form 8-K dated January 9, 2001, and incorporated herein by reference. Upon request, the Company will furnish a copy of any omitted schedule to the Commission.
(11)   Filed as an Exhibit to the report of the Company on Form 10-K for the year ended December 31, 2000, and incorporated herein by reference.
(12)   Filed as an Exhibit to the report of the Company on Form 8-K dated January 30, 2002, and incorporated herein by reference.
(13)   Filed as an Exhibit to the report of the Company on Form 10-Q for the quarter ended March 31, 2002, and incorporated herein by reference.
(14)   Filed as an Exhibit to the report of the Company on Form 8-K dated November 26, 2002, and incorporated herein by reference.
(15)   Filed as an Exhibit to the report of the Company on Form 10-K for the year ended December 31, 2002, and incorporated herein by reference.
(16)   Filed as an Exhibit to the report of the Company on Form 10-K/A for the year ended December 31, 2002, and incorporated herein by reference.
(17)   Filed herewith.
(18)   Furnished herewith.