e10vq

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(MARK ONE)


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

FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2005


o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT 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		75-1646002

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


6901 Preston Road, Plano, Texas		75024

(Address of Principal Executive Offices)		(Zip Code)


(972) 309-8000

(Registrant’s Telephone Number, Including Area Code)

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

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

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


		Number of Shares Outstanding at
Title of Each Class		August 5, 2005

Common stock, $.05 Par Value		20,091,083

ITEM 1. FINANCIAL STATEMENTS

Advanced Neuromodulation Systems, Inc. and Subsidiaries

Condensed Consolidated Balance Sheets
June 30, 2005 (Unaudited) and December 31, 2004


	June 30,		December 31,
	2005		2004
Assets
Current assets:
Cash and cash equivalents	$	6,405,232	$	6,654,712
Marketable securities		148,074,550		117,361,352
Receivables:
Trade accounts, less allowances of $464,933 in 2005 and $398,627 in 2004		29,860,358		25,322,813
Interest and other		1,699,372		638,987

Total receivables		31,559,730		25,961,800


Inventories:
Raw materials		8,219,072		10,067,802
Work-in-process		6,051,168		4,435,746
Finished goods		9,541,369		9,420,303

Total inventories		23,811,609		23,923,851


Deferred income taxes		1,997,418		2,029,091
Prepaid expenses and other current assets		1,725,235		1,888,957

Total current assets		213,573,774		177,819,763


Property, equipment and fixtures:
Land		3,191,427		3,191,427
Building		17,715,521		17,523,181
Furniture and fixtures		8,014,640		6,829,357
Machinery and equipment		20,937,213		18,757,126
Leasehold improvements		652,804		638,778

		50,511,605		46,939,869
Less accumulated depreciation and amortization		16,297,960		13,764,540

Net property, equipment and fixtures		34,213,645		33,175,329


Minority equity investments in preferred stock		1,104,000		1,104,000
Goodwill		12,078,668		12,078,668
Patents and licenses, net of accumulated amortization of $2,550,365 in 2005 and $2,301,780 in 2004		6,751,609		6,208,520
Purchased technology, net of accumulated amortization of $4,434,545 in 2005 and $3,917,268 in 2004		10,897,632		11,414,908
Tradenames, net of accumulated amortization of $1,349,759 in 2005 and $1,266,929 in 2004		1,886,312		1,901,470
Customer and supplier relations, net of accumulated amortization of $878,018 in 2005 and $645,336 in 2004		2,187,234		2,429,671
Other assets, net of accumulated amortization of $1,415,463 in 2005 and $1,202,605 in 2004		1,201,885		1,354,812

	$	283,894,759	$	247,487,141

See accompanying notes to condensed consolidated financial statements.

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Advanced Neuromodulation Systems, Inc. and Subsidiaries

Condensed Consolidated Balance Sheets (continued)
June 30, 2005 (Unaudited) and December 31, 2004


	June 30,			December 31,
	2005			2004
Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable	$	2,913,064		$	3,206,516
Accrued salary and employee benefit costs		3,549,714			2,390,721
Accrued commissions		2,641,180			2,656,112
Income taxes payable		16,626,851			708,412
Deferred revenue		107,028			165,861
Other accrued expenses		750,497			342,075

Total current liabilities		26,588,334			9,469,697


Deferred income taxes		6,126,604			14,734,487
Non-current deferred revenue		643,605			718,820

Commitments and contingencies

Stockholders’ equity:
Common stock $.05 par value
Authorized — 100,000,000 shares;
Issued — 20,837,953 shares in 2005 and 20,337,501 in 2004		1,041,897			1,016,875
Additional capital		173,608,096			161,625,018
Retained earnings		109,336,386			45,681,864
Accumulated other comprehensive income, net of tax expense of $4,227 in 2005 and $8,544,328 in 2004		7,045			14,240,380
Deferred compensation		(7,879,159	)		—
Treasury stock, at cost — 923,674 shares in 2005		(25,578,049	)		—

Total stockholders’ equity		250,536,216			222,564,137


	$	283,894,759		$	247,487,141

See accompanying notes to condensed consolidated financial statements.

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Advanced Neuromodulation Systems, Inc. and Subsidiaries

Condensed Consolidated Statements of Income (Unaudited)
For the Three Months and Six Months Ended June 30, 2005 and 2004


	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2005			2004			2005			2004
Net revenue	$	38,693,227		$	30,487,851		$	71,028,690		$	57,120,714
Cost of revenue		10,475,418			8,371,311			18,922,252			15,336,843

Gross profit		28,217,809			22,116,540			52,106,438			41,783,871


Operating expenses:
Sales and marketing		12,051,776			9,454,727			22,142,095			18,018,773
Research and development		4,464,991			2,869,660			7,789,698			5,184,610
General and administrative		4,007,926			2,706,956			7,351,380			5,023,696
Amortization of other intangibles		657,547			623,773			1,297,527			1,198,647

		21,182,240			15,655,116			38,580,700			29,425,726

Income from operations		7,035,569			6,461,424			13,525,738			12,358,145


Other income (expense):
Gain on sale of investment in common stock of Cyberonics, Inc.		—			—			85,244,301			—
Foreign currency transaction loss		(117,190	)		(25,506	)		(164,815	)		(54,853	)
Investment income		1,091,257			229,842			1,638,118			481,171

		974,067			204,336			86,717,604			426,318


Income before income taxes		8,009,636			6,665,760			100,243,342			12,784,463
Income taxes		2,923,517			2,342,348			36,588,820			4,492,460

Net income	$	5,086,119		$	4,323,412		$	63,654,522		$	8,292,003


Net income per share:
Basic	$	.26		$	.22		$	3.18		$	.41


Diluted	$	.25		$	.21		$	3.06		$	.39

See accompanying notes to condensed consolidated financial statements.

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Advanced Neuromodulation Systems, Inc. and Subsidiaries

Condensed Consolidated Statements of Cash Flows (Unaudited)
For the Six Months Ended June 30, 2005 and 2004


	Six Months Ended June 30,
	2005			2004
Cash flows from operating activities:
Net income	$	63,654,522		$	8,292,003
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Depreciation and amortization		3,804,508			3,221,292
Deferred income taxes		(9,852	)		(72,059	)
Stock-based compensation		416,913			(1,150	)
Increase in inventory reserve		4,543			—
Amortization of premiums on marketable securities		470,104			—
Gain on sale of marketable securities		(85,242,293	)
Changes in operating assets and liabilities, net of acquisitions:
Receivables		(5,597,930	)		(5,637,013	)
Inventories		107,699			(204,256	)
Income taxes receivable		—			931,075
Prepaid expenses and other current assets		(185,648	)		(1,029,176	)
Income taxes payable		15,918,438			—
Tax benefit from stock option exercises		1,112,537			3,429,444
Accounts payable		(293,452	)		(2,708,241	)
Accrued expenses		1,552,483			(1,665,633	)
Deferred revenue		(134,047	)		(412,039	)

Total adjustments		(68,075,997	)		(4,147,756	)

Net cash provided by (used in) operating activities		(4,421,475	)		4,144,247


Cash flows from investing activities:
Purchases of marketable securities		(254,606,951	)		(100,101,123	)
Proceeds from sale of investment in common stock of Cyberonics, Inc.		135,287,911			—
Proceeds from sales of marketable securities		150,883,781			101,157,866
New facility construction		—			(5,319,263	)
Acquisition of certain assets of microHelix, Inc.		—			(2,046,105	)
Acquisition of certain operations of distributors		—			(1,086,558	)
Additions to property, equipment, fixtures and intangible assets		(4,458,116	)		(5,202,664	)

Net cash provided by (used in) investing activities		27,106,625			(12,597,847	)


Cash flows from financing activities:
Purchase of treasury stock		(25,578,049	)		—
Exercise of stock options		2,599,491			4,365,088

Net cash provided by (used in) financing activities		(22,978,558	)		4,365,088


Net decrease in cash and cash equivalents		(293,408	)		(4,088,512	)
Effect of exchange rates on cash and cash equivalents		43,928			(103,188	)
Cash and cash equivalents at beginning of year		6,654,712			8,588,281

Cash and cash equivalents at June 30	$	6,405,232		$	4,396,581


Non-cash activity:
Stock issued for intangible assets	$	—		$	767,511

Assumed acquisition liabilities	$	—		$	131,574

See accompanying notes to condensed consolidated financial statements.

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Advanced Neuromodulation Systems, Inc. and Subsidiaries

Condensed Consolidated Statements of Stockholders’ Equity
For The Year Ended December 31, 2004 and the Six Months Ended June 30, 2005 (Unaudited)


									Accumulated
									Other									Total
	Common Stock				Additional		Retained		Comprehensive			Deferred			Treasury			Stockholders'
	Shares		Amount		Capital		Earnings		Income (Loss)			Compensation			Stock			Equity
Balance at December 31, 2003		19,712,938	$	985,647	$	149,644,033	$	27,515,001	$	(19,758	)	$	—		$	—		$	178,124,923
Net income		—		—		—		18,166,863		—			—			—			18,166,863
Adjustment to unrealized gains (losses) on marketable securities, net of tax		—		—		—		—		14,280,634			—			—			14,280,634
Foreign currency translation adjustment		—		—		—		—		(20,496	)		—			—			(20,496	)

Comprehensive income																			32,427,001

Issuance of shares for stock option exercises		607,858		30,393		5,995,463		—		—			—			—			6,025,856
Non-employee stock-based compensation		—		—		115,892		—		—			—			—			115,892
Issuance of earn-out shares for acquisition		16,705		835		766,676		—		—			—			—			767,511
Tax benefit from stock option exercises		—		—		5,102,954		—		—			—			—			5,102,954

Balance at December 31, 2004		20,337,501		1,016,875		161,625,018		45,681,864		14,240,380			—			—			222,564,137
Net income		—		—		—		63,654,522		—			—			—			63,654,522
Adjustment to unrealized gains (losses) on marketable securities, net of tax		—		—		—		—		(14,277,263	)		—			—			(14,277,263	)
Foreign currency translation adjustment		—		—		—		—		43,928			—			—			43,928

Comprehensive income																			49,421,187

Issuance of shares for stock option exercises		206,497		10,325		2,589,166		—		—			—			—			2,599,491
Non-employee stock-based compensation		—		—		75,160		—		—			—			—			75,160
Tax benefit from stock option exercises		—		—		1,112,537		—		—			—			—			1,112,537
Issuance of restricted stock awards		293,955		14,697		8,206,215		—		—			(8,220,912	)		—			—
Amortization of deferred compensation		—		—		—		—		—			341,753			—			341,753
Purchase of 923,674 treasury shares, at cost		—		—		—		—		—			—			(25,578,049	)		(25,578,049	)

Balance at June 30, 2005		20,837,953	$	1,041,897	$	173,608,096	$	109,336,386	$	7,045		$	(7,879,159	)	$	(25,578,049	)	$	250,536,216

See accompanying notes to condensed consolidated financial statements.

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Advanced Neuromodulation Systems, Inc. and Subsidiaries

Notes to Condensed 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. The Company also provides contract development and custom manufacturing, also known as O.E.M. or original equipment manufacturing, for other medical device companies through the Hi-tronics Designs, Inc. (HDI) subsidiary and through operations in Portland, Oregon (formerly the Cable and Wire Division of microHelix, Inc., which was acquired in April 2004). ANS neuromodulation revenues are derived primarily from sales throughout the United States, Europe and Australia while O.E.M. revenues are derived within the United States.

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

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

(2)		Condensed Financial Statements

		The unaudited condensed consolidated financial information contained in this report reflects all adjustments (consisting of normal recurring accruals) considered necessary, in the opinion of management, for a fair presentation of results for the interim periods presented. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from these estimates.

		Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted. These financial statements should be read in conjunction with the financial statements and notes thereto included in our December 31, 2004 Annual Report on Form 10-K. The results of operations for the period ended June 30, 2005 are not necessarily indicative of operations for the full year.

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Advanced Neuromodulation Systems, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Continued)

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

(3)		Marketable Securities

		In August 2004, the Company acquired 3,500,000 shares, or approximately 14.7%, of the outstanding common stock of Cyberonics, Inc. in open market purchases. The aggregate purchase price paid for the shares was $49.7 million. In February 2005, the Company sold the 3,500,000 shares and received gross proceeds on the sale of $135.3 million, resulting in a pre-tax gain of $85.2 million, net of acquisition costs.

(4)		Stock-Based Compensation

		The Company accounts for its stock-based compensation plans in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB 25) and related interpretations. Under APB 25, no compensation expense is recognized for stock option grants if the exercise price of the Company’s stock option grants is at or above fair market value of the underlying stock on the date of grant. Stock-based compensation to non-employees is measured at fair market value over the service period and recorded as compensation expense in the Condensed Consolidated Statements of Income. The Company recorded $154,775 and $18,248 of stock-based compensation expense to non-employees in the three months ended June 30, 2005 and 2004, respectively. The Company recorded $75,160 and $(1,150) of stock-based compensation expense (benefit) to non-employees in the six months ended June 30, 2005 and 2004, respectively. During the second quarter of 2005, the Company issued 293,955 restricted stock awards to employees and directors of the Company pursuant to the terms of the Company’s 2004 Stock Incentive Plan. The fair market value of the awards, based on the price of the Company’s common stock at issuance, has been recorded to deferred compensation in the Condensed Consolidated Statements of Stockholders’ Equity and is being amortized over the associated four-year vesting period.

		The Company has adopted the pro forma disclosure-only provisions of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (SFAS 123), as amended by Statement of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure.” The following table illustrates the effect on net income and net income per share amounts if the Company had applied the fair value recognition provisions of SFAS 123 to stock-based employee compensation:

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Advanced Neuromodulation Systems, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Continued)


	Three Months Ended June 30,						Six Months Ended June 30,
	2005			2004			2005			2004
Net income as reported	$	5,086,119		$	4,323,412		$	63,654,522		$	8,292,003
Add: Stock-based employee compensation expense included in reported earnings, net of tax		217,013			—			217,013			—
Deduct: Total stock-based employee compensation expense determined under fair value based methods for all awards, net of tax		(1,600,668	)		(1,259,896	)		(2,967,464	)		(2,426,203	)

Pro forma net income	$	3,702,464		$	3,063,516		$	60,904,071		$	5,865,800


Basic shares		19,678,020			20,107,481			20,022,505			20,018,213

Diluted shares		20,442,848			21,047,875			20,817,647			21,158,756

Pro forma Basic EPS	$	.19		$	.15		$	3.04		$	.29


Pro forma Diluted EPS	$	.18		$	.15		$	2.93		$	.28

(5)		Commitments and Contingencies

		The Company is a party to product liability claims related to its neurostimulation devices and other ordinary routine litigation claims arising in the ordinary course of business.

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

		On April 21, 2004, the Company filed a lawsuit in the U.S. District Court for the Eastern District of Texas, Sherman Division (Docket No. 4:404-CV-00131-PNB-DDB) (the Texas Action) against Advanced Bionics Corporation, asserting claims of patent infringement, misappropriation of trade secrets, tortious interference with contract, misappropriation of time, labor, skill, and money, violation of the Texas Theft Act, conversion and constructive trust. As initially filed, the lawsuit alleged, among other things, that Advanced Bionics is infringing U.S. Patent No. 4,793,353 entitled “Non-Invasive Multiprogrammable Tissue Stimulator and Method.” In addition, the lawsuit alleged that Advanced Bionics hired a former ANS employee to aid in the design, development and manufacture of its implantable stimulation lead, that Advanced Bionics misappropriated the former employee’s knowledge of ANS’ confidential, proprietary, and trade secret

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Advanced Neuromodulation Systems, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Continued)

information with respect to ANS’ implantable stimulation leads, and that this enabled Advanced Bionics to unfairly compete with ANS. The lawsuit seeks injunctive relief, compensatory and punitive damages, attorneys’ fees and costs. On October 15, 2004, the judge in the Texas Action granted the Company’s motion to amend its lawsuit to add two additional patent infringement claims against Advanced Bionics. One claim relates to the Company’s patent covering the design and structure of its electrode lead (U.S. Patent No. 6,216,045). The second claim relates to the Company’s trial cable connector patent (U.S. Patent No. 6,154,678). In addition, the judge denied Advanced Bionics’ motion to dismiss the Texas Action. Advanced Bionics filed a California action in federal court seeking to resolve the Company’s patent claims, which was subsequently dismissed. Advanced Bionics has also made motions to transfer the Texas Action to a California federal court, which the judge in the Texas Action has dismissed.

On January 28, 2005, the judge in the Texas Action granted Advanced Bionic’s motion to compel alternative dispute resolution of our trade secrets misappropriation claims, although the judge ruled that he retains jurisdiction over those claims. On March 11, 2005, Advanced Bionics filed its First Amended Answer and Counterclaims in the Texas Action, asserting, among other things, that the Company is infringing Advanced Bionics’ U.S. Patent Nos. 6,516,277 and 6,381,496. Advanced Bionics claims that the Company is infringing these patents at least by marketing and selling GenesisRC rechargeable IPG systems, and Advanced Bionics may assert that the Company’s newly-approved Eon system does as well. These patents relate to changing operational parameters sets (6,381,496) and to a specific type of rechargeable spinal cord stimulation system (6,516,277). The counterclaims seek temporary restraining orders, permanent injunctions, compensatory damages, exemplary damages including treble damages, pre and post judgment interest, attorneys’ fees and such other relief as the court may grant. The Company intends to vigorously defend itself against these claims, which the Company believes are meritless because, among other things, the Company believes the patents are not infringed or are invalid.

A “Markman Hearing,” which relates to the parties’ contending positions on the proper legal interpretation of the patent claims at issue, was held on April 15, 2005. This hearing only covered the three ANS patents at issue in the case. The judge has not yet issued a ruling on the Markman Hearing results, which could have a material impact on the relative strength or weakness of the parties’ position in the litigation.

On July 12, 2005, ANS and the former ANS employee attempted to resolve ANS’ trade secrets misappropriation claims through mediation. No resolution or settlement was effected by the mediation.

Although a specific trial date has not been set, the judge has indicated that he expects to commence the trial of the case on the ANS patents in January 2006.

In late January 2005, the Company received a subpoena from the Office of the Inspector General, Department of Health and Human Services (OIG), requesting documents related to certain of its sales and marketing, reimbursement, Medicare and Medicaid billing, and certain other business practices. The Company is cooperating fully with the OIG’s request for documents.

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Advanced Neuromodulation Systems, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Continued)

		In late May 2005, the United States District Court for the Eastern District of Texas granted an order consolidating the three previously filed class action securities lawsuits against the Company and certain of its officers and directors that were filed on behalf of purchasers of the Company’s securities between April 24, 2003 and February 16, 2005, inclusive (the Class Period) into a single consolidated complaint styled as: PLA, LLC vs. Advanced Neuromodulation Systems, Inc., et al. The court also granted an order appointing lead and liaison counsel and appointing the lead plaintiff in the lawsuit. The three previously filed suits each alleged the Company violated federal securities laws by the issuance of false and misleading statements to the market regarding the Company’s financial performance throughout the Class Period, which statements allegedly had the effect of artificially inflating the market price of the Company’s securities. In particular, the claims alleged that improper marketing and sales practices accounted for the Company’s revenue growth, citing, among other things, the Company’s public announcement made on February 17, 2005 that the Company had received a subpoena from the Office of the Inspector General, Department of Health and Human Services, requesting documents related to sales and marketing, reimbursement, Medicare and Medicaid billing and other business practices. The plaintiffs were seeking unspecified compensatory damages and costs and expenses of litigation. No class has been certified at this time. The Company currently anticipates that the lead plaintiff will file an amended consolidated complaint in September 2005. The Company intends to vigorously defend itself against the claims made in the lawsuit and believes the lawsuit is without merit.

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

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

		In addition, under its distributor agreements, sales agent agreements and certain other ordinary course commercial contracts with third parties, the Company typically agrees to indemnify the other contracting party from damages and costs that may arise from product liability claims. The terms of the agreements and contracts vary and the potential exposure under these indemnities cannot reasonably be estimated or determined. The Company currently is not aware of any indemnification claims, nor has the Company had any indemnification claims historically.

(6)		Income Taxes

		The Company recorded income tax expense during the three months and six months ended June 30, 2005 of $2,923,517 and $36,588,820, respectively, representing an overall effective tax rate in both periods of 36.5%. For the three months and six months

-12-

Advanced Neuromodulation Systems, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Continued)

		ended June 30, 2004, the Company recorded income tax expense of $2,342,348 and $4,492,460, respectively, representing an overall effective tax rate in both periods of 35.1%. The increased effective tax rate in 2005 is due to the $85.2 million pre-tax gain resulting from the sale of the Company’s investment in Cyberonics, Inc., which had the impact of increasing federal and state taxable income without a significant corresponding increase in other permanent exclusions from taxable income. The effective tax rates in 2005 and 2004 reflect a provision for federal income taxes at the statutory rate of 35% and a provision for state taxes, offset by tax-exempt investment income, the research and development tax credit, and benefits related to the extra-territorial income (ETI) exclusion.

(7)		Net Income Per Share

		Basic net income per share is computed based only on the weighted average number of common shares outstanding during the period. Diluted net income per share is computed using the additional dilutive effect, if any, of stock options and restricted stock awards 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:


	Three Months Ended				Six Months Ended
	June 30,				June 30,
	2005		2004		2005		2004
Weighted-average shares outstanding (basic shares)		19,678,020		20,107,481		20,022,505		20,018,213
Effect of dilutive stock options and restricted stock awards		764,828		940,394		795,142		1,140,543

Diluted shares		20,442,848		21,047,875		20,817,647		21,158,756

		For the three months and six months ended June 30, 2005 and 2004, the incremental shares used for dilutive earnings per share relate to stock options whose exercise price was less than the average market price in the underlying quarterly computations. For the three months ended June 30, 2005 and 2004, options to purchase 647,957 and 745,158 shares, respectively, and for the six months ended June 30, 2005 and 2004, options to purchase 643,260 and 374,919 shares, respectively, were outstanding but were not included in the computation of diluted earnings per share because the options’ exercise price were greater than the average market price of the common shares and, therefore, the effect would be antidilutive.

(8)		Comprehensive Income

		Comprehensive income is the total of net income and all other non-owner changes in equity net of tax effects, and consists of net income, unrealized gains or losses on the Company’s available for sale marketable securities, and foreign currency translation adjustments. Comprehensive income for the three months and six months ended June 30, 2005 and 2004 is as follows:

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Advanced Neuromodulation Systems, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Continued)


	Three Months Ended					Six Months Ended
	June 30,					June 30,
	2005		2004			2005			2004
Net income	$	5,086,119	$	4,323,412		$	63,654,522		$	8,292,003
Other comprehensive income (loss)		170,954		(111,299	)		(14,233,335	)		(100,023	)

Comprehensive Income	$	5,257,073	$	4,212,113		$	49,421,187		$	8,191,980

Components of accumulated other comprehensive income are net of tax and are as follows:


	June 30, 2005			December 31, 2004
Unrealized gains (losses) on marketable securities	$	(16,387	)	$	14,260,876
Foreign currency translation adjustments		23,432			(20,496	)

Accumulated Other Comprehensive Income	$	7,045		$	14,240,380

		The tax benefit (expense) on the unrealized gains (losses) on marketable securities was $9,832 at June 30, 2005 and $(8,556,625) at December 31, 2004. The tax benefit (expense) on foreign currency translation adjustment was $(14,059) at June 30, 2005 and $12,297 at December 31, 2004.

		In connection with the realized gain resulting from the sale of the Company’s investment in Cyberonics, Inc. in February 2005 as discussed in Note 3, $14,275,238 of the December 31, 2004 unrealized gain on marketable securities was realized into other income, and the associated tax expense of $8,565,143 was reclassified from deferred income taxes payable to income taxes payable

(9)		Treasury Stock

		In May 2004, the Company’s board of directors approved the repurchase of up to 1,000,000 shares of the Company’s common stock. In April 2005, the Company’s board of directors approved an increase in the amount of shares authorized to be repurchased by the Company up to a total of 2,000,000 shares. The Company repurchased 923,674 shares of its common stock at a cost of $25,578,049 during March and April 2005.

(10)		Segment Information

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

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Advanced Neuromodulation Systems, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Continued)

Segment data for the three months ended June 30, 2005 is as follows:


	Neuro					Intercompany			Consolidated
	Products		O.E.M.			Eliminations			Total
Revenue from external customers	$	34,855,453	$	3,837,774		$	—		$	38,693,227
Intersegment revenues	$	—	$	2,412,475		$	(2,412,475	)	$	—
Segment income from operations	$	7,298,034	$	(262,465	)	$	—		$	7,035,569

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


	Neuro					Intercompany			Consolidated
	Products		O.E.M.			Eliminations			Total
Revenue from external customers	$	27,633,459	$	2,854,392		$	—		$	30,487,851
Intersegment revenues	$	—	$	1,598,442		$	(1,598,442	)	$	—
Segment income from operations	$	6,726,894	$	(265,470	)	$	—		$	6,461,424

Segment data for the six months ended June 30, 2005 is as follows:


	Neuro				Intercompany			Consolidated
	Products		O.E.M.		Eliminations			Total
Revenue from external customers	$	63,572,475	$	7,456,215	$	—		$	71,028,690
Intersegment revenues	$	—	$	5,276,588	$	(5,276,588	)	$	—
Segment income from operations	$	13,482,086	$	43,652	$	—		$	13,525,738

Segment data for the six months ended June 30, 2004 is as follows:


	Neuro				Intercompany			Consolidated
	Products		O.E.M.		Eliminations			Total
Revenue from external customers	$	51,861,143	$	5,259,571	$	—		$	57,120,714
Intersegment revenues	$	—	$	3,281,020	$	(3,281,020	)	$	—
Segment income from operations	$	12,204,707	$	153,438	$	—		$	12,358,145

Foreign sales, primarily Europe and Australia, for the three months ended June 30, 2005 and 2004 were approximately 10.0% and 9.5% of net revenue from the Neuro Products segment, respectively. Foreign sales, primarily Europe and Australia, for the six month ended June 30, 2005 and 2004 were approximately 9.6% and 9.5% of net revenue from the Neuro Products segment. The O.E.M. segment had no foreign sales for the respective periods.

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Advanced Neuromodulation Systems, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Continued)

(11)		New Accounting Standard

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

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

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

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

Recent Developments

In March 2005, the FDA approved our second rechargeable implantable pulse generator (IPG) system, the Eon™ Neurostimulation System, for sale in the U.S. The Eon system is indicated as an aid in the management of chronic intractable pain of the trunk and/or limbs, including unilateral or bilateral pain associated with failed back surgery syndrome, intractable low back pain and leg pain. On June 21, 2005, we announced an expanded U.S. market launch of Eon after successfully completing a market test and increasing inventories. Sales of Eon significantly exceeded our expectations and consequently depleted our inventory within four weeks of our expanded launch. We are increasing production of Eon as quickly as possible, but until our capacity increases over the next few months to meet demand, we will have to carefully manage allocation.

We recently received FDA Investigational Device Exemptions (IDE) to implant our Libra™ Deep Brain Stimulation (DBS) System to investigate the safety and efficacy of Libra to treat essential tremor and Parkinson’s disease, and we recently received conditional approval from the FDA for an Interstitial Cystitis pilot study, which we expect to commence in the fourth quarter of 2005. We have also received approval in Canada to conduct a pilot study for chronic, treatment-resistant depression. We anticipate the first implants under the essential tremor, Parkinson’s disease, and depression studies to occur in the third quarter of 2005.

We also recently received approval from the FDA to expand our feasibility study to a pivotal study of neurostimulation for the treatment of migraine headache; however, we are in the process of submitting to the FDA a modification to our previously approved pivotal trial protocol, which slowed the initial progress of the trial but we believe has the potential to broaden the indicated population and accelerate patient enrollment. We anticipate the first implants under the migraine headache study to occur in the fourth quarter of 2005.

In addition to the planned pivotal studies to treat migraine headache, essential tremor, Parkinson’s disease, and the pilot studies to treat chronic, treatment-resistant depression and Interstitial Cystitis, we are working on the potential application of our platform technologies to address pelvic pain, obesity, tinnitus, angina, ischemic pain associated with peripheral vascular disease, obsessive compulsive disorder, and traumatic brain injury. As a result, in 2005, we intend to increase our investment in research and development and clinical trials. The amount of increase in research and development expense is primarily dependent on the progress of the planned clinical studies. Based on our current status and planned activities, we believe research and development expense for 2005 will be approximately $17 million to $18 million, or 11.7% and 12.4%, respectively, of targeted 2005 revenue.

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

In March and April 2005, we repurchased 923,674 shares of the Company’s common stock for $25.6 million under a 2,000,000-share repurchase authorization previously approved by the Company’s board of directors.

Critical Accounting Policies and Estimates

General

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

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

Revenue Recognition

We generate revenues primarily from product sales to end customers and to international distributors. We sell products primarily through a direct sales force in the U.S and a combination of direct sales representatives and independent distributors in international markets. A significant portion of revenue is generated from consigned inventory generally maintained with field representatives, which is recognized as revenue upon notification of implant or product usage. All other product sales to end

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customers and international distributors are recorded upon transfer of title and risk of loss to customers, provided an arrangement exists, the fee is fixed and determinable, and collectibility is reasonably assured. Estimated sales returns, discounts, and rebates are recorded as a reduction of sales when the related revenue is recognized. Certain of our customers are third-party payors who reimburse fixed amounts for products based on a specific diagnosis. Revenue is recognized on these third-party payor sales based on the sales price less a contractual adjustment, which is based on our history of reimbursement with the third-party payor, provided all other revenue recognition criteria are met. We do not have any continuing obligation to our customers for installation or training, and there are no acceptance clauses in our customer arrangements.

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

Bad Debt

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

Inventory Reserve

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

Intangible Assets

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

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

Contingencies and Litigation

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

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Income Taxes

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

Stock Compensation

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

Results of Operations

Comparison of the Three Months and Six Months Ended June 30, 2005 and 2004

Results for the second quarter and first half of 2005 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, the launch of GenesisRCä, our first rechargeable IPG system approved by the FDA in the fourth quarter of 2004, and the expanded market availability of our second rechargeable IPG system, Eonä, which was approved by the FDA in March 2005. References below to the second quarter are comparisons of the three months ended June 30, 2005 and 2004 and references to the first half are comparisons of the six months ended June 30, 2005 and 2004, unless otherwise specified.

Net revenue. Net revenue for the second quarter increased $8.2 million, or 26.9%, and for the first half increased $13.9 million, or 24.3%, due to increased sales of our neuro products and O.E.M. products during both periods. Neuro product revenue increased 26.1% to a record $34.9 million in the second quarter of 2005 from $27.6 million in 2004, and for the first half neuro product revenue increased 22.6% to $63.6 million in 2005 from $51.9 million in 2004. This growth in the neuro products during both periods in 2005 compared to 2004 was driven by increased sales of our Genesis family of IPG systems for the treatment of chronic pain, the market launch of our first rechargeable IPG system, GenesisRC, as well as expanded market availability beginning late in the second quarter of 2005 of our new flagship rechargeable IPG system, Eon. Revenue from our Renew® RF system declined during the second quarter and first half of 2005 compared to 2004 and is expected to continue to decline as rechargeable IPG systems that offer comparable features and benefits, including our own GenesisRC and Eon systems, begin to claim more of the market for neurostimulation devices. With the introduction of our rechargeable IPG systems, we would expect that the ratio of sales of rechargeable IPG systems to sales of non-rechargeable systems (including both conventional IPGs and RF systems) will increase over time, possibly to as much as 50%. Because average selling prices for rechargeable systems are generally higher

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than non-rechargeable systems, we would also expect overall average selling prices to trend upward over time.

Net revenue of our O.E.M. business for the second quarter increased to $3.8 million in 2005 from $2.9 million in 2004 and for the first half increased to $7.5 million in 2005 from $5.3 million in 2004, primarily due to revenue generated by our Portland, Oregon operations (formerly the Cable and Wire Division of microHelix, Inc., which we acquired in April 2004). Though we continue to use more of our O.E.M. manufacturing and development capabilities for our own increasing needs, we expect O.E.M. revenue of approximately $14 million in 2005, a 18% increase in O.E.M revenue from 2004, primarily resulting from additional revenues generated by our Portland, Oregon operations.

Gross profit. Gross profit for the second quarter increased $6.1 million, or 27.6%, and for the first half increased $10.3 million, or 24.7%, due to the increase in net revenue discussed above. Gross profit margins for the second quarter increased to 72.9% in 2005, compared to 72.5% in 2004, and for the first half increased to 73.4% in 2005, compared to 73.2% in 2004.

Operating expenses. Total operating expenses for the second quarter increased $5.5 million, or 35.3%, and increased as a percentage of revenue to 54.7% in 2005 from 51.3% in 2004. For the first half, total operating expenses increased $9.2 million, or 31.1%, and increased as a percentage of revenue to 54.3% in 2005 from 51.5% in 2004. In February 2005, we announced that we intend to accelerate our pursuit of new indications for our technology by accelerating clinical studies, regulatory approval efforts and product development. As such, we expect operating expenses as a percentage of revenue to increase in 2005 compared to 2004.

Sales and marketing. Sales and marketing expense for the second quarter, as a percentage of net revenue, increased marginally to 31.1% in 2005 from 31.0% in 2004, while the expense increased in absolute dollars by $2.6 million. Sales and marketing expense for the first half, as a percentage of net revenue, decreased to 31.2% in 2005 from 31.5% in 2004, while the expense increased in absolute dollars by $4.1 million. The increase in absolute dollars during both periods was principally due to higher salary and benefit expense from annual salary increases and staffing additions in direct sales, clinical specialists and regional sales managers, higher commission expense from increased neuro product sales, higher travel expense due to increased direct sales activities, and stock-based compensation associated with the issuance of restricted stock awards in 2005.

Research and development. Research and development expense for the second quarter, as a percentage of net revenue, increased to 11.5% in 2005 from 9.4% in 2004, and the expense increased in absolute dollars by $1.6 million. Research and development expense for the first half, as a percentage of net revenue, increased to 11.0% in 2005 from 9.1% in 2004, while the expense increased in absolute dollars by $2.6 million. As noted above, we intend to accelerate our investment in research and development and clinical trials to capitalize on the opportunity to pursue several new indications with our existing technology and products and to develop new technology and products for the future.

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We recently received FDA approval to commence separate pivotal studies to investigate the safety and efficacy of our technologies to treat migraine headaches, essential tremor and Parkinson’s disease. We expect to begin implants under the essential tremor and Parkinson’s disease studies during the third quarter of 2005. Regarding the migraine headache pivotal study, we are in the process of submitting to the FDA a modification to our previously approved pivotal trial protocol, which in the short-term has slowed the progress of the trial, but we believe has the potential to broaden the indicated population and, in the long-term, accelerate patient enrollment. As a result, we now expect to begin implants for the migraine headache study during the fourth quarter of 2005.

In April 2005, we indicated that as a result of these planned activities, we expected research and development expenditures of approximately $20 million in 2005, or 13.8% of targeted revenue compared to expenditures of $10.8 million, or 8.9% of revenue in 2004. Substantial progress has been made in the essential tremor and Parkinson’s disease studies; however, because implants for these studies are now anticipated to begin during the third quarter of 2005 and implants under the migraine headache study are anticipated to begin during the fourth quarter of 2005, we now expect research and development expenditures of approximately $17 million to $18 million, or 11.7% and 12.4%, respectively, of targeted 2005 revenue. We believe the increased investment is strategically important to achieving our mission in the long-term.

General and administrative. General and administrative expense for the second quarter, as a percentage of net revenue, increased to 10.4% in 2005 from 8.9% in 2004, and the expense increased in absolute dollars by $1.3 million. General and administrative expense for the first half, as a percentage of net revenue, increased to 10.3% in 2005 from 8.8% in 2004, while the expense increased in absolute dollars by $2.3 million. The increase in expense during both periods was principally due to higher legal expenses, including expenses associated with our lawsuit against Advanced Bionics and the OIG investigation, higher recruiting and relocation costs associated with an increased level of staffing additions, depreciation expense, and stock-based compensation associated with the issuance of restricted stock awards in 2005.

Amortization of intangibles. Amortization expense of intangibles for the second quarter, as a percentage of net revenue, decreased to 1.7% in 2005 from 2.0% in 2004, while the expense in absolute dollars increased by $34,000. Amortization expense of intangibles for the first half, as a percentage of net revenue, decreased to 1.8% in 2005 from 2.1% in 2004, while the expense increased in absolute dollars by $99,000. The increase in absolute dollars during both periods was principally due to additional expense for intangible assets we acquired in the April 2004 acquisitions of MedTel and microHelix.

Other income. Other income for the second quarter increased by $770,000 due to increased investment income resulting from higher funds available for investment after the liquidation of our position in Cyberonics, as well as a higher rate of return on those investments. Other income for the first half increased by $86.3 million due to the $85.2 million gain we recognized on the sale of our investment in Cyberonics, as well as increased investment income from the higher funds available for investment along with a higher rate of return on those investments.

Income tax expense. Income tax expense for the second quarter increased $581,000 primarily due to the increase in income before taxes and to a lesser extent an increase in our effective tax rate. Income tax expense for the first half increased $32.1 million primarily due to the substantial increase in income before taxes and to a lesser extent an

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

Net income. Net income for the second quarter increased $763,000, or 17.6%, in 2005 from 2004 primarily due to the $574,000 increase in income from operations resulting from the positive impact of revenue growth from increased unit sales of our Genesis, GenesisXP, and Eon systems and the $861,000 increase in investment income, partially offset by the $581,000 increase in tax expense which resulted from higher pre-tax income and a higher effective tax rate. Net income per diluted share during the second quarter increased to $0.25 in 2005 from $0.21 in 2004. For the first half, net income increased $55.4 million in 2005 from 2004 primarily due to the $85.2 million pre-tax realized gain on the Cyberonics investment and to a lesser extent the $1.2 million increase in income from operations from higher revenue and the $1.2 million increase in investment income, partially offset by the $32.1 million increase in tax expense resulting from higher pre-tax income and a higher effective tax rate. Net income per diluted share for the first half was $3.06 in 2005 compared to $0.39 in 2004.

Liquidity and Capital Resources

At June 30, 2005, our working capital increased to $187.0 million from $168.4 million at year-end 2004. The ratio of current assets to current liabilities was 8.03:1 at June 30, 2005, compared to 18.78:1 at December 31, 2004. Cash, cash equivalents, and marketable securities totaled $154.5 million at June 30, 2005 compared to $124.0 million at December 31, 2004.

In February 2005, we sold our investment in Cyberonics, Inc. We received proceeds of $135.3 million from the sale of the 3,500,000 shares. We reported a pre-tax gain in the first quarter of $85.2 million, after acquisition related expenses. Correspondingly, our income taxes payable increased substantially. In June 2005, we made an estimated tax payment of approximately $19.6 million from our cash reserves and additional tax payments will occur as required during the remainder of 2005.

We used $25.6 million of our cash reserves in the first half of 2005 to repurchase 923,674 shares of our common stock under a 2,000,000 share repurchase program.

We received $2.6 million of cash during the six months ended June 30, 2005, from the exercise of stock options to purchase 206,497 shares of our common stock.

Our investment in trade accounts receivable increased from year-end 2004 by $4.5 million due to increased sales. Days sales outstanding decreased to 70 days at June 30, 2005 from 72 days at December 31, 2004.

We spent $4.5 million during the six months ended June 30, 2005, for capital expenditures and additions to intangible assets. During the first half we purchased additional office furniture and equipment (including computer equipment) for new

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personnel and purchased additional tooling and equipment for current products as well as new products being developed.

Liquidity may be enhanced to the extent we realize tax benefits from stock option exercises. Exercises of nonqualified stock options, and exercises of incentive stock options followed by “disqualifying dispositions” of the underlying common stock within one year following exercise generate compensation expense for tax purposes in the year of exercise or disposition, as the case may be. During the six months ended June 30, 2005, we generated a $1.1 million tax benefit related to nonqualified stock option exercises and disqualifying dispositions of common stock acquired on exercise of incentive stock options, which will be utilized to offset current year taxes payable.

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

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

Currency Fluctuations

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

Off-Balance Sheet Arrangements

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

Guidance

On July 28, 2005, we reaffirmed our revenue guidance of $145 million for fiscal 2005, and provided earnings guidance for 2005 in the range of $3.54 to $3.57 per diluted share. The number of outstanding shares, which affects the earnings per share calculation, has been reduced by our repurchases of almost one million shares in March and April 2005. We believe our IPG systems, both rechargeable and conventional, will generate most of our growth during 2005. Our revenue guidance reflects a 22% growth in our neuromodulation product sales, a growth rate below that realized in 2002 through

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2004. Competition is growing. Because a new competitor has entered the neurostimulation for chronic pain market, and because our competitors are larger and have greater resources than we do, competitive pressure is increasing, which directly affects revenue growth.

Outlook and Uncertainties

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

•		failure to gain market acceptance of our new rechargeable IPGs, to maintain continued market acceptance of our conventional IPGs and radio-frequency powered spinal cord stimulation (SCS) systems, or failure to replace a substantial portion of lost RF sales with sales of our new rechargeable IPGs could adversely affect our revenue growth and profitability;

•		failure to increase production of our new rechargeable IPG, Eon, to meet customer demand and a failure to adequately manage allocation of supply could adversely affect our revenue growth and profitability;

•		competition from and the launch of new competitive products by Medtronic, Advanced Bionics/Boston Scientific or others, as well as other market factors that could impede growth in or reduce sales of the Company’s IPG and RF systems, which could adversely affect revenues and profitability;

•		patient or physician selection of less invasive or less expensive alternatives;

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

•		intellectual property protection and potential infringement issues;

•		the cost, uncertainty and other risks inherent in litigation generally, including without limitation, the intellectual property and patent litigation against Advanced Bionics, and the ongoing securities class action litigation filed in the first quarter of 2005;

•		successful patient enrollment in and timely implementation of the IDE clinical studies for migraine headache, essential tremor and Parkinson’s disease; physician and patient acceptance of the Libra DBS system for the essential tremor and Parkinson’s disease studies, for which already-approved products are already available on the market; the uncertainty of clinical results that may ensue from these clinical studies; the risk that the FDA may not approve our PMA applications for these applications following the completion of the clinical trials; and the satisfactory completion of

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		feasibility, pilot and pivotal studies and/or market tests prior to the introduction of new products generally;

•		obtaining necessary government approvals for other new products or applications and maintaining compliance with FDA product and manufacturing requirements;

•		product liability;

•		reliance on single suppliers for certain components;

•		completion of research and development projects in an efficient and timely manner;

•		successful integration of acquired businesses, products and technologies;

•		international trade risks

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

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

For the period ended June 30, 2005, the Company did not experience material changes in market risk exposures that affect the quantitative and qualitative disclosures presented in the Company’s Annual Report on Form 10-K for the year ended December 31, 2004.

ITEM 4. CONTROLS AND PROCEDURES

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

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

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PART II

OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

Advanced Bionics Litigation

On April 21, 2004, the Company filed a lawsuit in the U.S. District Court for the Eastern District of Texas, Sherman Division (Docket No. 4:404-CV-00131-PNB-DDB) (the Texas Action) against Advanced Bionics Corporation, asserting claims of patent infringement, misappropriation of trade secrets, tortious interference with contract, misappropriation of time, labor, skill, and money, violation of the Texas Theft Act, conversion and constructive trust. As initially filed, the lawsuit alleged, among other things, that Advanced Bionics is infringing U.S. Patent No. 4,793,353 entitled “Non-Invasive Multiprogrammable Tissue Stimulator and Method.” In addition, the lawsuit alleged that Advanced Bionics hired a former ANS employee to aid in the design, development and manufacture of its implantable stimulation lead, that Advanced Bionics misappropriated the former employee’s knowledge of ANS’ confidential, proprietary, and trade secret information with respect to ANS’ implantable stimulation leads, and that this enabled Advanced Bionics to unfairly compete with ANS. The lawsuit seeks injunctive relief, compensatory and punitive damages, attorneys’ fees and costs. On October 15, 2004, the judge in the Texas Action granted the Company’s motion to amend its lawsuit to add two additional patent infringement claims against Advanced Bionics. One claim relates to the Company’s patent covering the design and structure of its electrode lead (U.S. Patent No. 6,216,045). The second claim relates to the Company’s trial cable connector patent (U.S. Patent No. 6,154,678). In addition, the judge denied Advanced Bionics’ motion to dismiss the Texas Action. Advanced Bionics filed a California action in federal court seeking to resolve the Company’s patent claims, which was subsequently dismissed. Advanced Bionics has also made motions to transfer the Texas Action to a California federal court, which the judge in the Texas Action has dismissed.

A “Markman Hearing,” which relates to the parties’ contending positions on the proper legal interpretation of the patent claims at issue, was held on April 15, 2005. This

-27-

hearing only covered the three ANS patents at issue in the case. The judge has not yet issued a ruling on the Markman Hearing results, which could have a material impact on the relative strength or weakness of the parties’ position in the litigation.

On July 12, 2005, ANS and the former ANS employee attempted to resolve ANS’ trade secrets misappropriation claims through mediation. No resolution or settlement was effected by the mediation.

Although a specific trial date has not been set, the judge has indicated that he expects to commence the trial of the case on the ANS patents in January 2006.

Securities Class Action Litigation

In late May 2005, the United States District Court for the Eastern District of Texas granted an order consolidating the three previously filed class action securities lawsuits against the Company and certain of its officers and directors that were filed on behalf of purchasers of the Company’s securities between April 24, 2003 and February 16, 2005, inclusive (the Class Period) into a single consolidated complaint styled as: PLA, LLC vs. Advanced Neuromodulation Systems, Inc., et al. The court also granted an order appointing lead and liaison counsel and appointing the lead plaintiff in the lawsuit. The three previously filed suits each alleged the Company violated federal securities laws by the issuance of false and misleading statements to the market regarding the Company’s financial performance throughout the Class Period, which statements allegedly had the effect of artificially inflating the market price of the Company’s securities. In particular, the claims alleged that improper marketing and sales practices accounted for the Company’s revenue growth, citing, among other things, the Company’s public announcement made on February 17, 2005 that the Company had received a subpoena from the Office of the Inspector General, Department of Health and Human Services, requesting documents related to sales and marketing, reimbursement, Medicare and Medicaid billing and other business practices. The plaintiffs were seeking unspecified compensatory damages and costs and expenses of litigation. No class has been certified at this time. The Company currently anticipates that the lead plaintiff will file an amended consolidated complaint in September 2005. The Company intends to vigorously defend itself against the claims made in the lawsuit and believes the lawsuit is without merit.

Product Liability Litigation

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

Other Litigation

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

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

Issuer Purchases of Equity Securities

Total

Number of

Maximum

Number of

Purchased

Shares that

Total

Average

as Part of

May Yet be

Number of

Price

Publicly

Purchased

Paid Per

Announced

Under the

Period

Purchased

Plans

March 1 through March 31, 2005

381,894

27.96

381,894

1,618,106

April 1 through April 30, 2005

541,780

27.50

923,674

1,076,326

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

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

The Company held its 2005 Annual Meeting of Shareholders on May 24, 2005 at the Company’s corporate office in Plano, Texas. At the Annual Meeting, the following matters as proposed in the Proxy Statement dated as of April 15, 2005, were voted on and approved:


			Votes
	Votes For		Against		Votes Withheld
Proposal	Nominee		Nominee		From Nominee
(1) Election of seven directors for a one-year term

Christopher G. Chavez		18,051,583		—		621,722
Robert C. Eberhart, Ph.D		17,664,161		—		1,009,144
Joseph E. Laptewicz		18,155,284		—		518,021
J. Philip McCormick		18,149,944		—		523,361
Hugh M. Morrison		17,655,125		—		1,018,180
Richard D. Nikolaev		18,159,307		—		513,998
Michael J. Torma, M.D.		17,650,321		—		1,022,984

Votes For

Votes Against

Proposal

Votes Abstained

(2) Ratify the selection of Ernst & Young LLP as independent registered public accounting firm for the 2005 fiscal year

18,410,659

257,090

5,556

Votes

Votes For

Against

Votes

Broker

Proposal

Abstained

Non-Votes

(3) Approval of an amendment to the Advanced Neuromodulation Systems, Inc. 2004 Stock Incentive Plan to increase the number of shares available from 750,000 shares to 1,000,000 shares

10,553,874

4,305,517

14,432

3,799,482

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ITEM 6. EXHIBITS


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

				Exhibit 3.2 — Bylaws, as amended and restated (2)

				Exhibit 4.1 — Rights Agreement dated as of August 30, 1996, between Quest Medical, Inc. and KeyCorp Shareholder Services, Inc. as Rights Agent (3)

				Exhibit 4.2 — Amendment to Rights Agreement dated as of January 25, 2002, between Advanced Neuromodulation Systems, Inc and Computershare Investor Services LLC (formerly KeyCorp Shareholder Services, Inc.) (4)

				Exhibit 10.27 — Advanced Neuromodulation Systems, Inc. 2004 Stock Incentive Plan, as amended (5)

				Exhibit 31.1 — Certification of the Chief Executive Officer Pursuant to Rule 13a-14 of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (6)

				Exhibit 31.2 — Certification of the Chief Financial Officer Pursuant to Rule 13a-14 of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (6)

				Exhibit 32.1 — Certification of the Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (7)

				Exhibit 32.2 — Certification of the Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (7)


(1)		Filed as an Exhibit to the report of the Company on Form 10-K for the year ended December 31, 2004, 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, 2000, and incorporated herein by reference.

(3)		Filed as an Exhibit to the report of the Company on Form 8-K dated September 4, 1996, and incorporated herein by reference.

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

(5)		Filed as an Exhibit to the Definitive Proxy Statement on Schedule 14A dated April 15, 2005, and incorporated herein by reference.

(6)		Filed herewith.

(7)		Furnished herewith.

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EXHIBIT INDEX


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

Exhibit 3.2		Bylaws, as amended and restated (2)

Exhibit 4.1		Rights Agreement dated as of August 30, 1996, between Quest Medical, Inc. and KeyCorp Shareholder Services, Inc. as Rights Agent (3)

Exhibit 4.2		Amendment to Rights Agreement dated as of January 25, 2002 between Advanced Neuromodulation Systems, Inc and Computershare Investor Services LLC (formerly KeyCorp Shareholder Services, Inc.) (4)

Exhibit 10.27		Advanced Neuromodulation Systems, Inc. 2004 Stock Incentive Plan, as amended (5)

Exhibit 31.1		Certification of the Chief Executive Officer Pursuant to Rule 13a-14 of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (6)

Exhibit 31.2		Certification of the Chief Financial Officer Pursuant to Rule 13a-14 of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (6)

Exhibit 32.1		Certification of the Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (7)

Exhibit 32.2		Certification of the Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (7)

(1) Filed as an Exhibit to the report of the Company on Form 10-K for the year ended December 31, 2004, 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, 2000, and incorporated herein by reference.

(3) Filed as an Exhibit to the report of the Company on Form 8-K dated September 4, 1996, and incorporated herein by reference.

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

(5) Filed as an Exhibit to the Definitive Proxy Statement on Schedule 14A dated April 15, 2005, and incorporated herein by reference.

(6) Filed herewith.

(7) Furnished herewith.


PART I. Financial Information

			2
Item 1. Financial Statements

Condensed Consolidated Balance Sheets June 30, 2005 (Unaudited) and December 31, 2004			3-4

Condensed Consolidated Statements of Income (Unaudited) For the Three Months and Six Months Ended June 30, 2005 and 2004			5

Condensed Consolidated Statements of Cash Flows (Unaudited) For the Six Months Ended June 30, 2005 and 2004			6

Condensed Consolidated Statements of Stockholders’ Equity For the Year Ended December 31, 2004 and the Six Months Ended June 30, 2005 (Unaudited)			7

Notes to Condensed Consolidated Financial Statements			8-16

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			17-26

Item 3. Quantitative and Qualitative Disclosures About Market Risk			26

Item 4. Controls and Procedures			26

PART II. Other Information			27

Item 1. Legal Proceedings			27-28

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds			29

Item 4. Submission of Matters to a Vote of Security Holders			30

Item 6. Exhibits			31

Signatures			32
Certification of the CEO Pursuant to Section 302
Certification of the CFO Pursuant to Section 302
Certification of the CEO Pursuant to Section 906
Certification of the CFO Pursuant to Section 906


	ADVANCED NEUROMODULATION SYSTEMS, INC.
Date: August 8, 2005	By:	/s/ F. Robert Merrill III
		F. Robert Merrill III
		Executive Vice President, Finance Chief Financial Officer and Treasurer

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