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<SEC-DOCUMENT>0000351721-02-000008.txt : 20020415
<SEC-HEADER>0000351721-02-000008.hdr.sgml : 20020415
ACCESSION NUMBER: 0000351721-02-000008
CONFORMED SUBMISSION TYPE: 10-K
PUBLIC DOCUMENT COUNT: 1
CONFORMED PERIOD OF REPORT: 20011231
FILED AS OF DATE: 20020401
FILER:
COMPANY DATA:
COMPANY CONFORMED NAME: ADVANCED NEUROMODULATION SYSTEMS INC
CENTRAL INDEX KEY: 0000351721
STANDARD INDUSTRIAL CLASSIFICATION: SURGICAL & MEDICAL INSTRUMENTS & APPARATUS [3841]
IRS NUMBER: 751646002
STATE OF INCORPORATION: TX
FISCAL YEAR END: 1231
FILING VALUES:
FORM TYPE: 10-K
SEC ACT: 1934 Act
SEC FILE NUMBER: 000-10521
FILM NUMBER: 02597686
BUSINESS ADDRESS:
STREET 1: 6501 WINDCREST DRIVE SUITE 100
CITY: PLANO
STATE: TX
ZIP: 75024
BUSINESS PHONE: 9723098000
MAIL ADDRESS:
STREET 1: 6501 WINDCREST DRIVE SUITE 100
CITY: PLANO
STATE: TX
ZIP: 75024
FORMER COMPANY:
FORMER CONFORMED NAME: QUEST MEDICAL INC
DATE OF NAME CHANGE: 19920703
</SEC-HEADER>
<DOCUMENT>
<TYPE>10-K
<SEQUENCE>1
<FILENAME>body.htm
<DESCRIPTION>FORM 10-K
<TEXT>
<HTML>
<HEAD>
<TITLE>ADVANCED NEUROMODULATION SYSTEMS, INC. FORM 10-Q</TITLE>
</HEAD>
<BODY>
<H1 ALIGN=CENTER><FONT SIZE=3>SECURITIES AND EXCHANGE COMMISSION</FONT></H1>
<H1 ALIGN=CENTER><FONT SIZE=3>Washington, D.C. 20549</FONT></H1>
<HR SIZE=1 WIDTH=15% ALIGN=CENTER>
<H1 ALIGN=CENTER><FONT SIZE=4>FORM 10-K</FONT></H1>
<HR SIZE=1 WIDTH=15% ALIGN=CENTER>
<H1 ALIGN=CENTER><FONT SIZE=3>[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR
15(d) OF THE<BR>SECURITIES EXCHANGE ACT OF 1934</FONT></H1>
<P ALIGN=CENTER><FONT SIZE=3>For the Fiscal Year Ended December 31,
2001</FONT></P>
<P ALIGN=CENTER><FONT SIZE=3>OR</FONT></P>
<H1 ALIGN=CENTER><FONT SIZE=3>[ ] TRANSITION REPORT PURSUANT TO
SECTION 13 OR 15(d) OF THE<BR> SECURITIES EXCHANGE ACT OF 1934</FONT></H1>
<HR SIZE=1 WIDTH=15% ALIGN=CENTER>
<P ALIGN=CENTER><FONT SIZE=3>Commission file number 0-10521</FONT></P>
<H1 ALIGN=CENTER><FONT SIZE=4>ADVANCED NEUROMODULATION SYSTEMS, INC.</FONT></H1>
<P ALIGN=CENTER><FONT SIZE=3>Incorporated pursuant to the Laws of the State of
Texas</FONT></P>
<HR SIZE=1 WIDTH=15% ALIGN=CENTER>
<P ALIGN=CENTER><FONT SIZE=3>Internal Revenue Service — Employer
Identification No. 75-1646002</FONT></P>
<P ALIGN=CENTER><FONT SIZE=3>6501 Windcrest Drive, Plano, Texas 75024</FONT></P>
<P ALIGN=CENTER><FONT SIZE=3>(972) 309-8000</FONT></P>
<HR SIZE=1 WIDTH=15% ALIGN=CENTER>
<P><FONT SIZE=2>Indicate by check mark whether the registrant (1) has filed all
reports required to be filed by Section 13 or 15(d) of the Securities Exchange
Act of 1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports) and (2) has been subject to such
filing requirements for the past 90 days.
Yes [X] No [ ] </FONT></P>
<P><FONT SIZE=2>Indicate by check mark 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. [ ]</FONT></P>
<P><FONT SIZE=2>Aggregate market value of the registrant’s Common
Stock held by non-affiliates of the registrant as of March 12, 2002:
$243,743,398</FONT></P>
<P><FONT SIZE=2>Number of shares outstanding of the registrant’s Common
Stock as of March 12, 2002: 9,119,957</FONT></P>
<P ALIGN=CENTER><FONT SIZE=2><B>DOCUMENTS INCORPORATED BY REFERENCE</B></FONT>
</P>
<P><FONT SIZE=2>Portions of the registrant’s definitive Proxy Statement
for the registrant's Annual Meeting of Stockholders to be held on June 5, 2002,
are incorporated by reference into Part III.</FONT></P>
<HR SIZE=5>
<PAGE>
<P ALIGN=CENTER><B>Advanced Neuromodulation Systems, Inc.</B></P>
<P ALIGN=CENTER><B>Annual Report</B></P>
<P ALIGN=CENTER><B>Form 10-K</B></P>
<P ALIGN=CENTER><B>Year Ended December 31, 2001</B></P>
<P ALIGN=CENTER><B>PART I</B></P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR>
<TD WIDTH=15%><B>ITEM 1.</B></TD>
<TD WIDTH=85%><B>BUSINESS</B></TD></TR></TABLE>
<P ALIGN=CENTER><B><U>General</U></B></P>
<P>We design, develop, manufacture and market advanced implantable
neuromodulation devices that deliver electrical current or drugs directly to
targeted areas of the body to manage chronic pain. Neuromodulation devices
include implantable neurostimulation devices, which deliver electric current
directly to targeted nerves, and implantable infusion pumps, which deliver
small, precisely controlled doses of drugs directly to targeted sites within the
body. Our principal product in 2001 was our <I>Renew</I>® radio-frequency
(RF) spinal cord stimulation device, which we have sold in the U.S. since June
1999. On November 21, 2001, the U.S. Food and Drug Administration (FDA) approved
our <I>Genesis</I>™ totally implantable pulse generator (IPG) spinal cord
stimulation device. We began selling <I>Genesis</I> in Europe in the first
quarter of 2001 and fully launched this product in the U.S. and Australia in
January 2002. We began selling our <I>AccuRx</I>™ fully implantable
constant rate drug infusion pump in international markets in the second quarter
of 2001, and are currently conducting clinical trials of <I>AccuRx</I> in the
United States.</P>
<P>Chronic pain is a critical health care issue today. About 80% of all doctor
visits in the U.S. relate to patient pain. In the U.S. alone, nearly 100 million
people suffer from chronic pain, and over half of chronic pain sufferers are
partially or totally disabled. In particular, back pain is the single largest
healthcare problem in the U.S. today. Chronic pain disables more people than
cancer or heart disease, and costs the American public more than both combined,
accounting for $100 billion in medical expenses in the U.S. annually.</P>
<P>Our customers are doctors who specialize in chronic pain. There are currently
approximately 3,000 accredited pain specialists in the U.S. alone, approximately
80% of which are anesthesiologists and 20% of which are neurosurgeons or
orthopedic surgeons.</P>
<P>In 2001, we estimate that approximately $520 million in neuromodulation
products were sold, up 21% from the previous year, and according to industry
analysts, product sales are expected to grow to about $1.1 billion by 2005,
based solely on treatment indications that the FDA has already approved. Based
on industry data and conversations with pain specialists, management believes
that at least 3 million chronic pain sufferers worldwide may be good candidates
for neuromodulation therapies, while in 2001, only about 50,000 patients
benefited from either neurostimulation devices or implantable drug infusion
pumps. We and one other company design, manufacture and market neurostimulation
products for the treatment of chronic pain, and we and two other companies
compete in the implantable drug pump segment of the neuromodulation market.</P>
<P>A number of factors are driving the growth of the neuromodulation market,
including the following:</P>
<UL>
<LI>The number of pain specialists worldwide who understand our products and
techniques is growing.
<LI>Advances in technology that have decreased the size of the devices and
increased the longevity of their power sources have led to better results for
patients.
<LI>Current research and development in the industry is leading to new clinical
applications that utilize existing neuromodulation products, including essential
tremor, Parkinson's Disease, angina, migraine headaches, peripheral vascular
disease, and sacral nerve stimulation for pelvic pain and incontinence.</UL>
<P ALIGN=CENTER>Page 1</P>
<HR>
<PAGE>
<P>Our <I>Renew</I> device is the technology leader in the RF segment of the
neurostimulation market. <I>Renew's</I> advanced features provide more effective
treatment of complex and multi-extremity pain patterns and provide pain
specialists with significant flexibility in programming to accommodate a
patient's complex or changing pain patterns. <I>Renew</I> currently accounts for
over 50% of the worldwide RF market. Our new <I>Genesis</I> totally implantable
device offers several technological advances over our competitor's product. Our
<I>Genesis</I> IPG is smaller than the other eight channel IPGs on the market,
which results in greater patient comfort, and more flexible in its capability
to address different pain patterns. Finally, our <I>AccuRx</I> constant rate
implantable drug infusion pump incorporates a new polymeric diaphragm technology
that makes <I>AccuRx</I> more precise than our competitors' products.</P>
<P ALIGN=CENTER><B><U>Recent Developments</U></B></P>
<P>On November 21, 2001, the FDA approved the Pre-Market Approval (PMA)
application for our <I>Genesis</I> IPG. This approval enables us to commercially
market the <I>Genesis</I> IPG in the United States, which we formally commenced
in January 2002 and to participate in 100% of the neurostimulation market to
treat chronic pain of the trunk and limbs. Industry analysts estimate that the
worldwide IPG market is growing at a 26% annual rate and will approach $300
million in 2002. Until our launch of the <I>Genesis</I> IPG, only one other
company marketed an approved IPG device in the United States.</P>
<P>On January 2, 2001, we acquired the assets (primarily intellectual property
consisting of patents and know-how) of Implantable Devices Limited Partnership
(IDP) and ESOX Technology Holdings, LLC (ESOX), two privately held Minnesota
companies, for 119,100 shares of ANS 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 $2.43 million. IDP was formed in 1986 to commercialize certain
implantable infusion technologies developed at the University of Minnesota. We
entered a license agreement with IDP in 1995 to license rights to implantable
infusion pump technologies developed by IDP and ESOX for applications in pain
and cancer therapy. Under the license agreement, we were obligated to pay IDP
royalties on worldwide sales of implantable infusion pumps using IDP technology.
The January 2, 2001 acquisition canceled the license agreement, thereby
eliminating our future royalty obligations, and expanded our rights to use the
pump technologies in all applications through our acquisition of the
intellectual property. We completed development of our <I>AccuRx</I> fully
implantable constant rate infusion pump in late 2000 using technology we
licensed from IDP. We received CE mark approval to distribute the pump
internationally and commenced sales internationally during the second quarter of
fiscal 2001. We also received an Investigational Device Exemption (IDE) from the
FDA to initiate clinical trials in the United States. The clinical trials
include 109 patients and are being conducted in fifteen sites. The trials
commenced in the first quarter of 2001 and are progressing according to plan.
The data gathered during the trials will be used to support our PMA
application.</P>
<P>Also on January 2, 2001, we completed the acquisition of Hi-tronics Designs,
Inc. (HDI or Hi-tronics), a privately-held contract developer and original
equipment manufacturer (OEM) of electro-mechanical devices headquartered in Budd
Lake, New Jersey. We acquired HDI through a stock-for-stock merger in which we
issued 1,104,725 shares of ANS common stock. The transaction is accounted for on
a pooling of interests basis and accordingly, prior year results have been
restated. HDI developed and is the manufacturer of our <I>Genesis</I> IPG and is
also the O.E.M. manufacturer of the transmitter used with our <I>Renew</I>
radio-frequency spinal cord stimulation system. HDI was founded in 1987 and has
developed more than sixty medical devices for some of the leading medical device
companies in the fields of cardiology, neurology and orthopedics. The core
strength of HDI is in developing highly sophisticated electronic circuits with
very low power requirements, utilizing both discrete and highly integrated
technology. We believe this competency, when combined with our own strengths in
lead design and packaging, will allow us to develop more sophisticated products
in compressed, development-cycle timetables. In addition, the merger will result
in vertical integration benefits in manufacturing that should enhance margins on
our current and future products.</P>
<P ALIGN=CENTER>Page 2</P>
<HR>
<PAGE>
<P ALIGN=CENTER><B><U>The Neuromodulation Market</U></B></P>
<P><B><I>Neurostimulation</I></B></P>
<P>Neurostimulation involves delivering small, mild electrical pulses to nerve
fibers along the spinal cord or peripheral nerves to inhibit or block the
sensation of pain. This stimulation of the pain-inhibiting pathways of the brain
masks the sensation of pain by generating a tingling sensation, or
"paresthesia." In general, neurostimulation is generally indicated for managing
neuropathic pain such as the chronic intractable pain of the trunk or limbs.
Patients with pain in a single location are ideal candidates for
neurostimulation, as are patients with failed back syndrome, complex regional
pain syndrome, disorders of the spinal nerve root and chronic inflammation and
scarring of the membranes surrounding the spinal cord.</P>
<P>Neurostimulation is a reversible therapy, and is tested on a patient before
the patient receives a permanent device. Prescribed for carefully-selected
patients, clinical results demonstrate that the majority of patients experience
a substantial reduction in pain, an increase in activity level, a reduction in
use of narcotics, a reduction in hospitalization and an overall reduction in
health care costs.</P>
<P>A neurostimulation device consists of one to four stimulating leads, which
are connected to an extension wire on one end and tethered to the patient
anatomy on the other end. The primary role of the lead is to stimulate the
spinal cord or peripheral nerve. Each lead holds up to 16 electrodes, which are
placed in the targeted area. The second element of the stimulator is the power
source that generates the electrical pulses. The device is programmed to
superimpose the stimulation pattern or paresthesia to offset the pain pattern of
the patient. The secondary goal of programming is to optimize the stimulation
while prolonging the life of the battery.</P>
<P>There are two types of neurostimulators currently on the market: RF and IPG
stimulators. An RF stimulator consists of an RF receiver and implanted leads,
and a transmitter with power source that is worn externally. The device is
powered with the help of an antenna, which is tethered on the patient's skin
with adhesive tape. In contrast, an IPG is completely internal and its power
source, leads and electrodes are all surgically implanted. The IPG segment of
the market is much larger, with approximately 80% of the neurostimulation
procedures performed involving IPG devices and the remainder involving RF
devices. Despite the likely dominance of IPG products due to the convenience of
a completely internalized system, we believe RF stimulation offers unique
advantages and that RF stimulators will continue to address a market need. While
the IPG device can help most patients, management believes that between 10-20%
of the chronic pain patient population would be better candidates for an RF
device. One reason is that only the RF device is currently indicated for
peripheral nerve stimulation, as opposed to spinal cord stimulation. However,
the main reasons RF devices will continue to be prescribed are the benefits to
be derived from its external battery:</P>
<P ALIGN=CENTER>Page 3</P>
<HR>
<PAGE>
<UL>
<LI>The external battery power source allows the patient to recharge the device
by simply changing a special nine-volt battery, while the IPG requires surgical
intervention and replacement every two to four years (depending on mode and
intensity of use). The external power source makes the RF device less invasive
and more cost-efficient and, in those respects, more convenient than an IPG
device.
<LI>Because exhausting the rechargeable power source is not a concern, the RF
device can be programmed with a higher power and wider range of amplitude,
frequency and pulse width settings for a variety of programs controlled by the
patient. These features make the RF device more effective than an IPG device for
patients with complex pain patterns or who will require long-term stimulation
treatment.</UL>
<P>For these reasons, until rechargable batteries are available for IPGs or
until battery technology advances significantly, the RF device will continue to
be the best solution for patients with complex pain or widespread pain that
requires higher power levels. IPGs will be most often prescribed for patients
with simple unilateral and single extremity pain complaints or indications with
lower power requirements.</P>
<P>Industry analysts estimate that the worldwide neurostimulation market in 2001
was a $300 million market, and expect this market to grow at an annual rate of
about 23% to around $675 million in 2005, based solely on applications for the
devices that are currently approved by the FDA. We and one other company are the
only competitors who currently participate in this market. If new applications
are approved, the market may grow at a faster rate. New applications that are
currently in the development stages include sacral nerve stimulation for pelvic
pain, spinal cord stimulation for chronic intractable angina and peripheral
vascular disease, peripheral nerve stimulation for migraine headaches, deep
brain stimulation for epilepsy and cortical stimulation for strokes and other
indications.</P>
<P><B><I>Implantable Drug Pumps</I></B></P>
<P>Implantable drug pumps deliver medication directly into the spinal canal to
the site where it is needed. This intraspinal 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 1:300. These lower dosages help to minimize any
side effects, and are more economical for the patient. Today, implantable
infusion pumps are used for the intraspinal delivery of morphine and baclofen
for the treatment of pain (such as cancer or arthritis pain) and spasticity, and
for the intra-arterial delivery of various drugs for chemotherapy.</P>
<P>As is neurostimulation, implantable drug pump therapy is fully reversible.
Prescribed for carefully selected patients, clinical results demonstrate that
the majority of patients experience a substantial reduction in pain, an increase
in activity level, a reduction in the use of narcotics, a reduction in
hospitalization and an overall reduction in health care costs.</P>
<P>Implantable drug pumps are made up of the pump itself and a catheter. The
pump is a hockey puck-shaped device containing a reservoir to hold the
prescribed drug and the mechanisms that regulate the drug's delivery rate. The
pump is implanted under the skin in the abdominal area and is connected to the
catheter. The catheter is a piece of soft, pliable tubing that is tunneled under
the skin into either the epidural or intrathecal space of the spinal column. 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.</P>
<P ALIGN=CENTER>Page 4</P>
<HR>
<PAGE>
<P>Currently, there are two 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. The disadvantage of a programmable
pump is that it is battery-powered and must be surgically removed and replaced
after four to seven years. According to industry analysts, programmable drug
pumps make up approximately 90% of the implantable pump market, with constant
rate pumps accounting for the balance. Industry analysts estimate the worldwide
implantable drug pump market in 2001 was a $230 million market, and expect this
market to grow at an annual rate of about 19% to around $450 million by 2005.
If new applications are approved, the market may grow at a faster rate. New
applications that are currently being researched include different types of
chronic pain and, specifically related to programmable pumps, ALS (Lou Gehrig's
Disease), Parkinson's Disease, Huntington's Disease and Alzheimer's Disease.</P>
<P ALIGN=CENTER><B><U>Our Products</U></B></P>
<P>We currently have three main products on the market: our <I>Renew</I> RF and
<I>Genesis</I> IPG neurostimulation devices, which we are marketing in the U.S.
and internationally, and our <I>AccuRx</I> constant rate implantable drug pump,
which we currently market internationally and which is in clinical trials in the
U.S.</P>
<P><B><I>Renew</I></B></P>
<P><I>Renew</I> is the leading technology in the RF stimulation market, and in
2001 generated the majority of our revenues. We introduced <I>Renew</I> in the
U.S. during June 1999 and began selling it in international markets during 2000.
<I>Renew</I> is the latest generation device in the RF stimulation product line
in which we have been involved since acquiring our neuromodulation business in
1995.</P>
<P><I>Renew</I> offers leads with up to 16 closely-spaced electrodes, while our
competitor's product offers only up to eight electrodes. More electrodes results
in more effective treatment of complex and multi-extremity pain patterns, and
provides the doctor with increased flexibility in programming to accommodate a
patient's changing pain patterns. <I>Renew's</I> receiver has been designed for
ease of implantation, which reduces the time required to complete the procedure.
It is also the smallest receiver currently on the market, which results in
enhanced patient comfort. Additionally, it allows the use of from one to four
lead arrays, while our competitor's product offers a maximum of two. This choice
of lead arrays, combined with either an 8- or 16-channel model receiver (our
competitor offers only an 8-channel receiver), enables the doctor to choose from
the maximum number of alternatives to best treat complex pain. <I>Renew's</I>
transmitter provides the patient with a number of program choices for
stimulation. There are three stimulation modes (as compared with our
competitor's two modes), which include (1) our PC-Stim program, whereby patients
can manually select up to 24 programs to regulate their own therapy; (2) our
Multi-Stim program, which provides automatic delivery of multiple stimulation
programs important for the treatment of diffuse, multifocal pain patterns; and
(3) our C-Stim program, which provides a single, continuous stimulation program.
The transmitter also has easy-to-use controls and an interactive display that
includes a stimulation diagram for quick visual confirmation of pain coverage.
</P>
<P ALIGN=CENTER>Page 5</P>
<HR>
<PAGE>
<P><B><I>Genesis</I></B></P>
<P>In late 2000, we received CE mark approval for our <I>Genesis</I> IPG and
began selling the product in international markets during the first quarter of
2001. On November 21, 2001, we received FDA approval of <I>Genesis</I>. This
approval allowed us to launch our participation in the largest segment of the
neuromodulation market with our U.S. roll-out of <I>Genesis</I> that began in
January 2002, and to participate in 100% of the neurostimulation market for
treating chronic pain of the trunk and limbs.</P>
<P>We believe <I>Genesis</I> offers several technological advances over our
competitor's product that should make it attractive to doctors and patients:</P>
<UL>
<LI><I>Genesis</I> is significantly smaller than the other eight channel IPGs on
the market, which should make <I>Genesis</I> more comfortable for the patient.
<LI><I>Genesis</I> provides the patient with the option to choose from up to 24
different stimulation programs, while the competing product has a more limited
menu and requires the patient to go to the doctor's office for reprogramming.
<LI><I>Genesis</I> provides the option of one Octapolar lead, which enables
doctors to rectify the problem of lead movement or "migration" (a problem in
about 10-15% of cases) through reprogramming.
<LI><I>Genesis</I> provides constant current delivery to protect against body
impedance that can cause over- or under-stimulation.</UL>
<P><B><I>PainDoc</I></B></P>
<P>We have also developed a Windows-based, computerized support system designed
to work with both <I>Renew</I> and <I>Genesis</I>, called <I>PainDoc</I>®.
<I>PainDoc</I> interfaces with our RF transmitter and IPG programmer to optimize
stimulation therapy and document treatment outcomes. This system allows the
doctor to interact with the patient to map the location and intensity of the
patient's pain and input this information into a standardized database. In
addition, <I>PainDoc</I> serves as a patient management system, enabling the
doctor to record the pain maps, assess stimulation coverage and overlap,
standardize clinical data collection, and archive and manage patient
information.<P>
<P><B><I>AccuRx</I></B></P>
<P>We received CE mark approval to distribute our <I>AccuRx</I> constant rate
drug pump internationally and began selling the pump in Europe in the second
quarter of fiscal 2001. We also received an investigational device exemption
(IDE) from the FDA to initiate clinical trials in the U.S. The clinical trials
include 109 patients, are being conducted in 15 sites and will provide data to
support our PMA for U.S. market introduction. The clinical trials commenced in
the first quarter of 2001, and the first pump was successfully implanted in
April 2001. </P>
<P>Until recently, all constant rate pumps have been powered by pressurized gas
in a chamber that surrounds the drug reservoir. When the drug is injected into
the reservoir, the gas is compressed. At body temperature, the gas expands,
pushing the drug out of the reservoir into the catheter. Unlike our competitors'
products, <I>AccuRx</I> is powered by a polymeric diaphragm. The advantage of
this design is that our pump is more precise, because its operation is not
affected by changes in the body's temperature or pressure. We completed
development of <I>AccuRx</I> in 2000, using technology we licensed from IDP for
pain and cancer therapy applications. On January 2, 2001, we acquired the
intellectual property rights from IDP for 119,100 shares of our common stock,
then valued at $2.43 million. By purchasing the intellectual property rights, we
eliminated future royalty obligations and expanded our rights to use the
<I>AccuRx</I> pump for any application.</P>
<P>Industry analysts estimate worldwide sales of constant rate implantable drug
pumps in 2001 were $28 million, up 16% from 2000. We have two competitors in
this segment of the market.</P>
<P ALIGN=CENTER>Page 6</P>
<HR>
<PAGE>
<P ALIGN=CENTER><B><U>Other Business Matters</U></B></P>
<P><B><U>Research and Development</U></B></P>
<P>As of March 2002, we had an in-house research and development staff of 44
people, compared to 38 in March 2001. The 2002 total includes15 development
personnel and the 2001 total includes 12 development personnel employed by HDI.
In 2001, we spent $4.93 million (13.0% of total net revenue) on research and
development, compared to $3.85 million (12.1% of total net revenue) in 2000.
During 2002, we expect to increase our investment in research and development
and clinical trials and expect expenditures for the year to reach approximately
$6.1 million.</P>
<P>Our current research and development efforts include work on the following:
</P>
<UL>
<LI>next-generation IPG stimulation devices for spinal cord stimulation;
<LI>next-generation RF stimulation devices;
<LI>an IPG stimulation device for deep brain stimulation to address essential
tremor and tremor associated with Parkinson's Disease;
<LI>next-generation infusion pumps, including a prototype programmable pump that
will take several years to develop; and
<LI>clinical trials that we expect to initiate on several of our new products
upon approval from the FDA.</UL>
<P>Additionally, we are working on new applications for our IPG stimulation
platform outside our focus on chronic pain, including an application for
treating occipital headaches. During the first quarter of 2001, we initiated a
pilot clinical study in the U.S., which consists of ten patients at two sites,
to evaluate the efficacy of our <I>Genesis</I> IPG device for treating occipital
headaches. We expect to complete the pilot study during the second quarter of
2002. Data from the pilot study will be used to determine the parameters for a
larger pivotal clinical study to support a PMA application for our
<I>Genesis</I> IPG to treat occipital headaches. We are also evaluating other
new applications for our IPG stimulation platform including applications for
treating angina, peripheral vascular disease, peripheral nerve stimulation, and
urinary incontinence, any of which would require a PMA approval from the FDA. We
may seek strategic partners with established distribution systems to develop
these market opportunities.</P>
<P>Our HDI subsidiary developed and is the manufacturer of our <I>Genesis</I>
IPG, and is also the O.E.M. manufacturer of the transmitter used with
<I>Renew</I>. HDI has developed and introduced more than 60 medical devices for
leading medical device companies in the fields of cardiology, neurology and
orthopedics. 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. We
believe HDI's core competency, when combined with our own strengths in lead
design and packaging, will allow us to develop more sophisticated products in
compressed, development-cycle timetables. In 2001, HDI accounted for 27.6% of
our consolidated revenues.</P>
<P><B><U>Marketing and Sales</U></B></P>
<P><B><I>General</I></B></P>
<P>We target our marketing efforts at anesthesiologists, neurosurgeons and
orthopedic surgeons who specialize in pain management. Because most pain
practitioners implant both RF and IPG stimulators, we expect to leverage our RF
contacts and track record to establish our position in the IPG segment of the
market. Additionally, by rounding out our product offerings with our IPG device,
we expect that our sales representatives will now be able to expand their target
customer base to doctors who have historically preferred to implant only IPGs.
</P>
<P ALIGN=CENTER>Page 7</P><HR>
<PAGE>
<P>We derive 90% of net revenues from product sales of our neurostimulation
systems from domestic sales and approximately 10% from export sales.</P>
<P><B><I>U.S.</I></B></P>
<P>In the domestic market, which accounts for the vast majority of our sales, we
employ a hybrid sales force of a total of about 80 independent specialty
distributors and commissioned sales agents, and five direct sales persons, all
of whom are focused on the chronic pain market. We have divided the domestic
market into three distributor territories, which employ a total of 24 pain
specialists who devote the majority of their selling efforts to our products. We
sell our products to these distributors at a discount from our list prices, and
the distributors sell the products to and collect revenues from the customers.
We obtain approximately 35% of our sales through our specialty distributors. In
addition, we have 23 sales agent territories that employ 56 sales agents with
expertise and focus on the pain management market who tend to sell our products
as their flagship product line. The sale of products using commissioned sales
agents contributes approximately 60% of our total sales.</P>
<P>We also employ four regional sales managers, who interact with our customers
and oversee the distributors and the sales agents, and a Vice President of North
American Sales, who coordinates the sales efforts of our distribution network in
North America.</P>
<P>Our domestic marketing programs include:</P>
<UL>
<LI>medical marketing programs intended to educate doctors and their staff about
successfully promoting their practices, efficiently educate patients about the
diagnosis and treatment of various conditions and effectively train office staff
to work with patients;
<LI>surgical training programs offered to doctors interested in improving their
surgical techniques;
<LI>education materials, such as brochures and videos, to educate patients and
doctors about treatment options and about our products in particular;
<LI>reimbursement assistance, with the help of outside consultants, to assist
patients and doctors in obtaining appropriate reimbursement for our products;
<LI>advisory boards composed of key U.S. and international opinion leaders who
provide us feedback about our current and future products, diagnostic and
treatment trends and other areas of interest; and
<LI>website marketing focused on educating both patients and doctors about our
product alternatives, reimbursement for our procedures and our marketing
programs.</UL>
<P><B><I>International</I></B></P>
<P>Internationally, we market our products through 20 specialty pain
distributors who represent us in 22 countries. Additionally in Germany, we
employ two sales agents and two direct sales representatives. Our international
distribution network reports to our Director of International Operations, who is
headquartered in the United Kingdom. We are in the process of training and
signing additional distributors to market our products in additional foreign
countries.</P>
<P><B><I>Customer Service</I></B></P>
<P>Our sales representatives are also responsible for training doctors and
nurses on programming and trouble-shooting any problems with our RF and IPG
devices. Both the RF and IPG devices have 24 different program settings, which
can be programmed and saved into memory. Therefore, a significant amount of
training of doctors and nurses is required for new users of our products.</P>
<P ALIGN=CENTER>Page 8</P><HR>
<PAGE>
<P><B><I>Major Customers</I></B></P>
<P>During 2001 and 2000, we had one major customer that accounted for 10% or
more of our net revenue from our neuromodulation products segment. Sun Medical,
Inc., a specialty distributor of ANS stimulation products, accounted for $4.2
million, or 15% of our net revenue from the neuromodulation products segment for
the year ended December 31, 2001 and $3.2 million, or 14% of our net revenue
from the neuromodulation products segment for the year ended December 31, 2000.
While we believe our relations with Sun Medical are good, the loss of this
customer could have a material adverse effect on our business, financial
condition and results of operations. During 1999, we had two major customers
that accounted for 10% or more of our net revenue from the neuromodulation
products segment. Sun Medical, Inc. and Primesource Surgical, Inc., accounted
for $3.0 million and $2.3 million, respectively, or 15% and 11%, respectively,
of our net revenue from the neuromodulation products segment for the year ended
December 31, 1999.</P>
<P>During the year ended December 31, 2001, we had three major customers that
accounted for 10% or more of our net revenue from the HDI O.E.M. segment:
Medtronic, Inc. accounted for $6.3 million, or 60%; Arrow International, Inc.
accounted for $1.8 million or 17%; and Transneuronix, Inc. accounted for $1.1
million or 11%. For the year ended December 31, 2000, we had three major
customers that accounted for 10% or more of our net revenue from the HDI O.E.M.
segment: Medtronic, Inc. accounted for $4.3 million or 49%; Exogen accounted for
$2.1 million or 24%; and Cyberonics, Inc. accounted for $1.5 million or 17%. For
the year ended December 31, 1999, we had four major customers that accounted for
10% or more of our net revenue from the HDI O.E.M. segment: Exogen accounted for
$1.7 million or 27%; Medtronic, Inc. accounted for $1.7 million or 27%;
Cyberonics, Inc. accounted for $1.2 million or 19%; and EP MedSystems accounted
for $760,000 or 12%.</P>
<P><B><U>Manufacturing</U></B></P>
<P>We operate two manufacturing facilities, one in Plano, Texas and the other in
Hackettstown, New Jersey. 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, methods, facilities and quality assurance
controls used in manufacturing medical devices. In addition, we are subject to
compliance requirements of ISO 9001 certification and CE Mark directives for
international markets. Our Plano, Texas facility was re-certified to ISO 9001/EN
46001/ ISO 13485 in November 2001. HDI's manufacturing facility is also ISO 9001
certified and was re-certified in May 2000. Each facility is subject to
recurring surveillance audits by its notified body.</P>
<P>We manufacture and package the vast majority of our neurostimulation devices
and implantable drug pumps at our Plano facility. HDI manufactures a variety of
medical devices and products on an O.E.M. basis in Hackettstown.</P>
<P>For our implantable neurostimulation devices and drug pumps, our
manufacturing processes largely consist of the assembly of standard and custom
components, functional testing to ensure adherence to specifications and
inspection of completed products. Components are assembled in a "clean room"
environment designed and maintained to reduce product exposure to particulate
matter. We subcontract with various suppliers to provide us with the quantity of
component parts necessary to assemble our products and for sterilizing finished
product using ethylene oxide gas.</P>
<P>For our non-implantable (external) products, our manufacturing processes
largely consist of the assembly of standard and custom components, functional
testing to ensure adherence to specifications and inspection of completed
products. Like our implantable products, we rely on third party subcontractors
to supply us with standard and custom component parts.</P>
<P>We devote significant attention to quality assurance throughout all phases of
our manufacturing operation. In addition to product inspection and compliance
auditing, quality assurance supports process improvement, statistical problem
solving and product improvements.</P>
<P ALIGN=CENTER>Page 9</P><HR>
<PAGE>
<P>Skills of assembly workers required for the manufacture of medical products
are similar to those required in typical assembly operations. We believe that
workers with these skills are readily available in the Dallas and New Jersey
geographical areas.</P>
<P>We believe we currently have in place the manufacturing capabilities to meet
the needs of the neuromodulation market in which we participate. We estimate
that our current manufacturing capacity is sufficient to handle a three-fold
increase in product volume.</P>
<P><B><U>Intellectual Property</U></B></P>
<P>We rely on a combination of patents, trade secrets, know-how, trademarks and
agreements to protect our intellectual property. We currently own 25 patents
covering our stimulation devices' electrode, receiver, transmitter and
programmer technology, our <I>PainDoc</I> computer system technology and our
fully-implantable infusion pump technology. These patents, in part, cover both
RF and IPG stimulation devices for a wide range of current and future
applications. We currently have 8 pending U.S. patent applications and 21
pending foreign patent applications. Among other things, these pending patent
applications cover new stimulation lead technology, implant accessories,
improved connector mechanisms and implantable drug delivery technology.</P>
<p>Additionally, we are exclusively licensing from third parties a patent
directed to advanced placement techniques and a patent directed to methods to
facilitate relieving the effects of chronic pelvic pain, such as interstitial
cystitis.</P>
<P>The validity of any patents issued to us may be challenged by others and we
could encounter legal and financial difficulties in enforcing our patent rights
against infringers. In addition, new technologies may be developed, or patents
may be obtained by others, which would render our patents obsolete. The loss of
any one patent would not have a material adverse effect on our current revenue
base. However, although we do not believe that patents are the sole determinant
of the commercial success of our products, the loss of a significant percentage
of our patents could have a material adverse effect on our business, financial
condition and results of operations.</P>
<P>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 such employees 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.
</P>
<P>Claims by competitors and other third parties that our products allegedly
infringe the patent rights of others could adversely affect our revenues.
Although we are not currently a party to any patent infringement lawsuit and no
such claims have been made against us, we could become subject to such
litigation or claims. The interventional pain management market is characterized
by extensive patent and other intellectual property claims, which can create
greater potential than in less-developed markets for possible allegations of
infringement, particularly with respect to newly developed technology.
Intellectual property litigation is complex and expensive and its outcome is
difficult to predict. Any future litigation, regardless of outcome, could result
in substantial expense to us and significant diversion of the efforts of our
technical and management personnel. An adverse determination in any such
proceeding could subject us to significant liabilities to third parties, or
require us to seek licenses from third parties or pay royalties that may be
substantial. Furthermore, there can be no assurance that necessary licenses
would be available to us on satisfactory terms, or at all. Accordingly, an
adverse determination in a judicial or administrative proceeding or failure to
obtain necessary licenses could prevent us from manufacturing or selling certain
of our products, which could have a material adverse effect on our business,
financial condition and results of operations.</P>
<P ALIGN=CENTER>Page 10</P><HR>
<PAGE>
<P><I>Renew</I>®, <I>Multistim</I>®, <I>PainDoc</I>®,
<I>Octrode</I>®, <I>ANS</I>® and <I>Advanced Neuromodulation
Systems</I>® are among our registered trademarks. U.S trademark applications
are pending for various trademarks that we believe have value (or will have
value) in the marketplace, including <I>Compustim</I>™,
<I>Genesis</I>™ , <I>DuraCath</I>™ and <I>AccuRx</I>™.</P>
<P><B><U>Competition</U></B></P>
<P>We are a small company competing in a large and rapidly growing market. Our
only significant competitor at this time is Medtronic, Inc., one of the world's
largest medical device companies, which has substantially greater resources and
marketing power than we do. Furthermore, 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
neuromodulation. Also, a market with projected growth like this market is bound
to attract other large companies; however, barriers to entry are high due to
long and expensive product development and approval cycles and the intellectual
property and patent positions that we and Medtronic currently hold.</P>
<P>We believe that the principal competitive factors in the neuromodulation
market are:</P>
<UL>
<LI>cost-effectiveness
<LI>impact on patient outcomes
<LI>product performance
<LI>quality
<LI>ease of use
<LI>technical innovation
<LI>customer service</UL>
<P>We intend to continue to compete on the basis of our high-performance
products, innovative technologies, manufacturing capabilities, close customer
relations and support, and our strategy to increase our offerings of products
within the neuromodulation market.</P>
<P><B><U>Government Regulation</U></B></P>
<P>The manufacture and sale of our products are subject to regulation by
numerous governmental authorities, principally the FDA and corresponding foreign
agencies. 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 such
regulations and procedures.</P>
<P>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. Our Texas facility was last
inspected in July 2001, and no major non-conformities were found. In September
2000, the FDA inspected HDI's New Jersey facility, and no major non-conformities
were found.</P>
<P ALIGN=CENTER>Page 11</P><HR>
<PAGE>
<P>Under the FDA's requirements, a new medical device cannot be released for
commercial use until a PMA 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) premarket notification with the FDA, which usually takes less
time than a PMA. The process of obtaining FDA clearance can be lengthy,
expensive and uncertain. 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 <I>Genesis</I> IPG,
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 a PMA submission process, which is lengthier and more
costly than the 510(k) process.</P>
<P>Our recent experience with our <I>Genesis</I> IPG device demonstrates that,
even when the 510(k) process appears to be the appropriate path to regulatory
approval, the FDA may disagree, and the entire process is unpredictable. In
February 1999, we met with the FDA to discuss the submission of a PMA
application for <I>Genesis</I>. The FDA recommended that we instead seek
reclassification of our <I>Genesis</I> device in order to be able to use the
510(k) filing process, and we promptly did so. On September 17, 1999, the FDA's
neurological panel recommended approval of our reclassification. One year later,
on September 6, 2000, the FDA published its position supporting the
reclassification of <I>Genesis</I> in the Federal Register, and allowed a 30-day
"comment period" for our competitors to comment on the decision. Medtronic
submitted a request to the FDA for a one-month extension to the comment period,
which was granted. On February 26, 2001, the FDA reversed its position and
denied our petition to reclassify <I>Genesis</I>. This decision by the FDA made
it necessary for us to file a PMA application for <I>Genesis</I>, which we
promptly did. We received PMA approval from the FDA on November 21, 2001.</P>
<P>We are also subject to regulation in each of the foreign countries in which
we sell our products with regard to product standards, packaging requirements,
labeling requirements, import restrictions, tariff regulations, duties and tax
requirements. Many of the regulations applicable to our products in such
countries are similar to those of the FDA. The national health or social
security organizations of certain countries require our products to be qualified
before they can be marketed in those countries. To date, we have not experienced
significant difficulty in complying with these regulations.</P>
<P>To position ourselves for access to European and other international markets,
we have maintained certification under the ISO 9000 Series of Standards. ISO
9000 is a set of integrated requirements, which, when implemented, form the
foundation and framework for an effective quality management system. These
standards were developed and published by the ISO, a worldwide federation of
national standard bodies, founded in Geneva, Switzerland in 1946. ISO has over
92 member countries. ISO certification is essential to enter European Community
markets.</P>
<P>In November 2001, our quality system was re-certified to ISO 9001/EN
46001/ISO 13485 certification. The ISO 9001 registration is the most stringent
standard in the ISO series. The German notified body TUV Product Services issued
the re-certification certificates. The ISO 9001 standard covers design,
production, installation and servicing of products. EN 46001 and ISO 13485 cover
the same elements as the ISO 9001 standard; however, their focus is on quality
systems for medical device manufacturing. In addition, we are certified to the
Active Implantable Medical Device Directive allowing us to market devices
throughout the European Community. We are subject to an annual audit by the
notified body to maintain our registrations.</P>
<P>The financial arrangements through which we market, sell and distribute our
products may be subject to certain federal and state laws and regulations in the
U.S. with respect to the provision of services or products to patients who are
Medicare or Medicaid beneficiaries. The "fraud and abuse" laws and regulations
prohibit the knowing and willful offer, payment or receipt of anything of value
to induce the referral of Medicare or Medicaid patients for services or goods.
In addition, the physician anti-referral laws prohibit the referral of Medicare
or Medicaid patients for certain "Designated Health Services" to entities in
which the referring physician has an ownership or compensation interest.
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 the provision of services or products to all
patients, regardless of the source of payment, although there is variation from
state to state as to the exact provisions of such laws or regulations. In other
states, and on a national level, several health care reform initiatives have
been proposed that would have a similar impact. We believe that our operations
and our marketing, sales and distribution practices comply with applicable fraud
and abuse and physician anti-referral laws and regulations. Although we do not
believe that we will need to undertake any significant expense or modification
to our operations or our marketing, sales and distribution practices to comply
with federal and state fraud and abuse and physician anti-referral regulations
that are currently in effect or proposed, financial arrangements between
manufacturers of medical devices and other health care providers may be subject
to increasing regulation in the future. Compliance with such regulation could
adversely affect our marketing, sales and distribution practices, and may affect
us in other respects not presently foreseeable that could have an adverse impact
on our business, financial condition and results of operations.</P>
<P ALIGN=CENTER>Page 12</P><HR>
<PAGE>
<P><B><U>Third-Party Reimbursement</U></B></P>
<P>Hospitals and ambulatory surgery centers are the primary purchasers of our
products, which then bill various third-party payors for the services provided
to the patients. These payors, which include Medicare, Medicaid, private
insurance companies, managed care and worker's compensation organizations,
reimburse part or all of the costs and fees associated with the procedures
performed with these devices. We estimate that one-third of total reimbursements
for our products come from each of Medicare/Medicaid, private insurance
companies and managed care organizations, and worker's compensation
organizations.</P>
<P>Medicare and Medicaid reimbursement for hospitals is based on a fixed amount
for admitting a patient with a specific diagnosis. Because of this fixed
reimbursement method, hospitals have incentives to use less costly methods in
treating Medicare and Medicaid patients, and will frequently make capital
expenditures to take advantage of less costly treatment technologies.
Frequently, reimbursement is reduced to reflect the availability of a new
procedure or technique, and as a result hospitals are generally willing to
implement new cost-saving technologies before these downward adjustments take
effect. Likewise, because the rate of reimbursement for certain doctors who
perform certain procedures has been and may in the future be reduced in the
event of further changes in the resource-based relative value scale method of
payment calculation, doctors may seek greater cost efficiency in treatment to
minimize any negative impact of reduced reimbursement. Any amendments to
existing reimbursement rules and regulations which restrict or terminate the
reimbursement eligibility (or the extent or amount of coverage) of medical
procedures using our products or the eligibility (or the extent or amount of
coverage) of our products could have an adverse impact on our business,
financial condition and results of operations. Third-party payors routinely
challenge the prices charged for medical products and services and may deny
reimbursement if they determine that a device was not used in accordance with
cost-effective treatment methods as determined by the payor, was experimental or
was used for an unapproved application.</P>
<P>Our stimulation devices, while cost-effective compared to repeat back
surgeries, have encountered some resistance by third-party payors. Although
Medicare, Medicaid and many private insurers reimburse for our stimulation
devices and procedures, especially after repeated back surgeries have failed to
relieve chronic pain, some managed care and private payors occasionally refuse
to reimburse or restrict reimbursement for stimulation devices. We cannot assure
you that third-party payors will continue to reimburse for our products, or that
their reimbursement levels will not adversely affect the profitability of our
products. In addition, because health care costs have risen so significantly
there have been and will continue to be proposals by legislators and regulators
to curb these costs. Legislative action limiting reimbursement for certain
procedures could have a material adverse effect on our business, financial
condition and results of operations.</P>
<P ALIGN=CENTER>Page 13</P><HR>
<PAGE>
<P>In response to the focus of national attention on rising health care costs, a
number of changes to reduce costs have been proposed or have begun to emerge. In
addition to legislative and regulatory initiatives, the number of Americans
enrolling in some form of managed care plan continues to grow. It has become a
typical practice for hospitals to affiliate themselves with as many managed care
plans as possible. Higher managed care penetration typically drives down the
prices of health care procedures, which in turn places pressure on medical
supply prices. This causes hospitals to implement tighter vendor selection and
certification processes by reducing the number of vendors used, purchasing more
products from fewer vendors and trading discounts on price for guaranteed higher
volumes to vendors. Hospitals have also sought to control and reduce costs over
the last decade by joining group purchasing organizations or purchasing
alliances. We cannot predict what continuing or future impact existing or
proposed legislation, regulation or such third-party payor measures may have on
our future business, financial condition or results of operations.</P>
<P>Changes in reimbursement policies and practices of third-party payors could
have a substantial and material impact on sales of our products. The development
or increased use of more cost-effective treatments could cause such payors to
decrease or deny reimbursement to favor these other treatments.</P>
<P><B><U>Advisory Board</U></B></P>
<P>We have established the Advanced Neuromodulation Systems Advisory Board,
which is comprised of individuals with substantial expertise in neuromodulation
and pain management. Members of our management and scientific and technical
staff consult closely with members of the Advisory Board to identify specific
areas where techniques are changing and where existing products do not
adequately fulfill the needs of the pain physician. The Advisory Board helps
management evaluate new product ideas and concepts and, once a product is
approved for development, its subsequent design and development. The Advisory
Board may also participate in the clinical testing of products developed.</P>
<P>Certain members of the Advisory Board are employed by academic institutions
and may have commitments to or consulting or advisory agreements with other
entities that may limit their availability to us. The members of the Advisory
Board may also serve as consultants to other medical device companies. No member
of the Advisory Board is expected to devote more than a small amount of time to
ANS.</P>
<P><B><U>Employees</U></B></P>
<P>As of March 12, 2002, we employed 226 full-time employees, 44 in research and
development, 29 in sales and marketing, 133 in manufacturing and related
operations, and the remainder in executive and administrative positions. This
total includes 102 full-time employees at HDI, which we acquired on January 2,
2001. None of our employees is represented by a labor union and we consider our
employee relations to be good.</P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR>
<TD WIDTH=15%><B>ITEM 2.</B></TD>
<TD WIDTH=85%><B>PROPERTIES</B></TD></TR></TABLE>
<P>We entered a 63 month lease agreement in February 1999 for our 40,000 square
foot corporate headquarters and manufacturing facility in Plano, Texas. Under
the terms of the lease agreement, which became effective on June 1, 1999, we
received three months of free rent and the monthly rental rate for the remaining
term of the lease is $48,308. The monthly rental rate includes certain operating
expenses such as property taxes on the facility, insurance, landscape and
maintenance and janitorial services. We also have a right of first refusal to
acquire the facility.</P>
<P ALIGN=CENTER>Page 14</P><HR>
<PAGE>
<P>We also lease facilities in New Jersey as a result of our acquisition of
Hi-tronics Designs, Inc. on January 2, 2001. One of the facilities, located in
Budd Lake, New Jersey, is 8,800 square feet of office space that is used for
administration, design engineering, drafting, documentation and regulatory
affairs. The lease expires on May 31, 2003 and has a monthly rental rate of
$10,891. We also lease 15,000 square feet of space in Hackettstown, New Jersey
used for our O.E.M. manufacturing operations. The Hackettstown lease, which
expires on December 31, 2002, has a monthly rental rate of $9,636 and is
renewable for two additional one-year periods. In addition, on January 1, 2001,
Hi-tronics entered an agreement to lease an additional 2,200 square feet of
additional space in the Hackettstown facility adjacent to the 15,000 square feet
of manufacturing space. The lease expires on June 30, 2002 and has a monthly
rental rate of $2,269. All of the monthly rental rates include certain operating
expenses such as property taxes, insurance, utilities, landscape and maintenance
and janitorial services.</P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR>
<TD WIDTH=15%><B>ITEM 3.</B></TD>
<TD WIDTH=85%><B>LEGAL PROCEEDINGS</B></TD></TR></TABLE>
<P>We are a party to product liability claims that arise in the ordinary course
of business related to our neurostimulation devices. Product liability insurers
have assumed responsibility for defending us against these claims, subject to
reservation of rights in certain cases. While historically, product liability
claims for our neurostimulation devices have not resulted in significant
monetary liability beyond our insurance coverage, we cannot assure you that we
will not incur significant monetary liability in the future if such insurance is
unavailable or inadequate for any reason, or that our current neurostimulation
business and future neuromodulation products will not be adversely affected by
these product liability claims. While 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, we cannot
assure you that we will avoid significant future product liability claims
relating to our neurostimulation systems.</P>
<P>Except for the product liability claims discussed above, 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.</P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR>
<TD WIDTH=15% VALIGN=TOP><B>ITEM 4.</B></TD>
<TD WIDTH=85%><B>SUBMISSION OF MATTERS TO A VOTE OF SECURITY
HOLDERS</B></TD></TR></TABLE>
<P>Inapplicable.</P>
<P ALIGN=CENTER>Page 15</P><HR>
<PAGE>
<P ALIGN=CENTER><B>PART II</B></P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR>
<TD WIDTH=15% VALIGN=TOP><B>ITEM 5.</B></TD>
<TD WIDTH=85%><B>MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED
STOCKHOLDER MATTERS</B></TD></TR></TABLE>
<P>Our common stock is currently quoted on the Nasdaq National Market under the
symbol "ANSI." On March 12, 2002, there were approximately 588 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.</P>
<PRE>
2000: High Low
-------------- --------------
First Quarter $ 19.38 $ 9.94
Second Quarter $ 18.38 $ 12.25
Third Quarter $ 21.50 $ 14.25
Fourth Quarter $ 23.19 $ 19.25
2001: High Low
-------------- --------------
First Quarter $ 26.88 $ 11.00
Second Quarter $ 26.00 $ 10.63
Third Quarter $ 25.85 $ 19.00
Fourth Quarter $ 35.55 $ 20.02
2002: High Low
-------------- --------------
First Quarter $ 36.20 $ 28.53
(through March 12, 2002)
</PRE>
<P>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.</P>
<P ALIGN=CENTER>Page 16</P><HR>
<PAGE>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR>
<TD WIDTH=15%><B>ITEM 6.</B></TD>
<TD WIDTH=85%><B>SELECTED FINANCIAL DATA</B></TD></TR></TABLE>
<PRE>
----------------------------------------------------------------------
Years Ended December 31,
----------------------------------------------------------------------
2001 2000 1999 1998 1997
-------------- ------------- ------------- ------------- -------------
(in thousands, except per share data)
Statements of Income Data: (1) (2)
Net revenue (3) $ 37,916 $ 31,827 $ 26,879 $ 23,417 $ 19,129
Total net revenue 37,916 31,827 35,779 26,517 19,129
Gross profit 22,241 17,127 23,852 13,993 11,041
Research and development expense 4,928 3,854 4,097 2,790 1,091
Marketing, general and
administrative and
amortization expenses 14,504 12,328 11,286 10,701 8,301
Income from operations 2,809 945 8,469 3,602 1,649
Net income from continuing
operations 1,518 832 5,817 2,327 493
Loss from discontinued operations -- -- -- (212) (93)
Gain on the sale of assets of
discontinued operations -- -- -- 4,585 --
Net income (loss) from
discontinued operations -- -- -- 4,373 (93)
Net income $ 1,518 $ 832 $ 5,817 $ 6,700 $ 400
Diluted income (loss) per
share:
Continuing operations $ .15 $ .09 $ .64 $ .24 $ .05
Discontinued operations $ -- $ -- $ -- $ .45 $ (.01)
Net income (loss) $ .15 $ .09 $ .64 $ .69 $ .04
<PAGE>
----------------------------------------------------------------------
Years Ended December 31,
----------------------------------------------------------------------
2001 2000 1999 1998 1997
-------------- ------------- ------------- ------------- -------------
(in thousands)
Balance Sheet Data(2):
Cash, cash equivalents,
certificates of deposit and
marketable securities $ 11,937 $ 11,599 $ 9,736 $ 13,982 $ 4,630
Working capital 24,906 22,211 17,626 18,042 16,702
Total assets 55,865 49,565 48,407 49,546 53,548
Short-term notes payable and
current maturities of
long-term notes payable 52 30 -- 3,633 8,633
Notes payable, excluding
current maturities 137 212 -- 1,000 4,869
Stockholders' equity $ 46,812 $ 40,442 $ 36,536 $ 34,769 $ 35,530
</PRE>
<P>__________________________</P>
<P>(1) On January 30, 1998, the Company sold its cardiovascular and intravenous
fluid delivery product lines (CVS Operations). The CVS Operations have been
accounted for as discontinued operations.</P>
<P>(2) On January 2, 2001, the Company 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.</P>
<P>(3) Net revenue excludes contract research and development revenue in 1998
and 1999 from our former agreement with Sofamor Danek. See Note 12 of the
Notes to Consolidated Financial Statements.</P>
<P>The following is a reconciliation of previously reported amounts with
restated amounts for total net revenue and net income(loss):</P>
<PRE>
------------------------------------------------------------------------------
Years Ended December 31,
------------------------------------------------------------------------------
------------------------------------------------------------------------------
2000 1999 1998 1997
--------------- --------------- --------------- ---------------
(in thousands)
Reconciliation of total net revenue:
As previously reported by the Company $ 23,082 $ 29,478 $ 20,106 $ 14,718
HDI, for the year ended November 30 $ 10,366 7,989 6,746 4,411
Elimination of intercompany transactions $ (1,621) (1,688) (335) --
Total net revenue as restated $ 31,827 $ 35,779 $ 26,517 $ 19,129
Reconciliation of net income (loss):
As previously reported by the Company $ 954 $ 6,003 $ 6,959 $ 724
HDI, for the year ended November 30 $ 28 328 (174) (231)
Elimination of intercompany transactions $ (150) (514) (85) $ --
Total net revenue as restated $ 832 $ 5,817 $ 6,700 $ 493
</PRE>
<P ALIGN=CENTER>Page 17</P><HR>
<PAGE>
<P></P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR>
<TD WIDTH=15% VALIGN=TOP><B>ITEM 7.</B></TD>
<TD WIDTH=85%><B>MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS</B></TD></TR></TABLE>
<P>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.</P>
<P><B>Critical Accounting Policies and Estimates</B></P>
<P><I>General</I></P>
<P>ANS' discussion and analysis of its financial condition and results of
operations are based upon ANS' 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 revenues and
expenses during the reporting period. On an on-going basis, management evaluates
its estimates and judgments, including those related to product returns, bad
debts, inventories, intangible assets, warranty obligations 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.</P>
<P>Management believes the following critical accounting policies affect its
more significant judgments and estimates used in preparation of its consolidated
financial statements.</P>
<P><I>Revenue Recognition</I></P>
<P>Revenue from the sale of our neuromodulation products and custom manufactured
O.E.M. products at HDI is recognized when the goods are shipped to our
customers. We record, as a reduction in revenue, a provision for estimated sales
returns and allowances on these product sales in the same period as the related
revenues are recorded. These estimates are based on historical sales returns,
analysis of credit memo data and other known factors. If the historical data we
use to calculate these estimates does not properly reflect future returns,
revenue could be overstated.</P>
<P>We also design and develop products at HDI under fixed price development
agreements with third parties. Each development agreement reflects the terms and
conditions of the project, including project objectives, product specifications,
responsibilities for tasks, licenses and fields of use of intellectual
properties, manufacturing rights and compensation to be paid to HDI, amongst
other terms and conditions. A typical development project will take one to two
years to complete and is undertaken in accordance with the Design Controls of
the FDA's QSR and similar international standards. We recognize revenue and
profit under the development agreements using the percentage-of-completion
method, which relies on estimates of total expected revenue and costs. We follow
this method since reasonably dependable estimates of revenue and costs
applicable to various stages of a development agreement can be made. If we do
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.</P>
<P>In certain cases, HDI will undertake a development project on a cost plus
basis. In this event, we periodically invoice the customer for actual time and
material expended on the project at predetermined hourly billing rates and mark
ups.</P>
<P ALIGN=CENTER>Page 18</P><HR>
<PAGE>
<P><I>Bad Debt</I></P>
<P>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. 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.</P>
<P><I>Inventory</I></P>
<P>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.</P>
<P><I>Intangible Assets</I></P>
<P>Goodwill associated with the excess purchase price over the fair value of
assets acquired and other identifiable intangible assets, such as patents,
purchased technology, tradenames and covenants not to compete, are currently
amortized on the straight-line method over their estimated useful lives.</P>
<P>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 not previously recorded.</P>
<P><I>Warranty Obligations</I></P>
<P>Our products are generally covered by a one-year warranty. We accrue a
warranty reserve for estimated costs to provide warranty services. Our estimate
of costs to service our warranty obligations is based on historical experience
and expectation of future conditions. To the extent we experience increased
warranty claim activity or increased costs associated with servicing those
claims, our warranty accrual will increase resulting in decreased gross profit.
</P>
<P><I>Contingencies</I></P>
<P>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.</P>
<P>Currently, product liability claims 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.</P>
<P><B>Overview</B></P>
<P>On November 21, 2001, the FDA approved the Pre-Market Approval (PMA)
application for our <I>Genesis</I> IPG. This approval enables us to commercially
market the <I>Genesis</I> IPG in the United States, which we formally commenced
in January 2002 and to participate in 100% of the neurostimulation market to
treat chronic pain of the trunk and limbs. Industry analysts estimate that the
worldwide IPG market is growing at a 26% annual rate and will approach $300
million in 2002. Until our launch of the <I>Genesis</I> IPG, only one other
company marketed an approved IPG device in the United States.</P>
<P ALIGN=CENTER>Page 19</P><HR>
<PAGE>
<P>On January 2, 2001, we acquired the assets (primarily intellectual property
consisting of patents and know-how) of Implantable Devices Limited Partnership
(IDP) and ESOX Technology Holdings, LLC (ESOX), two privately held Minnesota
companies, for 119,100 shares of ANS 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 $2.43 million. IDP was formed in 1986 to commercialize certain
implantable infusion technologies developed at the University of Minnesota. We
entered a license agreement with IDP in 1995 to license rights to implantable
infusion pump technologies developed by IDP and ESOX for applications in pain
and cancer therapy. Under the license agreement, we were obligated to pay IDP
royalties on worldwide sales of implantable infusion pumps using IDP technology.
The January 2, 2001 acquisition canceled the license agreement, thereby
eliminating our future royalty obligations, and expanded our rights to use the
pump technologies in all applications through our acquisition of the
intellectual property. We completed development of our <I>AccuRx</I> fully
implantable constant rate infusion pump in late 2000 using technology we
licensed from IDP. We received CE mark approval to distribute the pump
internationally and commenced sales internationally during the second quarter of
fiscal 2001. We also received an Investigational Device Exemption (IDE) from the
FDA to initiate clinical trials in the United States. The clinical trials
include 109 patients and are being conducted in fifteen sites. The trials
commenced in the first quarter of 2001 and are progressing according to plan.
The data gathered during the trials will be used to support our PMA
application.</P>
<P>Also on January 2, 2001, we completed the acquisition of Hi-tronics Designs,
Inc. (HDI or Hi-tronics), a privately-held contract developer and original
equipment manufacturer (OEM) of electro-mechanical devices headquartered in Budd
Lake, New Jersey. We acquired HDI through a stock-for-stock merger in which we
issued 1,104,725 shares of ANS common stock. The transaction is accounted for on
a pooling of interests basis and accordingly, prior year results have been
restated. HDI developed and is the manufacturer of our <I>Genesis</I> IPG and is
also the O.E.M. manufacturer of the transmitter used with our <I>Renew</I>
radio-frequency spinal cord stimulation system. HDI was founded in 1987 and has
developed more than sixty medical devices for some of the leading medical device
companies in the fields of cardiology, neurology and orthopedics. The core
strength of HDI is in developing highly sophisticated electronic circuits with
very low power requirements, utilizing both discrete and highly integrated
technology. We believe this competency, when combined with our own strengths in
lead design and packaging, will allow us to develop more sophisticated products
in compressed, development-cycle timetables. In addition, the merger will result
in vertical integration benefits in manufacturing that should enhance margins on
our current and future products.</P>
<P>As a result of HDI's fiscal year ending on a different date than the
Company's, for the one-month period ended December 31, 2000 the results of
operations of HDI have been charged directly to retained earnings in the
Consolidated Statement of Stockholders' Equity for the period ended December 31,
2001. During the month of December 2000, HDI recorded net revenue of $119,481
and a loss before income tax benefit of $591,600. The net loss for the one-month
period ended December 31, 2000 was $347,679. Results of HDI for this one-month
period were negatively impacted by a problem with a component supplied by a
vendor. This resulted in substantially lower than normal revenue since the
products using the component could not be manufactured and delivered. The
component problem was quickly resolved with the vendor and shipments of
products using the component commenced in late January 2001.</P>
<P>In June 1998, we entered into an agreement under which we would develop and
manufacture products and systems for use in Deep Brain Stimulation ("DBS") for
Sofamor Danek. See Note 12 - "Product Development Agreement" of the Notes to
Consolidated Financial Statements. We received a payment of $4 million upon
execution of the agreement that was being recognized into income as revenue
based upon the estimated completion of the development project. During the year
ended December 31, 1998, we recognized $3.1 million into income as revenue. The
remaining $900,000 was recognized into income as revenue during January 1999 due
to the termination of the agreement with Sofamor Danek as a result of the merger
of Sofamor Danek and Medtronic, Inc. In connection with the termination, we also
received an additional payment of $8 million from Sofamor Danek, which was
recognized into income as revenue during January 1999.</P>
<P ALIGN=CENTER>Page 20</P><HR>
<PAGE>
<P><B>Results of Operations</B></P>
<P><I>Comparison of the Years Ended December 31, 2001 and 2000</I></P>
<P>We reported net income of $1.52 million or $.15 per diluted share in 2001
compared to $832,000 or $.09 per diluted share in 2000. The results for 2001
include a pretax expense of $484,000 for costs associated with our acquisition
of HDI on January 2, 2001. These costs were expensed instead of capitalized
because the acquisition is accounted for under the pooling of interests method.
</P>
<P>Total net revenue of $37.92 million for the year ended December 31, 2001
increased 19.1% from the comparable 2000 level of $31.83 million. This growth
was attributable to both continued strong sales of our advanced neuromodulation
products used to treat chronic pain, which increased 19.0% to $27.46 million,
and higher sales at HDI, which increased 19.6% to $10.46 million. On November
21, 2001, we received approval from the FDA to begin marketing our
<I>Genesis</I> IPG in the United States and the first implants occurred in late
December 2001. We formally launched the <I>Genesis</I> IPG in the United States
in January 2002.</P> <P>The launch of the <I>Genesis</I> IPG could temporarily
impede growth in sales of <I>Renew</I> systems, which could affect the rate of
our overall revenue and profitability growth. Although <I>Genesis</I> and
<I>Renew</I> are targeted towards patients with different types of pain and
<I>Genesis</I> is not intended to replace <I>Renew</I> in the neuromodulation
market, some pain specialists may recommend <I>Genesis</I> to their patients
when they would have otherwise recommended <I>Renew</I>, and consquently,
<I>Genesis</I> may substitute for some sales of <I>Renew</I>. Although it is too
early in the process to accurately predict the future impact of this factor,
management believes that it is possible that sales of <I>Renew</I> may plateau
or even decline modestly, at lease during the first several months of
<I>Genesis</I> sales.<P>
<P>Because neuromodulation devices have gained acceptance as a viable,
efficacious and cost-effective treatment alternative for relieving chronic
intractable pain and improving neurological function, we are continuing our
efforts to expand our product offerings in the high-growth market of
neuromodulation. Today, we are a market share and technology leader in the
radio-frequency stimulation segment of the neuromodulation market, which
industry analysts expect to approach $74 million in 2002, and we are now only
the second market participant in the totally implantable stimulation segment
which industry analysts expect to approach $300 million in 2002. Over the last
three years, to position us to participate in the other larger and more rapidly
growing segments of the neuromodulation market, we continued to aggressively
invest in development projects for our technology platforms, including our IPG
for spinal cord stimulation, IPG for deep brain stimulation and a fully
implantable constant-rate infusion pump. Some of the fruits of our development
efforts were realized during 2001 when we received CE mark approval and began
commercialization of our <I>Genesis</I> IPG and <I>AccuRx</I> constant flow
implantable infusion pump in international markets during the first half of 2001
and when we received FDA approval of our <I>Genesis</I> IPG in November 2001 and
subsequently launched it in the United States in January 2002. In 2002, we plan
to continue our development efforts on advanced technology platforms for
stimulation and drug delivery therapies.</P>
<P>Gross profit increased to $22.24 million in 2001 from $17.13 million in 2000
due to the increase in net revenue discussed above and an improvement in gross
profit margins. Gross profit margin increased to 58.7% in 2001 compared to 53.8%
in 2000, due to higher sales of the <I>Renew</I> radio frequency spinal cord
stimulation system, which contributes higher margins than HDI product sales, a
reduction in specialty distributor sales where we recognize lower margins than
sales through commissioned sales agents and operational efficiencies from higher
manufacturing volumes.</P>
<P>Total operating expenses (the aggregate of research and development,
marketing, amortization of intangibles and administrative expenses) increased to
$19.43 million in 2001 compared to $16.18 million in 2000, and as a percentage
of total net revenue, increased to 51.2% in 2001 from 50.8% in 2000. In 2001, we
continued to invest in our product development pipeline and in infrastructure to
enhance our sales and marketing capabilities.</P>
<P ALIGN=CENTER>Page 21</P><HR>
<PAGE>
<P>Research and development expense increased to $4.93 million in 2001, or 13.0%
of 2001 total net revenue, from $3.85 million during 2000, or 12.1% of 2000
total net revenue. This increase in the absolute dollar amount in 2001 compared
to 2000 was the result of higher consulting expense and test material expense.
During 2001, these expenditures were directed toward development of our IPG
stimulation system platforms for spinal cord stimulation, our next generation
radio-frequency stimulation system platform, our proprietary constant-rate
infusion pump and an IPG stimulation system for Deep Brain Stimulation.</P>
<P>Marketing expense, as a percentage of total net revenue, increased from 21.5%
in 2000 to 23.9% in 2001, and the absolute dollar amount increased from $6.85
million during 2000 to $9.06 million in 2001. This dollar increase during 2001
was attributable to higher commission expense from increased product sales and a
change from distributors to commissioned sales agents in certain United States
territories, higher salary and benefit expense from staffing additions in
reimbursement and direct sales personnel, higher expense for education and
training of new implanters and higher expense for new product introductions.</P>
<P>General and administrative expense decreased to $3.96 million during 2001
from $4.24 million in 2000 and as a percentage of total net revenue, decreased
to 10.4% in 2001 from 13.3% during 2000. The decrease in this expense during
2001 was principally the result of lower salary expense from a reduction in
certain salaries of the former owners of HDI effective as of January 2001 when
we acquired HDI.</P>
<P>Amortization of goodwill and other intangibles increased to $1.49 million in
2001 from $1.23 million in 2000 primarily due to additional amortization expense
for patents we acquired from ESOX on January 2, 2001.</P>
<P>Other income decreased to an expense of $26,000 in 2001 from income of
$546,000 in 2000 primarily as a result of an expense in 2001 of $484,000 for
costs associated with the acquisition of HDI and lower interest income due to
lower yields on invested funds.</P>
<P>Income tax expense increased to $1.27 million in 2001 from $659,000 in 2000,
and the overall effective tax rate was 45.5% in 2001 compared to 44.2% in 2000.
Our expense for amortization of costs in excess of net assets acquired
(goodwill) is not deductible for tax purposes, and, when combined with a
provision for state taxes, results in the higher effective tax rate during both
2001 and 2000 compared to the U.S. statutory rate for corporations of 34%. In
addition, approximately $234,000 of the $484,000 of costs incurred in the
acquisition of HDI are not deductible for tax purposes, which also contributed
to the higher effective tax rate during 2001 compared to the U.S. statutory rate
of 34%.</P>
<P><I>Comparison of the Years Ended December 31, 2000 and 1999</I><P>
<P>We reported net income of $832,000 or $.09 per diluted share in 2000 compared
to $5.82 million or $.64 per diluted share in 1999. The 1999 results benefited
from $8.9 million of revenue recorded in connection with our former development
agreement with Sofamor Danek.</P>
<P>Total net revenue of $31.83 million for the year ended December 31, 2000, was
$3.95 million below the comparable 1999 level of $35.78 million due to $8.9
million of net revenue in the 1999 period associated with our former development
agreement with Sofamor Danek. Excluding the development agreement revenue, net
revenue increased 18.4% to $31.83 million in 2000 from $26.88 million in 1999.
This increase in net revenue was the result of higher unit sales volume of our
<I>Renew</I> systems, which increased $2.5 million or 12.2% to $23.08 million.
Sales at HDI also increased $2.45 million or 38.9% to $8.75 million.<P>
<P>Gross profit decreased to $17.13 million in 2000 from $23.85 million in 1999
due to the decrease in total net revenue discussed above and a decrease in gross
profit margins. Gross profit margin decreased to 53.8% in 2000 from 66.7% in
1999 due to higher revenue from HDI, whose O.E.M. sales contribute lower gross
margins than our proprietary neuromodulation products and the contract revenue
in 1999 from our development agreement with Sofamor Danek, which contributed
higher gross margins. Gross profit margin from sales of the neuromodulation
products remained approximately the same at 67.6% in the 2000 period compared to
67.8% in the 1999 period.</P>
<P ALIGN=CENTER>Page 22</P><HR>
<PAGE>
<P>Total operating expenses (the aggregate of research and development,
marketing, amortization of intangibles and administrative expenses) increased to
$16.18 million in 2000 from $15.38 million in 1999, and as a percentage of total
net revenue, increased to 50.8% in 2000 from 43.0% in 1999.</P>
<P>Research and development expense decreased in absolute dollars to $3.85
million in 2000, or 12.1% of 2000 total net revenue, from $4.10 million during
1999, or 11.4% of 1999 total net revenue. This decrease in absolute dollars
during 2000 compared to 1999 was the result of lower consulting expense. During
2000, these expenditures were directed toward development of our IPG stimulation
system for spinal cord stimulation, our next generation radio-frequency
stimulation system, our proprietary constant-rate infusion pump and an IPG
stimulation system for Deep Brain Stimulation.</P>
<P>Marketing expense, as a percentage of total net revenue, increased from 17.6%
in 1999 to 29.7% in 2000, while the absolute dollar amount increased from $6.29
million during 1999 to $6.85 million in 2000. This dollar increase during 2000
was attributable to higher commission expense from increased product sales and a
change from distributors to commissioned sales agents in certain United States
territories, higher expense for education and training of new implanters and
higher convention expense.</P>
<P>General and administrative expense increased from $3.81 million during 1999
to $4.24 million in 2000 and as a percentage of total net revenue, increased to
13.3% in 2000 from 10.6% during 1999. The increase of $435,000 in absolute
dollar expense during 2000 was principally the result of higher legal expense,
property tax expense, investor relations expense and consulting expense.</P>
<P>Amortization of goodwill and other intangibles increased slightly to $1.23
million in 2000 from $1.19 million during 1999 due to expense for additional
patents we licensed.</P>
<P>Other income decreased to $546,000 in 2000 from $687,000 in 1999 primarily as
a result of lower interest income due to lower funds available for investment.
</P>
<P>Income tax expense decreased to $659,000 in 2000 from $3.34 million in 1999
due to lower income before income taxes in 2000 compared to 1999, as the 1999
period included the $8 million termination payment from our former development
agreement with Sofamor Danek. This represents effective tax rates of 43.6% in
2000 and 36.5% in 1999. Our expense for amortization of costs in excess of net
assets acquired (goodwill) was not deductible for tax purposes, and, when
combined with a provision for state taxes, resulted in the higher effective tax
rate during both 2000 and 1999 compared to the U.S. statutory rate for
corporations of 34%.</P>
<P><B>Liquidity and Capital Resources</B></P>
<P>At December 31, 2001 our working capital increased to $24.91 million from
$22.21 million at year-end 2000. The ratio of current assets to current
liabilities was 4.77:1 at December 31, 2001, compared to 5.37:1 at December 31,
2000. Cash, cash equivalents, certificates of deposit and marketable securities
totaled $11.94 million at December 31, 2001 compared to $11.60 million at
December 31, 2000.</P>
<P ALIGN=CENTER>Page 23</P><HR>
<PAGE>
<P>We increased our investment in inventories to $9.75 million at December 31,
2001, from $7.09 million at December 31, 2000. This increase from year-end 2000
was primarily the result of three factors. First, we increased our investment in
consignment inventories as a result of adding fifteen commissioned sales agents
during 2001 to whom we provide approximately $30,000 in consignment inventory
each. Second, we purchased raw material and produced finished goods inventory
for our <I>AccuRx</I> drug pump to support its launch internationally and for
clinical trails in the United States. Third and most significantly, we purchased
raw materials and produced finished goods of our <I>Genesis</I> IPG to support
our international launch during 2001 and to prepare for our launch in the United
States in January 2002.</P>
<P>We spent $3.11 million during 2001 for capital expenditures, non-competes and
license fees for additional patents and intellectual property we are licensing.
Of these expenditures, $1.96 million was spent for manufacturing tooling and
equipment for new products we developed, including the <I>Genesis</I> IPG and
<I>AccuRx</I> drug pump, $500,000 was spent for computer equipment and office
furniture, $557,000 was spent for license fees and non-competes and $85,000 was
spent for leasehold improvements. </P>
<P>We believe our current cash, cash equivalents, certificates of deposit and
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 or product lines, 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 be bank borrowings or the issuance
of debt or equity securities.</P>
<P><B>Cash Flows</B></P>
<P>Net cash provided by operating activities was $3.06 million in 2001, $690,000
in 2000 and $2.95 million in 1999. Net cash provided by operating activities
increased from $690,000 in 2000 to $3.06 million in 2001, an increase of
approximately $2.38 million. This increase in 2001 compared to 2000 was
primarily the result of an increase in net income of $685,000 ($1.52 million in
2001 from $832,000 in 2000) and a $1.41 million decrease in the amount of cash
used for changes in working capital components ($2.76 million in 2000 to $1.35
million in 2001). For 2000 compared to 1999, net cash provided by operating
activities decreased from $2.95 million in 1999 to $690,000 in 2000, a decrease
of approximately $2.26 million. This decrease in 2000 compared to 1999 was
primarily the result of a $4.98 million decrease in net income ($832,000 in 2000
from $5.82 million in 1999) due to the 1999 period including the $8 million
pretax termination payment from our former development agreement with Sofamor
Danek. In 2000 however, we reduced the cash used for changes in working capital
components from $5.13 million in 1999 to $2.76 million in 2000, a reduction of
$2.37 million.</P>
<P>Net cash used in investing activities was $3.09 million in 2001 and $2.94
million in 2000 while investing activities provided cash of $803,000 in 1999. 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 licensing fees for patents, while maturing
certificates of deposit and sales of marketable securities provided cash of
$3.92 million. In 2000, our primary investing activities using cash were the
purchase of marketable securities and certificates of deposit with maturities
over 90 days ($2.23 million) and capital expenditures ($1.65 million) for
additional manufacturing tooling and equipment, office furniture and equipment
and licensing fees for patents, while maturing certificates of deposit and the
sale of marketable securities provided cash of $949,000. In 1999, our primary
investing activities using cash were the purchase of marketable securities
($380,000) and capital expenditures ($5.64 million) for leasehold improvements
and furnishings and equipment for our newly leased Plano, Texas facility,
manufacturing tooling and equipment and licensing fees for patents, while we
received net proceeds of $6.35 million from the sale of our facility to Atrion
Corporation and $466,000 from the sale of marketable securities.</P>
<P ALIGN=CENTER>Page 24</P><HR>
<PAGE>
<P>Net cash provided by financing activities was $957,000 in 2001 and $2.57
million in 2000, while financing activities in 1999 used cash of $7.81 million.
During 2001, we used $48,000 to reduce certain debt obligations, while we
received approximately $1.0 million from the exercise of stock options. During
2000, we used $29,000 to reduce certain debt obligations, while we received $2.6
million of cash from the exercise of stock options ($1.93 million), the private
placement of common stock ($400,000) and proceeds from a long-term note payable
($270,000). During 1999, we used $3.63 million to repay our mortgage debt when
we sold our facility to Atrion Corporation and $4.75 million for share
repurchases, while we received approximately $573,000 from the exercise of stock
options.</P>
<P><B>Currency Fluctuations</B></P>
<P>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.</P>
<P><B>Outlook and Uncertainties</B></P>
<P>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," "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:</P>
<P><B>Failure of our <I>Genesis</I> IPG to gain market acceptance would
adversely affect our revenues and profitability.</B></P>
<P>We formally introduced our <I>Genesis</I> IPG device in the U.S. in January
2002. We believe that the potential for growth in the IPG segment of the
neuromodulation market is much greater than in the RF segment. 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 new IPG
device. As a new entrant into the IPG market, there are many reasons we might
not achieve market acceptance on a timely basis, if at all, including the
following:</P>
<UL>
<LI>competing products, technologies and therapies are available, and others may
be introduced, that gain greater and faster doctor and patient acceptance than
our IPG device; and
<LI>our only competitor in the IPG market has had its IPG product on the market
for some time and enjoys significant brand awareness among pain specialists.
</UL>
<P>If industry analysts are correct that the IPG segment of the neuromodulation
will grow at a much faster rate than the RF segment, our failure to successfully
market and sell our IPG device could negatively affect our revenue growth rate
and our profitability.</P>
<P ALIGN=CENTER>Page 25</P><HR>
<PAGE>
<P><B>Our main competitor has significantly greater resources, which may make it
difficult for us to successfully compete in the neurostimulation market.</B></P>
<P>The medical device market is highly competitive, subject to rapid change and
is significantly affected by new product introductions and other market
activities of industry participants. Medtronic, Inc. is the largest and
strongest competitor in the medical device sector, and is currently our sole
competitor in the neurostimulation market. Medtronic is a large publicly-traded
company and enjoys several competitive advantages over us, including:</P>
<UL>
<LI>substantially greater name recognition;
<LI>greater resources for product research and development, sales and marketing,
distribution, patent protection and pursuing regulatory approvals;
<LI>a greater number of established relationships with health care
professionals, customers and third-party payors; and
<LI>multiple product lines and the ability to bundle products together or offer
discounts, rebates or other incentives to secure a competitive advantage.</UL>
<P>Medtronic, and possibly other future competitors, 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. For all of these reasons, we
may not be able to compete successfully against Medtronic or against similar
future competitors.</P>
<P><B>Any adverse changes in coverage or reimbursement amounts by Medicare,
Medicaid, workers' compensation programs or private insurers, including
insurance companies and HMOs, may limit our ability to market and sell our
products.</B></P>
<P>In the United States, our products are generally covered by Medicare,
Medicaid and other third-party payors, such as workers' compensation programs,
insurance companies and HMOs, which reimburse patients for all or part of the
cost of the products. Third-party payors carefully scrutinize whether to cover
new products and the level of reimbursement for covered products. If the
neuromodulation market continues to grow, third-party payors may cut back their
coverage of 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.</P>
<P>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. 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.</P>
<P><B>If patients choose non-invasive alternatives to our products, our sales
could be negatively impacted.</B></P>
<P>We sell medical devices for invasive or minimally-invasive surgical
procedures. If patients choose non-invasive alternatives to our products, this
could negatively affect our sales. Patient acceptance of our products depends on
a number of factors, including the failure of non-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.</P>
<P ALIGN=CENTER>Page 26</P><HR>
<PAGE>
<P>Patients are always more likely first to consider non-invasive alternatives
to treat their pain. The first tier of therapies along the treatment continuum
available to patients includes over-the-counter medications and physical
therapy. If these therapies fail, patients generally try the second-tier of
therapies, which includes non-steroidal anti-inflammatory drugs, TENS therapy
(application of electrical impulses on the skin), psychological therapy and
nerve blocks (injections that provide temporary pain relief). If these therapies
were unsuccessful, patients might then try the third tier of therapies, which
includes narcotic and opiod drugs, neurolysis (destruction of the affected
nerve) and thermal procedures. If first-, second- and third-tier pain therapies
are not effective, patients might then consider whether to use our products or
undergo more invasive surgical procedures.</P>
<P><B>If doctors do not recommend and endorse our products, our sales could be
negatively impacted and we may be unable to increase our revenues and
profitability.</B></P>
<P>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 characteristics, perceived benefits, clinical
efficacy and cost-effectiveness of our products compared to alternative
therapies and competing products, and on training pain specialists in the proper
use of our products. In order for us to sell our products, we must successfully
educate and train pain specialists so that these pain specialists 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 specialists, there is no guarantee that we will obtain their
recommendations and endorsements.</P>
<P><B>If we fail to protect our intellectual property rights, our competitors
may take advantage of our ideas and compete directly against us.</B></P>
<P>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.</P>
<P><B>Other parties may sue us for infringing their intellectual property
rights.</B></P>
<P>There has been a substantial amount of litigation in the medical technology
industry regarding patents and intellectual property rights. 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. 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 or obtain a license. Any required license may not be available to us on
acceptable terms, if at all. In addition, some licenses may be non-exclusive,
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.</P>
<P ALIGN=CENTER>Page 27</P><HR>
<PAGE>
<P><B>Failure to obtain necessary government approvals for new products and for
new applications for existing products would mean we could not sell those new
products, or sell our existing products for those new applications.</B></P>
<P>Our products are medical devices, which are subject to extensive government
regulation in the United States and in foreign countries where we do business.
Unless an exemption applies, each medical device that we wish to market in the
United States must first receive either 510(k) clearance or PMA from the FDA
with respect to each application for which we intend to market it. Either
process can be lengthy and expensive. The FDA's 510(k) clearance process usually
takes from four to twelve months from the date the application is complete, but
may take longer. Additionally, 510(k) clearance can be revoked if safety or
effectiveness problems develop. The PMA process is much more costly, lengthy and
uncertain. It generally takes from one to three years from the date the
application is complete; however, completing the PMA application is a process
that can take 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, cannot be brought to market for a
number of years after it is developed. 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 in those
jurisdictions.</P>
<P><B>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.</B></P>
<P>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 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 did not agree with our decision not to
seek a new 510(k) clearance or PMA and decided to require us to seek either
510(k) clearance or PMA for modifications we have already made to a
previously-cleared product, we may 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.</P>
<P><B>We will be unable to sell our products if we fail to comply with
manufacturing regulations.</B></P>
<P>In order 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. For a description of the manufacturing
regulations with which we must comply, see "Item 1 - Business - Government
Regulation."</P>
<P><B>Our products are subject to product recalls even after receiving FDA
clearance or approval, which would harm our reputation.</B></P>
<P>The FDA and similar governmental authorities in other countries have the
authority to require the recall of our products in the event of material
deficiencies or defects in design or manufacture. A government-mandated or our
own voluntary recall could occur as a result of component failures,
manufacturing errors or design defects. Any recall of product would divert
managerial and financial resources and harm our reputation with customers.</P>
<P ALIGN=CENTER>Page 28</P><HR>
<PAGE>
<P><B>Our failure to comply with all applicable government regulations could
subject us to numerous penalties, any of which could adversely affect our
business.</B></P>
<P>If we do not comply with all applicable government regulations, government
authorities could do any of the following:</P>
<UL>
<LI>impose fines and penalties on us;
<LI>prevent us from manufacturing our products;
<LI>bring civil or criminal charges against us;
<LI>delay the introduction of our new products into the market;
<LI>recall or seize our products;
<LI>disrupt the manufacture or distribution of our products; or
<LI>withdraw or deny approvals for our products.</UL>
<P>Any one of these results could materially and adversely affect our revenues
and profitability.</P>
<P><B>Our reliance on a single supplier for a component used in both of our main
products could adversely affect our ability to deliver products on time.</B></P>
<P>We rely on a single supplier for the computer chip used in the receivers of
our RF device and the programmer of our IPG device. The supplier of this
computer chip has indicated its desire to cease manufacturing and supplying the
computer chip in the future, but to date has not determined when this will
occur. The supplier has agreed to notify us when a date has been determined and
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 receiver design that does not use a custom
computer chip. Until we develop this new receiver, any sudden disruption in
supply from our current computer chip supplier could adversely affect our
ability to deliver finished RF and IPG products on time.</P>
<P><B>One specialty distributor currently accounts for a significant percentage
of our neuromodulation products segment revenue.</B></P>
<P>During 2001, we had one specialty distributor, Sun Medical, Inc., that
accounted for $4.2 million, or 15%, of our net revenue from the neuromodulation
products segment. While we believe that our relationship with Sun Medical is
good, the loss of this distributor could adversely affect our revenues and
profitability.</P>
<P><B>The launch of <I>Genesis</I> could temporarily impede growth in sales of
<I>Renew</I>, which would adversely affect our short-term revenues and
profitability.</B></P> <P>Our <I>Genesis</I> device is currently the newest
neurostimulation product on the market. Although <I>Genesis</I> and <I>Renew</I>
are targeted towards patients with different types of pain and <I>Genesis</I> is
not intended to replace <I>Renew</I> in the neurostimulation market, some pain
specialists may recommend <I>Genesis</I> to their patients when they would have
otherwise recommended <I>Renew</I>, and, consequently, <I>Genesis</I> may
"cannibalize" or substitute for some sales of <I>Renew</I>. If this occurs, it
could lead to a short-term slowdown in the growth in sales of <I>Renew</I>. If
<I>Renew</I> sales growth slows and we do not gain enough market share through
IPG sales to compensate for these lost sales, our short-term revenues and
profitability would be adversely affected.</P>
<P><B>Our inability to continue to develop innovative products in the
neuromodulation market would adversely affect our business.</B></P>
<P>The neuromodulation market is subject to rapid technological change and
product innovation. Our competitors may succeed in developing or marketing
products that will be technologically superior to ours. If we are unable to
compete successfully in the development of new products, our products could be
rendered obsolete or non-competitive. This would materially adversely affect our
business.</P>
<P ALIGN=CENTER>Page 29</P><HR>
<PAGE>
<P></P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR>
<TD WIDTH=15% VALIGN=TOP><B>ITEM 7A.</B></TD>
<TD WIDTH=85%><B>QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK</B>
</TD></TR></TABLE>
<P>We do not use derivative financial instruments to manage the impact of
interest rate changes on our investments or debt instruments.</P>
<P>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 with no more than $100,000 in any one financial institution. At December
31, 2001, we had $1,869,704 invested in money market funds, $1,518,295 in
certificates of deposit with maturities less than 90 days from the purchase date
and $4,530,095 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 rate earned on these
investments would not have a material effect on our income or cash flows.</P>
<P>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, a real estate
investment trust traded on the New York Stock Exchange and FNMA and Federal Home
Loan Notes with maturities less than one-year from the date of purchase. The
cost of these investments is $2,183,921 and the fair value at December 31, 2001
was $2,151,722. The investments are subject to overall stock market and interest
rate risk. A hypothetical 20% decrease in the value of these investments from
the prices at December 31, 2001 would decrease the fair value by $430,344.</P>
<P>In connection with our acquisition of HDI, we acquired responsibility for a
note payable in a principal amount at December 31, 2001 of $189,722. The note is
payable in monthly installments of principal and interest of $5,623, matures in
March 2005 and bears interest at a fixed rate of 9%.</P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR>
<TD WIDTH=15% VALIGN=TOP><B>ITEM 8.</B></TD>
<TD WIDTH=85%><B>FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA</B></TD></TR>
</TABLE>
<P>The information required by this item is set forth in Appendices A, B and C.
</P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR>
<TD WIDTH=15% VALIGN=TOP><B>ITEM 9.</B></TD>
<TD WIDTH=85%><B>CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE</B></TD></TR></TABLE>
<P>None.</P>
<P ALIGN=CENTER><B>PART Ill</B></P>
<TABLE WIDTH=100% CELLSPACING=0 CELLPADDING=0>
<TR>
<TD WIDTH=15% VALIGN=TOP><B>ITEM 10.</B></TD>
<TD WIDTH=85%><B>DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT</B></TD>
</TR></TABLE>
<P>The information required by this item is contained under the captions
"Election of Directors", "Executive Officers" and "Compliance With Section 16(a)
of the Exchange Act" in our definitive proxy statement to be filed in connection
with our 2002 annual meeting of stockholders, which information is incorporated
herein by reference.</P>
<TABLE WIDTH=100% CELLSPACING=0 CELLPADDING=0>
<TR>
<TD WIDTH=15%><B>ITEM 11.</B></TD>
<TD WIDTH=85%><B>EXECUTIVE COMPENSATION</B></TD></TR></TABLE>
<P>The information required by this item is contained under the captions
"Compensation and Committees of the Board of Directors" and "Compensation of
Executive Officers" in our definitive proxy statement to be filed in connection
with our 2002 annual meeting of stockholders, which information is incorporated
herein by reference. Information under the captions "Compensation Committee
Report" and "Performance Graph" are not incorporated herein by reference,
however.</P>
<P ALIGN=CENTER>Page 30</P><HR>
<PAGE>
<P></P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR>
<TD WIDTH=15% VALIGN=TOP><B>ITEM 12.</B></TD>
<TD WIDTH=85%><B>SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
MANAGEMENT</B></TD></TR></TABLE>
<P>The information required by this item is contained under the caption
"Security Ownership of Management and Principal Shareholders" in our definitive
proxy statement to be filed in connection with our 2002 annual meeting of
stockholders, which information is incorporated herein by reference.</P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR>
<TD WIDTH=15%><B>ITEM 13.</B></TD>
<TD WIDTH=85%><B>CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS</B></TD></TR>
</TABLE>
<P>Inapplicable.</P>
<P ALIGN=CENTER><B>PART IV</B></P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR>
<TD WIDTH=15% VALIGN=TOP><B>ITEM 14.</B></TD>
<TD WIDTH=85%><B>EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM
8-K</B></TD></TR></TABLE>
<P></P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR>
<TD WIDTH=10%>(a)</TD>
<TD WIDTH=90%>Documents filed as part of this report.</TD></TR></TABLE>
<P></P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR>
<TD WIDTH=10%> </TD>
<TD WIDTH=10% VALIGN=TOP>1.</TD>
<TD WIDTH=90%>Financial Statements:<BR>See Index to Financial Statements on the
second page of Appendix A.</TD></TR>
<TR>
<TD> </TD>
<TD></TD>
<TD></TD></TR>
<TR>
<TD> </TD>
<TD VALIGN=TOP>2.</TD>
<TD>Financial Statement Schedules:*<BR>Schedule II - Valuation and Qualifying
Accounts.<BR>See Appendix B.</TD></TR>
</TABLE>
<P></P>
<P>*Those schedules not listed above are omitted as not applicable or not
required.</P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR>
<TD WIDTH=10%> </TD>
<TD WIDTH=10%>3.</TD>
<TD WIDTH=90%>Exhibits: See (c) below.</TD></TR></TABLE>
<P></P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR>
<TD WIDTH=10%>(b)</TD>
<TD WIDTH=90%>Reports on Form 8-K.</TD></TR></TABLE>
<P></P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR>
<TD WIDTH=10%> </TD>
<TD WIDTH=90%>The Company filed a report on Form 8-K on January 30, 2002
reporting certain amendments adopted by the Board of Directors on January 25,
2002 to the existing Rights Agreement between the Registrant and Computershare
Investor Services LLC dated as of August 30, 1996.</TD></TR>
<TR>
<TD> </TD><TD></TD></TR>
<TR>
<TD WIDTH=10%>(c)</TD>
<TD WIDTH=90%>Exhibits:</TD></TR></TABLE>
<P></P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR>
<TD WIDTH=10% ALIGN=RIGHT>Exhibit<BR><U>Number</U></TD>
<TD WIDTH=5%></TD>
<TD WIDTH=85% ALIGN=CENTER><U>Description</U></TD></TR>
</TABLE>
<P></P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR>
<TD WIDTH=10% ALIGN=RIGHT VALIGN=TOP>2.1 </TD>
<TD WIDTH=5%> </TD>
<TD WIDTH=85%>Agreement and Plan of Merger, dated as of November 30, 2000, by
and amoung Advanced Neuromodulation Systems, Inc., ANS Acquisition Corp, and
Hi-tronics Designs, Inc.(10)</TD></TR>
<TR>
<TD ALIGN=RIGHT VALIGN=TOP>3.1 </TD>
<TD></TD>
<TD>Articles of Incorporation, as amended and restated(11)</TD></TR>
<TR>
<TD ALIGN=RIGHT VALIGN=TOP>3.2 </TD>
<TD></TD>
<TD>Bylaws(11)</TD></TR>
<TR>
<TD ALIGN=RIGHT VALIGN=TOP>4.1 </TD>
<TD></TD>
<TD>Rights Agreement dated as of August 30, 1996, between Quest Medical, Inc.
and KeyCorp Shareholder Services, Inc. as Rights Agent(5)</TD></TR>
<TR>
<TD ALIGN=RIGHT VALIGN=TOP>10.1 </TD>
<TD></TD>
<TD>Quest Medical, Inc. 1979 Amended and Restated Employees Stock Option
Plan(2)</TD></TR></TABLE>
<P ALIGN=CENTER>Page 31</P><HR>
<PAGE>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR>
<TD WIDTH=10% ALIGN=RIGHT>Exhibit<BR><U>Number</U></TD>
<TD WIDTH=5%></TD>
<TD WIDTH=85% ALIGN=CENTER><U>Description</U></TD></TR>
</TABLE>
<P></P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR>
<TD WIDTH=10% ALIGN=RIGHT VALIGN=TOP>10.2 </TD>
<TD WIDTH=5%> </TD>
<TD WIDTH=85%>Form of 1979 Employees Stock Option Agreement(3)</TD></TR>
<TR>
<TD ALIGN=RIGHT VALIGN=TOP>10.3 </TD>
<TD></TD>
<TD>Quest Medical, Inc. Directors Stock Option Plan (as amended)(2)</TD></TR>
<TR>
<TD ALIGN=RIGHT VALIGN=TOP>10.4 </TD>
<TD></TD>
<TD>Form of Directors Stock Option Agreement(1)</TD></TR>
<TR>
<TD ALIGN=RIGHT VALIGN=TOP>10.5 </TD>
<TD></TD>
<TD>Quest Medical, Inc. 1987 Stock Option Plan(4)</TD></TR>
<TR>
<TD ALIGN=RIGHT VALIGN=TOP>10.6 </TD>
<TD></TD>
<TD>Form of 1987 Employee Stock Option Agreement(4)</TD></TR>
<TR>
<TD ALIGN=RIGHT VALIGN=TOP>10.7 </TD>
<TD></TD>
<TD>Quest Medical, Inc. 1995 Stock Option Plan(4)</TD></TR>
<TR>
<TD ALIGN=RIGHT VALIGN=TOP>10.8 </TD>
<TD></TD>
<TD>Form of 1995 Employee Stock Option Agreement(4)</TD></TR>
<TR>
<TD ALIGN=RIGHT VALIGN=TOP>10.9 </TD>
<TD></TD>
<TD>Quest Medical, Inc. 1998 Stock Option Plan(7)</TD></TR>
<TR>
<TD ALIGN=RIGHT VALIGN=TOP>10.10</TD>
<TD></TD>
<TD>Advanced Neuromodulation Systems, Inc. 2000 Stock Option Plan(9)</TD></TR>
<TR>
<TD ALIGN=RIGHT VALIGN=TOP>10.11</TD>
<TD></TD>
<TD>Employment Agreement dated April 9, 1998 between Christopher G. Chavez and
Quest Medical, Inc.(6)</TD></TR>
<TR>
<TD ALIGN=RIGHT VALIGN=TOP>10.12</TD>
<TD></TD>
<TD>Employment Agreement dated April 9, 1998 between Scott F. Drees and Quest
Medical, Inc.(6)</TD></TR>
<TR>
<TD ALIGN=RIGHT VALIGN=TOP>10.13</TD>
<TD></TD>
<TD>Employment Agreement dated April 9, 1998 between F. Robert Merrill III and
Quest Medical, Inc.(6)</TD></TR>
<TR>
<TD ALIGN=RIGHT VALIGN=TOP>10.14</TD>
<TD></TD>
<TD>Form of Employment Agreement and Covenant Not to Compete, between the
Company and key employees(1)</TD></TR>
<TR>
<TD ALIGN=RIGHT VALIGN=TOP>10.15</TD>
<TD></TD>
<TD>Lease Agreement dated as of February 4, 1999, between Advanced
Neuromodulation Systems, Inc. and Legacy Lincoln I, LTD. (8)</TD></TR>
<TR>
<TD ALIGN=RIGHT VALIGN=TOP>11.1 </TD>
<TD></TD>
<TD>Computation of Earnings Per Share(13)</TD></TR>
<TR>
<TD ALIGN=RIGHT VALIGN=TOP>21.1 </TD>
<TD></TD>
<TD>Subsidiaries(13)</TD></TR>
<TR>
<TD ALIGN=RIGHT VALIGN=TOP>23.1 </TD>
<TD></TD>
<TD>Consent of Independent Auditors(13)</TD></TR></TABLE>
<P>__________________________________</P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR>
<TD WIDTH=5% VALIGN=TOP>(1) </TD>
<TD WIDTH=2%></TD>
<TD WIDTH=93%>Filed as an Exhibit to the Company's Registration Statement on
Form S-18, Registration No. 2-71198-FW, and incorporated herein by reference.
</TD></TR>
<TR>
<TD>(2) </TD>
<TD></TD>
<TD>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.</TD></TR>
<TR>
<TD>(3) </TD>
<TD></TD>
<TD>Filed as an Exhibit to the Company's Registration Statement on Form S-1,
Registration No. 2-78186, and incorporated herein by reference.</TD></TR>
<TR>
<TD>(4) </TD>
<TD></TD>
<TD>Filed as an Exhibit to the Company's Registration Statement on Form SB-2,
Registration No. 33-62991, and incorporated herein by reference.</TD></TR>
<TR>
<TD>(5) </TD>
<TD></TD>
<TD>Filed as an Exhibit to the report of the Company on Form 8-K dated September
3, 1996, and incorporated herein by reference.</TD></TR>
<TR>
<TD>(6) </TD>
<TD></TD>
<TD>Filed as an Exhibit to the report of the Company on Form 10-Q dated for the
quarterly period ended March 31, 1998, and incorporated herein by reference.
</TD></TR>
<TR>
<TD>(7) </TD>
<TD></TD>
<TD>Filed as an Exhibit to the Definitive Proxy Statement on Schedule 14A dated
April 27, 1998, and incorporated herein by reference.</TD></TR>
<TR>
<TD>(8) </TD>
<TD></TD>
<TD>Filed as an Exhibit to the report of the Company on Form 10-K dated for the
year ended December 31, 1998, and incorporated herein by reference.</TD></TR>
<TR>
<TD>(9) </TD>
<TD></TD>
<TD>Filed as an Exhibit to the Definitive Proxy Statement on Schedule 14A dated
April 17, 2000, and incorporated herein by reference.</TD></TR>
<TR>
<TD>(10)</TD>
<TD></TD>
<TD>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.</TD></TR>
<TR>
<TD>(11)</TD>
<TD></TD>
<TD>Filed as an Exhibit to the report of the Company on Form 10-K dated for the
year ended December 31, 2000, and incorporated herein by reference.</TD></TR>
<TR>
<TD>(12)</TD>
<TD></TD>
<TD>Filed as an Exhibit to the report of the company on Form 8-K dated January
30, 2002, and incorporated herein by reference.</TD></TR>
<TR>
<TD>(13)</TD>
<TD></TD>
<TD>Filed herewith.</TD></TR></TABLE>
<P ALIGN=CENTER>Page 32</P><HR>
<PAGE>
<P ALIGN=CENTER><U><B>Signatures</B></U></P>
<P>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.</P>
<P>Date: March 28, 2002</P>
<P>ADVANCED NEUROMODULATION SYSTEMS, INC.</P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR>
<TD WIDTH=40%></TD>
<TD WIDTH=5%>By:</TD>
<TD WIDTH=55%><U>/s/Christopher G. Chavez</U></TD></TR>
<TR>
<TD></TD>
<TD></TD>
<TD>Christopher G. Chavez</TD></TR>
<TR>
<TD></TD>
<TD></TD>
<TD>President and Chief Executive Officer</TD></TR></TABLE>
<P></P>
<P>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:</P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR>
<TD WIDTH=25% ALIGN=CENTER><U>Signature</U></TD>
<TD WIDTH=5%></TD>
<TD WIDTH=45% ALIGN=CENTER><U>Title</U></TD>
<TD WIDTH=5%></TD>
<TD WIDTH=20% ALIGN=CENTER><U>Date</U></TD></TR>
<TR>
<TD> </TD><TD></TD><TD></TD><TD></TD><TD></TD></TR><TR>
<TD ALIGN=LEFT VALIGN=TOP><U>/s/Christopher G. Chavez</U><BR>Christopher G.
Chavez</TD>
<TD></TD>
<TD ALIGN=LEFT>Chief Executive Officer, President and Director of Advanced
Neuromodulation Systems, Inc. (Principal Executive Officer)</TD>
<TD></TD>
<TD ALIGN=CENTER VALIGN=TOP>March 28, 2002</TD></TR><TR>
<TD> </TD><TD></TD><TD></TD><TD></TD><TD></TD></TR><TR>
<TD ALIGN=LEFT VALIGN=TOP><U>/s/F. Robert Merrill III</U><BR>F. Robert Merrill
III</TD><TD></TD>
<TD ALIGN=LEFT>Executive Vice President-Finance, Treasurer and Secretary of
Advanced Neuromodulation Systems, Inc. (Principal Financial and Accounting
Officer)</TD>
<TD></TD>
<TD ALIGN=CENTER VALIGN=TOP>March 28, 2002</TD></TR><TR>
<TD> </TD><TD></TD><TD></TD><TD></TD><TD></TD></TR><TR>
<TD ALIGN=LEFT VALIGN=TOP><U>/s/Hugh M. Morrison</U><BR>Hugh M. Morrison</TD>
<TD></TD>
<TD ALIGN=LEFT>Chairman of the Board and Director of Advanced Neuromodulation
Systems, Inc.</TD>
<TD></TD>
<TD ALIGN=CENTER VALIGN=TOP>March 28, 2002</TD></TR><TR>
<TD> </TD><TD></TD><TD></TD><TD></TD><TD></TD></TR><TR>
<TD ALIGN=LEFT VALIGN=TOP><U>/s/Robert C. Eberhart</U><BR>Robert C. Eberhart
</TD><TD></TD>
<TD ALIGN=LEFT VALIGN=TOP>Director of Advanced Neuromodulation Systems, Inc.
</TD><TD></TD>
<TD ALIGN=CENTER VALIGN=TOP>March 28, 2002</TD></TR><TR>
<TD> </TD><TD></TD><TD></TD><TD></TD><TD></TD></TR><TR>
<TD ALIGN=LEFT VALIGN=TOP><U>/s/Joseph E. Laptewicz</U><BR>Joseph E. Laptewicz
</TD><TD></TD>
<TD ALIGN=LEFT VALIGN=TOP>Director of Advanced Neuromodulation Systems, Inc.
</TD><TD></TD>
<TD ALIGN=CENTER VALIGN=TOP>March 28, 2002</TD></TR><TR>
<TD> </TD><TD></TD><TD></TD><TD></TD><TD></TD></TR><TR>
<TD ALIGN=LEFT VALIGN=TOP><U>/s/A. Ronald Lerner</U><BR>A. Ronald Lerner
</TD><TD></TD>
<TD ALIGN=LEFT VALIGN=TOP>Director of Advanced Neuromodulation Systems, Inc.
</TD><TD></TD>
<TD ALIGN=CENTER VALIGN=TOP>March 28, 2002</TD></TR><TR>
<TD> </TD><TD></TD><TD></TD><TD></TD><TD></TD></TR><TR>
<TD ALIGN=LEFT VALIGN=TOP><U>/s/Richard D. Nikolaev</U><BR>Richard D. Nikolaev
</TD><TD></TD>
<TD ALIGN=LEFT VALIGN=TOP>Director of Advanced Neuromodulation Systems, Inc.
</TD><TD></TD>
<TD ALIGN=CENTER VALIGN=TOP>March 28, 2002</TD></TR><TR>
<TD> </TD><TD></TD><TD></TD><TD></TD><TD></TD></TR><TR>
<TD ALIGN=LEFT VALIGN=TOP><U>/s/Michael J. Torma</U><BR>Michael J. Torma
</TD><TD></TD>
<TD ALIGN=LEFT VALIGN=TOP>Director of Advanced Neuromodulation Systems, Inc.
</TD><TD></TD>
<TD ALIGN=CENTER VALIGN=TOP>March 28, 2002</TD></TR>
</TABLE>
<P ALIGN=CENTER>Page 33</P><HR>
<PAGE>
<P ALIGN=RIGHT><B><U>Appendix A</U></B></P>
<P></P><P></P>
<P ALIGN=CENTER><B>Consolidated Financial Statements<BR>Independent
Auditors’ Report<BR><BR>Three Years Ended December 31, 2001<BR><BR>
Forming a Part of the Annual Report<BR><BR>Form 10-K<BR><BR>Item 8<BR><BR><BR>
of<BR><BR>ADVANCED NEUROMODULATION SYSTEMS, INC.<BR>(Name of issuer)<BR><BR><BR>
<BR>Filed with the<BR><BR>Securities and Exchange Commission<BR><BR>Washington,
D.C. 20549<BR><BR><BR>under<BR><BR>The Securities Exchange Act of 1934</B>
</P><HR>
<PAGE>
<P ALIGN=CENTER><B>Advanced Neuromodulation Systems, Inc. and Subsidiaries<BR>
<BR>Table of Contents<BR>to<BR>Consolidated Financial Statements<BR><BR>
Form 10-K - Item 8</B></P>
<P></P><P></P><P></P><P></P>
<P><B>Independent Auditors’ Report</B></P>
<P></P><P></P>
<P><B>Consolidated Financial Statements:</B></P>
<P>Consolidated Balance Sheets - December 31, 2001 and 2000<BR>Consolidated
Statements of Income - Years ended December 31, 2001, 2000 and 1999<BR>
Consolidated Statements of Stockholders' Equity - Years ended December 31, 2001,
2000 and 1999<BR> Consolidated Statements of Cash Flows - Years ended December
31, 2001, 2000 and 1999<BR> Notes to Consolidated Financial Statements</P>
<HR>
<PAGE>
<P ALIGN=CENTER>Report of Independent Auditors</P>
<P>The Board of Directors<BR>Advanced Neuromodulation Systems, Inc.</P>
<P>We have audited the accompanying consolidated balance sheets of Advanced
Neuromodulation Systems, Inc. and subsidiaries (the Company) as of December 31,
2001 and 2000, and the related consolidated statements of income,
stockholders’ equity and cash flows for each of the three years in the
period ended December 31, 2001. Our audits also included the financial statement
schedule listed in the Index at Item 14A. 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.</P>
<P>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.</P>
<P>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, 2001 and 2000,
and the consolidated results of their operations and their cash flows for each
of the three years in the period ended December 31, 2001, 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.</P>
<P></P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR>
<TD WIDTH=40%> </TD>
<TD WIDTH=60%><U>/s/Ernst & Young LLP</U><BR>Ernst & Young LLP</TD></TR>
</TABLE>
<P></P>
<P></P>
<P>Dallas, Texas<BR>February 6, 2002</P>
<HR>
<PAGE>
<P ALIGN=CENTER><B>Advanced Neuromodulation Systems, Inc. and Subsidiaries<BR>
Consolidated Balance Sheets<BR>December 31, 2001 and 2000</B></P>
<PRE>
Assets 2001 2000
------------------ -------------------
Current assets:
Cash and cash equivalents $ 9,785,325 $ 9,528,721
Certificates of deposit with maturities over 90 days at purchase -- 1,040,000
Marketable securities 2,151,722 1,030,318
Receivables:
Trade accounts, less allowance for doubtful
accounts of $124,111 in 2001 and $213,249 in 2000 6,493,772 5,164,231
Interest and other 235,594 734,550
------------------ -------------------
Total receivables 6,729,366 5,898,781
------------------ -------------------
Inventories:
Raw materials 4,685,586 3,432,335
Work-in-process 1,723,419 1,075,111
Finished goods 3,339,840 2,580,193
------------------ -------------------
Total inventories 9,748,845 7,087,639
------------------ -------------------
Deferred income taxes 1,726,517 1,282,072
Refundable income taxes 678,341 359,953
Prepaid expenses and other current assets 685,169 1,064,850
------------------ -------------------
Total current assets 31,505,285 27,292,334
------------------ -------------------
Equipment and fixtures:
Furniture and fixtures 3,400,909 2,900,149
Machinery and equipment 8,550,504 6,585,774
Leasehold improvements 1,610,810 1,525,542
------------------ -------------------
13,562,223 11,011,465
Less accumulated depreciation and amortization 6,353,920 4,390,113
------------------ -------------------
Net equipment and fixtures 7,208,303 6,621,352
------------------ -------------------
Cost in excess of net assets acquired, net of accumulated
amortization of $3,404,427 in 2001 and $2,847,824 in 2000 7,407,237 7,963,840
Patents and licenses, net of accumulated amortization
of $1,045,106 in 2001 and $674,220 in 2000 5,368,213 3,104,254
Purchased technology from acquisitions, net of accumulated
amortization of $1,800,000 in 2001 and
$1,533,334 in 2000 2,200,000 2,466,666
Tradenames, net of accumulated amortization of
$843,736 in 2001 and $718,745 in 2000 1,656,264 1,781,255
Other assets, net of accumulated amortization of
$392,033 in 2001 and $221,320 in 2000 519,783 334,865
------------------ -------------------
$ 55,865,085 $ 49,564,566
================== ===================
</PRE>
<P>See accompanying notes to consolidated financial statements.</P>
<HR>
<PAGE>
<P ALIGN=CENTER><B>Advanced Neuromodulation Systems, Inc. and Subsidiaries<BR>
Consolidated Balance Sheets<BR>December 31, 2001 and 2000</B></P>
<PRE>
Liabilities and Stockholders' Equity 2001 2000
------------------ -------------------
Current liabilities:
Accounts payable $ 1,835,037 $ 1,269,102
Accrued salary and employee benefit costs 2,112,127 1,293,065
Accrued tax abatement liability 969,204 969,204
Customer deposits 1,042,690 543,885
Warranty reserve 383,477 422,182
Other accrued expenses 204,151 487,230
Current maturities of long-term note payable 52,325 29,601
Income taxes payable --- 67,240
------------------ -------------------
Total current liabilities 6,599,011 5,081,509
------------------ -------------------
Deferred income taxes 2,316,796 2,354,170
Long-term note payable 137,397 211,681
Non-current customer deposits -- 1,475,393
Commitments and contingencies
Stockholders' equity:
Common stock, $.05 par value
Authorized-25,000,000 shares;
Issued- 9,071,868 shares in 2001 and 8,883,059 in 2000 453,593 444,153
Additional capital 38,670,248 34,469,471
Retained earnings 7,709,290 6,539,223
Accumulated other comprehensive income (loss), net of
tax benefit of $10,949 in 2001 and $42,883 in 2000 (21,250) (83,241)
Cost of common shares in treasury; 119,100 in 2000 -- (927,793)
------------------ -------------------
Total stockholders' equity 46,811,881 40,441,813
------------------ -------------------
$ 55,865,085 $ 49,564,566
================== ===================
</PRE>
<P>See accompanying notes to consolidated financial statements.</P>
<HR>
<PAGE>
<P ALIGN=CENTER><B>Advanced Neuromodulation Systems, Inc. and Subsidiaries<BR>
Consolidated Statements of Income<BR>Years Ended December 31</B></P>
<PRE>
2001 2000 1999
--------------------- --------------------- ---------------------
Net revenue $ 37,916,435 $ 31,826,998 $ 26,879,019
Net revenue-contract research and development --- --- 8,900,000
--------------------- --------------------- ---------------------
Total net revenue 37,916,435 31,826,998 35,779,019
--------------------- --------------------- ---------------------
Operating expenses:
Cost of revenue 15,675,436 14,699,633 11,927,260
General and administrative 3,957,867 4,243,720 3,808,263
Research and development 4,928,432 3,854,084 4,096,506
Amortization of goodwill 556,604 556,604 556,604
Amortization of other intangibles 933,257 676,508 631,085
Marketing 9,055,932 6,851,022 6,290,004
--------------------- --------------------- ---------------------
35,107,528 30,881,571 27,309,722
--------------------- --------------------- ---------------------
Income from operations 2,808,907 945,427 8,469,297
Other income (expense):
Acquisition related costs (483,766) -- --
Interest expense (24,346) (59,015) (147,061)
Investment and other income, net 482,417 604,570 834,027
--------------------- --------------------- ---------------------
(25,695) 545,555 686,966
--------------------- --------------------- ---------------------
Income before income taxes 2,783,212 1,490,982 9,156,263
Income taxes 1,265,466 658,524 3,339,341
--------------------- --------------------- ---------------------
Net income $ 1,517,746 $ 832,458 $ 5,816,922
===================== ===================== =====================
Net income per share:
===================== ===================== =====================
Basic $ .17 $ .10 $ .73
===================== ===================== =====================
Diluted $ .15 $ .09 $ .64
===================== ===================== =====================
</PRE>
<P>See accompanying notes to consolidated financial statements.</P>
<HR>
<PAGE>
<P ALIGN=CENTER><B> Advanced Neuromodulation Systems, Inc. and Subsidiaries<BR>
Consolidated Statements of Cash Flows<BR> Years Ended December 31</B></P>
<PRE>
2001 2000 1999
-------------------- ------------------- -------------------
Cash flows from operating activities:
Net income $ 1,517,746 $ 832,458 $ 5,816,922
Adjustments to reconcile net income to net cash provided by
operating activities:
Depreciation 1,932,452 1,636,857 1,091,994
Amortization 1,489,861 1,233,112 1,187,689
Deferred income taxes (455,003) (330,804) (79,443)
Non-operating gain included in net income -- (33,509) (47,389)
Increase in inventory reserve 107,880 111,144 112,500
Changes in operating assets and liabilities
Receivables (1,027,050) (486,949) (1,295,739)
Inventories (2,672,605) 270,190 (4,277,363)
Refundable income taxes (318,388) (359,953) --
Prepaid expenses and other current assets 564,866 144,880 (426,357)
Customer deposits (706,916) (1,071,372) 1,368,018
Income taxes payable 1,580,025 82,848 (1,481,786)
Accounts payable 493,227 (1,348,526) 892,536
Accrued expenses 553,380 9,892 648,505
Deferred revenue -- -- (559,200)
-------------------- ------------------- -------------------
Total adjustments 1,541,729 (142,190) (2,866,035)
-------------------- ------------------- -------------------
Net cash provided by operating activities 3,059,475 690,268 2,950,887
-------------------- ------------------- -------------------
Cash flows from investing activities:
Purchases of certificates of deposit with maturities over 90 days -- (1,425,000) --
Proceeds from certificates of deposits with maturities over 90 days 1,040,000 385,000 --
Purchases of marketable securities (3,896,199) (808,760) (380,000)
Net proceeds from sales of marketable securities 2,876,720 564,194 466,217
Additions to equipment, fixtures and patent licenses (3,108,055) (1,653,194) (5,637,896)
Net proceeds from sale of assets in 2000 and discontinued
operations in 1999 -- 600 6,354,965
-------------------- ------------------- -------------------
Net cash provided by (used in) investing activities (3,087,534) (2,937,160) 803,286
-------------------- ------------------- -------------------
Cash flows from financing activities:
Decrease in short-term obligations -- -- (3,633,475)
Payment of long-term notes (47,807) (28,718) --
Proceeds from long-term note payable -- 270,000 --
Net proceeds from private placement of common stock -- 400,000 --
Exercise of stock options and warrants 1,004,914 1,929,450 573,272
Purchase of treasury stock -- -- (4,752,311)
-------------------- ------------------- -------------------
Net cash provided by (used in) financing activities 957,107 2,570,732 (7,812,514)
-------------------- ------------------- -------------------
Net increase (decrease) in cash and cash equivalents 929,048 323,840 (4,058,341)
Net cash used by Hi-tronics in December 2000 (see Note 3) (672,444) -- --
Cash and cash equivalents at beginning of year 9,528,721 9,204,881 13,263,222
-------------------- ------------------- -------------------
Cash and cash equivalents at end of year $ 9,785,325 9,528,721 $ 9,204,881
==================== =================== ===================
Supplemental cash flow information is presented below:
Income taxes paid $ 815,000 $ 1,138,685 $ 4,902,411
==================== =================== ===================
Interest paid $ 24,346 $ 59,015 $ 147,061
==================== =================== ===================
Non-cash activity:
Stock issued for patents and intangible assets $ 2,426,662 $ -- $ --
==================== =================== ===================
</PRE>
<P>See accompanying notes to consolidated financial statements.</P>
<HR>
<PAGE>
<P ALIGN=CENTER><B>Advanced Neuromodulation Systems, Inc. and Subsidiaries<BR>
Consolidated Statements of Stockholders' Equity<BR>Three Years Ended December
31, 2001</B></P>
<PRE>
Other
Retained Comprehensive Total
Common Stock Additional Earnings Income Treasury Stockholders'
Shares Amount Capital (Deficit) (Loss) Stock Equity
------------- ------------- ------------- ------------- ------------- ------------- -------------
Balance at
December 31, 1998 8,883,059 $ 444,153 $ 35,331,237 $ (110,157) $ (130,760) $ (765,424) $ 34,769,049
Net income -- -- -- 5,816,922 -- -- 5,816,922
Adjustment to
unrealized losses
on marketable
securities -- -- -- -- (91,821) -- (91,821)
-------------
Comprehensive income 5,725,101
-------------
Issuance of 162,068
shares from
treasury for
stock option
exercises -- -- (954,221) -- -- 1,527,493 573,272
Purchase of 602,275
treasury shares,
at cost -- -- -- -- -- (4,752,311) (4,752,311)
Tax benefit from
stock option
exercises -- -- 221,096 -- -- -- 221,096
------------- ------------- ------------- ------------- ------------- ------------- -------------
Balance at
December 31, 1999 8,883,059 444,153 34,598,112 5,706,765 (222,581) (3,990,242) 36,536,207
Net income -- -- -- 832,458 -- -- 832,458
Adjustment to
unrealized losse
on marketable
securities -- -- -- -- 139,340 -- 139,340
-------------
Comprehensive income 971,798
-------------
Issuance of 32,900
shares from
treasury for
private placement -- -- 100,000 -- -- 300,000 400,000
Issuance of 337,941
shares from
treasury for
stock option and
warrant exercises -- -- (832,999) -- -- 2,762,449 1,929,450
Tax benefit from
stock option
exercises -- -- 604,358 -- -- -- 604,358
------------- ------------- ------------- ------------- ------------- ------------- -------------
Balance at
December 31, 2000 8,883,059 444,153 34,469,471 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 -- -- -- -- 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 188,809 9,440 995,474 -- -- -- 1,004,914
Tax benefit from
stock option
exercises -- -- 1,669,405 -- -- -- 1,669,405
Issuance of 119,100
shares from
treasury for
acquisition -- -- 1,498,869 -- -- 927,793 2,426,662
------------- ------------- ------------- ------------- ------------- ------------- -------------
Balance at
December 31, 2001 9,071,868 $ 453,593 $ 38,670,248 $ 7,709,290 $ (21,250) $ -- $ 46,811,881
============= ============= ============= ============= ============= ============= =============
</PRE>
<P>See accompanying notes to consolidated financial statements.</P>
<HR>
<PAGE>
<P ALIGN=CENTER><B>Advanced Neuromodulation Systems, Inc. and Subsidiaries<BR>
Notes to Consolidated Financial Statements</B></P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR>
<TD WIDTH=5%><B>(1)</B></TD>
<TD WIDTH=95%><B>Business</B></TD></TR></TABLE>
<P>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.
</P>
<P>On January 2, 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 Minnesota
companies. See Note 3.</P>
<P>On January 2, 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. See Note 3.</P>
<P>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.</P>
<P>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.</P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR>
<TD WIDTH=5%><B>(2)</B></TD>
<TD WIDTH=95%><B>Summary of Significant Accounting Policies</B></TD></TR>
</TABLE>
<P><B>Principles of Consolidation</B></P>
<P>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.
</P>
<P><B>Use of Estimates</B></P>
<P>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.</P>
<P><B>Cash Equivalents</B></P>
<P>The Company considers all highly liquid investments with maturities of three
months or less at the time of purchase to be cash equivalents.</P>
<P ALIGN=CENTER>Page 1</P>
<HR>
<PAGE>
<P><B>Revenue Recognition</B></P>
<P>The Company recognizes revenue from neuro product sales when the goods are
shipped to its customers. 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 research and development
contracts. HDI recognizes revenue under such development contracts based upon
the percentage-of-completion method. Measurement of progress to completion is
based upon costs incurred and estimated total costs.</P>
<P><B>Marketable Securities</B></P>
<P>The Company's marketable securities and debt securities are classified as
available-for-sale and are carried at fair value with the unrealized gains and
losses reported in a separate component of stockholders' equity entitled "Other
comprehensive income". 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.</P>
<P><B>Inventories</B></P>
<P>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.</P>
<P><B>Equipment and Fixtures</B></P>
<P>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.</P>
<P>Depreciation is provided using the straight-line method over the estimated
useful lives of the various assets as follows:</P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR>
<TD WIDTH=40%>Leasehold improvements</TD>
<TD WIDTH=60% ALIGN=LEFT>3 to 5 years</TD>
</TR>
<TR>
<TD>Furniture and fixtures</TD>
<TD ALIGN=LEFT>2 to 10 years</TD>
</TR>
<TR>
<TD>Machinery and equipment</TD>
<TD ALIGN=LEFT>3 to 10 years</TD>
</TR></TABLE>
<P><B>Intangible Assets</B></P>
<P>The excess of cost over the net assets of acquired businesses ("goodwill") is
amortized on a straight-line basis over the estimated useful life of 20 years.
</P>
<P>The cost of purchased technology related to acquisitions is based on
appraised values at the date of acquisition and is amortized on a straight-line
basis over the estimated useful life (15 years) of such technology.</P>
<P>The cost of purchased tradenames is based on appraised values at the date of
acquisition and is amortized on a straight-line basis over the estimated useful
life (20 years) of such tradenames.</P>
<P>The cost of purchased patents is amortized on a straight-line basis over the
estimated useful life (17 years) of such patents. 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.</P>
<P ALIGN=CENTER>Page 2</P><HR>
<PAGE>
<P>The Company assesses the recoverability of all its intangible assets
primarily based on its current and anticipated future undiscounted cash flows.
At December 31, 2001, the Company does not believe there has been any impairment
of its intangible assets.</P>
<P><B>Research and Development</B></P>
<P>Product development costs including start-up and research and development are
charged to operations in the year in which such costs are incurred.</P>
<P><B>Advertising</B></P>
<P>Advertising expense is charged to operations in the year in which such costs
are incurred. Total advertising expense, included in marketing expense was
$20,592, $24,716 and $40,440 at December 31, 2001, 2000 and 1999, respectively.
</P>
<P><B>Deferred Taxes</B></P>
<P>Deferred income taxes are recorded based on the liability method and
represent the tax effect of the differences between the financial and tax basis
of assets and liabilities other than costs in excess of the net assets of
businesses acquired.</P>
<P><B>Stock-Based Compensation</B></P>
<P>The Company has adopted the disclosure-only provisions of SFAS No. 123,
"Accounting for Stock-Based Compensation", which disclosures are presented in
Note 7, "Stockholders' Equity". Because of this election, the Company continues
to account for its stock-based compensation plans under APB No. 25, "Accounting
for Stock Issued to Employees". All of the Company's stock option grants are at
exercise prices equal to the fair market value of the Company's stock on the
date of grant, and therefore, no compensation expense is recorded.<P>
<P><B>Earnings Per Share</B></P>
<P>Basic earnings per share is computed based only on the weighted average
number of common shares outstanding during the period, and the dilutive effect
of stock options and warrants is excluded. Diluted earnings per share is
computed using the additional dilutive effect, if any, of stock options and
warrants using the treasury stock method based on the average market price of
the stock during the period. Basic earnings per share for 2001, 2000 and 1999
are based upon 8,926,985, 8,507,048, and 8,679,952 shares, respectively. Diluted
earnings per share for 2001, 2000, and 1999 are based upon 9,917,007, 9,398,934,
and 9,105,289 shares, respectively. The following table presents the
reconciliation of basic and diluted shares:</P>
<P ALIGN=CENTER>Page 3</P><HR>
<PAGE>
<PRE>
2001 2000 1999
--------- --------- ---------
Weighted-average shares outstanding
(basic shares) 8,926,985 8,507,048 8,679,952
Effect of dilutive instruments(1)
Stock options 990,022 847,349 406,701
Warrants --- 44,537 18,636
--------- --------- ---------
Dilutive potential common shares 990,022 891,886 425,337
--------- --------- ---------
Diluted shares 9,917,007 9,398,934 9,105,289
========= ========= =========
</PRE>
<P>(1) See Note 7 for a description of these instruments.</P>
<P>For 2001, 2000 and 1999 the incremental shares used for dilutive earnings per
share relate to stock options and warrants whose exercise price was less than
the average market price in the underlying quarterly computations. Options to
purchase 24,750 shares at an average price of $19.79 per share were outstanding
in 2001, 12,975 shares at an average price of $15.38 per share were outstanding
in 2000, and options to purchase 250 shares at an average price of $8.94 per
share were outstanding in 1999 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.</P>
<P><B>Comprehensive Income</B></P>
<P>Statement of Financial Accounting Standards No. 130 - "Reporting
Comprehensive Income" - requires 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) to be included in "Other
comprehensive income" and be reported in the Consolidated Statements of
Stockholders' Equity.</P>
<P><B>New Accounting Standards</B></P>
<P>In June 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 133 ("SFAS 133"), "Accounting for Derivative
Instruments and Hedging Activities." SFAS 133 requires companies to record
derivatives on the balance sheet as assets or liabilities, measured at fair
value. Gains or losses resulting from changes in the values of those derivatives
would be accounted for depending on the use of the derivative and whether it
qualifies for hedge accounting. SFAS 133, as amended by SFAS 138, is effective
for fiscal years beginning after June 15, 2000. The adoption of SFAS 133 as of
January 1, 2001 did not have an impact on the financial position or results of
operations of the Company because the Company has no derivatives or hedges.</P>
<P>In June 2001, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 141 ("SFAS 141"), "Business Combinations" and
Statement of Financial Accounting Standards No. 142 ("SFAS 142"), "Goodwill and
Other Intangible Assets". SFAS 141 and SFAS 142 are effective for fiscal years
beginning after December 15, 2001. Under the new rules, goodwill and intangible
assets deemed to have indefinite lives will no longer be amortized but will be
subject to annual impairment tests in accordance with the statements. The
Company has determined that its goodwill at December 31, 2001 is unimpaired and
will eliminate amortization of the goodwill effective January 1, 2002. The
Company recorded an expense of $556,604 in each of the three years ended
December 31, 2001, 2000 and 1999 for amortization of goodwill.
<P ALIGN=CENTER>Page 4</P><HR>
<PAGE>
<P><B>Reclassification</B></P>
<P>Certain prior period amounts have been reclassified to conform to
current-year presentation.</P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR>
<TD WIDTH=5%><B>(3)</B></TD>
<TD WIDTH=95%><B>Acquistions</B></TD></TR></TABLE>
<P>On January 2, 2001, the Company acquired the assets of Implantable Devices
Limited Partnership (IDP) and ESOX Technology Holdings, LLC (ESOX), two
privately held Minnesota companies, for 119,100 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 $2.43 million. The assets
purchased consisted primarily of intellectual property and technology for the
fully implantable constant-rate infusion pump that ANS has developed. Prior to
the acquisition, the Company had licensed rights to the technology only for pain
and cancer therapy applications.</P>
<P>Also on January 2, 2001, the Company completed the acquisition of Hi-tronics
Designs, Inc. (HDI), a privately-held contract developer and original equipment
manufacturer (OEM) of electro-mechanical devices with headquarters in Budd Lake,
New Jersey. The Company acquired all of HDI's outstanding stock through a merger
in exchange for 1,104,725 shares of ANS common stock. The transaction was
accounted for on a pooling of interests basis and accordingly, prior periods
have been restated. HDI developed and manufactured the Company's totally
implantable pulse generator (IPG) used in the treatment of chronic intractable
pain and was also the O.E.M. manufacturer of the transmitter used with the
Company's <I>Renew</I> radio-frequency spinal cord stimulation system.</P>
<P>Prior to the Company's acquisition of HDI, HDI's fiscal year ended on
November 30. The Consolidated Balance Sheet at December 31, 2000 combines the
Balance Sheet of HDI at November 30, 2000 with the Balance Sheet of the Company
at December 31, 2000. Beginning in 2001, the fiscal year-ends have been
conformed to December 31. As a result, the results of operations of HDI for the
one-month period ending December 31, 2000 have been recorded directly to
retained earnings in the Consolidated Statement of Stockholders' Equity for the
period ended December 31, 2001 and are not reflected in the Consolidated
Statements of Income. Summary operating results of HDI for this one-month period
ending December 31, 2000, were as follows:</P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR>
<TD WIDTH=5%> </TD>
<TD WIDTH=40%>Net revenue</TD>
<TD WIDTH=2%>$</TD>
<TD WIDTH=53%> 119,481</TD></TR>
<TR>
<TD> </TD>
<TD>Loss before income tax benefit</TD>
<TD>$</TD>
<TD>(591,600)</TD></TR>
<TR>
<TD> </TD>
<TD>Net loss</TD>
<TD>$</TD>
<TD>(347,679)</TD></TR></TABLE>
<P>For the one-month period ended December 31, 2000, cash flows for HDI were as
follows:</P>
<TABLE WIDTH=100% CELLSPACING=0 CELLPADDING=0>
<TR>
<TD WIDTH=5%> </TD>
<TD WIDTH=40%>Net cash used by operating activities</TD>
<TD WIDTH=2%>$</TD>
<TD WIDTH=53%>(647,210)</TD></TR>
<TR>
<TD> </TD>
<TD>Net cash used by investing activities</TD>
<TD>$</TD>
<TD> (14,516)</TD></TR>
<TR>
<TD> </TD>
<TD>Net cash used by financing activities</TD>
<TD>$</TD>
<TD> (10,718)</TD></TR>
<TR>
<TD> </TD>
<TD>Net decrease in cash</TD>
<TD>$</TD>
<TD>(672,444)</TD></TR></TABLE>
<P></P>
The following is a reconciliation of previously reported amounts with restated
amounts for total net revenue and net income:
<PRE>
2000 1999
------------------ --------------------
Total net revenue:
As previously reported by the Company $23,081,624 $29,478,384
HDI, for the year ended November 30 10,366,270 7,989,177
Elimination of intercompany transactions (1,620,896) (1,688,542)
------------------ --------------------
As restated $31,826,998 $35,779,019
================== ====================
2000 1999
------------------ --------------------
Net income:
As previously reported by the Company $ 953,644 $ 6,003,281
HDI, for the year ended November 30 28,833 328,073
Elimination of intercompany transactions (150,019) (514,432)
------------------ --------------------
As restated $ 832,458 $ 9,398,934
================== ====================
</PRE>
<P>Prior to January 2, 2001, the Company and HDI, in the normal course of
business, entered into certain transactions for development and manufacture
related to the Company's products. These intercompany transactions have been
eliminated.</P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR>
<TD WIDTH=5%><B>(4)</B></TD>
<TD WIDTH=95%><B>Note Payable</B></TD></TR></TABLE>
<P>In connection with the acquisition of HDI (See Note 3), the Company acquired
responsibility for a note payable with a principal balance of $189,722 at
December 31, 2001. The note was entered into during March 2000, has a five-year
term, and bears interest at a fixed rate of 9% per annum. The monthly
installments for principal and interest are $5,623. The loan is collateralized
by equipment purchased from the proceeds of the note and accounts receivable of
HDI. Maturities of the note payable are as follows: $52,325 in 2002, $57,304 in
2003, $62,738 in 2004 and $17,355 in 2005.</P>
<P ALIGN=CENTER>Page 5<P><HR>
<PAGE>
<P></P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR>
<TD WIDTH=5%><B>(5)</B></TD>
<TD WIDTH=95%><B>Marketable Securities</B></TD></TR></TABLE>
<P>The following is a summary of available-for-sale securities at December 31,
2001:</P>
<PRE>
Gross Gross
Unrealized Unrealized Estimated
Cost Gains Losses Fair Value
---------- ---------- ---------- ----------
FNMA and Federal Home Loan Bank notes $1,038,783 $ -- $ 10,034 $1,028,749
Investment grade municipal bonds 1,047,456 258 4,241 1,043,473
Real estate investment trust 97,682 -- 18,182 79,500
---------- ---------- ---------- ----------
$2,183,921 $ 258 $ 32,457 $2,151,722
========== ========== ========== ==========
</PRE>
<P>Estimated fair value for the real estate investment trust is determined by
the closing price as reported on the New York Stock Exchange at each financial
reporting period. In the case of the investment grade municipal bonds and FNMA
and Federal Home Loan Bank notes, the brokerage firms holding such bonds and
notes provide the values at each reporting period by utilizing a standard
pricing service.</P>
<P>At December 31, 2001, no individual security represented more than 25% of the
total portfolio or 1% of total assets. The Company did not have any investments
in derivative financial instruments at December 31, 2001.</P>
<P>The following is a summary of available-for-sale securities at December 31,
2000:</P>
<PRE>
Gross Gross
Unrealized Unrealized Estimated
Cost Gains Losses Fair Value
---------- ---------- ---------- ----------
Investment grade preferred security $ 250,000 $ -- $ 89,380 $ 160,620
Investment grade municipal bonds 808,760 -- -- 808,760
Real estate investment trust 97,682 -- 36,744 60,938
---------- ---------- ---------- ----------
$1,156,442 $ -- $ 126,124 $1,030,318
========== ========== ========== ==========
</PRE>
<P>At December 31, 2000, no individual security represented more than 45% of the
total portfolio or 1% of total assets. The Company did not have any investments
in derivative financial instruments at December 31, 2000.</P>
<P ALIGN=CENTER>Page 6</P><HR>
<PAGE>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR>
<TD WIDTH=5%><B>(6)</B></TD>
<TD WIDTH=95%><B>Federal Income Taxes</B></TD></TR>
</TABLE>
<P>The significant components of the net deferred tax liability at December 31,
were as follows:</P>
<PRE>
2001 2000
------------ ------------
Deferred tax assets:
Net operating loss carry forwards $ 670,128 $ --
Accrued expenses and reserves 870,720 842,593
Marketable securities 10,949 42,883
------------ ------------
Total deferred tax asset 1,551,797 885,476
Deferred tax liabilities:
Purchased intangible assets (1,388,255) (1,116,851)
Equipment and fixtures (895,390) (723,862)
Other 140,686 (116,861)
------------ ------------
Total deferred tax liabilities (2,142,960) (1,957,574)
------------ ------------
Net deferred tax liabilities $ (590,279) $(1,072,098)
============ ============
</PRE>
<P>As of December 31, 2001, the Company had a net operating loss carry forward
of approximately $1.8 million which expires in years through 2021. This net
operating loss carry forward may be subject to 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.
<P>The provision for income taxes for the years ended December 31 consists of
the following:</P>
<PRE>
2001 2000 1999
----------- ----------- ----------
Current $1,747,285 $ 841,390 $3,755,113
Deferred (481,819) (182,866) (415,772)
----------- ----------- ----------
$1,265,466 $ 658,524 $3,339,341
=========== =========== ==========
</PRE>
<P>A reconciliation of the provision for income taxes to the expense calculated
at the U.S. statutory rate follows:</P>
<PRE>
2001 2000 1999
----------- ----------- ----------
Income tax expense at statutory rate $ 946,292 $ 506,934 $3,113,129
Tax effect of:
State taxes 42,959 4,581 183,625
Nondeductible amortization of goodwill 189,245 189,279 189,211
Other 86,970 (42,270) (146,624)
----------- ----------- ----------
Income tax expense $1,265,466 $ 658,524 $3,339,341
=========== =========== ==========
</PRE>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR>
<TD WIDTH=5%><B>(7)</B></TD>
<TD><B>Stockholders' Equity</B></TD></TR></TABLE>
<P>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.</P>
<P>At December 31, 2000, the Company had 119,100 treasury shares. These shares
were reissued on January 2, 2002 in connection with the acquisition of assets.
See Note 3.</P>
<P ALIGN=CENTER>Page 7</P><HR>
<PAGE>
<P>In 1998, the Company issued a five-year warrant to purchase 100,000 shares of
common stock at an exercise price of $6.50 per share in connection with a
$2,000,000 loan from a nonaffiliate shareholder. The warrant was exercised by
the nonaffiliate shareholder in December 2000.</P>
<P>The Company has various stock option plans pursuant to which stock options
may be granted to key employees, officers, directors and advisory directors of
the Company. The most recent of the plans, approved by the shareholders during
2000 (the "2000 Plan"), reserved 500,000 shares of common stock for options
under the plan. In accordance with the 2000 Plan, on January 1 of each year
(commencing in 2001), the aggregate number of shares of common stock reserved
for options under the 2000 Plan 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, 2002, options to purchase 95,538 shares of common stock
were added to the 2000 Plan.</P>
<P>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 a two-year or three-year vesting schedule.</P>
<P>At December 31, 2001, under all of the Company's stock option plans,
1,669,175 shares had been granted and were outstanding, 2,234,997 shares of
common stock had been issued upon exercise, and 74,402 shares were reserved for
future grants.</P>
<P>Data with respect to stock option plans of the Company are as follows:</P>
<PRE>
------------------------------------------------- -----------------------------
Options Outstanding Exercisable Options
------------------------------------------------- -----------------------------
Weighted Weighted
Average Average
Shares Exercise Price Shares Exercise Price
----------------- ------------ -------------- ------------ --------------
January 1, 1999 1,068,215 $ 4.82 465,340 $ 4.58
Granted 447,102 $ 7.08
Exercised (162,068) $ 3.99
Forfeited (18,000) $ 8.14
----------------- ------------ -------------- ------------ --------------
January 1, 2000 1,335,249 $ 5.63 563,333 $ 5.11
Granted 422,332 $ 14.21
Exercised (237,674) $ 5.50
Forfeited (55,270) $ 6.88
----------------- ------------ -------------- ------------ --------------
January 1, 2001 1,464,637 $ 8.08 607,664 $ 5.23
Granted 413,500 $ 12.51
Exercised (188,809) $ 5.58
Forfeited (20,153) $ 8.70
----------------- ------------ -------------- ------------ --------------
December 31, 2001 1,669,175 $ 9.44 750,215 $ 6.61
----------------- ============ ============== ============ ==============
</PRE>
<P ALIGN=CENTER>Page 8</P><HR>
<PAGE>
<PRE>
Exercisable Options
Options Outstanding at December 31, 2001 at December 31, 2001
- -------------------------------------------------------- ------------------------
Weighted
Average Weighted Weighted
Range of Remaining Average Average
Exercise Price Shares Life (Years) Exercise Price Shares Exercise Price
- -------------- --------- ------------ -------------- -------- --------------
$ 3.50 - 6.99 803,259 6.95 $ 5.46 625,384 $ 5.27
$ 7.00 - 10.49 88,959 8.30 $ 8.83 26,873 $ 8.52
$10.50 - 13.99 379,100 9.11 $ 11.13 24,275 $ 12.62
$14.00 - 17.49 274,607 8.57 $ 14.49 61,558 $ 14.49
$17.50 - 21.00 123,250 9.28 $ 19.37 12,125 $ 19.25
--------- ------------ -------------- -------- --------------
1,669,175 7.95 $ 9.44 750,215 $ 6.61
========= ============ ============== ======== ==============
</PRE>
<P>In accordance with APB No. 25, the Company has not recorded compensation
expense for its stock option awards. As required by SFAS No. 123, the Company
provides the following disclosure of hypothetical values for these awards. The
weighted-average fair value of an option granted in 2001, 2000 and 1999 was
$6.24, $5.76 and $2.73, respectively. For purposes of fair market value
disclosures, the fair market value of an option grant was estimated using the
Black-Scholes option pricing model with the following assumptions:</P>
<PRE>
2001 2000 1999
--------- --------- ---------
Risk-free interest rate 4.4% 5.9% 5.5%
Average life of options (years) 3.0 3.0 3.0
Volatility 74.5% 52.4% 49.1%
Dividend Yield -- -- --
</PRE>
<P>Had the compensation expense been recorded based on these hypothetical
values, pro forma net income (loss) for 2001, 2000 and 1999 would have been
$(95,632), $(436,109) and $4,812,553, respectively, and pro forma diluted net
income (loss) per common share for 2001, 2000 and 1999 would have been $(.01),
$(.05) and $.53, respectively.</P>
<TABLE WIDTH=100% CELLSPACING=0 CELLPADDING=0>
<TR>
<TD WIDTH=5%><B>(8)</B></TD>
<TD WIDTH=95%><B>Commitments and Contingencies</B></TD></TR></TABLE>
<P>On February 1, 1999, the Company sold its principal office and manufacturing
facility in Allen, Texas to Atrion Corporation. Atrion leased space to the
Company at the rate of $48,125 per month from February 1, 1999 through May 31,
1999. The Company entered into a sixty-three month lease agreement on 40,000
square feet of space located in the North Dallas area during February 1999. The
Company relocated its operations to the leased facility in May 1999 and the
rental period under the lease commenced on June 1, 1999. Under the terms of the
lease agreement, the Company received three months free rent and the monthly
rental rate for the remaining term of the lease is $48,308. The monthly rental
rate includes certain operating expenses such as property taxes on the facility,
insurance, landscape and maintenance and janitorial services. The Company also
has the first right of refusal to acquire the facility. Future minimum rental
payments relating to the leased facility for the years ended December 31 are
$579,696 in 2002 and 2003 and $386,464 in 2004.</P>
<P>The Company also leases facilities in New Jersey as a result of the January
2001 acquisition of HDI. One of the facilities, located in Budd Lake, New Jersey
is 8,800 square feet of office space that is used for administration, design
engineering, drafting, documentation and regulatory affairs. The lease expires
on May 31, 2003 and has a monthly rental rate of $10,891.The Company also leases
15,000 square feet of space in Hackettstown, New Jersey used for the O.E.M.
manufacturing operations. The Hackettstown lease, which expires on December 31,
2002, has a monthly rental rate of $9,636 and is renewable for two additional
one-year periods. In addition, during January 2001, the Company leased 2,200
square feet of additional space in the Hackettstown facility adjacent to the
15,000 square feet of manufacturing space until June 30, 2002 at a monthly
rental rate of $2,269. Future minimum rental payments relating to the leased
facilities for HDI for the years ended December 31 are $259,938 in 2002 and
$54,455 in 2003.</P>
<P ALIGN=CENTER>Page 9</P><HR>
<PAGE>
<P>The Company leases transportation equipment under non-cancelable operating
leases until May 2002. Future minimum rental payments under non-cancelable
transportation leases until the expiration of the leases in May 2002 are $5,889.
</P>
<P>The Company leases office equipment under non-cancelable operating leases
expiring through 2004. Monthly payments on the office equipment leases are
$3,600. Future minimum rental payments under non-cancelable equipment leases
until the expiration of the leases are $41,000 in 2002, $29,000 in 2003 and
$5,000 in 2004.</P>
<P>Total rent expense for facilities, transportation and office equipment for
the years ended December 31, 2001, 2000 and 1999 was $858,761, $791,192 and
$736,536, respectively.</P>
<P>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. 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.</P>
<P>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.</P>
<TABLE wIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR>
<TD WIDTH=5%><B>(9)</B></TD>
<TD WIDTH=95%><B>Financial Instruments, Risk Concentration and Major Customers
</B></TD></TR></TABLE>
<P>In the United States, the Company's accounts receivable from its Neuro
Products segment are due primarily from hospitals and distributors located
throughout the country. 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.</P>
<P>Net sales of implantable neurostimulation systems to one major customer for
each of the years ended December 31, as a percentage of net revenue from the
Neuro Products segment were as follows: 2001- 15% and 2000- 14%. Net sales of
implantable neurostimulation systems to two major customers for the year ended
December 31, 1999, as a percentage of net revenue from the Neuro Products
segment were 15% and 11%, respectively.</P>
<P>Net sales of 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. Net sales of O.E.M. products and
services to three major customers for the year ended December 31, 2000, as a
percentage of net revenue from the HDI O.E.M. segment were 49%, 24% and 17%,
respectively. Net sales of O.E.M. products and services to four major customers
for the year ended December 31, 1999, as a percentage of net revenue from the
HDI O.E.M. segment were 27% , 27%, 19% and 12%, respectively.</P>
<P>Foreign sales, primarily Europe and Australia, for the years ended December
31, 2001, 2000 and 1999 were approximately 10%, 7% and 7% 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, 2001, 2000 and 1999, respectively.</P>
<P ALIGN=CENTER>Page 10</P><HR>
<PAGE>
<P></P>
<TABLE WIDTH=100% CELLSPACING=0 CELLPADDING=0>
<TR>
<TD WIDTH=5%><B>(10)</B></TD>
<TD WIDTH=95%><B>Employee Benefit Plans</B></TD></TR></TABLE>
<P>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. As a result of the acquisition of HDI, 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 $305,091 in 2001, $270,987 in 2000 and $230,410 in 1999.</P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR>
<TD WIDTH=5%><B>(11)</B></TD>
<TD WIDTH=95%><B>Sale of Facility/Accrued Tax Abatement Liability</B></TD></TR>
</TABLE>
<P>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. The City preserved its rights to collect previously abated taxes if
Atrion fails to comply with its obligations any time prior to August 2003. The
Company retains monetary liability for the amount of abated taxes, even after
assignment, because pursuant to the purchase and sale agreement with Atrion, the
Company indemnified Atrion from any tax abatement liabilities that accrued to
the City of Allen prior to the sale of the cardiovascular operations in January
1998. If Atrion meets the minimum requirements under the agreement until August
2003, then no payment will be required. If no payment is required, the Company
intends to reverse the potential obligation of $969,204 in September 2003.</P>
<P>On February 1, 1999, the sale of the facility to Atrion was consummated. The
Company repaid the mortgage debt on the facility at the closing of the
transaction. After repayment of the mortgage debt and expenses related to the
transaction, the Company received $2.7 million of net proceeds. No material gain
or loss was recorded on the sale of the facility except related to the tax
abatement liability described above. The Company moved its operations to a
40,000 square foot leased facility in the North Dallas area during May 1999.
Until such time, the Company leased space from Atrion at a monthly expense of
$48,175 and paid Atrion fifty percent of certain operating expenses. The expense
of moving and transitioning into the new leased facility was immaterial.</P>
<P ALIGN=CENTER>Page 11</P><HR>
<PAGE>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR>
<TD WIDTH=5%><B>(12)</B></TD>
<TD WIDTH=95%><B>Product Development Agreement</B></TD></TR></TABLE>
<P>In June 1998, the Company entered an agreement with Sofamor Danek Group, Inc.
("Sofamor Danek") under which the Company agreed to develop and manufacture for
Sofamor Danek, products and systems for use in Deep Brain Stimulation ("DBS").
DBS products provide electrical stimulation to certain areas of the brain and
are intended to relieve the effects of various neurological disorders, such as
Parkinson's Disease and Essential Tremor. Under terms of the agreement, the
Company granted Sofamor Danek exclusive worldwide rights to use, market and sell
the DBS products developed and manufactured by ANS. The Company received a cash
payment of $4 million upon execution of the agreement that was being recognized
into income as revenue based upon the estimated percentage of completion of the
development project. During the year ended December 31, 1998, the Company
recognized $3.1 million into income as revenue. Due to the termination of the
agreement discussed below, the remaining $900,000 was recognized into income as
revenue during January 1999 and is included in the Statements of Income for the
year ended December 31, 1999. The agreement also called for ANS to receive four
additional payments of $2 million each, to be recognized into income upon the
satisfactory completion of certain domestic and international regulatory
milestones over the next several years.</P>
<P>In December 1998, the Company and Sofamor Danek agreed to terminate the June
1998 DBS agreement due to the impending merger of Sofamor Danek and Medtronic,
the Company's sole competitor in the DBS market. Under the termination
agreement, Sofamor Danek agreed to accelerate payments due the Company in the
amount of $8 million and the Company agreed to release Sofamor Danek from
further contractual obligations. The Company received the $8 million payment
from Sofamor Danek in January 1999. The $8 million payment was recognized into
revenue during January 1999 and is included in the Statements of Income for the
year ended December 31, 1999.</P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR>
<TD WIDTH=5%><B>(13)</B></TD>
<TD WIDTH=95%><B>Segment Information</B></TD></TR></TABLE>
<P>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.</P>
<P>Segment data for the year ended December 31, 2001 is as follows:</P>
<PRE>
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
</PRE>
<P>Segment data for the year ended December 31, 2000 is as follows:</P>
<P ALIGN=CENTER>Page 12</P><HR>
<PAGE>
<PRE>
Neuro HDI Intercompany Consolidated
Products O.E.M. Eliminations Total
------------- ------------- ------------- -------------
Revenue from external
customers $ 23,081,624 $ 8,745,374 $ --- $ 31,826,998
Intersegment revenues $ --- $ 1,620,896 $ (1,620,896) $ ---
Segment income from
operations $ 1,108,894 $ 67,985 $ (231,452) $ 945,427
Segment assets $ 45,371,687 $ 7,391,078 $ (3,198,199) $ 49,564,566
</PRE>
<P>Segment data for the year ended December 31, 1999 is as follows:</P>
<PRE>
Neuro HDI Intercompany Consolidated
Products O.E.M. Eliminations Total
------------- ------------- ------------- -------------
Revenue from external
customers $ 29,478,384 $ 6,300,635 $ --- $ 35,779,019
Intersegment revenues $ --- $ 1,688,542 $ (1,688,542) $ ---
Segment income from
operations $ 8,842,197 $ 432,900 $ (805,800) $ 8,469,297
Segment assets $ 43,554,774 $ 5,804,304 $ (952,152) $ 48,406,926
</PRE>
<P ALIGN=CENTER>Page 13</P><HR>
<PAGE>
<P ALIGN=RIGHT><B><U>Appendix B</U></B></P>
<P></P><P></P><P></P>
<P ALIGN=CENTER><B>Schedule II - Valuation and Qualifying Accounts</B></P>
<P></P><P></P>
<P ALIGN=CENTER><B>Forming a Part of the Annual Report<BR><BR>Form 10-K<BR><BR>
Item 14<BR><BR><BR>of<BR><BR>ADVANCED NEUROMODULATION SYSTEMS, INC.<BR>
(Name of issuer)</B></P>
<P></P><P></P>
<P ALIGN=CENTER><B>Filed with the<BR><BR>Securities and Exchange Commission<BR>
<BR>Washington, D.C. 20549<BR><BR><BR>under<BR><BR>The Securities Exchange
Act of 1934</B></P>
<HR>
<PAGE>
<PRE>
Schedule II - Valuation and Qualifying Accounts
Advanced Neuromodulation Systems, Inc. and Subsidiaries
December 31, 2001
Balance at Charged to
Beginning Charged to Other Balance at
Description of Year Expenses Accounts Deductions End of Year
- ----------------------------------- ----------- ----------- ----------- ----------- -----------
Year ended December 31, 2001:
Allowance for doubtful accounts $ 213,249 $ 10,000 $ -- $ 99,138 $ 124,111
Reserve for obsolete inventory 310,243 107,880 124,673 293,450
----------- ----------- ----------- ----------- ------------
Total $ 523,492 $ 117,880 $ -- $ 223,811 $ 417,561
=========== =========== ============ =========== ============
Year ended December 31, 2000
Allowance for doubtful accounts $ 140,824 $ 102,984 $ -- $ 30,559 $ 213,249
Reserve for obsolete inventory 199,099 111,144 -- -- 310,243
----------- ----------- ----------- ----------- ------------
Total $ 339,923 $ 214,128 $ -- $ 30,559 $ 523,492
=========== =========== =========== =========== ============
Year ended December 31, 1999:
Allowance for doubtful accounts $ 249,607 $ 35,756 $ -- $ 144,539 $ 140,824
Reserve for obsolete inventory 86,599 112,500 -- -- 199,099
----------- ----------- ----------- ----------- ------------
Total $ 336,206 $ 148,256 $ -- $ 144,539 $ 339,923
=========== =========== =========== =========== ============
</PRE><HR>
<PAGE>
<P ALIGN=RIGHT><B><U>Appendix C</U></B></P>
<P></P><P></P><P></P>
<P ALIGN=CENTER><B>Quarterly Financial Data<BR>(unaudited)</B></P>
<P></P><P></P>
<P ALIGN=CENTER><B>Forming a Part of the Annual Report<BR><BR>Form 10-K<BR><BR>
Item 8<BR><BR><BR>of<BR><BR>ADVANCED NEUROMODULATION SYSTEMS, INC.<BR>(Name of
issuer)</B></P>
<P></P><P></P>
<P ALIGN=CENTER><B>Filed with the<BR><BR>Securities and Exchange Commission<BR>
<BR>Washington, D.C. 20549<BR><BR><BR>under<BR><BR>The Securities Exchange
Act of 1934</B></P>
<HR>
<PRE>
2001 1st Qtr. 2nd Qtr. 3rd Qtr. 4th Qtr.
- --------------------------------------------- ------------- ------------- ------------- -------------
Net revenue $ 8,340,810 $ 9,204,721 $ 9,899,973 $ 10,470,931
Gross profit 4,768,021 5,270,066 5,830,956 6,371,956
Income from operations 332,764 530,936 783,321 1,161,886
Acquisition related costs (483,766) -- -- --
Income (loss) from operations before income
taxes (benefit) (13,160) 678,703 863,379 1,254,290
- --------------------------------------------- ------------- ------------- ------------- -------------
Net income (loss) $ (6,261) $ 368,514 $ 475,244 $ 680,249
- --------------------------------------------- ------------- ------------- ------------- -------------
- --------------------------------------------- ------------- ------------- ------------- -------------
Basic income per share $ -- $ 0.04 $ 0.05 $ 0.07
- --------------------------------------------- ------------- ------------- ------------- -------------
- --------------------------------------------- ------------- ------------- ------------- -------------
Diluted income per share $ -- $ 0.04 $ 0.05 $ 0.07
- --------------------------------------------- ------------- ------------- ------------- -------------
2000 1st Qtr. 2nd Qtr. 3rd Qtr. 4th Qtr.
- --------------------------------------------- ------------- ------------- ------------- -------------
Net revenue $ 7,427,624 $ 8,357,988 $ 8,176,084 $ 7,865,302
Gross profit 3,983,099 4,630,029 4,307,024 4,207,213
Income from operations 125,052 570,360 230,537 19,478
Income from operations before income taxes 278,607 687,551 354,431 170,393
- --------------------------------------------- ------------- ------------- ------------- -------------
Net income $ 155,555 $ 383,880 $ 197,890 $ 95,133
- --------------------------------------------- ------------- ------------- ------------- -------------
- --------------------------------------------- ------------- ------------- ------------- -------------
Basic income per share $ 0.02 $ 0.05 $ 0.02 $ 0.01
- --------------------------------------------- ------------- ------------- ------------- -------------
- --------------------------------------------- ------------- ------------- ------------- -------------
Diluted income per share $ 0.02 $ 0.04 $ 0.02 $ 0.01
- --------------------------------------------- ------------- ------------- ------------- -------------
</PRE>
<PAGE>
<P ALIGN=CENTER><B>INDEX TO EXHIBITS</B></P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR>
<TD WIDTH=10% ALIGN=RIGHT>Exhibit<BR><U>Number</U></TD>
<TD WIDTH=5%></TD>
<TD WIDTH=85% ALIGN=CENTER><U>Description</U></TD></TR>
</TABLE>
<P></P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR>
<TD WIDTH=10% ALIGN=RIGHT VALIGN=TOP>2.1 </TD>
<TD WIDTH=5%> </TD>
<TD WIDTH=85%>Agreement and Plan of Merger, dated as of November 30, 2000, by
and amoung Advanced Neuromodulation Systems, Inc., ANS Acquisition Corp, and
Hi-tronics Designs, Inc.(10)</TD></TR>
<TR>
<TD ALIGN=RIGHT VALIGN=TOP>3.1 </TD>
<TD></TD>
<TD>Articles of Incorporation, as amended and restated(11)</TD></TR>
<TR>
<TD ALIGN=RIGHT VALIGN=TOP>3.2 </TD>
<TD></TD>
<TD>Bylaws(11)</TD></TR>
<TR>
<TD ALIGN=RIGHT VALIGN=TOP>4.1 </TD>
<TD></TD>
<TD>Rights Agreement dated as of August 30, 1996, between Quest Medical, Inc.
and KeyCorp Shareholder Services, Inc. as Rights Agent(5)</TD></TR>
<TR>
<TD ALIGN=RIGHT VALIGN=TOP>10.1 </TD>
<TD></TD>
<TD>Quest Medical, Inc. 1979 Amended and Restated Employees Stock Option
Plan(2)</TD></TR>
<TR>
<TD WIDTH=10% ALIGN=RIGHT VALIGN=TOP>10.2 </TD>
<TD WIDTH=5%> </TD>
<TD WIDTH=85%>Form of 1979 Employees Stock Option Agreement(3)</TD></TR>
<TR>
<TD ALIGN=RIGHT VALIGN=TOP>10.3 </TD>
<TD></TD>
<TD>Quest Medical, Inc. Directors Stock Option Plan (as amended)(2)</TD></TR>
<TR>
<TD ALIGN=RIGHT VALIGN=TOP>10.4 </TD>
<TD></TD>
<TD>Form of Directors Stock Option Agreement(1)</TD></TR>
<TR>
<TD ALIGN=RIGHT VALIGN=TOP>10.5 </TD>
<TD></TD>
<TD>Quest Medical, Inc. 1987 Stock Option Plan(4)</TD></TR>
<TR>
<TD ALIGN=RIGHT VALIGN=TOP>10.6 </TD>
<TD></TD>
<TD>Form of 1987 Employee Stock Option Agreement(4)</TD></TR>
<TR>
<TD ALIGN=RIGHT VALIGN=TOP>10.7 </TD>
<TD></TD>
<TD>Quest Medical, Inc. 1995 Stock Option Plan(4)</TD></TR>
<TR>
<TD ALIGN=RIGHT VALIGN=TOP>10.8 </TD>
<TD></TD>
<TD>Form of 1995 Employee Stock Option Agreement(4)</TD></TR>
<TR>
<TD ALIGN=RIGHT VALIGN=TOP>10.9 </TD>
<TD></TD>
<TD>Quest Medical, Inc. 1998 Stock Option Plan(7)</TD></TR>
<TR>
<TD ALIGN=RIGHT VALIGN=TOP>10.10</TD>
<TD></TD>
<TD>Advanced Neuromodulation Systems, Inc. 2000 Stock Option Plan(9)</TD></TR>
<TR>
<TD ALIGN=RIGHT VALIGN=TOP>10.11</TD>
<TD></TD>
<TD>Employment Agreement dated April 9, 1998 between Christopher G. Chavez and
Quest Medical, Inc.(6)</TD></TR>
<TR>
<TD ALIGN=RIGHT VALIGN=TOP>10.12</TD>
<TD></TD>
<TD>Employment Agreement dated April 9, 1998 between Scott F. Drees and Quest
Medical, Inc.(6)</TD></TR>
<TR>
<TD ALIGN=RIGHT VALIGN=TOP>10.13</TD>
<TD></TD>
<TD>Employment Agreement dated April 9, 1998 between F. Robert Merrill III and
Quest Medical, Inc.(6)</TD></TR>
<TR>
<TD ALIGN=RIGHT VALIGN=TOP>10.14</TD>
<TD></TD>
<TD>Form of Employment Agreement and Covenant Not to Compete, between the
Company and key employees(1)</TD></TR>
<TR>
<TD ALIGN=RIGHT VALIGN=TOP>10.15</TD>
<TD></TD>
<TD>Lease Agreement dated as of February 4, 1999, between Advanced
Neuromodulation Systems, Inc. and Legacy Lincoln I, LTD. (8)</TD></TR>
<TR>
<TD ALIGN=RIGHT VALIGN=TOP>11.1 </TD>
<TD></TD>
<TD>Computation of Earnings Per Share(13)</TD></TR>
<TR>
<TD ALIGN=RIGHT VALIGN=TOP>21.1 </TD>
<TD></TD>
<TD>Subsidiaries(13)</TD></TR>
<TR>
<TD ALIGN=RIGHT VALIGN=TOP>23.1 </TD>
<TD></TD>
<TD>Consent of Independent Auditors(13)</TD></TR></TABLE>
<P>__________________________________</P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR>
<TD WIDTH=5% VALIGN=TOP>(1) </TD>
<TD WIDTH=2%></TD>
<TD WIDTH=93%>Filed as an Exhibit to the Company's Registration Statement on
Form S-18, Registration No. 2-71198-FW, and incorporated herein by reference.
</TD></TR>
<TR>
<TD>(2) </TD>
<TD></TD>
<TD>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.</TD></TR>
<TR>
<TD>(3) </TD>
<TD></TD>
<TD>Filed as an Exhibit to the Company's Registration Statement on Form S-1,
Registration No. 2-78186, and incorporated herein by reference.</TD></TR>
<TR>
<TD>(4) </TD>
<TD></TD>
<TD>Filed as an Exhibit to the Company's Registration Statement on Form SB-2,
Registration No. 33-62991, and incorporated herein by reference.</TD></TR>
<TR>
<TD>(5) </TD>
<TD></TD>
<TD>Filed as an Exhibit to the report of the Company on Form 8-K dated September
3, 1996, and incorporated herein by reference.</TD></TR>
<TR>
<TD>(6) </TD>
<TD></TD>
<TD>Filed as an Exhibit to the report of the Company on Form 10-Q dated for the
quarterly period ended March 31, 1998, and incorporated herein by reference.
</TD></TR>
<TR>
<TD>(7) </TD>
<TD></TD>
<TD>Filed as an Exhibit to the Definitive Proxy Statement on Schedule 14A dated
April 27, 1998, and incorporated herein by reference.</TD></TR>
<TR>
<TD>(8) </TD>
<TD></TD>
<TD>Filed as an Exhibit to the report of the Company on Form 10-K dated for the
year ended December 31, 1998, and incorporated herein by reference.</TD></TR>
<TR>
<TD>(9) </TD>
<TD></TD>
<TD>Filed as an Exhibit to the Definitive Proxy Statement on Schedule 14A dated
April 17, 2000, and incorporated herein by reference.</TD></TR>
<TR>
<TD>(10)</TD>
<TD></TD>
<TD>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.</TD></TR>
<TR>
<TD>(11)</TD>
<TD></TD>
<TD>Filed as an Exhibit to the report of the Company on Form 10-K dated for the
year ended December 31, 2000, and incorporated herein by reference.</TD></TR>
<TR>
<TD>(12)</TD>
<TD></TD>
<TD>Filed as an Exhibit to the report of the company on Form 8-K dated January
30, 2002, and incorporated herein by reference.</TD></TR>
<TR>
<TD>(13)</TD>
<TD></TD>
<TD>Filed herewith.</TD></TR></TABLE>
<HR>
<PAGE>
<P ALIGN=CENTER><B>EXHIBIT 11.1</B></P>
<PAGE>
<P ALIGN=CENTER><B>Advanced Neuromodulation Systems, Inc.<BR>Computation of
Income Per Share<BR>Years Ended December 31</B></P>
<PRE>
2001 2000 1999
------------ ------------ ------------
Basic income per share:
Weighted average common
Shares outstanding 8,926,985 8,507,048 8,679,952
------------ ------------ ------------
------------ ------------ ------------
Net income $ 1,517,746 $ 832,458 $5,816,922
------------ ------------ ------------
Net income per share $ 0.17 $ 0.10 $ 0.73
------------ ------------ ------------
Diluted income per share:
Weighted average common
shares outstanding 8,926,985 8,507,048 8,679,952
Stock options and warrants-based
on the treasury stock method
using average market price 990,022 891,886 425,337
------------ ------------ ------------
Diluted common and common equivalent
shares outstanding 9,917,007 9,398,934 9,105,289
------------ ------------ ------------
------------ ------------ ------------
Net income $ 1,517,746 $ 832,458 $5,816,922
------------ ------------ ------------
Net income per share $ 0.15 $ 0.09 $ 0.64
------------ ------------ ------------
</PRE>
<PAGE>
<P ALIGN=CENTER><B>EXHIBIT 21.1</B></P>
<PAGE>
<P ALIGN=CENTER><B><U>SUBSIDIARIES</U></B></P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR>
<TD WIDTH=40%>Hi-Tronics Designs, Inc.</TD>
<TD WIDTH=60%>New Jersey Corporation</TD></TR></TABLE>
<PAGE>
<P ALIGN=CENTER><B>EXHIBIT 23.1</B></P>
<PAGE>
<P ALIGN=CENTER><B><U>Consent of Independent Auditors</U></B></P>
<P>We consent to the incorporation by reference in the Registration Statements
(Form S-8 - Nos. 2-82414, 2-91410, 33-235312, 33-00967 and 333-75879, and Form
S-3 - Nos. 333-40927 and 333-53440) pertaining to the Advanced Neuromodulation
Systems, Inc. 1979 Amended and Restated Employees' Stock Option Plan; the
Advanced Neuromodulation Systems, Inc. Directors' Stock Option Plan; the
Advanced Neuromodulation Systems, Inc. 1987 Employees' Stock Option Plan; the
Advanced Neuromodulation Systems, Inc. 1995 Stock Option Plan; the Advanced
Neuromodulation Systems, Inc. Sales and Marketing Employees Stock Option Plan;
the Heaton Stock Option Plan; the Advanced Neuromodulation Systems, Inc. 1998
Stock Option Plan; the registration of 100,000 shares of Common Stock issued
pursuant to a Common Stock Purchase Warrant between Advanced Neuromodulation
Systems, Inc. and Robert L. Swisher, Jr., the registration of 1,223,825 shares
of Common Stock issued pursuant to an Agreement and Plan of Merger dated
November 30, 2000 between the Company and Hi-tronics Designs, Inc. and an Asset
Purchase Agreement dated as of January 2, 2001 between the Company and
Implantable Devices Limited Partnership, ESOX Technology Corporation and
Implantable Devices, Inc. and the related Prospectuses of our report dated
February 6, 2002, with respect to the consolidated financial statements and
schedule of Advanced Neuromodulation Systems, Inc. and Subsidiaries, included in
the Annual Report (Form 10-K) for the year ended December 31, 2001.</P>
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<TR>
<TD WIDTH=40%> </TD>
<TD WIDTH=60%><U>/s/Ernst & Young LLP</U><BR>Ernst & Young LLP</TD></TR>
</TABLE>
<P></P>
<P>Dallas, Texas<BR>March 26, 2002</P>
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