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<SEC-DOCUMENT>0000351721-03-000081.txt : 20030331
<SEC-HEADER>0000351721-03-000081.hdr.sgml : 20030331
<ACCEPTANCE-DATETIME>20030328173242
ACCESSION NUMBER: 0000351721-03-000081
CONFORMED SUBMISSION TYPE: 10-K
PUBLIC DOCUMENT COUNT: 1
CONFORMED PERIOD OF REPORT: 20021231
FILED AS OF DATE: 20030331
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: 03626517
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>k1003282003.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,
2002</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 June 30, 2002:
$349,090,251</FONT></P>
<P><FONT SIZE=2>Number of shares outstanding of the registrant’s Common
Stock as of March 17, 2003: 12,476,795</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 4, 2003,
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, 2002</B></P>
<P ALIGN=CENTER><B>PART I</B></P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR>
<TD WIDTH=15% VALIGN=TOP><B>ITEM 1.</B></TD>
<TD WIDTH=85%><B>BUSINESS</B></TD></TR></TABLE>
<P><B>Overview</B></P>
<P>We design, develop, manufacture and market advanced implantable
neuromodulation devices that improve the quality of life for people suffering
from chronic pain. Neuromodulation devices include implantable neurostimulation
devices, which deliver electric current directly to targeted nerves, and
implantable drug pumps, which deliver small, precisely controlled doses of drugs
directly to targeted sites within the body. Our products utilize innovative
technologies that offer advanced programming features, user-friendly interfaces
and smaller implanted devices, resulting in greater patient comfort. We are
leveraging our neuromodulation product platforms to develop new pain management
products and to expand into new applications.</P>
<P>We market our products to physicians who specialize in managing chronic pain.
We define chronic pain as pain that persists or recurs for more than six months,
is resistant to conservative therapies and significantly restricts a patient's
normal activities. There are approximately 3,000 pain management specialists in
the U.S., approximately 80% of whom are anesthesiologists and approximately 20%
of whom are neurosurgeons or orthopedic surgeons, and the number of pain
management specialists is growing steadily.</P>
<P>We currently market three principal product lines: our <I>Renew®</I>
radio frequency (RF) system, our <I>Genesis®</I> and <I>GenesisXP™</I>
implantable pulse generator (IPG) systems and our <I>AccuRx®</I> implantable
drug pump. We have sold <I>Renew</I> in the U.S. since June 1999 for treatment
of chronic pain of the trunk and limbs. Renew's advanced features effectively
manage complex and multi-extremity pain patterns and provide pain management
specialists with significant programming flexibility. We began selling
<I>Genesis</I> in Europe in the first quarter of 2001 and in the U.S. and
Australia in January 2002 for treatment of chronic pain of the trunk and limbs.
We believe that <I>Genesis</I> offers a superior size-to-function ratio, greater
patient comfort, more flexibility in addressing different pain patterns and
other technological advances, which provide us with a competitive advantage.
Additionally, we recently received approval from the U.S. Food and Drug
Administration (FDA) to market an enhanced version of <I>Genesis</I>, the
<I>GenesisXP</I> IPG system for treatment of chronic pain of the trunk and
limbs, which we launched in the U.S. in the fourth quarter of 2002. The
<I>GenesisXP</I> offers substantially more battery capacity than <I>Genesis</I>
resulting in enhanced longevity and/or additional power to treat more complex
pain. We began selling <I>AccuRx</I> in certain international markets in the
second quarter of 2001 and recently completed all implants in a 109 patient
clinical trial we are conducting of <I>AccuRx</I> in the U.S. under an
investigational device exemption (IDE) from the FDA. <I>AccuRx</I> is smaller
than the other constant rate drug pumps currently on the market, and it
incorporates a new polymeric diaphragm technology that makes it more precise
under varying conditions than other constant rate drug pumps. We expect to file
our pre-market approval (PMA) application for <I>AccuRx</I> with the FDA later
in 2003.</P>
<P ALIGN=CENTER>Page 1</P>
<HR>
<PAGE>
<P>Our Hi-tronics Designs, Inc. (HDI) subsidiary, which we acquired in January
2001, designs and manufactures medical devices for us, and for other companies
on an O.E.M. (original equipment manufacturer) basis. HDI's core strength is in
developing highly-sophisticated electromechanical devices featuring electronic
circuits with very low power requirements. We acquired HDI to leverage its
expertise in development and manufacturing and benefit from its technology
platforms.</P>
<P><B>The Neuromodulation Market Opportunity</B></P>
<P>When treating patients suffering from chronic pain, pain management
specialists can select from several therapy options, ranging from the least
invasive and lowest-cost therapies to the most aggressive and expensive
therapies. Initially, patients typically try over-the-counter medications and
physical therapy. If these therapies fail, patients generally try some
combination of prescription medications, TENS therapy (application of electrical
impulses to the skin), psychological therapy and nerve blocks (injections that
provide temporary pain relief). If these therapies do not succeed in relieving
pain, patients may then try narcotic and opioid drugs, neurolysis (destruction
of the affected nerve) and thermal procedures. At some point during their course
of treatment, patients may use neuromodulation products or undergo more invasive
surgical procedures.</P>
<P>Patients who opt for neurostimulation or drug pumps to treat chronic pain
typically range in age from 25 to 55, have suffered back or neck injuries or
otherwise suffer from degenerative spine conditions, and are in constant pain
that has not been alleviated by other therapies, including back surgeries. A
growing number of patients are choosing neuromodulation over prolonged systemic
use of narcotic or opioid drugs, which have negative side effects, or back
surgeries involving vertebral fusion or nerve destruction, which are
irreversible and often unsuccessful.</P>
<P>The use of neuromodulation devices to manage chronic pain is growing rapidly.
According to an independent study, spinal cord stimulation products were
forecasted to account for $293.2 million in revenues in 2002 in the United
States, up from $239.8 million in 2001. Total neurostimulation revenues for all
currently approved indications in the U.S. (including deep brain stimulation,
sacral nerve stimulation and other applications) were forecasted to account for
$435.7 million in 2002, up from $337.1 million, according to the same study. A
separate study reported that in 2001, worldwide sales of drug pumps were
approximately $230 million.</P>
<P>The primary factors driving this growth include the following:</P>
<UL>
<LI><I>Increased physician and patient awareness of the benefits of
neuromodulation.</I> Neuromodulation can manage pain effectively, is minimally
invasive, has few side effects and is generally reversible. As physicians and
their patients are becoming more aware of these benefits and more accepting of
this treatment option, neuromodulation is being used earlier in the process of
managing chronic pain. Consequently, the number of pain management specialists
worldwide who understand and are trained to use neuromodulation products and
techniques is growing steadily.
<LI><I>Expanded indications for the use of neuromodulation products.</I>
Neuromodulation products have demonstrated success in the treatment of
indications outside of chronic pain. The recent approval by other companies of
the use of these products to address new indications, including essential
tremor, Parkinson's Disease, and incontinence, as well as future approvals to
treat angina and severe headaches, should expand the neuromodulation market.
<LI><I>Technological advances in neuromodulation products.</I> Advances in
technology have decreased the size of neuromodulation devices, increased the
longevity of their power sources and enhanced programmability and other
functional components of the devices, leading to better results for patients.
<LI><I>Patients' increased focus on quality of life.</I> In the past, chronic
pain sufferers were often resigned to long-term use of pain-killing drugs, often
bedridden and unable to maintain a normal lifestyle. Today, many chronic pain
patients hope to resume an active lifestyle following an injury or illness, and
thus more likely to consider and accept neuromodulation therapy.</UL>
<P ALIGN=CENTER>Page 2</P>
<HR>
<PAGE>
<P><B>Our Strategy</B></P>
<P>Our objective is to be a leading provider of a full range of innovative
neuromodulation devices for the management of chronic pain and nervous system
disorders. To achieve this objective, we are pursuing the following business
strategies:</P>
<UL>
<LI><I>Expand our presence in the chronic pain market.</I> Through the recent
launches of our IPG systems, we have entered a market that is estimated to be
four times larger than the RF market, and thus significantly expanded our
potential market opportunity. We intend to increase our penetration of the
chronic pain market by enhancing our sales and marketing resources. We also
intend to leverage our relationships with pain management specialists as well as
our favorable track record with our RF systems to grow our market share in the
IPG portion of the neurostimulation market and to further strengthen our
position in the RF portion of this market.
<LI><I>Pursue regulatory approvals for new treatment indications.</I> We believe
our neurostimulation technology platforms have broad applicability for multiple
treatment indications beyond chronic pain conditions. We will pursue regulatory
approvals for new clinical applications to treat disorders affecting large
patient populations, including essential tremor, Parkinson's Disease, pelvic
pain and severe headaches, where neuromodulation has demonstrated success.
<LI><I>Continue to build and expand our technology leadership.</I> We have
focused on building a corporate infrastructure and core competency in research
and development, manufacturing, sales and marketing, reimbursement and
regulatory affairs to provide our customers with the highest quality products
and services. We believe this strategy will enable us to expand our existing
product platforms into new applications and product offerings. We will continue
to invest significant resources in the development of our infrastructure and
technology platforms to maintain our reputation as a leader in the
neuromodulation market.
<LI><I>Evaluate and pursue acquisitions and strategic alliances.</I> We will
pursue acquisitions and strategic alliances that complement our existing
neuromodulation business, products and technology platforms and that enhance our
product development, technological and marketing capabilities.</UL>
<P><B>Our Products</B></P>
<P>Within the neuromodulation market, there are two main categories of
treatment: neurostimulation, in which an implanted device delivers electrical
current directly to targeted nerve sites, and implantable drug pumps, in which
an implanted pump delivers drugs directly to a targeted site. We currently
market products in both of these treatment categories.</P>
<P><B><I>Neurostimulation Therapy Overview</I></B></P>
<P>Neurostimulation involves delivering small, mild electrical pulses to the
spinal cord or peripheral nerves to inhibit or block the sensation of pain. This
stimulation of nerves at or near the site where pain is perceived masks the
sensation of pain by generating a tingling sensation or "paresthesia."
Neurostimulation is generally used to manage sharp, intense and constant pain
arising from nerve damage or nervous system disorders.</P>
<P ALIGN=CENTER>Page 3</P>
<HR>
<PAGE>
<P>A neurostimulation system typically consists of a pulse generator that
produces electrical current, and an external or internal power source. The pulse
generator is generally implanted under the patient's skin in the abdominal area.
Leads, which are catheters that contain electrodes and connecting wires, extend
from the pulse generator to the targeted therapy site in the epidural space
along the spinal cord. The electrodes are centered on the therapy site and
deliver electrical current from the pulse generator to the prescribed area. An
external programmer allows the physician and patient to adjust the electrical
current to the electrodes to optimize the therapeutic effect.</P>
<P>Implant procedures are most often performed at hospitals on an outpatient
basis, with a small percentage of procedures also performed at ambulatory
surgery centers and at hospitals on an inpatient basis. In most cases, a patient
will receive a trial device for a period of up to two weeks. Based on our
experience, more than 70% of patients who undergo a trial procedure elect to
receive a permanent implant. Implant procedures cost between $30,000 and
$50,000, including the cost of the system. The cost of the system generally
ranges from $10,000 to $20,000, depending on whether an RF or IPG system is
used, the components utilized and the sophistication of the system selected.</P>
<P>Clinical results demonstrate that the majority of patients who are implanted
with a neurostimulation system experience a substantial reduction in pain, an
increase in activity level, a reduction in use of narcotics and a reduction in
hospitalization. We believe these benefits translate into an overall reduction
in healthcare costs as well as a significant improvement in the patient's
quality of life.</P>
<P><B><I>Our Neurostimulation Products</I></B></P>
<P>We currently have two neurostimulation product platforms that we market
worldwide: our <I>Renew</I> RF system, which uses an external power source, and
our family of totally implantable IPG systems, <I>Genesis</I> and <I>GenesisXP.
</I></P>
<P><I>Renew</I></P>
<P><I>Renew</I> is the latest generation system in our RF stimulation product
line and is the leading technology in the RF stimulation market. We introduced
<I>Renew</I> in the U.S. during June 1999 and began selling it in international
markets during 2000. The <I>Renew</I> system consists of an implanted RF
receiver/pulse generator and leads, and a transmitter containing a power source
that is worn externally. The system is powered with the help of an antenna that
is attached to the patient's skin with adhesive tape. Because <I>Renew</I> has a
rechargeable, external power source, we believe it is best suited for patients
with complex, changing or multi-extremity pain patterns that require higher
power levels for treatment.</P>
<P><I>Genesis</I></P>
<P>In late 2000, we received regulatory approvals to begin selling our
<I>Genesis</I> IPG system in certain international markets, and we commenced
sales during the first quarter of 2001. On November 21, 2001, we received FDA
approval of <I>Genesis</I> for treatment of chronic pain of the trunk and limbs,
and we launched <I>Genesis</I> in the U.S. in January 2002. Additionally, we
recently received approval from the FDA to market an enhanced version of
<I>Genesis</I>, the <I>GenesisXP</I> IPG system for the treatment of chronic
pain of the trunk and limbs, which we launched in the U.S. in the fourth quarter
of 2002. The <I>GenesisXP</I> offers substantially more battery capacity than
<I>Genesis</I>, resulting in enhanced longevity and/or additional power to treat
more complex pain. As a result, we now participate in the largest part of the
implantable neurostimulation market, as approximately 80% of neurostimulation
implantation procedures performed involve IPG systems and the remainder involve
RF systems.</P>
<P ALIGN=CENTER>Page 4</P>
<HR>
<PAGE>
<P>Like other IPGs, <I>Genesis</I> is totally implanted and contains a power
source with a life of two to five years, depending on stimulation parameters.
Generally, simple, localized pain sufferers require less power output than
complex, multi-site pain sufferers. These patients and their physicians will
usually select an IPG in order to benefit from the convenience of a totally
implantable system.</P>
<P><B><I>Our Neurostimulation Technologies</I></B></P>
<P>Although our <I>Renew</I> and <I>Genesis</I> systems differ in certain
significant respects, they share similar technology platforms and benefits,
including:</P>
<UL>
<LI><I>Greatest number of electrodes.</I> Our <I>Renew</I> system is the only
product on the market that can accommodate up to 16 electrodes. In addition, our
IPG systems not only allow the use of two quadrapolar, or 4-electrode, leads,
but also allow the use of one octapolar, or 8-electrode, lead. A greater number
of electrodes results in more comprehensive coverage along the spine, and
provides physicians with increased flexibility in accommodating a patient's
changing pain patterns. This advantage may also enable a physician to address
the problem of lead "migration", or lead movement along the spine after implant,
noninvasively by reprogramming the patient's stimulation, rather than using an
invasive procedure to revise the placement of the lead. We estimate that lead
migration occurs in 10% to 15% of cases.
<LI><I>Advanced programmability.</I> Our technologies allow physicians to
program the system for rapid and sequential delivery of multiple stimulation
programs to cover large, complex pain patterns. Additionally, our systems enable
a large number of program choices that allow patients to select a number of
different stimulation programs to optimize treatment as pain patterns change. We
have also developed <I>PainDoc®</I>, a Windows-based proprietary
computerized support system that serves as a programming tool for <I>Renew</I>,
<I>Genesis</I> and <I>GenesisXP</I>.
<LI><I>Innovative and patented technology.</I> Our neurostimulation devices
offer our advanced patented technology, which allows programmability of each
individual electrode to a "tri-state" position, either positive, negative or
neutral. This provides added flexibility in directing the flow of stimulation
and is a valuable tool in addressing lead migration.
<LI><I>Reduced size of implanted device.</I> Our <I>Renew</I> receiver, our
<I>Genesis</I> IPG and <I>GenesisXP</I> offer smaller "size-to-power" ratios
than comparable products currently on the market, which results in enhanced
patient comfort.
<LI><I>Ease of lead implantation.</I> Our leads are designed for ease of
implantation, which makes the procedure easier for physicians to perform and
reduces the time required to complete the procedure.
<LI><I>User-friendly interface.</I> Our neurostimulation devices have
easy-to-use controls and interactive displays that include a stimulation diagram
for quick visual confirmation of stimulation coverage.</UL>
<P ALIGN=CENTER>Page 5</P>
<HR>
<PAGE>
<PAGE>
<P>The following table summarizes some of the key features of the <I>Renew</I>
and <I>Genesis</I> systems:</P>
<PRE>
PRODUCT FEATURES RENEW GENESIS
- ----------------------------- ----------------------------- ------------------------------
Implanted Elements receiver/pulse generator, Pulse generator/power
leads supply, leads
External Elements programmer, Programmer
transmitter/power supply,
antenna
Battery external, rechargeable and internal with 2-5 year life,
replaceable depending on program
settings and system use
Programming Control Up to 24 programs, plus Up to 24 programs
some patient control
Lead and Electrode Capacity 1 to 4 leads utilizing up 1 or 2 leads utilizing up to
to 16 electrodes 8 electrodes
</PRE>
<P><B><I>Our Implantable Drug Pump Product - AccuRx</I></B></P>
<P>Implantable drug pumps deliver precise doses of medication directly to a
targeted site. This direct drug delivery creates a higher drug concentration at
the site, which can often provide faster relief with much lower quantities of
medication. For example, the difference in intraspinal versus oral morphine
dosage is approximately 1:300. These lower dosages help to minimize side
effects, and are more economical for the patient and the third-party
reimbursement system. Today, implantable drug pumps are used for the delivery of
morphine for the treatment of pain (such as cancer or arthritis pain), baclofen
for spasticity and other movement disorders, and for the intra-arterial delivery
of various drugs for chemotherapy.</P>
<P>Implantable drug pumps consist of the pump and a catheter. The pump contains
a reservoir that holds the drug and regulates the drug's delivery rate. The pump
is implanted under the skin in the abdominal area and is connected to the
catheter, which is tunneled under the skin into either the epidural or
intrathecal space of the spinal column. Implantation procedures are most often
performed at hospitals on an outpatient basis, with a small percentage of
procedures also performed at ambulatory surgery centers and at hospitals on an
inpatient basis. The pump is refilled by placing a needle through the skin into
an access port on the pump and injecting the drug into the reservoir.</P>
<P>Currently, there are two basic types of implantable drug pumps - constant
rate and programmable. Constant rate pumps provide drug infusion at a single,
continuous flow rate that cannot be changed once the pump has been implanted in
the patient. Programmable pumps allow the rate of drug delivery to be
non-invasively changed to meet the patient's needs. According to an industry
report, in 2001, worldwide sales of programmable drug pumps were approximately
$207 million, as compared with worldwide sales of constant rate drug pumps of
$23 million.</P>
<P ALIGN=CENTER>Page 6</P>
<HR>
<PAGE>
<P>We currently offer one drug pump product, our <I>AccuRx</I> constant rate
drug pump. We received regulatory approvals to distribute <I>AccuRx</I> in
certain international markets for the delivery of morphine and began selling
<I>AccuRx</I> in those markets in the second quarter of fiscal 2001. We also
received an IDE from the FDA to initiate clinical trials in the U.S. for the
delivery of morphine. The clinical trials included 15 sites and 109 patients,
all of whom have now been implanted with <I>AccuRx</I> systems. These trials
will provide data to support our PMA for U.S. market introduction. We expect to
file our PMA application with the FDA later in 2003.</P>
<P><I>AccuRx</I> is currently the only constant rate drug pump that is powered
by our proprietary polymeric diaphragm, rather than by pressurized gas in a
chamber surrounding the drug reservoir. The advantages of this design are that
our pump is more precise under varying conditions (because its operation is not
affected by changes in the body's temperature or pressure), simpler to
manufacture, smaller than other drug pumps on the market and can hold more drug
for its size than competing products.</P>
<P><B>Financial Segments</B></P>
<P>We operate in two business segments. The Neuro Products segment designs,
develops, manufactures and markets implantable medical devices that are used to
manage chronic intractable pain and other disorders of the central nervous
system through the delivery of electrical current or drugs directly to targeted
nerve fibers. The HDI O.E.M. segment provides contract development and O.E.M.
manufacturing of electro-mechanical devices. See Note 12 to the Consolidated
Financial Statements for segment financial data for the years ended December 31,
2002, 2001 and 2000.</P>
<P><B>Sales and Marketing</B></P>
<P><B><I>General</I></B></P>
<P>We target our sales and marketing efforts at pain management specialists,
which include anesthesiologists, neurosurgeons and orthopedic surgeons. Because
most pain management specialists implant both RF and IPG devices, as well as
drug pumps, we expect to leverage our relationships and experience with pain
management specialists and track record with our RF systems to establish our
position in the IPG portion of the neurostimulation market. Additionally, by
rounding out our product offerings with our IPG systems, we are now able to
target physicians who have historically implanted only IPGs.</P>
<P>In 2002, we derived 92% of our net revenues for neuromodulation products from
domestic sales and approximately 8% from international sales.</P>
<P><B><I>U.S.</I></B></P>
<P>With our March 2003 acquisition of Sun Medical's pain management business, we
have expanded our domestic sales force. In the domestic market, we currently use
a hybrid sales force, which now consists of 25 direct sales people (including 10
people we hired from Sun Medical), 15 people employed by 2 independent
distributors, and 48 commissioned sales agents. We typically have contracts with
all of our distributors and sales agents that provide for exclusive territories
and sales quotas.</P>
<P>Our independent distributors cover defined geographic territories, focus
predominantly on the chronic pain market and devote the majority of their
selling efforts to our products. We sell our products to our distributors at a
discount from our list prices, and, in turn, the distributors sell the products,
invoice their customers and collect their receivables.</P>
<P>Our sales agents cover defined geographic territories and focus predominantly
on the pain management market. Many of our sales agents sell our products as
their flagship product line. We pay our sales agents commissions at contractual
rates, and we invoice and collect revenues from end users.</P>
<P ALIGN=CENTER>Page 7</P>
<HR>
<PAGE>
<P>We also employ seven regional sales managers who interact with our customers
and oversee our independent distributors, commissioned sales agents and direct
sales people, a Director of North American Sales and a Vice President of North
American Sales, who both coordinate the sales efforts of our distribution
network in North America.</P>
<P>Our domestic marketing programs include:</P>
<UL>
<LI>medical marketing programs intended to educate physicians and their staffs
about our products and their use;
<LI>surgical training programs offered to physicians interested in improving
their surgical techniques;
<LI>education materials, such as brochures and videos, to educate patients and
physicians;
<LI>reimbursement assistance, with the help of outside consultants, to assist
physicians in obtaining appropriate reimbursement for our products and their
services;
<LI>consulting relationships with opinion leaders who provide us feedback about
our current and future products, diagnostic and treatment trends and other areas
of interest;
<LI>web site marketing focused on educating both physicians and patients about
our product alternatives, reimbursement for our procedures and our company;
<LI>medical journal advertisements; and
<LI>involvement in medical device societies and conferences.</UL>
<P><B><I>International</I></B></P>
<P>Internationally, we market our products through 18 independent distributors
who represent us in 22 countries. We are represented by direct salespersons
employed by us in Germany. Our Director of International Operations, who is
based in the United Kingdom, manages our international distribution network. We
are in the process of training and signing independent distributors to market
our products in additional countries.</P>
<P><B><I>Customer Service</I></B></P>
<P>Our sales representatives are responsible for training physicians and nurses
on programming and trouble-shooting any problems with our RF and IPG systems.
Both the RF and IPG systems have up to 24 different program settings, which can
be programmed and saved into memory. Therefore, significant training of
physicians and nurses is required for new users of our product. We typically
provide a warranty against defects in workmanship and materials for one year
from the date of sale of our products to end-users.</P>
<P><B><I>Major Customers</I></B></P>
<P>During 2002, 2001 and 2000, we had one major customer that accounted for 10%
or more of our net revenue from our Neuro Products segment. Sun Medical, Inc., a
specialty distributor, accounted for $6.3 million, or 13.5% of our Neuro
Products segment revenue for the year ended December 31, 2002, $4.2 million, or
15% of our Neuro Products segment revenue for the year ended December 31, 2001
and $3.2 million, or 14% of our Neuro Products segment revenue for the year
ended December 31, 2000. In March 2003, we acquired Sun Medical's pain
management business and hired substantially all of the salespeople who had
accounted for those sales. See Note 13 of the Notes to Consolidated Financial
Statements.</P>
<P ALIGN=CENTER>Page 8</P>
<HR>
<PAGE>
<P>During the year ended December 31, 2002, we had two major customers that
accounted for $9.52 million, or 89.3% of net revenue from our O.E.M. segment.
Medtronic, Inc., our most significant competitor, accounted for $6.74 million,
or 63.2% and Arrow International, Inc. accounted for $2.78 million, or 26.1%.
During the year ended December 31, 2001, we had three major customers that
accounted for 10% or more of net revenue from our 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 net revenue from our 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%.</P>
<P><B>Research and Development</B></P>
<P>We currently have an in-house research and development staff of 55 people. In
2002, we spent $5.84 million (10.2% of total net revenue) on research and
development, and we expect to increase our investment in research and
development and clinical trials for 2003 to approximately $7.9 million.</P>
<P>Our current research and development efforts include work on the following:
</P>
<UL>
<LI>An IPG stimulation system to address occipital headaches (frequent severe
headaches that begin in the back of the head and migrate forward). During the
first quarter of 2001, we initiated a pilot clinical study in the U.S., which
consisted of 10 patients at 2 sites, to evaluate the efficacy of <I>Genesis</I>
for treating occipital headaches. We completed the pilot study during the second
quarter of 2002, and the data will be used to determine the parameters for a
larger pivotal clinical study to support a PMA application for <I>Genesis</I> to
treat occipital headaches. There are approximately one million patients in the
U.S. alone who suffer from occipital headaches.
<LI>IPG stimulation systems for deep brain stimulation to address essential
tremor, Parkinson's Disease and other indications.
<LI>New applications of our neurostimulation systems to address angina,
peripheral vascular disease and sacral nerve stimulation for pelvic pain and
incontinence.
<LI>Next-generation IPG and RF neurostimulation systems.
<LI>Next-generation drug pumps, including a prototype programmable pump that
will take several years to develop, and new applications for drug pumps.
<LI>Clinical trials that we expect to initiate on several of our new products
upon IDE approval from the FDA.</UL>
<P ALIGN=CENTER>Page 9</P>
<HR>
<PAGE>
<P><B><I>Hi-tronics Designs, Inc.</I></B></P>
<P>Our HDI subsidiary developed and is the manufacturer of our <I>Genesis</I>
IPG and <I>GenesisXP</I> IPG, and is also the manufacturer of the transmitter
used with <I>Renew</I>. HDI's core strength is in developing highly
sophisticated electromechanical devices featuring electronic circuits with very
low power requirements, utilizing both discrete and highly integrated
technology. Combined with our capabilities in the design and manufacture of
implantable leads, electronic device control and communication systems and
implantable drug pumps, we believe this expertise will allow us to develop more
sophisticated products in less time.</P>
<P>As an O.E.M. manufacturer, HDI has developed and introduced more than 60
medical devices for leading medical device companies in the fields of
cardiology, neurology and orthopedics. Through HDI, we offer our customers
complete development and manufacturing services, beginning with product
definition and design and continuing through validation, prototyping, regulatory
approval and manufacturing. In 2002, our O.E.M. operations accounted for 18.6%
of our consolidated revenues. We expect this percentage to continue to decrease
as our neuromodulation sales continue to grow and as we continue to utilize more
of HDI's manufacturing and development capabilities for our own needs.</P>
<P><B><I>Manufacturing</I></B></P>
<P>We operate two manufacturing facilities: one in Plano, Texas and the other in
Hackettstown, New Jersey. We assemble and package the majority of our
neurostimulation devices and implantable drug pumps at our Plano facility. We
also manufacture a variety of medical devices and products on an O.E.M. basis in
our Hackettstown facility.</P>
<P>Our manufacturing processes largely consist of the assembly of standard and
custom components that we purchase from third-party subcontractors, functional
testing to ensure adherence to specifications and inspection of completed
products, and the manufacture of our own leads and drug pumps. Our implantable
devices are assembled and sterilized in a "clean room" environment designed and
maintained to reduce product exposure to particulate matter.</P>
<P>We rely on third-party suppliers for most of our products' components and on
single suppliers for several critical components used in our main products,
including the computer chip used in the receiver of our RF system, the computer
chip used in the IPG programmer and <I>Renew</I> transmitter, the batteries used
in our IPG systems and the medical-grade polyurethane (bionate) that we and our
competitors use in our products. We have been notified by the supplier of the
computer chip used in the receiver of our RF system that it will cease
manufacturing and supplying the computer chip in the future, but to date it has
not determined when this will occur. This supplier has agreed to allow us to
place a final one-time purchase order for the computer chip. In the interim, we
are maintaining a higher than normal inventory of the computer chip and are
working to develop a new product design that uses an alternative computer chip.
</P>
<P>We currently have sufficient manufacturing capacity to support our business
plan until we construct and relocate to our new corporate headquarter facility
in mid-2004. See Item 2 "Facilities". We have no backlog.</P>
<P><B><I>Intellectual Property</I></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 or hold
exclusive field of use licenses to 26 U.S. and 7 foreign patents relating to our
stimulation systems' electrode, receiver, transmitter and programmer technology
and our fully-implantable drug pump technology. These and other co-owned and
non-exclusively licensed patents cover important aspects of both our RF and IPG
stimulation systems for a wide range of current and future applications. We
currently have 35 pending U.S. patent applications assigned to us, and 18
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 ALIGN=CENTER>Page 10</P>
<HR>
<PAGE>
<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>We own a number of U.S. trademark registrations, including
<I>AccuRx</I>®, <I>Advanced Neuromodulation Systems</I>®, <I>ANS &
Design</I>®, <I>PainDoc</I>®, <I>Renew</I>®, and
<I>Genesis</I>®. U.S. trademark applications are pending for various
trademarks that we believe have value (or will have value) in the marketplace,
including <I>Life Gets Better</I>™. We also own trademark registrations and
applications in countries outside of the U.S.</P>
<P><B>Competition</B></P>
<P>We are a small company competing in a large and rapidly growing market. We
believe that the principal competitive factors in the neuromodulation market are
the quality, performance, cost-effectiveness, ease of use, customer service and
technical innovation of neuromodulation devices and the existence and benefits
of cost-effective alternative therapies.</P>
<P>Our only significant competitor at this time in the neurostimulation portion
of the market is Medtronic, one of the world's largest medical device companies,
which has substantially greater resources and marketing power than we do. The
neuromodulation market is one of Medtronic's fastest growing segments.
Competitive pressures could increase in the future as Medtronic attempts to
secure and grow its position in the neuromodulation market. In the constant rate
drug pump portion of the market, our principal competitors are Medtronic and
Johnson & Johnson.</P>
<P>We believe the neuromodulation market is a high growth-potential market and
that other companies are attempting and will attempt in the future to bring new
products or therapies into this market. Barriers to entry by new competitors are
high, due to a long and expensive product development and regulatory approval
process and the intellectual property and patent positions existing in the
market. However, other medical device companies may be able to enter the
neuromodulation market by leveraging their existing technologies into
neuromodulation platforms, thereby decreasing the time and resources required to
enter the market. For example, we are aware that Advanced Bionics, Inc., a
privately-held California-based company that currently manufactures and markets
a cochlear implant, is developing and may be testing an IPG system for the
treatment of chronic pain.</P>
<P><B>Government Regulation</B></P>
<P>In the U.S., we are subject to regulation by numerous governmental
authorities, principally the FDA. The research and development, manufacturing,
promotion, marketing and distribution of our products in the U.S. are governed
by the Federal Food, Drug and Cosmetic Act and the regulations promulgated
thereunder (the FDC Act and Regulations). We are subject to inspection by the
FDA for compliance with the procedures set forth in the FDC Act and Regulations.
Both of our manufacturing operations are required to comply with the FDA's
Quality System Regulations, commonly referred to as QSR. QSR addresses design
controls and methods, facilities and quality assurance controls used in
manufacturing medical devices.</P>
<P ALIGN=CENTER>Page 11</P>
<HR>
<PAGE>
<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. The FDA last inspected our Plano
facility in March 2003 and our Budd Lake and Hackettstown facilities in July
2002, and no Inspectional Observations were found at any of these locations.</P>
<P>The process of obtaining FDA clearance can be lengthy, expensive and
uncertain. Under the FDA's requirements, a new medical device cannot be released
for commercial use until a PMA application has been filed with the FDA and the
FDA has approved the device's release. If a manufacturer can establish that a
newly developed device is "substantially equivalent" to a legally marketed
device, the manufacturer may seek marketing clearance from the FDA to market the
device by filing a 510(k) premarket notification with the FDA, which usually
takes less time than a PMA. 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> and
<I>GenesisXP</I> IPGs, have been the subject of successful 510(k) submissions,
we believe that because the products we are currently developing are more
innovative, some of these products will require us to undertake the lengthier
and more costly PMA submission process.</P>
<P>On October 26, 2002, President Bush signed The Medical Device User Fee and
Modernization Act of 2002 (MDUFMA), amending the Federal Food, Drug, and
Cosmetic Act.</P>
<P>Under MDUFMA, we and other medical device manufacturers with gross sales or
receipts of $30 million or more will be required to pay a user fee to the FDA
for PMA and 510(k) reviews. According to the FDA, the user fees provided by
MDUFMA, and the additional appropriations that go with the new law, are intended
to ensure that safe and effective medical treatments will reach patients more
rapidly, provide greater certainty that manufacturers will receive timely, high
quality reviews, and provide resources to ensure that devices marketed in the
United States continue to meet high standards for safety and effectiveness. The
fee for PMA applications is $154,000 and the fee for 510(k) applications is
$2,187. Fees for supplements range from $11,088 to $154,000, depending on the
type of supplement. The FDA will adjust these fees each year to account for
inflation, changes in workloads, and other factors. The FDA will announce the
new fees for the next fiscal year in a Federal Register notice by August 1 of
each year. Although MDUFMA requires that a fee must be paid for each premarket
application, premarket report, supplement or 510(k) submitted on or after
October 1, 2002, under the provisions of the new legislation, before the FDA can
begin collecting fees, Congress must also pass an appropriation act providing
for the new medical device fees. The FDA must also develop systems to collect,
safeguard, process, and account for fees. For these reasons, the FDA has not yet
commenced collecting these fees. While we do not anticipate that compliance with
MDUFMA will have a material adverse effect on our financial results, MDUFMA will
increase the cost of regulatory compliance.</P>
<P>Medical device laws are also in effect in many of the countries outside the
U.S. in which we do business. These laws range from comprehensive device
approval and quality system requirements for some or all of our products to
simpler requests for product data or certifications. The number and scope of
these requirements are increasing and, as we expand our business into new
jurisdictions, we will be subject to additional laws. In June 1998, the European
Union Medical Device Directive became effective, and all medical devices sold in
Europe must now meet the Medical Device Directive standards and receive CE Mark
certification. CE Mark certification involves a comprehensive quality system
program and submission of data on a product to the Notified Body in Europe. The
Medical Device Directive and the ISO 13485 standard are recognized international
quality standards that are designed to ensure that companies develop and
manufacture quality medical devices. Our Plano facility was audited in November
2002, and our Budd Lake and Hackettstown facilities were audited in April 2002,
for compliance with the Medical Device Directive and ISO 13485, and all three
facilities are certified to these standards.</P>
<P ALIGN=CENTER>Page 12</P>
<HR>
<PAGE>
<P>The financial arrangements through which we market, sell and distribute our
products are subject to federal and state laws and regulations in the U.S. with
respect to patients who are Medicare or Medicaid beneficiaries. These laws
include "fraud and abuse" and physician anti-referral laws and regulations.
Violations of these laws and regulations may result in civil and criminal
penalties, including substantial fines and imprisonment. In a number of states,
the scope of fraud and abuse or physician anti-referral laws and regulations, or
both, have been extended to include all patients, as opposed to just Medicare
and Medicaid beneficiaries. Additionally, our financial arrangements with our
customers may be subject to increasing regulation in the future, due to proposed
health reform initiatives. Although we do not believe that we will need to
undertake any significant expense or modification to our manufacturing
operations or the conduct of our business to comply with current or proposed
federal or state fraud and abuse or physician anti-referral laws or regulations,
if we do not comply with any such laws or regulations, our business practices
could be adversely affected, and we may also be affected in other respects not
presently foreseeable that could have an adverse impact on our business,
financial condition and results of operations.</P>
<P><B>Third-Party Reimbursement</B></P>
<P>Hospitals and ambulatory surgery centers are the primary purchasers of
neuromodulation products. These primary purchasers then bill various third-party
payors for the neuromodulation products and procedures they provide to their
patients. In the U.S., these third-party payors include Medicare and Medicaid,
private insurance companies and managed care organizations, and workers'
compensation programs. Third-party payors carefully scrutinize whether to cover
new products and the level of reimbursement for covered products, and coverages
and reimbursement levels for neuromodulation products vary among these three
primary purchasing groups and the healthcare setting in which physicians perform
procedures, and change from year to year.</P>
<P>Internationally, reimbursement levels and coverages for neuromodulation
products vary significantly among the countries in which we do business due to
the wide variety of health care payment systems in these countries, which
include both government-sponsored health care and private insurance.</P>
<P>We currently employ seven individuals within our sales and marketing
department who work solely on issues related to third-party reimbursement. The
responsibilities of these employees include assisting and training physician
practices and medical facility staffs in obtaining pre-authorization and
confirmation of amount of reimbursement for our products, working with
third-party payors as they periodically evaluate reimbursement coverages and
levels, and communicating updates on reimbursement information to our sales
force.</P>
<P><B>Employees</B></P>
<P>As of February 27, 2003, we employed 291 full-time employees, including 55 in
research and development, 59 in sales and marketing (including support
personnel), 152 in manufacturing and related operations, and the remainder in
executive and administrative positions. None of our employees are represented by
a labor union and we consider our employee relations to be good.</P>
<P ALIGN=CENTER>Page 13</P>
<HR>
<PAGE>
<P><B>Website and Availability of SEC Reports.</B></P>
<P>Our website is located at www.ans-medical.com. We post our most recent annual
report on Form 10-K and quarterly reports on Form 10-Q filed subsequent to our
most recent annual report on Form 10-K on our website under the heading
Investors/Financial Information, and make our current reports on Form 8-K and
other SEC filings available through our website by way of a link to
www.freeedgar.com under the heading "Click here for additional financial
information." We have began posting our current reports on Form 8-K on our
website when we electronically file them with the SEC.</P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR>
<TD WIDTH=15% VALIGN=TOP><B>ITEM 2.</B></TD>
<TD WIDTH=85%><B>FACILITIES</B></TD></TR></TABLE>
<P>We entered a 63-month lease agreement, which became effective on June 1,
1999, for our 40,000 square foot corporate headquarters and manufacturing
facility in Plano, Texas. In September 2002, we amended our lease agreement to
add approximately 9,700 square feet of office space located in the same complex
as our 40,000 square foot corporate headquarters. The lease on the additional
space expires during August 2004, the same as the corporate headquarters
facility. We have two five-year renewal options on the facilities.</P>
<P>Because we expect our business to continue to grow at rates that will demand
added office and facility space, we acquired approximately 10 acres of land in
December 2002 for approximately $3.19 million. The land is located in Plano,
Texas near our current corporate headquarters. We intend to build a new
corporate headquarters facility on the land and relocate to the new facility
upon the expiration of our lease in August 2004. We are designing the new
facility to accommodate planned growth within a five-year horizon and anticipate
that the facility once constructed, will be 140,000 to 150,000 square feet and
will cost between $16 million and $17 million.</P>
<P>We also lease facilities in New Jersey as a result of our acquisition of HDI.
One of the facilities, located in Budd Lake, New Jersey, is 10,348 square feet
of office space that is used for administration, design engineering, drafting,
documentation and regulatory affairs. We renewed the lease in March 2002 and the
lease now expires on February 28, 2004. Our Budd Lake lease contains no renewal
option. We also lease 18,582 square feet of space in Hackettstown, New Jersey
used for our O.E.M. manufacturing operations. We renewed the Hackettstown lease
on December 31, 2002 and the lease now expires on December 31, 2005 and is
renewable for one additional three-year period.</P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR>
<TD WIDTH=15% VALIGN=TOP><B>ITEM 3.</B></TD>
<TD WIDTH=85%><B>LEGAL PROCEEDINGS</B></TD></TR></TABLE>
<P>We are a party to product liability claims and other ordinary routine
litigation claims arising in the ordinary course of business related to our
neurostimulation devices. Our product liability insurers have assumed
responsibility for defending us against product liability claims, subject to
reservation of rights in certain cases. Historically, product liability claims
for our neurostimulation devices have not resulted in significant monetary
liability beyond our insurance coverage. We seek to maintain appropriate levels
of product liability insurance with coverage that we believe is comparable to
that maintained by companies similar in size and serving similar markets.</P>
<P>Except for ordinary course product liability claims and other ordinary
routine litigation incidental to our business, we are not currently a party to
any other pending legal proceeding. We maintain general liability insurance
against risks arising out of the normal course of business.</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 14</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 17, 2003, there were approximately 578 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>
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 $ 28.52
Second Quarter $ 33.80 $ 28.50
Third Quarter $ 36.92 $ 24.92
Fourth Quarter $ 37.73 $ 28.51
2003: High Low
-------------- --------------
First Quarter
(through March 17, 2003) $ 38.84 $ 34.16
</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>Listed below is summary information on the Company's stock option plans as of
December 31, 2002:</P>
<PRE>
Equity Compensation Plan Information
Number of securities
remaining available
Number of for future issuance
securities to be under equity
issued upon Weighted-average compensation
exercise of out- exercise price of plans (excluding)
standing options, outstanding options securities reflected
Plan category warrants and rights warrants and rights in column (a)
- ------------------- ------------------- ------------------- --------------------
Equity compensation
plans approved by
security holders(2) 1,599,794 $13.24 26,950
Equity compensation
plans not approved
by security holders
(1)(2) 426,625 $22.40 6,192
------------------- ------------------- --------------------
Total 2,026,419 $15.17 33,142
------------------- ------------------- --------------------
(1) Executive officers and members of the Board of Directors are not eligible to
receive stock option grants under non-shareholder approved plans.
(2) Certain of the plans allow the aggregate number of shares of common stock
reserved for options under the plan to be increased by the same percentage that
the total number of issued and outstanding shares of common stock increased from
the preceding January 1 to the following December 31 (if such percentage is
positive).
</PRE>
<P ALIGN=CENTER>Page 15</P>
<HR>
<PAGE>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR>
<TD WIDTH=15% VALIGN=TOP><B>ITEM 6.</B></TD>
<TD WIDTH=85%><B>SELECTED FINANCIAL DATA</B></TD></TR></TABLE>
<PRE>
----------------------------------------------------------------------
Years Ended December 31,
----------------------------------------------------------------------
2002 2001 2000 1999 1998
-------------- ------------- ------------- ------------- -------------
(in thousands, except per share data)
Statements of Income Data: (1) (2)
Net revenue (3) $ 57,372 $ 37,916 $ 31,827 $ 26,879 $ 23,417
Total net revenue 57,372 37,916 31,827 35,779 26,517
Gross profit 36,713 22,241 17,127 23,852 17,093
Research and development expense 5,843 4,928 3,854 4,097 2,790
Marketing, general and
administrative and amortization
expenses 21,622 14,504 12,328 11,286 10,701
Income from operations 9,248 2,809 945 8,469 3,602
Net income from continuing
operations 6,684 1,518 832 5,817 2,327
Loss from discontinued operations -- -- -- -- (212)
Gain on the sale of assets of
discontinued operations -- -- -- -- 4,585
Net income from discontinued
operations -- -- -- -- 4,373
Net income $ 6,684 $ 1,518 $ 832 $ 5,817 $ 6,700
Diluted income per share:
Continuing operations $ .56 $ .15 $ .09 $ .64 $ .24
Discontinued operations $ -- $ -- $ -- $ -- $ .45
Net income $ .56 $ .15 $ .09 $ .64 $ .69
----------------------------------------------------------------------
Years Ended December 31,
----------------------------------------------------------------------
2002 2001 2000 1999 1998
-------------- ------------- ------------- ------------- -------------
(in thousands)
Balance Sheet Data(2):
Cash, cash equivalents,
certificates of deposit and
marketable securities $ 96,770 $ 11,937 $ 11,599 $ 9,736 $ 13,982
Working capital 114,280 24,906 22,211 17,626 18,042
Total assets 158,344 55,865 49,565 48,407 49,546
Short-term notes payable and
current maturities of
long-term notes payable -- 52 30 -- 3,633
Notes payable, excluding
current maturities -- 137 212 -- 1,000
Stockholders' equity $ 145,045 $ 46,812 $ 40,442 $ 36,536 $ 34,769
__________________________
(1) On January 30, 1998, we sold our cardiovascular and intravenous fluid
delivery product lines (CVS Operations). The CVS Operations have been accounted
for as discontinued operations.
(2) On January 2, 2001, we completed the acquisition of Hi-tronics Designs, Inc.
The transaction was accounted for on a pooling of interests basis and
accordingly, prior periods have been restated.
(3) Net revenue excludes contract research and development revenue in 1998 and
1999 from our former agreement with Sofamor Danek.
</PRE>
<P ALIGN=CENTER>Page 16</P>
<HR>
<PAGE>
<P>The following is a reconciliation of previously reported amounts with
restated amounts for total net revenue and net income:</P>
<PRE>
Years Ended December 31,
-----------------------------------------
2000 1999 1998
------------- ------------- -------------
(in thousands)
Reconciliation of total net revenue:
As previously reported by the Company $ 23,082 $ 29,478 $ 20,106
HDI, for the year ended November 30 10,366 7,989 6,746
Elimination of intercompany transactions (1,621) (1,688) (335)
------------- ------------- -------------
Total net revenue as restated $ 31,827 $ 35,779 $ 26,517
============= ============= =============
Reconciliation of net income:
As previously reported by the Company $ 954 $ 6,003 $ 6,959
HDI, for the year ended November 30 28 328 (174)
Elimination of intercompany transactions (150) (514) (85)
------------- ------------- -------------
Net income as restated $ 832 $ 5,817 $ 6,700
============= ============= =============
</PRE>
<P ALIGN=CENTER>Page 17</P>
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<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>Background</B></P>
<P>We entered the neuromodulation market in 1995 through the acquisition of a
company that had developed and marketed a radio-frequency (RF) neurostimulation
system. In 1998, we elected to reposition our business to focus exclusively on
the neuromodulation market. Implementation of this strategy involved selling our
cardiovascular and intravenous fluid product lines in January 1998. Through our
initiatives, we developed and launched our next generation neurostimulation
system, the <I>Renew</I>® RF spinal cord stimulation system, in 1999. We
also recently developed our <I>Genesis</I>® and <I>GenesisXP</I>™
totally implantable pulse generator (IPG) spinal cord stimulation systems. We
began selling <I>Genesis</I> in Europe in 2001 and in the U.S. in 2002
subsequent to the FDA's approval of our PMA application in November 2001, and
our <I>GenesisXP</I> IPG system following FDA approval, in the fourth quarter of
2002.</P>
<P>In 2000, we completed development of <I>AccuRx</I>, our constant rate
implantable drug pump, in part using proprietary technology we licensed from
Implantable Devices Limited Partnership (IDP). We initiated U.S. clinical trials
of <I>AccuRx</I> under an Investigational Device Exemption (IDE) in the first
quarter of 2001, and began selling <I>AccuRx</I> in certain international
markets in the second quarter of 2001. On January 2, 2001, we strengthened our
position in the neuromodulation market by acquiring the assets of IDP and ESOX
Technology Holdings, LLC (ESOX) for 119,100 shares of our common stock valued at
approximately $2.43 million. This acquisition provided us with intellectual
property surrounding implantable drug pump technologies in all applications,
including pain and cancer therapy.</P>
<P>Also on January 2, 2001, we completed the acquisition of HDI, a
privately-held O.E.M. developer and manufacturer, for approximately 1.1 million
shares of our common stock. We accounted for this acquisition using the pooling
of interests method and, accordingly, the financial information for all periods
prior to the acquisition has been restated. Prior to the acquisition, HDI
developed and manufactured our <I>Genesis</I> IPG as well as the transmitter for
our <I>Renew</I> system. Acquiring HDI provided us with additional in-house
expertise in the design and manufacture of highly sophisticated
electromechanical devices. Combined with our capabilities in the design and
manufacture of implantable leads, electronic device control and communication
systems and implantable drug pumps, we believe HDI's expertise will allow us to
develop more sophisticated products in less time. Additionally, HDI continues to
provide contract development and manufacturing services to third parties, which
we report as a separate segment for financial reporting purposes (the O.E.M.
segment). For the year ended December 31, 2002, our O.E.M. segment provided
$10.66 million or 18.6% of our total revenue. In the future, we expect our
O.E.M. segment revenue to decrease as a percentage of our total revenue as we
grow revenue from our proprietary neurostimulation systems and drug pumps and
increasingly utilize HDI's research and development capabilities for internal
product development.</P>
<P>In November 2002, we completed the acquisition of MicroNet Medical, Inc., a
privately-held developer of medical devices based on proprietary micro-lead
technology. MicroNet developed a line of very thin and steerable spinal cord
stimulation leads called <I>Axxess</I>™. These leads are the smallest
neurostimulation leads on the market, which we believe offers advantages in
certain applications. Under the terms of the transaction, which we structured as
a merger, we acquired only MicroNet's proprietary technology and certain
associated tangible assets. MicroNet's operations, other tangible assets,
certain liabilities and certain employees became part of a separate unaffiliated
company. We assumed no material debt, liabilities, or overhead in the
transaction. At closing, we paid the former MicroNet shareholders $500,000 in
cash and 156,302 shares of our common stock with a value at the time of issuance
of $4,648,421. In addition, we incurred expenses of $859,460, including an
investment-banking fee of $600,000. In March 2003, subsequent to the 2002 fiscal
year, we paid the former MicroNet shareholders an aggregate of 28,346 shares of
our common stock with a value at the time of issuance and release from escrow of
$1,020,173 upon the successful completion of half of the first product
milestone, and the former MicroNet shareholders may receive additional shares of
our common stock if certain additional product, regulatory approval and sales
milestones are met. The aggregate value of the additional potential milestone
earnout payments was $9 million as measured at the time the transaction was
completed. Important additional product milestone deadlines occur twelve and
eighteen months following the closing, while other milestones depend on the
receipt of regulatory approvals and meeting an aggregate sales milestone. All
milestones must be met within the next four to five years, depending on the
milestone.</P>
<P ALIGN=CENTER>Page 18</P>
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<PAGE>
<P> Our current neuromodulation product line includes our <I>Genesis</I> IPG
system, <I>GenesisXP</I> IPG system, <I>Renew</I> RF system and <I>AccuRx</I>
constant rate drug pump. With the launch of our <I>Genesis</I> and
<I>GenesisXP</I> IPG systems, we now compete in 100% of the implantable
neurostimulation market to treat chronic pain of the trunk and limbs. The launch
of the <I>Genesis</I> IPG and <I>GenesisXP</I> IPG in 2002 slowed our growth
rate in sales of <I>Renew</I> systems from an average percentage growth rate of
the mid-teens over the past several years to single-digit growth in 2002.
Management believes this trend may continue in 2003 and has assumed similar
single-digit growth in <I>Renew</I> sales during 2003.</P>
<P><B>Critical Accounting Policies and Estimates</B></P>
<P><I>General</I></P>
<P>Our discussion and analysis of our financial condition and results of
operations are based upon our consolidated financial statements, which have been
prepared in accordance with accounting principles generally accepted in the
United States. The preparation of these financial statements requires management
to make estimates and judgments that affect the reported amounts of assets,
liabilities and related disclosure of contingent assets and liabilities at the
date of the financial statements and the reported amounts of revenue and
expenses during the reporting period. On an on-going basis, management evaluates
its estimates and judgments, including those related to 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>We generate revenues from product sales to end customers, product sales to
distributors, and development contracts. We recognize revenue from neuro product
sales when the goods are shipped to our customers or distributors, provided an
arrangement exists, the fee is fixed and determinable, and collectibility is
reasonably assured. Certain of our customers are third-party payors who
reimburse fixed amounts for services based on a specific diagnosis. Revenue is
recognized on these third-party payor sales based on the sales price less a
contractual adjustment, which is based on our history of reimbursement with the
third-party payor, provided all other revenue recognition criteria are met. We
record, as a reduction in revenue a provision for estimated sales returns and
adjustments on these product sales in the same period as the related revenue is
recorded. These estimates are based on historical sales returns, analysis of
credit memo data, and other known factors. Payment received in advance of
revenue recognition requirements are recorded as deferred revenue on the
consolidated balance sheet. We recognize revenue from custom manufactured
products at HDI when the goods are shipped to the customer. HDI also develops
products for certain customers under fixed price research and development
contracts. 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. In certain
cases, HDI will undertake a development project on a cost plus basis. In these
cases, we invoice and recognize revenue for actual time and material expended on
the project at contractual hourly billing rates and markups.</P>
<P ALIGN=CENTER>Page 19</P>
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<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, the aging of receivables and our historical experience. If the
financial condition of our customers were to deteriorate, resulting in an
impairment of their ability to make payments, additional allowances or
write-offs may be required.</P>
<P><I>Inventory Reserve</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 was amortized using the straight-line method through December
31, 2001 over the estimated life of 20 years.</P>
<P>On January 1, 2002, we adopted Statement of Financial Accounting Standards
No. 141, "Business Combinations" and Statement of Financial Accounting Standards
No. 142, "Goodwill and Other Intangible Assets." Under the new accounting rules,
goodwill and intangible assets deemed to have indefinite lives are no longer
amortized but will be subject to annual impairment tests in accordance with the
statements. We determined that our goodwill at December 31, 2001 was unimpaired
and eliminated amortization of the goodwill effective January 1, 2002. Prior to
the adoption of these statements, our amortization expense for goodwill was
$556,604 on an annual basis.</P>
<P>Other identifiable definite-lived intangible assets, such as patents,
purchased technology, trademarks and covenants not to compete, are amortized
using the straight-line method over their 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.</P>
<P ALIGN=CENTER>Page 20</P>
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<PAGE>
<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><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 and other ordinary routine litigation
incidental to our business are the only litigation to which we are a party.
While historically our product liability claims have not resulted in significant
monetary liability beyond our insurance coverage, an adverse judgment beyond our
insurance coverage could have a material adverse impact on our results of
operations and financial condition.</P>
<P><I>Stock Compensation</I></P>
<P>See Note 7 to the Consolidated Financial Statements for a discussion of the
application of Statement of Financial Accounting Standards (SFAS) No. 123,
"Accounting for Stock-Based Compensation" and SFAS 148, "Accounting for
Stock-Based Compensation - an Amendment of FASB Statement No. 123" to our stock
compensation programs.</P>
<P><B>Results of Operations</B></P>
<P><I>Comparison of the Years Ended December 31, 2002 and 2001</I></P>
<P><I>Net income.</I> We reported net income of $6.68 million, or $.56 per
diluted share, in 2002 compared to $1.52 million, or $.15 per diluted share, in
2001. Financial results in 2002 reflect the January 2002 U.S. launch of our
<I>Genesis</I> IPG system and December 2002 U.S. launch of our <I>GenesisXP</I>
IPG system. Results for the 2001 period reflect amortization expense for
goodwill of $556,604.The 2002 results contain no similar expense since we
eliminated the amortization of goodwill on January 1, 2002 when we adopted the
new accounting standards for intangible assets described above. If the
amortization expense for goodwill were eliminated from the 2001 period, pro
forma net income would be $2.07 million and pro forma net income per diluted
share would be $.21.</P>
<P><I>Net revenue.</I> Net revenue increased 51.3% to $57.37 million compared to
$37.92 million in the comparable 2001 period. Net revenue of our neuromodulation
products increased 70.1% to $46.71 million in 2002 from $27.46 million in 2001
due to the U.S. launch of our <I>Genesis</I> IPG system in January 2002 and our
<I>GenesisXP</I> IPG system in December 2002. Net revenue from our HDI O.E.M.
business increased marginally to $10.66 million in 2002 from $10.46 million in
2001 as we continue to focus more of HDI's resources on our own manufacturing
and research and development needs.</P>
<P>The launch of the <I>Genesis</I> IPG in 2002 slowed our growth rate in sales
of <I>Renew</I> systems from an average percentage growth rate in the mid-teens
over the past several years to single-digit growth in 2002. Management believes
this trend may continue in 2003 and has assumed similar single-digit growth in
<I>Renew</I> sales during 2003.</P>
<P ALIGN=CENTER>Page 21</P>
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<PAGE>
<P><I>Gross profit.</I> Gross profit increased to $36.71 million in 2002 from
$22.24 million in 2001 due to the increase in net revenue discussed above and an
improvement in gross profit margins. Gross profit margins increased to 64.0% in
2002, compared to 58.7% in 2001, due to higher sales of our neuromodulation
products, which contribute higher margins than O.E.M. product sales, higher
neuromodulation product sales from direct sales and commissioned agents, which
contribute higher margins than distributor sales, and operational efficiencies
gained from higher manufacturing volumes.</P>
<P><I>Operating expenses.</I> Total operating expenses (the aggregate of
research and development, sales and marketing, general and administrative and
amortization of intangibles expense) increased to $27.47 million in 2002,
compared to $19.43 million in 2001. However, as a percentage of net revenue,
these expenses decreased to 47.9% in 2002 from 51.3% in 2001 due to leveraging
of research and development expense, leveraging of general and administrative
expense, and to a lesser extent, eliminating amortization expense of goodwill.
</P>
<P><I>Sales and marketing.</I> Sales and marketing expense, as a percentage of
net revenue, increased to 26.0% in 2002 from 23.9% in 2001, and the absolute
dollar amount increased to $14.93 million in 2002 compared to $9.06 million
during 2001. This dollar increase during 2002 compared to 2001 was principally
attributable to higher salary and benefit expense from staffing additions in
direct sales, reimbursement and sales support positions, higher commission
expense from increased product sales, and higher sample and promotional expense
in support of the <I>Genesis</I> and <I>GenesisXP</I> IPG launches.</P>
<P><I>Research and development.</I> Research and development expense increased
to $5.84 million, or 10.2% of net revenue, from $4.93 million, or 13.0% of net
revenue, during the same period in 2001. This increase in the absolute dollar
amount in 2002 compared to 2001 was principally attributable to higher salary
and benefit expense from staffing additions, higher test material expense and
higher expense associated with our clinical trials of <I>AccuRx</I>. We continue
to focus our development efforts on further broadening and strengthening our
product technology platforms both for stimulation devices as well as implantable
drug pumps.</P>
<P><I>General and administrative.</I> General and administrative expense
increased to $5.74 million during 2002 from $3.96 million in 2001 and, as a
percentage of net revenue, decreased to 10.0% in 2002 from 10.4% in 2001. The
increase in the absolute dollar amount in 2002 compared to 2001 was principally
attributable to higher salary expense from staffing additions (including a new
executive officer position), higher employee benefit costs, higher bonus
expense, higher property tax expense and higher fees for accounting and tax
services.</P>
<P><I>Amortization of intangibles.</I> No amortization expense of goodwill was
recorded in 2002 due to the adoption of Statement of Financial Accounting
Standards No. 141 and Statement of Financial Accounting Standards No. 142 on
January 1, 2002. During 2001, we recorded $557,000 for amortization expense of
goodwill.</P>
<P>Amortization of other intangibles increased modestly in 2002 to $952,000 from
$933,000 in 2001 due to additional amortization expense for intangible assets
acquired in November 2002 when we completed the acquisition of MicroNet Medical,
Inc. As a result of the MicroNet acquisition, we expect amortization expense to
increase in 2003 by approximately $400,000, excluding additional amortization
expense that may be generated as we acquire additional intangible assets. We
expect to acquire the additional intangible assets as milestones are met
pursuant to the purchase agreement. As the milestones are met, we will be
required to issue additional shares of our common stock as earn-out
consideration.</P>
<P ALIGN=CENTER>Page 22</P>
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<PAGE>
<P><I>Other income.</I> Other income increased to $923,000 in 2002 from an
expense of $26,000 in 2001 primarily attributable to a $451,000 increase in
interest income due to higher funds available for investment from our public
offering during the second quarter of 2002 and the expense in 2001 of $484,000
for costs associated with the acquisition of HDI. These costs were expensed
instead of capitalized because the acquisition was accounted for under the
pooling of interests method.</P>
<P><I>Income tax expense.</I> Income tax expense increased to $3.49 million in
2002 from $1.27 million in 2001, and the overall effective tax rate was 34.3% in
2002 compared to 45.5% in 2001. The decrease in the effective tax rate in 2002
compared to 2001 was the result of three factors. First, our amortization of
goodwill in the 2001 period was not deductible for tax purposes. Second, the HDI
acquisition costs expensed in the 2001 period of $484,000 were not fully
deductible for tax purposes. Finally, the 2002 period included tax-free interest
income.</P>
<P><I>Comparison of the Years Ended December 31, 2001 and 2000</I></P>
<P><I>Net income.</I> 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 was accounted for under the
pooling of interests method.</P>
<P><I>Net revenue.</I> 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><I>Gross profit.</I> 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 margins increased to 58.7% in
2001, compared to 53.8% in 2000, due to higher sales of our <I>Renew</I> 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><I>Operating expenses.</I> Total operating expenses (the aggregate of
research and development, sales and marketing, amortization of intangibles and
general and administrative expenses) increased to $19.43 million in 2001,
compared to $16.18 million in 2000, and, as a percentage of 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><I>Sales and marketing.</I> Sales and marketing expense, as a percentage of
net revenue, increased to 23.9% in 2001 from 21.5% in 2000, and the absolute
dollar amount increased to $9.06 million in 2001 from $6.85 million during 2000.
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 ALIGN=CENTER>Page 23</P>
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<PAGE>
<P><I>Research and development.</I> Research and development expense increased
to $4.93 million in 2001, or 13.0% of net revenue, from $3.85 million, or 12.1%
of net revenue, during the same period in 2000. 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 RF system platform, our proprietary constant
rate drug pump and an IPG system for deep brain stimulation.</P>
<P><I>General and administrative.</I> General and administrative expense
decreased to $3.96 million during 2001 from $4.24 million in 2000 and, as a
percentage of 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
when we acquired HDI in January 2001.</P>
<P><I>Amortization of intangibles.</I> 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><I>Other income.</I> 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><I>Income tax expense.</I> 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, or 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><B>Liquidity and Capital Resources</B></P>
<P>At December 31, 2002 our working capital increased to $114.28 million from
$24.91 million at year-end 2001. The ratio of current assets to current
liabilities was 13.15:1 at December 31, 2002, compared to 4.77:1 at December 31,
2001. Cash, cash equivalents, certificates of deposit and marketable securities
totaled $96.77 million at December 31, 2002 compared to $11.94 million at
December 31, 2001.</P>
<P>During the second quarter of 2002, we completed an underwritten public
offering of 2,875,000 shares of common stock managed by U.S. Bancorp Piper
Jaffray, CIBC World Markets and Gerard Klauer Mattison as underwriters. We
received net proceeds from the offering of approximately $83.2 million. We
intend to use the proceeds from the offering for general corporate purposes,
including expanding our worldwide sales and marketing resources, funding product
development, pursuing regulatory approvals and pursuing strategic acquisitions
of product lines, businesses, companies, services or technologies that
complement our current business through mergers, acquisitions, joint ventures or
otherwise. We discuss below certain transactions and investments we have made
since the public offering in which we have used cash. In addition, in March
2003, we acquired Sun Medical's pain management business, which will expand our
direct domestic salesforce, for approximately $5.1 million in cash. In January
2003, we invested $1 million in cash in Innovative Spinal Technologies, Inc., a
start-up company that develops spine technologies, products and services through
intellectual property development and contract research.</P>
<P ALIGN=CENTER>Page 24 </P>
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<PAGE>
<P>We increased our investment in inventories to $13.72 million at December 31,
2002, from $9.75 million at December 31, 2001. This increase from year-end 2001
was primarily the result of two factors. First, we increased our investment in
consignment inventories as a result of adding additional commissioned sales
agents during 2002 to whom we provide consignment inventory. Second, we
increased our investment in raw materials and finished goods for our
<I>Genesis</I> and <I>GenesisXP</I> IPG systems to support our successful launch
of these products in the U.S. market.</P>
<P>Our investment in trade accounts receivable increased to $10.85 million at
December 31, 2002, from $6.49 million at December 31, 2001 due to the increase
in sales of our neuromodulation products resulting from the launch of the
<I>Genesis</I> and <I>GenesisXP</I> IPG systems. Our days sales outstanding
decreased from 57 days at year-end 2001 to 55 days at year-end 2002.</P>
<P>In November 2002, we completed the acquisition of MicroNet Medical, Inc. At
closing we paid the former MicroNet shareholders $500,000 in cash and 156,302
shares of our common stock with a value at the time of issuance of $4,648,421.
In addition, we incurred expenses of $859,460, including an investment-banking
fee of $600,000. As previously noted, in March 2003, we paid the former MicroNet
shareholders an aggregate of 28,346 shares of our common stock with a value at
the time of issuance and release from escrow of $1,020,173 upon the successful
completion of half of the first product milestone, and the former MicroNet
shareholders may receive additional shares of our common stock if certain
additional product, regulatory approval and sales milestones are met. The
aggregate value of the additional potential milestone earnout payments was $9
million as measured at the time the transaction was completed. Important
additional product milestone deadlines occur twelve and eighteen months
following the closing, while other milestones depend on the receipt of
regulatory approvals and meeting an aggregate sales milestone. All milestones
must be met within the next four to five years, depending on the milestone.</P>
<P>We spent $2.94 million during 2002 for capital expenditures primarily for new
furniture and equipment for personnel we hired during 2002 and additional
manufacturing tooling and equipment to support our current products.</P>
<P>Because we expect our business to continue to grow at rates that will demand
added office and facility space, we acquired approximately 10 acres of land in
December 2002 for approximately $3.19 million. The land is located in Plano,
Texas, near our current corporate headquarters. Our current lease on our 50,000
square foot corporate headquarters expires in August 2004. We intend to build a
new corporate headquarters facility on the land and relocate to the new facility
upon the expiration of our lease in August 2004. We are designing the new
facility to accommodate planned growth within a five-year horizon and anticipate
that the facility will contain 140,000 to 150,000 square feet and cost between
$16 million and $17 million. While we have not yet determined the method by
which we will finance the facility, we believe our cash position and overall
balance sheet position provides us with various financing alternatives,
including financing the facility from our current cash, financing through a debt
vehicle such as a mortgage or other form of note, or a sale-and-leaseback
transaction.</P>
<P>Liquidity may also be enhanced based on our ability to utilize all or part of
a net operating loss of $3.4 million to offset future taxable income. We
acquired the net operating loss in connection with the MicroNet Medical
acquisition and its utilization may be subject to a limitation under Section 382
of the Internal Revenue Code.</P>
<P>We believe our current cash, cash equivalents, marketable securities and cash
generated from operations will be sufficient to fund our current levels of
operating needs and capital expenditures for the foreseeable future. We
currently have no credit facilities in place. If we decide to acquire
complementary businesses, product lines or technologies, or enter into joint
ventures or strategic alliances that require substantial capital, we intend to
finance those activities by the most attractive alternative available, which
could include utilizing our current cash, bank borrowings, or the issuance of
debt or equity securities.</P>
<P ALIGN=CENTER>Page 25</P>
<HR>
<PAGE>
<P><B>Cash Flows</B></P>
<P>Net cash provided by operating activities was $7.47 million in 2002, $3.06
million in 2001 and $690,000 in 2000. Net cash provided by operating activities
increased from $3.06 million in 2001 to $7.47 million in 2002, an increase of
approximately $4.41 million. This increase in 2002 compared to 2001 was
principally attributable to a $5.17 million increase in net income from $1.52
million in 2001 to $6.68 million in 2002. 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 and a $1.41
million decrease in the amount of cash used for changes in working capital
components.</P>
<P>Net cash used in investing activities was $91.14 million in 2002, $3.09
million in 2001 and $2.94 million in 2000. In 2002, our primary investing
activities using cash were the purchase of marketable securities ($188.39
million) the purchase of land ($3.19 million), capital expenditures ($2.94
million) and cash used in the purchase of MicroNet Medical, Inc. ($1.36
million), while net proceeds from the sale of marketable securities provided
cash of $104.75 million. In 2001, our primary investing activities using cash
were the purchase of marketable securities ($3.90 million) and capital
expenditures ($3.11 million) for additional manufacturing tooling and equipment,
office furniture and equipment, non-compete agreements and 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.</P>
<P>Net cash provided by financing activities was $84.86 million in 2002,
$957,000 in 2001 and $2.57 million in 2000. During 2002, we used $190,000 to
repay our entire outstanding long-term debt, while we received $83.18 million in
net proceeds from a public offering and $1.87 million from the exercise of stock
options. 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).</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 ALIGN=CENTER>Page 26</P>
<HR>
<PAGE>
<P><B>Outlook and Uncertainties</B></P>
<P><I>The following is a "safe harbor" statement under the Private Securities
Litigation Reform Act of 1995: Certain matters discussed in this Annual Report
on Form 10-K contain statements that constitute forward-looking statements
within the meaning of Section 21E of the Securities Exchange Act of 1934, as
amended. The words "expect," "estimate," "anticipate," "predict," "believe,"
"plan," "will," "should," "intend," "would," "scheduled," "new market,"
"potential market applications," and similar expressions and variations are
intended to identify forward-looking statements. Such statements appear in a
number of places in this Annual Report on Form 10-K and include statements
regarding our intent, belief or current expectations with respect to, among
other things: (i) trends affecting our financial condition or results of
operations; (ii) our financing plans; and (iii) our business growth strategies.
We caution our readers that any forward-looking statements are not guarantees of
future performance and involve risks and uncertainties. Actual results may
differ materially from those projected in the forward-looking statements as a
result of various factors. These risks and uncertainties include the following:
</I></P>
<P><B><I>Failure of our <I>Genesis</I> and <I>GenesisXP</I> IPG systems to gain
and maintain market acceptance would adversely affect our revenue growth and
profitability.</I></B></P>
<P>We formally introduced our <I>Genesis</I> IPG system in the U.S. in January
2002 and our <I>GenesisXP</I> IPG system (offering increased battery capacity
and longevity) in the U.S. in December 2002. We believe that the size and
potential for growth of the IPG portion of the neurostimulation market are
greater than in the RF portion. Accordingly, our ability to generate increased
revenue and profitability, and thus our general success, will depend, in large
part, on the market's acceptance of our IPG systems. As a new entrant into the
IPG portion of the neurostimulation market, there are many reasons we might not
achieve market acceptance on a timely basis, if at all, including the following:
</P>
<UL>
<LI>competing products, technologies and therapies are available, and others may
be introduced that gain greater and faster physician and patient acceptance than
our IPG systems; and
<LI>our only competitor in the IPG portion of the market has had its IPG product
on the market for some time and enjoys significant brand awareness and other
advantages among pain management specialists.</UL>
<P>If the IPG portion of the neurostimulation market grows at a faster rate than
the RF portion, our failure to successfully market and sell our IPG systems
could negatively affect our revenue growth and profitability.</P>
<P><B><I>Because our main competitor has significantly greater resources than we
do and new competitors may enter the neuromodulation market, it may be difficult
for us to compete in this market.</I></B></P>
<P>The medical device market is highly competitive, subject to rapid change and
significantly affected by new product introductions and other market activities
of industry participants. Medtronic, Inc. is one of the largest competitors in
the medical device sector, and is currently our sole competitor in the
neurostimulation market and our largest competitor in the implantable drug pump
market. Medtronic is a large publicly-traded company and enjoys several
competitive advantages over us, including:</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
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 ALIGN=CENTER>Page 27</P>
<HR>
<PAGE>
<P>Medtronic will continue to develop new products that compete directly with
our products, and its greater resources may allow it to respond more quickly to
new technologies, new treatment indications or changes in customer requirements.
Further, we generally price our products at a premium to those of Medtronic.
Additionally, because the neuromodulation market is a high growth-potential
market, other companies may attempt to bring new products or therapies into this
market. For example, we are aware that Advanced Bionics, Inc., a privately-held
company that currently manufactures and markets a cochlear implant product, is
developing and may be testing an IPG system for the treatment of chronic pain.
For all of these reasons, we may not be able to compete successfully against
Medtronic or against future competitors.</P>
<P><B><I>If pain management specialists do not recommend and endorse our
products, our sales could be negatively impacted and we may be unable to
increase our revenues and profitability.</I></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 features, benefits, clinical efficacy, safety
and cost-effectiveness of our products compared to alternative therapies and
competing products, and on training pain management specialists in the proper
use of our products. To sell our products, we must successfully educate and
train pain management specialists so that they will understand our products and
feel comfortable recommending and endorsing them. We may not be able to
accomplish this, and even if we are successful in educating and training pain
management specialists, there is no guarantee that we will obtain their
recommendations and endorsements.</P>
<P><B><I>The launch of Genesis and GenesisXP and other market
factors could impede growth in or reduce sales of Renew, which would
adversely affect our revenues and profitability.</I></B></P>
<P>Our<I>Genesis</I> and <I>GenesisXP</I> IPG systems are currently the newest
neurostimulation products on the market. Although <I>Genesis</I> and our
<I>Renew</I> RF system 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 management 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>. Further, we believe our principal market
competitor has chosen to emphasize the IPG as the therapy of choice in the
neurostimulation market. These factors could lead to a slowdown in growth, or a
reduction, in sales of <I>Renew</I> and similar RF-based neurostimulation
products. Although <I>Renew</I> and <I>Genesis</I> are targeted for different
patients, sales growth of <I>Renew</I> has slowed since the launch of <I>
</I>Genesis. If <I>Renew</I> sales growth continues to slow or sales are
reduced, and we do not gain enough market share through IPG sales to compensate
for these reduced sales, our revenues and profitability will be adversely
affected.</P>
<P><B><I>If patients choose less invasive or less expensive alternatives to our
products, our sales could be negatively impacted.</I></B></P>
<P>We sell medical devices for invasive and minimally-invasive surgical
procedures. Patient acceptance of our products depends on a number of factors,
including device and associated procedure costs, the failure of less invasive
therapies to help the patient, the degree of invasiveness involved in the
procedures used to implant our products, the rate and severity of complications
from the procedures used to implant our products and any adverse side effects
caused by the implanting of our products. If patients choose to use existing
less invasive or less expensive alternatives to our products, or if effective
new alternatives are developed, our revenues and profitability could be
materially adversely affected.</P>
<P ALIGN=CENTER>Page 28</P>
<HR>
<PAGE>
<P><B><I>Any adverse changes in coverage or reimbursement amounts by Medicare
and Medicaid, private insurance companies and managed care organizations, or
workers' compensation programs could limit our ability to market and sell our
products.</I></B></P>
<P>In the U.S., our products are generally covered by Medicare and Medicaid and
other third-party payors, such as private insurance companies and managed care
organizations, and workers' compensation programs, which reimburse patients for
all or part of the cost of our products and related medical procedures. The cost
of our products and related procedures are significant, and third-party payors
carefully scrutinize whether to cover new products and the level of
reimbursement for covered products. From time to time, payors may refuse to
reimburse our customers for all or a portion of the cost of our products, and we
may discount our product cost below expected selling prices or offer other
payment accommodations to customers in order to increase the likelihood of
reimbursement. Further, for certain types of procedures, gaps exist between the
rate of reimbursement paid by Medicare and Medicaid and the rates paid by
private insurers. In addition, gaps exist in reimbursement levels depending on
the health care setting in which physicians perform procedures using our
products. In the future, these gaps may narrow and public and private payors may
reduce levels of reimbursement for neuromodulation devices in an effort to
control increasing costs. If Medicare or other third-party payors decide to
eliminate or reduce coverage amounts on patient reimbursements for our products,
this could limit our ability to market and sell our products in the U.S., which
would materially adversely affect our revenues and profitability. In November
2002, for example, the Center for Medicare and Medicaid Services (CMS) issued a
final ruling establishing new 2003 reimbursement rates for Medicare hospital
outpatient procedures. Reimbursement levels for permanent implants of spinal
cord stimulation devices in the hospital outpatient setting were reduced as a
result of the ruling. CMS could decide to further reduce reimbursement rates for
our products in the same or other patient settings in 2004 and beyond.</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. Where reimbursement in foreign markets is
available, it tends to be at levels significantly below those in the U.S. Our
failure to receive international reimbursement approvals may negatively impact
market acceptance of our products in the international markets in which those
approvals are sought.</P>
<P><B><I>If we fail to protect our intellectual property rights, our competitors
may take advantage of our ideas and compete directly against us.</I></B></P>
<P>We rely in part on patents, certain of which are due to expire between 2004
and 2006, as well as 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 ALIGN=CENTER>Page 29</P>
<HR>
<PAGE>
<P><B><I>Other parties may sue us for infringing their intellectual property
rights, or we may have to sue them to protect our intellectual property rights.
</I></B></P>
<P>There has been a substantial amount of litigation in the medical technology
industry regarding patents and intellectual property rights. The neuromodulation
market is characterized by extensive patent and other intellectual property
rights, which can create greater potential than in less-developed markets for
possible allegations of infringement, particularly with respect to
newly-developed technology. We may be forced to defend ourselves against
allegations that we are infringing the intellectual property rights of others.
In addition, we may find it necessary, if threatened, to initiate a lawsuit
seeking a declaration from a court that we are not infringing the intellectual
property rights of others or that these rights are invalid or unenforceable, or
to protect our own intellectual property rights. Intellectual property
litigation is expensive and complex and its outcome is difficult to predict. If
we do not prevail in any litigation, in addition to any damages we might have to
pay, we would be required to stop the infringing activity, obtain a license, or
concede intellectual property rights. Any required license may not be available
to us on acceptable terms, if at all. In addition, some licenses may be
nonexclusive, and, therefore, our competitors may have access to the same
technology licensed to us. If we fail to obtain a required license or are unable
to design around a patent, we may be unable to sell some of our products, which
could adversely affect our revenues and profitability.</P>
<P><B><I>Failure to obtain necessary government approvals for new products or
for new applications for existing products would mean we could not sell those
new products, or sell our existing products for those new applications.
</I></B></P>
<P>Our products are medical devices, which are subject to extensive government
regulation in the U.S. and in foreign countries where we do business. Unless an
exemption applies, each medical device that we wish to market in the U.S. must
first receive either a premarket approval (PMA) or a 510(k) clearance from the
FDA with respect to each application for which we intend to market it. Either
process can be lengthy and expensive. According to the FDA, the average 510(k)
review period was 100 days in 2002, but reviews may take longer and approvals
may be revoked if safety or effectiveness problems develop. The PMA process is
much more costly, lengthy and uncertain. According to the FDA, the average PMA
submission-to-decision period was 364 days in 2002; however, reviews may take
much longer and completing a PMA application can require numerous clinical
trials and require the filing of amendments over time. The result of these
lengthy approval processes is that a new product, or a new application for an
existing product, often cannot be brought to market for a number of years after
it is developed. Additionally, we anticipate that many of the products we bring
to market in the future will require us to seek PMA approvals rather than 510(k)
clearances. If we fail to obtain or maintain necessary government approvals of
our new products or new applications for existing products on a timely and
cost-effective basis, we will be unable to market the affected products for
their intended applications.</P>
<P><B><I>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.</I></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 or supplemental PMA. Under FDA procedures, we would make the
initial determination of whether to seek a new 510(k) clearance or PMA, but the
FDA could review our decision. If the FDA disagrees with our decision not to
seek a new 510(k) clearance or PMA and requires us to seek either 510(k)
clearance or PMA for modifications we have already made to a previously-cleared
product, we might be required to cease marketing or recall the modified device
until we obtain this clearance or approval. We could also be subject to
significant regulatory fines or penalties.</P>
<P ALIGN=CENTER>Page 30</P>
<HR>
<PAGE>
<P><B><I>We will be unable to sell our products if we fail to comply with
manufacturing regulations.</I></B></P>
<P>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.</P>
<P><B><I>Our products are subject to product recalls even after receiving FDA
clearance or approval, which would negatively affect our financial performance
and could harm our reputation.</I></B></P>
<P>Any of our products may be found to have significant deficiencies or defects
in design or manufacture. The FDA and similar governmental authorities in other
countries have the authority to require the recall of any such defective
product. A government-mandated or voluntary recall could occur as a result of
component failures, manufacturing errors or design defects. We do not maintain
insurance to cover losses incurred as a result of product recalls. Any product
recall would divert managerial and financial resources and negatively affect our
financial performance, and could harm our reputation with customers.</P>
<P><B><I>We are subject to potential product liability and other claims and we
may not have the insurance or other resources to cover the cost of any
successful claim.</I></B></P>
<P>Defects in our implantable medical devices could subject us to potential
product liability claims that our devices were ineffective or caused some harm
to the human body. Our current product liability litigation involves assertions
that our products did not perform as intended and, in some cases, that they
caused discomfort or harm to the patient. Our product liability insurance may
not be adequate to cover current or future claims. Product liability insurance
is expensive and, in the future, may not be available on terms that are
acceptable to us, if it is available to us at all. Plaintiffs may also advance
other legal theories supporting their claims that our products or actions
resulted in some harm. A successful claim brought against us in excess of our
insurance coverage could significantly harm our business and financial
condition.</P>
<P><B><I>We are subject to substantial government regulation and our failure to
comply with all applicable government regulations could subject us to numerous
penalties, any of which could adversely affect our business.</I></B></P>
<P>We are subject to numerous government regulations relating to, among other
things, our ability to sell our products, third-party reimbursement, fraud and
abuse of Medicare or Medicaid and patient privacy. If we do not comply with all
applicable government regulations, government authorities could do any of the
following:</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 ALIGN=CENTER>Page 31</P>
<HR>
<PAGE>
<P>Any one of these results could materially adversely affect our revenues and
profitability and harm our reputation.</P>
<P><B><I>Our reliance on single suppliers for critical components used in our
main products could adversely affect our ability to deliver products on time.
</I></B></P>
<P>We rely on single suppliers for several critical components used in our main
products, including the computer chip used in the receiver of our RF system, the
computer chip used in the IPG programmer and <I>Renew</I> transmitter, the
batteries used in our IPG system and the medical-grade polyurethane (bionate)
that we use in all of our products. If any of our sole-source suppliers were to
stop supplying us with critical components, our manufacturing operations and our
business could be materially harmed, at least in the short term while we located
alternative suppliers or modified our product designs to eliminate the need for
these components.</P>
<P>The sole supplier of the computer chip used in the receiver of our RF system
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. This
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 product design that uses an alternative computer chip.
Until we develop this new design, any sudden disruption in supply from our
current computer chip supplier could adversely affect our ability to deliver
finished RF products on time.</P>
<P><B><I>One distributor currently accounts for a significant percentage of our
revenue from our neuromodulation products segment, and our major competitor in
the neuromodulation market currently accounts for a significant percentage of
our revenue from our O.E.M. segment.</I></B></P>
<P>During 2002, we had one independent distributor, Sun Medical, Inc., that
accounted for $6.33 million, or 13.5%, of our net revenue from our
neuromodulation products segment. In March 2003, we acquired Sun Medical's pain
management business and hired substantially all of the salespeople who had
generated those sales, but we continue to rely in large part on two other
distributors and on numerous independent sales representatives to buy and/or
sell our products. The loss of a major distributor or sales representative, or a
significant decrease in their sales volumes, could materially adversely affect
our revenues and profitability, at least in the short term.</P>
<P>In addition, during 2002, we had two major customers that accounted for $9.52
million, or 89.3%, of our net revenue from our O.E.M. segment. Medtronic, Inc.,
our most significant competitor, accounted for $6.74 million, or 63.2% and Arrow
International, Inc. accounted for $2.78 million, or 26.1%. Either of these
customers could cease doing business with us at any time. If this were to occur,
our revenues and profitability could be materially adversely affected, at least
in the short term.</P>
<P><B><I>We are dependent upon the success of neuromodulation technology. Our
inability to continue to develop innovative neuromodulation products, or the
failure of the neuromodulation market to develop as we anticipate, would
adversely affect our business.</I></B></P>
<P>Our current products focus on the treatment of chronic pain using
neuromodulation. Our development efforts focus on leveraging our neuromodulation
expertise. The neuromodulation market is subject to rapid technological change
and product innovation. Our competitors may succeed in developing or marketing
products, using neuromodulation technology or other technologies, that may be
superior to ours. If we are unable to compete successfully in the development of
new neuromodulation products, or if new and effective therapies not based on
neuromodulation are developed, our products could be rendered obsolete or
non-competitive. This would materially adversely affect our business.</P>
<P ALIGN=CENTER>Page 32</P>
<HR>
<PAGE>
<P><B><I>Our success will depend on our ability to attract and retain key
personnel and scientific staff.</I></B></P>
<P>We believe our future success will depend on our ability to manage our growth
successfully, including attracting and retaining scientists, engineers and other
highly-skilled personnel. Our key employees are subject to confidentiality,
trade secret and non-competition agreements, but may terminate their employment
with us at any time. Hiring qualified management and technical personnel is
difficult due to the limited number of qualified professionals. Competition for
these types of employees is intense in the medical device field. If we fail to
attract and retain personnel, particularly management and technical personnel,
we may not be able to continue to succeed in the neuromodulation market.</P>
<P><B><I>If we choose to acquire complementary businesses, products or
technologies instead of developing them ourselves, we may be unable to complete
these acquisitions or to successfully integrate an acquired business, product or
technology in a cost-effective and non-disruptive manner.</I></B></P>
<P>Our success depends on our ability to continually enhance and broaden our
product offerings in response to changing technologies, customer demands and
competitive pressures. Accordingly, we may, as we have in the past, acquire
complementary businesses, products or technologies instead of developing them
ourselves. We do not know if we will be able to identify prospective acquisition
targets or complete any future acquisitions, or whether we will be able to
successfully integrate any acquired business, operate it profitably or retain
its key employees. Integrating any business, product or technology we acquire
could be expensive and time-consuming, disrupt our ongoing business and distract
our management and key technical personnel. If we are unable to integrate any
acquired entities, products or technologies effectively, our business will
suffer. In addition, any impairment of goodwill or other intangible assets or
charges resulting from the costs of acquisitions could harm our business and
operating results.</P>
<P><B><I>We are subject to additional risks associated with international
operations.</I></B></P>
<P>Internationally, we market our products through 18 independent distributors
who represent us in 22 countries except in Germany where we are represented by
direct salespersons. In 2002, 8% of our sales revenue from our neuromodulation
products segment came from international sales. International sales are subject
to a number of additional risks, including the following:</P>
<UL>
<LI>establishment by foreign regulatory agencies of requirements different from
those in place in the U.S.;
<LI>fluctuations in exchange rates of the U.S. dollar against foreign currencies
that may affect demand for our products overseas;
<LI>export license requirements, changes in tariffs, and other general trade
restrictions;
<LI>difficulties in staffing and managing international operations;
<LI>political or economic instability; and
<LI>lower and more restrictive third-party reimbursement for our products.</UL>
<P>Any of these risks could make it difficult or impossible for us to continue
to expand our overseas operations, which could have an adverse effect on our
revenues.</P>
<P ALIGN=CENTER>Page 33</P>
<HR>
<PAGE>
<P><B><I>Our operations are conducted at three locations, and a disaster at any
of these facilities could result in a prolonged interruption of our business.
</I></B></P>
<P>We currently conduct all of our development, manufacturing and management
activities at our facilities in Plano, Texas and Budd Lake and Hackettstown, New
Jersey. However, a natural disaster, such as a tornado, fire or flood, or a
man-made disaster, could cause substantial delays in our operations, damage or
destroy our manufacturing equipment or inventory and cause us to incur
significant additional expenses. A disaster could seriously harm our business
and affect our reputation with customers. The insurance we maintain may not be
adequate to cover our losses in any particular case.</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 invest our cash reserves in high quality short-term liquid money market
instruments with major financial institutions, a high quality short-term
municipal bond fund with a major financial institution and certificates of
deposit. At December 31, 2002, we had $443,174 invested in money market funds,
$1,636,938 in certificates of deposit with maturities less than 90 days from the
purchase date and $5,636,212 in a tax-free municipal bond fund with daily
liquidity. The rate of interest earned on these investments will vary with
overall market rates. A hypothetical 100-basis point change in the interest
rates earned on these investments would not have a material effect on our income
or cash flows.</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, 7-day and 35-day AAA
municipal bond floaters and Freddie Mac and Federal Home Loan Notes with
maturities less than one-year from the date of purchase. The cost of these
investments is $85,817,984 and the fair value at December 31, 2002 was
$85,796,944. The investments are subject to overall bond market and interest
rate risk, however the Company believes the risk to be limited since a large
portion of the investments, $82,825,000, are in 7-day and 35-day municipal
floaters which have no principal risk. The investment grade municipal bonds and
Freddie Mac and Federal Home Loan Bank notes may have risk of principal
depending on the overall bond market. A hypothetical 10% decrease in the value
of these investments from their prices at December 31, 2002 would decrease the
fair value by $297,194.</P>
<P>We do not use derivative financial instruments to manage the impact of
interest rate changes on our investments or debt instruments.</P>
<P>At December 31, 2002, we had no interest bearing debt.</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>Page 34</P>
<HR>
<PAGE>
<P ALIGN=CENTER><B>PART III</B></P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=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 "Section 16(a) Beneficial
Ownership Reporting Compliance" in our definitive proxy statement to be filed in
connection with our 2003 annual meeting of shareholders, which information is
incorporated herein by reference.</P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR>
<TD WIDTH=15% VALIGN=TOP><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 2003 annual meeting of shareholders, which information is incorporated
herein by reference. Information under the captions "Compensation Committee
Report" and "Performance Graph" are not incorporated herein by reference.</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
AND RELATED STOCKHOLDER MATTERS</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 2003 annual meeting of
shareholders, which information is incorporated herein by reference.</P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR>
<TD WIDTH=15% VALIGN=TOP><B>ITEM 13.</B></TD>
<TD WIDTH=85%><B>CERTAIN RELATIONSHIPS AND RELATED
TRANSACTIONS</B></TD></TR></TABLE>
<P>Inapplicable.</P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR>
<TD WIDTH=15% VALIGN=TOP><B>ITEM 14.</B></TD>
<TD WIDTH=85%><B>CONTROLS AND PROCEDURES</B></TD></TR>
<TR>
<TD> </TD><TD></TD></TR>
<TR>
<TD VALIGN=TOP>(a)</TD>
<TD> Evaluation of disclosure controls and procedures. Based on their most
recent review, which was completed within 90 days of the filing of this annual
report, the Company's Disclosure Committee, which is comprised of our Chief
Executive Officer, Christopher G. Chavez, Chief Financial Officer, F. Robert
Merrill III and General Counsel, Kenneth G. Hawari, concluded that the Company's
disclosure controls and procedures are effective to ensure that information
required to be disclosed by the Company in the reports that it files or submits
under the Securities Exchange Act of 1934, as amended, is accumulated and
communicated to such officers as is appropriate to allow timely decisions
regarding required disclosure, and that these controls and procedures are
effective to ensure that such information is recorded, processed, summarized and
reported within the time periods specified in the SEC's rules and forms.</TD>
</TR>
<TR>
<TD> </TD><TD></TD></TR>
<TR>
<TD VALIGN=TOP>(b)</TD>
<TD>Changes in internal controls. Since the date of the evaluation described
above, there have not been any significant changes in the Company's internal
accounting controls or in other factors (including any corrective actions with
regard to significant deficiencies or material weaknesses) that could
significantly affect those controls.</TD></TR></TABLE>
<P ALIGN=CENTER>Page 35</P>
<HR>
<PAGE>
<P ALIGN=CENTER><B>PART IV</B><P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR>
<TD WIDTH=15% VALIGN=TOP><B>ITEM 15.</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%>(1) The Company filed a report on Form 8-K on November 5, 2002
reporting that the Company entered into an agreement to acquire MicroNet
Medical, Inc., a privately-held Minnesota corporation. </TD></TR>
<TR>
<TD WIDTH=10%> </TD>
<TD WIDTH=90%>(2) The Company filed a report on Form 8-K on November 26, 2002
reporting the completion of the MicroNet Medical, Inc. acquisition.</TD></TR>
<TR>
<TD WIDTH=10%> </TD>
<TD WIDTH=90%>(3 The Company filed a report on Form 8-K on December 3, 2002
reporting that Anthony J. Varrichio, an executive vice president of the Company,
entered into a "Preset Diversification Program" (PDP), a stock disposition plan
intended to qualify for the safe harbor offered by Rule 10b5-1 under the
Securities Exchange Act of 1934, as amended.</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 WIDTH=10% ALIGN=RIGHT VALIGN=TOP>2.2 </TD>
<TD WIDTH=5%> </TD>
<TD WIDTH=85%>Agreement and Plan of Merger, dated as of November 4, 2002, by and
amoung Advanced Neuromodulaiton Systems, Inc., MicroNet Acquisition, Inc. and
MicroNet Medical, Inc. (14)</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>4.2 </TD>
<TD></TD>
<TD>Amendment To Rights Agreement dated as of January 25, 2002 between Advanced
Neuromodulation Systems, Inc. and Computershare Investor Services LLC (formerly
KeyCorp Shareholder Services, Inc) (12)</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 36</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>10.6 </TD>
<TD></TD>
<TD>Quest Medical, Inc. 1995 Stock Option Plan (4)</TD></TR>
<TR>
<TD ALIGN=RIGHT VALIGN=TOP>10.7 </TD>
<TD></TD>
<TD>Form of 1995 Employee Stock Option Plan(4)</TD></TR>
<TR>
<TD ALIGN=RIGHT VALIGN=TOP>10.8 </TD>
<TD></TD>
<TD>Quest Medical, Inc. 1998 Stock Option Plan (7)</TD></TR>
<TR>
<TD ALIGN=RIGHT VALIGN=TOP>10.9 </TD>
<TD></TD>
<TD>Advanced Neuromodulation Systems, Inc. 2000 Stock Option Plan(9)</TD></TR>
<TR>
<TD ALIGN=RIGHT VALIGN=TOP>10.10</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>10.11</TD>
<TD></TD>
<TD>Employment Agreement dated April 9, 1998 between F. Robert Merrill and Quest
Medical, Inc.(6)</TD></TR>
<TR>
<TD ALIGN=RIGHT VALIGN=TOP>10.12</TD>
<TD></TD>
<TD>Employment Agreement dated April 1, 2002 between Christopher G. Chavez and
Advanced Neuromodulation Systems, Inc.(13)</TD></TR>
<TR>
<TD ALIGN=RIGHT VALIGN=TOP>10.13</TD>
<TD></TD>
<TD>Employment Agreement dated April 1, 2002 between Kenneth G. Hawari and
Advanced Neuromodulation Systems, Inc.(13)</TD></TR>
<TR>
<TD ALIGN=RIGHT VALIGN=TOP>10.14</TD>
<TD></TD>
<TD>Special Termination Agreement dated April 1, 2002 between Christopher G.
Chavez and Advanced Neuromodulation Systems, Inc.(13)</TD></TR>
<TR>
<TD ALIGN=RIGHT VALIGN=TOP>10.15</TD>
<TD></TD>
<TD>Special Termination Agreement dated April 1, 2002 between Kenneth G.
Hawari and Advanced Neuromodulation Systems, Inc.(13)</TD></TR>
<TR>
<TD ALIGN=RIGHT VALIGN=TOP>10.16</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>10.17</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>10.18</TD>
<TD></TD>
<TD>Second Amendment to Lease Agreement dated as of September 1, 2002, between
Advanced Neuromodulation Systems, Inc. and Plano R&D Associates, LTD. (15)
</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(15)</TD></TR>
<TR>
<TD ALIGN=RIGHT VALIGN=TOP>99.1 </TD>
<TD></TD>
<TD>Certification of the Chief Executive Officer(15)</TD></TR>
<TR>
<TD ALIGN=RIGHT VALIGN=TOP>99.1 </TD>
<TD></TD>
<TD>Certification of the Chief Financial Officer(15)</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 as an Exhibit to the report of the Company on Form 10-Q for the
quarter ended March 31, 2002, and incorporated herein by reference.
</TD></TR>
<TR>
<TD>(14)</TD>
<TD></TD>
<TD>Filed as an Exhibit to the report of the Company on Form 8-K dated November
26, 2002, and incorporated herein by reference.
</TD></TR>
<TR>
<TD>(15)</TD>
<TD></TD>
<TD>Filed herewith.</TD></TR></TABLE>
<P ALIGN=CENTER>Page 37 </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, 2003</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, 2003</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, 2003</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, 2003</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, 2003</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, 2003</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, 2003</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, 2003</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, 2003</TD></TR>
</TABLE>
<P ALIGN=CENTER>Page 38</P><HR>
<HR>
<PAGE>
<P ALIGN=CENTER><U>§302 Certification of Chief Executive Officer</U></P>
<P>I, Christopher G. Chavez, certify that:</P>
<P>1. I have reviewed this annual report on Form 10-K of Advanced
Neuromodulation Systems, Inc.;</P>
<P>2. Based on my knowledge, this annual report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this annual
report;</P>
<P>3. Based on my knowledge, the financial statements, and other financial
information included in this annual report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this annual report;</P>
<P>4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:</P>
<P>a) designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated subsidiaries,
is made known to us by others within those entities, particularly during the
period in which this annual report is being prepared;</P>
<P>b) evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
annual report (the "Evaluation Date"); and</P>
<P>c) presented in this annual report our conclusions about the
effectiveness of the disclosure controls and procedures based on our evaluation
as of the Evaluation Date;</P>
<P>5. The registrant's other certifying officers and I have disclosed, based on
our most recent evaluation, to the registrant's auditors and the audit committee
of registrant's board of directors (or persons performing the equivalent
function):</P>
<P>a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to record,
process, summarize and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and</P>
<P>b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal controls; and
</P>
<P>6. The registrant's other certifying officers and I have indicated in this
annual report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.</P>
<TABLE WIDTH=100% CELLSPACING=0 CELLPADDING=0>
<TR>
<TD WIDTH=40%></TD>
<TD WIDTH=60%> </TD></TR>
<TR>
<TD> </TD><TD></TD></TR>
<TR>
<TD> </TD><TD></TD></TR>
<TR>
<TD>Date: March 28, 2003</TD>
<TD><U>/s/ Christopher G. Chavez</U></TD></TR>
<TR>
<TD></TD><TD>Name: Christopher G. Chavez<BR>
Title: Chief Executive Officer</TD></TR></TABLE>
<HR>
<PAGE>
<P ALIGN=CENTER><U>§302 Certification of Chief Executive Officer</U></P>
<P>I, F. Robert Merrill III, certify that:</P>
<P>1. I have reviewed this annual report on Form 10-K of Advanced
Neuromodulation Systems, Inc.;</P>
<P>2. Based on my knowledge, this annual report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this annual
report;</P>
<P>3. Based on my knowledge, the financial statements, and other financial
information included in this annual report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this annual report;</P>
<P>4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:</P>
<P>a) designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated subsidiaries,
is made known to us by others within those entities, particularly during the
period in which this annual report is being prepared;</P>
<P>b) evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
annual report (the "Evaluation Date"); and</P>
<P>c) presented in this annual report our conclusions about the
effectiveness of the disclosure controls and procedures based on our evaluation
as of the Evaluation Date;</P>
<P>5. The registrant's other certifying officers and I have disclosed, based on
our most recent evaluation, to the registrant's auditors and the audit committee
of registrant's board of directors (or persons performing the equivalent
function):</P>
<P>a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to record,
process, summarize and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and</P>
<P>b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal controls; and
</P>
<P>6. The registrant's other certifying officers and I have indicated in this
annual report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.</P>
<TABLE WIDTH=100% CELLSPACING=0 CELLPADDING=0>
<TR>
<TD WIDTH=40%></TD>
<TD WIDTH=60%> </TD></TR>
<TR>
<TD> </TD><TD></TD></TR>
<TR>
<TD> </TD><TD></TD></TR>
<TR>
<TD>Date: March 28, 2003</TD>
<TD><U>/s/ F. Robert Merrill III</U></TD></TR>
<TR>
<TD></TD><TD>Name: F. Robert Merrill III<BR>
Title: Chief Financial Officer</TD></TR></TABLE>
<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, 2002<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>Report of Ernst & Young LLP, Independent Auditors</B></P>
<P></P><P></P>
<P><B>Consolidated Financial Statements:</B></P>
<P>Consolidated Balance Sheets - December 31, 2002 and 2001<BR>Consolidated
Statements of Income - Years ended December 31, 2002, 2001 and 2000<BR>
Consolidated Statements of Cash Flows - Years ended December
31, 2002, 2001 and 2000<BR>Consolidated Statements of Stockholders' Equity -
Years ended December 31, 2002, 2001 and 2000<BR> <BR> Notes to Consolidated
Financial Statements</P>
<HR>
<PAGE>
<P ALIGN=CENTER><B>Report of Ernst & Young LLP, Independent Auditors</B></P>
<P>The Board of Directors</P>
<P>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,
2002 and 2001, and the related consolidated statements of income, stockholders'
equity and cash flows for each of the three years in the period ended December
31, 2002. Our audits also included the financial statement schedule listed in
the Index at Item 15(a). These consolidated financial statements and schedule
are the responsibility of the Company's management. Our responsibility is to
express an opinion on these financial statements and schedule based on our
audits.</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, 2002 and 2001,
and the consolidated results of their operations and their cash flows for each
of the three years in the period ended December 31, 2002, 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>As discussed in Note 2 to the consolidated financial statements, in 2002 the
Company, as required by the recently issued standard for accounting for goodwill
and other intangible assets, changed its method of accounting for goodwill and
other intangible assets.</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>March 27, 2003</P>
<HR>
<PAGE>
<P ALIGN=CENTER><B>Advanced Neuromodulation Systems, Inc. and Subsidiaries<BR>
Consolidated Balance Sheets<BR>December 31, 2002 and 2001</B></P>
<PRE>
2002 2001
------------- ------------
Current assets:
Cash and cash equivalents $ 10,972,974 $ 9,785,325
Marketable securities 85,796,944 2,151,722
Receivables:
Trade accounts, less allowance
for doubtful accounts of $295,391
in 2002 and $124,111 in 2001 10,847,237 6,493,772
Interest and other 189,017 235,594
------------- ------------
Total receivables 11,036,254 6,729,366
------------- ------------
Inventories:
Raw materials 7,141,338 4,685,586
Work-in-process 2,364,386 1,723,419
Finished goods 4,217,222 3,339,840
------------- ------------
Total inventories 13,722,946 9,748,845
------------- ------------
Deferred income taxes 1,122,617 1,726,517
Refundable income taxes -- 678,341
Prepaid expenses and other current
assets 1,032,883 685,169
------------- ------------
Total current assets 123,684,618 31,505,285
------------- ------------
Property, equipment and fixtures:
Land 3,191,427 --
Furniture and fixtures 4,022,901 3,400,909
Machinery and equipment 10,343,953 8,550,504
Leasehold improvements 1,702,965 1,610,810
------------- ------------
19,261,246 13,562,223
Less accumulated depreciation and
amortization 8,653,255 6,353,920
------------- ------------
Net property, equipment and fixtures 10,607,991 7,208,303
------------- ------------
Cost in excess of net assets acquired, net 7,407,237 7,407,237
Patents and licenses, net of accumulated
amortization of $1,435,835 in 2002
and $1,045,106 in 2001 5,323,417 5,368,213
Purchased technology from acquisitions,
net of accumulated amortization of
$2,098,200 in 2002 and $1,800,000 in 2001 9,033,472 2,200,000
Tradenames, net of accumulated amortization
of $969,952 in 2002 and $843,736 in 2001 1,701,154 1,656,264
Other assets, net of accumulated
amortization of $529,102 in 2002
and $392,033 in 2001 586,238 519,783
------------- ------------
$158,344,127 $55,865,085
============= ============
See accompanying notes to consolidated financial statements.
</PRE>
<HR>
<PAGE>
<P ALIGN=CENTER><B>Advanced Neuromodulation Systems, Inc. and Subsidiaries<BR>
Consolidated Balance Sheets (continued)<BR>December 31, 2002 and 2001</B></P>
<PRE>
Liabilities and Stockholders' 2002 2001
------------- ------------
Current liabilities:
Accounts payable $ 2,392,579 $ 1,835,037
Accrued salary and employee benefit
costs 3,077,603 1,826,423
Accrued tax abatement liability 969,204 969,204
Accrued commissions 794,521 285,704
Income taxes payable 822,228 --
Deferred revenue 646,577 1,042,690
Warranty reserve 402,259 383,477
Other accrued expenses 299,905 204,151
Current maturities of long-term note
payable -- 52,325
------------- ------------
Total current liabilities 9,404,876 6,599,011
------------- ------------
Deferred income taxes 3,731,939 2,316,796
Long-term note payable -- 137,397
Non-current deferred revenue 162,504 --
Commitments and contingencies
Stockholders' equity:
Common stock, $.05 par value
Authorized -25,000,000 shares;
Issued - 12,350,676 shares
in 2002 and 9,071,868 in 2001 617,534 453,593
Additional capital 130,047,411 38,670,248
Retained earnings 14,393,748 7,709,290
Accumulated other comprehensive income
(loss), net of tax benefit of $7,155
in 2002 and $10,949 in 2001 (13,885) (21,250)
------------- -----------------
Total stockholders' equity 145,044,808 46,811,881
------------- -----------------
$158,344,127 $55,865,085
============= =================
See accompanying notes to consolidated financial statements.
</PRE>
<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>
2002 2001 2000
------------- ------------ ------------
Net revenue $ 57,372,013 $37,916,435 $ 31,826,998
Cost of revenue 20,658,798 15,675,436 14,699,633
------------- ------------ ------------
Gross profit 36,713,215 22,240,999 17,127,365
------------- ------------ ------------
Operating expenses:
Sales and marketing 14,931,826 9,055,932 6,851,022
Research and development 5,842,576 4,928,432 3,854,084
General and administrative 5,738,392 3,957,867 4,243,720
Amortization of other intangibles 952,214 933,257 676,508
Amortization of goodwill -- 556,604 556,604
------------- ------------ ------------
27,465,008 19,432,092 16,181,938
------------- ------------ ------------
Income from operations 9,248,207 2,808,907 945,427
Other income (expense):
Acquisition related costs -- (483,766) --
Interest expense (10,759) (24,346) (59,015)
Investment and other income, net 933,668 482,417 604,570
------------- ------------ ------------
922,909 (25,695) 545,555
------------- ------------ ------------
Income before income taxes 10,171,116 2,783,212 1,490,982
Income taxes 3,486,658 1,265,466 658,524
------------- ------------ ------------
Net income $ 6,684,458 $ 1,517,746 832,458
============= ============ ============
Net income per share:
============= ============ ============
Basic $ .61 $ .17 .10
============= ============ ============
Diluted $ .56 $ .15 .09
============= ============ ============
See accompanying notes to consolidated financial statements.
</PRE>
<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>
2002 2001 2000
-------------- ------------ ------------
Cash flows from operating activities:
Net income $ 6,684,458 $ 1,517,746 $ 832,458
Adjustments to reconcile net income to net
cash provided by operating activities:
Depreciation 2,299,335 1,932,452 1,636,857
Amortization 952,214 1,489,861 1,233,112
Deferred income taxes 645,134 (455,003) (330,804)
Non-operating loss (gain) included in net
income 8,666 -- (33,509)
Increase in inventory reserve 51,403 107,880 111,144
Changes in operating assets and
liabilities:
Receivables (4,306,888) (1,027,050) (486,949)
Inventories (4,025,504) (2,672,605) 270,190
Refundable income taxes 678,341 (318,388) (359,953)
Prepaid expenses and other current
assets (387,323) 564,866 144,880
Customer deposits (680,756) (706,916) (1,071,372)
Income taxes payable 822,228 (89,380) (521,510)
Tax benefit from stock option
exercises 1,847,438 1,669,405 604,358
Accounts payable 557,542 493,227 (1,348,526)
Accrued expenses 1,874,533 553,380 9,892
Deferred revenue 447,147 -- --
------------- ------------ ------------
Total adjustments 783,510 1,541,729 (142,190)
------------- ------------ ------------
Net cash provided by operating
activities 7,467,968 3,059,475 690,268
------------- ------------ ------------
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 (188,390,536) (3,896,199) (808,760)
Net proceeds from sales of marketable
securities 104,747,808 2,876,720 564,194
Purchase of land (3,191,427) -- --
Additions to equipment, fixtures and
patent licenses (2,942,227) (3,108,055) (1,653,194)
Acquisition of MicroNet (1,359,460) -- --
Net proceeds from sale of assets -- -- 600
------------- ------------ ------------
Net cash used in investing
activities (91,135,842) (3,087,534) (2,937,160)
------------- ------------ ------------
Cash flows from financing activities:
Payment of long-term notes (189,722) (47,807) (28,718)
Proceeds from long-term note payable -- -- 270,000
Net proceeds from public offering of
common stock 83,175,353 -- --
Net proceeds from private placement of
common stock -- -- 400,000
Exercise of stock options and warrants 1,869,892 1,004,914 1,929,450
------------- ------------ ------------
Net cash provided by financing
activities 84,855,523 957,107 2,570,732
------------- ------------ ------------
Net increase in cash and cash equivalents 1,187,649 929,048 323,840
Net cash used by Hi-tronics in December 2000
(see Note 3) -- (672,444) --
Cash and cash equivalents at beginning of year 9,785,325 9,528,721 9,204,881
------------- ------------ ------------
Cash and cash equivalents at end of year $ 10,972,974 $ 9,785,325 $ 9,528,721
============= ============ ============
Supplemental cash flow information is
presented below:
Income taxes paid (refund) $ (415,311) $ 815,000 $ 1,138,685
============= ============ ============
Interest paid $ 10,759 $ 24,346 $ 59,015
============= ============ ============
Non-cash activity:
Stock issued for patents and intangible assets $ 4,648,421 $ 2,426,662 $ --
============= ============ ============
See accompanying notes to consolidated financial statements.
</PRE>
<HR>
<PAGE>
<P ALIGN=CENTER><B>Advanced Neuromodulation Systems, Inc. and Subsidiaries<BR>
Consolidated Statements of Stockholders' Equity<BR>
Three Years Ended December 31, 2002</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, 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 losses
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
Net income -- -- -- 6,684,458 -- -- 6,684,458
Adjustment to
unrealized losses
on marketable
securities -- -- -- -- 7,365 -- 7,365
-------------
Comprehensive income 6,691,823
-------------
Sale of newly issued
common stock in a
public offering, net
of offering costs 2,875,000 143,750 83,031,603 -- -- -- 83,175,353
Issuance of shares for
stock option
exercises 247,506 12,376 1,857,516 -- -- -- 1,869,892
Issuance of 156,302
shares for
acquisition 156,302 7,815 4,640,606 -- -- -- 4,648,421
Tax benefit from stock
option exercises -- -- 1,847,438 -- -- -- 1,847,438
------------- ------------- ------------- ------------- ------------- ------------- -------------
Balance at
December 31, 2002 12,350,676 $ 617,534 $ 130,047,411 $ 14,393,748 $ (13,885) $ -- $ 145,044,808
============= ============= ============= ============= ============= ============= =============
See accompanying notes to consolidated financial statements.
</PRE>
<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 November 26, 2002, the Company acquired MicroNet Medical, Inc., a
privately-held developer of medical devices based on proprietary micro-lead
technology based in St. Paul, Minnesota. See Note 3.</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>
<HR>
<PAGE>
<P ALIGN=CENTER><B>Advanced Neuromodulation Systems, Inc. and Subsidiaries<BR>
Notes to Consolidated Financial Statements (continued)</B></P>
<P><B>Reclassification</B></P>
<P>Certain amounts in the prior years financial statements have been
reclassified to conform to the Company's 2002 presentation.</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><B>Revenue Recognition</B></P>
<P>The Company generates revenues from product sales to end customers, product
sales to distributors, and development contracts. The Company recognizes revenue
from neuro product sales when the goods are shipped to its customers or
distributors, provided an arrangement exists, the fee is fixed and determinable,
and collectibility is reasonably assured. Certain of the Company's customers are
third-party payors who reimburse fixed amounts for services based on a specific
diagnosis. Revenue is recognized on these third-party payor sales based on the
sales price less a contractual adjustment, which is based on the Company's
history of reimbursement with the third-party payor, provided all other revenue
recognition criteria are met. The Company records, as a reduction in revenue a
provision for estimated sales returns and adjustments on these product sales in
the same period as the related revenue is recorded. These estimates are based on
historical sales returns, analysis of credit memo data, and other known factors.
Payments received in advance of revenue recognition requirements are recorded as
deferred revenue on the consolidated balance sheet. The Company recognizes
revenue from custom manufactured products at HDI when the goods are shipped to
the customer. HDI also develops products for certain customers under fixed price
research and development contracts. The Company recognizes revenue and profit
under the development agreements using the percentage-of-completion method,
which relies on estimates of total expected revenue and costs. The Company
follows this method since reasonably dependable estimates of revenue and costs
applicable to various stages of a development agreement can be made. If the
Company does not accurately estimate the resources required or the scope of work
to be performed under a development agreement, then future profit margins and
results of operations may be negatively impacted. In certain cases, HDI will
undertake a development project on a cost plus basis. In these cases, the
Company invoices and recognizes revenue for actual time and material expended on
the project at contractual hourly billing rates and markups.</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>Accounts Receivable</B></P>
<P>The Company estimates the collectibility of its trade receivables. A
considerable amount of judgment is required in assessing the ultimate
realization of the receivables, including the current credit-worthiness of each
customer. The Company's historical bad debt experience has been within
management's expectations.</P>
<HR>
<PAGE>
<P ALIGN=CENTER><B>Advanced Neuromodulation Systems, Inc. and Subsidiaries<BR>
Notes to Consolidated Financial Statements (continued)</B></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. The Company reserves for excess and obsolete
inventory based upon forecasted demand for its products.</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>the lesser of 3 to 5 years or the term of the lease
</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>Goodwill represents the excess of the purchase price over the fair value of
net assets of acquired businesses. Effective January 1, 2002 the Company adopted
Statement of Financial Accounting Standards No. 142 ("SFAS 142"), "Goodwill and
other Intangible Assets". Under the provision of SFAS 142, goodwill and
intangible assets deemed to have indefinite lives are no longer amortized but
are subject to annual impairment tests in accordance with the statement.</P>
<P>The Company's initial review for impairment of goodwill and other intangible
assets performed during 2002 indicated no impairment of these assets as of
January 1, 2002. During the first quarter of 2003, the Company performed its
annual review for impairment of goodwill and other intangible assets as of
December 31, 2002 and, based on this review, no impairment was recorded. The
Company must make assumptions regarding estimated future cash flows and other
factors to determine the fair value of the respective assets in assessing the
recoverability of its goodwill and other intangibles. If these estimates or the
related assumptions change, the Company may be required to record impairment
charges for these assets in the future.</P>
<HR>
<PAGE>
<P ALIGN=CENTER><B>Advanced Neuromodulation Systems, Inc. and Subsidiaries<BR>
Notes to Consolidated Financial Statements (continued)</B></P>
<P>Prior to the adoption of SFAS 142, amortization expense was recorded for
goodwill and other intangibles with indefinite lives. The following table sets
forth a reconciliation of net earnings and net earnings per share information
for the three years ended December 31, 2002 as though SFAS 142 had been in
effect at the beginning of fiscal 2000:</P>
<PRE>
Year Ended December 31,
-----------------------------------
2002 2001 2000
----------- ----------- -----------
Reported net income $ 6,684,458 $ 1,517,746 $ 832,458
Goodwill amortization --- 556,604 556,604
----------- ----------- -----------
Adjusted net income $ 6,684,458 $ 2,074,350 $ 1,389,062
=========== =========== ===========
Basic net income per share:
Reported $ .61 $ .17 $ .10
Goodwill amortization --- .06 .06
----------- ----------- -----------
Adjusted $ .61 $ .23 $ .16
=========== =========== ===========
Diluted net income per share:
Reported $ .56 $ .15 $ .09
Goodwill amortization --- .06 .06
----------- ----------- -----------
Adjusted $ .56 $ .21 $ .15
=========== =========== ===========
</PRE>
<P>In October 2001, the FASB issued SFAS No. 144, "Accounting for Impairment or
Disposal of Long-Lived Assets". This Statement addresses financial accounting
and reporting for the impairment of long-lived assets, including definite-lived
intangible assets, and the disposal of long-lived assets and discontinued
operations. The Company adopted SFAS No. 144, which supersedes SFAS No. 121, on
January 1, 2002.</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 (15-20 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>The Company assesses the recoverability of its definite-lived intangible
assets primarily based on its current and anticipated future undiscounted cash
flows. At December 31, 2002, the Company does not believe there has been any
impairment of its intangible assets.</P>
<P>The Company expects to record annual amortization expense of approximately
$1,269,792 in 2003, $1,232,324 in 2004, $1,201,936 in 2005, $1,198,948 in 2006
and $1,198,052 in 2007 related to its intangible assets as of December 31, 2002.
</P>
<HR>
<PAGE>
<P ALIGN=CENTER><B>Advanced Neuromodulation Systems, Inc. and Subsidiaries<BR>
Notes to Consolidated Financial Statements (continued)</B></P>
<P><B>Warranty Obligations</B></P>
<P>The Company's products are generally covered by a one-year warranty. The
Company accrues a warranty reserve for estimated costs to provide warranty
services. The estimated costs to service the Company's warranty obligations are
based on historical experience and expectation of future conditions.</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
$74,673, $20,592 and $24,716 at December 31, 2002, 2001 and 2000, 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>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>Stock compensation issued to non-employees is measured at fair value over the
service period and recorded as compensation expense in the Statement of Income.
<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. 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 2002, 2001 and 2000
are based upon 10,900,040, 8,926,985, and 8,507,048 shares, respectively.
Diluted earnings per share for 2002, 2001 and 2000 are based upon 11,891,637,
9,917,007, and 9,398,934 shares, respectively. The following table presents the
reconciliation of basic and diluted shares:</P>
<PRE>
2002 2001 2000
---------- --------- ---------
Weighted-average shares outstanding
(basic shares) 10,900,040 8,926,985 8,507,048
Effect of dilutive instruments(1)
Stock options 991,597 990,022 847,349
Warrants --- --- 44,537
---------- --------- ---------
Dilutive potential common shares 991,597 990,022 891,886
---------- --------- ---------
Diluted shares 11,891,637 9,917,007 9,398,934
========== ========= =========
(1) See Note 7 for a description of these instruments.
</PRE>
<HR>
<PAGE>
<P ALIGN=CENTER><B>Advanced Neuromodulation Systems, Inc. and Subsidiaries<BR>
Notes to Consolidated Financial Statements (continued)</B></P>
<P>For 2002, 2001 and 2000 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 and options to purchase 12,975 shares at an average price of $15.38 per
share were outstanding in 2000 but were not included in the computation of
diluted earnings per share because the options' exercise prices were greater
than the average market price of the common shares and, therefore, the effect
would be antidilutive. In 2002, all options were included in the computation of
diluted earnings per share.</P>
<P>Following is the Company's computation of basic and diluted income per share
for the years ended December 31:</P>
<PRE>
2002 2001 2000
----------- ---------- ----------
Basic income per share:
Weighted average common
Shares outstanding 10,900,040 8,926,985 8,507,048
----------- ---------- ----------
----------- ---------- ----------
Net income $ 6,684,458 $1,517,746 $ 832,458
----------- ---------- ----------
Net income per share $ 0.61 $ 0.17 $ 0.10
----------- ---------- ----------
Diluted income per share:
Weighted average common
shares outstanding 10,900,040 8,926,985 8,507,048
Stock options and warrants - based
on the treasury stock method
using average market price 991,597 990,022 891,886
----------- ---------- ----------
Diluted common and common equivalent
shares outstanding 11,891,637 9,917,007 9,398,934
----------- ---------- ----------
----------- ---------- ----------
Net income $ 6,684,458 $1,517,746 $ 832,458
----------- ---------- ----------
Net income per share $ 0.56 $ 0.15 $ 0.09
----------- ---------- ----------
</PRE>
<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>
<HR>
<PAGE>
<P ALIGN=CENTER><B>Advanced Neuromodulation Systems, Inc. and Subsidiaries<BR>
Notes to Consolidated Financial Statements (continued)</B></P>
<P><B>New Accounting Standards</B></P>
<P>In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based
Compensation-Transition and Disclosure-an Amendment of FASB Statement No. 123."
This standard amends SFAS No. 123, "Accounting for Stock-Based Compensation" to
provide alternative methods of transition for a voluntary change to the fair
value based method of accounting for stock-based employee compensation and
amends the disclosure requirements of SFAS No. 123 to require prominent
disclosures in both annual and interim financial statements about the method of
accounting for stock-based employee compensation and the effect of the method
used on reported results. This statement is effective for financial statements
with fiscal years ending after December 15, 2002 and is effective for financial
reports containing condensed financial statements for interim periods beginning
after December 15, 2002 with earlier application permitted.</P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR>
<TD WIDTH=5%><B>(3)</B></TD>
<TD WIDTH=95%><B>Acquisitions</B></TD></TR>
</TABLE>
<P>On November 26, 2002, the Company completed the acquisition of MicroNet
Medical, Inc., a privately-held developer of medical devices based on
proprietary micro-lead technology based in St. Paul Minnesota. Under the terms
of the transaction, which was structured as a merger, the Company acquired only
MicroNet's proprietary technology and certain associated tangible assets. At
closing, the Company paid the former MicroNet shareholders $500,000 in cash and
156,302 shares of ANS common stock valued at $4,648,421. The Company also paid
acquisition related costs of $859,460. The allocation of the purchase price as
of December 31, 2002 is as follows: purchased technology $5,761,558, tradenames
$138,181 and non-compete agreements $108,142. In addition to the initial
purchase price paid at closing, if certain product, regulatory and sales
milestones are met, ANS could pay an additional number of shares of common stock
with an aggregate value of up to $9,000,000. All milestones must be met within
the next four to five years, depending on the milestone.</P>
<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 (O.E.M.) of electro-mechanical devices with headquarters in Budd
Lake, New Jersey. The Company acquired all of HDI's outstanding stock through a
merger in exchange for 1,104,725 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>
<HR>
<PAGE>
<P ALIGN=CENTER><B>Advanced Neuromodulation Systems, Inc. and Subsidiaries<BR>
Notes to Consolidated Financial Statements (continued)</B></P>
<PRE>
Net revenue $ 119,481
Loss before income tax benefit (591,600)
Net loss (347,679)
For the one-month period ended December 31, 2000, cash flows for HDI were as follows:
Net cash used by operating activities $(647,210)
Net cash used by investing activities (14,516)
Net cash used by financing activities (10,718)
Net decrease in cash $(672,444)
</PRE>
<P>The following is a reconciliation of previously reported amounts with
restated amounts for total net revenue and net income:</P>
<PRE>
2000
------------
Total net revenue:
As previously reported by the Company $23,081,624
HDI, for the year ended November 30 10,366,270
Elimination of intercompany transactions (1,620,896)
------------
As restated $31,826,998
============
2000
------------
Net income:
As previously reported by the Company $ 953,644
HDI, for the year ended November 30 28,833
Elimination of intercompany transactions (150,019)
------------
As restated $ 832,458
============
</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 repaid in its entirety during June 2002.</P>
<HR>
<PAGE>
<P ALIGN=CENTER><B>Advanced Neuromodulation Systems, Inc. and Subsidiaries<BR>
Notes to Consolidated Financial Statements (continued)</B></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,
2002:</P>
<PRE>
Gross Gross
Unrealized Unrealized Estimated
Cost Gains Losses Fair Value
----------- ---------- ---------- -----------
Freddie Mac and Federal Home Loan
Bank notes $ 770,814 $ -- $ 15,474 $ 755,340
Investment grade municipal bonds
2,222,170 5,349 10,915 2,216,604
7-day and 35-day AAA municipal bond
floaters 82,825,000 -- -- 82,825,000
----------- ---------- ---------- -----------
$85,817,984 $ 5,349 $ 26,389 $85,796,944
=========== ========== ========== ===========
</PRE>
<P>Estimated fair value for the investment grade municipal bonds, 7-day and
35-day municipal bond floaters and Freddie Mac and Federal Home Loan Bank notes
is provided by the brokerage firms holding such bonds and notes at each
reporting period by utilizing a standard pricing service.</P>
<P>At December 31, 2002, no individual security represented more than 6.5% of
the total portfolio or 3.5% of total assets. The Company did not have any
investments in derivative financial instruments at December 31, 2002.</P>
<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>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>
<HR>
<PAGE>
<P ALIGN=CENTER><B>Advanced Neuromodulation Systems, Inc. and Subsidiaries<BR>
Notes to Consolidated Financial Statements (continued)</B></P>
<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>
2002 2001
------------ ------------
Deferred tax assets:
Net operating loss carry forwards $ 1,181,086 $ 670,128
Accrued expenses and reserves 1,051,871 870,720
Marketable securities 8,303 10,949
Other 141,809 141,569
------------ ------------
Total deferred tax assets 2,383,069 1,693,366
------------ ------------
Deferred tax liabilities:
Purchased intangible assets (4,464,083) (1,388,255)
Equipment and fixtures (528,308) (895,390)
------------ ------------
Total deferred tax liabilities (4,992,391) (2,283,645)
------------ ------------
Net deferred tax liabilities $ (2,609,322) $ (590,279)
============ =============
</PRE>
<P>As of December 31, 2002, the Company had a net operating loss carry forward
of approximately $3.4 million which expires in years through 2021. This net
operating loss carry forward was acquired by the Company in connection with the
MicroNet Medical acquisition and its utilization in any future year may be
subject to a limitation under Section 382 of the Internal Revenue Code or other
provisions which may limit the use of the net operating loss carry forward in
any tax year.</P>
<P>The provision (benefit) for income taxes for the years ended December 31
consists of the following:</P>
<PRE>
2002 2001 2000
----------- ----------- ----------
Current $ 2,841,524 $ 1,747,285 $ 841,390
Deferred 645,134 (481,819) (182,866)
----------- ----------- ----------
$ 3,486,658 $ 1,265,466 $ 658,524
=========== =========== ===========
</PRE>
<P>A reconciliation of the provision for income taxes to the expense calculated
at the U.S. statutory rate follows:</P>
<PRE>
2002 2001 2000
----------- ----------- ----------
Income tax expense at statutory rate $ 3,458,179 $ 946,292 $ 506,934
Tax effect of:
State taxes 275,481 42,959 4,581
Nondeductible amortization of goodwill -- 189,245 189,279
Tax-exempt interest (291,745) -- --
Other 44,743 86,970 (42,270)
----------- ----------- ----------
Income tax expense $ 3,486,658 $ 1,265,466 $ 658,524
=========== =========== ===========
</PRE>
<HR>
<PAGE>
<P ALIGN=CENTER><B>Advanced Neuromodulation Systems, Inc. and Subsidiaries<BR>
Notes to Consolidated Financial Statements (continued)</B></P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR>
<TD WIDTH=5%><B>(7)</B></TD>
<TD WIDTH=95%><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, 2001 in connection with the acquisition of assets.
See Note 3.</P>
<P>The Company issued 2,875,000 shares of common stock during May 2002 in an
underwritten public offering. The Company received net proceeds from the
offering of approximately $83.2 million.</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). At December 31, 2002, the 2000 Plan had a total number of shares
reserved of 613,638. On January 1, 2003, options to purchase 221,769 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, 2002, under all of the Company's stock option plans,
2,026,419 shares had been granted and were outstanding, 2,482,503 shares of
common stock had been issued upon exercise, and 33,142 shares were reserved for
future grants.</P>
<HR>
<PAGE>
<P ALIGN=CENTER><B>Advanced Neuromodulation Systems, Inc. and Subsidiaries<BR>
Notes to Consolidated Financial Statements (continued)</B></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, 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
----------------- ------------ -------------- ------------ --------------
January 1, 2002 1,669,175 $ 9.44 750,215 $ 6.61
Granted 617,000 $ 27.54
Exercised (247,506) $ 7.31
Forfeited (12,250) $ 17.19
----------------- ------------ -------------- ------------ --------------
December 31, 2002 2,026,419 $ 15.17 869,738 $ 8.65
-------------------------------- ============== ============ ==============
Exercisable Options
Options Outstanding at December 31, 2002 at December 31, 2002
- -------------------------------------------------------- ------------------------
Weighted
Average Weighted Weighted
Range of Remaining Average Average
Exercise Price Shares Life (Years) Exercise Price Shares Exercise Price
- -------------- --------- ------------ -------------- -------- --------------
$ 5.00-7.49 623,684 5.57 $ 5.54 561,184 $ 5.42
$ 7.50-10.49 79,706 6.28 $ 8.80 39,691 $ 8.59
$10.50-13.99 338,047 7.53 $ 11.12 92,497 $ 11.58
$14.00-17.49 263,107 7.06 $ 14.50 119,241 $ 14.50
$17.50-21.00 106,875 8.30 $ 19.36 31,625 $ 19.37
$21.01-30.00 615,000 8.92 $ 27.54 25,500 $ 28.46
- -------------- --------- ------------ -------------- -------- --------------
2,026,419 7.28 $ 15.17 869,738 $ 8.65
========= ============ ============== ======== ==============
</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 2002, 2001 and 2000 was
$13.17, $6.24 and $5.76, 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>
2002 2001 2000
---------- -------- ---------
Risk-free interest rate 4.5% 4.4% 5.9%
Average life of options (years) 3.0 3.0 3.0
Volatility 67.6% 74.5% 52.4%
Dividend Yield -- -- --
</PRE>
<HR>
<PAGE>
<P ALIGN=CENTER><B>Advanced Neuromodulation Systems, Inc. and Subsidiaries<BR>
Notes to Consolidated Financial Statements (continued)</B></P>
<P>Had the compensation expense been recorded based on these hypothetical
values, pro forma net income (loss) for 2002, 2001 and 2000 would have been
$4,576,659, $(95,632) and $(436,109), respectively, and pro forma diluted net
income (loss) per common share for 2002, 2001 and 2000 would have been $.38,
$(.01) and $(.05), respectively.</P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=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, subject to certain
annual adjustments for increases in expenses for common area maintenance and
property taxes. The monthly rental rate was increased to $50,951 in January
2002. In September 2002, the Company amended its lease agreement to add
approximately 9,700 square feet of office space located in the same complex as
its 40,000 square foot corporate headquarters. The lease on the additional space
expires during August 2004, the same as the corporate headquarters facility. The
monthly rental rate on the 9,700 square feet of office space is $11,485. Future
minimum rental payments relating to the leased facilities for the years ended
December 31 are $749,244 in 2003 and $499,496 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 10,348 square feet of office space that is used for administration,
design engineering, drafting, documentation and regulatory affairs. The lease
expires on February 28, 2004 and has a monthly rental rate of $9,615. The
Company also leases 18,582 square feet of space in Hackettstown, New Jersey used
for the O.E.M. manufacturing operations. The Hackettstown lease, which expires
on December 31, 2005, has a monthly rental rate of $9,517 and is renewable for
one additional three-year period. Future minimum rental payments relating to the
leased facilities for HDI for the years ended December 31 are $229,584 in 2003,
$133,434 in 2004 and $114,204 in 2005.</P>
<P>The Company leases transportation equipment under non-cancelable operating
leases with expirations ranging from March 2005 until October 2006. Future
minimum rental payments under non-cancelable transportation leases for the years
ended December 31 are $47,768 in 2003, $47,768 in 2004, $26,496 in 2005 and
$8,481 in 2006.</P>
<P>The Company leases office equipment under non-cancelable operating leases
expiring through 2004. Monthly payments on the office equipment leases are
$2,412. Future minimum rental payments under non-cancelable equipment leases
until the expiration of the leases are $28,938 in 2003 and $4,824 in 2004.</P>
<P>Total rent expense for facilities, transportation and office equipment for
the years ended December 31, 2002, 2001 and 2000 was $1,063,097, $858,761 and
$791,192, 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>
<HR>
<PAGE>
<P ALIGN=CENTER><B>Advanced Neuromodulation Systems, Inc. and Subsidiaries<BR>
Notes to Consolidated Financial Statements (continued)</B></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>
<P>Certain of the Company's distributor sales agreements contain an early
termination provision that permits the Company to terminate the agreement
without cause by paying an early termination fee equal to 25% of the prior
year's sales to the distributor. The termination fee for the Company's two
existing distributors would range from $392,000 to $1,157,000. In addition,
under the Company's sales agreements with its independent sales agents, the
Company can terminate those agreements without cause by paying an early
termination fee equal to 100% of the commissions that would otherwise be payable
on sales in the territory for the 90 days after termination and 50% of the
commission that would otherwise be payable on sales in the territory for the 90
day period after the first 90 day period.</P>
<P>In addition, under its distributor agreements, sales agent agreements and
certain other ordinary course commercial contracts with third parties, the
Company typically agrees to indemnify the other contracting party from damages
and costs that may arise from product liability claims. The terms of the
agreements and contracts vary and the potential exposure under these indemnities
cannot reasonably be estimated or determined. Historically, product liability
claims for our neurostimulation devices have not resulted in significant
monetary liability beyond our insurance coverage. We seek to maintain
appropriate levels of product liability insurance with coverage that we believe
is comparable to that maintained by companies similar in size and serving
similar markets.</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, insurance companies 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, Sun
Medical, Inc., for each of the years ended December 31, as a percentage of net
revenue from the Neuro Products segment, were as follows: 2002- 14%, 2001- 15%
and 2000- 14%. In March 2003, the Company acquired Sun Medical's pain management
business and hired substantially all of that business' salesforce.</P>
<P>Net sales of O.E.M. products and services to two major customers for the year
ended December 31, 2002, as a percentage of net revenue from the HDI O.E.M.
segment were 63% and 26%, respectively. Net sales of 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.</P>
<P>Foreign sales, primarily Europe and Australia, for the years ended December
31, 2002, 2001 and 2000 were approximately 8%, 10% 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, 2002, 2001 and 2000, respectively.</P>
<HR>
<PAGE>
<P ALIGN=CENTER><B>Advanced Neuromodulation Systems, Inc. and Subsidiaries<BR>
Notes to Consolidated Financial Statements (continued)</B></P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=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 $346,125 in 2002, $305,091 in 2001 and $270,987 in 2000.</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, which
would result in the reporting of "other income" in this amount in the
Consolidated Statement of Income.</P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR>
<TD WIDTH=5%><B>(12)</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>
<HR>
<PAGE>
<P ALIGN=CENTER><B>Advanced Neuromodulation Systems, Inc. and Subsidiaries<BR>
Notes to Consolidated Financial Statements (continued)</B></P>
<P>Intersegment revenue from HDI is billed at cost with no intercompany mark-up.
</P>
<P>Segment data as of and for the year ended December 31, 2002 is as follows:
</P>
<PRE>
Neuro HDI Intercompany Consolidated
Products O.E.M. Eliminations Total
------------- ------------- ------------- -------------
Revenue from external
customers $ 46,712,158 $ 10,659,855 $ --- $ 57,372,013
Intersegment revenues $ --- $ 5,663,216 $ (5,663,216) $ ---
Segment income from
operations $ 7,013,895 $ 2,234,312 $ --- $ 9,248,207
Segment assets $ 154,451,136 $ 8,982,629 $ (5,089,638) $ 158,344,127
</PRE>
<P>Segment data as of and 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 as of and for the year ended December 31, 2000 is as follows:</P>
<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>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR>
<TD WIDTH=5%><B>(13)</B></TD>
<TD WIDTH=95%><B>Subsequent Event
</B></TD></TR>
</TABLE>
<P>In January 2003, the Company made a minority investment of $1 million in cash
to purchase common stock in Innovative Spinal Technologies, Inc., a start-up
company that develops spine technologies, products and services through
intellectual property development and contract research.</P>
<P>In March 2003, the Company acquired the assets of the pain management
business of Sun Medical, Inc. for approximately $5.1 million in cash. Sun
Medical was the largest distributor of the Company's Neuro Products and
accounted for $6.33 million, or 13.5% of revenue of the Neuro Products segment
during the twelve months ended December 31, 2002. As part of the acquisition,
the Company hired substantially all of the salespersons who worked for Sun
Medical's pain management business. The assets acquired consisted primarily of
customer lists, non-competes, inventory, contracts, equipment and other
intangible assets but specifically excludes cash and accounts receivable as of
the closing date.</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>
<P ALIGN=CENTER><B>Schedule II - Valuation and Qualifying Accounts<BR>
Advanced Neuromodulation Systems, Inc. and Subsidiaries<BR>December 31, 2002
</B></P>
<PRE>
Balance at Charged to
Beginning Charged to Other Balance at
Description of Year Expenses Accounts Deductions End of Year
- ----------------------------------- ----------- ----------- ----------- ----------- -----------
Year ended December 31, 2002:
Allowance for doubtful accounts $ 124,111 $ 186,336 $ -- $ 15,056 $ 295,391
Reserve for obsolete inventory 293,450 121,528 -- 112,698 302,280
----------- ----------- ----------- ----------- -----------
Total $ 417,561 $ 307,864 $ -- $ 127,754 $ 597,671
=========== =========== =========== =========== ===========
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
=========== =========== =========== =========== ===========
</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>
<PAGE>
<PRE>
2002 1st Qtr. 2nd Qtr. 3rd Qtr. 4th Qtr.
- --------------------------------------------- ------------- ------------- ------------- -------------
Net revenue $ 11,472,646 $ 13,423,371 $ 14,327,505 $ 18,148,491
Gross profit 6,958,486 8,359,944 9,474,096 11,920,689
Income from operations 1,239,225 2,084,679 2,532,874 3,391,429
Income from operations before income taxes 1,308,425 2,227,928 2,905,351 3,729,412
Net income $ 836,976 $ 1,448,441 $ 1,942,303 $ 2,456,738
- --------------------------------------------- ------------- ------------- ------------- -------------
Basic income per share $ 0.09 $ 0.14 $ 0.16 $ 0.20
- --------------------------------------------- ------------- ------------- ------------- -------------
- --------------------------------------------- ------------- ------------- ------------- -------------
Diluted income per share $ 0.08 $ 0.13 $ 0.15 $ 0.19
- --------------------------------------------- ------------- ------------- ------------- -------------
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
- --------------------------------------------- ------------- ------------- ------------- -------------
</PRE>
<HR>
<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 WIDTH=10% ALIGN=RIGHT VALIGN=TOP>2.2 </TD>
<TD WIDTH=5%> </TD>
<TD WIDTH=85%>Agreement and Plan of Merger, dated as of November 4, 2002, by and
amoung Advanced Neuromodulaiton Systems, Inc., MicroNet Acquisition, Inc. and
MicroNet Medical, Inc. (14)</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>4.2 </TD>
<TD></TD>
<TD>Amendment To Rights Agreement dated as of January 25, 2002 between Advanced
Neuromodulation Systems, Inc. and Computershare Investor Services LLC (formerly
KeyCorp Shareholder Services, Inc) (12)</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 36</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>10.6 </TD>
<TD></TD>
<TD>Quest Medical, Inc. 1995 Stock Option Plan (4)</TD></TR>
<TR>
<TD ALIGN=RIGHT VALIGN=TOP>10.7 </TD>
<TD></TD>
<TD>Form of 1995 Employee Stock Option Plan(4)</TD></TR>
<TR>
<TD ALIGN=RIGHT VALIGN=TOP>10.8 </TD>
<TD></TD>
<TD>Quest Medical, Inc. 1998 Stock Option Plan (7)</TD></TR>
<TR>
<TD ALIGN=RIGHT VALIGN=TOP>10.9 </TD>
<TD></TD>
<TD>Advanced Neuromodulation Systems, Inc. 2000 Stock Option Plan(9)</TD></TR>
<TR>
<TD ALIGN=RIGHT VALIGN=TOP>10.10</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>10.11</TD>
<TD></TD>
<TD>Employment Agreement dated April 9, 1998 between F. Robert Merrill and Quest
Medical, Inc.(6)</TD></TR>
<TR>
<TD ALIGN=RIGHT VALIGN=TOP>10.12</TD>
<TD></TD>
<TD>Employment Agreement dated April 1, 2002 between Christopher G. Chavez and
Advanced Neuromodulation Systems, Inc.(13)</TD></TR>
<TR>
<TD ALIGN=RIGHT VALIGN=TOP>10.13</TD>
<TD></TD>
<TD>Employment Agreement dated April 1, 2002 between Kenneth G. Hawari and
Advanced Neuromodulation Systems, Inc.(13)</TD></TR>
<TR>
<TD ALIGN=RIGHT VALIGN=TOP>10.14</TD>
<TD></TD>
<TD>Special Termination Agreement dated April 1, 2002 between Christopher G.
Chavez and Advanced Neuromodulation Systems, Inc.(13)</TD></TR>
<TR>
<TD ALIGN=RIGHT VALIGN=TOP>10.15</TD>
<TD></TD>
<TD>Special Termination Agreement dated April 1, 2002 between Kenneth G.
Hawari and Advanced Neuromodulation Systems, Inc.(13)</TD></TR>
<TR>
<TD ALIGN=RIGHT VALIGN=TOP>10.16</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>10.17</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>10.18</TD>
<TD></TD>
<TD>Second Amendment to Lease Agreement dated as of September 1, 2002, between
Advanced Neuromodulation Systems, Inc. and Plano R&D Associates, LTD. (15)
</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(15)</TD></TR>
<TR>
<TD ALIGN=RIGHT VALIGN=TOP>99.1 </TD>
<TD></TD>
<TD>Certification of the Chief Executive Officer(15)</TD></TR>
<TR>
<TD ALIGN=RIGHT VALIGN=TOP>99.1 </TD>
<TD></TD>
<TD>Certification of the Chief Financial Officer(15)</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 as an Exhibit to the report of the Company on Form 10-Q for the
quarter ended March 31, 2002, and incorporated herein by reference.
</TD></TR>
<TR>
<TD>(14)</TD>
<TD></TD>
<TD>Filed as an Exhibit to the report of the Company on Form 8-K dated November
26, 2002, and incorporated herein by reference.
</TD></TR>
<TR>
<TD>(15)</TD>
<TD></TD>
<TD>Filed herewith.</TD></TR></TABLE>
<P ALIGN=CENTER>Page 37 </P>
<HR>
<PAGE>
<P ALIGN=CENTER><B>EXHIBIT 10.18</B></P>
<HR>
<PAGE>
<P ALIGN=CENTER><B><U>SECOND AMENDMENT TO LEASE AGREEMENT</U></B></P>
<P>THIS SECOND AMENDMENT TO LEASE AGREEMENT ("Second Amendment") is entered into
to be effective as of September 1, 2002, by and between PLANO R&D ASSOCIATES,
LTD., a Texas limited partnership ("Landlord") and ADVANCED NEUROMODULATION
SYSTEMS, INC., a Texas corporation ("Tenant").</P>
<P><U>Recitals</U></P>
<P>A. Legacy Lincoln I, Ltd., Landlord's
predecessor-in-interest, leased to tenant approximately 40,680 square feet of
Net Rentable Area (the "Premises") in Building D located at 6501 Windcrest of
that certain project known as "Lincoln R&D at Legacy: in Plano, Texas
pursuant to a certain Lease Agreement dated February 4, 1999 (the "Original
Lease"). The Original Lease was amended pursuant to a certain First Amendment to
Lease Agreement dated April 21, 1999 (the "First Amendment"), which together
with the Original Lease is hereunder called the "Lease". Unless otherwise
defined in this Second Amendment, the terms used in this Second Amendment shall
have the same meanings as ascribed to such terms in the Lease.</P>
<P>B. Tenant now desires to expand the Premises by
leasing additional space containing 9,672 square feet of net Rentable Area in
Building C of the Project located at 6509 Windcrest ("Expansion Premises"). A
Site Plan depicting the Premises and the Expansion Premises is attached hereto
as Exhibit "A" and made a part hereof for all purposes.</P>
<P>C. Landlord is willing to lease the Expansion
Premises to Tenant, and Tenant is willing to lease and take from Landlord the
Expansion Premises, all upon the terms and conditions set forth in this Second
Amendment.</P>
<P><U>Agreements</U></P>
<P>NOW, THEREFORE, for and in consideration of the foregoing recitals, together
with other good and valuable consideration, the receipt and sufficiency of which
are hereby acknowledged, Landlord and tenant hereby agree as follows:</P>
<P>1. Landlord herby leases to Tenant, and Tenant
hereby leases and takes from Landlord, the Expansion Premises, on the terns and
conditions set forth in the Lease, as amended by the First Amendment and the
Second Amendment. Upon execution of this Second Amendment, the Premises will be
deemed to include the Expansion Premises, unless different terms apply to the
Expansion Premises under the terms of this Second Amendment.</P>
<P>2. The Term of the Lease as it relates to the
Expansion Premises shall begin on September 1, 2002 ("Expansion Premises
Commencement Date") and end coterminously with the last day of the Term for the
Premises.</P>
<P>3. Tenant shall pay to landlord with respect to
the Expansion Premises, Base Rent, in advance, without demand, deduction or
setoff, equal to $11,485.50/month ($14.25/SF/Year), with the first such monthly
installment being due and payable on the Expansion Premises Commencement Date,
and like monthly installments of Base Rent being due and payable on the first
day of each month thereafter during the remainder of the Term.</P>
<P>4. For purposes of determining "Tenant's
Proportionate Share" of Operating Expenses, the Premises shall be deemed to
include the Expansion Premises and Section 2(h) of the Lease shall be amended to
change Tenant's Proportionate Share from 22.32% to 27.62%. Additionally, the
Base year for the Expansion Premises shall be the actual Operating Expenses for
the calendar year 2002.</P>
<P>5. Tenant acknowledges that it has inspected the
Expansion Premises and is accepting it "As Is" except as otherwise provided in
the Lease. Tenant shall not be entitled to any cash allowance with respect to
the Expansion Premises.</P>
<P>6. Each of the parties represents and warrants
to the other that except as expressly set forth in this Paragraph 6, such party
has not dealt with any broker, agent or other person in connection with this
Second Amendment through the acts of or employment of either party, and each
party hereby agrees to indemnify, defend and hold the other party harmless from
all liability arising from any claim for brokerage commissions of any kind
(including, without limitation, attorneys' fees incurred in connection
therewith( in connection with this Second Amendment, which claim arises
(directly or indirectly) out of an agreement, contract, course of dealings or
relationship between Tenant and the claiming party.</P>
<P>Notwithstanding anything to the contrary contained herein, Tenant has
retained Henry S. Miller Commercial as its broker (the "Broker"). Landlord
agrees to pay all brokerage commissions that may be due to the Broker in
connection with this Second Amendment pursuant to a separate agreement entered
into between Landlord and Broker.</P>
<P>7. Except as provided otherwise in this Second
Amendment, all of the terms and provisions of the Lease shall apply and be in
effect with respect to the Expansion Premises in the same manner and to the same
extent that they apply and are in effect with respect to the Premises.</P>
<P>8. Except as modified hereby, the Lease, as to
both the Premises and the Expansion Premises, remains unchanged and in full
force and effect, and by their execution hereof, Landlord and Tenant ratify and
confirm all of the terms and provisions thereof.</P>
<P>9. If for any reason Landlord is unable to
deliver possession of the Premises to Tenant on the Expansion Premises
Commencement Date, then the Expansion Premises Commencement Date shall be
extended to the date Landlord can deliver the Premises to Tenant, and Landlord
shall have no liability to Tenant for such delay, except that Tenant shall have
no obligation to pay rent until the actual Expansion Premises Commencement Date.
<P>
<HR>
<PAGE>
<P>IN WITNESS WHEREOF, Landlord and Tenant have executed this Second Amendment
as of the day and year first above written.</P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR>
<TD WIDTH=30%> </TD>
<TD WIDTH=70%><U>LANDLORD:</U><BR>PLANO R&D ASSOCIATES, LTD.,<BR>a Texas
limited partnership</TD></TR>
</TABLE>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR>
<TD WIDTH=30%> </TD>
<TD WIDTH=10%> </TD>
<TD WIDTH=60%>By: LINCOLN-LEGACY TECH I, LTD.,<BR>
a Texas limited partnership, General Partner</TD></TR>
<TR>
<TD> </TD>
<TD> </TD>
<TD>By: LINCOLN GP LEGACY TECH I, INC.,<BR>
a Texas Corporation, General Partner</TD></TR></TABLE>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR>
<TD WIDTH=30%> </TD>
<TD WIDTH=70%>By: <U>/s/ Thomas H. Kuhlmann</U><BR>Name: Thomas H. Kuhlmann<BR>
Title: Vice President</TD></TR>
<TR>
<TD> </TD><TD></TD></TR>
<TR>
<TD> </TD><TD></TD></TR>
<TR>
<TD> </TD>
<TD><U>TENANT:</U><BR>
ADVANCED NEUROMODULATION SYSTEMS, INC.,<BR>
a Texas corporation</TD></TR>
<TR>
<TD> </TD><TD></TD></TR>
<TR>
<TD> </TD>
<TD>By: <U>/s/ Stuart B. Johnson</U><BR>Name: Stuart B. Johnson<BR>
Title: Vice President Operations</TD></TR></TABLE>
<HR>
<PAGE>
<P ALIGN=CENTER><B>EXHIBIT 21.1</B></P>
<HR>
<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>
<TR>
<TD>MicroNet Medical, Inc.</TD>
<TD>Minnesota Corporation</TD></TR>
</TABLE>
<HR>
<PAGE>
<P ALIGN=CENTER><B>EXHIBIT 23.1</B></P>
<HR>
<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 No. 2-82414) pertaining to the Advanced Neuromodulation Systems, Inc.
1979 Amended and Restated Employees' Stock Option Plan; (Form S-8 No. 2-91410)
pertaining to the Advanced Neuromodulation Systems, Inc. Directors' Stock Option
Plan; (Form S-8 No. 333-00967) pertaining to the Advanced Neuromodulation
Systems, Inc. 1995 Stock Option Plan and the Advanced Neuromodulation Systems,
Inc. Sales and Marketing Employees Stock Option Plan; (Form S-8 No. 333-75879)
pertaining to the Advanced Neuromodulation Systems, Inc. 1998 Stock Option Plan;
(Form S-8 No. 333-61240) pertaining to the Advanced Neuromodulation Systems,
Inc. 2000 Stock Option Plan; (Form S-8 No. 333-85968) pertaining to the Advanced
Neuromodulation Systems, Inc. 2001 Employee Stock Option Plan; (Form S-3 No.
333-40927) pertaining to 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.; (Form S-3 No.
333-53440) pertaining to 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.; (Form
S-3 No. 333-101911) pertaining to the registration of 156,302 shares of Common
Stock issued pursuant to an Agreement and Plan of Merger dated November 4, 2002
between the Company and MicroNet Medical, Inc. and the related Prospectuses of
our report dated March 27, 2003, 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, 2002.</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>Dallas, Texas<BR>March 27, 2003</P>
<HR>
<PAGE>
<P ALIGN=CENTER><B>EXHIBIT 99.1</B></P>
<HR>
<PAGE>
<P ALIGN=CENTER><B>CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350<BR>
(AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002)</B></P>
<P>In connection with the Annual Report of Advanced Neuromodulation Systems,
Inc. (the "Company") on Form 10-K for the period ending December 31, 2002 as
filed with the Securities and Exchange Commission on the date hereof (the
"Report"), I, Christopher G. Chavez, Chief Executive Officer of the Company,
certify to the best of my knowledge and in my capacity as an officer of the
Company, pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002, that:</P>
<P>1. The Report fully complies with the
requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934,
as amended; and</P>
<P>2. The information contained in the Report
fairly presents, in all material respects, the financial condition and results
of operations of the Company as of the dates and for the periods expressed in
the Report.</P>
<P>IN WITNESS WHEREOF, the undersigned has executed this Certificate, effective
as of March 28, 2003.</P>
<TABLE WIDTH=100% CELLSPACING=0 CELLPADDING=0>
<TR>
<TD WIDTH=40%></TD>
<TD WIDTH=60%> </TD></TR>
<TR>
<TD> </TD><TD></TD></TR>
<TR>
<TD> </TD><TD></TD></TR>
<TR>
<TD> </TD>
<TD><U>/s/ Christopher G. Chavez</U></TD></TR>
<TR>
<TD></TD><TD>Name: Christopher G. Chavez<BR>
Title: Chief Executive Officer</TD></TR></TABLE>
<P>Note: The foregoing certification is being furnished solely pursuant to 18
U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
2002, and is not being filed as part of the Form 10-K or as a separate
disclosure document.</P>
<HR>
<PAGE>
<P ALIGN=CENTER><B>EXHIBIT 99.2</B></P>
<HR>
<PAGE>
<P ALIGN=CENTER><B>CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350<BR>
(AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002)</B></P>
<P>In connection with the Annual Report of Advanced Neuromodulation Systems,
Inc. (the "Company") on Form 10-K for the period ending December 31, 2002 as
filed with the Securities and Exchange Commission on the date hereof (the
"Report"), I, F. Robert Merrill III, Chief Financial Officer of the Company,
certify to the best of my knowledge and in my capacity as an officer of the
Company, pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002, that:</P>
<P>1. The Report fully complies with the
requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934,
as amended; and</P>
<P>2. The information contained in the Report
fairly presents, in all material respects, the financial condition and results
of operations of the Company as of the dates and for the periods expressed in
the Report.</P>
<P>IN WITNESS WHEREOF, the undersigned has executed this Certificate, effective
as of March 28, 2003.</P>
<TABLE WIDTH=100% CELLSPACING=0 CELLPADDING=0>
<TR>
<TD WIDTH=40%></TD>
<TD WIDTH=60%> </TD></TR>
<TR>
<TD> </TD><TD></TD></TR>
<TR>
<TD> </TD><TD></TD></TR>
<TR>
<TD> </TD>
<TD><U>/s/ F. Robert Merrill III</U></TD></TR>
<TR>
<TD></TD><TD>Name: F. Robert Merrill III<BR>
Title: Chief Financial Officer</TD></TR></TABLE>
<P>Note: The foregoing certification is being furnished solely pursuant to 18
U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
2002, and is not being filed as part of the Form 10-K or as a separate
disclosure document.</P>
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