UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

Form 10-K

 

Commission file number: 0-19806

 

 

 

 

Cyberonics, Inc.

(Exact name of registrant as specified in its charter)

 

 

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

 

Registrant’s telephone number, including area code:

(281) 228-7200

 

 

 

 

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

 

 

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

None

 

 

 

 

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

 

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

 

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

 

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

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer o     Accelerated filer þ     Non-accelerated filer o

 

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

 

The aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant as of October 27, 2006, the last business day of the registrant’s most recently completed second fiscal quarter, was based upon the last sales price reported for such date on the NASDAQ Global Market, approximately $225 million. For purposes of this disclosure, shares of common stock held by persons who hold more than 5% of the outstanding shares of common stock and shares held by officers and directors of the registrant have been excluded in that such persons may be deemed to be affiliates.

 

At June 22, 2007, 26,579,760 shares of common stock were outstanding.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the definitive proxy statement of Cyberonics, Inc. for the 2007 Annual Meeting of Stockholders, which will be filed within 120 days of April 27, 2007, are incorporated by reference into Part III of this Annual Report on Form 10-K.

 

 

TABLE OF CONTENTS

 

 

 

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

 

 

CAUTIONARY STATEMENT ABOUT FORWARD-LOOKING STATEMENTS

 

This Annual Report on Form 10-K (this “Form 10-K”) contains forward-looking statements. These statements relate to future events or our future financial performance. We have attempted to identify forward-looking statements by terminology such as “expect,” “may,” “will,” “intend,” “anticipate,” “believe,” “estimate,” “could,” “possible,” “plan,” “project,” “forecast” and similar expressions. Our forward-looking statements generally relate to our growth strategies, financial results, reimbursement programs, product acceptance programs, product development programs, clinical and new indication development programs, regulatory approval programs, manufacturing processes and sales and marketing programs. Forward-looking statements should be carefully considered as involving a variety of risks and uncertainties, which include, but are not limited to:

 

 

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

 

General

 

Cyberonics, Inc. is a neuromodulation company founded to design, develop and bring to market medical devices that provide a unique therapy, VNS Therapy, for the treatment of epilepsy, TRD and other debilitating neurological or psychiatric diseases and other disorders. VNS Therapy consists of the electrical stimulation of the vagus nerve with an implantable device.

 

Our mission is to improve the lives of people touched by epilepsy, depression and other chronic disorders that may prove to be treatable with our VNS Therapy System. To achieve this mission, our plan is to become the market leader in neuromodulation by:

 

 

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

 

Our ability to expand successfully the commercialization of the VNS Therapy System depends on obtaining and maintaining favorable coverage, coding and reimbursement for the implant procedure and follow-up care. Currently, we have broad coverage, coding and reimbursement for VNS Therapy for the treatment of epilepsy, but not for TRD. In May 2007, the Centers for Medicare & Medicaid Services (formerly the Healthcare Financing Administration) (“CMS”) issued a national non-coverage determination for TRD. CMS’s national non-coverage determination means that Medicare coverage is not available for VNS Therapy to treat TRD. Prior to the non-coverage determination, some patients were able to obtain coverage on a case-by-case basis through their local Medicare contractor or Fiscal Intermediary. Since the national non-coverage determination is binding on all local Medicare contractors, patients will no longer be able to obtain Medicare coverage on a case-by-case basis. As a consequence, CMS’s non-coverage determination will result in fewer sales of the VNS Therapy System for TRD. The determination may also have an adverse impact on coverage decisions by other payers. We will continue to pursue favorable coverage decisions to expand reimbursement to include VNS Therapy for TRD. We will also continue to assist some patients seeking TRD coverage on a case-by-case basis; however, our long-term growth in TRD is dependent on our progress in obtaining favorable regional and national coverage policies from third-party payers in the use of VNS Therapy to treat TRD.

 

Our clinical development program has included pilot and pivotal studies using VNS Therapy (1) as an adjunctive therapy for reducing the frequency of seizures in patients over 12 years of age with partial onset seizures that are refractory to antiepileptic drugs and (2) as an adjunctive treatment of patients 18 years of age and older with chronic or recurrent TRD in a major depressive episode. We have also conducted or provided support for small pilot studies for the treatment of Alzheimer’s Disease, anxiety disorders, chronic headache, bulimia and other disorders. These studies have been conducted to determine the safety and effectiveness of VNS Therapy and to determine new indications that might be considered for pivotal studies.

Since inception, we have incurred substantial expenses, primarily for research and development activities that include product and process development and clinical trials and related regulatory activities, sales and marketing activities, manufacturing start-up costs and systems infrastructure. We made significant investments in connection with sales and marketing activities in the U.S. in fiscal 2006 and clinical research costs in fiscal 2006 and 2007 associated most notably with depression; however, we began scaling back our TRD sales and marketing spending in fiscal year 2007 after it became apparent that difficulties in obtaining reimbursement coverage for TRD are limiting TRD sales. Since our inception through April 27, 2007, we incurred an accumulated net deficit of approximately $259 million. For more information, see “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this Form 10-K.

 

VNS Therapy Epilepsy Indication Overview

 

Epilepsy is a disorder of the brain characterized by recurrent seizures that are categorized as either partial or generalized at onset. Patients who continue to have unsatisfactory seizure control or intolerable side effects after treatment with appropriate antiepileptic therapies for a reasonable period of time are said to suffer from refractory epilepsy. For reasons that are not clear, partial onset seizures are generally more refractory to existing therapies than generalized seizures. Epilepsy is the second most prevalent neurological disorder. It is estimated that approximately 2.8 million individuals in the U.S. have epilepsy, with approximately 150,000 new cases diagnosed each year, and that there are in excess of 3.3 million individuals with epilepsy in Western Europe with over 210,000 new cases diagnosed each year. In addition, it is estimated that approximately 50% of patients with epilepsy suffer from partial onset seizures and that over 30% of these patients continue to suffer from seizures in spite of treatment with antiepileptic drugs. The medical, psychological, sociological and financial implications of refractory epilepsy can be profound for individuals and their families. Medical consequences may include brain damage from recurrent seizures, injuries and accidents associated with the loss or impairment of consciousness and death. Personal implications of epilepsy may include suffering the side effects of antiepileptic drugs, strained personal and family relations, and the inability to obtain and hold meaningful employment or a driver’s license. There are two standard types of treatment available to persons with epilepsy: drug therapy and surgery. Antiepileptic drugs serve as a first-line treatment and are prescribed for virtually all individuals being treated for epilepsy. When drug therapy is not effective, surgical resection may be an option for some patients. There are a number of other treatments under development for the treatment of epilepsy, including direct deep brain stimulation (“DBS”) and the Responsive Neurostimulator System (“RNS^tm”), but these treatments are not currently approved for commercial distribution.

 

VNS Therapy for Epilepsy

 

The VNS Therapy System is indicated as an adjunctive treatment for patients who are refractory to antiepileptic drugs. In the two randomized, parallel, double-blind, active-controlled studies that led to FDA approval of the epilepsy indication, the patients who received adjunctive VNS Therapy had a mean seizure reduction of approximately 24% and 28% during the three-month acute phase of the studies. Additionally, many patients, including some who reported no change or an increase in seizure frequency, also reported a reduction in seizure severity. Long-term follow-up data, derived from an uncontrolled protocol, on the 440 patients in five studies showed that efficacy was maintained and, for many patients, improved over time during treatment with the VNS Therapy System. Analysis of the pooled data showed that the median percent seizure reduction was 44% after 24 months of treatment and was sustained at that level at 36 months. In the treatment of refractory epilepsy, the side effects associated with the VNS Therapy System are generally mild, localized and related to the period of time in which stimulation is activated. The side effects include voice alteration, neck discomfort, increased cough, shortness of breath and difficulty swallowing. The VNS Therapy System has not typically been associated with the debilitating central nervous system side effects that frequently accompany antiepileptic drugs. Additionally, side effects typically decrease over time. To date, over 42,000 patients have accumulated in excess of 175,000 patient years of treatment experience with the VNS Therapy System.

 

VNS Therapy Depression Indication Overview

 

Major depressive disorder is one of the most prevalent and serious illnesses in the U.S. It affects nearly 19 million Americans 18 years of age or older every year. Recently published data indicate that approximately one-

third of patients with major depressive disorder will not achieve a remission of their depressive symptoms after four acute treatment steps using standard therapies. Depression is the second leading cause of disability for the general population and is the leading cause of disability for American women. Depression interferes with a person’s ability to function, feel pleasure or maintain interest in everyday living. It is associated with increased mortality due to suicide and co-morbid general medical conditions. Total annual costs for depression in the U.S. are estimated to exceed $80 billion, including $30 billion in annual direct treatment costs. Standard treatment modalities for depression include antidepressant drugs, psychotherapy and electroconvulsive therapy (“ECT”). First-line therapy often consists of an antidepressant drug. For patients who do not respond adequately to initial antidepressant treatment, physicians will often switch to a different drug or use two drugs in combination. Physicians usually reserve ECT for patients who have not had an adequate response to multiple trials of antidepressant drugs or when they determine a rapid response to treatment is desirable. There are a number of other treatments under development for the treatment of TRD, including repetitive transcranial magnetic stimulation (“rTMS”) and DBS, but these treatments are not currently approved for commercial distribution.

 

VNS Therapy for Depression

 

The VNS Therapy System is indicated as an adjunctive treatment for patients who have chronic or recurrent treatment-resistant depression. In Canada and the European Union, the indication for use also encompasses patients who do not tolerate standard treatment. FDA approved the TRD indication for the VNS Therapy System based on a long-term uncontrolled trial (the “pivotal” trial) of adjunctive VNS Therapy that showed significant, sustained improvement of depressive symptoms over one and two years, and based on a comparison of the 12-month outcomes in the pivotal trial with the 12-month outcomes among a non-randomized, but well-matched, group of patients who received only standard treatments for their TRD. After one year of adjunctive VNS Therapy in the pivotal trial, response to treatment ranged from 22% to 37% (depending on the outcome measure). Moreover, 60% of the patients who responded after three months of adjunctive VNS Therapy were still responders at one year and 70% of the three-month responders were responders at the two-year evaluation. For those patients who were responders at the one-year evaluation, 69% were still responders at the two-year evaluation. VNS Therapy was generally well tolerated in the depression clinical studies. The most commonly reported adverse events were similar to those observed in patients being treated with VNS Therapy for epilepsy and included voice alteration, neck discomfort, increased cough, shortness of breath and difficulty swallowing. These side effects tended to occur during stimulation, tended to be reported as mild or moderate and tended to be reported less frequently over time.

 

FDA Post-Approval Study Commitments and Other Clinical Research Studies

 

As a condition of approval for the VNS Therapy System TRD indication, the FDA is requiring us to conduct two post-approval studies. One is a 460-patient randomized, controlled study that compares outcomes for different levels of vagus nerve stimulation. The other is a patient registry that will include 1,000 patients treated with adjunctive VNS Therapy. Both studies are actively enrolling patients. To maintain timely progress in the 460-patient dosing study, we announced a program in early 2007 whereby we are donating the VNS Therapy Systems and paying for the surgical implantation of the devices (at a negotiated rate) for patients being enrolled in the study. We are also sponsoring post-marketing studies in refractory epilepsy, and we are supporting a variety of mechanism-of-actions studies to improve the fundamental understanding of how VNS Therapy works. We expect to continue to invest in similar research activities as appropriate.

 

VNS Therapy System

 

VNS Therapy is the first treatment approved by FDA for both medically refractory epilepsy and TRD. The safety profiles for VNS Therapy and the VNS Therapy System, including the implant procedure, are well established in clinical studies of refractory epilepsy and TRD and in commercial use in over 45,000 patients with over 180,000 total patient years of experience.

 

The VNS Therapy System is a proprietary, integrated system consisting of an implantable generator that delivers an electrical signal to an implantable lead attached to the left vagus nerve. The vagus nerve is the longest of the cranial nerves, extending from the brain stem through the neck to organs in the chest and abdomen. The left vagus nerve has been shown to have influence over numerous areas of the brain. Preclinical studies and mechanism-

of-action research suggest that intermittent stimulation of the left vagus nerve in the neck modulates a number of structures and alters blood flow bilaterally in several areas of the brain. These studies have also shown that stimulation of the left cervical vagus nerve is effective in blocking seizures and results in persistent or carryover antiepileptic effects, which increase with chronic intermittent stimulation. The mechanism-of-action research associated with our TRD studies has shown stimulation of the left vagus nerve results in modulation of areas of the brain thought to be important in the regulation of mood.

 

The VNS Therapy System consists of a pulse generator, a bipolar lead, a programming wand and software and a tunneling tool. The pulse generator and bipolar lead are surgically implanted in a procedure that takes from 30 to 90 minutes, during which time the patient is under general, regional or local anesthesia. The pulse generator is surgically implanted in a subcutaneous pocket in the upper left chest. The bipolar lead is connected to the pulse generator and attached to the vagus nerve in the lower left side of the patient’s neck. The patient is generally admitted to the hospital on the day of surgery and discharged the same or following day.

 

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

 

Pulse Generator.  The pulse generator is an implantable, programmable signal generator designed to be coupled with the bipolar lead to deliver electrical signals to the vagus nerve. The pulse generator is a battery powered device. Upon depletion of the battery, the pulse generator is removed and a new generator is implanted in a short, outpatient procedure using local anesthesia.

 

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

 

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

 

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

 

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

 

The implant procedure, including the cost of the device (approximately $17,000 for a Model 102 VNS Therapy System), hospital charges and physician fees, generally costs between $23,000 and $38,000.

 

Manufacturing and Sources of Supply

 

Our manufacturing operations are required to comply with FDA’s Quality System Regulation (“QSR”), which incorporates the agency’s former Good Manufacturing Practices regulations. The QSR is promulgated under

section 520 of the Food, Drug and Cosmetic Act. It requires that manufacturers have a quality system for the design and production of medical devices. The regulation also requires that:

 

 

Thus, the QSR helps assure that medical devices are safe and effective for their intended use. In addition, certain international markets have regulatory, quality assurance and manufacturing requirements that may be more or less rigorous than those in the U.S. Specifically, we have authorized KEMA Registered Quality, Inc. (“KEMA”) to ensure that we are in compliance with the requirements of International Standards Organization 13485:2003, “Medical devices — Quality management systems — Requirements for regulatory purposes” and the European Council Directive 90/385/CEE relating to Active Implantable Medical Devices (“AIMD”). KEMA is a Notified Body within the scope and framework of the European Council Directive 90/385/CEE relating to AIMD. We are audited by KEMA on an annual basis for such compliance.

 

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

 

Marketing and Sales

 

United States

 

We market and sell our products for refractory epilepsy and treatment-resistant depression through a direct sales force in the U.S. Our sales and marketing plan focuses on creating awareness and demand for the VNS Therapy System among epileptologists and neurologists who treat refractory epilepsy, psychiatrists who treat TRD, implanting surgeons, nurses, third-party payers, hospitals, patients and their families.

 

To reach each of these groups, we are using a specialized sales force consisting of:

 

 

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

 

In July 2005, FDA approved VNS Therapy as a long-term adjunctive treatment for patients 18 years of age or older with chronic or recurrent treatment-resistant depression in a major depressive episode and who have not

responded to at least four adequate antidepressant treatments. Throughout fiscal 2006, we focused the efforts of our organization on the U.S. launch in TRD, and we structured our sales and case management organization to support anticipated sales demand in both the epilepsy and depression markets. Although patient and physician demand was strong, our actual sales did not increase to the extent anticipated due to a particularly challenging reimbursement environment. In fiscal 2007, we did not experience and do not anticipate any meaningful sales growth in TRD until such time as we obtain favorable coverage policies for VNS Therapy in TRD.

 

International

 

We market and sell our products in 71 countries through a combination of a direct sales force in certain European countries and distributors elsewhere. The VNS Therapy System is currently sold by a direct sales force in Austria, Belgium, Denmark, France, Germany, Italy, Luxemburg, The Netherlands, Norway, Spain, Sweden, Switzerland and the United Kingdom. We have distribution agreements with independent distributors covering a number of other countries, principally in Europe, Asia, South Africa, Australia, Mexico, South America and Canada. The distribution agreements generally grant the distributor exclusive rights for the particular territory for a period of three years. The distributor generally assumes responsibility for obtaining regulatory and reimbursement approvals for such territory and agrees to certain minimum marketing and sales expenditures and purchase commitments. Under the terms of the distributor agreements, no product return rights are granted to the distributor and no additional product performance issues exist for us after shipment to the distributor. Pricing is generally fixed under the terms of the distribution agreements, but may change at our election, with as little as 30 days prior notice under most agreements. Sales incentives, if provided, are recorded as a reduction of net sales in the same period revenue is recognized.

 

Third-Party Reimbursement

 

Our ability to expand successfully the commercialization of the VNS Therapy System depends on obtaining and maintaining favorable coding, reimbursement and coverage for the implant procedure and follow-up care. In fiscal 2007, the coding that describes VNS related procedures was unchanged and continues to adequately and appropriately describe services of providers. Reimbursement or payment rates were largely unchanged over the past year, with a slight decline in the Medicare allowable amount. In epilepsy, the coverage environment was largely unchanged. In TRD, coverage for VNS Therapy was difficult to obtain throughout the year.

 

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

 

 

Our Reimbursement Department is available to assist hospitals and physicians with reimbursement questions. Regional Reimbursement Managers and Case Managers are available through our Reimbursement Hotline, to help with coverage, coding and reimbursement issues on a case-by-case basis and/or policy level. In epilepsy, virtually all technology assessments are favorable and most payers have coverage policies. In TRD, all the technology assessments are negative, and there are few plans with favorable coverage policies.

 

Medicare

 

Effective July 1, 1999, CMS issued National Coverage Policy Transmittal 114 (CIM Section 60-22). Under the policy, VNS Therapy is covered for patients with medically refractory partial onset seizures for whom surgery is not recommended or for whom surgery has failed. In May 2007, CMS issued its Coverage Decision Memorandum for

Vagus Nerve Stimulation for Treatment-Resistant Depression, concluding that Medicare coverage is not available for VNS Therapy as a treatment for TRD. For additional information, see “General” above.

 

Medicaid

 

Medicaid programs generally cover hospital inpatient and outpatient services that are medically necessary and appropriate. In epilepsy, most state Medicaid agencies have developed their own coverage policy for VNS Therapy or have adopted the National CMS coverage policy. In TRD, a small number of Medicaid programs provide coverage for VNS Therapy on a case-by-case basis, but most are still evaluating a coverage policy or have issued a non-coverage policy. CMS’s non-coverage determination on Medicare coverage for the treatment of TRD will make gaining coverage with Medicaid programs more difficult.

 

Medicaid reimbursement mechanisms vary state by state. Medicaid policy and payment methodologies change on a regular basis, so vigilant and ongoing work is necessary to ensure continued access and acceptable reimbursement for patients covered by Medicaid programs. Reimbursement codes are already in place to pay for the cost of the device implantation and the surgeon implant fees, both of which are identical in the treatment of refractory epilepsy and TRD. Existing prescriber codes for device interrogation and dosage adjustment currently cover medical professionals in the epilepsy medical community.

 

Private Payers

 

Private payers generally cover hospital inpatient and outpatient services that are considered to be medically necessary. Currently, private payers (commercial, managed care and other third-party payers) account for 50% to 60% of patients implanted with the VNS Therapy System. As with other payers, many private payers have developed clinical guidelines for coverage or adopted the national CMS coverage policy for use of VNS Therapy in epilepsy. As of the end of fiscal year 2007, coverage for VNS Therapy for TRD is very limited. Only a few plans have issued favorable coverage policies for VNS Therapy in TRD, and less than 100 are providing coverage on a case-by-case basis. Most plans have either no policy or a non-coverage policy. Following the May 2007 CMS national non-coverage determination for TRD, we may have difficulty expanding or even maintaining coverage among private payers.

 

While we believe the clinical evidence supporting VNS Therapy for TRD should be adequate to convince private payers to provide coverage over the long term, coverage approval is subject to each payer’s assessment program. We are actively working with private payers to gain approval of coverage for VNS Therapy in TRD, but we cannot give any assurances that private payers will expand or maintain coverage for VNS Therapy in TRD.

 

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

 

Although the VNS Therapy System has been approved for commercial distribution in European Union countries and Canada for the treatment of chronic or recurrent depression, we do not anticipate significant sales volumes until reimbursement approvals are achieved in these countries. We are continuing to pursue appropriate reimbursement approvals in these countries.

 

Product Development

 

Our product development efforts are directed toward improving the VNS Therapy System and developing new products that provide additional features and functionality while improving cost effectiveness.

 

In May 2005, we received approval from KEMA Medical, our European Regulatory Notified body, to market our DEMIPULSE^tm and DEMIPULSE DUO^tm VNS Therapy System generators in the member countries of the European Union for the approved epilepsy and depression indications for use. The DEMIPULSE^tm generator is the next generation single-connector VNS Therapy System generator for use in new patients, and the DEMIPULSE DUO^tm generator is the next generation dual-connector VNS Therapy System generator for use in patients who have elected replacement of their previous dual-connector generator at the end of its battery life. Both the DEMIPULSE^tm and DEMIPULSE DUO^tm generators are capable of delivering greater functionality and are smaller and

lighter than the previous models. We submitted the Premarket Approval Application Supplement (“PMA-S”) for both the DEMIPULSE^tm and the DEMIPULSE DUO^tm generators to FDA in January 2007 and initiated limited release in Europe in May 2007. We anticipate FDA approval during the latter half of 2007 and commercial release prior to the end of 2007.

 

The VNS Therapy PERENNIA^tm Lead was approved by FDA in May 2006 and by KEMA Medical in August 2006. The lead is currently in a limited commercial release. Functionally, the new lead is the same as its reliable predecessor, the Model 302 Lead, but it incorporates a new design and is constructed from more durable components. Mechanical tests conducted in a laboratory setting have shown the PERENNIA^tm Lead to be more robust than its predecessor.

 

We received approval for Model 250, Version 7.1 software from KEMA in May 2006 and from FDA in June 2006.

 

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

 

Competition

 

We believe that in the fields of refractory epilepsy and TRD, existing and future drug therapies are and will continue to be the primary competition for the VNS Therapy System. We may also face competition from other medical device companies for the treatment of partial seizures and TRD. Medtronic, Inc., for example, continues to conduct clinical studies involving an implantable signal generator used with an invasive deep brain probe for the treatment of neurological disorders including depression, and has received FDA approval for the device for the treatment of essential tremor and Parkinson’s Disease. We could also face competition from other large medical device and pharmaceutical companies that have the technology, experience and capital resources to develop alternative devices for the treatment of epilepsy. Many of our competitors have substantially greater financial, manufacturing, marketing and technical resources than we have. In addition, the healthcare industry is characterized by extensive research efforts and rapid technological progress. Our competitors may develop technologies and obtain regulatory approval for products that are more effective in treating epilepsy or TRD than our current or future products. In addition, advancements in surgical techniques could make surgery a more attractive therapy for epilepsy. The development by others of new treatment methods with novel antiepileptic and depression drugs, medical devices or surgical techniques for epilepsy could render the VNS Therapy System noncompetitive or obsolete.

 

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

 

While no other therapies have been specifically approved for TRD, a well-established array of antidepressant drugs, typically combined with other antidepressants of complementary action or with atypical antipsychotic drugs and/or mood stabilizers, are frequently used for refractory patients. For severe patients or those at acute risk for suicide, ECT is often used. These treatment modalities may pose a competitive threat in the near term, to the extent that they may delay a decision to offer VNS Therapy to TRD patients. As other forms of neurostimulation are investigated and developed for TRD, these may emerge as competition for VNS patient candidates. Less invasive procedures like rTMS and MST (magnetic seizure therapy) may compete for a similar place in the TRD treatment algorithm. More invasive technology like DBS is also being investigated for TRD. Finally, ECT is undergoing refinements in technique to increase specificity and reduce the cognitive deficit side effects; if successful, the tolerability and patient acceptance of ECT could improve in the future. These neurostimulation techniques could prove to be more effective, more predictable, or have a more rapid onset of antidepressant activity than VNS Therapy.

We face similar competition with respect to the development and sale of VNS Therapy as a treatment for the other disorders we are evaluating, including, but not limited to Alzheimer’s Disease, anxiety disorders and bulimia.

 

Patents, Licenses and Proprietary Rights

 

Proprietary protection for our products is important to our business. We maintain a policy of seeking method and device patents on our inventions, acquiring licenses under selected patents of third parties, and entering into invention and confidentiality agreements with our employees and consultants with respect to technology that we consider important to our business. We also rely on trade secrets, unpatented know-how and continuing technological innovation to develop and maintain our competitive position.

 

We have an exclusive license agreement with Jacob Zabara, Ph.D., a co-founder and consultant to us, pursuant to which we currently maintain exclusive licenses on five U.S. method patents (and such international counterparts as have been or may be issued) covering the VNS Therapy System for vagus nerve and other cranial nerve stimulation for the control of movement disorders (including epilepsy), neuropsychiatric disorders (including depression) and other disorders. We believe that these patents give us an advantage by limiting competition in vagus nerve stimulation to treat refractory epilepsy and TRD. The license agreement will give us coverage until expiration of the licensed patents in July 2011 for movement disorders and May 2011 for neuropsychiatric disorders. Pursuant to the license agreement, we are obligated to pay Dr. Zabara a royalty equal to 3.0% of net sales through July 2011, after which royalties will be reduced to 1.0% for the duration of any remaining patents covering licensed products.

 

We have an agreement with Mitchell S. Roslin, M.D. on two U.S. patents that we co-own with Dr. Roslin for bilateral VNS for the treatment of obesity. Pursuant to the agreement, we are obligated to pay Dr. Roslin a royalty rate of 1.0% of the first $10 million of net obesity sales covered by one of the patents and 0.5% of net obesity sales thereafter. Pursuant to the agreement, we paid Dr. Roslin advances on royalties in the amount of $25,000 per year for five years beginning January 1, 2000, and we will be obligated to pay, upon the completion of certain milestones, up to $325,000 in additional advances on royalties.

 

Including the patents referred to in the agreements described above, as of April 27, 2007, we owned or licensed 34 U.S. patents and 75 pending U.S. patent applications, covering various aspects of the VNS Therapy System, potential improvements to the VNS Therapy System and methods of treatment for a variety of disorders through electrical stimulation of the vagus nerve or other cranial nerves. In addition to movement disorders, other method patents cover the fields of eating disorders (including obesity and bulimia), endocrine disorders, migraine headaches, dementia, neuropsychiatric disorders (including depression and anxiety disorders), motility disorders, sleep disorders, coma, chronic pain, cardiac disorders and hypertension. We have filed counterparts of certain of our key U.S. patent applications in certain key international jurisdictions and currently own or license 31 patents issued by the European Patent Office or other international authorities and 48 patent applications pending in the European Patent Office or before other international authorities.

 

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

 

We believe that the patents we own and license provide us with protection in the U.S. in the field of cranial nerve stimulation, including VNS for the control of epilepsy and other movement disorders, (including Parkinson’s Disease and essential tremor), neuropsychiatric disorders (including clinical depression), eating disorders, anxiety disorders, obesity, dementia (including Alzheimer’s Disease) and additional indications for which method patents have been issued. The protection provided by our international patents is not as strong as that provided by our U.S. patents due to differences in patent laws. In particular, European and other countries prohibit patents covering methods for treatment of the human body by surgery or therapy.

 

There has been substantial litigation regarding patent and other intellectual property rights in the medical device industry. In the future, we may need to engage in litigation to enforce patents issued or licensed to us, to protect our trade secrets or know-how or to defend us against claims of infringement of the rights of others and to determine the scope and validity of the proprietary rights of others. Litigation could be costly and could divert our

attention from other functions and responsibilities. Adverse determinations in litigation could subject us to significant liabilities to third parties, could require us to seek licenses from third parties and could prevent us from manufacturing, selling or using the VNS Therapy System, any of which could severely harm our business. We are not currently a party to any patent litigation or other litigation regarding proprietary rights and are not aware of any challenge to our patents or proprietary rights.

 

Product Liability and Insurance

 

The manufacture and sale of our products subjects us to the risk of product liability claims. We are currently named as a defendant in two product liability lawsuits alleging negligence, strict liability and breach of warranty. We likely will be named in the future as a defendant in product liability lawsuits alleging claims of negligence, strict liability, breach of warranty, negligent misrepresentation, failure to warn, wrongful death and other claims. We do not believe that the VNS Therapy System is defective or otherwise has caused or will cause injury to patients who are or may be involved in these lawsuits; however, the outcome of litigation is inherently unpredictable and could result in an adverse judgment and an award of substantial and material damages against us. We establish a liability reserve on our balance sheet in an amount less than our self-insured retention for all matters that we believe is probable of payment as a result of a judgment or settlement. Although we maintain product liability insurance in amounts that we believe to be reasonable, coverage limits may prove not to be adequate in some circumstances. Product liability insurance is expensive and in the future may be available only at significantly higher premiums or not be available on acceptable terms, if at all. A successful claim brought against us in excess of our insurance coverage could severely harm our business and consolidated results of operations and financial position.

 

We endeavor to maintain executive and organization liability insurance in a form and with aggregate coverage limits that we believe are adequate for our business purposes. On May 31, 2007, we renewed our executive and organization liability policies through May 31, 2008.

 

Employees

 

As of June 1, 2007, we had approximately 547 full-time employees. We believe that the success of our business depends, in part, on our ability to attract and retain qualified personnel. We believe our relationship with our employees is good. However, we cannot assure you that we will be successful in hiring or retaining qualified personnel. The loss of key personnel, or the inability to hire or retain qualified personnel, could significantly harm our business.

 

Financial Information About Segment and Geographical Areas

 

Our financial information, including our revenues and long-lived assets by geographical area, is included in the Consolidated Financial Statements and the related Notes beginning on page F-1.

 

Internet Website and Availability of Public Filings with the SEC

 

Our internet address is www.cyberonics.com. We make available free of charge on or through our website our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended (“Exchange Act”), as soon as reasonably practicable after electronically filing such material with, or furnishing it to the SEC. Also available on our website are our corporate governance guidelines, corporate code of business conduct and ethics, financial code of ethics and charters for each standing committee of our Board of Directors.

 

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

 

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

 

Our common stock price constantly changes.

 

Our common stock is traded on the NASDAQ Global Market under the ticker symbol “CYBX.” The price of stock on that trading market fluctuates, and we expect that the market price of our common stock will continue to fluctuate. For example, during the fiscal year ended April 27, 2007, our stock traded from a high of $27.55 to a low of $14.70 per share. Our stock price may be affected by a number of factors, some of which are beyond our control, including, without limitation:

 

 

In addition, the stock market in recent years has experienced broad price and volume fluctuations that have often been unrelated to the operating performance of companies. These broad market fluctuations have also adversely affected, and may continue to adversely affect, the market price of our common stock.

 

We are not profitable now, and we have been profitable for only seven fiscal quarters since our inception.

 

Through April 27, 2007, we incurred an accumulated net deficit of approximately $259 million. We continue to incur substantial expenses, including:

 

 

We can provide no assurance that our revenues will grow or that our expenses will decline sufficiently to enable us to become profitable in the future. The report of our auditors with respect to their audit of our Consolidated Financial Statements for the fiscal year ended April 27, 2007 contains an explanatory paragraph relating to the preparation of our financial statements as a “going concern.” While our management expects to resolve the conditions referenced in “Note 2. Going Concern” in the Notes to the Consolidated Financial Statements, we can offer no assurance that we will be able to resolve these conditions and continue as a going concern.

 

In the future, we could have a material weakness in our internal control over financial reporting.

 

We reported in our Annual Report on Form 10-K for the fiscal year ended April 28, 2006 (“2006 Form 10-K”) that management identified a material weakness in our internal control over financial reporting. Our management concluded that, as a result of this material weakness, our internal control over financial reporting was not effective as of April 28, 2006 based upon the criteria issued by the Committee of Sponsoring Organizations of the Treadway Commission. This material weakness resulted in the material misstatement of stock-based compensation expense in our consolidated financial statements for the 2004 and 2005 fiscal years and each of the quarters of fiscal 2005 and 2006 and we restated previously issued financial statements for the 2004 and 2005 fiscal years and each of the quarters of fiscal years 2005 and 2006. We have successfully remediated this material weakness. However, if management determines or our independent registered public accountants conclude that we have a material weakness in the future, it could adversely affect our credit rating, lead to short-term price volatility, trigger an investigation by a regulatory authority or result in additional stockholder litigation, any of which could severely harm our business, our consolidated financial position and results of operations.

 

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

 

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

 

 

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

 

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

 

We are subject to extensive and rigorous ongoing regulation of the research, development, testing, manufacture, labeling, promotion, advertising, distribution and marketing of our product. Our failure to comply with regulations or to identify and resolve manufacturing or safety problems prior to commercial marketing could lead to the need for product marketing restrictions, product withdrawal or recall or other voluntary or regulatory action, any

of which could delay further marketing until our product is brought into compliance. Our failure to comply with these requirements could have a significant negative impact on our future operating results and may also subject us to stringent penalties and lawsuits.

 

Our indebtedness and debt service obligations may adversely affect our cash flow, cash position and stock price.

 

As of April 27, 2007, we had approximately $125.0 million in convertible debt with aggregate annual debt service obligations, excluding full repayment of principal, of approximately $3.8 million and $7.5 million in outstanding borrowings against our revolving credit facility. If we issue other securities in the future, our debt service obligations and interest expense will increase further. We intend to fulfill our debt service obligations from earnings and our existing cash and investments. In the future, if we are unable to generate cash or raise additional cash through financing sufficient to meet these obligations, we may have to delay or curtail our research, development and commercialization programs. Our indebtedness could have significant additional negative consequences, including, without limitation:

 

 

Upon the occurrence of a fundamental change, holders of our senior subordinated Convertible Notes may force us to purchase their Convertible Notes at the full amount owed, including accrued but unpaid interest.

 

If we undergo a fundamental change, including, but not limited to, the acquisition by any person of the beneficial ownership of 50% of our common stock, our consolidation or merger with or into any other person, our liquidation, or our common stock being removed from listing on The NASDAQ Global Market, holders of our $125.0 million of 3% Senior Subordinated Convertible Notes due in 2012 (“Convertible Notes”) may, at their option, require us to purchase their Convertible Notes for the full amount owed including accrued but unpaid interest. This amount may be greater than the value of the Convertible Notes at the time of repurchase. As a result, the possibility of a repurchase requirement may inhibit the consummation of certain transactions such as mergers that may be beneficial to our stockholders.

 

Upon the occurrence of certain events, the initial conversion rate of our Convertible Notes will be adjusted, which could result in an increased number of shares being issued upon conversion.

 

The initial conversion rate of our Convertible Notes will be adjusted upon the occurrence of certain events, including, among others, the issuance to our stockholders of certain rights to purchase our common stock at less than the current market price of our common stock or the issuance of cash dividends to substantially all of our stockholders. If the conversion rate is adjusted, holders of our Convertible Notes will receive a greater number of shares of our common stock per Convertible Note, resulting in increased percentage ownership of our common stock by the noteholders.

 

We may be forced to repay the full amount of our outstanding $125.0 million convertible note indebtedness and senior credit indebtedness on an accelerated basis.

 

In July 2006, we received a notice of default and demand letter (“Notice of Default”) from Wells Fargo Bank, National Association (the “Trustee”), pursuant to which the Trustee asserted that we were in default of our obligations under the Indenture dated September 27, 2005 (“Indenture”), between us, as issuer, and the Trustee with respect to our Convertible Notes, as a result of our failure (1) to file with the SEC our 2006 Form 10-K by July 12, 2006 and (2) to deliver a copy of the 2006 Form 10-K to the Trustee by July 27, 2006. In October 2006, we received a notice of

acceleration and demand letter (“Notice of Acceleration”) from the Trustee informing us that, pursuant to the Indenture, the Trustee has declared the Convertible Notes due and payable at their principal amount together with accrued and unpaid interest, and fees and expenses and demanding that all such principal, interest, fees and expenses under the Convertible Notes be paid to the Trustee immediately. As a result, although the Convertible Notes mature in 2012, we have included them as a current liability on our Consolidated Balance Sheet as of April 27, 2007. We deny that a default occurred under the Indenture, and on June 13, 2007, a federal district court granted summary judgment to Cyberonics and declared that no default occurred under the Indenture. In its court filings, the Trustee stated that it was seeking approximately $20.0 million in damages plus interest and attorney fees, but it reserved the right to seek immediate payment of full value of the Convertible Notes. The Trustee has not appealed the district court’s decision; however, if the Trustee appeals the decision of the district court, and if the court of appeals reverses the district court’s decision and determines that a default occurred, then all unpaid principal and accrued interest on the outstanding Convertible Notes could be due and payable immediately unless we negotiate an amendment to the terms of the Indenture. In addition, a default under the Indenture constitutes a default under our Credit Agreement dated January 13, 2006 (“Credit Agreement”) with Merrill Lynch Capital, a division of Merrill Lynch Business Financial Services Inc. (“Administrative Agent”) and the lenders who are party thereto (“Lenders”). If the principal and accrued interest on the outstanding Convertible Notes and our outstanding indebtedness under the credit agreement must be repaid immediately, we may not have or be able to obtain access to the funds needed to repay the indebtedness, and we may be forced to seek protection under the U.S. Bankruptcy Code.

 

We may not be able to access sufficient additional capital sources or to access capital on terms which are acceptable to us.

 

Our capital requirements are substantial and depend on many factors, including market acceptance of our product and clinical and strategic development opportunities. A large portion of our expenses is currently fixed, including expenses related to our facilities, equipment and personnel, and we may need to spend significant amounts to conduct our post-marketing clinical studies or for product improvement and development. We will need to generate significant additional revenues to achieve profitability in the future. Even if we do achieve profitability, we may not be able to increase profitability on a quarterly or annual basis. Furthermore, if additional capital is required, we may not be able to access sufficient sources or to access capital on terms which are acceptable to us.

 

We may not be successful in our efforts to develop VNS Therapy for the treatment of other indications and, as such, we may not experience revenue growth from these other indications.

 

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

 

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

 

Our product portfolio is limited to VNS Therapy Systems for two indications, refractory epilepsy and TRD. Market acceptance of the VNS Therapy System for these indications depends on our ability to convince the medical community and third-party payers of the clinical efficacy and safety of vagus nerve stimulation and the VNS Therapy System. On May 4, 2007, CMS issued a national non-coverage determination with respect to VNS Therapy for TRD. Prior to the non-coverage determination, some patients were able to obtain coverage on a case-by-case basis through their local Medicare contractor or Fiscal Intermediary. Since the national non-coverage determination is binding on all local Medicare contractors, patients will no longer be able to obtain Medicare coverage on a case-by-case basis. In addition, CMS’s non-coverage determination may have a detrimental effect on coverage decisions by other payers, including Medicaid. While the VNS Therapy System has been implanted in more than

45,000 patients, many physicians are still unfamiliar with this form of therapy. We believe that existing pharmacological therapies, surgery (for refractory epilepsy) and ECT (for TRD) are the only other approved and currently available therapies competitive with the VNS Therapy System. These therapies may be more attractive to patients or their physicians than the VNS Therapy System in terms of efficacy, cost or reimbursement availability. Furthermore, we have not funded significant post-market clinical research that could change physicians’ opinions or use of our product for refractory epilepsy. We cannot assure you that we will receive broad reimbursement coverage for TRD or that our sales will increase for epilepsy or TRD. Additionally, we cannot assure you that the VNS Therapy System will achieve expanded market acceptance for the treatment of epilepsy, depression or for any other indication. Failure of the VNS Therapy System to gain additional market acceptance would severely harm our business, our consolidated financial position and results of operations.

 

We may not be successful in our marketing and sales efforts, which could severely harm our business.

 

We launched VNS Therapy for TRD in August 2005 following expansion of our sales and case management organization to support anticipated sales demand in both epilepsy and TRD markets. Although patient demand has been strong, our sales have not increased to the extent we anticipated in August 2005. At the present time, we do not expect sales of the VNS Therapy System for TRD to result in any consistent revenue growth until the product receives broader regional or national coverage by insurers and other payers. In addition, the absence of broad regional or national insurance coverage may have a negative effect on psychiatrists’ prescribing habits, resulting in decreasing sales of VNS Therapy Systems for TRD. Our inability to achieve annual or quarterly revenue growth could substantially harm our consolidated results of operations and financial position.

 

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

 

The Health Insurance Portability and Accountability Act of 1996 (“HIPAA”) establishes federal rules protecting the privacy and security of personal health information. The privacy and security rules address the use and disclosure of individual health care information and the rights of patients to understand and control how such information is used and disclosed. HIPAA provides both criminal and civil fines and penalties for covered entities that fail to comply with HIPAA. We intend to comply with applicable privacy and security standards. However, if we fail to comply with the applicable regulations, we could suffer civil penalties up to $25,000 per calendar year for each violation and criminal penalties with fines up to $250,000 and potential imprisonment. In addition to HIPAA, virtually every state has enacted one or more laws to safeguard privacy, and these laws vary significantly from state to state and change frequently. Even if our business model is compliant with the HIPAA Privacy and Security Rule and the Texas privacy laws, it may not be compliant with the privacy laws of all states. Because the operation of our business involves the collection and use of substantial amounts of “protected health information,” we endeavor to conduct our business as a “covered entity” under the HIPAA Privacy and Security Rule and consistent with the Texas privacy laws, obtaining HIPAA-compliant patient authorizations where required to support the collection and use of patient information. We also sometimes act as a “business associate” for a covered entity. Despite extensive efforts to conduct our business as a covered entity under the HIPAA Privacy and Security Rules, the Office for Civil Rights of the Department of Health and Human Services or another government enforcement agency may determine that our business model or operations are not in compliance with the HIPAA Privacy and Security Rules, which could subject us to penalties, could severely limit our ability to market and sell VNS Therapy under our existing business model and could harm our business growth and consolidated financial position.

 

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

 

Our ability to commercialize the VNS Therapy System successfully depends, in part, on whether third-party payers, including private healthcare insurers, managed care plans, Medicare and Medicaid programs and others, agree to cover the VNS Therapy System and associated procedures and services and to reimburse at adequate levels for the costs of the VNS Therapy System and the related services in the U.S. or internationally. While we currently have reimbursement approval for epilepsy, we have not yet received substantial reimbursement coverage approval for the treatment of depression. In May 2007, CMS issued a national non-coverage determination with respect to VNS Therapy for TRD.

This non-coverage determination means that Medicare will not cover VNS Therapy for TRD. Prior to the non-coverage determination, some patients were able to obtain coverage on a case-by-case basis through their local Medicare contractor or Fiscal Intermediary. Since the national non-coverage determination is binding on all local Medicare contractors, patients will no longer be able to obtain Medicare coverage on a case-by-case basis. In addition, the CMS non-coverage determination also may have a detrimental effect on potential and existing coverage by Medicaid and private payers. In addition, periodic changes to reimbursement methodology for medical devices under the Medicare and Medicaid programs occur and may reduce the rate of increase in federal expenditures for health care costs. Such changes, as well as any future regulatory changes and the failure of the VNS Therapy System to continue to qualify for reimbursement under these programs, may have an adverse impact on our business.

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

In November 2006, we sent physicians a safety alert letter warning of a rare software anomaly that can cause the VNS Therapy System pulse generator to deliver an output current of eight milliamps during an interrupted programming session. This amount of output current is within the range of currents originally approved by the FDA

as safe and effective, but it is higher than is recommended for use. We are aware of eight occurrences of this anomaly, among more than 45,000 VNS Therapy Systems implanted. Although none of the occurrences was associated with permanent injury to a patient, most resulted in at least temporary discomfort. FDA has classified this anomaly as a Class II recall, which we have addressed by means of the safety alert letter. If we fail to follow up appropriately regarding distribution of the safety alert letter, we could be subject to regulatory sanctions.

 

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

 

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

 

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

 

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

 

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

 

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

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

 

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

 

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

 

The preclinical and clinical design, testing, manufacturing, labeling, sale, distribution, servicing and promotion of the VNS Therapy System are subject to extensive and rigorous federal and state laws and regulations, including regulations from the Department of Health and Human Services (related to Medicare, Medicaid, HIPAA and FDA) and from comparable state agencies. In the future, it will be necessary for us to obtain additional government approvals for other indications of the VNS Therapy System, if we choose to develop new indications, and for modified or future-generation products. It is also necessary for us to ensure that our marketing and sales practices comply with all laws and regulations. Commercial distribution in certain foreign countries is also subject to regulatory approvals from the appropriate authorities in such countries. The process of obtaining FDA and other required regulatory approvals is lengthy, expensive and uncertain. Moreover, regulatory approvals may include regulatory restrictions on the indicated uses for which a product may be marketed. Failure to comply with applicable regulatory requirements can result in, among other things, fines, suspension or withdrawal of approvals, confiscations or recalls of products, operating restrictions and criminal prosecution. Adverse results in post-approval studies may result in limitations on or withdrawal of previously granted approvals. Furthermore, changes in existing regulations or adoption of new regulations could prevent us from obtaining, or affect the timing of, future regulatory approvals. We may not be able to obtain additional future regulatory approvals on a timely basis or at all. Delays in receipt of or failure to receive such future approvals, suspension or withdrawal of previously received approvals or recalls of the VNS Therapy System could severely harm our ability to market and sell our current and future products and improvements. As a condition of approval for the TRD indication, the FDA has required us to conduct a post-approval 460-patient dosing study and a 2,000-patient registry of which 1,000 will be treated with VNS Therapy. The results of these studies may be included in product labeling. If we fail to complete these studies in a timely manner, we may be subject to regulatory action, including withdrawal of our TRD indication approval.

 

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

 

We are subject to certain laws and regulations, including the federal Anti-Kickback Statute, the federal False Claims Act and the HIPAA Privacy Rule, that govern the sales and marketing practices of healthcare companies. The Anti-Kickback Statute contains both civil and criminal sanctions, which are enforced by the Office of the Inspector General of Health and Human Services Department (“OIG”) and the U.S. Department of Justice (“DOJ”). Over the past several years, the U.S. government has accused an increasing number of pharmaceutical and medical device manufacturers of violating the Anti-Kickback Statute based on certain marketing and sales practices and compensation arrangements with referral sources. Pharmaceutical and medical device manufacturers also have been accused of alleged violations of the federal False Claims Act, which imposes civil liability (including substantial monetary penalties and damages) on any person or corporation that (1) knowingly presents a false or fraudulent claim for payment to the U.S. government, (2) knowingly uses a false record or statement to obtain payment or (3) engages in a conspiracy to defraud the federal government to obtain allowance for a false claim. Under the qui tam, or whistleblower, provisions of the False Claims Act, private parties may bring actions on behalf of the U.S. government. These private parties are entitled to share in any amounts recovered by the government through trial or settlement. Both direct enforcement activity by the government and whistleblower lawsuits have increased significantly in recent years and have increased the risk that we may be forced to defend a prosecution under the Anti-Kickback Statute, a

false claims action, be liable for monetary fines or be excluded from the Medicare and Medicaid programs as a result of an investigation resulting from an enforcement action or a whistleblower case.

 

In 2004, we adopted a healthcare law compliance program, including our Business Practice Standards, which is a set of policies that embody the AdvaMed Code of Ethics for Interactions with Health Care Professionals. In January 2006, we adopted significant revisions to our Business Practice Standards that we believe more thoroughly address our compliance risks. We endeavor to conduct our business in compliance with our Business Practice Standards and to ensure continued compliance through regular education of our employees, audits of employee activities, and appropriate responses to violations of the Business Practice Standards. Although we believe that these efforts have been successful and that we are in substantial compliance with our policies and the healthcare laws, given the complexity of our business model, including extensive interactions with patients and healthcare professionals, and the large number of field personnel employed by us, violations of our policy and the law could occur. We could be subject to investigation by the OIG or the DOJ or a comparable state agency. If investigated, we could be forced to incur substantial expense responding to the investigation and defending our actions. If unsuccessful in our defense, we could be found to be in violation of the healthcare laws and be subject to substantial fines and penalties, including exclusion of our products from Medicare and Medicaid reimbursement.

 

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

 

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

 

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

 

In connection with the commercialization of the VNS Therapy System in the U.S. for TRD, we made significant changes to our organization, including an initial scale up in personnel from February 2005 through July 2005 of approximately 50% and subsequent reductions in personnel of 11% in fiscal 2006 and 15% in fiscal 2007. Such activities have placed, and may continue to place a significant strain on our resources and operations. Our ability to grow in the future will depend upon our ability to attract, hire and retain highly qualified employees and management personnel. We compete for such personnel with other companies, academic institutions, government entities and other organizations and we may not be successful in hiring or retaining qualified personnel. In November 2006, the Chief Executive Officer and Chief Financial Officer resigned, and in May 2007 we hired a new Chief Executive Officer and our Interim Chief Financial Officer resigned. These changes in key management positions strain our existing resources, creating a risk of loss of other key employees. As a result, our business could be affected detrimentally.

 

We have in the past and are again now involved in an investigation conducted by the Staff of the Senate Finance Committee resulting in adverse publicity, expenditure of substantial resources and diversion of management attention, all with an adverse effect on our business.

 

We received a letter in November 2006 and a second letter in March 2007 from Senator Charles Grassley on behalf of the United States Senate Committee on Finance (“SFC”) requesting our cooperation in providing certain documents and information relating to (1) our employees, agents and consultants regarding their meetings and communications with the CMS regarding coverage of the VNS Therapy System for TRD and (2) our agents’ and consultants’ participation in presentations, preparation of publications and advice to government agencies on VNS Therapy for TRD. A discussion of the SFC investigation is contained in “Note 15. Litigation — Senate Finance Committee Investigation.” We are unable to provide assurance at this time as to any further action that may be taken by the SFC or its staff in regard to this matter. Any further action taken by the SFC or its staff could have a material adverse effect on our business, including but not limited to increased expense to comply with requests and diversion of management attention from the conduct of our business.

We have been named in a putative securities class action lawsuit.

 

We and certain of our officers have been named as defendants in a putative class action lawsuit. A discussion of this lawsuit is contained in “Note 15. Litigation — Securities Class Action Lawsuit.” Although it is not possible at this early stage to predict the likely outcome of this lawsuit, an adverse result could have a material adverse effect on us, our consolidated financial position, results of operations and cash flows. Even if the result of such litigation is not adverse, the cost of defending against such litigation has been and will continue to be expensive and could have a material adverse effect on our consolidated financial position.

 

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

 

In June 2006, the SEC staff advised us that it had commenced an informal inquiry of our stock option grants and related practices, procedures and accounting. In June 2006, we also received a subpoena from the U.S. Attorney requesting documents related to the same matters. In October 2006, the SEC staff made an additional request for certain documents and information related to our revised guidance on February 8, 2006 and our financial results announced on May 1, 2006, our sales for the quarter ended April 28, 2006, coverage or potential coverage of our VNS Therapy System by Alabama BlueCross BlueShield and Aetna and the aging of our accounts receivable since January 1, 2003. We are cooperating with these governmental investigations. A more detailed discussion of these matters is contained in “Note 15. Litigation — Governmental Investigations of Options Granting Practices.” Although it is not possible at this early stage to predict the likely outcome of these inquiries, an adverse result could have a material adverse effect on us, our consolidated financial position, results of operations and cash flows. Even if the result of such inquiries is not adverse, the cost of defending against such inquiries has been and will continue to be expensive and could have a material adverse effect on our consolidated financial position.

 

We are named as a nominal defendant in six stockholder derivative lawsuits which, as a result of our indemnity obligations to the current and former officers and directors named as defendants, could be costly to us.

 

A discussion of the pending stockholder derivative claims is contained in “Note 15. Litigation — Stockholder Derivative Litigation.” Our bylaws require us to advance fees and expenses to officers and directors in certain situations. The advancement of fees and expenses to officers and directors, both current and former, to defend the stockholder derivative claims could be costly and could have a material adverse effect on our consolidated financial position.

 

 

We have previously disclosed that we are subject to an inquiry by the SEC relating to our accounting for stock option grants. To date, we have not received written comments by the SEC regarding any of our periodic or current reports filed under the Exchange Act, as amended, not less than 180 days before the fiscal year ended April 27, 2007 that remain unresolved.

 

 

We have agreed to lease approximately 143,000 square feet of office and manufacturing space in Houston, Texas through December 2009. We have also agreed to lease approximately 17,000 square feet in sales offices in Europe through April 2010. All leased properties have been expanded to accommodate expected growth in our domestic and international businesses.

 

 

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

 

Two matters were submitted to a vote at our annual meeting of stockholders held on February 1, 2007: (1) the election of directors to the Cyberonics’ Board of Directors and (2) the ratification of the selection of KPMG LLP as Cyberonics’ independent registered public accounting firm for the fiscal year ending April 27, 2007.

In the election of directors, Guy C. Jackson received 21,211,392 votes for election and 90,799 votes were withheld from voting for Mr. Jackson; Hugh M. Morrison received 21,215,224 votes for election and 86,967 votes were withheld from voting for Mr. Morrison; Alfred J. Novak received 14,924,461 votes for election and 1,370,777 votes were withheld from voting for Mr. Novak; Alan Olsen received 21,236,043 votes for election and 66,148 votes were withheld from voting for Mr. Olsen; Arthur L. Rosenthal received 16,072,226 votes for election and 223,012 votes were withheld from voting for Mr. Rosenthal; Jeffrey E. Schwartz received 16,228,014 votes for election and 67,224 votes were withheld from voting for Mr. Schwartz; Michael J. Strauss, M.D., M.P.H. received 21,235,263 votes for election and 66,928 votes were withheld from voting for Dr. Strauss; and Reese S. Terry, Jr. received 21,235,799 votes for election and 66,392 votes were withheld from voting for Mr. Terry. There were no broker non-votes for the election of directors.

 

On the proposal to ratify the selection of KPMG LLP as our independent registered public accounting firm for the fiscal year ending April 27, 2007, 19,178,345 votes were received for approval of the proposal, 850,175 votes were received against approval of the proposal and holders of 1,273,671 shares abstained from voting on this proposal. There were no broker non-votes on this proposal.

 

On April 24, 2007, our Board appointed Daniel J. Moore as President, Chief Executive Officer and member of the Board effective on May 1, 2007, subject to his execution of an employment agreement prior to May 5, 2007. We executed an employment agreement with Mr. Moore on April 26, 2007 and he joined our Board on May 1, 2007.

 

Our common stock is quoted on The NASDAQ Global Market under the symbol “CYBX.” The high and low sale prices for our common stock during fiscal years 2006 and 2007 are set forth below. Price data reflect actual transactions, but do not reflect mark-ups, mark-downs or commissions.

 

 

As of June 22, 2007, according to data provided by our transfer agent, there were 387 stockholders of record.

 

During fiscal 2006 and 2007, we did not pay any cash dividends to our stockholders. We currently intend to retain future earnings to fund the development and growth of our business and, therefore, do not anticipate paying cash dividends within the foreseeable future. Any future payment of dividends will be determined by our Board of Directors and will depend on our consolidated financial position and results of operations and other factors deemed relevant by our Board of Directors. In addition, the credit agreement restricts us from issuing dividends if we are in default of any term of the agreement or if after paying the dividend, we should not be in compliance with the financial covenants of the agreement.

 

For a discussion of the securities authorized under our equity compensation plans, see “Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.”

 

The following table summarizes certain selected financial data and is qualified by reference to, and should be read in conjunction with the Consolidated Financial Statements and related Notes and with “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in this Form 10-K. The selected financial data and the related Notes for the 52 weeks ended April 27, 2007, April 28, 2006 and April 29, 2005 is derived from consolidated financial statements that are included in this Form 10-K. The selected financial data for the 53 weeks ended April 30, 2004 and 52 weeks ended April 25, 2003 is derived from unaudited financial statements that are not included in this Form 10-K.

 

 

As discussed in “Note 10. Stock Incentive and Purchase Plans” in the Notes to the Financial Statements, we adopted SFAS 123 (revised 2004) “Share-Based Payment” (“SFAS 123(R)”) effective April 29, 2006. As a result, we recognized non-cash compensation expenses during fiscal 2007 in the amount of $19.4 million. See “Note 10. Stock Incentive and Purchase Plans” in the notes to the Financial Statements for additional information.

 

You should read the following discussion and analysis together with “Item 6. Selected Financial Data” and our Consolidated Financial Statements and the related Notes.

 

This discussion contains forward-looking statements based on our current expectations, assumptions, estimates and projections about our industry and us. For a discussion of the risks and uncertainties affecting these statements, see “Cautionary Statement about Forward-Looking Statements” as well as “Item 1. Business” and “Item 1A. Risk Factors” in this Form 10-K. We undertake no obligation to update publicly any forward-looking statements, even if new information becomes available or other events occur in the future.

 

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

 

Going Concern

 

The accompanying Consolidated Financial Statements have been prepared assuming that we will continue as a going concern. Since inception, we have incurred an accumulated deficit of approximately $259 million. We have incurred substantial expenses, primarily for research and development activities that include product and process development, clinical trials and related regulatory activities, sales and marketing activities, manufacturing start-up costs and systems infrastructure. For the fiscal years ended April 27, 2007 and April 28, 2006 we had a net loss of $51 million and $59 million, respectively. To fund our operations, in fiscal 2006, we incurred additional indebtedness through the issuance of $125 million of Convertible Notes and the establishment of a $40 million line of credit.

 

In July 2006, we received the Notice of Default from the Trustee, pursuant to which the Trustee asserted that we were in default of our obligations under the Indenture with respect to our Convertible Notes as a result of our failure (1) to file with the SEC our 2006 Form 10-K by July 12, 2006 and (2) to deliver a copy of the 2006 Form 10-K to the Trustee by July 27, 2006. In October 2006, we received the Notice of Acceleration from the Trustee informing us that, pursuant to the Indenture, the Trustee declared the Convertible Notes due and payable at their principal amount together with accrued and unpaid interest, and fees and expenses and demanding that all such principal, interest, fees and expenses under the Convertible Notes be paid to the Trustee immediately. We believe that no default occurred under the Indenture, and on June 13, 2007, a federal district court granted summary judgment to Cyberonics and declared that no default occurred under the Indenture. In its court filings, the Trustee stated that it was seeking approximately $20.0 million in damages plus interest and attorney fees, but it reserved the right to seek immediate payment of full value of the Convertible Notes. The Trustee has not appealed the district court’s decision; however, if the Trustee appeals the decision of the district court and if the court of appeals reverses the district court’s decision, then all unpaid principal and accrued interest on the outstanding Convertible Notes could be due and payable immediately. Accordingly, until this matter is resolved, we have included them as a current liability on our Consolidated Balance Sheets as of April 27, 2007 and April 28, 2006. In addition, if a default occurred under the Indenture, we would also be in default of the $40.0 million Line of Credit. If principal and interest on our indebtedness must be repaid immediately, we do not have the cash resources available to repay the debt. If we were not able to renegotiate the terms of the Indenture, or to secure additional financing, this could raise substantial doubt regarding our ability to continue as a going concern. The accompanying consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.

 

Business Overview

 

We are a neuromodulation company founded to design, develop and bring to market medical devices that provide a unique therapy, VNS Therapy, for the treatment of epilepsy, TRD and other debilitating neurological, psychiatric diseases and other disorders. The FDA approved the VNS Therapy System in July 1997 for use as an adjunctive therapy in patients over 12 years of age in reducing the frequency of partial onset seizures that are

refractory or resistant to antiepileptic drugs. Regulatory bodies in Canada, Europe, South America, Africa, India, Australia and certain countries in Eastern Asia have approved VNS Therapy for the treatment of epilepsy without age restrictions or seizure-type limitations. FDA also approved the VNS Therapy System for the adjunctive long-term treatment of chronic or recurrent depression for patients 18 years of age or older who are experiencing a major depressive episode and have not had an adequate response to four or more adequate anti-depressant treatments. Regulatory bodies in the European Union countries and Canada approved the VNS Therapy System for the treatment of chronic or recurrent depression in patients who are in a treatment-resistant or in a treatment-intolerant depressive episode without age restrictions.

 

Our ability to expand successfully the commercialization of the VNS Therapy System depends on obtaining and maintaining favorable coverage, coding and reimbursement for the implant procedure and follow-up care. Currently, we have broad coverage, coding and reimbursement for VNS Therapy for the treatment of epilepsy. We are actively pursuing favorable coverage decisions to expand reimbursement to include VNS Therapy for TRD. Absent favorable national and regional coverage policies, we have been obtaining certain TRD case-by-case approvals since FDA approval in July 2005. Our long-term growth in TRD is dependent on our progress in obtaining favorable national and regional coverage policies in TRD.

 

Our clinical development program has included pilot and pivotal studies in using VNS Therapy (1) as an adjunctive therapy for reducing the frequency of seizures in patients over 12 years of age with partial onset seizures that are refractory to antiepileptic drugs and (2) as an adjunctive treatment of patients 18 years of age and older with chronic or recurrent TRD in a major depressive episode. We have also conducted or provided support for small pilot studies for the treatment of Alzheimer’s Disease, anxiety, chronic migraine headache, bulimia and other indications. These studies have been conducted to determine the safety and effectiveness of VNS Therapy and to determine which new indications might be considered for pivotal studies and, therefore, are an important component of our clinical research activities.

 

Since inception, we have incurred substantial expenses, primarily for research and development activities that include product and process development and clinical trials and related regulatory activities, sales and marketing activities, manufacturing start-up costs and systems infrastructure. We have also made significant investments in recent periods in connection with sales and marketing activities in the U.S. and clinical research costs associated with new indications development, most notably depression. For the period from inception through April 27, 2007, we incurred an accumulated net deficit of approximately $259 million. We anticipate increasing investments in post-approval clinical studies in epilepsy and depression.

 

The primary exchange rate movements that impact our consolidated net sales growth include the U.S. dollar as compared to the Euro. The weakening of the U.S. dollar in fiscal 2006 generally has a favorable impact on our sales for the year. The impact of foreign currency fluctuations on net sales is not indicative of the impact on our operations due to the offsetting foreign currency impact on operating costs and expenses.

 

Related Proceedings

 

Regulatory Proceedings.  In June 2006, the SEC staff advised us that it had commenced an informal inquiry of our stock option grants and related practices, procedures and accounting. In addition, we received a subpoena from the U.S. Attorney requesting documents related to the same matters. For additional information, see “Note 15. Litigation” in the Notes to the Consolidated Financial Statements.

 

Legal Proceedings.  We are named as a nominal defendant in stockholder derivative lawsuits pending in Texas state and federal courts wherein a stockholder purports to pursue claims on our behalf against several of our current and former officers and members of our Board of Directors. For additional information, see “Note 15. Litigation” in the Notes to the Consolidated Financial Statements. In June 2005, a putative class action lawsuit was filed against us and certain of our current and former officers in the United States District Court for the Southern District of Texas. For additional information, see “Note 15. Litigation” in the Notes to the Consolidated Financial Statements.

 

Significant Accounting Policies and Critical Accounting Estimates

 

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

 

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

 

We consider the following accounting policies as the most significant because, in management’s view, they are most important to the portrayal of our consolidated financial position and results of operations and most demanding in terms of requiring estimates and other exercises of judgment.

 

Accounts Receivable.  We provide an allowance for doubtful accounts based upon specific customer risks and a general provision based upon historical trends. An increase in losses beyond that expected by management or what we have historically experienced would reduce earnings when they become known.

 

Inventories.  We state our inventories at the lower of cost, first-in, first-out (“FIFO”) method, or market. Cost includes the acquisition cost of raw materials and components, direct labor and overhead. Management considers potential obsolescence at each balance sheet date. An acceleration of obsolescence could occur if consumer demand differs from expectations.

 

Property and Equipment.  Property and equipment are carried at cost, less accumulated depreciation. Maintenance, repairs and minor replacements are charged to expense as incurred; significant renewals, improvements and expansions are capitalized. For financial reporting purposes, we compute depreciation using the straight-line method over useful lives ranging from two to nine years. An unanticipated change in the utilization or expected useful life of property and equipment could result in acceleration in the timing of the expenses.

 

Revenue Recognition.  We sell our products through a combination of a direct sales force in the U.S. and certain European countries and through distributors elsewhere. We recognize revenue when title to the goods and risk of loss transfer to customers, providing there are no remaining performance obligations required of us or any matters requiring customer acceptance. We record estimated sales returns and discounts as a reduction of net sales in the same period revenue is recognized. Our revenues are dependent upon sales to new and existing customers pursuant to our current policies. Changes in these policies or sales terms could impact the amount and timing of revenue recognized.

 

Research and Development.  All research and development costs are expensed as incurred. We have entered into contractual obligations for the conduct of clinical studies. Costs are incurred primarily at the time of enrollment and paid under the terms of the contracts. Research and development expenses could vary significantly with changes in the timing of clinical activity.

 

Stock Options.  Prior to April 29, 2006, we adopted the disclosure-only provisions of Statement of Financial Accounting Standards Board (“SFAS”) No. 123, “Accounting for Stock-Based Compensation” and SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure,” which disclosures are presented in “Note 1. Summary of Significant Accounting Policies and Related Data” in the Notes to the Consolidated Financial Statements. Because of this election, we accounted for our employee stock-based compensation plans under Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees” and the related interpretations.

 

We adopted SFAS 123(R) on April 29, 2006 using The Black-Scholes option pricing model and The Modified Prospective Method, which requires the compensation cost to be recognized under SFAS 123(R) for grants issued after the adoption date and the unvested portion of grants issued prior to the adoption date. As a result of the adoption of

SFAS 123(R), we recognized non-cash share-based compensation expense of approximately $19.4 million during fiscal 2007 including the impact associated with the resignation of certain former officers and employees and we anticipate recognizing approximately $11.4 million in non-cash compensation expense during fiscal 2008. This estimate is affected by assumptions regarding a number of complex and subjective variables.

 

Income Taxes.  We account for income taxes under the asset and liability method. Under this method, deferred income taxes reflect the impact of temporary differences between financial accounting and tax bases of assets and liabilities. Such differences relate primarily to the deductibility of certain accruals and reserves and the effect of tax loss and tax credit carryforwards not yet utilized. Deferred tax assets are evaluated for realization based on a more-likely-than-not criterion in determining if a valuation allowance should be provided.

 

Results of Operations

 

Net Sales

 

U.S. net sales increased by $3.2 million, or 2.9%, in fiscal year 2007 compared to fiscal year 2006 primarily due to higher average selling prices. International net sales increased by $4.3 million, or 28%, in fiscal year 2007 compared to fiscal year 2006, due to a 22% increase in new patient sales and a 9% higher average selling price.

 

U.S. net sales increased by $17.6 million, or 20%, in fiscal year 2006 compared to fiscal year 2005, primarily due to an 18% increase in new patient sales, partially offset by a decrease in replacement sales. International net sales increased by $2.4 million, or 18%, in fiscal year 2006 compared to fiscal 2005 due to increases in new patient sales.

 

Gross Profit

 

Gross profit increased by $5.1 million, or 5% in fiscal year 2007, compared to fiscal year 2006 primarily due to higher average selling prices and increased sales volumes. Gross profit margin decreased by 112 basis points to 86.1% compared to fiscal 2006 due to lower production volumes affecting operational efficiencies, which had an adverse impact of 233 basis points, non-cash stock — based compensation expense of $0.8 million with an impact of 60 basis points offset by higher average selling prices with a favorable impact of 181 basis points.

 

Gross profit increased by $19.9 million, or 23%, in fiscal year 2006 compared to fiscal year 2005, primarily due to higher sales volumes. Gross profit margin increased by 235 basis points to 87.2% due to increased production volumes resulting in improved operational efficiencies impacting gross profit margin by approximately 125 basis points and improvement in average selling prices due to mix which had a favorable impact of 110 basis points.

 

Cost of sales consists primarily of direct labor, allocated manufacturing overhead, third-party contractor costs, royalties and the acquisition cost of raw materials and components. Gross margins can be expected to fluctuate in future periods based upon the mix between U.S. and international sales, direct and distributor sales, the VNS Therapy System selling price, applicable royalty rates and the levels of production volume.

 

Operating Expenses

 

Selling, General and Administrative (“SG&A”) Expenses.  SG&A expenses are comprised of sales, marketing, development, general and administrative activities. SG&A expenses for the fiscal year 2007 decreased by $3.2 million, or 2.3%, as compared to fiscal year 2006. The decrease is primarily due to a decrease of $37.9 million in sales, marketing and related expenses associated with the TRD launch during fiscal year 2006, which was partially offset by higher Finance and Administration expenses of $5.4 million primarily associated with the resignations of our Chief Executive Officer (“CEO”) and our Chief Financial Officer (“CFO”), proxy cost of approximately $1.6 million associated with a director election contest, an increase of $10.9 million in legal and other expenses primarily due to costs associated with the investigation into our stock options granting and accounting practices, and an increase in non-cash charges of $17.7 million applicable to our adoption of SFAS 123(R). SG&A expenses increased by $50.3 million, or 58%, in fiscal year 2006 as compared to fiscal year 2005. SG&A expenses include pre-tax non-cash stock-based compensation expense of $15.4 million, ($2.3) million and $6.1 million for fiscal years ended April 27, 2007, April 28, 2006 and April 29, 2005, respectively. In fiscal 2006, SG&A expense included a credit of $2.3 million for pre-tax non-

cash stock-based compensation expense due to variable accounting treatment for certain grants and a drop in our common stock price relative to the price at the end of fiscal 2005.

 

Research and Development (“R&D”) Expenses.  R&D expenses are comprised of expenses related to our product and process development, product design efforts, clinical trials programs and regulatory activities. R&D expenses decreased by $1.4 million, or 4.9%, as compared to fiscal year 2006 and increased by $9.4 million, or 47%, in fiscal year 2006 as compared to fiscal year 2005. The decrease in fiscal year 2007 is primarily due to a reduction in engineering and regulatory expenses of $4.9 million, partially offset by an increase of $2.4 million in international clinical expenses and $2.5 million in higher non-cash charges. The increases during fiscal year 2006 as compared to fiscal year 2005 were primarily due to additional product development programs and expanded regulatory activities primarily related to the depression approval and launch. R&D expenses include pre-tax non-cash stock-based compensation expense of $3.3 million, $1.7 million and $0.9 million for fiscal years ended April 27, 2007, April 28, 2006 and April 29, 2005, respectively.

 

Interest Income

 

Interest income of $4.6 million during fiscal year 2007 increased by 45% as compared to interest income of $3.2 million for fiscal year 2006, due to increased interest rates. Interest income for fiscal year 2006 increased by 199% as compared to fiscal year 2005 due to higher average investment balances attributable to the net proceeds of $98.3 million received from the Convertible Notes and higher interest rates.

 

Interest Expense

 

Interest expense of $5.9 million for fiscal year 2007 increased 96% from $3.0 million in fiscal 2006 primarily due to higher loan balances and interest and fees applicable to the Convertible Notes, including $0.4 million of penalty interest. The average interest rate for fiscal 2007 was 7.06% as compared to 6.17% in fiscal 2006.

 

Other Income (Expense), Net

 

Other expense, net of $0.3 million for the 52 weeks ended April 27, 2007, represented a decrease of $0.4 million, or 548% as compared to other income of $0.1 million for the same period during the previous fiscal year. It primarily includes income related to the transaction gains and losses associated with the impact of changes in foreign currency exchange rates offset by derivative expense associated with the extension of certain stock option grants to former employees whose grants would have expired unexercised due to our inability to issue stock under our stock option plans as a consequence of our delinquent SEC reports. Other income, net was $0.1 million for the 52 weeks ended April 28, 2006 and April 29, 2005. It primarily includes income related to the transaction gains and losses associated with the impact of changes in foreign currency exchange rates.

 

Income Taxes

 

At April 27, 2007, we had net operating loss carryforwards for federal income tax purposes of approximately $253.4 million. The following is a reconciliation of statutory federal income tax rates to our effective income tax rate expressed as a percentage of loss before income taxes:

 

Liquidity and Capital Resources

 

Overview

 

We generated a net loss of $51.2 million for the year ended April 27, 2007, as compared to a net loss of $59.1 million for the year ended April 28, 2006 and net loss of $18.6 million for the year ended April 29, 2005. The decrease in net loss during fiscal year 2007 as compared to the loss during fiscal 2006 is primarily due to decreases in SG&A expenses in the amount of $37.9 million as a result of lower sales, marketing and related expenses associated with the TRD launch, and $5.6 million reduction in clinical, engineering and regulatory expenses, partially offset by $18.7 million in higher non-cash charges, $4.3 million associated with the resignation of the CEO and CFO, $1.6 million contested proxy cost and $12.0 million in legal and other expenses related to the SEC investigation. As a result, cash used in operations was $20.7 million for the year ended April 27, 2007, as compared to $70.9 million used in operations for the year ended April 28, 2006 and $4.0 million used in operations for the year ended April 29, 2005. To fund operations, we incurred $5.0 million in additional indebtedness in fiscal 2007 through additional borrowings against our line of credit facility.

 

We believe our current financial and capital resources will be adequate to fund anticipated business activities through fiscal 2008, although there can be no assurance of this as this estimate is based upon a number of assumptions, which may not hold true. Our current assumptions include, consistent with the federal district court’s June 2007 decision, the assumption that no default has occurred under the Indenture for our Convertible Notes, which include principal maturity of greater than 24 months. The Trustee has not appealed the district court’s decision; however, if the Trustee appeals the district court’s decision, and if the court of appeals reverses the district court’s decision, then all unpaid principal and accrued interest on the outstanding Convertible Notes will be due and payable immediately, and we may not be able to maintain our operations as a going concern. Our projections of the future TRD markets for VNS Therapy will be significantly impacted by the timing and outcome of pending reimbursement decisions for depression by major payers. Furthermore, our liquidity could be adversely affected by the factors affecting future operating results that are discussed in “Item 1A. Risk Factors.”

 

Cash Flows

 

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

 

 

Operating Activities

 

Net cash used in operating activities during fiscal year 2007 was approximately $20.7 million as compared to net cash used in operating activities of approximately$70.9 million in fiscal 2006 and approximately $4.0 million in fiscal 2005. Operational cash flow increased by approximately $50.2 million during fiscal year 2007 primarily due to a decrease of approximately $7.9 million in net loss, and favorable changes in non-cash expenses of approximately $19.9 million and in operating assets and liabilities of approximately $22.4 million. Operational cash flow decreased by approximately $66.9 million in fiscal year 2006 as compared to fiscal year 2005 due to a net loss in fiscal 2006 of approximately $59.1 million and an increase of approximately $15.9 million in working capital to support the U.S. TRD launch in fiscal 2006.

 

Investing Activities

 

Net cash used by investing activities during fiscal year 2007 was approximately $1.4 million compared to cash provided by investing activities in fiscal 2006 of approximately $17.5 million and cash used during fiscal year 2005 of approximately $11.6 million. Cash used during fiscal year 2007 was invested in the purchase of property and equipment. Net proceeds during fiscal year 2006 of approximately $22.8 million from the sale of short-term marketable securities were offset by purchases of property and equipment of approximately $4.3 million and

approximately $1.0 million in restricted cash. Net cash used in investing activities in fiscal 2005 was approximately $11.6 million and included net purchases of short-term marketable securities of approximately $7.9 million and purchases of property and equipment of approximately $3.7 million.

 

Financing Activities

 

Net cash provided by financing activities during fiscal year 2007 was approximately $14.4 million compared to net proceeds of approximately $107.0 million in fiscal 2006 and approximately $10.9 million in fiscal year 2005. The net proceeds during fiscal year 2007 include approximately $5.0 million in borrowings against our line of credit facility and approximately $9.7 million in proceeds from issuance of common stock, partially offset by approximately $0.3 million in payments on financing obligations. On January 13, 2006, we established a $40.0 million revolving line of credit that replaced the $20.0 million revolving line of credit that expired in September 2005. Borrowings against the line of credit were reduced by approximately $0.5 million to $2.5 million in fiscal 2006. On September 27, 2005, we issued Convertible Notes in the amount of $125.0 million. Interest on the Convertible Notes at the rate of 3% per year on the principal amount is payable semi-annually in arrears in cash on March 27 and September 27 of each year, beginning March 27, 2006. Holders may convert their Convertible Notes, which were issued in the form of $1,000 bonds, into 24.0964 shares of our common stock per bond, which equal to a conversion price of approximately $41.50 per share, subject to adjustments, at any time prior to maturity. This offering provided net proceeds of approximately $121 million. We used the proceeds for (1) a simultaneous share buyback of 301,000 shares at $33.20 for a total of $10.0 million and (2) the net cost of $13.0 million of separate convertible bond hedge and common stock warrant transactions, which transactions were designed to limit our exposure to potential dilution from conversion of the Convertible Notes. These transactions resulted in net cash proceeds of $98.3 million. We received approximately $10.5 million in connection with the issuance of shares pursuant to our stock option and employee stock purchase plans in fiscal year 2006.

 

Net cash provided by financing activities in fiscal 2005 was approximately $10.9 million. We received approximately $18.0 million in connection with the issuance of shares pursuant to our stock option and employee stock purchase plans in fiscal year 2005. Borrowings against the line of credit were reduced by approximately $7.0 million to $3.0 million.

 

Debt Instruments and Related Covenants

 

Line of Credit

 

On January 13, 2006, we established a $40.0 million revolving line of credit (“Credit Agreement”) with Merrill Lynch Capital, a division of Merrill Lynch Business Financial Services Inc. (“Administrative Agent”) and the lenders who are party thereto (“Lenders”). The credit facility has a three-year term ending January 13, 2009 and is collateralized by accounts receivable, inventory, subsidiary stock, general intangibles, equipment and other collateral. The collateral does not include our intellectual property and provides the lender only limited rights and remedies with respect to the funds raised in our Convertible Notes offering. Pursuant to the terms of the Credit Agreement, we agreed to maintain a minimum liquidity, which is defined as the sum of the revolving loan limit minus the revolving loan outstanding plus the unrestricted cash and cash equivalent balances of $25.0 million, and to provide periodic certifications of compliance in connection with the facility. The amount available under the facility is limited to 85% of the eligible accounts receivable and a portion of eligible inventory. As of April 27, 2007 our available borrowing capacity was approximately $19.8 million with a loan balance of $7.5 million.

 

On December 29, 2006, we entered into a Consent and Amendment Agreement with the Administrative Agent and Lenders which provided that our receipt of the Notice of Default from the Trustee in connection with the Indenture as a result of our failure to file and deliver our 2006 Form 10-K as purportedly required by the Indenture will not constitute a default under the Credit Agreement so long as there is no determination by a court and we have not otherwise acknowledged that a default has occurred under the Indenture. The Consent and Amendment Agreement with the Administrative Agent and Lenders further provided that for the term of the Consent and Amendment Agreement our borrowing under the Line of Credit is limited to $7.5 million. On February 1, 2007 the terms of the Credit Agreement required that we begin paying interest on the minimum loan balance of $10.0 million.

 

If an event of default has occurred under the Indenture as discussed below, we would also be in default of the $40.0 million line of credit.

 

Convertible Notes

 

In September 2005, we issued the Convertible Notes. Interest on the Convertible Notes at the rate of 3% per year on the principal amount is payable semi-annually in arrears in cash on March 27 and September 27 of each year, beginning March 27, 2006. The Convertible Notes are unsecured and subordinated to all of our existing and future senior debt and equal in right of payment with our existing and future senior subordinated debt. Holders may convert their Convertible Notes, which were issued in the form of $1,000 bonds, into 24.0964 shares of our common stock per bond, which equal to a conversion price of approximately $41.50 per share, subject to adjustments, at any time prior to maturity.

 

In July 2006, we received the Notice of Default from the Trustee, pursuant to which the Trustee asserted that we were in default of our obligations under the Indenture as a result of our failure (1) to file with the SEC our 2006 Form 10-K by July 12, 2006 and (2) to deliver a copy of our 2006 Form 10-K to the Trustee by July 27, 2006. In October 2006, we received the Notice of Acceleration from the Trustee informing us that, pursuant to the Indenture, the Trustee declared the Convertible Notes due and payable at their principal amount, together with accrued and unpaid interest, and fees and expenses, and demanding that all such principal, interest, fees and expenses under the Convertible Notes be paid to the Trustee immediately. As such, although the Convertible Notes mature in 2012, we have included them as a current liability on our Consolidated Balance Sheets as of April 27, 2007 and April 28, 2006. On June 13, 2007, a federal district court granted summary judgment to Cyberonics and declared that no default occurred under the Indenture. In its court filings, the Trustee stated that it was seeking approximately $20.0 million in damages plus interest and attorney fees, but it reserved the right to seek immediate payment of full value of the Convertible Notes. See “Note 15. Litigation — Indenture Default Litigation.”

 

The Trustee has not appealed the district court’s decision. If the Trustee appeals the decision of the district court, and if the court of appeals reverses the decision of the district court and determines that a default occurred under the Indenture, then all unpaid principal and accrued interest on the outstanding Convertible Notes could be due and payable immediately unless we negotiate an amendment to the terms of the Indenture. If the principal and accrued interest on the outstanding Convertible Notes must be repaid immediately, we may not have or be able to obtain access to the funds needed to repay the indebtedness, and we may be forced to seek protection under the Bankruptcy Code.

 

If principal and interest on our indebtedness must be repaid immediately, we do not have the cash resources available to repay the debt. If we were not able to secure additional financing, our ability to continue as a going concern would be uncertain.

 

Contractual Obligations

 

We are party to a number of contracts pursuant to which we are paying for clinical studies for current operating obligations payable totaling $2.7 million as of April 27, 2007. Although we have no firm commitments, we expect to make capital expenditures of approximately $2.8 million during fiscal year 2008, primarily to expand organizational capacity and to enhance business infrastructure and facilities.

 

The chart below reflects our obligations under our material contractual obligations as of April 27, 2007.

 

 

 

Factors Affecting Future Operating Results and Common Stock Price

 

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

 

We are exposed to limited market risk on interest rates and foreign currency exchange rates.

 

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

 

Due to the global reach of our business, we are also exposed to market risk from changes in foreign currency exchange rates, particularly with the U.S. dollar over the Euro. Our wholly owned foreign subsidiary is consolidated into our financial results and is subject to risks typical of an international business including, but not limited to, differing economic conditions, changes in political climate, differing tax structures, other regulations and restrictions and foreign exchange rate volatility. Accordingly, our future results could be materially impacted by changes in these or other factors. At this time, we have not deemed it to be cost effective to engage in a program of hedging the effect of foreign currency fluctuations on our operating results using derivative financial instruments. A sensitivity analysis indicates that, if the U.S. dollar uniformly weakened 10% against the Euro, the effect upon the net loss recorded during fiscal year 2007 would be favorable by approximately $0.7 million, or 1.3%. Conversely, if the U.S. dollar uniformly strengthened 10% against the Euro, the impact on our operations would be unfavorable by approximately $0.4 million, or 0.8%.

 

Our Convertible Notes are sensitive to fluctuations in the price of our common stock into which the debt is convertible. Changes in equity prices may result in changes in the fair value of the convertible subordinated debt due to the difference between the current market price of the debt and the market price at the date of issuance of the debt. At April 27, 2007, a 10% decrease in the price of our common stock could have resulted in a decrease of approximately $4.0 million on the net fair value of our Convertible Notes, while a 10% increase in the price of our common stock could have resulted in an increase of approximately $5.0 million on the fair value of our Convertible Notes.

 

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

 

None.

 

Disclosure Controls and Procedures

 

 

We maintain a system of disclosure controls and procedures that are designed to ensure that information required to be disclosed in our reports filed under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Such information is also accumulated and communicated to management, including our CEO and Principal Financial and Accounting Officer (“CAO”), as appropriate, to allow timely decisions regarding required disclosure. Our management, under the supervision and with the participation of our CEO and CAO, evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the most recent fiscal quarter reported on herein. Based on that evaluation, our CEO and CAO concluded that our disclosure controls and procedures were effective as of April 27, 2007.

 

 

Our management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act. Internal control over financial reporting is a process designed by, or under the supervision of, the company’s board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles and includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of our assets; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the company’s assets that could have a material effect on the financial statements.

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

In connection with the preparation of our annual consolidated financial statements, our management, under the supervision and with the participation of our CEO and CAO, assessed the effectiveness of our internal control over financial reporting based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). Our management has concluded that our internal control over financial reporting was effective as of April 27, 2007.

 

KPMG LLP, our independent registered public accounting firm, has issued an audit report on management’s assessment of internal control over financial reporting as of April 27, 2007.

 

 

The following were changes in our internal control over financial reporting that occurred during our most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

 

In addition, the Board of Directors approved and implemented a new equity incentive policy effective November 18, 2006, which limited the issuance of grants to certain pre-defined dates and required that all grants be approved by the Compensation Committee or the Board;

 

Based on the changes in internal control, a material weakness did not exist as of April 27, 2007.

 

Other Changes in Internal Control Over Financial Reporting

 

There have been no other changes in our internal control over financial reporting during the quarter ended in April 27, 2007 in connection with the aforementioned evaluation that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

Audit Committee Oversight

 

The adequacy of our internal control over financial reporting, the accounting principles employed in our financial reporting and the scope of independent audits are reviewed by the Audit Committee, consisting solely of outside directors. The independent auditors meet with, and have confidential access to, the Audit Committee to discuss the results of their audit work.

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

The Board of Directors and Stockholders

Cyberonics, Inc.:

 

We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control Over Financial Reporting (Item 9A(b)) that Cyberonics, Inc. maintained effective internal control over financial reporting as of April 27, 2007, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Cyberonics, Inc.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.

 

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

 

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

In our opinion, management’s assessment that Cyberonics, Inc. maintained effective internal control over financial reporting as of April 27, 2007, is fairly stated, in all material respects, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also, in our opinion, Cyberonics, Inc., maintained, in all material respects, effective internal control over financial reporting as of April 27, 2007, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

 

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Cyberonics, Inc. and subsidiary as of April 27, 2007 and April 28, 2006, and the related consolidated statements of operations, stockholders’ equity (deficit) and comprehensive loss, and cash flows for the 52 weeks ended April 27, 2007, April 28, 2006, and April 29, 2005, and our report dated July 6, 2007 expressed an unqualified opinion on those consolidated financial statements.

 

 

Houston, Texas

July 6, 2007

 

None.

 

Pursuant to general instruction G to Form 10-K, we incorporate by reference into this item the information to be disclosed in our definitive proxy statement for our 2007 Annual Meeting of Stockholders.

 

Pursuant to general instruction G to Form 10-K, we incorporate by reference into this item the information to be disclosed in our definitive proxy statement for our 2007 Annual Meeting of Stockholders.

 

Pursuant to general instruction G to Form 10-K, we incorporate by reference into this item the information to be disclosed in our definitive proxy statement for our 2007 Annual Meeting of Stockholders.

 

Pursuant to general instruction G to Form 10-K, we incorporate by reference into this item the information to be disclosed in our definitive proxy statement for our 2007 Annual Meeting of Stockholders.

 

Pursuant to general instruction G to Form 10-K, we incorporate by reference into this item the information to be disclosed in our definitive proxy statement for our 2007 Annual Meeting of Stockholders.

 

(1) Financial Statements.

 

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

 

 

(2) Financial Statement Schedules

 

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

 

(3) Index to Exhibits

 

The exhibits marked with the asterisk symbol (*) are filed with this Form 10-K. The exhibits marked with the cross symbol (†) are management contracts or compensatory plans or arrangements filed pursuant to Item 601(b)(10)(iii) of Regulation S-K.

 

SIGNATURES

 

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

 

Cyberonics, Inc.

 

Interim Principal Accounting Officer

(Principal Financial Officer and
Principal Accounting Officer)

 

Date: July 6, 2007

 

POWER OF ATTORNEY

 

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

 

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

 

 

CONSOLIDATED FINANCIAL STATEMENTS
April 27, 2007, April 28, 2006 and April 29, 2005
TOGETHER WITH INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM’S REPORT

 

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

The Board of Directors and Stockholders

Cyberonics, Inc.:

 

We have audited the accompanying consolidated balance sheets of Cyberonics, Inc. and subsidiary as of April 27, 2007 and April 28, 2006, and the related consolidated statements of operations, stockholders’ equity (deficit) and comprehensive loss, and cash flows for the 52 weeks ended April 27, 2007, April 28, 2006, and April 29, 2005. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Cyberonics, Inc. and subsidiary as of April 27, 2007 and April 28, 2006, and the results of their operations and their cash flows for the 52 weeks ended April 27, 2007, April 28, 2006, and April 29, 2005, in conformity with U.S. generally accepted accounting principles.

 

As discussed in Note 1 to the consolidated financial statements, effective April 29, 2006, the Company changed its method of accounting for share-based payments.

 

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Cyberonics, Inc.’s internal control over financial reporting as of April 27, 2007, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated July 6, 2007 expressed an unqualified opinion on management’s assessment of, and the effective operation of, internal control over financial reporting.

 

The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 2 to the consolidated financial statements, the Company has suffered recurring losses from operations, received a Notice of Default and demand letter and Notice of Acceleration for the $125 million senior subordinated convertible notes and incurred a potential default of the $40 million Line of Credit. These matters raise substantial doubt about its ability to continue as a going concern. Management’s plans in regard to these matters are also described in Note 2. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.

 

 

Houston, Texas

July 6, 2007

CYBERONICS, INC. AND SUBSIDIARY

 

CONSOLIDATED BALANCE SHEETS

 

 

See accompanying Notes to Consolidated Financial Statements

CYBERONICS, INC. AND SUBSIDIARY

 

CONSOLIDATED STATEMENTS OF OPERATIONS

 

 

See accompanying Notes to Consolidated Financial Statements

 

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