You should read the following discussion and analysis together with Part I of this Form 10-K, including the matters set forth in "Cautionary Statement About Forward-Looking Statements," "Item 1A. Risk Factors" and our consolidated financial statements and the related notes included elsewhere in this Form 10-K.

This item provides material historical and prospective disclosures enabling investors and other users to assess our consolidated financial position and results of operations.

Overview

We are a medical device company incorporated as a Delaware corporation in 1987, engaged in the design, development, sales and marketing of implantable medical devices that provide a unique neuromodulation therapy, vagus nerve stimulation therapy (VNS Therapy®), for the treatment of refractory epilepsy and treatment-resistant depression ("TRD") and other device solutions for the management of epilepsy.

Our proprietary VNS Therapy System includes the following:

- An implantable pulse generator to provide the appropriate stimulation to the vagus nerve;
- A lead that connects the generator to the vagus nerve;
- Associated equipment to assist with the implant procedure;
- Equipment to assist the treating physician with setting the stimulation parameters for each patient;
- Appropriate instruction manuals; and
- Magnets to temporarily suspend or induce stimulation manually.

The VNS Therapy pulse generator and lead are surgically implanted, generally during an outpatient procedure. The battery contained in the generator has a finite life, which varies according to the model and the stimulation parameters and settings used for each patient. At or near the end of the useful life of a battery, a patient may, with the advice of a physician, choose to implant a new generator with or without replacing the original lead.

We sell the VNS Therapy System to hospitals and ambulatory surgery centers ("ASCs") on payment terms that are generally 30 days from the shipment date. Our ability to successfully expand the commercialization of the VNS Therapy System depends on obtaining and maintaining favorable insurance coverage, coding and reimbursement for the device, the implant procedure and follow-up care. Currently, there is broad coverage, coding and reimbursement for VNS Therapy for the treatment of refractory epilepsy. The Centers for Medicare and Medicaid Services ("CMS"), which we estimate pays for approximately 25% of the VNS Therapy System implants, issues an annual update to the reimbursement amounts to be received by our customers. There can be no assurance that future changes to CMS reimbursement will not have an adverse effect on our future operating results. A decrease in reimbursement rates or a change in reimbursement methodology by CMS could have an adverse impact on our business and our future operating results. We continue to work with CMS to ensure favorable and appropriate reimbursement for our products and related procedures.

We continue to invest and support the development of future generations of our VNS Therapy System, including generators employing new stimulation paradigms, cardiac and brain-based seizure detection, rechargeable battery technology and wireless communication technology. We also continue to fund and develop other devices that support our focus on device solutions for epilepsy management, such as event monitoring, logging and notification technology using external heart monitoring and movement-related sensor advancements. We sponsor post-marketing studies in appropriate indications, including treatment resistant depression ("TRD"), to build clinical evidence for VNS Therapy. In addition, we are investing in pre-clinical research related to the use of VNS Therapy for the treatment of chronic heart failure.

In August 2011, we announced that we discovered a hardware-related design issue with the AspireHC™ (High Capacity) Model 105 and AspireSR™ (Seizure Response) Model 106 generators. The hardware-related design issue did not affect earlier models of our pulse generator, and we continued to sell earlier models. We found that the stimulation output current delivered by the AspireHC and AspireSR generators to a patient's nerve could be less than the output current programmed by a physician. While we believe that the generators do not pose an immediate health risk to patients, we (i) stopped shipment of AspireHC and AspireSR generators, (ii) suspended enrollment in our E-36 AspireSR generator clinical trial, (iii) notified physicians treating patients implanted with the AspireHC generator of the issue and what to consider as they monitor these patients, (iv) withdrew the AspireHC and AspireSR generators from the field, (v) identified the cause of the problem and implemented and tested the solution, and (vi) submitted applications to both the FDA and the European notified body, DEKRA, for the approval of the improved AspireHC generator.

In December 2011, the FDA approved our re-designed AspireHC generator and we resumed our limited commercial release of the generator in the U.S. With CE Mark approval from DEKRA in November 2011, we are planning to resume limited commercial release in Europe.

In April 2011, we commenced a European clinical trial (E-36) to support regulatory approval in Europe of our AspireSR generator with the first human implant. The AspireSR generator is a device that employs a cardiac-based seizure detection system and delivers responsive VNS Therapy. We suspended this trial in August 2011; however, we re-submitted the appropriate applications and have received approval to re-start the trial, and are currently screening patients.

Proprietary protection for our products is important to our business. We seek U.S. and foreign patents on selected inventions, acquire licenses under selected patents of third parties, and enter into confidentiality agreements with our employees, vendors 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. Under the terms of our epilepsy patent license agreement, we paid royalties at a rate of 3% of net sales of generators and leads. The epilepsy patent expired on July 16, 2011 in the U.S. and, as a result, we discontinued paying this royalty. Also, as a result of the epilepsy patent expiration, competitors may enter this market. For instance, a company based in Europe, Neurotech, SA, has obtained CE Mark approval for a device capable of vagus nerve stimulation, however the device is not yet marketed. Another company, CerebralRx Ltd. based in Israel, developed an implantable device capable of vagus nerve stimulation and has CE Mark approval. CerebralRx has initiated commercialization efforts in several European countries.

We continuously evaluate whether to out-license or to in-license intellectual property rights to optimize our portfolio. This includes identifying our intellectual property rights for indications we do not have plans to develop and determining whether these rights can be licensed or otherwise granted to third parties. It also involves assessing the intellectual property rights owned by third parties to determine whether we should attempt to license or otherwise acquire those rights. We have entered into several license and technology agreements that may involve substantial future payments; see "Note 10. Commitments and Contingencies - License Agreements" in our consolidated financial statements for additional information.

In order to accommodate expected growth of our business, to secure our future in our current manufacturing and headquarters facility and to realize operating efficiencies, we purchased the building and property in which we are headquartered during the quarter ended October 28, 2011. Our headquarters building is located in Houston, Texas and consists of approximately 144,000 square feet of manufacturing and office space. We currently occupy approximately 79% of this space. In addition, as part of our disaster contingency plans, we lease a 19,800 square foot facility in Austin, Texas that we utilize for warehousing and distribution. We are currently negotiating terms for the construction of a second manufacturing facility to be located in Costa Rica. We intend for this facility to manufacture product for our international markets and to be completed in fiscal year 2014 and operational in fiscal year 2015. We also lease 15,400 square feet of overseas administrative and sales office space primarily in Brussels, Belgium and elsewhere in Europe, China and Hong Kong.

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. ("U.S. GAAP"). Our most significant accounting policies are disclosed in "Note 1. Summary of Significant Accounting Policies and Related Data" in the consolidated financial statements.

To prepare our consolidated financial statements in conformity with U.S. GAAP, management makes estimates and assumptions that may affect the reported amounts of our assets and liabilities, the disclosure of contingent liabilities as of the date of our financial statements and the reported amounts of our revenues and expenses during the reporting period. Our actual results may differ from these estimates. We consider estimates to be critical if we are required to make assumptions about material matters that are uncertain at the time of estimation, or if materially different estimates could have been made or it is reasonably likely that the accounting estimate will change from period to period. The following are areas requiring management's judgment that we consider critical:

Intangible Assets

Intangible assets, as shown on the consolidated balance sheets, consisted of purchased licenses of patents and technology rights that are feasible and ready to integrate into our products. The technology rights are purchased from our collaborative partners and pertain primarily to seizure detection, wireless communication, rechargeable battery technology, external charging accessory hardware and associated software, an implantable lead and micro-processor technologies. We amortize our intangible assets on a straight-line basis, over an average period of 9 years, beginning with the effective date of the license agreement and ending with the shorter of either the expiration of the license or with the estimated end of the useful life of the product. We evaluate our intellectual property each reporting period to determine whether events and circumstances indicate either a different amortization period or impairment. The intangible asset is impaired if the technology no longer factors into our product commercialization plans. The risks associated with achieving commercialization include, but are not limited to, failure of the acquired technology to function as planned, failure to obtain regulatory approvals for clinical trials, failure of clinical trials, failure to obtain regulatory approval to market, failure to obtain insurance reimbursement and patent litigation. Amortization and impairment are subject to a high degree of estimation and management judgment. If we change our estimate of the useful lives of our intellectual property, we amortize the carrying amount over the revised remaining useful life. If we identify an impairment indicator, we test the intellectual property for recoverability, and if the carrying amount is not recoverable and exceeds its fair value. The carrying value of our intangible assets amounted to $4.5 million at April 27, 2012.

Investments in Debt and Equity Securities

We have invested in two privately held entities with a total carrying value of $9.5 million as of April 27, 2012. The first investment is convertible debt, which we account for at fair value as an available-for-sale debt security. The second investment consists of convertible preferred shares accounted for under the cost method. We own less than 20% of the equity in the second entity and do not have the ability to exercise significant influence over the investee. This investment has not been impaired because there have been no identified events or changes in circumstances that indicate a significant adverse effect on its fair value. Impairment and fair value adjustments are subject to a high degree management judgment as these investments do not have quoted market prices. We cannot guarantee that such investments will be successful or will not adversely affect our consolidated balance sheet, statement of income or cash flow. See "Note 5. Long-Term Investments in Debt and Equity Securities" and "Note 20. Fair Value Measurements," for further details of these investments.

Revenue Recognition

Product Revenue: We sell our products through a direct sales force in the U.S. and a combination of direct sales representatives and independent distributors in international markets. We recognize revenue when title to the goods and risk of loss transfers to customers or our independent distributors. We maintain policies for sales returns and exchanges. We estimate sales returns based on historical data and we record a reduction in sales and a return reserve when we sell the initial product. The balance of our reserve for sales returns for the fiscal years ending April 27, 2012 and April 29, 2011 was $1.2 million and $1.3 million, respectively. Our increasing business activity, new product introductions and variations in product utilization could cause product returns to differ from our estimates.

License Revenue: We amortize upfront payments received under license agreements over the life of our obligations under the agreements to prosecute the licensed patent applications. Effective in December 2007, we entered into an agreement granting an exclusive license to certain patents and patent applications pertaining to weight reduction, hypertension and diabetes in exchange for an up-front, non-refundable payment of $9.5 million, plus a royalty on future commercial sales of any product covered by the licensed patents. We retain the responsibility to prosecute the licensed patent applications and estimate that our obligation will be satisfied by April 2014. Accordingly, we have recognized revenue of approximately $0.4 million per quarter based on the straight-line amortization of the $9.5 million payment. However, a change in our estimate of the amortization period or a release of our obligation to prosecute the patent applications could materially change the timing of the recognition of the license revenue.

Stock-Based Compensation

Stock Option Awards

Our stock option award compensation expense is based on the fair market value of our awards. The fair market value of an award is amortized over the award vesting period. We use the Black-Scholes option pricing methodology to estimate the grant date fair market value of stock option award. This methodology takes into account variables such as the future expected volatility of our stock price, the amount of time expected to elapse between the date of grant and the date of exercise and a risk-free interest rate. Fair values of stock options issued in the future may vary significantly from fair values recorded in the current period depending on our estimates of these variables and therefore expense in future periods may differ significantly from current-period stock option compensation expenses. In addition, compensation expense may vary significantly from our estimates if forfeiture rates differ from our expectations. The estimated forfeiture rate used for stock option awards granted during the fiscal year ended April 27, 2012 ranged from 0.6% to 10.1%. Recognized compensation cost for stock option awards for the 52 weeks ended April 27, 2012, 52 weeks ended April 29, 2011 and the 53 weeks ended April 30, 2010 was $2.7 million, $2.5 million and $3.9 million, respectively.

Restricted Stock and Restricted Stock Unit Awards

Service-Based Restricted Stock. We grant restricted stock and restricted stock units at no purchase cost to the grantee. The fair market values of serviced-based restricted stock and restricted stock units are determined using the market closing price on the grant date and compensation is expensed ratably over the vesting period. Calculation of compensation for service-based restricted share awards requires estimation of employee turnover and forfeiture rates. Compensation expense may vary significantly from our estimates if employee turnover rates differ from our expectations. The estimated forfeiture rates used for restricted share awards and share unit awards during the fiscal year ended April 27, 2012 ranged from 1.5% to 6.4%.

Market and Performance-Based Restricted Stock and Performance-Based Restricted Stock Units. We grant restricted stock and restricted stock unit awards subject to market or performance conditions that vest based on the satisfaction of the conditions of the award. The fair market values of market condition-based awards are determined using the Monte Carlo simulation method. The Monte Carlo simulation method is subject to variability as several factors utilized must be estimated, including the derived service period estimate based on our judgment of likely future performance and our stock price volatility. The fair value of performance-based awards is based on the market closing price on the grant date. Derived service periods and the periods charged with compensation expense for performance-based awards are estimated based on our judgment of likely future performance and may be adjusted significantly in future periods depending on actual performance.

Recognized compensation cost for service-based, performance-based and market-based restricted stock and restricted stock unit awards for the 52 weeks ended April 27, 2012, the 52 weeks ended April 29, 2011 and the 53 weeks ended April 30, 2010 was $8.5 million, $3.9 million and $4.7 million, respectively.

Income Taxes

We are subject to federal, state and foreign income taxes, and we use significant judgment and estimates in accounting for our income taxes. This involves assessing the changes in temporary differences resulting from differing treatment of events for tax and accounting purposes. These assessments result in deferred tax assets and liabilities which are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Income tax expense compared to pre-tax income yields an effective tax rate. Actual tax expense may significantly differ from our expectations if, for example, judicial interpretations of tax law or tax rates change. Cumulative adjustments to the tax provision are recorded in the interim period in which a change in the estimated annual effective rate is determined.

We periodically assess the recoverability of our deferred tax assets by considering whether it is more likely than not that some or all of the actual benefit of those assets will be realized. To the extent that realization does not meet the "more-likely-than-not" criterion, we establish a valuation allowance. We periodically review the adequacy and necessity of the valuation allowance by considering significant positive and negative evidence relative to our ability to recover deferred tax assets and to determine the timing and amount of valuation allowance that should be released. This evidence includes:
a) profitability in the most recent fiscal years, b) internal forecasts for the current and next two future fiscal years, c) size of the deferred tax asset relative to estimated profitability, d) the potential effects on future profitability from increasing competition, healthcare reforms and overall economic conditions, e) limitations and potential limitations on the use of our net operating losses due to ownership changes, pursuant to Internal Revenue Code ("IRC") Section 382, and f) the implementation of prudent and feasible tax planning strategies, if any. Projecting future taxable income requires significant judgment about the trend and nature of our sales and operating expenses, which include an evaluation of the potential effects of new markets, changing technology, patent protection, governmental and private insurance reimbursement trends and regulatory trends. Changes in our assessment of the factors related to the recoverability of our deferred tax assets could result in materially different income tax provisions. During fiscal 2011, based on our evaluation of the recoverability of our deferred tax assets, we reduced our valuation allowance by $19.9 million, of which $8.9 million was recorded as a tax benefit on our consolidated statement of income and $11.0 million was recorded as a benefit in additional paid-in capital on our consolidated balance sheet. During fiscal 2010, based on our evaluation of the recoverability of our deferred tax assets, we reduced our valuation allowance by $40.5 million. This reduction in the valuation allowance was recorded as a tax benefit in our consolidated statement of income.

At April 27, 2012, we had a valuation allowance of $37.9 million against the net operating losses from our foreign operations and excess tax benefits from stock-based awards. The net operating losses for the excess tax benefits from stock-based awards are deemed more likely than not to be realized; however, the associated valuation allowance will not be released until the benefit is used to reduce income taxes payable. The benefit will be recorded in additional paid-in capital on our consolidated balance sheet. Our foreignnet operating losses are not likely to be realized and consequently the associated valuation allowance has not been released.

We operate in Europe with a subsidiary, Cyberonics Europe BVBA/SPRL ("Cyberonics Europe BVBA"). Cyberonics Europe BVBA, based in Belgium, is the successor organization arising from the restructuring of Cyberonics, NV/SA, which was also based in Belgium. We made an election to treat Cyberonics Europe BVBA as a disregarded entity for U.S. federal tax purposes during fiscal 2011. In conjunction with this transaction, we recognized a net $9.0 million income tax benefit resulting from claiming a worthless stock deduction with respect to the shares we own in Cyberonics Europe BVBA. The Internal Revenue Service ("IRS") could challenge the characterization of this type of transaction. The resolution of any challenge could result in reversal of all, part or none of the benefit recorded during fiscal year 2011. Consequently, we have estimated and recorded a $2.3 million liability for uncertain tax benefits, which increased our income tax provision. Changes in our assessment of the factors related to sustainability of this deduction would have resulted in a materially different income tax provision.

Our effective tax rate for fiscal year 2012 is approximately 40.3%, including the impact of federal tax rate of 35%, state and foreign income taxes. We estimate that our effective tax rate for fiscal year 2013 will be between approximately 38% and 39%. Fluctuations in the effective tax rate will be due primarily to permanent differences including the research and development tax credit (which expired effective December 31, 2011), meals and entertainment expenditures, the domestic manufacturing deduction, and other compensation-related differences. The uncertainty surrounding the timing of the possible reenactment of the research & development tax credit, the potential increase in the research & development tax credit percentage, and the retroactive nature of the research & development tax credit may have an impact on the effective tax rate in subsequent years. Also, other permanent differences including differences related to meals and entertainment, compensation, and the domestic manufacturing deduction will impact the effective tax rate in subsequent years. Our cash payments for income taxes for fiscal year 2012 were approximately 2% of income before tax. We estimate similar cash tax payments for fiscal years 2013 and increased cash tax payments in fiscal year 2014 due to the full utilization of our tax net operating losses.

Tax authorities may disagree with certain positions we have taken and assess additional taxes. We regularly assess the likely outcomes of our tax positions in order to determine the appropriateness of our reserves for uncertain tax positions. However, there can be no assurance that we will accurately predict the outcome of these audits and the actual outcome of an audit could have a material impact on our consolidated results of income, financial position or cash flows.

Results of Operations

We had one extra week in the fiscal year ended April 30, 2010 as compared to the fiscal years ended April 27, 2012, and April 29, 2011.

Net Sales

The table below illustrates comparative net product revenue and unit sales by geographic area and our license revenues. Product shipped to destinations outside the U.S. is classified as "International" sales (in thousands, except unit sales and percentages):

                                                                                                      Fiscal year
                                                                                                        2010 to
                    52 Weeks Ended     52 Weeks Ended     53 Weeks Ended      Fiscal year 2011 to     Fiscal year
                    April 27, 2012     April 29, 2011     April 30, 2010       Fiscal year 2012           2011
                                                                                   % Change             % Change
U.S.               $      181,436     $      161,224     $      135,060                   12.5 %           19.4 %
International              35,548             27,736             31,193                   28.2 %          (11.1 %)
Total net
product sales      $      216,984     $      188,960     $      166,253                   14.8 %           13.7 %

Unit Sales by
Geographic
Area: (1)
U.S.                        8,455              7,906              7,069                    6.9 %           11.8 %
International               2,939              2,480              2,717                   18.5 %           (8.7 %)
Total unit sales           11,394             10,386              9,786                    9.7 %            6.1 %
License revenue    $        1,519     $        1,504      $       1,523

(1) Units represent the number of generators sold.

U.S. net product sales for the 52 weeks ended April 27, 2012 increased $20.2 million, or 12.5%, as compared to the 52 weeks ended April 29, 2011, due to a sales volume increase of 6.9% and increase average selling price of 5.6%. The average selling price increased due to continued higher market penetration of our Demipulse® generators, the limited commercial release of our AspireHC generator and price increases in January of 2011 and January 2012.

U.S. net product sales for the 52 weeks ended April 29, 2011 increased by $26.2 million, or 19.4%, as compared to the 53 weeks ended April 30, 2010, due to a sales volume increase of 11.8% and an increase in average selling price of 7.6%. . . .