Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

We caution stockholders that, in addition to the historical financial information included herein, this Report on Form 10-Q includes “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 that are based on management’s beliefs, as well as on assumptions made by and information currently available to management. All statements other than statements of historical fact included in this Report on Form 10-Q, including without limitation, statements under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and statements located elsewhere herein regarding our financial position and business strategy, may constitute forward-looking statements. In addition, you generally can identify forward-looking statements by the use of forward-looking terminology such as “believes,” “may,” “will,” “expects,” “intends,” “estimates,” “anticipates,” “plans,” “seeks,” or “continues,” or the negative thereof or variations thereon or similar terminology. Such forward-looking statements involve known and unknown risks, including, but not limited to, market acceptance of our Powerlink System, economic and market conditions, the regulatory environment in which we operate, the availability of third party payor medical reimbursements, competitive activities or other business conditions. We cannot assure you that our actual results, performance or achievements will not differ materially from any future results, performance or achievements expressed or implied from such forward-looking statements. Important factors that could cause actual results to differ materially from our expectations (“Cautionary Statements”) are disclosed in our Annual Report on Form 10-K for the year ended December 31, 2003, but not limited to, those discussed in “Risk Factors.” All subsequent written and oral forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by these Cautionary Statements. We disclaim any obligation to update information contained in any forward-looking statement.

Overview

Organizational History

        We were formed in 1992, and our common stock began trading publicly in 1996. The current Endologix, Inc. resulted from the May 2002 acquisition of all of the capital stock of a private company, Endologix, Inc., (“former Endologix”), and the subsequent change of our company name from Radiance Medical Systems, Inc. to Endologix, Inc. The terms of the merger are described below under the caption “Merger with Endologix, Inc.” and also Note 10 to the unaudited Condensed Consolidated Financial Statements.

Our Business

        We are engaged in the development, manufacture, marketing and sale of minimally invasive therapies for the treatment of vascular disease. Our primary focus is the marketing and sale of the Powerlink System, a catheter-based alternative treatment to surgery for abdominal aortic aneurysms, or AAA. AAA is a weakening of the wall of the aorta, the largest artery of the body. Once AAA develops, it continues to enlarge and if left untreated becomes increasingly susceptible to rupture. The overall patient mortality rate for ruptured abdominal aortic aneurysms is approximately 75%, making it the 13th leading cause of death in the United States.

17

        The Powerlink System is a catheter and endoluminal graft, or ELG system. The self-expanding cobalt-chromium alloy stent is covered by ePTFE, a commonly-used surgical graft material. The Powerlink ELG is implanted in the abdominal aorta by gaining access through the femoral artery. Once deployed into its proper position, the blood flow is shunted away from the weakened or “aneurysmal” section of the aorta, reducing pressure and the potential for the aorta to rupture. The Powerlink System is made in two basic configuration, an “infrarenal” and “suprarenal” design. The wire stent in the infrarenal device does not extend above the renal arteries, while the wire stent (without ePTFE covering) in the suprarenal device extends above the graft material to allow the physician to anchor the top of the device above the renal arteries without obstructing them. We believe that implantation of the Powerlink System will reduce the mortality and morbidity rates associated with conventional AAA surgery.

        We are currently selling the infrarenal and suprarenal Powerlink System in Europe. We completed Japanese clinical trials for our AAA technology in November 2001 and have submitted for Japanese MOH approval to commercialize the product. We believe that Japanese MOH review should be completed in the first half of 2005, and we will file for reimbursement for the device thereafter.

        We completed enrollment in the first quarter of 2003 for the infrarenal arm of our two arm Phase II U.S. clinical trial and filed a pre-market approval, or PMA, application in January 2004. We were granted conditional approval to market the infrarenal Powerlink System in the United States from the U.S Food and Drug Administration on October 29, 2004, and will commence commercial selling of the Powerlink System in the U.S. market in the fourth quarter of 2004. The condtions of approval require the standard continued post-marketing surveillance and annual update reports to the FDA and physician users.

        We are in the patient enrollment phase for the suprarenal study arm of the Powerlink System. As of September 30, 2004, we have enrolled a total of 91 patients of the targeted 193 total patient enrollment in the suprarenal arm of the study.

        Prior to the acquisition of former Endologix and the restructuring that occurred during the third and fourth quarters of 2001 (see below under the caption “Merger with Endologix, Inc.”), we were researching, developing and marketing a radiation therapy catheter for the treatment of blockages in arteries after angioplasty, or restenosis. Prior to that we developed, manufactured and marketed other catheter and stent products for treatment of cardiovascular disease.

        Since 1999, our source of revenues shifted gradually from direct sales of catheter and stent products to royalties from licenses of our stent delivery technology. In June 1998, we licensed to Guidant Corporation rights to manufacture and distribute products using our Focus technology for the delivery of stents. In exchange, we received milestone payments based upon the transfer of know-how to Guidant, and continue to receive royalty payments from Guidant based upon the sale of products using the Focus technology. See Note 7 to the unaudited Condensed Consolidated Financial Statements for more information on the Guidant agreement.

        Following the introduction by Guidant of non-licensed products to replace some licensed products in 2002, and we believe, more importantly, the introduction by Guidant’s competitors of drug-coated stents, which compete with the licensed products, in 2003 and 2004, the license royalties we receive have been materially decreasing. Following the acquisition of former Endologix in May 2002, sales of Powerlink System products have somewhat offset reductions in Guidant license royalties. We anticipate that Guidant license royalties will continue to materially decrease during

18

and that Powerlink System product sales will become our major, and only material source of revenues by the first half of 2005.

        We have experienced an operating loss for each of the last five years and expect to continue to incur annual operating losses through at least December 31, 2005 due primarily to expenditures to build our sales, marketing and distribution capability. Our results of operations have varied significantly from quarter to quarter, and we expect that our results of operations will continue to vary significantly in the future. Our quarterly operating results depend upon several factors, including:

Merger with former Endologix, Inc.

        In May 2002, we acquired all of the capital stock of former Endologix. We paid stockholders of former Endologix $0.75 cash for each share of former Endologix common stock, for an aggregate of $8.4 million, and issued one share of our common stock for each share of former Endologix common stock, for an aggregate of 11,140,541 shares.

        We accounted for the acquisition as a purchase under SFAS No. 141, “Business Combinations.” In accordance with SFAS No. 141, we allocated the purchase price based on the fair value of the assets acquired and liabilities assumed. See Note 10 to the unaudited Condensed Consolidated Financial Statements for further description of the accounting for the merger.

Impact of Recent Accounting Pronouncements

        In March 2004, the EITF reached a consensus on EITF 03-01, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” (EITF 03-01). EITF 03-01 provides guidance to determine when an investment is considered to be impaired, whether that impairment is other-than-temporary, and the measurement of an impairment loss. It also requires disclosure related to unrealized losses that have not been recognized as other-than-temporary impairments. The recognition and measurement guidance was effective for other-than-temporary impairment evaluations in the third quarter of 2004 and did not have a material impact to the Company’s consolidated financial position, results of operations or cash flows. The other provisions of EITF 03-01, which principally consist of disclosure requirements, are not expected to have a material impact to the Company’s consolidated financial position, results of operations or cash flows.

        In December 2003, the FASB issued Interpretation No. 46R, Consolidation of Variable Interest Entities (FIN 46R). FIN 46R requires the application of either FIN 46R or FIN 436R by public entities to all Special Purpose Entities (SPE) created prior to February 1, 2003 as of December 31, 2003 for calendar year-end companies. FIN 46R is applicable to all non-SPEs created prior to February 1, 2003 at the end of the first interim or annual period ending after March 15, 2004. For all

19

entities created subsequent to January 31, 2003, Public Entities were required to apply the provisions of FIN 46. The adoption of FIN 46 and FIN 46R did not have a material impact on the Company’s consolidated financial position, results of operations or cash flows.

Results of Operations

Comparison of the Three Months Ended September 30, 2004 and 2003

        Product Revenue. Product revenue increased to $1.1 million in the three months ended September 30, 2004 from $285,000 in the three months ended September 30, 2003. Product revenue increased primarily due to sales of the Powerlink System to Edwards Lifesciences (“Edwards”) pursuant to an exclusive distribution agreement for certain European markets, including Germany and France, entered into in the second quarter of 2004. During the three months ended September 30, 2004, the Company recognized product revenue from Edwards of $814,000 which represented 77% of total product revenue. The purchases by Edwards were to set up inventory levels to service their customers, and we cannot assure future sales to Edwards will remain consistent. As a result of this new distribution agreement and the approval of our infrarenal Powerlink system in the U.S., we believe that product revenue for the remainder of 2004 will be materially higher in 2004 than in the same period of 2003.

        License Revenue. License revenue decreased 54% to $294,000 in the three months ended September 30, 2004 from $634,000 in the three months ended September 30, 2003. We believe that the reduction is due primarily to the introduction of non-royalty bearing products by Guidant and sales of drug-coated stents in the U.S. which decreased sales of royalty-bearing products. We also believe that license revenue will continue to decrease during 2004 and in future periods compared with the comparable periods of 2003 due to increasing acceptance of drug-coated stents. The agreement with Guidant expires in 2008, unless terminated sooner, and provides for minimum annual royalties of $250,000.

        Cost of Product Revenue. The cost of product revenue increased 400% to $665,000, or 63% of product revenue, in the three months ended September 30, 2004 from $133,000, or 47% of product revenue, in the three months ended September 30, 2003. Cost of product revenue increased primarily due to the increase in the volume of Powerlink System sales and because of a greater mix of sales to distributors in Europe at lower average selling prices.

        During the third quarter of 2004, we continued significant development efforts to improve and expand our manufacturing capability. Although we believe that we have sufficient capacity and resources to support the production requirement we are forecasting through 2005, we plan to develop our manufacturing capability to support our sales plans thereafter. See Liquidity and Capital Resources, below, for more information about our manufacturing development projects.

        Research, Development and Clinical. Research, development and clinical expenses were $1.5 million in the three months ended September 30, 2004 and September 30, 2003. A reduction in expenditures for clinical studies of our legacy radiation therapy system, the RDX System, was offset by an increase in expenditures for the development of the Powerlink System in the third quarter of 2004.

        We continue to conduct new product research and development for our Powerlink System product line, and we anticipate continuing enrollment in the suprarenal arm of our pivotal U.S.

20

clinical trials throughout 2004. We expect to begin enrollment in a third arm of our pivotal U.S. clinical trials for a study of a large diameter cuff later in 2004. We believe we will be able to treat a broader patient population, using a large diameter cuff with our Powerlink System stent grafts.

        Marketing and Sales. Marketing and sales expenses increased 332% to $791,000 in the three months ended September 30, 2004 from $183,000 in the three months ended September 30, 2003. The increase in costs for third quarter 2004 marketing and sales expenses resulted from increased staffing in anticipation of a second half 2004 launch of our infrarenal Powerlink System. We anticipate that marketing and sales expenses over the remainder of 2004 will be materially higher than those for the same period of 2003 as we increase our direct sales force in the U.S., and initiate our focused launch of the Powerlink System in the fourth quarter.

        General and Administrative. General and administrative expenses totaled $914,000 in the three months ended September 30, 2004, compared to $652,000 in the three months ended September 30, 2003. Key reasons for the 40% increase were costs for the review of our internal controls over financial reporting, as required under section 404 of the Sarbanes-Oxley Act, severance charges related to the departure of our former chief financial officer, and a bad debt recovery of $104 in 2003. We anticipate that general and administrative expenses over the remainder of 2004 will be higher than those for the same period of 2003.

        Other Income (Expense). Other income increased 49% to $94,000 in the three months ended September 30, 2004, compared to $63,000 in the same period of 2003. The increase was due primarily to an increase in interest income of $44,000 resulting from a higher average cash balance, including $15.4 million in proceeds from a private offering of common stock in March 2004, somewhat offset by the effect of a lower weighted average interest rate for the invested cash.

Comparison of the Nine Months Ended September 30, 2004 and 2003

        Product Revenue. Product revenue increased 113% to $2.3 million in the nine months ended September 30, 2004 from $1.1 million in the nine months ended September 30, 2003. Product revenue increased primarily because of sales to Edwards totaling $1.2 million.

        License Revenue. License revenue decreased 44% to $1.1 million in the nine months ended September 30, 2004 from $2.0 million in the nine months ended September 30, 2003. We believe that the reduction in license revenue is due primarily to the introduction of non-royalty bearing products by Guidant and sales of drug-coated stents in the U.S.

        Cost of Product Revenue. The cost of product revenue increased 166% to $1.3 million, or 58% of product revenue, in the nine months ended September 30, 2004 from $498,000, or 47% of product revenue, in the nine months ended September 30, 2003. Cost of product revenue increased primarily because of an increase in the volume of product sales. The increase in cost of product revenue as a percentage of product revenue, was due primarily to an increase in sales to international distributors as a percent of total sales, which are typically sold at a significantly lower average price than the average selling price paid by U.S. hospitals.

        Research, Development and Clinical. Research, development and clinical expenses decreased 9% to $4.6 million in the nine months ended September 30, 2004 from $5.1 million in the nine months ended September 30, 2003. The decrease resulted primarily from a decrease in legacy radiation catheter technology clinical trial costs as the trials were nearly completed in 2003.

21

        Marketing and Sales. Marketing and sales expenses increased 168% to $1.7 million in the nine months ended September 30, 2004 from $620,000 in the nine months ended September 30, 2003. The increase in costs for the first nine months of 2004 occurred because of the increase in sales and marketing staffing in anticipation of the launch of our infrarenal Powerlink System in the U.S. market.

        General and Administrative. General and administrative expenses increased 64% to $2.4 million in the nine months ended September 30, 2004 from $1.5 million in the nine months ended September 30, 2003. The increase in expenses for the first nine months of 2004, compared with the same period of 2003, was due primarily to a reimbursement of $468,000 for legal and other expenses as part of a settlement in the first quarter of 2003 with Jomed-Endsonics, which is described in Note 11 to the unaudited Condensed Consolidated Financial Statements, and net bad debt recoveries of $104,000 in the 2003 period; combined with expenses of $186,000 related to our review of internal controls over financial reporting as required by Section 404 of the Sarbanes-Oxley Act, and severance charges related to the departure of our former chief financial officer.

        Other Income (Expense). Other income decreased 10% to $225,000 in the nine months ended September 30, 2004, compared to $251,000 in the same period of 2003. The decrease in other income for the first nine months of 2004 compared with the same period of 2003 was primarily due to a decrease in interest income of $18,000. The decrease was a result of the 2003 settlement with Jomed-Endosonics, described above, partially offset by the net effect of a higher average cash balance, and a lower weighted average interest rate on investments during the 2004 period.

Liquidity and Capital Resources

        For the nine months ended September 30, 2004, we incurred a net loss of $6.4 million. As of September 30, 2004, we had an accumulated deficit of $80.3 million. Historically, we have relied on the sale and issuance of equity securities to provide a significant portion of funding of our operations. In July 2003 and March 2004, we completed two private placements of our common stock, resulting in aggregate net proceeds of $23.8 million.

        At September 30, 2004, we had cash, cash equivalents and marketable securities available for sale of $24.6 million. We believe that current cash and cash equivalents and marketable securities will be sufficient to meet anticipated cash needs for operating and capital expenditures through at least December 31, 2005. We expect to continue to incur substantial costs and cash outlays in 2004 to support Powerlink research and development, manufacturing capability development, and the U.S. market launch of the Powerlink System. However, if we fail to effectively penetrate the market following the launch of the Powerlink product, or if we fail to reduce certain discretionary expenditures, if necessary, we may need to seek additional sources of financing. We may not be able to obtain such financing on acceptable terms or at all, which would adversely affect the operations of our business.

        In February 1999, the former Endologix agreed to purchase a key component for its Powerlink product from Bard Peripheral Vascular Systems, a subsidiary of C.R. Bard, Inc., which at the time was a significant shareholder and thus a related party, under a supplier agreement that expires in December 2007, and which then automatically renews for additional one year periods without notice, unless a party provides notice not to renew within thirty days from the expiration of the renewal period. Under the terms of the agreement, the Company has agreed to purchase certain unit quantities of the component, with built in annual quantity increases. In January 2002,

22

the agreement was amended, increasing the minimum quantity purchase requirements for 2002 and thereafter and increasing the prices each year after 2002 according to the general increase in the Consumer Price Index. In the first nine months of 2004, the Company purchased $1,188 of materials towards fulfilling its 2004 purchase commitment. To complete fulfilling its 2004 unit purchase commitment, which the Company estimated to cost approximately $622, and to purchase additional inventory in anticipation of receipt of FDA approval to commercially distribute devices using the component, the Company committed to purchasing, and the supplier agreed to provide, approximately $1,140 in components at existing prices. Because the Company has now received FDA approval to commercially distribute devices using the component, the terms of the agreement provide that prices for subsequent orders for the component will increase materially. However, the Company does not expect the increase to have a material impact on the financial results of the Company.

        In June 2004, we entered into an agreement under which a third party will develop, install and test manufacturing equipment for the expansion of our manufacturing capability. Over a period through March 2006, we anticipate spending approximately $1.7 million for this project. The terms of the agreement also provide for estimated milestone payments totaling $520,000. During the third quarter and first nine months of 2004, we incurred costs of approximately $214,000 and $289,000, respectively, associated with this capital project. We can terminate the agreement on 15 days notice, and we would be responsible for costs incurred to the date of termination.

Our future capital requirements will depend on many factors, including:

        In July 2002, the board of directors authorized a program for repurchases of our outstanding common stock of up to $1.5 million under certain parameters. As of September 30, 2004, we have repurchased an aggregate of 495,000 shares for $661,000, with the last such purchase in the quarter ended September 30, 2003.

        Accounts Receivable. Trade accounts receivable, net, increased 169% to $643,000 at September 30, 2004 from $239,000 at December 31, 2003. The increase is due primarily to an increase in sales to Edwards, a new European distributor. As of September 30, 2004, receivables from Edwards amounted to $413 or 64% of total accounts receivable, net.

        Other Receivables. Other receivables decreased 54% to $301,000 at September 30, 2004 from $656,000 at December 31, 2003 due to the decrease in royalties receivable from Guidant. See Comparisons of Quarters Ended September 30, 2004 and 2003 in subsection License Revenue, regarding Guidant royalty revenues, above.

    Inventories.        Inventories increased 14% to $3.2 million at September 30, 2004 from $2.8 million at December 31, 2003. The increase is due to purchases of a key component of the Powerlink

23

product from Bard Peripheral Vascular Systems, in anticipation of FDA approval for the product. FDA approval is expected to result in a significant increase in manufacturing requirements for this component.

        Deferred Income Taxes. Because of our continuing operating losses and the uncertainty of realization of our net, deferred income tax asset, we recorded an offsetting valuation allowance equal to 100% of the net deferred income tax asset.

        Accounts Payable and Accrued Expenses. Accounts payable and accrued expenses increased 28% to $1.9 million at September 30, 2004 from $1.5 million at December 31, 2003. The increase is attributable primarily to an increase in purchases from Bard Peripheral Vascular Systems for a key component of our Powerlink System, and increases in other payables as a result of our preparations for the Powerlink launch in the U.S.

        Accrued Compensation. During 2004, the Company has issued Performance Units to certain employees in the U.S. Sales organization under its 2004 Performance Compensation Plan. Accrued compensation related to this plan in 2004 is $300,000. See Note 2 to the unaudited Condensed Consolidated Financial Statements for a further description of the Performance Plan.

24