UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549


                                    FORM 10-Q


                QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
                     OF THE SECURITIES EXCHANGE ACT OF 1934

                For the quarterly period ended December 31, 1997

                         Commission file number 0-27802

                       ARTERIAL VASCULAR ENGINEERING, INC.
             (Exact name of registrant as specified in its charter)

        Delaware                                         94-3144218
(State of incorporation)                    (I.R.S. Employer Identification No.)

3576 Unocal Place, Santa Rosa, California                 95403
(Address of principal executive offices)               (Zip code)

                                 (707) 525-0111
              (Registrant's telephone number, including area code)

         Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the  Securities  Exchange  Act of
1934  during  the  preceding  12 months  (or for such  shorter  period  that the
registrant was required to file such reports),  and (2) has been subject to such
filing requirements for the past 90 days.

Yes    X           No
   -------           -------

         Indicate  the  number of  shares  outstanding  of each of the  issuer's
classes of common stock, as of the latest practicable date.

Class                                          Outstanding
Common Stock, $0.001 par value                 31,283,674 as of January 13, 1998


<PAGE>

<TABLE>

                                                 INDEX TO FORM 10-Q




<CAPTION>
                                                                                                                Page
                                                                                                                ----
<S>             <C>                                                                                              <C>
PART I          FINANCIAL INFORMATION

                Item 1.    Financial Statements

                           Condensed Consolidated Balance Sheets as of December 31, 1997                          3
                                 and June 30, 1997

                           Condensed Consolidated Statements of Operations for the three                          4
                                 and six months ended December 31, 1997 and 1996

                           Condensed Consolidated Statements of Cash Flows for the                                5
                                 six months ended December 31, 1997 and 1996

                           Notes to Condensed Consolidated Financial Statements                                   6

                Item 2.    Management's Discussion and Analysis of Financial Condition                           13
                                 and Results of Operations


PART II         OTHER INFORMATION

                Item 1.    Legal Proceedings                                                                     19

                Item 2.    Change in Securities and Use of Proceeds                                              19

                Item 4.    Submissions of Matters to a Vote of Security Holders                                  20

                Item 6.    Exhibits and Reports on Form 8-K                                                      20


SIGNATURES                                                                                                       22

                                                         2
</TABLE>

<PAGE>


PART I          FINANCIAL INFORMATION
<TABLE>

         Item 1.     Financial Statements

                           ARTERIAL VASCULAR ENGINEERING, INC. AND SUBSIDIARIES
                                   CONDENSED CONSOLIDATED BALANCE SHEETS
                                                (Unaudited)
                                               (In thousands)
<CAPTION>

                                                                            December 31,         June 30,
                                                                                1997               1997
                                                                            -------------      -------------
                                                  ASSETS
<S>                                                                           <C>                <C>  
Current assets:
     Cash and cash equivalents                                                $  14,471          $  25,036
     Short-term investments                                                      68,920             62,192
     Trade accounts receivable, net                                              34,778             22,850
     Inventories                                                                 13,590              7,302
     Deferred income tax                                                          2,413              2,413
     Prepaid expenses and other current assets                                    6,074              4,472
                                                                            -------------      -------------
        Total current assets                                                    140,246            124,265
Deferred income tax                                                               1,598              1,598
Property, plant and equipment, net                                               41,666             21,759
Purchased technology, net                                                           292                357
                                                                            -------------      -------------
        Total assets                                                           $183,802           $147,979
                                                                            =============      =============


                                                LIABILITIES
Current liabilities:
     Short-term borrowings                                                   $   10,148         $        -
     Accounts payable                                                             7,933              4,035
     Accrued expenses                                                             8,417              5,744
     Income taxes payable                                                           995                  -
                                                                            -------------      -------------
        Total current liabilities                                                27,493              9,779
                                                                            -------------      -------------


                                           STOCKHOLDERS' EQUITY
Common stock                                                                         31                 31
Additional paid-in capital                                                       97,974             93,021
Treasury stock                                                                     (390)              (390)
Cumulative translation adjustment                                                (1,672)            (1,364)
Retained earnings                                                                60,366             46,902
                                                                            -------------      -------------
        Total stockholders' equity                                              156,309            138,200
                                                                            -------------      -------------
        Total liabilities and stockholders' equity                             $183,802           $147,979
                                                                            =============      =============
<FN>

                                              See accompanying notes
</FN>
</TABLE>
                                                         3

<PAGE>


<TABLE>
              ARTERIAL VASCULAR ENGINEERING, INC. AND SUBSIDIARIES
                 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
                                   (Unaudited)
                      (In thousands, except per share data)

<CAPTION>

                                                          Three Months Ended                    Six Months Ended
                                                             December 31,                         December 31,
                                                     -----------------------------        ------------------------------
                                                        1997              1996               1997              1996
                                                     -----------       -----------        ------------      ------------
<S>                                                     <C>               <C>                 <C>               <C>    
Net sales                                               $38,303           $18,228             $64,565           $36,796
Cost of sales                                             7,656             3,733              13,145             6,644
                                                     -----------       -----------        ------------      ------------
Gross profit                                             30,647            14,495              51,420            30,152
                                                     -----------       -----------        ------------      ------------

Operating expenses:
     Research and development                             7,920             2,259              13,398             4,114
     Selling, general and administrative                 11,897             6,204              19,414             9,335
                                                     -----------       -----------        ------------      ------------
        Total operating expenses                         19,817             8,463              32,812            13,449
                                                     -----------       -----------        ------------      ------------
Operating income                                                                               
                                                         10,830             6,032              18,608            16,703
Interest and other income                                 1,099             1,054               2,106             2,329
                                                     -----------       -----------        ------------      ------------
Income before provision for income taxes                 11,929             7,086              20,714            19,032
Provision for income taxes                                4,175             2,480               7,250             6,661
                                                     -----------       -----------        ------------      ------------
Net income                                             $  7,754          $  4,606             $13,464         $  12,371
                                                     ===========       ===========        ============      ============

Net income per share--basic                           $    0.25          $   0.15           $    0.43         $    0.40
                                                                         
Net income per share--diluted                         $    0.24          $   0.15           $    0.42         $    0.39

Shares used to calculate net income per share:
         Basic                                           31,215            30,959              31,140            30,910
         Diluted                                         32,503            31,590              32,370            31,611
<FN>


                                              See accompanying notes
</FN>
                                                         4
</TABLE>
<PAGE>

<TABLE>
                            ARTERIAL VASCULAR ENGINEERING, INC. AND SUBSIDIARIES
                              CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
                                                (Unaudited)
                                               (In thousands)
<CAPTION>

                                                                                      Six Months Ended
                                                                                        December 31,
                                                                                -----------------------------
                                                                                   1997              1996
                                                                                -----------       -----------
<S>                                                                             <C>                <C>
Cash flows from operating activities:
     Net income                                                                 $  13,464          $ 12,371
     Adjustments to reconcile net income to net cash
        used in operating activities:
            Depreciation and amortization                                           1,549               736
            Provision for doubtful accounts                                         1,415               111
            Provision for obsolete inventory                                           97                13
            Amortization of deferred compensation                                       -                27
            Income tax reduction relating to stock plans                            3,867               763
            Changes in assets and liabilities:
                Short-term investments                                             (6,729)          (30,737)
                Accounts receivable                                               (13,582)           (5,566)
                Inventories                                                        (6,454)           (2,602)
                Prepaids and other current assets                                  (1,912)             (281)
                Accounts payable                                                    3,911               654
                Accrued liabilities                                                 2,723               467
                Income taxes payable                                                1,289            (5,625)
                                                                                -----------       -----------
                   Net cash used in operating activities                             (362)          (29,669)
                                                                                -----------       -----------

Cash flows from investing activities:
     Acquisition of property, plant and equipment                                 (21,425)           (7,761)
                                                                                -----------       -----------
                   Net cash used in investing activities                          (21,425)           (7,761)
                                                                                -----------       -----------

Cash flows from financing activities:
     Increase in short-term borrowings                                             10,148                -
     Proceeds from issuance of common stock                                         1,086                50
     Acquisition of treasury stock                                                      -              (390)
                                                                                -----------       -----------
                   Net cash provided by (used in) financing activities             11,234              (340)
                                                                                -----------       -----------

Effect of exchange rate changes on cash and cash equivalents                          (12)             (149)

Net decrease in cash and cash equivalents                                         (10,565)          (37,919)
Cash and cash equivalents, at beginning of period                                  25,036            59,238
                                                                                -----------       -----------
Cash and cash equivalents, at end of period                                      $ 14,471          $ 21,319
                                                                                ===========       ===========
<FN>

                                              See accompanying notes
</FN>
                                                       5
</TABLE>


<PAGE>


              ARTERIAL VASCULAR ENGINEERING, INC. AND SUBSIDIARIES
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                   (Unaudited)

1.         Basis of Presentation

                    The condensed  consolidated  financial  statements  included
           herein  have  been  prepared  by  the  Company,   without  audit,  in
           accordance with generally accepted accounting  principles for interim
           financial  information  and pursuant to the rules and  regulations of
           the Securities and Exchange Commission. In the opinion of management,
           all  adjustments  (consisting of only normal  recurring  adjustments)
           considered  necessary  to  present  fairly  the  financial  position,
           results  of  operations  and cash  flows  have been  included.  These
           consolidated  financial statements should be read in conjunction with
           the  audited  consolidated  financial  statements  contained  in  the
           Company's Form 10-K for the fiscal year ended June 30, 1997.

                    Certain  information  and  footnote   disclosures   normally
           included  in  financial   statements   prepared  in  accordance  with
           generally  accepted  accounting  principles  have been  condensed  or
           omitted.  The  year-end  balance  sheet data was derived from audited
           financial  statements,  but does not include disclosures  required by
           generally accepted accounting principles.

                    Operating results for the three- and six-month periods ended
           December 31, 1997 are not necessarily indicative of the results to be
           expected for any other interim period or for the full fiscal year.

2.         Inventories (in thousands):
                                                 December 31,       June 30,
                                                    1997              1997
                                                ------------      -----------

                           Raw materials        $     1,933       $      925
                           Work in process            4,414            3,044
                           Finished goods             7,243            3,333
                                                ------------      -----------
                                                $    13,590       $    7,302
                                                ============      ===========

3.         Computation of Net Income Per Share

                    In 1997,  the Financial  Accounting  Standards  Board issued
           Statement of Financial  Accounting  Standards  No. 128,  Earnings per
           Share.  Statement 128 replaced the  previously  reported  primary and
           fully diluted  earnings per share with basic and diluted earnings per
           share.  Unlike primary  earnings per share,  basic earnings per share
           excludes any dilutive  effects of options,  warrants and  convertible
           securities.  Diluted  earnings  per  share  is  very  similar  to the
           previously  reported fully diluted  earnings per share.  All earnings
           per share  amounts for all  periods  have been  presented,  and where
           necessary, restated to conform to the Statement 128 requirements.

                                       6
<PAGE>
              ARTERIAL VASCULAR ENGINEERING, INC. AND SUBSIDIARIES
        NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
                                   (Unaudited)

4.         Stock Repurchase Program

                  During  the  first  quarter  of  fiscal  1997,  the  Board  of
            Directors  authorized a stock  repurchase  program pursuant to which
            the  Company  may  repurchase  shares of its  common  stock  with an
            aggregate value of up to $10 million. The repurchases were made from
            time to time on the open market at  prevailing  market  prices or in
            negotiated transactions off the market. In November 1997 the program
            was discontinued by the Board of Directors. As of the termination of
            the program, the Company had repurchased 30,000 shares of its common
            stock at an aggregate cost of $390,000.

5.         Contingencies

                  ESS Litigation.  Effective as of October 1992, a subsidiary of
           the Company  purchased  substantially  all the assets of  Endothelial
           Support Systems,  Inc.  (subsequently  known as Endovascular  Support
           Systems,  Inc.) ("ESS") in  consideration of certain royalty payments
           payable by the Company  based on the net sales of  products  using or
           adapted  from  such  assets.   The  Company  was  informed  that  the
           shareholders  of ESS ratified the  transaction  on May 27, 1993.  The
           purchased  assets  included an  application  for a stent patent which
           resulted  in a patent  owned by the  Company.  Following  such  asset
           purchase,  the Company  between June 1993 and March 1995 purchased in
           several  transactions 100% of the shares of capital stock of ESS from
           its  shareholders in  consideration  of shares of common stock of the
           Company and, in certain instances,  other consideration,  and ESS was
           merged into the Company. In June 1996, the Company received notice of
           a lawsuit filed by Dr. Azam Anwar and Benito Hidalgo, each of whom is
           a former  shareholder of ESS (who together held  approximately 48% of
           ESS's outstanding  shares of common stock) and each of whom currently
           holds shares of common stock of the Company, in the District Court of
           Dallas  County,  Texas.  The suit names as  defendants  the  Company,
           Bradly A. Jendersee and John D. Miller, each a director,  officer and
           principal  stockholder  of the  Company,  Dr.  Simon H.  Stertzer,  a
           director and  principal  stockholder  of the Company,  and Dr. Gerald
           Dorros, a principal  stockholder of the Company. In January 1997, the
           plaintiffs  filed an  amended  petition  alleging  common  law fraud,
           negligent  misrepresentation,  securities fraud pursuant to the Texas
           Securities  Act,  fraud pursuant to the Texas Business and Commercial
           Code,  control person  liability,  aider and abetter liability of the
           individual  defendants,  civil conspiracy,  breach of fiduciary duty,
           and constructive  fraud in connection with the Company's  acquisition
           of ESS and the Company's  acquisition  of shares of ESS capital stock
           from  the  plaintiffs. The plaintiffs  seek  $395 million in damages,
           rescission  of the  Company's  acquisition  of the ESS assets and its
           subsequent  acquisition  of the  ESS  stock,  reconstitution  of ESS,
           punitive  damages,  interest and attorneys' fees and other relief. On
           February 10 and 12, 1997,  the court  overruled  defendants'  special
           appearances and denied motions objecting to jurisdiction,  motions to
           dismiss based on forum non  conveniens,  and motions to abate or stay
           the Texas proceedings.  The defendants,  including the Company,  have
           filed an answer  denying  the  plaintiffs'  claims,  and also filed a
           counterclaim against the plaintiffs.  The counterclaim alleges claims
           against Mr.  Hidalgo for  specific  performance,  breach of contract,
           breach of the implied  covenant of good faith and fair  dealing,  and
           declaratory relief based on comparative  indemnity,  contribution and
           absence of fraud. The  counterclaim  alleges claims against

                                       7

<PAGE>
              ARTERIAL VASCULAR ENGINEERING, INC. AND SUBSIDIARIES
        NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
                                   (Unaudited)


           Dr. Anwar for intentional and negligent  interference  with contract,
           equitable  estoppel and declaratory relief based on absence of fraud.
           A trial date of  February  1, 1998 had been  scheduled  for the Texas
           action. As of the date of this Form 10-Q, however, the trial date had
           been  continued  for at  least  three  weeks,  and the  parties  were
           discussing  whether to  continue  such date  further  and to drop the
           Consolidated  Action (as defined  below) in  California.  The Company
           believes it has  meritorious  defenses  to the claims  alleged by the
           plaintiffs,   and  that  it  has   meritorious   claims  against  the
           plaintiffs,  in the Texas action.  However, no assurance can be given
           as to the  outcome of the  action.  The  inability  of the Company to
           prevail in the action,  including the loss or impairment of the right
           to produce products based on the Company's issued patents, could have
           a  material  adverse  effect  on the  Company's  business,  financial
           condition and results of operations.

                  The Company also  received  notice in August 1996 of a lawsuit
           filed by Messrs.  Anwar and Hidalgo in the  Superior  Court of Sonoma
           County,  California,  which names the same defendants as in the Texas
           action and  alleges  claims  for  securities  fraud and  unregistered
           securities under the California  securities laws, breach of fiduciary
           duty and fraud. The plaintiffs seek unspecified  damages,  rescission
           of the  Company's  acquisition  of the ESS assets and its  subsequent
           acquisition of the ESS stock, reconstitution of ESS and other relief.
           The defendants,  including the Company,  have filed an answer denying
           plaintiff's  claims,  and also filed a  cross-complaint  against  the
           plaintiffs.  The  cross-complaint  alleges claims against Mr. Hidalgo
           for specific performance,  breach of contract,  breach of the implied
           covenant of good faith and fair dealing, and declaratory relief based
           on  comparative  indemnity,  contribution  and absence of fraud.  The
           cross-complaint  alleges claims against Dr. Anwar for intentional and
           negligent   interference  with  contract,   equitable   estoppel  and
           declaratory  relief  based on absence of fraud.  Mr.  Hidalgo and Dr.
           Anwar have filed an answer generally  denying the claims contained in
           the cross-complaint.

                  On July 11,  1996,  the  Company,  along  with the  individual
           defendants  named in the Texas and Sonoma County  actions,  filed two
           actions  against  Mr.  Hidalgo  in the  Superior  Court of San  Mateo
           County,  California.  The first  action  alleges  claims for specific
           performance,  breach of contract,  breach of the implied  covenant of
           good  faith  and  fair  dealing,  and  declaratory  relief  based  on
           indemnity.  These  claims  arise  out of a stock  exchange  agreement
           entered  into  between Mr.  Hidalgo and the  Company,  and out of Mr.
           Hidalgo's  actions as a director of ESS.  The second  action  alleges
           claims for specific  performance,  breach of contract,  and breach of
           the implied  covenant of good faith and fair  dealing.  These  claims
           arise out of a separation and release  agreement entered into between
           Mr. Hidalgo and the Company.

                  On  December 6, 1996,  the  Superior  Court of Sonoma  County,
           California,  pursuant to the stipulation of the parties,  transferred
           the Sonoma County  action to the Superior  Court of San Mateo County.
           On  December  11,  1996,  the  Superior  Court of San  Mateo  County,
           pursuant to the  stipulation of the parties,  consolidated  all three
           pending  California  actions into a single action (the  "Consolidated
           Action"),  and  ordered  that the  pleadings  from the Sonoma  County
           action shall be the operative pleadings in the Consolidated Action. A
           motion by the  Company  and the  individual  defendants  for  summary
           judgment against Mr. Hidalgo in the Consolidated Action was denied by
           the Superior Court of San Mateo County on May 5, 1997 with respect to
           each of the

                                       8

<PAGE>
              ARTERIAL VASCULAR ENGINEERING, INC. AND SUBSIDIARIES
        NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
                                   (Unaudited)


           plaintiffs'  claims. A trial date of March 2, 1998 has been scheduled
           for  the  Consolidated  Action.  The  Company  believes  that  it has
           meritorious  defenses to the claims  alleged by the  plaintiffs,  and
           that  it  has  meritorious  claims  against  the  plaintiffs,  in the
           Consolidated  Action.  However,  no assurance  can be given as to the
           outcome of the Consolidated  Action.  The inability of the Company to
           prevail in the Consolidated Action,  including the loss or impairment
           of the  right  to  produce  products  based on the  Company's  issued
           patents,  could  have a  material  adverse  effect  on the  Company's
           business, financial condition and results of operations.

                  The Company has agreed to  indemnify  each of the  individuals
           named as defendants in the lawsuits  against the Company  relating to
           the ESS transaction.

                  U.S. Patent Litigation.  Two of the Company's competitors have
           filed  claims  against  the  Company  with  respect to their  alleged
           intellectual property rights. The Company has filed for declatory and
           injunctive relief in connection with one of the claims.

                  On October 21, 1997, the Company  received  notice that it had
           been named as an additional  defendant,  along with Boston Scientific
           Corporation  and SCIMED Life Systems,  Inc., in a lawsuit  originally
           filed by Cordis Corporation  ("Cordis")  against Guidant  Corporation
           and Advanced  Cardiovascular  Systems, Inc. in federal district court
           in Delaware. Cordis alleges, among other things, that the sale by the
           Company of its stents in the United States would  infringe on certain
           patents  licensed by Cordis.  The  complaint  seeks  declaratory  and
           injunctive  relief,  unspecified  damages,  attorneys' fees and other
           relief.  On November 6, 1997,  the Company  filed a motion to dismiss
           Cordis'  complaint.  The  Company  believes  that it has  meritorious
           defenses to the claims alleged by Cordis in the action.  However,  no
           assurance can be given as to the outcome of the action. The inability
           of the  Company  to  prevail  in the  action,  including  the loss or
           impairment  of the right to produce  products  in the United  States,
           could  have a  material  adverse  effect on the  Company's  business,
           financial condition and results of operations.

                  On  December  24,  1997,  the  Company  received  notice  that
           Advanced  Cardiovascular  Systems,  Inc.  ("ACS"),  a  subsidiary  of
           Guidant  Corporation,  had filed a lawsuit  against  the  Company  in
           federal district court in San Jose,  California.  ACS alleges,  among
           other things, that the Company is selling in the United States stents
           that  infringe  on  certain  patents  of  ACS.  The  complaint  seeks
           injunctive  relief,  unspecified  damages,  attorneys' fees and other
           relief. The Company believes that it has meritorious  defenses to the
           claims  alleged by ACS in the action.  However,  no assurance  can be
           given as to the outcome of the action.  The  inability of the Company
           to prevail in the action,  including  the loss or  impairment  of the
           right to produce products in the United States, could have a material
           adverse  effect on the Company's  business,  financial  condition and
           results of operations.

                  On December  26,  1997,  the Company  filed an action  against
           Johnson &  Johnson,  Cordis  and  Expandable  Grafts  Partnership  in
           federal   district  court  in  Delaware.   The  action  seeks  (i)  a
           declaration that certain patents are invalid, void, unenforceable and
           not infringed by the Company's  activities  with respect to its stent
           systems in the United  States,  (ii) an  injunction  prohibiting  the
           defendants  from asserting  infringement  of such patents against the
           Company and (iii) a  declaration  that the  defendants  have violated
           certain  antitrust laws. The Company believes that it has meritorious
           claims against the defendants.  However, no assurance can be given as
           to the outcome of the action.

                  Claims of  Terminated  Distributors.  In  connection  with the
           Company's termination of certain distributor  relationships,  several
           of such  distributors  have filed  claims  against the  Company  with
           respect to such terminations.

                  In November 1996, in connection with the Company's termination
           of  its   distribution   relationship   with   Alfatec-Medicor   N.V.
           ("Alfatec-Medicor")  and Medicor

                                       9
<PAGE>
              ARTERIAL VASCULAR ENGINEERING, INC. AND SUBSIDIARIES
        NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
                                   (Unaudited)


           Nederland B.V. ("Medicor  Nederland") in Belgium and The Netherlands,
           respectively,  effective  September  30, 1996,  the Company  received
           notice of a lawsuit filed by Alfatec-Medicor in the Second Chamber of
           the  Commercial  Court of Brussels,  Belgium,  alleging  insufficient
           notice  of  termination  of  a  distribution  agreement  between  the
           parties,   promotion  costs,   personnel   restructuring  claims  and
           additional   compensation.   Alfatec-Medicor  seeks  compensation  of
           BF189,389,135  (approximately  $5.1 million  using  current  exchange
           rates), of which BF30,000,000 (approximately $810,000) is sought as a
           provisional  payment.  The  Company  has  entered  counterclaims  for
           $257,000  in  unpaid  accounts  receivable  and  has  requested  from
           Alfatec-Medicor   information  that  would  support  its  claims  for
           indemnification, but has not yet received such information. Following
           a  hearing  on  April  18,   1997,   the  court   postponed   further
           consideration  of the matter  until the  parties  have  conducted  an
           appropriate exchange of information and prepared written pleadings. A
           pleadings  hearing is scheduled  for April 24, 1998.  On February 20,
           1997,  the Company  commenced  an action  against  Medicor  Nederland
           before the Amsterdam District Court for payment of $269,000 in unpaid
           accounts  receivable.  On July 23, 1997,  Medicor  Nederland  filed a
           statement  of defense  and  entered a  counterclaim  for  DG2,284,379
           (approximately  $1.1 million  using  current  exchange  rates) on the
           grounds  of  insufficient  notice of  termination  of a  distribution
           agreement between the parties and unjust  enrichment.  On October 29,
           1997,  the Company filed a reply and answer to the  counterclaim.  On
           December 24, 1997,  Medicor  Nederland filed a statement of rejoinder
           and reply to the counterclaim.

                  On  August  19,  1996,  in   connection   with  the  Company's
           termination of its  distribution  relationship  in  Switzerland  with
           Medicor AG, effective  September 30, 1996, such distributor  filed an
           action  against the Company in the United States  District  Court for
           the Northern District of California alleging breach of written,  oral
           and  implied-in-fact  contracts,  inducement  to breach an employment
           contract  with  one  of  such  distributor's  employees,  intentional
           interference  with contractual  relations,  intentional and negligent
           interference with prospective economic advantage, misappropriation of
           trade secrets,  and intentional and negligent  misrepresentation.  On
           October 11,  1996,  the court  denied the  distributor's  request for
           preliminary and temporary injunctive relief. On January 30, 1997, the
           court  entered an order  dismissing  the  entire  action on forum non
           conveniens  grounds.  As part of the  dismissal,  AVE has  agreed  to
           submit to the  jurisdiction of the appropriate  forum in Switzerland,
           waive any  defense  of statute of  limitations  to any  substantially
           similar  claims made there,  make  available  witnesses and documents
           there  and  satisfy  any  judgment  entered  against  it  there.  The
           distributor  has  appealed the court's  dismissal  of the action.  On
           January 27, 1997, the Company filed an action in the debt  collection
           office of Cham,  Switzerland against the distributor for $93,000 plus
           accrued  interest in connection with unpaid accounts  receivable from
           the distributor relationship.  The distributor obtained a preliminary
           stay on the debt collection proceedings and a hearing with respect to
           the Company's motion to lift such stay was held on March 11, 1997. On
           July 14, 1997, the District Court of Zug denied the Company's  motion
           to lift such  stay in a summary  proceeding.  The  Company  is in the
           process  of filing a claim in  ordinary  court  proceedings  with the
           District  Court of Zug to have the stay lifted and to be  compensated
           for attorneys' fees incurred by the Company in the U.S. proceedings.

                                       10
<PAGE>
              ARTERIAL VASCULAR ENGINEERING, INC. AND SUBSIDIARIES
        NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
                                   (Unaudited)


                  In   connection   with  the  Company's   termination   of  its
           distribution    relationship    in   France   with   Medi    Service,
           S.A.R.L./Fournitures Hospitalieres S.A. effective September 30, 1996,
           the Company  received notice from such  distributor that it had filed
           an action  before the  Tribunal  de Grande  Instance  of  Mulhouse in
           France  seeking  compensation  for  breach  of an  alleged  exclusive
           distribution  agreement  for  an  indeterminate  period  between  the
           parties.  The action included a claim for  compensation  equal to the
           total value of such  distributor's  business,  which the  distributor
           valued at  FF400,000,000  (approximately  $67 million  using  current
           exchange  rates).  The  Company  counterclaimed  for unpaid  accounts
           receivable of approximately  $1.8 million and for damages for abusive
           legal  proceedings.  On September 23, 1996, the Tribunal rejected the
           distributor's  claims for damages for unlawful termination as well as
           the  Company's  counterclaim  for  abusive  legal  proceedings.   The
           Tribunal  reserved  judgement  with respect to the  repurchase of the
           distributor's  inventory  of AVE  products  and the payment of unpaid
           accounts receivable sought by the Company. The parties have submitted
           briefs on these issues and a procedural hearing was held on March 10,
           1997,  at which time the  distributor  filed an additional  brief.  A
           procedural hearing was held on May 9, 1997, at which time the Company
           added a counterclaim for unfair competition. Oral argument took place
           on  December  15,  1997,  and the  Tribunal is expected to render its
           decision on February 2, 1998. On February 10, 1997,  the  distributor
           filed an appeal of the Tribunal's decision of September 23, 1996 with
           the Court of Appeals of Colmar, and the parties have exchanged briefs
           in the appellate proceeding.

                  The Company has terminated a distributor relationship in South
           Korea.  The Company is in ongoing  discussions  with the  distributor
           with respect to approximately $491,000 in accounts receivable due the
           Company, and the Company has filed a writ of attachment on certain of
           the distributor's assets in connection therewith.

                  With respect to each of the aforementioned  distributors,  the
           Company has consulted  with local counsel in the  applicable  country
           and  believes  that  the  termination  of  each  of  the  distributor
           relationships was lawful. The Company understands that under the laws
           of certain  countries,  including Belgium and The Netherlands,  under
           certain   circumstances,   certain  indemnities  may  be  claimed  by
           distributors for insufficient  notice of termination  and/or goodwill
           compensation. The Company intends to vigorously defend itself against
           pending  claims  and any other  claims  that may be  brought  by such
           distributors  and to pursue  claims  for unpaid  accounts  receivable
           against such distributors.  However,  no assurance can be given as to
           the  outcome  of  any  pending  or  threatened  litigation,  and  any
           successful  claim for damages or injunctive  relief by one or more of
           such  distributors,  or the  failure by the Company to succeed on its
           claims against its former French  distributor,  could have a material
           adverse  effect on the Company's  business,  financial  condition and
           results of operations.

                  Employee Hiring  Litigation.  In connection with the hiring by
           the Company of employees in the United States,  several of the former
           employers of such employees have filed,  or have  threatened to file,
           claims  against the Company  with  respect to alleged  noncompetition
           obligations of such employees.

                                       11
<PAGE>
              ARTERIAL VASCULAR ENGINEERING, INC. AND SUBSIDIARIES
        NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
                                   (Unaudited)


                  On October 6, 1997,  the Company  received  notice that Cordis
           Corporation,  a subsidiary of Johnson & Johnson ("Cordis"), had filed
           a claim in federal  district  court in Buffalo,  New York against the
           Company and Charles J. Soles in connection with the Company's  hiring
           of Mr. Soles and several other former Cordis employees. The complaint
           alleges breach of contract by Mr. Soles and tortious  interference by
           the Company with Cordis'  alleged  contractual  rights.  Cordis seeks
           preliminary  and  permanent   injunctive  relief,   compensatory  and
           punitive damages,  attorneys' fees and other relief.  The Company has
           answered the complaint and moved for summary  judgment on the grounds
           that the agreement at issue is inapplicable  and  unenforceable  as a
           matter of law.  The District  Court held a hearing on Cordis'  motion
           for  preliminary  injunction in late October 1997, and further briefs
           and oral  arguments  were completed in December 1997. The Company has
           agreed to limit its  contact  with Mr.  Soles  pending  the  District
           Court's  determination on preliminary  injunctive relief. The Company
           believes that it has  meritorious  defenses to the claims  alleged by
           Cordis in the action.  However,  no assurance  can be given as to the
           outcome of the action.

                  On November 18, 1997, the Company  received notice that United
           States  Surgical  Corporation,  Inc.  ("USSC"),  had filed a claim in
           federal district court in Hartford,  Connecticut  against the Company
           in  connection  with the  Company's  hiring of Gregory  F. Toso.  The
           complaint   alleges   tortious   interference   with  USSC's  alleged
           contractual  rights  and  unfair  business  competition.  USSC  seeks
           permanent  injunctive  relief,  compensatory  and  punitive  damages,
           attorneys'  fees and other relief.  The Company  believes that it has
           meritorious  defenses  to the claims  alleged by USSC in the  action.
           However, no assurance can be given as to the outcome of the action.

                  From time to time,  the  Company is  involved  in other  legal
           proceedings arising in the ordinary course of its business. As of the
           date  hereof,  the  Company  is  not  a  party  to  any  other  legal
           proceedings  with  respect  to which an  adverse  outcome  would,  in
           management's opinion, have a material adverse effect on the Company's
           business, financial condition or results of operations.

                                       12

<PAGE>

Item 2.    Management's Discussion and Analysis of Financial Condition and
           Results of Operations

            Overview

                  The  statements  contained  in this  Form  10-Q  that  are not
           historical  are  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,  including  statements regarding the
           Company's expectations,  beliefs,  intentions or strategies regarding
           the future.  Forward-looking  statements made herein include, without
           limitation,   statements  regarding   manufacturing   scale-up,   the
           intellectual  property  positions  of  competitors,  the  anticipated
           outcome  of  litigation,   the  extent  and  timing  of  new  product
           introductions, future revenues, customer demand, competition, pricing
           pressure,  regulatory approvals,  expenditures and margin levels, and
           the establishment of direct sales forces in targeted  countries.  All
           forward-looking  statements in this document are based on information
           available  to the  Company  as of the date  hereof,  and the  Company
           assumes no obligation to update any such  forward-looking  statement.
           It is  important  to note that the  Company's  actual  results  could
           differ  materially  from  those in such  forward-looking  statements.
           Additional  risk factors include those discussed in the reports filed
           by the Company from time to time on Forms 10-K, 10-Q and 8-K.

                  The   Company   is  engaged   in  the   design,   development,
            manufacturing  and  marketing  of  stent  systems  and  percutaneous
            transluminal  coronary angioplasty ("PTCA") catheters designed to be
            utilized   in   connection   with   less   invasive   treatment   of
            cardiovascular  disease.  The Company began  commercial sales of its
            PTCA  catheters  in October  1993,  its  coronary  stent  systems in
            October 1994, and its peripheral  stent systems in December 1996. In
            June 1997, the Company's Japanese  distributor  received  regulatory
            approval  for the  sale in  Japan of the  Company's  coronary  stent
            systems;  however,  as of the date hereof,  such distributor had not
            yet received the related  reimbursement  approval.  The Company does
            not expect  reimbursement  approval in Japan prior to February 1998,
            and  there  can be no  assurance  when or if such  approval  will be
            obtained.  In  December  1997,  the  Company  received a  pre-market
            approval ("PMA") from the United States Food and Drug Administration
            (the "FDA") in connection with its  commencement of commercial sales
            of its coronary  stent systems in the United  States.  Prior to that
            time,  international  sales accounted for  substantially  all of the
            Company's revenues.

                  The Company has a limited history of operations.  The increase
           in the  Company's  sales to date has  primarily  been due to  greater
           demand for the Company's coronary stent systems. The Company believes
           that it is currently one of the leading  providers of coronary  stent
           systems  internationally.  In order to  support  increased  levels of
           sales  in the  future  and  to  augment  its  long  term  competitive
           position,  the Company  anticipates  that it will be required to make
           continuing  significant  additional  expenditures  in  manufacturing,
           research and  development  (including  clinical  study and regulatory
           costs),  sales and marketing,  and  administration,  both in absolute
           dollars and as a percentage of net sales. The Company also expects to
           incur  significant  legal  expenses  relating to ongoing  litigation,
           including patent litigation.

                  Generally,  the Company manufactures and ships product shortly
            after the receipt of orders,  and anticipates  that it will do so in
            the future.  The Company developed a

                                       13
<PAGE>

           significant short-term backlog during January 1997 in connection with
           the scale-up of  manufacturing  of its GFX(TM)  stent  product.  Such
           backlog was  significantly  reduced during the same fiscal quarter in
           which it arose. The Company is currently manufacturing  over-the-wire
           models of its coronary  stent systems for sale in the United  States,
           unlike  the  rapid  exchange  models   generally   manufactured   for
           international  markets.  There can be no  assurance  that the Company
           will be  successful  in  scaling  up  production  of new or  modified
           products or that it will not experience manufacturing difficulties or
           develop  backlogs in the  future,  particularly  with  respect to the
           potentially  significant  demands of the U.S. market. The Company has
           produced and continues to produce inventory for the short-term supply
           of the potential U.S.  market,  and is  constructing a 130,000 square
           foot building  adjacent to its corporate  headquarters in Santa Rosa,
           California,  at  an  estimated  cost  of  $20  million,  which,  when
           completed,  will be  largely  devoted  to  manufacturing  activities.
           However,  there  can be no  assurance  that  such  new  manufacturing
           facility will be completed in time, or will be  sufficient,  to allow
           the Company to adequately supply the potentially  significant demands
           of the U.S. market on a long-term basis, or that such new facility or
           other   potentially   necessary   facilities   will  pass  regulatory
           inspection for  compliance  with  applicable U. S. and  international
           regulations.

                  Since the  commencement of sales of its coronary stent systems
           in the United States, several of the Company's competitors have filed
           claims against the Company  alleging,  among other things,  that such
           stent  systems  infringe  on  certain  patents  of such  competitors.
           Although the Company  continually  reviews the scope of relevant U.S.
           and  foreign  patents  and  related   litigation,   the  question  of
           infringement  involves complex legal and factual issues and is highly
           uncertain.  There can be no assurance that any conclusion  reached by
           the  Company  regarding  infringement  will be  consistent  with  the
           resolution of such issue by a court.  If the  Company's  products are
           determined to infringe such patents and it cannot obtain a license on
           commercially  reasonable  terms or modify its current  technology  or
           develop  new  products  to avoid  infringement,  such  outcome  could
           require the Company to cease its  commercial  activities and sales of
           the affected  products in the United States and could have a material
           adverse  affect on the Company's  business,  financial  condition and
           results  of  operations.  See  Note  5  to  the  unaudited  Condensed
           Consolidated Financial Statements in Item 1.

                  The increasing  number of devices in the  international  stent
            market  and the  desire  of  companies  to obtain  market  share has
            resulted in increased price competition,  particularly in the second
            and third  quarters of fiscal  1997.  Such  competition  has, in the
            past, caused the Company to reduce prices on its stent systems.  The
            Company  expects that, as the stent industry  develops,  competition
            and pricing  pressures  will  increase.  If the Company is forced to
            effect further price  reductions,  such reductions  would reduce net
            sales in future  periods  if not offset by  increased  unit sales or
            other factors.

                  Until April 1996,  substantially  all of the  Company's  sales
            were to  international  distributors  who resell  products to health
            care  providers.   The  Company  terminated  its  relationship  with
            distributors  in  Germany  and the  United  Kingdom in April and May
            1996,  respectively,  and in France,  Switzerland,  Belgium  and The
            Netherlands  effective September 30, 1996. Moreover, in October 1997
            the Company  established  a direct sales force in Canada and largely
            completed the  development of a sales force in the United States for
            the direct sales of its coronary stent systems. The Company believes
            that the  establishment  and  maintenance  of direct sales forces in
            Canada,  France,  Germany,  the  Netherlands  (servicing the Benelux
            countries),  Switzerland,  the United  Kingdom and the United States
            has  required  and will  continue  to  require  significant  ongoing
            expenditures,  additional management resources and has resulted, and
            may continue to result,  in additional  costs to eliminate  existing
            distributor  relationships  (including  costs relating to litigation
            with former  distributors).  See Note 5 to the  unaudited  Condensed
            Consolidated Financial Statements in Item 1.

                  The Company  anticipates  that its results of  operations  may
            fluctuate  for  the  foreseeable  future  due  to  several  factors,
            including  variations  in  operating  expenses,  the  costs  and the
            outcome of litigation,  competition  (including pricing  pressures),
            fluctuations in  international  currency  exchange  rates,  costs of
            establishing  direct  sales  operations,  the timing of research and
            development    expenses    (including    clinical    trial   related
            expenditures),   the  timing  of  new   product   introductions   or
            transitions to new products, sales by distributors, the mix of sales
            among  distributors and the Company's direct sales force,  timing of
            regulatory  and third party  reimbursement  approvals,  the level of
            third-party reimbursement,  the Company's ability to manufacture its
            products efficiently, and seasonal factors impacting the number of

                                       14
<PAGE>

            elective angioplasty or stent procedures. In addition, the Company's
            results of operations could be affected by the timing of orders from
            its  distributors,  changes  in the  Company's  distributor  network
            (including   expenses  in  connection  with  termination  of  former
            distributors),   the  ability  of  the  Company's   distributors  to
            effectively  promote the  Company's  products and the ability of the
            Company to  quickly  and  cost-effectively  establish  an  effective
            direct  sales force in targeted  countries.  The  Company's  limited
            operating  history makes  accurate  prediction  of future  operating
            results   difficult   or   impossible.   Although  the  Company  has
            experienced  growth in recent years, there can be no assurance that,
            in the future,  the Company  will sustain  revenue  growth or remain
            profitable on a quarterly or annual basis or that its growth will be
            consistent with predictions made by securities analysts. The Company
            has experienced,  and may experience in one or more future quarters,
            operating  results that are below the  expectations of public market
            analysts and  investors.  In such event,  the price of the Company's
            common stock has been, and would likely be, materially and adversely
            affected.

            Results of Operations - Three and Six Months Ended December 31, 1997
            and 1996

                  Net sales.  For the three months ended  December 31, 1997, net
            sales   increased  to  $38.3  million  from  $18.2  million  in  the
            comparable  period in fiscal 1997. For the six months ended December
            31, 1997, net sales increased to $64.6 million from $36.8 million in
            the comparable  period in fiscal 1997. The increase in net sales was
            due  to  significant  increases  in  sales  of the  Company's  stent
            systems,  particularly  the  GFX  family  of  products.  The GFX was
            released in certain countries internationally in September 1996, and
            the  GFX  2.5(TM)  and the  GFX  XL(TM)  were  released  in  certain
            countries internationally in June 1997.

                  The Company  anticipates that coronary stent system sales will
           continue to  constitute  the vast majority of total net sales for the
           near future.  In the second  quarter of fiscal 1997 the Company began
           selling  directly in France,  Switzerland,  and the  Netherlands  (to
           service the  Benelux  countries).  In the three and six months  ended
           December 31, 1997, these direct sales operations, together with those
           established previously in Germany and the United Kingdom,  produced a
           significant portion of the Company's total net sales. On December 23,
           1997, the Company received  pre-market  approval to commence sales of
           its coronary stent systems in the United States.  The Company expects
           that its direct sales  operations in the United States will produce a
           significant  portion of the Company's  total net sales in the future.
           All other  commercial  sales made by the Company were to unaffiliated
           distributors,  with a significant  portion of total net sales for the
           three and six months ended December 31, 1997  attributable  to orders
           from the Company's Japanese distributor. The Company believes that it
           may be  forced  to effect  price  reductions,  for one or more of its
           distributors  in Asia as a result of the recent  fluctuations  in the
           exchange rates of many Asian currencies. Such reductions would reduce
           net sales in future  periods if not offset by increased unit sales or
           other factors.

                  Cost of Sales.  Cost of sales increased to $7.7 million in the
            three  months  ended  December  31,  1997 from $3.7  million  in the
            comparable  period in fiscal 1997,  and decreased as a percentage of
            net  sales to 20.0% in the  fiscal  1998  period  from  20.5% in the
            fiscal 1997 period.  Cost of sales increased to $13.1 million in the
            six  months  ended  December  31,  1997  from  $6.6  million  in the
            comparable  period in fiscal 1997,  and increased as a percentage of
            net  sales to 20.4% in the  fiscal  1998  period  from  18.1% in the
            fiscal 1997  period.  The  increase in absolute  dollars  during the
            three- and  six-month  periods,  and the increase as a percentage of
            sales during the  six-month  period,  was  primarily a result of the
            increased volume of products sold and, to a lesser extent, the costs
            of  additional  manufacturing  capacity and  personnel  necessary to
            support increased

                                       15
<PAGE>

           sales  volume.  The decrease as a percentage  of net sales during the
           three-month  period was primarily  the result of  leveraging  certain
           fixed overhead expenses across a higher base of sales.

                  The Company  expects  cost of sales to continue to increase in
            absolute  dollars as the  Company  increases  the volume of products
            sold and adds additional manufacturing capacity and personnel.

                  Research and Development.  Research and development  expenses,
            which include clinical study and regulatory costs, increased to $7.9
            million  in the  three  months  ended  December  31,  1997 from $2.3
            million in the comparable  period in fiscal 1997, and increased as a
            percentage  of net sales to 20.7% in the  fiscal  1998  period  from
            12.4% in the fiscal 1997 period.  Research and development  expenses
            increased to $13.4 million in the six months ended December 31, 1997
            from $4.1  million  in the  comparable  period in fiscal  1997,  and
            increased as a  percentage  of net sales to 20.8% in the fiscal 1998
            period  from  11.2% in the  fiscal  1997  period.  The  increase  in
            absolute  dollars and in  percentage  of sales during the three- and
            six-month  periods was primarily due to the addition of research and
            development  personnel,  increased  levels of spending in connection
            with  clinical  studies  relating to the GFX, the Micro Stent II and
            Micro Stent II XL systems and costs incurred in connection  with the
            development of additional products.

                  The  Company  expects  research  and  development  expenses to
            continue to increase  in absolute  dollars as the Company  increases
            clinical trial activities and pursues development of next generation
            products.

                  Selling,  General  and  Administrative.  Selling,  general and
           administrative  expenses  increased  in  absolute  dollars  to  $11.9
           million in the three months ended December 31, 1997 from $6.2 million
           in  the  comparable  period  in  fiscal  1997,  and  decreased  as  a
           percentage of net sales to 31.1% in the 1998 period from 34.0% in the
           1997 period.  Selling,  general and administrative expenses increased
           in absolute dollars to $19.4 million in the six months ended December
           31, 1997 from $9.3 million in the  comparable  period in fiscal 1997,
           and  increased  as a  percentage  of net  sales  to 30.1% in the 1998
           period from 25.4% in the 1997 period.  The increase during the three-
           and  six-month  periods in absolute  dollars,  and the  increase as a
           percentage of net sales for the six-month period, primarily reflected
           additional  costs of  marketing  and  other  personnel  necessary  to
           support the  Company's  higher  level of  operations,  including  the
           commencement of direct sales  operations in the United States in late
           December 1997.  Additionally,  the increase reflects  increased legal
           costs relating  primarily to litigation  with former  shareholders of
           Endothelial Support Systems, Inc., subsequently known as Endovascular
           Support  Systems,   Inc.  ("ESS"),   patent  litigation  and  certain
           distributor  terminations,  which together  resulted in related legal
           expenses of $1.3  million for the three  months  ended  December  31,
           1997. The decrease in percentage of sales for the three-month  period
           was   primarily  the  result  of   leveraging   sales,   general  and
           administrative expenses across a higher base of sales.

                  The Company expects selling,  general and administrative costs
           to continue to increase in absolute  dollars in the future  primarily
           due to increased levels of sales,  product support and  manufacturing
           operations, as well as increases in finance, legal and administrative
           costs relating to, among other things, ongoing litigation,  including
           patent litigation.

                  Interest and Other Income.  The Company had interest and other
            income of $1.1 million in the three months ended  December 31, 1997,
            compared to $1.1  million in the

                                       16
<PAGE>

            comparable period in fiscal 1997. The Company had interest and other
            income of $2.1  million in the six months  ended  December 31, 1997,
            compared to $2.3  million in the  comparable  period in fiscal 1997.
            The  decrease  during  the  six-month  period was  primarily  due to
            greater short-term investment balances in the prior period.

                  Provision for Income Taxes. The Company's provision for income
            taxes was $4.2 million in the three months ended  December 31, 1997,
            compared to $2.5  million in the  comparable  period in fiscal 1997.
            The Company's provision for income taxes was $7.2 million in the six
            months  ended  December  31,  1997,  compared to $6.7 million in the
            comparable  period in fiscal 1997.  The  increase in this  provision
            during  the  three-  and  six-month  periods  was a  result  of  the
            Company's higher earnings during the fiscal 1998 periods.

                  Net Income.  The Company  had net income of $7.8  million,  or
            20.2% of net sales,  in the three  months  ended  December  31, 1997
            compared to net income of $4.6 million,  or 25.3% of net sales,  for
            the comparable  period in fiscal 1997. The Company had net income of
            $13.5  million,  or  20.9% of net  sales,  in the six  months  ended
            December 31, 1997 compared to net income of $12.4 million,  or 33.6%
            of net sales, for the comparable period in fiscal 1997.

            Liquidity and Capital Resources

                  Net cash used in operating activities was $362,000 for the six
            months ended December 31, 1997. Excluding the effect of transactions
            in  short-term  investments,  the Company  had net cash  provided by
            operating  activities  of $6.4  million  for the  six-month  period,
            principally  arising  as a result of  positive  net  income  for the
            period.  Cash, cash equivalents and short-term  investments  totaled
            $83.4  million at December 31, 1997 as compared to $87.2  million at
            June 30,  1997.  Working  capital  decreased  to $112.8  million  at
            December  31, 1997 as compared to $114.5  million at June 30,  1997.
            Inventories  increased  to $13.6  million at December  31, 1997 from
            $7.3 million at June 30, 1996,  primarily due to increased levels of
            sales activity. Included in accounts receivable at December 31, 1997
            is  approximately  $2.4 million due from former  distributors of the
            Company that have  threatened or commenced  litigation in connection
            with the termination of distribution relationships.  The Company has
            commenced litigation against such terminated distributors to collect
            such  amounts.  See Note 5 to the Condensed  Consolidated  Financial
            Statements in Item 1. The Company  expects  accounts  receivable and
            inventories  to  increase  in  absolute   dollar  amounts  as  sales
            increase.

                  In  August  1997,  the  Company  entered  into a  bank  credit
            agreement  for a  revolving  credit  facility of $20  million.  Such
            revolving  credit  facility  is secured by certain of the  Company's
            short-term  investments  and is due and payable on August 31,  1998.
            The  bank  credit   agreement   contains  no  material   restrictive
            covenants.  As of  December  31,  1997,  the  Company had drawn down
            approximately  $10.1 million of such revolving credit facility.  The
            interest  rate  on such  facility  is  LIBOR  plus  one-half  of one
            percent.

                  The Company  expects to incur  substantial  additional  costs,
            including  costs  relating  to  capital  equipment  and other  costs
            associated   with   expansion   of   the   Company's   manufacturing
            capabilities,  increased sales and marketing  activities  (including
            the  establishment  of direct  sales  forces  internationally),  and
            increased  research and development  expenditures in connection with
            seeking  regulatory  approvals and

                                       17
<PAGE>

           conducting  additional  clinical  trials.  Among  other  things,  the
           Company  expects  to  spend   approximately  $20  million  on  a  new
           manufacturing  facility  currently under  construction in Santa Rosa,
           California.  The  Company  may  require  additional  equity  or  debt
           financing to address its working  capital needs or to provide funding
           for capital expenditures in the future.  Furthermore,  any additional
           equity financing may be dilutive to stockholders, and debt financing,
           if available,  may involve restrictive covenants.  However, there can
           be no  assurance  that  events in the  future  will not  require  the
           Company to seek additional  capital or, if so required,  that it will
           be available on terms acceptable to the Company.

                                       18


<PAGE>


PART II           OTHER INFORMATION


                  Item 1.    Legal Proceedings

                                    Reference is made to Note 5 to the Condensed
                             Consolidated  Financial  Statements  in  this  Form
                             10-Q.


                  Item 2.    Change in Securities and Use of Proceeds

                                    The   effective   date   of  the   Company's
                             registration  statement filed on Form S-1 under the
                             Securities Act of 1933 (No. 333-00824) was April 2,
                             1996 (the "Registration  Statement").  The class of
                             securities   registered   was  Common  Stock.   The
                             offering   commenced  on  April  2,  1996  and  all
                             securities were sold in the offering.  The managing
                             underwriters for the offering were Cowen & Company,
                             Bear, Stearns & Co. Inc. and J.P. Morgan & Co.

                                    Pursuant to the Registration Statement,  the
                             Company sold  4,250,000  shares of Common Stock for
                             its own account, for an aggregate offering price of
                             $89,250,000,  and 1,500,000  shares of Common Stock
                             for the  account of certain  selling  stockholders,
                             for an aggregate offering price of $31,500,000.

                                    The    Company    incurred    expenses    of
                             approximately  $7,897,500  in  connection  with the
                             offering,    of   which   $6,247,500    represented
                             underwriting    discounts   and   commissions   and
                             $1,650,000  represented  estimated  other expenses.
                             All such expenses were direct or indirect  payments
                             to others. The net offering proceeds to the Company
                             after total expenses was approximately $81,352,000.

                                    The   Company    has   used    approximately
                             $12,800,000 of the net proceeds of the offering, of
                             which $6,200,000  represents  payments  relating to
                             the construction of plant,  building and facilities
                             and $6,600,000  represents payments relating to the
                             purchase of real  estate.  All such  payments  were
                             direct or indirect  payments  to others.  All other
                             net proceeds of the offering  have been invested in
                             various  short-term  investments.  The  use  of the
                             proceeds  of the  offering  does  not  represent  a
                             material change in the use of proceeds described in
                             the   prospectus   that   formed   a  part  of  the
                             Registration Statement.

                                       19



<PAGE>



                  Item 4.    Submission of Matters to a Vote of Security Holders

                             The Company's  annual meeting of  stockholders  was
                             held on October 29, 1997, to consider and vote upon
                             four  matters.  The  first  matter  related  to the
                             election  of  five  director  nominees:  Bradly  A.
                             Jendersee,  Scott J. Solano,  John D.  Miller,  Dr.
                             Simon H.  Stertzer and Craig E.  Dauchy.  The votes
                             cast  and  withheld  for  such   nominees  were  as
                             follows:

                             Name                       For          Withheld
                             ----                       ---          --------

                             Bradly A. Jendersee     27,395,212       97,144
                             Scott J. Solano         27,420,804       71,552
                             John D. Miller          27,395,062       97,294
                             Dr. Simon H. Stertzer   27,423,562       68,794
                             Craig E. Dauchy         27,420,892       71,464




                             The second  matter  related to the  approval  of an
                             amendment to the  Company's  1996 Equity  Incentive
                             Plan to increase the shares issuable  thereunder by
                             1,000,000. 19,927,987 votes were cast for approval,
                             4,042,940 were cast against,  and there were 18,952
                             abstentions  and  3,502,477  broker  nonvotes.  The
                             third  matter   related  to  the  approval  of  the
                             Company's   1997  Employee   Stock  Purchase  Plan.
                             21,299,461 votes were cast for approval,  2,672,791
                             were   cast   against,   and  there   were   17,627
                             abstentions  and  3,502,477  broker  nonvotes.  The
                             fourth matter  related to the  ratification  of the
                             appointment  of  Ernst & Young  LLP as  independent
                             auditors of the Company for fiscal 1997. 27,479,867
                             votes  were  cast for  approval,  5,462  were  cast
                             against and there were 7,027 abstentions.

                             Based  on  these  voting   results,   each  of  the
                             directors  nominated  was  elected  and the second,
                             third and fourth matters were passed.

                  Item 6.    Exhibits and Reports on Form 8-K

                  (a)         Exhibits

                             10.32    Lease,  dated  as  of  October  29,  1997,
                                      between the  Company  and SBR  Development
                                      concerning  the  facility at 7975  Cameron
                                      Center  Drive,   Building  200,   Windsor,
                                      California.

                             10.33    Third Amendment,  dated as of December 22,
                                      1997,   to  that   certain   International
                                      Distributorship  Agreement,  dated  as  of
                                      January 22, 1997, as amended,  between the
                                      Company  and  Japan   Lifeline  Co.,  Ltd.
                                      (Confidential treatment has been requested
                                      for certain information  contained in this
                                      document.   Such   information   has  been
                                      omitted  and  filed  separately  with  the
                                      Securities    and   Exchange    Commission
                                      pursuant to Rule 24b-2  promulgated  under
                                      the  Securities  and Exchange Act of 1934,
                                      as amended.)

                             11.1     Statement  regarding  calculation  of  net
                                      income per share.

                             27        Financial Data Schedule.


                                       20

<PAGE>

                  (b)        Reports on Form 8-K

                             On October 23, 1997,  the Company  filed a Form 8-K
                             with  respect to its being  named as an  additional
                             defendant, along with Boston Scientific Corporation
                             and  SCIMED  Life  Systems,   Inc.,  in  a  lawsuit
                             originally  filed  by  Cordis  Corporation  against
                             Guidant  Corporation  and  Advanced  Cardiovascular
                             Systems,   Inc.  in  federal   district   court  in
                             Delaware.   The  lawsuit  alleges  infringement  or
                             potential  infringement of one or more U.S. patents
                             held by Cordis.

                             Report Date: October 21, 1997
                             Filing Date: October 23, 1997
                             Item 5 - Other Events
                             Item 7 - Exhibits

                                       21

<PAGE>


SIGNATURES

         Pursuant to the  requirements  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.



                       ARTERIAL VASCULAR ENGINEERING, INC.



Date:    January 15, 1998     /s/ John D. Miller
                              ------------------
                              John D. Miller
                              Vice President of Finance, Chief Financial Officer
                              (Principal Financial and Accounting Officer)

                                       22

<PAGE>




                                INDEX TO EXHIBITS


Exhibit


10.32             Lease,  dated as of October 29, 1997,  between the Company and
                  SBR Development concerning the facility at 7975 Cameron Center
                  Drive, Building 200, Windsor, California.

10.33             Third  Amendment,  dated  as of  December  22,  1997,  to that
                  certain International  Distributorship  Agreement, dated as of
                  January 22,  1997,  as amended,  between the Company and Japan
                  Lifeline  Co.,  Ltd.  (Confidential  treatment  requested  for
                  certain   information   contained  in  this   document.   Such
                  information  has been  omitted and filed  separately  with the
                  Securities  and  Exchange  Commission  pursuant  to Rule 24b-2
                  promulgated  under the Securities and Exchange Act of 1934, as
                  amended).

11.1              Statement regarding computation of net income per share.

27                Financial Data Schedule