<PAGE>
 
                                   FORM 10-K

                      SECURITIES AND EXCHANGE COMMISSION
                            WASHINGTON, D.C. 20549

             [X]  ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
                    OF THE SECURITIES EXCHANGE ACT OF 1934

                 For the fiscal year ended SEPTEMBER 26, 1998

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

                For the transition period from ______ to ______

                         Commission file No.  0-15338
                                        
                            SEATTLE FILMWORKS, INC.
                            -----------------------
            (Exact name of registrant as specified in its charter)
<TABLE>
<S>                                                                                     <C>
                              WASHINGTON                                                91-0964899
                              ----------                                                ----------
         (State or other jurisdiction of incorporation or organization)      (IRS Employer Identification No.)
 
                 1260 16TH AVENUE WEST, SEATTLE,  WA                                       98119
                 -----------------------------------                                       -----
               (Address of principal executive offices)                                 (Zip Code)
 
           Registrant's telephone number, including area code:                        (206) 281-1390
                                                                                      --------------
        Securities registered pursuant to Section 12(b) of the Act:                        NONE
                                                                                           ----
</TABLE> 
Securities registered pursuant to Section 12(g) of the Act: COMMON STOCK, PAR 
                                                            -----------------
VALUE $.01 PER SHARE.
--------------------         

     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 the
filing requirements for the past 90 days.  Yes:  [ X ]   No:  [    ]

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

     As of November 30, 1998, there were issued and outstanding 16,242,011
shares of Common Stock, par value $.01 per share.  As of November 30, 1998, the
aggregate market value of the Registrant's Common Stock held by non-affiliates
of the Registrant was $47,041,269, based on the last sale price of the
Registrant's Common Stock as reported by the Nasdaq National Market.

                     Documents incorporated by reference:

     Portions of the registrant's proxy statement relating to its 1998 annual
meeting of shareholders, to be held on February 9, 1999, are incorporated by
reference into Part III of this Annual Report on Form 10-K.

                                 Page 1 of 60

                           Exhibit Index at Page 52
<PAGE>
 
                                     PART I
                                        
ITEM 1 - BUSINESS

DESCRIPTION OF BUSINESS

     Seattle FilmWorks, Inc. ("Seattle FilmWorks" or the "Company") is a leading
direct-to-consumer marketer and provider of high-quality amateur photofinishing
and digital imaging services and products.  The Company offers an array of
complementary services and products primarily on a mail-order basis under the
brand name Seattle FilmWorks(R).

     Since 1978, the Company has been an industry leader in the introduction of
value-added photo-related services and products.  The Company offers prints,
slides and digital images, all from the same roll of 35mm film.  Seattle
FilmWorks was among the first to provide express-mail delivery, cross-referenced
data on prints and negatives, a composite photo index and a convenient reorder
system.  To a lesser extent, the Company provides photofinishing services,
products and supplies on a wholesale basis.

     Since 1994, the Company has been a pioneer in providing digital-imaging
technologies which enable photofinishing customers to creatively enhance and
share personal photographs with friends, family and business associates.
Products incorporating these technologies include (i) Pictures On Disk(TM) a
floppy disk containing digital images from a roll of film; (ii) PhotoWorks(R)
software, which can be used to create digital photograph albums and screen
savers; (iii) PhotoMail(TM), a service which reduces turnaround time by
privately delivering digital images to customers over the Internet; (iv)
FilmWorksNet(TM), a free service which provides customers the ability to share
pictures through the creation of a private photographic home page uploaded to
the Seattle FilmWorks Web site (www.filmworks.com); (v) PictureWorks(TM), a
digital reprint service with which customers upload digital image files across
the Internet to the Company for digital reproduction on Kodak(TM) photographic
paper; and most recently, (vi) Pictures On Disk(TM) on CD, a CD containing
digital images from a roll of film. The Company is currently developing
additional digital-imaging and Internet-related services and products. For
example, Seattle FilmWorks and Excite, Inc. ("Excite") recently announced an
agreement to give Excite users free photo scanning and Web posting when they
purchase film processing from Seattle FilmWorks. This service will allow Excite
users to view their photos privately and use them in their Excite communities.
Excite, Inc. is a global Internet (excite.com) media company.

     The Company uses direct-marketing techniques to target selected consumers,
measure customer response and obtain direct customer feedback to changes in
marketing strategies.  Over the past several years, the Company has targeted the
growing population of personal computer users in connection with the
introduction of digital-imaging services and products.  The Company has
developed comprehensive statistical models for the design and analysis of its
direct-response marketing programs using proprietary customer data compiled over
17 years.

     The Company was incorporated in Washington State in June 1976.  The
executive offices of the Company are located at 1260 Sixteenth Avenue West,
Seattle, Washington 98119, and the Company's telephone number is (206) 281-1390.
References to Seattle FilmWorks and the Company in this Report include Seattle
FilmWorks, Inc., and its wholly-owned subsidiaries, Seattle FilmWorks
Manufacturing Company, OptiColor, Inc. and FilmWorks Express, Inc.  The Company
formed FilmWorks Express, Inc. in fiscal 1998.

FORWARD-LOOKING INFORMATION
 
     Statements in this report concerning the Company's strength in Photo-
Computing, additional revenue sources, enhancement of customer retention,
expected increase in share of the market for reprints, introduction of
additional digital services and any other statement which may be construed as a
prediction of future performance or events are forward-looking statements, the
occurrence of which are subject to a number of known and unknown risks,
uncertainties and other factors which may cause actual results, performance or
achievements of the Company or industry trends to differ materially from those
expressed or implied by such forward-looking statements.

                                       2
<PAGE>
 
Relevant risks and uncertainties include, among others, those discussed in Item
1 of Part 1 under the heading "Risk Factors" and elsewhere in this Report and
those described from time to time in the Company's other filings with the
Securities and Exchange Commission, press releases and other communications.
All forward-looking statements contained in this report reflect the Company's
expectations at the time of this report only, and the Company disclaims any
responsibility to revise or update any such forward-looking statement except as
may be required by law.

PHOTOFINISHING INDUSTRY AND DIRECT-MARKETING OVERVIEW

  According to information published by the Photo Marketing Association
International ("PMAI"), domestic amateur photofinishing sales totaled
approximately $5.8 billion in 1996, an increase of approximately $360,000,000
from the prior year.  The dominant method of distributing photofinishing
services and products was through retail stores, including discount and mass
merchants, drugstores, supermarkets and camera/specialty stores. Management
believes the majority of rolls of film are sent to wholesale photofinishing
laboratories for processing, although a growing percentage are processed in-
store using on-site equipment.

  Outside the photofinishing industry, leading users of direct marketing include
mail-order houses and catalog mailers, magazine publishers, insurance companies,
book and record clubs, financial institutions and credit card companies.
Management believes growth in the use of direct-marketing is generally
attributable to social, economic and technological changes and to the relative
cost-effectiveness of direct-marketing techniques. Management also believes
several factors have enhanced consumer responsiveness to direct marketing as a
purchasing medium, including growth in the number of people in the most active
segment of the purchasing population, growth in the number of two-career
families that have more disposable income and less time to shop, and increased
availability and use of credit cards. Increasingly, the Internet, on-line
services and increased use of personal computers provide additional channels for
direct-to-consumer marketing. See "Risk Factors--Dependence on Direct-Marketing
Programs; Accounting for Customer Acquisition" and "--Dependence on the Internet
and Potential Liability for Content."

OPERATING STRATEGY

     Seattle FilmWorks strives to achieve growth in net revenues and net income
through the execution of its operating strategy, the principal elements of which
are the introduction of innovative, value-added services and products,
application of direct-to-consumer marketing techniques, and a commitment to
customer satisfaction.

     Innovative, Value-Added Services and Products.  Management believes that
Seattle FilmWorks has distinguished itself from its competitors through service
and product differentiation.  The Company endeavors to develop and introduce
value-added photofinishing services and products based on focused research and
development efforts as well as anticipation of consumer demand by monitoring
customer feedback.  Management believes that the expansion of its array of
complementary services and products promotes (i) increased acquisition of new
customers, (ii) retention of existing customers and (iii) higher average-order
sizes.

     In the late 1970s, the Company introduced Seattle FilmWorks(R) branded film
and shortly thereafter offered its customers the option of prints and/or
individually color-corrected slides from the same roll of film.  More recently,
the Company has been a leader in introducing numerous other value-added
features, including express-mail delivery, cross-referencing data on prints and
negatives, Pictures Plus(TM) Index prints, a convenient Easy-Order System and
Professor FilmWorks(TM) (free telephone pre-recorded mini-lessons on
photography).

     In addition, the Company has been a leader in marketing photofinishing
services which employ digital technology.  These include (i) Pictures On
Disk(TM), a floppy disk containing digital images from a roll of film; (ii)
PhotoWorks(R) software, which can be used to create digital photograph albums
and screen savers; (iii) PhotoMail(TM), a service which reduces turnaround time
by privately delivering digital images to customers over the Internet; (iv)
FilmWorksNet(TM), a free service which provides customers the ability to share
pictures through the creation of a private photographic home page uploaded to
the Seattle FilmWorks Web site (www.filmworks.com); (v) PictureWorks(TM), a
digital reprint service with which customers upload digital image files across
the Internet to the Company for digital

                                       3
<PAGE>
 
reproduction on Kodak(TM) photographic paper; and most recently, (vi) Pictures
On Disk(TM) on CD, a CD containing digital images from a roll of film; and (vii)
Digital Reprints, a service allowing customers purchasing digital products to
order reprints over a touch-tone telephone. The Company is currently developing
additional digital-imaging and Internet-related services and products. For
example, Seattle FilmWorks and Excite recently announced an agreement to give
Excite users free photo scanning and Web posting when they purchase film
processing from Seattle FilmWorks. This service will allow Excite users to view
their photos privately and use them in their Excite communities. See "Business--
Services and Products."

     Direct-to-Consumer Marketing.  The Company's business model is founded on
direct-response marketing.  Management believes an important advantage of its
direct-marketing strategy is the opportunity to contact a large number of
consumers who may appreciate the convenience of mail order and the Company's
array of complementary services and products.  Direct access to consumers
permits the Company to target and monitor selected potential and existing
customers, measure customer response and obtain direct customer feedback to
changes in marketing strategies.  Generally, the Company attempts to identify
prospective customers by targeting specific groups of individuals with common
characteristics.  For example, the Company has targeted the growing population
of personal computer users in connection with the introduction of its digital-
imaging services and products.  Information derived from the Company's database
compiled over 17 years has been used to create statistical models to develop
targeted marketing programs and estimate future demand.  In addition, the
Company's proprietary database is used to plan, personalize, implement and
evaluate marketing programs for existing customers.  See "Business --Marketing
and Customer Acquisition."

     Commitment to Customer Satisfaction.  The Company seeks to develop and
provide high-quality, user-friendly and reliable photofinishing services and
products to enhance brand recognition for "Seattle FilmWorks" and to engender
customer loyalty.  Management believes that a significant portion of its
business comes from repeat customers.  As part of its dedication to customer
service, Seattle FilmWorks offers a 100% satisfaction guarantee, provides an
Easy-Order System whereby a customer sets up a standing order, thus avoiding the
need to fill out an order form with each order, and offers photo-taking advice
with its Professor FilmWorks(TM) service.  In addition, to achieve its customer
service goals the Company conducts customer surveys and holds management
meetings to identify areas for service enhancement. Through investments in
automation, state-of-the-art photofinishing equipment, and the commitment of its
employees to quality control, the Company strives to deliver greater than 99.8%
of its orders without loss or damage.  See "Business --Customer Service and
Support."

GROWTH STRATEGY

     The Company's strategy for growth is to leverage the strength of its
services, products and marketing programs to acquire additional customers and
increase the level of business with prospective and existing customers.  In
addition, the Company intends to complement its mail order distribution channel
with both retail and Internet delivery of its services and products.

     New Customers.  Historically, the Company has grown primarily through the
acquisition of new customers.  In a mail-order photofinishing environment that
has until recently exhibited little or no growth, the Company has increased net
revenues at an 18% compound annual growth rate during the past five years.  The
Company continuously refines existing marketing programs.  In addition, the
Company develops, tests and implements new marketing programs to additional
groups of consumers with different demographic characteristics to offset the
potential impact of market saturation in any given target customer group.  The
Company continues to explore alternative direct-marketing platforms in order to
acquire additional customers.  To this end, the Company has established a Web
site on the Internet (www.filmworks.com) from which customers can access answers
to frequently asked questions, download versions of Company software, create and
view personal home pages, upload images to Seattle FilmWorks for printing,
obtain the status of their orders and send electronic messages to customer
service.  Management intends to pursue additional Internet-related services and
marketing programs.

                                       4
<PAGE>
 
     Increasing Sales to New and Existing Customers.  Management believes its
complementary value-added services and products promote customer loyalty and
increase customer demand.  The Company strives to increase both average order
size and order frequency by informing both targeted consumers and its existing
customer base of its integrated array of services and products.  The Company's
commitment to expanding its service and product offerings, including
enhancements to its Internet-related offerings, supports this strategy.  In
addition, the Company employs a variety of other direct-marketing techniques to
increase business from existing customers and generate business from inactive
customers.

MARKETING AND CUSTOMER ACQUISITION

  One of the key elements of the Company's operating strategy is to generate
demand for its services and products by using its proprietary direct-marketing
techniques and extensive database to efficiently target existing and prospective
customers.  The Company maintains and analyzes extensive data and segments
markets using geographic and demographic information about potential customers.
The Company has used mail, print media, television, radio, telephone and, more
recently, the Internet, on-line services and retail outlets to target groups of
consumers and businesses.

  The Company makes extensive use of marketing tests in order to evaluate which
of a variety of marketing programs offers the best probable return on
investment. The Company's direct-marketing programs use coded advertisements to
monitor consumer response and to provide measurable results for each specific
marketing program. Measuring the effectiveness of marketing tests takes into
account both the response rate to advertised offers and estimates of customer
lifetime value to the Company, measured in terms of profit generated from the
estimated future stream of orders, thereby allowing for the targeting of a
marketing effort to specific market segments through selected media.  During
fiscal years 1998 and 1997, the Company expanded its retail operations in the
Pacific Northwest to provide a "drop off" alternative to mail order delivery.
Management believes the Company's 42 retail stores attract customers who might
not use the Company's mail order services.

  Since the early 1980s, the primary method the Company has used to acquire new
film processing customers has been its introductory offer of two rolls of film
for $2.00 or less (the "Introductory Offer").  The Company regularly refines the
Introductory Offer in the effort to improve its effectiveness, but the basic
concept of sending Seattle FilmWorks(R) branded film to targeted potential
customers has remained fairly constant. The Introductory Offer has been
nationally advertised through direct-response media, including package inserts,
newspaper supplements and magazines.  The Company also has a customer referral
program in which existing customers suggest family and friends to whom the
Company mails an introductory package.  Over the past several years, the Company
has refined its Introductory Offer program by targeting the growing population
of personal computer users.  See "Risk Factors-Dependence on Direct-Marketing
Programs; Accounting for Customer Acquisition."

SERVICES AND PRODUCTS

  Seattle FilmWorks is a leader in the development and introduction of
innovative photofinishing services and products. Beginning in 1978 with the
introduction of Seattle FilmWorks(R) branded film and continuing with the option
of receiving both photographic prints and individually color-corrected slides
from the same roll of film, the Company established an early tradition of
service and product differentiation.

                                       5
<PAGE>
 
The following table illustrates the Company's service and product introductions
during the past eight years:
<TABLE>
<CAPTION>
     Service or Product                                        YEAR OF INTRODUCTION
     ------------------                                        --------------------
     <S>                                                       <C>
     Pictures On Disk(TM) on CD.........................                1998
     Digital Reprints via touch-tone telephone..........                1998
     Enhanced PhotoMail(TM).............................                1998
     PhotoWorks(R) Cards................................                1997
     PictureWorks(TM)...................................                1997
     PhotoWorks(R) Composer for Windows.................                1997
     PhotoWorks(R) Plus - How to Use Every Feature(C)...                1996
     ------------------------------------------------
     FilmWorksNet(TM)...................................                1996
     PhotoMail(TM)......................................                1995
     PhotoWorks(R) for Macintosh........................                1995
     PhotoWorks(R) Plus for Windows.....................                1994
     PhotoWorks(R) for Windows..........................                1994
     PhotoWorks(R) for MS-DOS...........................                1994
     Pictures On Disk(TM)...............................                1994
     Pictures Plus(TM) Index............................                1993
     Professor FilmWorks(TM)............................                1992
     Backprinting & Referenced Negatives................                1992
     Easy-Order System..................................                1991
     Express-Mail Delivery..............................                1991
</TABLE>

  In 1991, the Company began to offer mail-order photofinishing customers the
options of express-mail pickup and delivery service and the Easy-Order System,
whereby a customer sets up a standing order, thus avoiding the need to fill out
an order form with each order. This pattern of service and product innovation
continued with the introduction in early 1992 of the Company's system for
printing the date, roll identification and print number on the back of each
print and the corresponding information on each strip of negatives (known as
backprinting) and free telephone pre-recorded mini-lessons on photography from
Professor FilmWorks(TM).  In 1993, the Company introduced the Pictures Plus(TM)
Index, which offers thumbnail-size copies of images from a roll of film on a
single 4" by 6" print as a handy reference for the customer.

  In 1994, the Company introduced Pictures On Disk(TM), which delivers, on a
floppy disk, a digital version of each photograph on a roll of film. This
product was coupled with the introduction of the Company's internally developed
PhotoWorks(R) software, which enables users to create digital albums of their
photographs and to incorporate the digital images into text, slide shows and
screen savers. PhotoWorks(R) software is available in Microsoft Windows, MS-DOS
and Apple Macintosh versions and is provided at no charge with a customer's
first order of Pictures On Disk(TM). PhotoWorks(R) is also available for free
download over the Internet from the Company's Web site. A more fully featured
version, PhotoWorks(R) Plus, is sold directly to customers as an upgrade.

  In 1995, the Company introduced the private delivery of digital images from
its laboratory directly to customers over the Internet through its PhotoMail(TM)
delivery service. This service was enhanced in 1998 to provide customers easier
access and additional features for the images. Customers requesting
PhotoMail(TM) delivery are sent an e-mail notifying them that their photographs
are ready for downloading at the Company's Web site (www.filmworks.com). Such
customers can then share their photographs with friends, family and business
associates who may view and download the photographs at no additional charge.
Management believes that communication with digital versions of personal
photographs is a natural extension of the rapid proliferation of e-mail and
other forms of Internet communication.

  In 1996, the Company announced FilmWorksNet(TM), a free service through which
its customers can create and upload a private personalized photographic home
page to the Seattle FilmWorks Web site using the most recent version of the
PhotoWorks(R) software (which is available for download at no charge).  By
providing the guest password to their home page, Seattle FilmWorks customers can
share their photographs with friends, family and business associates worldwide.
Both PhotoMail(TM) and FilmWorksNet(TM) provide flexibility and creativity in
this new way of sharing photographs.  In addition, the Company published
                                                                        
PhotoWorks(R) Plus - How to Use Every Feature(C).  This 260-page reference book
------------------------------------------------                               
provides customers with detailed information on using the Company's 
PhotoWorks(R) Plus software.

                                       6
<PAGE>
 
  In 1997, the Company introduced PhotoWorks(R) Composer, which allows consumers
to create frame-ready prints with a variety of backgrounds and create business
reports, product sheets, e-mail attachments and newsletters using Pictures On
Disk(TM) images.  In addition, the Company introduced PictureWorks(TM), a
service that allows customers to upload personal digitized images directly to
the Company for printing digital images on photographic paper.  The software for
this service is available for free download over the Internet from the Company's
Web site and is included with the Company software products PhotoWorks(R) Plus
and PhotoWorks(R) Composer.

  In November 1997, the Company introduced PhotoWorks(R) Cards, a service which
allows customers to create greeting cards using proprietary software included on
PhotoWorks(R) Plus and PhotoWorks(R) Composer.  The software enables customers
to create a variety of photo greeting cards from Pictures on Disk(TM) images,
then upload these files to Seattle FilmWorks for printing on photographic paper.

  In July 1998, the Company enhanced Pictures on Disk(TM) by beginning to
deliver the digital version of each roll of film on a CD instead of a floppy
disk.  This enables the Company to provide higher quality digital images and
also to include PhotoWorks(R) and other software with the images.  In 1998, the
Company introduced an improved PhotoMail(TM) service which provides customers
faster and easier access to their pictures.  Additionally, the Company
introduced a digital reprint service, allowing customers purchasing digital
products to order reprints over a touch-tone telephone.

  Although mail-order photofinishing is viewed as a convenience by many
consumers, mail-order turnaround time (generally seven to ten days) is longer
than many alternative sources for photofinishing services (in some cases within
one hour).  The Company has addressed this issue by offering the option of
express-mail pickup and delivery service by means of the U.S. Postal Service for
an extra charge and with an immediate delivery-after-processing option through
its PhotoMail(TM) Internet delivery service. However, turnaround time remains a
competitive disadvantage for the Company.

  Management believes that the prices for its services and products are
competitive.  However, the Company has chosen not to compete primarily on the
basis of price, but rather by offering a variety of value-added, innovative and
high-quality services and products, thereby seeking to differentiate itself from
other photofinishers.

  The Company also provides a variety of reprint and enlargement services for
its mail-order customers, as well as selling 35mm rolled film, single-use
cameras and photofinishing supplies on a wholesale basis to photofinishing
minilabs, retail stores and commercial users of photographic film.  These
products are packaged by the Company and marketed under the brand OptiColor(TM)
Film & Photo.  Rolled film and single-use cameras are also marketed on a private
label basis with the customer specifying its own brand name.  Although it
represents a small percentage of revenues, the Company also provides
photofinishing services on private label and retail bases.  The Company also
licenses certain digital technology, including Pictures On Disk(TM) and
PhotoWorks(R), to other photofinishers outside of the U.S.

  Net revenues generated by sales outside the United States accounted for 3.7%
of the Company's total net revenues in fiscal 1998, as compared to 6.6% in
fiscal 1997 and 8.5% in fiscal 1996.  In the fourth quarter of fiscal 1998, the
Company discontinued its international wholesale film sales to certain markets
in Asia.

RESEARCH AND DEVELOPMENT

  Through internal and external research and development efforts, the Company
has developed innovative digital media and photofinishing services and products.
The Company seeks to identify customer needs and shifts in consumer preferences
in order to design or refine the Company's services and products.  In fiscal
1998, fiscal 1997, and fiscal 1996, the Company incurred research and
development expenses of $588,000, $696,000 and $732,000, respectively, primarily
in connection with development and enhancement of its FilmWorksNet(TM),
PhotoMail(TM), PhotoWorks(R), Pictures On Disk(TM) PictureWorks(TM), and most
recently, Pictures On Disk(TM) on CD.  See Item 7 of Part II--"Management's
Discussion and Analysis of Financial Condition and Results of Operations."

                                       7
<PAGE>
 
CUSTOMER SERVICE AND SUPPORT

  Management believes that customer satisfaction is critical to the Company's
ongoing success.  The Company has a 100% satisfaction-guarantee policy under
which it will provide a full refund if a customer's complaint cannot otherwise
be resolved.

  The direct-to-consumer photofinishing business involves contacts with a large
number of customers.  For customer convenience, the Company provides toll-free
telephone access at 1-800-FILMWORKS.  As of November 21, 1998, the Company had a
customer service staff of 60, which is equipped with direct access to the
Company's database and is trained to promote certain of the Company's services
and products, as well as to answer questions regarding order status, basic
photography and photofinishing and use of PhotoWorks(R) software.  On average,
in a week the Company's customer support personnel respond to approximately
36,000 telephone calls from customers, 2,500 written inquiries and 22,500 e-mail
messages.  The majority of these inquiries are general information requests and
order status inquiries.  In addition, the Company offers free pre-recorded mini-
lessons on photography over the telephone from its Professor FilmWorks(TM)
service.

  The Company also maintains a Web site on the Internet (www.filmworks.com).
While on-line, customers may download Pictures On Disk(TM) orders and versions
of Company software, create and view personal home pages, access answers to
frequently asked questions, upload images for printing at Seattle FilmWorks,
obtain the status of their orders and send electronic messages to customer
service.

OPERATIONS

  The Company operates a single laboratory in  Seattle, Washington, which is
designed to produce consistent, high-quality photofinishing.  The system is
designed for 24-hour in-house processing of most photofinishing orders.  The
photofinishing process begins with the entry of each order into the Company's
customer database, primarily using information provided by the customer.  Each
roll received for processing is bar-coded with an identification number which
enables the tracking of each order throughout the production process.  Following
order entry, individual rolls of film are spliced together into a reel of film
which is then developed as a batch.  Once the film is developed, each negative
is computer analyzed, and the color-corrected image is printed on photographic
paper using state-of-the-art equipment.  Order information is then printed on
the back of customers' prints and the corresponding information is printed on a
paper tab which is attached to the sleeved negatives.  After a visual quality
inspection, the orders are packaged for delivery to the customer.  If requested
by the customer, photographs are digitized and delivered through the mail on CD
or floppy diskettes or via download over the Internet.  Although much of the
photofinishing and order handling process has been automated, trained personnel
operate machinery and regularly monitor product quality with the assistance of
computerized control and measurement systems.

  The Company has the ability to process various types of 35mm color film,
including those manufactured by Eastman Kodak Company, Fuji Photo Film U.S.A.,
Inc., Konica U.S.A., Inc., Imation Enterprises Corp., Agfa Division of Bayer
Corporation ("Agfa") and other major producers of conventional 35mm color
negative film.  The Company also has the ability to process 35mm color negative
film manufactured by Eastman Kodak Company for professional motion picture
studios which has been packaged by the Company or others for use in 35mm still
cameras.  In addition, the Company can process 24mm format Advanced Photo System
("APS") film with special equipment acquired during fiscal 1998.

  Currently, the Company estimates that it is capable of processing up to
approximately 200,000 rolls of film per week with its existing facilities and
equipment.  The Company will continue to expand its processing facility in
fiscal 1999.

                                       8
<PAGE>
 
SUPPLIERS

  The Company obtains its conventional 35mm film from a few large manufacturers
of photographic film, including Agfa and Imation Enterprises Corp., its supply
of Eastman Kodak motion picture film as surplus from motion picture studios and
television production companies, and its photographic paper and chemicals from a
single supplier, Eastman Kodak Company.  The individual cassettes into which the
Company spools 35mm film for still cameras are manufactured for the Company by
foreign sources, principally in China and South Korea.  In addition, the Company
obtains new and recycled single use cameras principally from suppliers in China.
Currently, substantially all of the Company's purchases from foreign suppliers
are paid for in U.S. dollars. The Company's mail-order services and products are
handled largely through the U.S. Postal Service and other common carriers.  See
"Risk Factors--Reliance on Key Vendor and Supplier Relationships; Foreign
Sourcing."

MANAGEMENT INFORMATION SYSTEMS

  Management information systems ("MIS") are an essential component of the
Company's strategy to provide superior service to its customers, as well as to
effectively support internal operations.  The systems support all major aspects
of the Company's business, including mail-order operations, order entry,
production, warehousing, distribution, purchasing, inventory control and
customer service, as well as various financial systems and electronic
communication systems.  All shared data, including the Company's customer
database files, are backed up on a regular basis, with tapes stored in an off-
site secure facility.  The Company uses MIS to automate much of its
photofinishing and digital imaging operations.

  In fiscal years 1998 and 1996, the Company replaced and upgraded a portion of
its systems software and hardware.  The Company has taken a number of
precautions against certain events that could disrupt the operation of its
management information systems, including events associated with continuing
software and hardware upgrades.  However, the Company could still experience
systems failures or interruptions, which could have a material adverse effect on
its business, financial condition and operating results.  See "Risk Factors--
Dependence on Production Capabilities, Statistical Models and Management
Information Systems" and "--Year 2000."

COMPETITION

  The market for consumer photofinishing services is characterized by intense
competition among a number of firms competing in a segment in which average
revenue per roll processed has declined during the 1990s, according to
photofinishing industry data. Many of the Company's competitors have
substantially greater financial, technical and other resources than the Company.
The Company faces competition in the consumer photofinishing market from other
direct marketers and from competitors in other distribution channels, including
much larger companies which provide photofinishing services on a wholesale basis
to independent retail outlets and, in some cases, through multiple retail
outlets owned by the photofinisher, many of which provide photofinishing service
within hours.  The largest of the wholesale photofinishers are Qualex Inc., and
Fuji TruColor, Inc.  In addition, management believes that the largest mail-
order photofinishers include District Photo Inc. (dba York and Clark Labs) and
Mystic Color Lab Inc.

  Management believes that the principal competitive factors in the consumer
photofinishing industry are price, convenience, range of available services,
quality of processing, speed of service and product differentiation.  There are
no significant proprietary or other barriers to entry into the photofinishing
industry. The Company has sought to differentiate its photofinishing services by
offering a number of value-added services and products and emphasizing quality
and convenience rather than seeking to be a low-price or rapid turnaround
provider.  Although management believes the Company is a leader in developing
and marketing innovative photo-related services and products, competitors can
and do provide similar services and products.  Some of these competitors have
introduced products which compete with the Company's Pictures On Disk(TM) and
PhotoWorks(R) products.  For example, Eastman Kodak and American On Line ("AOL")
announced their plans to introduce a digital image delivery service through
AOL's website.  See "Business--Photofinishing Industry and Direct-Marketing
Overview."

                                       9
<PAGE>
 
  In addition, the wholesale distribution market for rolled film, single use
cameras and photofinishing supplies is highly competitive and is dominated by
suppliers which manufacture what they sell and may, therefore, potentially have
lower costs of goods for these items than the Company.  Relatively few firms,
however, have the capability to produce small-production quantities of private
label rolled film.  Management believes the principal competitive factors in
this segment of the wholesale distribution market are price, ability to provide
private label products and capability to deliver small-production quantities on
short notice.

  The photography industry is characterized by evolving technology and changing
services and products.  The introduction of photographic services and products
involving new technologies could render existing services and products obsolete.
The Company's future success will depend on its ability to adapt to new
technologies and develop new or modify existing services and products to satisfy
evolving consumer needs.  For example, the commercialization of filmless digital
imaging technologies may have a negative impact on the photofinishing industry.
In addition, APS, which includes a 24mm film format, is a small but growing
percentage of the film that the Company is asked to process.  To respond to
customer requests, the Company purchased equipment in fiscal 1998 in order to
offer processing services for this format. The development of these or other new
technologies or any failure by the Company to anticipate or successfully respond
to such developments could have a material adverse effect on the Company's
business, financial condition and operating results.  See "Risk Factors--
Competition" and "--Rapid Technological Change."

PROPRIETARY TECHNOLOGY

  The Company markets its services and products under registered and common-law
trademarks and service marks, including Seattle FilmWorks(R), OptiColor(TM) Film
& Photo, Pictures On Disk(TM), Pictures On Disk(TM) on CD, PhotoMail(TM),
PhotoWorks(R), Pictures Plus(TM) Index, Professor FilmWorks(TM),
PictureWorks(TM) and FilmWorksNet(TM). See "Risk Factors--Intellectual
Property."

  The Company considers a large portion of its PhotoWorks(R) software, its
process for production of Pictures On Disk(TM) and certain other processes to be
proprietary.  The Company has not filed any patents or patent applications, in
part to avoid disclosure of its competitive strengths.  The Company, however,
does attempt to protect its proprietary rights to software through a combination
of copyright, trademark and trade secret laws and employee and third-party
nondisclosure agreements, by restricting access to certain portions of its
premises and by including contractual restrictions on use and disclosure in its
end-user licenses.  The legal and practical enforceability and extent of
liability for violations of license agreements are unclear.

  This Report contains trademarks other than those of the Company.

GOVERNMENTAL REGULATION

  The Company's direct-mail operations, including its transmission of digital
images over the Internet, are subject to regulation by the U.S. Postal Service,
the Federal Trade Commission and various state, local and private consumer
protection and other regulatory authorities.  In general, these regulations
govern the manner in which orders may be solicited, the form and content of
advertisements, information which must be provided to prospective customers, the
time within which orders must be filled, obligations to customers if orders are
not shipped within a specified period of time and the time within which refunds
must be paid if the ordered merchandise is unavailable or returned.  The law
relating to the liability of on-line services companies, Internet access and/or
content providers, Web hosts and electronic publishers for information carried
on or disseminated through their systems for, among other things, infringement
of copyrighted material or trademarks, violations of personal rights of privacy
and publicity and dissemination of material legally judged to be obscene,
indecent or defamatory, is currently unclear.  Such claims have been brought,
some of which have been successful, against on-line services, including a case
against Prodigy.  Some states have enacted legislation which makes the
transmission of certain kinds of information, such as obscene content and
information which facilitates the commission of criminal acts, a crime.  In
addition, the Telecommunications Act of 1996 (the "Telecommunication Act")
imposes, in some circumstances, liability for or prohibits the transmission over

                                       10
<PAGE>
 
the Internet of certain types of information and content.  Legislation enacted
by Congress and the state legislatures could result in additional regulation or
prohibition of the transmission of certain types of content over the Internet.
This could result in significant potential liability to the Company, as well as
additional costs and technological challenges in complying with mandatory
requirements.  See "Risk Factors--Dependence on the Internet and Potential
Liability for Content" and "--Governmental Regulation."

ENVIRONMENTAL COMPLIANCE

  The Company's photofinishing operations involve the use of several chemicals
which are subject to federal, state and local governmental regulations relating
to the storage, use, handling and disposal of such chemicals.  The Company
actively monitors its compliance with applicable regulations and works with
regulatory authorities to ensure compliance.  To the best of management's
knowledge, the Company has never received a significant citation or fine for
failure to comply with applicable environmental requirements.  However, changes
in environmental regulations or in the kinds of chemicals used by the Company
could impose the need for additional capital equipment or other requirements.
See "Risk Factors--Potential Adverse Impact of Environmental Regulations."

EMPLOYEES

  As of November 21, 1998, the Company had 681 employees, of whom approximately
508 were engaged in production operations, 79 in administration, 26 in
marketing, 60 in customer service and 8 in research and development.  None of
the Company's employees are covered by a collective bargaining agreement, and
the Company believes its relations with its employees are good.

DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

The executive officers and directors of the Company as of November 30, 1998
were:
<TABLE>
<CAPTION>
 
Name                        Age      Position
------------------------------------------------------------------------------------
<S>                         <C>      <C>
Gary R. Christophersen       52      President, Chief Executive Officer and Director
Michael F. Lass              44      Vice President-Operations
Case H. Kuehn                46      Vice President-Finance, Chief Financial Officer
                                       and Treasurer
Gary T. Tashjian             45      Vice President-Marketing
Annette F. Mack              41      Vice President-Human Resources
Sam Rubinstein               81      Director
Douglas A. Swerland          53      Director
Craig E. Tall                52      Director
Peter H. van Oppen           46      Director
</TABLE>

     Directors are divided into three classes, with each class as nearly equal
in number as possible with one class elected at each annual meeting to serve for
a three-year term.  Directors may be removed only for cause and only by a vote
of a majority of shares of the Company's common stock entitled to vote on an
election of directors.  Officers serve at the discretion of the Board of
Directors.

  GARY R. CHRISTOPHERSEN, has been the Company's President and Chief Executive
Officer since August 1988.  Mr. Christophersen joined the Company in January
1982 as Vice President-Operations and has served as a Director of the Company
since 1982.  From May 1983 to August 1988, Mr. Christophersen was a Senior Vice
President of the Company and its General Manager.

                                       11
<PAGE>
 
  MICHAEL F. LASS, has been the Company's Vice President-Operations since
September 1988.  Mr. Lass joined the Company in 1984 as Manager of Operations.
From 1982 to 1984, Mr. Lass was Vice President and General Manager of Breezin'
Sportswear, a manufacturer and marketer of sportswear, and, from 1980 to 1982,
General Manager and a director of Mountain Safety Research, Inc., a manufacturer
of outdoor recreational products.

  CASE H. KUEHN, has been the Company's Vice President-Finance, Chief Financial
Officer and Treasurer since February 1995.  From April 1994 to February 1995,
Mr. Kuehn was Chief Financial Officer of Shoe Inn, Inc., doing business as Shoe
Pavilion.  From January 1992 to March 1994, Mr. Kuehn was General Manager of Pro
Mark Technologies, Inc., a manufacturer of  computer/video-based inspection
equipment, and, from March 1990 to January 1992, Vice President, Commercial
Lending, at First National Bank of Chicago.  From November 1985 to February
1990, Mr. Kuehn performed business valuation consulting with Price Waterhouse.

  GARY T. TASHJIAN, has been the Company's Vice President-Marketing since May
1998.  From October 1991 to January 1997, Mr. Tashjian was employed by Eddie
Bauer, Inc., as Manager of Relationship Marketing and Director of Retail
Marketing.  From January 1990 to October 1991, Mr. Tashjian was Director of
Marketing Communications for Holland America Line/Westours, Inc.

  ANNETTE F. MACK, has been the Company's Vice President-Human Resources since
January 1996.  Ms. Mack joined the Company in March 1986 as Human Resources
Manager, and, from August 1988 to December 1995, was its Director of Human
Resources.

  SAM RUBINSTEIN became a Director of the Company in March 1986.  From June 1985
to May 1988, he was the Chairman of the Board and Chief Executive Officer of
Farwest Fisheries, Inc., a seafood processing and marketing firm.  From 1974 to
December 1987, Mr. Rubinstein was the Chairman of the Board and Chief Executive
Officer of Bonanza Stores, Inc., an operator of variety stores and drugstores,
and, from February 1984 to January 1986, the Chairman of the Board and Chief
Executive Officer of Whitney-Fidalgo Seafoods, Inc., a seafood processor.

  DOUGLAS A. SWERLAND became a Director of the Company in October 1988.  In
December 1993, Mr. Swerland founded and became the Chairman and Chief Executive
Officer of SAVI, Inc., a clothing superstore retailer specializing in men's and
women's apparel and accessories.  Mr. Swerland had been employed by Jay Jacobs,
Inc., the operator of a chain of specialty retail apparel stores, in various
capacities beginning in 1969, most recently as President and a director from
1978 to November 1993.

  CRAIG E. TALL became a Director of the Company in October 1988.  Since
September 1990, Mr. Tall has been an Executive Vice President of Washington
Mutual, Inc., a bank holding company.  In addition, since April 1987, Mr. Tall
has been an Executive Vice President of Washington Mutual Bank.

  PETER H. VAN OPPEN became a Director of the Company in October 1988.  Since
February 1994, Mr. van Oppen has been Chairman and Chief Executive Officer of
Advanced Digital Information Corporation ("ADIC"), a manufacturer of automated
tape data libraries for network and workstation markets.  ADIC was a wholly-
owned subsidiary of Interpoint Corporation, a diversified publicly-traded
manufacturer, until it was spun-off as a separate public company in October
1996.  Mr. van Oppen served as a Director of Interpoint from 1984 to 1996,
President and Chief Executive Officer from 1989 to 1996 and Chairman and Chief
Executive Officer from 1995 through October 1996.  Mr. van Oppen is also a
Director of ADIC, Spacelabs Medical, Inc., a provider of integrated healthcare
information systems and medical devices and Key Technology, Inc., a manufacturer
of automated inspection and sorting systems.

                                       12
<PAGE>
 
                                 RISK FACTORS

  In addition to the other information in this Report, the following risk
factors should be carefully considered in evaluating the Company and its
business.

ABILITY TO SUSTAIN AND MANAGE GROWTH

  Until fiscal 1998, the Company experienced significant growth in revenues and
profitability.  This growth occurred despite little or no growth in the U.S.
photofinishing industry throughout most of  the 1990s and an actual decline in
the number of rolls processed by the mail-order portion of the domestic
photofinishing market during the same period.  Future growth of the Company's
revenues and profitability is dependent in large part on its ability to acquire
new customers at a reasonable cost.  The Company may not grow or effectively be
able to manage its growth.  The Company could acquire other businesses that are
compatible with the Company's business, but the Company has no current
understanding, agreement or arrangement to make any acquisitions.  Acquisitions
involve numerous risks, which could have a negative effect on the Company's
business, financial condition and operating results.  Additional information
related to growth can be found in the risk factors, under "Business-
Photofinishing Industry and Direct Marketing Overview" and in "Item 7 of Part II
- Management's Discussion and Analysis of Financial Condition and Results of
Operations" which appears later in this report.

DEPENDENCE ON DIRECT-MARKETING PROGRAMS; ACCOUNTING FOR CUSTOMER ACQUISITION

  Management uses its direct-marketing programs, which since the early 1980's
have been primarily based on its customer acquisition technique of offering two
rolls of film for $2.00 or less, as its primary customer acquisition technique
to get new customers.  The Company devotes substantial resources to implement
and test direct-marketing programs to improve the efficiency of its customer
acquisition and retention efforts.  There can be no assurance that the Company's
customer acquisition and retention efforts will be effective.  If the Company
fails to market successfully against competitors it could have a negative effect
on the Company's business, financial condition and operating results. Additional
information related to marketing can be found in the risk factors, under
"Business-Marketing and Customer Acquisition" and "-Competition" which is in the
risk factor section of this report.

  Until the fourth quarter of fiscal 1998, the direct costs of the customer
acquisition program, primarily the cost of film, postage and printed materials
for the Company's free or low-cost film offers sent to prospective and existing
customers, but excluding advertising costs, were deferred and amortized over a
period of up to three years as part of customer acquisition costs.  The Company
established amortization rates for these capitalized assets based on estimates
of the timing of future roll processing volumes per customer.  Rates of
amortization were compared from time to time with the actual timing of roll
processing volumes in order to assess whether the amortization rates
appropriately matched the direct costs of customer acquisition with the related
revenues.  During the fourth quarter of fiscal 1998, management concluded that
lower response rates to customer acquisition programs required an adjustment to
the amount of capitalized costs associated with those programs.  Accordingly,
the Company recorded a pre-tax charge of $613,000 relating to accelerating
amortization of customer acquisition costs.  In addition, as a result of recent
negative trends in customer responses, the Company's marketing plans and
Internet and retail distribution strategies, management concluded  that the net
profit margin on identifiable responses will be insufficient to justify
deferring such costs in the future due to the trend of lower response rates and
to an expected decline in the percentage of identifiable responses to individual
programs.  Starting with the first quarter of fiscal 1999, the Company will
expense all customer acquisition costs as incurred.  In addition, management
estimates twelve months to be the period in which the benefits of these
previously capitalized marketing costs will be able to be identified before the
ability to determine the source of the response becomes obscured by supplemental
marketing efforts to this customer base.  Therefore, the Company will amortize
the $16,800,000 of capitalized customer acquisition costs, as of September 26,
1998, over a twelve month period on a straight-line basis.  As a result of the
twelve-month amortization of previously capitalized costs and the expensing of
costs on a current basis, operating expenses related to customer acquisition
activities will increase significantly in fiscal 1999 compared to prior periods.
Additional information related to marketing expenses can be 

                                       13
<PAGE>
 
found in "Item 7 of Part II - Management's Discussion and Analysis of Financial
Condition and Results of Operations" which is in this report.

RAPID TECHNOLOGICAL CHANGE

  The photography industry is characterized by evolving technology and changing
services and products.  The introduction of photographic services and products
which use new technologies could render existing services and products obsolete.
The Company's future success will depend on its ability to adapt to new
technologies and develop new or modify existing services and products to satisfy
changing consumer needs.  For example, digital cameras that do not use
traditional film may have a negative impact on companies such as Seattle
FilmWorks which primarily process traditional film-based images and slides.  The
development of these or other new technologies, or failure by the Company to
anticipate or successfully respond to such developments, could have a negative
effect on the Company's business, financial condition and operating results.
Additional information can be found in the risk factors under "Business-
Competition."

FLUCTUATIONS IN QUARTERLY RESULTS AND SEASONALITY

  The Company's quarterly operating results have fluctuated in the past and are
expected to fluctuate in the future. Changes can occur due to sales mix,
promotional activities, price increases by suppliers, introductions of new
products, research and development requirements, actions by competitors, and
foreign currency exchange rates.  In addition, changes can occur due to
conditions in the direct-to-consumer market and the photofinishing industry in
general, national and global economic conditions and other factors.  Demand for
the Company's photo-related services and products is seasonal, with the highest
volume of photofinishing activity occurring during the summer months.
Seasonality may be offset by introduction of new services and products, by
increasing or decreasing marketing activity, and other factors.  As a result,
the Company's operating results for any period are not necessarily what can be
expected for any future period.  During fiscal 1999, the Company will experience
significant variations between quarters and in comparison to prior periods due
to the timing of marketing promotions, the twelve-month amortization of
previously deferred customer acquisition costs, and the variations in customer
acquisition costs which will be recognized as incurred.  The Company's operating
results in a future period may be below the expectations of public market
analysts and investors and the price of the Common Stock may decline. Additional
information can be found in the risk factors, under "Dependence on Direct-
Marketing Programs; Accounting for Customer Acquisition", and in "Item 7 of Part
II - Management's Discussion and Analysis of Financial Condition and Results of
Operations" which is contained in this report.

COMPETITION

  The market for consumer photofinishing services is characterized by intense
competition among a number of firms competing in a segment in which average
revenue per roll processed declined during the 1990s, according to
photofinishing industry data. Many of the Company's competitors have
substantially greater financial, technical and other resources than the Company.
The Company faces competition in the consumer photofinishing market from other
direct marketers and from competitors in other distribution channels, including
much larger companies.  These companies provide photofinishing services on a
wholesale basis to independent retail outlets and, in some cases, through
multiple retail outlets owned by the photofinisher.  Many of these competitors
provide photofinishing service within hours.  There are no significant
proprietary or other barriers to entry into the photofinishing industry.  Many
of the Company's competitors offer similar photofinishing services and products
at lower prices and with a more rapid turnaround time than those offered by the
Company.  However, the Company has sought to differentiate its photofinishing
services by offering a number of value-added services and products and
emphasizing quality and convenience rather than seeking to be a low-price or
rapid turnaround provider.  Although management believes the Company is a leader
in developing and marketing innovative photo-related services and products,
competitors can and do provide similar services and products.  There can be no
assurance the Company will continue to compete effectively through development
of innovative services and products or respond appropriately to industry trends
or to activities of competitors.  The wholesale distribution market for rolled
film, single use cameras and photofinishing supplies is highly 

                                       14
<PAGE>
 
competitive and is dominated by suppliers that manufacture what they sell.
Competitors may have lower costs of goods for these items than the Company. In
addition, the Company is a defendant in a claim filed by Fuji Photo Film Co.,
Ltd. ("Fuji") with the International Trade Commission. Fuji alleges that a
number of companies, including the Company's OptiColor subsidiary, violate
patents on single use cameras by bringing recycled single use cameras into the
United States for resale. If Fuji prevails in this action, the Company's ability
to compete in the single-use camera market will be negatively affected. The
Company may not be able to compete effectively with current or future
competitors and the competitive pressures faced by the Company may have a
negative effect on the Company's business, financial condition and operating
results. See "Business-Competition" and Item 3 - "Legal Proceedings."

DEPENDENCE ON KEY PERSONNEL

  The Company's success depends in large part on the abilities and continued
service of its executive officers and other key employees, in particular Gary R.
Christophersen, the Company's President and Chief Executive Officer.  These
individuals, including Mr. Christophersen, are not subject to employment
agreements that would prevent them from leaving the Company.  There can be no
assurance that the Company will be able to retain the services of such executive
officers and other key employees.  The loss of key personnel could have a
negative effect on the Company's business, financial condition and operating
results.  See "Management."

DEPENDENCE ON THE INTERNET AND POTENTIAL LIABILITY FOR CONTENT

  The Company offers private delivery of digital images from its laboratory
directly to customers over the Internet through its PhotoMail(TM) delivery
service.  The Company also provides FilmWorksNet(TM), a free service to its
customers through which customers can create and upload a private personal
photographic home page to the Seattle FilmWorks Web site for viewing by friends,
family and business associates to whom the customer gives a guest password, and
PictureWorks(TM), a service that allows customers to upload personal digitized
images directly to the Company for printing high definition digital images on
photographic paper.  Although the Company provides its services and products
through multiple distribution channels, the Company's success may depend in part
on the continued expansion of the Internet and its network infrastructure.
Rapid growth in interest in and use of the Internet is a recent phenomenon, and
the Company's Internet-related services may not prove to be a competitive
advantage.

  Critical issues concerning the commercial use of the Internet (including
security, reliability, cost, ease of use and access and quality of service)
remain unresolved and may affect both the growth of Internet use and the
Company's financial results.  The laws relating to the liability of on-line
services companies, Internet access and/or content providers, Web hosts and
electronic publishers for information carried on or disseminated through their
systems for, among other things, infringement of copyrighted material or
trademarks, violations of personal rights of privacy and publicity and
dissemination of material legally judged to be obscene, indecent or defamatory,
is currently unclear.  Claims have been brought, some of which have been
successful, against on-line services, including a case against Prodigy.  Some
states have enacted legislation which makes the transmission of certain kinds of
information, such as obscene content and information which facilitates the
commission of criminal acts, a crime.  In addition, the Telecommunications Act
of 1996 imposes, in some circumstances, liability for or prohibition against the
transmission over the Internet of certain types of information and content.
Other legislation currently before Congress and the state legislatures could
result in additional regulation or prohibition of the transmission of certain
types of content over the Internet.  This could result in significant potential
liability to the Company, as well as additional costs and technological
challenges in complying with mandatory requirements.  From time to time, the
Company has assisted authorities in the discovery and prosecution of child
pornography.  However, the Company does not assume responsibility to edit the
content of its customers' photographs, slides, digital images or personal home
pages unless responding to a specific complaint.  The potential liability for
content made available over the Internet through its Web site could require the
Company to implement additional measures to reduce its exposure to such
liability, which may require it to incur significant costs or discontinue
certain service or product offerings.  The Company carries general liability
insurance, but such insurance may not cover potential claims of this type or may
not be adequate to compensate the Company for any liability that may be imposed
for information carried on or disseminated through its systems.  Any costs not

                                       15
<PAGE>
 
covered by insurance incurred as a result of such liability or asserted
liability could have a negative effect on the Company's business, financial
condition and operating results.  See "Business-Governmental Regulation."

RELIANCE ON KEY VENDOR AND SUPPLIER RELATIONSHIPS; FOREIGN SOURCING

  The Company obtains its conventional 35mm film from a few large manufacturers
of photographic film, including Agfa Photo Imaging Systems, a division of Bayer
("Agfa") and Imation Enterprises, Corp., its supply of Eastman Kodak motion
picture film as surplus from motion picture studios and television production
companies, and its photographic paper and chemicals from a single supplier,
Eastman Kodak.  The individual cassettes into which the Company spools 35mm film
for still cameras are manufactured for the Company by foreign sources,
principally in China and South Korea.  The Company obtains new and recycled
single use cameras principally from suppliers in China.  In addition, the
Company acquires photofinishing equipment to maintain and increase
photofinishing production capacity.  As there are relatively few suppliers of
film, photographic paper and chemicals and photofinishing equipment, the
elimination of any one supplier or failure of a supplier to deliver specified
goods could cause a material disruption in the Company's operations and could
materially adversely affect the Company's business, financial condition and
operating results.

  Other than agreements with Agfa and Eastman Kodak, which are subject to
termination under certain circumstances, the Company has no significant long-
term purchase contracts or agreements to insure continued supply, pricing or
access to film, paper, chemicals or cassettes.  During fiscal 1997, the Company
experienced a delay in the delivery and implementation of certain new equipment.
This delay caused production problems which led to extended delivery times to
customers.  Management believes the Company lost a significant number of
customers due to the extended delivery times.  In addition, the Company has
experienced limited delays in the delivery of certain supplies and equipment in
the past, but these delays have not had a significant impact on the Company's
operations.  While management believes that alternate sources of film, paper,
chemicals, cassettes and equipment are available, it is not known if  the
Company will be able to continue to meet its requirements for supplies and
equipment. The Company may not be able to purchase sufficient quantities or on
terms as favorable to the Company as those currently available.  Also, changing
to an alternate supplier may cause delays, reduced quality or other problems.
The Company's operations may be adversely affected by political instability
resulting in disruption of trade with foreign countries in which the Company's
contractors and suppliers are located.  Existing or potential duties, tariffs or
quotas may limit the quantity of certain types of goods that may be imported
into the United States.  Sales of the Company's services and products on a
direct-to-consumer mail-order basis largely depend on the U.S. Postal Service
and other common carriers for receipt of orders and delivery of processed film
or other products.  Any significant changes in the operations of or prices
charged by the U.S. Postal Service or other common carriers or extended
interruptions in postal deliveries could negatively affect the Company's
business, financial condition and operating results. See "Business-Operations"
and "-Suppliers."

DEPENDENCE ON PRODUCTION CAPABILITIES, STATISTICAL MODELS AND MANAGEMENT
INFORMATION SYSTEMS

  The Company depends on its management information systems to process orders,
provide rapid response to customer inquiries, manage inventory and accounts
receivable collections, and purchase, sell and ship products efficiently.  In
fiscal 1998 and 1996, the Company replaced and upgraded a portion of its systems
software and hardware.  The Company took a number of precautions against certain
events that could disrupt its management information systems, including events
associated with continuing software and hardware upgrades. The Company may
experience systems failures or interruptions, which could negatively affect its
business, financial condition and operating results.  See "Business--Management
Information Systems" and "--Year 2000."

  The Company also depends on statistical models developed to measure the
effectiveness of its marketing programs and on its employees who are
knowledgeable about such models.  The Company continually faces risks regarding
the availability and cost of labor, the potential need for additional capital
equipment, plant and equipment obsolescence, quality control, excess or
insufficient capacity and disruption in the Company's operations.  The loss of
employees knowledgeable about the Company's statistical models or a disruption
in the Company's photofinishing or 

                                       16
<PAGE>
 
direct-marketing operations could negatively affect the Company's business,
financial condition and operating results. See "Business--Operations" and 
"--Suppliers."

GOVERNMENTAL REGULATION

  The Company's direct-mail operations are subject to regulation by the U.S.
Postal Service, the Federal Trade Commission and various state, local and
private consumer protection and other regulatory authorities.  In general, these
regulations govern the manner in which orders may be solicited, the form and
content of advertisements, information which must be provided to prospective
customers, the time within which orders must be filled, obligations to customers
if orders are not shipped within a specified period of time and the time within
which refunds must be paid if the ordered merchandise is unavailable or
returned.  From time to time the Company has modified its methods of doing
business and its marketing operations in response to inquiries and requests from
regulatory authorities.  To date, such changes have not adversely affected the
Company's business.  However, future regulatory requirements or actions may
negatively affect the Company's business, financial condition and operating
results.  See "Business--Governmental Regulation."

POTENTIAL ADVERSE IMPACT OF ENVIRONMENTAL REGULATIONS

  The Company's photofinishing operations involve the use of several chemicals
which are subject to federal, state and local governmental regulations relating
to the storage, use, handling and disposal of such chemicals.  The Company
actively monitors its compliance with applicable regulations and works with
regulatory authorities to ensure compliance.  Changes in environmental
regulations or in the kinds of chemicals used by the Company may impose the need
for additional capital equipment or other requirements.  Any failure by the
Company to control the use or adequately restrict the discharge of hazardous
substances under present or future regulations could subject it to substantial
liability.  This could cause its operations to be suspended.  Such liability or
suspension of operations could negatively affect the Company's business,
financial condition and operating results.  See "Business--Environmental
Compliance."

STATE SALES TAX

  Many states impose taxes on the sale or use of products and the sale of
certain services within the taxing state's borders.  If a seller of taxable
products or services is subject to the jurisdiction of a taxing state, the state
may impose a sales tax directly on the seller.  The state may impose a duty on
the seller to collect a sales or use tax from its customers.  A seller is
generally considered subject to the jurisdiction of a taxing state for sales or
use tax purposes when it has an in-state presence that is beyond de minimis.  An
in-state presence can include soliciting orders for sales in the taxing state
either in-person or through an employee or other agent.  The Company currently
collects and pays sales tax only with respect to shipments in the state of
Washington.  The Company structured its operations in a manner designed to
minimize the likelihood that it has more than a de minimis physical presence in
any state other than Washington. However, if a state taxing authority determines
that the Company has established more than a de minimis physical presence in
that particular state, the Company could be obligated to collect and pay a sales
or use tax on some sales of its services and products.  If the Company is found
liable by a state taxing authority for unpaid prior sales and use taxes, such
liabilities could negatively affect the Company's business, financial condition
and operating results.  From time to time, legislation has been introduced in
the U.S. Congress that, if enacted into law, would impose a state sales or use
tax collection obligation on out-of-state mail-order companies such as the
Company. Enactment of any such legislation could negatively affect the Company's
business, financial condition and operating results.  In October 1998, Congress
passed the "Federal Internet Tax Freedom Act".  This bill imposes a three-year
moratorium on new taxes on Internet access fees and on new state taxes that
discriminate or result in multiple taxation.  A commission, the Advisory
Commission on Electronic Commerce, will review taxation of Internet activities
and taxation of other forms of remote selling such as mail order, telemarketing
and other forms of electronic commerce.

                                       17
<PAGE>
 
INTELLECTUAL PROPERTY

  The Company considers a large portion of its PhotoWorks(R) software, its
process for production of Pictures On Disk(TM), and certain other processes to
be proprietary. The Company has not filed any patents or patent applications, in
part to avoid disclosure of its competitive strengths. The Company markets its
services and products under registered and common-law trademarks and service
marks, including Seattle FilmWorks(R), OptiColor(TM) Film & Photo, Pictures On
Disk(TM), Pictures On Disk(TM) on CD, PhotoMail(TM), PhotoWorks(R), Pictures
Plus(TM) Index, Professor FilmWorks(TM), PictureWorks(TM) and FilmWorksNet(TM).

  The Company considers a large portion of its PhotoWorks(R) software, its
process for production of Pictures On Disk(TM) and certain other processes to be
proprietary.  The Company has not filed any patents or patent applications, in
part to avoid disclosure of its competitive strengths.  The Company, however,
does attempt to protect its proprietary rights to software through a combination
of copyright, trademark and trade secret laws and employee and third-party
nondisclosure agreements, by restricting access to certain portions of its
premises and by including contractual restrictions on use and disclosure in its
end-user licenses.  The legal and practical enforceability and extent of
liability for violations of license agreements are unclear.  See "Business--
Proprietary Technology."

POSSIBLE VOLATILITY OF STOCK PRICE

  The market price of the Common Stock has been, and is likely to continue to
be, volatile.  There can be no assurance that the market price of the Common
Stock will not change significantly from its current level.  The market price of
the Common Stock is subject to significant changes in response to a number of
factors.  Some factors are actual or anticipated changes in the Company's
quarterly operating results, the introduction of new services or products by the
Company or by its competitors and changes in other conditions or trends in the
Company's industry.  It is also subject to changes in governmental regulations,
changes in securities analysts' estimates of the Company's, its competitors' or
the industry's future performance or general market conditions.  See Item 7 of
Part II-"Management's Discussion and Analysis of Financial Condition and Results
of Operations."  In addition, stock markets have experienced extreme price and
volume volatility in recent years.  This volatility has a substantial effect on
the market prices of securities of many smaller public companies which do not
relate to the operating performance of such companies.  Market conditions can
negatively affect the market price of the Common Stock.  See "Price Range of
Common Stock."

YEAR 2000

     The Company recognizes the need to ensure that its operations will not be
adversely affected by Year 2000 systems failures.  Year 2000 issues arise
because some computer software and hardware ("computer systems") were designed
to handle only a two-digit year, not a four-digit year (e.g. 1997 is seen by the
computer as "97").  When the year 2000 begins, these computer systems may
interpret "00" as the year 1900 and not 2000, and could either stop processing
date-related computations or process them incorrectly.

     In order to minimize the impact of the Year 2000 on the Company, a Year
2000 committee has been established for the evaluation and management of risks
associated with material Year 2000 issues.  The committee's plan includes a
review of material computer and imbedded systems that the Company currently has
in place, modification or replacement of such systems if required, assessment of
Company's software products as relates to Year 2000 issues, inquiry to third-
party providers with whom the Company has material business relationships as to
their state of readiness for potential Year 2000 issues and the development of
contingency plans in the event material Year 2000 issues arise in Company or
third-party computer systems.  The Company estimates that as of November 30,
1998, it had completed approximately 60% of the initiatives that it believes
will be necessary to fully address potential Year 2000 issues relating to its
computer equipment and software.  The projects comprising the 60% of the
initiatives are in process and expected to be completed on or about June 30,
1999.  The Company anticipates that testing of additional systems and required
modifications or replacements will be completed by June 30, 1999.  As of
September 26, 1998, the Company has not expended any material amount to address
potential Year 2000 issues, exclusive of costs associated with previously
scheduled modifications, upgrades or replacements 

                                       18
<PAGE>
 
unrelated to Year 2000 issues. Other non-Year 2000 information system efforts
have not been materially delayed or impacted by Year 2000 initiatives. The
Company does not anticipate spending material amounts for additional testing,
modification, upgrade and replacement related to Year 2000 during fiscal year
1999. Based on current and anticipated operating needs, many of the Company's
critical computer systems do not rely on a two-digit year field as part of the
process or are in the process of being replaced with more technologically
advanced versions. Each new system being installed has been reviewed for Year
2000 compliance. The computer systems that have been or are in the process of
being replaced, include, but are not limited to, the Company's accounting
system, inventory control system, workstation and network operating systems. The
remaining computer and imbedded systems, including but not limited to, plant
equipment, alarm systems, phone equipment and general office equipment are
currently being reviewed for Year 2000 compliance as part of the overall plan
for testing and modification referenced above. The Company has determined that
most products the Company sells in the ordinary course of business do not have
issues relating to Year 2000. Software products previously supplied by the
Company, in some cases, may display an incorrect date but will continue to
function. At their option, customers may upgrade to newer versions of the
Company's software to correct the date display. Any Year 2000 issues in products
sold by the Company that are manufactured by another vendor will be referred to
that vendor.

     In addition to reviewing its own computer systems, the Company has sent
letters to material third-party providers, including, but not limited to,
suppliers, product sponsors, financial institutions, service providers, and
other companies with which the Company has material business relationships in
order to assess these companies' state of Year 2000 readiness.  These letters
request, among other things, disclosure of the companies' plans for minimizing
the impact of the Year 2000 on their computer systems and the Company.  As of
November 30, 1998, the Company had received responses from approximately 30% of
such third parties, and 90% of the companies that have responded have provided
written assurances that they expect to address all their significant Year 2000
issues on a timely basis.  A follow-up mailing to significant vendors and
service providers that did not initially respond, or whose responses were deemed
unsatisfactory by the Company, has been completed, with responses due by
December 31, 1998.  To date, the Company has not received from any third-party
provider with which a material business relationship exists notice of a material
Year 2000 issue or inability to address material Year 2000 issues prior to the
Year 2000.  The Company is not in a position to verify whether third-party
service providers are or will become Year 2000 ready apart from such assurances
or until a Year 2000 issue arises.  The Company presently believes that the Year
2000 issue will not pose significant operational problems for the Company.
However, if all Year 2000 issues are not properly identified, or assessment,
remediation and testing are not effected timely with respect to Year 2000
problems that are identified, there can be no assurance that the Year 2000 issue
will not materially adversely affect the Company's results of operations or
adversely affect the Company's relationships with customers, vendors, or others.
Additionally, there can be no assurance that the Year 2000 issues of other
entities will not have a material adverse impact on the Company's systems or
results of operations.  If the Company were to experience a material disruption
in its computer systems from Year 2000 issues, the Company is prepared to
conduct business, particularly the processing of customer orders, utilizing
manual processes and third party vendors and back-up data routinely archived by
the Company.  The Company anticipates that the cost of conducting business
utilizing the Company's contingency plans would be higher than conducting
business utilizing current and anticipated operational plans.

ANTITAKEOVER CONSIDERATIONS

  The Company's Board of Directors has the authority, without requiring
shareholder approval, to issue up to 2,000,000 shares of Preferred Stock and to
define the rights and preferences of those shares.  This authority, together
with certain provisions of the Articles, including those providing for a
classified board and removal of directors only for cause, and the Washington
Business Corporation Act, may discourage takeover attempts or tender offers that
could result in shareholders receiving a premium over the market price for the
Common Stock or that shareholders may otherwise consider to be in their best
interests.

                                       19
<PAGE>
 
ITEM 2 - PROPERTIES

     The Company's headquarters are located in Seattle, Washington.  This 60,000
square foot building which houses the Company's photofinishing and mail-order
operations, is occupied under a lease which expires in September 2005, with an
option to extend for an additional five years.

     The Company has a lease agreement for 46,000 square feet of office and
production space adjoining the Company's headquarters.  This lease expires
September 2000 with two options to extend for additional five-year periods
through September 2010.

     The Company also occupies 80,000 square feet in a building primarily used
for warehouse storage.  This building, located in Seattle, Washington, is
occupied under a three-year lease expiring January 31, 1999, with options to
extend the lease for two additional one-year periods to January 31, 2001.

     The Company has various leases for its retail store locations with lease
terms generally ranging from three to five years.

ITEM 3 - LEGAL PROCEEDINGS

     The Company is a defendant in a legal proceeding filed by Fuji Photo Film
Co., Ltd. ("Fuji") with the International Trade Commission ("ITC") on February
13, 1998.  The action was filed against a number of importers, including the
Company's OptiColor, Inc. subsidiary, alleging patent infringement of U.S.
patents on single use cameras through the importation and resale into the U.S.
of recycled cameras.  Fuji is seeking an order prohibiting importation of the
alleged infringing cameras into the U.S. and prohibiting further sales of such
products which have been imported.  Sales of recycled cameras accounted for 
3.8% of the Company's net revenues during fiscal 1998.  An evidentiary hearing
before an ITC Administrative Law Judge ("ALJ") was held in November, 1998 and
the ALJ is expected to issue an initial decision in February, 1999.  Such
decision is subject to review by the ITC Commissioners, who would then issue a
final decision, most likely in May, 1999.  That decision would be subject to
appeal to the Federal Circuit Court of Appeals.  In addition, the Company is
involved in various routine legal proceedings incident to the ordinary course of
its business.


ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

     No matters were submitted to a vote of shareholders during the fourth
quarter of the Company's fiscal year.

                                       20
<PAGE>
 
                                 PART II

ITEM 5 - MARKET PRICES AND DIVIDENDS ON COMMON STOCK

  The Company's Common Stock trades on the Nasdaq National Market under the
symbol "FOTO."  The following table sets forth, for the periods indicated, the
high and low sale prices of the Common Stock as reported on Nasdaq, as adjusted
for stock splits.

<TABLE>
<CAPTION>
                                                   HIGH           LOW     
                                                   ----           ---
<S>                                                <C>           <C>
Fiscal Year Ended September 26, 1998                                      
       First Quarter........................       $12.19       $ 8.50                       
       Second Quarter.......................        12.00         7.88                       
       Third Quarter........................        13.19         6.06                       
       Fourth Quarter.......................         8.25         3.00                       
     Fiscal Year Ended September 27, 1997                                                    
       First Quarter........................       $15.00       $11.67                       
       Second Quarter.......................        13.67         9.83                       
       Third Quarter........................        12.88         9.50                       
       Fourth Quarter.......................        14.56        11.00                       
</TABLE>

     On November 30, 1998, the last sale price reported for the Common Stock was
$3.25 per share and as of that date, the Common Stock was held by an estimated
9,700 shareholders with approximately 547 holders of record.

  The Company has never declared or paid cash dividends on the Common Stock and
does not anticipate paying any dividends in the foreseeable future.  The Company
is restricted under the covenants of a bank loan agreement from declaring any
dividends on shares of its capital stock without the bank's prior consent.  The
Company currently intends to retain its earnings, if any, for developing its
business.


ITEM 6 - SELECTED FINANCIAL DATA

     The selected financial data set forth below with respect to the Company's
consolidated statements of income for the years ended September 26, 1998,
September 27, 1997 and September 28, 1996 and the Company's consolidated balance
sheets at September 26, 1998 and September 27, 1997 are derived from the audited
consolidated financial statements included elsewhere in this report and should
be read in conjunction with those consolidated financial statements and their
related footnotes.  The selected income statement data for the years ended
September 30, 1995 and September 24, 1994 and selected balance sheet data at
September 28, 1996, September 30, 1995 and September 24, 1994 are derived from
audited consolidated financial statements which are not included in this report.

                                       21
<PAGE>
 
                            SEATTLE FILMWORKS, INC.
                            SELECTED FINANCIAL DATA
                (in thousands, except per share and share data)
<TABLE>
<CAPTION>
 
 
                                                                               FISCAL YEARS
                                         ------------------------------------------------------------------------------
                                                1998                1997            1996           1995           1994
=======================================================================================================================
<S>                                      <C>                 <C>            <C>            <C>            <C> 
CONSOLIDATED INCOME STATEMENT DATA:
----------------------------------
 
Net revenues                             $    96,716         $   101,189     $    84,152    $    62,185    $    49,753
 
Gross profit                                  40,693              42,565          34,993         24,057         18,907
 
Operating expenses                            30,506              27,752          23,084         15,729         12,709
 
Net income                               $     7,575         $    10,145     $     8,017    $     5,682    $     4,438
                                         ===========         ===========     ===========    ===========    ===========
 
Income as a percent of revenues                  7.8%               10.0%            9.5%           9.1%           8.9%
 
Diluted earnings per share*              $       .43         $       .57     $       .45    $       .33    $       .24
                                         ===========         ===========     ===========    ===========    ===========
 
Weighted average shares and
 equivalents outstanding - Diluted*       17,474,000          17,770,000      17,726,000     17,430,000     18,431,000
                                         ===========         ===========     ===========    ===========    ===========
 
CONSOLIDATED BALANCE SHEET DATA:
-------------------------------
 
Capitalized customer acquisition
 expenditures                            $    16,800         $    13,882     $    11,334    $     7,356    $     4,458
 
Total assets                                  55,116 **           51,366          37,826         28,244         18,835
 
Long-term obligations                            706                   0               0              0              0

Shareholders' equity                     $    43,701 **      $    37,601     $    26,675    $    17,932    $    11,347
                                         ===========         ===========     ===========    ===========    ===========  
</TABLE> 

See notes to consolidated financial statements.

* All share and per share data are retroactively adjusted to reflect a two for
one stock split distributed March 16, 1994, a three for two stock split
distributed March 15, 1995, a three for two stock split distributed March 15,
1996 and a three for two stock split distributed March 17, 1997.

The earnings per share amounts prior to fiscal 1998 have been restated as
required to comply with Statement of Accounting Standards No. 128, Earnings per
Share.  For further discussion of earnings per share and the impact of Statement
No. 128, see the notes to consolidated financial statements.

**  Reflects the impact of repurchasing 843,367 shares of common stock for
$4,829,000 in fiscal year 1998.

                                       22
<PAGE>
 
ITEM 7 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

FORWARD-LOOKING INFORMATION

  Statements in this report concerning the Company's strength in Photo-
Computing, additional revenue sources, enhancement of customer retention,
expected increase in share of the market for reprints, introduction of
additional digital services and any other statement which may be construed as a
prediction of future performance or events are forward-looking statements, the
occurrence of which are subject to a number of known and unknown risks,
uncertainties and other factors which may cause actual results, performance or
achievements of the Company or industry trends to differ materially from those
expressed or implied by such forward-looking statements.  Relevant risks and
uncertainties include, among others, those discussed in Item 1 of Part 1 under
the heading "Risk Factors" and elsewhere in this Report and those described from
time to time in the Company's other filings with the Securities and Exchange
Commission, press releases and other communications.  All forward-looking
statements contained in this report reflect the Company's expectations at the
time of this report only, and the Company disclaims any responsibility to revise
or update any such forward-looking statement except as may be required by law.

OVERVIEW

  Seattle FilmWorks, Inc. (the "Company") is a leading direct-to-consumer
marketer and provider of high-quality amateur traditional photofinishing and
digital imaging services and products.  The Company offers an array of
complementary services and products primarily on a mail-order basis under the
brand name Seattle FilmWorks(R). To promote its service and products, the
Company relies primarily on direct-marketing programs, including the customer
acquisition technique of offering two rolls of film for $2.00 or less (the
"Introductory Offer").  The Introductory Offer has been nationally advertised in
package inserts, newspaper supplements and magazines and through various other
direct-response media.  Beginning in fiscal 1995, the Company shifted the focus
of, and substantially expanded, its customer acquisition programs.  This shift
in focus included mailing of two rolls of film to users of personal computers,
together with materials promoting the Company's digital imaging services and
products, such as Pictures On Disk(TM) and PhotoMail(TM) Internet image
delivery.

  Customer acquisition costs are comprised of the costs of generating a lead and
the amortization of direct costs associated with the Company's promotional
offers sent to prospective and existing customers.  The costs of generating a
lead include all direct-response media, advertising and other costs associated
with developing target customer lists.  The direct costs of customer acquisition
include film, postage and printed material costs associated with mailings to
prospective and existing customers.

  Until the end of fiscal 1998, the direct costs of customer acquisition were
capitalized as an asset on the Company's consolidated balance sheet as
"capitalized customer acquisition expenditures."  Historically, capitalized
customer acquisition expenditures relating to prospective customers were
amortized over three years, and, beginning in fiscal 1996, capitalized customer
acquisition expenditures relating to certain marketing activities to groups of
existing customers were amortized over six months.  These amortization rates
were based on estimates of the timing of future roll processing volumes per
customer.  The proportion of capitalized customer acquisition expenditures
amortized over three years relative to those to be amortized over six months
varied from period to period based on the timing and mix of promotional
activities.  Based on developments in fiscal 1998 as discussed below, the
Company has taken a pre-tax charge to earnings of $613,000 in the fourth quarter
of fiscal 1998, relating to the net realizable value of the capitalized customer
acquisition cost asset, and has changed its accounting estimate for customer
acquisition costs in future periods.

     For approximately 75% of rolls received from customers, the Company has the
ability to determine the specific mailing to which a customer is responding.
These "identifiable responses" serve as the basis for estimates of future
response rates for the purpose of determining the appropriate amortization
period and for the purpose of 

                                       23
<PAGE>
 
assessing recoverability of the investment in customer acquisition expenditures.
Net recoverability estimates of the capitalized costs are assessed each quarter
based on identifiable responses to the programs for which costs are recorded as
an asset. Specifically, the Company compares amortized expense of customer
acquisition programs with the actual profitability of such programs to assess
whether the costs are fully recoverable. Quarterly analyses prior to fiscal 1998
indicated that the marketing programs for which costs were capitalized were
consistently yielding net profits from identifiable responses in excess of the
program costs. During the first three quarters of fiscal 1998, the quarterly
analyses showed a decline in net profitability, but capitalized costs appeared
to be fully recoverable. As discussed in the 10-Q filing for the third fiscal
quarter ended June 27, 1998, management's statistical analysis of marketing
programs indicated that photofinishing volumes continued to be adversely
affected by extended delivery times experienced by customers during the summer
of 1997. Based on this analysis completed in the third fiscal quarter,
management believed that these extended delivery times had a negative impact on
customer responses. Nevertheless, the amount of net capitalized costs at the end
of the third quarter were not in excess of the estimated net profit from
identifiable responses expected to be received under the programs in the future.

     During the fourth quarter the overall performance of customer acquisition
programs continued to decline.  Upon completing the quarterly review of the
recoverability of capitalized costs as of September 26, 1998, management
concluded lower response rates to customer acquisition programs required an
adjustment to the amount of capitalized costs associated with those programs.
Accordingly, the Company reduced the capitalized customer acquisition cost asset
by $613,000, or 3.5% of the total asset of $17,400,000, recognizing the $613,000
as a pre-tax expense in the fourth quarter of fiscal 1998 and reducing the
capitalized customer acquisition cost asset to $16,800,000 as of September 26,
1998.  Management attributes the need for this action to a gradual decline in
profitability of the average customer, primarily related to response rates.

     Through fiscal 1998, capitalized customer acquisition costs have been
amortized over 36 months on an accelerated basis.  Historical statistical data
supported this amortization schedule as a good approximation of identifiable
responses to specific customer acquisition marketing programs.  As a result,
this amortization estimate provided a good matching of the amortization of
capitalized direct marketing costs with related revenue in accordance with the
American Institute of Certified Public Accountants ("AICPA") Statement of
Position 93-7, Accounting for Advertising Costs ("SOP 93-7").  The Company has
               ---------------------------------------------                  
not sent repeat mailings of its introductory free film to households which have
received such a mailing within the last 36 months, because to do so would
obscure the response rates to the initial mailing.  However, recent marketing
tests show that repeat mailings may, in some cases, more productive than seeking
out a marginal new target customer.  Under current marketing plans, scheduled to
commence in the first quarter of fiscal 1999, a significant number of previously
targeted and existing customers will receive additional marketing mailings.

     Given the negative trend in identifiable response rates to the Company's
marketing programs, management believes there is growing uncertainty about the
reliability of historical response rates to predict future performance of its
marketing programs.  Management believes significant costs remain capitalized on
the Company's balance sheet which relate to prior marketing activity to a number
of individuals likely to receive additional marketing mailings during fiscal
1999 as a result of these plans.  In addition, industry trends suggest that
direct marketing with free film may have decreasing marginal returns.  Digital
technologies are an emerging substitute to film-based systems and growing
acceptance of these technologies may cause further deterioration of results from
direct marketing programs as consumer behavior changes.

     The Company is actively pursuing Internet and retail distribution as a
complement to its mail order business.  It is more difficult to track direct
marketing program response rates in a retail environment because customers do
not generally submit their orders with coded response forms.  As noted above, in
accounting for customer acquisition costs, the Company follows SOP 93-7.
Previously, the Company was required by SOP 93-7 to capitalize and then amortize
customer acquisition costs so that the expenses resulting from the amortization
of these costs would match the period in which associated estimated revenue
would be received from identifiable responses  to those marketing efforts.
However, as a result of recent trends in customer responses, the Company's
marketing 

                                       24
<PAGE>
 
plans and Internet and retail distribution strategies, management believes that
the net profit margin on identifiable responses will be insufficient to justify
deferral of such costs in the future due to the trend of lower response rates
and to an expected decline in the percentage of identifiable responses to
individual programs. As a result of these changes in circumstances, management
no longer has persuasive evidence that future direct response advertising will
have identifiable results to the degree of reliability that would otherwise
require capitalization of such costs pursuant to SOP 93-7. Consequently,
effective in the first quarter of fiscal 1999, the Company will expense all
customer acquisition costs as incurred. In addition, management estimates twelve
months to be the period in which the benefits of the previously capitalized
marketing costs to this customer base will be enjoyed before the benefits of
these previous programs are obscured by the supplemental marketing efforts to
this customer base. Therefore, the Company will amortize the $16,800,000
capitalized customer acquisition costs, as of September 26, 1998, over a twelve
month period on a straight-line basis. Accordingly, operating expenses related
to customer acquisition activities will increase significantly in fiscal 1999
compared to prior periods. Future periods may reflect increased or decreased
customer acquisition costs due to the expensing of such costs as incurred, as
well as the timing and magnitude of customer acquisition activities.

  Customer acquisition costs as a percentage of net revenues increased to 18.5%
in fiscal 1998 as compared to 15.6% in fiscal 1997 and 14.2% in fiscal 1996.
Management believes this increase in customer acquisition costs as a percentage
of net revenues is due primarily to expansion of the Company's customer
acquisition programs and to lower net revenues as a result of decreased
responses to marketing programs conducted in fiscal years 1997 and 1998.
Included in the fiscal 1998 customer acquisition costs is a $613,000 adjustment
based on management's analysis of estimated net profit from identifiable
responses to the Company's acquisition programs. For tax purposes, customer
acquisition expenditures are expensed as incurred.  For fiscal 1998, this
reduced current federal income tax liabilities and increased deferred federal
income tax liabilities.  For fiscal 1999, it is likely current federal income
tax liabilities will exceed the provision for income taxes for financial
statement purposes, thereby reducing deferred federal income tax liabilities.
See Note G of Notes to Consolidated Financial Statements.

  Net income as a percentage of net revenues decreased to 7.8% in fiscal 1998 as
compared to 10.0% in fiscal 1997 and 9.5% in fiscal 1996 primarily due to
increased customer acquisition costs and higher general and administrative costs
relating to depreciation, information systems and legal expenses. Operating
results will fluctuate in the future due to changes in the mix of sales,
intensity and effectiveness of promotional activities, price increases by
suppliers, introductions of new products, research and development requirements,
actions by competitors, foreign currency exchange rates, conditions in the
direct-to-consumer market and the photofinishing industry in general, national
and global economic conditions and other factors.

  Cost of goods and services consist of labor, postage and supplies related to
the Company's services and products.  Other selling expenses include marketing
costs associated with building brand awareness, testing new marketing strategies
and marketing to existing customers, as well as certain costs associated with
acquiring new customers.  Research and development expenses consist primarily of
costs incurred in researching new computerized digital imaging concepts,
developing computer software products and creating equipment necessary to
provide customers with new computer-related photographic services and products.
General and administrative expenses consist of costs related to computer
operations, human resource functions, finance, legal, accounting, investor
relations and general corporate activities.

  Demand for  the Company's photo-related services and products is highly
seasonal, with the highest volume of photofinishing activity occurring during
the summer months.  However, seasonality of demand may be offset by the
introduction of new services and products, changes in the level of effectiveness
of customer acquisition programs and other factors.  This seasonality, when
combined with the general growth of the Company's photofinishing business, has
produced greater photofinishing net revenues during the last half of the
Company's fiscal year (April through September), with a peak occurring in the
fourth fiscal quarter.  Net income is affected by the seasonality of the
Company's net revenues due to the fixed nature of a portion of the Company's
operating expenses, seasonal variation in sales mix and the Company's practice
of relatively higher marketing program expenditures prior to the summer months.

                                       25
<PAGE>
 
RESULTS OF OPERATIONS

     The following table presents information from the Company's statements of
income, expressed as a percentage of net revenues for the periods indicated.

<TABLE>
<CAPTION>
 
                                                     FISCAL YEARS ENDED
                                 -----------------------------------------------------
                                    SEPTEMBER 26,      SEPTEMBER 27,    SEPTEMBER 28,
                                        1998                1997             1996
======================================================================================
<S>                              <C>                   <C>              <C>
 
Net revenues                           100.0%            100.0%           100.0%          
                                                                                          
Cost of goods and services              57.9              57.9             58.4           
                                       -----             -----            -----           
                                                                                          
GROSS PROFIT                            42.1              42.1             41.6           
                                                                                          
Operating expenses:                                                                       
 Customer acquisition costs             18.5              15.6             14.2           
 Other selling expenses                  7.9               7.7              8.2           
 Research and development                0.6               0.7              0.9           
 General and administrative              4.5               3.5              4.2           
                                       -----             -----            -----           
  Total operating expenses              31.5              27.5             27.5           
                                       -----             -----            -----           
                                                                                          
INCOME FROM OPERATIONS                  10.6              14.6             14.1           
                                                                                          
Total other income                       0.9               0.6              0.4           
                                       -----             -----            -----           
                                                                                          
INCOME BEFORE INCOME TAXES              11.5              15.2             14.5           
                                                                                          
Provision for income taxes               3.7               5.2              5.0           
                                       -----             -----            -----           
                                                                                          
NET INCOME                               7.8%             10.0%             9.5%          
                                       =====             =====            =====            
 
</TABLE>

  Net revenues decreased 4.4% to $96,716,000 in fiscal 1998 from $101,189,000 in
fiscal 1997.  Net revenues in fiscal 1997 increased 20.2% to $101,189,000 from
$84,152,000 in fiscal 1996.  Net revenues for fiscal year 1998 were affected by
lower photofinishing volumes and a decline in net revenues from ancillary
businesses.  Approximately 71% of the decline in net revenues for fiscal 1998 is
attributable to sales of wholesale film to certain markets in Asia which were
discontinued at the beginning of the fourth quarter of fiscal 1998 coupled with
a planned reduction in the Company's continuity Photo Home Study course
operations which have been phased out.  During the fourth quarter of fiscal
1997, international wholesale film orders produced $2,300,000 in net revenues.
Management attributes reduced photofinishing volumes to lower response rates to
its 1998 customer acquisition programs, the loss of customers as a result of
production problems experienced during the summer months of fiscal 1997,
increased competition and other factors. Net revenues in fiscal 1997 increased
as compared to fiscal 1996 primarily due to expanded customer acquisition
activities and marketing to existing customers.

  Gross profit as a percentage of net revenues for fiscal 1998 and fiscal 1997
was 42.1%, and 41.6% for fiscal 1996.  The increase in gross profit in fiscal
1998 and fiscal 1997 compared to fiscal 1996 was primarily due to a product mix
containing a higher percentage of Seattle FilmWorks(R) branded products, which
carry a higher gross profit margin than the Company's other services and
products.  Fiscal 1998 gross profit included higher retail and production labor
costs and equipment costs to ensure timely delivery of photofinishing volumes
that had been planned for earlier in the year.  The fiscal 1997 gross profit
included higher labor costs as a result of incremental overtime to compensate
for production problems during the third quarter and increased overhead expenses
as a percentage of net revenues from increased customer service costs.
Fluctuations in gross profit will occur in future periods due to the seasonal
nature of revenues, mix of product sales, intensity and effectiveness of
promotional activities and other factors.

  Total operating expenses as a percentage of net revenues for fiscal 1998 were
31.5%, compared to 27.5% for fiscal years 1997 and 1996.  The increase in total
operating expenses in fiscal 1998 was primarily due to increased 

                                       26
<PAGE>
 
customer acquisition costs and legal expenses related to defending an action
filed by Fuji with the ITC against a numbers of importers of recycled single use
cameras, including the Company's subsidiary, OptiColor, Inc. If Fuji prevails in
this action, OptiColor would likely be prohibited from selling recycled cameras,
sales of which accounted for 3.8% of the Company's net revenues in fiscal 1998.
See Item 3 of Part I-"Legal Proceedings." Operating expenses in fiscal 1998 also
include higher costs related to information systems to enhance and support the
marketing and production systems.

  Other selling expenses in fiscal 1998 increased as a percentage of net
revenues to 7.9% compared to 7.7% in fiscal 1997. Other selling expenses for
fiscal 1997 decreased to 7.7% of net revenues as compared to 8.2% in fiscal 1996
but declined slightly in fiscal 1998 in actual dollars.  Fiscal 1996 included
increased marketing activities associated with expanded promotional activities
to new and existing customers.

  Research and development expenses during fiscal 1998 were $588,000 as compared
to $696,000 for fiscal 1997 and $732,000 for fiscal 1996.  The decreases are
primarily attributable to lower contract service and equipment costs.

  General and administrative expenses increased to $4,361,000 in fiscal 1998 as
compared to $3,503,000 in fiscal 1997 and $3,460,000 in fiscal 1996.  The
increase in fiscal 1998 as compared to fiscal 1997 was due primarily to
increased legal expenses associated with the Fuji Photo Film Co., Ltd. action
and management anticipates increased legal expenses to continue in the future.
General and administrative expenses in fiscal 1998 also include increased costs
related to the Company's management information systems.  Fiscal 1997 costs
increased over fiscal 1996 primarily due to increased costs related to the
Company's management information systems.  General and administrative expenses
as a percent of net revenues increased to 4.5% for fiscal 1998 as compared to
3.5% in fiscal 1997 and 4.2 % in fiscal 1996.

  Total other income in fiscal 1998 was $940,000 as compared to $574,000 in
fiscal 1997 and $328,000 in fiscal 1996.  The increases in total other income in
fiscal 1998 are due primarily to higher interest income and cash discounts.  The
increase in fiscal 1997 compared to fiscal 1996 was due primarily to higher
interest income.

  The income tax rate for fiscal 1998 was 31.9% as compared to 34.1% for fiscal
1997 and 34.5% for fiscal 1996.  The decrease in the effective tax rate for
fiscal 1998 as compared to fiscal 1997 was due primarily to a decrease in the
marginal federal corporate tax rate due to lower income levels and a higher
percentage of research and development credits and tax exempt interest.  The
decrease for fiscal 1997 as compared to fiscal 1996 was primarily due to
increases in tax exempt interest and federal research and development tax
credits.

  Net income decreased to $0.43 diluted earnings per share in fiscal 1998 as
compared to $0.57 diluted earnings per share in fiscal 1997 and $0.45 diluted
earnings per share in fiscal 1996.  The decrease in fiscal 1998 was primarily
attributable to lower net revenues and increases in operating expenses.  The
increase in fiscal 1997 compared to fiscal 1996 was due primarily to increases
in net revenues and gross profit.

LIQUIDITY AND CAPITAL RESOURCES

  Net cash provided by operating activities in fiscal 1998 was $10,601,000,
compared to $9,493,000 in fiscal 1997 and $4,554,000 in fiscal 1996.  The
increases in cash provided by operating activities were primarily a result of
changes in net income, adjusted for depreciation and amortization, amortization
of customer acquisition expenditures and net changes in receivables,
inventories, payables, and other.

  Net cash used in investing activities was $5,243,000 in fiscal 1998,
$5,282,000 in fiscal 1997 and $7,281,000 in fiscal 1996.  Net cash used in
investing activities during fiscal years 1998 and 1997 decreased as compared to
1996 primarily due to the net decrease in net purchases of securities available-
for-sale, partially offset by an increase in purchases of furniture, fixtures
and equipment.

                                       27
<PAGE>
 
  Net cash used in financing activities was $3,830,000 in fiscal 1998 and
$94,000 in fiscal 1997 compared to $302,000 provided from financing activities
in fiscal 1996.  The decreases were primarily due to the repurchase of shares of
the Company's  Common Stock, partially offset by increases in the level of stock
options exercised.  On January 22, 1997, the Company announced that it may
repurchase shares of its Common Stock, either through open market purchases at
prevailing market prices, through block purchases or in privately negotiated
transactions.  Repurchases may be commenced or discontinued at any time.
Although the number of shares to be repurchased is uncertain, any repurchased
shares will to some degree offset the dilutive effect on earnings per share of
shares of Common Stock issued under the Company's stock option and stock
purchase plans.  During fiscal 1998, the Company purchased 843,000 shares for a
total of $4,829,000.  During fiscal 1997, the Company purchased 80,000 shares
for a total of $824,000.

  As of November 30, 1998, the Company's principal sources of liquidity included
$16,421,000 in cash and securities available-for-sale together with an unused
operating line of credit of $6,000,000.  The ratio of current assets to current
liabilities for the Company was 4.9 to 1 at the end of fiscal 1998, which
reflects an increase from the current ratio of 3.1 to 1 at the end of fiscal
1997.  The increase was primarily due to decreases in taxes payable of
$2,443,000, and accounts payable of $1,229,000, and an increase in cash and
short-term investments of $1,021,000 offset by decreases in inventory of
$1,437,000 and accounts receivable of $1,766,000.

  Capital expenditures during fiscal 1998 totaled $5,750,000 principally for
photofinishing equipment, data processing equipment to support its digital and
Internet-related imaging services and for leasehold improvements.  During fiscal
1998, approximately $969,000 of capital purchases were financed through a
capital leasing transaction.  In fiscal 1997, the Company made capital
expenditures of $4,779,000 relating to photofinishing equipment, data processing
equipment and for expanding the capacity of photofinishing operations.  The
Company has plans to expend approximately $7,000,000 in fiscal 1999, principally
for additional photofinishing processing equipment, data storage and computer
network equipment and for leasehold improvements, although at this time it has
no binding commitments to do so.

  The Company currently anticipates that existing funds together with
anticipated cash flow from operations and the Company's available line of credit
of $6,000,000 will be sufficient to finance its operations, including planned
capital expenditures, and to service its indebtedness for the foreseeable
future.  However, if the Company does not generate sufficient cash from
operations to satisfy its ongoing expenses, the Company will be required to seek
external sources of financing or refinance its obligations.  Possible sources of
financing include the sale of equity securities or additional bank borrowings.
There can be no assurance that the Company will be able to obtain adequate
financing in the future.  See Item 1 of Part I-"Risk Factors."

INFLATION

  The results of the Company's operations have not been significantly affected
by inflation during any of the last three fiscal years.  Although the Company
has incurred moderately increased costs for labor, materials, postage and
overhead, it has been able to offset the impact of such increases primarily
through enhanced operating efficiencies.

ADOPTION OF ACCOUNTING STANDARDS

  In February 1997, the Financial Accounting Standards Board issued Statement
No. 128, "Earnings per Share."  Under the new requirements for calculating
primary (basic) earnings per share, the dilutive effect of stock options will be
excluded, but are included in the computation of diluted earnings per share.
The Company adopted Statement No. 128 in the first quarter of fiscal 1998.

                                       28
<PAGE>
 
YEAR 2000

     The Company recognizes the need to ensure that its operations will not be
adversely affected by Year 2000 systems failures.  Year 2000 issues arise
because some computer software and hardware ("computer systems") were designed
to handle only a two-digit year, not a four-digit year (e.g. 1997 is seen by the
computer as "97").  When the year 2000 begins, these computer systems may
interpret "00" as the year 1900 and not 2000, and could either stop processing
date-related computations or process them incorrectly.

     In order to minimize the impact of the Year 2000 on the Company, a Year
2000 committee has been established for the evaluation and management of risks
associated with material Year 2000 issues.  The committee's plan includes a
review of material computer and imbedded systems that the Company currently has
in place, modification or replacement of such systems if required, assessment of
Company's software products as relates to Year 2000 issues, inquiry to third-
party providers with whom the Company has material business relationships as to
their state of readiness for potential Year 2000 issues and the development of
contingency plans in the event material Year 2000 issues arise in Company or
third-party computer systems.  The Company estimates that as of November 30,
1998, it had completed approximately 60% of the initiatives that it believes
will be necessary to fully address potential Year 2000 issues relating to its
computer equipment and software.  The projects comprising the 60% of the
initiatives are in process and expected to be completed on or about June 30,
1999.  The Company anticipates that testing of additional systems and required
modifications or replacements will be completed by June 30, 1999.  As of
September 26, 1998, the Company has not expended any material amount to address
potential Year 2000 issues, exclusive of costs associated with previously
scheduled modifications, upgrades or replacements unrelated to Year 2000 issues.
Other non-Year 2000 information system efforts have not been materially delayed
or impacted by Year 2000 initiatives.  The Company does not anticipate spending
material amounts for additional testing, modification, upgrade and replacement
related to Year 2000 during fiscal year 1999.  Based on current and anticipated
operating needs, many of the Company's critical computer systems do not rely on
a two-digit year field as part of the process or are in the process of being
replaced with more technologically advanced versions.  Each new system being
installed has been reviewed for Year 2000 compliance.  The computer systems that
have been or are in the process of being replaced, include, but are not limited
to, the Company's accounting system, inventory control system, workstation and
network operating systems.  The remaining computer and imbedded systems,
including but not limited to, plant equipment, alarm systems, phone equipment
and general office equipment are currently being reviewed for Year 2000
compliance as part of the overall plan for testing and modification referenced
above.  The Company has determined that most products the Company sells in the
ordinary course of business do not have issues relating to Year 2000.  Software
products previously supplied by the Company, in some cases, may display an
incorrect date but will continue to function.  At their option, customers may
upgrade to newer versions of the Company's software to correct the date display.
Any Year 2000 issues in products sold by the Company that are manufactured by
another vendor will be referred to that vendor.

     In addition to reviewing its own computer systems, the Company has sent
letters to material third-party providers, including, but not limited to,
suppliers, product sponsors, financial institutions, service providers, and
other companies with which the Company has material business relationships in
order to assess these companies' state of Year 2000 readiness.  These letters
request, among other things, disclosure of the companies' plans for minimizing
the impact of the Year 2000 on their computer systems and the Company.  As of
November 30, 1998, the Company had received responses from approximately 30% of
such third parties, and 90% of the companies that have responded have provided
written assurances that they expect to address all their significant Year 2000
issues on a timely basis.  A follow-up mailing to significant vendors and
service providers that did not initially respond, or whose responses were deemed
unsatisfactory by the Company, has been completed, with responses due by
December 31, 1998.  To date, the Company has not received from any third-party
provider with which a material business relationship exists notice of a material
Year 2000 issue or inability to address material Year 2000 issues prior to the
Year 2000.  The Company is not in a position to verify whether third-party
service providers are or will become Year 2000 ready apart from such assurances
or until a Year 2000 issue arises.  The Company presently believes that the Year
2000 issue will not pose significant operational problems for the Company.
However, if all Year 2000 issues are not properly identified, or assessment,
remediation and testing are not effected timely with 

                                       29
<PAGE>
 
respect to Year 2000 problems that are identified, there can be no assurance
that the Year 2000 issue will not materially adversely affect the Company's
results of operations or adversely affect the Company's relationships with
customers, vendors, or others. Additionally, there can be no assurance that the
Year 2000 issues of other entities will not have a material adverse impact on
the Company's systems or results of operations. If the Company were to
experience a material disruption in its computer systems from Year 2000 issues,
the Company is prepared to conduct business, particularly the processing of
customer orders, utilizing manual processes and third party vendors and back-up
data routinely archived by the Company. The Company anticipates that the cost of
conducting business utilizing the Company's contingency plans would be higher
than conducting business utilizing current and anticipated operational plans.

ITEM 7A - QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK

     Not material.


ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

     See pages 31 through 44.

                                       30
<PAGE>
 
               Report of Ernst & Young LLP, Independent Auditors


Shareholders and Board of Directors
Seattle FilmWorks, Inc.

     We have audited the accompanying consolidated balance sheets of Seattle
FilmWorks, Inc. (the Company) as of September 26, 1998 and September 27, 1997,
and the related consolidated statements of income, shareholders' equity, and
cash flows for each of the three years in the period ended September 26, 1998.
Out audits also included the financial statement schedule listed in the Index at
Item 14(a).  These financial statements and schedule are the responsibility of
the Company's management.  Our responsibility is to express an opinion on these
financial statements and schedule based on our audits.

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

     In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the consolidated financial position of
Seattle FilmWorks, Inc. at September 26, 1998 and September 27, 1997, and the
results of its operations and its cash flows for each of the three years in the
period ended September 26, 1998, in conformity with generally accepted
accounting principles.  Also, in our opinion, the related financial statement
schedule, when considered in relation to the basic financial statements taken as
a whole, presents fairly in all material respects the information set forth
therein.


                                                     /s/ ERNST & YOUNG LLP
Seattle, Washington
November 6, 1998

                                       31
<PAGE>
 
                            SEATTLE FILMWORKS, INC.
                          CONSOLIDATED BALANCE SHEETS
                (in thousands, except per share and share data)

                                     ASSETS
<TABLE>
<CAPTION>
                                                                             SEPTEMBER 26,   SEPTEMBER 27,
                                                                                 1998            1997     
                                                                             -------------   -------------
<S>                                                                          <C>             <C>          
CURRENT ASSETS                                                                                            
 Cash and cash equivalents                                                         $11,780         $10,252
 Securities available-for-sale                                                       4,555           5,062
 Accounts receivable, net of allowance for doubtful accounts                                              
   of $208 and $240 in 1998 and 1997, respectively                                   1,914           3,680
 Inventories                                                                         7,561           8,998
 Capitalized promotional expenditures                                                  121             211
 Prepaid expenses and other                                                            831             743
 Deferred income taxes                                                                 387             313
                                                                                   -------         ------- 
   TOTAL CURRENT ASSETS                                                             27,149          29,259
                                                                                                          
FURNITURE, FIXTURES, AND EQUIPMENT,                                                                       
 at cost, less accumulated depreciation (Note D)                                    10,954           7,564
                                                                                                          
CAPITALIZED CUSTOMER ACQUISITION EXPENDITURES (Note B)                              16,800          13,882
                                                                                                          
DEPOSITS AND OTHER ASSETS                                                              213             285
                                                                                                          
NONCOMPETE AGREEMENT (Note C)                                                                          376
                                                                                   -------         ------- 
                                                                                                          
TOTAL ASSETS                                                                       $55,116         $51,366
                                                                                   =======         ======= 

                      LIABILITIES AND SHAREHOLDERS' EQUITY

CURRENT LIABILITIES
 Accounts payable                                                                  $ 2,359         $ 3,588        
 Current portion of capital lease obligation                                           174                       
 Accrued expenses                                                                    1,376           1,402       
 Accrued compensation                                                                1,570           1,931       
 Income taxes payable                                                                    7           2,450       
                                                                                   -------         -------       
   TOTAL CURRENT LIABILITIES                                                         5,486           9,371       
                                                                                                                 
LONG-TERM CAPITAL LEASE OBLIGATIONS, net of current portion (Note F)                   706       
                                                                                                                 
DEFERRED INCOME TAXES                                                                5,223           4,394       
                                                                                   -------         -------       
                                                                                                                 
TOTAL LIABILITIES                                                                   11,415          13,765       
                                                                                                                 
SHAREHOLDERS' EQUITY (Notes H and I)                                                                             
 Preferred Stock, $.01 par value, authorized 2,000,000 shares, none issued                                       
 Common Stock, $.01 par value, authorized 101,250,000 shares, issued and                                         
   outstanding 16,641,891 and 16,436,258 in 1998 and 1997, respectively                167             164       
 Additional paid-in capital                                                            981           2,459       
 Retained earnings                                                                  42,553          34,978       
                                                                                   -------         -------       
   TOTAL SHAREHOLDERS' EQUITY                                                       43,701          37,601       
                                                                                   -------         -------       
                                                                                                                 
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY                                         $55,116         $51,366       
                                                                                   =======         =======        
</TABLE>

See notes to consolidated financial statements.

                                       32
<PAGE>
 
                            SEATTLE FILMWORKS, INC.
                       CONSOLIDATED STATEMENTS OF INCOME
                (in thousands, except per share and share data)

<TABLE>
<CAPTION>
 
 
                                                       FISCAL YEARS ENDED
                                         ----------------------------------------------
                                         SEPTEMBER 26,   SEPTEMBER 27,   SEPTEMBER 28,
                                             1998            1997             1996
=======================================================================================
<S>                                      <C>             <C>             <C>
Net revenues                               $    96,716     $   101,189     $    84,152
 
Cost of goods and services                      56,023          58,624          49,159
                                           -----------     -----------     -----------
 
GROSS PROFIT                                    40,693          42,565          34,993
 
Operating expenses:
 Customer acquisition costs                     17,903          15,764          11,981
 Other selling expenses                          7,654           7,789           6,911
 Research and development                          588             696             732
 General and administrative                      4,361           3,503           3,460
                                           -----------     -----------     -----------
  Total operating expenses                      30,506          27,752          23,084
                                           -----------     -----------     -----------
 
INCOME FROM OPERATIONS                          10,187          14,813          11,909
 
Other income (expense):
 Interest income                                   731             561             449
 Nonoperating income (expense), net                209              13            (121)
                                           -----------     -----------     -----------
  Total other income                               940             574             328
                                           -----------     -----------     -----------
 
INCOME BEFORE INCOME TAXES                      11,127          15,387          12,237
 
Provision for income taxes (Note G)              3,552           5,242           4,220
                                           -----------     -----------     -----------
 
NET INCOME                                 $     7,575     $    10,145     $     8,017
                                           ===========     ===========     ===========
 
Diluted earnings per share                 $       .43     $       .57     $       .45
                                           ===========     ===========     ===========
Basic earnings per share                   $       .45     $       .62     $       .50
                                           ===========     ===========     ===========
 
Weighted average shares and
 equivalents outstanding - Diluted          17,474,000      17,770,000      17,726,000
                                           ===========     ===========     ===========
Weighted average shares - Basic             16,652,000      16,307,000      16,170,000
                                           ===========     ===========     ===========
 
</TABLE>
See notes to consolidated financial statements.

                                       33
<PAGE>
 
                            SEATTLE FILMWORKS, INC.
                CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
                       (in thousands, except share data)
<TABLE>
<CAPTION>
 
                                                  COMMON STOCK
                                              -------------------
                                                 SHARES       PAR     PAID-IN    RETAINED
                                              OUTSTANDING    VALUE    CAPITAL    EARNINGS    TOTAL
====================================================================================================
<S>                                           <C>            <C>      <C>        <C>        <C>
 
BALANCE AS OF SEPTEMBER 30, 1995               16,073,484    $ 160     $  954     $16,816   $17,930
 
 Stock options exercised                          155,902        2        350                   352
 Income tax benefit of stock options                                      424                   424
 Employee stock purchase plan                      20,172                 162                   162
 Purchase and retirement of Common Stock          (17,712)               (210)                 (210)
 Net income                                                                         8,017     8,017
                                               ----------    -----     ------     -------   ------- 
 
BALANCE AS OF SEPTEMBER 28, 1996               16,231,846      162      1,680      24,833    26,675
 
 Stock options exercised                          247,002        2        358                   360
 Income tax benefit of stock options                                      875                   875
 Employee stock purchase plan                      37,410        1        369                   370
 Purchase and retirement of Common Stock          (80,000)      (1)      (823)                 (824)
 Net income                                                                        10,145    10,145
                                               ----------    -----     ------     -------   ------- 
 
BALANCE AS OF SEPTEMBER 27, 1997               16,436,258      164      2,459      34,978    37,601
 
 Stock options exercised                        1,013,618       10        778                   788
 Income tax benefit of stock options                                    2,266                 2,266
 Employee stock purchase plan                      35,382        1        299                   300
 Purchase and retirement of Common Stock         (843,367)      (8)    (4,821)               (4,829)
 Net income                                                                         7,575     7,575
                                               ----------    -----     ------     -------   ------- 
 
BALANCE AS OF SEPTEMBER 26, 1998               16,641,891    $ 167     $  981     $42,553   $43,701
                                               ==========    =====     ======     =======   =======
</TABLE>
See notes to consolidated financial statements.

                                       34
<PAGE>
 
                            SEATTLE FILMWORKS, INC.
                     CONSOLIDATED STATEMENTS OF CASH FLOWS
                                 (in thousands)
<TABLE>
<CAPTION>
 
                                                                                    Fiscal Years Ended                 
                                                                    -------------------------------------------------  
                                                                    September 26,    September 27,     September 28,  
                                                                        1998             1997              1996       
=====================================================================================================================
<S>                                                                    <C>           <C>               <C>
OPERATING ACTIVITIES:
--------------------
 Net income                                                            $  7,575         $ 10,145         $  8,017
 Charges to income not affecting cash:
  Depreciation                                                            3,422            2,488            1,642
  Amortization of non-compete                                               375              376              376
  Amortization of capitalized customer
    acquisition expenditures                                             16,558           14,723           10,772
  Deferred income taxes                                                     755              790            1,379
 Net change in receivables, inventories,
    payables, and other                                                   1,302           (1,785)          (2,802)
 Capitalized promotional expenditures, net                                   90               27              (80)
 Additions to capitalized customer
  acquisition expenditures                                              (19,476)         (17,271)         (14,750)
                                                                       --------         --------         --------
 
NET CASH FROM OPERATING ACTIVITIES                                       10,601            9,493            4,554
 
INVESTING ACTIVITIES:
--------------------
 Purchase of furniture, fixtures, and equipment                          (5,750)          (4,779)          (4,067)
 Purchases of securities available-for-sale                              (4,898)          (9,642)          (7,409)
 Sales of securities available-for-sale                                   5,405            9,139            4,195
                                                                       --------         --------         --------
 
NET CASH USED IN INVESTING ACTIVITIES                                    (5,243)          (5,282)          (7,281)
 
FINANCING ACTIVITIES:
--------------------
 Proceeds from issuance of Common Stock                                   1,088              730              512
 Payment on purchase of Common Stock                                     (4,829)            (824)            (210)
 Payment on capital lease obligations                                       (89)
                                                                       --------
NET CASH FROM (USED IN) FINANCING ACTIVITIES                             (3,830)             (94)             302
                                                                       --------         --------         --------
 
INCREASE (DECREASE) IN CASH AND
 CASH EQUIVALENTS                                                         1,528            4,117           (2,425)
 
Cash and cash equivalents
 at beginning of year                                                    10,252            6,135            8,560
                                                                       --------         --------         --------
 
CASH AND CASH EQUIVALENTS
 AT END OF YEAR                                                        $ 11,780         $ 10,252         $  6,135
                                                                       ========         ========         ========
 
Supplemental cash flow information:
----------------------------------
 Cash paid for interest                                                $     26
 Cash paid for income taxes                                            $  3,315         $  2,095         $  2,300
 
Supplemental non-cash financing and investing activity:
------------------------------------------------------
 Capital lease obligation incurred                                     $    969                                     
</TABLE>

See notes to consolidated financial statements.

                                       35
<PAGE>
 
                            SEATTLE FILMWORKS, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


NOTE  A --  OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

SEATTLE FILMWORKS, INC. and subsidiaries (the "Company") is a leading direct-to-
consumer marketer and provider of high-quality amateur traditional
photofinishing and digital imaging services and products. The Company offers an
array of complementary services and products, primarily on a mail-order basis,
under the brand name SeattleFilmWorks(R). To a lesser extent, the Company
provides services, products, and photofinishing supplies on a wholesale basis to
a variety of commercial customers.

PRINCIPLES OF CONSOLIDATION:  The consolidated financial statements include
Seattle FilmWorks, Inc. and its subsidiaries, all of which are wholly-owned.
Significant inter-company accounts and transactions have been eliminated in
consolidation.

CASH AND CASH EQUIVALENTS:  Cash and cash equivalents include cash on hand and
highly liquid short-term investments with a maturity of three months or less on
the date of purchase.

SECURITIES AVAILABLE-FOR-SALE: Securities available-for-sale consist primarily
of bankers' acceptances, commercial paper, and government securities issued by
financial institutions with high credit ratings; all of which mature no later
than November 1999.  Company policy limits the amount of credit exposure with
any one financial institution.  The fiscal 1998 and fiscal 1997 balance
consisted primarily of government securities.  Securities available-for-sale are
carried at amortized cost, which approximates market.

OTHER FINANCIAL INSTRUMENTS:  At September 26, 1998, the carrying value of
financial instruments such as trade receivables and payables, approximate their
fair values, based on the short-term maturities of these instruments.

ACCOUNTS RECEIVABLE:  Accounts receivable primarily include amounts due from
mail-order customers from the sale of related photographic products and amounts
due from wholesale customers from the sale of film and single-use cameras.  An
allowance for doubtful accounts is established for an estimate of bad debts.

INVENTORIES:  Inventories are stated at the lower of cost (using the first-in,
first-out method) or market.  Inventories consist primarily of film and
photofinishing supplies.

CAPITALIZED PROMOTIONAL EXPENDITURES:  The Company's promotional programs run
for periods of one to six months. Promotional expenditures primarily consist of
advertising and media costs related to generating consumer interest in the
Company's photofinishing services.  The Company capitalizes these costs as
capitalized promotional expenditures and expenses them the first time the
promotion is run.  Advertising expense was $3,610,000, $3,582,000, and
$2,989,000 in fiscal years 1998, 1997, and 1996, respectively.

DEPRECIATION:  Furniture, fixtures, and equipment are depreciated using the
straight-line and accelerated methods based on the estimated useful asset lives
ranging from three to five years.  Expenditures for major remodeling and
improvements are capitalized as leasehold improvements.  Leasehold improvements
are depreciated over the shorter of the life of the lease or the life of the
asset.

INCOME TAXES:  The provision for federal income taxes is computed based on
pretax income reported in the consolidated financial statements.  Research and
development tax credits are recorded as a reduction of the provision for federal
income taxes in the year realized.  The provision for income taxes differs from
income taxes currently payable because certain items of income and expense are
recognized in different periods for financial reporting purposes than they are
for federal income tax purposes.  Deferred income taxes have been recorded in
recognition of these temporary differences.

                                       36
<PAGE>
 
                            SEATTLE FILMWORKS, INC.
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


NOTE  A --  OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(CONTINUED)

EARNINGS PER SHARE:  Earnings per share is based on the weighted average number
of shares and dilutive Common Stock equivalents outstanding during the fiscal
year. Common Stock equivalents consist of stock options.  The dilutive effect of
stock options is excluded from the calculation of basic earnings per share, but
included in the computation of diluted earnings per share.

STOCK-BASED COMPENSATION:  The Company has adopted the disclosure-only
provisions of Statement of Financial Accounting Standards No. 123, "Accounting
for Stock-Based Compensation" and applies Accounting Principles Board Opinion No
25 (APB 25) and related Interpretations in accounting for its stock option
plans.  Accordingly, the Company's stock-based compensation expense is
recognized based on the intrinsic value of the option on the date of grant.  Pro
forma disclosure of diluted earnings per share under Statement 123 is provided
in Note H to the consolidated financial statements.

REVENUE RECOGNITION:  The Company recognizes revenue when products are shipped
or services are delivered.

SEGMENT REPORTING:  In June 1997, the Financial Accounting Standards Board
issued Statement of Financial Accounting Standards (SFAS) No. 131, "Disclosure
about Segments of an Enterprise and Related Information."  SFAS No. 131, which
is effective for years beginning after December 15, 1997, establishes standards
for the way that public business enterprises report information about operating
segments in published financial reports.  The Company will adopt the new
requirements in fiscal 1999.  Management has not yet determined the manner in
which it will present the information required by SFAS No. 131.

USE OF ESTIMATES:  The preparation of financial statements in conformity with
generally accepted accounting principles requires management to make estimates
and assumptions that affect the amounts reported in the consolidated financial
statements and accompanying notes.  Actual results could differ from those
estimates.

RECLASSIFICATIONS:  Certain prior year balances have been reclassified to
conform to the current year's presentation.

NOTE  B --  CUSTOMER AQUISITION EXPENDITURES

     The Company's principal technique for acquiring new customers is its
Introductory Offer of two rolls of 35mm film for $2.00 or less.  Customer
acquisition costs are comprised of the costs of generating a lead and the
amortization of direct costs associated with the Company's promotional offers
sent to prospective and existing customers.  The costs of generating a lead,
which are expensed when the promotion is run, include all direct-response media,
advertising, and other costs associated with developing target customer lists.
The direct costs of customer acquisition include film, postage, and printed
material costs associated with mailings to prospective and existing customers.
The direct costs of customer acquisition were capitalized as an asset on the
Company's consolidated balance sheet under "capitalized customer acquisition
expenditures."

                                       37
<PAGE>
 
                            SEATTLE FILMWORKS, INC.
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


NOTE  B -- CUSTOMER AQUISITION EXPENDITURES (CONTINUED)

     During the fourth quarter of fiscal 1998, the overall performance of the
customer acquisition programs showed a decline.  Upon completing the quarterly
review of the recoverability of the capitalized costs as of September 26, 1998,
management concluded lower response rates to customer acquisition programs
required an adjustment to the amount of capitalized costs associated with those
programs.  Accordingly, the Company reduced the capitalized customer acquisition
cost asset by $613,000 to its net realizable value.  In accounting for customer
acquisition costs, the Company follows the American Institute of Certified
Public Accountants Statement of Position 93-7, Reporting on Advertising Costs
(SOP 93-7).  Previously, the Company capitalized and then amortized customer
acquisition costs so that the expenses resulting from the amortization of these
costs would match the period in which associated estimated revenue would be
received with respect to those marketing efforts.  However, as a result of
recent trends in customer responses, the Company's marketing plans, and Internet
and retail distribution strategies, management believes that the net profit
margin on identifiable responses will be insufficient to justify deferral of
such future costs.  Effective in the first quarter of fiscal 1999, the Company
will expense customer acquisition costs as incurred and will amortize the
remaining $16,800,000 of capitalized customer acquisition costs over a twelve-
month period on a straight-line basis.


NOTE  C --  ACQUISITION OF PRIVATE LABEL FILM BUSINESS

     On December 30, 1993, the Company acquired certain assets of Private Label
Film, Inc. for approximately $1,637,000.  The assets relate to the manufacture
and sale of private-label film and related products to retailers and commercial
users. This acquisition has been accounted for using the purchase method. The
purchase price was recorded as follows: equipment $100,000; and other assets of
$1,536,830 related to non-compete agreements, which includes capitalized legal
and accounting expenses. The non-compete agreement was amortized as other
selling expenses on a straight-line basis over five years and has been fully
amortized at September 26, 1998.

NOTE  D --  FURNITURE, FIXTURES, AND EQUIPMENT

Furniture, fixtures, and equipment, at cost consist of the following:

<TABLE>
<CAPTION>
 
 
                                                    SEPTEMBER 26,    SEPTEMBER 27,
                                                         1998             1997
===================================================================================
                                                            (in thousands)
<S>                                                      <C>              <C>
Furniture, fixtures, and equipment                       $ 20,437         $ 15,389
Equipment under capital lease                                 969
Leasehold improvements                                      3,176            2,949
                                                         --------         --------
                                                           24,582           18,338
Less accumulated depreciation and amortization            (13,628)         (10,774)
                                                         --------         --------
 
                                                         $ 10,954         $  7,564
                                                         ========         ========
</TABLE>

                                       38
<PAGE>
 
                            SEATTLE FILMWORKS, INC.
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


NOTE  E --  CREDIT AGREEMENT

     At September 26, 1998, the Company had a $6,000,000 available line of
credit. At the option of the Company, the interest rate on borrowings under the
agreement may be at the lending bank's prime rate or at a rate of 0.75% above
the London Interbank Offered Rate. There were no borrowings outstanding at the
end of fiscal 1998 or fiscal 1997 under the line of credit.


NOTE  F --  PROPERTY AND LEASES

     The Company's primary operating leases relate to its main operating
facilities.  These two leases, one for 60,000 square feet and one for 46,000
square feet, expire in September  2005 and 2000, respectively.  Both leases have
five-year options to extend through September 2010.  The Company has a lease
agreement for additional warehouse and production space, which expires in
January 1999 with an option to extend the lease for two one-year periods.  The
Company also has various operating leases for its retail stores, with lease
terms generally ranging from three to five years.  During fiscal 1998, the
Company entered into a five-year capital lease transaction to finance the
purchase of certain equipment.  At September 26, 1998, future minimum payments
under capital leases and non-cancelable operating leases are as follows:

<TABLE>
<CAPTION>
 
                                                 CAPITAL    OPERATING
                                                  LEASE      LEASES
=====================================================================
                                                    (in thousands)
<S>                                              <C>        <C>
 
Fiscal 1999                                       $  227       $1,149
Fiscal 2000                                          227          993
Fiscal 2001                                          227          586
Fiscal 2002                                          227          430
Fiscal 2003                                          111          400
Thereafter                                                        774
                                                  ------       ------
                                                   1,019       $4,332
                                                               ======
Amounts representing interest                       (139)
                                                  ------
Present value of net minimum lease payments
  (including current portion of $174)             $  880
                                                  ======
</TABLE>

     Rental expense relating to operating leases for fiscal years 1998, 1997,
and 1996 was $1,119,000, $792,000, and $481,000, respectively.  Interest expense
relating to the capital lease was $26,000 for fiscal year 1998.
 
NOTE  G --  INCOME TAXES

 
The provision for income taxes is as follows (in thousands):

<TABLE> 
<CAPTION> 
                                                                    1998     1997     1996
==========================================================================================
<S>                                                               <C>      <C>      <C>   
Provision for income taxes:
     Current                                                      $2,797   $4,452   $2,841
     Deferred                                                        755      790    1,379
                                                                  ------   ------   ------
                                                                  $3,552   $5,242   $4,220
                                                                  ======   ======   ======
</TABLE>

                                       39
<PAGE>
 
                            SEATTLE FILMWORKS, INC.
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

 
NOTE  G --  INCOME TAXES (CONTINUED)
 
A reconciliation of the federal statutory tax rates to the effective tax rates
is as follows:

<TABLE> 
<CAPTION> 
 
                                                   1998        1997      1996
================================================================================
<S>                                               <C>         <C>        <C>                                             
Statutory tax rate                                34.0%       35.0%      35.0%                                           
Research and development tax credits               (.4)        (.3)       (.1)                                           
Tax exempt interest                                (.8)        (.5)       (.1)                                           
Other, net                                         (.9)        (.1)       (.3)                                           
                                                  ----        ----       ----                                            
                                                  31.9%       34.1%      34.5%                                           
                                                  ====        ====       ====                                            
</TABLE>

Principal items comprising the cumulative deferred income taxes are as follows:

<TABLE>
<CAPTION>
 
                                                    1998         1997  
                                                   ======       ====== 
<S>                                                <C>          <C>    
                                                                       
Deferred tax liabilities:                                              
 Customer acquisition expenditures                 $5,880       $4,859 
 Other liabilities                                    190          300 
                                                   ------       ------ 
Total deferred tax liabilities                      6,070        5,159 
                                                                       
Deferred tax assets:                                                   
 Accrued expenses                                     577          342 
 Non-compete agreement                                368          272 
 Depreciation and amortization                        289          464 
                                                   ------       ------ 
Total deferred tax assets                           1,234        1,078 
                                                   ------       ------ 
                                                                       
Net deferred tax liabilities                       $4,836       $4,081 
                                                   ======       ======  
</TABLE>

NOTE  H --  STOCK-BASED COMPENSATION

STOCK OPTIONS

     Pursuant to the Company's Stock Option Plans adopted in 1982 and 1987,
options may be granted to purchase up to 6,904,688 shares of Common Stock at
prices equal to the fair market value of the shares at the time the options are
granted.  Options generally vest over four years and become exercisable
commencing one year after the date of grant and expiring five years after the
date of grant.

                                       40
<PAGE>
 
                            SEATTLE FILMWORKS, INC.
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


NOTE  H --  STOCK-BASED COMPENSATION (CONTINUED)

     The following schedule summarizes stock option activity for fiscal years
1996, 1997, and 1998.

<TABLE>
<CAPTION>
 
                                       NUMBER                PRICE PER          WEIGHTED AVERAGE
                                      OF SHARES                SHARE             EXERCISE PRICE
================================================================================================
<S>                                  <C>                 <C>                     <C>
  Balance at September 30, 1995       1,947,932          $ 0.19 -   $ 9.44             $ 1.72
    Granted during 1996                 213,075          $ 8.55 -   $13.67             $11.37
    Canceled during 1996                (28,886)         $ 2.07 -   $ 9.44             $ 4.68
    Exercised during 1996              (155,902)         $ 0.19 -   $ 6.78             $ 2.24
                                     ----------          
                                                         
  Balance at September 28, 1996       1,976,219          $ 0.21 -   $13.67             $ 2.67
    Granted during 1997                 194,100          $ 9.63 -   $14.67             $12.04
    Canceled during 1997                (25,679)         $ 2.07 -   $14.67             $ 5.48
    Exercised during 1997              (247,002)         $ 0.21 -   $11.72             $ 1.45
                                     ----------
 
  Balance at September 27, 1997       1,897,638          $0.21 - $14.67                $ 3.75
    Granted during 1998                 206,650          $3.75 - $11.31                $ 8.96
    Canceled during 1998                (29,677)         $2.67 - $14.67                $11.23
    Exercised during 1998            (1,013,618)         $0.21 - $ 4.96                $ 0.78
                                     ----------
 
  Balance at September 26, 1998       1,060,993          $0.21 - $14.67                $ 7.41
                                     ==========
</TABLE>

          The following schedule summarizes the weighted-average remaining
contractual life and weighted-average exercise price of options outstanding and
options exercisable as of September 26, 1998.

<TABLE>
<CAPTION>
 
                                OPTIONS OUTSTANDING                    OPTIONS EXERCISABLE
                             --------------------------                -------------------
                                             REMAINING
RANGE OF                       OPTIONS     CONTRACTUAL    EXERCISE     OPTIONS     EXERCISE
EXERCISE PRICES              OUTSTANDING   LIFE (YEARS)    PRICE     EXERCISABLE    PRICE
---------------              -----------   -----------    --------   -----------   --------
<S>                          <C>           <C>            <C>        <C>           <C>  
$ 0.21 - $ 2.00                151,212         1.7        $ 0.92       151,212      $ 0.92          
$ 2.01 - $ 5.00                210,264         3.2        $ 3.79       192,554      $ 3.71          
$ 5.01 - $10.00                338,968         4.1        $ 7.90       161,432      $ 6.89          
$10.01 - $14.67                360,549         3.9        $11.79       197,019      $11.77          
                             ---------                               ---------      
                             1,060,993         2.3        $ 7.41       702,217      $ 6.10
                            ==========                               =========
</TABLE>

     Options considered fully vested as of September 26, 1998, September 27,
1997 and September 28, 1996 were 702,217, 1,553,053 and 1,562,568, respectively,
at weighted average exercise prices of $6.10, $2.31 and $1.60, respectively.
Shares of Common Stock reserved for issuance under these stock option plans
totaled 1,269,514 at September 26, 1998, of which 208,521 shares were available
for options to be granted in the future.

    The per share weighted-average fair value of stock options granted during
fiscal years 1998, 1997 and 1996 was $.26, $5.90, and $5.49, respectively.

                                       41
<PAGE>
 
                            SEATTLE FILMWORKS, INC.
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


NOTE  H --  STOCK-BASED COMPENSATION (CONTINUED)

     Pro forma information regarding net income and diluted earnings per share
required by Statement No. 123 has been determined as if the Company had
accounted for its employee stock options under the fair value method of that
Statement.  The fair value for the options was estimated at the date of grant
using a Black-Scholes option pricing model with the following weighted-average
assumptions on the option grant date:  Risk free interest rate of 5.59% for
fiscal year 1998, 6.39% for fiscal year 1997, and 5.74% for fiscal year 1996,
expected volatility of 58.27% for fiscal year 1998 and 46.75% for fiscal years
1997 and 1996, expected option life of 4.47 years for fiscal year 1998 and 4.99
for fiscal years 1997 and 1996, and a dividend yield of 0.0%.

     Under Statement No. 123, if the Company had elected to recognize the
compensation cost based upon the fair value of the options granted at grant
date, net income would have been reduced as follows:

<TABLE>
<CAPTION>
 
                                                                 SEPTEMBER 26,   SEPTEMBER 27,   SEPTEMBER 28,
                                                                     1998            1997            1996
                                                                 ---------------------------------------------
                                                                    (in thousands, except per share data)
<S>                                                             <C>             <C>             <C>
Net income:
  As reported................................................          $7,575         $10,145          $8,017
  Pro forma..................................................          $7,034         $ 9,687          $7,706
Diluted earnings per share:
  As reported................................................          $  .43         $   .57          $  .45
  Pro forma..................................................          $  .40         $   .54          $  .43
</TABLE>

    The pro forma effects on net income for fiscal year 1998, 1997 and 1996 are
not indicative of pro forma effects in future years because SFAS No. 123 does
not apply to grants prior to fiscal 1996 and additional grants in future years
are anticipated.

          In September 1998, the Board of Directors passed a resolution to allow
employees the opportunity to surrender previously granted options in exchange
for a new option grant at current market prices.  Employees would be granted
options for two shares of common stock in exchange for the surrender of options
for three shares of common stock.   All vesting periods would start at the new
grant date at the rate of 25% for each year employed after the new grant date.
The new grant date was October 9, 1998, with a grant price of $3.125.  Total old
options surrendered and canceled were 217,150.  Total new options issued on
October 9, 1998 were 144,765.  Executive officers and non-employee directors
were not eligible to participate in this option exchange.

EMPLOYEE STOCK PURCHASE PLAN

     Effective September 22, 1993, the Company adopted an Employee Stock
Purchase Plan under which substantially all employees have the option to
purchase 506,250 shares of Common Stock.  Under the Plan, eligible employees may
purchase shares of the Company's Common Stock at six-month intervals at 85% of
the fair market value on the first or last day of the six-month offering period,
whichever is lower.  Employees may purchase shares having a value not exceeding
10% of their gross compensation during the purchase period.  During fiscal 1998
and 1997, shares totaling 35,382 and 37,410 were issued under the Plan at an
average price of $8.47 and $9.89 per share, respectively.  At September 26,
1998, 231,492 shares were reserved for future issuance.

                                       42
<PAGE>
 
                            SEATTLE FILMWORKS, INC.
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


NOTE  I --  SHAREHOLDERS' EQUITY

STOCK SPLITS

     All share data, per share data, and related accounts in the accompanying
consolidated financial statements and these notes reflect a retroactive
adjustment for a three-for-two stock split effective March 15, 1996, and a
three-for-two stock split effective March 17, 1997.

SHARE REPURCHASES

     In January 1997, the Board of Directors authorized the repurchase of the
Company's Common Stock, either through open market purchases at prevailing
market prices, through block purchases or in privately negotiated transactions.
Repurchases may be commenced or discontinued at any time.  Although the number
of shares to be repurchased is uncertain, any repurchased shares will to some
degree offset the dilutive effect on earnings per share of shares of Common
Stock issued under the Company's stock option and stock purchase plans.

     During fiscal year 1998, the Company had purchased a total of 843,367
shares for a total of $4,829,000.  In addition, in October 1998, the Company
purchased a total of 466,000 shares for a total of $1,493,000.

NOTE  J  --  EARNINGS PER SHARE

     The Company calculates earnings per share in accordance with the Financial
Accounting Standards Board Statement of Financial Accounting Standards No. 128,
"Earnings per Share".  Statement No. 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.  Diluted earnings per share is similar to the
previously reported primary earnings per share.  All earnings per share amounts
for all prior periods presented have been restated to conform to Statement No.
128 requirements.

     The following table sets forth the computation of basic and diluted
earnings per share:

<TABLE>
<CAPTION>
 
                                                         SEPTEMBER 26, 1998   SEPTEMBER 27, 1997   SEPTEMBER 26, 1996
=====================================================================================================================
<S>                                                      <C>                  <C>                  <C>
Numerator for basic and diluted earnings per share:
   Net income                                                   $ 7,575,000          $10,145,000          $ 8,017,000
                                                                ===========          ===========          ===========
 
Denominator:
   Denominator for basic earnings per share -
      weighted-average shares                                    16,652,000           16,307,000           16,170,000
 
   Effect of dilutive securities:
      Stock options                                                 822,000            1,463,000            1,556,000
                                                                -----------          -----------          -----------
 
   Denominator for diluted earnings per share                    17,474,000           17,770,000           17,726,000
                                                                ===========          ===========          ===========
 
Basic earnings per share                                        $       .45          $       .62          $       .50
                                                                ===========          ===========          ===========
Diluted earnings per share                                      $       .43          $       .57          $       .45
                                                                ===========          ===========          ===========
</TABLE>

                                       43
<PAGE>
 
                            SEATTLE FILMWORKS, INC.
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


NOTE  K --  RETIREMENT AND PROFIT SHARING PLAN

     The Company maintains a 401(k) Plan for substantially all employees.  The
Company's contributions are based on matching a percentage of up to 2% of
voluntary employee contributions and discretionary profit sharing contribution
determined by the Board of Directors.  The Company's contributions were
$377,000, $547,000, and $488,000 for  fiscal years 1998, 1997, and 1996,
respectively.

NOTE L  --  CONTINGENCIES

     The Company is a defendant in a legal proceeding filed by Fuji Photo Film
Co., Ltd. ("Fuji") with the International Trade Commission ("ITC") on February
13, 1998.  The action was filed against a number of importers, including the
Company's OptiColor, Inc. subsidiary, alleging patent infringement of U.S.
patents on single use cameras through the importation and resale into the U.S.
of recycled cameras.  Fuji is seeking an order prohibiting importation of the
alleged infringing cameras into the U.S. and prohibiting further sales of such
products which have been imported. Sales of recycled cameras accounted for 3.8%
of the Company's net revenues during fiscal 1998. An evidentiary hearing before
an ITC Administrative Law Judge ("ALJ") was held in November, 1998 and the ALJ
is expected to issue an initial decision in February, 1999. Such decision is
subject to review by the ITC Commissioners, who would then issue a final
decision, most likely in May, 1999. That decision would be subject to appeal to
the Federal Circuit Court of Appeals. In addition, the Company is involved in
various routine legal proceedings incident to the ordinary course of its
business.

NOTE  M  --  SELECTED QUARTERLY FINANCIAL DATA (Unaudited)

     The following table sets forth summary financial data for the Company by
quarter for fiscal years 1998 and 1997 (in thousands, except per share data).

<TABLE>
<CAPTION>
                                                          QUARTERS
                                      -----------------------------------------------
                                       FIRST        SECOND        THIRD        FOURTH
-------------------------------------------------------------------------------------
<S>                                    <C>        <C>        <C>        <C>       
Fiscal 1998
-----------
     Net revenue                      $22,471       $21,439      $24,928      $27,878       
     Gross profit                       9,499         9,031       10,635       11,528       
     Net income                         1,558         1,177        2,241        2,599       
     Diluted earnings per share           .09           .07          .13          .15       
     Basic earnings per share             .09           .07          .13          .15       
 
Fiscal 1997
-----------
     Net revenue                      $21,236       $21,657      $25,553      $32,743  
     Gross profit                       8,254         8,895       11,576       13,840    
     Net income                         1,357         1,146        2,792        4,850
     Diluted earnings per share*          .08           .06          .16          .27
     Basic earnings per share*            .08           .07          .17          .30 
</TABLE>

   *    The 1997 earnings per share amounts have been restated to comply with
Statement of Financial Accounting Standards No. 128, Earnings per share.

     The sum of quarterly diluted earnings per share will not necessarily equal
the diluted earnings per share reported for the entire year since the weighted
average shares outstanding used in the diluted earnings per share computation
changes throughout the year.  All diluted earnings per share data presented
above have been adjusted to reflect stock splits.  See Note J.

                                       44
<PAGE>
 
ITEM 9 - CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE

     None.

                                    PART III

ITEM 10 -- DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

     See "Directors and Executive Officers of the Registrant" under Item 1 -
Part I above.

     Information concerning compliance with Section 16 of the Securities
Exchange Act is incorporated herein by reference to information appearing in the
Company's Proxy Statement for its annual meeting of shareholders to be held on
February 9, 1999, which information appears under the caption "Section 16(a)
Beneficial Ownership Reporting Compliance".  Such Proxy Statement will be filed
within 120 days of the Company's last fiscal year-end, September 26, 1998.


ITEMS 11, 12, AND 13

     The information called for by Part III (Items 11, 12, and 13) is included
in the Company's Proxy Statement relating to the Company's annual meeting of
shareholders to be held on February 9, 1999, and is incorporated herein by
reference.  The information appears in the Proxy Statement under the captions
"Election of Directors", and "Remuneration of Executive Officers," "Voting
Securities and Principal Holders," "Compensation Committee Report on Executive
Compensation" and "Stock Price Performance Graph".  Such Proxy Statement will be
filed within 120 days of the Company's last fiscal year-end, September 26, 1998.


                                    PART IV

ITEM 14 -- EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K

a. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND CONSOLIDATED FINANCIAL
   ---------------------------------------------------------------------
   STATEMENT SCHEDULES
   -------------------

<TABLE> 
<CAPTION> 

(1)  Consolidated Financial Statements                                                Page
     ---------------------------------                                                ----
<S>                                                                                   <C>                           
     Report of Ernst & Young LLP, Independent Auditors                                  31
 
     Consolidated Balance Sheets as of September 26, 1998 and September 27, 1997        32
 
     Consolidated Statements of Income for the years ended September 26, 1998,
     September 27, 1997, and September 28, 1996                                         33
 
     Consolidated Statements of Shareholders' Equity for the years ended
     September 26, 1998, September 27, 1997, and September 28, 1996                     34
 
     Consolidated Statements of Cash Flows for the years ended September 26, 1998,
     September 27, 1997, and September 28, 1996                                         35
 
     Notes to Consolidated Financial Statements                                      36-44
</TABLE> 

                                       45
<PAGE>
 
     Supplemental Consolidated Financial Statement Schedule.  The following
additional information should be read in conjunction with the Consolidated
Financial Statements of the Company included in Part II, Item 8.


  (2)  Schedule                                             Page
       --------                                             ----

     II - Valuation and Qualifying Accounts                 50

     All other schedules have been omitted because the required information is
included in the consolidated financial statements or the notes thereto, or is
not applicable or required.

b. REPORTS ON FORM 8-K
   -------------------

     None.

c. EXHIBITS
   --------

     The following list is a subset of the exhibits set forth below and contains
all compensatory plans, contracts, or arrangements in which any director or
executive officer of the Company is a participant, unless the method of
allocation of benefits thereunder is the same for management and non-management
participants:

     (1)  The Company's Incentive Stock Option Plan, as amended and restated as
          of April 1, 1996. See Exhibit 10.5
 
     (2)  The Company's 1987 Stock Option Plan, as amended and restated as of
          April 1, 1996. See Exhibit 10.7
 
Exhibit
Number     Exhibit Description
------     -------------------

3.1        Articles of Incorporation of the Company, as amended through February
           23, 1989. (Incorporated by reference to Exhibit 3.1 filed with the
           Company's Annual Report on Form 10-K for the year ended September 30,
           1989.)

3.2        Bylaws of the Company, as amended and restated on November 13,
           1996. (Incorporated by reference to Exhibit 3.2 filed with the
           Company's 1996.) Annual Report on Form 10-K for the year ended
           September 28,

3.3        Articles of Amendment to Articles of Incorporation dated March 2,
           1994. (Incorporated by reference to Exhibit 3.4 filed with the
           Company's Annual Report on Form 10-K for the year ended September 24,
           1994.)

3.4        Articles of Amendment to Articles of Incorporation dated February 16,
           1995. (Incorporated by reference to Exhibit 3.4 filed with the
           Company's Annual Report on Form 10-Q for the year ended March 25,
           1995.)

3.5        Second Restated Articles of Incorporation of Seattle FilmWorks, Inc.
           dated March 5, 1996. (Incorporated by reference to Exhibit 3.0 filed
           with the Company's Quarterly Report on Form 10-Q for the quarter
           ended March 30, 1996.)

                                       46
<PAGE>
 
3.6       Articles of Amendment to Articles of Incorporation dated February 13,
          1997. (Incorporated by reference to Exhibit 3.0 filed with the
          Company's Quarterly Report on Form 10-Q for the quarter ended March
          29, 1997.)

10.1      Lease Agreement dated September 10, 1985 between Gilbert Scherer and
          Marlyn Friedlander, Lessors, and the Company with respect to certain
          office and plant facilities in Seattle, Washington. (Incorporated by
          reference to the exhibit with a corresponding number filed with the
          Company's registration statement on Form S-1 (file no. 33-4388.)

10.2      First Amendment to Facility Lease Agreement dated April 29, 1989, with
          Gilbert Scherer and Marlyn Friedlander, Lessors. (Incorporated by
          reference to Exhibit 10.48 filed with the Company's Annual Report on
          Form 10-K for the year ended September 30, 1989.)

10.3      Second Amendment to Facility Lease Agreement dated November 2, 1998,
          with Gilbert Scherer and Marlyn Friedlander, Lessors.

10.4      Consent to Sublease dated September 30, 1996, between Gilbert Scherer
          and Marlyn Friedlander and Seattle FilmWorks, Inc. (Incorporated by
          reference to Exhibit 10.3 filed with the Company's Annual Report on
          Form 10-K for the year ended September 28, 1996.)

10.5      Incentive Stock Option Plan, as amended and restated as of April 1,
          1996. (Incorporated by reference to Exhibit 10.1 filed with the
          Company's Quarterly Report on Form 10-Q for the quarter ended June 29,
          1996.)

10.6      Form of Incentive Stock Option Agreement. (Incorporated by reference
          to Exhibit 10.2 filed with the Company's Registration Statement on
          Form S-8, file no. 33-24107.)

10.7      1987 Stock Option Plan, as amended and restated as of April 1, 1996.
          (Incorporated by reference to Exhibit 10.2 filed with the Company's
          Quarterly Report on Form 10-Q for the quarter ended June 29, 1996.)

10.8      Form of Stock Option Agreement. (Incorporated by reference to Exhibit
          10.4 filed with the Company's Registration Statement on Form S-8, file
          no. 33-24107.)

10.9      1993 Employee Stock Purchase Plan as amended and restated as of May
          31, 1995. (Incorporated by reference to Exhibit 10.58 filed with the
          Company's Annual Report on Form 10-K for the year ended September 30,
          1995.)

10.10     Purchase and Sale Agreement dated as of December 16, 1993 and related
          Amendment to Purchase and Sale Agreement dated December 30, 1993 among
          Seattle FilmWorks, Inc., Private Label Film, Inc. and certain
          shareholders of Private Label Film, Inc. (Incorporated by reference to
          Exhibits 2.1 and 2.2 filed with the Company's Report on Form 10-Q
          dated February 7, 1994.)

10.11     Business Loan Agreement with First Interstate Bank of Washington N.A.
          as amended and restated on March 31, 1994. (Incorporated by reference
          to Exhibit 10.60 filed with the Company's Annual Report on Form 10-K
          for the year ended September 24, 1994.)

                                       47
<PAGE>
 
10.12     Business Loan Agreement with First Interstate Bank of Washington N.A.
          as amended and restated on February 28, 1995. (Incorporated by
          reference to Exhibit 10.0 filed with the Company's Quarterly Report on
          Form 10-Q for the quarter ended March 25, 1995.)

10.13     Business Loan Agreement with First Interstate Bank of Washington N.A.
          as amended and restated on January 31, 1996. (Incorporated by
          reference to Exhibit 10.1 filed with the Company's Quarterly Report on
          Form 10-Q for the quarter ended March 30, 1996.)

10.14     Business Loan Agreement with Wells Fargo Bank, National Association as
          amended and restated on December 13, 1996. (Incorporated by reference
          to Exhibit 10.13 filed with the Company's Annual Report on Form 10-K
          for the year ended September 28, 1996.)

10.15     Credit Agreement with Wells Fargo Bank, National Association as of
          March 1, 1997. (Incorporated by reference to Exhibit 10.1 filed with
          the Company's Quarterly Report on Form 10-Q for the quarter ended June
          28, 1997.)
 
10.16     First Amendment to Credit Agreement with Wells Fargo Bank, National
          Association as of February 24, 1998 (Incorporated by reference to
          Exhibit 10.1 filed with the Company's Quarterly Report on Form 10-Q
          for the quarter ended June 27, 1998.)

10.17     Stock Redemption Agreement dated July 20,1994 between the Company and
          Sam Rubinstein and related promissory note. (Incorporated by reference
          to Exhibits 5.1 and 5.2 filed with the Company's Report on Form 8-K
          dated July 22, 1994.)

10.18     Lease Agreement dated September 22, 1995 between the United States of
          America, Lessors, and the Company with respect to certain plant and
          warehouse facilities in Seattle, Washington. (Incorporated by
          reference to Exhibit 10.63 filed with the Company's Annual Report on
          Form 10-K for the year ended September 30, 1995.)
 
10.19     Addendum to Lease Agreement dated January 1, 1996 between the United
          States of America, Lessors, and the Company. (Incorporated by
          reference to Exhibit 10.3 filed with the Company's Quarterly Report on
          Form 10-Q for the quarter ended March 30, 1996.)
 
10.20     Supplemental Lease Agreement dated October 21, 1996 between the United
          States of America, Lessors, and the Company. (Incorporated by
          reference to Exhibit 10.17 filed with the Company's Annual Report on
          Form 10-K for the year ended September 28, 1996.)

10.21     Lease agreement dated March 4, 1997 between Smith Cove Partnership and
          the Company. (Incorporated by reference to Exhibit 10.3 filed with the
          Company's Quarterly Report on Form 10-Q for the quarter ended March
          29, 1997.)
 
10.22*    Sales contract dated August 18, 1995 between the Company and Agfa
          Division of Miles, Inc. with respect to the purchase of certain
          products. (Incorporated by reference to Exhibit 10.64 filed with the
          Company's Quarterly Report on Form 10-Q for the quarter ended March
          30, 1996.)

10.23*    Supplement to sales contract with Agfa Division of Miles, Inc. dated
          March 29, 1996. (Incorporated by reference to Exhibit 10.2 filed with
          the Company's Quarterly Report on Form 10-Q for the quarter ended
          March 30, 1996.)

                                       48
<PAGE>
 
10.24*    Agfa Sales Contract and Sales Contract Addendum dated May 21, 1997.
          (Incorporated by reference to Exhibit 10.2 filed with the Company's
          Quarterly Report on Form 10-Q for the quarter ended June 28, 1997.)

10.25*    Supply Agreement effective January 1, 1997 with Fuji Photo Film
          U.S.A., Inc. (Incorporated by reference to Exhibit 10.1 filed with the
          Company's Quarterly Report on Form 10-Q for the quarter ended March
          29, 1997.)

10.26*    Kodak Agreement dated May 13, 1997. (Incorporated by reference to
          Exhibit 10.3 filed with the Company's Quarterly Report on Form 10-Q
          for the quarter ended June 28, 1997.)
 
10.27*    AT&T Agreement dated March 5, 1997. (Incorporated by reference to
          Exhibit 10.2 filed with the Company's Quarterly Report on Form 10-Q
          for the quarter ended March 29, 1997.)

10.28     Warehouse Sublease between Seattle FilmWorks, Inc. and OptiColor, Inc.
          dated September 30, 1996. (Incorporated by reference to Exhibit 10.20
          filed with the Company's Annual Report on Form 10-K for the year ended
          September 28, 1996.)

10.29     Warehouse Sublease between Seattle FilmWorks, Inc. and Seattle
          FilmWorks Manufacturing Company dated September 30, 1996.
          (Incorporated by reference to Exhibit 10.21 filed with the Company's
          Annual Report on Form 10-K for the year ended September 28, 1996.)

10.30     1260 16th Avenue West Sublease between Seattle FilmWorks, Inc. and
          OptiColor Inc. dated September 30, 1996. (Incorporated by reference to
          Exhibit 10.22 filed with the Company's Annual Report on Form 10-K for
          the year ended September 28, 1996.)

10.31     1260 16th Avenue West Sublease between Seattle FilmWorks, Inc. and
          Seattle FilmWorks Manufacturing Company dated September 30, 1996.
          (Incorporated by reference to Exhibit 10.23 filed with the Company's
          Annual Report on Form 10-K for the year ended September 28, 1996.)

10.32     General Assignment between Seattle FilmWorks, Inc., Seattle FilmWorks
          Manufacturing Company and OptiColor, Inc. dated September 30, 1996.
          (Incorporated by reference to Exhibit 10.24 filed with the Company's
          Annual Report on Form 10-K for the year ended September 28, 1996.)

21        Seattle FilmWorks, Inc. Subsidiaries

23        Consent of Ernst & Young LLP, Independent Auditors

27.1      Financial Data Schedule

27.2      Financial Data Schedule -- Restated 1997

27.3      Financial Data Schedule -- Restated 1996

  * Exhibit for which confidential treatment has been granted.

                                       49
<PAGE>
 
                            SEATTLE FILMWORKS, INC.

                                  SCHEDULE  II

                       VALUATION AND QUALIFYING ACCOUNTS
                                 (in thousands)
<TABLE>
<CAPTION>
 
 
                                                         Additions
                                                  -----------------------
                                     Balance at   Charged to   Charged to                 Balance
                                     Beginning    Costs and      Other                    at End
Description                           of Year      Expenses     Accounts    Deductions   of Period
==================================================================================================
<S>                                  <C>          <C>          <C>          <C>          <C>
FOR THE YEAR ENDED
SEPTEMBER 28, 1996
 
Allowance for doubtful accounts          $546        $158         $0          $417         $287         
Allowance for returns                    $ 97        $130         $0          $182         $ 45         
                                                                                                        
FOR THE YEAR ENDED                                                                                      
SEPTEMBER 27, 1997                                                                                      
                                                                                                        
Allowance for doubtful accounts          $287        $ 97         $0          $144         $240         
Allowance for returns                    $ 45        $155         $0          $147         $ 53         
                                                                                                        
FOR THE YEAR ENDED                                                                                      
SEPTEMBER 26, 1998                                                                                      
                                                                                                        
Allowance for doubtful accounts          $240        $ 53         $0          $ 85         $208         
Allowance for returns                    $ 53        $105         $0          $143         $ 15         
</TABLE>
____________________________

                                       50
<PAGE>
 
                                   SIGNATURES


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

                                                  SEATTLE FILMWORKS, INC.
                                                       (REGISTRANT)

DATED:  December 22, 1998                    By: /s/ Gary R. Christophersen
                                                 --------------------------
                                                   Gary R. Christophersen
                                           President and Chief Executive Officer
                                                (Principal Executive Officer)

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

<TABLE>
<CAPTION>
 
 
NAME                                     TITLE                           DATE
<S>                                      <C>                             <C>  
By: /s/ Gary R. Christophersen           President                       December 22, 1998
    --------------------------           Chief Executive Officer
    Gary R. Christophersen               Director
                                         (Principal Executive Officer)
                                  
By: /s/ Sam Rubinstein                   Director                        December 22, 1998
    --------------------------
    Sam Rubinstein              
                                  
By: /s/ Douglas A. Swerland              Director                        December 22, 1998
    --------------------------
    Douglas A. Swerland        
                                  
By: /s/ Craig E. Tall                    Director                        December 22, 1998
    --------------------------
    Craig E. Tall                   
                                  
By: /s/ Peter H. van Oppen               Director                        December 22, 1998
    --------------------------
    Peter H. van Oppen              
                                  
By: /s/ Case H. Kuehn                    Vice President-Finance          December 22, 1998
    --------------------------           Chief Financial Officer
    Case H. Kuehn                        (Principal Financial and 
                                         Accounting Officer)       
</TABLE>

                                       51
<PAGE>
 
                                 EXHIBIT INDEX
                                 -------------

                           Annual Report on Form 10-K
                     For The Year Ended September 26, 1998

Exhibit
Number   Exhibit Description
-------  -------------------

3.1       Articles of Incorporation of the Company, as amended through February
          23, 1989. (Incorporated by reference to Exhibit 3.1 filed with the
          Company's Annual Report on Form 10-K for the year ended September 30,
          1989.)

3.2       Bylaws of the Company, as amended and restated on November 13, 1996.
          (Incorporated by reference to Exhibit 3.2 filed with the Company's
          Annual Report on Form 10-K for the year ended September 28, 1996.)

3.3       Articles of Amendment to Articles of Incorporation dated March 2,
          1994. (Incorporated by reference to Exhibit 3.4 filed with the
          Company's Annual Report on Form 10-K for the year ended September 24,
          1994.)

3.4       Articles of Amendment to Articles of Incorporation dated February 16,
          1995. (Incorporated by reference to Exhibit 3.4 filed with the
          Company's Annual Report on Form 10-Q for the year ended March 25,
          1995.)

3.5       Second Restated Articles of Incorporation of Seattle FilmWorks, Inc.
          dated March 5, 1996. (Incorporated by reference to Exhibit 3.0 filed
          with the Company's Quarterly Report on Form 10-Q for the quarter ended
          March 30, 1996.)

3.6       Articles of Amendment to Articles of Incorporation dated February 13,
          1997. (Incorporated by reference to Exhibit 3.0 filed with the
          Company's Quarterly Report on Form 10-Q for the quarter ended March
          29, 1997.)

10.1      Lease Agreement dated September 10, 1985 between Gilbert Scherer and
          Marlyn Friedlander, Lessors, and the Company with respect to certain
          office and plant facilities in Seattle, Washington. (Incorporated by
          reference to the exhibit with a corresponding number filed with the
          Company's registration statement on Form S-1 (file no. 33-4388.)

10.2      First Amendment to Facility Lease Agreement dated April 29, 1989, with
          Gilbert Scherer and Marlyn Friedlander, Lessors. (Incorporated by
          reference to Exhibit 10.48 filed with the Company's Annual Report on
          Form 10-K for the year ended September 30, 1989.)

10.3      Second Amendment to Facility Lease Agreement dated November 2, 1998,
          with Gilbert Scherer and Marlyn Friedlander, Lessors.

10.4      Consent to Sublease dated September 30, 1996, between Gilbert Scherer
          and Marlyn Friedlander and Seattle FilmWorks, Inc. (Incorporated by
          reference to Exhibit 10.3 filed with the Company's Annual Report on
          Form 10-K for the year ended September 28, 1996.)

10.5      Incentive Stock Option Plan, as amended and restated as of April 1,
          1996. (Incorporated by reference to Exhibit 10.1 filed with the
          Company's Quarterly Report on Form 10-Q for the quarter ended June 29,
          1996.) 

                                       52
<PAGE>
 
10.6      Form of Incentive Stock Option Agreement. (Incorporated by reference
          to Exhibit 10.2 filed with the Company's Registration Statement on
          Form S-8, file no. 33-24107.)

10.7      1987 Stock Option Plan, as amended and restated as of April 1, 1996.
          (Incorporated by reference to Exhibit 10.2 filed with the Company's
          Quarterly Report on Form 10-Q for the quarter ended June 29, 1996.)

10.8      Form of Stock Option Agreement. (Incorporated by reference to Exhibit
          10.4 filed with the Company's Registration Statement on Form S-8, file
          no. 33-24107.)

10.9      1993 Employee Stock Purchase Plan as amended and restated as of May
          31, 1995. (Incorporated by reference to Exhibit 10.58 filed with the
          Company's Annual Report on Form 10-K for the year ended September 30,
          1995.)

10.10     Purchase and Sale Agreement dated as of December 16, 1993 and related
          Amendment to Purchase and Sale Agreement dated December 30, 1993 among
          Seattle FilmWorks, Inc., Private Label Film, Inc. and certain
          shareholders of Private Label Film, Inc. (Incorporated by reference to
          Exhibits 2.1 and 2.2 filed with the Company's Report on Form 10-Q
          dated February 7, 1994.)

10.11     Business Loan Agreement with First Interstate Bank of Washington N.A.
          as amended and restated on March 31, 1994. (Incorporated by reference
          to Exhibit 10.60 filed with the Company's Annual Report on Form 10-K
          for the year ended September 24, 1994.)

10.12     Business Loan Agreement with First Interstate Bank of Washington N.A.
          as amended and restated on February 28, 1995. (Incorporated by
          reference to Exhibit 10.0 filed with the Company's Quarterly Report on
          Form 10-Q for the quarter ended March 25, 1995.)

10.13     Business Loan Agreement with First Interstate Bank of Washington N.A.
          as amended and restated on January 31, 1996. (Incorporated by
          reference to Exhibit 10.1 filed with the Company's Quarterly Report on
          Form 10-Q for the quarter ended March 30, 1996.)

10.14     Business Loan Agreement with Wells Fargo Bank, National Association as
          amended and restated on December 13, 1996. (Incorporated by reference
          to Exhibit 10.13 filed with the Company's Annual Report on Form 10-K
          for the year ended September 28, 1996.)

10.15     Credit Agreement with Wells Fargo Bank, National Association as of
          March 1, 1997.  (Incorporated by reference to Exhibit 10.1 filed with
          the Company's Quarterly Report on Form 10-Q for the quarter ended June
          28, 1997.)

10.16     First Amendment to Credit Agreement with Wells Fargo Bank, National
          Association as of February 24, 1998 (Incorporated by reference to
          Exhibit 10.1 filed with the Company's Quarterly Report on Form 10-Q
          for the quarter ended June 27, 1998.)

10.17     Stock Redemption Agreement dated July 20,1994 between the Company and
          Sam Rubinstein and related promissory note. (Incorporated by reference
          to Exhibits 5.1 and 5.2 filed with the Company's Report on Form 8-K
          dated July 22, 1994.)

10.18     Lease Agreement dated September 22, 1995 between the United States of
          America, Lessors, and the Company with respect to certain plant and
          warehouse facilities in Seattle, Washington. (Incorporated by
          reference to Exhibit 10.63 filed with the Company's Annual Report on
          Form 10-K for the year ended September 30, 1995.)

                                       53
<PAGE>
 
10.19     Addendum to Lease Agreement dated January 1, 1996 between the United
          States of America, Lessors, and the Company. (Incorporated by
          reference to Exhibit 10.3 filed with the Company's Quarterly Report on
          Form 10-Q for the quarter ended March 30, 1996.)
 
10.20     Supplemental Lease Agreement dated October 21, 1996 between the United
          States of America, Lessors, and the Company. (Incorporated by
          reference to Exhibit 10.17 filed with the Company's Annual Report on
          Form 10-K for the year ended September 28, 1996.)

10.21     Lease agreement dated March 4, 1997 between Smith Cove Partnership and
          the Company. (Incorporated by reference to Exhibit 10.3 filed with the
          Company's Quarterly Report on Form 10-Q for the quarter ended March
          29, 1997.)
 
10.22*    Sales contract dated August 18, 1995 between the Company and Agfa
          Division of Miles, Inc. with respect to the purchase of certain
          products. (Incorporated by reference to Exhibit 10.64 filed with the
          Company's Quarterly Report on Form 10-Q for the quarter ended March
          30, 1996.)

10.23*    Supplement to sales contract with Agfa Division of Miles, Inc. dated
          March 29, 1996. (Incorporated by reference to Exhibit 10.2 filed with
          the Company's Quarterly Report on Form 10-Q for the quarter ended
          March 30, 1996.)

10.24*    Agfa Sales Contract and Sales Contract Addendum dated May 21, 1997.
          (Incorporated by reference to Exhibit 10.2 filed with the Company's
          Quarterly Report on Form 10-Q for the quarter ended June 28, 1997.)

10.25*    Supply Agreement effective January 1, 1997 with Fuji Photo Film
          U.S.A., Inc. (Incorporated by reference to Exhibit 10.1 filed with the
          Company's Quarterly Report on Form 10-Q for the quarter ended March
          29, 1997.)
 
10.26*    Kodak Agreement dated May 13, 1997. (Incorporated by reference to
          Exhibit 10.3 filed with the Company's Quarterly Report on Form 10-Q
          for the quarter ended June 28, 1997.)

10.27*    AT&T Agreement dated March 5, 1997. (Incorporated by reference to
          Exhibit 10.2 filed with the Company's Quarterly Report on Form 10-Q
          for the quarter ended March 29, 1997.)

10.28     Warehouse Sublease between Seattle FilmWorks, Inc. and OptiColor, Inc.
          dated September 30, 1996. (Incorporated by reference to Exhibit 10.20
          filed with the Company's Annual Report on Form 10-K for the year ended
          September 28, 1996.)

10.29     Warehouse Sublease between Seattle FilmWorks, Inc. and Seattle
          FilmWorks Manufacturing Company dated September 30, 1996.
          (Incorporated by reference to Exhibit 10.21 filed with the Company's
          Annual Report on Form 10-K for the year ended September 28, 1996.)

10.30     1260 16th Avenue West Sublease between Seattle FilmWorks, Inc. and
          OptiColor Inc. dated September 30, 1996. (Incorporated by reference to
          Exhibit 10.22 filed with the Company's Annual Report on Form 10-K for
          the year ended September 28, 1996.)

10.31     1260 16th Avenue West Sublease between Seattle FilmWorks, Inc. and
          Seattle FilmWorks Manufacturing Company dated September 30, 1996.
          (Incorporated by reference to Exhibit 10.23 filed with the Company's
          Annual Report on Form 10-K for the year ended September 28, 1996.)

                                       54
<PAGE>
 
10.32     General Assignment between Seattle FilmWorks, Inc., Seattle FilmWorks
          Manufacturing Company and OptiColor, Inc. dated September 30, 1996.
          (Incorporated by reference to Exhibit 10.24 filed with the Company's
          Annual Report on Form 10-K for the year ended September 28, 1996.)

21        Seattle FilmWorks, Inc. Subsidiaries

23        Consent of Ernst & Young LLP, Independent Auditors

27.1      Financial Data Schedule

27.2      Financial Data Schedule -- Restated 1997

27.3      Financial Data Schedule -- Restated 1996

  * Exhibit for which confidential treatment has been granted.

                                       55