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                                 UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549
                            ------------------------
 
                                   FORM 10-K
                            ------------------------
(MARK ONE)
 
     [X]   ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
           EXCHANGE ACT OF 1934
 
                  FOR THE FISCAL YEAR ENDED DECEMBER 31, 1998
 
                                       OR
 
     [ ]   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
           EXCHANGE ACT OF 1934
 
                       COMMISSION FILE NUMBER: 000-23461
                            ------------------------
 
                          SPECTRA-PHYSICS LASERS, INC.
             (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
 
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<S>                                            <C>
                   DELAWARE                                      77-0264342
       (STATE OR OTHER JURISDICTION OF                        (I.R.S. EMPLOYER
        INCORPORATION OR ORGANIZATION)                      IDENTIFICATION NO.)
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           1335 TERRA BELLA AVENUE, MOUNTAIN VIEW, CALIFORNIA, 94043
              (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)
 
        REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: 650-961-2550
 
          SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:
 
                              TITLE OF EACH CLASS:
 
                                      NONE
 
                   NAME OF EACH EXCHANGE ON WHICH REGISTERED:
 
                                      NONE
 
          SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
 
                         COMMON STOCK, $0.01 PAR VALUE
                                (TITLE OF CLASS)
 
     Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports) and (2) has been subject to such
filing requirements for the past 90 days.  Yes [X]  No [ ]
 
     Indicate 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 the 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.  [ ]
 
     As of February 26, 1999, 16,168,043 shares of common stock were
outstanding. The aggregate market value of the voting shares (based on the
closing price reported by the NASDAQ National Market System on February 26,
1999) of Spectra-Physics Lasers, Inc., held by nonaffiliates was $16,105,000.
For purpose of this disclosure, shares of common stock held by persons who own
5% or more of the outstanding common stock and shares of common stock held by
each officer and director have been excluded in that such persons may be deemed
to be 'affiliates' as that term is defined under the Rules and Regulations of
the Act. This determination of affiliate status is not necessarily conclusive.
 
                      DOCUMENTS INCORPORATED BY REFERENCE
 
     Portions of the definitive proxy statement to be filed prior to April 30,
1999, pursuant to Regulation 14A of the Securities Exchange Act of 1934, are
incorporated by reference into Part III of this Form 10-K.
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                                     PART I
 
ITEM 1. BUSINESS
 
GENERAL
 
     Spectra-Physics Lasers, Inc. (the "Company") is a leader in the design,
development, manufacture and distribution of lasers and laser systems for a
broad range of markets. The Company has been a pioneer in the laser industry and
has developed a proprietary and patented portfolio of laser, optic and related
manufacturing technologies. The Company offers two broad product lines: high
power semiconductor-based lasers and laser-based systems (high power
semiconductor lasers (HPSL) and semiconductor laser pumped solid state (SLPSS)
lasers) and conventional lasers and laser-related products. The Company's high
power semiconductor-based products range from semiconductor lasers, the basic
engine, through semiconductor laser pumped lasers to end user systems. Through
technological innovation, the Company is leading the transition to high power
semiconductor-based lasers from conventional lasers such as gas, liquid and lamp
pumped lasers. The Company has been at the forefront of high power
semiconductor-based laser technology for the last 15 years and is leveraging its
technical strengths to develop high power semiconductor-based lasers, which are
generally more efficient, reliable, cost-effective and compact than conventional
lasers. These lasers are enabling many new applications and replacing
conventional lasers in existing applications in industrial, OEM and research and
development markets. According to Strategies Unlimited, a market research firm,
the use of high power semiconductor-based lasers is expected to increase
approximately 20% to 40% annually over the next several years.
 
     The Company is also a leading supplier of conventional lasers and
laser-related products to industrial and research and development customers.
These lasers, while based on older technology, have unique performance
characteristics that make them the only current solution for certain demanding
technical applications. According to Laser Focus World, the market for high
power conventional lasers is expected to grow from $1.6 billion in 1998 to $1.8
billion in 1999. The Company's conventional products include ultrafast systems,
amplifier systems, optical parametric oscillators, air and water-cooled ion
lasers, high energy flash lamp pumped YAG lasers, optics and optical systems.
The Company's strong market position and technology leadership in these
conventional laser applications enhances its opportunity to expand its high
growth semiconductor-based laser business by generating funds, capitalizing on
strong customer relationships and leveraging its technological expertise.
 
     The Company works closely with its customers to develop its products and is
focused on providing innovative solutions to customer needs. To control critical
aspects of product quality, significantly improve time-to-market, reduce costs
and identify new applications, the Company has vertically integrated into
strategic technologies. The Company sells its products to a wide range of
customers for use in a variety of applications in markets such as materials
processing, life sciences, research and development, printing and
telecommunications. The Company's customers include 3D Systems, Becton
Dickinson, DaiNippon Screen, Electro-Scientific Industries, ETEC, General
Scanning, Haemonetics, IBM, Inspex, KLA/Tencor, Komag, Presstek, Rofin-Sinar,
Seagate and Western Digital.
 
     Spectra-Physics AB, a multinational corporation based in Sweden which is
listed for trading on the Stockholm Stock Exchange, indirectly owns 80.4% of the
Company's outstanding Common Stock. On February 22, 1999, shareholders of
Spectra-Physics AB holding approximately 98.4% of the outstanding shares of
Spectra-Physics AB tendered their shares to Thermo Instrument Systems Inc.
(TIS), which shares were thereafter accepted by TIS for approximately $355
million. Accordingly, TIS now indirectly owns approximately 79.1% of the
Company's outstanding common stock.
 
     Prior to the Reorganization described below, the Company, Opto Power
Corporation ("Opto Power") and Spectra-Physics Laser Data Systems, Inc. ("Laser
Data"), together with various foreign subsidiaries of Spectra-Physics AB that
conducted sales and technical support operations on their behalf, were operated
as a functional group called the Lasers and Optics Group (collectively, the
"Lasers and Optics Group"). In preparation for the Company's initial public
offering, the Lasers and Optics Group was reorganized (the
 
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"Reorganization") in October 1997 so that the assets and liabilities (including
contractual rights and obligations) of the Lasers and Optics Group are now held
by the Company. In connection with the Reorganization, the Company entered into
certain agreements with Spectra-Physics AB or its subsidiaries relating to
certain aspects of the ongoing relationships between them, such as
administrative support services and distribution, facilities leasing, trademark
and patent license arrangements. In December 1997, the Company also entered into
a registration rights agreement with Spectra-Physics Holdings USA, Inc.
("Holdings"), a wholly-owned subsidiary of Spectra-Physics AB.
 
     In December 1997, the Company completed an initial public offering of
2,400,000 shares of common stock, at an offering price of $10.00 per share. An
additional 360,000 shares of common stock were sold in January 1998 in
accordance with an overallotment option granted to the underwriters. The net
proceeds from the sale of these shares was approximately $23.9 million.
 
STATEMENT UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT
 
     Certain information in this Annual Report on Form 10-K, including but not
limited to the Management's Discussion and Analysis of Financial Condition and
Results of Operations, may constitute forward-looking statements as such term is
defined in Section 27A of the Securities Act of 1933 (the "Securities Act") and
Section 21E of the Securities Exchange Act of 1934. Certain forward-looking
statements can be identified by the use of forward-looking terminology such as,
"believes," "expects," "may," "will," "should," "seeks," "approximately,"
"intends," "plans," "estimates," "anticipates," or "hopeful," or the negative
thereof or other comparable terminology, or by discussions of strategy, plans or
intentions. Forward-looking statements involve risks and uncertainties,
including those described in the Risk Factors section of Item 1 of this Annual
Report on Form 10-K, which could cause actual results to be materially different
than those in the forward-looking statements. Readers are cautioned not to place
undue reliance on these forward-looking statements, which speak only as of the
date hereof. The Company assumes no obligation to update such information.
 
RISK FACTORS
 
Fluctuations In Quarterly Operating Results
 
     The Company's operating results have fluctuated significantly in the past
and are expected to fluctuate in the future on a quarterly and annual basis as a
result of a number of factors, many of which are beyond the Company's control.
Results in any period could be affected by changes in market demand, competitive
market conditions, market acceptance of new or existing products, fluctuations
in foreign currency exchange rates, the cost and availability of components, the
Company's ability to manufacture and ship products, the mix of the Company's
customer base and sales channels, the mix of products sold, the Company's
ability to expand its sales and marketing organization effectively, the
Company's ability to attract and retain key technical and managerial employees
and general economic conditions. Due to the foregoing factors, the Company's
operating results in one or more future periods are expected to be subject to
significant fluctuations. In the event such fluctuations result in the Company's
financial performance being below the expectations of public market analysts and
investors, the price of the Company's Common Stock would likely decline, perhaps
substantially.
 
     Sales to individual customers are often related to a customer's specific
requirements, the timing of which is subject to change. From time to time, the
Company has experienced accelerations and slowdowns in shipments to customers,
causing changes in the sales level of a given quarter relative to both the
preceding and subsequent quarters. A significant portion of the Company's sales
are to customers in the research and development market. Sales into this market
have historically varied from quarter-to-quarter due to seasonal fluctuations
and governmental spending patterns. In addition, announcements by the Company or
its competitors of new products or technologies could cause customers to defer
purchases of the Company's existing products. In the event that anticipated
orders from customers fail to materialize, or delivery schedules are deferred or
canceled as a result of the above factors or other unanticipated factors, the
Company's business, operating results and financial condition would be
materially adversely affected. As a result, the
 
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Company believes that period-to-period comparisons of its operating results are
not necessarily meaningful and should not be relied upon as indicative of future
performance.
 
     The Company has experienced a trend in its sales whereby its fiscal fourth
quarter net sales represent a disproportionate share of the Company's annual net
sales and whereby the Company's first quarter net sales decline significantly
compared to the fourth quarter of the prior fiscal year. The Company believes
these sales patterns occur in part because of seasonal sales patterns related to
customers' fiscal years and in part from the Company's incentive compensation
plan which compensates employees based on annual results. The Company recognizes
that the non-linear pattern of its shipments leads to inefficiencies in asset
and employee utilization. The Company is taking steps to mitigate this sales
trend, but this pattern is likely to continue in the near term.
 
     Despite the fluctuations in its quarterly sales patterns, the Company's
operating expenses are incurred on an approximately ratable basis. As a result,
if expected sales are deferred for any reason, the Company's business, operating
results and financial condition could be materially adversely affected.
 
     The Company's gross margin is affected by a number of factors, including
product mix, product pricing, cost of components, the proportion of third party
products incorporated into the Company's systems, foreign currency exchange
rates and manufacturing costs. For example, since high power semiconductor-based
lasers and laser systems generally have higher gross margins than conventional
lasers, absent other factors, a shift in sales toward semiconductor-based lasers
and systems would lead to a gross margin improvement for the Company. On the
other hand, if market conditions in the highly competitive conventional laser
market forced the Company to lower unit prices, the Company would suffer a
decline in gross margin unless the Company were able to timely offset the price
reduction by a reduction in production costs or by sales of other products with
higher gross margins. Either of these events could have a material effect on the
Company's business, operating results and financial condition.
 
     The Company's backlog on a given date consists of written purchase orders
or other commitments for products which are scheduled to be shipped within the
following twelve months. Orders in backlog are firm, but are generally subject
to cancellation or rescheduling without penalty. Decisions by customers to
reduce inventory levels could lead to reductions in purchases from the Company
and could have a material adverse effect on the Company's business, operating
results and financial condition.
 
Control by Principal Stockholder
 
     TIS beneficially owns 79.1% of the outstanding shares of Common Stock of
the Company. As a result, TIS will be able to control the outcome of matters
requiring stockholder approval, including the election of directors, and will
have the ability to control the business and affairs of the Company. So long as
TIS continues to beneficially own a significant amount of the Company's
outstanding Common Stock, only a limited percentage of the Common Stock will be
traded in the public market.
 
     The Company has entered into certain agreements with Spectra-Physics AB or
its affiliates relating to certain aspects of the ongoing relationships between
them, such as tax sharing, administrative support service, office space rental
and trademark and patent license arrangements. Accordingly, the Company will
depend in part on its continuing relationship with Spectra-Physics AB.
 
Risks Associated with Sole Suppliers and Limited Sources
 
     A number of components necessary for the manufacture and operation of many
of the Company's products such as crystals, ceramic components and Q switches
are obtained from sole suppliers or a limited group of suppliers. The Company
has experienced shortages of such supplies in the past. The Company does not
maintain any long-term supply agreements with any of its suppliers. The
Company's reliance on sole or a limited group of suppliers involves several
risks, including a potential inability to obtain an adequate supply of required
components and reduced control over pricing. The disruption or termination of
any of these sources could have a material adverse effect on the Company's
business, operating results and financial condition. Any inability to obtain
adequate deliveries or any other circumstance that would require the Company to
seek
 
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alternative sources of supply or to manufacture such components internally could
significantly delay the Company's ability to ship its products, which could
damage relationships with current and prospective customers and could have a
material adverse effect on the Company's business, operating results and
financial condition.
 
Dependence on Key Personnel
 
     The success of the Company depends to a significant degree on the efforts
of the Company's senior management team. The Company's operations may be
adversely affected if one or more members of senior management were to leave the
Company. The Company is also dependent upon its ability to attract and retain
qualified employees, particularly highly skilled design, process and test
engineers involved in the manufacture of existing products and the development
of new products and processes. The competition for such personnel is intense,
and the loss of key employees or the failure to attract qualified new employees
could have a material adverse effect on the Company's business, operating
results and financial condition.
 
Manufacturing Risks
 
     The manufacture of certain of the laser and optic components, products and
systems sold by the Company is a highly complex and precise process. As a result
of the technical complexity of the Company's products, changes in the Company's
or its suppliers' manufacturing processes, or the inadvertent use of defective
or contaminated materials by the Company or its suppliers, could result in a
material adverse effect on the Company's ability to achieve acceptable
manufacturing yields and product reliability. To the extent the Company does not
achieve such yields or product reliability, its business, operating results,
financial condition and customer relationships would be adversely affected.
 
     The Company relies exclusively on its own production capability to
manufacture certain optics and optical systems, semiconductor lasers, lasers and
laser-based systems. Because the Company manufactures, packages and tests these
components, products and systems at its own facilities, and such components,
products and systems are not readily available from other sources, any
interruption in manufacturing resulting from shortages of parts or equipment,
fire, earthquake, natural disaster, equipment failures or otherwise would have a
material adverse effect on the Company's business, operating results and
financial condition.
 
Dependence on Key Markets and Successful Identification of New Markets
 
     The Company's current products serve many applications in the materials
processing, life sciences, research and development, printing and
telecommunications markets. No assurances can be given that these markets will
continue to generate significant or consistent demand for the Company's
products. Existing markets could be significantly diminished by new technologies
or products that replace or render obsolete the Company's technologies and
products. The Company is dependent on successfully identifying new markets for
its products. There can be no assurance that the Company will be able to
successfully identify new high-growth markets in the future. Moreover, there can
be no assurance that new markets will develop for the Company's or its
customers' products, or that the Company's technology or pricing will enable
such markets to develop.
 
Dependence on Key Customers
 
     The Company's customers are generally not contractually obligated to
purchase any specified quantity of products in any particular period, and
product sales to major customers have varied widely from quarter to quarter and
year to year. There can be no assurance that the Company's current customers
will continue to place orders with the Company, that orders by existing
customers will continue at the levels of previous periods or that the Company
will be able to obtain orders from new customers. Loss of, or a material
reduction in orders by, one or more of the Company's major customers would have
a material adverse effect on the Company's business, operating results and
financial condition. Even if relationships with existing major customers
continue, such customers' requirements for the Company's products will depend on
the success of their product development, marketing, sales and other business
efforts. The Company's or its customer's
 
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products could be replaced or made obsolete by other technologies or products,
potentially leading to an adverse impact on the Company's business, operating
results and financial condition.
 
Risks of Managing Future Growth
 
     Any significant growth in the Company's sales or any significant expansion
in the scope of its operations would likely strain the Company's management,
financial, manufacturing and other resources and may require the Company to
implement and improve a variety of operating, financial and other systems,
procedures and controls. While the Company plans significant expansion of its
manufacturing, sales, accounting and other information systems to meet these
challenges, there can be no assurance that these efforts will succeed, or that
any existing or new systems, procedures or controls will be adequate to support
the Company's operations or that its systems, procedures and controls will be
designed, implemented or improved in a cost effective and timely manner. Any
failure to implement, improve and expand such systems, procedures and controls
in a timely and efficient manner could have a material adverse effect on the
Company's business, operating results and financial condition.
 
Rapid and Fundamental Technological Change
 
     The laser and optics industry is characterized by extensive research and
development expenditures and rapid technological change. The development by
current or future competitors of new or improved products, processes or
technologies may make the Company's current or proposed products obsolete or
less competitive. Although the Company devotes significant resources to further
develop and enhance its existing products, including its high power
semiconductor-based lasers, there can be no assurance that new or alternative
technologies will not make the Company's products obsolete or less competitive.
The Company's future business, operating results and financial condition will
depend on its ability to enhance its existing products, develop new products
that address the particular needs of its customers and respond to technological
advances and emerging industry standards and practices.
 
Competition
 
     The Company's various markets are highly competitive. The Company's overall
competitive position depends on a number of factors including the price, quality
and performance of its products, the level of customer service, the development
of new technology and the Company's ability to participate in emerging markets.
The Company faces competition from three primary sources: current direct
competitors, potential competitors and suppliers of new technologies. The
Company offers a range of components, subsystems, products and systems and has a
number of competitors worldwide in various segments of its markets. In its HPSL
markets, direct competitors include SDL, Inc., Coherent, Inc., Siemens and
Thompson-CSF. In its SLPSS laser markets, major competitors include Coherent,
Inc. and Lightwave Electronics Inc. In the laser disk texturing market, the
Company's major competitor is IBM Corporation. In its other product markets, the
Company's major competitors include Coherent, Inc., Continuum (a division of
Hoya) and Uniphase Corporation. None of the Company's competitors competes in
all of the product areas and industries currently served by the Company.
However, as existing or new markets continue to grow, the Company expects that
new competitors will emerge and present competitors will seek to increase their
market share.
 
     New technologies may emerge to compete with the Company's products. In most
of the Company's product lines, both the Company and its competitors are working
to develop new technologies, or improvements and modifications to existing
technologies, which will render present products obsolete. There can be no
assurance that the Company's development efforts will be successful. In
addition, there can be no assurance that markets will develop for any such
future products, or that any such products will be competitive with other
technologies or products that may be developed by others. Some of the Company's
competitors have significantly greater financial, technical, manufacturing,
marketing, sales and other resources than the Company. In addition, some of
these competitors may be able to respond more quickly to new or emerging
technologies, evolving industry trends and changes in customer requirements and
to devote greater resources to the development, promotion and sale of their
products than the Company. There can be no assurance that the Company's current
or potential competitors will not develop or acquire products comparable or
superior to
 
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those developed by the Company, combine or merge to form larger, more
significant competitors, or adapt more quickly than the Company to new
technologies, evolving industry trends and changing customer requirements.
Increased competition has resulted and is expected, in the future, to result in
price reductions, reduced margins or loss of market share, any of which could
materially and adversely affect the Company's business, operating results and
financial condition. There can be no assurance that the Company will be able to
compete successfully against current or future competitors or that competitive
pressures faced by the Company will not have a material adverse effect on its
business, operating results and financial condition. The Company expects that
both direct and indirect competition will increase in the future. Additional
competition could adversely affect the Company's business, operating results and
financial condition through price reductions or loss of market share.
 
Dependence on Proprietary Technology; Risk of Patent Infringement Claims
 
     The Company's future success and competitive position is dependent upon its
proprietary technology, and the Company relies on patent, trade secret,
trademark and copyright law to protect its intellectual property. There can be
no assurance that the patents owned or licensed by the Company will not be
invalidated, circumvented, challenged or licensed to others, that the rights
granted thereunder will provide competitive advantages to the Company or that
any of the Company's pending or future patent applications will be issued within
the scope of the claims sought by the Company, if at all. Furthermore, there can
be no assurance that others will not develop technologies that are similar or
superior to the Company's technology, duplicate the Company's technology or
design around the patents owned by the Company. In addition, effective
copyright, patent and trade secret protection may be unavailable, limited or not
applied for in certain foreign countries. Certain of the Company's technology is
licensed on a non-exclusive basis from third parties which may license such
technology to others, including competitors of the Company. There can be no
assurance that the steps taken by the Company to protect its technology will
prevent misappropriation of such technology.
 
     The laser and optics industry is characterized by frequent litigation
regarding patent and other intellectual property rights. Litigation has been
necessary and may be necessary in the future to enforce the Company's patents
and other intellectual property rights, to protect the Company's trade secrets,
to determine the validity and scope of the proprietary rights of others or to
defend against claims of infringement or invalidity. Such litigation has in the
past resulted in substantial costs and diversion of resources and any future
actions could have a material adverse effect on the Company's business,
operating results and financial condition. In particular, the Company has been
involved in litigation with two of its principal competitors, SDL, Inc. and
Uniphase Corporation. The SDL litigation, which was settled in 1997, was
initiated by the Company in 1995 to enforce its rights under a technology
agreement with SDL. The Uniphase litigation, which was settled in 1994, was
initiated by the Company in 1991 to enforce the Company's rights under one of
its patents.
 
     From time to time the Company has received and expects in the future to
receive notices of claims of infringement of other parties' proprietary rights.
There can be no assurance that infringement claims (or claims for
indemnification resulting from infringement claims) will not be asserted against
the Company or will not result in an injunction against the sale of allegedly
infringing products or otherwise materially adversely affect the Company's
business, operating results and financial condition.
 
Risks Associated With International Sales
 
     International sales accounted for approximately 46%, 45%, and 52%, of the
Company's net sales in 1998, 1997 and 1996, respectively. International sales
carry a number of inherent risks, including exposure to currency fluctuations,
potentially adverse tax consequences, reduced protection for intellectual
property rights in some countries, the impact of recessionary environments in
economies outside the United States, generally longer receivable collection
periods, changes in political and regulatory environments, tariffs and other
potential trade barriers. In addition, certain of the Company's international
sales are subject to export licensing and approvals by U.S. governmental
agencies. Although to date the Company has experienced no significant difficulty
in obtaining such licenses or approvals, the failure to obtain such licenses or
approvals or comply with such regulations in the future could have a material
adverse effect on the Company's business, operating results and financial
condition.
 
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Potential Adverse Impact of Environmental and Other Governmental Regulations
 
     The Company's facilities and operations are subject to a wide variety of
foreign, federal, state and local environmental laws, regulations and
ordinances, including those related to air emissions, wastewater discharges and
chemical and hazardous waste management and disposal ("Environmental Laws"). The
Company's operations also are governed by laws relating to workplace safety and
worker health, primarily the Occupational Safety and Health Act ("Employee
Safety Laws"). Further, compliance with Environmental Laws also may require the
acquisition of permits or other authorizations for certain activities and
compliance with various standards or procedural requirements. Although the
Company believes that its operations are in compliance in all material respects
with current requirements under Environmental Laws and Employee Safety Laws, the
nature of the Company's operations exposes it to the risk of liabilities or
claims with respect to such matters.
 
     Certain of these Environmental Laws, including the Comprehensive
Environmental Response, Compensation and Liability Act, as amended by the
Superfund Amendments and Reauthorization Act of 1986 ("CERCLA") and similar
state laws (collectively, "Superfund Laws"), hold owners or operators of land or
businesses liable for their own and for previous owners' or operators' releases
of hazardous or toxic substances, materials or wastes, pollutants or
contaminants, including petroleum and petroleum products ("Hazardous
Substances"). Such Superfund Laws also provide for responses to and liability
for releases of certain Hazardous Substances into the environment. The nature of
the Company's operations and the long history of industrial uses at some of its
current or former facilities expose the Company to risk of liabilities or claims
under Superfund Laws. In 1988, the Company was named on the General Notification
List of the Environmental Protection Agency (EPA)stating that the Company may be
a Potentially Responsible Party (PRP) under the Superfund Laws for Hazardous
Substances which may have been generated by its former operations at a former
site. Since that time, the Company has not been named in the EPA's first or
second tier lists, and has not been pursued as a PRP by the EPA or any of the
other PRPs.
 
     Since 1984, the Company's facilities in Mountain View, California
("Mountain View Site") have been undergoing investigation and remediation in
response to past releases of industrial solvents to the soil and groundwater. In
addition, the impacted groundwater has migrated to what is referred to as the
North Bayshore Area. As a result of these past releases, the Mountain View Site
and other neighboring sites are listed on the National Priorities List ("NPL" or
the "Superfund List") under CERCLA. The Company is subject to orders issued by
the California Regional Water Quality Control Board ("Orders") that require the
Company to perform remediation on-site and off-site and investigate other
potentially responsible parties. Pursuant to the Orders and other orders issued
to other responsible parties, the Company and other responsible parties are
jointly performing and funding remediation which includes soil vapor extraction
and groundwater extraction, treatment and monitoring. All of the required soil
and groundwater remediation and monitoring systems currently required by the
Orders are in place, and consequently the initial capital expenses for such
systems have been incurred. As of November 1998, the Company had received
permission from the Regional Water Quality Control Board (RWQCB) to shut down
one of its extraction wells and one of its soil vapor extraction units. The
Company has also been given permission to run tests that may allow it to shut
down a second well. The Company is further in process of applying for permission
to shut down its second soil vapor extraction system. In October 1997, the
Company was served with a complaint that had been filed in the Superior Court of
the State of California seeking an unspecified amount of damages for personal
injuries and property damage incurred by residents of a single location alleged
to have resulted from the Company's and others' negligent and/or intentional
handling of toxic chemicals (Rosario Balcita et al. v. Teledyne Semiconductor,
Spectra-Physics Lasers, et al.). As of December 31, 1998, there has been a
summary judgement ruling in the case in favor of the Company and its
co-defendants in regards to the four adults involved in the case. There can be
no assurance that the summary judgement will not be successfully appealed or
that the complaint will be resolved without adverse impact to the Company's
financial position or results of operations. There can be no assurances that
other parties will not come forward and claim personal injury or property
damage.
 
     Based on the Company's experience to date, the Company believes that the
future cost of compliance with existing Environmental Laws (or liability for
known environmental liabilities or claims) and Employee Safety Laws should not
have a material adverse effect on the Company's business, operating results and
 
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financial condition. However, future events, such as changes in existing laws
and regulations or their interpretation, or the discovery of heretofore unknown
contamination, may give rise to additional compliance costs or liabilities that
could have a material adverse effect on the Company's business, operating
results and financial condition. Compliance with more stringent laws or
regulations, as well as more vigorous enforcement policies of regulatory
agencies or stricter or different interpretations of existing laws, may require
additional expenditures by the Company that may be material.
 
Potential Sales of Stock by Holdings; Shares Eligible for Future Sale
 
     Future sales by Spectra-Physics Holdings USA, Inc. of the Company's Common
Stock could adversely affect the prevailing market price of the Common Stock.
Holdings is permitted to sell in the public market specified amounts of Common
Stock without registration pursuant to Rule 144 under the Securities Act of
1933, as amended (the "Securities Act"). In addition, the Company is obligated
under a registration rights agreement with Holdings to register under the
Securities Act the shares of Common Stock owned by Holdings upon its demand.
 
     No predictions can be made as to the effect, if any, that sales in the
public market of shares or the availability of additional shares for future sale
will have on the market price of the Common Stock. The market price of the
Common Stock could be adversely affected by future sales of Common Stock or the
perception that such sales may occur.
 
Certain Anti-Takeover Matters; Possible Issuance of Preferred Stock
 
     Certain provisions of Delaware law, the Company's Certificate of
Incorporation and the Company's Bylaws could delay or make more difficult a
merger, tender offer or proxy contest involving the Company. The Company is
subject to Section 203 of the Delaware General Corporation Law ("DGCL") which,
subject to certain exceptions, prohibits a Delaware corporation from engaging in
any of a broad range of business combinations with any "interested stockholder"
for a period of three years following the date that such stockholder became an
interested stockholder. Under the Company's Certificate of Incorporation and
Bylaws, the directors may enlarge the size of the Board and fill any vacancies
on the Board. The Company's Bylaws provide that nominations for directors may
not be made by stockholders at any annual meeting unless the stockholder
intending to make a nomination notifies the Company of its intention a specified
period in advance and furnishes certain information, and require advance notice
of business to be brought by a stockholder before the annual meeting. The shares
of the Company's Preferred Stock may be issued in the future without further
stockholder approval and upon such terms and conditions, and having such rights,
privileges and preferences, as the Board of Directors may determine. The rights
of holders of Common Stock will be subject to, and may be adversely affected by,
the rights of any holders of Preferred Stock that may be issued in the future.
The issuance of Preferred Stock and the application of Section 203 of the DGCL
and certain other provisions of the Company's Certificate of Incorporation and
Bylaws could have the effect of discouraging, delaying or preventing a change of
control of the Company.
 
INDUSTRY BACKGROUND
 
     A laser uses energy from a power source to stimulate a particular type of
material, which creates and emits photons (i.e., light). The light emitted by
lasers is more intense and has higher purity than the light emitted by
conventional light sources. These characteristics enable applications in several
broad markets such as materials processing, life sciences, research and
development, printing and telecommunications. The principal factors that
distinguish different types of lasers and determine the particular laser
suitable for a specific application are wavelength (color), output power,
repetition rate, cost and operating life.
 
     During the early years of laser development in the 1960s and 1970s, lasers
were relatively expensive and large, and had low reliability and performance
characteristics. Consequently, lasers were used primarily for scientific
research and limited industrial applications where there were few alternatives
to lasers. Since then, improvements in laser technology have resulted in lower
cost, smaller, more reliable and more efficient lasers. As a result, the use of
lasers for industrial and other commercial applications has increased
significantly.
 
                                        9
<PAGE>   10
 
Today, lasers are used in a wide range of applications and various markets
including biotechnology, consumer electronics, industrial process control,
materials processing, measurement, medical, printing, research and development,
semiconductor manufacturing and telecommunications. According to Laser Focus
World, the worldwide market for lasers grew from approximately $1.1 billion in
1993 to an estimated $3.9 billion in 1998, which represents a compound annual
growth rate of approximately 29%.
 
     Lasers can be generally classified into four basic types: gas, liquid, lamp
pumped solid state and semiconductor-based. A significant portion of the
installed base of lasers is comprised of gas, liquid and lamp pumped lasers. The
principal markets for these conventional lasers have been materials processing,
medical and scientific applications. According to Laser Focus World, the market
for high power conventional lasers was approximately $1.6 billion in 1998, and
is expected to increase to approximately $1.8 billion in 1999. Despite
continuous advances in technology, significant shortcomings still exist with
most conventional lasers. Most gas lasers are large, expensive, inefficient and
fragile, many liquid lasers use carcinogenic dyes and have limited performance
ranges, and lamp pumped lasers are limited by their dependence on inefficient
and unreliable incandescent lamps. These lasers, while based upon older
technology, have unique performance characteristics that make them the only
current solution for certain demanding technical applications.
 
     Semiconductor-based lasers are a relatively new and innovative technology.
A semiconductor-based laser creates light from the flow of an electric current
through a specially designed semiconductor device. Semiconductor-based lasers
include both high and low power devices as well as semiconductor laser pumped
solid state lasers.
 
     The laser industry has been characterized by a high degree of technological
innovation. Today, the laser industry is undergoing a fundamental technology
transition to semiconductor-based lasers from conventional lasers. This
transition is being driven by a number of advantages of semiconductor-based
lasers including:
 
     - Lower Operating Cost. The annual costs for power and water to operate a
       10 W SLPSS laser is less than 5% of the cost to operate a gas laser. For
       example, the annual cost in California for power and water to operate a
       10 W SLPSS laser for 2,000 hours is $300, compared to more than $17,000
       for a 10 W gas laser.
 
     - Smaller Size. Semiconductor-based lasers are much smaller than
       conventional lasers of comparable power. For example, a 10 W
       semiconductor-based laser is one-tenth the size of a 10 W gas laser, and
       semiconductor laser diodes can be as small as a grain of salt.
 
     - Higher Reliability. Semiconductor pumped solid state lasers have
       lifetimes exceeding 10,000 hours, compared to 500 hours for a lamp pumped
       laser.
 
     - Greater Efficiency. Semiconductor lasers convert electrical power to
       light much more efficiently, converting greater than 40% of input power
       compared to 0.02% for a gas laser.
 
     As a result of the foregoing advantages, semiconductor-based lasers are
replacing conventional laser technologies in existing applications as well as
enabling many new applications. However, semiconductor-based lasers currently
cannot address applications that require very high power output and laser light
of certain wavelengths. Conventional lasers are the only solution for these
technically demanding applications due to their unique performance
characteristics.
 
     The semiconductor-based laser market generally can be divided into two
categories: low power (less than 0.5 W), such as lasers used in CD players and
laser printers, and high power (0.5 W or greater). To date, the greatest
penetration of semiconductor-based lasers has been in applications that require
low power. As high power semiconductor-based laser technology continues to
advance, the use of high power semiconductor-based lasers is expected to
increase approximately 20% to 40% annually over the next several years according
to Strategies Unlimited, a market research firm.
 
     Customers for high power semiconductor-based lasers are seeking improved
performance and reliability, reduced cost and a greater number of product
offerings. Faced with these challenges and increasing time-to-market pressures,
customers are increasingly relying upon third party technology providers for
further innovations in lasers, optics and other related technologies. Meeting
these requirements is extremely complex
 
                                       10
<PAGE>   11
 
and requires significant expertise, breadth of technology and engineering
resources and a substantial financial commitment.
 
STRATEGY
 
     The Company has been a leading supplier of lasers and laser systems for
over 37 years and has been developing high power semiconductor-based lasers for
the last 15 years. The Company has a significant proprietary and patented
portfolio of lasers, optics and other related laser and manufacturing
technologies. As a result, the Company believes that it is uniquely positioned
to capitalize on the significant market opportunities for high power
semiconductor-based lasers and end-user systems. Key elements of the Company's
strategy include the following:
 
     Capitalize on Leadership in Semiconductor-based Laser Technology. To
enhance its leadership position, the Company is continuing to focus substantial
resources on semiconductor-based laser technology, enabling the Company to
continue developing new products for existing and emerging markets. For example,
the Company continues to offer the highest power and brightest commercially
available semiconductor-based lasers.
 
     Develop New Applications and Markets. The Company leverages its technology
and close working relationships with its key customers to develop innovative
solutions to complex customer requirements. In response to specific customer
needs, the Company has developed systems incorporating laser technology in
applications such as hard disk texturing and floptical disk manufacturing, and
is working with customers to develop systems incorporating laser technology in
enhanced magnetic resonance imaging, fiber laser pumping, diamond machining and
PC board drilling.
 
     Introduce Systems Products. The Company's expertise in semiconductor-based
laser and optics technology has enabled it to successfully introduce and market
systems products in the disk drive industry. The Company's LZT-500, LZT-1000 and
LZT-2000 systems use a Spectra-Physics SLPSS laser and optical beam train
together with custom hardware and software to laser zone texture hard disks.
Laser disk texturing systems increase the storage capacity of a hard disk. The
Company is focused on developing other laser data storage systems based on its
laser and optics technology.
 
     Continue Supporting Conventional Laser Technology. The Company intends to
maintain a leadership position in the supply of conventional laser systems
through continued targeted research and development investments. The Company
also intends to seek new applications for certain conventional technologies such
as the application of ultra-fast technology to inspect and test semiconductor
wafers.
 
     Leverage Benefits of Strategic Vertical Integration. The Company has
vertically integrated into strategic laser technologies, components and
manufacturing processes such as optics and semiconductor wafers, and expects to
continue such strategic vertical integration in the future. This vertical
integration enables the Company to control the quality of strategic components,
significantly improve time-to-market for new products and technologies and more
easily identify new applications.
 
MARKETS
 
     The Company produces a broad range of lasers, laser systems, optics,
optical systems and end user systems for the industrial, OEM and research and
development markets. The primary applications for the Company's products in
these markets are as follows:
 
     - Printing/Graphics. Historically, the commercial printing market has used
       silver halide-based film. In recent years, the commercial printing
       industry has increasingly shifted to thermal-based materials which
       require high power semiconductor-based lasers in the film exposure
       process. The Company believes that the incremental use of thermal-based
       materials for commercial printing will increase the demand for high power
       semiconductor-based lasers. The Company's high power semiconductor-based
       lasers are being used in conjunction with thermal-based plate development
       by a number of major film suppliers as well as in direct-to-press
       applications.
 
                                       11
<PAGE>   12
 
     - Materials Processing. Materials processing encompasses a wide range of
       industrial processes that require the delivery of precisely controlled
       heat or light. Major segments of this market include:
 
         Hard Disk Texturing. In hard disk drive manufacturing, disks must be
         roughened or "textured" to prevent the head from fusing to the smooth
         surface of the disk causing the hard drive to "crash." Traditional
         texturing involves the mechanical application of a diamond paste to the
         entire disk surface. Laser-based texturing -- in which a laser is used
         to create tiny bumps on the disk surface -- is rapidly replacing
         mechanical texturing. A laser produces faster, cleaner, less wasteful
         and more consistent texturing over a smaller area of the disk, enabling
         more of the disk to be used for storage and increases the disk's
         storage capacity.
 
         Rapid Prototyping. Rapid Prototyping is the computer generation of
         three-dimensional objects from CAD/CAM system input which typically is
         used for producing models, manufacturing prototypes, masters and
         patterns. Rapid Prototyping involves exposing a proprietary
         photopolymer with ultraviolet light which "cures" the polymer creating
         a solid model in hours. Traditional hand crafting or machining methods
         can take weeks or even months to achieve the same result. Because of
         the advantages of SLPSS lasers, they have replaced conventional lasers
         in Rapid Prototyping applications requiring high power. The Company
         recently commenced shipments of a second generation high power laser
         for the Rapid Prototyping market.
 
         Semiconductor Manufacturing, Inspection and Repair. Lasers are used to
         adjust the electrical characteristics of resistors, to inspect
         semiconductor wafers for defects and to repair semiconductor devices
         such as DRAMs and SRAMs. Because of their high reliability and ease of
         use, SLPSS lasers are widely used in these applications.
 
         Via Hole Drilling. Historically, holes in printed circuit boards have
         been made using mechanical drilling techniques. Increased packing
         density has led to a new technique where very small holes are drilled
         from an outer layer to specific inner layers and then plated to make
         electrical contact. The size of these holes (80 microns or less)
         preclude efficient mechanical drilling and manufacturers are moving to
         laser-based methods. SLPSS lasers are increasingly being utilized for
         this application. The Company is actively involved in developing
         ultraviolet SLPSS laser sources for this application.
 
         Marking. Marking applications include plastics marking (e.g., marking
         the keys on a computer keyboard) and the marking of finished electronic
         components (e.g., marking very small semiconductor packages in final
         stages of semiconductor manufacturing). SLPSS lasers are replacing
         conventional flash lamp pumped YAG lasers in these and other
         direct-write marking applications where the performance characteristics
         of SLPSS lasers are required.
 
     - Research and Development. Research and development has historically been
       a major market for conventional laser technology, such as water cooled
       gas lasers, high energy flash lamp pumped YAG lasers and ultrafast
       systems with an installed base of tens of thousands of lasers. As new
       SLPSS lasers that can replicate the performance of conventional lasers
       are developed, they are rapidly replacing conventional lasers in this
       market. For example, in 1996 the Company commenced shipments of a 5 W CW
       green SLPSS laser called the Millennia to research and development
       customers. Recently, the Company introduced the Millennia s series of 2 W
       to 10 W systems packaged in the industry's smallest footprint. To date,
       approximately 900 Millennia lasers have been sold, many of which are
       being used by research and development customers to replace their
       existing water cooled ion lasers. Current applications for SLPSS lasers
       in the research and development market include pump lasers for ultrafast
       systems, confocal microscopy systems and seed lasers in amplifier
       systems.
 
     - Life Sciences. Semiconductor-based lasers are increasingly used in
       therapeutic, surgical, dental and diagnostic medical applications.
       Therapeutic applications include a variety of skin treatments, such as
       hair removal, and thermal treatments using endoscopic delivery to
       internal organs such as the prostate. Surgical applications are expanding
       rapidly and now include general purpose endoscopic contact and
       non-contact surgical tools. Several diagnostic techniques, including
       magnetic resonance imaging, also
 
                                       12
<PAGE>   13
 
       employ semiconductor lasers. In this market, the Company provides
       semiconductor-based lasers to medical device OEMs.
 
     - Other. Part of the Company's strategy is to continue to identify
       applications for its technology in other markets. For example, the
       Company manufactures and sells conventional lasers for use in light shows
       and other entertainment market applications.
 
PRODUCTS
 
     The Company produces a broad range of lasers, laser systems, optics,
optical systems and end user systems. The Company's semiconductor-based laser
products include HPSLs, SLPSS lasers and other SLPSS-based systems. Conventional
products include gas lasers, flash lamp pumped yttrium aluminum garnet (YAG)
lasers, optical parametric oscillators (OPOs), amplifiers, accessories, optics
and optical systems, and related services.
 
     The following chart illustrates the Company's principal products and their
applications.
 
<TABLE>
<CAPTION>
                                                                             PRODUCT
                                                              -------------------------------------
                     LASER APPLICATION                        HPSL   SLPSS   SYSTEMS   CONVENTIONAL
                     -----------------                        ----   -----   -------   ------------
<S>                                                           <C>    <C>     <C>       <C>
Printing/Graphics...........................................   M       M                    M
Materials Processing
  -- Hard Disk Texturing....................................           M        M
  -- Rapid Prototyping......................................           M                    M
  -- Semiconductor and Micromachining.......................   M       M                    M
  -- Marking................................................   M       M                    M
Research and Development....................................   M       M        M           M
Medical.....................................................   M       M                    M
Other
  -- Telecommunications.....................................   M       M                    M
  -- Entertainment..........................................   M       M                    M
</TABLE>
 
     High Power Semiconductor Lasers. HPSLs are extremely efficient converters
of electrical power to light and are also highly efficient in focusing generated
light into small spots. While many applications require small spots of very
intense heat, many others, such as pumping crystals and illumination, depend on
the semiconductor laser's ability to create large amounts of nearly
monochromatic photons. These lasers are compact, enabling more cost effective
solutions to a large number of problems. Because the light from
semiconductor-based lasers is emitted in a pattern very different from other
lasers (more like a fan of light rather than a "beam"), the Company has
developed technology to couple the light into an optical fiber to enhance the
"beam" quality or more conveniently deliver the light to the desired location.
 
     The Company manufactures a range of HPSL products with wavelengths from 785
nm to 1800 nm and output powers from less than one Watt to stacked bars (two
dimensional arrays) which produce hundreds or thousands of Watts. These products
are available in various forms, from bare diodes on heat sinks, to fiber-
coupled single emitters and bars, to two dimensional arrays, to fully integrated
modules and microprocessor-controlled units containing power supplies and active
coolers.
 
     Semiconductor Laser Pumped Solid State Lasers. SLPSS lasers use
semiconductor lasers to pump a crystal to produce laser beams with special
characteristics in terms of mode quality, power stability, optical noise,
monochromaticity or energy storage. Like HPSLs, SLPSS lasers are smaller, more
efficient, more reliable and less costly to operate than the conventional laser
technologies they are replacing.
 
     The Company produces SLPSS lasers to satisfy a broad range of customer
requirements. Depending on customer needs, an SLPSS laser can combine various
features including a modular power supply and laser head designs, various
crystals, fiber coupling, and different repetition rates, pulse widths and
wavelengths. The Company's SLPSS lasers contain several design features that
distinguish them from competing products. Examples of such features include: air
cooled laser heads that do not require a separate water supply;
 
                                       13
<PAGE>   14
 
semiconductor lasers in the power supply rather than in the head which allow the
lasers to be replaced in the field without disturbing system alignment; and
lasers designed with significant overhead which increases reliability and
product life. The Company has also developed a complete line of intelligent
power supplies to satisfy demanding customer requirements. All of these power
supplies support remote mounting of the fiber-coupled HPSL to enhance field
serviceability.
 
     Laser Disk Texturing Products. The Company's laser disk texturing products
offer significant advantages over conventional mechanical processing. The
Company's LZT-1000 and LZT-2000 have two main components: a laser texturing
component, in which a semiconductor-based laser creates tiny bumps on the
surface of the disks, and a material handling component, in which a robot
inserts and removes the disks from the laser texturing fixture. The Company's
LZT-500 includes only the laser texturing component which enables the customer
to integrate the laser texturing system into its own proprietary material
handling process. The LZT-2000, the Company's most recently released laser disk
texturing system, uses a green laser to produce smaller bumps on the disk,
further increasing the capacity of the disk. The Company's laser disk texturing
systems can process up to 350 disks per hour.
 
     Conventional Products. The Company is a leading supplier of high power
conventional lasers to industrial and research and development customers. These
lasers, while based upon older technology, have unique performance
characteristics that make them the only current solution for certain demanding
technical applications. According to Laser Focus World, the market for high
power conventional lasers is expected to grow from $1.6 billion to $1.8 billion
in 1999. The Company's strong market position and technology leadership in these
conventional laser applications enhances its opportunity to expand its high
growth semiconductor-based laser business by generating funds, capitalizing on
strong customer relationships and leveraging its technological expertise. The
Company manufactures and sells a broad range of conventional laser products
including:
 
     - Air-cooled gas lasers ranging from 5 to 300 mW (14 models)
 
     - Water-cooled gas lasers ranging from 4 to 30 W (8 models)
 
     - Flash lamp pumped YAG lasers ranging from 500 mJ to 3 J as well as 4
       harmonic wavelengths (12 models)
 
     - Ultrafast lasers with pulse widths as low as 50 femtoseconds (7 models)
 
     - OPOs covering wavelengths from 220 nm to 2600 nm (4 basic models with
       numerous options)
 
     - Amplifiers covering a wide range of powers, wavelengths, pulse widths and
       repetition rates (2 basic models with numerous options)
 
     - Optics and optical systems with super-smooth surfaces (1 angstrom or
       less), damage thresholds of up to 1000 watts per square millimeter of
       continuous power and very low scatter optics
 
TECHNOLOGY
 
     General. The word "laser" is an acronym for "light amplification by
stimulated emission of radiation." A laser consists of (i) an active lasing
medium that gives off its own light (radiation) when excited; (ii) an optical
resonator with a partially reflective output mirror at one end and a fully
reflective rear mirror at the other that permits the light to bounce back and
forth between the mirrors through the lasing medium; and (iii) an external
energy source used to excite the lasing medium. The energy source can be light
from special lamps, light from another laser, an electric current or a chemical
reaction. The lasing medium can be a gas (such as helium and neon, argon or
carbon dioxide), a liquid (such as an organic dye), a semiconductor material
(such as aluminum gallium arsenide) or a crystal (such as ruby, YAG or titanium
sapphire). A laser works by causing the energy source to excite (pump) the
lasing medium, converting the energy from the source into an emission consisting
of particles of light (photons). These photons stimulate the release of more
photons as they are reflected back and forth between the two mirrors that make
up the laser's resonator. The resulting build-up in the number of photons is
emitted in the form of a laser beam through the output port or "window" created
by the partially reflective mirror. By changing the energy and the lasing
medium, different
 
                                       14
<PAGE>   15
 
wavelengths and types of laser light can be produced. Heat generated by the
excitation of the lasing medium is dissipated through a cooling mechanism, which
varies according to the type of laser technology; lasers can be cooled by water,
air or, in the case of semiconductor-based lasers, heat sinks attached to the
semiconductor lasers.
 
     Laser light has three fundamental properties that distinguish it from
conventional "spontaneous emission" light sources: monochromaticity,
directionality and coherence. Monochromaticity refers to the purity of color or
spectral bandwidth of emitted light; directionality describes the degree of
collimation or parallelism of the light rays; and coherence refers to the phase
relationship of the light waves as they are propagated. Laser light features
each of these properties to a high degree, and laser design revolves around
modulating and combining the three properties to serve the requirements of
specific applications. For example, monochromatic laser light can be used to
probe the structure of atoms, control complex chemical reactions or produce
realistic three dimensional holograms. Highly directional and coherent laser
light can be focused to much smaller spot sizes than any ordinary light source
which enables a wide range of applications including printing, marking and
inspection and measurement. Lasers can be continuous wave, pulsed or modelocked
with varying repetition rates; they can have different bandwidths (more or less
monochromatic) and different line widths; and they come in different powers from
microJoules to thousands of Watts. Different laser designs result in various
output characteristics in terms of power, pulse width, repetition rate and
wavelength depending on the needs of the application.
 
     Spectra-Physics Technology. Formed in 1961 as the first commercial laser
company, the Company has a long history of introducing innovative technologies
and laser products. Some of the innovative laser products successfully
introduced by the Company include: commercial argon gas lasers (1964), high
power helium neon lasers (1976), sealed cavity air cooled gas lasers (1981),
HPSLs (1983), fiber-coupled SLPSS lasers (1986), titanium-sapphire ultrafast
lasers (1990), FC bar semiconductor technology (1992), high power CW SLPSS green
lasers (1996) and the highest power (60 W) commercially available HPSLs (1998).
 
     Recent examples of the Company's technological leadership in
semiconductor-based lasers and systems include its discovery of QMAD, a patented
technique for shortening the fundamental output wavelength from an SLPSS laser
that enables the Company to produce green lasers with powers up to 12 W. The
high efficiency QMAD technique has also enabled the Company to produce green
SLPSS lasers with lower powers for price sensitive OEM markets. The Company also
recently developed and commercialized high power semiconductor bars that produce
over 60 W of power. In addition, the Company recently developed and
commercialized a second generation high power SLPSS laser producing more than
300 mW of power. These new SLPSS lasers are displacing large frame gas lasers in
the rapid prototyping market.
 
     The Company is also a technology leader in laser disk texturing systems for
the hard disk drive market. The Company's disk texturing systems incorporate
diffraction limited optics capable of producing bumps on either aluminum or
glass substrates less than 3 micons in diameter and below 20 nm in height with
an autofocus servo to maintain long term consistency. Each tool incorporates
conveyors and robotic automation capable of processing over 3 million disks
annually, resulting in the lowest process costs per disk in the industry.
 
     The Company also has state-of-the-art technology in its conventional
products. For example, the Company's Tsunami offers the highest power, broadest
tunability and widest pulse width coverage of any commercial ultrafast system.
During 1998 the Company introduced green and ultraviolet versions of its INDI
series pulsed, flash lamp-pumped Nd: YAG lasers for industrial applications such
as marking of plastics and ceramic components, laser cleaning and flat-panel
display repair. Additionally, the Company recently introduced its Advantage(TM)
series of air-cooled argon ion lasers. These lasers utilize a power supply
design which automatically senses and compensates for variations in line
voltage. This power supply is also extremely compact, being only half the weight
and 2/3 the size of previous designs. These air-cooled lasers can be used in
such applications as semiconductor wafer inspection, confocal microscopy, DNA
sequencing, flow cytometry, image setting and computer-to-plate printing.
 
                                       15
<PAGE>   16
 
SALES AND MARKETING
 
     The Company's sales and service strategy is to have one primary channel to
the customer on a worldwide basis. This is accomplished through a separate
distribution organization responsible for selling and servicing products
directly in several countries and through over 30 independent distributors in
the rest of the world. The Company has direct sales units in North America,
Japan, Germany, France, the Netherlands and the United Kingdom. The Company
began establishing international direct sales offices in the mid-1970s.
Distributors are managed by the Company's export unit which is based in Mountain
View, California and has an office in Darmstadt, Germany.
 
     As of January 31, 1999, the Company's direct sales units employ
approximately 184 people performing sales, service engineering, customer support
and administrative functions. They are responsible for the complete order
fulfillment cycle, from quotation through order placement to delivery. The sales
organization is also responsible for bringing the appropriate marketing and
technical resources to bear on a customer's requirements and ensuring the
customer receives high-quality support.
 
     The Company's sales strategy also involves establishing long-term
relationships with its customers. For industrial and OEM customers, this
relationship starts at the early design-in of the Company's lasers and laser
systems into customer applications. The Company supports its customers with
on-site field service, technical service engineers and training programs and
telephone support from its direct sales units. Each sales unit maintains an
inventory of critical components and certain replacement systems and sub-systems
to help minimize customer downtime. The Company in general warrants its products
for twelve to twenty-four months depending on the product line. Certain
manufacturing intensive industries such as the hard disk manufacturing industry
require high levels of support to minimize costly downtime. The Company provides
direct service to its hard disk drive customers which are principally located in
California, Japan, Taiwan and Southeast Asia.
 
     The Company's marketing activities include: analyzing and understanding
future product requirements of the Company's target markets and translating
those requirements into product specifications and cost targets by working
closely with customers and key technologists in industry and academia; providing
applications engineering support as part of the sales process to industrial and
OEM customers; and product promotion, which includes participating in trade
shows and conferences and advertising through trade journals, new product
announcements and direct mailings.
 
     Backlog consists of written purchase orders or other commitments for
products which are scheduled to be shipped within the following twelve months.
As of December 31, 1998, the Company's backlog was approximately $38.0 million,
compared with approximately $49.1 million at December 31, 1997. Orders in
backlog are firm, but are subject to cancellation or rescheduling by the
customer without penalty. Because of the possible changes in product delivery
schedules and cancellation of product orders and because the Company's sales
will often not reflect orders shipped in the same quarter that they are booked,
the Company's backlog at any particular date is not necessarily indicative of
actual sales for any succeeding period.
 
CUSTOMERS
 
     Through its global distribution and service network the Company provides a
range of laser solutions to its major markets. The Company has approximately
2000 customers, over 800 of which are OEM customers and over 1200 are research
and development customers. The Company's major customers include: 3D Systems,
Becton Dickinson, DaiNippon Screen, Electro-Scientific Industries, ETEC, General
Scanning, Haemonetics, IBM, Inspex, KLA/Tencor, Komag, Presstek, Rofin-Sinar,
Seagate and Western Digital. During 1998 and 1997, 54.2% and 54.8% of the
Company's sales were in North America, 19.4% and 19.7% were in Japan, 19.9% and
19.8% were in Europe, 3.9% and 2.9% were in Other Asia, and 2.6% and 2.8% were
in Rest of the World respectively. No single customer accounted for more than
10% of the Company's sales for 1998 or 1997.
 
                                       16
<PAGE>   17
 
RESEARCH AND DEVELOPMENT
 
     The Company's research and development activities are divided into two main
areas: advanced research in selected fields such as optics fabrication and
coating, HPSLs and SLPSS lasers; and product engineering which focuses on
designing and developing products for known, quantified markets with clearly
defined performance goals and cost targets. The primary focus of these research
and development efforts is high power semiconductor-based lasers and laser
systems. The Company often develops new products at the customer's design-in
stage in order to maximize the functionality of the product for the customer.
The Company's products are designed for manufacturability and serviceability. In
addition, high parts commonality is a goal that has been achieved on a number of
product lines through the use of common power supplies and laser head platforms.
 
     In 1998, 1997 and 1996, the Company expended approximately $16.7 million,
$14.4 million and $12.0 million, respectively, on internally funded research and
development. In these three years, such expenditures included significant
investments in the development of the Company's laser disk texturing system. The
Company expects to continue to spend substantial amounts on research and
development activities. The Company's ability to successfully compete will be
substantially dependent on its ability to design, develop and introduce new
products on a timely basis.
 
     As of January 31, 1999, the Company had approximately 127 employees engaged
in advanced research and product development and engineering, of whom
approximately 74 are professional engineers or have master's or doctor's degrees
(including 23 Ph.D.s). The Company's research and development activities are
carried out in Mountain View, California for SLPSS lasers, optical coatings,
laser disk texturing and conventional products, in Oroville, California for
optical systems and optics fabrication and in Tucson, Arizona for HPSLs. The
Company maintains close working relationships with several leading industrial,
government and university research laboratories around the world. Such
relationships include funding of third party research, joint development
programs and licensing of patents developed by such organizations. The Company
also participates in certain U.S. government funded programs such as Technology
Reinvestment Program (TRP), when the programs' objectives are consistent with
the Company's technology road map.
 
MANUFACTURING OPERATIONS
 
     The Company's manufacturing activities include semiconductor laser
manufacturing, plasma tube manufacturing, optics fabrication and coating, fine
mechanics manufacturing and assembly, integration and test. One of the Company's
core business philosophies is to concentrate its manufacturing efforts on
strategic activities and to outsource production of other components. This
philosophy forms the basis for the Company's vertical integration into
semiconductor wafer fabrication, semiconductor lasers, optics fabrication and
coating and very fine mechanical parts. The Company believes each of these
operations is essential to the rapid development of new products and to
maintaining a high level of product quality.
 
     The Company focuses substantial efforts on maintaining and enhancing the
efficiency and quality of its manufacturing operations. The Company uses kanban,
just-in-time and product flow line techniques to reduce manufacturing cycle
times and inventory levels and to enable it to offer on-time delivery and high
quality products to its customers.
 
     The Company has manufacturing operations in Mountain View and Oroville,
California and Tucson, Arizona. The Company's four manufacturing operations in
Mountain View include research optics manufacturing, plasma tube manufacturing,
laser manufacturing and laser disk texturing manufacturing. The Company's
manufacturing operations in Tucson include semiconductor laser manufacturing and
integrated unit assembly. The Company has manufacturing operations in Oroville
that include optics fabrication and coating, optical system manufacturing and
metal component fabrication. The Company's principal manufacturing operations
are:
 
     - Semiconductor Laser Manufacturing. The Company's semiconductor laser
       manufacturing operation is vertically integrated and has capabilities in
       wafer fabrication, wafer processing, bar processing, device
 
                                       17
<PAGE>   18
 
       packaging, test and burn-in and fiber-coupling. The Company has three
       large scale epitaxial deposition units, two of which are capable of
       handling three inch wafers.
 
     - Plasma Tube Manufacturing. The Company makes three types of plasma tubes:
       glass, metal beryllium oxide and metal ceramic. These tubes are used as
       the photon source for its gas lasers.
 
     - Optics Fabrication and Coating. The Company fabricates and coats many of
       the optics used in its lasers. These operations are conducted in a
       state-of-the-art facility constructed to Class 10,000 clean room
       standards with portions of the building maintained at either Class 1000
       or Class 100 levels as required.
 
     - Fine Mechanics Manufacturing. The fine mechanics operation primarily
       produces aluminum and stainless steel components with relatively high
       feature content and surface finish requirements for use in the Company's
       laser and optical systems.
 
     - Research Optics Manufacturing. The Company's film coating facility is
       designed for the development of new coating technology and the production
       of very large optics up to three feet in diameter.
 
     - Assembly, Integration and Test. As part of the manufacturing process, the
       Company assembles, integrates and tests its systems, including laser,
       laser disk texturing, optical and power supply systems.
 
INTELLECTUAL PROPERTY
 
     The Company has approximately 152 active patents and approximately 79
additional patent applications pending. The Company also has a royalty-free
license to all of SDL's patents applied for or issued prior to June 25, 1993.
 
     The Company's future success and competitive position is dependent upon its
proprietary technology, and the Company relies on patent, trade secret,
trademark and copyright law to protect its intellectual property. There can be
no assurance that any of the patents owned or licensed by the Company will not
be invalidated, circumvented, challenged or licensed to others, that the rights
granted thereunder will provide competitive advantages to the Company or that
any of the Company's pending or future patent applications will be issued within
the scope of the claims sought by the Company, if at all. Furthermore, there can
be no assurance that others will not develop technologies that are similar or
superior to the Company's technology, duplicate the Company's technology or
design around the patents owned by the Company. In addition, effective
copyright, patent and trade secret protection may be unavailable, limited or not
applied for in certain foreign countries. Certain of the Company's technology is
licensed on a non-exclusive basis from third parties which may license such
technology to others, including competitors of the Company. There can be no
assurance that the steps taken by the Company to protect its technology will
prevent misappropriation of such technology.
 
COMPETITION
 
     The Company's various markets are highly competitive. The Company's overall
competitive position depends on a number of factors including the price, quality
and performance of its products, the level of customer service, the development
of new technology and the Company's ability to participate in emerging markets.
The Company faces competition from three primary sources: current direct
competitors, potential competitors and suppliers of new technologies. The
Company offers a range of components, subsystems, products and systems and has a
number of competitors worldwide in various segments of its markets. In its HPSL
markets, direct competitors include SDL, Inc., Coherent, Inc., Siemens and
Thompson-CSF. In its SLPSS laser markets, major competitors include Coherent,
Inc. and Lightwave Electronics Inc. In the laser disk texturing market, the
Company's major competitor is IBM Corporation. In its other product markets, the
Company's major competitors include Coherent, Inc., Continuum (a division of
Hoya) and Uniphase Corporation. None of the Company's competitors competes in
all of the product areas and industries currently served by the Company.
However, as existing or new markets continue to grow, the Company expects that
new competitors will emerge and present competitors will seek to increase their
market share.
 
                                       18
<PAGE>   19
 
EMPLOYEES
 
     At January 31, 1999, the Company had 864 full time employees, including 127
in research, development and engineering, 184 in sales, service and marketing,
450 in operations and 103 in general management, administration and finance. The
Company intends to hire additional personnel in each of these areas. The Company
also had approximately 31 temporary workers and consultants at January 31, 1999.
The Company's employees are not represented by any collective bargaining
organization, and the Company has never experienced a general work stoppage,
slowdown or strike. The Company considers its employee relations to be good.
 
ITEM 2. PROPERTIES
 
     The Company conducts its business from office and manufacturing facilities
at six locations in Mountain View, California, two facilities in Oroville,
California and one facility in Tucson, Arizona. In the aggregate, the Company
occupies approximately 46,100 square feet of owned space and 129,500 square feet
of leased space in Mountain View, 63,000 square feet of leased space in Oroville
and 78,956 square feet of owned space in Tucson. The Company's lease agreements
have expiration dates ranging from 1999 to 2008. In addition, the Company leases
sales and service offices in Tokyo and Osaka, Japan, Darmstadt, Germany, Z.A. de
Courtaboeuf, France, Eindhoven, the Netherlands and Hemel Hempstead, Great
Britain. These leases have expiration dates ranging from 2000 to 2002.
 
ITEM 3. LEGAL PROCEEDINGS
 
     The Company's facilities and operations are subject to a wide variety of
Environmental Laws and Employee Safety Laws. Further, compliance with
Environmental Laws also may require the acquisition of permits or other
authorizations for certain activities and compliance with various standards or
procedural requirements. Although the Company believes that its operations are
in compliance in all material respects with current requirements under
Environmental Laws and Employee Safety Laws, the nature of the Company's
operations exposes it to the risk of liabilities or claims with respect to such
matters.
 
     Certain of these Environmental Laws, including Superfund Laws, hold owners
or operators of land or businesses liable for their own and for previous owners'
or operators' releases of Hazardous Substances. Such Superfund Laws also provide
for responses to and liability for releases of certain Hazardous Substances into
the environment. The nature of the Company's operations and the long history of
industrial uses at some of its current or former facilities expose the Company
to risk of liabilities or claims under Superfund Laws. In 1988, the Company was
named on the General Notification List of the Environmental Protection Agency
(EPA)stating that the Company may be a Potentially Responsible Party (PRP) under
the Superfund Laws for Hazardous Substances which may have been generated by its
former operations at a former site. Since that time, the Company has not been
named in the EPA's first or second tier lists, and has not been pursued as a PRP
by the EPA or any of the other PRPs.
 
     Since 1984, the Company's facilities in Mountain View, California
("Mountain View Site") have been undergoing investigation and remediation in
response to past releases of industrial solvents to the soil and groundwater. In
addition, the impacted groundwater has migrated to what is referred to as the
North Bayshore Area. As a result of these past releases, the Mountain View Site
and other neighboring sites are listed on the NPL or the Superfund List under
CERCLA. The Company is subject to Orders that require the Company to perform
remediation on-site and off-site and investigate other potentially responsible
parties. Pursuant to the Orders and other orders issued to other responsible
parties, the Company and other responsible parties are jointly performing and
funding remediation which includes soil vapor extraction and groundwater
extraction, treatment and monitoring. All of the required soil and groundwater
remediation and monitoring systems currently required by the Order are in place,
and consequently the initial capital expenses for such systems have been
incurred. As of November 1998, the Company had received permission from the
Regional Water Quality Control Board (RWQCB) to shut down one of its extraction
wells and one of its vapor extraction units. The Company has also been given
permission to run tests that may allow it to shut down a second well. The
Company is further in process of applying for permission to shut down its second
soil vapor extraction
 
                                       19
<PAGE>   20
 
system. In October 1997, the Company was served with a complaint that had been
filed in the Superior Court of the State of California seeking an unspecified
amount of damages for personal injuries and property damage incurred by
residents of a single location alleged to have resulted from the Company's and
others' negligent and/or intentional handling of toxic chemicals (Rosario
Balcita et al. v. Teledyne Semiconductor, Spectra-Physics Lasers, et al.). As of
December 31, 1998, there has been a summary judgement ruling in the case in
favor of the Company and its co-defendants in regards to the four adults in the
case. There can be no assurance that the summary judgement will not be
successfully appealed or that the complaint will be resolved without adverse
impact to the Company's financial position or results of operations. There can
be no assurances that other parties will not come forward and claim personal
injury or property damage.
 
     Based on the Company's experience to date, the Company believes that the
future cost of compliance with existing Environmental Laws (or liability for
known environmental liabilities or claims) and Employee Safety Laws should not
have a material adverse effect on the Company's business, operating results and
financial condition. However, future events, such as changes in existing laws
and regulations or their interpretation, or the discovery of heretofore unknown
contamination, may give rise to additional compliance costs or liabilities that
could have a material adverse effect on the Company's business, operating
results and financial condition. Compliance with more stringent laws or
regulations, as well as more vigorous enforcement policies of regulatory
agencies or stricter or different interpretations of existing laws, may require
additional expenditures by the Company that may be material.
 
ITEM 4. SUBMISSION OF MATTERS TO A VOTE BY SECURITY HOLDERS
 
     None.
 
ITEM 5.MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
 
     Spectra-Physics Lasers, Inc.'s Common Stock began trading on the NASDAQ
National Market System under the symbol SPLI on December 12, 1997. Prior to such
time, there was no public market for the Common Stock of the Company. The
following table sets forth for the periods indicated the high and low sale
prices per share for the Company's Common Stock as reported on the Nasdaq
National Market.
 
<TABLE>
<CAPTION>
                                                               HIGH     LOW
                                                              ------   ------
<S>                                                           <C>      <C>
Fiscal 1998:
  First quarter.............................................  $18.50   $12.25
  Second quarter............................................   21.50     9.00
  Third quarter.............................................   12.81     6.50
  Fourth quarter............................................    9.50     5.63
 
Fiscal 1997:
  Fourth quarter (from December 12, 1997)...................  $13.63   $12.13
</TABLE>
 
     The number of stockholders of record as of February 26, 1999 was 24. No
cash dividends have been declared or paid and the Company has no present
intention to declare or pay cash dividends.
 
     On December 18, 1997, the Company issued a total of 408,043 shares of
Common Stock to three employees of Opto Power Corporation, the Company's wholly
owned subsidiary, pursuant to the Spectra-Physics Restricted Stock Plan and in
partial exchange for such employees' agreement to cancel options to purchase, in
the aggregate, up to 20% of the outstanding common stock of Opto Power
Corporation on a fully diluted basis.
 
                                       20
<PAGE>   21
 
     The subparagraph numbers listed below correspond to the applicable sections
on Item 701 (f) of Regulation S-K.
 
<TABLE>
<S>  <C>    <C>                                                         <C>
(1)         Effective date:                                             December 11, 1997
            Commission file number:                                     333-38329
(2)         Offering dates:                                             December 11, 1997;
                                                                        January 5, 1998*
(3)         Not applicable.
(4)  (i)    The offering was terminated in January 1998 after the
            sale of all securities registered.
     (ii)   Managing underwriters:                                      NationsBanc Montgomery
                                                                        Securities, Inc.
                                                                        Cowen & Company
     (iii)  Title of each class of securities registered:               Common stock, par
                                                                        value:
                                                                        $0.01 per share
     (iv)   Amount of securities registered:                            2,760,000 shares
            Aggregate price of the offering amount registered:          $27,600,000
            Amount of securities sold:                                  2,760,000 shares
            Aggregate offering price of the amount sold to date:        $27,600,000
     (v)    Expenses incurred:
            Underwriting discount and commissions                       $ 1,932,000
            Other expenses                                                1,766,000
                                                                        ------------
            Total expenses                                                3,698,000
                                                                        ------------
     (vi)   Net offering proceeds to issuer                             $23,902,000
                                                                        ------------
                                                                        ------------
     (vii)  Use of proceeds by issuer from
            December 11, 1997 to December 31, 1998:                     Short-term
                                                                        investments:
                                                                        $23,902,000
</TABLE>
 
---------------
* On January 5, 1998, the Company received net proceeds of $3,248,000 pursuant
  to the offering of 360,000 shares of Common stock upon the exercise of the
  underwriters' overallotment option.
 
     None of the expenses incurred in the offering, nor the use of proceeds of
the offering, were paid to (i) directors, officers, general partners of the
issuer or their associates, (ii) persons owning 10% or more of any class of
securities of the issuer or (iii) affiliates of the issuer.
 
                                       21
<PAGE>   22
 
ITEM 6. SELECTED FINANCIAL DATA
 
<TABLE>
<CAPTION>
                                                            YEARS ENDED DECEMBER 31,
                                               ---------------------------------------------------
                                                 1998       1997       1996       1995      1994
                                               --------   --------   --------   --------   -------
                                                    (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<S>                                            <C>        <C>        <C>        <C>        <C>
STATEMENT OF OPERATIONS DATA:
Net sales....................................  $169,016   $159,174   $135,434   $112,527   $95,123
Cost of products sold........................   103,724     98,772     88,320     73,040    62,482
                                               --------   --------   --------   --------   -------
  Gross margin...............................    65,292     60,402     47,114     39,487    32,641
Operating expenses:
  Research and development...................    16,728     14,365     12,005      7,933     7,788
  Selling, general and administrative........    34,903     32,539     28,966     27,848    24,812
  Other(1)...................................        --     15,757      6,915      1,863        --
                                               --------   --------   --------   --------   -------
          Total operating expenses...........    51,631     62,661     47,886     37,644    32,600
                                               --------   --------   --------   --------   -------
     Operating income (loss).................    13,661     (2,259)      (772)     1,843        41
Other income (expense):
  Interest income (expense)..................     1,335     (4,005)    (5,374)    (4,590)   (3,492)
  Foreign currency gain (loss)...............        --      2,067      2,532      1,046    (1,439)
  Legal settlement(2)........................        --     17,010         --         --        --
                                               --------   --------   --------   --------   -------
          Total other income (expense).......     1,335     15,072     (2,842)    (3,544)   (4,931)
                                               --------   --------   --------   --------   -------
     Income (loss) before income taxes.......    14,996     12,813     (3,614)    (1,701)   (4,890)
Income tax expense (benefit).................     5,349    (21,048)       634        318       311
                                               --------   --------   --------   --------   -------
     Net income (loss).......................  $  9,647   $ 33,861   $ (4,248)  $ (2,019)  $(5,201)
                                               ========   ========   ========   ========   =======
     Net income (loss) per share:
          Basic..............................  $   0.60   $   2.57   $  (0.33)
                                               ========   ========   ========
          Diluted............................  $   0.59   $   2.57   $  (0.33)
                                               ========   ========   ========
     Shares used in computing net income
       (loss) per share (3):
          Basic..............................    16,168     13,162     13,000
                                               ========   ========   ========
          Diluted............................    16,473     13,191     13,000
                                               ========   ========   ========
</TABLE>
 
<TABLE>
<CAPTION>
                                                               AS OF DECEMBER 31,
                                              ----------------------------------------------------
                                                1998       1997       1996       1995       1994
                                              --------   --------   --------   --------   --------
                                                                 (IN THOUSANDS)
<S>                                           <C>        <C>        <C>        <C>        <C>
BALANCE SHEET DATA:
Working capital.............................  $ 72,277   $ 68,941   $ 27,531   $ 30,273   $ 26,452
Total assets................................   157,028    140,524     86,848     80,691     65,915
Long term liabilities.......................     1,983      1,677     71,584     69,067     58,775
Stockholders' equity (deficit)..............   110,068     96,324    (21,223)   (16,480)   (14,348)
OTHER DATA:
Operating income (loss) before infrequent or
  unusual items(4)..........................  $ 13,661   $ 13,498   $  6,143   $  3,706   $     41
                                              ========   ========   ========   ========   ========
</TABLE>
 
---------------
(1) Includes $1,657,000 in 1997, $1,915,000 in 1996, and $863,000 in 1995 of
    legal expenses associated with a lawsuit which was settled in the second
    quarter of fiscal 1997; and $14,100,000 in 1997, $5,000,000 in 1996 and
    $1,000,000 in 1995 of compensation expense associated with certain stock
    options.
 
(2) In May 1997, the Company received net proceeds of $17,010,000 in settlement
    of a lawsuit.
 
(3) See Note 2 of the Notes to the Consolidated Financial Statements for an
    explanation of shares used in computing net income (loss) per share.
 
                                       22
<PAGE>   23
 
(4) Other data is presented as supplemental information and should not be
    construed as a substitute, or better, indicator of, results of operations
    than operating income (loss) or net income (loss) determined in accordance
    with generally accepted accounting principles. This data represents actual
    operating income (loss) adjusted for the following: (a)legal expenses
    associated with a lawsuit of $1,657,000 in 1997, $1,915,000 in 1996 and
    $863,000 in 1995; and (b) compensation expense associated with stock options
    of $14,100,000 in 1997, $5,000,000 in 1996 and $1,000,000 in 1995. While
    such items are not expected to be incurred in the future, there can be no
    assurances that similar items might not occur.
 
                                       23
<PAGE>   24
 
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
 
OVERVIEW
 
     The Company is a leader in the design, development, manufacture and
distribution of lasers and laser systems for a broad range of markets.
Spectra-Physics AB, a multinational corporation based in Sweden which is listed
for trading on the Stockholm Stock Exchange, indirectly owns 80.4% of the
Company's outstanding Common Stock. On February 22, 1999, shareholders of
Spectra-Physics AB holding approximately 98.4% of the outstanding shares of
Spectra-Physics AB tendered their shares to Thermo Instrument Systems Inc.
(TIS), which shares were thereafter accepted by TIS for approximately $355
million. Accordingly, TIS now indirectly owns approximately 79.1% of the
Company's outstanding common stock. Prior to the Reorganization described below,
the Company, Opto Power Corporation and Spectra-Physics Laser Data Systems,
Inc., together with various foreign subsidiaries of Spectra-Physics AB that
conducted sales and technical support operations on their behalf, were operated
as a functional group called the Lasers and Optics Group. In preparation for the
Company's initial public offering, the Lasers and Optics Group was reorganized
(the "Reorganization") in October 1997 so that the assets and liabilities
(including contractual rights and obligations) of the Lasers and Optics Group
are now held by the Company.
 
     In December 1997, the Company completed an initial public offering of
2,400,000 shares of Common Stock, at an offering price of $10.00 per share. An
additional 360,000 shares of common stock were sold in January 1998 in
accordance with an overallotment option granted to the underwriters. The net
proceeds from the sale of these shares was approximately $23.9 million.
 
     The 1997 and 1996 consolidated financial statements reflect the financial
position, results of operations and cash flows of the Company as if it were a
separate entity. The Company's historical results have varied significantly from
period to period due to the inclusion of charges related to legal expenses
associated with a lawsuit and compensation expenses associated with certain
stock options. The Company also incurred interest expense on loans and advances
from Spectra-Physics AB and foreign currency gains and losses resulting from the
Company's participation in Spectra-Physics AB's foreign currency hedging
program. None of these charges and credits are expected to be incurred in the
future. However, there can be no assurance that similar items might not occur.
 
     Net sales for products are recognized upon shipment. The Company derives
its revenue primarily from the sale of high power semiconductor-based and
conventional lasers and laser systems. High power semiconductor-based lasers and
laser systems are sold into the OEM/industrial market and the research and
development market. The OEM/industrial market is characterized by unit sales,
with varying prices, in volumes of as much as several thousand units.
Conventional lasers are primarily sold into the research and development market.
This market is typically characterized by the sale of single units and systems
with prices that range from approximately $3,000 to $500,000. Sales in this
market have historically varied from quarter to quarter due to seasonal
fluctuations and governmental spending patterns. Over the last three years, a
growing proportion of the Company's total net sales and most of its sales growth
have been from high power semiconductor-based lasers.
 
     The Company's sales have shown a pattern in the last several years whereby
the fiscal fourth quarter net sales represent a large share of the Company's
annual net sales and whereby the Company's first quarter net sales decline
significantly compared to the fourth quarter of the prior fiscal year. The
Company believes these sales patterns occur in part because of seasonal sales
patterns related to customers' fiscal years and in part from the Company's
incentive compensation plan which compensates employees based on annual results.
The Company recognizes that the non-linear pattern of its shipments leads to
inefficiencies in asset and employee utilization. The Company is taking steps to
mitigate this sales trend, but this pattern is likely to continue in the near
term.
 
     The Company's gross margin is affected by a number of factors, including
product mix, product pricing, cost of components, the proportion of third party
products incorporated into the Company's systems, foreign currency exchange
rates and manufacturing costs. For example, since high power semiconductor-based
lasers and laser systems generally have higher gross margins than conventional
lasers, absent other factors, a shift in
 
                                       24
<PAGE>   25
 
sales toward high power semiconductor-based lasers and laser systems would lead
to a gross margin improvement for the Company. On the other hand, if market
conditions in the highly competitive conventional laser market forced the
Company to lower unit prices, the Company would suffer a decline in gross margin
unless the Company were able to timely offset the price reduction by a reduction
in production costs or by sales of other products with higher gross margins.
Either of these events could have a material effect on the Company's business,
operating results and financial condition.
 
     The Company spends a significant amount of resources on research and
development. In recent years, the Company has focused much of these resources on
high power semiconductor-based lasers and laser systems. The Company expects to
continue to spend substantial resources in developing high power semiconductor-
based lasers and laser systems while making focused research and development
expenditures to maintain its leadership position in conventional lasers.
 
     A significant proportion of the Company's sales are to international
customers and are denominated in currencies other than the U.S. dollar. The
Company also has sales and support operations located in certain European
countries and in Japan which operate in local currencies. As a result, while the
Company attempts to hedge its economic risk of foreign currency fluctuations,
the Company is exposed to fluctuations in foreign currency exchange rates. These
fluctuations have had in the past, and may have in the future, a significant
impact on the Company's results of operations.
 
     The Company has five reportable segments: the Commercial Systems Group
(CSG) business unit; the Industrial and Scientific Lasers (ISL) business unit;
the Original Equipment Manufacturer (OEM) business unit; Opto Power Corporation
(OPC); and Spectra-Physics Distribution (SPD) business unit. CSG designs and
manufactures optics, thin films, fabricated parts, plasma tubes, and subsystems
for all operating units within the Company and external customers. CSG also
designs, manufactures and markets low power laser sources and beam delivery
systems for OEM products in the industrial and medical instrumentation markets.
ISL designs, markets and manufactures high power semiconductor-based and
conventional lasers for the industrial and scientific markets. OEM designs,
markets and manufactures high power semiconductor-based lasers for various OEM
markets. OPC designs, markets and manufactures high power semiconductor-based
laser diodes, components and systems. SPD is the Company's worldwide sales,
service and support organization. Reference is made to Footnote 10 of the
Consolidated Financial Statements for disclosures of certain financial
information related to the reportable segments.
 
                                       25
<PAGE>   26
 
RESULTS OF OPERATIONS
 
     The following table sets forth, for the periods indicated, the Company's
results of operations as a percentage of net sales:
 
<TABLE>
<CAPTION>
                                                               YEARS ENDED DECEMBER 31,
                                                              --------------------------
                                                               1998      1997      1996
                                                              ------    ------    ------
<S>                                                           <C>       <C>       <C>
Net sales...................................................  100.0%    100.0%    100.0%
Cost of products sold.......................................   61.4%     62.1%     65.2%
                                                              -----     -----     -----
  Gross margin..............................................   38.6%     37.9%     34.8%
Operating expenses:
  Research and development..................................    9.9%      9.0%      8.9%
  Selling, general and administrative.......................   20.7%     20.4%     21.4%
  Other.....................................................     --       9.9%      5.1%
                                                              -----     -----     -----
          Total operating expenses..........................   30.5%     39.3%     35.4%
                                                              -----     -----     -----
          Operating income (loss)...........................    8.1%     (1.4)%    (0.6)%
Other income (expense):
  Interest income (expense).................................    0.8%     (2.5)%    (4.0)%
  Foreign currency gain.....................................     --       1.3%      1.9%
  Legal settlement..........................................     --      10.7%       --
                                                              -----     -----     -----
          Total other income (expense)......................    0.8%      9.5%     (2.1)%
                                                              -----     -----     -----
          Income (loss) before income taxes.................    8.9%      8.1%     (2.7)%
Income tax expense (benefit)................................    3.2%    (13.2)%     0.5%
                                                              -----     -----     -----
          Net income (loss).................................    5.7%     21.3%     (3.2)%
                                                              =====     =====     =====
Other Data:
  Operating income (loss) before infrequent or unusual
     items*.................................................    8.1%      8.5%      4.5%
                                                              =====     =====     =====
</TABLE>
 
---------------
* See footnote (4) of Item 6. Selected Financial Data.
 
     YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
 
Net sales
 
     Net sales were $169.0 million in 1998, $159.2 million in 1997, and $135.4
million in 1996, representing an increase of 6.2% from 1997 to 1998 and 17.5%
from 1996 to 1997. Net sales for 1998, calculated using foreign currency
exchange rates for 1997, and for 1997, calculated using foreign currency
exchange rates for 1996, increased 8.2% from 1997 to 1998, and 23.2% from 1996
to 1997. The growth in sales in actual terms was principally due to increased
volumes of high-power semiconductor-based lasers and laser systems, as the
market for these products expanded due to customers' acceptance of these
products. Sales of high power semiconductor based lasers increased to 50.2% of
total sales in 1998 from 48.1% in 1997 and 34.9% in 1996. Net sales were in the
following geographic markets:
 
<TABLE>
<CAPTION>
                                                                 YEARS ENDED DECEMBER 31,
                                                             --------------------------------
                                                               1998        1997        1996
                                                             --------    --------    --------
                                                                      (IN THOUSANDS)
<S>                                                          <C>         <C>         <C>
North America..............................................  $ 91,545    $ 87,262    $ 65,327
Japan......................................................    32,834      31,334      30,517
Europe.....................................................    33,707      31,536      30,449
Other Asia.................................................     6,508       4,673       4,645
Rest of the World..........................................     4,422       4,369       4,496
                                                             --------    --------    --------
                                                             $169,016    $159,174    $135,434
                                                             ========    ========    ========
</TABLE>
 
                                       26
<PAGE>   27
 
     Net sales are attributed in the above table based on the location of the
Company's customer. Substantially all sales in North America, Other Asia and
Rest of the World are denominated in U.S. dollars. Europe and Japan in the above
table include sales from the Company's European and Japan sales subsidiaries,
respectively. Export sales to countries not located in Asia are included in Rest
of the World.
 
     Net sales at actual currency exchange rates increased: 4.9% from 1997 to
1998 and 33.6% from 1996 to 1997 for North America; 4.8% from 1997 to 1998 and
2.7% from 1996 to 1997 for Japan; 6.9% from 1997 to 1998 and 3.6% from 1996 to
1997 for Europe; 39.3% from 1997 to 1998 and 0.6% from 1996 to 1997 for Other
Asia; and 1.2% from 1997 to 1998 for Rest of the World. Net sales at actual
currency exchange rate decreased 2.8% from 1996 to 1997 for Rest of the World.
Net sales for 1998, calculated using foreign currency exchange rates for 1997,
and for 1997, calculated using foreign currency exchange rates for 1996,
increased: 4.9% from 1997 to 1998 and 33.6% from 1996 to 1997 for North America;
12.9% from 1997 to 1998 and 14.6% from 1996 to 1997 for Japan; 8.7% from 1997 to
1998 and 15.1% from 1996 to 1997 for Europe; 39.3% from 1997 to 1998 and 0.6%
from 1996 to 1997 for Other Asia; and 1.2% from 1997 to 1998 for Rest of the
World. Net sales at constant currency exchange rate decreased 2.8% from 1996 to
1997 for Rest of the World.
 
     Reduced orders and sales in the commercial printing and graphics market due
to an announced production slowdown by a major customer and the unavailability
of direct-to-press thermal printing plates negatively impacted sales growth for
1998. The materials processing market was similarly affected by the worldwide
slowdown in the semiconductor and disk drive industries. Widely published
reports foresee no upturn in the semiconductor or disk drive industries until
late 1999 thereby limiting the growth of the Company's sales into these markets.
The Company's strategy continues to be to seek sales and profit growth in
OEM/industrial opportunities and the Company is pursuing OEM/industrial
opportunities in other markets.
 
Cost of products sold and gross margin
 
     Cost of products sold includes all manufacturing materials and labor and a
proportionate share of manufacturing overhead costs, as well as costs of
shipping, tooling, royalties, third party products incorporated in the Company's
products and provisions for excess and obsolete inventories and warranty. Cost
of products sold varies by product mix, product pricing, cost of components, the
proportion of third party products incorporated in systems manufactured by the
Company, and manufacturing costs.
 
     Gross margin was $65.3 million in 1998, $60.4 million in 1997, and $47.1
million in 1996, representing an increase of 8.1% from 1997 to 1998, and 28.2%
from 1996 to 1997. As a percentage of net sales, gross margin was 38.6%, 37.9%,
and 34.8% in 1998, 1997 and 1996, respectively. The principal reasons for the
improvement in gross margin as a percentage of net sales in 1998 compared to
1997 and in 1997 compared to 1996 was the higher proportion of sales of high
power semiconductor-based lasers and laser systems which generally have higher
gross margins than conventional products and the increase in sales that allowed
the absorption of fixed manufacturing overhead expenses over a larger unit base.
Additionally, the Company experienced improved manufacturing yields in 1998
compared to 1997 in the production of semiconductor-based lasers. Mitigating
these favorable factors in 1998 was the negative effect on gross margins from
the strengthening of the U.S. dollar compared to non-U.S. dollar currencies,
particularly the Yen.
 
Operating expenses
 
     Operating expenses totaled $51.6 million in 1998, $62.7 million in 1997,
and $47.9 million in 1996, representing a decrease of 17.6% from 1997 to 1998
and an increase of 30.9% from 1996 to 1997. As a percentage of net sales,
operating expenses were 30.5%, 39.3%, and 35.4% in 1998, 1997, and 1996,
respectively. Included in other operating expenses were legal expenses
associated with a lawsuit which was settled in the second quarter of 1997 of
$1.7 million in 1997 and $1.9 million in 1996, and compensation expense
associated with certain stock options of two subsidiaries of $14.1 million in
1997 and $5.0 million in 1996. The stock options for one subsidiary were
modified so as to establish the measurement date and the amount of compensation
expense the Company is required to record and, for the other subsidiary, were
cancelled for a combination of cash and common stock of the Company.
Accordingly, the Company does not expect to incur additional compensation
expense relating to these stock options in the future. Excluding such
 
                                       27
<PAGE>   28
 
legal and compensation expenses, operating expenses increased 10.1% from 1997 to
1998 and 14.5% from 1996 to 1997 and were 30.5%, 29.4% and 30.3% of net sales in
1998, 1997 and 1996, respectively.
 
     Research and development expenses represent expenses associated with
Company funded research and new product development, and efforts designed to
improve the performance of existing products and manufacturing processes.
Customer funded product development engineering for certain OEM customers and
the U.S. government, which to date has been minimal, is recorded as a reduction
of research and development expenses. Research and development expenses are
charged to operations as incurred.
 
     Research and development expenses totaled $16.7 million in 1998, $14.4
million in 1997 and $12.0 million in 1996, representing an increase of 16.5%
from 1997 to 1998 and 19.7% from 1996 to 1997. As a percentage of net sales,
research and development expenses were 9.9%, 9.0% and 8.9% in 1998, 1997 and
1996, respectively. The increase in research and development expenses was
principally focused on semiconductor-based lasers and laser systems.
 
     Selling, general and administrative expenses include the expenses of the
Company's sales and support subsidiaries in the United Kingdom, France, Germany,
the Netherlands and Japan as well as the Company's North American sales and
support organization, and other administrative expenses such as legal,
accounting and corporate offices.
 
     Selling, general and administrative expenses totaled $34.9 million in 1998,
$32.5 million in 1997 and $29.0 million in 1996, representing an increase of
7.3% from 1997 to 1998 and 12.3% from 1996 to 1997. As a percentage of net
sales, selling, general and administrative expenses were 20.7%, 20.4% and 21.4%
in 1998, 1997 and 1996, respectively. The principal reasons for the increase in
selling, general and administrative expenses in dollar terms in 1998 compared to
1997 were increased expenses associated with penetrating the industrial/OEM
markets and costs of being a public company. The principal reasons for the
increase in selling, general and administrative expenses in dollar terms in 1997
compared to 1996 were increased salaries and benefits, including performance and
incentive bonuses, and increased sales and marketing efforts aimed at the high
powered semi-conductor based lasers and laser systems markets offset in part by
the impact of the strengthening U.S. dollar compared to non-U.S. dollar
currencies.
 
Interest income (expense)
 
     Interest income totaled $1.3 million in 1998. Interest expense totaled $4.0
million in 1997 and $5.4 million in 1996. Interest income for 1998 was earned on
the Company's invested cash and cash equivalents. Interest expense in 1997 and
1996 was incurred on loans and advances from Spectra-Physics AB and affiliates.
Interest expense was also imputed on the certain non-interest bearing advances
from Spectra-Physics AB and affiliates. The amount of such imputed interest was
$0.6 million in 1997 and $1.0 million in 1996. In connection with the
Reorganization, Spectra-Physics AB and affiliates converted all loans and
advances to the Company to equity. Accordingly, beginning October 1, 1997, the
Company no longer incurred interest expense on such loans and advances.
 
Foreign currency gain (loss)
 
     Effective October 1, 1998, the Company adopted SFAS No. 133 "Accounting for
Derivative Instruments and Hedging Activities." SFAS No. 133 requires that all
derivatives, including foreign currency exchange contracts, be recognized on the
balance sheet at fair value. Derivatives that are not hedges must be recorded at
fair value through earnings. If a derivative is a hedge, depending on the nature
of the hedge, changes in the fair value of the derivative are either offset
against the change in fair value of assets, liabilities or firm commitments
through earnings or recognized in other comprehensive income until the hedged
item is recognized in earnings. The ineffective portion of a derivative's change
in fair value is to be immediately recognized in earnings. The adoption of SFAS
No. 133 resulted in no cumulative effect on income or other comprehensive income
for the Company.
 
     Forward foreign exchange contracts are used primarily by the Company to
hedge certain operational ("cash flow" hedges) and balance sheet ("fair value"
hedges) exposures resulting from changes in foreign
 
                                       28
<PAGE>   29
 
currency exchange rates. Such exposures primarily result from portions of the
Company's operations and assets that are denominated in currencies other than
the U.S. dollar, primarily the Japanese Yen and certain European currencies.
These foreign exchange contracts are entered into to hedge anticipated
intercompany product sales and recorded accounts receivable made in the normal
course of business, and accordingly, are not speculative in nature. As part of
its overall strategy to manage the level of exposure to the risk of foreign
currency exchange rate fluctuations, the Company hedges a portion of its foreign
currency exposures anticipated over the ensuing twelve-month period. At December
31, 1998, the Company had effectively hedged approximately 60% of its estimated
foreign currency exposures that principally relate to anticipated cash flows to
be remitted to the U.S. over the ensuing twelve month period, using foreign
exchange contracts that generally have maturities of twelve months or less. The
Company does not hold or transact in financial instruments for purposes other
than risk management.
 
     The Company records its foreign currency exchange contracts at fair value
in its consolidated balance sheet as accrued and other current liabilities and
the related gains or losses on these hedge contracts are deferred as a component
of other comprehensive income. These deferred gains and losses are recognized in
income in the period in which the underlying anticipated transaction occurs.
Unrealized gains and losses resulting from the impact of currency exchange rate
movements on forward foreign exchange contracts designated to offset certain
non-U.S. dollar denominated assets are recognized as other income or expense in
the period in which the exchange rates change and offset the foreign currency
losses and gains on the underlying exposures being hedged.
 
     The Company discontinues hedge accounting prospectively when (1) it is
determined that the derivative is no longer effective in offsetting changes in
fair value or cash flows of a hedged item (including forecasted transactions);
(2) the derivative is sold or terminated; (3) the derivative is dedesignated as
a hedge instrument, because it is unlikely that a forecasted transaction will
occur or a balance sheet exposure ceases to exist; or (4) management determines
that designation of the derivative as a hedge instrument is no longer
appropriate.
 
     When hedge accounting is discontinued because it is determined that the
derivative no longer qualifies as an effective fair value hedge, the derivative
will continue to be carried on the balance sheet at its fair value until it
settles, and the hedged asset will no longer be adjusted for changes in fair
value. When hedge accounting is discontinued because it is probable that a
forecasted transaction will not occur, the derivative will continue to be
carried on the balance sheet at its fair value until it settles, and gains and
losses that were accumulated in other comprehensive income will be recognized
immediately in income. In all other situations in which hedge accounting is
discontinued, the derivative will be carried at its fair value on the balance
sheet until it settles, with changes in its fair value recognized in current
period earnings.
 
     The Company has also entered into foreign currency exchange contracts to
hedge certain intercompany loan transactions. These forward contracts
effectively change certain foreign currency denominated debt into U.S. dollar
denominated debt. No such contracts existed at December 31, 1998.
 
     At December 31, 1998, the Company had contracts for the sale of foreign
currencies and the purchase of U.S. dollars totaling $ 44.0 million. At December
31, 1998, the Company had deferred losses relating to its foreign currency
contracts of approximately $0.1 million, which is all expected to be recognized
in income over the next twelve months.
 
     The following table provides information about the Company's foreign
currency derivative financial instruments outstanding as of December 31, 1998.
The information is provided in U.S. dollar amounts, as presented in the
Company's consolidated financial statements. The table presents the notional
amount (at contract exchange rates) and the weighted average contractual foreign
currency exchange rates. All contracts mature within twelve months.
 
                                       29
<PAGE>   30
 
     Foreign currency spot/forward contracts (in thousands, except average
contract rates):
 
<TABLE>
<CAPTION>
                                                                          AVERAGE
                                                              NOTIONAL    CONTRACT
                                                               AMOUNT       RATE
                                                              --------    --------
<S>                                                           <C>         <C>
Japanese Yen................................................  $25,319     114.3436
British Pound Sterling......................................    3,992       0.5953
German Marks................................................    7,588       1.6225
Netherland Guilder..........................................    2,196       1.8236
French Franc................................................    4,865       5.4674
Other.......................................................       15       1.6129
                                                              -------
                                                              $43,975
                                                              =======
Estimated fair value........................................  $   (79)*
                                                              =======
</TABLE>
 
---------------
* The estimated fair value is based on the estimated amount at which the
  contracts could be settled based on forward exchange rates.
 
     The cash requirements of the above described financial instruments
approximate their fair value. Cash flows associated with these financial
instruments are classified consistent with the cash flows from the transactions
being hedged. The Company's forward foreign exchange contracts contain market
and credit risk not recognized in the consolidated financial statements. The
market risk associated with these instruments resulting from currency exchange
rate movements is expected to offset the market risk of the underlying
transactions and assets being hedged. The credit risk is that the Company's
banking counterparties may be unable to meet the terms of the agreements. The
Company minimizes such risk by limiting its counterparties to major financial
institutions with credit ratings of A/A-2 or better. In addition, the potential
risk of loss with any one party resulting from this type of credit risk is
monitored. Management does not expect any loss as a result of default by other
parties. However, there can be no assurances that the Company will be able to
mitigate market and credit risks described above.
 
     For the period from the fourth quarter of 1997 to the adoption of SFAS No.
133, the Company followed SFAS No. 52, "Foreign Currency Translation," and used
forward exchange contracts to hedge only assets and firm commitments that
exposed the Company to enterprise risk as a result of fluctuations in foreign
currency exchange rates. Gains and losses on forward exchange contracts that
were designated as hedges of firm orders were deferred in other current
liabilities and were included in the measurement of the underlying transaction.
Hedge accounting was only applied if the derivative reduced the risk of the
underlying hedged item and was designated at inception as a hedge. Derivatives
were measured for effectiveness both at inception and on an ongoing basis.
During this period, no derivative ceased to meet the criteria for deferral and
all expected firm commitments occurred. No contract was sold or terminated prior
to maturity.
 
     Prior to the fourth quarter of 1997, the Company entered into forward
foreign exchange contracts with Spectra-Physics AB. These contracts were entered
into in anticipation of product sales made in the normal course of business, and
accordingly, did not qualify for hedge accounting under SFAS No. 52. Since the
forward foreign exchange contracts were not designated as hedges of firm,
identifiable foreign currency commitments, the unrealized gains and losses
resulting from the impact of foreign currency exchange rate movements on these
contracts were recognized in the periods in which the exchange rates changed.
Such gains and losses were recorded as other income or expense.
 
Income tax expense (benefit)
 
     The Company is part of a tax sharing arrangement with affiliates of
Spectra-Physics AB. For periods prior to September 30, 1997, income tax expense
reflected foreign taxes only due to the expectation by the Company at that time
of continuing losses in the U.S. Deferred tax assets were established relating
to differences between the financial statements and tax basis of assets and
liabilities based on enacted tax laws and rates applicable to the period in
which the differences are expected to affect taxable income. These
 
                                       30
<PAGE>   31
 
deferred tax assets were offset in total by a valuation allowance due to the
expectation of continued losses in the U.S.
 
     During the quarter ended September 30, 1997, the Company decreased the tax
valuation allowance and recognized a tax benefit relating to the above items
(net of foreign taxes) totaling $23.3 million. The decrease of the valuation
allowance and the recognition of the tax benefit in the quarter was based on
management's expectations regarding future taxable income for the Company.
Management's expectations included the consideration of the conversion of loans
and advances from Spectra-Physics AB and affiliates to equity in October 1997
which eliminated related interest charges in the future.
 
     Under the tax sharing agreement in place through September 1997, the
Company's net operating loss carryovers referred to above were used to offset
the taxable income of other members of the tax filing group with no benefit to
the Company. Accordingly, the deferred tax asset arising from the net operating
loss carryforwards (amounting to $10.2 million) was recorded as a dividend to
Spectra-Physics AB. Effective October 1997, the Company and affiliates of
Spectra-Physics AB entered into a new tax sharing arrangement which generally
requires the Company to determine its U.S. tax liability as a separate
consolidated group.
 
     The Company's effective tax rate is 38% of pre-tax income. During the third
quarter of 1998, the Company recorded an income tax adjustment of $0.4 million
to reverse excess income tax reserves. Income tax expense was $5.3 million in
1998, and $0.6 million in 1996. Income tax benefit was $21.0 million in 1997.
The income tax expense in 1996 represented foreign taxes currently payable at
each of the applicable country's statutory rate.
 
     The Company expects its future effective tax rate to approximate statutory
rates.
 
LIQUIDITY AND CAPITAL RESOURCES
 
     Through the third quarter of 1997, the Company had satisfied its liquidity
requirements through cash provided by Spectra-Physics AB and affiliates in the
form of loans and advances. As of October 1, 1997, all outstanding loans and
advances from Spectra-Physics AB and affiliates were converted to equity. At
December 31, 1998, the Company had working capital of $72.3 million, including
cash and cash equivalents of $34.6 million, compared to working capital at
December 31, 1997 of $68.9 million, including cash and cash equivalents of $33.5
million.
 
     Cash provided by operating activities was $8.8 million, $26.6 million and
$4.3 million in the years ended December 31, 1998, 1997 and 1996, respectively.
Substantially all the net cash provided by operating activities in 1998
represented the net income for the year ($9.6 million) adjusted for the non-cash
impact of depreciation and amortization ($5.8 million) and for the increase in
accounts receivable ($6.3 million). The increase in accounts receivable was the
result of a proportionately higher amount of sales in the last month of 1998
compared to 1997 causing days sales outstanding (DSO) to increase from 82 days
at December 31, 1997, to 92 days at December 31, 1998. Substantially all the net
cash provided by operating activities in 1997 represented the net income for the
year ($33.9 million, which included a $21.0 million income tax benefit) adjusted
for the non-cash impact of depreciation, amortization and deferred taxes ($3.4
million) and for the increase in inventories ($4.0 million). Substantially all
the net cash provided by operating activities in 1996 represented the net loss
for the year ($4.2 million) adjusted for the non-cash impact of depreciation and
amortization ($4.4 million) and for the increase in accounts receivable ($4.3
million) and accrued and other liabilities ($8.4 million). The increase in
accounts receivable in 1996 was principally the result of a 23% increase in
sales in the fourth quarter of 1996 compared to the fourth quarter of 1995. The
increase in accrued and other liabilities was principally the result of
increased accrued compensation expense related to certain stock options ($5.0
million).
 
     Cash used in investing activities, mostly purchases of property, plant and
equipment, was $15.7 million, $9.4 million and $5.0 million in the years ended
December 31, 1998, 1997 and 1996, respectively.
 
     Cash provided by financing activities was $7.7 million, $13.7 million, and
$2.1 million in the years ended December 31, 1998, 1997 and 1996, respectively.
During the year ended December 31, 1998, financing activities include the sale
of 360,000 shares of common stock in accordance with an overallotment option
 
                                       31
<PAGE>   32
 
granted to the underwriters of the Company's initial public offering of $3.2
million and increases in net borrowings under the Company's credit facilities of
$4.4 million. During the year ended December 31, 1997, net transfers to
Spectra-Physics AB and affiliates and changes in loans and advances from
Spectra-Physics AB amounted to a net decrease in cash of $25.7 million,
principally relating to the utilization by affiliates of Spectra-Physics AB of
the Company's net operating loss carryfoward for tax purposes and the remittance
to Spectra-Physics AB of cash received by the Company on the settlement of
litigation. This amount was offset by the net proceeds from the Company's
initial public offering of its common stock of $20.7 million, by $17.2 million
of cash provided by Spectra-Physics AB to settle certain stock options and other
liabilities, and by $1.5 million of net borrowings under the Company's credit
facilities. All of the cash provided by financing activities during the year
ended December 31, 1996, represented changes in loans and advances from Spectra-
Physics AB and affiliates.
 
     The effect of foreign currency exchange rate changes on cash was $0.4
million in the year ended December 31, 1998. These activities resulted in an
increase in cash and cash equivalents of $1.1 million, $31.0 million and $1.5
million in the years ended December 31, 1998, 1997 and 1996, respectively.
 
     In October 1997, the Company entered into certain agreements with employees
of its Opto Power subsidiary who held stock options to purchase common stock of
the subsidiary. Under the agreements, the option holders agreed to terminate the
options in exchange for a combination of cash payment and the Company's common
stock. Such cash payments totalled approximately $14.7 million and were funded
by a capital contribution by Spectra-Physics AB and affiliates.
 
     As part of the Reorganization, the Company assumed a short-term credit
facility in Japan. The credit facility is with several banks, is unsecured,
allows aggregate borrowings of 2.1 billion Yen ($18.2 million) and bears
interest at 1.625% per annum. At December 31, 1998, there were approximately
$11.8 million of borrowings outstanding under this facility. The Company's
foreign subsidiaries other than Japan have credit facilities aggregating $4.5
million, none of which was outstanding as of December 31, 1998. The Company also
has available in the U.S. two committed, unsecured credit facilities aggregating
$20.0 million and a $10.0 million uncommitted, unsecured credit facility with a
bank. The committed facilities are through June 2000. At December 31, 1998,
there were no borrowings under either facility.
 
     The Company has reviewed its short- and long-term liquidity needs. The
Company's liquidity needs for at least the next twelve months will be met by
cash flows from operations, existing cash balances and borrowings available
under its credit facilities.
 
QUALITATIVE AND QUANTITATIVE DISCLOSURE ABOUT MARKET RISK
 
     The fair value of the Company's cash and cash equivalents would not be
significantly impacted by either a 100 basis point increase or decrease in
interest rates due to the short-term nature of the Company's portfolio.
 
     The Company regularly hedges its non-U.S. dollar-based exposures in the
U.S. by entering into forward foreign exchange contracts. The terms of these
contracts are for periods matching the duration of the underlying exposure and
generally range from three months up to one year. The short-term nature of these
contracts has resulted in these instruments having insignificant fair values at
December 31, 1998. The Company's largest foreign currency exposure is against
the Japanese yen, primarily because Japan has a higher proportion of local
currency denominated sales. Relative to foreign currency exposures existing at
December 31, 1998, a 10% unfavorable movement in foreign exchange rates would
not expose the Company to significant losses in earnings or cash flows or
significantly diminish the fair value of its foreign currency financial
instruments, primarily due to the short lives of the affected financial
instruments that effectively hedge substantially all of the Company's year-end
exposures to fluctuations in foreign currency exchange rates. The calculation
assumes that each exchange rate would change in the same direction relative to
the U.S. dollar. In addition to the direct effects of changes in exchange rates,
such changes typically affect the volume of sales or the foreign currency sales
price as competitors' products become more or less attractive. The Company's
sensitivity analysis of the effects of changes in foreign currency exchange
rates does not factor in a potential change in sales levels or local currency
selling prices. See additional discussion of foreign currency exchange contracts
under the heading "Foreign currency gain (loss)".
 
                                       32
<PAGE>   33
 
YEAR 2000 COMPLIANCE
 
     An issue exists for all companies that rely on computers as the year 2000
approaches. Known as the "Millennium Bug" or the "Year 2000 (Y2K) Problem" the
problem stems from the way that some computer systems and other chip containing
equipment were programmed to process date information. To conserve memory, dates
were stored as two digit, rather than as four digit, numbers with all the dates
assumed to be between 1900 and 1999. Thus the year 2000 would be stored as "00"
and be assumed to be 1900, and year 2001 as "01", and be assumed to be 1901,
etc. This practice will result in incorrect results when computers so programmed
perform arithmetic operations, comparisons or data field sorting with dates
later than 1999.
 
     The Board of Directors of Spectra-Physics, and all levels of management,
are well aware of the Y2K problem, and plans have been made to address the
issue. Spectra-Physics' Y2K compliance plans are supervised by the Vice
President of Finance, and progress is under ongoing review by the Board. The
Company's Year 2000 Project Team has completed its review of Spectra-Physics'
(a) Information Technology (IT) and non-IT systems, (b) products, (c) vendors
and (d) customers and is acting to correct identified problems.
 
Information Technology (IT) and non-IT systems
 
     Spectra-Physics has completed a review of its Information Technology (IT)
and non-IT systems at all of its sites. The Company has identified a few items
that are not Y2K compliant and has created a plan to bring them into compliance
in advance of the year 2000. The Company feels that it will be able to
accomplish this goal by (a) using its internal programming staff, (b) using
outside computer consultants in a few limited cases, and (c) buying replacements
for some specific systems. Costs in connection with these solutions are expected
to be in the range of $0.5 million to $0.8 million over the period of January 1,
1998 to June 30, 1999, and these costs will be funded by operating cash flow.
Through December 31, 1998, the Company has not incurred any of these costs.
 
     If such modifications or replacements are not completed in a timely manner,
the Y2K problem may have a material adverse effect on the operations of the
Company.
 
Products
 
     The Company has completed a thorough review of its products. This review
has uncovered no material Y2K issues with Spectra-Physics products.
 
Vendors and Suppliers
 
     The Company has performed a review of its suppliers and vendors and has
identified a subset of them as being "critical" vendors. Spectra-Physics has
sent letters to each of these critical vendors asking them about their Y2K
readiness. The Company has received responses from a majority of these vendors
and is satisfied with their Y2K readiness. Those vendors who did not respond, or
whose response the Company found inadequate, will be sent a second letter. The
responses to the second letter are expected by the end of the first quarter of
1999. The Company will then assess their responses and, for those who are not
Y2K compliant, or have not yet responded, the Company's purchasing department
will contact them. If a critical vendor is not Y2K compliant, and such vendor
cannot remedy its noncompliance and Spectra-Physics cannot identify an
alternative vendor, there may be a material adverse effect on the operations of
the Company.
 
Customers
 
     The Company will prepare a listing of its top customers during the first
quarter of 1999 and send a Y2K compliance letter to them. Since no one customer
of the Company makes up more than 5% of the Company's total sales, the Company
is not subject to as much risk as companies with more concentrated sales. The
Company expects to complete the survey of its customers during the second
quarter of 1999. The Company will assess their Y2K readiness and will work with
those who are not compliant to identify alternative methods for them to order
from Spectra-Physics.
 
                                       33
<PAGE>   34
 
     The business communities' understanding of the Y2K Problem is continually
evolving, and all plans may need to be reviewed as the year 2000 approaches.
Further third party Y2K problems (suppliers to Spectra-Physics' vendors, for
example) which are outside the control of Spectra-Physics may have an effect on
Spectra-Physics' ability to serve its customers. This, in turn, may have a
material adverse effect on the Company's operations. The Company is working to
be ready for the year 2000 and will continue to modify plans and efforts as
necessary.
 
Costs
 
     The reviews of Company products, vendors and suppliers, and customers are
performed by the Company's manufacturing, research and development, and IT staff
as part of their on-going duties. No incremental costs have been, or are
expected to be, incurred.
 
EUROPEAN MONETARY UNION (EMU)
 
     The euro is a new currency introduced by certain European countries
collectively known as the European Monetary Union (EMU). The euro was introduced
on January 1, 1999 and the eleven participating EMU members established fixed
conversion rates between their existing currencies (legacy currencies) and the
euro. The legacy currencies have no value of their own but will be subsets of
the euro. The legacy currencies and the euro will both be used through June 30,
2002 when the legacy currencies will be withdrawn (euro only environment).
 
     The introduction of the euro could have an adverse impact on a company's
information systems, its markets and the economies in which it operates.
 
     With regards to information systems, the Company has completed a thorough
review of its information systems and believes the introduction of the euro in
1999 will have no material impact on its systems. Furthermore, the Company's
review indicates that the Company's information systems can operate in the "euro
only" environment in 2002. As that date gets closer the Company expects to
conduct another survey concerning the euro's impact on information systems.
 
     With regards to the Company's markets, the Company has reviewed its
customer list and current selling practices and expects no material adverse
impact from the introduction of the euro.
 
     The Company is currently unable to determine the ultimate long term
financial impact of the exclusive use of the euro on the Company's markets and
on the economies of the countries in which the Company operates. This impact
will be dependent upon the evolving competitive situations and macro-economic
impact of the introduction of the euro.
 
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
 
     See Item 14(a) for an index to the consolidated financial statements and
supplementary information which are attached hereto.
 
ITEM 9.CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
       DISCLOSURE
 
     Not applicable.
 
                                       34
<PAGE>   35
 
                                    PART III
 
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
 
     Information regarding Registrant's officers and directors will be set forth
under the captions "Management" and "Election of Directors" in the Registrant's
proxy statement for use in connection with the Annual Meeting of Stockholders to
be held in May 1999 (the "1999 Proxy Statement"), and is incorporated herein by
reference. The 1999 Proxy Statement will be filed with the Securities and
Exchange Commission within 120 days after the end of the Registrant's fiscal
year end.
 
ITEM 11. EXECUTIVE COMPENSATION
 
     Information concerning compensation of the Registrant's directors and
executive officers will be set forth under the captions "Election of
Directors -- Compensation of Directors" and "Management -- Summary Compensation
of Named Executive Officers" in the Registrant's 1999 Proxy Statement and is
incorporated herein by reference.
 
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
 
     Information regarding security ownership of certain beneficial owners and
management will be set forth under the caption "Security Ownership of Certain
Beneficial Owners and Management" in the Registrant's 1999 Proxy Statement and
is incorporated herein by reference.
 
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
 
     Information regarding certain relationships and related transactions will
be set forth under the caption "Certain Relationships and Related Transactions"
in the Registrant's 1999 Proxy Statement and is incorporated herein by
reference.
 
                                       35
<PAGE>   36
 
                                    PART IV
 
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND FORM 8-K REPORTS
 
(a) 1. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
 
     The following consolidated financial statements of Spectra-Physics Lasers,
Inc. are filed as part of this report on Form 10-K:
 
     Independent Accountants' Report
 
     Consolidated Balance Sheet -- December 31, 1998 and 1997
 
     Consolidated Statement of Operations -- Years ended December 31, 1998, 1997
     and 1996
 
     Consolidated Statement of Cash Flows -- Years Ended December 31, 1998, 1997
     and 1996
 
     Consolidated Statement of Stockholders' Equity -- Years Ended December 31,
     1998, 1997, and 1996
 
     Notes to Consolidated Financial Statements
 
    2. CONSOLIDATED FINANCIAL STATEMENT SCHEDULES
 
     Schedule II -- Valuation and Qualifying Accounts
 
     Schedules not listed above have been omitted because the matter or
     conditions are not present or the information required to be set forth
     therein is included in the Consolidated Financial Statements hereto.
 
(b) REPORTS ON FORM 8-K
 
     No reports on Form 8-K were filed during the three-months ended December
31, 1998.
 
(c) EXHIBITS
 
<TABLE>
<CAPTION>
EXHIBIT
NUMBER                         EXHIBIT DESCRIPTION
-------                        -------------------
<C>        <S>
 2.1       Plan of Reorganization of the Company (Incorporated by
           reference to exhibit 2.1 of the Company's Registration
           Statement on Form S-1 (No. 333-38329))
 3.1       Certificate of Incorporation of the Company, as amended
           (Incorporated by reference to exhibit 3.1 of the Company's
           Registration Statement on Form S-1 (No. 333-38329))
 3.2       Bylaws of the Company (Incorporated by reference to exhibit
           3.2 of the Company's Registration Statement on Form S-1 (No.
           333-38329))
 4.1       Specimen of Common Stock Certificate (Incorporated by
           reference to exhibit 4.1 of Amendment No. 1 of the Company's
           Registration Statement on Form S-1 (No. 333-38329))
10.1       Agreement by and between Spectra-Physics USA and the
           Company, dated as of August 29, 1997 (Incorporated by
           reference to exhibit 10.1 of the Company's Registration
           Statement on Form S-1 (No. 333-38329))
10.2       Registration Rights Agreement between Spectra-Physics USA
           and the Company (Incorporated by reference to exhibit 10.2
           of Amendment No. 2 of the Company's Registration Statement
           on Form S-1 (No. 333-38329))
10.3       Form of Executive Employment Agreement with certain officers
           of the Company (Incorporated by reference to exhibit 10.3 of
           Amendment No. 2 of the Company's Registration Statement on
           Form S-1 (No. 333-38329))
10.4       Form of Executive Incentive Plan (Incorporated by reference
           to exhibit 10.5 of Amendment No. 1 of the Company's
           Registration Statement on Form S-1 (No. 333-38329))
</TABLE>
 
                                       36
<PAGE>   37
 
<TABLE>
<CAPTION>
EXHIBIT
NUMBER                         EXHIBIT DESCRIPTION
-------                        -------------------
<C>        <S>
10.5       1997 Spectra-Physics Lasers, Inc. Stock Option Plan
           (Incorporated by reference to exhibit 10.6 of Amendment No.
           1 of the Company's Registration Statement on Form S-1 (No.
           333-38329))
10.6       Patent License Agreement dated as of October 4, 1997 by and
           between the Company, as licensor, and Spectra Precision,
           Inc., as licensee (Incorporated by reference to exhibit 10.7
           of Amendment No. 1 of the Company's Registration Statement
           on Form S-1 (No. 333-38329))
10.7       Patent License Agreement dated as of October 4, 1997 by and
           between Spectra Precision, Inc., as licensor, and the
           Company, as licensee (Incorporated by reference to exhibit
           10.8 of Amendment No. 1 of the Company's Registration
           Statement on Form S-1 (No. 333-38329))
10.8       Tradename and Trademark License Agreement dated as of August
           29, 1997 by and between the Company, Spectra-Physics AB and
           certain Spectra-Physics AB subsidiaries (Incorporated by
           reference to exhibit 10.9 of Amendment No. 1 of the
           Company's Registration Statement on Form S-1 (No.
           333-38329))
10.9       Form of Restricted Stock Plan Agreement among the Company,
           Opto Power and certain Opto Power employees (Incorporated by
           reference to exhibit 10.10 of Amendment No. 1 of the
           Company's Registration Statement on Form S-1 (No.
           333-38329))
10.10      Employment Agreement dated January 1, 1998, between the
           Company and Patrick L. Edsell
21.1       List of Subsidiaries (Incorporated by reference to exhibit
           21.1 of the Company's Registration Statement on Form S-1
           (No. 333-38329))
23.1       Consent of PriceWaterhouseCoopers L.L.P.
23.2       Report of PriceWaterhouseCoopers L.L.P. (included on page
           61)
24.1       Powers of Attorney (included on signature page)
27.1       Financial Data Schedule
</TABLE>
 
                                       37
<PAGE>   38
 
                                   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 on March 10, 1999.
 
                                          SPECTRA-PHYSICS LASERS, INC.
 
                                          By:     /s/ PATRICK L. EDSELL
 
                                            ------------------------------------
                                            Patrick L. Edsell
                                            Chairman, President and Chief
                                            Executive Officer
 
                               POWER OF ATTORNEY
 
     Know all men by these presents, that each person whose signature appears
below constitutes and appoints Patrick L. Edsell and Thomas J. Scannell, jointly
and severally, his attorneys-in-fact, each with the power of substitution for
him in any and all capacities, to sign any amendments to this report, and to
file the same, with exhibits thereto and other documents in connection
therewith, with the Securities and Exchange Commission, hereby ratifying and
confirming that each of said attorneys-in-fact, or his substitute or
substitutes, may do or cause to be done by virtue hereor.
 
     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
                        ----                                        -----                    ----
<C>                                                      <S>                            <C>
 
                /s/ PATRICK L. EDSELL                    (Director, Chairman,           March 3, 1999
-----------------------------------------------------      President and Chief
                  Patrick L. Edsell                        Executive Officer)
 
               /s/ THOMAS J. SCANNELL                    (Vice President -- Finance)    March 3, 1999
-----------------------------------------------------      (Principal Financial and
                  Thomas J. Scanell                        Accounting Officer)
 
               /s/ LAWRENCE C. KARLSON                   (Director)                     March 5, 1999
-----------------------------------------------------
                 Lawrence C. Karlson
 
                /s/ LENNART F. RAPPE                     (Director)                     March 4, 1999
-----------------------------------------------------
                  Lennart F. Rappe
 
                 /s/ LARS SPONGBERG                      (Director)                     March 4, 1999
-----------------------------------------------------
                   Lars Spongberg
 
             /s/ THOMAS T. VAN OVERBEEK                  (Director)                     March 8, 1999
-----------------------------------------------------
               Thomas T. van Overbeek
</TABLE>
 
                                       38
<PAGE>   39
 
                       REPORT OF INDEPENDENT ACCOUNTANTS
 
To the Board of Directors and Stockholders
Spectra-Physics Lasers, Inc.
 
     We have audited the accompanying consolidated balance sheet of
Spectra-Physics Lasers, Inc. as of December 31, 1998 and 1997, and the related
consolidated statements of operations, cash flows, and stockholders' equity for
each of the three years in the period ended December 31, 1998. These financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements 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 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 financial statements referred to above present fairly,
in all material respects, the consolidated financial position of Spectra-Physics
Lasers, Inc. as of December 31, 1998 and 1997, and the consolidated results of
its operations and its cash flows for each of the three years in the period
ended December 31, 1998, in conformity with generally accepted accounting
principles.
 
                                          PRICEWATERHOUSECOOPERS LLP.
 
San Jose, California
January 22, 1999
 
                                       39
<PAGE>   40
 
                          SPECTRA-PHYSICS LASERS, INC.
 
                           CONSOLIDATED BALANCE SHEET
               (IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
 
                                     ASSETS
 
<TABLE>
<CAPTION>
                                                                  DECEMBER 31,
                                                              --------------------
                                                                1998        1997
                                                              --------    --------
<S>                                                           <C>         <C>
Current assets:
  Cash and cash equivalents.................................  $ 34,620    $ 33,487
  Accounts receivable, including $339 and $86, respectively,
     due from affiliated companies, less allowance for
     doubtful accounts of $405 and $540, respectively.......    45,824      39,511
  Inventories...............................................    25,566      25,857
  Deferred tax assets.......................................     7,300       8,200
  Prepaid expenses and other current assets.................     3,944       4,409
                                                              --------    --------
     Total current assets...................................   117,254     111,464
Property, plant and equipment, net..........................    35,156      25,480
Intangible assets, net of accumulated amortization of $2,160
  and $1,995, respectively..................................     2,122       1,637
Other assets................................................     2,496       1,943
                                                              --------    --------
          Total assets......................................  $157,028    $140,524
                                                              ========    ========
 
                       LIABILITIES AND STOCKHOLDERS' EQUITY
 
Current liabilities:
  Accounts payable..........................................  $  9,262    $ 10,453
  Borrowings under credit facilities........................    11,756       7,321
  Accrued and other current liabilities.....................    23,959      24,749
                                                              --------    --------
     Total current liabilities..............................    44,977      42,523
Long term liabilities.......................................     1,983       1,677
Commitments and contingencies
Stockholders' equity:
  Common stock, par value $0.01:
     Authorized -- 60,000,000 shares
     Outstanding -- 16,168,043 in 1998 and 15,808,043 in
      1997..................................................       162         158
  Additional paid-in capital................................    97,235      93,991
  Retained earnings.........................................    13,276       3,629
  Accumulated other comprehensive income....................      (605)     (1,454)
                                                              --------    --------
     Total stockholders' equity.............................   110,068      96,324
                                                              --------    --------
          Total liabilities and stockholders' equity........  $157,028    $140,524
                                                              ========    ========
</TABLE>
 
                See Notes to Consolidated Financial Statements.
 
                                       40
<PAGE>   41
 
                          SPECTRA-PHYSICS LASERS, INC.
 
                      CONSOLIDATED STATEMENT OF OPERATIONS
                    (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
 
<TABLE>
<CAPTION>
                                                                 YEARS ENDED DECEMBER 31,
                                                             --------------------------------
                                                               1998        1997        1996
                                                             --------    --------    --------
<S>                                                          <C>         <C>         <C>
Net sales..................................................  $169,016    $159,174    $135,434
Cost of products sold......................................   103,724      98,772      88,320
                                                             --------    --------    --------
  Gross margin.............................................    65,292      60,402      47,114
Operating expenses:
  Research and development.................................    16,728      14,365      12,005
  Selling, general and administrative......................    34,903      32,539      28,966
  Other....................................................        --      15,757       6,915
                                                             --------    --------    --------
          Total operating expenses.........................    51,631      62,661      47,886
                                                             --------    --------    --------
     Operating income (loss)...............................    13,661      (2,259)       (772)
Other income (expense):
  Interest income (expense)................................     1,335      (4,005)     (5,374)
  Foreign currency gain....................................        --       2,067       2,532
  Legal settlement.........................................        --      17,010          --
                                                             --------    --------    --------
          Total other income (expense).....................     1,335      15,072      (2,842)
                                                             --------    --------    --------
     Income (loss) before income taxes.....................    14,996      12,813      (3,614)
Income tax expense (benefit)...............................     5,349     (21,048)        634
                                                             --------    --------    --------
     Net income (loss).....................................  $  9,647    $ 33,861    ($ 4,248)
                                                             ========    ========    ========
Net income (loss) per share:
  Basic....................................................  $   0.60    $   2.57    ($  0.33)
                                                             ========    ========    ========
  Diluted..................................................  $   0.59    $   2.57    ($  0.33)
                                                             ========    ========    ========
Shares used in computing net income (loss) per share:
  Basic....................................................    16,168      13,162      13,000
                                                             ========    ========    ========
  Diluted..................................................    16,473      13,191      13,000
                                                             ========    ========    ========
</TABLE>
 
                See Notes to Consolidated Financial Statements.
 
                                       41
<PAGE>   42
 
                          SPECTRA-PHYSICS LASERS, INC.
 
                      CONSOLIDATED STATEMENT OF CASH FLOWS
                                 (IN THOUSANDS)
 
<TABLE>
<CAPTION>
                                                                YEARS ENDED DECEMBER 31,
                                                              -----------------------------
                                                                1998      1997       1996
                                                              --------   -------   --------
<S>                                                           <C>        <C>       <C>
OPERATING ACTIVITIES
Net income (loss)...........................................  $  9,647   $33,861   ($ 4,248)
Adjustments to reconcile net income (loss) to cash provided
  by (used in) operating activities:
  Depreciation and amortization.............................     5,821     4,839      4,420
  Deferred income taxes.....................................       600    (8,200)        --
  Changes in operating assets and liabilities:
       Accounts receivable..................................    (6,313)   (1,559)    (4,285)
       Inventories..........................................       291    (4,048)       896
       Prepaid expenses and other current assets............       465    (2,279)      (763)
       Accounts payable.....................................    (1,191)    2,325        (79)
       Accrued and other liabilities........................      (484)    1,683      8,359
                                                              --------   -------   --------
          Total cash provided by (used in) operating
            activities......................................     8,836    26,622      4,300
                                                              --------   -------   --------
INVESTING ACTIVITIES
Purchases of property, plant and equipment..................   (15,159)   (8,672)    (5,055)
Other.......................................................      (583)     (720)       103
                                                              --------   -------   --------
          Total cash provided by (used in) investing
            activities......................................   (15,742)   (9,392)    (4,952)
                                                              --------   -------   --------
FINANCING ACTIVITIES
Net transfers (to) from SPAB................................        --   (27,743)      (479)
Contribution of cash by SPAB to settle certain stock options
  and other liabilities.....................................        --    17,249         --
Net borrowings under credit facilities......................     4,435     1,508         --
Changes in loans and advances from SPAB.....................        --     2,058      2,620
Net proceeds from initial public offering of common stock...     3,248    20,654         --
                                                              --------   -------   --------
          Total cash provided by (used in) financing
            activities......................................     7,683    13,726      2,141
                                                              --------   -------   --------
Effect of changes in foreign currency exchange rates........       356        --         --
                                                              --------   -------   --------
          Increase in cash..................................     1,133    30,956      1,489
Cash and cash equivalents at beginning of year..............    33,487     2,531      1,042
                                                              --------   -------   --------
Cash and cash equivalents at end of year....................  $ 34,620   $33,487   $  2,531
                                                              ========   =======   ========
Non-cash financing activity:
  Reorganization:
  Conversion of debt and accrued interest to equity.........             $73,758
  Transfer of assets, net of cash...........................               2,299
  Assumption of liabilities.................................              (2,968)
                                                                         -------
                                                                         $73,089
                                                                         =======
</TABLE>
 
                See Notes to Consolidated Financial Statements.
 
                                       42
<PAGE>   43
 
                          SPECTRA-PHYSICS LASERS, INC.
 
                 CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
                      (IN THOUSANDS, EXCEPT SHARE AMOUNTS)
 
<TABLE>
<CAPTION>
                                                                                    ACCUMULATED
                                        COMMON STOCK       ADDITIONAL                  OTHER        PARENT
                                     -------------------    PAID-IN     RETAINED   COMPREHENSIVE    EQUITY
                                       SHARES     AMOUNT    CAPITAL     EARNINGS      INCOME       (DEFICIT)    TOTAL
                                     ----------   ------   ----------   --------   -------------   ---------   --------
<S>                                  <C>          <C>      <C>          <C>        <C>             <C>         <C>
BALANCE-DECEMBER 31, 1995..........  13,000,000    $ --     $    --     $    --       $   (24)     $(16,456)   $(16,480)
  Net transfers (to) from SPAB.....          --      --          --          --            --          (479)       (479)
  Foreign currency translation.....          --      --          --          --           (16)           --         (16)
  Net loss.........................          --      --          --          --            --        (4,248)     (4,248)
                                     ----------    ----     -------     -------       -------      --------    --------
         Total comprehensive
           income..................          --      --          --          --           (16)       (4,248)     (4,264)
                                     ----------    ----     -------     -------       -------      --------    --------
BALANCE-DECEMBER 31, 1996..........  13,000,000                                           (40)      (21,183)    (21,223)
                                     ----------    ----     -------     -------       -------      --------    --------
  Net transfers (to) from SPAB.....          --      --          --          --            --       (27,743)    (27,743)
  Reorganization...................          --     130      54,265          --            --        18,694      73,089
  Initial public offering of common
    stock..........................   2,400,000      24      20,630          --            --            --      20,654
  Contribution of cash by SPAB and
    issuance of common stock by the
    Company to settle certain stock
    options of a subsidiary........     408,043       4      19,096          --            --            --      19,100
  Foreign currency translation.....          --      --          --          --        (1,414)           --      (1,414)
  Net income prior to the
    Reorganization.................          --      --          --          --            --        30,232      30,232
  Net income subsequent to the
    Reorganization.................          --      --          --       3,629            --            --       3,629
                                     ----------    ----     -------     -------       -------      --------    --------
         Total comprehensive
           income..................          --      --          --       3,629        (1,414)       30,232      32,447
                                     ----------    ----     -------     -------       -------      --------    --------
BALANCE-DECEMBER 31, 1997..........  15,808,043     158      93,991       3,629        (1,454)           --      96,324
                                     ----------    ----     -------     -------       -------      --------    --------
  Initial public offering of common
    stock (exercise of
    underwriters' overallotment
    option)........................     360,000       4       3,244          --            --            --       3,248
  Other comprehensive income (net
    of taxes):.....................
    Foreign currency translation...          --      --          --          --           890            --         890
    Unrealized losses on forward
      contracts....................          --      --          --          --           (41)           --         (41)
    Net income.....................          --      --          --       9,647            --            --       9,647
                                     ----------    ----     -------     -------       -------      --------    --------
         Total comprehensive
           income..................          --      --          --       9,647           849            --      10,496
                                     ----------    ----     -------     -------       -------      --------    --------
BALANCE-DECEMBER 31, 1998..........  16,168,043    $162     $97,235     $13,276       $  (605)     $     --    $110,068
                                     ==========    ====     =======     =======       =======      ========    ========
</TABLE>
 
                See Notes to Consolidated Financial Statements.
                                       43
<PAGE>   44
 
                          SPECTRA-PHYSICS LASERS, INC.
 
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
 1. BUSINESS AND BASIS OF PRESENTATION
 
     Spectra-Physics Lasers, Inc. designs, develops, manufactures and
distributes lasers and laser systems for the industrial, original equipment
manufacturer (OEM), and research and development markets.
 
     Prior to the Reorganization referred to below, Spectra-Physics Lasers, Opto
Power Corporation, and Spectra-Physics Laser Data Systems, Inc., together with
various foreign subsidiaries of Spectra-Physics AB that conducted sales and
technical support operations on their behalf (collectively the "Company"), were
operated as a functional group called the Lasers and Optics Group. In
preparation for its initial public offering the Company was reorganized in
October 1997 so that the assets and liabilities (including contractual rights
and obligations) of the Lasers and Optics Group were held directly or indirectly
by the Company. Accordingly, pursuant to various agreements (i) the assets and
liabilities of the Lasers and Optics Group not held by the Company were
transferred to the Company and (ii) the assets and liabilities of the Company
not part of the Lasers and Optics Group were transferred to SPAB's subsidiaries
(other than the Company and its subsidiaries.) In connection with the
Reorganization, intercompany receivables and payables were eliminated. Unless
specified otherwise, SPAB refers to Spectra-Physics AB and/or affiliates of
Spectra-Physics AB (other than the Company and its subsidiaries). All entities
involved in the reorganization were direct or indirect wholly-owned subsidiaries
of SPAB.
 
     The accompanying consolidated financial statements includes the accounts of
the Company and reflects the financial position, results of operations, and cash
flows of the Company as if it were a separate entity for each period presented.
The accompanying financial statements do not include assets and liabilities not
part of the Laser and Optics Group. These net assets were transferred to SPAB.
The Reorganization described above has been accounted for as a transfer between
entities under common control in a manner similar to a pooling of interests.
 
     The accompanying consolidated financial statements also include allocations
of certain SPAB corporate and group expenses (including cash management and
treasury, legal, employee benefits, insurance, income taxes and corporate
overhead services) relating to the Company's businesses. Management believes
these allocations are reasonable. However, the financial information included
herein may not necessarily reflect the consolidated financial position, results
of operations, and cash flows of the Company in the future or what they would
have been had the Company been a separate entity during the periods presented.
 
     In connection with the Reorganization, the Company entered into several
agreements with SPAB that provide for (1) certain tax sharing matters, (2)
registration rights in favor of SPAB, (3) the use of the Spectra-Physics name
and trademark, (4) cross licensing of certain patents, (5) certain distribution
arrangements, and (6) various indemnification arrangements. In addition, certain
subsidiaries of the Company and certain subsidiaries of SPAB entered into
agreements providing for the continuation of certain ongoing service and
facilities leasing arrangements.
 
 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
 
  Principles of Consolidation:
 
     The consolidated financial statements include the accounts of the Company
and its wholly owned subsidiaries. All significant intercompany balances and
transactions have been eliminated.
 
  Use of Estimates:
 
     The preparation of the financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the amounts reported in the financial statements and
accompanying notes. Such estimates relate to the useful lives of property, plant
and equipment, allowances for doubtful accounts and customer returns, inventory
realizability, potential accruals
 
                                       44
<PAGE>   45
                          SPECTRA-PHYSICS LASERS, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
relating to litigation matters, warranty and other accruals, and contingent
assets and liabilities. Actual results could differ from those estimates, and
such differences may be material to the financial statements.
 
  Cash Equivalents:
 
     The Company considers all highly liquid investments with a maturity of 90
days or less when purchased to be cash equivalents. Cash equivalents (which are
classified as available for sale) are stated at cost, which approximates fair
value, and consist of bankers' acceptances, repurchase agreements, commercial
paper, time deposits, and money market funds of major banks and other
institutions.
 
  Inventories:
 
     Inventories are stated at the lower of cost (determined on a first-in,
first-out basis) or market.
 
  Property, Plant and Equipment:
 
     Property, plant and equipment are stated at cost and are depreciated on a
straight-line basis over the estimated useful lives of the related assets of 3
to 25 years.
 
     The Company adopted Statement of Financial Accounting Standards (SFAS) No.
121, "Accounting for Impairment of Long-Lived Assets and for Long-Lived Assets
to be Disposed Of " effective as of the beginning of fiscal 1997. The adoption
of this statement had no material effect on the Company's financial statements.
 
  Intangible Assets:
 
     Intangible assets, principally patent rights, are stated at cost and
amortized on a straight-line basis over their estimated useful lives of
generally 7 to 17 years.
 
  Foreign Currency Translation:
 
     The local currency of the Company's subsidiaries in the United Kingdom,
Germany, the Netherlands, France and Japan are the functional currencies for
each entity. The assets and liabilities and sales and expense accounts of these
foreign subsidiaries have been translated using the exchange rate at the balance
sheet date and the weighted average exchange rate for the period, respectively.
 
     The net effect of the translation of the accounts of the Company's
subsidiaries has been included in stockholders' equity as foreign currency
translation adjustments. The net effect of adjustments that arise from exchange
rate changes on transactions denominated in a currency other than the local
currency are included in other income (expense) as incurred.
 
  Environmental Matters:
 
     Accruals for remediation costs are recognized when management determines
that it is probable that a liability has been incurred and such costs can be
reasonably estimated. Such accruals are recorded at undiscounted amounts and are
recorded even if significant uncertainties exist over the ultimate cost of the
remediation. Ongoing environmental compliance costs, including maintenance and
monitoring costs, are charged against the accrual.
 
  Sales Recognition:
 
     Net sales and related cost of sales for products are recognized upon
shipment.
 
                                       45
<PAGE>   46
                          SPECTRA-PHYSICS LASERS, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
  Concentrations:
 
     Cash is invested in deposits with banks in the United States and in
countries where subsidiaries operate. Deposits in these banks may exceed the
amount of insurance provided on such deposits; however, the Company is exposed
to loss only to the extent of the amount of cash reflected on its balance sheet.
The Company has not experienced any losses on its deposits of cash.
 
     The Company markets its products on both a direct and an OEM basis
principally in North America, Europe and Japan to companies for use in printing,
micro-machining, marking, materials processing, medical, semiconductor
manufacturing, inspection and repair applications, as well as universities and
other entities involved in research. No individual customer accounts for more
than 10% of net sales. The Company has adopted credit policies and standards to
accommodate growth into these markets. The Company performs continuing credit
evaluations of its customers' financial condition and although the Company
generally does not require collateral, letters of credit may be required from
its customers in certain circumstances. Bad debt losses to date have been
insignificant.
 
     A number of components necessary for the manufacture and operation of many
of the Company's products are obtained from a sole supplier or a limited group
of suppliers. The disruption or termination of any of these sources could have a
material adverse effect on the Company's business, operating results and
financial condition.
 
  Warranty Costs:
 
     Upon shipment of product, the Company accrues the estimated cost of
warranty. The Company in general warrants its products for twelve to twenty-four
months depending on the product line.
 
  Advertising and Promotion Costs:
 
     The Company's policy is to expense advertising and promotion costs as they
are incurred. The Company's advertising and promotion expenses were
approximately $1.8 million, $1.9 million, and $1.3 million in the years ended
December 31, 1998, 1997, and 1996, respectively.
 
  Income Taxes:
 
     The accompanying financial statements reflect the provisions of SFAS No.
109, "Accounting for Income Taxes." Accordingly, the Company uses the liability
method to calculate deferred taxes. The realization of deferred tax assets is
based on historical tax positions and expectations about future taxable income.
Deferred income tax assets and liabilities are computed for differences between
the financial statement and tax basis of assets and liabilities based on enacted
tax laws and rates applicable to the period in which differences are expected to
affect taxable income. Valuation allowances are established, when necessary, to
reduce deferred tax assets to amounts that are more likely than not to be
realized.
 
     Income taxes have been provided as if the Company were a separate taxable
entity. Under the Company's tax sharing agreement with SPAB prior to the
Reorganization, however, the consolidated tax liability of the tax group for a
given year was allocated only to companies in the group which had separate
taxable income for that year. The tax liability was allocated pro-rata based on
each company's relative separate taxable income. Companies with losses were not
allocated any of the tax liability and were not given any benefit for their
losses. Any differences between the Company's method for providing income tax
expense (benefit) in the historical financial statements and the tax sharing
arrangement it had with SPAB were reflected in Parent equity (deficit) as
contributions or dividends. Effective October 1997, the Company and SPAB entered
into a new tax sharing arrangement that generally requires the Company to
determine its U.S. tax liability as a separate consolidated group.
 
                                       46
<PAGE>   47
                          SPECTRA-PHYSICS LASERS, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
  Derivative Instruments and Hedging:
 
     Effective October 1, 1998, the Company adopted SFAS No. 133 "Accounting for
Derivative Instruments and Hedging Activities." SFAS No. 133 requires that all
derivatives, including foreign currency exchange contracts, be recognized on the
balance sheet at fair value. Derivatives that are not hedges must be recorded at
fair value through earnings. If a derivative is a hedge, depending on the nature
of the hedge, changes in the fair value of the derivative are either offset
against the change in fair value of assets, liabilities or firm commitments
through earnings or recognized in other comprehensive income until the hedged
item is recognized in earnings. The ineffective portion of a derivative's change
in fair value is to be immediately recognized in earnings. The adoption of SFAS
No. 133 resulted in no cumulative effect on income or other comprehensive income
for the Company.
 
     Forward foreign exchange contracts are used primarily by the Company to
hedge certain operational ("cash-flow" hedges) and balance sheet("fair value"
hedges) exposures resulting from changes in foreign currency exchange rates.
Such exposures primarily result from portions of the Company's operations and
assets that are denominated in currencies other than the U.S. dollar, primarily
the Japanese Yen and certain European currencies. These foreign exchange
contracts are entered into to hedge anticipated intercompany product sales and
recorded accounts receivable made in the normal course of business, and
accordingly, are not speculative in nature. As part of its overall strategy to
manage the level of exposure to the risk of foreign currency exchange rate
fluctuations, the Company hedges a portion of its foreign currency exposures
anticipated over the ensuing twelve-month period. At December 31, 1998, the
Company had effectively hedged approximately 60% of its estimated foreign
currency exposures that principally relate to anticipated cash flows to be
remitted to the U.S. over the ensuing twelve month period, using foreign
exchange contracts that generally have maturities of twelve months or less. The
Company does not hold or transact in financial instruments for purposes other
than risk management.
 
     The Company records its foreign currency exchange contracts at fair value
in its consolidated balance sheet as accrued and other current liabilities and
the related gains or losses on these hedge contracts are deferred as a component
of other comprehensive income. These deferred gains and losses are recognized in
income in the period in which the underlying anticipated transaction occurs.
Unrealized gains and losses resulting from the impact of currency exchange rate
movements on forward foreign exchange contracts designated to offset certain
non-U.S. dollar denominated assets are recognized as other income or expense in
the period in which the exchange rates change and offset the foreign currency
losses and gains on the underlying exposures being hedged.
 
     The Company discontinues hedge accounting prospectively when (1) it is
determined that the derivative is no longer effective in offsetting changes in
fair value or cash flows of a hedged item (including forecasted transactions);
(2) the derivative is sold or terminated; (3) the derivative is dedesignated as
a hedge instrument, because it is unlikely that a forecasted transaction will
occur or a balance sheet exposure ceases to exist; or (4) management determines
that designation of the derivative as a hedge instrument is no longer
appropriate.
 
     When hedge accounting is discontinued because it is determined that the
derivative no longer qualifies as an effective fair value hedge, the derivative
will continue to be carried on the balance sheet at its fair value until it
settles, and the hedged asset will no longer be adjusted for changes in fair
value. When hedge accounting is discontinued because it is probable that a
forecasted transaction will not occur, the derivative will continue to be
carried on the balance sheet at its fair value until it settles, and gains and
losses that were accumulated in other comprehensive income will be recognized
immediately in income. In all other situations in which hedge accounting is
discontinued, the derivative will be carried at its fair value on the balance
sheet until it settles, with changes in its fair value recognized in current
period earnings.
 
                                       47
<PAGE>   48
                          SPECTRA-PHYSICS LASERS, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
     The Company has also entered into foreign currency exchange contracts to
hedge certain intercompany loan transactions. These forward contracts
effectively change certain foreign currency denominated debt into U.S. dollar
denominated debt. No such contracts existed at December 31, 1998.
 
     At December 31, 1998, the Company had contracts for the sale of foreign
currencies and the purchase of U.S. dollars totaling $44.0 million. At December
31, 1998 the Company had deferred losses relating to its foreign currency
contracts of approximately $0.1 million, which is all expected to be recognized
in income over the next twelve months.
 
     The following table provides information about the Company's foreign
currency derivative financial instruments outstanding as of December 31, 1998.
The information is provided in U.S. dollar amounts, as presented in the
Company's consolidated financial statements. The table presents the notional
amount (at contract exchange rates) and the weighted average contractual foreign
currency exchange rates. All contracts mature within twelve months.
 
     Foreign currency spot/forward contracts (in thousands, except average
contract rates):
 
<TABLE>
<CAPTION>
                                                                          AVERAGE
                                                              NOTIONAL    CONTRACT
                                                               AMOUNT       RATE
                                                              --------    --------
<S>                                                           <C>         <C>
Japanese Yen................................................  $25,319     114.3436
British Pound Sterling......................................    3,992       0.5953
German Marks................................................    7,588       1.6225
Netherlands Guilder.........................................    2,196       1.8236
French Franc................................................    4,865       5.4674
Other.......................................................       15       1.6129
                                                              -------
                                                              $43,975
                                                              =======
Estimated fair value........................................  $   (79)*
                                                              =======
</TABLE>
 
---------------
* The estimated fair value is based on the estimated amount at which the
  contracts could be settled based on forward exchange rates.
 
     The cash requirements of the above described financial instruments
approximate their fair value. Cash flows associated with these financial
instruments are classified consistent with the cash flows from the transactions
being hedged. The Company's forward foreign exchange contracts contain market
and credit risk not recognized in the consolidated financial statements. The
market risk associated with these instruments resulting from currency exchange
rate movements is expected to offset the market risk of the underlying
transactions and assets being hedged. The credit risk is that the Company's
banking counterparties may be unable to meet the terms of the agreements. The
Company minimizes such risk by limiting its counterparties to major financial
institutions with credit ratings of A/A-2 or better. In addition, the potential
risk of loss with any one party resulting from this type of credit risk is
monitored. Management does not expect any loss as a result of default by other
parties. However, there can be no assurances that the Company will be able to
mitigate market and credit risks described above.
 
     For the period from the fourth quarter of 1997 to the adoption of SFAS No.
133, the Company followed SFAS No. 52, "Foreign Currency Translation," and used
forward exchange contracts to hedge only assets and firm commitments that
exposed the Company to enterprise risk as a result of fluctuations in foreign
currency exchange rates. Gains and losses on forward exchange contracts that
were designated as hedges of firm orders were deferred in other current
liabilities and were included in the measurement of the underlying transaction.
Hedge accounting was only applied if the derivative reduced the risk of the
underlying hedged item and was designated at inception as a hedge. Derivatives
were measured for effectiveness both at inception and on an
 
                                       48
<PAGE>   49
                          SPECTRA-PHYSICS LASERS, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
ongoing basis. During this period, no derivative ceased to meet the criteria for
deferral and all expected firm commitments occurred. No contract was sold or
terminated prior to maturity.
 
     Prior to the fourth quarter of 1997, the Company entered into forward
foreign exchange contracts with SPAB. These contracts were entered into in
anticipation of product sales made in the normal course of business, and
accordingly, did not qualify for hedge accounting under SFAS No. 52. Since the
forward foreign exchange contracts were not designated as hedges of firm,
identifiable foreign currency commitments, the unrealized gains and losses
resulting from the impact of foreign currency exchange rate movements on these
contracts were recognized in the periods in which the exchange rates changed.
Such gains and losses were recorded as other income or expense.
 
  Net Income (Loss) Per Share:
 
     The Company has adopted SFAS No. 128, "Earnings Per Share" effective
December 31, 1997. SFAS No. 128 requires the presentation of basic and diluted
net income (loss) per share. Basic net income (loss) per share is computed by
dividing net income (loss) by the weighted average number of common shares
outstanding during the period. Diluted net income (loss) per share is computed
giving effect to all diluted potential common shares that were outstanding
during the period. Dilutive potential common shares consist of the incremental
common shares issuable upon the exercise of stock options. In 1998 and 1997,
weighted average shares were 16,168,000 and 13,162,000, respectively, and in
1998 and 1997 the shares used in the diluted calculation included 305,000 shares
and 29,000 shares, respectively, due to grants of options to purchase shares of
common stock. The shares used in the diluted net income per share calculation in
the fourth quarter of 1998 excluded the effects of 2,113,645 options as these
options had exercise prices greater than the average market price of the
Company's common stock for that quarter, and accordingly, were anti-dilutive.
Stock options granted by subsidiaries of the Company were not included in the
calculation of net income (loss) per share as they were anti-dilutive. Basic and
diluted net loss per share for 1996 gives effect to the Reorganization.
 
  Stock Based Compensation:
 
     In 1995, the Financial Accounting Standards Board ("FASB") issued SFAS No.
123, "Accounting for Stock-Based Compensation," which establishes a fair value
based method of accounting for stock-based compensation plans and is effective
for fiscal years beginning after December 15, 1995. SFAS No. 123 allows a
company to continue to follow the provisions of Accounting Principles Board
Opinion No. 25, "Accounting for Stock Issued to Employees" and disclose the pro
forma impact of SFAS No. 123 on results of operations and earnings per share.
The Company has elected to continue to account for its stock-based compensation
plans in accordance with the provisions of APB 25. As the terms of certain
stock-based compensation plans obligated the Company to settle the options in
cash in certain instances, the Company has reflected compensation expense
relating to these stock-based compensation plans in the statement of operations.
 
  Reclassifications:
 
     Certain 1997 and 1996 amounts have been reclassified to conform to the 1998
presentation.
 
 3. TRANSACTIONS WITH SPAB
 
     SPAB allocated certain expenses relating to cash management and treasury,
legal, employee benefits, insurance, income taxes and corporate overhead
services. Charges were allocated to the Company based on actual amounts incurred
on behalf of the Company or agreed upon amounts or percentages based on the
Company's headcount and sales that management of the Company believes were
reasonable. Amounts charged to operations were $0.3 million in each of the years
ended December 31, 1997 and 1996, respectively.
 
                                       49
<PAGE>   50
                          SPECTRA-PHYSICS LASERS, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
     SPAB used a centralized cash management program to finance its operations.
Cash deposits from the Company's operations were transferred to SPAB on a
periodic basis and SPAB funded the Company's disbursement bank account as
required. Prior to the Reorganization, the Company and SPAB had an agreement
whereby SPAB charged the Company interest based on certain of the Company's net
balance payable to SPAB calculated using SPAB cost of related borrowed funds.
Certain borrowings from SPAB were not subject to interest charges; however,
interest expense has been imputed in the accompanying statement of operations at
rates consistent with actual rates charged to the Company. Beginning in October
1997, the Company no longer participates in SPAB's centralized cash management
program.
 
     The activity in the net transfers (to) from SPAB account, is summarized
below (in thousands):
 
<TABLE>
<CAPTION>
                                                                  YEARS ENDED
                                                                 DECEMBER 31,
                                                              -------------------
                                                                1997       1996
                                                              --------    -------
<S>                                                           <C>         <C>
SPAB service and other charges..............................  $    249    $   328
Income taxes paid by (owed by) SPAB, net....................   (10,863)    (1,365)
Liabilities paid by SPAB for the benefit of the Company.....        --      1,775
Cash transfers (to) SPAB....................................   (17,702)    (2,202)
Interest expense imputed on non-interest bearing loans......       573        985
                                                              --------    -------
          Net transfers (to) from SPAB......................  $(27,743)   $  (479)
                                                              ========    =======
</TABLE>
 
 4. BALANCE SHEET ACCOUNTS
 
     Inventories, property, plant and equipment, and accrued and other current
liabilities consisted of the following (in thousands):
 
<TABLE>
<CAPTION>
                                                               AT DECEMBER 31,
                                                              ------------------
                                                               1998       1997
                                                              -------    -------
<S>                                                           <C>        <C>
Inventories:
  Raw material..............................................  $ 9,866    $10,250
  Work in process...........................................    7,582      8,077
  Finished goods............................................    8,118      7,530
                                                              -------    -------
                                                              $25,566    $25,857
                                                              =======    =======
Property, plant and equipment:
  Land, buildings and leasehold improvements................  $28,843    $21,021
  Machinery and office equipment............................   55,763     48,821
                                                              -------    -------
                                                               84,606     69,842
  Less accumulated depreciation and amortization............   49,450     44,362
                                                              -------    -------
                                                              $35,156    $25,480
                                                              =======    =======
Accrued and other current liabilities:
  Salaries, wages, benefits, bonus and commissions..........  $ 6,912    $ 9,647
  Accrued compensation for stock options....................    1,000      1,000
  Warranty..................................................    3,001      2,802
  Advance payments from customers...........................    4,929      5,676
  Other.....................................................    8,117      5,624
                                                              -------    -------
                                                              $23,959    $24,749
                                                              =======    =======
</TABLE>
 
                                       50
<PAGE>   51
                          SPECTRA-PHYSICS LASERS, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
  Credit facilities:
 
     As part of the Reorganization, the Company assumed a short-term credit
facility in Japan. The credit facility is with several banks, is unsecured,
allows aggregate borrowings of 2.1 billion Yen ($18.2 million) and bears
interest at 1.625% per annum. At December 31, 1998, there were approximately
$11.8 million of borrowings outstanding under this facility. The Company's
foreign subsidiaries other than Japan have credit facilities aggregating $4.5
million, none of which was outstanding as of December 31, 1998. The Company also
has available in the U.S. two committed, unsecured credit facilities aggregating
$20.0 million and a $10.0 million uncommitted, unsecured credit facility with a
bank. The committed facilities are through June 2000. At December 31, 1998,
there were no borrowings under either facility.
 
 5. STOCKHOLDERS' EQUITY
 
  Preferred Stock:
 
     After the Reorganization, the Company's authorized preferred stock was
10,000,000 shares with a par value of $0.01 per share. The Board of Directors
may, at its discretion, designate one or more series of preferred stock and
establish the voting, dividend, liquidation, and other rights and preferences of
the shares of each series, and provide for the issuance of shares of any series.
 
  Stock Options:
 
     Spectra-Physics Lasers, Inc. The Company has adopted the 1997
Spectra-Physics Lasers, Inc. Stock Option Plan which provides for the granting
of non-qualified stock options ("options") to certain officers, key employees
and non-employee directors of the Company. The aggregate maximum number of
shares of common stock available for award under the 1997 Plan is 2,309,721
shares, subject to adjustment to reflect changes in the Company's
capitalization. No awards can be made under the 1997 Plan more than 10 years
after the date the plan was adopted. The exercise price of the options will be
determined by the Board of Directors, provided that the exercise price must be
at least 100% of the fair market value of a share of common stock on the date
the option is granted. An option's term shall not exceed ten years from the date
of grant. No option may be exercised sooner than six months from the date of
grant.
 
     Options vest 25% upon the first anniversary of the grant date and 6.25% at
the end of each three-month period thereafter. Subject to the terms of the 1997
Plan, options will be exercisable to the extent vested beginning two years after
the grant date. Accordingly, no option was exercisable at December 31, 1998 and
1997. These options may not be exercised following termination of the grantee's
employment with the Company, except that in the event that a grantee's
employment terminates due to death, disability or retirement, options held by
such grantee or his estate shall be exercisable, to the extent vested at the
time of termination of employment, for a period of three (3) months after
termination of employment or, if later, the
 
                                       51
<PAGE>   52
                          SPECTRA-PHYSICS LASERS, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
end of the foregoing two-year period. The weighted average fair value of options
granted in 1998 and 1997 were $5.74 per share and $4.33 per share, respectively.
A summary of option activity follows:
 
<TABLE>
<CAPTION>
                                                                   OPTIONS OUTSTANDING
                                                                  ---------------------
                                                                               WEIGHTED
                                                     OPTIONS                   AVERAGE
                                                    AVAILABLE                  EXERCISE
                                                    FOR GRANT      OPTIONS      PRICE
                                                    ----------    ---------    --------
<S>                                                 <C>           <C>          <C>
Balance -- December 31, 1996......................          --           --         --
Shares reserved...................................   2,309,721           --         --
Granted...........................................  (2,087,145)   2,087,145     $10.00
                                                    ----------    ---------     ------
Balance -- December 31, 1997......................     222,576    2,087,145     $10.00
Granted...........................................     (52,750)      52,750     $13.05
Cancelled.........................................      26,250      (26,250)    $10.00
                                                    ----------    ---------     ------
Balance -- December 31, 1998......................     196,076    2,113,645     $10.08
                                                    ==========    =========     ======
</TABLE>
 
     Exercise prices of outstanding options at December 31, 1998 were:
 
<TABLE>
<S>                                                         <C>
$ 8.63 - $10.00...........................................  2,064,645
$10.88 - $12.81...........................................     30,000
$15.00 - $17.25...........................................     19,000
                                                            ---------
                                                            2,113,645
                                                            =========
</TABLE>
 
     As permitted under SFAS 123, the Company has elected to follow APB No. 25,
in accounting for stock awards to employees. Under APB No. 25, the Company
generally recognizes no compensation expense with respect to such awards under
fixed plans. Pro forma information regarding net income (loss) and earnings
(loss) per share is required by SFAS 123 which also requires that the
information be determined as if the Company has accounted for its employee stock
options under the fair value method of SFAS 123. The fair value for these
options was estimated at the date of grant using the Black-Scholes
option-pricing model with the following weighted average assumptions:
 
<TABLE>
<CAPTION>
                                                     1998       1997
                                                    -------    -------
<S>                                                 <C>        <C>
Risk-free interest rate...........................  4.6%       5.7%
Dividend yield....................................  0.0%       0.0%
Volatility........................................  93.0%      47.0%
Average life......................................  4 years    4 years
</TABLE>
 
     The Black-Scholes option valuation model was developed for use in
estimating the fair value of traded options which have no vesting restrictions
and are fully transferable. In addition, option valuation models require the
input of highly subjective assumptions including the expected stock price
volatility. Because the Company's employee stock options have characteristics
significantly different from those of traded options, and because changes in
these subjective input assumptions can materially affect the fair value
estimate, in management's opinion, the existing models do not provide a reliable
single measure of the fair value of its employee stock options.
 
     The effect of applying SFAS No. 123 resulted in pro forma net income of
$8.9 million and $33.8 million in 1998 and 1997, respectively, and earnings per
share basic and diluted of $0.55 and $0.54, respectively in 1998 and $2.56 in
1997.
 
     Spectra-Physics Laser Data Systems, Inc. Spectra-Physics Laser Data
Systems, Inc. ("Laser Data"), a subsidiary of the Company, granted certain of
its employees options to purchase up to 20% of total common stock outstanding.
One-half of the options vested annually beginning in 1996 and ending in 1999 and
one-half
 
                                       52
<PAGE>   53
                          SPECTRA-PHYSICS LASERS, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
were performance-based options. At December 31, 1996, all the options remained
outstanding and 40 shares under option were vested. The options were exercisable
from the effective date of an initial public offering of Laser Data's common
stock until the earlier of the first anniversary of such initial public offering
or May 1, 2000. If a sale of control of the subsidiary occurred before May 1,
2000, the subsidiary was to redeem the options, to the extent vested, by paying
the holders the difference between the exercise price and the per share value
received in the sale of control (unless the acquirer in the sale of control did
not wish such options to be cancelled, in which case they were not to be
redeemed). Subject to certain qualifications, if neither an initial public
offering nor a sale of control occurred before May 1, 2000, the subsidiary was
to redeem the options by paying its option holders the difference, on a
per-share basis, between the exercise price and the fair value of the
subsidiary's common stock as determined by the board of directors, provided that
the holders of a majority of the options were allowed to request an independent
appraisal of the board's valuation. In 1997, prior to the modifications
described below, the Company recorded a charge to operations of $0.2 million in
connection with the Laser Data options.
 
     In December 1997, these options were modified so that all of the options
became exercisable (a) during the period (i) beginning on the effective date of
a Laser Data initial public offering, if any, and (ii) ending on the earlier to
occur of the first anniversary following any such initial public offering and
February 28, 2000 (after which time the right to exercise vested options is
terminated) or (b) during the period commencing on February 28, 2000 and ending
on December 31, 2002. The options were also modified such that 31% of the
options were vested with the remaining options vesting at varying rates through
December 31, 1999, and Laser Data's requirement to redeem the options was
eliminated. These modifications resulted in (1) a new measurement date for the
options, for which the Company recorded a charge of $1.0 million, based on the
difference between the exercise price of the options and the estimated fair
value of Laser Data on the date the options were modified, and (2) the
establishment of the amount of compensation expense related to these options. At
December 31, 1998 and 1997 options to purchase 180 shares and 174 shares were
outstanding at a weighted average price of $0.05 per share, none were
exercisable, and 118 shares and 54 shares under option were vested.
 
 6. BENEFIT AND INCENTIVE PLANS
 
     The Company sponsors a defined contribution plan covering substantially all
U.S. employees. The plan provides for limited Company matching of participants'
contributions. Contributions to the plan by the Company and charged to
operations were $0.8 million, $0.6 million and $0.5 million in the years ended
December 31, 1998, 1997 and 1996, respectively.
 
     The Company's Executive Incentive Plan and Employee Bonus Plan provides
certain officers and employees of the Company with annual incentive cash bonus
awards based on the achievement of certain pre-established quantitative and
qualitative goals, including overall Company profitability. The Company charged
to operations $0.0 million, $2.4 million and $1.9 million in the years ended
December 31, 1998, 1997 and 1996, respectively, under these plans.
 
 7. INCOME TAXES
 
     Income (loss) before income taxes consisted of the following (in
thousands):
 
<TABLE>
<CAPTION>
                                                  YEARS ENDED DECEMBER 31,
                                                -----------------------------
                                                 1998       1997       1996
                                                -------    -------    -------
<S>                                             <C>        <C>        <C>
U.S. .........................................  $12,410    $ 9,169    $(5,814)
Foreign.......................................    2,586      3,644      2,200
                                                -------    -------    -------
                                                $14,996    $12,813    $(3,614)
                                                =======    =======    =======
</TABLE>
 
                                       53
<PAGE>   54
                          SPECTRA-PHYSICS LASERS, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
     The provision for income taxes for the year ended December 31, 1996
represented foreign taxes currently payable at each of the applicable country's
statutory rate. Income tax expense (benefit) for the years ended December 31,
1998 and 1997 consisted of the following (in thousands):
 
<TABLE>
<CAPTION>
                                                              YEARS ENDED DECEMBER 31,
                                                              ------------------------
                                                                1998           1997
                                                              --------      ----------
<S>                                                           <C>           <C>
U.S. Federal and state:
  Current...................................................   $3,994        $     --
  Deferred..................................................      572           1,213
                                                               ------        --------
                                                                4,566           1,213
                                                               ------        --------
Foreign:
  Current...................................................      755           2,651
  Deferred..................................................       28            (816)
                                                               ------        --------
                                                                  783           1,835
                                                               ------        --------
Decrease in valuation allowance.............................       --         (24,096)
                                                               ------        --------
          Total.............................................   $5,349        $(21,048)
                                                               ======        ========
</TABLE>
 
     The following table summarizes the significant differences between the U.S.
Federal statutory rate and the Company's income tax expense (benefit) for
financial statement purposes (in thousands):
 
<TABLE>
<CAPTION>
                                                          YEARS ENDED DECEMBER 31,
                                                        -----------------------------
                                                         1998       1997       1996
                                                        ------    --------    -------
<S>                                                     <C>       <C>         <C>
Tax expense (benefit) at statutory rate...............  $5,099    $  4,485    $(1,265)
Foreign taxes.........................................     189         666        209
State taxes, net of Federal benefit...................     451         316       (161)
Decrease in valuation allowance.......................      --     (26,704)        --
Losses for which no tax benefit was recognized........      --          --      1,602
Other.................................................    (390)        189        249
                                                        ------    --------    -------
Income tax expense (benefit)..........................  $5,349    $(21,048)   $   634
                                                        ======    ========    =======
</TABLE>
 
     The Company's deferred tax assets are comprised of the following (in
thousands):
 
<TABLE>
<CAPTION>
                                                              AS OF DECEMBER 31,
                                                              ------------------
                                                               1998       1997
                                                              -------    -------
<S>                                                           <C>        <C>
Deferred tax assets:
  Inventory valuation accounts..............................  $3,477     $3,298
  Accrued expenses..........................................   3,817      3,945
  Other.....................................................     926      1,262
                                                              ------     ------
          Total deferred tax assets.........................   8,220      8,505
Deferred tax liabilities:
  Property, plant and equipment.............................    (510)      (223)
  Other.....................................................    (110)       (82)
                                                              ------     ------
          Total deferred tax liabilities....................    (620)      (305)
                                                              ------     ------
Net deferred tax assets.....................................  $7,600     $8,200
                                                              ======     ======
</TABLE>
 
     Income taxes have been provided as if the Company were a separate taxable
entity. For periods prior to September 30, 1997, income tax expense reflected
foreign taxes only due to the expectation by the Company at that time of
continuing losses in the U.S. Deferred tax assets were established relating to:
(i) net operating loss carryforwards, which included interest expense from SPAB;
(ii) accrued compensation associated with
 
                                       54
<PAGE>   55
                          SPECTRA-PHYSICS LASERS, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
employee stock options; (iii) inventory valuation reserves; and (iv) other
accruals. These deferred tax assets were offset in total by a valuation
allowance due to the expectation of continued losses in the U.S.
 
     During the quarter ended September 30, 1997, the Company decreased the tax
valuation allowance and recognized a tax benefit relating to the above items
(net of foreign taxes) totaling $23.3 million. The decrease of the valuation
allowance and the recognition of the tax benefit in the quarter was based on
management's expectations regarding future taxable income for the Company.
Management's expectations included the consideration of the conversion of loans
and advances from SPAB to equity in October 1997 which will eliminate related
interest charges in the future.
 
     For U.S. income tax return purposes, the Company was part of a U.S.
consolidated group pursuant to a tax sharing agreement among SPAB affiliated
companies through September 1997. Under this tax sharing agreement, the
Company's net operating loss carryovers referred to above were used to offset
the taxable income of other members of the tax filing group with no benefit to
the Company. Accordingly, the deferred tax asset arising from the net operating
loss carryforwards (amounting to $10.2 million) was recorded as a dividend to
SPAB.
 
 8. COMMITMENTS
 
     The Company leases manufacturing, research and development and office
facilities under non-cancellable operating leases which expire in 1999 through
2008. The Company is responsible for taxes, insurance and maintenance expenses
related to the leased facilities. Under the terms of certain lease agreements,
the leases may be extended, at the Company's option, and certain of the leases
provide for adjustments of the minimum monthly rent.
 
     Future minimum annual lease payments under the leases are as follows (in
thousands):
 
<TABLE>
<CAPTION>
                  YEAR ENDING DECEMBER 31,
                  ------------------------
<S>                                                           <C>
     1999...................................................  $2,400
     2000...................................................   1,600
     2001...................................................     940
     2002...................................................     850
     2003...................................................     500
     Thereafter.............................................     700
                                                              ------
                                                              $6,990
                                                              ======
</TABLE>
 
     Rent expense was $3.2 million, $2.5 million and $2.4 million in the years
ended December 31, 1998, 1997, and 1996, respectively.
 
 9. ENVIRONMENTAL MATTERS
 
     Since 1984, the Company has been identified by federal and state
authorities as one of several potentially responsible parties ("PRPs") in
conjunction with past releases of industrial solvents to soil and groundwater at
one of the Company's facilities. The site has been listed on the National
Priorities List, or "Superfund List," and the Company is subject to orders
requiring it to perform remediation on-and off-site. Applicable federal law
imposes joint and several liability on each PRP for the cleanup of this site.
Pursuant to these orders, the Company and other PRPs are jointly performing and
funding remediation that includes soil treatment, on-site and off-site
groundwater extraction, treatment and monitoring. All of the required soil and
groundwater remediation and monitoring systems currently required by the order
are in place, and consequently the initial capital expenditures for such systems
have been incurred. Generally, the Company has determined its share of total
estimated clean up and remediation costs and has accrued the amount that it
believes to be its share of the total cost.
 
                                       55
<PAGE>   56
                          SPECTRA-PHYSICS LASERS, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
     Measurement of environmental accruals is subject to uncertainties,
including the evolving nature of environmental regulations and their
enforcement, the amount of time required to complete remediation, and the extent
to which other PRPs will bear their share of the remediation costs. The Company
estimates that at December 31, 1998 the remediation process will be completed at
a cost ranging from approximately $2.1 million to $4.3 million. It is possible
that the Company's recorded estimate of its obligation may change. At December
31, 1998 and 1997, the Company had accrued its best estimate of the liability of
approximately $2.0 million (of which $1.2 million was included in long term
liabilities) and $2.1 million (of which $1.5 million was included in long term
liabilities), respectively, for anticipated future remediation costs associated
with the Superfund site referred to above. During the years ended December 31,
1998, 1997 and 1996, the Company paid approximately $0.1 million, $0.1 million,
and $0.5 million, respectively, for remediation of this site.
 
     In October 1997, the Company was served with a complaint that had been
filed in the Superior Court of the State of California seeking an unspecified
amount of damages for personal injuries and property damage incurred by
residents of a single location alleged to have resulted from the Company's and
others' negligent and/or intentional handling of toxic chemicals. As of December
1998, there has been a summary judgement ruling in the case in favor of the
Company and its co-defendants in regards to the four adults involved in the
case. There can be no assurance that the summary judgement will not be
successfully appealed or that the complaint will be resolved without adverse
impact to the Company's financial position or results of operations. There can
be no assurances that other parties will not come forward and claim personal
injury or property damage.
 
10. SEGMENT REPORTING
 
     Effective December 31, 1998, the Company adopted SFAS No. 131, "Disclosures
about Segments of an Enterprise and Related Information." Statement 131 requires
enterprises to report information about operating segments in annual financial
statements and selected information about reportable segments in interim
financial reports issued to shareholders. It also establishes standards for
related disclosures about products and services, geographic areas and major
customers.
 
  Description of the types of products and services from which each of the
reportable segment derives its revenues
 
     Spectra-Physics Lasers, Inc. has five reportable segments: the Commercial
Systems Group (CSG) business unit; the Industrial and Scientific Lasers (ISL)
business unit; the Original Equipment Manufacturer (OEM) business unit; Opto
Power Corporation (OPC); and Spectra-Physics Distribution (SPD) business unit.
CSG designs and manufactures optics, thin films, fabricated parts, plasma tubes,
and subsystems for all operating units within the Company and external
customers. CSG also designs, manufactures, and markets low power laser sources
and beam delivery systems for OEM products in the industrial and medical
instrumentation markets. ISL designs, markets and manufactures high power
semiconductor-based and conventional lasers for the industrial and scientific
markets. OEM designs, markets and manufactures high power semiconductor-based
lasers for various OEM markets. OPC designs, markets and manufactures high power
semiconductor-based laser diodes, components and systems. SPD is the Company's
worldwide sales, service and support organization.
 
  Measurement of segment profit or loss and segment assets
 
     The Company evaluates performance and allocates resources based on Earnings
Before Interest and Taxes (EBIT). The accounting policies of the reportable
segments are the same as those described in the summary of significant
accounting policies.
 
                                       56
<PAGE>   57
                          SPECTRA-PHYSICS LASERS, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
     Intersegment sales and transfers are recorded at intercompany transfer
prices which approximate sales as if conducted on an arm's length basis.
 
  Factors management used to identify the Company's reportable segments
 
     The Company's reportable segments are business units that are, except for
SPD, organized primarily by technology (for example, high power
semiconductor-based, semiconductor laser pumped solid state, optics, air cooled
lasers.) The reportable segments are each managed separately because they
manufacture and distribute distinct products with different production methods
and different customer bases.
 
     Information about segments (in thousands):
 
<TABLE>
<CAPTION>
                                                                                               ALL
                                            CSG       ISL       OEM       OPC       SPD      OTHERS     TOTAL
                                          -------   -------   -------   -------   --------   -------   --------
<S>                                       <C>       <C>       <C>       <C>       <C>        <C>       <C>
Year ended December 31, 1998
  Net sales to external customers.......  $ 1,125   $    --   $    --   $26,961   $135,893   $ 5,037   $169,016
  Intersegment net sales................   32,864    65,477    33,924     9,829         --        --    142,094
  Depreciation and amortization
    expense.............................    1,876       500       610     1,971        405       459      5,821
  Segment EBIT..........................    1,222    10,532     4,332     8,687     (4,410)     (925)    19,438
  Segment assets........................   14,600    17,410     6,716    37,497     54,725     2,520    133,468
  Expenditures for long-lived assets....    2,799       429       472    10,255        441       763     15,159
Year ended December 31, 1997
  Net sales to external customers.......  $ 1,048   $    --   $    --   $24,694   $128,440   $ 4,992   $159,174
  Intersegment net sales................   34,314    62,622    31,055     5,990         --        --    133,981
  Depreciation and amortization
    expense.............................    1,659       486       438     1,592        302       362      4,839
  Segment EBIT..........................    3,824     8,884     4,173     7,450         21      (826)    23,526
  Segment assets........................   13,725    18,194     8,830    23,371     43,273     3,288    110,681
  Expenditures for long-lived assets....    2,496       404     1,173     3,776        333       490      8,672
Year ended December 31, 1996
  Net sales to external customers.......  $ 1,005   $    --   $    --   $14,396   $119,513   $   520   $135,434
  Intersegment net sales................   30,701    56,480    22,159     3,705         --        --    113,045
  Depreciation and amortization
    expense.............................    1,659       496       419     1,294        252       300      4,420
  Segment EBIT..........................    3,503     5,900     2,652     4,101       (422)   (2,797)    12,937
  Segment assets........................   11,856    17,685     9,450    18,619     36,246     1,239     95,095
  Expenditures for long-lived assets....    2,095       206       676     1,323        310       445      5,055
</TABLE>
 
                                       57
<PAGE>   58
                          SPECTRA-PHYSICS LASERS, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
     Reconciliations of segments information to financial statements (in
thousands):
 
<TABLE>
<CAPTION>
                                                            1998         1997         1996
                                                          ---------    ---------    ---------
<S>                                                       <C>          <C>          <C>
NET SALES
Total external sales for reportable segments............  $ 163,979    $ 154,182    $ 134,914
Intersegment sales for reportable segments..............    142,094      133,981      113,045
Other sales.............................................      5,037        4,992          520
Elimination of intersegment sales.......................   (142,094)    (133,981)    (113,045)
                                                          ---------    ---------    ---------
          Total consolidated net sales..................  $ 169,016    $ 159,174    $ 135,434
                                                          =========    =========    =========
INCOME (LOSS) BEFORE INCOME TAXES
Total EBIT for reportable segments......................  $  20,363    $  24,352    $  15,734
Other EBIT..............................................       (925)        (826)      (2,797)
Corporate expenses......................................     (5,003)      (4,896)      (4,186)
Other operating expenses:
  Stock options.........................................         --      (14,100)      (5,000)
  Legal expenses........................................         --       (1,657)      (1,915)
  Incentive and Bonus Plans Expenses....................         --       (2,400)      (1,900)
  Other expenses not allocated to segments..............       (774)      (2,732)        (708)
Interest income (expense)...............................      1,335       (4,005)      (5,374)
Foreign currency gain...................................         --        2,067        2,532
Legal settlement........................................         --       17,010           --
                                                          ---------    ---------    ---------
          Total consolidated income (loss) before income
            taxes.......................................  $  14,996    $  12,813    $  (3,614)
                                                          =========    =========    =========
ASSETS
Total assets for reportable segments....................  $ 130,948    $ 107,393
Other assets............................................      2,520        3,288
Corporate assets........................................     71,917       68,854
Eliminations............................................    (48,357)     (39,011)
                                                          ---------    ---------
          Total consolidated assets.....................  $ 157,028    $ 140,524
                                                          =========    =========
</TABLE>
 
                                       58
<PAGE>   59
                          SPECTRA-PHYSICS LASERS, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
<TABLE>
<CAPTION>
                                                                NET       LONG-LIVED
                                                               SALES        ASSETS
                                                              --------    ----------
<S>                                                           <C>         <C>
GEOGRAPHIC INFORMATION:
1998
  North America.............................................  $ 91,545     $ 37,240
  Japan.....................................................    32,834        1,261
  Europe....................................................    33,707        1,273
  Other Asia................................................     6,508           --
  Rest of the World.........................................     4,422           --
                                                              --------     --------
          Total.............................................  $169,016     $ 39,774
                                                              ========     ========
1997
  North America.............................................  $ 87,262     $ 26,947
  Japan.....................................................    31,334        1,137
  Europe....................................................    31,536          976
  Other Asia................................................     4,673           --
  Rest of the World.........................................     4,369           --
                                                              --------     --------
          Total.............................................  $159,174     $ 29,060
                                                              ========     ========
1996
  North America.............................................  $ 65,327
  Japan.....................................................    30,517
  Europe....................................................    30,449
  Other Asia................................................     4,645
  Rest of the World.........................................     4,496
                                                              --------
          Total.............................................  $135,434
                                                              ========
</TABLE>
 
Net sales are attributed in the above table based on the location of the
Company's customer. Substantially all sales in North America, Other Asia, and
Rest of the World are denominated in U.S. dollars. Europe and Japan in the above
table include sales from the Company's European and Japan sales subsidiaries,
respectively. Export sales to countries not located in Asia are included in Rest
of the World.
 
For all years presented, no one customer accounted for 10% or more of total net
sales.
 
11. OTHER STATEMENT OF OPERATIONS ITEMS
 
     Included in other operating expenses in the years ended December 31, 1997
and 1996, was $1.7 million and $1.9 million, respectively, of legal expenses
associated with a lawsuit which was settled in the second quarter of 1997. As a
result of the settlement, the Company received $17.0 million of net proceeds
which was included as other income in the year ended December 31, 1997.
 
     Also included in other operating expenses in the years ended December 31,
1997 and 1996, was $14.1 million and $5.0 million, respectively, of compensation
expense associated with certain stock options of two subsidiaries. The stock
options for one subsidiary were modified so as to establish the measurement date
and the amount of compensation expense the Company is required to record and,
for the other subsidiary, were cancelled for a combination of cash and common
stock of the Company. Accordingly, the Company does not expect to incur
additional compensation expense relating to these stock options in the future.
In the fourth quarter of 1997, the Company paid approximately $14.9 million and
issued 408,043 shares of common stock to cancel the stock options of the second
subsidiary. The cash payments were funded through an equity contribution by
SPAB.
 
                                       59
<PAGE>   60
                          SPECTRA-PHYSICS LASERS, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
12. SUBSEQUENT EVENT (UNAUDITED)
 
     On February 22, 1999, shareholders of SPAB holding approximately 98.4% of
the outstanding shares of SPAB tendered their shares to Thermo Instrument
Systems Inc. (TIS), which shares were thereafter accepted by TIS for
approximately $355 million. Accordingly, TIS now indirectly owns approximately
79.1% of the Company's outstanding common stock.
 
13. UNAUDITED QUARTERLY FINANCIAL DATA
 
     The following is a summary of quarterly financial results (in thousands
except per share amounts):
 
<TABLE>
<CAPTION>
                                                                  QUARTER ENDED
                                               ----------------------------------------------------
                                               MARCH 31    JUNE 30    SEPTEMBER 30     DECEMBER 31
                                               --------    -------    -------------    ------------
<S>                                            <C>         <C>        <C>              <C>
1998:
  Net sales..................................  $43,606     $40,227       $39,731         $45,452
  Gross margin...............................   16,586      15,739        15,157          17,810
  Net income.................................    2,116       1,937         2,261           3,333
  Net income per share:
     Basic...................................     0.13        0.12          0.14            0.21
     Diluted.................................     0.13        0.12          0.14            0.21
1997:
  Net sales..................................  $35,080     $38,368       $39,613         $46,113
  Gross margin...............................   12,545      14,618        14,720          18,519
  Net income (loss)..........................   (3,963)     13,470        20,725           3,629
  Pro forma net income (loss) per share:
     Basic...................................    (0.30)       1.04          1.59            0.27
     Diluted.................................    (0.30)       1.04          1.59            0.26
</TABLE>
 
                                       60
<PAGE>   61
 
       REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULE
 
To the Board of Directors and Stockholders
Spectra-Physics Lasers, Inc.
 
     In connection with our audits of the consolidated financial statements of
Spectra-Physics Lasers, Inc. as of December 31, 1998 and 1997, and for each of
the three years in the period ended December 31, 1998, which financial
statements are included in this Form 10-K, we have also audited the financial
statement schedule listed in Item 14(a) herein.
 
     In our opinion, this financial statement schedule, when considered in
relation to the basic financial statements taken as a whole, presents fairly, in
all material respects, the information required to be included therein.
 
                                          PRICEWATERHOUSECOOPERS LLP
 
San Jose, California
January 22, 1999
 
                                       61
<PAGE>   62
 
                                  SCHEDULE II
 
                       VALUATION AND QUALIFYING ACCOUNTS
              FOR THE YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
                                 (IN THOUSANDS)
 
<TABLE>
<CAPTION>
                                                      BALANCE                                BALANCE
                                                        AT                                     AT
                                                     BEGINNING                               END OF
                                                      OF YEAR     ADDITIONS    DEDUCTIONS     YEAR
                                                     ---------    ---------    ----------    -------
<S>                                                  <C>          <C>          <C>           <C>
Allowance for Doubtful Accounts:
  December 31, 1998................................   $  540       $   --       $  (135)     $  405
  December 31, 1997................................      361          179            --         540
  December 31, 1996................................      328           33            --         361
Warranty Reserves:
  December 31, 1998................................   $2,802       $  195       $    --      $2,997
  December 31, 1997................................    2,433        3,437        (3,068)      2,802
  December 31, 1996................................    2,280        2,429        (2,276)      2,433
</TABLE>
 
                                       62
<PAGE>   63
 
                                 EXHIBIT INDEX
 
<TABLE>
<CAPTION>
EXHIBIT
NUMBER                       DESCRIPTION OF DOCUMENT
-------    ------------------------------------------------------------
<C>        <S>
10.10      Employment Agreement dated January 1, 1998, between the
           Company and Patrick L. Edsell
23.1       Consent of PriceWaterhouseCoopers L.L.P.
27.1       Financial Data Schedule
</TABLE>